**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

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**(Mark One)**

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

**Forthe quarterly period ended March 31, 2006**

**OR**

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

**Forthe transition period from                       to                       **

**Commissionfile number: 0-30863**

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**NETWORK ENGINES, INC.**

(Exact name of registrantas specified in its charter)

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

 

(781) 332-1000

**(Registrant’stelephone number, including area code)**

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

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

| Large accelerated file o |   | Accelerated  filer x |   | Non-accelerated  filer o |
|-------------------------------|--------|---------------------------|--------|-------------------------------|

 

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

As of May 8, 2006, there were 38,100,453 sharesof the registrant’s Common Stock, par value $.01 per share, outstanding.

 

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**NETWORKENGINES, INC.**

**INDEX**

 
|                                                                                                     | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------|------------|
|                                                                                                |       |       |       |
| **PART I.  FINANCIAL INFORMATION**                                                             |       |       |       |
|                                                                                                |       |       |       |
| ITEM 1.  FINANCIAL STATEMENTS (UNAUDITED)                                                           |       |       |       |
|                                                                                                |       |       |       |
| CONDENSED  CONSOLIDATED BALANCE SHEETS                                                              |       |       |       |
| CONDENSED  CONSOLIDATED STATEMENTS OF OPERATIONS                                                    |       |       |       |
| CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS                                                     |       |       |       |
| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                                |       |       |       |
|                                                                                                |       |       |       |
| ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF  RESULTS OF OPERATIONS AND FINANCIAL CONDITION |       |       |       |
|                                                                                                |       |       |       |
| ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISK                                 |       |       |       |
|                                                                                                |       |       |       |
| ITEM 4. CONTROLS AND PROCEDURES                                                                     |       |       |       |
| ** **                                                                                          |       |       |       |
| **PART II.  OTHER INFORMATION**                                                                |       |       |       |
|                                                                                                |       |       |       |
| ITEM  1. LEGAL PROCEEDINGS                                                                          |       |       |       |
|                                                                                                |       |       |       |
| ITEM  1A. RISK FACTORS                                                                              |       |       |       |
|                                                                                                |       |       |       |
| ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND  USE OF PROCEEDS                                |       |       |       |
|                                                                                                |       |       |       |
| ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY  HOLDERS                                        |       |       |       |
|                                                                                                |       |       |       |
| ITEM 6.  EXHIBITS                                                                                   |       |       |       |
|                                                                                                |       |       |       |
| SIGNATURES                                                                                          |       |       |       |

 

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**PART I.FINANCIAL INFORMATION**

***ITEM I.FINANCIAL STATEMENTS***

 

**NETWORK ENGINES, INC.****CONDENSED CONSOLIDATED BALANCE SHEETS****(in thousands)**

** **
| ** **                                                                                                                                                                                                             | ** ** | **March 31,  2006** | ** ** | **September 30,**2005 | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                                             | ** ** | **(unaudited)**          | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                                                                             | ** ** | ** **               |       |                       |       |
| **Current assets:**                                                                                                                                                                                                    |       |                     |       |                       |       |
| Cash and cash equivalents                                                                                                                                                                                              |       | $                        | 9,416      |                       | $          | 9,468 |   |
| Short-term investments                                                                                                                                                                                                 |       | 24,286                   |       | 27,894                     |       |
| Restricted cash                                                                                                                                                                                                        |       | 47                       |       | 47                         |       |
| Accounts receivable, net of allowances                                                                                                                                                                                 |       | 14,421                   |       | 10,442                     |       |
| Receivable for insurance recovery                                                                                                                                                                                      |       | 2,875                    |       | -                          |       |
| Inventories                                                                                                                                                                                                            |       | 10,026                   |       | 9,227                      |       |
| Prepaid expenses and other current assets                                                                                                                                                                              |       | 848                      |       | 905                        |       |
| Total current assets                                                                                                                                                                                                   |       | 61,919                   |       | 57,983                     |       |
|                                                                                                                                                                                                                   |       |                     |       |                       |       |
| Property and equipment, net                                                                                                                                                                                            |       | 1,512                    |       | 1,699                      |       |
| Other assets                                                                                                                                                                                                           |       | 43                       |       | 122                        |       |
| Total assets                                                                                                                                                                                                           |       | $                        | 63,474     |                       | $          | 59,804 |   |
|                                                                                                                                                                                                                   |       |                     |       |                       |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                         |       |                     |       |                       |       |
| **Current liabilities:**                                                                                                                                                                                               |       |                     |       |                       |       |
| Accounts payable                                                                                                                                                                                                       |       | $                        | 8,367      |                       | $          | 5,645 |   |
| Accrued compensation and other related benefits                                                                                                                                                                        |       | 1,357                    |       | 1,276                      |       |
| Accrued litigation settlement                                                                                                                                                                                          |       | 2,875                    |       | -                          |       |
| Other accrued expenses                                                                                                                                                                                                 |       | 2,020                    |       | 1,669                      |       |
| Current portion of capital lease obligation                                                                                                                                                                            |       | 17                       |       | 18                         |       |
| Deferred revenue                                                                                                                                                                                                       |       | 858                      |       | 891                        |       |
| Total current liabilities                                                                                                                                                                                              |       | 15,494                   |       | 9,499                      |       |
|                                                                                                                                                                                                                   |       |                     |       |                       |       |
| Long-term portion of capital lease obligation                                                                                                                                                                          |       | 71                       |       | 79                         |       |
| Deferred revenue                                                                                                                                                                                                       |       | 403                      |       | 365                        |       |
|                                                                                                                                                                                                                   |       |                     |       |                       |       |
| Commitments and  contingencies (Note 6)                                                                                                                                                                                |       |                     |       |                       |       |
|                                                                                                                                                                                                                   |       |                     |       |                       |       |
| **Stockholders’ equity:**                                                                                                                                                                                         |       |                     |       |                       |       |
| Preferred stock, $.01 par value, 5,000,000  authorized, no shares issued or outstanding                                                                                                                                |       | —                   |       | —                     |       |
| Common stock, $.01 par value, 100,000,000 shares  authorized; 40,617,020 and 40,341,890 shares issued; 38,055,162 and  37,780,032 shares outstanding at March 31, 2006 and September 30,  2005, respectively |       | 406                      |       | 403                        |       |
| Additional paid-in capital                                                                                                                                                                                             |       | 180,172                  |       | 178,446                    |       |
| Accumulated deficit                                                                                                                                                                                                    |       | (130,234                 | )          | (126,150                   | )          |
| Treasury stock, at cost, 2,561,858 shares at  March 31, 2006 and September 30, 2005                                                                                                                          |       | (2,838                   | )          | (2,838                     | )          |
| Total stockholders’ equity                                                                                                                                                                                        |       | 47,506                   |       | 49,861                     |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                        |       | $                        | 63,474     |                       | $          | 59,804 |   |

 

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

1

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** **

**NETWORK ENGINES, INC.****CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS****(in thousands, except per share data)****(unaudited)**
| ** **                                                     | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                         | ** ** | **2005**                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                     | ** ** | ** **                                       | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                           |       |                                             |       |                                           |       |   |   |   |   |
| Net revenues                                                   |       | $                                                | 28,036     |                                           | $          | 23,673 |   | $ | 55,305 |   | $ | 50,632 |   |
|                                                           |       |                                             |       |                                           |       |   |   |   |   |
| Cost of revenues  (1)                                          |       | 23,705                                           |       | 18,552                                         |       | 46,313 |   | 40,468 |   |
|                                                           |       |                                             |       |                                           |       |   |   |   |   |
| Gross profit                                                   |       | 4,331                                            |       | 5,121                                          |       | 8,992 |   | 10,164 |   |
|                                                           |       |                                             |       |                                           |       |   |   |   |   |
| Operating expenses:                                            |       |                                             |       |                                           |       |   |   |   |   |
| Research and development (1)                                   |       | 2,182                                            |       | 1,989                                          |       | 4,202 |   | 3,968 |   |
| Selling and marketing (1)                                      |       | 2,812                                            |       | 2,352                                          |       | 5,590 |   | 4,777 |   |
| General and administrative (1)                                 |       | 2,187                                            |       | 2,130                                          |       | 3,994 |   | 4,114 |   |
| Restructuring charge                                           |       | —                                           |       | —                                         |       | — |   | 366 |   |
|                                                           |       |                                             |       |                                           |       |   |   |   |   |
| Total operating expenses                                       |       | 7,181                                            |       | 6,471                                          |       | 13,786 |   | 13,225 |   |
|                                                           |       |                                             |       |                                           |       |   |   |   |   |
|                                                           |       |                                             |       |                                           |       |   |   |   |   |
| Loss from  operations                                          |       | (2,850                                           | )          | (1,350                                         | )          | (4,794 | ) | (3,061 | ) |
| Interest and  other income, net                                |       | 390                                              |       | 238                                            |       | 710 |   | 400 |   |
|                                                           |       |                                             |       |                                           |       |   |   |   |   |
| Net loss                                                       |       | $                                                | (2,460     | )                                              | $          | (1,112 | ) | $ | (4,084 | ) | $ | (2,661 | ) |
|                                                           |       |                                             |       |                                           |       |   |   |   |   |
| Net loss per  share — basic and diluted                   |       | $                                                | (0.06      | )                                              | $          | (0.03 | ) | $ | (0.11 | ) | $ | (0.07 | ) |
|                                                           |       |                                             |       |                                           |       |   |   |   |   |
| Shares used in  computing basic and diluted net loss per share |       | 37,987                                           |       | 37,306                                         |       | 37,926 |   | 37,246 |   |

 

 
| ** **                                                                     | ** ** | **Three months ended  March 31,** | ** ** | **Six months endedMarch 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                     | ** ** | **2006**                                         | ** ** | **2005**                                     | ** ** | **2006** | ** ** | **2005** | ** ** |
| (1) Employee  stock-based compensation expenses was allocated as follows: | ** ** | ** **                                       | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                                           | ** ** | ** **                                       | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of Revenues                                                               |       | $                                                | 46         |                                         | $          | — |   | $ | 86 |   | $ | — |   |
| Research and  development                                                      |       | 284                                              |       | —                                       |       | 538 |   | — |   |
| Selling and  marketing                                                         |       | 243                                              |       | —                                       |       | 409 |   | — |   |
| General and  administrative                                                    |       | 215                                              |       | —                                       |       | 339 |   | — |   |
|                                                                                |            |                                                  |            |                                              |            |  |  |  |  |  |  |  |  |

 

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

2

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**NETWORKENGINES, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**(in thousands)(unaudited)
| ** **                                                                                       | ** ** | **Six months ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2006**                                       | ** ** | **2005** | ** ** |
| ** **                                                                                       | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Cash flows from  operating activities:                                                           |       |                                           |       |   |   |
| Net loss                                                                                         |       | $                                              | (4,084     | ) | $ | (2,661 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating  activities: |       |                                           |       |   |   |
| Depreciation and amortization                                                                    |       | 537                                            |       | 626 |   |
| Provision for doubtful accounts                                                                  |       | (23                                            | )          | 29 |   |
| Stock-based compensation                                                                         |       | 1,372                                          |       | 16 |   |
| Changes in  operating assets and liabilities:                                                    |       |                                           |       |   |   |
| Accounts receivable                                                                              |       | (3,956                                         | )          | 3,298 |   |
| Inventories                                                                                      |       | (788                                           | )          | 701 |   |
| Prepaid expenses and other current assets                                                        |       | 57                                             |       | 160 |   |
| Accounts payable                                                                                 |       | 2,722                                          |       | 994 |   |
| Accrued expenses                                                                                 |       | 432                                            |       | (689 | ) |
| Deferred revenue                                                                                 |       | 5                                              |       | 3,163 |   |
| Receivable for insurance recovery                                                                |       | (2,875                                         | )          | — |   |
| Accrued litigation settlement                                                                    |       | 2,875                                          |       | — |   |
|                                                                                             |       |                                           |       |   |   |
| Net cash provided by (used in) operating activities                                              |       | (3,726                                         | )          | 5,637 |   |
|                                                                                             |       |                                           |       |   |   |
| Cash flows from  investing activities:                                                           |       |                                           |       |   |   |
| Purchases of property and equipment                                                              |       | (350                                           | )          | (678 | ) |
| Purchases of short-term investments                                                              |       | (17,392                                        | )          | (28,669 | ) |
| Proceeds from sales and maturities of short-term  investments                                    |       | 21,000                                         |       | 23,251 |   |
| Changes in other assets                                                                          |       | 79                                             |       | (80 | ) |
|                                                                                             |       |                                           |       |   |   |
| Net cash provided by (used in) investing activities                                              |       | 3,337                                          |       | (6,176 | ) |
|                                                                                             |       |                                           |       |   |   |
| Cash flows from  financing activities:                                                           |       |                                           |       |   |   |
| Proceeds from issuance of common stock                                                           |       | 346                                            |       | 248 |   |
| Payments on capital lease obligation                                                             |       | (9                                             | )          | — |   |
|                                                                                             |       |                                           |       |   |   |
| Net cash provided by financing activities                                                        |       | 337                                            |       | 248 |   |
|                                                                                             |       |                                           |       |   |   |
| Net decrease in  cash and cash equivalents                                                       |       | (52                                            | )          | (291 | ) |
| Cash and cash equivalents,  beginning of period                                                  |       | 9,468                                          |       | 12,974 |   |
|                                                                                             |       |                                           |       |   |   |
| Cash and cash  equivalents, end of period                                                        |       | $                                              | 9,416      |   | $ | 12,683 |   |

 

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

3

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**NETWORKENGINES, INC.NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.BASIS OF PRESENTATION**

The accompanying condensed consolidated financialstatements have been prepared by Network Engines, Inc. (“Network Engines”or the “Company”) in accordance with accounting principles generally acceptedin the United States of America and pursuant to the rules and regulationsof the Securities and Exchange Commission. Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith generally accepted accounting principles have been condensed or omittedpursuant to such rules and regulations. The year-end condensed 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. These financial statements should be read inconjunction with the audited financial statements and the accompanying notesincluded in the Company’s 2005 Annual Report on Form 10-K filed bythe Company with the Securities and Exchange Commission.

The information furnished reflects all adjustments,which, in the opinion of management, are of a normal recurring nature and areconsidered necessary for a fair presentation of results for the interimperiods. It should also be noted that results for the interim periods are notnecessarily indicative of the results expected for the full year or any futureperiod.

The preparation ofthese condensed consolidated financial statements in conformity with generallyaccepted accounting principles requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosures of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. The most significant estimates reflected in these financialstatements include allowance for doubtful accounts, inventory valuation,valuation of deferred tax assets, warranty reserves and stock-basedcompensation. Actual results could differ from those estimates.

**2.SIGNIFICANT ACCOUNTING POLICIES**

***Recent Accounting Pronouncements***

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123(revised 2004), *“Share-Based Payment”* (“SFAS123(R)”). SFAS 123(R) is a revision of FASB Statement No. 123, *“Accounting for Stock-Based Compensation”*, supersedesAccounting Principles Board Opinion No. 25, *“Accountingfor Stock Issued to Employees”*, and amends FASB Statement No. 95,*“Statement of Cash Flows”*. SFAS 123(R) requiresall share-based payments to employees, including grants of employee stockoptions and stock purchases under employee stock purchase plans, to be recognizedin the financial statements based on their fair values. The Company adoptedSFAS 123(R) using the modified prospective method during the quarter endedDecember 31, 2005. As noted in footnote 3 below, the adoption of SFAS 123(R) hada material impact on the Company’s condensed consolidated statements ofoperations and net loss per share.

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

The Companyconsiders all highly liquid investments purchased with an original maturity ofthree months or less to be cash equivalents; cash equivalents are carried atcost plus accrued interest, which approximates fair market value. Allsecurities purchased with an original maturity of greater than three months andthat mature within 12 months from the balance sheet date are consideredshort-term investments. All investments are classified as available for saleand are carried at fair value, with unrealized gains and losses included inother comprehensive income or loss, which is a separate component ofstockholders’ equity, until realized. The Company invests excess cash primarilyin municipal bonds and auction rate securities, money market funds andgovernment agency securities. Details of the Company’s cash, cash equivalentsand short-term investments are as follows (in thousands):

4

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| ** **                           | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|--------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                           | ** ** | **2006**           | ** ** | **2005**               | ** ** |
| **Cash and cash equivalents:**       |       |               |       |                   |       |
| Cash                                 |       | $                  | 4,384      |                   | $          | 2,722 |   |
| Money market funds                   |       | 5,032              |       | 5,018                  |       |
| Municipal bonds                      |       | —             |       | 1,728                  |       |
|                                 |       |               |       |                   |       |
| **Total  cash and cash equivalents** |       | $                  | 9,416      |                   | $          | 9,468 |   |
|                                 |       |               |       |                   |       |
| **Short-term investments:**          |       |               |       |                   |       |
| Municipal  auction rate securities   |       | $                  | 24,286     |                   | $          | 27,894 |   |

####  

***Comprehensive Loss***

Duringeach period presented, comprehensive loss was equal to net loss.

