Table of Contents

 

 

 

##### **UNITED STATES**

##### **SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

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

##### ** **

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**(MarkOne)**

 

**x****     ****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended March 31, 2010**

 

###### **OR**

###### ** **

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

 

**For the transition period from            to           **

 

###### **Commissionfile number: 000-30863**

###### ** **

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**NETWORKENGINES, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**(781) 332-1000**

(Registrant’s telephone number, including area code)

 

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

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T during thepreceding 12 months (or for such shorter period that the registrant wasrequired to submit and post such files). Yes o No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reportingcompany.  See the definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act. (Check one):

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

 

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

 

Asof May 6, 2010, there were 42,631,017 shares of the registrant’s CommonStock, par value $.01 per share, outstanding.

 

 

 

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**NETWORKENGINES, INC.**

 

**INDEX**

 
| ** **                                                                                          | ** ** | **PAGE  NUMBER** |
|-----------------------------------------------------------------------------------------------------|------------|------------------|
|                                                                                                |       |             |
| **PART I.  FINANCIAL INFORMATION**                                                        |       |             |
|                                                                                                |       |             |
| ITEM 1.  FINANCIAL STATEMENTS (UNAUDITED)                                                           |       | 1                |
|                                                                                                |       |             |
| CONDENSED  CONSOLIDATED BALANCE SHEETS                                                              |       | 1                |
| CONDENSED  CONSOLIDATED STATEMENTS OF OPERATIONS                                                    |       | 2                |
| CONDENSED  CONSOLIDATED STATEMENTS OF CASH FLOWS                                                    |       | 3                |
| NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED  FINANCIAL STATEMENTS                                 |       | 4                |
|                                                                                                |       |             |
| ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS |       | 13               |
|                                                                                                |       |             |
| ITEM  3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                 |       | 24               |
|                                                                                                |       |             |
| ITEM 4.  CONTROLS AND PROCEDURES                                                                    |       | 24               |
| ** **                                                                                          |       |             |
| **PART II.  OTHER INFORMATION**                                                           |       |             |
|                                                                                                |       |             |
| ITEM  1. LEGAL PROCEEDINGS                                                                          |       | 24               |
|                                                                                                |       |             |
| ITEM  1A. RISK FACTORS                                                                              |       | 25               |
|                                                                                                |       |             |
| ITEM 6.  EXHIBITS                                                                                   |       | 36               |
|                                                                                                |       |             |
| SIGNATURES                                                                                          |       | 37               |

 

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Table ofContents

 

**PART I. FINANCIAL INFORMATION**

 

**ITEM I. FINANCIAL STATEMENTS**

 

**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(inthousands, except share data)**

**(unaudited)**

 
| ** **                                                                                                                                                                                                              | ** ** | **March 31,  2010** | ** ** | **September 30,  2009** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| **ASSETS**                                                                                                                                                                                                              | ** ** | ** **               |       |                         |       |
| **Current assets:**                                                                                                                                                                                                     | ** ** | ** **               | ** ** | ** **                   | ** ** |
| Cash and cash equivalents                                                                                                                                                                                               |       | $                        | 16,138     |                         | $          | 21,039 |   |
| Accounts receivable, net of allowances of $80 and  $117 at March 31, 2010 and September 30, 2009, respectively                                                                                                |       | 34,304                   |       | 27,479                       |       |
| Refundable acquisition consideration                                                                                                                                                                                    |       | —                   |       | 3,629                        |       |
| Inventories                                                                                                                                                                                                             |       | 23,897                   |       | 13,078                       |       |
| Prepaid expenses and other current assets                                                                                                                                                                               |       | 1,467                    |       | 1,521                        |       |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| Total current assets                                                                                                                                                                                                    |       | 75,806                   |       | 66,746                       |       |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| Property and equipment, net                                                                                                                                                                                             |       | 1,557                    |       | 1,622                        |       |
| Intangible asset, net                                                                                                                                                                                                   |       | 7,351                    |       | 8,128                        |       |
| Other assets                                                                                                                                                                                                            |       | 230                      |       | 174                          |       |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| Total assets                                                                                                                                                                                                            |       | $                        | 84,944     |                         | $          | 76,670 |   |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                                                                          | ** ** | ** **               | ** ** | ** **                   | ** ** |
| **Current liabilities:**                                                                                                                                                                                                | ** ** | ** **               | ** ** | ** **                   | ** ** |
| Accounts payable                                                                                                                                                                                                        |       | $                        | 21,029     |                         | $          | 14,200 |   |
| Accrued compensation and other related benefits                                                                                                                                                                         |       | 1,729                    |       | 1,466                        |       |
| Accrued warranty                                                                                                                                                                                                        |       | 593                      |       | 641                          |       |
| Other accrued expenses                                                                                                                                                                                                  |       | 1,695                    |       | 2,043                        |       |
| Deferred revenue                                                                                                                                                                                                        |       | 4,393                    |       | 4,233                        |       |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| Total current liabilities                                                                                                                                                                                               |       | 29,439                   |       | 22,583                       |       |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| Deferred revenue, net of current portion                                                                                                                                                                                |       | 2,951                    |       | 2,517                        |       |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| Total liabilities                                                                                                                                                                                                       |       | 32,390                   |       | 25,100                       |       |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| Commitments and contingencies (Note 9)                                                                                                                                                                                  |       |                     |       |                         |       |
| ** **                                                                                                                                                                                                              | ** ** | ** **               | ** ** | ** **                   | ** ** |
| **Stockholders’ equity:**                                                                                                                                                                                          | ** ** | ** **               | ** ** | ** **                   | ** ** |
| Preferred stock, $0.01 par value, 5,000,000  authorized, and no shares issued and outstanding                                                                                                                           | ** ** | **—**               | ** ** | **—**                   | ** ** |
| Common stock, $0.01 par value, 100,000,000 shares  authorized; 47,280,097 and 47,132,540 shares issued; 42,136,693 and 42,147,336  shares outstanding at March 31, 2010 and September 30, 2009,  respectively |       | 473                      |       | 471                          |       |
| Additional paid-in capital                                                                                                                                                                                              |       | 197,436                  |       | 196,711                      |       |
| Accumulated deficit                                                                                                                                                                                                     |       | (140,336                 | )          | (140,770                     | )          |
| Treasury stock, at cost, 5,143,404 and 4,985,204  shares at March 31, 2010 and September 30, 2009, respectively                                                                                               |       | (5,019                   | )          | (4,842                       | )          |
| Total stockholders’ equity                                                                                                                                                                                         |       | 52,554                   |       | 51,570                       |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                         |       | $                        | 84,944     |                         | $          | 76,670 |   |

 

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

 

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**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

**(inthousands, except per share data)**

**(unaudited)**

 
| ** **                                                    | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                    | ** ** | **2010**                                         | ** ** | **2009**                                       | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Net revenues                                                  |       | $                                                | 55,030     |                                           | $          | 37,461 |   | $ | 99,082 |   | $ | 74,696 |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Cost of revenues                                              |       | 48,527                                           |       | 31,693                                         |       | 86,524 |   | 63,320 |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Gross profit                                                  |       | 6,503                                            |       | 5,768                                          |       | 12,558 |   | 11,376 |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Operating expenses:                                           |       |                                             |       |                                           |       |   |   |   |   |
| Research and development                                      |       | 1,584                                            |       | 1,653                                          |       | 3,267 |   | 3,095 |   |
| Selling and marketing                                         |       | 2,060                                            |       | 2,024                                          |       | 3,818 |   | 4,201 |   |
| General and administrative                                    |       | 2,199                                            |       | 2,275                                          |       | 4,220 |   | 4,350 |   |
| Amortization of intangible asset                              |       | 389                                              |       | 439                                            |       | 778 |   | 878 |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Total operating expenses                                      |       | 6,232                                            |       | 6,391                                          |       | 12,083 |   | 12,524 |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Income (loss) from operations                                 |       | 271                                              |       | (623                                           | )          | 475 |   | (1,148 | ) |
| Interest and other (expense) income, net                      |       | (26                                              | )          | (47                                            | )          | (8 | ) | 12 |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Income (loss) before income taxes                             |       | 245                                              |       | (670                                           | )          | 467 |   | (1,136 | ) |
| Provision for income taxes                                    |       | 9                                                |       | —                                         |       | 33 |   | — |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Net income (loss)                                             |       | $                                                | 236        |                                           | $          | (670 | ) | $ | 434 |   | $ | (1,136 | ) |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Net income (loss) per share — basic                      |       | $                                                | 0.01       |                                           | $          | (0.02 | ) | $ | 0.01 |   | $ | (0.03 | ) |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Net income (loss) per share — diluted                    |       | $                                                | 0.01       |                                           | $          | (0.02 | ) | $ | 0.01 |   | $ | (0.03 | ) |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Shares used in computing basic net income (loss)  per share   |       | 42,050                                           |       | 43,177                                         |       | 42,039 |   | 43,156 |   |
| Shares used in computing diluted net income  (loss) per share |       | 43,566                                           |       | 43,177                                         |       | 43,199 |   | 43,156 |   |

 

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

 

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**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(inthousands)**

**(unaudited)**

 
| ** **                                                                                          | ** ** | **Six  months ended********March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2010**                                    | ** ** | **2009** | ** ** |
| ** **                                                                                          | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Cash flows from operating activities:                                                               |       |                                        |       |   |   |
| Net income (loss)                                                                                   |       | $                                           | 434        |   | $ | (1,136 | ) |
| Adjustments to reconcile net income (loss) to net  cash (used in) provided by operating activities: |       |                                        |       |   |   |
| Depreciation and amortization                                                                       |       | 1,241                                       |       | 1,334 |   |
| (Gain) loss on disposal of property and equipment                                                   |       | (9                                          | )          | 7 |   |
| Provision for doubtful accounts                                                                     |       | (31                                         | )          | 25 |   |
| Stock-based compensation                                                                            |       | 594                                         |       | 680 |   |
| Changes in operating assets and liabilities:                                                        |       |                                        |       |   |   |
| Accounts receivable                                                                                 |       | (6,794                                      | )          | 3,614 |   |
| Income tax receivable                                                                               |       | —                                      |       | 1,856 |   |
| Inventories                                                                                         |       | (10,817                                     | )          | 6,275 |   |
| Prepaid expenses and other assets                                                                   |       | 37                                          |       | 536 |   |
| Accounts payable                                                                                    |       | 6,829                                       |       | (2,898 | ) |
| Accrued expenses                                                                                    |       | (104                                        | )          | (726 | ) |
| Deferred revenue                                                                                    |       | 593                                         |       | (548 | ) |
|                                                                                                |       |                                        |       |   |   |
| Net cash (used in) provided by operating activities                                                 |       | (8,027                                      | )          | 9,019 |   |
|                                                                                                |       |                                        |       |   |   |
| Cash flows from investing activities:                                                               |       |                                        |       |   |   |
| Receipt of refundable acquisition consideration                                                     |       | 3,629                                       |       | — |   |
| Purchases of property and equipment                                                                 |       | (408                                        | )          | (544 | ) |
|                                                                                                |       |                                        |       |   |   |
| Net cash provided by (used in) investing activities                                                 |       | 3,221                                       |       | (544 | ) |
|                                                                                                |       |                                        |       |   |   |
| Cash flows from financing activities:                                                               |       |                                        |       |   |   |
| Purchase of treasury stock                                                                          |       | (177                                        | )          | (218 | ) |
| Proceeds from issuance of common stock                                                              |       | 130                                         |       | 89 |   |
| Payment of bank line of credit fees                                                                 |       | (38                                         | )          | — |   |
| Payments on capital lease obligation                                                                |       | (10                                         | )          | (14 | ) |
|                                                                                                |       |                                        |       |   |   |
| Net cash used in financing activities                                                               |       | (95                                         | )          | (143 | ) |
|                                                                                                |       |                                        |       |   |   |
| Net (decrease) increase in cash and cash  equivalents                                               |       | (4,901                                      | )          | 8,332 |   |
| Cash and cash equivalents, beginning of period                                                      |       | 21,039                                      |       | 10,003 |   |
|                                                                                                |       |                                        |       |   |   |
| Cash and cash equivalents, end of period                                                            |       | $                                           | 16,138     |   | $ | 18,335 |   |

 

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

 

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**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.  Basis of Presentation**

 

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

 

The informationfurnished reflects all adjustments, which, in the opinion of management, are ofa normal recurring nature and are considered necessary for a fair statement ofresults for the interim periods.  Itshould also be noted that results for the interim periods are not necessarily indicativeof the results expected for the full year or any future period.

 

The preparation of thesecondensed 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 mostsignificant estimates reflected in these financial statements include allowancefor doubtful accounts, inventory valuation, valuation of deferred tax assets,valuation of intangible assets, warranty reserves and stock-based compensation.  Actual results could differ from thoseestimates.

 

**2.  Significant Accounting Policies**

 

***Recent Accounting Pronouncements***

 

In September 2006,the Financial Accounting Standards Board (“FASB”) issued authoritative guidancewhich defines fair value, establishes a framework for measuring fair value inaccordance with generally accepted accounting principles and expandsdisclosures about fair value measurements. This guidance was effective forfiscal years beginning after November 15, 2007; however, the FASB delayedthe effective date to fiscal years beginning after November 15, 2008 fornonfinancial assets and nonfinancial liabilities, except those items recognizedor disclosed at fair value on an annual or more frequent basis. The Companyadopted this guidance, as it applies to its financial assets and liabilitieswhich are recognized or disclosed at fair value on a recurring basis (at leastannually), as of October 1, 2008. The Company adopted this guidance, as itapplies to its nonfinancial assets and liabilities, as of October 1,2009.  The adoption of this guidance did not have an impact on the Company’sfinancial position, results of operations, or cash flows.

 

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

 

In April 2008,the FASB issued authoritative guidance used to determine the useful life ofintangible assets. This guidance amends the factors that should be considered indeveloping renewal or extension assumptions used to determine the useful lifeof a recognized intangible asset. This change is intended to improve theconsistency between the useful life of a recognized intangible asset and theperiod of expected cash flows used to measure the fair value of the asset. Therequirement for determining useful lives must be applied prospectively tointangible assets acquired after the effective date and the disclosurerequirements must be applied prospectively to all 

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

intangible assets recognizedas of, and subsequent to, the effective date. The Company adopted this guidanceas of October 1, 2009 and the adoption did not have an impact on itsfinancial position, results of operations, or cash flows.

