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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



(Mark One)

|x |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
|- |  | -------------------------------------------------------

SECURITIES EXCHANGE ACT OF 1934



For the quarterly period ended March 31, 2003



OR



| ̈ |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
|- |  | --------------------------------------------------------

SECURITIES EXCHANGE ACT OF 1934



For the transition period
from to



Commission file number: 0-30863



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NETWORK ENGINES, INC.

(Exact name of
registrant as specified in its charter)







|Delaware                                       |  | 04-3064173                          
|---------------------------------------------- |  | ------------------------------------
|(State or other jurisdiction of 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 check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period than the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x  No ̈



Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the
Exchange Act.)

Yes ̈No  x



As of April 30, 2003, there were 33,711,354 shares of the registrants Common Stock, par value $.01 per share, outstanding.



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##### Table of Contents



NETWORK
ENGINES, INC.



INDEX



|                                                                                              |  | Page Number
|--------------------------------------------------------------------------------------------- |  | -----------
|                                                                                             
|PART I. FINANCIAL
INFORMATION                                                                 |  |            
|                                                                                             
|ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)                                                      |  |            
|                                                                                              | 
|                                                                                             
|CONDENSED CONSOLIDATED BALANCE SHEETS                                                         |  | 1          
|                                                                                             
|CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS                                               |  | 2          
|                                                                                             
|CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS                                               |  | 3          
|                                                                                             
|NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                          |  | 4          
|                                                                                             
|ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION |  | 13         
|                                                                                             
|ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            |  | 30         
|                                                                                             
|ITEM 4. CONTROLS AND PROCEDURES                                                               |  | 30         
|                                                                                             
|PART II. OTHER INFORMATION                                                                    |  |            
|                                                                                             
|ITEM 1. LEGAL PROCEEDINGS                                                                     |  | 31         
|                                                                                             
|ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS                                             |  | 31         
|                                                                                             
|ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                   |  | 32         
|                                                                                             
|ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K                                                      |  | 32         
|                                                                                             
|SIGNATURES                                                                                    |  | 33         
|                                                                                             
|CERTIFICATIONS                                                                                |  | 34         





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##### Table of Contents



PART I. FINANCIAL
INFORMATION



ITEM I. FINANCIAL STATEMENTS



NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)



|                                                               |  | March 31, 2003 |          |   | September 30, 2002 |  
|-------------------------------------------------------------- |  | -------------- | -------- | - | ------------------ | -
|ASSETS                                                         |  |                |          |   |                    |  
|Current assets:                                                |  |                |          |   |                    |  
|Cash and cash equivalents                                      |  | $              | 38,846   |   |                    | $
|Short-term investments                                         |  |                |         |   |                    |  
|Restricted cash                                                |  |                | 47       |   |                    |  
|Accounts receivable, net of allowances                         |  |                | 12,707   |   |                    |  
|Inventories                                                    |  |                | 5,876    |   |                    |  
|Prepaid expenses and other current assets                      |  |                | 1,077    |   |                    |  
|                                                               |  |                |          |   |                    |  
|Total current assets                                           |  |                | 58,553   |   |                    |  
|Property and equipment, net                                    |  |                | 2,038    |   |                    |  
|Goodwill                                                       |  |                | 7,753    |   |                    |  
|Intangible assets, net                                         |  |                | 4,817    |   |                    |  
|Other assets                                                   |  |                | 54       |   |                    |  
|                                                               |  |                |          |   |                    |  
|Total assets                                                   |  | $              | 73,215   |   |                    | $
|                                                               |  |                |          |   |                    |  
|LIABILITIES AND STOCKHOLDERS
EQUITY                           |  |                |          |   |                    |  
|Current liabilities:                                           |  |                |          |   |                    |  
|Accounts payable                                               |  | $              | 7,945    |   |                    | $
|Accrued compensation and other related benefits                |  |                | 1,156    |   |                    |  
|Other accrued expenses                                         |  |                | 1,192    |   |                    |  
|Current portion of accrued restructuring and other charges     |  |                | 569      |   |                    |  
|Deferred revenue                                               |  |                | 314      |   |                    |  
|Current portion of capital lease obligations and notes payable |  |                | 3        |   |                    |  
|                                                               |  |                |          |   |                    |  
|Total current liabilities                                      |  |                | 11,179   |   |                    |  
|Long-term portion of accrued restructuring and other charges   |  |                | 434      |   |                    |  
|Contingencies (Note 6)                                         |  |                |          |   |                    |  
|Stockholders equity:                                          |  |                |          |   |                    |  
|Preferred stock                                                |  |                |         |   |                    |  
|Common stock                                                   |  |                | 363      |   |                    |  
|Additional paid-in capital                                     |  |                | 175,431  |   |                    |  
|Accumulated deficit                                            |  |                | (110,426 | ) |                    |  
|Notes receivable from stockholders                             |  |                |         |   |                    |  
|Deferred stock compensation                                    |  |                | (928     | ) |                    |  
|Treasury stock, at cost                                        |  |                | (2,838   | ) |                    |  
|Accumulated other comprehensive income                         |  |                |         |   |                    |  
|                                                               |  |                |          |   |                    |  
|Total stockholders equity                                     |  |                | 61,602   |   |                    |  
|                                                               |  |                |          |   |                    |  
|Total liabilities and stockholders equity                     |  | $              | 73,215   |   |                    | $
|                                                               |  |                |          |   |                    |  



The
accompanying notes are an integral part of the condensed consolidated financial statements.



1



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NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)



|                                                              |  | Three months ended March 31, |        |   | Six months ended March 31, |  
|------------------------------------------------------------- |  | ---------------------------- | ------ | - | -------------------------- | -
|                                                              |  | 2003                         |        |   | 2002                       |  
|Net revenues                                                  |  | $                            | 19,427 |   |                            | $
|Cost of revenues:                                             |  |                              |        |   |                            |  
|Cost of revenues                                              |  |                              | 15,352 |   |                            |  
|Cost of revenues stock compensation                           |  |                              | 14     |   |                            |  
|                                                              |  |                              |        |   |                            |  
|Total cost of revenues                                        |  |                              | 15,366 |   |                            |  
|                                                              |  |                              |        |   |                            |  
|Gross profit                                                  |  |                              | 4,061  |   |                            |  
|Operating expenses:                                           |  |                              |        |   |                            |  
|Research and development                                      |  |                              | 917    |   |                            |  
|Selling and marketing                                         |  |                              | 1,564  |   |                            |  
|General and administrative                                    |  |                              | 1,899  |   |                            |  
|Stock compensation                                            |  |                              | 279    |   |                            |  
|Amortization of intangible assets                             |  |                              | 254    |   |                            |  
|Restructuring and other charges, net                          |  |                              | (30    | ) |                            |  
|                                                              |  |                              |        |   |                            |  
|Total operating expenses                                      |  |                              | 4,883  |   |                            |  
|                                                              |  |                              |        |   |                            |  
|Loss from operations                                          |  |                              | (822   | ) |                            |  
|Interest and other income, net                                |  |                              | 138    |   |                            |  
|                                                              |  |                              |        |   |                            |  
|Net loss                                                      |  | $                            | (684   | ) |                            | $
|                                                              |  |                              |        |   |                            |  
|Net loss per share  basic and diluted                        |  | $                            | (0.02  | ) |                            | $
|                                                              |  |                              |        |   |                            |  
|Shares used in computing basic and diluted net loss per share |  |                              | 33,524 |   |                            |  



The
accompanying notes are an integral part of the condensed consolidated financial statements.



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NETWORK
ENGINES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



|                                                                                                                  |  | Six months ended March 31, |        
|----------------------------------------------------------------------------------------------------------------- |  | -------------------------- | -------
|                                                                                                                  |  | 2003                       |        
|Cash flows from operating activities:                                                                             |  |                            |        
|Net loss                                                                                                          |  | $                          | (2,863 
|Adjustments to reconcile net loss to net cash used in operating
activities:                                       |  |                            |        
|Depreciation and amortization                                                                                     |  |                            | 1,134  
|Provision for doubtful accounts                                                                                   |  |                            | 32     
|Reversal of provision for stockholder notes receivable                                                            |  |                            | (228   
|Provision for uncollectible sub-tenant receivables                                                                |  |                            | 138    
|Stock compensation                                                                                                |  |                            | 499    
|Interest on notes receivable from stockholders                                                                    |  |                            | (7     
|Changes in operating assets and liabilities, net of effects of
acquisition:                                       |  |                            |        
|Accounts receivable                                                                                               |  |                            | (4,061 
|Inventories                                                                                                       |  |                            | (1,056 
|Prepaid expenses and other current assets                                                                         |  |                            | 231    
|Due from contract manufacturer                                                                                    |  |                            |       
|Accounts payable                                                                                                  |  |                            | 2,184  
|Due to contract manufacturer                                                                                      |  |                            |       
|Accrued expenses                                                                                                  |  |                            | 482    
|Deferred revenue                                                                                                  |  |                            | 259    
|                                                                                                                  |  |                            |        
|Net cash used in operating activities                                                                             |  |                            | (3,256 
|Cash flows from investing activities:                                                                             |  |                            |        
|Purchases of property and equipment                                                                               |  |                            | (234   
|Sales of short-term investments                                                                                   |  |                            | 8,546  
|Refunds and repayments of restricted cash under guarantee agreement                                               |  |                            | 540    
|Changes in other assets                                                                                           |  |                            | 3      
|Acquisition of TidalWire, net of cash acquired                                                                    |  |                            | (11,101
|Payments of transaction costs                                                                                     |  |                            | (2,129 
|                                                                                                                  |  |                            |        
|Net cash used in investing activities                                                                             |  |                            | (4,375 
|Cash flows from financing activities:                                                                             |  |                            |        
|Payments on capital lease obligations and notes payable                                                           |  |                            | (11    
|Collection of notes receivable from stockholders                                                                  |  |                            | 4      
|Proceeds from issuance of common stock                                                                            |  |                            | 244    
|Acquisition of treasury stock                                                                                     |  |                            | (312   
|                                                                                                                  |  |                            |        
|Net cash used in financing activities                                                                             |  |                            | (75    
|                                                                                                                  |  |                            |        
|Net decrease in cash and cash equivalents                                                                         |  |                            | (7,706 
|Cash and cash equivalents, beginning of period                                                                    |  |                            | 46,552 
|                                                                                                                  |  |                            |        
|Cash and cash equivalents, end of period                                                                          |  | $                          | 38,846 
|                                                                                                                  |  |                            |        
|Non-cash investing and financing activities:                                                                      |  |                            |        
|Repurchase of common stock through cancellation of notes receivable from stockholders,
including accrued interest |  | $                          | 512    
|Repurchase of common stock in exchange for amounts owed by stockholder under guarantee
agreement                  |  | $                          | 518    



The
accompanying notes are an integral part of the condensed consolidated financial statements.



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NETWORK
ENGINES, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



1. BASIS OF PRESENTATION



The accompanying condensed consolidated financial statements have been prepared by Network Engines, Inc. (Network Engines or the Company) in accordance with generally accepted accounting principles and
pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been
condensed or omitted pursuant to such rules and regulations. These financial statements should be read in conjunction with the audited financial statements and the accompanying notes included in the Companys 2002 Annual Report on Form 10-K
filed by the Company with the Securities and Exchange Commission.



The information furnished reflects all adjustments, which, in the opinion of management, are of a normal recurring nature and are considered necessary for a fair presentation of results for the interim periods. It should
also be noted that results for the interim periods are not necessarily indicative of the results expected for the full year or any future period.



The preparation of these condensed consolidated financial statements in conformity with generally accepted accounting principles requires
management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses
during the reporting period. The most significant estimates included in the financial statements are restructuring and other charges, accounts receivable and sales allowances, inventory valuation, reserves for warranty and valuation and recovery of
acquisition-related intangible assets and expected useful lives of such intangible assets. Actual results could differ from those estimates.



2. ACQUISITION OF TIDALWIRE INC.



On December 27, 2002, the Company acquired all of the outstanding capital stock of TidalWire Inc. (TidalWire), a privately
held corporation located in Westborough, Massachusetts, dedicated to the distribution and support of storage networking products. The estimated fair values of the acquired assets and assumed liabilities have been included in the Companys
financial statements as of the acquisition date and the results of the operations of TidalWire have been included in the financial statements since that date.



The estimated aggregate purchase price of $17,580,000 included a net cash payment of approximately $9,320,000, representing gross cash
payments of approximately $9,910,000 less amounts due to TidalWire by a stockholder under a note of approximately $590,000, and the reissuance of 3,331,043 shares of the Companys Common Stock that were held by the Company as treasury stock
(valued at approximately $3,331,000, based on the average market price of the Companys Common Stock over the period three days before and after the terms of the acquisition were agreed to and announced). In addition, the Company assumed
approximately $1,878,000 outstanding under TidalWires working capital line of credit, which the Company repaid and cancelled on December 27, 2002. As part of the acquisition, the Company also replaced all outstanding TidalWire common stock
options with options for the purchase of 1,035,033 shares of the Companys Common Stock with an average exercise price of $0.36 (valued, based on the Black-Scholes valuation model, at approximately $882,000, of which $304,000 is attributable to
unvested stock options and has been allocated to deferred stock compensation). The Company also incurred fees and expenses of approximately $2,169,000 in connection with this acquisition. In addition, included in the aggregate purchase price is
$3,350,443 of cash payments and the issuance of 1,407,092 shares of the Companys Common Stock (valued at approximately $1,407,000) made to related parties (See Note 9).



The Company acquired TidalWire primarily because TidalWire has historically been a profitable company with
customer management, marketing, logistics and support systems in place to support a growing channel of integrators, resellers and service and solutions providers. The Company distributes certain of its Independent Software Vendor (ISV)
partners server appliances through TidalWires channel of integrators, resellers and service and solutions providers thereby allowing the Companys current and potential ISV partners to eliminate the cost of sales associated with the
hardware component of the server appliance sale. The Company also utilizes TidalWires existing infrastructure to diversify its revenues beyond the server appliance market and plans to expand TidalWires data storage product offerings to
include products involved in network security.



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NETWORK
ENGINES, INC.