***Segment Reporting***

The Company is organizedinto two reportable segments: OEM Appliance and Distribution. The Company’ssegments have been determined based upon the channels through which thesegments sell products. Sales of server appliances to the Company’s networkequipment and ISV partners are included in the Company’s OEM Appliance segment.Sales of server appliances and data storage products to distributors, valueadded resellers (or VARs) and systems integrators are included in the Company’sDistribution segment. The accounting policies of these segments are the same asthose described in the Company’s summary of significant accounting policies inits Annual Report on Form 10-K for the year ended September 30,2005. The Company evaluates its segments’ performance based on net revenues,gross profit and segment operating income (loss), and the Company’s managementregularly evaluates the Company’s segments in deciding how to allocateresources and assess performance. There are no inter-segment sales ortransfers. Management does not review assets as part of the assessment ofsegment performance.

The following is asummary of the Company’s operations by reporting segment (in thousands):
| ** **                             | ** ** | **OEM Appliance** | ** ** | **Distribution** | ** ** | **Total**  | ** ** |
|----------------------------------------|------------|------------------------|------------|------------------|------------|------------|------------|
| **Three  Months Ended March 31,** | ** ** | ** **             | ** ** | ** **       | ** ** | ** ** | ** ** |
| **2006**                               |       |                   |       |             |       |       |       |
| Net Revenue                            |       | $                      | 27,691     |             | $          | 345        |       | $ | 28,036 |   |
| Segment Operating Income (Loss)        |       | $                      | 3,134      |             | $          | (3,224     | )          | $ | (90 | ) |
|                                   |       |                   |       |             |       |       |       |
| **2005**                               |       |                   |       |             |       |       |       |
| Net Revenue                            |       | $                      | 23,588     |             | $          | 85         |       | $ | 23,673 |   |
| Segment Operating Income (Loss)        |       | $                      | 3,898      |             | $          | (3,118     | )          | $ | 780 |   |
|                                   |       |                   |       |             |       |       |       |
| **Six  Months Ended March 31,**   | ** ** | ** **             | ** ** | ** **       | ** ** | ** ** | ** ** |
| **2006**                               |       |                   |       |             |       |       |       |
| Net Revenue                            |       | $                      | 54,703     |             | $          | 602        |       | $ | 55,305 |   |
| Segment Operating Income (Loss)        |       | $                      | 6,845      |             | $          | (6,612     | )          | $ | 233 |   |
|                                   |       |                   |       |             |       |       |       |
| **2005**                               |       |                   |       |             |       |       |       |
| Net Revenue                            |       | $                      | 45,890     |             | $          | 4,742      |       | $ | 50,632 |   |
| Segment  Operating Income (Loss)       |       | $                      | 7,197      |             | $          | (6,144     | )(a)       | $ | 1,053 |   |

----

(a)             Includes$366 of restructuring charges

5

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The Company does notallocate general and administrative expenses to its reportable segments,because these activities are managed separately from the reportable segments.The Company does not allocate the costs of stock-based compensation to itsreportable segments, because these expenses pertain to grants of awards thatare managed and measured at the corporate level.  Additionally, management excludes theseexpenses when planning or measuring the periodic financial performance of theCompany’s segments since they are not directly related to its segment operatingperformance. A reconciliation of the totals reported for the reportablesegments to the loss from operations in the consolidated financial statementsis as follows, in thousands:
| ** **                                                             | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                         | ** ** | **2005**                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Total segment  operating income (loss)                                 |       | $                                                | (90        | )                                              | $          | 780 |   | $ | 233 |   | $ | 1,053 |   |
| General and  administrative                                            |       | 2,187                                            |       | 2,130                                          |       | 3,994 |   | 4,114 |   |
| Stock-based  compensation (not included in general and administrative) |       | 573                                              |       | —                                         |       | 1,033 |   | — |   |
| Loss from operations                                                   |       | $                                                | (2,850     | )                                              | $          | (1,350 | ) | $ | (4,794 | ) | $ | (3,061 |   |

 

All of the Company’slong-lived assets were located in the United States as of December 31,2005 and 2004.

***Significant Customers***

The following tablesummarizes those customers who accounted for greater than 10% of the Company’snet revenues or accounts receivable:
| ** **      | ** ** | **Net Revenues**            | ** ** | ** **                     | ** ** | ** **                           | ** ** |
|-----------------|------------|----------------------------------|------------|--------------------------------|------------|--------------------------------------|------------|
| ** **      | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** | **Accounts Receivable at** | ** ** |
| ** **      | ** ** | **March 31,**               | ** ** | **March 31,**             | ** ** | **March 31,**                   | ** ** | **September 30,** | ** ** |
| ** **      | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| EMC Corporation |       | 79                               | %          | 85                             | %          | 81                                   | %          | 77 | % | 73 | % | 67 | % |

 

**3.STOCK-BASED COMPENSATION**

Effective October 1,2005, the Company adopted the provisions of Statement of Financial AccountingStandards 123(R), *“Share-Based Payment,”*(“SFAS 123(R)”),**whichestablishes accounting for equity instruments exchanged for employee services.Under the provisions of SFAS 123(R), stock-based compensation cost ismeasured at the grant date, based on the fair value of the award, and isrecognized as an expense over the employee’s requisite service period(generally the vesting period of the equity award). Prior to October 1,2005, the Company accounted for share-based compensation to employees inaccordance with Accounting Principles Board Opinion No. 25,*“Accounting for Stock Issued to Employees,”*(“APB 25”) and related interpretations. The Company also followed thedisclosure requirements of Statement of Financial Accounting Standards No. 123,*“Accounting for Stock-Based Compensation”*(“SFAS 123”). The Company elected to adopt the modified prospectivetransition method as provided by SFAS 123(R) and, accordingly,financial statement amounts for the prior periods presented in this Form 10-Qhave not been restated to reflect the fair value method of expensing stock-basedcompensation.

6

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**StockIncentive Plans**

In October 1999,the Company’s shareholders approved the 1999 Stock Incentive Plan (the “1999Plan”). Under the 1999 Plan, stock option and restricted stock or otherstock-based awards for up to 4,747,902 shares of common stock may be issued toemployees, officers, directors, consultants and advisors of the Company.Options are granted for terms of up to ten years and vest over varying periods.Option grants to new employees generally vest 25% on the first anniversary ofthe grant date and thereafter in equal quarterly installments over the nextthree years. Subsequent grants to existing employees generally vest in equalquarterly installments over four years. The option price per share isdetermined by the board of directors on the grant date.

In May 2000,the Company’s shareholders approved an increase of 3,300,000 in the number ofshares authorized under the 1999 Plan and an automatic annual increase in thenumber of shares authorized under the 1999 Plan. The automatic annual increaseis equal to the lesser of: 5% of the outstanding shares on the first day ofeach fiscal year; 4,000,000 shares; or an amount determined by the board ofdirectors, which is subject to a maximum of 20,047,902 authorized shares underthe plan. As of March 31, 2006, the Company is authorized to grantoptions, restricted stock or other awards of up to 13,807,273 shares of commonstock.

In May 2000,the Company’s shareholders approved the 2000 Director Option Plan (the “DirectorPlan”). Under the Director Plan, the Company may make formula grants of stockoptions to non-employee directors of up to 500,000 shares of common stock. Newdirectors to the Company’s board are granted an initial grant of 50,000 shares,which vest 25% on the first anniversary of the grant date and thereafter inequal quarterly installments over the next three years. Subsequent annualgrants of 15,000 shares to directors vest 100% upon the first anniversary ofthe grant date. In March 2004, the Company’s shareholders approved anincrease of an additional 325,000 shares of common stock authorized to beissued under this plan, resulting in a total of 825,000 options authorized tobe issued. Under the Director Plan, options to purchase 595,000 shares havebeen granted, options to purchase 45,000 shares have been exercised and optionsto purchase 30,000 shares have been cancelled through March 31, 2006.

In May 2000,the Company’s shareholders approved the 2000 Employee Stock Purchase Plan (the “PurchasePlan”). Under the Purchase Plan, the Company may issue up to an aggregate of750,000 shares of common stock to eligible employees. In March 2004, theCompany’s shareholders approved an increase of an additional 500,000 shares ofcommon stock authorized to be issued under the Purchase Plan, resulting in atotal of 1,250,000 shares authorized to be issued. Eligible employees must beemployed by the Company for more than 20 hours per week and more than fivemonths in a fiscal year. Under the Purchase Plan, the Company makes twoofferings each fiscal year, at the end of which employees may purchase sharesof common stock through payroll deductions made over the term of each offering.The per-share purchase price for offerings prior to May 15, 2005, wasequal to the lesser of 85% of the closing price of the common stock at thebeginning or end of the offering period. During the year ended September 30,2005, the board of directors amended the Purchase Plan to limit the per-sharepurchase price for offerings to 85% of the closing price at the end of theoffering period, beginning with the offering period ended May 15, 2005.Offering periods begin on the 15th day of November and May each year.During the six months ended March 31, 2006, 163,883 shares of commonstock, were issued under the Purchase Plan. The Company had 214,000 sharesavailable for issuance under its Purchase Plan as of March 31, 2006.

7

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The followingtable presents stock-based employee compensation expenses included in theCompany’s unaudited condensed consolidated statements of operations (inthousands):
| ** **                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                        | ** ** | **March 31, 2006**     | ** ** | **March 31, 2006**   | ** ** |
|                              | ** ** | ** **                       | ** ** | ** **                     | ** ** |
| Cost of revenues                  |       | $                                | 46         |                           | $          | 86 |   |
| Research and  development         |       | 284                              |       | 538                            |       |
| Selling and  marketing            |       | 243                              |       | 409                            |       |
| General and  administrative       |       | 215                              |       | 339                            |       |
| Stock-based  compensation expense |       | $                                | 788        |                           | $          | 1,372 |   |

 

As a result ofadopting SFAS 123(R), the Company’s net loss for the three and six monthsended March 31, 2006, is $788,000 and $1,372,000 greater, respectively,than if it had continued to account for stock-based compensation underAPB 25. Basic and diluted net loss per share for the three and six monthsended March 31, 2006 was also greater by $0.02 and $0.04, respectively,due to the adoption of SFAS 123(R).

The Companyestimates the fair value of stock options using the Black-Scholes valuationmodel. This valuation model takes into account the exercise price of the award,as well as a variety of significant assumptions. These assumptions used toestimate the fair value of stock options include the expected term, theexpected volatility of the Company’s stock over the expected term, therisk-free interest rate over the expected term, and the Company’s expectedannual dividend yield. The Company believes that the valuation technique andthe approach utilized to develop the underlying assumptions are appropriate incalculating the fair values of the Company’s stock options granted in the threeand six months ended March 31, 2006. Estimates of fair value are notintended to predict actual future events or the value ultimately realized bypersons who receive equity awards.

Assumptions usedto determine the fair value of options granted during the three and six monthsended March 31, 2006, using the Black-Scholes valuation model were:
| ** **                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                      | ** ** | **March 31, 2006**     | ** ** | **March 31, 2006**   | ** ** |
|                            |       |                             |       |                           |       |
| Expected term(1)                |       | 5.50 to 6.25 years               |       | 5.50 to 6.25 years             |       |
| Expected  volatility factor(2)  |       | 78.21                            | %          | 77.00% to 78.21                | %          |
| Risk-free  interest rate(3)     |       | 4.39                             | %          | 4.39                           | %          |
| Expected annual dividend  yield |       | —                           |       | —                         |       |

----

(1)             Expectedterm for each grant was determined as the midpoint between the vesting date andthe end of the contractual term, also known as the “simplified method” forestimating expected term described by Staff Accounting Bulletin No. 107,(“SAB 107”).

(2)             Theexpected volatility for each grant is estimated based on a weighted average ofhistorical volatility. 

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

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

8

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Prior to October 1,2005, the Company accounted for stock-based compensation to employees inaccordance with APB 25. The Company also had previously adopted the provisionsof SFAS 123, which required disclosure only of stock-based compensationand its impact on net loss and net loss per share. The following tableillustrates the effects on net loss and net loss per share for the three andsix months ended March 31, 2005 as if the Company had applied the fairvalue recognition provisions of SFAS 123 to stock-based employee awards.

    

|                                                                                                | ** ** | **Three Months  Ended  March 31, 2005** | ** ** | **Six Months  Ended  March 31, 2005** | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
|                                                                                           | ** ** | ** **                                             | ** ** | ** **                                           | ** ** |
| Net loss as  reported                                                                          |       | $                                                      | (1,112     | )                                                    | $          | (2,661 | ) |
| Add: Stock-based  employee compensation expense included in net loss                           |       | 7                                                      |       | 7                                                    |       |
| Less: Total  stock-based employee compensation expense determined under the fair value  method |       | (792                                                   | )          | (1,550                                               | )          |
| Pro forma net  loss                                                                            |       | $                                                      | (1,897     | )                                                    | $          | (4,204 | ) |
| Net loss per share:                                                                            |       |                                                   |       |                                                 |       |
| Basic and Diluted — as reported                                                      |       | $                                                      | (0.03      | )                                                    | $          | (0.07 | ) |
| Basic and  Diluted — pro-forma                                                       |       | $                                                      | (0.05      | )                                                    | $          | (0.11 | ) |

 

Assumptions usedto determine the fair value of options granted under SFAS 123 during the threeand six months ended March 31, 2005 were:

 

|                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **March 31, 2005**     | ** ** | **March 31, 2005**   | ** ** |
|                     |       |                             |       |                           |       |
| Expected term            |       | 5 years                     |       | 5 years                   |       |
| Volatility               |       | 117                              | %          | 122                            | %          |
| Risk-free  interest rate |       | 3.79                             | %          | 3.69                           | %          |
| Dividend yield           |       | —                           | %          | —                         | %          |

 

The Company issuescommon stock from previously authorized but unissued shares to satisfy optionexercises and purchases under the Company’s Purchase Plan.

A summary of theCompany’s stock option activity for the six months ended March 31, 2006 isas follows:  

|                                       | ** ** | **Six Months ended March 31, 2006** | ** ** |
|---------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                            | ** ** | **Number of  Options**                                  | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted  Average  Remaining Contractual  Term (in years)** | ** ** |
|                                  |       |                                                         |       |   |   |   |   |
| Outstanding,  September 30, 2005 |       | 6,701,268                                                    |       | $ | 2.41 |   |   |   |
| Granted                               |       | 2,576,282                                                    |       | 1.53 |   |   |   |
| Exercised                             |       | (111,247                                                     | )          | 1.73 |   |   |   |
| Cancelled                             |       | (491,324                                                     | )          | 3.22 |   |   |   |
| Outstanding,  March 31, 2006     |       | 8,674,979                                                    |       | $ | 2.11 |   | 7.58 |   |
| Exercisable at  March 31, 2006   |       | 4,466,263                                                    |       | $ | 2.13 |   | 6.13 |   |

 

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All optionsgranted during the three and six months ended March 31, 2006 and 2005 weregranted with exercise prices equal to the fair market value of the Company’scommon stock on the grant date. Options granted during the three and six monthsended March 31, 2006 had weighted average grant date fair values of $1.12and $1.08, respectively. Options granted during the three and six months ended March 31,2005 had weighted average grant date fair values of $1.95 and $2.03,respectively.

At March 31,2006, the aggregate intrinsic value of options outstanding and optionsexercisable was $12,782,000 and $7,392,000, respectively. The intrinsic valueof a stock option is the amount by which the market value of the underlyingstock exceeds the exercise price of the option.

Theaggregate intrinsic value of options exercised during the three and six monthsended March 31, 2006 was $73,000 and $80,000, respectively.

Thefollowing table summarizes the stock options outstanding at March 31,2006:

 
| ** **                         | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                   | ** ** |
|------------------------------------|------------|------------------------------|------------|------------------------------------------------|------------|
| **Exercise Price Range** | ** ** | **Number**                   | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted Average  Remaining  Contractual  Term (in years)** | ** ** | **Number** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| $0.07 - $0.92                      |       | 1,482,294                    |       | $                                              | 0.62       |   | 5.35 |   | 1,388,543 |   | $ | 0.60 |   |
| $0.95 - $1.06                      |       | 970,938                      |       | 1.01                                           |       | 6.49 |   | 800,297 |   | 1.01 |   |
| $1.07 - $1.35                      |       | 814,368                      |       | 1.19                                           |       | 5.29 |   | 765,118 |   | 1.19 |   |
| $1.36 - $1.36                      |       | 1,469,282                    |       | 1.36                                           |       | 9.77 |   | 0 |   | 1.36 |   |
| $1.38 - $1.65                      |       | 975,386                      |       | 1.46                                           |       | 9.07 |   | 193,706 |   | 1.48 |   |
| $1.70 - $2.61                      |       | 1,309,805                    |       | 2.15                                           |       | 8.40 |   | 452,763 |   | 2.13 |   |
| $2.65 - $4.40                      |       | 1,116,984                    |       | 3.65                                           |       | 8.44 |   | 493,197 |   | 3.95 |   |
| $4.58 - $39.81                     |       | 535,922                      |       | 9.55                                           |       | 6.69 |   | 372,639 |   | 10.10 |   |
|                               |       | 8,674,979                    |       | $                                              | 2.11       |   | 7.58 |   | 4,466,263 |   | 2.13 |   |
|                                    |            |                              |            |                                                |            |  |  |  |  |  |  |  |  |

 

The Company’snon-vested stock option activity for the six months ended March 31, 2006was as follows:
| ** **                                     | ** ** | **Number of  Options** | ** ** | **Weighted  Average  Fair Value** | ** ** |
|------------------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|
|                                           |       |                        |       |                                   |       |
| Non-vested  options at September 30, 2005 |       | 2,721,275                   |       | $                                      | 2.39       |   |
| Granted                                        |       | 2,576,282                   |       | 1.08                                   |       |
| Vested                                         |       | (661,823                    | )          | 2.07                                   |       |
| Forfeited                                      |       | (427,018                    | )          | 2.17                                   |       |
| Non-vested options at  March 31, 2006     |       | 4,208,716                   |       | 1.66                                   |       |
|                                                |            |                             |            |                                        |            |  |

 

At March 31,2006, unrecognized compensation expense related to non-vested stock options was$4,927,000, which is expected to be recognized over a weighted average periodof 2.61 years.