 

In October 2009,the FASB issued authoritative guidance for multiple-deliverable revenuearrangements, which amends previously issued guidance to require an entity touse its best estimate of selling price when vendor-specific objective evidenceor acceptable third party evidence of selling price does not exist for anyproducts or services included in a multiple element arrangement. Thearrangement consideration should be allocated among the products and servicesbased upon their relative selling prices, thus eliminating the use of theresidual method of allocation. This guidance also requires expanded qualitativeand quantitative disclosures regarding significant judgments made and changesin applying this guidance. This guidance is effective on a prospective basisfor revenue arrangements entered into or materially modified in fiscal yearsbeginning on or after June 15, 2010. Early adoption and retrospectiveapplication are also permitted. The Company adopted this guidance as of January 1,2010 and the adoption did not have a material impact on its financial position,results of operations, or cash flows, and does not change the units ofaccounting for our revenue transactions.

 

In October 2009,the FASB issued authoritative guidance for certain revenue arrangements thatinclude software elements. Under this guidance, tangible products containingsoftware elements that function together to deliver the product’s essentialfunctionality are no longer within the scope of software revenue guidance.Entities that sell joint hardware and software products that meet this scopeexception will be required to follow the guidance for multiple-deliverablerevenue arrangements outside of the scope of software revenue guidance. Thisguidance is effective on a prospective basis for revenue arrangements enteredinto or materially modified in fiscal years beginning on or after June 15,2010. Early adoption and retrospective application are also permitted. TheCompany adopted this guidance as of January 1, 2010 and the adoption didnot have a material impact on its financial position, results of operations, orcash flows.

 

In January 2010,the FASB issued authoritative guidance requiring additional disclosure relatedto fair value measurements that are made on a recurring and non-recurringbasis.  This guidance updates the guidance previously issued by the FASBrelated to fair value measurement disclosures.  Under this guidance,entities will be required to provide disclosures for transfers in and out ofLevel 1 and Level 2 fair value inputs.  In addition, entities will be requiredto provide disclosures for activity within the Level 3 fair value input tier,including purchases, sales, issuances, and settlements during the reportingperiod.  This guidance is effective for interim and annual reportingperiods beginning after December 15, 2009, except for the Level 3disclosure requirements, which will be effective for fiscal years beginningafter December 15, 2010.  The Company adopted the guidance as itrelates to Level 1 and Level 2 fair value inputs as of January 1, 2010 andthe adoption did not have a material impact on its financial position, resultsof operations, or cash flows.  TheCompany does not expect the adoption of this guidance as it relates to Level 3inputs to have a material impact on its financial position, results ofoperations, or cash flows.

 

***Adoption of NewAuthoritative Guidance***

 

In October 2009, the FASB amended theauthoritative guidance related to revenue recognition for arrangements withmultiple deliverables and arrangements that include software elements. TheCompany elected to early adopt this guidance on a prospective basis forapplicable transactions originating or materially modified on or after January 1,2010, the start of the second fiscal quarter of the Company’s fiscal year 2010.

 

Under previous authoritative guidance, for revenuearrangements that contained multiple elements, such as the sale of both theproduct and post-sales support and/or extended warranty and related serviceselement, in which software was not incidental to the product as a whole, theCompany was required to determine the fair value of the undelivered elementsbased upon vendor-specific objective evidence (“VSOE”) of fair value. VSOE wasestablished through contractual post-sales support renewal rates.  The Company used the residual fair valuemethod to allocate the arrangement consideration to the product. For revenuearrangements that contained software elements that were not incidental to theproduct as a whole, and VSOE was not available for the undelivered elements, theCompany deferred all revenue associated with the arrangement and recognized therevenue over the related service period.

 

Under the amended authoritative guidance forarrangements with multiple deliverables and arrangements that include softwareelements, the Company is required to determine if the software elementsfunction together with the tangible product to deliver the tangible product’sessential functionality.  The Companydetermined that its software elements provide additional functionality but arenot necessary to deliver the tangible product’s essential 

 

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**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

functionality; as such, the Company is required toallocate the arrangement consideration to the hardware and software elementsbased upon the relative selling price of the hardware and softwaredeliverables.

 

The Company’s software elements consist of softwareand software maintenance.  Revenueassociated with the software is recognized upon delivery, when VSOE isavailable for the undelivered software maintenance.  Revenue associated with the softwaremaintenance is recognized over the term of the maintenance period, which isgenerally one year.  When VSOE is notavailable for the undelivered software maintenance, revenue associated with thesoftware elements is deferred and recognized over the software maintenanceperiod.

 

The Company’s hardware elements generally consist ofan application platform and post-sales support and/or an extendedwarranty.  Revenue associated with theapplication platform is recognized upon delivery.  The Company allocates revenue associated withthe post-sales support and/or extended warranty based upon separately pricedcontractual rates for these elements. Revenue associated with the post-sales support and/or extended warrantyis deferred and recognized over the support period, generally one to threeyears.

 

The following table presents the effect that theadoption of the authoritative guidance would have had on the Company’sCondensed Consolidated Statement of Operations for the three months ended December 31,2009, assuming the Company had adopted the authoritative guidance on October 1,2009:

 
| ** **                                             | ** ** | **Three months ended December 31, 2009** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **As Reported**                                              | ** ** | **Adjustments** | ** ** | **As Amended** | ** ** |
|                                                   |       |                                                              |       |   |   |   |   |
| Net revenues                                           |       | $                                                                 | 43,878     |   | $ | 175 |   | $ | 44,053 |   |
|                                                   |       |                                                              |       |   |   |   |   |
| Cost of revenues                                       |       | 37,882                                                            |       | 116 |   | 37,998 |   |
|                                                   |       |                                                              |       |   |   |   |   |
| Gross profit                                           |       | 5,996                                                             |       | 59 |   | 6,055 |   |
|                                                   |       |                                                              |       |   |   |   |   |
| Operating expenses:                                    |       |                                                              |       |   |   |   |   |
| Research and development                               |       | 1,683                                                             |       | — |   | 1,683 |   |
| Selling and marketing                                  |       | 1,758                                                             |       | — |   | 1,758 |   |
| General and administrative                             |       | 2,021                                                             |       | — |   | 2,021 |   |
| Amortization of intangible asset                       |       | 389                                                               |       | — |   | 389 |   |
|                                                   |       |                                                              |       |   |   |   |   |
| Total operating expenses                               |       | 5,851                                                             |       | — |   | 5,581 |   |
|                                                   |       |                                                              |       |   |   |   |   |
| Income from operations                                 |       | 145                                                               |       | 59 |   | 204 |   |
| Interest and other income, net                         |       | 18                                                                |       | — |   | 18 |   |
|                                                   |       |                                                              |       |   |   |   |   |
| Income before income taxes                             |       | 163                                                               |       | 59 |   | 222 |   |
| Provision for income taxes                             |       | 24                                                                |       | — |   | 24 |   |
|                                                   |       |                                                              |       |   |   |   |   |
| Net income                                             |       | $                                                                 | 139        |   | $ | 59 |   | $ | 198 |   |
|                                                   |       |                                                              |       |   |   |   |   |
| Net income per share – basic and diluted          |       | $                                                                 | 0.00       |   | $ | 0.00 |   | $ | 0.00 |   |
|                                                   |       |                                                              |       |   |   |   |   |
| Shares used in computing basic net income per  share   |       | 42,027                                                            |       | 42,027 |   | 42,027 |   |
| Shares used in computing diluted net income per  share |       | 42,833                                                            |       | 42,833 |   | 42,833 |   |

 

The Company’s Condensed Consolidated Statement ofOperations for the six months ended March 31, 2010 includes the impact ofthe adjustments above.

 

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**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

***Cash and Cash Equivalents***

 

The Company held $16.1million in cash as of March 31, 2010. The Company held cash and cash equivalents totaling $21.0 million as of September 30,2009.  Cash equivalents consisted of amoney market fund purchased with an original maturity of three months or less.  The following table presents balances of cashand cash equivalents held as of March 31, 2010 and September 30, 2009(in thousands):

 
| ** **                          | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|-------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                          | ** ** | **2010**           | ** ** | **2009**               | ** ** |
| **Cash**                            |       | $                  | 16,138     |                   | $          | 4,009 |   |
| **Cash equivalents:**               |       |               |       |                   |       |
| Money market funds                  |       | —             |       | 17,030                 |       |
|                                |       |               |       |                   |       |
| **Total cash and cash equivalents** |       | $                  | 16,138     |                   | $          | 21,039 |   |

 

#### ***ComprehensiveIncome (Loss)***

 

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

 

***Significant Customers***

 

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

 
| ** **           | ** ** | **Net Revenues**            | ** ** | ** **                     | ** ** | ** **                           | ** ** |
|----------------------|------------|----------------------------------|------------|--------------------------------|------------|--------------------------------------|------------|
| ** **           | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** | **Accounts Receivable at** | ** ** |
| ** **           | ** ** | **March 31,**               | ** ** | **March 31,**             | ** ** | **March 31,**                   | ** ** | **September 30,** | ** ** |
| ** **           | ** ** | **2010**                         | ** ** | **2009**                       | ** ** | **2010**                             | ** ** | **2009** | ** ** | **2010** | ** ** | **2009** | ** ** |
| EMC Corporation      |       | 44                               | %          | 38                             | %          | 42                                   | %          | 36 | % | 29 | % | 30 | % |
| Tektronix, Inc. |       | 25                               | %          | 9                              | %          | 23                                   | %          | 12 | % | 35 | % | 17 | % |

 

**3.Business Combination**

 

On October 11,2007, the Company acquired all of the equity of Alliance Systems, Inc. (“AllianceSystems”), a privately held corporation located in Plano, Texas, which providedapplication platforms and related equipment supporting carrier communicationsand enterprise communications solutions.  For further information on theacquisition, refer to the Company’s Annual Report on Form 10-K for theyear ended September 30, 2009.

 

The acquisition ofAlliance Systems was structured to include an adjustment to decrease thepurchase price based on the net working capital of Alliance Systems as of October 11,2007, as defined in the merger agreement, and therefore approximately$4.0 million of the cash paid was contingently returnable to the Companyand was previously recorded as contingently returnable acquisitionconsideration. The former Alliance Systems shareholders disputed the amountsclaimed by the Company under this provision of the merger agreement. In September 2009,the Company engaged in arbitration with the former Alliance Systemsshareholders to resolve the disputed claims as provided for in the mergeragreement. In October 2009, the arbitrator’s decision was rendered. As aresult, approximately $3.6 million of the contingently returnableconsideration was returned to the Company from escrow funds on November 3,2009. This amount was recorded as refundable acquisition consideration in theCompany’s consolidated balance sheet as of September 30, 2009.  The $393,000 not returned to the Company was recorded as settlement ofacquisition dispute in the statement of operations for the year ended September 30,2009.

 

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**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**4.  Stock-Based Compensation**

 

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

 

The following tablepresents stock-based employee compensation expense included in the Company’sunaudited condensed consolidated statements of operations (in thousands):

 
| ** **                             | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|----------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                             | ** ** | **2010**                                         | ** ** | **2009**                                       | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                   |       |                                             |       |                                           |       |   |   |   |   |
| Cost of revenues                       |       | $                                                | 39         |                                           | $          | 40 |   | $ | 77 |   | $ | 75 |   |
| Research and development               |       | 43                                               |       | 58                                             |       | 89 |   | 142 |   |
| Selling and marketing                  |       | 92                                               |       | 77                                             |       | 169 |   | 138 |   |
| General and administrative             |       | 108                                              |       | 166                                            |       | 259 |   | 325 |   |
| Total stock-based compensation expense |       | $                                                | 282        |                                           | $          | 341 |   | $ | 594 |   | $ | 680 |   |

 

The Companyestimates the fair value of stock options using the Black-Scholes valuationmodel.  This valuation model takes into account the exercise price of theaward, as well as a variety of significant assumptions.  These assumptionsinclude the expected term, the expected volatility of the Company’s commonstock over the expected term, the risk-free interest rate over the expectedterm, and the Company’s expected annual dividend yield.  The Companybelieves that the valuation technique and the approach utilized to develop theunderlying assumptions are appropriate in calculating the fair values of theCompany’s stock options granted during the three and six month periods ended March 31,2010 and 2009.  Estimates of fair value are not intended to predict thevalue ultimately realized by persons who receive equity awards.  Indetermining the amount of expense to be recorded, judgment is also required toestimate forfeitures of the awards based on the probability of employeescompleting the required service period.  Historical forfeitures are usedas a starting point for developing the estimate of future forfeitures.

 

Assumptionsused to determine the fair value of options granted during the three and sixmonths ended March 31, 2010 and 2009, using the Black-Scholes valuationmodel, were:

 
| ** **                      | ** ** | **Three months ended March 31,** | ** ** | **Six months ended March 31,** | ** ** |
|---------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                      | ** ** | **2010**                                             | ** ** | **2009**                                           | ** ** | **2010** | ** ** | **2009** | ** ** |
|                            |       |                                                 |       |                                               |       |   |   |   |   |
| Expected term (1)               |       | 3.75 to 6.50 years                                   |       | 3.50 to 6.00 years                                 |       | 3.75 to 6.50 years |   | 3.50 to 6.00 years |   |
| Expected volatility  factor (2) |       | 71.56% to 72.09%                                     |       | 73.36% to 80.11%                                   |       | 71.56% to 74.03% |   | 66.82% to 80.11% |   |
| Risk-free interest rate  (3)    |       | 1.71% to 2.97%                                       |       | 1.28% to 2.21%                                     |       | 1.45% to 2.97% |   | 1.28% to 2.21% |   |
| Expected annual  dividend yield |       | —                                               |       | —                                             |       | — |   | — |   |

 

----

(1)   The expected term for each grant was determined basedon analysis of the Company’s historical exercise and post-vesting cancellationactivity.

 

(2)   The expected volatility foreach grant was estimated based on a weighted average of the historicalvolatility of the Company’s common stock.

 

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

 

Stock-basedcompensation expense incurred related to the Company’s Employee Stock PurchasePlan (the “Purchase Plan”) is determined based on the discount of 15% from theper share market price on the close of the purchase period.  No expenserelated to the Purchase Plan was incurred during the three and six months endedMarch 31, 2010 as there have been no new offerings under the Purchase Plansince the most recent purchase in May 2009.

