<PAGE>

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                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                               ----------------

                                   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 December 31, 2000

                                       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

                               ----------------

                             NETWORK ENGINES, INC.
             (Exact name of registrant as specified in its charter)

                Delaware                               04-3064173
      (State or other jurisdiction                  (I.R.S. Employer
           of incorporation)                      Identification No.)

        25 Dan Road, Canton, MA                          02021
         (Address of principal                         (Zip Code)
           executive offices)

                                 (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

   As of February 1, 2001, there were 34,986,659 shares of the registrant's
Common Stock, par value $.01 per share, outstanding.

--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
<PAGE>

                             NETWORK ENGINES, INC.

                                     INDEX

<TABLE>
<CAPTION>
                                                                          PAGE
                                                                         NUMBER
                                                                         ------

                         PART I. FINANCIAL INFORMATION

 <C>     <S>                                                             <C>
 ITEM 1. FINANCIAL STATEMENTS

         CONDENSED CONSOLIDATED BALANCE SHEETS........................      3

         CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS..............      4

         CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS..............      5

         NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.........      6

 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
          AND FINANCIAL CONDITION.....................................     10

 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK...     26

                           PART II. OTHER INFORMATION

 ITEM 1. LEGAL PROCEEDINGS............................................     27

 ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS....................     27

 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS..........     27

 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.............................     27

 SIGNATURES............................................................    28

 EXHIBIT INDEX.........................................................    29
</TABLE>
<PAGE>

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

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

<TABLE>
<CAPTION>
                                                     December 31, September 30,
                                                         2000         2000
                                                     ------------ -------------
                                                      (unaudited)
<S>                                                  <C>          <C>
                      ASSETS
                      ------
Current assets:
  Cash and cash equivalents........................    $113,446     $112,382
  Restricted cash..................................          47           47
  Accounts receivable, net of allowance............       5,468       11,805
  Inventories......................................       5,561        6,600
  Prepaid expenses and other current assets........       1,419        1,031
  Due from contract manufacturer...................       1,432        7,113
                                                       --------     --------
    Total current assets...........................     127,373      138,978
Property and equipment, net........................       8,003        7,098
Goodwill and intangible assets.....................       2,542          --
Other assets.......................................         349          136
                                                       --------     --------
    Total assets...................................    $138,267     $146,212
                                                       ========     ========

       LIABILITIES AND STOCKHOLDERS' EQUITY
       ------------------------------------

Current liabilities:
  Accounts payable.................................    $ 16,253     $  6,906
  Due to contract manufacturer.....................       5,832          --
  Accrued compensation and other related benefits..         962        1,773
  Other accrued expenses...........................         570        1,077
  Deferred revenue.................................         665          827
  Current portion of capital lease obligations and
   notes payable...................................          71           63
                                                       --------     --------
    Total current liabilities......................      24,353       10,646
Capital lease obligations and notes payable, net of
 current portion...................................          56           90

Stockholders' equity:
  Preferred stock..................................         --           --
  Common stock.....................................         348          342
  Additional paid-in capital.......................     180,355      171,314
  Accumulated deficit..............................     (49,777)     (23,915)
  Note receivable from stockholder.................         (96)         (94)
  Deferred stock compensation......................     (16,972)     (12,171)
                                                       --------     --------
    Total stockholders' equity.....................     113,858      135,476
                                                       --------     --------
    Total liabilities and stockholders' equity.....    $138,267     $146,212
                                                       ========     ========
</TABLE>

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

                                       3
<PAGE>

                             NETWORK ENGINES, INC.
                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                     (in thousands, except per share data)
                                  (unaudited)

<TABLE>
<CAPTION>
                                                              Three months
                                                             ended December
                                                                  31,
                                                            -----------------
                                                              2000     1999
                                                            --------  -------
<S>                                                         <C>       <C>
Net revenues............................................... $  6,894  $ 4,415
Cost of revenues:
  Cost of revenues (excluding stock compensation)..........    5,196    2,613
  Cost of revenues stock compensation......................       91       10
  Inventory write-down.....................................   14,965      --
                                                            --------  -------
    Total cost of revenues.................................   20,252    2,623
    Gross profit (loss)....................................  (13,358)   1,792
Operating expenses:
  Research and development ................................    3,874    1,174
  Selling and marketing....................................    6,501    1,615
  General and administrative...............................    2,577      432
  Stock compensation (excluding cost of revenues stock
   compensation)...........................................    1,254      187
  Amortization of goodwill and intangible assets...........      150      --
                                                            --------  -------
    Total operating expenses...............................   14,356    3,408
                                                            --------  -------
Loss from operations.......................................  (27,714)  (1,616)
Interest income, net.......................................    1,852       30
                                                            --------  -------
Net loss...................................................  (25,862)  (1,586)
Accretion of redeemable convertible preferred stock........      --      (810)
                                                            --------  -------
Net loss attributable to common stockholders............... $(25,862) $(2,396)
                                                            ========  =======
Net loss per common share--basic and diluted............... $  (0.76) $ (0.70)
                                                            ========  =======
Shares used in computing net loss per common share--basic
 and diluted...............................................   33,862    3,417
Pro forma net loss per common share--basic and diluted.....           $ (0.09)
Shares used in computing pro forma net loss per common
 share--basic and diluted..................................            16,993
</TABLE>


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

                                       4
<PAGE>

                             NETWORK ENGINES, INC.
                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)
                                  (unaudited)

<TABLE>
<CAPTION>
                                                               Three months
                                                              ended December
                                                                   31,
                                                             -----------------
                                                               2000     1999
                                                             --------  -------
<S>                                                          <C>       <C>
Cash flows from operating activities:
 Net loss................................................... $(25,862) $(1,586)
 Adjustments to reconcile net loss to net cash provided by
  (used in) operating activities:
  Depreciation and amortization.............................    1,242      106
  Provision for inventory reserve...........................   15,055       83
  Provision for doubtful accounts...........................      575       30
  Stock compensation........................................    1,345      197
  Interest on note receivable from stockholder..............       (2)     --
  Changes in operating assets and liabilities, net of
   effects of acquisition:
   Accounts receivable......................................    5,762     (220)
   Inventories..............................................  (14,016)    (560)
   Prepaid expenses and other current assets................     (360)    (284)
   Due from contract manufacturer...........................    5,681      --
   Accounts payable.........................................    9,143    1,206
   Due to contract manufacturer.............................    5,832      --
   Accrued compensation and related benefits and other
    accrued expenses........................................   (1,318)    (121)
   Deferred revenue.........................................     (162)      (8)
                                                             --------  -------
    Net cash provided by (used in) operating activities.....    2,915   (1,157)
Cash flows from investing activities:
  Purchases of property and equipment.......................   (1,943)    (422)
  Deposit of restricted cash................................      --      (279)
  Increase in other assets..................................     (213)     (83)
  Cash of business acquired, net of acquisition expenses....      (30)     --
                                                             --------  -------
    Net cash used in investing activities...................   (2,186)    (784)
Cash flows from financing activities:
  Proceeds from notes payable...............................      --     2,205
  Payments on capital lease obligations and notes payable...      (26)  (2,070)
  Proceeds from issuance of common stock....................      361       71
  Proceeds from issuance of redeemable convertible preferred
   stock, net of issuance costs.............................      --    25,176
                                                             --------  -------
    Net cash provided by financing activities...............      335   25,382
                                                             --------  -------
Net increase in cash and cash equivalents...................    1,064   23,441
Cash and cash equivalents, beginning of period..............  112,382    1,435
                                                             --------  -------
Cash and cash equivalents, end of period.................... $113,446  $24,876
                                                             ========  =======
</TABLE>