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**4.NET LOSS PER SHARE**

Basic net loss per share is computed by dividing thenet loss for the period by the weighted average number of shares of commonstock outstanding during the period. Diluted net loss per share is computed bydividing the net loss for the period by the weighted average number of sharesof common stock and potential common stock outstanding during the period, ifdilutive. Potential common stock includes incremental shares of common stockissuable upon the exercise of stock options. For the three month periods ended March 31,2006 and 2005, stock options totaling 5,189,000 and 4,768,000 sharesrespectively, and for the six month periods ended March 31, 2006 and 2005,stock options totaling 4,575,000 and 4,443,000 shares respectively, wereexcluded from the calculation of net loss per share because their inclusionwould be anti-dilutive.

**5. INVENTORIES**

Inventories consisted of the following (in thousands):
| ** **      | ** ** | **March 31, 2006** | ** ** | **September 30, 2005** | ** ** |
|-----------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **      | ** ** | ** **                   | ** ** | ** **                       | ** ** |
| Raw materials   |       | $                            | 5,037      |                             | $          | 3,972 |   |
| Work in process |       | 1,020                        |       | 302                              |       |
| Finished goods  |       | 3,969                        |       | 4,953                            |       |
|            |       | $                            | 10,026     |                             | $          | 9,227 |   |

** **

**6. COMMITMENTS ANDCONTINGENCIES**

***Guarantees and Indemnifications***

Acquisition-relatedindemnifications - When, as part of an acquisition, the Company acquires allthe stock of a company, the Company assumes liabilities for certain events orcircumstances that took place prior to the date of acquisition. The maximumpotential amount of future payments the Company could be required to make forsuch obligations is undeterminable. While the provisions of the agreementsremain in effect indefinitely, the Company believes that the probability ofreceiving a claim is unlikely. As a result, the Company has not recorded aliability for these indemnification clauses as of March 31, 2006.

The Company entersinto standard indemnification agreements in the ordinary course of itsbusiness. Pursuant to these agreements, the Company indemnifies, holdsharmless, and agrees to reimburse the indemnified party for losses suffered orincurred by the indemnified party, generally its business partners orcustomers, in connection with any patent, copyright, trademark, trade secret orother intellectual property infringement claim by any third party with respectto its products. The term of these indemnification agreements is generallyperpetual. The Company has never incurred costs to defend lawsuits or settleclaims related to these indemnification agreements. As a result, the Companybelieves the estimated fair value of these agreements is minimal. Accordingly,the Company has no liabilities recorded for these indemnifications as of March 31,2006.

Product warranties — The Company offers and fulfillswarranty services on certain of its server appliances. In addition, while theCompany was selling third-party data storage networking products it contractedwith a third party to provide warranty services for these products. The Company’sagreement with this third-party warranty provider expired in March 2005 asscheduled. However, the terms of the agreement require the third-party warrantyprovider to service these products for the entire warranty period. Warrantyterms vary in duration depending upon the product sold but generally providefor the repair or replacement of any defective products for periods of up to 36months after shipment. Based upon historical experience and expectation offuture conditions, the Company reserves for the estimated costs to fulfill 

 

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customerwarranty obligations upon the recognition of the related revenue. Forwarranties related to third-party data storage networking products, the Companyrecorded warranty expense based on its agreement with its third-party warrantyfulfillment provider, whose fees were determined based on fixed periodic amountsas well as activity-based charges. The following table presents changes in theCompany’s product warranty liability for the three months and six months ended March 31,2006 and 2005 (in thousands):

 

|                                              | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                         | ** ** | **2005**                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                         |       |                                             |       |                                           |       |   |   |   |   |
| Beginning  balance                           |       | $                                                | 487        |                                           | $          | 389 |   | $ | 455 |   | $ | 433 |   |
| Accruals for  warranties issued              |       | 224                                              |       | 201                                            |       | 613 |   | 543 |   |
| Fulfillment of  warranties during the period |       | (196                                             | )          | (163                                           | )          | (553 | ) | (549 | ) |
| Ending balance                               |       | $                                                | 515        |                                           | $          | 427 |   | $ | 515 |   | $ | 427 |   |

 

***Contingencies***

*Announcement Timing Lawsuit*

On March 17,2004, the United States District Court for the District of Massachusetts (the “Court”)consolidated a number of purported class action lawsuits filed against NetworkEngines, Inc. and certain individual Network Engines defendants(collectively the “Defendants”). These suits generally concern the timing ofthe announcement of an amendment to Network Engines’ agreement with EMCCorporation regarding the resale of EMC-approved Fibre Channel HBAs. ThePlaintiffs filed an amended consolidated complaint on June 4, 2004. TheDefendants on August 13, 2004 filed a motion to dismiss the amendedconsolidated complaint. The Plaintiffs on October 12, 2004 filed anopposition to the Defendants’ motion to dismiss and the Defendants filed areply to the Plaintiff’s opposition on November 12, 2004. The Court on November 22,2004 denied the Defendant’s motion to dismiss the amended consolidatedcomplaint. On December 9, 2004, the Defendants filed an answer to theamended consolidated complaint.

Since that time theparties engaged in some informal discovery, have exchanged formal discoveryrequests, and then pursued active settlement discussions. On March 31,2006, the parties filed a motion for preliminary approval of a class actionsettlement. On April 4, 2006, the Court entered an Order preliminarilyapproving the settlement and scheduled deadlines for the settlement approvalprocess, including scheduling a settlement conference for July 25, 2006. Thesettlement is subject to a notice and comment period, during which classmembers may object, opt out of the settlement, or file claims under thesettlement. The terms of the settlement require the Company’s insuranceprovider to pay $2,875,000 in full settlement of the claims asserted by theclass. As a result at March 31, 2006, the Company recorded accruedlitigation settlement and a receivable for insurance recovery in the amount of$2,875,000.

*Initial Public Offering Lawsuit*

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

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The suit alleges that the defendants violated thefederal securities laws by issuing and selling securities pursuant to theCompany’s initial public offering in July 2000 (“IPO”) without disclosingto investors that the Underwriter Defendants had solicited and receivedexcessive and undisclosed commissions from certain investors. The suit alsoalleges that the Underwriter Defendants entered into agreements with certaincustomers whereby the Underwriter Defendants agreed to allocate to those customersshares of the Company’s common stock in the offering, in exchange for which thecustomers agreed to purchase additional shares of the Company’s common stock inthe aftermarket at pre-determined prices. The suit alleges that such tie-inarrangements were designed to and did maintain, distort and/or inflate theprice of the Company’s common stock in the aftermarket. The suit furtheralleges that the Underwriter Defendants received undisclosed and excessivebrokerage commissions and that, as a consequence, the Underwriter Defendantssuccessfully increased investor interest in the manipulated IPO securities andincreased the Underwriter Defendants’ individual and collective underwritings,compensation and revenues. 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 July 2002, the Company, Lawrence A. Genovesiand Douglas G. Bryant joined in an omnibus motion to dismiss the suitchallenging the legal sufficiency of plaintiffs’ claims. The motion was filedon behalf of hundreds of issuer and individual defendants named in similarlawsuits. Plaintiffs opposed the motion, and the Court heard oral argument onthe motion in November 2002. On February 19, 2003, the Court issuedan opinion and order denying the motion as to the Company. However, in October 2002,Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this casewithout prejudice.

On July 9, 2003, a Special Committee of theCompany’s Board of Directors authorized the Company to negotiate a settlementof the pending claims substantially consistent with a memorandum ofunderstanding negotiated among class plaintiffs, all issuer defendants andtheir insurers. The parties have negotiated the settlement, which provides,among other things, for a release of the Company and the Individual Defendantsfor the conduct alleged in the amended complaint to be wrongful. The Companywould agree to undertake other responsibilities under the settlement, includingagreeing to assign, or not assert, certain potential claims that it may haveagainst its underwriters. Any direct financial impact of the proposedsettlement is expected to be borne by the Company’s insurers. Any such settlementwould be subject to various contingencies, including approval by the Courtoverseeing the litigation. On February 15, 2005, the Court issued anOpinion and Order preliminarily approving the settlement, provided that thedefendants and plaintiffs agree to a modification narrowing the scope of thebar order set forth in the original settlement agreement.  The partiesagreed to a modification narrowing the scope of the bar order, and on August 31,2005, the Court issued an order preliminarily approving the settlement. TheCompany is unable to predict the outcome of this suit and as a result, noamounts have been accrued as of March 31, 2006.

**7. RELATED PARTYTRANSACTIONS**

Robert M. Wadsworth, one of the Company’s directors,is a managing director of the limited liability corporation that controlsHarbourVest Partners (and its affiliates), one of the Company’s significantstockholders. Mr. Wadsworth, is also a director of PSI Holding Group, Inc.(“PSI”), the parent company of Akibia, Inc. (“Akibia”). During the threeand six months ended March 31, 2006 and 2005, HarbourVest owned greaterthan 5% of the outstanding stock of the Company and greater than 5% of theoutstanding stock of PSI. While the Company was selling third-party datastorage networking products it engaged Akibia to provide certain customersupport and warranty fulfillment services related to the Company’s sales ofHBAs. The Company’s agreement with Akibia expired in March 2005 asscheduled. However, the terms of the agreement required Akibia fulfill thewarranty services for the entire warranty period. Akibia charged the Company aquarterly fixed fee of $83,000 and a variable fee based upon the Company’ssales of HBAs which ended December 2004. In the three and six months endedMarch 31, 2005, the Company recognized $0 and $201,000, respectively, ofexpense as a result of its HBA customer support and warranty 

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fulfillmentservices agreements with Akibia. The Company recognized no such expense in thethree or six months ended March 31, 2006. In connection with this customersupport and warranty fulfillment services agreement, the Company also sold HBA’sto Akibia to allow Akibia to fulfill the Company’s warranty obligations forthese products. In the three and six months ended March 31, 2005, the Companyrecorded revenues of approximately $0 and $40,000, respectively, from sales ofHBAs to Akibia. The Company recorded no such revenues in the three or sixmonths ended March 31, 2006. There were no amounts receivable from orpayable to Akibia at March 31, 2006 or September 30, 2005. In November 2005,Mr. John A. Blaeser, one of the Company’s directors, also joined the boardof directors of Akibia.

Mr. Wadsworthalso serves as a director of Innoveer Solutions, Inc. (“Innoveer”),formerly Akibia Consulting, and previously a subsidiary of Akibia. The Companyengages Innoveer to provide professional services related to modifications ofits Customer Resource Management (“CRM”) software system. During the three andsix months ended March 31, 2006, the Company incurred approximately$18,000 and $47,000, respectively, related to these services. During the threeand six months ended March 31, 2005, the Company incurred approximately$12,000 related to these services. The Company owed Innoveer $4,000 at March 31,2006. There were no amounts outstanding to Innoveer at September 30, 2005.

Additionally, theCompany engaged the consulting services of Mapleworks Technologies (“Mapleworks”),a software development services provider. Both Mr. Blaeser and Mr. Wadsworthare investors in Mapleworks and are members of its board of advisors. For thethree and six months ended March 31, 2006 the Company incurred $38,000 and$83,000, respectively, in fees for these consulting services. The Company hadno amounts outstanding to Mapleworks at March 31, 2006 and September 30,2005.

 

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**ITEM 2. MANAGEMENT’S DISCUSSIONAND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION**

**Special NoteRegarding Forward-Looking Statements**

ThisQuarterly Report on Form 10-Q contains forward-looking statementswithin the meaning of Section 21E of the Securities Exchange Act of 1934,as amended, that involve risks and uncertainties. All statements other thanstatements of historical information provided herein are forward-lookingstatements and may contain projections related to financial results, economicconditions, trends and known uncertainties. Our actual results could differmaterially from those discussed in the forward-looking statements as a resultof a number of factors, which include those discussed in this section and in Part II,Item 1A, Risk Factors, of this report and the risks discussed in our otherfilings with the Securities and Exchange Commission. Readers are cautioned notto place undue reliance on these forward-looking statements, which reflectmanagement’s analysis, judgment, belief or expectation only as of the datehereof. We undertake no obligation to publicly reissue these forward-lookingstatements to reflect events or circumstances that arise after the date hereof.

Thefollowing discussion and analysis should be read in conjunction with thecondensed consolidated financial statements and the notes thereto included inItem 1 in this Quarterly Report on Form 10-Q and our Annual Reporton Form 10-K for the fiscal year ended September 30, 2005 filedby the Company with the Securities and Exchange Commission.

**Overview**

We develop andmanufacture server appliance solutions that deliver data storage and networksecurity applications on server appliances. Server appliances arepre-configured network infrastructure devices designed to optimally deliverspecific software application functionality and facilitate ease of deploymentand support of a software application in a customer’s network. We are organizedinto two reportable segments: OEM Appliance and Distribution.

**OEMAppliance segment**

In our OEMAppliance segment, we develop and manufacture server appliance solutions thatenable network equipment providers and independent software vendors, or ISVs,to deliver their data storage and network security applications in the form ofa server appliance. We offer our server appliance partners a comprehensivesuite of services, including development, manufacturing, fulfillment andpost-sale support. We produce and fulfill devices branded for our networkequipment and ISV partners, and derive our revenues from the sale ofvalue-added hardware platforms to these partners. These partners subsequentlysell and support the device under their own brands to their customer base.During the three and six months ended March 31, 2006, sales to EMCrepresented 80% and 82%, respectively, of our OEM Appliance segment revenues,compared to 86% and 84% for the three and six months ended March 31, 2005,respectively.

For the three andsix months ended March 31, 2006 our OEM Appliance segment had segmentoperating income of $3.1 million and $6.8 million, respectively, compared tosegment operating income of $3.9 million and $7.2 million for the three and sixmonths ended March 31, 2005, respectively. Refer to footnote 2 of ourCondensed Consolidated Financial Statements contained in Item I of this reportfor purposes of determining segment operating income.

**Distributionsegment**

Currently in ourDistribution segment, we develop, manufacture, sell, market and support ourNS Series Security Appliances that are based on Microsoft’s InternetSecurity and Acceleration (ISA) Server 2004. We license and integrate thissoftware with server appliance platforms and our proprietary software to sellour own branded server appliances primarily to distributors,Microsoft-certified or network security value added resellers and systemintegrators. Sales of these servers commenced in the first quarter 

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of  fiscal year 2005.We believe that it may takeseveral quarters more before revenues from sales of these server appliancesbecome significant.

Previously in ourDistribution segment we also distributed third-party data storage networkingconnectivity products for the leading Fibre Channel host bus adapter, or HBA,and storage switch manufacturers in the data storage industry to a customerbase of value-added resellers and systems integrators. For the three monthsended December 31, 2004, 98% of our Distribution segment’s revenue hadbeen derived from the sale of third-party data storage networking componentsand products, predominantly EMC-approved Fibre Channel HBAs. As a result of anamendment to a key distribution agreement, there was a decline in our grossprofits related to sales of EMC-approved Fibre Channel HBAs, which in turn hada negative impact on our Distribution segment gross profits as well as ourconsolidated gross profits and operating results. In addition, as a result ofthe higher costs per EMC-approved Fibre Channel HBA that this amendment imposedupon us, our Distribution segment’s ability to compete in large sales transactionsinvolving EMC-approved Fibre Channel HBAs was negatively affected. Thisamendment, the commoditization of Fibre Channel HBA technology, and theincreasing competition in the market resulted in declining gross profitsrelated to our distribution of HBAs. During the quarter ended December 31,2004, we discontinued sales of these third-party data storage networkingproducts, as a result of these factors and the future prospects of this portionof our segment.

For the three andsix months ended March 31, 2006 our Distribution segment had segmentoperating losses of $3.2 million and $6.6 million, respectively, compared tosegment operating losses of $3.1 million and $6.1 million for the three and sixmonths ended March 31, 2005, respectively. Refer to footnote 2 of ourCondensed Consolidated Financial Statements contained in Item I of this reportfor purposes of determining segment operating income.

**CriticalAccounting Policies and Estimates**

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

***Revenue recognition***

Revenues fromproducts are generally recognized upon delivery to customers if persuasiveevidence of an arrangement exists, the fee is fixed or determinable,collectibility is reasonably assured and title and risk of loss have passed tothe customer. In the event we have unfulfilled future obligations, revenue andrelated costs are deferred until those future obligations are met. We have aninventory consignment agreement with our largest customer related to certainserver appliances sold through our OEM Appliance segment. This customernotifies us when it utilizes inventory and we recognize revenues from sales tothis customer based upon these notifications.

Maintenancerevenues are derived from customer support agreements generally entered into inconnection with the initial server appliance sales and subsequent renewals.Maintenance fees are typically for one to three year renewable periods andinclude the right to unspecified software updates when-and-if-available,hardware repairs, 24-hour customer support, and advanced replacement ofserver appliances. Maintenance revenues are recognized ratably over the term ofthe maintenance period. Payments for maintenance fees are generally made inadvance and are included in deferred revenue.