 

A summary of the Company’sstock option activity for the six months ended March 31, 2010 is asfollows:

 

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**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 
| ** **                              | ** ** | **Six months ended March 31, 2010** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                              | ** ** | **Number of  Options**                                  | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted********Average Remaining  Contractual  Term (in years)** | ** ** |
|                                    |       |                                                         |       |   |   |   |   |
| Outstanding  at September 30, 2009 |       | 7,959,408                                                    |       | $ | 2.08 |   |   |   |
| Granted                                 |       | 518,500                                                      |       | $ | 1.50 |   |   |   |
| Exercised                               |       | (147,557                                                     | )          | $ | 0.88 |   |   |   |
| Forfeited                               |       | (36,458                                                      | )          | $ | 1.49 |   |   |   |
| Expired                                 |       | (141,671                                                     | )          | $ | 2.72 |   |   |   |
| Outstanding  at March 31, 2010     |       | 8,152,222                                                    |       | $ | 2.06 |   | 6.27 |   |
| Exercisable  at March 31, 2010     |       | 5,993,123                                                    |       | $ | 2.33 |   | 5.50 |   |

 

All stock options grantedduring the six months ended March 31, 2010 were granted with exerciseprices equal to the fair market value of the Company’s common stock on thegrant date and had a weighted average grant date fair value of $0.93.

 

AtMarch 31, 2010,unrecognized compensation expense related to non-vested stock options was$1,511,000, which is expected to be recognized over a weighted average vestingperiod of 2.25 years.

 

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

** **

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

 

The followingtable sets forth the computation of basic and diluted net income (loss) pershare as well as the weighted average potential common stock excluded from thecalculation of net income (loss) per share because their inclusion would beanti-dilutive (in thousands, except per share data):

 
| ** **                                                                                                              | ** ** | **Three months  ended March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                                                              | ** ** | **2010**                                         | ** ** | **2009**                                       | ** ** | **2010** | ** ** | **2009** | ** ** |
| Numerator:                                                                                                              |       |                                             |       |                                           |       |   |   |   |   |
| Net  income (loss)                                                                                                      |       | $                                                | 236        |                                           | $          | (670 | ) | $ | 434 |   | $ | (1,136 | ) |
|                                                                                                                    |       |                                             |       |                                           |       |   |   |   |   |
| Denominator:                                                                                                            |       |                                             |       |                                           |       |   |   |   |   |
| Shares  used in computing basic net income (loss) per share                                                             |       | 42,050                                           |       | 43,177                                         |       | 42,039 |   | 43,156 |   |
| Common  stock equivalents from employee stock options                                                                   |       | 1,516                                            |       | —                                         |       | 1,160 |   | — |   |
|                                                                                                                    |       |                                             |       |                                           |       |   |   |   |   |
| Shares  used in computing diluted net income (loss) per share                                                           |       | 43,566                                           |       | 43,177                                         |       | 43,199 |   | 43,156 |   |
|                                                                                                                    |       |                                             |       |                                           |       |   |   |   |   |
| Net  income (loss) per share:                                                                                           |       |                                             |       |                                           |       |   |   |   |   |
| Basic                                                                                                                   |       | $                                                | 0.01       |                                           | $          | (0.02 | ) | $ | 0.01 |   | $ | (0.03 | ) |
| Diluted                                                                                                                 |       | $                                                | 0.01       |                                           | $          | (0.02 | ) | $ | 0.01 |   | $ | (0.03 | ) |
|                                                                                                                    |       |                                             |       |                                           |       |   |   |   |   |
| Anti-dilutive  potential common stock equivalents excludedfrom the calculation of diluted net  income (loss) per share: |       |                                             |       |                                           |       |   |   |   |   |
| Options  to purchase common stock                                                                                       |       | 4,313                                            |       | 8,020                                          |       | 5,247 |   | 7,763 |   |

 

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**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**6.  Intangible Asset**

 

The Company recorded an intangible asset asthe result of its acquisition of Alliance Systems (see Note 3 above).  The acquired intangible asset is customer relationships,which is being amortized over 17 years, which is the estimated period ofeconomic benefit expected to be received, resulting in a weighted averageamortization period of 4.97 years.  Thefollowing table presents the intangible asset balances as of March 31, 2010 and September 30, 2009 (in thousands):

 
| ** **              | ** ** | **March 31, 2010** | ** ** | **September 30, 2009** | ** ** |
|-------------------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **              | ** ** | **Gross  Carrying  Amount**  | ** ** | **Accumulated  Amortization**    | ** ** | **Net Book  Value** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Book  Value** | ** ** |
| ** **              | ** ** | ** **                   | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Customer  relationships |       | $                            | 11,775     |                             | $          | 4,424 |   | $ | 7,351 |   | $ | 11,775 |   | $ | 3,647 |   | $ | 8,128 |   |
|                         |            |                              |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Amortizationexpense for the three and six months ended March 31, 2010 was $389,000 and$778,000, respectively.  The estimatedfuture amortization expense for the intangible asset as of March 31, 2010by fiscal year is $778,000 for the remainder of 2010, $1,330,000 for 2011,$1,119,000 for 2012, $868,000 for 2013, $678,000 for 2014 and $2,578,000thereafter.

 

The Companyreviews long-lived assets, including definite-lived intangible assets, to determineif any adverse conditions exist that would indicate impairment.  Factorsthat could lead to an impairment of acquired customer relationships include aworsening in customer attrition rates compared to historical attrition rates,or lower than initially anticipated cash flows associated with customerrelationships.  The Company assesses the recoverability of long-livedassets based on the projected undiscounted future cash flows estimated to begenerated over the asset’s remaining life.  The amount of impairment, ifany, is measured based on the excess of the carrying value over fairvalue.  Fair value is generally calculated as the present value ofestimated future cash flows using a risk-adjusted discount rate, which requiressignificant management judgment with respect to revenue and expense growthrates, and the selection and use of an appropriate discount rate.

 

**7.  Inventories**

 

Inventories consisted of the following (in thousands):

 
| ** **       | ** ** | **March 31, 2010** | ** ** | **September 30, 2009** | ** ** |
|------------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **       | ** ** | ** **                   | ** ** | ** **                       | ** ** |
| Raw  materials   |       | $                            | 11,685     |                             | $          | 8,246 |   |
| Work  in process |       | 2,357                        |       | 1,063                            |       |
| Finished  goods  |       | 9,855                        |       | 3,769                            |       |
|             |       |                         |       |                             |       |
| Total            |       | $                            | 23,897     |                             | $          | 13,078 |   |

 

**8.  Equity**

 

On June 12,2008, the Board of Directors of the Company authorized the repurchase of up to$5 million of its common stock through a share repurchase program.  Asauthorized by the program, shares may be purchased in the open market orthrough privately negotiated transactions, in a manner consistent withapplicable securities laws and regulations.  This stock repurchase programdoes not obligate the Company to acquire any specific number of shares, doesnot have an expiration date, and may be terminated at any time by the Company’sBoard of Directors.  All repurchases are expected to be funded from theCompany’s current cash balances or from cash generated from operations. To facilitate repurchases of shares under this program, the Company hasestablished Rule 10b5-1 plans intended to comply with the requirements of Rule 10b5-1and Rule 10b-18 under the Securities Exchange Act of 1934.  A Rule 10b5-1plan permits the repurchase of shares by a company at times when it otherwisemight be prevented from doing so under insider trading laws or because ofcompany blackout periods, provided that the plan is adopted when the company isnot aware of material non-public information.  Pursuant to the plan, abroker designated by the Company has the authority to repurchase shares, inaccordance with the terms of the plan, without 

 

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**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

further direction fromthe Company.  The amount and timing ofspecific repurchases are subject to the terms of the plan and marketconditions.  Upon the expiration of thefirst 10b5-1 plan on November 7, 2008, the Company suspended repurchasesof its common stock.  The Company resumedthe stock repurchase program on March 16, 2009 under a new 10b5-1 plan, asauthorized by the Board of Directors.  During the three months ended March 31,2010, the Company did not repurchase any shares of its common stock.  During the six months ended March 31,2010, the Company repurchased 158,200 shares of its common stock at an averagecost of $1.12 per share.  From theinception of the share repurchase program through March 31, 2010, theCompany had repurchased 2,581,546 shares of its common stock at an average costof $0.84 per share.  As of March 31, 2010, the maximum dollar valuethat may yet be used for purchases under the program was $2,820,000.

 

**9.  Commitments andContingencies**

 

***Guarantees and Indemnifications***

 

Acquisition-relatedindemnifications — When, as part of an acquisition, the Company acquires allthe stock of a company, the Company assumes liabilities for certain events orcircumstances that took place prior to the date of acquisition.  Themaximum potential amount of future payments the Company could be required tomake for such obligations is undeterminable.  Although certain provisionsof the agreements remain in effect indefinitely, the Company believes that theprobability of receiving a claim related to acquisitions other than AllianceSystems is unlikely.  As a result, the Company had not recorded anyliabilities for such indemnification clauses as of March 31, 2010. As of March 31, 2010, the Company had received two claims related to theAlliance Systems acquisition.  For one of the claims, the Company paid asettlement of $88,000 during the fiscal year ended September 30, 2008.  The second claim was brought in January 2009by Cordsen Engineering GmbH (“Cordsen”), a former customer of Alliance Systems,alleging that certain products that Cordsen purchased from Alliance Systems(prior to the Company’s acquisition of Alliance Systems) were defective and didnot meet Cordsen’s desired specifications.  Cordsen alleges that by virtueof the Company’s acquisition of Alliance Systems in October 2007, theCompany became the assignee of Alliance Systems’ agreement with Cordsen. In April 2010, a settlement was reached with Cordsen, whereby the formerAlliance Systems shareholders have agreed to pay a settlement of $100,000 andthe Company’s insurer has agreed to pay a settlement of $300,000 to Cordsen.   Payment of the settlement is due on May 12,2010.

 

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 isgenerally perpetual.  The Company has never incurred costs to defendlawsuits or settle claims related to these indemnification agreements.  Asa result, the Company believes the estimated fair value of these agreements isminimal.  Accordingly, the Company has no liabilities recorded for theseindemnifications as of March 31, 2010.

 

Product warranties— The Company offers and fulfills standard warranty services on its applicationplatform solutions.  Warranty terms vary in duration depending upon theproduct sold, but generally provide for the repair or replacement of anydefective products for periods of up to 36 months after shipment.  Basedupon historical experience and expectation of future conditions, the Companyreserves for the estimated costs to fulfill customer warranty obligations uponthe recognition of the related revenue.  The following table presentschanges in the Company’s product warranty liability for the three and sixmonths ended March 31, 2010 and 2009 (in thousands):

 
| ** **                                  | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended********March 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                  | ** ** | **2010**                                         | ** ** | **2009**                                             | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                        |       |                                             |       |                                                 |       |   |   |   |   |
| Beginning balance                           |       | $                                                | 602        |                                                 | $          | 876 |   | $ | 641 |   | $ | 931 |   |
| Accruals for warranties issued              |       | 463                                              |       | 249                                                  |       | 787 |   | 582 |   |
| Fulfillment of warranties during the period |       | (472                                             | )          | (329                                                 | )          | (835 | ) | (717 | ) |
| Ending balance                              |       | $                                                | 593        |                                                 | $          | 796 |   | $ | 593 |   | $ | 796 |   |

 

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**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

***Contingencies***

 

*Initial Public Offering Lawsuit*

 

On or about December 3,2001, a putative class action lawsuit was filed in the United States DistrictCourt for the Southern District of New York against the Company, Lawrence A.Genovesi (the Company’s former Chairman and Chief Executive Officer), DouglasG. Bryant (the Company’s Chief Financial Officer), and several underwriters ofthe Company’s initial public offering. The suit alleges, *inter alia*, that the defendants violatedthe federal securities laws by issuing and selling securities pursuant to theCompany’s initial public offering in July 2000 (“IPO”) without disclosingto investors that the underwriter defendants had solicited and receivedexcessive and undisclosed commissions from certain investors. The suit seeksdamages and certification of a plaintiff class consisting of all persons whoacquired shares of the Company’s common stock between July 13, 2000 and December 6,2000.

 

In October 2002,Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this casewithout prejudice. On December 5, 2006, the United States Court of Appealsfor the Second Circuit overturned the District Court’s certification of aplaintiff class. On April 6, 2007, the Second Circuit denied plaintiffs’petition for rehearing, but clarified that the plaintiffs may seek to certify amore limited class in the District Court. On September 27, 2007,plaintiffs filed a motion for class certification in certain designated “focuscases” in the District Court. That motion has since been withdrawn. On November 13,2007, the issuer defendants in certain designated “focus cases” filed a motionto dismiss the second consolidated amended class action complaints that werefiled in those cases. On March 26, 2008, the District Court issued anOpinion and Order denying, in large part, the motions to dismiss the amendedcomplaints in the “focus cases.” On April 2, 2009, the plaintiffs filed amotion for preliminary approval of a new proposed settlement betweenplaintiffs, the underwriter defendants, the issuer defendants and the insurersfor the issuer defendants. On June 10, 2009, the Court issued an opinionpreliminarily approving the proposed settlement, and scheduling a settlementfairness hearing for September 10, 2009. On October 5, 2009, theCourt issued an opinion granting plaintiffs’ motion for final approval of thesettlement, approval of the plan of distribution of the settlement fund, andcertification of the settlement classes. An Order and Final Judgment wasentered on December 30, 2009.  Various notices of appeal of theDistrict Court’s October 5, 2009 order have been filed. The Company isunable to predict the outcome of this suit and as a result, no amounts havebeen accrued as of March 31, 2010.

 

**10. Lineof Credit**

 

On October 11,2007, the Company entered into a Loan and Security Agreement (the “LoanAgreement”) with Silicon Valley Bank (the “Bank”). On August 5, 2008, theCompany and the Bank entered into the First Loan Modification Agreement (the “FirstModification “). The First Modification amended the Loan Agreement to extendits term to August 5, 2010, and to change the amount of the revolving loanfacility to $10 million.

 

On February 5,2010, the Company and the Bank entered into an Amended and Restated Loan andSecurity Agreement.  This agreement amended the Loan Agreement to extendits term to February 4, 2012, and to change the interest rate on the lineto one half of a point (0.50%) above the Prime Rate with interest payablemonthly.  The Prime Rate is the rateannounced from time to time by the Bank.  The Company is also required tocomply with certain financial covenants relating to liquidity and minimum operatingcash flows per quarter.  As of May 10,2010, the Company had not drawn on this line of credit.

