##### **Table ofContents**

 

##### ** **

 

##### **UNITED STATES**

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

**Washington, D.C. 20549**

 

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

 

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**(MarkOne)**

 

| **x**                                                     | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**   |
|-----------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
|                                                      |       |                                                                                                     |
| **For the quarterly period ended December 31, 2009** |
|                                                      |       |                                                                                                     |
| **OR**                                                    |
|                                                      |       |                                                                                                     |
| **o**                                                     | ** ** | **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:000-30863**

###### ** **

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**NETWORK ENGINES, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

| **(781) 332-1000**                                        |
|-----------------------------------------------------------|
| (Registrant’s telephone number, including area code) |

 

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

 

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

 

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

 

| Large accelerated filer o |   | Accelerated filer x         |
|---------------------------|--------|-----------------------------|
|                      |   |                        |
| Non-accelerated filer o   |   | Smaller reporting company o |

 

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

 

Asof February 4, 2010, there were 42,008,229 shares of the registrant’sCommon Stock, par value $.01 per share, outstanding.

 

 

 

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Table of Contents

 

**NETWORK ENGINES, INC.**

 

**INDEX**

 
| ** **                                                                                           | **PAGE  NUMBER** |
|------------------------------------------------------------------------------------------------------|------------------|
|                                                                                                 |             |
| **PART I.  FINANCIAL INFORMATION**                                                              |             |
|                                                                                                 |             |
| ITEM 1.  FINANCIAL STATEMENTS (UNAUDITED)                                                            | 1                |
|                                                                                                 |             |
| CONDENSED  CONSOLIDATED BALANCE SHEETS                                                               | 1                |
| CONDENSED  CONSOLIDATED STATEMENTS OF OPERATIONS                                                     | 2                |
| CONDENSED  CONSOLIDATED STATEMENTS OF CASH FLOWS                                                     | 3                |
| NOTES TO UNAUDITED  CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                      | 4                |
|                                                                                                 |             |
| ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF  OPERATIONS | 13               |
|                                                                                                 |             |
| ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                  | 20               |
|                                                                                                 |             |
| ITEM 4. CONTROLS AND  PROCEDURES                                                                     | 20               |
|                                                                                                 |             |
| **PART II. OTHER  INFORMATION**                                                                 |             |
|                                                                                                 |             |
| ITEM  1. LEGAL PROCEEDINGS                                                                           | 21               |
|                                                                                                 |             |
| ITEM  1A. RISK FACTORS                                                                               | 21               |
|                                                                                                 |             |
| ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                 | 33               |
|                                                                                                 |             |
| ITEM  5. OTHER INFORMATION                                                                           | 33               |
|                                                                                                 |             |
| ITEM 6.  EXHIBITS                                                                                    | 34               |
|                                                                                                 |             |
| SIGNATURES                                                                                           | 35               |

 

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Table of Contents

 

**PART I. FINANCIAL INFORMATION**

 

**ITEM I. FINANCIAL STATEMENTS**

 