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Contracts and/orcustomer purchase orders are generally used to determine the existence of anarrangement. Shipping documents and consignment usage notifications are used toverify shipment or transfer of ownership, as applicable. We assess whether thesales price is fixed or determinable based on the payment terms associated withthe transaction and whether the sales price is subject to refund or adjustment.We assess collectibility based primarily on the creditworthiness of thecustomer as determined by credit checks and analysis, as well as the customer’spayment history.

For revenuearrangements that contain multiple elements, such as the sale of both theproduct and post-sales support, in which software is not incidental to theproduct, such as our sales of server appliances through our Distributionsegment, we determine fair value based upon vendor specific objective evidence,which is typically established through contractual post-sales support renewalrates whereby the residual fair value is allocated to the server appliance. Forrevenue arrangements that contain multiple elements, in which software is notincluded or is incidental to the product, such as our sales of serverappliances through our OEM Appliance segment, we determine fair value based onobjective and reliable evidence of fair value, which is typically determinedthrough contractual refund rates for cancellations, and stand-alone sales ofpost sales support, whereby the residual fair value is allocated to the serverappliance.

We recognizerevenue when the revenue recognition criteria for each element of the sale ismet. If we are not able to derive the fair value of the undelivered element ofthe sale (maintenance), all revenues from the arrangement are deferred andrecognized ratably over the period of the support arrangement, which istypically one to three years.

***Allowances for Doubtful Accounts***

Our allowance fordoubtful accounts is based on our assessment of the collectibility of customeraccounts. We regularly review the allowance by considering factors such ashistorical experience, credit quality, age of the accounts receivable balances,and current economic conditions that may affect a customer’s ability to pay. Ifa major customer’s creditworthiness deteriorates, or if actual defaults arehigher than our historical experience, or if other circumstances arise, ourestimates of the recoverability of amounts due to us could be overstated, andadditional allowances could be required, which could have an adverse impact onour results of operations.

***Inventories***

We value inventoryat the lower of cost or estimated market, and determine cost on a first-in,first-out basis. We regularly review inventory quantities on hand and record awrite-down for excess or obsolete inventory based primarily on our estimatedforecast of product demand and anticipated production requirements in the nearfuture. Any rapid technological changes, regulatory changes or future productdevelopment could result in an increase in the amount of obsolete inventoryquantities on hand. Agreements with certain of our OEM Appliance customersinclude inventory protection provisions, however, these provisions may notprovide us with complete protection from loss due to excess or obsoleteinventory.

***Product Warranty Obligations***

We offer awarranty on certain of our products that generally provide for us to repair orreplace any defective products for a period of up to 36 months after shipment.We reserve for the estimated costs to fulfill customer warranty obligationsupon the recognition of the related revenue and record warranty expense as acomponent of cost of sales.

*OEMServer appliance products—*Costs included in our server appliance product warrantyobligation include shipping, materials, internal and external labor, andtravel. Significant judgment and estimates are involved in estimating ourwarranty reserve on our OEM server appliance products. Although our current OEMserver appliance products use more standards-based technologies than in thepast, certain of our server appliance products incorporate customizedcomponents, which may increase our risks related to product warrantyobligations. In the past we have experienced unexpected component failures incertain of our server appliance products, which have required us to increaseour product warranty accruals. At the 

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time any unexpectedcomponent failure arises, we assess the costs to repair any defects and recordwhat we believe to be an appropriate warranty obligation based on the availableinformation at the time. To the extent we may experience increased warrantyclaim activity, increased costs associated with servicing those claims, or useestimates that prove to be materially different from actual claims, our productwarranty obligations may need to be increased, resulting in decreased grossprofits.

*NSSeries Security Appliance products—*Our NS Series SecurityAppliances typically do not include a general warranty, but instead customerstypically are required to purchase an annual maintenance program at the time ofthe appliance purchase.

*HBAproducts—*Our HBA warranty expense was determined based uponcontractual rates with a third-party warranty provider who we paid to performsubstantially all activities related to the fulfillment of our HBA productwarranty obligations. As such, the warranty expense that we recognized for pastshipments is fixed and is not subject to change.

***Long-lived assets***

We reviewlong-lived assets at least annually to determine if any adverse conditionsexist that would indicate impairment. Conditions that would trigger a more frequentimpairment assessment include, but are not limited to, a significant adversechange in certain agreements, or business climate that could affect the valueof an asset. We assess the recoverability of long-lived assets based on theprojected undiscounted future cash flows over the asset’s remaining life. Theamount of impairment, if any, is measured based on the excess of the carryingvalue over fair value. Fair value is generally calculated as the present valueof estimated future cash flows using a risk-adjusted discount rate, whichrequires significant management judgment with respect to revenue and expensegrowth rates, and the selection and use of an appropriate discount rate.

***Income tax asset valuation***

We record deferredtax assets and liabilities based on the net tax effects of tax credits,operating loss carryforwards and temporary differences between the carryingamounts of assets and liabilities for financial reporting purposes and theamounts used for income tax purposes. We then assess the likelihood that ourdeferred tax assets will be recovered from future taxable income and, to theextent we believe that recovery is not likely, we establish a valuationallowance. The valuation allowance is based on our estimate of future taxableincome and the period over which our deferred tax assets will be recoverable.At March 31, 2006, we believe that it is more likely than not that all ofour deferred tax assets will not be realized, and, accordingly, we haverecorded a valuation allowance against all of our deferred tax assets. Ifresults of operations in the future indicate that some or all of the deferredtax assets will be recovered, the reduction of the valuation allowance will berecorded as a tax benefit.

***Stock-based compensation***

We adopted theprovisions of Statement of Financial Accounting Standards 123(R), *“Share-Based Payment,”* (“SFAS 123(R)”),**onOctober 1, 2005 which requires us to measure compensation cost atthe grant date, based on the fair value of the award, and to recognize that costas an expense over the employee’s requisite service period (generally thevesting period of the equity award). Prior to October 1, 2005, weaccounted for stock-based compensation to employees in accordance withAccounting Principles Board Opinion No. 25,*“Accounting for Stock Issued to Employees,”* (“APB 25”) andrelated interpretations. We also followed the disclosure requirements ofStatement of Financial Accounting Standards No. 123,*“Accounting for Stock-Based Compensation”*(“SFAS 123”). We elected to adopt the modified prospective transitionmethod as provided by SFAS 123(R) and, accordingly, financialstatement amounts for the prior periods presented in this Form 10-Qhave not been restated to reflect the fair value method of expensingstock-based compensation.

Under SFAS 123(R),we determine the fair value of stock options awarded based on the grant-datefair value of the award using an option pricing model. Such an option pricingmodel requires us to make judgments for certain assumptions used, in particular,the expected term of the option and the expected 

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volatility over that term.We have determined the expected term using the midpoint between the vestingdate and the end of the contractual term for our options, also known as the “simplifiedmethod” described under Staff Accounting Bulletin No. 107, (“SAB 107”). Wehave determined our expected volatility based primarily on our historicalvolatility, however we have assigned a higher weighting to more recent periods.In addition, we have excluded the volatility of our stock for the periodfollowing our Initial Public Offering (“IPO”) in July 2000 to December 31,2000, because we believe this period to be an abnormality directly related toour IPO and therefore would not expect it to recur.

In determining theamount of expense to be recorded, judgment is also required to estimateforfeitures of the awards based on the probability of employees completing therequired service period. If actual forfeitures differ significantly from ourestimates, our results of operations could be materially impacted.

**Resultsof Operations**

**Threemonths ended March 31, 2006 compared to the three months ended March 31,2005**

Thefollowing table summarizes financial data for the periods indicated inthousands and as a percentage of net revenues and provides the changes inthousands and percentages:
| ** **            | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------|------------|------------------------------------------------------|------------|
| ** **            | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **            | ** ** | **Dollars**                                          | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues          |       | $                                                    | 28,036     |   | 100.0 | % | $ | 23,673 |   | 100.0 | % | $ | 4,363 |   | 18.4 | % |
| Gross profit          |       | 4,331                                                |       | 15.4 | % | 5,121 |   | 21.6 | % | (790 | ) | (15.4 | )% |
| Operating  expenses   |       | 7,181                                                |       | 25.6 | % | 6,471 |   | 27.3 | % | 710 |   | 11.0 | % |
| Loss from  operations |       | (2,850                                               | )          | (10.2 | )% | (1,350 | ) | (5.7 | )% | (1,500 | ) | (111.1 | )% |
| Net loss              |       | (2,460                                               | )          | (8.8 | )% | (1,112 | ) | (4.7 | )% | (1,348 | ) | (121.2 | )% |
|                       |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

# ***NetRevenues and Gross Profit (Loss)***

The followingtable summarizes our net revenues and gross profit (loss) by reportablesegment, in thousands and as a percentage of net revenues and provides thechanges in thousands and percentages:
| ** **              | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------|------------|------------------------------------------------------|------------|
| ** **              | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **              | ** ** | **Dollars**                                          | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| **OEM Appliance:**      |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net revenues            |       | $                                                    | 27,691     |   | 100.0 | % | $ | 23,588 |   | 100.0 | % | $ | 4,103 |   | 17.4 | % |
| Gross profit            |       | 4,638                                                |       | 16.7 | % | 5,184 |   | 22.0 | % | (546 | ) | (10.5 | )% |
|                    |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| **Distribution:**       |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net revenues            |       | 345                                                  |       | 100.0 | % | 85 |   | 100.0 | % | 260 |   | 305.9 | % |
| Gross loss              |       | (307                                                 | )          | (89.0 | )% | (63 | ) | (74.1 | )% | (244 | ) | (387.3 | )% |
|                    |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| **Total net revenues**  |       | 28,036                                               |       | 100.0 | % | 23,673 |   | 100.0 | % | 4,363 |   | 18.4 | % |
| **Total  gross profit** |       | 4,331                                                |       | 15.4 | % | 5,121 |   | 21.6 | % | (790 | ) | (15.4 | )% |
|                         |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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*** ***

***Net Revenues***

Our revenues are derivedfrom sales of server appliances primarily to our OEM network equipment and ISVpartners.

Our OEM Appliance segmentnet revenues increased in the three months ended March 31, 2006 primarilydue to an increase in sales volumes to EMC, partially offset by lower averageselling prices. Net revenues from sales to EMC represented 80% of OEM Appliancenet revenues in the three months ended March 31, 2006 versus 86% in thethree months ended March 31, 2005. In addition, net revenues from otherOEM Appliance partners for the three months ended March 31, 2006 increasedto $5.5 million from $3.4 million for the three months ended March 31,2005. This increase was broad based and included both new customers andincreased sales to existing customers, partially offset by decreases amongother customers.

Our Distribution segmentnet revenues for the three months ended March 31, 2006 were attributableto sales of NS Series Security Appliances. Because the market penetrationof these security appliances is in the early stages, we expect that it willtake several more quarters before revenues from our NS Series SecurityAppliances become significant.

***Gross profit (loss)***

Gross profit(loss) represents net revenues recognized less the cost of revenues. Cost ofrevenues includes cost of materials, warranty costs, inventory write-downs,shipping and handling costs, customer support costs, and manufacturing costs,which are primarily comprised of compensation, contract labor costs and, whenapplicable, contract manufacturing costs.

Gross profit inour OEM Appliance segment decreased for the quarter ended March 31, 2006,compared to the quarter ended March 31, 2005, primarily as a result oflower selling prices, partially offset by increased sales volumes. Gross profitas a percentage of net revenues in our OEM Appliance segment decreased for 2006compared to 2005. This is due primarily to changes in product mix andcompetitive price pressure, which was partially offset by higher sales volumes.The increase in gross loss and gross loss as a percentage of net revenues inour Distribution segment was attributable to increased sales discounts andpromotional activities in an attempt to raise awareness of our NS Series SecurityAppliances during the quarter ended March 31, 2006.

Gross profit inour OEM Appliance segment is affected by product mix, pricing and the volume ofserver appliance orders. OEM Appliance gross profit is also affected by the mixof product manufactured internally compared to product manufactured by acontract manufacturer, which results in higher manufacturing costs. We expectthat gross profit as a percentage of net revenue in our OEM segment for thethree months ended June 30, 2006 will be comparable to the three monthsended March 31, 2006. Because our NS Series Security Appliances arestill an emerging product, until sales volumes become significant, we do notexpect our Distribution segment to generate gross profit.

We expect grossprofit to continue to be affected by these factors in both the OEM Applianceand Distribution segments. We expect that the gross profits as a percentage ofrevenue on our NS Series Security Appliances will continue to besignificantly influenced by promotional pricing activities targeted atachieving market acceptance of these products.

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***Operating Expenses***

The most significant components of our operatingexpenses are research and development, selling and marketing, and general andadministrative expenses. The following table presents operating expenses duringthe periods indicated, in thousands and as a percentage of net revenues:
| ** **                 | ** ** | **Three Months Ended March 31,** | ** ** |
|----------------------------|------------|------------------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                 | ** ** | **Dollars**                                          | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating Expenses:        |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Research and development   |       | $                                                    | 2,182      |   | 7.8 | % | $ | 1,989 |   | 8.4 | % | $ | 193 |   | 9.7 | % |
| Selling and marketing      |       | 2,812                                                |       | 10.0 | % | 2,352 |   | 9.9 | % | 460 |   | 19.6 | % |
| General and administrative |       | 2,187                                                |       | 7.8 | % | 2,130 |   | 9.0 | % | 57 |   | 2.7 | % |
|                       |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total operating  expenses  |       | $                                                    | 7,181      |   | 25.6 | % | $ | 6,471 |   | 27.3 | % | $ | 710 |   | 11.0 | % |

***Research anddevelopment***

Research and developmentexpenses consist primarily of salaries and related expenses for personnelengaged in research and development, fees paid to consultants and outsideservice providers, material costs for prototype and test units and otherexpenses related to the design, development, testing and enhancements of ourserver appliance products. We expense all of our research and development costsas they are incurred. The following table summarizes the most significantcomponents of research and development expense for the periods indicated, inthousands and as a percentage of total research and development expense andprovides the changes in thousands and percentages: 
| ** **                            | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------------------|------------|------------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                                          | ** ** | **% of Expense  Category** | ** ** | **Dollars** | ** ** | **% of Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:            |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses     |       | $                                                    | 1,272      |   | 58 | % | $ | 1,179 |   | 59 | % | $ | 93 |   | 8 | % |
| Stock-based compensation              |       | 284                                                  |       | 13 | % | — |   | — |   | 284 |   | 100 | % |
| Prototype                             |       | 292                                                  |       | 13 | % | 282 |   | 14 | % | 10 |   | 4 | % |
| Consulting and outside services  |       | 148                                                  |       | 7 | % | 332 |   | 17 | % | (184 | ) | (55 | )% |
| Other                                 |       | 186                                                  |       | 9 | % | 196 |   | 10 | % | (10 | ) | (5 | )% |
|                                  |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total research  and development       |       | $                                                    | 2,182      |   | 100 | % | $ | 1,989 |   | 100 | % | $ | 193 |   | 10 | % |

Our research anddevelopment expenses have increased as a result of recognizing stock-basedcompensation and an increase in compensation and related costs partially offsetby a decrease in consulting and outside services. The increase in compensationand related expenses is attributable to increased headcount. We have increasedour research and development personnel to 44 at March 31, 2006 from 41 at March 31,2005. The decrease in consulting costs relates to the timing of certaindevelopment projects.

Our serverappliance development strategy emphasizes the utilization of standard serverappliance platforms, which utilize off-the-shelf components. However, we expectthat in some cases significant development efforts will be required to fulfillour current and potential ISV and network equipment partners’ needs usingcustomized platforms. In addition, we intend to focus our software developmentin areas that improve the ease of server appliance implementation and use,which we believe will enhance our value proposition. We expect that prototypeand consulting costs will be variable and could fluctuate depending on thetiming and magnitude of our server appliance development projects. We expect amodest increase in our research and development costs in the remainder offiscal 2006.

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***Selling and marketing***

Selling and marketing expenses consist primarily ofsalaries and commissions for personnel engaged in sales and marketing; costsassociated with our marketing programs, which include costs associated with ourattendance at trade shows, advertising, web site enhancements and productevaluation costs; consulting and outside services costs and travel. Thefollowing table summarizes the most significant components of selling andmarketing expense for the periods indicated in thousands and as a percentage oftotal selling and marketing expense and provides the changes in thousands andpercentages:
| ** **                        | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:            |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                    | 1,706      |   | 61 | % | $ | 1,386 |   | 59 | % | $ | 320 |   | 23 | % |
| Stock-based compensation          |       | 243                                                  |       | 9 | % | — |   | — |   | 243 |   | 100 | % |
| Marketing programs                |       | 495                                                  |       | 18 | % | 562 |   | 24 | % | (67 | ) | (12 | )% |
| Travel                            |       | 263                                                  |       | 9 | % | 231 |   | 10 | % | 32 |   | 14 | % |
| Consulting and outside services   |       | 39                                                   |       | 1 | % | 4 |   | 0 | % | 35 |   | 875 | % |
| Other                             |       | 66                                                   |       | 2 | % | 169 |   | 7 | % | (103 | ) | (61 | )% |
|                              |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total selling  and marketing      |       | $                                                    | 2,812      |   | 100 | % | $ | 2,352 |   | 100 | % | $ | 460 |   | 20 | % |

 

As indicated in the table above, the primary componentsof the increase in selling and marketing expenses are compensation and relatedexpenses and stock-based compensation. The increase in compensation and relatedexpense primarily relates to  to ouraddition of a European sales force.