 

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**ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

 

**Special Note RegardingForward-Looking Statements**

 

This Quarterly Report on Form 10-Qcontains forward-looking statements within the meaning of Section 21E ofthe Securities Exchange Act of 1934, as amended, that involve risks anduncertainties.  All statementsother than statements of historical information provided herein areforward-looking statements and may contain projections related to financialresults, economic conditions, trends and known uncertainties.  Our actual results could differ materiallyfrom those discussed in the forward-looking statements as a result of a numberof 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 (the “SEC”).  Readers are cautioned not to place unduereliance on these forward-looking statements, which reflect management’sanalysis, judgment, belief or expectation only as of the date hereof.  We undertake no obligation to publiclyreissue these forward-looking statements to reflect events or circumstancesthat arise after the date hereof.

 

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 Report on Form 10-Kfor the fiscal year ended September 30, 2009 filed by us with the SEC.

 

**Overview**

 

We design andmanufacture application platform solutions that enable original equipmentmanufacturers, or OEMs, and independent software vendors, or ISVs, that thendeliver their software applications in the form of a network-ready device.Application platforms are pre-configured server-based network infrastructuredevices, engineered to deliver specific software application functionality,ease deployment challenges, improve integration and manageability, acceleratetime-to-market and increase the security of that software application in an enduser’s network. We offer our customers an extensive suite of services includingsolution design, integration control, global logistics, Smart Services, andsupport and maintenance. We produce and fulfill devices branded for ourcustomers, and derive our revenues primarily from the sale of value-addedhardware platforms to these customers. Our customers subsequently resell andsupport these platforms under their own brands to their customer bases.

 

**CriticalAccounting Policies and Estimates**

 

Ourdiscussion and analysis of financial condition and results of operations arebased upon our condensed consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States of America.  In preparingthese financial statements, we have made estimates and judgments in determiningcertain amounts included in the financial statements.  We base our estimates and judgments onhistorical experience and other assumptions that we believe to be reasonableunder the circumstances.  Actual resultsmay differ from these estimates under different assumptions or conditions.

 

On January 1, 2010, weadopted the authoritative guidance issued by the Financial Accounting StandardsBoard (“FASB”) related to revenue arrangements with multiple deliverables andrevenue arrangements which include software elements.  Under the amended authoritative guidance forarrangements with multiple deliverables and arrangements that include softwareelements, we are required to determine if the software elements functiontogether with the tangible product to deliver the tangible product’s essentialfunctionality.  We determined that oursoftware elements provide additional functionality but are not necessary todeliver the tangible product’s essential functionality; as such, we arerequired to allocate the arrangement consideration to the hardware and softwareelements based upon the relative selling price of the hardware and softwaredeliverables.  Our software elementsconsist of software and software maintenance. Revenue associated with the software is recognized upon delivery, whenVSOE is available for the undelivered software maintenance.  Revenue associated with the softwaremaintenance is recognized over the term of the maintenance period, which isgenerally one year.  When VSOE is notavailable for the undelivered software maintenance, revenue associated with thesoftware elements is deferred and recognized over the software maintenanceperiod.  Our hardware elements generallyconsist of an application platform and post-sales support and/or an extendedwarranty.  Revenue associated with theapplication platform is recognized upon delivery.  We allocate revenue associated with thepost-sales support and/or extended warranty based upon separately pricedcontractual rates for these elements. Revenue associated with the post-sales support and/or extended warrantyis deferred and recognized over the support period, generally one to three years.  With the exception of the adoption of theauthoritative guidance related to revenue arrangements withmultiple deliverables and revenue arrangements which include software elements,there have been no changes to our critical accounting policies since September 30,2009.

 

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**Resultsof Operations**

 

**Threemonths ended March 31, 2010 compared to the three months ended March 31,2009**

 

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****,** | ** ** |
|--------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                     | ** ** | **2010**                                                     | ** ** | **2009** | ** ** | ** ** | ** ** |
| ** **                     | ** ** | ** **                                                   | ** ** | **% of Net** | ** ** | ** ** | ** ** | **% of Net** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                     | ** ** | **Dollars**                                                  | ** ** | **Revenues** | ** ** | **Dollars** | ** ** | **Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net  revenues                  |       | $                                                            | 55,030     |   | 100.0 | % | $ | 37,461 |   | 100.0 | % | $ | 17,569 |   | 46.9 | % |
| Gross  profit                  |       | 6,503                                                        |       | 11.8 | % | 5,768 |   | 15.4 | % | 735 |   | 12.7 | % |
| Operating  expenses            |       | 6,232                                                        |       | 11.3 | % | 6,391 |   | 17.1 | % | (159 | ) | (2.5 | )% |
| Income  (loss) from operations |       | 271                                                          |       | 0.5 | % | (623 | ) | (1.7 | )% | 894 |   | — |   |
| Net  income (loss)             |       | $                                                            | 236        |   | 0.4 | % | $ | (670 | ) | (1.8 | )%  | $ | 906 |   | — |   |

 

***Net Revenues***

 

Our revenues arederived primarily from sales of application platform solutions to our OEM andISV customers.  The increase in net revenues during the three months endedMarch 31, 2010 as compared to the three months ended March 31, 2009was primarily the result of increased sales volume to some of our largercustomers, in particular a design win achieved in the fourth quarter of fiscalyear 2009 with our largest customer, combined with lower overall sales volumesin the three months ended March 31, 2009 due to the global economicdownturn.  The increases in revenues were partially offset by a decreasein net revenues related to our transition away from some of our non-strategic,transactional revenues to projects that are more in line with our businessmodel.

 

***Gross Profit***

 

Gross profitrepresents net revenues recognized less the cost of revenues. Cost of revenuesincludes cost of materials, manufacturing costs, warranty costs, inventorywrite-downs, shipping and handling costs and customer support costs.Manufacturing costs are primarily comprised of compensation, contract laborcosts and, when applicable, contract manufacturing costs.

 

Gross profitincreased in the three months ended March 31, 2010 as compared to thethree months ended March 31, 2009, primarily due to increased salesvolumes with our largest customer.  Grossprofit as a percentage of net revenues decreased for the three months ended March 31,2010, as compared to the three months ended March 31, 2009. The decreasefrom the prior year was primarily due to the high volume design win achieved inthe fourth quarter of fiscal year 2009 with our largest customer, which hasgross margins that are lower than historical levels.  The first shipmentsof product related to some of this business occurred (and the related revenueswere recognized) during the three months ended December 31, 2009 andcontinued to ramp up in the three months ended March 31, 2010.  Wehave pursued such opportunities in order to increase revenues and leveragethose revenues over our existing infrastructure to improve operatingmargins.  In addition, certain planned price decreases were in effectduring the three months ended March 31, 2010 in connection with the designwin achieved in the fourth quarter of fiscal year 2009 with our largestcustomer.

 

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

 

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***Operating Expenses***

 

The followingtable presents operating expenses during the periods indicated, in thousandsand as a percentage of net revenues, and provides the changes in thousands andpercentages:

 
| ** **                        | ** ** | **Three months ended ****March 31****,** | ** ** |
|-----------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                        | ** ** | **2010**                                                     | ** ** | **2009** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **                                                   | ** ** | **% of Net** | ** ** | ** ** | ** ** | **% of Net** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                                  | ** ** | **Revenues** | ** ** | **Dollars** | ** ** | **Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating  expenses:              |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Research  and development         |       | $                                                            | 1,584      |   | 2.9 | % | $ | 1,653 |   | 4.4 | % | $ | (69 | ) | (4.2 | )% |
| Selling  and marketing            |       | 2,060                                                        |       | 3.7 | % | 2,024 |   | 5.4 | % | 36 |   | 1.8 | % |
| General  and administrative       |       | 2,199                                                        |       | 4.0 | % | 2,275 |   | 6.1 | % | (76 | ) | (3.3 | )% |
| Amortization  of intangible asset |       | 389                                                          |       | 0.7 | % | 439 |   | 1.2 | % | (50 | ) | (11.4 | )% |
|                              |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Total  operating expenses         |       | $                                                            | 6,232      |   | 11.3 | % | $ | 6,391 |   | 17.1 | % | $ | (159 | ) | (2.5 | )% |

 

***Research and Development***

 

Research and development expenses consist primarily of salaries andrelated expenses for personnel engaged in research and development, materialcosts for prototype and test units, fees paid to consultants and outsideservice providers, and other expenses related to the design, development,testing and enhancements of our application platform solutions.  We expense all of our research and developmentcosts as they are incurred.  Thefollowing table summarizes the most significant components of research anddevelopment expense for the periods indicated, in thousands and as a percentageof total research and development expense, and provides the changes inthousands and percentages:

 
| ** **                            | ** ** | **Three months ended ****March 31****,** | ** ** |
|---------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                            | ** ** | **2010**                                                     | ** ** | **2009** | ** ** | ** ** | ** ** |
| ** **                            | ** ** | ** **                                                   | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** | ** ** | ** ** |
| ** **                            | ** ** | ** **                                                   | ** ** | **Expense** | ** ** | ** ** | ** ** | **Expense** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                                                  | ** ** | **Category** | ** ** | **Dollars** | ** ** | **Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research  and development:            |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Compensation  and related expenses    |       | $                                                            | 1,227      |   | 77.5 | % | $ | 1,035 |   | 62.6 | % | $ | 192 |   | 18.6 | % |
| Stock-based  compensation             |       | 43                                                           |       | 2.7 | % | 58 |   | 3.5 | % | (15 | ) | (25.9 | )% |
| Prototype                             |       | 188                                                          |       | 11.9 | % | 244 |   | 14.8 | % | (56 | ) | (23.0 | )% |
| Consulting  and professional services |       | 72                                                           |       | 4.5 | % | 197 |   | 11.9 | % | (125 | ) | (63.5 | )% |
| Other                                 |       | 54                                                           |       | 3.4 | % | 119 |   | 7.2 | % | (65 | ) | (54.6 | )% |
|                                  |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Total  research and development       |       | $                                                            | 1,584      |   | 100 | % | $ | 1,653 |   | 100 | % | $ | (69 | ) | (4.2 | )% |

 

Research and development expenses decreased in the three months ended March 31,2010, as compared to the three months ended March 31, 2009, primarily dueto decreases in prototype and consulting and professional services.  These costs often tend to fluctuate based onthe status of our development projects which are in process at any given time. Although our application platform development strategy emphasizes theutilization of standard component technologies, which utilize off-the-shelfcomponents, some of our designs require customized platforms which requireadditional prototype and consulting and professional services.  As such,we expect that prototype and consulting and professional services costs willcontinue to be variable and could fluctuate depending on the timing andmagnitude of our development projects.

 

These decreases in prototype and consulting and professional serviceswere partially offset by an increase in compensation and related expenses.  Compensation and related expenses increasedprimarily due to an increase in headcount from 37 at March 31, 2009 to 40at March 31, 2010 and an increase in variable compensation, which wasdirectly related to the results of operations.

 

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***Selling and Marketing***

 

Selling and marketing expenses consist primarily of salaries andcommissions for personnel engaged in sales and marketing, and costs associatedwith our marketing programs, which include costs associated with our attendanceat trade shows, public relations, product literature costs, web siteenhancements, and travel.  The followingtable summarizes the most significant components of selling and marketingexpense for the periods indicated, in thousands and as a percentage of totalselling and marketing expense, and provides the changes in thousands andpercentages:

 
| ** **                         | ** ** | **Three months ended ****March 31****,** | ** ** |
|------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                         | ** ** | **2010**                                                     | ** ** | **2009** | ** ** | ** ** | ** ** |
| ** **                         | ** ** | ** **                                                   | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** | ** ** | ** ** |
| ** **                         | ** ** | ** **                                                   | ** ** | **Expense** | ** ** | ** ** | ** ** | **Expense** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                         | ** ** | **Dollars**                                                  | ** ** | **Category** | ** ** | **Dollars** | ** ** | **Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling  and marketing:            |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Compensation  and related expenses |       | $                                                            | 1,567      |   | 76.0 | % | $ | 1,570 |   | 77.6 | % | $ | (3 | ) | (0.2 | )% |
| Stock-based  compensation          |       | 92                                                           |       | 4.5 | % | 77 |   | 3.8 | % | 15 |   | 19.5 | % |
| Marketing  programs                |       | 150                                                          |       | 7.3 | % | 116 |   | 5.7 | % | 34 |   | 29.3 | % |
| Travel                             |       | 70                                                           |       | 3.4 | % | 76 |   | 3.8 | % | (6 | ) | (7.9 | )% |
| Other                              |       | 181                                                          |       | 8.8 | % | 185 |   | 9.1 | % | (4 | ) | (2.2 | )% |
|                               |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Total  selling and marketing       |       | $                                                            | 2,060      |   | 100 | % | $ | 2,024 |   | 100 | % | $ | 36 |   | 1.8 | % |

 

Selling and marketing expenses increased in the threemonths ended March 31, 2010, as compared to the three months ended March 31,2010, primarily due to increased marketing program costs.  The increase in marketing programs wasprimarily attributed to increased expenses associated with industry trade showsduring the three months ended March 31, 2010.  Historically, we have attended a major tradeshow during the third quarter of our fiscal year; however, that trade showoccurred during the three months ended March 31, 2010 instead of the thirdquarter of fiscal year 2010. Compensation and related expenses decreased primarily as a result of adecrease in headcount from 43 at March 31, 2009 to 38 at March 31,2010, partially offset by an increase in variable compensation which wasdirectly related to the results of operations.

 

***General and Administrative***

 

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

 
| ** **                            | ** ** | **Three months ended ****March 31****,** | ** ** |
|---------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                            | ** ** | **2010**                                                     | ** ** | **2009** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                            | ** ** | ** **                                                   | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                            | ** ** | ** **                                                   | ** ** | **Expense** | ** ** | ** ** | ** ** | **Expense** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                                                  | ** ** | **Category** | ** ** | **Dollars** | ** ** | **Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General  and administrative:          |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Compensation  and related expenses    |       | $                                                            | 1,303      |   | 59.3 | % | $ | 1,096 |   | 48.2 | % | $ | 207 |   | 18.9 | % |
| Stock-based  compensation             |       | 108                                                          |       | 4.9 | % | 166 |   | 7.3 | % | (58 | ) | (34.9 | )% |
| Consulting  and professional services |       | 490                                                          |       | 22.3 | % | 660 |   | 29.0 | % | (170 | ) | (25.8 | )% |
| Director  and officer insurance       |       | 38                                                           |       | 1.7 | % | 56 |   | 2.5 | % | (18 | ) | (32.1 | )% |
| Other                                 |       | 260                                                          |       | 11.8 | % | 297 |   | 13.0 | % | (37 | ) | (12.5 | )% |
|                                  |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Total  general and administrative     |       | $                                                            | 2,199      |   | 100 | % | $ | 2,275 |   | 100 | % | $ | (76 | ) | (3.3 | )% |

 

General and administrative expenses decreased in the three months endedMarch 31, 2010, as compared to the three months ended March 31, 2009,primarily due to decreases in consulting and professional services andstock-based compensation, partially offset by an increase in compensation andrelated expenses.  Compensation and 

 

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related expenses increased primarily due to anincrease in variable compensation, which was directly related to the results ofoperations.  The decrease in consultingand professional services was primarily attributed to a decrease in legal andoutside service expenses incurred during the three months ended March 31,2010 as compared to the three months ended March 31, 2009.  The decrease in stock-based compensation wasprimarily due to the fact that certain stock options granted in prior periodsreached the end of their vesting periods during the three months ended March 31,2010.