NOTES TO UNAUDITED
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



A summary of the estimated assets acquired and liabilities assumed in the acquisition and the fair values recorded for each is as follows (in thousands):



|Tangible current assets                                                  |  | $ | 9,294  |  
|------------------------------------------------------------------------ |  | - | ------ | -
|Property and equipment                                                   |  |   | 477    |  
|Goodwill                                                                 |  |   | 7,753  |  
|Customer relationships (amortized on a straight-line basis over 5 years) |  |   | 5,071  |  
|Deferred compensation for unvested employee stock options                |  |   | 304    |  
|Assumed liabilities                                                      |  |   | (5,319 | )
|                                                                         |  |   |        |  
|Net assets acquired                                                      |  | $ | 17,580 |  
|                                                                         |  |   |        |  



The
goodwill has been assigned to the Companys Distribution segment. The Company expects all goodwill to be deductible for tax purposes over a period of 15 years.



The Company expects to recognize amortization expense associated with customer relationships of $253,550 per
quarter for each of the next five years, resulting in estimated amortization expense of $507,100 for the remainder of fiscal year 2003, $1,014,200 in each of fiscal years 2004, 2005, 2006 and 2007, and $253,550 in fiscal year 2008. The Company
recorded amortization expense of $253,550 during the six months ended March 31, 2003.



Pro forma results for the three months ended March 31, 2002 and the six months ended March 31, 2003 and 2002, as if the acquisition of TidalWire had been completed as of the beginning of each of these
periods, are as follows (in thousands, except per share data):



|                                     |  | Three months ended March 31, 2002 |        |   | Six months ended March 31, |     
|------------------------------------ |  | --------------------------------- | ------ | - | -------------------------- | ----
|                                     |  |                                   | 2003   |   |                            | 2002
|Net revenues                         |  | $                                 | 8,262  |   |                            | $   
|Net loss                             |  | $                                 | (3,274 | ) |                            | $   
|Net loss per sharebasic and diluted |  | $                                 | (0.09  | ) |                            | $   



Pro
forma results for the three months ended March 31, 2003 are not presented as Network Engines and TidalWire were combined for the entire three months ended March 31, 2003. Pro forma results are not necessarily indicative of the results that would
have occurred had the business combination been in effect on the dates indicated and are not necessarily indicative of future results.



During the three months ended March 31, 2003, the Company reduced goodwill by $205,000 due to the collection of certain receivables, held
by TidalWire on December 27, 2002, which were deemed uncollectible at the acquisition date.



3. SIGNIFICANT ACCOUNTING POLICIES



Recent Accounting Pronouncements



In November 2002, the FASB issued FASB Interpretation No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an
interpretation of FASB Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34(FIN 45). FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about
its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. FIN 45
does not prescribe a specific approach for subsequently measuring the guarantors recognized liability over the term of the related guarantee. It also incorporates, without change, the guidance in FASB Interpretation No. 34, Disclosure of
Indirect Guarantees of Indebtedness of Others, which is being superseded. The disclosure provisions of FIN 45 are effective for financial statements of interim or annual periods that end after December 15, 2002 and the provisions for initial
recognition and measurement are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002, irrespective of a guarantors year-end. The adoption of FIN 45 did not have a material impact on its financial
position or results of operations.



In November 2002, the Emerging Issues Task Force of the FASB reached a consensus on Issue 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (EITF 00-21). EITF 00-21 requires that for revenue
arrangements with



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NETWORK
ENGINES, INC.



NOTES TO UNAUDITED
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



multiple deliverables, those deliverables be divided into separate units of accounting if the deliverables meet certain criteria as defined by EITF 00-21. Arrangement consideration is to be allocated among the separate units of
accounting based on their relative fair values and revenue recognition decisions should be considered separately for each separate unit of accounting. EITF 00-21 is effective for all arrangements entered into in fiscal periods beginning after June
15, 2003, with early adoption permitted. The Company is currently evaluating the scope of EITF 00-21 but does not expect the adoption of EITF 00-21 will have a material impact on its financial position or results of operations.



Comprehensive Loss



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



Segment Reporting



Prior to the acquisition of TidalWire, the Company organized
itself as a single business segment. As a result of the acquisition of TidalWire, the Company now organizes itself into two reportable business segments: OEM Appliance and Distribution. The Companys segments have been determined based upon the
channels through which the segments sell products. Sales of server appliances to the Companys ISV partners are included in the Companys OEM Appliance segment. Sales of server appliances and data storage products to resellers and
integrators are included in the Companys Distribution segment. The accounting policies of these segments are the same as those described in the Companys summary of significant accounting policies in its Annual Report on Form 10-K for the
year ended September 30, 2002. The Company evaluates its segments performance based on revenues and gross profit. There are no inter-segment sales or transfers. Management does not review assets as part of the assessment of segment
performance; as such, after integration of the TidalWire distribution business, segment asset information is not available.



The following is a summary of the Companys operations by reporting segment (in thousands):



|                   |  | Three months ended March 31, |        | Six months ended March 31,
|------------------ |  | ---------------------------- | ------ | --------------------------
|                   |  | 2003                         |        | 2002                      
|OEM Appliance:     |  |                              |        |                           
|Net revenues       |  | $                            | 9,181  |                           
|                   |  |                              |        |                           
|Gross profit       |  | $                            | 2,207  |                           
|                   |  |                              |        |                           
|Distribution:      |  |                              |        |                           
|Net revenues       |  | $                            | 10,246 |                           
|                   |  |                              |        |                           
|Gross profit       |  | $                            | 1,854  |                           
|                   |  |                              |        |                           
|Combined Segments: |  |                              |        |                           
|Net revenues       |  | $                            | 19,427 |                           
|                   |  |                              |        |                           
|Gross profit       |  | $                            | 4,061  |                           
|                   |  |                              |        |                           



Significant
Customers



The following table
summarizes those customers who accounted for greater than 10% of the Companys net revenues or accounts receivable:





|           |  | Net Revenues for the three months ended March 31, |   |  | Net Revenues for the six months ended March 31, |   |  | Accounts Receivable at March 31, |  
|---------- |  | ------------------------------------------------- | - |  | ----------------------------------------------- | - |  | -------------------------------- | -
|           |  | 2003                                              |   |  | 2002                                            |   |  | 2003                             |  
|Customer A |  | 42                                                | % |  | 76                                              | % |  | 52                               | %



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##### Table of Contents

NETWORK ENGINES, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)





4. NET LOSS PER SHARE
AND STOCK-BASED COMPENSATION



Basic net loss
per share is computed by dividing the net loss for the period by the weighted average number of shares of common stock outstanding during the period, excluding shares of common stock subject to repurchase by the Company (restricted
shares). Diluted net loss per share is computed by dividing the net loss for the period by the weighted average number of shares of common stock and potential common stock outstanding during the period, if dilutive. Potential common stock
includes unvested restricted shares and incremental shares of common stock issuable upon the exercise of stock options and warrants. Because the inclusion of potential common stock would be anti-dilutive for all periods presented, diluted net loss
per share is the same as basic net loss per share.



The following table sets forth the potential common stock excluded from the calculation of net loss per share because their inclusion would be anti-dilutive (in thousands):



|                                  |  | As of March 31,
|--------------------------------- |  | ---------------
|                                  |  | 2003           
|Options to purchase common stock  |  | 6,121          
|Warrants to purchase common stock |  | 1,462          
|Unvested restricted common stock  |  | 116            
|                                  |  |                
|                                  |  | 7,699          
|                                  |  |                



Stock
options and restricted stock issued to employees and members of the Companys board of directors are accounted for in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related
interpretations (APB 25); accordingly, compensation expense is recorded for options and restricted stock awarded to employees and directors to the extent that the exercise or purchase prices are less than the common stocks fair
market value on the date of grant, where the number of shares and exercise or purchase price are fixed. The difference between the fair value of the Companys Common Stock and the exercise or purchase price of the stock option or restricted
stock award is recorded as deferred stock compensation. Deferred stock compensation is amortized to compensation expense over the vesting period of the underlying stock option or restricted stock. Upon cancellation of options, or repurchase of
restricted common stock, with residual deferred compensation balances at the date of cancellation, the remaining amount of unrecognized deferred compensation is reversed as an adjustment to additional paid-in capital. The Company follows the
disclosure requirements of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123). Stock-based awards to non-employees are accounted for under provisions of SFAS 123.



Had compensation expense for the Companys
stock option plans been determined based on the fair value, estimated using the Black-Scholes option pricing model, at the date of grant for awards made since the adoption of the Companys stock option plans, consistent with the provisions of
SFAS 123, the Companys net loss and net loss per share for the three and six months ended March 31, 2002 and 2003 would have increased to the pro forma amounts indicated below:



|                                                                        |  | Three months ended March 31,          |        
|----------------------------------------------------------------------- |  | ------------------------------------- | -------
|                                                                        |  | 2003                                  |        
|                                                                        |  | Net loss                              |        
|                                                                        |  | (in thousands, except per share data) |        
|As reported                                                             |  | $                                     | (684   
|Add: stock-based compensation expense from options included in net loss |  |                                       | 245    
|Deduct: total stock-based compensation expense                          |  |                                       | (684   
|                                                                        |  |                                       |        
|Pro forma                                                               |  | $                                     | (1,123 
|                                                                        |  |                                       |        
|Assumptions used in determination of option fair value:                 |  |                                       |        
|Risk-free interest rate                                                 |  |                                       | 2.68   
|Volatility factor                                                       |  |                                       | 139    
|Dividend yield                                                          |  |                                       | 0      
|Weighted average expected option life                                   |  |                                       | 5 years



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NETWORK ENGINES, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)





|                                                                        |  | Six months ended March 31,            |        
|----------------------------------------------------------------------- |  | ------------------------------------- | -------
|                                                                        |  | 2003                                  |        
|                                                                        |  | Net loss                              |        
|                                                                        |  | (in thousands, except per share data) |        
|As reported                                                             |  | $                                     | (2,863 
|Add: stock-based compensation expense from options included in net loss |  |                                       | 403    
|Deduct: total stock-based compensation expense                          |  |                                       | (1,221 
|                                                                        |  |                                       |        
|Pro forma                                                               |  | $                                     | (3,681 
|                                                                        |  |                                       |        
|Assumptions used in determination of option fair value:                 |  |                                       |        
|Risk-free interest rate                                                 |  |                                       | 2.73   
|Volatility factor                                                       |  |                                       | 139    
|Dividend yield                                                          |  |                                       | 0      
|Weighted average expected option life                                   |  |                                       | 5 years



5. INVENTORIES



Inventories consisted of the following (in
thousands):



|                |  | March 31, 2003 |       | September 30, 2002
|--------------- |  | -------------- | ----- | ------------------
|Raw materials   |  | $              | 1,156 |                   
|Work in process |  |                | 760   |                   
|Finished goods  |  |                | 3,960 |                   
|                |  |                |       |                   
|                |  | $              | 5,876 |                   
|                |  |                |       |                   



6. CONTINGENCIES



Guarantees and Indemnifications



Director and officer indemnifications  Pursuant to the
Companys Second Amended and Restated Certificate of Incorporation, as permitted under Delaware law, the Company indemnifies its officers and directors for certain events or occurrences while the officer or director is, or was serving in his
capacity as a director or officer of the Company or as a director, officer or trustee of a different entity, at the Companys request. The term of the indemnification period is for the officers or directors lifetime. The maximum
potential amount of future payments the Company could be required to make under these indemnifications is unlimited; however, the Company has a Director and Officer insurance policy that limits its exposure and enables it to recover a portion of any
future amounts paid. As a result of the Companys insurance policy coverage, the Company believes the estimated fair value of these indemnifications is minimal. Accordingly, the Company has no liabilities recorded for these indemnifications as
of March 31, 2003.



Acquisition-related
indemnifications  When, as part of an acquisition, the Company acquires all the stock of a company, the Company assumes liabilities for certain events or circumstances that took place prior to the date of acquisition. The maximum potential
amount of future payments the Company could be required to make for such obligations is undeterminable. While the provisions of the agreements remain in effect indefinitely, the Company believes that the probability of receiving a claim is unlikely.
As a result, the Company believes that the estimated fair value of these indemnification clauses is minimal and no liabilities have been recorded as of March 31, 2003.



Product warranties  The Company offers a warranty on all of the products that it sells. Warranties are
provided by the Company directly, a third-party contracted to perform warranty service on the Companys behalf or the product manufacturer, depending upon the product sold. Warranty terms vary in duration depending upon the product sold but
generally provide for the repair or replacement of any defective products for a period of up to 36 months after shipment. Based upon historical experience and expectation of future conditions, the Company reserves for the estimated costs to fulfill
customer warranty obligations upon



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NETWORK ENGINES, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)





the
recognition of the related revenue. The following table presents changes in the Companys product warranty liability (in thousands):



|Balance at September 30, 2002                               |  | $ | 231  |  
|----------------------------------------------------------- |  | - | ---- | -
|Accruals for warranties issued                              |  |   | 14   |  
|Warranty liability assumed in acquisition of TidalWire Inc. |  |   | 109  |  
|Cost of warranties honored during the period                |  |   | (100 | )
|                                                            |  |   |      |  
|Balance at December 31, 2002                                |  |   | 254  |  
|Accruals for warranties issued                              |  |   | 285  |  
|Cost of warranties honored during the period                |  |   | (312 | )
|Balance at March 31, 2003                                   |  | $ | 227  |  
|                                                            |  |   |      |  



Contingencies



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



The suit alleges that the defendants violated the federal securities laws by issuing and selling securities pursuant to the Companys initial public offering in July 2000 (IPO) without disclosing to investors that
the Underwriter Defendants had solicited and received excessive and undisclosed commissions from certain investors. The suit also alleges that the Underwriter Defendants entered into agreements with certain customers whereby the Underwriter
Defendants agreed to allocate to those customers shares of the Companys stock in the offering, in exchange for which the customers agreed to purchase additional shares of the Companys stock in the aftermarket at pre-determined prices.
The suit alleges that such tie-in arrangements were designed to and did maintain, distort and/or inflate the price of the Companys Common Stock in the aftermarket. The suit further alleges that the Underwriter Defendants received undisclosed
and excessive brokerage commissions and that, as a consequence, the Underwriter Defendants successfully increased investor interest in the manipulated IPO securities and increased the Underwriter Defendants individual and collective
underwritings, compensation and revenues. The suit seeks damages and certification of a plaintiff class consisting of all persons who acquired shares of the Companys Common Stock between July 13, 2000 and December 6, 2000.