Currently our Distribution segment by its natureincurs more of the marketing and sales burden of the products that it sells andmust engage in a higher level of marketing program activities than our OEMAppliance segment. Sales in our OEM Appliance segment are to our ISV andnetwork equipment partners who market and sell their products, whichincorporate our server appliances. As a result, our OEM Appliance segmentengages in a limited level of marketing programs.

We believe that we must continue our selling andmarketing efforts in order to enhance our position as a leading provider ofserver appliance products and to establish ourselves as a leader in networksecurity appliances. Variable marketing costs, such as marketing programs, aresomewhat dependent on the timing and magnitude of new product introductions andwill fluctuate depending on the level of this activity. We expect increases inselling and marketing expenses in the remainder of fiscal 2006 in an effort togain recognition in the market for our NS Series Security Appliances.

***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 costs of compliance with theSarbanes-Oxley Act; and director and officer insurance. The following tablesummarizes the most significant components of general and administrativeexpense for the periods indicated in thousands and as a percentage of totalgeneral and administrative expense and provides the changes in thousands andpercentages:

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| ** **                           | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and  administrative          |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                    | 812        |   | 37 | % | $ | 735 |   | 35 | % | $ | 77 |   | 10 | % |
| Stock-based compensation             |       | 215                                                  |       | 10 | % | — |   | — |   | 215 |   | 100 | % |
| Consulting and professional services |       | 635                                                  |       | 29 | % | 965 |   | 45 | % | (330 | ) | (34 | )% |
| Director and officer insurance       |       | 231                                                  |       | 11 | % | 238 |   | 11 | % | (7 | ) | (3 | )% |
| Other                                |       | 294                                                  |       | 13 | % | 192 |   | 9 | % | 102 |   | 53 | % |
|                                 |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total general  and administrative    |       | $                                                    | 2,187      |   | 100 | % | $ | 2,130 |   | 100 | % | $ | 57 |   | 3 | % |

 

As indicated in the table above, the general and administrativeexpenses remained relatively constant in the three months ended March 31,2006 versus the three months ended March 31, 2005.  This was a result of increases in compensationand related expenses, stock-based compensation and other costs being offset bya decrease in consulting and professional services.  At March 31, 2005, we had 24 employees inour general and administrative department compared to 26 employees at March 31,2006. The decrease in consulting and professional services is due primarily toa decrease in costs associated with Sarbanes-Oxley compliance now that we arein our second year of implementation, and a decrease in legal costs associatedwith the timing of certain litigation activities. We expect general andadministrative expenses to remain consistent over the remainder of fiscal 2006.

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

Interest and other income, net increased to $390,000for the three months ended March 31, 2006 from $238,000 for the threemonths ended March 31, 2005. This increase is primarily due to higherinterest rates earned on our cash, cash equivalents, and short-terminvestments.

**Sixmonths ended March 31, 2006 compared to the six months ended March 31,  2005**

Thefollowing table summarizes financial data for the periods indicated inthousands and as a percentage of net revenues and provides the changes inthousands and percentages:

 
| ** **            | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------|------------|----------------------------------------------------|------------|
| ** **            | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **            | ** ** | **Dollars**                                        | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues          |       | $                                                  | 55,305     |   | 100.0 | % | $ | 50,632 |   | 100.0 | % | $ | 4,673 |   | 9.2 | % |
| Gross profit          |       | 8,992                                              |       | 16.3 | % | 10,164 |   | 20.1 | % | (1,172 | ) | (11.5 | )% |
| Operating  expenses   |       | 13,786                                             |       | 24.9 | % | 13,225 |   | 26.1 | % | 561 |   | 4.2 | % |
| Loss from  operations |       | (4,794                                             | )          | (8.7 | )% | (3,061 | ) | (6.0 | )% | (1,733 | ) | (56.6 | )% |
| Net loss              |       | (4,084                                             | )          | (7.4 | )% | (2,661 | ) | (5.3 | )% | (1,423 | ) | (53.5 | )% |
|                       |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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# ***NetRevenues and Gross Profit (Loss)***

The followingtable summarizes our net revenues and gross profit (loss) by reportablesegment, in thousands and as a percentage of net revenues and provides thechanges in thousands and percentages:

 
| ** **              | ** ** | **Six Months Ended March 31,** | ** ** |
|-------------------------|------------|----------------------------------------------------|------------|
| ** **              | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **              | ** ** | **Dollars**                                        | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| **OEM Appliance:**      |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Net revenues            |       | $                                                  | 54,703     |   | 100.0 | % | $ | 45,890 |   | 100.0 | % | $ | 8,813 |   | 19.2 | % |
| Gross profit            |       | 9,610                                              |       | 17.6 | % | 9,841 |   | 21.4 | % | (231 | ) | (2.3 | )% |
|                    |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| **Distribution:**       |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Net revenues            |       | 602                                                |       | 100.0 | % | 4,742 |   | 100.0 | % | (4,140 | ) | (87.3 | )% |
| Gross profit (loss)     |       | (618                                               | )          | (103 | )% | 323 |   | 6.8 | % | (941 | ) | (291.3 | )% |
|                    |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| **Total net revenues**  |       | 55,305                                             |       | 100.0 | % | 50,632 |   | 100.0 | % | 4,673 |   | 9.2 | % |
| **Total  gross profit** |       | 8,992                                              |       | 16.3 | % | 10,164 |   | 20.1 | % | (1,172 | ) | (11.5 | )% |
|                         |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Net Revenues***

Our OEM Appliance segmentnet revenues increased in the six months ended March 31, 2006 primarilydue to an increase in sales volumes to EMC, partially offset by lower averageselling prices. Net revenues from sales to EMC represented 82% of OEM Appliancenet revenues in the six months ended March 31, 2006 versus 84% in the sixmonths ended March 31, 2005. In addition, net revenues to other OEMAppliance partners for the six months ended March 31, 2006 increased to$10.0 million from $7.1 million for the six months ended March 31, 2005.This increase was broad based and included both new customers and increasedsales to existing customers, partially offset by decreases among othercustomers.

Our Distribution segmentnet revenues for the six months ended March 31, 2006 were attributable tosales of NS Series Security Appliances. Because the market penetration ofthese security appliances is in the early stages, we expect that it will takeseveral more quarters before revenues from our NS Series SecurityAppliances become significant. In the quarter ended December 31, 2004, wediscontinued sales of third-party data storage networking products. Our netrevenues in the six months ended March 31, 2005 from these products wereprimarily the result of our focus on disposing of existing on-hand inventoriesand represented our final sales of these products.

***Gross profit (loss)***

Gross profit andgross profit as a percentage of net revenue in our OEM Appliance segmentdecreased for the six months ended March 31, 2006, compared to the sixmonths ended March 31, 2005, primarily as a result of competitive pricingpressure resulting in lower average selling prices, partially offset by highersales volumes attributable to a change in our product mix. The decrease ingross profits and gross profits as a percentage of net revenues in our Distributionsegment was attributable to our exit from distributing third-party data storagenetworking products combined with low sales volume of our NS Series SecurityAppliances during the six months ended March 31, 2006.

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***Operating Expenses***

The following table presents operating expenses duringthe periods indicated, in thousands and as a percentage of net revenues:
| ** **                 | ** ** | **Six Months Ended March 31,** | ** ** |
|----------------------------|------------|----------------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                 | ** ** | **Dollars**                                        | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating Expenses:   |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Research and development   |       | $                                                  | 4,202      |   | 7.6 | % | $ | 3,968 |   | 7.8 | % | $ | 234 |   | 5.9 | % |
| Selling and marketing      |       | 5,590                                              |       | 10.1 | % | 4,777 |   | 9.4 | % | 813 |   | 17.0 | % |
| General and administrative |       | 3,994                                              |       | 7.2 | % | 4,114 |   | 8.1 | % | (120 | ) | (2.9 | )% |
| Restructuring charge       |       | —                                             |       | — |   | 366 |   | 0.7 | % | (366 | ) | (100.0 | )% |
|                       |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total operating  expenses  |       | $                                                  | 13,786     |   | 24.9 | % | $ | 13,225 |   | 26.1 | % | $ | 561 |   | 4.2 | % |

***Research anddevelopment***

The following tablesummarizes the most significant components of research and development expensefor the periods indicated, in thousands and as a percentage of total researchand development expense and provides the changes in thousands and percentages: 
| ** **                        | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                        | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:        |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                  | 2,489      |   | 59 | % | $ | 2,255 |   | 57 | % | $ | 234 |   | 10 | % |
| Stock-based compensation          |       | 538                                                |       | 13 | % | — |   | 0 | % | 538 |   | 100 | % |
| Prototype                         |       | 389                                                |       | 9 | % | 601 |   | 15 | % | (212 | ) | (35 | )% |
| Consulting and outside services   |       | 376                                                |       | 9 | % | 675 |   | 17 | % | (299 | ) | (44 | )% |
| Other                             |       | 410                                                |       | 10 | % | 437 |   | 11 | % | (27 | ) | (6 | )% |
|                              |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total research  and development   |       | $                                                  | 4,202      |   | 100 | % | $ | 3,968 |   | 100 | % | $ | 234 |   | 6 | % |

Our research anddevelopment expenses have increased as a result of recognizing stock-basedcompensation and an increase in compensation and related costs partially offsetby decreases in prototype development and consulting and outside services. Theincrease in compensation and related expenses is attributable to increasedheadcount. We have increased our research and development personnel to 44 at March 31,2006 from 41 at March 31, 2005. The decreases in prototype and consultingcosts relate to the timing of certain development projects specifically withour largest OEM customer.

***Selling and marketing***

The following table summarizes the most significantcomponents of selling and marketing expense for the periods indicated inthousands and as a percentage of total selling and marketing expense andprovides the changes in thousands and percentages:

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| ** **                        | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                        | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:            |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                  | 3,213      |   | 57 | % | $ | 2,996 |   | 63 | % | $ | 217 |   | 7 | % |
| Stock-based compensation          |       | 409                                                |       | 7 | % | — |   | — |   | 409 |   | 100 | % |
| Marketing programs                |       | 932                                                |       | 17 | % | 955 |   | 20 | % | (23 | ) | (2 | )% |
| Travel                            |       | 529                                                |       | 9 | % | 355 |   | 7 | % | 174 |   | 49 | % |
| Consulting and outside services   |       | 280                                                |       | 5 | % | 14 |   | 0 | % | 266 |   | 1900 | % |
| Other                             |       | 227                                                |       | 4 | % | 457 |   | 10 | % | (230 | ) | (50 | )% |
|                              |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total selling  and marketing      |       | $                                                  | 5,590      |   | 100 | % | $ | 4,777 |   | 100 | % | $ | 813 |   | 17 | % |

 

As indicated in the table above, the primarycomponents of the increase in selling and marketing expenses are stock-basedcompensation, compensation and related expenses, consulting and outsideservices and travel. Our compensation and related expenses, consulting andoutside services and our travel expenses have increased significantly as aresult of our continued expansion of our European sales presence during the sixmonths ended March 31, 2006. For the six months ended March 31, 2005,we had not yet established our sales operations in Europe. These increases arepartially offset by decreases from terminations and attrition related to ourdecision to discontinue the distribution of third-party data storage networkingproducts.

***General and administrative***

The following table summarizes the most significantcomponents of general and administrative expense for the periods indicated inthousands and as a percentage of total general and administrative expense andprovides the changes in thousands and percentages:

 
| ** **                           | ** ** | **Six Months Ended March 31,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                        | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and  administrative:         |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                  | 1,501      |   | 38 | % | $ | 1,495 |   | 36 | % | $ | 6 |   | 0 | % |
| Stock-based compensation             |       | 339                                                |       | 8 | % | — |   | 0 | % | 339 |   | 100 | % |
| Consulting and professional services |       | 1,180                                              |       | 30 | % | 1,601 |   | 39 | % | (421 | ) | (26 | )% |
| Director and officer insurance       |       | 462                                                |       | 12 | % | 476 |   | 12 | % | (14 | ) | (3 | )% |
| Bad debts                            |       | (26                                                | )          | (1 | )% | 30 |   | 1 | % | (56 | ) | (187 | )% |
| Other                                |       | 538                                                |       | 13 | % | 512 |   | 12 | % | 26 |   | 5 | % |
|                                 |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total general  and administrative    |       | $                                                  | 3,994      |   | 100 | % | $ | 4,114 |   | 100 | % | $ | (120 | ) | (3 | )% |

 

As indicated in the table above, the primarycomponents of the decrease in general and administrative expenses areconsulting and professional services. This decrease was partially offset by theaddition of stock-based compensation. The decrease in consulting andprofessional services is due primarily to a decrease in costs associated withSarbanes-Oxley compliance now that we are in our second 

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year of implementation,and a decrease in legal costs associated with the timing of certain litigationactivities.

***Restructuring charge***

During the three months ended December 31, 2004,we recorded a restructuring of approximately $366,000 related to our exit fromthat portion of the business related to the distribution of third-party datastorage networking products. Approximately $283,000 of the charge related toone-time employee benefits associated with terminating certain employees inthat portion of the business during the quarter. We also incurred $83,000 for afixed payment related to our warranty fulfillment contract with an externalservice provider.

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

Interest and other income, net increased to $710,000for the six months ended March 31, 2006 from $400,000 for the six monthsended March 31, 2005. This increase is primarily due to higher interestrates earned on our cash, cash equivalents, and short-term investments.

**Liquidity and Capital Resources**

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

 

|                                                  | ** ** | **Six Months Ended  March 31,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                       | ** ** | **2005** | ** ** |
|                                             | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Net loss                                         |       | $                                              | (4,084     | ) | $ | (2,661 | ) |
| Non-cash  adjustments to net loss                |       | 1,886                                          |       | 671 |   |
| Changes in  working capital                      |       | (1,528                                         | )          | 7,627 |   |
|                                             |       |                                           |       |   |   |
| Cash (used in)  provided by operating activities |       | (3,726                                         | )          | 5,637 |   |
|                                             |       |                                           |       |   |   |
| Cash provided by  (used in) investing activities |       | 3,337                                          |       | (6,176 | ) |
| Cash provided by  financing activities           |       | 337                                            |       | 248 |   |
|                                             |       |                                           |       |   |   |
| Decrease in cash  and cash equivalents           |       | (52                                            | )          | (291 | ) |
| Beginning cash  and cash equivalents             |       | 9,468                                          |       | 12,974 |   |
|                                             |       |                                           |       |   |   |
| Ending cash and cash  equivalents                |       | $                                              | 9,416      |   | $ | 12,683 |   |

 

The following table presents our short-terminvestments as of the periods indicated (in thousands):

 

|                        | ** ** | **March 31,  2006** | ** ** | **September 31,  2005** | ** ** |
|------------------------|------------|--------------------------|------------|------------------------------|------------|
|                   | ** ** | ** **               | ** ** | ** **                   | ** ** |
| Short-term investments |       | $                        | 24,286     |                         | $          | 27,894 |   |
|                        |            |                          |            |                              |            |  |  |

 

 

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***OperatingActivities***

Cash flows used in operating activities for the six months ended March 31, 2006 isprimarily a result of the net loss of $4.1 million for the period partiallyoffset by non-cash adjustments to the net loss of $1.9 million and a decreasein working capital of $1.5 million. The most significant non-cash adjustment tonet loss for the six months ended March 31, 2006 was $1.4 million ofstock-based compensation expense, which we were not required to record in thesix months ended March 31, 2005. The most significant changes in workingcapital for the six months ended March 31, 2006 were an increase in theaccounts receivable balance of $4.0 million partially offset by an increase inthe accounts payable balance of $2.7 million. Cash flows provided by operationsfor the six months ended March 31, 2005, included significant cash flowsfrom the changes in working capital as a result of our exit from thedistribution of third-party storage networking products.

***InvestingActivities***

 Cash flows providedby investing activities during the six months ended March 31, 2006consisted of net proceeds received from the maturity of our short-terminvestments of approximately $3.6 million. This increased cash flow was offsetby the purchase of property and equipment of approximately $350,000.

***FinancingActivities***

Cash flows provided by financing activities primarilyconsisted of cash received as a result of employee stock option and stockpurchase plan activity of $346,000 in the six months ended March 31, 2006.We expect employee stock option and stock purchase plan activity to continue infiscal 2006, however we cannot predict its level given the volatility ofcapital markets.

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

·                  the timing and size of orders fromour largest customer;

·                  the level of success of our OEMAppliance partners in selling server appliance solutions that include ourserver appliance hardware platforms;

·                  the level of investment required fordevelopment and sales and marketing related to our NS Series SecurityAppliances;

·                  our ability to integrate third partysoftware applications on our NS Series appliances that are being demandedby the marketplace

·                  our ability to enter into agreementswith distributors, value added resellers and system integrators and theirability to sell our NS Series Security Appliances;

·                  our ability to market and sell our NSSeries Security Appliances;

·                  our ability to form an adequatenumber of OEM partnerships with network equipment providers and ISVs;

·                  the costs and timing of productengineering efforts and the success of these efforts;

·                  the outcome of pending litigation;and

·                  marketdevelopments.