**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(inthousands, except share data)**

**(unaudited)**

 
| ** **                                                                                                                                                                                                                 | ** ** | **December 31,  2009** | ** ** | **September 30, 2009** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                 | ** ** | ** **                  |       |                        |       |
| **Current assets:**                                                                                                                                                                                                        | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                                                                                                  |       | $                           | 21,101     |                        | $          | 21,039 |   |
| Accounts receivable, net of allowances of $121 and  $117 at December 31, 2009 and September 30, 2009, respectively                                                                                               |       | 29,720                      |       | 27,479                      |       |
| Refundable acquisition consideration                                                                                                                                                                                       |       | —                      |       | 3,629                       |       |
| Inventories                                                                                                                                                                                                                |       | 15,864                      |       | 13,078                      |       |
| Prepaid expenses and other current assets                                                                                                                                                                                  |       | 1,706                       |       | 1,521                       |       |
|                                                                                                                                                                                                                       |       |                        |       |                        |       |
| Total current assets                                                                                                                                                                                                       |       | 68,391                      |       | 66,746                      |       |
|                                                                                                                                                                                                                       |       |                        |       |                        |       |
| Property and equipment, net                                                                                                                                                                                                |       | 1,508                       |       | 1,622                       |       |
| Intangible asset, net                                                                                                                                                                                                      |       | 7,739                       |       | 8,128                       |       |
| Other assets                                                                                                                                                                                                               |       | 171                         |       | 174                         |       |
|                                                                                                                                                                                                                       |       |                        |       |                        |       |
| Total assets                                                                                                                                                                                                               |       | $                           | 77,809     |                        | $          | 76,670 |   |
|                                                                                                                                                                                                                       |       |                        |       |                        |       |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                                                                             | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| **Current liabilities:**                                                                                                                                                                                                   | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Accounts payable                                                                                                                                                                                                           |       | $                           | 15,491     |                        | $          | 14,200 |   |
| Accrued compensation and other related benefits                                                                                                                                                                            |       | 942                         |       | 1,466                       |       |
| Accrued warranty                                                                                                                                                                                                           |       | 602                         |       | 641                         |       |
| Other accrued expenses                                                                                                                                                                                                     |       | 1,675                       |       | 2,043                       |       |
| Deferred revenue                                                                                                                                                                                                           |       | 4,298                       |       | 4,233                       |       |
|                                                                                                                                                                                                                       |       |                        |       |                        |       |
| Total current liabilities                                                                                                                                                                                                  |       | 23,008                      |       | 22,583                      |       |
|                                                                                                                                                                                                                       |       |                        |       |                        |       |
| Deferred revenue, net of current portion                                                                                                                                                                                   |       | 2,952                       |       | 2,517                       |       |
|                                                                                                                                                                                                                       |       |                        |       |                        |       |
| Total liabilities                                                                                                                                                                                                          |       | 25,960                      |       | 25,100                      |       |
|                                                                                                                                                                                                                       |       |                        |       |                        |       |
| Commitments and contingencies (Note 10)                                                                                                                                                                                    |       |                        |       |                        |       |
| ** **                                                                                                                                                                                                                 | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| **Stockholders’ equity:**                                                                                                                                                                                             | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Preferred stock, $0.01 par value, 5,000,000  authorized, and no shares issued and outstanding                                                                                                                              | ** ** | **—**                  | ** ** | **—**                  | ** ** |
| Common stock, $0.01 par value, 100,000,000 shares  authorized; 47,139,383 and 47,132,540 shares issued; 41,995,979 and  42,147,336 shares outstanding at December 31, 2009 and  September 30, 2009, respectively |       | 471                         |       | 471                         |       |
| Additional paid-in capital                                                                                                                                                                                                 |       | 197,028                     |       | 196,711                     |       |
| Accumulated deficit                                                                                                                                                                                                        |       | (140,631                    | )          | (140,770                    | )          |
| Treasury stock, at cost, 5,143,404 and 4,985,204  shares at December 31, 2009 and September 30, 2009, respectively                                                                                               |       | (5,019                      | )          | (4,842                      | )          |
| Total stockholders’ equity                                                                                                                                                                                            |       | 51,849                      |       | 51,570                      |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                            |       | $                           | 77,809     |                        | $          | 76,670 |   |

 

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

 

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**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

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

**(unaudited)**

** **
| ** **                                                    | ** ** | **Three months ended  December 31,** | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                    | ** ** | **2009**                                       | ** ** | **2008** | ** ** |
|                                                          |       |                                           |       |   |   |
| Net revenues                                                  |       | $                                              | 43,878     |   | $ | 37,235 |   |
|                                                          |       |                                           |       |   |   |
| Cost of revenues                                              |       | 37,882                                         |       | 31,627 |   |
|                                                          |       |                                           |       |   |   |
| Gross profit                                                  |       | 5,996                                          |       | 5,608 |   |
|                                                          |       |                                           |       |   |   |
| Operating expenses:                                           |       |                                           |       |   |   |
| Research and development                                      |       | 1,683                                          |       | 1,442 |   |
| Selling and marketing                                         |       | 1,758                                          |       | 2,177 |   |
| General and administrative                                    |       | 2,021                                          |       | 2,075 |   |
| Amortization of intangible asset                              |       | 389                                            |       | 439 |   |
|                                                          |       |                                           |       |   |   |
| Total operating expenses                                      |       | 5,851                                          |       | 6,133 |   |
|                                                          |       |                                           |       |   |   |
| Income (loss) from operations                                 |       | 145                                            |       | (525 | ) |
| Interest and other income, net                                |       | 18                                             |       | 59 |   |
|                                                          |       |                                           |       |   |   |
| Income (loss) before income taxes                             |       | 163                                            |       | (466 | ) |
| Provision for income taxes                                    |       | 24                                             |       | — |   |
|                                                          |       |                                           |       |   |   |
| Net income (loss)                                             |       | $                                              | 139        |   | $ | (466 | ) |
|                                                          |       |                                           |       |   |   |
| Net income (loss) per share — basic and diluted          |       | $                                              | 0.00       |   | $ | (0.01 | ) |
|                                                          |       |                                           |       |   |   |
| Shares used in computing basic net income (loss)  per share   |       | 42,027                                         |       | 43,137 |   |
| Shares used in computing diluted net income  (loss) per share |       | 42,833                                         |       | 43,137 |   |