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

                                       5
<PAGE>

                             NETWORK ENGINES, INC.

              NOTES TO 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 2000 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. Actual results could differ from those estimates.

2. SIGNIFICANT ACCOUNTING POLICIES

 Recent Accounting Pronouncements

   In December 1999, the Securities and Exchange Commission released Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements"
("SAB 101"). This bulletin summarizes certain views of the staff of the
Securities and Exchange Commission (the "Staff") on applying generally accepted
accounting principles to revenue recognition in financial statements. The Staff
believes that revenue is realized or realizable and earned when all of the
following criteria are met: persuasive evidence of an arrangement exists;
delivery has occurred or services have been rendered; the seller's price to the
buyer is fixed or determinable; and collectibility is reasonably assured. In
June 2000, the Staff issued Staff Accounting Bulletin No. 101B, "Second
Amendment: Revenue Recognition in Financial Statements," ("SAB 101B"). SAB 101B
delays the implementation of SAB 101 until the fourth quarter of the Company's
fiscal year 2001. The Company does not expect the application of SAB 101 to
have a material impact on the Company's financial position or results of
operations.

 Comprehensive Loss

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

 Segment Reporting

   During each period presented, the Company operated in a single business
segment, primarily in the United States.

                                       6
<PAGE>

                             NETWORK ENGINES, INC.

       NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


3. NET LOSS PER SHARE

   Basic net loss per share is computed by dividing the net loss attributable
to common stockholders 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 attributable to common
stockholders 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 restricted shares and incremental shares of
common stock issuable upon the exercise of stock options and warrants and upon
conversion of redeemable convertible preferred stock. 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 common share because their inclusion would be anti-
dilutive (in thousands):

<TABLE>
<CAPTION>
                                                                       As of
                                                                   December 31,
                                                                   -------------
                                                                    2000   1999
                                                                   ------ ------
   <S>                                                             <C>    <C>
   Options to purchase common stock...............................  5,816  2,844
   Warrants to purchase common stock..............................  1,729  2,350
   Unvested restricted common stock...............................    472    675
                                                                   ------ ------
                                                                    8,017  5,869
                                                                   ====== ======
</TABLE>

   Pro forma basic and diluted net loss for the three months ended December 31,
1999 is calculated assuming the automatic conversion of all preferred stock
outstanding had occurred as of the date of issuance of the preferred stock.
Therefore, accretion of redeemable convertible preferred stock is excluded from
the calculation of pro forma net loss per common share. The redeemable
convertible preferred stock automatically converted into 21,448,442 shares of
common stock upon the completion of the Company's initial public offering in
July 2000. During the three months ended December 31, 2000, no shares of
preferred stock were outstanding; accordingly, pro forma basic and diluted net
loss per share equaled actual basic and diluted net loss per share.

4. INVENTORIES

   Inventories consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                      December 31, September 30,
                                                          2000         2000
                                                      ------------ -------------
   <S>                                                <C>          <C>
   Raw materials.....................................    $2,018       $3,524
   Work in process...................................        95          847
   Finished goods....................................     3,448        2,229
                                                         ------       ------
                                                         $5,561       $6,600
                                                         ======       ======
</TABLE>

5. CONTINGENCIES

   As a normal incidence of the nature of the Company's business, various
claims, charges and litigation have been asserted or commenced against the
Company arising from or related to employee relations. Management does not
believe these claims will have a material adverse effect of the financial
position or results of operations of the Company.

                                       7
<PAGE>

                             NETWORK ENGINES, INC.

       NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


6. ACQUISITION OF IP PERFORMANCE

   On November 8, 2000, the Company completed its acquisition of IP
Performance, Inc. ("IP Performance"), a developer of network acceleration
technology, through the exchange of 128,693 shares of unrestricted Network
Engines common stock for all outstanding shares of IP Performance capital
stock. The acquisition was accounted for using the purchase method of
accounting. Accordingly, the fair market value 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 IP Performance operations have been
included in the Company's financial statements thereafter. The purchase price
of approximately $2,540,000, assumed net liabilities of approximately $94,000
and acquisition expenses of approximately $58,000 resulted in goodwill and
intangible assets of approximately $2,692,000. The Company is amortizing the
goodwill and intangible assets over a three-year period resulting in
approximately $150,000 of amortization during the three months ended December
31, 2000. The Company's pro forma statements of operations prior to the
acquisition would not differ materially from reported results.

   The Company also issued 321,756 shares of restricted common stock to key
employee shareholders of IP Performance. These shares are restricted as to sale
and such restrictions lapse in three equal annual installments beginning on
November 8, 2001, contingent upon continued employment of the holder. In
connection with the issuance of these restricted shares, the Company recorded
approximately $6,351,000 of deferred compensation, which is being recognized as
stock compensation expense ratably over the vesting period. During the three
months ended December 31, 2000, the Company recognized approximately $353,000
of stock compensation expense. The amount of stock compensation expense to be
recorded in future periods could decrease if holders of unvested restricted
stock cease to be employees of the Company prior to the lapse of the vesting
period.

7. INVENTORY WRITE-DOWN

   In the first quarter of fiscal 2001, the Company recorded an inventory
write-down of $14,965,000 for excess and obsolete inventory related to the
Company's WebEngine Blazer product. This excess and obsolete inventory was due
to an unforeseen decline in sales of the WebEngine Blazer product during the
first quarter of fiscal 2001 and to the Company's transition from sales of the
WebEngine Blazer product to sales of its next-generation WebEngine Sierra
product.

