**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

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**(MarkOne)**

| x                                                                                                                                                                                                                | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                       |       | ** **                                                                                    |
| **For the  quarterly period ended March 31, 2007**                                                                                                                                                               |
| ** **                                                                                                                                                                                                       |
| **OR**                                                                                                                                                                                                           |
| ** **                                                                                                                                                                                                       |
| **o**                                                                                                                                                                                                            | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                       |       | ** **                                                                                    |
| **For the transition period from                  to              ** |

 

**Commissionfile number: 0-30863**

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**NETWORK ENGINES, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                                               |   | **04-3064173**                        |
|------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation)           |   | (I.R.S. 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) |

 

Indicate by checkmark whether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. Yes  x  No o

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

Large acceleratedfiler o Acceleratedfiler x Non-accelerated filer o

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

As of May 7, 2007,there were 40,826,084 shares of the registrant’s Common Stock, par value $.01per share, outstanding.

 

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**NETWORK ENGINES, INC.**

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

 

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**PARTI. FINANCIAL INFORMATION**

**ITEM I.FINANCIAL STATEMENTS**

**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

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

**(unaudited)**
| ** **                                                                                                                                                                                                    | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                    | ** ** | **2007**           | ** ** | **2006**               | ** ** |
| **ASSETS**                                                                                                                                                                                                    | ** ** | ** **         | ** ** | ** **             | ** ** |
| **Current assets:**                                                                                                                                                                                           | ** ** | ** **         | ** ** | ** **             | ** ** |
| Cash and cash  equivalents                                                                                                                                                                                    |       | $                  | 14,115     |                   | $          | 8,014 |   |
| Short-term  investments                                                                                                                                                                                       |       | 24,545             |       | 24,804                 |       |
| Restricted cash                                                                                                                                                                                               |       | 47                 |       | 47                     |       |
| Accounts  receivable, net of allowances                                                                                                                                                                       |       | 16,714             |       | 17,178                 |       |
| Inventories                                                                                                                                                                                                   |       | 10,495             |       | 8,445                  |       |
| Prepaid expenses  and other current assets                                                                                                                                                                    |       | 1,143              |       | 1,460                  |       |
| Total current  assets                                                                                                                                                                                         |       | 67,059             |       | 59,948                 |       |
|                                                                                                                                                                                                          |       |               |       |                   |       |
| Property and  equipment, net                                                                                                                                                                                  |       | 1,174              |       | 1,093                  |       |
| Other assets                                                                                                                                                                                                  |       | 63                 |       | 20                     |       |
|                                                                                                                                                                                                          |       |               |       |                   |       |
| Total assets                                                                                                                                                                                                  |       | $                  | 68,296     |                   | $          | 61,061 |   |
|                                                                                                                                                                                                          |       |               |       |                   |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                | ** ** | ** **         | ** ** | ** **             | ** ** |
| **Current liabilities:**                                                                                                                                                                                      | ** ** | ** **         | ** ** | ** **             | ** ** |
| Accounts payable                                                                                                                                                                                              |       | $                  | 8,787      |                   | $          | 7,047 |   |
| Accrued  compensation and other related benefits                                                                                                                                                              |       | 1,577              |       | 1,762                  |       |
| Other accrued  expenses                                                                                                                                                                                       |       | 2,714              |       | 2,180                  |       |
| Current portion  of capital lease obligation                                                                                                                                                                  |       | 19                 |       | 19                     |       |
| Deferred revenue                                                                                                                                                                                              |       | 2,435              |       | 1,049                  |       |
| Total current  liabilities                                                                                                                                                                                    |       | 15,532             |       | 12,057                 |       |
|                                                                                                                                                                                                          |       |               |       |                   |       |
| Long-term portion  of capital lease obligation                                                                                                                                                                |       | 50                 |       | 60                     |       |
| Deferred revenue                                                                                                                                                                                              |       | 959                |       | 541                    |       |
|                                                                                                                                                                                                          |       |               |       |                   |       |
| Total  liabilities                                                                                                                                                                                            |       | 16,541             |       | 12,658                 |       |
|                                                                                                                                                                                                          |       |               |       |                   |       |
| Commitments and  contingencies (Note 6)                                                                                                                                                                       |       |               |       |                   |       |
|                                                                                                                                                                                                          |       |               |       |                   |       |
| **Stockholders’ equity:**                                                                                                                                                                                | ** ** | ** **         | ** ** | ** **             | ** ** |
| Preferred stock,  $0.01 par value, 5,000,000 authorized, no shares issued  or outstanding                                                                                                                     |       | —             |       | —                 |       |
| Common stock,  $0.01 par value, 100,000,000 shares authorized; 43,387,962 and 41,751,304  shares issued; 40,826,104 and 39,189,446 shares outstanding at March 31, 2007  and September 30, 2006, respectively |       | 434                |       | 418                    |       |
| Additional  paid-in capital                                                                                                                                                                                   |       | 185,505            |       | 182,420                |       |
| Accumulated  deficit                                                                                                                                                                                          |       | (131,346           | )          | (131,597               | )          |
| Treasury stock,  at cost, 2,561,858 shares at March 31, 2007 and  September 30, 2006                                                                                                                          |       | (2,838             | )          | (2,838                 | )          |
|                                                                                                                                                                                                          |       |               |       |                   |       |
| Total  stockholders’ equity                                                                                                                                                                              |       | 51,755             |       | 48,403                 |       |
|                                                                                                                                                                                                          |       |               |       |                   |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                              |       | $                  | 68,296     |                   | $          | 61,061 |   |

 

**The accompanying notes are anintegral part of the condensed consolidated financial statements.**

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**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(unaudited)**
| ** **                                                    | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                    | ** ** | **2007**                                         | ** ** | **2006**                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                    | ** ** | ** **                                       | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues                                                  |       | $                                                | 29,305     |                                           | $          | 28,036 |   | $ | 56,543 |   | $ | 55,305 |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Cost of revenues                                              |       | 23,215                                           |       | 23,705                                         |       | 45,220 |   | 46,313 |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Gross profit                                                  |       | 6,090                                            |       | 4,331                                          |       | 11,323 |   | 8,992 |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Operating  expenses:                                          |       |                                             |       |                                           |       |   |   |   |   |
| Research and development                                      |       | 2,410                                            |       | 2,182                                          |       | 4,403 |   | 4,202 |   |
| Selling and marketing                                         |       | 1,810                                            |       | 2,812                                          |       | 3,540 |   | 5,590 |   |
| General and administrative                                    |       | 1,954                                            |       | 2,187                                          |       | 4,015 |   | 3,994 |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Total operating expenses                                      |       | 6,174                                            |       | 7,181                                          |       | 11,958 |   | 13,786 |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Loss from  operations                                         |       | (84                                              | )          | (2,850                                         | )          | (635 | ) | (4,794 | ) |
| Interest and  other income, net                               |       | 462                                              |       | 390                                            |       | 909 |   | 710 |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Net income (loss) before income taxes                         |       | 378                                              |       | (2,460                                         | )          | 274 |   | (4,084 | ) |
| Provision for income taxes                                    |       | 13                                               |       | —                                         |       | 23 |   | — |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Net income  (loss)                                            |       | $                                                | 365        |                                           | $          | (2,460 | ) | $ | 251 |   | $ | (4,084 | ) |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Net income  (loss) per share — basic and diluted         |       | $                                                | 0.01       |                                           | $          | (0.06 | ) | $ | 0.01 |   | $ | (0.11 | ) |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Shares used in  computing basic net income (loss) per share   |       | 40,735                                           |       | 37,987                                         |       | 40,339 |   | 37,926 |   |
|                                                          |       |                                             |       |                                           |       |   |   |   |   |
| Shares used in  computing diluted net income (loss) per share |       | 41,438                                           |       | 37,987                                         |       | 41,251 |   | 37,926 |   |

 

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

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**NETWORK ENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                                          | ** ** | **Six months ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2007**                                       | ** ** | **2006** | ** ** |
| ** **                                                                                          | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Cash flows from  operating activities:                                                              |       |                                           |       |   |   |
| Net income (loss)                                                                                   |       | $                                              | 251        |   | $ | (4,084 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |       |                                           |       |   |   |
| Depreciation and amortization                                                                       |       | 407                                            |       | 537 |   |
| Provision for doubtful accounts                                                                     |       | (11                                            | )          | (23 | ) |
| Loss on disposal of long-lived assets                                                               |       | 7                                              |       | — |   |
| Stock-based compensation                                                                            |       | 1,260                                          |       | 1,372 |   |
| Changes in operating assets and liabilities:                                                        |       |                                           |       |   |   |
| Accounts receivable                                                                                 |       | 475                                            |       | (3,956 | ) |
| Inventories                                                                                         |       | (2,044                                         | )          | (788 | ) |
| Prepaid expenses and other current assets                                                           |       | 317                                            |       | 57 |   |
| Accounts payable                                                                                    |       | 1,740                                          |       | 2,722 |   |
| Accrued expenses                                                                                    |       | 349                                            |       | 432 |   |
| Deferred revenue                                                                                    |       | 1,804                                          |       | 5 |   |
| Receivable for insurance recovery                                                                   |       | —                                         |       | (2,875 | ) |
| Accrued litigation settlement                                                                       |       | —                                         |       | 2,875 |   |
|                                                                                                |       |                                           |       |   |   |
| Net cash provided by (used in) operating activities                                                 |       | 4,555                                          |       | (3,726 | ) |
|                                                                                                |       |                                           |       |   |   |
| Cash flows from  investing activities:                                                              |       |                                           |       |   |   |
| Purchases of property and equipment                                                                 |       | (495                                           | )          | (350 | ) |
| Purchases of short-term investments                                                                 |       | (9,541                                         | )          | (17,392 | ) |
| Proceeds from sales and maturities of short-term  investments                                       |       | 9,800                                          |       | 21,000 |   |
| Changes in other assets                                                                             |       | (43                                            | )          | 79 |   |
|                                                                                                |       |                                           |       |   |   |
| Net cash (used in) provided by investing activities                                                 |       | (279                                           | )          | 3,337 |   |
|                                                                                                |       |                                           |       |   |   |
| Cash flows from  financing activities:                                                              |       |                                           |       |   |   |
| Proceeds from issuance of common stock                                                              |       | 1,835                                          |       | 346 |   |
| Payments on capital lease obligation                                                                |       | (10                                            | )          | (9 | ) |
|                                                                                                |       |                                           |       |   |   |
| Net cash provided by financing activities                                                           |       | 1,825                                          |       | 337 |   |
|                                                                                                |       |                                           |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                               |       | 6,101                                          |       | (52 | ) |
| Cash and cash  equivalents, beginning of period                                                     |       | 8,014                                          |       | 9,468 |   |
|                                                                                                |       |                                           |       |   |   |
| Cash and cash  equivalents, end of period                                                           |       | $                                              | 14,115     |   | $ | 9,416 |   |

 

**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 accompanying condensed consolidated financialstatements have been prepared by Network Engines, Inc. (“Network Engines” orthe “Company”) in accordance with accounting principles generally accepted inthe United States of America and pursuant to the rules and regulations of theSecurities and Exchange Commission. Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith generally accepted accounting principles have been condensed or omittedpursuant to such rules and regulations. The year-end condensed balance sheetdata was derived from audited financial statements, but does not include allyear-end disclosures required by accounting principles generally accepted inthe United States of America.  Thesefinancial statements should be read in conjunction with the audited financialstatements and the accompanying notes included in the Company’s 2006 AnnualReport on Form 10-K filed by the Company with the Securities and ExchangeCommission.

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

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

**2.  SIGNIFICANT ACCOUNTING POLICIES**

***Recent Accounting Pronouncements***

In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin No.108, “Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in the Current YearFinancial Statements” (“SAB 108”).  SAB108 addresses how the effects of prior-year uncorrected misstatements should beconsidered when quantifying misstatements in current-year financial statements.SAB 108 requires an entity to quantify misstatements using a balance sheet andincome statement approach and to evaluate whether either approach results in anerror that is material in light of relevant quantitative and qualitativefactors. The requirements of SAB 108 are effective for fiscal years endingafter November 15, 2006. The adoption of SAB 108 is not expected to havean impact on the Company’s financial position, results of operations, or cashflows.