 

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

 

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**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(inthousands)**

**(unaudited)**

 
| ** **                                                                                          | ** ** | **Three  months ended********December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2009**                                         | ** ** | **2008** | ** ** |
| ** **                                                                                          | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Cash flows from operating activities:                                                               |       |                                             |       |   |   |
| Net income (loss)                                                                                   |       | $                                                | 139        |   | $ | (466 | ) |
| Adjustments to reconcile net income (loss) to net  cash (used in) provided by operating activities: |       |                                             |       |   |   |
| Depreciation and amortization                                                                       |       | 617                                              |       | 672 |   |
| Gain on disposal of asset                                                                           |       | (9                                               | )          | — |   |
| Provision for doubtful accounts                                                                     |       | 11                                               |       | 25 |   |
| Stock-based compensation                                                                            |       | 312                                              |       | 339 |   |
| Changes in operating assets and liabilities:                                                        |       |                                             |       |   |   |
| Accounts receivable                                                                                 |       | (2,253                                           | )          | 1,896 |   |
| Income tax receivable                                                                               |       | —                                           |       | 1,856 |   |
| Inventories                                                                                         |       | (2,787                                           | )          | 3,332 |   |
| Prepaid expenses and other assets                                                                   |       | (181                                             | )          | (769 | ) |
| Accounts payable                                                                                    |       | 1,292                                            |       | (3,493 | ) |
| Accrued expenses                                                                                    |       | (909                                             | )          | (359 | ) |
| Deferred revenue                                                                                    |       | 500                                              |       | 387 |   |
|                                                                                                |       |                                             |       |   |   |
| Net cash (used in) provided by operating activities                                                 |       | (3,268                                           | )          | 3,420 |   |
|                                                                                                |       |                                             |       |   |   |
| Cash flows from investing activities:                                                               |       |                                             |       |   |   |
| Receipt of refundable acquisition consideration                                                     |       | 3,629                                            |       | — |   |
| Purchases of property and equipment                                                                 |       | (123                                             | )          | (178 | ) |
|                                                                                                |       |                                             |       |   |   |
| Net cash provided by (used in) investing activities                                                 |       | 3,506                                            |       | (178 | ) |
|                                                                                                |       |                                             |       |   |   |
| Cash flows from financing activities:                                                               |       |                                             |       |   |   |
| Purchase of treasury stock                                                                          |       | (177                                             | )          | (166 | ) |
| Proceeds from issuance of common stock                                                              |       | 6                                                |       | 89 |   |
| Payments on capital lease obligation                                                                |       | (5                                               | )          | (8 | ) |
|                                                                                                |       |                                             |       |   |   |
| Net cash used in financing activities                                                               |       | (176                                             | )          | (85 | ) |
|                                                                                                |       |                                             |       |   |   |
| Net increase in cash and cash equivalents                                                           |       | 62                                               |       | 3,157 |   |
| Cash and cash equivalents, beginning of period                                                      |       | 21,039                                           |       | 10,003 |   |
|                                                                                                |       |                                             |       |   |   |
| Cash and cash equivalents, end of period                                                            |       | $                                                | 21,101     |   | $ | 13,160 |   |

 

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

 

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**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**1.  Basis of Presentation**

 

The accompanyingcondensed consolidated financial statements have been prepared by Network Engines, Inc.(“Network Engines” or the “Company”) in accordance with accounting principlesgenerally accepted in the United States of America and pursuant to the rules andregulations of the Securities and Exchange Commission (the “SEC”).  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with generallyaccepted accounting principles have been condensed or omitted pursuant to such rules andregulations.  The year-end condensedconsolidated balance sheet data was derived from audited financial statements,but does not include all year-end disclosures required by accounting principlesgenerally accepted in the United States of America.  These financial statements should be read inconjunction with the audited financial statements and the accompanying notesincluded in the Company’s 2009 Annual Report on Form 10-K (the “2009 Form 10-K”)filed by the Company with the SEC.