We believe thatour available cash resources, including cash, cash equivalents and short terminvestments, and cash that we expect to generate from sales of our productswill be sufficient to meet our operating and capital requirements through atleast the next twelve months. After that, we may need to raise additional funds.We may in the future seek to raise additional funds through borrowings, publicor private equity financings or from other sources. There can be no assurancethat additional financing will be available at all or, if available, will be onterms acceptable to us. If additional financing is needed and is not availableon acceptable terms, we may need to reduce our operating expenses.

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***ContractualObligations and Commitments***

The following table sets forth certain informationconcerning our obligations and commitments to make certain payments (inthousands).
| ** **      | ** ** | **Payments Due by Period** | ** ** |
|-----------------|------------|-------------------------------------------|------------|
| ****            | ** ** | **Less than  1 Year**           | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **After   5 Years** | ** ** | **Total** | ** ** |
|            |       |                                      |       |   |   |   |   |   |   |   |   |
| Operating lease |       | $                                         | 610        |   | $ | — |   | $ | — |   | $ | — |   | $ | 610 |   |
| Capital lease   |       | 24                                        |       | 48 |   | 30 |   | - |   | 102 |   |
|            |       |                                      |       |   |   |   |   |   |   |   |   |
| Total           |       | $                                         | 634        |   | $ | 48 |   | $ | 30 |   | $ | — |   | $ | 712 |   |

 

**Off-BalanceSheet 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 anytransactions with unconsolidated entities whereby the Company has subordinatedretained interests, derivative instruments or other contingent arrangementsthat expose the Company to material continuing risks, contingent liabilities,or any other obligation under a variable interest in an unconsolidated entitythat provides financing, liquidity, market risk or credit risk support to theCompany.

**RelatedParty Transactions**

Robert M. Wadsworth, one of the Company’s directors,is a managing director of the limited liability corporation that controlsHarbourVest Partners (and its affiliates), one of the Company’s significantstockholders. Mr. Wadsworth, is also a director of PSI Holding Group, Inc.(“PSI”), the parent company of Akibia, Inc. (“Akibia”). During the threeand six months ended March 31, 2006 and 2005, HarbourVest owned greaterthan 5% of the outstanding stock of the Company and greater than 5% of theoutstanding stock of PSI. While the Company was selling third-party datastorage networking products it engaged Akibia to provide certain customersupport and warranty fulfillment services related to the Company’s sales ofHBAs. The Company’s agreement with Akibia expired in March 2005 asscheduled. However, the terms of the agreement required Akibia fulfill thewarranty services for the entire warranty period. Akibia charged the Company aquarterly fixed fee of $83,000 and a variable fee based upon the Company’ssales of HBAs which ended December 2004. In the three and six months endedMarch 31, 2005, the Company recognized $0 and $201,000, respectively, ofexpense as a result of its HBA customer support and warranty fulfillmentservices agreements with Akibia. The Company recognized no such expense in thethree or six months ended March 31, 2006. In connection with this customersupport and warranty fulfillment services agreement, the Company also sold HBA’sto Akibia to allow Akibia to fulfill the Company’s warranty obligations forthese products. In the three and six months ended March 31, 2005, theCompany recorded revenues of approximately $0 and $40,000, respectively, fromsales of HBAs to Akibia. The Company recorded no such revenues in the three orsix months ended March 31, 2006. There were no amounts receivable from orpayable to Akibia at March 31, 2006 or September 30, 2005. In November 2005,Mr. John A. Blaeser, one of the Company’s directors, also joined the boardof directors of Akibia.

Mr. Wadsworthalso serves as a director of Innoveer Solutions, Inc. (“Innoveer”),formerly Akibia Consulting, and previously a subsidiary of Akibia. The Companyengages Innoveer to provide professional services related to modifications ofits Customer Resource Management (“CRM”) software system. During the three andsix months ended March 31, 2006, the Company incurred approximately$18,000 and $47,000, respectively, related to these services. During the threeand six months ended March 31, 2005, the Company incurred approximately $12,000related to these services. The Company owed Innoveer $4,000 at March 31,2006. There were no amounts outstanding to Innoveer at September 30, 2005.

29

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Additionally, theCompany engaged the consulting services of Mapleworks Technologies (“Mapleworks”),a software development services provider. Both Mr. Blaeser and Mr. Wadsworthare investors in Mapleworks and are members of its board of advisors. For thethree and six months ended March 31, 2006 the Company incurred $38,000 and$83,000, respectively, in fees for these consulting services. The Company hadno amounts outstanding to Mapleworks at March 31, 2006 and September 30,2005.

**Recent AccountingPronouncements**

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards 123(revised 2004), “Share-Based Payment” (“SFAS 123(R)”). SFAS 123(R) is arevision of FASB Statement No. 123, “Accounting for Stock-BasedCompensation”, supersedes Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees”, and amends FASB Statement No. 95, “Statementof Cash Flows”. SFAS 123(R) requires all share-based payments toemployees, including grants of employee stock options and stock purchases underemployee stock purchase plans, to be recognized in the financial statementsbased on their fair values. We adopted SFAS 123(R) using the modifiedprospective method during the quarter ended December 31, 2005. As noted infootnote 3 to our Condensed Consolidated Financial Statements, the adoption ofSFAS 123(R) had a material impact on our consolidated statements ofoperations and net loss per share.

**ITEM 3.   QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

We do not engage in any foreign currency hedgingtransactions and therefore, do not believe we are subject to material exchangerate risk. We are exposed to market risk related to changes in interest rates.We invest excess cash balances in cash equivalents and short-term investmentsand as a result, we believe that the effect, if any, of reasonably possiblenear-term changes in interest rates on our financial position, results ofoperations and cash flows will not be material. In addition, a hypothetical 10%increase or decrease in interest rates would not have a material adverse effecton our financial condition.

**ITEM 4.   CONTROLS ANDPROCEDURES**

Our management, with the participation of our chiefexecutive officer and chief financial officer, evaluated the effectiveness ofour disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act) as of March 31,2006. Based on this evaluation, our chief executive officer and chief financialofficer concluded that, as of March 31, 2006, our disclosure controls andprocedures (1)  were designed to effectively accumulate and communicateinformation to the Company’s management, as appropriate, to allow timelydecisions regarding required disclosure  (2) wereeffective, in that they provide reasonable assurance that information requiredto be disclosed by the Company in the reports that it files or submits underthe Securities Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms.

No change in ourinternal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) occurred during the three monthsended March 31, 2006 that has materially affected, or is reasonably likelyto materially affect, our internal control over financial reporting.

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**PART II—OTHERINFORMATION**

**ITEM 1.    LEGALPROCEEDINGS**

*Announcement Timing Lawsuit*

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

Since that time theparties engaged in some informal discovery, have exchanged formal discoveryrequests, and then pursued active settlement discussions. On March 31,2006, the parties filed a motion for preliminary approval of a class actionsettlement. On April 4, 2006, the Court entered an Order preliminarilyapproving the settlement and scheduled deadlines for the settlement approvalprocess, including scheduling a settlement conference for July 25, 2006. Thesettlement is subject to a notice and comment period, during which classmembers may object, opt out of the settlement, or file claims under thesettlement. The terms of the settlement require our insurance provider to pay$2,875,000 in full settlement of the claims asserted by the class. As a resultat March 31, 2006, we recorded accrued litigation settlement and areceivable for insurance recovery in the amount of $2,875,000.

*Initial Public Offering Lawsuit*

On or about December 3, 2001, a putative classaction lawsuit was filed in the United States District Court for the SouthernDistrict of New York against us, Lawrence A. Genovesi (our former Chairman andChief Executive Officer), Douglas G. Bryant (our Chief Financial Officer andVice President of Finance and Administration), and the following underwritersof our initial public offering: FleetBoston Robertson Stephens, Inc.,Credit Suisse First Boston Corp., Goldman Sachs & Co., Lehman BrothersInc. and Salomon Smith Barney, Inc. (collectively, the “UnderwriterDefendants”). An amended class action complaint, captioned in re NetworkEngines, Inc. Initial Public Offering Securities Litigation, 01 Civ. 10894(SAS), was filed on April 20, 2002.

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

In July 2002, we, Lawrence A. Genovesi andDouglas G. Bryant joined in an omnibus motion to dismiss the suit challengingthe legal sufficiency of plaintiffs’ claims. The motion was filed on behalf ofhundreds of issuer and individual defendants named in similar lawsuits.Plaintiffs opposed the motion, and 

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the Courtheard oral argument on the motion in November 2002. On February 19,2003, the Court issued an opinion and order denying the motion as to us.However, in October 2002, Lawrence A. Genovesi and Douglas G. Bryant weredismissed from this case without prejudice.

On July 9, 2003, a Special Committee of our Boardof Directors authorized us to negotiate a settlement of the pending claimssubstantially consistent with a memorandum of understanding negotiated amongclass plaintiffs, all issuer defendants and their insurers. The parties havenegotiated the settlement, which provides, among other things, for a release ofus and the Individual Defendants for the conduct alleged in the amendedcomplaint to be wrongful. We would agree to undertake other responsibilitiesunder the settlement, including agreeing to assign, or not assert, certainpotential claims that we may have against the underwriters. Any directfinancial impact of the proposed settlement is expected to be borne by ourinsurers. Any such settlement would be subject to various contingencies,including approval by the Court overseeing the litigation. On February 15,2005, the Court issued an Opinion and Order preliminarily approving thesettlement, provided that the defendants and plaintiffs agree to a modificationnarrowing the scope of the bar order set forth in the original settlementagreement.  The parties agreed to a modification narrowing the scope ofthe bar order, and on August 31, 2005, the Court issued an orderpreliminarily approving the settlement. We are unable to predict the outcome ofthis suit and as a result, have not accrued any amounts as of March 31,2006.

**ITEM 1A. RISK FACTORS**

The risks and uncertainties described below are notthe only ones we are faced with. Additional risks and uncertainties notpresently known to us, or that are currently deemed immaterial, may also impairour business operations. If any of the following risks actually occur, ourfinancial condition and operating results could be materially adverselyaffected.

***Risksof dependence on one strategic partner.***

**We derive a significantportion of our revenues from sales of server appliances directly to EMC throughour OEM Appliance segment and our revenues may decline significantly if thiscustomer cancels or delays purchases of our products, terminates itsrelationship with us, or exercises certain of its contractual rights.**

In the six months ended March 31, 2006 and 2005,sales directly to EMC, our largest customer, accounted for 81% and 77% of ourtotal net revenues and 82% and 84% of our OEM Appliance revenues, respectively.Primarily all of these sales are attributable to one OEM Appliance productpursuant to a non-exclusive contract. We anticipate that our future operatingresults will continue to depend heavily on sales to, and our relationship with,this customer. Accordingly, the success of our business will depend, in largepart, on this customer’s willingness to continue to utilize our serverappliance solutions in its existing and future products. Further, our financialsuccess is dependent upon the future success of the products we sell to thiscustomer and the continued growth, viability and financial stability of thiscustomer, whose industry has experienced rapid technological change, shortproduct life cycles, consolidation and pricing and margin pressures. Asignificant reduction in sales to this customer, or significant pricing andadditional margin pressures exerted on us by this customer, would have amaterial adverse effect on our results of operations. In addition, if thiscustomer delays or cancels purchases of our products, our operating resultswould be harmed and our ability to accurately predict revenues, profitabilityand cash flows would decrease.

Under the terms of our non-exclusive contract, thiscustomer has the right to enter into agreements with third parties for similarproducts, is not obligated to purchase any minimum quantity of products from usand may choose to stop purchasing from us at any time, with or without cause. Inaddition, this customer may terminate the agreement in the event that weattempt to assign our rights under the agreement to another party without thiscustomer’s prior approval. Furthermore, in the event that we default on certainportions of the agreement, this customer has the right to manufacture certainproducts in exchange for a mutually agreeable royalty fee. If any of theseevents were to occur, or if this customer were to delay or discontinuepurchases of our products as a result of dissatisfaction or otherwise, ourrevenues and 

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operating results wouldbe materially adversely affected and our reputation in the industry mightsuffer and our ability to accurately predict revenues, profitability and cashflows would decrease.

***Risksrelated to business strategy.***

**If potential customers donot accept our NS Series Security Appliances as a solution to certain oftheir network security needs, our business will be adversely affected.**

We currently expect that future Distribution segmentrevenues will be primarily generated through sales of our NS Series SecurityAppliances and the related maintenance service, and we will not succeed if themarket does not accept these products and services as a viable solution tocertain network security needs. Our NS Series Security Appliances arepowered by Microsoft’s Internet Server Acceleration (“ISA”) Server 2004software application. If customers don’t perceive this application to betechnically superior to other competitive security products or if customers don’tbelieve that our security appliance will provide increased security forMicrosoft applications, then our future revenues and operating results willsuffer. We also may not be successful in marketing and selling these productsin the future if we are unable to educate and train channel customers on ourproduct line, or if we are unable to gain market acceptance of these products.

Sales of NS Series Security Appliances throughour Distribution segment requires a greater selling and marketing burden thanany of our other server appliance products. We may find the selling andmarketing burden to be greater than was originally planned. We have investedand plan to continue to invest in a significant level of sales and marketingresources and programs along with engineering resources for the continueddevelopment of our NS Series Security Appliances. If we are unable togenerate sufficient revenues to recover these costs and achieve an appropriategross profit, our operating results will suffer. To date, we have been unableto achieve substantial sales of these server appliances and there is noguarantee that we will be able to achieve substantial amounts of such sales inthe future. If we are unable to generate sufficient revenues by leveraging ourDistribution operation to increase sales of server appliances in a costeffective and timely manner, our operating results may suffer and we maydetermine that we need to increase our investment in this business, therebyincreasing our costs and increasing our losses, or we may determine that wemust discontinue this component of our business strategy, any of which couldnegatively affect our business.

**Market acceptance anddemand of Microsoft’s ISA Server 2004 software will depend on Microsoft’sdecision to prioritize and concentrate its marketing efforts for this software.**

**Because our NS Series line ofsecurity appliances are powered by Microsoft’s ISA Server 2004, our successwill depend on the extent the marketplace perceives this software as superiorto other forms of security protection. We believe this perception will bedetermined substantially as a result of marketing efforts undertaken byMicrosoft directly. In order to achieve broad recognition that ISA Server 2004provides necessary protection of specific Microsoft applications better thanother competing products, we will rely to a significant extent on Microsoft’sfinancial and technical resources to educate its channel of certified resellersand, equally as important, the ultimate end-users. If Microsoft does notprioritize these marketing and promotional campaigns, or delays the timing ofsuch programs, then we may not achieve significant sales of our NS Series SecurityAppliances, which may adversely affect our business.**

Even if Microsoft’s ISA Server 2004 software is widelyaccepted as the best protection of Microsoft applications, customers may chooseto purchase ISA Server 2004 in the form of software instead of a serverappliance. Although many network security applications are sold in the form ofan appliance to allow for better deployment, management and security, Microsoftcould continue to sell and/or customers may elect to purchase ISA Server 2004in the form of software only or may choose to purchase appliances from othervendors. If Microsoft does not promote the advantages of ISA Server 2004 in theform of a server appliance, this would have a negative impact on our business.

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**If we fail to engage witha significant number of new distributors, resellers and systems integratorscapable of selling our NS Series Security Appliances, our revenues andoperating results may be adversely affected.**

In order for our NS Series Security Appliances tobe successful we believe we must establish a two tiered distribution channeldistributors, backed by quality value added resellers (or VARs) and systemsintegrators that are familiar with Microsoft products or the network securitymarket and are committed to sell our security appliances. To date, we haveengaged with distributors in North America, Europe, the Middle East and SouthAfrica. Microsoft has been instrumental in our entering certain of thesedistribution agreements. Also, many of the North American resellerrelationships were derived through working closely with Microsoft’s sales andmarketing team.   As such, we believethat signing additional distributors and resellers will continue to depend, inpart, on our relationship with Microsoft, and our ability to leverage thatrelationship to gain access to quality VARs and system integrators. Therefore,we will need to further establish and strengthen our relationship withMicrosoft in order to be considered a preferred provider of Microsoft ISAServer 2004 in the form of an appliance. Additionally, we must effectivelymanage our relationships with our distributors to gain access to theirresellers, direct marketers and marketing programs. If we fail to strengthenour relationship with Microsoft enabling us to enter into partnerships with asignificant number of new resellers and systems integrators, or are unable tomaintain a two-tiered distribution channel our revenues and operating resultsmay be adversely affected.

In addition, because our channel of distributors, VARsand system integrators have the ability to sell products and services that arecompetitive with ours, to devote more resources to those competitive productsor to cease selling our products and services altogether, we will need toeducate and train our reseller partners on the benefits of Microsoft ISA Server2004 and the added value of selling this application in the form of our NS Series SecurityAppliances. Additionally, we will need to effectively market to end-users ofour NS Series Security Appliances to educate them on the value of deployingISA Server 2004 in the form of an appliance in order to stimulate demand in thedistribution channel.

If we are not successful in marketing to resellers andend-users, training our resellers, or if these resellers are not committed tosell our security appliances, our revenue growth may be limited and ouroperating results may be adversely affected. Further, to entice these resellersto sell our security appliances we may be required to offer certain financialincentives that would result in a reduction of revenues or an increase inoperating expenses, which would adversely affect our operating results.