In July 2002, Network Engines, Lawrence A. Genovesi and
Douglas G. Bryant joined in an omnibus motion to dismiss challenging the legal sufficiency of plaintiffs claims. The motion was filed on behalf of hundreds of issuer and individual defendants named in similar lawsuits. Plaintiffs opposed the
motion, and the Court heard oral argument on the motion in November 2002. On February 19, 2003, the Court issued an opinion and order denying the motion as to the Company and the case may now proceed to discovery. In addition, in October 2002,
Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this case without prejudice.



The Company is unable to predict the outcome of this suit and its ultimate effect, if any, on the Companys financial condition; however, the Companys defense against this suit has and may
continue to result in the expenditure of significant financial and managerial resources. No amounts have been accrued for this matter.



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NETWORK ENGINES, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)





A
purported class action and derivative lawsuit was filed on January 7, 2003 in the Court of Chancery in the State of Delaware against Network Engines and its Board of Directors relating to the acquisition of TidalWire. The plaintiffs in the complaint
allege that the Company and its Board of Directors breached their fiduciary duties by, among other things, paying an excessive amount in the acquisition of TidalWire and purportedly failing to disclose material facts in the Companys Joint
Proxy



Statement/Information Statement distributed to
stockholders for approval of the issuance of shares of Network Engines in the merger. The plaintiffs are seeking damages, rescission of the merger and other relief. On February 10, 2003, the Company and the individual defendants filed a motion to
dismiss the Complaint for failure to state a claim on which relief could be granted, and related relief. The parties are in the process of briefing the motion. The Court has scheduled a hearing on the motion in June 2003. The Company believes that
it has highly meritorious defenses and intends to vigorously defend against the suit, but given the early stage of the proceedings, the Company cannot predict the ultimate outcome of the litigation.



7. RESTRUCTURING AND OTHER CHARGES



During the year ended September 30, 2002, the Company reduced
its workforce, which impacted employees in all of the Companys groups. The implementation of this reduction in workforce resulted in a charge of $353,000 to operations, which was comprised entirely of employee related charges, including
severance payments to terminated employees.



In
December 2002, the Company recorded a charge to operations of approximately $914,000. This charge is comprised entirely of future lease and lease-related payments and resulted from the continued vacancy of certain leased facilities and the expected
future vacancy of certain leased facilities currently occupied by a sub-tenant. When the Company restructured in fiscal 2001, a portion of the charges that were taken were based on the curtailment of a planned expansion into leased facilities of
approximately 24,000 square feet as well as a move out of approximately 17,000 square feet of leased space. Based on the current real estate market in the area of these facilities, the lack of interest in the spaces that the Company has been
actively marketing to sublease and the deteriorating financial condition of the sub-tenant, the Company revised its estimates as to the duration of an expected sublease of these facilities, if any, and the estimated sublease income. These revised
estimates assume no sublease income from the Companys vacant 17,000 square foot space through the end of its current lease and approximately $126,000 of sublease income during the final nine months of its current lease on the 24,000 square
foot space. Both leases currently expire in March 2005. During the three months ended March 31, 2003, the Company received $30,000 of sublease income not previously anticipated, which is reflected as a recovery of the December 2002 restructuring and
other charges.



The following table sets forth
restructuring and other charges accrual activity during the six months ended March 31, 2003 (in thousands):



|                                                                      |  | Employee Related |     |   | Facility Related |   |       | Other |  |   | Total |  
|--------------------------------------------------------------------- |  | ---------------- | --- | - | ---------------- | - | ----- | ----- |  | - | ----- | -
|Restructuring and other charges accrual balance at September 30,
2002 |  | $                | 32  |   |                  | $ | 281   |       |  | $ | 42    |  
|Cash payments                                                         |  |                  | (1  | ) |                  |   | (70   | )     |  |   | (30   | )
|Restructuring and other charges                                       |  |                  |     |   |                  |   | 914   |       |  |   |       |  
|                                                                      |  |                  |     |   |                  |   |       |       |  |   |       |  
|Restructuring and other charges accrual balance at December 31,
2002  |  |                  | 31  |   |                  |   | 1,125 |       |  |   | 12    |  
|Cash payments                                                         |  |                  | (12 | ) |                  |   | (116  | )     |  |   | (7    | )
|Sub-lease income received                                             |  |                  |     |   |                  |   | (30   | )     |  |   |       |  
|                                                                      |  |                  |     |   |                  |   |       |       |  |   |       |  
|Restructuring and other charges accrual balance at March 31, 2003     |  | $                | 19  |   |                  | $ | 979   |       |  | $ | 5     |  
|                                                                      |  |                  |     |   |                  |   |       |       |  |   |       |  



The
Company expects the remaining restructuring accrual balance to be fully utilized by March 31, 2005, including cash payments of approximately $332,000 during the remainder of fiscal 2003, approximately $448,000 during fiscal 2004 and approximately
$223,000 during fiscal 2005.



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NETWORK ENGINES, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)





8. ACQUISITION OF IP
PERFORMANCE



In connection with the
Companys acquisition of IP Performance, Inc. in November 2000, the Company issued 321,756 shares of restricted common stock to key employee stockholders of IP Performance. In connection with the issuance of these restricted shares, the Company
recorded approximately $6.4 million of deferred compensation, which was being recognized as stock compensation expense ratably over the three-year vesting period, beginning on November 8, 2000. In December 2001, the Company terminated the employment
of all of the former IP Performance employees. In accordance with the restricted stock agreements with these individuals, all of the remaining unvested restricted stock vested upon termination. As a result, during the six months ended March 31,
2002, the Company recognized the remaining deferred stock compensation of approximately $3.5 million.



9. RELATED PARTY TRANSACTIONS



In January 2001, the Company entered into a series of related agreements with Lawrence A. Genovesi, currently Chairman of the Board and formerly President, Chief Executive Officer and Chief Technology
Officer of the Company. These agreements were entered into to avoid significant sales of the Companys stock by Mr. Genovesi as a result of a margin call on a personal loan collateralized by Mr. Genovesis holdings of the Companys
Common Stock. The Company guaranteed a personal loan obtained by Mr. Genovesi from a financial institution (the Bank) through a deposit of $1,051,850 of the Companys cash with the Bank (the Guarantee), which was to
expire in January 2002. In January 2002, the Company extended the Guarantee period to January 2003. Mr. Genovesi and the Company also entered into an agreement whereby Mr. Genovesi agreed to reimburse the Company for any obligations incurred by the
Company under the Guarantee (the Reimbursement Agreement). Any unpaid balances under the Reimbursement Agreement bore interest at a rate 10% per annum. On January 6, 2003, pursuant to the Guarantee, the Bank applied $968,596 of the
Companys cash deposit to the repayment of Mr. Genovesis personal loan and refunded $83,254 to the Company. On January 27, 2003, Mr. Genovesi repaid the Company $974,168 to satisfy his obligations under the Reimbursement Agreement,
including accrued interest. Of that amount, $456,276 was paid in cash and $517,892 was paid with the proceeds from the repurchase by the Company of 391,128 shares of the Companys Common Stock owned by Mr. Genovesi. The purchase price was
determined based on the average closing price of the Companys Common Stock over the ten trading days prior to and including January 17, 2003.



The Company and Mr. Genovesi had previously, in November 1999, entered into a recourse note (the Recourse Note) in the
principal amount of $90,000, bearing interest at an annual rate of 6.08% and payable upon the earlier of demand by the Company or November 18, 2004. In addition, in January 2001, Mr. Genovesi executed a revolving promissory note of up to $210,000
(the Note) with the Company. The Note had an interest rate of 5.9% per annum and was due and payable in full upon the earlier of January 9, 2002 or 30 days following the date Mr. Genovesi ceased to be an employee of the Company. In
November 2001, the Company repurchased 234,822 shares of the Companys Common Stock from Mr. Genovesi for $225,195 in a private transaction. The purchase price was determined based on the average closing price of the Companys Common Stock
over the ten trading days prior to the purchase date. Mr. Genovesi used the proceeds to pay off all amounts outstanding under the Note of $140,343, to pay down $39,813, including accrued interest, of the Recourse Note and to pay taxes incurred in
connection with the Companys repurchase of its common stock from Mr. Genovesi. Also in November 2001, the Company repurchased 93,750 shares of the Companys Common Stock held by Mr. Genovesi as restricted stock for $22,500. The purchase
price was equal to the price at which these shares were sold to Mr. Genovesi in November 1999. The proceeds were used to pay down $22,500 of the Recourse Note. At December 31, 2002, $22,500 remained outstanding under the Recourse Note, which was
repaid by Mr. Genovesi on January 27, 2003 with the proceeds from the repurchase by the Company of 17,070 shares of the Companys Common Stock owned by Mr. Genovesi. The purchase price was determined based on the average closing price of the
Companys Common Stock over the ten trading days prior to and including January 17, 2003.



In conjunction with the Guarantee, the Reimbursement Agreement and the Note, the Company and Mr. Genovesi entered into a pledge agreement whereby Mr. Genovesi pledged to the Company all shares of the
Companys Common Stock owned by Mr. Genovesi as of the date of the agreement or subsequently acquired, and all options and other rights to acquire shares of the Companys Common Stock owned by Mr. Genovesi as of the date of the agreement
or subsequently acquired (collectively the Pledged Securities). Additionally, Mr. Genovesi pledged to the Company all additional securities or other consideration from time to time acquired by Mr. Genovesi in substitution for, or in
respect of the Pledged Securities. If Mr. Genovesi had elected to sell any additional Pledged Securities during the term of the agreement, all proceeds of such sale would have been applied to any amounts payable under the Reimbursement Agreement. In
addition to the Pledged Securities, the obligations of Mr. Genovesi under the Reimbursement Agreement were collateralized by a second mortgage on certain real property owned by Mr. Genovesi. As stated above, on January 27, 2003, Mr. Genovesi
satisfied his obligations in full under each of the Guarantee, the Reimbursement Agreement, the Recourse Note and pledge agreement.



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NETWORK ENGINES, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS(Continued)





In April
2001, the Company entered into full recourse loan agreements with certain employees and certain officers of the Company all of whom were employees or officers of the Company at that time (the Loan Agreements). The Loan Agreements were
entered into to avoid substantial sales of the Companys Common Stock by these employees and officers as a result of alternative minimum tax obligations incurred by these employees and officers in connection with their exercise of options to
purchase shares of the Companys Common Stock. The amount loaned to the employees and officers under the Loan Agreements was approximately $736,000, which was recorded net of approximately $228,000 of reserves for uncollectibility. Outstanding
amounts under the Loan Agreements accrued interest at a rate of 4.63% per annum and were originally due and payable in full upon the earlier of one year from the date of each individual agreement or thirty days after termination of employment with
the Company, unless termination was involuntary and without cause. In conjunction with the Loan Agreements, each employee and officer pledged all shares of capital stock, and options to purchase capital stock, of the Company then owned, or acquired
in the future (the Pledged Stock), and any distributions on the Pledged Stock or proceeds from their sale. Amounts due under these Loan Agreements were included in the balance sheet as notes receivable from stockholders.



In April 2002, one former officers loan was repaid in
full, including accrued interest of approximately $2,500, through a payment to the Company of $29,727 of cash and a sale to the Company of 30,000 shares of the Companys Common Stock in exchange for the retirement of $27,000 of the former
officers note payable. The price per share of the Companys Common Stock was based on the market price as of the close of business on the date of the repurchase. Because the amounts outstanding under certain of the Loan Agreements
exceeded the value of the Companys Common Stock pledged as collateral, in January 2002, the Company extended the repayment dates to September 2002 for loans with an aggregate principal amount of $226,996 due from one of its current officers
and one of its former officers and in March 2002, the Company extended the repayment dates to July 2002 for the remaining loans with a net principal amount of $255,000. Subsequently, in early July 2002, the Company also extended the repayment dates
for these remaining loans to September 2002. In September 2002, loans to one current officer and one former officer totaling approximately $240,000 were repaid in full, including accrued interest of approximately $13,000, through sales to the
Company of 230,777 shares of the Companys Common Stock in exchange for the retirement of these loans. The remaining loans due from one former officer and one former employee totaling approximately $489,000 as of December 31, 2002, were repaid
in full, including accrued interest of approximately $33,000, in January 2003 through the repurchase by the Company of 278,600 shares of the Companys Common Stock. The price per share of the Companys Common Stock was based on the market
price as of the close of business on the dates of these repurchases. As of December 31, 2002, the Company determined that there was no need for reserves for the uncollectibility of these stockholder notes receivable and reversed reserves of $228,000
as a decrease to general and administrative expenses during the three months ended December 31, 2002.



All common stock repurchased under these related party agreements was recorded as treasury stock at the cost to repurchase.



In connection with the Companys acquisition of
TidalWire, the Company paid $1,144,615 to Ascent Venture Partners (together with its affiliated entities, Ascent) and $2,205,828 to HarbourVest Partners (together with its affiliated entities, HarbourVest), two substantial
stockholders of the Company. At the time of the acquisition, Ascent and HarbourVest owned approximately 18.1% and 16.3% of the outstanding common stock of the Company, respectively. Ascent and HarbourVest also owned 12.9% and 24.9% of the
outstanding common stock of TidalWire, respectively. Pursuant to the terms of the merger agreement, the Company issued 480,706 shares and 926,386 shares of its common stock previously held as treasury stock to Ascent and HarbourVest, respectively
and made the aforementioned cash payments to Ascent and HarbourVest in exchange for all of the TidalWire common stock held by Ascent and HarbourVest. The consideration paid to Ascent and HarbourVest may be deemed to have been indirectly paid to
Frank M. Polestra and Robert M. Wadsworth, two of the Companys directors. As a managing member or general partner of each of the general partners that control Ascent, Mr. Polestra may be deemed to have indirectly received the $1,144,615 of
cash paid to Ascent as well as beneficial ownership of 480,706 shares of the Companys common stock issued to Ascent. As a managing director of the limited liability corporation that controls HarbourVest, Mr. Wadsworth may be deemed to have
indirectly received the $2,205,828 of cash paid to HarbourVest as well as beneficial ownership of 926,386 shares of the Companys common stock issued to HarbourVest.