 

***Amortization of Intangible Asset***

 

Amortization of the intangible asset decreased by $50,000 in the threemonths ended March 31, 2010, as compared to the three months ended March 31,2009.  Amortization expense for theintangible asset decreases annually over its life of 17 years, to reflect thefact that the estimated economic benefit expected to be received from theintangible asset declines over time.

 

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

* *

Interest and otherincome (expense), net, totaled $(26,000) of expense for the three months ended March 31,2010, compared to $(47,000) of expense for the three months ended March 31,2009.  This change was primarily due toforeign currency exchange losses of $13,000 recorded during the three monthsended March 31, 2010 as compared to foreign currency exchange losses of$83,000 recorded during the three months ended March 31, 2009.  Theselosses relate primarily to value-added tax (“VAT”) refunds receivable. The refundable VAT amounts, which we pay on products and services purchasedfrom our contract manufacturer located in Ireland, are denominated inEuros.  The decrease in the foreign currency exchange loss incurred duringthe three months ended March 31, 2010 was partially offset by a decreaseof $48,000 in interest income, primarily attributable to lower interest rateson the cash balances held by us during the three months ended March 31,2010 as compared to the three months ended March 31, 2009.

 

***Provision for Income Taxes***

 

The provision forincome taxes for the three months ended March 31, 2010 was $9,000, basedupon our estimated effective tax rate for fiscal year 2010.  There was noprovision for income taxes during the three months ended March 31,2009.  Although we have significant net operating loss carryforwards whichcan be used to offset taxable income, we are still subject to federalalternative minimum tax.  In addition, we will be subject to state taxesin various jurisdictions where we do not have net operating loss carryforwardsor where states have suspended the use of net operating loss carryforwards tooffset taxable income.

 

**Sixmonths ended March 31, 2010 compared to the six months ended March 31,2009**

 

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****,** | ** ** |
|--------------------------------|------------|------------------------------------------------------------|------------|
| ** **                     | ** ** | **2010**                                                   | ** ** | **2009** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                     | ** ** | ** **                                                 | ** ** | **% of Net** | ** ** | ** ** | ** ** | **% of Net** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                     | ** ** | **Dollars**                                                | ** ** | **Revenues** | ** ** | **Dollars** | ** ** | **Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net  revenues                  |       | $                                                          | 99,082     |   | 100.0 | % | $ | 74,696 |   | 100.0 | % | $ | 24,386 |   | 32.6 | % |
| Gross  profit                  |       | 12,558                                                     |       | 12.7 | % | 11,376 |   | 15.2 | % | 1,182 |   | 10.4 | % |
| Operating  expenses            |       | 12,083                                                     |       | 12.2 | % | 12,524 |   | 16.7 | % | (441 | ) | (3.5 | )% |
| Income  (Loss) from operations |       | 475                                                        |       | 0.5 | % | (1,148 | ) | (1.5 | )% | 1,623 |   | — |   |
| Net  income (loss)             |       | $                                                          | 434        |   | 0.4 | % | $ | (1,136 | ) | (1.5 | )%  | $ | 1,570 |   | — |   |

 

***Net Revenues***

 

The increase innet revenues during the six months ended March 31, 2010 as compared to thesix months ended March 31, 2009 was primarily the result of increasedsales volume to some of our larger customers, in particular a design winachieved in the fourth quarter of fiscal year 2009 with our largest customer,combined with lower overall sales volumes in the six months ended March 31,2009 due to the global economic downturn.  The 

 

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increase in revenues waspartially offset by a decrease in net revenues related to our transition awayfrom some of our non-strategic, transactional revenues to projects that aremore in line with our business model.

 

***Gross Profit***

 

Gross profitincreased in the six months ended March 31, 2010 as compared to the sixmonths ended March 31, 2009, primarily due to increased sales volumes toour largest customer.

 

Gross profit as apercentage of net revenues decreased for the six months ended March 31,2010, as compared to the six months ended March 31, 2009. The decreasefrom the prior year was primarily due to changes in customer and product mix,which were impacted by a high volume design win achieved in the fourth quarterof fiscal year 2009 with our largest customer, which has gross margins that arelower than historical levels.  The first shipments of product related tosome of this business occurred (and the related revenues were recognized)during the three months ended December 31, 2009 and continued to ramp upin the three months ended March 31, 2010.  We have pursued suchopportunities in order to increase revenues and leverage those revenues over ourexisting infrastructure to improve operating margins.  In addition,certain planned price decreases took effect during the six months ended March 31,2010 in connection with the design win achieved in the fourth quarter of fiscalyear 2009 with our largest customer.

 

***Operating Expenses***

 

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

 
| ** **                        | ** ** | **Six months ended****March 31****,** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|
| ** **                        | ** ** | **2010**                                   | ** ** | **2009** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **                                 | ** ** | **% of Net** | ** ** | ** ** | ** ** | **% of Net** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                | ** ** | **Revenues** | ** ** | **Dollars** | ** ** | **Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating  expenses:              |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Research  and development         |       | $                                          | 3,267      |   | 3.3 | % | $ | 3,095 |   | 4.1 | % | $ | 172 |   | 5.6 | % |
| Selling  and marketing            |       | 3,818                                      |       | 3.9 | % | 4,201 |   | 5.6 | % | (383 | ) | (9.1 | )% |
| General  and administrative       |       | 4,220                                      |       | 4.3 | % | 4,350 |   | 5.8 | % | (130 | ) | (3.0 | )% |
| Amortization  of intangible asset |       | 778                                        |       | 0.8 | % | 878 |   | 1.2 | % | (100 | ) | (11.4 | )% |
|                              |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Total  operating expenses         |       | $                                          | 12,083     |   | 12.2 | % | $ | 12,524 |   | 16.7 | % | $ | (441 | ) | (3.5 | )% |

 

***Research and Development***

 

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

 
| ** **                            | ** ** | **Six months ended****March 31****,** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                            | ** ** | **2010**                                   | ** ** | **2009** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                            | ** ** | ** **                                 | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                            | ** ** | ** **                                 | ** ** | **Expense** | ** ** | ** ** | ** ** | **Expense** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                                | ** ** | **Category** | ** ** | **Dollars** | ** ** | **Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research  and development:            |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Compensation  and related expenses    |       | $                                          | 2,242      |   | 68.6 | % | $ | 2,005 |   | 64.8 | % | $ | 237 |   | 11.8 | % |
| Stock-based  compensation             |       | 89                                         |       | 2.7 | % | 142 |   | 4.6 | % | (53 | ) | (37.3 | )% |
| Prototype                             |       | 514                                        |       | 15.7 | % | 384 |   | 12.4 | % | 130 |   | 33.9 | % |
| Consulting  and professional services |       | 214                                        |       | 6.6 | % | 289 |   | 9.3 | % | (75 | ) | (26.0 | )% |
| Other                                 |       | 208                                        |       | 6.4 | % | 275 |   | 8.9 | % | (67 | ) | (24.4 | )% |
|                                  |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Total  research and development       |       | $                                          | 3,267      |   | 100 | % | $ | 3,095 |   | 100 | % | $ | 172 |   | 5.6 | % |

 

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Research and developmentexpenses increased in the six months ended March 31, 2010, as compared tothe six months ended March 31, 2009, primarily due to an increase in compensation andrelated expenses and prototype expenses. Compensation and related expenses increased primarily due to an increasein headcount from 37 at March 31, 2009 to 40 at March 31, 2010 and anincrease in variable compensation, which was directly related to the results ofoperations.  Because our prototype and consulting and professionalservices expenses are project driven, the timing of these expenditures canvary.

 

***Selling and Marketing***

 

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

 
| ** **                         | ** ** | **Six months ended ****March 31****,** | ** ** |
|------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                         | ** ** | **2010**                                                   | ** ** | **2009** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                         | ** ** | ** **                                                 | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                         | ** ** | ** **                                                 | ** ** | **Expense** | ** ** | ** ** | ** ** | **Expense** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                         | ** ** | **Dollars**                                                | ** ** | **Category** | ** ** | **Dollars** | ** ** | **Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling  and marketing:            |       |                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Compensation  and related expenses |       | $                                                          | 2,878      |   | 75.5 | % | $ | 3,135 |   | 74.6 | % | $ | (257 | ) | (8.2 | )% |
| Stock-based  compensation          |       | 169                                                        |       | 4.4 | % | 138 |   | 3.3 | % | 31 |   | 22.5 | % |
| Marketing  programs                |       | 204                                                        |       | 5.3 | % | 287 |   | 6.8 | % | (83 | ) | (28.9 | )% |
| Travel                             |       | 169                                                        |       | 4.4 | % | 185 |   | 4.4 | % | (16 | ) | (8.6 | )% |
| Other                              |       | 398                                                        |       | 10.4 | % | 456 |   | 10.9 | % | (58 | ) | (12.7 | )% |
|                               |       |                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Total  selling and marketing       |       | $                                                          | 3,818      |   | 100 | % | $ | 4,201 |   | 100 | % | $ | (383 | ) | (9.1 | )% |

 

Selling and marketing expenses decreased in the sixmonths ended March 31, 2010, as compared to the six months ended March 31,2009, primarily due to decreases in compensation and related expenses andmarketing programs.  The decrease incompensation and related expenses was primarily attributed to a decrease inheadcount from 43 at March 31, 2009 to 38 at March 31, 2010.  The decrease in marketing programs wasprimarily attributed to a decrease in market research, public relations, andadvertising related expenses incurred during the six months ended March 31,2010 as compared to the six months ended March 31, 2009, in an effort tomanage operating expenses.

 

***General and Administrative***

 

Thefollowing table summarizes 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:

 
| ** **                            | ** ** | **Six months ended****March 31****,** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                            | ** ** | **2010**                                   | ** ** | **2009** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                            | ** ** | ** **                                 | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                            | ** ** | ** **                                 | ** ** | **Expense** | ** ** | ** ** | ** ** | **Expense** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                                | ** ** | **Category** | ** ** | **Dollars** | ** ** | **Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General  and administrative:          |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Compensation  and related expenses    |       | $                                          | 2,381      |   | 56.4 | % | $ | 2,158 |   | 49.6 | % | $ | 223 |   | 10.3 | % |
| Stock-based  compensation             |       | 259                                        |       | 6.1 | % | 325 |   | 7.5 | % | (66 | ) | (20.3 | )% |
| Consulting  and professional services |       | 930                                        |       | 22.1 | % | 1,125 |   | 25.9 | % | (195 | ) | (17.3 | )% |
| Director  and officer insurance       |       | 76                                         |       | 1.8 | % | 111 |   | 2.5 | % | (35 | ) | (31.5 | )% |
| Other                                 |       | 574                                        |       | 13.6 | % | 631 |   | 14.5 | % | (57 | ) | (9.0 | )% |
|                                  |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Total  general and administrative     |       | $                                          | 4,220      |   | 100 | % | $ | 4,350 |   | 100 | % | $ | (130 | ) | (3.0 | )% |

 

General and administrative expenses decreased in the six months ended March 31,2010, as compared to the six months ended March 31, 2009, primarily due todecreases in consulting and professional services and stock-

 

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based compensation expenses, partially offset by anincrease in compensation and related expenses. The decrease in consulting and professional services was primarilyattributed to a decrease in legal and outside service expenses incurred duringthe six months ended March 31, 2010 as compared to the six months ended March 31,2009.  The decrease in stock-basedcompensation was primarily due to the fact that certain stock options grantedin prior periods reached the end of their vesting periods during the six monthsended March 31, 2010.  Compensationand related expenses increased primarily due to an increase in variablecompensation, which was directly related to the results of operations.

 

***Amortization of Intangible Asset***

 

Amortization of the intangible asset decreased by $100,000 in the sixmonths ended March 31, 2010, as compared to the six months ended March 31,2009.  Amortization expense for theintangible asset decreases annually over its life of 17 years, to reflect thefact that the estimated economic benefit expected to be received from theintangible asset declines over time.

 

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

 

Interestand other income (expense), net, decreased to $(8,000) of expense for the sixmonths ended March 31, 2010, as compared to $12,000 of income for the sixmonths ended March 31, 2009.  The change was primarily due to a decrease of $86,000in interest income, primarily attributable to lower interest rates on the cashbalances held by us during the six months ended March 31, 2010 as comparedto the six months ended March 31, 2009. The decrease in interest income was partially offset by foreign currencyexchange losses of $18,000 recorded during the six months ended March 31,2010, as compared to foreign currency exchange losses of $80,000 recordedduring the six months ended March 31, 2009.  These gains and losses relate primarily toVAT refunds receivable.  The refundableVAT amounts, which we pay on products and services purchased from our contractmanufacturer located in Ireland, are denominated in Euros.

 

***Provision for Income Taxes***

 

The provision forincome taxes for the six months ended March 31, 2010 was $33,000, basedupon our estimate of effective tax rate for fiscal year 2010.  There wasno provision for income taxes during the six months ended March 31,2009.  Although we have significant net operating loss carryforwards whichcan be used to offset taxable income, we are still subject to federalalternative minimum tax.  In addition, wewill be subject to state taxes in various jurisdictions where we do not havenet operating loss carryforwards or where states have suspended the use of netoperating loss carryforwards to offset taxable income.