**We may not be able toeffectively commercialize our NS Series Security Appliances if we cannotcontinue to license or integrate third-party security applications that areessential for the functionality of these appliances.**

We believe our success will significantly depend onour ability to license or integrate security applications from additionalthird-parties that would be incorporated in our NS Series SecurityAppliances. Because we do not currently know with certainty which of theseprospective technologies will be desired in the marketplace, we may incorrectlyinvest in development or prioritize our efforts to integrate these technologiesin our NS Series Security Appliances.   Additionally, even if we correctly focus ourefforts, there can be no assurance that we will select the preferred providerof these technologies, or that the third-party provider will be committed tothe relationship and integration of their technology or that we will be able tointegrate these technologies in a timely manner. If we are unable tosuccessfully integrate these third-party technologies in a timely manner, ourNS Series Security Appliances may be inferior with other competitiveproducts in the marketplace, which may adversely affect the results of ouroperations and our ability to grow our Distribution segment business.

We also believe our success will depend on ourcontinued ability to license or integrate technology  from Microsoft that is essential for thefunctionality of our security appliances. A material adverse change in ourrelationship with Microsoft or the functionality of its software would have asignificant adverse result on our Distribution segment operations. We depend onMicrosoft to deliver reliable, high-quality software, develop new software on atimely and cost-effective basis and respond to evolving technology and changesin industry standards. Further, ifMicrosoft does not continue to make ISA Server 2004 

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availableto OEM customers on a favorable basis, our ability to sell our NS Series SecurityAppliances may be substantially reduced.

**If we are unable toleverage the existing customers and sales, channel and marketing organizationsof third-party security application partners for our NS Series SecurityAppliances, the growth of our business may be limited.**

**Our sales and marketingorganization for our NS Series Security Appliances is relatively small andwe believe that we need to partner with application providers that haveexisting customers as well as sales, channel and marketing organizations thatwe can leverage for the sale of our NS Series Security Appliances.  For most security applications, there areseveral companies with whom we may partner. Because we have not worked withthese companies previously, we may partner with third-party securityapplication partners that have superior technological solutions, but haveinferior sales, channel and marketing organizations. Even if we select partnerswith superior sales, channel and marketing organizations, there can be noassurances as to their commitment to assist with the sales of their securityapplications on our NS Series Security Appliances. If we are unable toleverage the existing customers and sales, channel and marketing organizationsof third-party security application partners for our NS Series SecurityAppliances, the growth of our business may be limited.**

**If we are unable toexpand our international operations and successfully overcome the risksinherent in international business activities, the growth of our business maybe limited.**

Our ability to grow will depend in part on theexpansion of our international sales. We currently have agreements withdistributors headquartered outside the United States for the distribution ofour NS Series Security Appliances throughout Europe, the Middle East andSouth Africa. The failure of our distributors to sell our products across theseregions, or their de-emphasizing their support of our products would limit ourability to increase our revenues in those regions. In addition, ourinternational sales are subject to the risks inherent in international businessactivities, including:

·                  costof customizing products for foreign countries;

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

·                  difficultiesin providing customer support;

·                  reducedprotection of intellectual property rights and increased liability exposure;

·                  regionaleconomic and political conditions; and

·                  uniqueproduct requirements of certain foreign countries which may limit sales and/orrequire significant additional research and development investments, such asbeing able to comply with European Union directive Restriction of HazardousSubstances (RoHS) which restricts the use of hazardous substances in electricaland electronic equipment, by July 1, 2006.

Our international sales currently are U.S.dollar-denominated. As a result, any increase in the value of the U.S. dollarrelative to foreign currencies makes our products less competitive ininternational markets. Because of this our revenues may be adversely affected,or we may be required to denominate our sales in foreign currencies at somepoint in the future to remain competitive. In addition, because certain of ouroperating expenses related to our international sales are denominated inforeign currency, we may have difficulty controlling expenses in the event ofsignificant currency fluctuations.

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**Our future success isdependent upon our ability to generate significant revenues from serverappliance development relationships in our OEM Appliance segment.**

A major component of our business strategy is to formserver appliance development relationships with new network equipment providersand ISVs in our OEM Appliance segment. Under this strategy, we work with ourpartners to develop a server appliance, which is branded with their name, whothen performs all of the selling and marketing efforts related to furthersales.

There are multiple risks associated with this strategyincluding:

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

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

·                  the possibilitythat our partners will continue selling their application software products asseparate products in addition to selling it in the form of a server appliance;

·                  our reliance onour partners to perform all of the selling and marketing efforts associatedwith further sales of the server appliance product we develop with them; and

·                  our ability toprovide our partners with high quality server appliances at competitive prices.

**Additionally, our future successwill depend on our ability to expand sales of server appliances to our existingpartners, as well as establishing relationships with new partners. If thesepartners are unsuccessful in their marketing and sales efforts, or if we areunable to expand our sales to existing partners and develop relationships with newpartners, our revenues and operating results could suffer.**

**Both our OEM Applianceand Distribution segments could be harmed if we fail to adequately integratenew technologies into our server appliance products 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 toincorporate products and technologies that could be required in order to addnew customers, retain existing customers, expand the breadth of productofferings or enhance our technical capabilities.  Investing in new technologies presentsnumerous risks, including:

·                  wemay experience difficulties integrating new technologies into our current orfuture products;

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

·                  wemay incorporate technologies that do not result in the desired improvements toour current and/or future server appliance products;

·                  wemay incorporate new technologies that either may not be desired by ourcustomers or may not be compatible with our customer’s existing technology;

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

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

 

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**If we are unable to adequatelyintegrate new technologies into our server appliance products or if we investin technologies that do not result in the desired effects on our current and/orfuture product offerings, our business could be harmed and operating resultscould suffer.**

***Risksrelated to the server appliance, data storage and network security markets.***

**If server appliances arenot increasingly adopted as a solution to meet a significant portion ofcompanies’ network security and data storage application needs, the market forserver appliances may not grow, which could negatively impact our revenues.**

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

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

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

The markets we serve are characterized by rapidtechnological change, frequent new product introductions and enhancements,potentially short product life cycles, changes in customer demands and evolvingindustry standards. In the server appliance market, we attempt to mitigatethese risks by utilizing standards-based hardware platforms and by maintainingan adequate knowledge base of available technologies. However, the serverappliance products that we sell could be rendered obsolete if products based onnew technologies are introduced or new industry standards emerge and we are notable to incorporate these technological changes into our products. In addition,we depend on third parties for the base platforms of our server appliances formany of our OEM Appliance segment customers and our NS Series Security Appliances,and we are at risk if these third parties do not integrate new technologies. Specifically,product development for network security appliances requires considerableengineering time and testing. Releasing new products and services prematurelymay result in quality problems, and delays may result in loss of customerconfidence and market share. We may be unable to develop new products andservices or achieve and maintain market acceptance of them once they have cometo market. Furthermore, when we do introduce new or enhanced products andservices, we may be unable to manage the transition from the older products andservices to minimize disruption in customer ordering patterns, avoid excessiveinventories of older products and deliver enough new products and services tomeet customer demand.

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

***Risksrelated to financial results.***

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

Since our inception, we have incurred significant netlosses and could continue to incur net losses in the future. At March 31,2006 and September 30, 2005 our accumulated deficit was $130 million and 

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$126 million,respectively. We believe that any future growth will require us to incursignificant engineering, selling and marketing and administrative expenses. Asa result, we will need to generate significant revenues to achieve and sustainprofitability. If we do not achieve and sustain profitability, the market pricefor our common stock may decline.

**If our estimates orjudgments relating to our critical accounting policies are based on assumptionsthat change or prove to be incorrect, our operating results could fall belowexpectations of securities analysts and investors, resulting in a decline inour stock price.**

Our discussion and analysis of financial condition andresults of operations are based on our consolidated financial statements, whichhave been prepared in accordance with accounting principles generally acceptedin the United States. The preparation of financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the amounts reported in the consolidatedfinancial statements and accompanying notes. On an ongoing basis, we evaluatesignificant estimates used in preparing our consolidated financial statements,including those related to:

·                  revenuerecognition, including sales returns and allowances;

·                  provisionfor doubtful accounts;

·                  inventorywrite-downs;

·                  stock-basedcompensation; and

·                  warrantyreserves.

We base our estimates on historical experience and onvarious other assumptions that we believe to be reasonable under thecircumstances, as provided in our discussion and analysis of financialcondition and results of operations, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results may differ from these andother estimates if our assumptions change or if actual circumstances differfrom those in our assumptions, which could cause our operating results to fallbelow the expectations of securities analysts and investors, resulting in adecline in our stock price.

**Our quarterly revenuesand operating results may fluctuate seasonally, which could result in decreasedrevenue from quarter to quarter, which in turn could cause the market price ofour common stock to decline.**

Seasonal fluctuations in revenues and operatingresults in the data storage industry are common. In particular, this industrytypically experiences increased orders and resulting revenues in the quarterended December 31, and a subsequent decline in orders and resultingrevenues during the quarter ended March 31. With a substantial amount ofour revenues currently derived from data storage products, we may experiencesignificant quarter-to-quarter fluctuations in revenues and operating resultsdue to customers timing their orders based on their own quarterly financialand/or operational considerations, which we have no influence over. In addition,to the extent that revenues in our Distribution segment from internationalsales become significant, we may experience seasonal fluctuations during thequarter ended September 30, as a result of European holiday patterns.

Accordingly, we believe that quarter-to-quartercomparisons of results of operations are not necessarily meaningful and shouldnot be relied upon as an indication of future performance. Nonetheless, themarket price of our common stock could decline in response to these variations.

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**Our quarterly revenuesand operating results may also fluctuate for reasons other than seasonality,which could cause our operating results to fall below expectations and thusimpact the market price of our common stock.**

In addition to seasonality issues, our quarterlyrevenues and operating results are difficult to predict and may fluctuatesignificantly from quarter to quarter. None of our customers are obligated topurchase any quantity of our products in the future nor are they obligated tomeet forecasts of their product needs. Our operating expense levels are basedin part 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 aparticular quarter do not meet expectations, operating results could suffer andthe market price of our common stock could decline. Factors affecting quarterlyoperating results include:

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

·                  theproduct mix within our OEM Appliance segment;

·                  thetiming of new product introductions by our OEM Appliance partners;

·                  theavailability and/or price of products from suppliers;

·                  theloss of key suppliers or customers;

·                  pricecompetition;

·                  costsassociated with our introduction of our NS Series Security Appliances andthe market acceptance of those products;

·                  themix of product manufactured internally and by our contract manufacturer;

**If the products and servicesthat we sell become more commoditized and competition in the server appliance,data storage and network security markets continues to increase, then our grossprofit as a percentage of net revenues may decrease and our operating resultsmay suffer.**

Products and services in the server appliance, datastorage and network security markets may be subject to further commoditizationas these industries continue to mature and other businesses introduceadditional competing products and services. The gross profit as a percentage ofrevenues of our products may decrease, in response to changes in our productmix, competitive pricing pressures, or new product introductions into theserver appliance, data storage and network security markets. If we are unable tooffset decreases in our gross profits as a percentage of revenues by increasingour sales volumes, or by decreasing our product costs, operating results willdecline. Changes in the mix of sales of our products, including the mix ofhigher margin sales of products sold in smaller quantities and lower marginsales of products sold in larger quantities, could adversely affect ouroperating results for future quarters. To maintain our gross profits, we alsomust continue to reduce the manufacturing cost of our server appliance products.Our efforts to produce higher margin server appliance products, continue toimprove our server appliance products and produce new server appliance productsmay make it difficult to reduce our manufacturing cost per product. Further,utilization of a contract manufacturer to produce a portion of our customerrequirements for certain of our server appliance products may not allow us toreduce our cost per product. If we fail to respond adequately to pricingpressures, to competitive products with improved performance or to developmentswith respect to the other factors on which we compete, we could lose customersor orders. If we are unable to compete effectively, our business will suffer.

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***Risksrelated to competition.***

**Competition in the serverappliance market is significant and if we fail to compete effectively, ourfinancial results will suffer.**

In the server appliance market, we face significantcompetition from a number of different types of companies. Our competitorsinclude companies who market general-purpose servers, specific-purpose serversand server appliances as well as companies that sell custom integrationservices utilizing hardware produced by other companies. Many of thesecompanies are larger than we are and have greater financial resources and namerecognition than we do, as well as significant distribution capabilities andlarger, more established service organizations to support their products. Ourlarger competitors may be able to leverage their existing resources, includingtheir extensive distribution capabilities and service organizations, to providea wider offering of products and services and higher levels of support on amore cost-effective basis than we can. We expect competition in the serverappliance 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 increasedcompetition could adversely affect sales of our current and future products. Inaddition, competing companies may be able to undertake more extensivepromotional activities, adopt more aggressive pricing policies and offer moreattractive terms to their customers than we can. If our competitors providelower cost products with greater functionality or support than our serverappliance solutions, or if some of their products are comparable to ours andare offered as part of a range of products that is broader than ours, ourserver appliance solutions could become undesirable.

Even if the functionality of competing products isequivalent to ours, we face a risk that a significant number of customers wouldelect to pay a premium for similar functionality from an established vendorrather than purchase products from a less-established vendor. We attempt todifferentiate ourselves from our competition by offering a wide variety ofsoftware integration, branding, supply-chain management, engineering, support,logistics and fulfillment services. If we are unable to effectivelydifferentiate ourselves from our competition, we may be forced to offer pricereductions to maintain certain customers. As a result, our revenues may notincrease and may decline, and our gross margins may decline. Furthermore,increased competition could lead to higher selling expenses which wouldnegatively affect our business and future operating results.

**If we are unable tocompete successfully in the highly competitive market for network securityappliances and services for any reason, such as current or potentialcompetitors gaining competitive advantage through partnering or acquisition,our business could be adversely affected.**

The market for network security appliances isintensely competitive and we expect competition to intensify in the future. Anincrease in competitive pressures in our market or our failure to competeeffectively may result in pricing reductions, reduced gross margins and loss ofmarket share. Currently, the primary competitors relating to network securityappliances with Microsoft ISA Server 2004 include Hewlett-Packard Company,Celestix Networks, Inc. and Pyramid Computer GmbH. However, because ouragreement with Microsoft to license ISA Server 2004 is not exclusive, Microsoftmay enter into similar license agreements with additional competitors. Suchcompetitors may be larger and have significantly greater resources andexperience than us, which may negatively affect our business.

Competitors in the security industry with appliancesusing technology other than Microsoft ISA Server 2004 include Cisco Systems, Inc.,Nokia Corporation, Juniper Networks, Inc, Watchguard Technologies, Inc.and SonicWALL, Inc. Substantially all of our competitors have longeroperating histories, greater name recognition, larger customer bases andsignificantly greater financial, technical, marketing and other resources thanwe do. Our current and potential competitors may establish cooperativerelationships among themselves or with third parties that may further enhancetheir resources. In addition, current or potential competitors may be acquiredby third parties with greater available resources. As a result of suchpotential acquisitions, our current or potential competitors might be able toadapt more quickly to new technologies and customer needs, devote greaterresources to the promotion or sale of their products and services, initiate orwithstand substantial price competition, take advantage of acquisition or otheropportunities more readily or develop and expand their product and serviceofferings more quickly. In 

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addition, our competitorsmay bundle products competitive with ours with other products that they maysell to our current or potential customers. These customers may accept thesebundled products rather than separately purchasing our products.

***Risksrelated to marketing and sales efforts and customer service.***

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

Although we currently have a relatively small salesand marketing organization, we must continue to increase market awareness andsales of our products and promote our brand in the marketplace. In our OEMAppliance segment, we believe that to compete successfully we will need networkequipment providers and ISVs to recognize Network Engines as a top-tierprovider of server appliance platforms and custom integration services.

We must also effectively market to VARs, systemsintegrators, and their end customers our NS Series Security Appliances.This marketing effort requires a significant investment in personnel and otherareas, and an appropriate level of technical knowledge about the security market,Microsoft applications such as Exchange, and other software applicationsincluded in these server appliance products. It also requires substantialunderstanding of the targeted market into which these products are sold and mayrequire the expenditure of a material amount of managerial and financialresources. We have limited experience marketing and selling security applianceproducts through indirect channels and therefore, may not be successful inthese efforts. If we are unable to design and implement marketing campaignsthat are effective in promoting our network security appliances, or if we failto promote and maintain the Network Engines brand, we may not increase ormaintain sales and our business may be adversely affected. Our business wouldalso suffer if we incur excessive expenses in these marketing campaigns butfail to achieve the expected or desired increase in revenues.

**If we are unable toeffectively manage our customer service and support activities, we may not beable to retain our existing customers or attract new customers.**

We need to effectively manage our customer supportoperations to ensure that we maintain good relationships with our customers. Becauseour NS Series Security Appliances provide critical protection for certainapplications, managing software updates to the appliance, when and if they areavailable, will be essential to the performance of the appliance. In addition,as we integrate more third party software applications our NS Series SecurityAppliances will become increasingly complex to maintain and support. As aresult, managing any updates released by Microsoft, or the third party softwarevendor will require careful consideration to determine the sensitivity andimpact on the function of our appliance. Additionally, any updates designatedas vital to the function of our appliance will require rapid deployment toensure the customers’ applications are properly protected. We expect thatproviding this increased customer service for our NS Series SecurityAppliances will require more technically qualified staff either within theCompany or from third parties, which could be more costly and if we are unableto provide this higher level of service we may be unable to successfully sellour security appliances.