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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION



Special Note Regarding Forward-Looking Statements



This Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended,
that involve risks and uncertainties. All statements other than statements of historical information provided herein are forward-looking statements and may contain information about financial results, economic conditions, trends and known
uncertainties. Our actual results could differ materially from those discussed in the forward-looking statements as a result of a number of factors, which include those discussed in this section and elsewhere in this report and the risks discussed
in our other filings with the Securities and Exchange Commission. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect managements analysis, judgment, belief or expectation only as of the date
hereof. We undertake no obligation to publicly reissue these forward-looking statements to reflect events or circumstances that arise after the date hereof.



The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and the notes
thereto included in Item 1 in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended September 30, 2002 filed by the Company with the Securities and Exchange Commission.



Overview



We are a provider of server appliance hardware platforms and custom integration services. Server appliances
are pre-configured computer network infrastructure devices designed to deliver specific application functionality. We are focused on partnering with independent software vendors (ISVs) to provide these strategic partners with server
appliance development, integration, fulfillment and support services to allow these strategic partners to deliver turn-key solutions to their end-user customers.



Working closely with our software partners, our goal is to ensure that appliance performance is optimized
with maximum price/performance and minimum total cost of ownership. Appliance solutions built using our hardware platforms and custom integration services are designed to be secure and easy to install and operate.



In December 2002, we acquired TidalWire Inc.
(TidalWire), a specialist distributor of data storage networking connectivity products that provides extensive pre- and post-sales support to their customers. In addition to the revenue associated with the distribution of storage
networking connectivity products, the acquisition of TidalWire provides us with a sophisticated logistics system, relationships with a significant number of value-added resellers and systems integrators in North America, and expanded post sales
support capabilities. A key reason for acquiring TidalWire was to allow us to offer these distribution capabilities to both current and potential ISV partners and thereby give us the ability to expand our server appliance business. We believe that
the distribution of server appliances will be an attractive value proposition to ISVs because it provides them with the option of not taking ownership of the hardware component of the appliance and maintaining a pure software company financial
profile. In addition to enhancing our server appliance business, we plan to expand the product offerings of TidalWire into other vertical markets, in particular network security and network management. We believe that by providing channel partners
with new products from major data storage, network security and network management system and component vendors, we will be able to attract and retain key channel partners.



As a result of our acquisition of TidalWire, the combined company will be able to develop, manufacture, and
distribute server appliances and complementary products for mission-critical data storage, network security and network management applications. By offering a combination of application integration services, value-added utilities, a suite of
hardware reference platforms, and fulfillment and distribution services, we expect to enable our partners to achieve rapid time-to-market while minimizing their customer support costs.



Critical Accounting Policies And Estimates



Our discussion and analysis of financial condition and results of operations are based upon our consolidated
financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates and judgments, including those related to revenue recognition; allowance for doubtful
accounts; inventory valuation; goodwill and intangible assets; acquisition accounting; restructuring and other charges; stock compensation expense; and income tax asset valuation. We base our estimates and judgments on historical experience and on
various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for



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making judgments about the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different assumptions or conditions.



We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our
financial statements.



Revenue Recognition



We generally recognize revenue from sales
of our products upon shipment to customers provided persuasive evidence of the arrangement has been received, the sales price is fixed or determinable, collection of the related receivable is reasonably assured, title and risk of loss have passed to
the customer, and all other revenue recognition criteria of SEC Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements are met. At the time of a sale transaction, we make an assessment of the collectibility of the
amount due from the customer. Revenue is only recognized at that time if we are reasonably assured that collection will occur. In making this assessment, management considers customer creditworthiness and historical payment experience. Our server
appliance customers are not granted rights to return our products after the purchase has been made. However, in certain circumstances, we have accepted returns, although we were not contractually obligated to do so. Our distribution customers are
offered a thirty day right of return. We record a provision for potential returns based on our historical return rate. Material differences may result in the amount and timing of our revenue for any period if management makes judgments or uses
estimates that prove to be materially different from actual experiences.



We offer a warranty on all of our products that generally provide for us to repair or replace any defective products for a period of up to 36 months after shipment. Based upon historical experience and expectation of future
conditions, we reserve for the estimated costs to fulfill customer warranty obligations upon the recognition of the related revenue. To the extent we may experience increased warranty claim activity or increased costs associated with servicing those
claims, our warranty reserve may need to be increased, resulting in decreased gross profits.



Allowance for Doubtful Accounts



We perform ongoing credit evaluations of our customers and adjust credit limits based upon payment history and each customers current credit worthiness, as determined by our review of their
current credit information. We continuously monitor collections and payments from our customers and maintain an allowance for doubtful accounts based upon historical experience and any specifically identified customer collection issues. In addition,
when evaluating the overall adequacy of the allowance for doubtful accounts, we also consider customer concentrations and current economic trends. While actual bad debts recorded against the allowance for doubtful accounts have historically been
within expectations and the allowance established, we cannot be sure that we will continue to be able to estimate our future experience with the same success. If the financial condition of our customers were to deteriorate, resulting in their
inability to make payments, additional allowances may be required.



Inventories



We
value our inventory at the lower of cost (first-in, first-out method) or market. We regularly review inventory quantities on hand and record a reserve for excess and obsolete inventory based primarily on our estimated forecast of product demand and
anticipated production requirements in the near future, giving effect to general market conditions. Any rapid technological changes and future product development could result in an increase in the amount of obsolete inventory quantities on hand.
Agreements with certain vendors to our distribution business include stock rotation provisions however, these provisions may not provide us with complete protection from loss due to excess or obsolete inventory. If our estimates of future product
demand prove to be inaccurate, additional reserves may be required for incremental excess and obsolete inventory.



Goodwill, Intangible Assets and Long-Lived Assets



Goodwill and intangible assets are a result of our acquisition of TidalWire. Goodwill resulting from our
acquisition of TidalWire will be tested for impairment at least annually. Intangible assets and goodwill are assessed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Any impairment
loss will be charged to operations in the period of the loss. We assess the recoverability of long-lived assets based on the projected undiscounted future cash flows over the assets remaining life. The amount of impairment, if any, is measured
based on the excess of the carrying value over fair value, determined using projected discounted future operating cash flows. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.



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Acquisition
Accounting



In December 2002, we acquired
TidalWire for total consideration of $17.6 million, which was allocated to net tangible assets and liabilities acquired of $4.4 million, deferred stock compensation of $304,000, customer relationships of $5.1 million and goodwill of $7.8 million.
The fair value of the customer relationships was determined based on the discounted estimated future cash flows from these relationships. We have estimated that the useful life of these customer relationships would be five years. Significant
judgments and estimates are involved in determining the fair value of assets acquired and their useful lives. Different assumptions could yield materially different results.



Restructuring and Other Charges



Involuntary termination benefits and exit costs are recognized when management approves and commits to a
sufficiently detailed plan of termination or exit plan. Management must assess whether costs incurred in connection with involuntary terminations and exit activities meet certain specific requirements to be recorded and classified as restructuring
and other costs. During compilation of a plan of termination or exit plan, we make certain assumptions and estimates regarding certain costs contained in these plans based on information gathered from internal and external sources. In addition,
charges taken for vacant facilities are recognized when the available information indicates that a loss is probable and estimable. If actual results related to any of these assumptions or estimates were to exceed or not meet our expectations in the
future, we may need to adjust certain restructuring and other charges in future reporting periods, resulting in increased or decreased operating expenses.



Stock Compensation



In connection with the grant of certain options and restricted stock awards to employees issued prior to our initial public offering in
July 2000, we recorded deferred stock compensation within stockholders equity of $15.5 million, representing the difference between the estimated fair value of the common stock for accounting purposes and the option exercise price of these
options or restricted stock awards at the date of grant. Such amount is presented as a reduction of stockholders equity and is being amortized over the vesting period of the applicable options. Significant judgments and estimates were involved
in determining the proper valuation of deferred stock compensation because at the time of grant there was no available market for our common stock. Different assumptions would have yielded materially different results.



Income Tax Asset Valuation



We record deferred tax assets and liabilities based on the
net tax effects of tax credits, operating loss carryforwards and temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. We then assess the
likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we establish a valuation allowance. The valuation allowance is based on our estimate of future taxable
income and the period over which our deferred tax assets will be recoverable. Through March 31, 2003, we believe that it is more likely than not that all of our deferred tax assets will not be realized, and, accordingly, we have recorded a valuation
allowance against all of our deferred tax assets. If results of operations in the future indicate that some or all of the deferred tax assets will be recovered, the reduction of the valuation allowance will be recorded as a tax benefit during one
period or over several periods.



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Results of Operations



The following table sets forth the results
of our operations for the three and six months ended March 31, 2003 and 2002, respectively in thousands and as a percentage of net revenues.



|                     |  | Three months ended |        |   | Six months ended  |      
|-------------------- |  | ------------------ | ------ | - | ----------------- | -----
|                     |  | March 31, 2003     |        |   | March 31, 2002    |      
|                     |  | Dollars            |        |   | % of Net Revenues |      
|Net revenues         |  | $                  | 19,427 |   |                   | 100.0
|Gross profit         |  |                    | 4,061  |   |                   | 20.9 
|Operating expenses   |  |                    | 4,883  |   |                   | 25.1 
|Loss from operations |  |                    | (822   | ) |                   | (4.2 
|Net (loss)           |  | $                  | (684   | ) |                   | (3.5 



Recent Events



On December 27, 2002, we completed our
acquisition of TidalWire. As a result, the quarter ended March 31, 2003 was the first quarter that included the TidalWire operations in our consolidated results for an entire quarter. Our financial results for the six months ended March 31, 2003
only include TidalWire financial results for the period from December 28, 2002 through March 31, 2003. As such, the presentation of historical financial information and any discussion regarding the comparison of historical financial information to
financial information for the three or six months ended March 31, 2003, does not include any financial information for TidalWire prior to December 28, 2002, unless otherwise indicated. Forward-looking statements made regarding our expected future
operating results include the expected results of both Network Engines and TidalWire on a combined basis.



Net Revenues and Gross Profit



The following table summarizes our net revenues and gross profit by reportable segment (dollars in
thousands):



|                   |  | Three months ended |        |                           | Six months ended |  
|------------------ |  | ------------------ | ------ | ------------------------- | ---------------- | -
|                   |  | March 31, 2003     |        |                           | March 31, 2002   |  
|                   |  | Dollars            |        | % of Segment Net Revenues |                  |  
|OEM Appliance:     |  |                    |        |                           |                  |  
|Net revenues       |  | $                  | 9,181  |                           | 100.0            | %
|Gross profit       |  | $                  | 2,207  |                           | 24.0             | %
|Distribution:      |  |                    |        |                           |                  |  
|Net revenues       |  | $                  | 10,246 |                           | 100.0            | %
|Gross profit       |  | $                  | 1,854  |                           | 18.1             | %
|Total net revenues |  | $                  | 19,427 |                           | 100.0            | %
|Total gross profit |  | $                  | 4,061  |                           | 20.9             | %



Prior to
our acquisition of TidalWire on December 27, 2002, our revenues were derived from sales of server appliance hardware platforms and related pre-sales integration and supply-chain management services in the United States. Sales of server appliances to
one OEM customer have been a major portion of our revenues. We provide this customer with customized



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platforms that are used as components in their data storage solution. During our fiscal 2002, this OEM
customer publicly announced the availability of their product. Since then we have seen quarterly increases in sales to this customer and we expect to experience continued OEM appliance sales growth as a result of sales to this customer as well as
other OEM appliance customers. As a result of our acquisition of TidalWire, we also distribute storage networking connectivity products through a channel of value-added resellers and systems integrators. We intend to expand upon the number of
storage networking products offered by our distribution business to include products in the network security market.



The quarterly and year-to-date increases in net revenues in the second quarter and six months ended March 31 of fiscal 2003 versus the
same periods in fiscal 2002 are primarily due to incremental revenues from our recently acquired distribution business, which accounted for approximately 53% and 42% of our total net revenues in the three and six months ended March 31, 2003,
respectively. The increase in net revenues is also due to increased sales to our large OEM appliance customer, to whom sales represented approximately 42% and 52% of total net revenues in the three and six months ended March 31, 2003, respectively,
as compared to 76% and 75% of total net revenues in the same periods of fiscal 2002. We expect that OEM appliance sales will continue to grow as sales to our OEM appliance customers continue to increase and as we add additional OEM appliance
customers. We believe that sales through our distribution business will continue to contribute a substantial portion of total quarterly net revenues, but we expect that server appliance sales will constitute a larger portion of total net revenues
than distribution sales for the remainder of fiscal 2003.



Gross profit represents net revenues recognized less the cost of revenues. Cost of revenues includes cost of materials, manufacturing costs, manufacturing personnel expenses, obsolescence charges, packaging and warranty costs. The
quarterly and year-to-date increases in gross profit in the three and six months ended March 31 of fiscal 2003 versus the same periods in fiscal 2002 are primarily due to increased appliance sales volumes, which carry a higher gross profit than
distribution sales. In addition, incremental revenues from our distribution business in the three and six months ended March 31, 2003 contributed to the increase in gross profits versus the same periods in fiscal 2002. To a lesser extent the
increases in gross profit were due to lower manufacturing costs per unit sold as compared to manufacturing costs per unit in the second quarter and six months ended March 31, 2002. To date, our gross profit has been affected by the product mix
within our OEM appliance business and our OEM appliance product pricing as well as the timing, size and configuration of appliance orders. With our newly acquired distribution business, our gross profit was further affected by the relative size of
distribution revenues to server appliance revenues in the second quarter of fiscal 2003 as well as the mix of data storage networking products sold through our distribution business as each of these products carries a different gross profit as a
percentage of revenues. We expect gross profit to continue to be affected by these factors as well as competitive pricing pressure in both the appliance and distribution lines of business.