 

**Liquidityand Capital Resources**

 

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

 
| ** **                                            | ** ** | **Six months ended********March 31****,** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                            | ** ** | **2010**                                       | ** ** | **2009** | ** ** |
|                                                  | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Net  income (loss)                                    |       | $                                              | 434        |   | $ | (1,136 | ) |
| Non-cash  adjustments to net income (loss)            |       | 1,795                                          |       | 2,046 |   |
| Changes  in working capital                           |       | (10,256                                        | )          | 8,109 |   |
|                                                  |       |                                           |       |   |   |
| Net  cash (used in) provided by operating activities  |       | (8,027                                         | )          | 9,019 |   |
|                                                  |       |                                           |       |   |   |
| Net  cash provided by (used in) investing activities  |       | 3,221                                          |       | (544 | ) |
| Net  cash used in financing activities                |       | (95                                            | )          | (143 | ) |
|                                                  |       |                                           |       |   |   |
| Net  (decrease) increase in cash and cash equivalents |       | (4,901                                         | )          | 8,332 |   |
| Beginning  cash and cash equivalents                  |       | 21,039                                         |       | 10,003 |   |
|                                                  |       |                                           |       |   |   |
| Ending  cash and cash equivalents                     |       | $                                              | 16,138     |   | $ | 18,335 |   |

 

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***OperatingActivities***

 

Cash used in operating activities of $8.0 million during the six monthsended March 31, 2010 was primarily the result of net cash used in changesin working capital, partially offset by net income and the impact of non-cashadjustments to net income.  The changesin working capital were partially the result of an increase in accountsreceivable, which was primarily related to higher net revenues in the threemonths ended March 31, 2010 compared to the three months ended September 30,2009.  The changes in working capital were also partially the result of anincrease in inventories, which was primarily due to increased purchasing tomeet expected future customer demand, in particular as a result of the rampingup of new business relating to our fiscal year 2009 design wins.

 

Cash provided byoperating activities of $9.0 million during the six months ended March 31,2009 was primarily the result of net cash provided by changes in workingcapital and the impact of non-cash adjustments to net loss, partially offset bythe net loss for the period.  The change in accounts receivable wasrelated to collections of payments from customers.  The change ininventories was related to the depletion of inventories on hand and lowerpurchases during the six months ended March 31, 2009, which was related tothe downward trend in revenues and efforts undertaken by management to controlinventory quantities on hand.  Changes in working capital during the sixmonths ended March 31, 2009 also included the receipt of $1.9 million ofincome tax refunds related to taxes paid by Alliance Systems in prior years.

 

***InvestingActivities***

 

Cash provided by investing activities during the six months ended March 31,2010 was primarily the result of the receipt of the $3.6 million in refundableacquisition consideration, which was a return of cash we originally paid inconnection with our acquisition of Alliance Systems (see Note 3 in thenotes to the condensed consolidated financial statements for details regardingthe acquisition).  This increase in cashwas partially offset by the use of $408,000 of cash for purchases of propertyand equipment.

 

Cash used in investing activities during the six months ended March 31,2009 consisted of the use of $544,000 of cash for purchases of property andequipment.

 

***FinancingActivities***

 

Cash used in financing activities during the six months ended March 31,2010 consisted primarily of $177,000 used to repurchase shares of our commonstock and $38,000 used to pay fees associated with our bank line of credit,partially offset by the receipt of $130,000 as the result of employee stockoption exercises (see Note 10 in the notes to the condensed consolidatedfinancial statements for details regarding the line of credit). Cash used infinancing activities during the six months ended March 31, 2009 consistedprimarily of $218,000 used to repurchase shares of our common stock, partiallyoffset by the receipt of $89,000 as the result of purchases under the EmployeeStock Purchase Plan.

 

On June 12,2008, our Board of Directors authorized the repurchase of up to $5 million ofour common stock through a share repurchase program.  As authorized by the program, shares may bepurchased in the open market or through privately negotiated transactions, in amanner consistent with applicable securities laws and regulations.  This stock repurchase program does notobligate us to acquire any specific number of shares, does not have anexpiration date, and may be terminated at any time by our Board of Directors.  All repurchases are expected to be fundedfrom our current cash balances or from cash generated from operations.  Tofacilitate repurchases of shares under this program, we have established Rule 10b5-1plans intended to comply with the requirements of Rule 10b5-1 and Rule 10b-18under the Securities Exchange Act of 1934.  A Rule 10b5-1 planpermits the repurchase of shares by a company at times when it otherwise mightbe prevented from doing so under insider trading laws or because of companyblackout periods, provided that the plan is adopted when the company is notaware of material non-public information.  Pursuant to the plan, a brokerdesignated by us has the authority to repurchase shares, in accordance with theterms of the plan, without further direction from us.  The amount andtiming of specific repurchases are subject to the terms of the plan and marketconditions.  During the threemonths ended March 31, 2010, we did not repurchase any shares of ourcommon stock.  During the six monthsended March 31, 2010, we repurchased 158,200 shares of our common stock atan average cost of $1.12 per share.  Fromthe inception of the share repurchase program through March 31, 2010, wehad repurchased 2,581,546 shares of our common stock at an average cost of$0.84 per share.  Upon the expiration ofthe first 10b5-1 plan on November 7, 2008, we suspended repurchases of ourcommon stock.  We resumed the stockrepurchase program on March 16, 2009 under a new 

 

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10b5-1 plan, asauthorized by the Board of Directors.  Asof March 31, 2010, the maximum dollar value that may yet be used forpurchases under the program was $2,820,000.

 

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

 

·      the timing and size of orders from our customers;

 

·      the timeliness of receipts of payments from ourcustomers;

 

·      the timing and size of our purchases of inventories;

 

·      our ability to enter into partnerships with OEMs andISVs;

 

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

 

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

 

·      market developments.

 

We believe that our available cash resources and cash that we expect togenerate from sales of our products and services will be sufficient to meet ouroperating and capital requirements through at least the next twelve months.

 

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

 

There can be no assurance that additional financing will be availableat all or, if available, will be on terms acceptable to us.  Additional equity financings could result indilution to our shareholders.  Ifadditional financing is needed and is not available on acceptable terms, we mayneed to reduce our operating expenses and scale back our operations.

 

***ContractualObligations and Commitments***

 

During the six months ended March 31, 2010, there were no materialchanges to our contractual obligations and commitments as disclosed in ourAnnual Report on Form 10-K for the year ended September 30, 2009.

 

**Off-Balance Sheet Arrangements**

 

We have not created, and are not party to, any special-purpose oroff-balance sheet entities for the purpose of raising capital, incurring debtor operating parts of our business that are not consolidated into our financialstatements.  We have not entered into anytransactions with unconsolidated entities whereby the Company has subordinatedretained interests, derivative instruments or other contingent arrangements thatexpose the Company to material continuing risks, contingent liabilities, or anyother obligation under a variable interest in an unconsolidated entity thatprovides financing, liquidity, market risk or credit risk support to theCompany.

 

**RecentAccounting Pronouncements**

** **

In September 2006,the Financial Accounting Standards Board (“FASB”) issued authoritative guidancewhich defines fair value, establishes a framework for measuring fair value inaccordance with generally accepted accounting principles, and expandsdisclosures about fair value measurements. This guidance was effective forfiscal years beginning after November 15, 2007; however, the FASB delayedthe effective date to fiscal years beginning 

 

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after November 15,2008 for nonfinancial assets and nonfinancial liabilities, except those itemsrecognized or disclosed at fair value on an annual or more frequent basis. Weadopted this guidance, as it applies to our financial assets and liabilitieswhich are recognized or disclosed at fair value on a recurring basis (at leastannually), as of October 1, 2008. We adopted this guidance, as it appliesto our nonfinancial assets and liabilities, as of October 1, 2009. The adoption of this guidance did not have an impact on our financial position,results of operations, or cash flows.

 

In December 2007,the FASB issued authoritative guidance related to business combinations. Thisguidance establishes principles and requirements for how the acquirerrecognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, and any noncontrolling interest in theacquiree, recognizes and measures the goodwill acquired in the businesscombination or a gain from a bargain purchase and determines what informationto disclose to enable users of the financial statements to evaluate the natureand financial effects of the business combination. This guidance is effectivefor business combinations on a prospective basis for which the acquisition dateis on or after the beginning of our first annual reporting period beginning onor after December 15, 2008. We adopted this guidance on October 1,2009 and the adoption did not have a material impact on our financial position,results of operations, or cash flows.

 

In April 2008,the FASB issued authoritative guidance used to determine the useful life ofintangible assets. This guidance amends the factors that should be consideredin developing renewal or extension assumptions used to determine the usefullife of a recognized intangible asset. This change is intended to improve theconsistency between the useful life of a recognized intangible asset and theperiod of expected cash flows used to measure the fair value of the asset. Therequirement for determining useful lives must be applied prospectively tointangible assets acquired after the effective date and the disclosurerequirements must be applied prospectively to all intangible assets recognizedas of, and subsequent to, the effective date. This guidance is effective as ofthe beginning of our fiscal year that begins after December 15, 2008. Weadopted this guidance on October 1, 2009 and the adoption did not have amaterial impact on our financial position, results of operations, or cashflows.

 

In October 2009,the FASB issued authoritative guidance for multiple-deliverable revenuearrangements, which amends previously issued guidance to require an entity touse its best estimate of selling price when vendor-specific objective evidenceor acceptable third party evidence of selling price does not exist for anyproducts or services included in a multiple element arrangement. Thearrangement consideration should be allocated among the products and servicesbased upon their relative selling prices, thus eliminating the use of theresidual method of allocation. This standard also requires expanded qualitativeand quantitative disclosures regarding significant judgments made and changes inapplying this guidance. This standard is effective on a prospective basis forrevenue arrangements entered into or materially modified in fiscal yearsbeginning on or after June 15, 2010. Early adoption and retrospectiveapplication are also permitted. We adopted this authoritative guidance as of January 1,2010 and the adoption did not have a material impact on our financial position,results of operations, or cash flows, and does not change the units ofaccounting for our revenue transactions.

 

In October 2009,the FASB issued authoritative guidance for certain revenue arrangements thatinclude software elements. Under this guidance, tangible products containingsoftware elements that function together to deliver the product’s essentialfunctionality are no longer within the scope of software revenue guidance.Entities that sell joint hardware and software products that meet this scopeexception will be required to follow the guidance for multiple-deliverablerevenue arrangements. This standard is effective on a prospective basis forrevenue arrangements entered into or materially modified in fiscal yearsbeginning on or after June 15, 2010. Early adoption and retrospectiveapplication are also permitted. We adopted this authoritative guidance as of January 1,2010 and the adoption did not have a material impact on our financial position,results of operations, or cash flows.

 

In January 2010,the FASB issued authoritative guidance requiring additional disclosure relatedto fair value measurements that are made on a recurring and non-recurringbasis.  This guidance updates the guidance previously issued by the FASBrelated to fair value measurement disclosures.  Under this guidance,entities will be required to provide disclosures for transfers in and out of Level1 and Level 2 fair value inputs.  In addition, entities will be requiredto provide disclosures for activity within the Level 3 fair value input tier,including purchases, sales, issuances, and settlements during the reportingperiod.  This guidance is effective for interim and annual reportingperiods beginning after December 15, 2009, except for the Level 3disclosure requirements, which will be effective for fiscal years beginningafter December 15, 2010.  We adopted the guidance as it relates toLevel 1 and Level 2 fair value inputs as of January 1, 2010 and theadoption did not have a material impact on our financial position, results ofoperations, or cash flows.  We do notexpect the adoption of this guidance as it relates to Level 3 inputs to have amaterial impact on our financial position, results of operations, or cashflows.

 

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**ITEM3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKETRISK**

 

We engage incertain transactions which are denominated in currencies other than the U.S. dollar(primarily the Euro). These transactions may subject us to exchange rate riskbased on fluctuations in currency exchange rates, which occur between the timesuch a transaction is recognized in our financial statements and the time thatthe transaction is settled. However, based on the historical magnitudes andtiming of such transactions, we do not believe we are subject to materialexchange rate risk. We do not engage in any foreign currency hedgingtransactions. We are exposed to market risk related to changes in interestrates. In the past, we have invested excess cash balances in cash equivalentsand short-term investments, and if we were to do so in the future, we believethat the effect, if any, of reasonably possible near-term changes in interestrates on our financial position, results of operations and cash flows would notbe material. In addition, we believe that a hypothetical 10% increase ordecrease in interest rates would not have a material adverse effect on ourfinancial condition.

 

**ITEM 4.    CONTROLS AND PROCEDURES**

 

Our management,with the participation of our Chief Executive Officer and Chief FinancialOfficer, evaluated the effectiveness of our disclosure controls and procedures(as defined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act) as of March 31, 2010. Based on this evaluation, our Chief Executive Officer and ChiefFinancial Officer concluded that, as of March 31, 2010, our disclosurecontrols and procedures (1) were designed to effectively accumulate and communicateinformation to the Company’s management, as appropriate, to allow timelydecisions regarding required disclosure and (2) were effective, in thatthey provide reasonable assurance that information required to be disclosed bythe Company in the reports that it files or submits under the SecuritiesExchange Act is recorded, processed, summarized and reported within the timeperiods specified in the Securities and Exchange Commission’s rules andforms.

 

During the threemonths ended March 31,2010, no change in our internal control overfinancial reporting (as defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) occurred that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

**PART II—OTHERINFORMATION**

 

**ITEM 1.     LEGAL PROCEEDINGS**

 

*InitialPublic Offering Lawsuit*

 

On or about December 3,2001, a putative class action lawsuit was filed in the United States DistrictCourt for the Southern District of New York against us, Lawrence A. Genovesi(our former Chairman and Chief Executive Officer), Douglas G. Bryant (our ChiefFinancial Officer), and several underwriters of our initial public offering.The suit alleges, *inter alia*,that the defendants violated the federal securities laws by issuing and sellingsecurities pursuant to our initial public offering in July 2000 (“IPO”)without disclosing to investors that the underwriter defendants had solicitedand received excessive and undisclosed commissions from certain investors. Thesuit 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 October 2002,Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this casewithout prejudice. On December 5, 2006, the United States Court of Appealsfor the Second Circuit overturned the District Court’s certification of aplaintiff class. On April 6, 2007, the Second Circuit denied plaintiffs’petition for rehearing, but clarified that the plaintiffs may seek to certify amore limited class in the District Court. On September 27, 2007,plaintiffs filed a motion for class certification in certain designated “focuscases” in the District Court. That motion has since been withdrawn. On November 13,2007, the issuer defendants in certain designated “focus cases” filed a motionto dismiss the second consolidated amended class action complaints that werefiled in those cases. On March 26, 2008, the District Court issued anOpinion and Order denying, in large part, the motions to dismiss the amendedcomplaints in the “focus cases.” On April 2, 2009, the plaintiffs filed amotion for preliminary approval of a new proposed settlement betweenplaintiffs, the underwriter defendants, the issuer defendants and the insurersfor the issuer defendants. On June 10, 2009, the District Court issued anopinion preliminarily approving the proposed settlement, and scheduling asettlement fairness hearing for September 10, 2009. On October 5,2009, the District Court issued an opinion granting plaintiffs’ motion forfinal approval of the settlement, approval of the plan of distribution of thesettlement fund, and certification of the settlement classes. An 

 

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Order and Final Judgmentwas filed on December 30, 2009.  Various notices of appeal of theDistrict Court’s October 5, 2009 order have now been filed. We are unableto predict the outcome of this suit and as a result, no amounts have beenaccrued as of March 31, 2010.