In September 2006, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation No. 48, “Accounting forUncertainty in Income Taxes—an Interpretation of FASB Statement No. 109” (“FIN48”). FIN 48 clarifies the accounting for uncertainty in income taxesrecognized in companies’ financial statements in accordance with FASB StatementNo. 109, “Accounting for Income Taxes,” and provides guidance on financialstatement recognition and disclosure for tax positions taken or expected to betaken on a tax return. The evaluation of a tax position in accordance with FIN48 is a two-step process. The first step is recognition whereby companies mustdetermine whether it is more likely than not that a tax position will be sustainedupon examination. The second step is measurement whereby a tax position thatmeets the more-likely-than-not recognition threshold is measured to determinethe amount of benefit to recognize in the financial statements. FIN 48 alsoprovides guidance on derecognition of recognized tax benefits, classification,interest and penalties, accounting in interim periods, disclosure, andtransition. The guidance of FIN 48 is applicable for fiscal years beginningafter December 15, 2006. The Company is evaluating the adoption of FIN 48on its consolidated financial statements.

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In September 2006, the FASB issued Statement ofFinancial Accounting Standard No. 157, “Fair Value Measurements”, (“FAS 157”).  This statement address how companies shouldmeasure fair value when they are required to use a fair value measure forrecognition or disclosure purposes under accounting principles generallyaccepted in the United States.  FAS 157will be effective for all financial statements issued for fiscal yearsbeginning November 15, 2007. The Company is in the process of evaluatingwhether the adoption of this statement will have a material impact on itsfinancial position, results of operations or cash flows.

In February 2007, the Financial Accounting StandardsBoard (“FASB”) issued Statement of Financial Accounting Standard No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities — Including anamendment of FASB Statement No. 115” (“FAS 159”).  This Statement permits entities to choose tomeasure many financial instruments and certain other items at fair value atspecified election dates. Subsequent unrealized gains and losses on items forwhich the fair value option has been elected will be reported in earnings. ThisStatement is effective as of the beginning of the Company’s fiscal year thatbegins after November 15, 2007.  TheCompany is in the process of evaluating whether the adoption of FAS 159 willhave a material effect on the Company’s financial position, results ofoperations, or cash flows.

#### ***Cash, Cash Equivalents, Short-termInvestments and Restricted Cash***

Cash equivalentsconsist principally of money market funds, commercial paper, and othermarketable securities purchased with an original maturity of three months orless.  These investments are carried atcost, which approximates market value. The Company also invests excess cash inauction rate securities.  Thesesecurities have long-term underlying maturities, however the market is highlyliquid and the interest rates reset every 7, 28 or 35 days.  The Company’s intent is not to hold thesesecurities to maturity, but rather to use the interest rate reset feature tosell securities to provide liquidity as needed. The Company’s short-term investments are classified as available forsale and are carried at fair value, with unrealized gains and losses includedin other comprehensive income or loss, which is a separate component ofstockholders’ equity, until realized. At March 31, 2007 and September 30, 2006,there were no unrealized gains or losses. At March 31, 2007 and September 30, 2006, $47,000 of cash was restrictedand pledged as collateral for a letter of credit related to the lease of theCompany’s facilities.  Details of theCompany’s cash, cash equivalents and short-term investments are as follows (inthousands):
|                                      | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|--------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                           | ** ** | **2007**           | ** ** | **2006**               | ** ** |
| **Cash  and cash equivalents:**      | ** ** | ** **         | ** ** | ** **             | ** ** |
| Cash                                 |       | $                  | 2,631      |                   | $          | 718 |   |
| Money market funds                   |       | 3,121              |       | 5,105                  |       |
| Commercial paper                     |       | 8,363              |       | 2,191                  |       |
|                                 |       |               |       |                   |       |
| **Total  cash and cash equivalents** |       | $                  | 14,115     |                   | $          | 8,014 |   |
|                                 |       |               |       |                   |       |
| **Short-term  investments:**         | ** ** | ** **         | ** ** | ** **             | ** ** |
| Municipal  auction rate securities   |       | $                  | 24,545     |                   | $          | 24,804 |   |

 

#### ***Comprehensive Income ( Loss)***

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

#### ***Segment Reporting***

During the quarter ended December 31, 2006, theCompany changed the manner in which management viewed information regardingresults of the Company’s operations for purposes of making decisions affectingthe business. This resulted from changes in the operations of the Company,including

5

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consolidationof financial and operational information reviewed by management to evaluate theCompany’s operations, discontinuing market demand creation for its NS SeriesSecurity Appliances and using certain of those products as reference platformsfor developing and selling appliances to system integrators and IndependentSoftware Vendors (“ISVs”), and the consolidation of the Company’s sales force.Therefore, the Company now has one reportable segment, which represents how managementnow evaluates the Company’s operations. Substantially all of the Company’s long-lived assets were located in theUnited States as of March 31, 2007 and September 30, 2006.

***Significant Customers***

The followingtable summarizes those customers who 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,** | ** ** |
| ** **      | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007**                             | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** |
| EMC Corporation |       | 80                               | %          | 79                             | %          | 81                                   | %          | 81 | % | 80 | % | 85 | % |

 

**3.  STOCK-BASED COMPENSATION**

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

The followingtable presents stock-based employee compensation expense included in theCompany’s unaudited condensed consolidated statements of operations (inthousands):
| ** **                        | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|-----------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                         | ** ** | **2006**                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
|                              |       |                                             |       |                                           |       |   |   |   |   |
| Cost of revenues                  |       | $                                                | 40         |                                           | $          | 46 |   | $ | 80 |   | $ | 86 |   |
| Research and  development         |       | 300                                              |       | 284                                            |       | 580 |   | 538 |   |
| Selling and  marketing            |       | 67                                               |       | 243                                            |       | 167 |   | 409 |   |
| General and  administrative       |       | 241                                              |       | 215                                            |       | 433 |   | 339 |   |
| Stock-based  compensation expense |       | $                                                | 648        |                                           | $          | 788 |   | $ | 1,260 |   | $ | 1,372 |   |

 

The Companyestimates the fair value of stock options using the Black-Scholes valuationmodel. This valuation model takes into account the exercise price of the award,as well as a variety of significant assumptions. These assumptions include theexpected term, the expected volatility of the Company’s stock over the expectedterm, the risk-free interest rate over the expected term, and the Company’sexpected annual dividend yield. The Company believes that the valuationtechnique and the approach utilized to develop the underlying assumptions areappropriate in calculating the fair values of the Company’s stock optionsgranted in the three and six months ended March 31, 2007 and 2006. Estimates offair value are not intended to predict the value ultimately realized by personswho receive equity awards. In determining the amount of expense to be recorded,judgment is also required to estimate forfeitures of the awards based on theprobability of employees completing the required service period.   Historical forfeitures are used as astarting point for developing our estimate of future forfeitures.

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Assumptions usedto determine the fair value of options granted using the Black-Scholesvaluation model were:
| ** **                                 | ** ** | **Expected Term  (1)** | ** ** | **Expected  Volatility Factor  (2)** | ** ** | **Risk Free  Interest Rate  (3)** | ** ** | **Expected Annual  Dividend Yield** |
|--------------------------------------------|------------|------------------------|------------|--------------------------------------|------------|-----------------------------------|------------|-------------------------------------|
|                                       |       |                   |       |                                 |       |                              |       |                                |
| Three and six  months ended March 31, 2007 |       | 5.50 - 6.25  years     |       | 65.77% - 72.67%                      |       | 4.44% - 4.65%                     |       | —                              |
|                                       |       |                   |       |                                 |       |                              |       |                                |
| Three and six months  ended March 31, 2006 |       | 5.50 - 6.25  years     |       | 77.00% - 78.21%                      |       | 4.39%                             |       | —                              |

----

| (1)    |   | Expected term for each grant was determined as the  midpoint between the vesting date and the end of the contractual term, also  known as the “simplified method” for estimating expected term described by  Staff Accounting Bulletin No. 107 (“SAB 107”). |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                            |
| (2)    |   | The expected volatility for each grant is estimated  based on a weighted average of historical volatility.                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                            |
| (3)    |   | The risk-free interest rate for each grant is based  on the U.S. Treasury yield curve in effect at the time of grant for a period  equal to the expected term of the stock option.                                                                                              |

 

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

A summary of theCompany’s stock option activity for the six months ended March 31, 2007 is asfollows:  
|                                  | ** ** | **Number of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  years)** | ** ** |
|----------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|----------------------------------------------------------------------|------------|
|                             |       |                        |       |                                   |       |                                                                 |       |
| Outstanding,  September 30, 2006 |       | 7,366,964                   |       | $                                      | 2.29       |                                                                 |       |   |
| Granted                          |       | 1,042,900                   |       | 2.25                                   |       |                                                                 |       |
| Exercised                        |       | (1,586,184                  | )          | 1.10                                   |       |                                                                 |       |
| Cancelled                        |       | (508,152                    | )          | 3.07                                   |       |                                                                 |       |
| Outstanding,  March 31, 2007     |       | 6,315,528                   |       | $                                      | 2.52       |                                                                 | 7.74       |   |
| Exercisable at  March 31, 2007   |       | 2,979,894                   |       | $                                      | 3.07       |                                                                 | 6.49       |   |

 

Alloptions granted during the six months ended March 31, 2007 and 2006 weregranted with exercise prices equal to the fair market value of the Company’scommon stock on the grant date and had weighted average grant date fair valuesof $1.50 and $1.08 respectively.

At March 31, 2007,unrecognized compensation expense related to non-vested stock options was$3,708,000 which is expected to be recognized over a weighted average period of2.72 years.

7

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**4.  NET INCOME (LOSS) PER SHARE**

Basic net income (loss)per share is computed by dividing the net income (loss) for the period by theweighted average number of shares of common stock outstanding during theperiod. Diluted net income (loss) per share is computed by dividing the netincome (loss) for the period by the weighted average number of shares of commonstock and potential common stock outstanding during the period, if dilutive.Potential common stock includes incremental shares of common stock issuableupon the exercise of stock options.

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 loss per share because their inclusion would beanti-dilutive (in thousands):
| ** **                                                                                                                                         | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                                                                                         | ** ** | **2007**                                         | ** ** | **2006**                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| Numerator:                                                                                                                                         |       |                                             |       |                                           |       |   |   |   |   |
| Net income (loss)                                                                                                                                  |       | $                                                | 365        |                                           | $          | (2,460 | ) | $ | 251 |   | $ | (4,084 | ) |
|                                                                                                                                               |       |                                             |       |                                           |       |   |   |   |   |
| Denominator:                                                                                                                                       |       |                                             |       |                                           |       |   |   |   |   |
| Shares used in computing basic net income (loss) per  share                                                                                        |       | 40,735                                           |       | 37,987                                         |       | 40,339 |   | 37,926 |   |
| Common stock equivalents from employee stock options                                                                                               |       | 703                                              |       | —                                         |       | 912 |   | — |   |
|                                                                                                                                               |       |                                             |       |                                           |       |   |   |   |   |
| Shares used in computing diluted net income (loss)  per share                                                                                      |       | 41,438                                           |       | 37,987                                         |       | 41,251 |   | 37,926 |   |
|                                                                                                                                               |       |                                             |       |                                           |       |   |   |   |   |
| Net income  (loss) per share:                                                                                                                      |       |                                             |       |                                           |       |   |   |   |   |
| Basic                                                                                                                                              |       | $                                                | 0.01       |                                           | $          | (0.06 | ) | $ | 0.01 |   | $ | (0.11 | ) |
| Diluted                                                                                                                                            |       | $                                                | 0.01       |                                           | $          | (0.06 | ) | $ | 0.01 |   | $ | (0.11 | ) |
|                                                                                                                                               |       |                                             |       |                                           |       |   |   |   |   |
| Anti-dilutive potential  common stock equivalents excluded from the calculation of net income (loss) per  share: Options  to purchase common stock |       | 3,273                                            |       | 5,189                                          |       | 3,131 |   | 4,575 |   |

 

**5.  INVENTORIES**

Inventoriesconsisted of the following (in thousands):
|                 | ** ** | **March 31,  2007** | ** ** | **September 30,  2006** | ** ** |
|-----------------|------------|--------------------------|------------|------------------------------|------------|
| ** **      | ** ** | ** **               | ** ** | ** **                   | ** ** |
| Raw materials   |       | $                        | 4,947      |                         | $          | 4,628 |   |
| Work in process |       | 794                      |       | 432                          |       |
| Finished goods  |       | 4,754                    |       | 3,385                        |       |
|            |       |                     |       |                         |       |
|            |       | $                        | 10,495     |                         | $          | 8,445 |   |

 

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**6.  COMMITMENTS AND CONTINGENCIES**

***Guarantees and Indemnifications***

Acquisition-relatedindemnifications – When, as part of an acquisition, the Company acquires allthe stock of a company, the Company assumes liabilities for certain events orcircumstances that took place prior to the date of acquisition.  The maximum potential amount of futurepayments the Company could be required to make for such obligations isundeterminable.  While the provisions ofthe agreements remain in effect indefinitely, the Company believes that theprobability of receiving a claim is unlikely. As a result, the Company has not recorded a liability for theseindemnification clauses as of March 31, 2007.