Operating Expenses



The following table presents operating expenses during the
periods indicated (dollars in thousands):



|                                     |  | Three months ended |   |  | Six months ended  |   
|------------------------------------ |  | ------------------ | - |  | ----------------- | --
|                                     |  | March 31, 2003     |   |  | March 31, 2002    |   
|                                     |  | Dollars            |   |  | % of Net Revenues |   
|Operating Expenses:                  |  |                    |   |  |                   |   
|Research and development             |  | 917                |   |  | 4.7               | % 
|Selling and marketing                |  | 1,564              |   |  | 8.1               | % 
|General and administrative           |  | 1,899              |   |  | 9.8               | % 
|Stock compensation                   |  | 279                |   |  | 1.4               | % 
|Amortization of intangible assets    |  | 254                |   |  | 1.3               | % 
|Restructuring and other charges, net |  | (30                | ) |  | (0.2              | %)
|                                     |  |                    |   |  |                   |   
|Total operating expenses             |  | 4,883              |   |  | 25.1              | % 
|                                     |  |                    |   |  |                   |   



Research and Development. Research and development expenses consist primarily of salaries and related expenses for personnel engaged in research and development, fees paid to consultants and outside service providers, material
costs for prototype and test units and other expenses related to the design, development, testing and enhancements of our products. We expense all of our research and development costs as they are incurred. The decreases in research and development
in the three and six months ended March 31 of fiscal 2003 versus the same periods in fiscal 2002 were due primarily to decreased compensation costs, which decreased as a result of our closure of our Austin, Texas software development center in
December



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2001 and our June 2002 headcount reduction, which together resulted in a reduction in research and
development personnel. These headcount reductions were a result of our transition away from the use of significant proprietary technology in our products. As a result, we have significantly increased the use of standard off-the-shelf technology in
our products, which has decreased our need for engineering personnel in our product design process. Prior to these headcount reductions, we had 30 people in our engineering group. At March 31, 2003, there were 18 employees in research and
development. We believe that a significant level of investment in product development is required to remain competitive and we expect to continue to devote substantial resources to product development. However, based on our engineering process of
utilizing standard, off-the-shelf components in our server appliance hardware platforms, we expect research and development expenses to fluctuate in absolute dollars during the remainder of fiscal 2003 but decrease as a percentage of net revenues,
depending upon actual project activity.



Selling and Marketing. Selling and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged in sales, marketing, business development and customer support functions, as well as
costs associated with public relations and marketing programs. The increases in selling and marketing expenses in the three and six months ended March 31 of fiscal 2003 versus the same periods in fiscal 2002 were due to increased compensation costs
as sales, marketing, business development and customer support personnel increased from 14 employees at March 31, 2002 to 36 employees at March 31, 2003, which was primarily due to our acquisition of TidalWire in December 2002. We expect selling and
marketing expenses to increase in absolute dollars during the remainder of fiscal 2003 as we continue to expand our sales and marketing efforts to further increase our market presence. However, we expect selling and marketing expenses to decrease as
a percentage of net revenues during the remainder of fiscal 2003 due to forecasted revenue growth.



General and Administrative. General and administrative expenses consist primarily of salaries and other related costs for
executive, finance, accounting, information technology, facilities and human resources personnel, as well as accounting, legal, other professional fees, administrative expenses associated with operating as a public company and allowance for doubtful
accounts. The increases in general and administrative expenses in the three and six months ended March 31 of fiscal 2003 versus the same periods in fiscal 2002 are primarily attributable to increased compensation costs as general and administrative
personnel increased from 14 at March 31, 2002 to 22 at March 31, 2003 due to our acquisition of TidalWire in December 2002. The increase in general and administrative expenses in the second quarter of fiscal 2003 versus the second quarter of fiscal
2002 is also due to increased legal costs resulting from our defense of certain legal cases related to our acquisition of TidalWire. To a lesser extent, the increases in general and administrative expenses in the three and six months ended March 31
of fiscal 2003 versus the same periods of fiscal 2002 are due to increased legal, consulting and insurance expenses due to the rising costs associated with our operation as a public company. In addition, in the second quarter of fiscal 2002, we
settled a lawsuit brought against us by a former employee for less than $350,000, which was recorded in general and administrative expenses, which partially offset the increase in general and administrative expenses in the three and six months ended
March 31 of fiscal 2003 versus the same periods of fiscal 2002. We expect general and administrative expenses to remain relatively constant in absolute dollars during the remainder of fiscal 2003 and we expect general and administrative expenses to
decrease as a percentage of revenues during the remainder of fiscal 2003 due to forecasted revenue growth.



Stock Compensation. We recorded deferred stock compensation on our balance sheet of $15.5 million in connection with stock option
and restricted stock grants to our employees and directors that were granted between February 1, 1999 and June 30, 2000. This amount represents the difference between the exercise price and the deemed fair value of our common stock for financial
reporting purposes at the date of grant. We are amortizing this stock compensation over the vesting period of the related options. All options granted subsequent to June 30, 2000 have been issued with exercise prices equal to the fair market value
of our common stock and, accordingly, no additional deferred compensation has been recorded. Through March 31, 2003, we amortized $7.6 million to stock compensation expense and $7.1 million of deferred stock compensation has been reversed due to the
cancellation of options for terminated employees.



We recorded $6.4 million of deferred compensation on our balance sheet as a result of restricted stock issued to the former employees of IP Performance, Inc. (IP Performance). In December 2001, we terminated the
employment of all of the former IP Performance employees. In accordance with the restricted stock agreements, all of the remaining unvested restricted stock vested upon termination. As a result, we recognized the remaining deferred stock
compensation of approximately $3.5 million in December 2001.



In connection with our acquisition of TidalWire, we replaced all of TidalWires outstanding options with options to purchase 1,035,033 shares of our common stock. We recorded approximately $304,000 of deferred stock compensation
on our balance sheet related to unvested options. This amount represents the difference between the exercise price and the fair market value of our common stock on the option conversion date. We are amortizing this deferred stock compensation over
the remaining vesting period of the related options. Through March 31, 2003, we amortized $87,000 to stock compensation expense and $52,000 of deferred stock compensation has been reversed due to the cancellation of options for terminated employees.



The increase in stock compensation expense in
the second quarter of fiscal 2003 versus the second quarter of fiscal 2002 is due to the additional amortization of deferred stock compensation attributable to our acquisition of TidalWire. The decrease in stock compensation expense in the six
months ended March 31, 2003 versus the six months ended March 31, 2002 is due to the



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accelerated amortization of $3.5 million of deferred stock compensation recorded in December 2001 as a
result of our closure of our Austin, Texas development center and the termination of employee stockholders as a result of this facility closure. There was no comparable charge in the six months ended March 31, 2003. We expect quarterly stock
compensation amortization of approximately $245,000 during the remainder of fiscal 2003 and an aggregate of approximately $435,000 thereafter. The amount of stock compensation expense to be recorded in future periods could change if restricted stock
or options for accrued but unvested compensation are forfeited.



Amortization of intangible assets. In connection with our acquisition of TidalWire, we engaged an independent valuation firm to evaluate the intangible assets generated as a result of the acquisition. As a result of this
valuation work, we recorded approximately $5.1 million of intangible assets attributable to TidalWires existing customer relationships as of December 27, 2002. We estimated the useful life of the relationships to be five years and as such, we
are amortizing the related intangible assets on a straight-line basis over five years. We expect quarterly amortization of intangible assets of approximately $254,000 through December 31, 2007.



Restructuring and other charges. In the first quarter
of fiscal 2003, we recorded a charge to operations of $914,000. This charge was comprised entirely of future lease and lease-related payments and resulted from the continued vacancy of certain leased facilities and the expected future vacancy of
certain leased facilities currently occupied by a sub-tenant. This change in estimated sub-lease income and related charge was determined through an analysis of the real estate market in and around these facilities, the likelihood that these
facilities could be leased during the remainder of the existing lease terms and the financial condition of our sub-tenant. In the second quarter of fiscal 2003, we received unanticipated sub-lease income of approximately $30,000 from our existing
sub-tenant. As a result, we recorded a $30,000 reversal of the associated restructuring accrual as a decrease to restructuring and other charges.



Interest and other income, net



Interest and other income, net decreased to $138,000 and $365,000 in the three and six months ended March 31,
2003, respectively, versus $522,000 and $946,000 in the three and six months ended March 31, 2002. This decrease was due to lower average interest rates earned on our cash equivalents and a lower average cash and cash equivalents balance in fiscal
2003 as a result of utilizing cash and cash equivalents to fund net operating losses incurred since March 31, 2002 and to fund our acquisition of TidalWire in December 2002.



Liquidity and Capital Resources



Since fiscal 1997, we have financed our operations primarily
through the sale of equity securities, borrowings and the sale of our products. On July 18, 2000, we completed our initial public offering by selling 7,475,000 shares of common stock, including the exercise of the underwriters over-allotment
option of 975,000 shares, at $17 per share and raised approximately $116.9 million, net of offering costs and underwriting fees totaling approximately $10.2 million. Prior to the initial public offering, we raised approximately $37.3 million, net of
offering costs, from the issuance of preferred stock. As of March 31, 2003, we had $38.8 million in cash and cash equivalents.



Cash used in operating activities was $3.3 million in the six months ended March 31, 2003, which, excluding the effects of TidalWire
assets and liabilities acquired, was primarily due to our net loss of $2.9 million and increases in accounts receivable and inventories and was partially offset by an increase in accounts payable and non-cash charges for depreciation and
amortization and stock compensation. Cash used in operating activities in the six months ended March 31, 2002 was $10.2 million and was primarily due to our net loss of $10.1 million and decreases in the amount due to a former contract manufacturer
and accrued expenses and was partially offset by non-cash charges for stock compensation and depreciation and amortization.



Cash used in investing activities was $4.4 million and $140,000 in the six months ended March 31, 2003 and 2002, respectively. Cash used
in investing activities in the six months ended March 31, 2003 was primarily due to the cash paid as part of our acquisition of TidalWire in December 2002, including transaction costs, and was offset in part by the sale of short-term securities and
refunds and repayments of restricted cash. Cash used in investing activities was primarily due to purchases of property and equipment and changes in other assets during the six months ended March 31, 2002.



Cash used in financing activities was $75,000 and $1.8 million
in the six months ended March 31, 2003 and 2002, respectively. Cash used in financing activities during both periods was primarily for repurchases of common stock under our $5.0 million stock repurchase program and was offset by the collection of
stockholder notes receivable and proceeds from the issuance of common stock through the exercise of employee stock options and our employee stock purchase plan.



In August 2001, the board of directors authorized the repurchase of up to $5.0 million of our common stock
from time to time on the open market or in non-solicited privately negotiated transactions. In November 2002, we completed the stock repurchase program. Through the end of this program, we repurchased approximately 4,594,000 shares of common stock
for



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approximately $4.6 million of cash and repurchased approximately 589,000 shares of common stock in
exchange for the cancellation of approximately $411,000 of stockholder notes receivable.



As a result of the restructurings that we implemented in our fiscal 2001 and 2002 and the three months ended December 31, 2002, we are obligated to make additional cash payments of approximately
$569,000 over the next twelve months and $434,000 thereafter. We anticipate that funds required to make all restructuring payments will be available from our current working capital. We believe that the restructuring actions undertaken during the
three months ended December 31, 2002 will result in reduction of our operating expenses of approximately $168,000 during the remainder of fiscal 2003, approximately $438,000 during fiscal 2004 and approximately $227,000 during fiscal 2005.



In January 2001, we deposited $1.1 million of
cash with a bank to guarantee a personal loan of Lawrence A. Genovesi, our current Chairman and former President, Chief Executive Office and Chief Technology Officer. This guarantee was made in order to avoid significant sales of our stock by Mr.
Genovesi as a result of a margin call on a personal loan collateralized by Mr. Genovesis holdings of the our stock. In conjunction with our guarantee of this loan, we entered into an agreement whereby Mr. Genovesi agreed to reimburse us for
any obligations incurred by us under the guarantee. On January 6, 2003, the bank applied $968,596 of our funds that were on deposit with the bank in satisfaction of all amounts due to the bank from Mr. Genovesi and refunded $83,254 to us. On January
27, 2003, Mr. Genovesi repaid us $974,168 to satisfy his obligations to us in full under the reimbursement agreement. Of that amount, $456,276 was paid in cash and $517,892 was paid with the proceeds from the repurchase by us of 391,128 shares of
our common stock owned by Mr. Genovesi in a private transaction.



During fiscal year 2002, we repurchased 328,572 shares of common stock held by Mr. Genovesi at a cost of $248,000. Of the purchase price, $203,000 was applied against Mr. Genovesis outstanding loans due to Network Engines,
while the remaining $45,000 was paid in cash to Mr. Genovesi. Mr. Genovesi also repaid $15,000 due to us under his remaining outstanding loans. On January 27, 2003, Mr. Genovesi, repaid to us a recourse note payable of $22,500 with proceeds from our
repurchase of 17,070 shares of our common stock owned by Mr. Genovesi.



In April 2001, we entered into five recourse loans with certain of our officers and employees at that time totaling approximately $736,000, which was recorded net of a reserve of $228,000. We entered into these loan
agreements to avoid substantial sales of our common stock by these individuals as a result of their alternative minimum tax obligations incurred as a result of their exercise of common stock options. The loans had an interest rate of 4.63% per year
and were due, as amended, in September 2002. These officers and employees pledged to us all shares of our common stock owned by them, all common stock options held by them and all proceeds received by them on the sale of either our common stock or
common stock options. During fiscal year 2002, we received proceeds from loans principal and interest payments of approximately $30,000; we repurchased 260,777 shares of common stock as repayment for principal and interest for an additional
$267,000. In January 2003, the remaining loans of approximately $489,000 were repaid in full, including accrued interest, through our repurchase of 278,600 shares of our common stock.