 

*CustomerClaim*

 

On January 20,2009, a lawsuit was filed in the United States District Court for the EasternDistrict of Texas against us and several other co-defendants. The suit, filedby Cordsen Engineering GmbH (“Cordsen”), a former customer of AllianceSystems, alleges breach of contract and other claims with regard to certainproducts that Cordsen purchased from Alliance Systems (prior to our acquisitionof Alliance Systems) and which Cordsen alleges did not meet its desiredspecifications. (See Note 3 in the notes to the consolidated financialstatements for details regarding the acquisition.) Cordsen alleges that byvirtue of our acquisition of Alliance Systems in October 2007, we becamethe assignee of Alliance Systems’ agreement with Cordsen. In April 2010, asettlement was reached with Cordsen, whereby the former Alliance Systemsshareholders have agreed to pay a settlement of $100,000 and our insurer hasagreed to pay a settlement of $300,000 to Cordsen.   Payment of the settlement is due on May 12,2010.

 

**ITEM 1A. RISK FACTORS**

 

Therisks and uncertainties described below are not the only ones we are facedwith.  Additional risks and uncertaintiesnot presently known to us, or that are currently deemed immaterial,may also impair our business operations. If any of the following risks actually occur, our financial conditionand operating results could be materially adversely affected.  Subsequent to the previous disclosure of riskfactors in Item 1A of Part I of our most recent Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009, there have been nosignificant changes in our risk factors.

 

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

 

**Wederive a significant portion of our revenues from sales of application platformsolutions directly to EMC and our revenues may decline significantly if thiscustomer reduces, cancels or delays purchases of our products, terminates itsrelationship with us or exercises certain of its contractual rights.**

 

For the threemonths ended March 31, 2010 and 2009, sales directly to EMC, our largestcustomer, accounted for 44% and 38%, of our total net revenues,respectively.  For the six months ended March 31, 2010 and 2009,sales directly to EMC accounted for 42% and 36%, of our total net revenues,respectively.  These sales are primarily attributable to a limited numberof products pursuant to non-exclusive contracts. We anticipate that our futureoperating results will continue to depend heavily on sales to, and ourrelationship with, this customer. Accordingly, the success of our business willdepend, in large part, on this customer’s willingness to continue to utilizeour application platform solutions in its existing and future products. In thefourth quarter of fiscal year 2009, we won new business to provide additionalproducts to this customer. As this business ramps up, we expect our revenuesfrom this customer to increase during the remainder of fiscal year 2010.However, gross margins associated with this customer have decreased and maycontinue to decrease, due to the nature of the new business that we have begunproviding to this customer.

 

Our financialsuccess is dependent upon the future success of the products we sell to thiscustomer and the continued growth of this customer, whose industry has ahistory of rapid technological change, short product lifecycles, consolidationand pricing and margin pressures. As we have experienced in recent periods,advances in hard drive storage capacity could also result in lower salesvolumes to this customer. A significant reduction in sales to this customer, orsignificant pricing and additional margin pressures exerted on us by this customer,would have a material adverse effect on our results of operations. In addition,if this customer delays or cancels purchases of our products, our operatingresults would be harmed and we may be unable to accurately predict revenues,profitability and cash flows.

 

Under the terms ofour non-exclusive contracts, this customer has the right to enter intoagreements with third parties for similar products, is not obligated topurchase any minimum quantity of products from us and may choose to stoppurchasing from us at any time, with or without cause. In addition, thiscustomer may terminate the agreements in the event that we attempt to assignour rights under the agreements to another party without this customer’s priorapproval. Furthermore, in the event that we default on certain portions of theagreement, this customer has the right to manufacture certain products inexchange for a mutually agreeable royalty fee. If any of 

 

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these events were tooccur, or if this customer were to delay or discontinue purchases of ourproducts as a result of dissatisfaction or otherwise, our revenues andoperating results would be materially adversely affected, our reputation in theindustry might suffer, and we may be unable to accurately predict revenues,profitability and cash flows.

 

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

 

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

 

We believe we mustdiversify our revenues and a major component of our business strategy is toform application platform design relationships with new OEMs and ISVs.Under this strategy, we work with our customers to design an applicationplatform branded with their name. The customers then perform all of the sellingand marketing efforts related to sales of their branded appliance.

 

There are multiplerisks associated with this strategy including:

 

·      the expenditure of significant product design andengineering costs, which if not recovered through application platform salescould negatively affect our operating results;

 

·      a significant reliance on our customers’ applicationsoftware products, which could be technologically inferior to competitiveproducts and result in limitations on our application platform sales, causingour revenues and operating results to suffer;

 

·      our customers will most likely continue selling theirsoftware products as separate products in addition to selling them in the formof an application platform, which will require us to effectively communicatethe benefits of delivering their software in the form of an applicationplatform;

 

·      our reliance on our customers to perform all of theselling and marketing efforts associated with further sales of the applicationplatform solution we develop with them;

 

·      continued consolidation within the data storage,network security, carrier communications and enterprise communicationsindustries that results in existing customers being acquired by othercompanies;

 

·      our ability to leverage strategic relationships toobtain new sales leads;

 

·      our ability to provide our customers with high qualityapplication platform solutions at competitive prices; and

 

·      there is no guarantee that design wins will result inactual orders or sales. A “design win” occurs when a new customer or a separatedivision within an existing customer notifies us that we have been selected tointegrate the customer’s application. There can be delays of several months ormore between the design win and when a customer initiates actual orders. Thedesign win may never result in actual orders or sales. Further, if the customer’splans change, we may commit significant resources to design wins that do notresult in actual orders.

 

Additionally, ourfuture success will depend on our ability to establish relationships with newcustomers while expanding sales of application platform solutions within ourexisting customer base. If these customers are unsuccessful in their marketingand sales efforts, or if we are unable to expand our sales to existingcustomers and develop relationships with new customers, our revenues andoperating results could suffer.

 

We have begun topursue (and in some cases we have won) larger opportunities which we expect tohave a more significant impact on our net revenues. We expect that theseopportunities will have gross margins as a percentage of revenues which arelower than historical levels, but we believe that such opportunities can beleveraged over our existing infrastructure without requiring us to incursignificant additional operating costs. However, if we cannot meet customerdemand utilizing our existing infrastructure, we may need to increase ourinfrastructure and associated operating costs, which would negatively impactour operating results. Also, our 

 

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revenue growth may belower than expected if we are unsuccessful in winning large opportunities,which would lead us to pursue smaller opportunities in order to grow revenues.

 

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

 

We believe oursuccess will depend on our ability to license or integrate certain applicationsfrom third-parties that would be incorporated in certain of our applicationplatform solutions. Because we do not currently know with certainty which ofthese prospective technologies will be desired in the marketplace, we mayincorrectly invest in development or prioritize our efforts to integrate thesetechnologies in our application platforms. Additionally, even if we correctlyfocus our efforts, there can be no assurance that we will select the preferredprovider of these technologies, the third-party provider will be committed tothe relationship and integration of their technology, or that they will licensetheir technology to us without obtaining significant certification or training,which could be costly and time consuming. If we are unable to successfullyintegrate the correct third-party technologies in a timely manner, ourapplication platform solutions may be inferior to other competitive products inthe marketplace, which may adversely affect the results of our operations andour ability to grow our business. We believe that our services are a keycompetitive differentiation point and an important element of the totalsolution we offer. If our current and prospective customers do not find theservices we offer to be of value to them or their end users, they may decide toperform these services in-house or we may lose their business to competitors.If this were to occur, our revenues and operating results would be adverselyimpacted.

 

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

 

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

 

·      we may experience difficulties integrating newtechnologies into our current or future products;

 

·      our new products may be delayed because selected newtechnologies themselves are delayed or have defects and/or performance limitations;

 

·      we may incorporate technologies that do not result inthe desired improvements to our current and/or future application platformproducts;

 

·      we may incorporate new technologies that either maynot be desired by our customers or may not be compatible with our customers’existing technology;

 

·      new technologies are unproven and could contain latentdefects, which could result in high product failure rates; and

 

·      we could find that the new products and/ortechnologies that we choose to incorporate into our products aretechnologically inferior to those utilized by our competitors.

 

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

 

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

 

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

 

We expect that allof our future revenues will come from sales of application platform solutionsand related services. As a result, we are substantially dependent on thegrowing use of application platforms to meet businesses’ software applicationneeds. Our revenues may not grow and the market price of our common stock coulddecline if the application platform market does not grow as rapidly as weexpect.

 

Our expectationsfor the growth of the application platform market may not be fulfilled ifcustomers continue to use general-purpose servers or proprietary platforms. Therole of our products could, for example, be limited if general-purpose serversout-perform application platforms, provide more capabilities and/or flexibilitythan application platforms or are offered at a lower cost. This could force usto lower the prices of our application platform solutions or could result infewer sales of these products, which would negatively impact our revenues and decreaseour gross profits.

 

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

 

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

 

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

 

To remaincompetitive in the application platform market, we must successfully identifynew product opportunities and partners and develop and bring new products tomarket in a timely and cost-effective manner. Our failure to select theappropriate partners and keep pace with rapid industry, technology or marketchanges could have a material adverse effect on our business, results ofoperations or financial condition.

 

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

 

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

 

In the past, wehave incurred significant net losses and could incur net losses in the future.At March 31, 2010 and September 30, 2009, our accumulated deficit was$140 million and $141 million, respectively. If we are successful inwinning large opportunities in future periods but cannot meet our customerrequirements utilizing our existing infrastructure and production capabilities,we may need to increase our infrastructure. This would increase operatingexpenses and negatively impact our operating results. Also, our revenue growthmay be lower than 

 

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expected if we areunsuccessful in winning large opportunities, which would lead us to pursuesmaller opportunities in order to grow revenues. As a result, we will need togenerate significant revenues to achieve and sustain profitability. If we donot achieve and sustain profitability, the market price for our common stockmay decline. Even if we achieve sustained profitability there can be noguarantee that our stock price will increase.

 

**We maynot be able to borrow funds under our credit facility or secure futurefinancing if there is a material adverse change in our business.**

 

In October 2007,we entered into an agreement with Silicon Valley Bank to provide for a line ofcredit. We view this line of credit as a source of available liquidity to fundfluctuations in our working capital requirements. This facility containsvarious conditions, covenants and representations with which we must be incompliance in order to borrow funds. However, if we wish to borrow under thisfacility in the future, there can be no assurance that we will be in compliancewith these conditions, covenants and representations. In addition, this line ofcredit facility with Silicon Valley Bank expires on February 4, 2012.After that, we may need to secure new financing to continue fundingfluctuations in our working capital requirements. However, we may not be ableto secure new financing, or financing on favorable terms, if we experience anadverse change in our business. If we experience an increase in order activityfrom our customers, our cash balance may decrease due to the need to purchaseinventories to fulfill those orders. If this occurs, we may have to draw onthis facility, or secure other financing, in order to maintain our liquidity.As of May 10, 2010, we have not borrowed on this line of credit.

 

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

 

Ourdiscussion and analysis of financial condition and results of operations isbased on our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America.  The preparation of financialstatements in conformity with generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the amounts reportedin the consolidated financial statements and accompanying notes.  On an ongoing basis, we evaluate significantestimates used in preparing our consolidated financial statements, includingthose related to:

 

·   revenue recognition;

 

·   collectibility of accountsreceivable;

 

·   inventory write-downs;

 

·   stock-based compensation;

 

·   valuation of intangibleassets;

 

·   warranty reserves; and

 

·   realization of deferred taxassets.

 

Webase our estimates on historical experience and on various other assumptionsthat we believe to be reasonable under the circumstances, as provided in ourdiscussion and analysis of financial condition and results of operations, theresults of which form the basis for making judgments about the carryingvalues of assets and liabilities that are not readily apparent from othersources.  Actual results may differfrom these and other estimates if our assumptions change or if actualcircumstances differ from those in our assumptions, which could cause ouroperating results to fall below the expectations of securities analysts andinvestors, resulting in a decline in our stock price.

 

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

 

Our quarterly revenuesand operating results are difficult to predict and may fluctuate significantlyfrom quarter to quarter. None of our customers are obligated to purchase anyquantity of our products in the future nor are they obligated to meet forecastsof their product needs. Our operating expense levels are based in part onexpectations of future revenues and gross profits, which are partiallydependent on our customers’ ability to accurately forecast and communicatetheir future product needs. If revenues or gross profits in a particularquarter do not meet expectations, operating results could suffer and the marketprice of our common stock could decline. Factors affecting quarterly operatingresults include:

 

·      the degree to which our customers are successful in resellingapplication platform solutions to their end customers;

 

·      our customers’ consumption of their existinginventories of our products;

 

·      the variability of orders we receive from customerswho have project-based businesses;

 

·      the loss of key suppliers or customers;

 

·      the product mix of our sales;

 

·      the timing of new product introductions by ourcustomers;

 

·      the availability and/or price of products fromsuppliers;

 

·      price competition;

 

·      costs associated with our introduction of newapplication platform solutions and the market acceptance of those products; and

 

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

 

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

 

Products and services inthe data storage, network security, carrier communications and enterprisecommunications markets may be subject to further commoditization as theseindustries continue to mature and other businesses introduce additionalcompeting products and services. Our gross profit as a percentage of revenuesfor our products may decrease in response to changes in our product mix,competitive pricing pressures, or new product introductions into these markets.If we are unable to offset decreases in our gross profits as a percentage ofrevenues by increasing our sales volumes, or by decreasing our product costs,operating results will decline. Changes in the mix of sales of our products,including the mix of higher margin products sold in smaller quantities andlower margin 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 application platformsolutions. Our efforts to produce higher margin application platform solutions,continue to improve our application platform solutions and produce newapplication platform solutions may make it difficult to reduce ourmanufacturing cost per product. Further, utilization of a contract manufacturerto produce a portion of our customer requirements for certain applicationplatform solutions may not allow us to reduce our cost per product. If we failto respond adequately to pricing pressures, to competitive products withimproved performance or to developments with respect to the other factors onwhich we compete, we could lose customers or orders and may lose new customeropportunities. If we are unable to offset decreases in the prices we are ableto charge our customers and/or our gross margin percentage with increased salesvolumes, our business will suffer.