The Company entersinto standard indemnification agreements in the ordinary course of itsbusiness. Pursuant to these agreements, the Company indemnifies, holdsharmless, and agrees to reimburse the indemnified party for losses suffered orincurred by the indemnified party, generally its business partners orcustomers, in connection with any patent, copyright, trademark, trade secret orother intellectual property infringement claim by any third party with respectto its products. The term of these indemnification agreements is generallyperpetual. The Company has never incurred costs to defend lawsuits or settleclaims related to these indemnification agreements. As a result, the Companybelieves the estimated fair value of these agreements is minimal. Accordingly,the Company has no liabilities recorded for these indemnifications as of March31, 2007.

Product warranties – The Company offers and fulfills warrantyservices on certain of its server appliances. Warranty terms vary in durationdepending upon the product sold but generally provide for the repair orreplacement of any defective products for periods of up to 36 months aftershipment. Based upon historical experience and expectation of futureconditions, the Company reserves for the estimated costs to fulfill customerwarranty obligations upon the recognition of the related revenue. The followingtable presents changes in the Company’s product warranty liability for thethree and six months ended March 31, 2007 and 2006 (in thousands):
| ** **                                   | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                   | ** ** | **2007**                                         | ** ** | **2006**                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                         |       |                                             |       |                                           |       |   |   |   |   |
| Beginning balance                            |       | $                                                | 702        |                                           | $          | 487 |   | $ | 559 |   | $ | 455 |   |
| Accruals for warranties  issued              |       | 598                                              |       | 224                                            |       | 919 |   | 613 |   |
| Fulfillment of  warranties during the period |       | (283                                             | )          | (196                                           | )          | (461 | ) | (553 | ) |
| Ending balance                               |       | $                                                | 1,017      |                                           | $          | 515 |   | $ | 1,017 |   | $ | 515 |   |

 

***Contingencies***

*AnnouncementTiming Lawsuit*

On March 17, 2004,the United States District Court for the District of Massachusetts (the “Court”)consolidated a number of purported class action lawsuits filed against NetworkEngines, Inc. and certain individual Network Engines defendants (collectivelythe “Defendants”).  These suits generally concern the timing of theannouncement of an amendment to Network Engines’ agreement with EMC Corporationregarding the resale of EMC-approved Fibre Channel HBAs.  The Plaintiffsfiled an amended consolidated complaint on June 4, 2004.  The Defendantson August 13, 2004 filed a motion to dismiss the amended consolidatedcomplaint.  The Plaintiffs on October 12, 2004 filed an opposition to theDefendants’ motion to dismiss and the Defendants filed a reply to thePlaintiffs’ opposition on November 12, 2004. The Court on November 22, 2004 denied the Defendants’ motion to dismissthe amended consolidated complaint. On December 9, 2004, the Defendants’ filedan answer to the amended consolidated complaint.

9

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Since that time, theparties engaged in some informal discovery, exchanged formal discoveryrequests, and then pursued active settlement discussions.  On March 31, 2006, the parties filed a motionfor preliminary approval of a class action settlement.  On April 4, 2006, the Court entered an Orderpreliminarily approving the settlement and scheduled deadlines for thesettlement approval process. The settlement was subject to a notice and commentperiod during which class members could object, opt out of the settlement, orfile claims under the settlement.  Noclass members objected to the settlement or opted out of the class.  On July 25, 2006, the Court approved thesettlement.  The Court entered an Orderand Final Judgment approving the terms of the settlement in its entirety.  The terms of the settlement required theCompany’s insurance provider to pay $2,875,000 in full settlement of the claimsasserted by the class.

*Initial Public Offering Lawsuit*

On or about December 3, 2001, a putative class actionlawsuit was filed in the United States District Court for the Southern Districtof New York against the Company, Lawrence A. Genovesi (the Company’s Chairmanand former Chief Executive Officer), Douglas G. Bryant (the Company’s ChiefFinancial Officer and Vice President of Finance and Administration), and thefollowing underwriters of the Company’s initial public offering: FleetBostonRobertson Stephens Inc., Credit Suisse First Boston Corp., Goldman Sachs &Co., Lehman Brothers Inc. and Salomon Smith Barney, Inc. (collectively, the “UnderwriterDefendants”). An amended class action complaint, captioned In re NetworkEngines, Inc. Initial Public Offering Securities Litigation, 01 Civ. 10894(SAS), was filed on April 20, 2002.

The suit alleges that the defendants violated thefederal securities laws by issuing and selling securities pursuant to theCompany’s initial public offering in July 2000 (“IPO”) without disclosing toinvestors that the Underwriter Defendants had solicited and received excessiveand undisclosed commissions from certain investors. The suit also alleges thatthe Underwriter Defendants entered into agreements with certain customerswhereby the Underwriter Defendants agreed to allocate to those customers sharesof the Company’s common stock in the offering, in exchange for which thecustomers agreed to purchase additional shares of the Company’s common stock inthe aftermarket at pre-determined prices. The suit alleges that such tie-inarrangements were designed to and did maintain, distort and/or inflate theprice of the Company’s common stock in the aftermarket. The suit furtheralleges that the Underwriter Defendants received undisclosed and excessivebrokerage commissions and that, as a consequence, the Underwriter Defendantssuccessfully increased investor interest in the manipulated IPO securities andincreased the Underwriter Defendants’ individual and collective underwritings,compensation and revenues. The suit seeks damages and certification of aplaintiff class consisting of all persons who acquired shares of the Company’scommon stock between July 13, 2000 and December 6, 2000.

In July 2002, the Company, Lawrence A. Genovesi andDouglas G. Bryant joined in an omnibus motion to dismiss the suit challengingthe legal sufficiency of plaintiffs’ claims. The motion was filed on behalf ofhundreds of issuer and individual defendants named in similar lawsuits.Plaintiffs opposed the motion, and the Court heard oral argument on the motionin November 2002. On February 19, 2003, the Court issued an opinion and orderdenying the motion as to the Company. However, in October 2002, Lawrence A.Genovesi and Douglas G. Bryant were dismissed from this case without prejudice.

On July 9, 2003, a SpecialCommittee of the Company’s Board of Directors authorized the Company tonegotiate a settlement of the pending claims substantially consistent with amemorandum of understanding negotiated among class plaintiffs, all issuerdefendants and their insurers.  Theparties have negotiated the settlement, which provides, among other things, fora release of the Company and the Individual Defendants for the conduct allegedin the amended complaint to be wrongful. The Company would agree to undertake other responsibilities under thesettlement, including agreeing to assign, or not assert, certain potentialclaims that it may have against its underwriters.  Any direct financial impact of the proposedsettlement is expected to be borne by the Company’s insurers.  Any such settlement would be subject tovarious contingencies, including approval by the Court overseeing thelitigation. On February 15, 2005, the Court issued an Opinion and Order preliminarilyapproving the settlement, provided that the

10

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defendantsand plaintiffs agree to a modification narrowing the scope of the bar order setforth in the original settlement agreement. The parties agreed to a modification narrowing the scope of the barorder, and on August 31, 2005, the Court issued an order preliminarilyapproving the settlement and setting a public hearing on its fairness, whichtook place on April 24, 2006.  OnDecember 5, 2006, the United States Court of Appeals for the Second Circuitoverturned the District Court’s certification of the class of plaintiffs whoare pursuing the claims that would be settled in the settlement against theunderwriter defendants. Thereafter, the District Court ordered a stay of allproceedings in all of the lawsuits pending the outcome of plaintiffs’ petitionto the Second Circuit for rehearing en banc and resolution of the classcertification issue.  On April 6, 2007,the Second Circuit denied plaintiffs’ petition for rehearing, but clarifiedthat the plaintiffs may seek to certify a more limited class in the DistrictCourt.  Accordingly, the stay remains inplace and the plaintiffs and issuer defendants have stated that they areprepared to discuss how the settlement might be amended or renegotiated tocomply with the Second Circuit decision. The Company is unable to predict theoutcome of this suit and as a result, no amounts have been accrued as of March31, 2007.

**7.  RELATED PARTY TRANSACTIONS**

Robert M. Wadsworth, one ofthe Company’s directors, also serves as a director of Innoveer Solutions, Inc. (“Innoveer”).  The Company engages Innoveer to provideprofessional services related to modifications of its customer resourcemanagement (“CRM”) software system. During the three and six months ended March 31, 2007, the Companyincurred approximately $31,000 and $41,500, respectively, and during the threeand six months ended March 31, 2006, the Company incurred approximately $18,000and $47,000, respectively, related to these services.   The Company had $5,000 and $7,000 payable toInnoveer at March 31, 2007 and September 30, 2006, respectively.

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

**Special Note RegardingForward-Looking Statements**

This Quarterly Report on Form10-Q contains forward-looking statements within the meaning of Section 21E ofthe Securities Exchange Act of 1934, as amended, that involve risks anduncertainties.All statements other than statements of historical information provided hereinare forward-looking statements and may contain projections related to financialresults, economic conditions, trends and known uncertainties. Our actualresults could differ materially from those discussed in the forward-lookingstatements as a result of a number of factors, which include those discussed inthis section and in Part II, Item 1A, Risk Factors, of this report and therisks discussed in our other filings with the Securities and ExchangeCommission. Readers are cautioned not to place undue reliance on theseforward-looking statements, which reflect management’s analysis, judgment,belief or expectation only as of the date hereof. We undertake no obligation topublicly reissue these forward-looking statements to reflect events orcircumstances that arise after the date hereof.

The followingdiscussion and analysis should be read in conjunction with the condensed consolidatedfinancial statements and the notes thereto included in Item 1 in this QuarterlyReport on Form 10-Q and our Annual Report on Form 10-K for the fiscal yearended September 30, 2006 filed by the Company with the Securities and ExchangeCommission.

**Overview**

Wedevelop and manufacture server appliance solutions that deliver data storageand network security applications on server appliances. Server appliances arepre-configured network infrastructure devices designed to optimally deliverspecific software application functionality and facilitate ease of deploymentand support of a software application in a customer’s network.

Duringthe quarter ending December 31, 2006, we changed the manner in which we viewinformation regarding results of our operations for purposes of makingdecisions affecting the business. These changes included consolidation offinancial and operational information reviewed to evaluate our operations,discontinuing market demand creation for our NS Series Security Appliances andusing certain of those products as reference platforms for developing andselling appliances to system integrators and Independent Software Vendors (“ISVs”),and the consolidation of our sales force. Therefore, we now have one reportablesegment, which represents how we evaluate our operations.

**CriticalAccounting Policies and Estimates**

Our discussion andanalysis of financial condition and results of operations are based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America. Inpreparing these financial statements, we have made estimates and judgments indetermining certain amounts included in the financial statements. We base ourestimates and judgments on historical experience and other various assumptionsthat we believe to be reasonable under the circumstances. Actual results maydiffer from these estimates under different assumptions or conditions. Nochanges to our critical accounting policies have taken place since September30, 2006.

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**Resultsof Operations**

**Threemonths ended March 31, 2007 compared to the three months ended March 31, 2006**

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,** | ** ** |
|-----------------------|------------|------------------------------------------------------|------------|
| ** **            | ** ** | **2007**                                             | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **            | ** ** | **Dollars**                                          | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues          |       | $                                                    | 29,305     |   | 100.0 | % | $ | 28,036 |   | 100.0 | % | $ | 1,269 |   | 4.5 | % |
| Gross profit          |       | 6,090                                                |       | 20.8 | % | 4,331 |   | 15.4 | % | 1,759 |   | 40.6 | % |
| Operating  expenses   |       | 6,174                                                |       | 21.1 | % | 7,181 |   | 25.6 | % | (1,007 | ) | (14.0 | )% |
| Loss from  operations |       | (84                                                  | )          | (0.3 | )% | (2,850 | ) | (10.2 | )% | 2,766 |   | 97.1 | % |
| Net income (loss)     |       | 365                                                  |       | 1.2 | % | (2,460 | ) | (8.8 | )% | 2,825 |   | 114.8 | % |
|                       |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Net Revenues***

Our revenues are derivedfrom sales of server appliances and related maintenance services.