The following table sets forth future payments that we are obligated to make under capital and operating
lease commitments as of March 31, 2003 (in thousands):



|                                   |  | Remainder of year ending September 30, 2003 |      | Year ending September 30, |      |    
|---------------------------------- |  | ------------------------------------------- | ---- | ------------------------- | ---- | ---
|Contractual obligations            |  |                                             | 2004 |                           | 2005 |    
|Operating leases                   |  | $                                           | 458  |                           | $    | 916
|Capital leases                     |  |                                             | 3    |                           |      |   
|                                   |  |                                             |      |                           |      |    
|Total contractual cash obligations |  | $                                           | 461  |                           | $    | 916
|                                   |  |                                             |      |                           |      |    



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



| |  | our ability to form an adequate number of strategic partnerships with ISVs, resellers, integrators and suppliers;
|- |  | -----------------------------------------------------------------------------------------------------------------



| |  | our ability to distribute server appliances for software companies through our newly acquired distribution business;
|- |  | --------------------------------------------------------------------------------------------------------------------



| |  | our ability to maintain and increase the revenues from our newly acquired distribution business;
|- |  | ------------------------------------------------------------------------------------------------



| |  | the level of success of our strategic OEM appliance partners in selling server appliance solutions that include our server appliance hardware platforms;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our ability to successfully integrate our recently acquired distribution business into our existing server appliance business;
|- |  | ------------------------------------------------------------------------------------------------------------------------------



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| |  | the costs and timing of product engineering efforts and the success of these efforts; and
|- |  | -----------------------------------------------------------------------------------------



| |  | market developments.
|- |  | --------------------



We believe that our available cash resources, including cash and cash equivalents, together with cash we expect to generate from sales of
our products will be sufficient to meet our operating and capital requirements through at least the next twelve months. After that, we may need to raise additional funds. We may seek to raise additional funds through borrowings, public or private
equity financings or from other sources. There can be no assurance that additional financing will be available at all or, if available, will be on terms acceptable to us. If additional financing is needed and is not available on acceptable terms, we
may need to reduce our operating expenses.



Recent Accounting
Pronouncements



In November 2002, the FASB
issued FASB Interpretation No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57, and 107 and Rescission of FASB
Interpretation No. 34 (FIN 45). FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a
guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. FIN 45 does not prescribe a specific approach for subsequently measuring the guarantors
recognized liability over the term of the related guarantee. It also incorporates, without change, the guidance in FASB Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others, which is being superseded. The
disclosure provisions of FIN 45 are effective for financial statements of interim or annual periods that end after December 15, 2002 and the provisions for initial recognition and measurement are effective on a prospective basis for guarantees that
are issued or modified after December 31, 2002, irrespective of a guarantors year-end. The adoption of FIN 45 did not have a material impact on our financial position or results of operations.



In November 2002, the Emerging Issues Task Force of the FASB
reached a consensus on Issue 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (EITF 00-21). EITF 00-21 requires that for revenue arrangements with multiple deliverables, those deliverables be divided into
separate units of accounting if the deliverables meet certain criteria as defined by EITF 00-21. Arrangement consideration is to be allocated among the separate units of accounting based on their relative fair values and revenue recognition
decisions should be considered separately for each separate unit of accounting. EITF 00-21 is effective for all arrangements entered into in fiscal periods beginning after June 15, 2003, with early adoption permitted. We are currently evaluating the
scope of EITF 00-21 we do not expect the adoption of EITF 00-21 to have a material impact on our financial position or results of operations.



FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS



The risks and uncertainties described below are not the only ones we are faced with. Additional risks and
uncertainties not presently known to us, or that are currently deemed immaterial, may also impair our business operations. If any of the following risks actually occur, our financial condition and operating results could be materially adversely
affected.



Risks of dependence on one
strategic partner.



We derive a
significant portion of our revenues from one customer, and our revenues may decline significantly if this customer cancels or delays purchases of our products, terminates their contract with us, or exercises certain of their other rights under the
terms of the contract.



In the three and six
months ended March 31, 2003, one customer accounted for 42% and 52% of our total net revenues, respectively. Under the terms of a non-exclusive contract with this customer, the customer has the right to enter into agreements with other parties for
similar products, the customer is not obligated to purchase any minimum quantity of products from us and the customer may choose to stop purchasing from us at any time. In addition, the customer may terminate the agreement in the event that we
attempt to assign its rights under the agreement to another party without the customers prior approval. Furthermore, in the event that we default on certain portions of the agreement and do not cure during the prescribed cure period, the
customer may obtain the right to manufacture the products defined in the agreement in exchange for a mutually agreeable royalty fee. If any of these events were to occur, or if this customer delays purchases of our products, our revenues and
operating results would be adversely affected, our reputation in the industry may suffer and our ability to predict cash flow accurately would decrease.



Our distribution business relies on reference sales originating from our largest customer and our business would suffer if we lost
these reference sales.



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A significant
portion of our distribution revenues are derived from reference sales of products, which are approved for configuration in the data storage networks sold by our largest customer. We are one of two North American distributors that this customer
refers its customers to for the supply of data storage network components that have been authorized for use in this customers data storage networks. We expect this to continue in the future. These reference sales have historically had a higher
margin and have represented a substantial amount of TidalWires revenues as compared to revenues from other sales. If we were to lose these reference sales or if the margins we derive from such sales were reduced to any significant degree, our
results of operations and financial condition would suffer.



Risks related to the integration of TidalWire.



On December 27, 2002, we completed our acquisition of TidalWire. If we are not able to successfully integrate TidalWire into our operations, our revenues and operating results may be adversely
affected.



The integration of TidalWire into
our operations involves a number of risks, including:



| |  | difficulty integrating TidalWires operations and personnel;
|- |  | ------------------------------------------------------------



| |  | diversion of management attention;
|- |  | ----------------------------------



| |  | potential disruption of ongoing business;
|- |  | -----------------------------------------



| |  | inability to retain key personnel;
|- |  | ----------------------------------



| |  | inability to successfully incorporate TidalWires products and services into our product and service offerings and to develop new products and services; and
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | impairment of relationships with employees, customers or vendors.
|- |  | -----------------------------------------------------------------



Failure to successfully integrate TidalWire into our operations may adversely affect our revenues and
operating results.





Risks related to business strategy.



If we fail to form a significant enough number of strategic partnerships with independent software vendors, we may be unable to
generate significant sustainable revenues and our operations could be materially adversely affected and, as a result, we may choose to discontinue one or more of the components of our business strategy.



A major component of our business strategy is to focus our
sales and marketing efforts on indirect sales through strategic partnerships with independent software vendors (ISVs). To date, we have not entered into a significant number of definitive agreements with ISVs. As a result of acquiring
TidalWire, we can now offer distribution to our ISV partners. We believe this capability will attract additional ISVs. However, we may not be able to develop a significant number of strategic partnerships with ISVs and, even if we are successful in
developing strategic partnerships with ISVs, this strategy may fail to generate sufficient revenues to offset the demands that this strategy will place on our business. A failure to generate significant revenues from strategic partnerships could
materially adversely affect our operations and, as a result, we may choose to discontinue one or more of the components of our business strategy.



We plan to increase the number of resellers we support and to add additional data storage networking products to our distribution
product line. If we fail to increase the number of resellers or fail to add additional products to our distribution product line, our revenues and operating results may be adversely affected.



Historically, TidalWire has grown its business by increasing
the number of its reseller and system integrator partners and by increasing the number of data storage networking products it supports. We believe that, in order to continue to grow this distribution business, we must add additional reseller and
system integrator partners and to further expand the products offered. If we fail to increase the number of resellers or fail to add additional products to our distribution product line, our revenues and operating results may be adversely affected.



In addition to the data storage market, we
plan to focus our sales and marketing efforts in the network security market. If we are not successful in expanding in this market, our revenue growth may be limited and our operating results may be adversely affected.



With a substantial amount of our server appliance business
heavily concentrated in our large OEM data storage customer and TidalWires current business of distributing storage connectivity products, we believe we have established a good working knowledge of the data storage market. As we try to expand
into the network security market, it may take us longer to establish



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strategic partnerships in this markets due to our lack of experience in the network security market. If we
are not successful in expanding in this market, our revenue growth may be limited and our operating results may be adversely affected.



We changed our server appliance product strategy during fiscal 2001. There can be no assurance that the change in our product strategy
will have the intended effect on our business.



Our server appliance product strategy is to concentrate resources on our core competencies, which we believe to be hardware platform packaging and the ability to integrate hardware platforms with various operating systems, management
systems and application software systems. This strategy includes a transformation of our product development process from one requiring significant proprietary hardware development to one of integrating and customizing off-the-shelf
technologies based on standard third party hardware platforms. There can be no assurance that our server appliance product strategy will have a positive effect on operations, market share, the market price of our common stock or public perception of
us in the server appliance marketplace, or that we will ever achieve substantial revenues or profitability.



Risks related to the server appliance, data storage and network security markets.



If server appliances are not increasingly adopted as a
solution to meet companies computer application needs, the market for our server appliance products may not grow and the market price of our common stock could decline as a result of lower revenues or reduced investor expectations.



We expect that a substantial portion of our
revenues will come from sales of server appliance platforms and customized integration services and, eventually, the sale of server appliances through our distribution channel. As a result, we depend on the growing use of server appliances to meet
businesses storage and security network application needs. The market for server appliance products has only recently begun to develop and we believe it is evolving rapidly. Because this market is new, we cannot predict its potential size or
future growth rate with a high degree of certainty. Our revenues may not grow and the market price of our common stock could decline if the server appliance market does not grow rapidly.



We believe that our expectations for the growth of the server appliance market may not be fulfilled if
customers continue to use general-purpose servers. The role of our products could, for example, be limited if general-purpose servers become better at performing functions currently being performed by server appliances or are offered at a lower
cost. This could force us to further lower the prices of our products or result in fewer sales of our products.



Server appliance products are subject to rapid technological change due to changing operating system software and network hardware and
software configurations, and our server appliance sales will suffer if our server appliance products are rendered obsolete by new technologies.



The server appliance market is characterized by rapid technological change, frequent new product introductions and enhancements,
potentially short product life cycles, changes in customer demands and evolving industry standards. We attempt to mitigate these risks by utilizing standards-based hardware platforms and by maintaining an adequate knowledge base of available
technologies. However, our server appliance products could be rendered obsolete if products based on new technologies are introduced or new industry standards emerge and we are not able to incorporate these technological changes into our products.



Our future success depends upon our ability to
utilize our creative packaging and hardware and software integration skills to combine industry-standard hardware and software to produce low-cost, high-performance server appliance products that satisfy our strategic partners requirements and
achieve market acceptance. We cannot be certain that we will successfully identify new product opportunities and develop and bring new products to market in a timely and cost-effective manner.



The cyclical nature of the data storage industry could
hurt our operating results.



The data
storage industry has historically been characterized by fluctuations in product demand and supply, and, consequently, severe fluctuations in price. Over the past year, the industry in which our newly acquired distribution business operates has
experienced a significant downturn in demand and excess production levels. Although our distribution agreements with manufacturers provide us with limited price protection and certain rights of return, any shortfalls in demand and excess production
could hurt our distribution sales and gross margins. If any such shortfalls in demand and excess production were to continue for a prolonged period of time, our results of operations would be adversely affected. In addition, many of our reseller and
system integrator customers in the data storage industry are subject to the risks of significant shifts in demand and severe price pressures by their customers, which may increase the risk that we may not be able to collect accounts receivable owed
by some of our customers. If we are unable to collect accounts receivable, our results of operations and financial condition may suffer.



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If the data
storage industry experiences significant unit volume growth that, in turn, results in increased demand for many of the products we distribute, we may experience a shortage of our products. In such event, our operating results may depend on the
amount of product allocated to us by manufacturers and the timely receipt of such product.



Data storage and network security products are subject to rapid technological change and our distribution sales will suffer if the products that we currently distribute, or if our newest or future
products, are rendered obsolete by new technologies.



The data storage and network security markets are characterized by rapid technological change, frequent new product introductions and enhancements, potentially short product life cycles, changes in customer demands and evolving
industry standards. If data storage vendors develop products that incorporate the functionality of the data storage components that we distribute, the marketability of the products that we distribute will suffer and our distribution sales will be
materially affected. We do not have extensive experience in the network security market and if we are unable to provide the appropriate products for the network security market, our distribution sales will suffer.



Risks related to competition.



If we are not able to effectively compete against
providers of general-purpose servers, specific-purpose servers or other server appliance providers, our server appliance revenues will not increase and may decrease.



In the server appliance market, we face significant competition from a number of different types of
companies. Our competitors include companies who market general-purpose servers, specific-purpose servers and server appliances as well as companies that sell custom integration services utilizing hardware produced by other companies. Many of these
companies are larger than we are and have greater financial resources and name recognition than we do as well as significant distribution capabilities and larger, more established service organizations to support their products. Our large
competitors may be able to leverage their existing resources, including their extensive distribution capabilities and their service organizations, to provide a wider offering of products and services as well as higher levels of support on a more
cost-effective basis than we can. In addition, competing companies may be able to undertake more extensive promotional activities, adopt more aggressive pricing policies and offer more attractive terms to their customers than we can. If our
competitors provide lower cost solutions with greater functionality or support than our products, or if some of their products are comparable to ours and are offered as part of a range of products that is broader than ours, our products could become
undesirable. Even if the functionality of competing products is equivalent to ours, we face a substantial risk that a significant number of customers would elect to pay a premium for similar functionality rather than purchase products from a
less-established vendor. We attempt to differentiate ourselves from our competition by offering a wide variety of software integration, branding, supply-chain management, distribution and fulfillment services. If we are unable to effectively
differentiate our products from those of our competition, our revenues will not increase and may decline. Furthermore, increased competition could negatively affect our business and future operating results by leading to price reductions, higher
selling expenses and a reduction in our market share.



The data storage and network security markets are highly competitive and competition could reduce our market share and harm our ability to sell the products we currently offer or may offer in the future.



The data storage industry is highly competitive. As a result
of our acquisition of TidalWire, we now compete against a variety of third parties including other commercial distributors of data storage products. As we enter the network security market, the number of companies that we compete with will increase.
Some of our current and future competitors have significantly greater financial, technical, marketing, distribution and other resources than we do and may be able to respond more quickly than us to new or emerging technologies and changes in
customer requirements, which could reduce our market share. These competitors may also establish or strengthen cooperative relationships with our key customers and other parties with whom we have strategic relationships, which could harm our ability
to distribute our current and future products.



Our revenues could be negatively affected if our larger competitors make acquisitions in order to join their extensive distribution capabilities with our smaller competitors products.



Large server manufacturers may not only develop their own
server appliance solutions, but they may also acquire or establish cooperative relationships with our smaller competitors, including smaller private companies. Because large server manufacturers have significant financial and organizational
resources available, they may be able to quickly penetrate the server appliance market by leveraging the technology and expertise of smaller companies and utilizing their own extensive distribution channels. We expect that the server industry will
experience further consolidation. It is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share through consolidation. Consolidation within the server marketplace could adversely affect
our revenues.