8. SUBSEQUENT EVENTS

   In January 2001, the Company entered into a series of related agreements
with Lawrence A. Genovesi, the Company's Chief Executive Officer. These
agreements were entered into in order to avoid significant sales of the
Company's stock by Mr. Genovesi as a result of a margin call on a personal loan
that was collateralized by Mr. Genovesi's holdings of the Company's common
stock. The Company agreed to guarantee 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"). The Guarantee period ends
on January 9, 2002 and the balance of the amount deposited with the Bank will
be returned to the Company. Mr. Genovesi and the Company also entered into an
agreement whereby Mr. Genovesi has 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 bear
interest at a rate of 10% per annum. In the event of a default of the
Reimbursement Agreement by Mr. Genovesi, the Company has the right to apply any
and all compensation due to Mr. Genovesi against all of Mr. Genovesi's
obligations outstanding under the Reimbursement Agreement. In addition, the
Company and Mr. Genovesi entered into a revolving promissory note of up to
$210,000 (the "Note"). The Note bears interest at a rate of 5.9% per annum and
is due and payable in full upon the earlier of January 9, 2002 or 30 days
following the date Mr. Genovesi ceases to be an employee of the Company.

                                       8
<PAGE>

                             NETWORK ENGINES, INC.

       NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   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 elects to sell any of the Pledged Securities during
the term of the agreement, all proceeds of such sale will be applied first to
any outstanding obligations related to the Note and then to any amounts payable
under the Reimbursement Agreement. In addition to the Pledged Securities, the
Note is collateralized by a second mortgage on certain real property owned by
Mr. Genovesi. As of February 12, 2001, no amounts were outstanding under the
Note or were required to be reimbursed to the Company under the Reimbursement
Agreement.

                                       9
<PAGE>

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 2000 Annual Report on Form
10-K filed by the Company with the Securities and Exchange Commission.

Overview

   We are a leading provider of scalable server appliances. Server appliances
combine hardware and software to deliver information and applications over the
Internet. By combining specific application functionality within small physical
packaging, our server appliances are designed to meet the complex needs and
requirements of e-commerce and Internet-based organizations, including web-
hosting and service providers, content infrastructure providers, application
service providers and larger enterprises.

   In June 1999, we introduced our WebEngine Blazer product, our first
generation of server appliances. Since July 1999, substantially all of our
revenue has been attributable to the WebEngine Blazer product. We introduced
our AdminEngine server appliance in February 2000 and our WebEngine Roadster
and WebEngine Viper server appliances in the third quarter of fiscal 2000. In
November 2000, we introduced our StorageEngine Voyager network attached server
appliance and in the second quarter of fiscal 2001, we expect to formally
introduce the WebEngine Sierra, our next generation server appliance, designed
to replace our WebEngine Blazer product.

   Since we began focusing on server appliances in 1998, we have incurred
substantial costs to develop our technology and products, to recruit and train
personnel for our engineering, sales and marketing and technical support
departments, and to establish an administrative organization. As a result, we
had an accumulated deficit of $49.8 million as of December 31, 2000. We
anticipate that our operating expenses will increase in the future as we
increase our sales and marketing operations, develop new channels, fund greater
levels of research and development, expand our technical support and improve
our operational and financial systems. Accordingly, we will need to generate
significant revenues to achieve profitability. In addition, our limited
operating history in the server appliance market makes it difficult for us to
predict future operating results, and, accordingly, there can be no assurances
that we will achieve revenue growth or profitability in future periods.

   We derive revenues from the sale of our products to customers and from
license fees. License fees are generated by granting customers a right to
manufacture specific configurations of our product and to distribute that
product under their name. For direct sales and sales to resellers, we recognize
revenues upon delivery, provided evidence of an arrangement has been received,
no obligations remain outstanding and collectibility is reasonably assured. For
the license agreements, we recognize license revenues upon the sale to the
licensee's customers.

   We have strategic agreements that allow certain customers to manufacture our
WebEngine Blazer hardware design. Until these licensees are able to manufacture
the licensed product for themselves at volume

                                       10
<PAGE>

levels that meet customer demand, we have contracted for the manufacture of the
product for them and have charged them a higher unit sales price for this
service than we would have received in license fees had they manufactured the
product. As these licensees manufacture the units, we will not incur any
substantial cost of revenues and our gross profit as a percentage of revenue
will be high for license revenues. There are no minimum license fee commitments
under any of these agreements.

   We sell our products through a direct sales force, through systems
integrators acting as resellers, and to Original Equipment Manufacturers, or
OEMs, and licensed manufacturers. The majority of our sales to date have been
to customers in the United States. We intend to expand our reseller channel in
the United States and to further expand our international sales channels.

   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, license fees and shipping
and warranty costs. Our gross profit will be affected primarily by the mix of
product revenues versus license revenues, the timing, size and configuration of
customer orders, and new product introductions by us and our competitors.

   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. We believe that a significant level of investment
in product research and development is required to remain competitive.
Accordingly, we expect to continue to devote substantial resources to product
research and development. As a result, we expect research and development
expenses to increase in absolute dollars but continue to fluctuate as a
percentage of net revenues.

   Selling and marketing expenses consist primarily of salaries, commissions
and related expenses for personnel engaged in sales, marketing and customer
support functions, as well as costs associated with advertising, trade shows,
public relations and marketing materials. We intend to expand our sales and
marketing operations and efforts, both domestically and internationally, in
order to increase market awareness and to generate sales of our products.
Accordingly, we expect selling and marketing expenses to increase in absolute
dollars but continue to fluctuate as a percentage of net revenues.

   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 and allowance for doubtful accounts. We expect these expenses
to increase in absolute dollars but continue to fluctuate as a percentage of
net revenues as we add administrative personnel and incur additional costs
related to the growth of our business, expansion of our information
infrastructure and our operation as a public company.

   We have 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 deemed fair market value of
the common stock and, accordingly, no additional deferred compensation has been
recorded. Through December 31, 2000, we amortized $4.0 million to stock
compensation expense and $468,000 of deferred stock compensation has been
cancelled 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 in connection with our acquisition of IP
Performance, Inc. in November 2000. Through December 31, 2000, we amortized
$353,000 to stock compensation expense.