Our net revenues increased for the three months endedMarch 31, 2007 versus the same period in fiscal 2006, primarily due to an increasein sales volumes, partially offset by lower average selling prices.  Net revenues from sales to EMC represented80% of net revenues in the three months ended March 31, 2007 versus 79% in thethree months ended March 31, 2006. Net revenues from other customers for thethree months ended March 31, 2007 were $5.8 million compared to $3.6 million inthe three months ended March 31, 2006, after excluding revenues from NetworkIntelligence Corporation due to its acquisition by EMC on September 18, 2006.  This growth was attributable to an increasein revenue from existing customers, revenue for servicing Microsoft Whalecustomers, and revenue from new customers in the first half of fiscal 2007.

***Gross profit***

Gross profitrepresents net revenues recognized less the cost of revenues. Cost of revenuesincludes cost of materials, warranty costs, inventory write-downs, shipping andhandling costs, customer support costs and manufacturing costs. Manufacturingcosts are primarily comprised of compensation, contract labor costs and, whenapplicable, contract manufacturing costs.

Gross profit andgross profit as a percentage of net revenue increased for the quarter endedMarch 31, 2007 compared to the quarter ended March 31, 2006, primarily as aresult of cost reductions relative to the timing of price reductions tocustomers, the cost recovery of inventory previously written down and changesin customer and product mix.

Gross profit isaffected by customer and product mix, pricing and the volume of orders as wellas by the mix of product manufactured internally compared to productmanufactured by a contract manufacturer, which results in higher manufacturingcosts.  We expect that gross profit as apercentage of net revenue for the three months ended June 30, 2007 will beslightly lower when compared to the three months ended March 31, 2007, since weare not expecting any additional inventory cost recoveries in the next quarter.

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***Operating Expenses***

The following table presents operating expenses duringthe periods indicated, in thousands and as a percentage of net revenues:
| ** **                 | ** ** | **Three Months Ended March 31,** | ** ** |
|----------------------------|------------|------------------------------------------------------|------------|
| ** **                 | ** ** | **2007**                                             | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                 | ** ** | **Dollars**                                          | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating Expenses:   |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Research and development   |       | $                                                    | 2,410      |   | 8 | % | $ | 2,182 |   | 8 | % | $ | 228 |   | 10 | % |
| Selling and marketing      |       | 1,810                                                |       | 6 | % | 2,812 |   | 10 | % | (1,002 | ) | (36 | )% |
| General and administrative |       | 1,954                                                |       | 7 | % | 2,187 |   | 8 | % | (233 | ) | (11 | )% |
|                       |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total operating  expenses  |       | $                                                    | 6,174      |   | 21 | % | $ | 7,181 |   | 26 | % | $ | (1,007 | ) | (14 | )% |

 

***Research anddevelopment***

Research and development expenses consist primarily ofsalaries and related expenses for personnel engaged in research anddevelopment, fees paid to consultants and outside service providers, materialcosts for prototype and test units and other expenses related to the design,development, testing and enhancements of our server appliance products. Weexpense all of our research and development costs 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 in thousandsand percentages: 
| ** **                        | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                             | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:        |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                    | 1,388      |   | 58 | % | $ | 1,272 |   | 58 | % | $ | 116 |   | 9 | % |
| Stock-based compensation          |       | 300                                                  |       | 12 | % | 284 |   | 13 | % | 16 |   | 6 | % |
| Prototype                         |       | 270                                                  |       | 11 | % | 292 |   | 13 | % | (22 | ) | (8 | )% |
| Consulting and outside services   |       | 257                                                  |       | 11 | % | 148 |   | 7 | % | 109 |   | 74 | % |
| Other                             |       | 195                                                  |       | 8 | % | 186 |   | 9 | % | 9 |   | 5 | % |
|                              |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total research  and development   |       | $                                                    | 2,410      |   | 100 | % | $ | 2,182 |   | 100 | % | $ | 228 |   | 10 | % |

 

Our research and development expenses have increasedthis quarter as compared to the same period last fiscal year. Because ourresearch and development expenses are project driven, the timing of theseexpenditures can vary.  The increase incompensation and related expenses is attributable to an increase inheadcount.  The increase in consultingcosts relates to the timing of certain development projects.

Our server appliance development strategy emphasizesthe utilization of standard server appliance platforms, which utilizeoff-the-shelf components. However, we expect that in some cases significantdevelopment efforts will be required to fulfill our current and potentialcustomers’ needs using customized platforms. In addition, we intend to focusour software development in areas that improve the ease of server applianceimplementation and use, which we believe will enhance our valueproposition.  We expect that prototypeand consulting costs will be variable and could fluctuate depending on thetiming and magnitude of our development projects. We expect our research anddevelopment costs to remain consistent during our quarter ended June 30, 2007.

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***Selling andmarketing***

Selling and marketing expenses consist primarily ofsalaries and commissions for personnel engaged in sales and marketing; costsassociated with our marketing programs, which include costs associated with ourattendance at trade shows, advertising, web site enhancements and productevaluation costs; consulting and outside services costs and travel. Thefollowing table summarizes the most significant components of selling andmarketing expense for the periods indicated in thousands and as a percentage oftotal selling and marketing expense and provides the changes in thousands andpercentages:
| ** **                        | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                             | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and  marketing:           |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                    | 1,182      |   | 65 | % | $ | 1,706 |   | 61 | % | $ | (524 | ) | (31 | )% |
| Stock-based compensation          |       | 67                                                   |       | 4 | % | 243 |   | 9 | % | (176 | ) | (72 | )% |
| Marketing programs                |       | 226                                                  |       | 12 | % | 495 |   | 18 | % | (269 | ) | (54 | )% |
| Travel                            |       | 144                                                  |       | 8 | % | 263 |   | 9 | % | (119 | ) | (45 | )% |
| Other                             |       | 191                                                  |       | 11 | % | 105 |   | 4 | % | 86 |   | 82 | % |
|                              |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total selling  and marketing      |       | $                                                    | 1,810      |   | 100 | % | $ | 2,812 |   | 100 | % | $ | (1,002 | ) | (36 | )% |

 

As indicated in the table above, our selling andmarketing expenses have significantly decreased.  This decrease is the result of our strategicchange to decrease demand creation sales and marketing activities and morefully leverage our customers’ sales and marketing resources.  The primary components of the decrease inselling and marketing expenses are compensation and related expenses, marketingprograms, stock-based compensation and travel. The decrease in compensation andrelated expenses primarily relate to a reduction in headcount from 35 at March31, 2006 to 22 at March 31, 2007, as a result of the evolving sales model.  The decrease in our stock-based compensationrelates to the scheduled completion of vesting for certain option grants.  Additionally, the reduction in marketingexpenses, and travel is a result of reduced spending on end user leadgeneration programs for our NS Series products.

We believe that we must target our selling andmarketing efforts on network equipment providers, system integrators andindependent software vendors (“ISVs”) in order to enhance our position as aleading provider of server appliance products. We expect selling and marketingexpenses to remain consistent during our quarter ended June 30, 2007.

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***General andadministrative***

General and administrative expenses consist primarilyof salaries and other related costs for executive, finance, informationtechnology and human resources personnel; professional services, which includelegal, accounting, audit and tax fees, and costs of compliance with theSarbanes-Oxley Act; and director and officer insurance. The following tablesummarizes the most significant components of general and administrativeexpense for the periods indicated in thousands and as a percentage of totalgeneral and administrative expense and provides the changes in thousands andpercentages:
| ** **                           | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                             | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and  administrative:         |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                    | 956        |   | 49 | % | $ | 812 |   | 37 | % | $ | 144 |   | 18 | % |
| Stock-based compensation             |       | 241                                                  |       | 12 | % | 215 |   | 10 | % | 26 |   | 12 | % |
| Consulting and professional services |       | 519                                                  |       | 27 | % | 635 |   | 29 | % | (116 | ) | (18 | )% |
| Director and officer insurance       |       | 83                                                   |       | 4 | % | 231 |   | 11 | % | (148 | ) | (64 | )% |
| Other                                |       | 155                                                  |       | 8 | % | 294 |   | 13 | % | (139 | ) | (47 | )% |
|                                 |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total general  and administrative    |       | $                                                    | 1,954      |   | 100 | % | $ | 2,187 |   | 100 | % | $ | 233 |   | (11 | )% |

 

As indicated in the table above, general andadministrative expenses decreased in the three months ended March 31, 2007versus the three months ended March 31, 2006.  This was primarily a result of decreases in director and officerinsurance, other expenses and consulting and professional services partiallyoffset by an increase in compensation and related expenses.   The decrease in consulting and professionalservices is due primarily to a decrease in legal expenses attributable to thetiming of certain litigation activities. The decreases in other expenses primarily relates to higher recruitingand relocation expenses incurred in the prior year as a result of our change inour Chief Executive Officer.  We expectgeneral and administrative expenses to remain consistent during our quarter endedJune 30, 2007.

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

Interest and other income,net increased to $462,000 for the three months ended March 31, 2007 from$390,000 for the three months ended March 31, 2006. This increase is primarilydue to higher interest rates and higher balances of our cash, cash equivalents,and short-term investments.

**Sixmonths ended March 31, 2007 compared to the six months ended March 31, 2006**

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,** | ** ** |
|-----------------------|------------|----------------------------------------------------|------------|
| ** **            | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **            | ** ** | **Dollars**                                        | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues          |       | $                                                  | 56,543     |   | 100.0 | % | $ | 55,305 |   | 100.0 | % | $ | 1,238 |   | 2.2 | % |
| Gross profit          |       | 11,323                                             |       | 20.0 | % | 8,992 |   | 16.3 | % | 2,331 |   | 25.9 | % |
| Operating  expenses   |       | 11,958                                             |       | 21.1 | % | 13,786 |   | 24.9 | % | (1,828 | ) | (13.3 | )% |
| Loss from  operations |       | (635                                               | )          | (1.1 | )% | (4,794 | ) | (8.7 | )% | 4,159 |   | 86.8 | % |
| Net income(loss)      |       | 251                                                |       | (0.4 | )% | (4,084 | ) | (7.4 | )% | 4,335 |   | 106.1 | % |
|                       |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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***Net Revenues***

Our net revenues increased slightly for the six monthsended March 31, 2007 versus the same period in fiscal 2006. This was primarilydue to an increase in sales volume, partially offset by lower average sellingprices.  Net revenues from sales to EMCrepresented 81% of net revenues in the six months ended March 31, 2007 and2006. In addition, net revenues from other customers for the six months endedMarch 31, 2007 increased to $10.9 million from $7.0 million (excluding NetworkIntelligence) for the six months ended March 31, 2006.  This growth was attributable to a ramp inrevenue from existing customers, revenue for servicing Microsoft Whalecustomers and revenue from new customer wins in the first half of fiscal 2007.

***Gross profit***

Gross profit andgross profit as a percentage of net revenue increased for the six months endedMarch 31, 2007, compared to the six months ended March 31, 2006, primarily as aresult of the timing of cost reductions relative to price reductions tocustomers, the cost recovery of inventory previously written down and changesin the customer and product mix.

***Operating Expenses***

The following table presents operating expenses duringthe periods indicated, in thousands and as a percentage of net revenues:
| ** **                 | ** ** | **Six Months Ended March 31,** | ** ** |
|----------------------------|------------|----------------------------------------------------|------------|
| ** **                 | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                 | ** ** | **Dollars**                                        | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating Expenses:   |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Research and development   |       | $                                                  | 4,403      |   | 8 | % | $ | 4,202 |   | 8 | % | $ | 201 |   | 5 | % |
| Selling and marketing      |       | 3,540                                              |       | 6 | % | 5,590 |   | 10 | % | (2,050 | ) | (37 | )% |
| General and administrative |       | 4,015                                              |       | 7 | % | 3,994 |   | 7 | % | 21 |   | 1 | % |
|                       |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total operating  expenses  |       | $                                                  | 11,958     |   | 21 | % | $ | 13,786 |   | 25 | % | $ | (1,828 | ) | (13 | )% |

 

***Research anddevelopment***

The following table summarizes the most significantcomponents of research and development expense for the periods indicated, inthousands and as a percentage of total research and development expense andprovides the changes in thousands and percentages: 
| ** **                        | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                        | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:        |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                  | 2,607      |   | 59 | % | $ | 2,489 |   | 59 | % | $ | 118 |   | 5 | % |
| Stock-based compensation          |       | 580                                                |       | 13 | % | 538 |   | 13 | % | 42 |   | 8 | % |
| Prototype                         |       | 411                                                |       | 9 | % | 389 |   | 9 | % | 22 |   | 6 | % |
| Consulting and outside services   |       | 399                                                |       | 9 | % | 376 |   | 9 | % | 23 |   | 6 | % |
| Other                             |       | 406                                                |       | 9 | % | 410 |   | 10 | % | (4 | ) | (1 | )% |
|                              |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total research  and development   |       | $                                                  | 4,403      |   | 100 | % | $ | 4,202 |   | 100 | % | $ | 201 |   | 5 | % |

 

Our research and development expenses have increasedin the six months ended March 31, 2007 as compared to the same period lastfiscal year primarily due to increased compensation and related

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expenses and stock-basedcompensation charges. This increase was the result of increased headcount from44 at March 31, 2006 to 47 at March 31, 2007.