 

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

 

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

 

**2.  Significant Accounting Policies**

 

***Recent Accounting Pronouncements***

 

In September 2006,the Financial Accounting Standards Board (“FASB”) issued authoritative guidancewhich defines fair value, establishes a framework for measuring fair value inaccordance with generally accepted accounting principles and expandsdisclosures about fair value measurements. This guidance was effective forfiscal years beginning after November 15, 2007; however, the FASB delayedthe effective date to fiscal years beginning after November 15, 2008 fornonfinancial assets and nonfinancial liabilities, except those items recognizedor disclosed at fair value on an annual or more frequent basis. The Companyadopted this guidance, as it applies to its financial assets and liabilitieswhich are recognized or disclosed at fair value on a recurring basis (at leastannually), as of October 1, 2008. The Company adopted this guidance, as itapplies to its nonfinancial assets and liabilities, as of October 1,2009.  The adoption of this guidance didnot have an impact on the Company’s financial position, results of operations,or cash flows.

 

In December 2007,the FASB issued authoritative guidance related to business combinations. Thisguidance establishes principles and requirements for how the acquirer recognizesand measures in its financial statements the identifiable assets acquired, theliabilities assumed, and any noncontrolling interest in the acquiree,recognizes and measures the goodwill acquired in the business combination or again from a bargain purchase and determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination. This guidance is effective for businesscombinations on a prospective basis for which the acquisition date is on orafter the beginning of the Company’s first annual reporting period beginning onor after December 15, 2008. The Company adopted this guidance as of October 1,2009 and the adoption did not have an impact on its financial position, resultsof operations, or cash flows.

 

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

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

intangibleassets recognized as of, and subsequent to, the effective date. The Companyadopted this guidance as of October 1, 2009 and the adoption did not havean impact on its financial position, results of operations, or cash flows.

 

In October 2009,the FASB issued authoritative guidance for multiple-deliverable revenue arrangements,which amends previously issued guidance to require an entity to use anestimated selling price when vendor specific objective evidence or acceptablethird party evidence does not exist for any products or services included in amultiple element arrangement. The arrangement consideration should be allocatedamong the products and services based upon their relative selling prices, thuseliminating the use of the residual method of allocation. This guidance alsorequires expanded qualitative and quantitative disclosures regardingsignificant judgments made and changes in applying this guidance. This guidanceis effective on a prospective basis for revenue arrangements entered into ormaterially modified in fiscal years beginning on or after June 15, 2010.Early adoption and retrospective application are also permitted. The Company isin the process of evaluating whether the adoption will have a material impacton its financial position, results of operations, or cash flows.

 

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

 

In January 2010,the FASB issued authoritative guidance requiring additional disclosure relatedto fair value measurements that are made on a recurring and non-recurringbasis.  This guidance updates theguidance previously issued by the FASB related to fair value measurementdisclosures.  Under this guidance,entities will be required to provide disclosures for transfers in and out ofLevel 1 and Level 2 fair value inputs. In addition, entities will be required to provide disclosures foractivity within the Level 3 fair value input tier, including purchases, sales,issuances, and settlements during the reporting period.  This guidance is effective for interim andannual reporting periods beginning after December 15, 2009, except for theLevel 3 disclosure requirements, which will be effective for fiscal yearsbeginning after December 15, 2010. The Company does not expect the adoption of this guidance to have amaterial impact on its financial position, results of operations, or cashflows.