 

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**Anintangible asset represents a significant portion of our assets, and anyimpairment of the intangible asset would adversely impact our operatingresults.**

 

At March 31,2010, the carrying value of our intangible asset, which consists of customerrelationships associated with our acquisition of Alliance Systems, Inc. (“AllianceSystems”), was approximately $7.4 million, net of accumulatedamortization. We will continue to incur non-cash charges relating to theamortization of our intangible asset over its remaining useful life. Futuredeterminations of significant write-offs of the intangible asset resulting froman impairment test or any accelerated amortization of the intangible assetcould have a significant impact on our operating results and affect our abilityto achieve or maintain profitability. Although we do not believe that anyimpairment of the intangible asset exists at this time, in the event that anyindicators of possible impairment exist, we may record charges which could havea material adverse effect on our results of operations. Such indicatorsinclude, but are not limited to, a worsening in customer attrition ratescompared to historical attrition rates, or lower than initially anticipatedcash flows associated with customer relationships.

 

***Risks related to competition.***

 

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

 

In the applicationplatform market, we face significant competition from a number of differenttypes of companies. Our competitors include companies who marketgeneral-purpose servers, server virtualization software, specific-purposeservers and application platforms as well as companies that sell customintegration services utilizing hardware produced by other companies. Many ofthese companies are larger than we are and have greater financial resources andname recognition than we do, as well as significant distribution capabilitiesand larger, more established service organizations to support their products.Our larger competitors may be able to leverage their existing resources,including their extensive distribution capabilities and service organizations,to provide a wider offering of products and services and higher levels ofsupport on a more cost-effective basis than we can. We expect competition in theapplication platform market to increase significantly as more companies enterthe market and as our existing competitors continue to improve the performanceof their current products and to introduce new products and technologies. Suchincreased competition could adversely affect sales of our current and futureproducts. In addition, competing companies may be able to undertake moreextensive promotional activities, adopt more aggressive pricing policies andoffer more attractive terms to their customers than we can. If our competitorsprovide lower cost products with greater functionality or support than ourapplication platform solutions, or if some of their products are comparable toours and are offered as part of a range of products that is broader than ours,our application platform solutions could become undesirable.

 

Even if thefunctionality of competing products is equivalent to ours, we face a risk thata significant number of customers would elect to pay a premium for similarfunctionality from a larger vendor rather than purchase products from us. Weattempt to differentiate ourselves from our competition by offering a widevariety of software integration, branding, supply-chain management,engineering, support, logistics and fulfillment services. If we are unable toeffectively differentiate ourselves from our competition, we may be forced tooffer price reductions to maintain certain customers. As a result, our revenuesmay not increase and may decline, and our gross margins may decline. Furthermore,increased competition could lead to higher selling expenses which wouldnegatively affect our business and future operating results.

 

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

 

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

 

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

 

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

 

We need to effectivelymanage our customer support operations to ensure that we maintain goodrelationships with our customers. We believe that providing a level of high qualitycustomer support will be a key differentiator for our product offerings and mayrequire more technically qualified staff which could be more costly. If we areunable to provide this higher level of service we may be unable to successfullyattract and retain customers.

 

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

 

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

 

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

 

We depend uponsingle source and limited source suppliers for our industry standardprocessors, main logic boards, telephony boards, certain disk drives, hardwareplatforms and power supplies as well as certain of our chassis and sheet metalparts. Additionally, we depend on limited sources to supply certain otherindustry standard and customized components. We have in the past experienced,and may in the future experience, shortages of or difficulties in acquiringcomponents in the quantities and of the quality needed to produce ourapplication platform solutions. Shortages in supply or quality issues relatedto these key components for an extended time would cause delays in theproduction of our application platform solutions, prevent us from satisfying ourcontractual obligations and meeting customer expectations, and result in lostsales and customers. If we are unable to buy components in the quantities andof the quality that we need on a timely basis or at acceptable prices, we willnot be able to manufacture and deliver our application platform solutions on atimely or cost effective basis to our customers, and our competitive position,reputation, business, financial condition and results of operations could beseriously harmed. If we are able to secure other sources of supply for suchcomponents, our costs to purchase such components could increase, which wouldnegatively impact our gross margins. A significant portion of our componentsare purchased from suppliers located in China. During the past year, severalfactories in China have closed without notice. If a factory which suppliesparts to us closes with little or no notice, we could experience shortages anddifficulties in locating alternative sources of supply.

 

**Tightermanagement of inventories across global supply chains may lead to longer leadtimes for our purchases of certain inventory components. If we are unable tomanage our supply chain and maintain sufficient inventories to meet customerdemand, this could result in lost sales and customers.**

 

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

 

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

 

As applicationplatform solutions are complex, they may contain errors that can be detected atany point in a product’s lifecycle. If flaws in design, production, assembly ortesting of our products (by us or our suppliers) were to occur, we couldexperience a rate of failure in our products that could result in substantialrepair, replacement or service costs and potential damage to our reputation. Inaddition, because our solutions are combined with products from other vendors,should problems occur, it might be difficult to identify the source of theproblem. Continued improvement in manufacturing capabilities, control ofmaterial and manufacturing quality and costs, and product testing are criticalfactors in our future growth. There can be no assurance that our efforts tomonitor, develop, modify and implement appropriate test and manufacturingprocesses for our products will be sufficient to permit us to avoid a rate offailure in our products that results in substantial delays in shipment,significant repair or replacement costs or potential damage to our reputation,any of which could have a material adverse effect on our business, results ofoperations or financial condition.

 

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

 

·      the loss of or delay in market acceptance and sales ofour application platform solutions;

 

·      diversion of engineering resources;

 

·      increased manufacturing costs;

 

·      the loss of customers;

 

·      injury to our reputation and other customer relationsproblems; and

 

·      increased maintenance and warranty costs.

 

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

 

Moreover, becauseour application platform solutions may be used in connection with criticalcomputing systems services, including providing security to protect valuableinformation, we may receive significant liability claims if they do not workproperly. While our agreements with customers typically contain provisionsintended to limit our exposure to liability claims, these limitations do notpreclude all potential claims. Liability claims could exceed our insurancecoverage and require us to spend significant time and money in litigation or topay significant damages. Any claims for damages, even if unsuccessful, couldseriously damage our reputation and business.

 

**If we donot accurately forecast our application platform materials requirements, ourbusiness and operating results could be adversely affected.**

 

We use rollingforecasts based on anticipated product orders to determine our applicationplatform component requirements. Lead times for materials and components thatwe order may change significantly depending on variables such as specific supplierrequirements, contract terms and current market demand for those components. Inaddition, a variety of factors, including the timing of product releases,potential delays or cancellations of orders, the timing of large orders and theunproven acceptance of new products in the market make it difficult to predictproduct orders. As a result, our materials requirement forecasts may not beaccurate. If we overestimate our materials requirements, we may have excessinventory, which would increase costs and negatively impact our cash position.Our agreements with certain customers provide us with protections related toinventory purchased in accordance with the terms of these agreements; however,these protections may not be sufficient to prevent certain losses as a resultof excess or obsolete inventory. If we underestimate our materialsrequirements, we 

 

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may have inadequateinventory which could interrupt our manufacturing and delay delivery of ourapplication platform solutions to customers, resulting in a loss of sales orcustomers. Any of these occurrences would negatively impact our business andoperating results.

 

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

 

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

 

Substantiallitigation regarding intellectual property rights exists in the technologyindustry. We expect that application platform solutions may be subject to third-partyinfringement claims as the number of competitors in the industry segment growsand the functionality of products in different industry segments overlap. Inthe past we have received claims from third parties that our applicationplatform solutions infringed their intellectual property rights. We do notbelieve that our application platform solutions employ technology thatinfringes the proprietary rights of any third parties. We are also not aware ofany claims made against any of our customers related to their infringement ofthe proprietary rights of other parties in relation to products that includeour application platform solutions. Other parties may make claims against us orour customers that, with or without merit, could:

 

·      be time consuming for us to address;

 

·      require us to enter into royalty or licensingagreements;

 

·      result in costly litigation, including potentialliability for damages;

 

·      divert our management’s attention and resources; and

 

·      cause product shipment delays.

 

In addition, otherparties may make claims against our customers related to products that areincorporated into our application platform solutions. Our business could beadversely affected if such claims resulted in the inability of our customers tocontinue producing the infringing product.

 

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

 

Our successdepends in large part on our ability to retain and attract highly skilledengineering, sales, marketing, customer service and managerial personnel. If weare unable to attract a sufficient number of qualified personnel, we may not beable to meet key objectives such as developing, upgrading, or enhancing ourproducts in a timely manner, which could negatively impact our business andcould hinder any future growth.

 

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

 

Section 404of the Sarbanes-Oxley Act of 2002 requires our management to report on, and ourindependent registered public accounting firm to attest to, the effectivenessof our internal control over financial reporting.  We have an ongoing program toperform the system and process evaluation and testing necessary to comply withthese requirements.  As a result, we haveincurred expenses and have devoted additional management resources to Section 404compliance.  Effective internal controlsare necessary for us to provide reliable financial reports.  If we cannot provide reliable financialreports, our business and operating results could be harmed.

 

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

 

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

 

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

 

The market priceof our common stock has been subject to significant fluctuations and maycontinue to fluctuate or decline. During the fiscal year ended September 30,2009, the closing price of our common stock ranged from a low of $0.29 to ahigh of $1.32, and during the six months ended March 31, 2010, from a lowof $1.07 to a high of $2.19.  The market for technology and micro-capstocks has been extremely volatile and frequently reaches levels that bear norelationship to the past or present operating performance of those companies.General economic conditions, such as recession or interest rate or currencyrate fluctuations in the United States or abroad, could negatively affect themarket price of our common stock. In addition, our operating results may bebelow the expectations of securities analysts and investors. If this were tooccur, the market price of our common stock may decrease significantly. In thepast, following periods of volatility in the market price of a company’ssecurities, securities class action litigation has often been institutedagainst such companies. Such litigation could result in substantial cost and adiversion of management’s attention and resources.

 

Any decline in themarket price of our common stock or negative market conditions could adverselyaffect our ability to raise additional capital, to complete future acquisitionsof or investments in other businesses and to attract and retain qualifiedtechnical and sales and marketing personnel.

 

**If themarket price o**f**our commonstock is not quoted on a national exchange, our ability to raise future capitalmay be hindered and the market price of our common stock may be negativelyimpacted.**

 

At certain timesin the past, the market price of our common stock has been less than $1.00 pershare. If we are unable to meet the stock price listing requirements of NASDAQ,our common stock could be de-listed from the NASDAQ Global Market. If ourcommon stock were de-listed from the NASDAQ Global Market, among other things,this could result in a number of negative implications, including reduced liquidityin our common stock as a result of the loss of market efficiencies associatedwith NASDAQ and the loss of federal preemption of state securities laws, aswell as the potential loss of confidence by suppliers, customers and employees,the loss of institutional investor interest, fewer business developmentopportunities and greater difficulty in obtaining financing. As of May 10,2010, we were in compliance with all applicable requirements for continuedlisting on the NASDAQ Global Market.

 

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

 

The currentdownturn in the economy, and any further slowdown in future periods, couldadversely affect our business in ways that we are unable to fully anticipate.Tightened credit markets may negatively impact operations by affecting solvencyof customers, suppliers and other business partners, or the ability of ourcustomers to obtain credit to finance purchases of our products and services,which in turn could lead to increased difficulty in collecting accountsreceivable. Tightened credit markets may also negatively impact our ability toborrow funds, if needed, either under our line of credit with Silicon Valley Bankor from other sources. In addition, government responses to the disruptions inthe financial markets may not stabilize the markets or increase liquidity orthe availability of credit for us or our customers. A widespread reduction ofglobal business activity could cause customers to reduce capital expenditures,put increased pricing pressure on our products and services, and subject us,our suppliers and our customers to interest rate risks and tax changes thatcould impact our financial strength. These and other economic factors couldhave a material adverse effect on our financial condition, operating resultsand liquidity.

 

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

 

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

 

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

 

**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.**

 

InDecember 2001, a class action lawsuit relating to our initial publicoffering was filed against us, our chairman, one of our executive officers andthe underwriters of our initial public offering.  For more information on lawsuits, see “Part II,Item 1 — Legal Proceedings.”  We arecurrently attempting to settle the lawsuit filed against us related to ourinitial public offering.  We are unableto predict the effects on our financial condition or business of the lawsuitrelated to our initial public offering or other lawsuits that may arisefrom time to time.  While we maintaincertain insurance coverage, there can be no assurance that claims against uswill not result in substantial monetary damages in excess of such insurancecoverage.  This class actionlawsuit, or any future lawsuits, could cause our director and officer insurancepremiums to increase and could affect our ability to obtain director andofficer insurance coverage, which would negatively affect our business.  In addition, we have expended, andmay in the future expend, significant resources to defend suchclaims.  This class action lawsuit,or other similar lawsuits that may arise from time to time, couldnegatively impact both our financial condition and the market price of ourcommon stock and could result in management devoting a substantial portion oftheir time to these lawsuits, which could adversely affect the operation of ourbusiness.

 

**ITEM 6.     EXHIBITS**

 

(a)    Exhibits

 

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

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, as amended, the Registranthas duly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
|                    | **NETWORK  ENGINES, INC.**                                      |
|-------------------------|-----------------------------------------------------------------|
|                    |                                                            |
| Date: May 10, 2010 | /s/  Gregory A. Shortell                                        |
|                    |                                                            |
|                    | Gregory  A. Shortell                                            |
|                    | President and Chief  Executive Officer                          |
|                    | (Principal Executive  Officer)                                  |
|                    |                                                            |
|                    | /s/  Douglas G. Bryant                                          |
|                    |                                                            |
|                    | Douglas G. Bryant                                               |
|                    | Chief Financial  Officer, Treasurer and Secretary               |
|                    | (Principal Financial Officer and Principal  Accounting Officer) |
|                         |                                                                 |  |

 

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Exhibit**                                                                                                                                         |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **           | ** ** | ** **                                                                                                                                          |
| 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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