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We may
sell fewer products if other vendors products are no longer compatible with our products or other vendors bundle their products with those of our competitors and sell them at lower prices.



Our ability to sell our products depends in part on the
compatibility of our products with other vendors software and hardware products. Developers of these products may change their products so that they will no longer be compatible with our products. These other vendors may also decide to bundle
their products with other server appliances for promotional purposes and discount the sales price of the bundle. If that were to happen, our business and future operating results could suffer if we were no longer able to offer commercially viable
products.



Risks related to financial
results.



We have a history of losses
and may continue to experience losses in the future, which could result in the market price of our common stock declining further.



Since our inception, we have incurred significant net losses and we may continue to have net losses in the future. At March 31, 2003, we
had an accumulated deficit of $110.4 million. We believe that any future growth will require us to incur significant engineering, selling and marketing and administrative expenses. As a result, we will need to generate significant revenues to
achieve profitability. We cannot be certain that we will achieve profitability in the future or, if we achieve profitability, that we will be able to sustain it. If we do not achieve and maintain profitability, the market price for our common stock
may decline.



Our quarterly revenues and
operating results may fluctuate, which could cause our operating results to fall below expectations and cause the market price of our common stock to decline.



Our quarterly revenues and operating results are difficult to predict and may fluctuate significantly from
quarter to quarter. None of our customers are obligated to purchase any quantity of our products in the future. Our operating expense levels are based in part on expectations of future revenues. If revenues or gross margins in a particular quarter
do not meet expectations, operating results 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 customer;
|- |  | --------------------------------------------------------------------------------



| |  | the loss of key manufacturers or customers;
|- |  | -------------------------------------------



| |  | the mix of server appliance revenues and distribution revenues and the product mix within each;
|- |  | -----------------------------------------------------------------------------------------------



| |  | the ability to expand our production capacity;
|- |  | ----------------------------------------------



| |  | the availability of products from manufacturers;
|- |  | ------------------------------------------------



| |  | price competition;
|- |  | ------------------



| |  | changing economic conditions in North America; and
|- |  | --------------------------------------------------



| |  | the timing of expenditures in anticipation of increased revenues.
|- |  | -----------------------------------------------------------------



If the commoditization of products and competition in the server appliance market increases, then our
gross profit as a percentage of net revenues may decrease and our operating results may suffer.



Products and services in the server appliance market may be subject to further commoditization as the industry matures and other
businesses introduce more competing products and services. The gross margin as a percentage of revenues of our products is already low, and may not grow to our targeted gross margin percentages or may even decrease, in response to changes in our
product mix, competitive pricing pressures, or new product introductions into the server appliance marketplace. If we are unable to offset decreases in our gross margins as a percentage of revenues by increasing our sales volumes, operating results
will decline. Changes in the mix of sales of our products, including the mix of higher margin sales of products sold in smaller quantities and somewhat lower margin sales of products sold in larger quantities, could adversely affect our operating
results for future quarters. To maintain our gross margins, we also must continue to reduce the manufacturing cost of our server appliance products. Our efforts to produce higher margin products, continue to improve our products and produce new
server appliance products may make it difficult to reduce our manufacturing cost per product. Further, utilization of a contract manufacturer may not allow us to reduce our cost per product.



Risks related to marketing and sales efforts.



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We need to
effectively manage our sales and marketing operations to increase market awareness and sales of our products and to promote our brand recognition. If we fail to do so, our growth will be limited.



Although we have a relatively small selling and marketing
organization, we must continue to increase market awareness and sales of our products. In the fast growing market for server appliance solutions, we believe that we need software companies to recognize Network Engines as a top-tier provider of
server appliance platforms, custom integration services and server appliance distribution services to compete successfully. In the market for storage connectivity and network security products, we believe that we need resellers and integrators to
recognize TidalWire as a leading value-added distributor of these products. If we are unable to design and implement effective marketing campaigns or otherwise fail to promote and maintain the Network Engines and TidalWire brands, our sales may not
increase and our business may be adversely affected. Our business may also suffer if we incur excessive expenses promoting and maintaining these brands but fail to achieve the expected or desired increase in revenues.



If we are unable to effectively manage our customer service
and support activities, we may not be able to retain our existing customers and attract new customers.



We need to effectively manage our customer support operations to ensure that we maintain good relationships with our customers. If our
customer support organization is unsuccessful in maintaining good customer relationships, we may lose customers to our competitors and our reputation in the market could be damaged. As a result, we may lose revenue and incur losses greater than
expected.



Risks related to product
manufacturing.



Our dependence on
sole source and limited source suppliers for key components makes us susceptible to supply shortages that could prevent us from shipping customer orders on time, if at all, and could result in lost sales or customers.



We depend upon single source and limited source suppliers for
our industry-standard processors, main logic boards, certain disk drives, and power supplies as well as our internally developed heat-pipe, chassis and sheet metal parts. We also depend on limited sources to supply several other industry-standard
components. We have in the past experienced, and may in the future experience, shortages of or difficulties in acquiring components needed to produce our products. Shortages have been of limited duration and have not yet caused material delays in
production of our products. However, shortages in supply of these key components for an extended time would cause delays in the production of our products, prevent us from satisfying our contractual obligations and meeting customer expectations, and
result in lost sales or customers. If we are unable to buy components that we need or if we are unable to buy components at acceptable prices, we will not be able to manufacture and deliver our products on a timely or cost-effective basis to our
customers.



Our future success is dependent on
our ability to expand production capacity.



Our existing manufacturing facility is limited in its production capacity. For us to be successful our product sales volumes must increase significantly. Our production capacity must increase to support significant increases in
product sales volumes. In order to increase our production capacity, we may have to utilize the services of a contract manufacturer to produce our products at high volumes. We may have difficulties in identifying and engaging a contract manufacturer
to produce our products with terms that are favorable to us. Using a contract manufacturer may increase the cost of producing products and we could experience transitional difficulties including production delays and quality control issues, which
could cause customer relationships to suffer and result in lost sales. Also, the use of a contract manufacturer may not guarantee us production levels, manufacturing line space or manufacturing prices, which could interrupt our business operations
and have a negative effect on operating results.



If we do not accurately forecast our component and product requirements, our business and operating results could be adversely affected.



We use rolling forecasts based on anticipated product orders to determine our component requirements. Lead
times for materials and components that we order vary significantly and depend on factors including specific supplier requirements, contract terms and current market demand for those components. In addition, a variety of factors, including the
timing of product releases, potential delays or cancellations of orders and the timing of large orders, make it difficult to predict product orders. As a result, our component requirement forecasts may not be accurate. If we overestimate our
component requirements, we may have excess inventory, which would increase costs and negatively impact our cash position. If we underestimate our component requirements, we may have inadequate inventory, which could interrupt our manufacturing and
delay delivery of our products to customers. Any of these occurrences would negatively impact our business and operating results.



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Our storage
distribution business is dependent on certain manufacturers and our business would suffer if we lost any significant manufacturer or faced a product shortage.



Our storage distribution business, is highly dependent on manufacturers for substantially all of the products
that it sells. A small number of manufacturers provided products that historically represented a significant majority of TidalWires storage distribution sales. The loss of any significant manufacturer could harm our financial condition and
results of operations. Our storage distribution agreements are cancelable on short notice. Our reliance on a small number of manufacturers for our storage distribution business leaves us vulnerable to having an inadequate supply of required
products, price increases, late deliveries and poor product quality. Historically, from time to time TidalWire, like other distributors in its industry, has experienced supply shortages and was unable to purchase its desired volume of products. If
we are unable to enter into and maintain satisfactory distribution arrangements with leading manufacturers and an adequate supply of products, our revenues could suffer considerably.



Risks related to product dependence on intellectual property and use of the Network Engines and
TidalWire brands.



Our reliance upon
contractual provisions, domestic patent, copyright and trademark laws and applied-for patents to protect our proprietary rights may not be sufficient to protect our intellectual property from others who may sell similar products.



Certain of our products are differentiated from those of our
competitors by our internally developed software and hardware and the manner in which they are integrated into our products. If we fail to protect our intellectual property, other vendors could sell products with features similar to ours, and this
could reduce demand for our products. We believe that the steps we have taken to safeguard our intellectual property afford only limited protection. Others may develop technologies that are similar or superior to our technology or design around the
copyrights and trade secrets we own. Despite the precautions we have taken, laws and contractual restrictions may not be sufficient to prevent misappropriation of our technology or deter others from developing similar technologies. In addition,
there can be no guarantee that any of our patent applications will result in patents, or that any such patents would provide effective protection of our technology.



In addition, the laws of the countries in which we decide to market our services and solutions may offer
little or no effective protection of our proprietary technology. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technology could enable third-parties to benefit from our technology without paying us for it,
which would significantly harm our business.



We have invested substantial resources in developing our server appliance products and the Network Engines brand, and our operating results would suffer if we were subject to a protracted infringement claim or one that resulted in
a significant damages award.



Substantial
litigation regarding intellectual property rights and brand names exists in the server appliance industry. We expect that server appliance products may be increasingly subject to third-party infringement claims as the number of competitors in the
industry segment grows and the functionality of products in different industry segments overlaps. From time to time we receive claims from third parties that our products have infringed their intellectual property rights. We do not believe that our
products employ technology that infringes any proprietary rights of third parties. However, third parties may make claims that we have infringed upon their proprietary rights. Any claims, with or without merit, could:



| |  | be time-consuming to defend;
|- |  | ----------------------------



| |  | result in costly litigation, including potential liability for damages;
|- |  | -----------------------------------------------------------------------



| |  | divert our managements attention and resources;
|- |  | ------------------------------------------------



| |  | cause product shipment delays; or
|- |  | ---------------------------------



| |  | require us to enter into royalty or licensing agreements.
|- |  | ---------------------------------------------------------



Royalty or licensing agreements may not be available on terms acceptable to us, if at all. A successful claim of product infringement
against us or the failure or inability to license the infringed or similar technology could adversely affect our business because we would not be able to sell the impacted product without redeveloping it or incurring significant additional expenses.



Other risks related to our business.



A disruption in the operations of
our distribution center could have a material adverse effect on our financial condition and results of our operations.



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Our
distribution center in Memphis, Tennessee handles much of the distribution of the products of our newly acquired data storage distribution business. This distribution center, and thus our distribution operations are vulnerable to damage or
interruption from fire, flood, power loss, break-ins and similar events. We have no formal disaster recovery plan, however, we believe that we have the ability to mitigate this risk through alternative means of delivering our distribution products
to our customers. The occurrence of unanticipated problems at the distribution center, all of which may not be covered by insurance, could cause interruptions or delays in our data storage distribution business, which would have a material adverse
effect on our financial condition and results of operations.



Class action lawsuits have been filed against us, our board of directors, our chairman and one of our executive officers.



On or about December 3, 2001, a class action lawsuit relating to our initial public offering was filed against us, our chairman, one of
our executive officers and the underwriters of our initial public offering. In addition, on or about January 7, 2003, a purported class action lawsuit was filed against us and our board of directors relating to the acquisition of TidalWire Inc. We
are unable to predict the effects of these suits, or other similar suits, on our financial condition and business and, although we maintain certain insurance coverage, there can be no assurance that these claims will not result in substantial
monetary damages in excess of such insurance coverage. In addition, we may expend significant resources to defend these cases. These class action lawsuits, or other similar suits, could negatively impact both our financial condition and the market
price of our common stock.



If our products
fail to perform properly and conform to specifications, our customers may demand refunds or assert claims for damages and our reputation and operating results may suffer.



Because our server appliance hardware platforms are complex, they could contain errors that can be detected
at any point in a products life cycle. In the past we have discovered errors in some of our products and have experienced delays in the shipment of our products during the period required to correct these errors or we have had to replace
defective products that were already shipped. These delays and replacements have principally related to new product releases. Errors in our products may be found in the future and any of these errors could be significant. Detection of any
significant errors may result in:



| |  | the loss of or delay in market acceptance and sales of our products;
|- |  | --------------------------------------------------------------------



| |  | diversion of engineering resources;
|- |  | -----------------------------------



| |  | injury to our reputation; or
|- |  | ----------------------------



| |  | increased maintenance and warranty costs.
|- |  | -----------------------------------------



These problems could harm our business and future operating results. Product errors or delays could be material, including any product
errors or delays associated with the introduction of new products or the versions of our products that support Windows or UNIX-based operating systems. While we attempt to limit our risk contractually, if our products fail to conform to warranted
specifications, customers could demand a refund for the purchase price or assert claims for damages.



Moreover, because our products may be used in connection with critical computing systems services, we may receive significant liability
claims if our products do not work properly. Our agreements with customers typically contain provisions intended to limit our exposure to liability claims. However, these limitations may not preclude all potential claims. Liability claims could
exceed our insurance coverage and require us to spend significant time and money in litigation or to pay significant damages. Any claims for damages, even if unsuccessful, could seriously damage our reputation and business.



If we fail to retain appropriate levels of qualified
technical personnel, we may not be able to develop and introduce our products on a timely basis.



We require the services of qualified technical personnel. We have experienced the negative effects of an economic slowdown. In the past,
we have experienced significant declines in our revenues and, since our fiscal year ended September 30, 2000 the market price of our common stock has decreased significantly. As a result, we have implemented various personnel reductions, which have
placed added pressure on the remaining employees and management. These and other factors may make it difficult for us to retain the qualified employees and management that we need to effectively manage our business operations, including key
engineering activities. If we are unable to retain a sufficient number of technical personnel we may not be able to complete development of, or upgrade or enhance, our products in a timely manner or successfully integrate our ISV Partners
software with our hardware platforms, which could negatively impact our business and could hinder any future growth.



Our stock may be subject to substantial price and volume fluctuations due to a number of factors, many of which will be beyond our
control that may prevent our stockholders from reselling our common stock at a profit.



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The
securities markets have experienced significant price and volume fluctuations in the past and the market prices of the securities of technology companies have been especially volatile. This market volatility, as well as general economic, market or
political conditions, could reduce the market price of our common stock in spite of our operating performance. In addition, our operating results could be below the expectations of public market analysts and investors, and in response, the market
price of our common stock could decrease significantly. Investors may be unable to resell their shares of our common stock for a profit. In the past, companies that have experienced volatility in the market price of their stock have been the object
of securities class action litigation. If we were the object of securities class action litigation, it could result in substantial costs and a diversion of managements attention and resources. The decline in the market price of our common
stock and market conditions generally could adversely affect our ability to raise additional capital, to complete future acquisitions of or investments in other businesses and to attract and retain qualified technical and sales and marketing
personnel.