                                       11
<PAGE>

   During the next twelve months, we expect to amortize stock compensation of:

<TABLE>
<CAPTION>
                                                                      Expected
                                                                    Amortization
                                                                      of Stock
   Fiscal Quarter Ending                                            Compensation
   ---------------------                                            ------------
                                                                        (in
                                                                     thousands)
   <S>                                                              <C>
   March 31, 2001..................................................    $1,509
   June 30, 2001...................................................     1,450
   September 30, 2001..............................................     1,450
   December 31, 2001...............................................     1,436
</TABLE>

   We then expect aggregate per quarter stock compensation amortization of
approximately $1.4 million during the remainder of fiscal 2002 and fiscal 2003
and between $17,000 and $893,000 during fiscal 2004 and the quarter ended
December 31, 2004. The amount of stock compensation expense to be recorded in
future periods could decrease if restricted common stock, or options, for
accrued but unvested compensation are forfeited.

Results of Operations

   The following table sets forth financial data for the periods indicated as a
percentage of net revenues:

<TABLE>
<CAPTION>
                                                              Three months
                                                                  ended
                                                              December 31,
                                                              ---------------
                                                               2000     1999
                                                              ------   ------
   <S>                                                        <C>      <C>
   Net revenues..............................................    100%    100%
   Cost of revenues:
     Cost of revenues (excluding stock compensation).........     76      59
     Cost of revenues stock compensation.....................      1     --
     Inventory write-down....................................    217     --
                                                              ------   -----
       Total cost of revenues................................    294      59
                                                              ------   -----
         Gross profit (loss).................................   (194)     41
   Operating expenses:
     Research and development................................     56      27
     Selling and marketing ..................................     94      37
     General and administrative..............................     38      10
     Stock compensation (excluding cost of revenues stock
      compensation)..........................................     18       4
     Amortization of goodwill and intangible assets..........      2     --
                                                              ------   -----
         Total operating expenses............................    208      78
                                                              ------   -----
   Loss from operations......................................   (402)    (37)
   Interest income, net......................................     27       1
                                                              ------   -----
   Net loss..................................................   (375%)   (36%)
                                                              ======   =====
</TABLE>

                                       12
<PAGE>

Three Months Ended December 31, 2000 and December 31, 1999

 Net Revenues

   Net revenues increased to $6.9 million in the three months ended December
31, 2000 from $4.4 million in the three months ended December 31, 1999. The
increase is due primarily to a higher average selling price of our WebEngine
Blazer product due to a higher percentage of our revenue from direct sales and,
to a lesser extent, increased license revenues. During the three months ended
December 31, 2000, we earned license revenues of approximately $411,000,
primarily from IBM's sales of its Netfinity 4000R, which incorporates our
WebEngine Blazer hardware design, compared to no license revenues during the
three months ended December 31, 1999. We expect license revenues to
significantly decline in future periods because we expect IBM to sell fewer of
the Netfinity 4000R.

 Gross Profit (Loss)

   Gross profit (loss) decreased to a loss of ($13.4) million for the three
months ended December 31, 2000 from a profit of $1.8 million in the three
months ended December 31, 1999. This decrease is primarily attributable to a
charge of approximately $15.0 million to write-down excess and obsolete
inventory in the three months ended December 31, 2000, for which there was no
comparable charge in the three months ended December 31, 1999. Excluding the
inventory write-down and stock compensation, gross profit (loss) decreased to a
profit of $1.7 million, or 25% of net revenues, in the three months ended
December 31, 2000 from a profit of $1.8 million, or 41% of net revenues, in the
three months ended December 31, 1999. This decrease was primarily due to a
cost-plus sales arrangement with a significant customer during the three months
ended December 31, 1999, which we were not engaged in during the three months
ended December 31, 2000. This cost-plus sales arrangement generated higher
gross profits as a percentage of net revenues and was converted to a license
arrangement during the three months ended March 31, 2000. License revenue
during the three months ended December 31, 2000 partially offset the decrease
in gross profit as a percentage of net revenues.

 Operating Expenses

   Research and Development. Research and development expenses increased to
$3.9 million in the three months ended December 31, 2000 from $1.2 million in
the three months ended December 31, 1999. This increase was due primarily to
increased compensation costs as research and development personnel increased
from 35 employees at December 31, 1999 to 83 employees at December 31, 2000. To
a lesser extent, the increase in research and development expenses was due to
increased consulting and increased prototype and test unit costs related to
development efforts associated with the StorageEngine Voyager and WebEngine
Sierra products.

   Selling and Marketing. Selling and marketing expenses increased to
$6.5 million in the three months ended December 31, 2000 from $1.6 million in
the three months ended December 31, 1999. This increase was due primarily to
increased compensation costs as sales, marketing and customer support personnel
increased from 33 employees at December 31, 1999 to 95 employees at
December 31, 2000. The increase in selling and marketing expenses is also
attributable to increased advertising costs. To a lesser extent, the increase
in selling and marketing expenses was due to increased depreciation of
demonstration equipment and increased travel costs associated with the increase
in sales, marketing and customer support personnel.

   General and Administrative. General and administrative expenses increased to
$2.6 million in the three months ended December 31, 2000 from $432,000 in the
three months ended December 31, 1999. This increase was due primarily to
increased bad debt expense, as a result of recent economic conditions, and
increased compensation costs as general and administrative personnel increased
from ten employees at December 31, 1999 to 34 employees at December 31, 2000.
To a lesser extent, the increase in general and administrative expenses, was
due to increased accounting, legal and other professional service fees
associated with our operation as a public company, increased consulting costs
associated with the expansion of our information technology infrastructure and
higher corporate recruiting costs.

                                       13
<PAGE>

   Amortization of Goodwill and Intangible Assets. In connection with our
acquisition of IP Performance, Inc. in November 2000, we recorded goodwill and
intangible assets of $2.7 million, of which we amortized $150,000 in the three
months ended December 31, 2000.

   Stock Compensation. We recognized stock compensation expense of $992,000 in
the three months ended December 31, 2000 related to the grant of options and
restricted stock to employees and directors during fiscal 1999 and prior to our
initial public offering in fiscal 2000. We recognized $197,000 of stock
compensation expense in the three months ended December 31, 1999. In connection
with restricted stock issued to employees as a result of our acquisition of IP
Performance, Inc., we recorded deferred stock compensation of $6.4 million, of
which we recognized $353,000 as stock compensation expense during the three
months ended December 31, 2000.

 Interest income, net

   Interest income, net increased to $1.9 million in the three months ended
December 31, 2000 from $30,000 in the three months ended December 31, 1999.
This increase was due to the investment of the net proceeds from our initial
public offering in July 2000.

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
our common stock, including the exercise of the underwriters' overallotment
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 our initial public offering, we raised approximately
$37.3 million, net of offering costs, from the issuance of preferred stock. As
of December 31, 2000, we had $113.4 million in cash and cash equivalents.