***Selling andmarketing***

The following table summarizes the most significantcomponents of selling and marketing expense for the periods indicated inthousands and as a percentage of total selling and marketing expense andprovides the changes in thousands and percentages:
| ** **                        | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                        | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and  marketing:           |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                  | 2,407      |   | 68 | % | $ | 3,213 |   | 57 | % | $ | (806 | ) | (25 | )% |
| Stock-based compensation          |       | 167                                                |       | 5 | % | 409 |   | 7 | % | (242 | ) | (59 | )% |
| Marketing programs                |       | 395                                                |       | 11 | % | 932 |   | 17 | % | (537 | ) | (58 | )% |
| Travel                            |       | 256                                                |       | 7 | % | 529 |   | 9 | % | (273 | ) | (52 | )% |
| Other                             |       | 315                                                |       | 9 | % | 507 |   | 9 | % | (192 | ) | (38 | )% |
|                              |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total selling  and marketing      |       | $                                                  | 3,540      |   | 100 | % | $ | 5,590 |   | 100 | % | $ | (2,050 | ) | (37 | )% |

 

As indicated in the table above, our selling andmarketing expenses have significantly decreased.  This decrease is the result of our strategicchange to decrease demand creation sales and marketing activities and morefully leverage our customers’ sales and marketing resources.  In particular resulting from this change, wasa decrease in headcount from 35 at March 31, 2006 to 22 at March 31, 2007thereby causing the compensation and related expenses to decrease.  In addition, the reduction in marketingexpenses and travel is a result of reduced spending on end user lead generationprograms for our NS Series products.

***General andadministrative***

The following table summarizes the most significantcomponents of general and administrative expense for the periods indicated inthousands and as a percentage of total general and administrative expense andprovides the changes in thousands and percentages:
| ** **                           | ** ** | **Six Months Ended March 31,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                        | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and  administrative:         |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                  | 1,730      |   | 43 | % | $ | 1,501 |   | 38 | % | $ | 229 |   | 15 | % |
| Stock-based compensation             |       | 433                                                |       | 11 | % | 339 |   | 8 | % | 94 |   | 28 | % |
| Consulting and professional services |       | 1,362                                              |       | 34 | % | 1,180 |   | 30 | % | 182 |   | 15 | % |
| Director and officer insurance       |       | 166                                                |       | 4 | % | 462 |   | 12 | % | (296 | ) | (64 | )% |
| Other                                |       | 324                                                |       | 8 | % | 512 |   | 12 | % | (188 | ) | (37 | )% |
|                                 |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total general  and administrative    |       | $                                                  | 4,015      |   | 100 | % | $ | 3,994 |   | 100 | % | $ | 21 |   | 1 | % |

 

As indicated in the table above, general andadministrative expenses increased slightly in the six months ended March 31,2007 versus the six months ended March 31, 2006.   Increases in compensation and relatedexpenses, which were related to changes in our senior management, andconsulting and professional services, were partially offset by decreases in thecost of director and officer insurance and other expenses.   The increase in consulting and professionalservices is due primarily to costs associated

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with the investigation ofembezzlement by a former non-management employee which was detected during thefourth quarter of fiscal 2006 and was completed during the first quarter offiscal 2007.

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

Interest and other income,net increased to $909,000 for the six months ended March 31, 2007 from $710,000for the six months ended March 31, 2006. This increase is primarily due tohigher interest rates and higher balances of our cash, cash equivalents, andshort-term investments.

**Liquidityand Capital Resources**

The following tablesummarizes cash flow activities, in thousands, for the periods indicated:
|                                                   | ** ** | **Six Months Ended  March 31,** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                        | ** ** | **2007**                                       | ** ** | **2006** | ** ** |
|                                              |       |                                           |       |   |   |
| Net income  (loss)                                |       | $                                              | 251        |   | $ | (4,084 | ) |
| Non-cash  adjustments to net income (loss)        |       | 1,663                                          |       | 1,886 |   |
| Changes in  working capital                       |       | 2,641                                          |       | (1,528 | ) |
|                                              |       |                                           |       |   |   |
| Cash provided by  (used in) operating activities  |       | 4,555                                          |       | (3,726 | ) |
|                                              |       |                                           |       |   |   |
| Cash (used in)  provided by investing activities  |       | (279                                           | )          | 3,337 |   |
| Cash provided by  financing activities            |       | 1,825                                          |       | 337 |   |
|                                              |       |                                           |       |   |   |
| Increase  (decrease) in cash and cash equivalents |       | 6,101                                          |       | (52 | ) |
| Beginning cash  and cash equivalents              |       | 8,014                                          |       | 9,468 |   |
|                                              |       |                                           |       |   |   |
| Ending cash and cash  equivalents                 |       | $                                              | 14,115     |   | $ | 9,416 |   |

 

The following table presents our short-terminvestments as of the periods indicated (in thousands):
|                        | ** ** | **March 31,  2007** | ** ** | **September 30,  2006** | ** ** |
|------------------------|------------|--------------------------|------------|------------------------------|------------|
|                   |       |                     |       |                         |       |
| Short-term investments |       | $                        | 24,545     |                         | $          | 24,804 |   |
|                        |            |                          |            |                              |            |  |  |

 

***Operating Activities***

Cash flowsprovided by operating activities of $4.6 million for the six months ended March31, 2007 were a result of the increase in net income between the two periods aswell as non-cash adjustments to our net income and changes in our workingcapital.  The most significant changes inour working capital were increases in deferred revenue of $1.8 million relatedto the transfer of the support obligations of the previously installed Whaleappliances from Microsoft, and accounts payable of $1.7 million due to thetiming of shipments from and payments to our vendors.  These were partially offset by an increase inour inventory balances of $2.0 million as a result of the timing of shipmentsto our customers.

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***Investing Activities***

Cash flows used in investingactivities during the six months ended March 31, 2007 consisted of the purchaseof property and equipment of approximately $495,000, which was partially offsetby net proceeds from the sale of short-term investments of $259,000.

***Financing Activities***

Cash flows provided byfinancing activities primarily consisted of cash received as a result ofemployee stock option and stock purchase plan activity of $1.8 million in thesix months ended March 31, 2007 primarily as a result of exercises by formerofficers. We expect employee stock option and stock purchase plan activity tocontinue in fiscal 2007; however, we cannot predict its level given thevolatility of capital markets.

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

·                  the timing and size of orders from our largest customer;

·                  our ability to enter into partnerships with network equipment providers,systems integrators and independent software vendors;

·                  the level of success of our customers in selling server appliancesolutions that include our server appliance hardware platforms;

·                  the costs and timing of product engineering efforts and the success ofthese efforts; and

·                  market developments.

We believe that our availablecash resources, including cash, cash equivalents and short-term investments andcash that we expect to generate from sales of our products will be sufficientto meet our operating and capital requirements through at least the next twelvemonths. After that, we may need to raise additional funds. We may in the futureseek to raise additional funds through borrowings, public or private equityfinancings or from other sources. There can be no assurance that additionalfinancing will be available at all or, if available, will be on termsacceptable to us. If additional financing is needed and is not available onacceptable terms, we may need to reduce our operating expenses.

***Contractual Obligations andCommitments***

In addition to ourcontractual obligations disclosed in our Annual Report on Form 10-K forthe year ended September 30, 2006, during the quarter ended March 31, 2007, weentered into an agreement that includes a minimum purchase commitment thatrequires us to purchase approximately $150,000, $420,000, and $140,000 worth ofadditional product in fiscal 2007, 2008, and 2009 respectively.

**Off-Balance Sheet Arrangements**

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

**Related Party Transactions**

Robert M. Wadsworth, one ofour directors, also serves as a director of Innoveer Solutions, Inc. (“Innoveer”).  We engage Innoveer to provide professionalservices related to modifications of its customer resource management (“CRM”)software system.  During the three andsix months ended March 31, 2007,

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we incurred approximately$31,000 and $41,500, respectively, and during the three and six months endedMarch 31, 2006, we incurred approximately $18,000 and $47,000, respectively,related to these services.   We had$5,000 and $7,000 payable to Innoveer at March 31, 2007 and September 30, 2006,respectively.

**Recent Accounting Pronouncements**

In September 2006, theSecurities and Exchange Commission issued Staff Accounting Bulletin No. 108, “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements in theCurrent Year Financial Statements” (“SAB 108”). SAB 108 addresses how the effects of prior-year uncorrectedmisstatements should be considered when quantifying misstatements incurrent-year financial statements. SAB 108 requires us to quantifymisstatements using a balance sheet and income statement approach and toevaluate whether either approach results in an error that is material in lightof relevant quantitative and qualitative factors. The requirements of SAB 108are effective for fiscal years ending after November 15, 2006. Theadoption of SAB 108 is not expected to have an impact on our financialposition, results of operations or cash flows.

In September 2006, the Financial AccountingStandards Board (“FASB”) issued FASB Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes—an Interpretation of FASB StatementNo. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertaintyin income taxes recognized in companies’ financial statements in accordancewith FASB Statement No. 109, “Accounting for Income Taxes,” and providesguidance on financial statement recognition and disclosure for tax positionstaken or expected to be taken on a tax return. The evaluation of a tax positionin accordance with FIN 48 is a two-step process. The first step is recognitionwhereby companies must determine whether it is more likely than not that a taxposition will be sustained upon examination. The second step is measurementwhereby a tax position that meets the more-likely-than-not recognitionthreshold is measured to determine the amount of benefit to recognize in thefinancial statements. FIN 48 also provides guidance on derecognition of recognizedtax benefits, classification, interest and penalties, accounting in interimperiods, disclosure and transition. The guidance of FIN 48 is applicable forfiscal years beginning after December 15, 2006. We are evaluating theimpact of adopting FIN 48 on our financial position, results of operations andcash flows.

In September 2006, the FASB issued Statement ofFinancial Accounting Standard No. 157, “Fair Value Measurements”, (“FAS 157”).  This statement address how companies shouldmeasure fair value when they are required to use a fair value measure forrecognition or disclosure purposes under accounting principles generallyaccepted in the United States.  FAS 157will be effective for all financial statements issued for fiscal yearsbeginning November 15, 2007. We are in the process of evaluating whether theadoption of this statement will have a material impact on its financialposition, results of operations and cash flows.

In February 2007, the Financial Accounting StandardsBoard (“FASB”) issued FASB Statement No. 159, “The Fair Value Option forFinancial Assets and Financial Liabilities – Including an amendment of FASBStatement No. 115” (“FAS 159”).  ThisStatement permits entities to choose to measure many financial instruments andcertain other items at fair value at specified election dates. Subsequentunrealized gains and losses on items for which the fair value option has beenelected will be reported in earnings. This Statement is effective for ourfiscal year ending September 30, 2009.  We are in the process of evaluating whetherthe adoption of FAS 159 will have a material effect on the our financialposition, results of operations and cash flows.

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

We do not engage in anyforeign currency hedging transactions and therefore do not believe we aresubject to material exchange rate risk. We are exposed to market risk relatedto changes in interest rates. We invest excess cash balances in cashequivalents and short-term investments and as a result, we believe that theeffect, if any, of reasonably possible near-term changes in interest rates onour financial position, results of operations and cash flows will not bematerial. In addition, a hypothetical 10% increase or decrease in interestrates would not have a material adverse effect on our financial condition.

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**ITEM 4.    CONTROLS ANDPROCEDURES**

Our management, with theparticipation of our Chief Executive Officer and Chief Financial Officer,evaluated the effectiveness of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the Securities ExchangeAct) as of March 31, 2007. Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer concluded that, as of March 31, 2007, ourdisclosure controls and procedures (1) were designed to effectively accumulateand communicate information to the Company’s management, as appropriate, toallow timely decisions regarding required disclosure and (2) wereeffective, in that they provide reasonable assurance that information requiredto be disclosed by the Company in the reports that it files or submits underthe Securities Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’srules and forms.