 

#### ***Cash,Cash Equivalents and Short-Term Investments***

 

The Company held $21.1million in cash and cash equivalents as of December 31, 2009.  Cash equivalents consisted of a money marketfund purchased with an original maturity of three months or less.  Cash equivalents are measured at fair value,as described in more detail in Note 3. The Company held cash and cash equivalents totaling $21.0 million as of September 30,2009.  The following table presentsbalances of cash and cash equivalents held as of December 31, 2009 and September 30,2009 (in thousands):

 
| ** **                          | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                          | ** ** | **2009**              | ** ** | **2009**               | ** ** |
| **Cash**                            |       | $                     | 6,101      |                   | $          | 4,009 |   |
| **Cash equivalents:**               |       |                  |       |                   |       |
| Money market fund                   |       | 15,000                |       | 17,030                 |       |
|                                |       |                  |       |                   |       |
| **Total cash and cash equivalents** |       | $                     | 21,101     |                   | $          | 21,039 |   |

 

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

 

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

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

***Significant Customers***

 

The following tablessummarize those customers which accounted for greater than 10% of the Company’snet revenues or accounts receivable:

 
| ** **           | ** ** | **Net Revenues for the three  months ended December 31,** | ** ** |
|----------------------|------------|----------------------------------------------------------------|------------|
| ** **           | ** ** | **2009**                                                       | ** ** | **2008** | ** ** |
| EMC  Corporation     |       | 40                                                             | %          | 33 | % |
| Tektronix, Inc. |       | 21                                                             | %          | 14 | % |

 
| ** **           | ** ** | **Accounts Receivable at** | ** ** |
|----------------------|------------|----------------------------|------------|
| ** **           | ** ** | **December 31, 2009** | ** ** | **September 30, 2009** | ** ** |
| EMC  Corporation     |       | 36                         | %          | 30 | % |
| Tektronix, Inc. |       | 25                         | %          | 17 | % |

 

***SubsequentEvents***

 

The Company evaluatedsubsequent events through February 9, 2010, the date of issuance of thesecondensed consolidated financial statements. With the exception of the subsequent event related to the Amended andRestated Loan and Security Agreement entered into between the Company andSilicon Valley Bank on February 5, 2010, which is more fully described inNote 11, no material recognizable subsequent events occurred during thisperiod.

 

**3. FairValue Measurements**

 

The Companyrecords its financial assets and liabilities at fair value, which is defined asthe price that would be received to sell an asset or paid to transfer aliability (an “exit price”), in the principal or most advantageous market forthe asset or liability, in an orderly transaction between market participantsat the measurement date. Valuation techniques used to measure fair valueinclude observable and unobservable inputs. Observable or market inputs reflectmarket data obtained from independent sources, while unobservable inputsreflect the Company’s assumptions about market participant assumptions based onbest information available.

 

Observableinputs are the preferred source of fair values. These two types of inputscreate the following fair value hierarchy:

 

·                  Level 1—Valuationsare based on unadjusted quoted prices in active markets that are accessible atthe measurement date for identical assets or liabilities.

 

·                  Level 2—Valuationsare based on quoted prices for similar assets or liabilities in active markets,or quoted prices for identical or similar assets or liabilities in markets thatare not active for which significant inputs are observable, either directly orindirectly.

 

·                  Level 3—Valuationsare based on prices or valuation techniques that require inputs that are bothunobservable and significant to the overall fair value measurement. Inputsreflect management’s best estimates regarding the assumptions that marketparticipants would use in valuing the asset or liability at the measurementdate.

 

Asof December 31, 2009, the Company held certain assets that are required tobe measured at fair value on a recurring basis, consisting of a money marketfund, which is classified as cash equivalents. The following table presents thefair value hierarchy for the Company’s financial assets measured at fair valueon a recurring basis as of December 31, 2009 (in thousands):

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 
| ** **        | ** ** | **Fair Value  Measurements at December 31, 2009 Using:** | ** ** |
|-------------------|------------|---------------------------------------------------------------|------------|
|              | ** ** | **Level 1 Inputs**                                            | ** ** | **Level 2 Inputs** | ** ** | **Level 3 Inputs** |   |
| Assets:           |       |                                                          |       |   |   |   |   |
| Money market fund |       | $                                                             | 15,000     |   | $ | — |   | $ | — |   |
|                   |            |                                                               |            |  |  |  |  |  |  |  |

 

Effective October 1,2008, the Company also adopted authoritative guidance regarding the fair valueoption, which allows an entity to choose to measure certain financialinstruments and liabilities at fair value on an investment-by-investment basis.Subsequent fair value measurement for the financial instruments and liabilitiesan entity chooses to measure at fair value will be recognized in earnings. Asof December 31, 2009, the Company had not elected this option for anyeligible financial instrument.