   In April 2000, we amended our equipment line of credit agreement to provide
for an additional $2.0 million of equipment financing and a $4.0 million
working capital revolving line of credit. The additional equipment financing is
separated into two consecutive six-month borrowing periods of $1.0 million
beginning on the date of the amendment. Interest at the rate of prime plus
1.25% is payable monthly. Any outstanding balances at the end of each of the
two borrowing periods will be repaid in 36 equal monthly installments. The
revolving line of credit matures in April 2001 and bears interest at prime plus
1%. As of December 31, 2000, no amounts were outstanding under these lines of
credit.

   Cash used in operating activities was $1.2 million in the three months ended
December 31, 1999 and cash provided by operating activities was $2.9 million
during the three months ended December 31, 2000. Cash used in operating
activities during the three months ended December 31, 1999 was primarily due to
a net loss of $1.6 million and increases in accounts receivable and
inventories, offset in part by increases in accounts payable and accrued
expenses and adjusted for non-cash charges for depreciation, inventory reserves
and stock compensation. Cash provided by operating activities in the three
months ended December 31, 2000 was primarily due to increases in accounts
payable and amounts due to contract manufacturer, decreases in accounts
receivable and amounts due from contract manufacturer, adjusted for non-cash
charges for depreciation and amortization, inventory reserves and stock
compensation, offset by a net loss of $25.9 million and an increase in
inventories.

   Cash used in investing activities was $784,000 and $2.2 million in the three
months ended December 31, 1999 and 2000, respectively. Cash used in investing
activities in the three months ended December 31, 1999

                                       14
<PAGE>

was primarily for purchases of property and equipment and a security deposit on
our leased facility in Canton, Massachusetts. Cash used in investing activities
in the three months ended December 31, 2000 was primarily for purchases of
property and equipment.

   Cash provided by financing activities was $25.4 million and $335,000 in the
three months ended December 31, 1999 and 2000, respectively. Cash provided by
financing activities in the three months ended December 31, 1999 was primarily
generated through the sale of series D preferred stock through which we raised
net proceeds of approximately $25.2 million. Cash provided by financing
activities in the three months ended December 31, 2000 was primarily from the
sale of common stock through our employee stock purchase plan.

   We intend to continue to invest heavily in the development of new products
and enhancements to our existing products. Our future liquidity and capital
requirements will depend upon numerous factors, including:

  . the costs and timing of expansion of sales and marketing activities;

  . the costs and timing of expansion of product development efforts and the
    success of these development efforts;

  . the extent to which our existing and new products gain market acceptance;

  . the level and timing of license revenues;

  . the costs involved in maintaining and enforcing intellectual property
    rights;

  . market developments;

  . the costs and timing of expanding and improving our facilities;

  . available borrowings under line of credit arrangements; and

  . other factors.

   We believe that our available cash resources, including cash and cash
equivalents, together with cash we expect to generate from sales of our
products and licensing of our technology and cash from borrowings, will be
sufficient to meet our debt service, operating and capital requirements through
at least the next 12 months. After that, we may need to raise additional funds.
We may seek to raise additional funds through additional 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 would need to reduce our planned rate of growth and
reduce our operating expenses.

Recent Accounting Pronouncements

   In December 1999, the Securities and Exchange Commission released Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements"
("SAB 101"). This bulletin summarizes certain views of the staff of the
Securities and Exchange Commission (the "Staff") on applying generally accepted
accounting principles to revenue recognition in financial statements. The Staff
believes that revenue is realized or realizable and earned when all of the
following criteria are met: persuasive evidence of an arrangement exists;
delivery has occurred or services have been rendered; the seller's price to the
buyer is fixed or determinable; and collectibility is reasonably assured. In
June 2000, the Staff issued Staff Accounting Bulletin No. 101B, "Second
Amendment: Revenue Recognition in Financial Statements," ("SAB 101B"). SAB 101B
delays the implementation of SAB 101 until the fourth quarter of the Company's
fiscal year 2001. The Company does not expect the application of SAB 101 to
have a material impact on the Company's financial position or results of
operations.

                                       15
<PAGE>

                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 Related to Our Financial Results

We are an early-stage company in the new and rapidly evolving market for server
appliances.

   Because of our limited operating history in the server appliance market, it
is difficult to discern trends that may emerge and affect our business. We may
experience negative trends associated with seasonality that, due to our limited
operating history, we have not experienced in the past. We began shipping our
WebEngine Blazer and AdminEngine in June 1999 and February 2000, respectively.
We began shipping our WebEngine Roadster and WebEngine Viper products in the
third quarter of fiscal 2000. In November 2000 we introduced our StorageEngine
Voyager network attached server appliance and in the second quarter of fiscal
2001 we expect to formally introduce the WebEngine Sierra, our next generation
server appliance, designed to replace our WebEngine Blazer product. Our limited
historical financial performance may make it difficult for you to evaluate the
success of our business to date and to assess its future viability.

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

   Since our inception, we have incurred significant net losses, including net
losses of $4.2 million, $5.8 million and $12.5 million in fiscal 1998, 1999 and
2000, respectively, as well as a net loss of $25.9 million in the three months
ended December 31, 2000. We expect to have net losses in the future. In
addition, we had an accumulated deficit of $49.8 million as of December 31,
2000. We believe that our future growth depends upon the success of our new
product development and selling and marketing efforts, which will require us to
incur significant product development, 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, perhaps substantially.

   We anticipate that our expenses will increase through at least the remainder
of the current fiscal year as we:

  . increase our direct sales and marketing activities;

  . develop our technology, expand our existing product lines and create and
    market additional server appliance products;

  . develop strategic alliances with third-party technology vendors;

  . expand our distribution and reseller channels; and

  . implement additional internal systems, develop additional infrastructure
    and hire additional management to keep pace with our growth.

   Any failure to significantly increase our revenues and control costs as we
implement our product and distribution strategies would also harm our ability
to achieve and maintain profitability and could negatively impact the market
price of our common stock.

                                       16
<PAGE>

We may not be able to return to our historical revenue growth rates, which
could cause our stock price to decline.

   Our revenues grew rapidly in fiscal 1999 and fiscal 2000 and fell sharply in
the three months ended December 31, 2000. We are unable to predict whether or
not we will be able to return to the rate of revenue growth achieved in fiscal
1999 and fiscal 2000 because of uncertain economic conditions, growing
competition, the incremental manner in which customers implement server
appliances and our inexperience in selling our products. If we are unable to
return to our historical rate of revenue growth, our stock price could decline.