Future sales by existing
stockholders could depress the market price of our common stock.



Sales of a substantial number of shares of our common stock by existing stockholders could depress the market price of our common stock and impair our ability to raise capital through the sale of additional equity
securities.



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



The market price of our common stock has declined since our fiscal year 2000 and at times was less than $1.00
per share. If we are unable to meet the stock price listing requirements of NASDAQ, our common stock could be de-listed from the NASDAQ National Market. If our common stock were de-listed from the NASDAQ National Market, among other things, this
could result in a number of negative implications, including reduced liquidity in our common stock as a result of the loss of market efficiencies associated with NASDAQ and the loss of federal preemption of state securities laws as well as the
potential loss of confidence by suppliers, customers and employees, the loss of analyst coverage and institutional investor interest, fewer business development opportunities and greater difficulty in obtaining financing.



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



Our board of directors has the authority to issue up to 5,000,000 shares of preferred stock and, without any further vote or action on the part of the stockholders, will have the authority to determine
the price, rights, preferences, privileges and restrictions of the preferred stock. This preferred stock, if issued, might have preference over the rights of the holders of common stock and could adversely affect the price of our common stock. The
issuance of this preferred stock may make it more difficult for a third party to acquire us or to acquire a majority of our outstanding voting stock. We currently have no plans to issue preferred stock.



In addition, provisions of our second amended and restated
certificate of incorporation, second amended and restated by-laws and equity compensation plans may deter an unsolicited offer to purchase us. These provisions, coupled with the provisions of the Delaware General Corporation Law, may delay or impede
a merger, tender offer or proxy contest involving us. For example, our board of directors is divided into three classes, only one of which is elected at each annual meeting. These factors may further delay or prevent a change of control of our
business.



If we do not retain our senior
management, we may not be able to successfully execute our business plan.



As a result of past restructurings, we have lost members of our management team. The loss of key members of our current management team could harm us. Our success is substantially dependent on the
ability, experience and performance of our senior management team. Because of their ability and experience, we may not be able to implement successfully its business strategy if we were to lose one or more of these individuals.



We may need additional capital that may not be available to
us and, if raised, may dilute our existing investors ownership interests.



We may need to raise additional funds to develop or enhance our services and solutions, to fund expansion, to respond to competitive pressures or to acquire complementary products, businesses or
technologies. Additional financing may not be available on terms that are acceptable to us. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders would be reduced and
these securities might have rights, preferences and privileges senior to those of our current stockholders. If adequate funds are not available on acceptable terms, our ability to fund expansion, take advantage of unanticipated opportunities,
develop or enhance products or services, or otherwise respond to competitive pressures would be significantly limited.



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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



We do not engage in any foreign currency hedging transactions and therefore, do not believe we are subject to material exchange rate risk. We are exposed to market risk related to changes in interest
rates. We invest excess cash balances in cash equivalents and as a result, we believe that the effect, if any, of reasonably possible near-term changes in interest rates on our financial position, results of operations and cash flows will not be
material.



ITEM 4. CONTROLS AND PROCEDURES



(a) Evaluation of disclosure controls and procedures. Based on their evaluation of the Companys disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934)
as of a date within 90 days of the filing date of this Quarterly Report on Form 10-Q, the Companys chief executive officer and chief financial officer have concluded that the Companys disclosure controls and procedures are designed to
ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms and
are operating in an effective manner.



(b)
Changes in internal controls. There were no significant changes in the Companys internal controls or in other factors that could significantly affect these controls subsequent to the date of their most recent evaluation.



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PART IIOTHER
INFORMATION



ITEM 1. LEGAL PROCEEDINGS



On or about December 3, 2001, a putative class action lawsuit was filed in the United States District Court for the Southern District of New York against Network Engines, Lawrence A. Genovesi (our Chairman and former Chief Executive
Officer), Douglas G. Bryant (our Chief Financial Officer and Vice President of Administration), and the following underwriters of our initial public offering: FleetBoston Robertson Stephens, Inc., Credit Suisse First Boston Corp., Goldman Sachs
& Co., Lehman Brothers Inc. and Salomon Smith Barney, Inc. (collectively, the Underwriter Defendants). An amended class action complaint, captioned In re Network Engines, Inc. Initial Public Offering Securities Litigation, 01 Civ.
10894 (SAS), was filed on April 20, 2002.



The
suit alleges that the defendants violated the federal securities laws by issuing and selling securities pursuant to the Companys initial public offering in July 2000 (IPO) without disclosing to investors that the Underwriter
Defendants had solicited and received excessive and undisclosed commissions from certain investors. The suit also alleges that the Underwriter Defendants entered into agreements with certain customers whereby the Underwriter Defendants agreed to
allocate to those customers shares of the Companys stock in the offering, in exchange for which the customers agreed to purchase additional shares of the Companys shares in the aftermarket at pre-determined prices. The suit alleges that
such tie-in arrangements were designed to and did maintain, distort and/or inflate the price of the Companys Common Stock in the aftermarket. The suit further alleges that the Underwriter Defendants received undisclosed and excessive brokerage
commissions and that, as a consequence, the Underwriter Defendants successfully increased investor interest in the manipulated IPO securities and increased the Underwriter Defendants individual and collective underwritings, compensation and
revenues. The suit seeks damages and certification of a plaintiff class consisting of all persons who acquired shares of Network Engines common stock between July 13, 2000 and December 6, 2000.



In July 2002, Network Engines, Lawrence A. Genovesi and
Douglas G. Bryant joined in an omnibus motion to dismiss challenging the legal sufficiency of plaintiffs claims. The motion was filed on behalf of hundreds of issuer and individual defendants named in similar lawsuits. Plaintiffs opposed the
motion, and the Court heard oral argument on the motion in November 2002. On February 19, 2003, the Court issued an opinion and order denying the motion as to the Company and the case may now proceed to discovery. In addition, in October 2002,
Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this case without prejudice.



We are unable to predict the outcome of this suit and its ultimate effect, if any, on our financial condition; however, our defense against this suit could result in the expenditure of significant
financial and managerial resources.



A purported
class action and derivative lawsuit was filed on January 7, 2003 in the Court of Chancery in the State of Delaware against Network Engines and its Board of Directors relating to the acquisition of TidalWire Inc. The plaintiffs in the complaint
allege that the Company and its Board of Directors breached their fiduciary duties by, among other things, paying an excessive amount in the acquisition of TidalWire and purportedly failing to disclose material facts in the Companys Joint
Proxy Statement/Information Statement distributed to stockholders for approval of the issuance of shares of Network Engines in the merger. The plaintiffs are seeking damages, rescission of the merger and other relief. On February 10, 2003, the
Company and the individual defendants filed a motion to dismiss the Complaint for failure to state a claim on which relief could be granted, and related relief. The parties are in the process of briefing the motion. The Court has scheduled a hearing
on the motion in June 2003. The Company believes that it has highly meritorious defenses and intends to vigorously defend against the suit, but given the early stage of the proceedings, the Company cannot predict the ultimate outcome of the
litigation.



ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS



(c) Sales of Unregistered Securities



During the three months ended March 31, 2003, the Company did not issue any unregistered securities.



(d) Use of Proceeds from Sales of Registered Securities



On July 18, 2000, the Company sold 7,475,000 shares of common stock in an initial public offering at a price
of $17.00 per share pursuant to a Registration Statement on Form S-1 (the Registration Statement) (Registration No. 333-34286), which was declared effective by the Securities and Exchange Commission on July 12, 2000. The managing
underwriters of the initial public offering were Donaldson, Lufkin & Jenrette, Dain Rauscher Wessels, Robertson Stephens and DLJdirect Inc. The offering terminated upon the sale of all of the securities registered. The aggregate proceeds to the
Company from the offering were approximately $116.9 million reflecting gross proceeds of $127.0 million net of underwriting fees of approximately $8.9 million and other offering costs of approximately $1.3 million.



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During the
period from the offering through March 31, 2003, the Company has used the proceeds as follows: approximately $56.4 million was used to fund the operations of the Company, approximately $5.1 million was used for the purchase of property and
equipment, approximately $4.6 million was used to repurchase the Companys Common Stock under a stock repurchase plan and approximately $13.2 million for the Companys acquisition of TidalWire Inc. Of the $13.2 million of proceeds used to
acquire TidalWire, $3,350,443 was paid to Ascent Venture Partners (together with its affiliated entities, Ascent) and HarbourVest Partners (together with its affiliated entities, HarbourVest), two substantial stockholders of
the Company. At the time of the acquisition, Ascent and HarbourVest owned approximately 18.1% and 16.3% of the outstanding common stock of the Company, respectively. Ascent and HarbourVest also owned 12.9% and 24.9% of the outstanding common stock
of TidalWire, respectively. Pursuant to the terms of the merger agreement, the Company paid Ascent and HarbourVest $1,144,615 and $2,205,828, respectively, in exchange for their shares of TidalWire common stock. Furthermore, the proceeds paid to
Ascent and HarbourVest may be deemed to be indirect payments to Frank M. Polestra and Robert M. Wadsworth, two of the Companys directors. As a managing member or general partner of each of the general partners that control Ascent, Mr. Polestra
may be deemed to have indirectly received the $1,144,615 of proceeds paid to Ascent. As a managing director of the limited liability corporation that controls HarbourVest, Mr. Wadsworth may be deemed to have indirectly received the $2,205,828 of
proceeds paid to HarbourVest.



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



The Companys Annual Meeting of Stockholders was held on March 12, 2003. Of the 33,995,512 shares outstanding as of January 17, 2003 (the record date), 25,729,014 (75.7%) were present or
represented by proxy at the meeting. The table below presents the voting results of the matters voted upon by the Companys stockholders at the meeting:



|Proposal I  election to the Companys board of directors: |  |                |  |                  
|---------------------------------------------------------- |  | -------------- |  | -----------------
|John A. Blaeser                                            |  | 23,792,947 For |  | 1,936,067 Against
|Lawrence A. Genovesi                                       |  | 23,722,910 For |  | 2,006,104 Against
|Robert M. Wadsworth                                        |  | 23,773,431 For |  | 1,955,583 Against



The terms of John H.
Curtis, Frank M. Polestra, Fontaine K. Richardson and Dennis Kirshy, as directors of the Company, continued after this meeting.



|Proposal II  ratification of the appointment of PricewaterhouseCoopers LLP as the
Companys independent accountants for the fiscal year ending September 30, 2003: |  | 25,704,209 For |  | 14,705 Against |  | 10,100 Abstain
|------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- |  | -------------- |  | --------------



ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



(a) Exhibits



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



(b) Reports on Form 8-K



On January 13, 2003, we filed a Current Report on Form 8-K disclosing that we had completed our acquisition of TidalWire Inc. on December
27, 2002.



On January 29, 2003, we filed a
Current Report on Form 8-K disclosing the repurchase of 408,198 shares of our Common Stock from Lawrence A. Genovesi on January 27, 2003.



On February 6, 2003, we filed a Current Report on Form 8-K disclosing the transcript from our first quarter 2003 results conference call
and webcast held on January 30, 2003.



On
February 14, 2003, we filed a Current Report on Form 8-K/A disclosing required pro forma financial information related to our acquisition of TidalWire Inc. on December 27, 2002.



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SIGNATURES



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



|                   |  | NETWORK ENGINES, INC.
|------------------ |  | ---------------------
|Date: May 15, 2003 |  |                      
|                  
|                   |  |                      
|                   |  |                      
|                  
|                   |  |                      
|                   |  |                      



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CERTIFICATION



I,
John H. Curtis, certify that:



1. I have reviewed this quarterly report on Form 10-Q of Network Engines, Inc.;



2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state
a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;



3. Based on my knowledge, the financial
statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this
quarterly report;



4. The
registrants other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:



a) Designed such disclosure controls and
procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;



b) Evaluated the effectiveness
of the registrants disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the Evaluation Date); and



c) Presented in this quarterly report our conclusions about the effectiveness of the
disclosure controls and procedures based on our evaluation as of the Evaluation Date;



5. The registrants other certifying officers and I have disclosed, based on our most recent evaluation, to the
registrants auditors and the audit committee of registrants board of directors (or persons performing the equivalent functions):



a) All significant deficiencies in the design or operation of internal controls which could adversely affect the
registrants ability to record, process, summarize and report financial data and have identified for the registrants auditors any material weaknesses in internal controls; and



b) Any fraud, whether or not material, that involves management or other employees who have a
significant role in the registrants internal controls; and



6. The registrants other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could
significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.



Dated: May 15, 2003



LOGOJohn H. Curtis President and Chief Executive Officer




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CERTIFICATION



I,
Douglas G. Bryant, certify that:



1. I have reviewed this quarterly report on Form 10-Q of Network Engines, Inc.;



2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state
a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;



3. Based on my knowledge, the financial
statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this
quarterly report;



4. The
registrants other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:



a) Designed such disclosure controls and
procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;



b) Evaluated the effectiveness
of the registrants disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the Evaluation Date); and



c) Presented in this quarterly report our conclusions about the effectiveness of the
disclosure controls and procedures based on our evaluation as of the Evaluation Date;



5. The registrants other certifying officers and I have disclosed, based on our most recent evaluation, to the
registrants auditors and the audit committee of registrants board of directors (or persons performing the equivalent functions):



a) All significant deficiencies in the design or operation of internal controls which could adversely affect the
registrants ability to record, process, summarize and report financial data and have identified for the registrants auditors any material weaknesses in internal controls; and



b) Any fraud, whether or not material, that involves management or other employees who have a
significant role in the registrants internal controls; and



6. The registrants other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could
significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.



Dated: May 15, 2003



LOGODouglas G. Bryant Vice President of Finance and Administration, Chief Financial Officer, Treasurer and Secretary
(Principal Financial Officer)






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EXHIBIT
INDEX





|Exhibit No. |  | Exhibit                                                                                   
|----------- |  | ------------------------------------------------------------------------------------------
|99.1        |  | John H. Curtis Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.   
|           
|99.2        |  | Douglas G. Bryant Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.





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