Nochange in our internal control over financial reporting (as defined in Rules13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the threemonths ended March 31, 2007 that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

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**PART II—OTHER INFORMATION**

**ITEM 1.     LEGAL PROCEEDINGS**

*InitialPublic Offering Lawsuit*

On or about December 3, 2001, a putative classaction lawsuit was filed in the United States District Court for the SouthernDistrict of New York against us, Lawrence A. Genovesi (our former Chairman andChief Executive Officer), Douglas G. Bryant (our Chief Financial Officer andVice President of Finance and Administration), and the following underwritersof our initial public offering: FleetBoston Robertson Stephens Inc., CreditSuisse First Boston Corp., Goldman Sachs & Co., Lehman Brothers Inc. andSalomon Smith Barney, Inc. (collectively, the “Underwriter Defendants”). Anamended class action complaint, captioned In re Network Engines, Inc. InitialPublic Offering Securities Litigation, 01 Civ. 10894 (SAS), was filed on April20, 2002.

The suit alleges that thedefendants violated the federal securities laws by issuing and sellingsecurities pursuant to our initial public offering in July 2000 (“IPO”) withoutdisclosing to investors that the Underwriter Defendants had solicited andreceived excessive and undisclosed commissions from certain investors. The suitalso alleges that the Underwriter Defendants entered into agreements withcertain customers whereby the Underwriter Defendants agreed to allocate tothose customers shares of our common stock in the offering, in exchange forwhich the customers agreed to purchase additional shares of our common stock inthe aftermarket at pre-determined prices. The suit alleges that such tie-inarrangements were designed to and did maintain, distort and/or inflate theprice of our common stock in the aftermarket. The suit further alleges that theUnderwriter Defendants received undisclosed and excessive brokerage commissionsand that, as a consequence, the Underwriter Defendants successfully increasedinvestor interest in the manipulated IPO securities and increased theUnderwriter Defendants’ individual and collective underwritings, compensationand revenues. The suit seeks damages and certification of a plaintiff classconsisting of all persons who acquired shares of our common stock between July13, 2000 and December 6, 2000.

In July 2002, we, Lawrence A. Genovesi and DouglasG. Bryant joined in an omnibus motion to dismiss the suit challenging the legalsufficiency of plaintiffs’ claims. The motion was filed on behalf of hundredsof issuer and individual defendants named in similar lawsuits. Plaintiffsopposed the motion, and the Court heard oral argument on the motion in November2002. On February 19, 2003, the Court issued an opinion and order denying themotion as to us. However, in October 2002, Lawrence A. Genovesi and Douglas G.Bryant were dismissed from this case without prejudice.

On July 9, 2003, a Special Committee of our Board ofDirectors authorized us to negotiate a settlement of the pending claimssubstantially consistent with a memorandum of understanding negotiated amongclass plaintiffs, all issuer defendants and their insurers.  The parties have negotiated the settlement,which provides, among other things, for a release of us and the individualdefendants for the conduct alleged in the amended complaint to be wrongful.  We would agree to undertake otherresponsibilities under the settlement, including agreeing to assign, or notassert, certain potential claims that we may have against the underwriters.  Any direct financial impact of the proposedsettlement is expected to be borne by our insurers.  Any such settlement would be subject tovarious contingencies, including approval by the Court overseeing thelitigation. On February 15, 2005, the Court issued an Opinion and Order preliminarilyapproving the settlement, provided that the defendants and plaintiffs agree toa modification narrowing the scope of the bar order set forth in the originalsettlement agreement.   The partiesagreed to a modification narrowing the scope of the bar order, and on August31, 2005, the Court issued an order preliminarily approving the settlement andsetting a public hearing on its fairness, which took place on April 24,2006.  On December 5, 2006, the UnitedStates Court of Appeals for the Second Circuit overturned the District Court’scertification of the class of plaintiffs who are pursuing the claims that wouldbe settled in the settlement against the underwriter defendants. Thereafter,the District Court ordered a stay of all proceedings in all of the lawsuitspending the outcome of plaintiffs’ petition to the Second Circuit for rehearingen banc and resolution of the class certification issue.  On April 6, 2007, the Second Circuit deniedplaintiffs’ petition for rehearing, but clarified that the plaintiffs may seekto certify a more limited class in the District Court.  Accordingly, the stay remains in place andthe plaintiffs and issuer defendants have stated that they are prepared todiscuss how the settlement might be amended or renegotiated to

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complywith the Second Circuit decision. We are unable to predict the outcome of thissuit and as a result, no amounts have been accrued as of March 31, 2007.

**ITEM 1A.      RISK FACTORS**

The risks and uncertaintiesdescribed below are not the only ones we may face. Additional risks anduncertainties not presently known to us, or that are currently deemedimmaterial, may also impair our business operations. If any of thefollowing risks actually occur, our financial condition and operating resultscould be materially adversely affected.

The following discussionincludes two revised risk factors (“We may not be able to effectivelycommercialize our appliances or may be at a competitive disadvantage if wecannot license or integrate third-party applications that are essential for thefunctionality of certain appliances”; “If we are unable to effectively manageour customer service and support activities, we may not be able to retainour existing customers or attract new customers”)  and two risk factors (“Market acceptance anddemand of Microsoft’s ISA Server software will depend on Microsoft’s decisionto prioritize and concentrate its marketing efforts for this software, and onthe success of Microsoft’s ISA Server software “; “If we are unable toeffectively leverage our relationship with Microsoft to establish newrelationships with independent software vendors and other systems integratorsour revenues and operating results may be adversely affected”) that havebeen removed from our discussion of risk factors included in our most recentAnnual Report on From 10-K.

***Risks of dependence on onestrategic partner.***

**We derive a significant portion of our revenuesfrom sales of server appliances directly to EMC and our revenuesmay decline significantly if this customer cancels or delays purchases ofour products, terminates its relationship with us or exercises certain of itscontractual rights.**

In the three months endedMarch 31, 2007 and 2006, sales directly to EMC, our largest customer, accountedfor 80% and 79% of our total net revenues. These sales are primarilyattributable to one product pursuant to a non-exclusive contract.  We anticipate that our future operatingresults will continue to depend heavily on sales to, and our relationship with,this customer. Accordingly, the success of our business will depend, in largepart, on this customer’s willingness to continue to utilize our serverappliance solutions in its existing and future products. Further, our financialsuccess is dependent upon the future success of the products we sell to thiscustomer and the continued growth of this customer, whose industry has ahistory of rapid technological change, short product life cycles, consolidationand pricing and margin pressures. A significant reduction in sales to thiscustomer, or significant pricing and additional margin pressures exerted on usby this customer, would have a material adverse effect on our results ofoperations. In addition, if this customer delays or cancels purchases of ourproducts, our operating results would be harmed and our ability to accuratelypredict revenues, profitability and cash flows would decrease.

Under the terms of ournon-exclusive contract, this customer has the right to enter into agreementswith third parties for similar products, is not obligated to purchase any minimumquantity of products from us and may choose to stop purchasing from us atany time, with or without cause. In addition, this customer may terminatethe agreement in the event that we attempt to assign our rights under theagreement to another party without this customer’s prior approval. Furthermore,in the event that we default on certain portions of the agreement, thiscustomer has the right to manufacture certain products in exchange for amutually agreeable royalty fee. If any of these events were to occur, or ifthis customer were to delay or discontinue purchases of our products as aresult of dissatisfaction or otherwise, our revenues and operating resultswould be materially adversely affected, our reputation in the industry mightsuffer, and our ability to accurately predict revenues, profitability and cashflows would decrease.

***Risks related to businessstrategy.***

**Our future success is dependent upon our abilityto generate significant revenues from server appliance developmentrelationships.**

We believe we must diversifyour revenues and a major component of our business strategy is toform server appliance development relationships with new network equipmentproviders, ISVs and systems integrators. Under this strategy, we work with ourcustomers to develop a server appliance branded with

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their name.  Our partner then performs all of the sellingand marketing efforts related to sales of their branded appliance.

There are multiple risksassociated with this strategy including:

·                              the expenditure of significant product development costs, which if notrecovered through server appliance sales could negatively affect our operatingresults;

·                              a significant reliance on our customers’ application software products,which could be technologically inferior to competitive products and result inlimitations on our server appliance sales, causing our revenues and operatingresults to suffer;

·                              our customers will most likely continue selling their software productsas separate products in addition to selling it in the form of a serverappliance, which will require us to effectively communicate the benefits ofdelivering their software in the form of a server appliance;

·                              our reliance on our customers to perform all of the selling andmarketing efforts associated with further sales of the server appliance productwe develop with them;

·                              continued consolidation within the network equipment and softwareindustries that results in existing customers being acquired by othercompanies; and

·                              our ability to provide our customers with high quality server appliancesat competitive prices.

Additionally, our futuresuccess will depend on our ability to establish relationships with newcustomers while expanding sales of server appliances to our existing customers.If these customers are unsuccessful in their marketing and sales efforts, or ifwe are unable to expand our sales to existing customers and developrelationships with new customers, our revenues and operating results couldsuffer.

**We may not be able to effectively commercializeour appliances or may be at a competitive disadvantage if we cannot license orintegrate third-party applications that are essential for the functionality ofcertain appliances.**

We believe our success willdepend on our ability to license or integrate certain applications fromthird-parties that would be incorporated in certain of our server appliancesolutions. Because we do not currently know with certainty which of theseprospective technologies will be desired in the marketplace, we may incorrectlyinvest in development or prioritize our efforts to integrate these technologiesin our appliances. Additionally, even if we correctly focus our efforts, therecan be no assurance that we will select the preferred provider of thesetechnologies, the third-party provider will be committed to the relationshipand integration of their technology, or that they will license their technologyto us without obtaining significant certification or training, which could becostly and time consuming. If we are unable to successfully integrate thecorrect third-party technologies in a timely manner, our appliances may beinferior with other competitive products in the marketplace, whichmay adversely affect the results of our operations and our ability to growour business.

**If we are unable to grow our internationalrevenues and successfully overcome the risks inherent in international businessactivities, the growth of our business may be limited.**

Our ability to grow willdepend in part on the growth of our international revenues. If our serverappliance solutions are not accepted across this region, our ability toincrease our revenues in this region would be limited. In addition, ourinternational sales are subject to the risks inherent in international businessactivities, including:

·                              cost of customizing products for foreign countries;

·                              export and import restrictions, such as those affecting encryptioncommodities and software or those requiring local content;

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·                              difficulties in providing customer support;

·                              reduced protection of intellectual property rights and increasedliability exposure;

·                              regional economic and political conditions; and

·                              unique product requirements of certain foreign countries whichmay limit sales and/or require significant additional research anddevelopment investments.

The majority of ourinternational sales currently are U.S. dollar-denominated. As a result, anyincrease in the value of the U.S. dollar relative to foreign currencies makesour products less competitive in international markets. Because of this ourrevenues may be adversely affected, or we may be required todenominate more of our sales in foreign currencies at some point in the futureto remain competitive. In addition, because certain of our operating expenses relatedto our international sales are denominated in foreign currency, wemay have difficulty controlling expenses in the event of significantcurrency fluctuations.

**Our business could be harmed if we fail toadequately integrate new technologies into our server appliance products or ifwe invest in technologies that do not result in the desired effects on ourcurrent and/or future 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 new technologies into ourcurrent or future products;

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

·                  we may incorporate technologies that do not result in the desiredimprovements to our current and/or future server appliance products;

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

·                  new technologies are unproven and could contain latent defects, whichcould result in high product failures; and

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

If we are unable toadequately integrate new technologies into our server appliance products or ifwe invest in technologies that do not result in the desired effects on ourcurrent and/or future product offerings, our business could be harmed andoperating results could suffer.

***Risks related to the serverappliance, data storage and network security markets.***

**If server appliances are not increasingly adoptedas a solution to meet a significant portion of companies’ network security anddata storage application needs, the market for server appliances may notgrow, which could negatively impact our revenues.**

We expect that all of ourfuture revenues will come from sales of server appliances and relatedmaintenance. As a result, we are substantially dependent on the growing use ofserver appliances to meet businesses’ data storage and network securityapplication needs. Our revenues may not grow and the market price of ourcommon stock could decline if the server appliance market does not grow asrapidly as we expect.

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Our expectations for thegrowth of the server appliance market may not be fulfilled if customerscontinue to use general-purpose servers. The role of our products could, forexample, be limited if general-purpose servers out-perform server appliances,provide more capabilities and/or flexibility than server appliances or areoffered at a lower cost. This could force us to lower the prices of our serverappliance products or could result in fewer sales of these products, whichwould negatively impact our revenues and decrease our gross profits.