If the commodification of products and competition in the server appliance
market increases, then the average unit price of our products may decrease and
our operating results may suffer.

   Products in the server appliance market may be subject to potential
commodification as the industry matures and other businesses introduce
competing products. The average unit price of our products may also decrease in
response to changes in product mix, competitive pricing pressures, or new
product introductions by us or our competitors. If we are unable to offset a
decrease in our average selling prices by increasing our sales volumes, our
revenues 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
products. Our efforts to produce higher margin products, continue to improve
our products and produce new products may make it difficult to reduce our
manufacturing cost per product. Further, our current reliance on our single
manufacturer, SCI Systems, may not allow us to reduce our cost per product.

Our quarterly revenues and operating results may fluctuate due to a lack of
growth of the server appliance market in general or failure of our products to
achieve market acceptance.

   Our quarterly revenues and operating results are difficult to predict and
may fluctuate significantly from quarter to quarter because server appliances
generally, and our current products in particular, are relatively new and the
future growth of the market for our products is uncertain. In addition, we
expect to rely on additional new products for growth in our net revenues in the
future. If the server appliance market in general fails to grow as expected or
our products fail to achieve market acceptance, our quarterly net revenues and
operating results may fall below the expectations of investors and public
market research analysts. In this event, the price of our common stock could
decline substantially.

If sales of our new or enhanced products are lower than expected, our revenues
and operating results will be adversely affected.

   If our customers do not continue to purchase our new and enhanced products,
our revenues and operating results will be adversely affected. Factors that may
affect the market acceptance of our products, some of which are beyond our
control, include the following:

  . the growth and changing requirements of the server appliance market;

  . the performance, quality, price and total cost of ownership of our
    products;

  . the availability, price, quality and performance of competing products
    and technologies; and

  . the successful development of our relationships with existing and
    potential channel partners, licensed manufacturers and OEMs.

                                       17
<PAGE>

We may not succeed in developing and marketing new types of server appliance
products, or do so in a timely manner, and our operating results may decline as
a result.

   We have recently released our StorageEngine product and expect to formally
announce our next generation WebEngine Sierra product in the three months ended
March 31, 2001. We are continuing to develop additional types of server
appliance products. Developing new products that meet the needs of the server
appliance market requires significant additional expense and development
resources. If we fail to successfully develop and market new products, our
operating results may suffer.

We derive a substantial portion of our revenues from a small number of
customers, and our revenues may decline significantly if any major customer
cancels or delays a purchase of our products.

   A relatively small number of customers accounted for a significant portion
of our net revenues. In fiscal 1999, sales to three customers accounted for
46%, 28% and 14% of net revenues. In fiscal 2000, sales to two customers
accounted for 16% and 12% of net revenues. In the three months ended December
31, 2000, one customer accounted for 17% of our net revenues. None of our
customers, including our licensed manufacturers and OEMs, is obligated to
purchase any quantity of our products in the future. If any of our large
customers stop purchasing from us, delay future purchases or discontinue use of
our technology, our revenues and profitability may be adversely affected, our
reputation in the industry may suffer and our ability to predict cash flow
accurately may decrease. Accordingly, unless and until we diversify and expand
our customer base, our future success will depend upon the timing and size of
future purchase orders, if any, from our largest customers.

    Risks Related to Growth of the Internet and the Server Appliance Market

If server appliances are not increasingly adopted as a means to deliver
information and conduct commerce over the Internet, the market for our products
will not grow and the market price for our common stock could decline as a
result of lower revenues or reduced investor expectations.

   We expect that substantially all of our revenues will continue to come from
sales of our current and future server appliance products. As a result, we
depend on the growing use of server appliances as a means to deliver
information and conduct commerce over the Internet. The market for server
appliance products, particularly those using the Internet to deliver
information and process commercial transactions, has only recently begun to
develop and is evolving rapidly. Because this market is new, we cannot predict
its potential size or future growth rate. Our revenues may not grow and the
market price for 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 server appliances could, for example, be limited if
general-purpose servers become better at performing functions currently being
performed by our specific-purpose server appliances or are offered at a lower
cost. This could force us to lower the prices of our products or result in
fewer sales of our products.

If the market for server appliance products does not grow because medium to
large Internet service providers and application service providers in our
target market are not receptive to them, our revenues may not grow.

   Large Internet service providers and application service providers that
offer hosting services may not be as receptive to our products as other
organizations because they currently rely on, and their buying programs are
more likely to be based on, established, proprietary operating systems and
general-purpose servers. In addition, we expect that Internet service providers
that specialize in providing Internet access and non-hosting services to
consumers will not be substantial purchasers of our products. Consolidation has
begun to occur in the Internet service provider and application service
provider market, with many large Internet service providers and

                                       18
<PAGE>

application service providers acquiring smaller and regional companies.
Continued consolidation in this market could result in some of our customers
being absorbed into larger organizations. This consolidation may increase the
number of larger corporations that may not be as receptive to our products and,
as a result, our revenues would not grow and may even decrease.

Potential increases or changes in governmental regulation of Internet
communication and commerce could discourage the growth of the Internet, which
could decrease the demand for our products.

   Due to concerns arising from the increasing use of the Internet, a number of
laws and regulations have been, and may be, adopted covering issues including
user privacy, taxation, pricing, acceptable content and quality of products and
services. Legislative changes could dampen the growth in use of the Internet
generally and decrease the acceptance of the Internet as a communications and
commercial medium. Further, due to the global nature of the Internet, it is
possible that multiple federal, state or foreign jurisdictions might attempt to
regulate Internet transmissions or levy sales or other taxes relating to
Internet-based activities. Moreover, the applicability to the Internet of
existing laws, including laws governing property ownership, libel and personal
privacy, is uncertain. We cannot assess the possible negative impact of any
future regulation of the Internet on our business.

                Risks Related to Competition Within Our Industry

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

   In the market for server appliances, we face significant competition from
larger companies who market general-purpose or specific-purpose servers and
have greater financial resources and name recognition than we do. Many of these
companies have larger and more established service organizations to support
these products. These and other large competitors may be able to leverage their
existing resources, including their service organizations, and provide a wider
offering of products and 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 these large
competitors provide lower cost server appliances 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. Increased
competition may negatively affect our business and future operating results by
leading to price reductions, higher selling expenses or a reduction in our
market share.

Our revenues could be reduced if general-purpose server manufacturers make
acquisitions in order to join their extensive distribution capabilities with
our smaller competitors' products.