 

The net assetamount recorded in the balance sheet (carrying amount) and the estimated fairvalues of financial instruments at December 31, 2009 consisted of thefollowing:

 
| ** **        | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** |
|-------------------|------------|----------------------|------------|----------------|------------|
| Assets:           |       |                 |       |           |       |
| Money market fund |       | $                    | 15,000     |           | $          | 15,000 |   |
|                   |            |                      |            |                |            |  |  |

 

The fair values of the money market fund were based on the quotedmarket prices on securities exchanges.

 

Effective October 1, 2009, the Company adopted a newly issuedaccounting standard for fair value measurements of all nonfinancial assets andnonfinancial liabilities not recognized or disclosed at fair value in thefinancial statements on a recurring basis. The adoption of the accountingstandard for these assets and liabilities did not have an impact on the Company’sfinancial position, results of operations, or cash flows as there were nononfinancial assets or liabilities measured at fair value during the threemonths ended December 31, 2009. However, this standard may impact the Company in future periods andrequire additional disclosures.

 

**4.Business Combination**

 

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

 

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

 

7

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**5.  Stock-Based Compensation**

 

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

 

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

 
| ** **                             | ** ** | **Three months ended** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|
| ** **                             | ** ** | **December 31,**            | ** ** |
| ** **                             | ** ** | **2009**                         | ** ** | **2008** | ** ** |
|                                   |       |                             |       |   |   |
| Cost of revenues                       |       | $                                | 38         |   | $ | 35 |   |
| Research and development               |       | 46                               |       | 84 |   |
| Selling and marketing                  |       | 77                               |       | 61 |   |
| General and administrative             |       | 151                              |       | 159 |   |
| Total stock-based compensation expense |       | $                                | 312        |   | $ | 339 |   |

 

The Company estimates thefair value of stock options using the Black-Scholes valuation model.  This valuation model takes into account theexercise price of the award, as well as a variety of significantassumptions.  These assumptions includethe expected term, the expected volatility of the Company’s common stock overthe expected term, the risk-free interest rate over the expected term, and theCompany’s expected annual dividend yield. The Company believes that the valuation technique and the approachutilized to develop the underlying assumptions are appropriate in calculatingthe fair values of the Company’s stock options granted during the three monthperiods ended December 31, 2009 and 2008. Estimates of fair value are not intended to predict the value ultimatelyrealized by persons who receive equity awards. In determining the amount of expense to be recorded, judgment is alsorequired to estimate forfeitures of the awards based on the probability ofemployees completing the required service period.  Historical forfeituresare used as a starting point for developing the estimate of future forfeitures.

 

Assumptionsused to determine the fair value of options granted during the three monthsended December 31, 2009 and 2008, using the Black-Scholes valuation model,were:

 
| ** **                      | ** ** | **Three months ended December 31,** | ** ** |
|---------------------------------|------------|------------------------------------------|------------|
|                            | ** ** | **2009**                                 |       | **2008** |   |
|                            |       |                                     |       |   |   |
| Expected term (1)               |       | 3.75 to 5.75 years                       |       | 4.75 to 5.50 years |   |
| Expected volatility  factor (2) |       | 71.99 to 74.03%                          |       | 66.82 to 69.73% |   |
| Risk-free interest rate  (3)    |       | 1.45 to 2.51%                            |       | 1.55 to 1.72% |   |
| Expected annual  dividend yield |       | —                                   |       | — |   |

 

----

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

 

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

 

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

 

Stock-based compensationexpense incurred related to the Company’s Employee Stock Purchase Plan (the “PurchasePlan”) is determined based on the discount of 15% from the per share marketprice on the close of the purchase period. No expense related to the Purchase Plan was incurred during the threemonths ended December 31, 2009 as there have been no new offerings underthe Purchase Plan since the most recent purchase in May 2009.