**The products that we sell are subject to rapidtechnological change and our sales will suffer if these products are renderedobsolete by new technologies.**

The markets we serve arecharacterized by rapid technological change, frequent new product introductionsand enhancements, potentially short product life cycles, changes in customerdemands and evolving industry standards. In the server appliance market, weattempt to mitigate these risks by utilizing standards-based hardware platformsand by maintaining an adequate knowledge base of available technologies.However, the server appliance products that we sell could be rendered obsoleteif products based on new technologies are introduced or new industry standardsemerge and we are not able to incorporate these technological changes into ourproducts. In addition, we depend on third parties for the base platforms of ourserver appliances and we are at risk if these third parties do not integratenew technologies. Releasing new products and services prematurelymay result in quality problems, and delays may result in loss ofcustomer confidence and market share. We may be unable to develop newproducts and services or achieve and maintain market acceptance of them oncethey have come to market. Furthermore, when we do introduce new or enhancedproducts and services, we may be unable to manage the transition from theolder products and services to minimize disruption in customer orderingpatterns, avoid excessive inventories of older products and deliver enough newproducts and services to meet customer demand.

 To remain competitivein the server appliance market, we must successfully identify new productopportunities and partners and develop and bring new products to market in atimely and cost-effective manner. Our failure to select the appropriatepartners and keep pace with rapid industry, technology or market changes couldhave a material adverse effect on our business, results of operations orfinancial condition.

***Risks related to financialresults.***

**We have a history of losses and may continueto experience losses in the future, which could cause the market price of ourcommon stock to decline.**

Since our inception, we haveincurred significant net losses and could continue to incur net losses in thefuture. At March 31, 2007 and September 30, 2006 our accumulated deficitwas $131 million and $132 million, respectively. We believe that any futuregrowth will require us to incur significant engineering, selling and marketingand administrative expenses. As a result, we will need to generate significantrevenues to achieve and sustain profitability. If we do not achieve and sustainprofitability, the market price for our common stock may decline.

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

Our discussion and analysisof financial condition and results of operations are based on our consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States. The preparation offinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the consolidated financial statements and accompanyingnotes. On an ongoing basis, we evaluate significant estimates used in preparingour consolidated financial statements, including those related to:

·                              revenue recognition;

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·                              inventory write-downs;

·                              stock-based compensation; and

·                              warranty reserves.

We base our estimates onhistorical experience and on various other assumptions that we believe to bereasonable under the circumstances, as provided in our discussion and analysisof financial condition and results of operations, the results of whichform the basis for making judgments about the carrying values of assetsand liabilities that are not readily apparent from other sources. Actualresults may differ from these and other estimates if our assumptionschange or if actual circumstances differ from those in our assumptions, whichcould cause our operating results to fall below the expectations of securitiesanalysts and investors, resulting in a decline in our stock price.

**Our quarterly revenues and operating resultsmay fluctuate seasonally, which could result in decreased revenue fromquarter to quarter, which in turn could cause the market price of our commonstock to decline.**

Seasonal fluctuations inrevenues and operating results in the data storage industry are common. Inparticular, this industry typically experiences increased orders and resultingrevenues in the quarter ended December 31, and a subsequent decline inorders and resulting revenues during the quarter ended March 31. With asubstantial amount of our revenues currently derived from data storageproducts, we may experience significant quarter-to-quarter fluctuations inrevenues and operating results due to customers timing their orders based ontheir own quarterly financial and/or operational considerations, which we haveno influence over. In addition, to the extent that revenues from internationalsales become significant, we may experience seasonal fluctuations duringthe quarter ending September 30 as a result of European holiday patterns.

Accordingly, we believe thatquarter-to-quarter comparisons of results of operations are not necessarilymeaningful and should not be relied upon as an indication of futureperformance. Nonetheless, the market price of our common stock could decline inresponse to these variations.

**Our quarterly revenues and operating resultsmay also fluctuate for reasons other than seasonality, which could causeour operating results to fall below expectations and thus impact the marketprice of our common stock.**

In addition to seasonalityissues, our quarterly revenues and operating results are difficult to predictand may fluctuate significantly from quarter to quarter. None of ourcustomers are obligated to purchase any quantity of our products in the futurenor are they obligated to meet forecasts of their product needs. Our operatingexpense levels are based in part on expectations of future revenues andgross profits, which are partially dependent on our customers’ ability toaccurately forecast and communicate their future product needs. If revenues orgross profits in a particular quarter do not meet expectations, operatingresults could suffer and the market price of our common stock could decline.Factors affecting quarterly operating results include:

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

·                              the product mix of our sales;

·                              the timing of new product introductions byour customers;

·                              the availability and/or price of productsfrom suppliers;

·                              the loss of key suppliers or customers;

·                              price competition;

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·                              costs associated with our introduction of newserver appliances and the market acceptance of those products; and

·                              the mix of product manufactured internallyand by our contract manufacturer.

**If the products and services that we sell becomemore commoditized and competition in the server appliance, data storage and networksecurity markets continues to increase, then our gross profit as a percentageof net revenues may decrease and our operating results may suffer.**

Products and services in theserver appliance, data storage and network security markets may be subjectto further commoditization as these industries continue to mature and otherbusinesses introduce additional competing products and services. The grossprofit as a percentage of revenues of our products may decrease inresponse to changes in our product mix, competitive pricing pressures, or newproduct introductions into the server appliance, data storage and networksecurity markets. If we are unable to offset decreases in our gross profits asa percentage of revenues by increasing our sales volumes, or by decreasing ourproduct costs, operating results will decline. Changes in the mix of sales ofour products, including the mix of higher margin products sold in smallerquantities and lower margin products sold in larger quantities, could adverselyaffect our operating results for future quarters. To maintain our grossprofits, we also must continue to reduce the manufacturing cost of our serverappliance products. Our efforts to produce higher margin server applianceproducts, continue to improve our server appliance products and produce newserver appliance products 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 of our server applianceproducts may not allow us to reduce our cost per product. If we fail torespond adequately to pricing pressures, to competitive products with improvedperformance or to developments with respect to the other factors on which wecompete, we could lose customers or orders. If we are unable to competeeffectively, our business will suffer.

***Risks related to competition.***

**Competition in the server appliance market issignificant and if we fail to compete effectively, our financial results willsuffer.**

In the server appliancemarket, we face significant competition from a number of different types ofcompanies. Our competitors include companies who market general-purposeservers, server virtualization software, specific-purpose servers and serverappliances as well as companies that sell custom integration services utilizinghardware produced by other companies. Many of these companies are larger thanwe are and have greater financial resources and name recognition than we do, aswell as significant distribution capabilities and larger, more establishedservice organizations to support their products. Our larger competitorsmay be able to leverage their existing resources, including theirextensive distribution capabilities and service organizations, to provide awider offering of products and services and higher levels of support on a morecost-effective basis than we can. We expect competition in the server appliancemarket to increase significantly as more companies enter the market and as ourexisting competitors continue to improve the performance of their currentproducts and to introduce new products and technologies. Such increasedcompetition could adversely affect sales of our current and future products. Inaddition, competing companies may be able to undertake more extensivepromotional activities, adopt more aggressive pricing policies and offer moreattractive terms to their customers than we can. If our competitors providelower cost products with greater functionality or support than our server appliancesolutions, or if some of their products are comparable to ours and are offeredas part of a range of products that is broader than ours, our serverappliance solutions could become undesirable.

Even if the functionality ofcompeting products is equivalent to ours, we face a risk that a significantnumber of customers would elect to pay a premium for similar functionality froman established vendor rather than purchase products from a less-establishedvendor. We attempt to differentiate ourselves from our competition by offeringa wide variety of software integration, branding, supply-chain management,engineering, support, logistics and fulfillment services. If we are unable toeffectively differentiate ourselves from our competition, we may be forcedto offer price reductions to maintain certain customers. As a result, ourrevenues may not increase and may decline, and our gross marginsmay decline. Furthermore, increased competition could lead to higherselling expenses which would negatively affect our business and futureoperating results.

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***Risks related to marketing andsales efforts and customer service.***

**We need to effectively manage our sales andmarketing operations to increase market awareness and sales of our products andto promote our brand recognition. If we fail to do so, our growth will belimited.**

Although we currently have arelatively small sales and marketing organization, we must continue to increasemarket awareness and sales of our products and promote our brand in themarketplace. We believe that to compete successfully we will need networkequipment providers, ISVs and systems integrators to recognize Network Enginesas a top-tier provider of server appliance platforms and custom integrationservices.  If we are unable to increasemarket awareness and promote ourselves as a leading provider of serverappliance solutions with our available resources, we may be unable to developnew customer relationships or expand our product and service offerings atexisting customers.

**If we are unable to effectively manage ourcustomer service and support activities, we may not be able to retain ourexisting customers or attract new customers.**

We need to effectivelymanage our customer support operations to ensure that we maintain goodrelationships with our customers..   Webelieve that providing a level of high quality customer support will be a keydifferentiator for our product offering and may require more technicallyqualified staff which could be more costly.If we are unable to provide thishigher level of service we may be unable to successfully attract andretain customers.

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

***Risks related to productmanufacturing.***

**Our dependence on sole source and limited sourcesuppliers for key server appliance components makes us susceptible to supplyshortages and potential quality issues that could prevent us from shippingcustomer orders on time, if at all, and could result in lost sales andcustomers.**

We depend upon single sourceand limited source suppliers for our industry-standard processors, main logicboards, certain disk drives, hardware platforms and power supplies as well ascertain of our chassis and sheet metal parts. Additionally, we depend onlimited sources to supply certain other industry-standard and customizedcomponents. We have in the past experienced, and may in the futureexperience, shortages of or difficulties in acquiring components in thequantities and of the quality needed to produce our server appliance products.Shortages in supply or quality issues related to these key components for anextended time would cause delays in the production of our server applianceproducts, prevent us from satisfying our contractual obligations and meetingcustomer expectations, and result in lost sales and customers. If we are unableto buy components in the quantities and of the quality that we need on a timelybasis or at acceptable prices, we will not be able to manufacture and deliverour server appliance products on a timely or cost-effective basis to ourcustomers, and our competitive position, reputation, business, financialcondition and results of operations could be seriously harmed.

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

Because server appliancesolutions are complex, they could contain errors that can be detected at anypoint in a product’s life cycle. 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. In addition, because

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our solutions are combinedwith products from other vendors, should problems occur, it might be difficultto identify the source of the problem. Continued improvement in manufacturingcapabilities, control of material and manufacturing quality and costs, andproduct testing are critical factors in our future growth. There can be noassurance that our efforts to monitor, develop, modify and implementappropriate test and manufacturing processes for our products will besufficient to permit us to avoid a rate of failure in our products that resultsin substantial delays in shipment, significant repair or replacement costs orpotential damage to our reputation, any of which could have a material adverseeffect on our business, results of operations or financial condition.

In the past, we havediscovered errors in some of our server appliance solutions and haveexperienced delays in the shipment of our server appliance products during theperiod required to correct these errors or we have had to replace defectiveproducts that were already shipped. Errors in our server appliance solutionsmay be found in the future and any of these errors could be significant.Significant errors, including those discussed above, may result in:

·                              the loss of or delay in market acceptance andsales of our server appliance products;

·                              diversion of engineering resources;

·                              increased manufacturing costs;

·                              the loss of new or existing server appliancecustomers;

·                              injury to our reputation and other customerrelations problems; and

·                              increased maintenance and warranty costs.

Any of these problems couldharm our business and future operating results. Product errors or delays couldbe material, including any product errors or delays associated with theintroduction of new products or versions of existing products. If our serverappliance solutions fail to conform to warranted specifications, customerscould demand a refund for the purchase price and assert claims for damages.

Moreover, because our serverappliance solutions may be used in connection with critical computingsystems services, including providing security to protect valuable information,we may receive significant liability claims if they do not work properly.While our agreements with customers typically contain provisions intended tolimit our exposure to liability claims, these limitations do not preclude allpotential claims. Liability claims could exceed our insurance coverage and requireus to spend significant time and money in litigation or to pay significantdamages. Any claims for damages, even if unsuccessful, could seriously damageour reputation and business.

**Our future server appliance revenue growthmay be limited by our ability to expand production capacity.**

Our existing manufacturingfacility is limited in its production capacity. For us to achieve significantserver appliance revenue growth, our server appliance sales volumes mustincrease significantly and our production capacity must increase to supportsuch sales volumes.

To supplement our currentproduction capacity, to provide for increased capacity for “production spikes”and to provide disaster backup capabilities, we currently utilize the servicesof a contract manufacturer for certain server appliance products on a limitedbasis. However, our contract manufacturer is not obligated to supply productsto us for any specific period, or in any specific quantity, except asmay be provided in an accepted purchase order. Using a contractmanufacturer increases our cost of producing server appliance products andcould decrease our gross profits. In the event that we need to change contractmanufacturers or require significantly increased production levels, we couldexperience transitional difficulties, including production delays and qualitycontrol issues, that could prevent us from satisfying our productionrequirements on a timely basis, cause customer relationships to suffer andresult in lost sales. Also, the use of a contract manufacturer does notguarantee us production levels, 

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manufacturing line space ormanufacturing prices, the lack of which could interrupt our business operationsand have a negative effect on operating results.