   Compaq, Dell, Hewlett-Packard, IBM and other server manufacturers may not
only develop their own server appliance solutions, but they may also acquire or
establish cooperative relationships with our other current competitors,
including smaller private companies. Because general-purpose 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. For example, Cobalt, a server
appliance company was acquired by Sun Microsystems in December 2000. We expect
that the server appliance 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.

                                       19
<PAGE>

We may sell fewer products if other vendors' products are no longer compatible
with ours 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.

Server appliance products are subject to rapid technological change due to
changing operating system software and network hardware and software
configurations, and our sales will suffer if our 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. Our
products could be rendered obsolete if products based on new technologies are
introduced or new industry standards emerge.

   New products and product enhancements can require long development and
testing periods, which requires us to hire and retain increasingly scarce,
technically competent personnel. Significant delays in new product releases or
significant problems in installing or implementing new products could seriously
damage our business. We have on occasion experienced delays in the scheduled
introduction of new and enhanced products and cannot be certain that we will
avoid similar delays in the future.

   Our future success depends upon our ability to enhance existing products,
develop and introduce new products, satisfy customer 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.

                Risks Related to Our Marketing and Sales Efforts

We need to expand our direct sales channel and build our indirect sales channel
of system integrators and resellers to distribute our products and, if we fail
to do so, our growth could be limited.

   In order to increase market awareness and sales of our products, we will
need to substantially expand our direct sales programs and build our network of
system integrators and resellers, both domestically and internationally. If we
fail in this endeavor, our growth will be limited. To date, we have relied
primarily on our direct sales force to generate demand for our products. We
have recently expanded our direct sales force and plan to hire additional sales
personnel. Competition for qualified sales people is intense, and we might not
be able to hire the quality and number of sales people we require. We have
limited experience working with systems integrators and resellers. We expect we
will need to expend significant resources to enlist systems integrators and
resellers and educate them regarding our products.

We may incur significant costs to promote our brand that may not result in the
desired brand recognition by customers or increased sales.

   In the fast growing market for server appliances, we believe we need to
establish a strong brand to compete successfully. In order to attract and
retain customers, we believe that our brand must be recognized and viewed
favorably by our customers and end users. Although we intend to advertise and
promote our brand, these strategies may fail. If we are unable to design and
implement effective marketing campaigns or otherwise fail to promote and
maintain our brand, our sales could decline. Our business may also suffer if we
incur excessive expenses promoting and maintaining our brand but fail to
achieve the expected or desired increase in revenues.

                                       20
<PAGE>

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

   We currently have a small customer service and support organization and will
need to increase our staff to support new customers and the expanding needs of
our existing customers. Hiring customer service and support personnel is very
competitive in our industry due to the limited number of people available with
the necessary technical skills and understanding of server appliance products.
If we are unable to expand our customer service and support organization, we
may not be able to retain our existing customers and attract new customers. In
addition, we may be required to pay higher compensation and benefits to hire
these people than we expect. In this event, the cost of expanding our customer
service and support organization may have a negative impact on margins and
operating results.

                   Risks Related to Our 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 and power supplies and our custom-printed circuit boards,
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. In particular, there have also been
recent industry-wide shortages and delays in the production of commodities,
including high-performance processor boards, memory chips and disk drives.
Shortages have been of limited duration and have not yet caused 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 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.

We rely on a single contract manufacturer to produce our products and, if our
manufacturer fails to meet our requirements, we will be unable to meet customer
requirements and our customer relationships would suffer.

   Our agreement with SCI Systems does not guarantee production levels or
manufacturing prices. SCI Systems may not have additional facilities available
when we need them. Commencing volume production or expanding production to
another facility owned by SCI Systems may be expensive and time-consuming. In
addition, commencement of the manufacturing of our products at additional SCI
Systems manufacturing sites we may need in the future may cause transitional
problems, including delays and quality control issues, which could cause us to
lose sales and impair our ability to achieve profitability. We may need to find
new outside manufacturers to manufacture our products in higher volume and at
lower costs to meet increased demand and competition. If we are required or
choose to change outside manufacturers, we may lose sales and customer
relationships may suffer.

If we do not accurately forecast our component requirements, our manufacturing
may be interrupted and delivery of products may be delayed.

   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,

                                       21
<PAGE>

which would increase our costs. If we underestimate our component requirements,
we may have inadequate inventory, which could interrupt our manufacturing and
delay delivery of our products to our customers. Any of these occurrences would
negatively impact our business and operating results.

 Risks Related to Our Products' Dependence on Intellectual Property and Our Use
                                  of Our Brand

Our reliance upon contractual provisions and domestic trademark laws to protect
our proprietary rights may not be sufficient to protect our intellectual
property from others who may sell similar products.

   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, 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 products and our
brand, and our operating results would suffer if we were subject to a
protracted infringement claim or one with a significant damages award.

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

  . be time-consuming to defend;

  . result in costly litigation;

  . 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 our
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.

                                       22
<PAGE>

                      Other Risks Related to Our Business

Failure to manage our growth successfully could lead to inefficiencies in
conducting our business, increased expenses and slower growth.

   In the past year, our operations have expanded greatly. Our growth has
placed, and will continue to place, a significant strain on our management and
operating and financial systems, as well as sales and marketing and
administrative resources. As of December 31, 2000, we had a total of 240
employees, and as of December 31, 1999 we had a total of 96. Additional growth
will further strain these resources. If we cannot manage our expanding
operations, we may not be able to continue to grow or we may grow at a slower
rate. To manage any future growth effectively, we must continue to improve our
financial and accounting systems, inventory and production controls, reporting
and procedures, integrate new personnel and manage expanded operations. If we
fail to do so, the quality of our products and our ability to respond to our
customers' needs and retain key personnel would cause our business to suffer.
Also, we may fail to add capacity in a cost-effective manner or allow our
operating costs to escalate faster than planned.

If we fail to recruit and retain a significant number of qualified technical
personnel and sales and marketing personnel, we may not be able to develop and
introduce our products on a timely basis.

   We require the services of a substantial number of qualified technical
personnel. The market for qualified personnel is characterized by intense
competition, as well as a high level of employee mobility, which makes it
particularly difficult to attract and retain the qualified technical personnel
we require. We have experienced, and we expect to continue to experience,
difficulty in hiring and retaining highly-skilled employees with appropriate
technical qualifications. If we are unable to recruit and 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.

   The expansion of our sales and marketing department will also require the
hiring and retention of personnel for whom there is also a high demand. If we
are unable to recruit and retain a sufficient number of sales and marketing
personnel, we may not be able to increase market awareness of our products and
generate sales of our products as quickly as we would like. Moreover, we may
only be able to expand our staff of technical personnel and sales and marketing
personnel by providing individuals with compensation packages that are higher
than expected.