 

8

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

A summary of the Company’sstock option activity for the three months ended December 31, 2009 is asfollows:

 
| ** **                              | ** ** | **Three months ended December 31, 2009** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------|------------|
| ** **                              | ** ** | **Number of  Options**                        | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted********Average Remaining  Contractual  Term (in years)** | ** ** |
|                                    |       |                                          |       |   |   |   |   |
| Outstanding  at September 30, 2009 |       | 7,959,408                                     |       | $ | 2.08 |   |   |   |
| Granted                                 |       | 423,500                                       |       | $ | 1.38 |   |   |   |
| Exercised                               |       | (6,843                                        | )          | $ | 0.83 |   |   |   |
| Forfeited                               |       | (20,845                                       | )          | $ | 1.67 |   |   |   |
| Expired                                 |       | (2,734                                        | )          | $ | 1.74 |   |   |   |
| Outstanding  at December 31, 2009  |       | 8,352,486                                     |       | $ | 2.05 |   | 6.38 |   |
| Exercisable  at December 31, 2009  |       | 5,848,600                                     |       | $ | 2.38 |   | 5.47 |   |

 

All stock options grantedduring the three months ended December 31, 2009 were granted with exerciseprices equal to the fair market value of the Company’s common stock on thegrant date and had a weighted average grant date fair value of $0.84.

 

AtDecember 31, 2009,unrecognized compensation expense related to non-vested stock options was$1,307,000, which is expected to be recognized over a weighted average periodof 2.33 years.

 

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

** **

Basic net income(loss) per share is computed by dividing the net income (loss) for the periodby the weighted average number of shares of common stock outstanding during theperiod.  Diluted net income (loss) pershare is computed by dividing the net income (loss) for the period by theweighted average number of shares of common stock and potential common stock,if dilutive, outstanding during the period. Potential common stock includes incremental shares of common stockissuable upon the exercise of stock options, calculated using the treasurystock method.  For periods in which theCompany incurs a net loss, diluted net loss per share is the same as basic netloss per share because the inclusion of these common stock equivalents would beanti-dilutive.

 

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

 
| ** **                                                                                                      | ** ** | **Three months  ended  December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                      | ** ** | **2009**                                   | ** ** | **2008** | ** ** |
| Numerator:                                                                                                      |       |                                       |       |   |   |
| Net income (loss)                                                                                               |       | $                                          | 139        |   | $ | (466 | ) |
|                                                                                                            |       |                                       |       |   |   |
| Denominator:                                                                                                    |       |                                       |       |   |   |
| Shares  used in computing basic net income (loss) per share                                                     |       | 42,027                                     |       | 43,137 |   |
| Common  stock equivalents from employee stock options                                                           |       | 806                                        |       | — |   |
|                                                                                                            |       |                                       |       |   |   |
| Shares  used in computing diluted net income (loss) per share                                                   |       | 42,833                                     |       | 43,137 |   |
|                                                                                                            |       |                                       |       |   |   |
| Net  income (loss) per share:                                                                                   |       |                                       |       |   |   |
| Basic                                                                                                           |       | $                                          | 0.00       |   | $ | (0.01 | ) |
| Diluted                                                                                                         |       | $                                          | 0.00       |   | $ | (0.01 | ) |
|                                                                                                            |       |                                       |       |   |   |
| Anti-dilutive  potential common stock equivalents excludedfrom the calculation of net income  (loss) per share: |       |                                       |       |   |   |
| Options  to purchase common stock                                                                               |       | 6,180                                      |       | 7,524 |   |

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**7.  Intangible Asset**

 

The Company recorded an intangible asset asthe result of its acquisition of Alliance Systems (see Note 4 above).  The acquired intangible assetis customer relationships, which is being amortized over 17 years, which is theestimated period of economic benefit expected to be received, resulting in aweighted average amortization period of 4.97 years.  Thefollowing table presents the intangible asset balances as of December 31, 2009 andSeptember 30, 2009 (in thousands):

 
| ** **              | ** ** | **December 31, 2009**  | ** ** | **September 30, 2009**   | ** ** |
|-------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **              | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Book  Value** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Book  Value** | ** ** |
| ** **              | ** ** | ** **                  | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Customer  relationships |       | $                           | 11,775     |                          | $          | 4,036 |   | $ | 7,739 |   | $ | 11,775 |   | $ | 3,647 |   | $ | 8,128 |   |
|                         |            |                             |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Amortizationexpense for the three months ended December 31, 2009 and 2008 was $389,000and $439,000, respectively.  Theestimated future amortization expense for the intangible asset as of December 31,2009 by fiscal year is $1,166,000 for the remainder of 2010, $1,330,000 for2011, $1,119,000 for 2012, $868,000 for 2013, $678,000 for 2014, and $2,578,000thereafter.