Our channel partners in some cases will providesupport for the end-user customers. We may be unable to provide these channelpartners with the necessary training and back-up support. Therefore they may beunable to provide end-user customers with the necessary level of support, whichmay be detrimental to our reputation and ability to sell our products. Also,some of our channel partners may choose not to provide this service, whichwould require us to hire more support staff to provide the first level supportto end user customers, which would increase our costs and lower our margins.

If our customer support organization is unsuccessfulin maintaining good customer relationships, we may lose customers to ourcompetitors and our reputation in the market could be damaged. As a result, wemay lose revenues and our business could suffer. Furthermore, the costs of thisservice could be higher than we expect, which could adversely affect ouroperating results.

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***Risksrelated to product manufacturing.***

**Our dependence on sole sourceand limited source suppliers for key server appliance components makes ussusceptible to supply shortages and potential quality issues that could preventus from shipping customer orders on time, if at all, and could result in lostsales and customers.**

We depend upon single source and limited sourcesuppliers for our industry-standard processors, main logic boards, certain diskdrives, hardware platforms and power supplies as well as certain of our coolingsystems, chassis and sheet metal parts. We also rely upon a single sourcesupplier to provide the hardware platform for our NS Series SecurityAppliances. Additionally, we depend on limited sources to supply certain otherindustry-standard and customized components. We are relying on our suppliers tobe compliant with the European Union directive on RoHS by July 1, 2006 forproducts that we ship into the European Union. We have in the past experienced,and may in the future experience, shortages of or difficulties in acquiringcomponents in the quantities and of the quality needed to produce our serverappliance products. Shortages in supply or quality issues related to these keycomponents for an extended time would cause delays in the production of ourserver appliance products, prevent us from satisfying our contractualobligations and meeting customer expectations, and result in lost sales andcustomers. If we are unable to buy components in the quantities and of thequality that we need on a timely basis or at acceptable prices, we will not beable to manufacture and deliver our server appliance products on a timely orcost-effective basis to our customers, and our competitive position,reputation, business, financial condition and results of operations could beseriously harmed.

**If our server applianceproducts fail to perform properly and conform to specifications, our customersmay demand refunds, assert claims for damages or terminate existingrelationships with us and our reputation and operating results may suffermaterially.**

Because server appliance solutions are complex, theycould contain errors that can be detected at any point in a product’s lifecycle. If flaws in design, production, assembly or testing of our products (byus or our suppliers) were to occur, we could experience a rate of failure inour products that could result in substantial repair, replacement or servicecosts and potential damage to our reputation.  In addition, because our solutions arecombined with products from other vendors, should problems occur, it might bedifficult to identify the source of the problem. Continued improvement inmanufacturing capabilities, control of material and manufacturing quality andcosts, and product testing are critical factors in our future growth. There canbe no assurance 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 some of ourserver appliance solutions and have experienced delays in the shipment of ourserver appliance products during the period required to correct these errors orwe have had to replace defective products that were already shipped. Errors inour server appliance solutions may be found in the future and any of theseerrors could be significant. Significant errors, including those discussedabove, may result in:

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

·                  diversionof engineering resources;

·                  increasedmanufacturing costs;

·                  theloss of new or existing server appliance partners;

·                  injuryto our reputation and other customer relations problems; and

·                  increasedmaintenance and warranty costs.

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

Moreover, because our server appliance solutions maybe used in connection with critical computing systems services, includingproviding security to protect valuable information, we may receive significantliability claims if they do not work properly. 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 insurance coverage and require us to spendsignificant time and money in litigation or to pay significant damages. Anyclaims for damages, even if unsuccessful, could seriously damage our reputationand business.

**Our future serverappliance revenue growth may be limited by our ability to expand productioncapacity.**

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

  To supplementour current production capacity, to provide for increased capacity for “productionspikes” and to provide disaster backup capabilities, we currently utilize theservices of a contract manufacturer for certain server appliance products on alimited basis. However, our contract manufacturer is not obligated to supplyproducts to us for any specific period, or in any specific quantity, except asmay be provided in an accepted purchase order. Using a contract manufacturerincreases our cost of producing server appliance products and could decreaseour gross profits. In the event that we need to change contract manufacturersor require significantly increased production levels, we could experiencetransitional difficulties, including production delays and quality controlissues, that could prevent us from satisfying our production requirements on atimely basis, cause customer relationships to suffer and result in lost sales. Also,the use of a contract manufacturer does not guarantee us production levels,manufacturing line space or manufacturing prices, the lack of which couldinterrupt our business operations and have a negative effect on operatingresults.

 In the past, weexpanded our internal production capacity through expansion and reorganizationof our current production facilities. Although we believe that our currentfacility, along with our use of a contract manufacturer to supplementproduction, is sufficient to support our business for the foreseeable future,we may need additional production capacity. We believe that we could expandproduction levels in our existing facility, but we are currently utilizing allavailable manufacturing space in our existing facility and we may havedifficulties expanding this facility any further. Therefore, significantfurther expansion of the production capacity either in our existing facilitiesor by expanding into additional facilities could require substantialinvestments, which could detract from our ability to invest in other areas ofour business and may not result in the desired return on investment, whichcould negatively affect our operating results.

**If we do not accuratelyforecast our server appliance materials requirements, our business andoperating results could be adversely affected.**

We use rolling forecasts based on anticipated productorders to determine our server appliance component requirements. Lead times formaterials and components that we order vary significantly, depending amongother things, on specific supplier requirements, contract terms and currentmarket demand for those components. In addition, a variety of factors,including the timing of product releases, potential delays or cancellations oforders, the timing of large orders, and the unproven acceptance of new productsin the market make it difficult to predict product orders. As a result, ourmaterials requirement forecasts may not be accurate. If we overestimate ourmaterials requirements, we may have excess inventory, which would increasecosts and negatively impact our cash position. Our agreements with certaincustomers provide us with protections related to inventory purchased inaccordance with the terms of these agreements; however, these protections maynot be sufficient to prevent certain losses as a result of excess or obsoleteinventory. If we underestimate our materials requirements, we may haveinadequate 

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inventory, which couldinterrupt our manufacturing and delay delivery of our server appliance productsto customers resulting in a loss of sales or customers. Any of theseoccurrences would negatively impact our business and operating results.

***Risksrelated to product dependence on intellectual property.***

**Our reliance uponcontractual provisions, domestic patent, copyright and trade secret laws andapplied-for patents to protect our proprietary rights may not be sufficient toprotect our intellectual property.**

Certain of our server appliance solutions aredifferentiated from the products of our competitors by our internally developedsoftware and hardware and the manner in which they are integrated into ourserver appliance solutions. If we fail to protect our intellectual property,other vendors could sell products with features similar to ours, which couldreduce demand for our solutions. We have taken what we believe to be thenecessary and appropriate steps to safeguard our intellectual property.However, these steps may afford us only limited protection. Others may developtechnologies that are similar or superior to our technology or design aroundthe patents we own. Despite the precautions we have taken, laws and contractualrestrictions may not be sufficient to prevent misappropriation of our technologyor deter others from developing similar technologies. In addition, there can beno guarantee that any of our patent applications will result in patents, orthat any such patents would provide effective protection of our technology.

In addition, the laws of the countries in which we maydecide to market our services and solutions may offer little or no effectiveprotection of our proprietary technology. Reverse engineering, unauthorizedcopying or other misappropriation of our proprietary technology could enablethird parties to benefit from our technology without paying us for it, whichwould significantly harm our business. In addition, our U.S. patents have noeffect in foreign jurisdictions and obtaining patent protection in foreigncountries is expensive and time consuming.

**Our operating resultswould suffer if we, or our ISV or network equipment provider partners, weresubject to an infringement claim that resulted in protracted litigation, theaward of significant damages against us or the payment of substantial ongoingroyalties.**

Substantial litigation regarding intellectual propertyrights exists in the technology industry. We expect that server applianceproducts may 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. In the past we have received claims fromthird parties that our server appliance products infringed their intellectualproperty rights. We do not believe that our server appliance products employtechnology that infringes the proprietary rights of any third parties. We arealso not aware of any claims made against any of our ISV or network equipmentprovider partners related to their infringement of the proprietary rights ofother parties in relation to products that include our server applianceproducts. Other parties may make claims against us that, with or without merit,could:

·                  betime-consuming for us to address;

·                  requireus to enter into royalty or licensing agreements;

·                  resultin costly litigation, including potential liability for damages;

·                  divertour management’s attention and resources; and

·                  causeproduct shipment delays.

In addition, other parties may make claims against ourISV or network equipment provider partners related to products that areincorporated into our server appliance products. Our business could beadversely affected if such claims resulted in the inability of our ISV ornetwork equipment provider partners’ to continue to produce the infringingproduct.

 

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***Other risks related toour business.***

**If we fail to retain andattract appropriate levels of qualified employees and members of seniormanagement, we may not be able to successfully execute our business strategy.**

Our success depends in large part on our ability toretain, and attract highly skilled engineering, sales, marketing, customerservice, and managerial personnel. If we are unable to attract a sufficientnumber of qualified personnel, particularly personnel knowledgeable in softwareengineering and channel sales and marketing, experienced in the network storageand security market, we may not be able to meet key objectives such asdeveloping, upgrading, or enhancing our products in a timely manner, andeffectively marketing our products to customers, any of which could negativelyimpact our business and could hinder any future growth.

**If we fail to maintain aneffective system of internal controls, we may not be able to accurately reportour financial results. As a result, current and potential stockholders couldlose confidence in our financial reporting, which could have a negative marketreaction.**

Section 404 of the Sarbanes-Oxley Act of 2002requires our management to report on, and our independent registered publicaccounting firm to attest to, the effectiveness of our internal control overfinancial reporting. We have an ongoing program to perform the system andprocess evaluation and testing necessary to comply with these requirements. Asa result, we have incurred increased expense and have devoted additionalmanagement resources to Section 404 compliance. Effective internalcontrols are necessary for us to provide reliable financial reports. If wecannot provide reliable financial reports, our business and operating resultscould be harmed.

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

**In December 2001, a classaction lawsuit relating to our initial public offering was filed against us,our chairman, one of our executive officers and the underwriters of our initialpublic offering. In addition, in January 2003, a purported class actionlawsuit was filed against us and our Board of Directors relating to theacquisition of TidalWire Inc. and on December 16, 2003, a number ofpurported class action lawsuits were filed against us and John H. Curtis, ourformer President and CEO, Douglas G. Bryant, our CFO, Vice President of Financeand Administration, Treasurer and Secretary, and Lawrence Genovesi, ourChairman of the Board relating to the timing of our announcement of theamendment of our HBA distribution agreement with EMC. For more information onthese lawsuits, see “Part II, Item 1 — Legal Proceedings.” In December 2003,we settled the class action lawsuit filed against us relating to theacquisition of TidalWire Inc. and we are currently attempting to settle thelawsuit filed against us related to our initial public offering and the lawsuitrelated to the timing of our announcement of the amendment of our HBAdistribution agreement with EMC. We are unable to predict the effects on ourfinancial condition or business of the lawsuit related to our initial publicoffering, the lawsuit related to our announcement of the amendment of our HBAdistribution agreement with EMC or other lawsuits that may arise from time totime. While we maintain certain insurance coverage, there can be no assurancethat claims against us will not result in substantial monetary damages inexcess of such insurance coverage. These class action lawsuits, 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, andmay in the future expend, significant resources to defend such claims. Theseclass action lawsuits, or other similar lawsuits that may arise from time totime, could negatively impact both our financial condition and the market priceof our common stock and could result in management devoting a substantialportion of their time to these lawsuits, which could adversely affect theoperation of our business.**

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**Ifthe site of our manufacturing operations were to experience a significantdisruption in its operations, it would have a material adverse effect on ourfinancial condition and results of our operations.**

Our manufacturing facility and headquarters areconcentrated in one location.  If theoperations in this 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 as a result of interruptions or delaysin our manufacturing, engineering, distribution or post-sales supportoperations.

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

The market price of our common stock has been subjectto significant fluctuations and may continue to fluctuate or decline. Duringfiscal 2005, the price of our common stock ranged from a low of $1.37 to a highof $3.16 and in the six months ended March 31, 2006, from a low of $1.07to a high of $3.25. The market for technology stocks has been extremelyvolatile and frequently reaches levels that bear no relationship to the past orpresent operating performance of those companies. General economic conditions,such as recession or interest rate or currency rate fluctuations in the UnitedStates or abroad, could negatively affect the market price of our common stock.In addition, our operating results may be below the expectations of securitiesanalysts and investors. If this were to occur, the market price of our commonstock 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 litigationcould result in substantial cost and a diversion of management’s attention andresources.

**Any decline in the market price ofour common stock or negative market conditions could adversely affect ourability to raise additional capital, to complete future acquisitions of or investmentsin other businesses and to attract and retain qualified technical and sales andmarketing personnel.**

**Wehave anti-takeover defenses that could delay or prevent an acquisition andcould adversely affect the market price of our common stock.**

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

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

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**ITEM 2.    UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

*RecentSales of Unregistered Securities*

During the quarter ended March 31, 2006, we didnot issue any unregistered shares of our common stock.

*Useof Proceeds from Sales of Registered Securities*

On July 18, 2000, the Company sold 7,475,000shares of common stock in an initial public offering at a price of $17.00 pershare pursuant to a Registration Statement on Form S-1 (RegistrationNo. 333-34286), which was declared effective by the Securities andExchange Commission on July 12, 2000. The aggregate proceeds to us from theoffering were approximately $116.9 million reflecting gross proceeds of $127.0million net of underwriting fees of approximately $8.9 million and otheroffering costs of approximately $1.3 million. During the period from theoffering through March 31, 2006, we used the proceeds from its initialpublic offering as follows: approximately $63.0 million to fund our operations,approximately $9.1 million for the purchase of property and equipment,approximately $4.6 million to repurchase our common stock under a stockrepurchase plan and approximately $13.2 million for our acquisition ofTidalWire Inc.

**ITEM4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

Our Annual Meetingof Stockholders was held on March 15, 2006. Of the 37,967,890 sharesoutstanding as of January 24, 2006, 34,058,306 (89.7%) were present orrepresented by proxy at the meeting. The table below presents the votingresults of the matters voted upon by our stockholders at the meeting:

**ProposalI—Election of Directors:**
| **Nominee**         | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|---------------------|------------|--------------------|------------|-------------------------|------------|
| John A. Blaeser     |       | 33,817,740         |       | 240,566                 |       |
| Robert M. Wadsworth |       | 33,311,300         |       | 747,006                 |       |

 

The terms of GaryE. Haroian, Dennis A. Kirshy, Fontain K. Richardson and Gregory A. Shortell, asdirectors of the Company, continued after this meeting.

**ProposalII—Ratification of the appointment of PricewaterhouseCoopers LLP as ourIndependent Registered Public Accounting Firm for the fiscal year ending September 30,2006:**
| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Non Votes** |
|------------|------------|-------------|------------|-------------|------------|--------------------|
| 33,880,569 |       | 137,706     |       | 40,031      |       | —             |

 

**ITEM 6.    EXHIBITS**

(a)    Exhibits

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

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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, as amended, the Registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.
|                          | ** ** | **NETWORK ENGINES, INC.**                                                                       |
|--------------------------|------------|-------------------------------------------------------------------------------------------------|
| ** **               | ** ** | ** **                                                                                      |
| ** **               | ** ** | ** **                                                                                      |
| Date:  May 10, 2006 |       | /s/ Gregory A. Shortell                                                                         |
|                     |       |                                                                                            |
|                     |       |                                                                                            |
|                     |       | Gregory A. Shortell                                                                             |
|                     |       | President and  Chief  Executive Officer                                                         |
|                     |       | (Principal Executive Officer)                                                                   |
|                     |       |                                                                                            |
|                     |       |                                                                                            |
|                     |       | /s/ Douglas G. Bryant                                                                           |
|                     |       |                                                                                            |
|                     |       | Douglas G. Bryant                                                                               |
|                     |       | Vice President of Finance and Administration, Chief  Financial Officer, Treasurer and Secretary |
|                     |       | (Principal  Financial Officer and Principal                                                     |
|                     |       | Accounting Officer)                                                                             |

 

 

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**EXHIBIT INDEX**

 
| Exhibit No. | ** ** | **Exhibit**                                                                                                                                                                                                                                                                    | ** ** |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|             |       |                                                                                                                                                                                                                                                                           |       |
| 10.1             |       | Severance Terms Agreement, dated January 9,  2006, between the Company and Gregory A. Shortell (Filed as Exhibit 10.1  to the Company’s Quarterly Report on Form 10-Q for the quarter  ended December 31, 2005 and incorporated by reference herein). |       |
|             |       |                                                                                                                                                                                                                                                                           |       |
| 10.2             |       | Letter Agreement, dated January 6, 2006,  between the Company and Gregory A. Shortell (Filed as Exhibit 10.2 to  the Company’s Quarterly Report on Form 10-Q for the quarter ended  December 31, 2005 and incorporated by reference herein).          |       |
|             |       |                                                                                                                                                                                                                                                                           |       |
| 10.3             |       | Offer Letter  dated March 7, 2006 between Network Engines, Inc. and Kevin Murphy  (Filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K  dated April 6, 2006 and incorporated by reference herein).                                 |       |
|             |       |                                                                                                                                                                                                                                                                           |       |
| 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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