If we cannot manage and expand our international operations profitably, our
revenues may not increase and our business and results of operations would be
adversely affected.

   We currently conduct limited business activity outside of North America.
However, we expect international revenue to account for a more significant
percentage of our total revenue in the future and to play an important role in
the growth of our business. We believe that we must continue to expand our
international sales and fulfillment activities in order to be successful. We
have limited experience developing and managing an international sales
operation. Also, there are risks and complexities inherent in conducting
international operations, including, for example, longer payment cycles, local
labor laws and practices and the complexity of complying with additional
regulatory requirements. As we attempt to expand our international sales, any
of these factors and our inexperience may limit our ability to expand our
international operations and, consequently, our business and results of
operations may suffer.

If we are unable to find suitable acquisition candidates, our growth could be
impeded.

   A component of our business strategy is the acquisition of, or investment
in, complementary businesses, technologies or products. In November 2000, we
completed our acquisition of IP Performance, Inc., a developer of network
acceleration technology. Our ability to continue to identify and invest in
suitable acquisition and investment candidates on acceptable terms is crucial
to this strategy. We may not be able to identify, acquire or make investments
in promising acquisition candidates on acceptable terms. Moreover, in pursuing
acquisition and investment opportunities, we may be in competition with other
companies having

                                       23
<PAGE>

similar growth and investment strategies. Competition for these acquisitions or
investment targets could result in increased acquisition or investment prices
and a diminished pool of businesses, technologies, services or products
available for acquisition or investment. An inability to find suitable
acquisition or investment candidates at reasonable prices could slow our growth
rate.

Our acquisition strategy could have an adverse effect on our existing business,
customer satisfaction and operating results.

   Acquisitions involve a number of risks, including:

  . adverse effects on our reported operating results due to accounting
    charges associated with the acquisitions;

  . difficulties in management and integration of the acquired business;

  . increased expenses, including compensation expense resulting from newly-
    hired employees;

  . diversion of management resources and attention; and

  . potential disputes with sellers of acquired businesses, technologies,
    services or products.

Our future success is dependent on the services of our founder and other key
personnel, and those persons' knowledge of our business and technical expertise
would be difficult to replace.

   Our products and technologies are complex and we are substantially dependent
upon the continued service of our existing engineering personnel, and
especially Lawrence A. Genovesi, our President, Chief Executive Officer and
Chief Technology Officer. We do not have employment agreements with any of our
officers. The loss of any of our key employees could adversely affect our
business and slow our product development processes or sales and marketing
efforts. Although we maintain a key person life insurance policy on
Mr. Genovesi, the amount of this insurance may be inadequate to compensate us
for his loss.

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

   Because our server appliance products are complex, they could contain errors
or bugs 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 development 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 Linux operating systems. 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 are used in connection with critical
distributed 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

                                       24
<PAGE>

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,
whether or not successful, could seriously damage our reputation and our
business.

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

   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 our expansion, take advantage of unanticipated opportunities,
develop or enhance products or services, or otherwise respond to competitive
pressures would be significantly limited.

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.

   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 recent 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.

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 Network Engines. These
provisions, coupled with the provisions of the Delaware General Corporation
Law, may delay or impede a merger, tender offer or proxy contest involving
Network Engines. For example, our board of directors will be divided into three
classes, only one of which will be elected at each annual meeting. These
factors may further delay or prevent a change of control of our business.

                                       25
<PAGE>

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.

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 exchange rate risk. We are exposed to market
risk related to changes in interest rates. We invest excess cash balances in
cash equivalents. 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.

                                       26
<PAGE>

PART II--OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

   There has been no material change related to legal proceedings since
September 30, 2000.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

   (c) Sales of Unregistered Securities

   On November 8, 2000, we issued 450,449 shares of our common stock to the
former stockholders of IP Performance, Inc., a Delaware corporation ("IP
Performance"), in connection with our acquisition of IP Performance in a
merger transaction. The shares of common stock were exempt from registration
under Section 4(2) of the Securities Act of 1933, as amended, because there
was no public offering of the common stock issued. No underwriters were
involved in the sale of these securities.

   (d) Use of Proceeds from Sales of Registered Securities

   On July 18, 2000, we sold 7,475,000 shares of our 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 aggregate proceeds to us from
the offering were approximately $116.9 million reflecting gross proceeds of
$127.1 million net of underwriting fees of approximately $8.9 million and
other offering costs of approximately $1.3 million. None of the proceeds of
the offering was paid by us, directly or indirectly, to any director, officer
or general partner of ours or any of their associates, to any persons owning
ten percent or more of our outstanding stock, or to any of our affiliates.
During the period from the offering to December 31, 2000, we have used the
proceeds as follows: approximately $4.8 million was used to fund the
operations of the Company and approximately $3.4 million was used for capital
acquisitions.

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

   No matters were submitted to a vote of security holders during the three
months ended December 31, 2000.

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

   We did not file any reports on Form 8-K during the period covered by this
report.

                                      27
<PAGE>

                                  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: February 13, 2001

                                                 /s/ Lawrence A. Genovesi
                                         By: __________________________________
                                                   Lawrence A. Genovesi
                                             Chairman of the Board, President,
                                             Chief Executive Officer and Chief
                                               Technology Officer (Principal
                                                     Executive Officer)

                                                   /s/ Douglas G. Bryant
                                         By: __________________________________
                                                     Douglas G. Bryant
                                             Vice President of Administration,
                                                  Chief Financial Officer,
                                                  Treasurer and Secretary
                                              (Principal Financial Officer and
                                               Principal Accounting Officer)

                                      28
<PAGE>

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
 Exhibit
   No.                                   Exhibit
 -------                                 -------
 <C>     <S>
  4.2*   Agreement and Plan of Merger dated November 7, 2000, among Network
          Engines, Inc., IPP Acquisition Co. and IP Performance, Inc.

 10.19   Reimbursement Agreement, dated January 9, 2001, between the Registrant
          and Lawrence A. Genovesi

 10.20   Secured Revolving Promissory Note, dated January 9, 2001, between the
          Registrant and Lawrence A. Genovesi

 10.21   Pledge Agreement, dated January 9, 2001, between the Registrant and
          Lawrence A. Genovesi
</TABLE>
--------
* Incorporated by reference from exhibits filed with the Company's Annual
  Report on Form 10-K filed with the Securities and Exchange Commission on
  December 21, 2000.

                                       29