In the past, we expanded ourinternal production capacity through expansion and reorganization of ourcurrent production facilities. Although we believe that our current facility,along with our use of a contract manufacturer to supplement production, issufficient to support our business for the foreseeable future, we may needadditional production capacity. We believe that we could expand productionlevels in our existing facility by increasing the number of manufacturingshifts, but we are currently utilizing all available manufacturing space in ourexisting facility and have limited opportunity to expand further.  We would have difficulties expanding thisfacility beyond this limited ability, and therefore, significant furtherexpansion of the production capacity would require additional facilities.  Expansion of our existing facilities oradditional facilities could require substantial investments, which coulddetract from our ability to invest in other areas of our business andmay not result in the desired return on investment, which could negativelyaffect our operating results.

**If we do not accurately forecast our serverappliance materials requirements, our business and operating results could beadversely affected.**

We use rolling forecastsbased on anticipated product orders to determine our server appliance componentrequirements. Lead times for materials and components that we order varysignificantly depending on variables such as specific supplier requirements,contract terms and current market demand for those components. In addition, avariety of factors, including the timing of product releases, potential delaysor cancellations of orders, the timing of large orders and the unprovenacceptance of new products in the market make it difficult to predict productorders. As a result, our materials requirement forecasts may not beaccurate. If we overestimate our materials requirements, we may haveexcess inventory, which would increase costs and negatively impact our cashposition. Our agreements with certain customers provide us with protectionsrelated to inventory purchased in accordance with the terms of theseagreements; however, these protections may not be sufficient to preventcertain losses as a result of excess or obsolete inventory. If we underestimateour materials requirements, we may have inadequate inventory, which couldinterrupt our manufacturing and delay delivery of our server appliance productsto customers, resulting in a loss of sales or customers. Any of theseoccurrences would negatively impact our business and operating results.

***Risks related to productdependence on intellectual property.***

**Our reliance upon contractual provisions, domesticpatent, copyright and trade secret laws and applied-for patents to protect ourproprietary rights may not be sufficient to protect our intellectualproperty.**

Certain of our serverappliance solutions are differentiated from the products of our competitors byour internally developed software and hardware and the manner in which they areintegrated into our server appliance solutions. If we fail to protect ourintellectual property, other vendors could sell products with features similarto ours, which could reduce demand for our solutions. We have taken what webelieve to be the necessary and appropriate steps to safeguard our intellectualproperty. However, these steps may afford us only limited protection.Others may develop technologies that are similar or superior to ourtechnology or design around the patents we own. Despite the precautions we havetaken, laws and contractual restrictions may not be sufficient to preventmisappropriation of our technology or deter others from developing similartechnologies. In addition, there can be no guarantee that any of our patentapplications will result in patents, or that any such patents would provideeffective protection of our technology.

In addition, the laws of thecountries in which we may decide to market our services and solutionsmay offer little or no effective protection of our proprietary technology.Reverse engineering, unauthorized copying or other misappropriation of ourproprietary technology could enable third parties to benefit from ourtechnology without paying us for it, which could harm our business. Inaddition, our U.S. patents have no effect in foreign jurisdictions andobtaining patent protection in foreign countries is expensive and timeconsuming.

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**Our operating results would suffer if we, our ISVor network equipment customers, or other third-party software providers fromwhom we license technology, were subject to an infringement claim that resultedin protracted litigation, the award of significant damages against us or thepayment of substantial ongoing royalties.**

Substantial litigationregarding intellectual property rights exists in the technology industry. Weexpect that server appliance products 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 server applianceproducts infringed their intellectual property rights. We do not believe thatour server appliance products employ technology that infringes the proprietaryrights of any third parties. We are also not aware of any claims made againstany of our ISV or network equipment provider customers related to theirinfringement of the proprietary rights of other parties in relation to productsthat include our server appliance products. Other parties may make claimsagainst us 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, includingpotential liability for damages;

·                              divert our management’s attention andresources; and

·                              cause product shipment delays.

In addition, other partiesmay make claims against our ISV or network equipment customers, orthird-party software providers related to products that are incorporated intoour server appliance products. Our business could be adversely affected if suchclaims resulted in the inability of our customers to continue producing theinfringing product, or if we are unable to cost effectively continue licensingthe third-party software.

***Other risks related to ourbusiness.***

**If we fail to retain and attract appropriatelevels of qualified employees and members of senior management, we may notbe able to successfully execute our business strategy.**

Our success depends in largepart on our ability to retain and attract highly skilled engineering,sales, marketing, customer service and managerial personnel. If we are unableto attract a sufficient number of qualified personnel, particularly personnelknowledgeable in software engineering and product management, we may notbe able 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 we fail to maintain an effective system ofinternal controls, we may not be able to accurately report our financialresults. As a result, current and potential stockholders could lose confidencein our financial reporting, which could have a negative market reaction.**

Section 404 of theSarbanes-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 complywith these requirements. As a result, we have incurred increased expense andhave devoted additional management resources to Section 404 compliance.Effective internal controls are necessary for us to provide reliable financialreports. If we cannot provide reliable financial reports, our business andoperating results could be harmed.

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**Class action lawsuits have been filed againstus, our board of directors, our former chairman and certain of our executiveofficers and other lawsuits may be instituted against us from time totime.**

In December 2001, aclass action lawsuit relating to our initial public offering was filedagainst us, our chairman, one of our executive officers and the underwriters ofour 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 unable to predict the effects on our financialcondition or business of the lawsuit related to our initial public offering orother lawsuits that may arise from time to time. While we maintain certaininsurance coverage, there can be no assurance that claims against us will notresult in substantial monetary damages in excess of such insurance coverage.This class action lawsuit, or any future lawsuits, could cause ourdirector and officer insurance premiums to increase and could affect ourability to obtain director and officer insurance coverage, which wouldnegatively affect our business. In addition, we have expended, and may inthe future expend, significant resources to defend such claims. Thisclass action lawsuit, or other similar lawsuits that may arise fromtime to time, could negatively impact both our financial condition and themarket price of our common stock and could result in management devoting asubstantial portion of their time to these lawsuits, which could adverselyaffect the operation of our business.

**If the site of our manufacturing operations wereto experience a significant disruption in its operations, it would have amaterial adverse effect on our financial condition and results of ouroperations.**

Our manufacturing facilityand headquarters are concentrated in one location. If the operations in thisfacility were disrupted as a result of a natural disaster, fire, power or otherutility outage, work stoppage or other similar event, our business couldbe seriously harmed as a result of interruptions or delays in ourmanufacturing, engineering, or post-sales support operations.

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

The market price of ourcommon stock has been subject to significant fluctuations and may continueto fluctuate or decline. During fiscal 2006, the closing price of our commonstock ranged from a low of $1.12 to a high of $3.17, and in the six monthsended March 31, 2007, from a low of $1.94 to a high of $2.81. The market fortechnology stocks has been extremely volatile and frequently reaches levelsthat bear no relationship to the past or present operating performance of thosecompanies. General economic conditions, such as recession or interest rate orcurrency rate fluctuations in the United States or abroad, could negativelyaffect the market price of our common stock. In addition, our operating resultsmay be below the expectations of securities analysts and investors. Ifthis were to occur, the market price of our common stock may decreasesignificantly. In the past, following periods of volatility in the market priceof a company’s securities, securities class action litigation has oftenbeen instituted against such companies. Such litigation could result insubstantial cost and a diversion of management’s attention and resources.

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

**We have anti-takeover defenses that could delay orprevent an acquisition and could adversely affect the market price of ourcommon stock.**

Our Board of Directors hasthe authority to issue up to 5,000,000 shares of preferred stock and, withoutany further vote or action on the part of the stockholders, to determinethe price, rights, preferences, privileges and restrictions of the preferredstock. This preferred stock, if issued, might have preference over the rightsof the holders of common stock and could adversely affect the market price ofour common stock. The issuance of this preferred stock may make it moredifficult for a third party to acquire us or to acquire a majority of ouroutstanding voting stock. We currently have no plans to issue preferred stock.

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In addition, provisions ofour second amended and restated certificate of incorporation and our secondamended and restated by-laws may deter an unsolicited offer to purchaseus. These provisions, coupled with the provisions of the Delaware GeneralCorporation Law, may delay or impede a merger, tender offer or proxycontest involving us. For example, our Board of Directors is divided into threeclasses, only one of which is elected at each annual meeting. These factorsmay further delay or prevent a change of control of our business.

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

Our Annual Meeting ofStockholders was held on March 14, 2007. Of the 40,661,950 shares outstanding as of January 19, 2007, 37,702,990(92.72%) were present or represented by proxy at the meeting.  The table below presents the voting resultsof the matters voted upon by our stockholders at the meeting:

**Proposal I—Election of Directors:**
| **Nominee**      | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|------------------|------------|---------------|------------|--------------------|------------|
| Gary E. Haroian  |       | 35,775,012    |       | 1,927,978          |       |
| Dennis A. Kirshy |       | 35,815,060    |       | 1,887,930          |       |

 

The terms of Gregory A.Shortell, Fontaine K. Richardson, John A. Blaeser, and Robert M. Wadsworth, asdirectors of the Company, continued after this meeting.

**Proposal II—Ratification of the appointment ofPricewaterhouseCoopers LLP as our Independent Registered Public Accounting Firmfor the fiscal year ending September 30, 2007:**
| For        | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Non Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|--------------------|------------|
| 37,585,545 |       | 97,868      |       | 19,577      |       | —             |       |

 

**Proposal III – To approve an amendment to increasethe number of shares of common stock reserved for issuance under the 2000Employee Stock Purchase Plan (the “Employee Stock Purchase Plan”) from1,250,000 to 1,500,000 shares:**
| For        | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Non Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|--------------------|------------|
| 13,719,747 |       | 1,738,477   |       | 27,095      |       | 22,217,671         |       |

 

**ITEM 6.     EXHIBITS**

(a)    Exhibits

The exhibits which are filedwith this report or which are incorporated by reference are set forth in the ExhibitIndex hereto.

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**SIGNATURES**

Pursuant to the requirementsof the Securities Exchange Act of 1934, as amended, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

|                    |   | **NETWORK ENGINES, INC.**                          |
|--------------------|--------|----------------------------------------------------|
| ** **         |   | ** **                                         |
| Date: May 10, 2007 |   |                                               | /s/ Gregory A.  Shortell |   |
|               |   |                                               |
|               |   |                                               |
|               |   | Gregory A.  Shortell                               |
|               |   | President and  Chief  Executive Officer            |
|               |   | (Principal  Executive  Officer)                    |
|               |   |                                               |
|               |   |                                               |
|               |   |                                               | /s/ Douglas G.  Bryant |   |
|               |   |                                               |
|               |   | Douglas G.  Bryant                                 |
|               |   | Chief Financial  Officer,  Treasurer and Secretary |
|               |   | (Principal  Financial Officer   and Principal      |
|               |   | Accounting  Officer)                               |

 

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**EXHIBIT INDEX**

 
| Exhibit No. | ** ** | **Exhibit**                                                                                                                                                                                                                                     |
|------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                                                                                                            |
| 10.1             |       | Offer Letter dated February 16, 2007 between Network  Engines, Inc. and Mr. Paul D. Butler (filed as exhibit 10.1 to the Company’s  Current Report on Form 8-K dated February 26, 2007 and incorporated by  reference herein).             |
|             |       |                                                                                                                                                                                                                                            |
| 10.2             |       | Severance Terms Agreement dated February 26, 2007  between Network Engines Inc. and Mr. Paul D. Butler (filed as exhibit 10.2 to  the Company’s Current Report on Form 8-K dated February 26, 2007 and  incorporated by reference herein). |
|             |       |                                                                                                                                                                                                                                            |
| 31.1             |       | Certification of Gregory A. Shortell, the Chief  Executive Officer of the Company, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                  |
|             |       |                                                                                                                                                                                                                                            |
| 31.2             |       | Certification of Douglas G. Bryant, the Chief  Financial Officer of the Company, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                    |
|             |       |                                                                                                                                                                                                                                            |
| 32.1             |       | Certification of Gregory A. Shortell, the Chief  Executive Officer of the Company, pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                  |
|             |       |                                                                                                                                                                                                                                            |
| 32.2             |       | Certification of Douglas G. Bryant, the Chief  Financial Officer of the Company, pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                    |

 

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