 

The Companyreviews long-lived assets, including definite-lived intangible assets, todetermine if any adverse conditions exist that would indicate impairment.  Factors that could lead to an impairment ofacquired customer relationships include a worsening in customer attrition ratescompared to historical attrition rates, or lower than initially anticipatedcash flows associated with customer relationships.  The Company assesses the recoverability oflong-lived assets based on the projected undiscounted future cash flowsestimated to be generated over the asset’s remaining life.  The amount of impairment, if any, is measuredbased on the excess of the carrying value over fair value.  Fair value is generally calculated as thepresent value of estimated future cash flows using a risk-adjusted discountrate, which requires significant management judgment with respect to revenueand expense growth rates, and the selection and use of an appropriate discountrate.

 

**8.  Inventories**

 

Inventoriesconsisted of the following (in thousands):

 
| ** **       | ** ** | **December 31,  2009** | ** ** | **September 30, 2009** | ** ** |
|------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **       | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Raw  materials   |       | $                           | 9,551      |                        | $          | 8,246 |   |
| Work  in process |       | 1,478                       |       | 1,063                       |       |
| Finished  goods  |       | 4,835                       |       | 3,769                       |       |
|             |       |                        |       |                        |       |
| Total            |       | $                           | 15,864     |                        | $          | 13,078 |   |

 

**9.  Equity**

 

On June 12,2008, the Board of Directors of the Company authorized the repurchase of up to$5 million of its common stock through a share repurchase program.  As authorized by the program, shares may bepurchased in the open market or through privately negotiated transactions, in amanner consistent with applicable securities laws and regulations.  This stock repurchase program does notobligate the Company to acquire any specific number of shares, does not have anexpiration date, and may be terminated at any time by the Company’s Board ofDirectors.  All repurchases are expectedto be funded from the Company’s current cash balances or from cash generatedfrom operations.  To facilitate repurchases of shares under this program, the Company hasestablished Rule 10b5-1 plans intended to comply with the requirements of Rule 10b5-1and Rule 10b-18 under the Securities Exchange Act of 1934.  A Rule 10b5-1plan permits the repurchase of shares by a company at times when it otherwisemight be prevented from doing so under insider trading laws or because ofcompany blackout periods, provided that the plan is adopted when the company isnot aware of material non-public information.  Pursuant to the plan, abroker

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

designatedby the Company has the authority to repurchase shares, in accordance with theterms of the plan, without further direction from the Company.  Theamount and timing of specific repurchases are subject to the terms of the planand market conditions.  Upon the expiration of the first 10b5-1 planon November 7, 2008, the Company suspended repurchases of its commonstock.  The Company resumed the stockrepurchase program on March 16, 2009 under a new 10b5-1 plan, asauthorized by the Board of Directors. During the three months ended December 31, 2009, the Companyrepurchased 158,200 shares of its common stock at an average cost of $1.12 pershare.  From the inception of the sharerepurchase program through December 31, 2009, the Company had repurchased2,581,546 shares of its common stock at an average cost of $0.84 pershare.  As of December 31, 2009, themaximum dollar value that may yet be used for purchases under the program was$2,820,000.

 

**10.  Commitments andContingencies**

 

***Guarantees and Indemnifications***

 

Acquisition-relatedindemnifications — When, as part of an acquisition, the Company acquires allthe stock of a company, the Company assumes liabilities for certain events orcircumstances that took place prior to the date of acquisition.  The maximum potential amount of futurepayments the Company could be required to make for such obligations isundeterminable.  Although certainprovisions of the agreements remain in effect indefinitely, the Companybelieves that the probability of receiving a claim related to acquisitionsother than Alliance Systems is unlikely. As a result, the Company had not recorded any liabilities for suchindemnification clauses as of December 31, 2009.  As of December 31, 2009, the Company hadreceived two claims related to the Alliance Systems acquisition.  For one of the claims, the Company paid asettlement of $88,000 during the fiscal year ended September 30,2008.  The second claim was brought in January 2009by Cordsen Engineering GmbH (“Cordsen”), a former customer of Alliance Systems,alleging that certain products that Cordsen purchased from Alliance Systems(prior to the Company’s acquisition of Alliance Systems) were defective and didnot meet Cordsen’s desired specifications. Cordsen alleges that by virtue of the Company’s acquisition of AllianceSystems in October 2007, the Company became the assignee of AllianceSystems’ agreement with Cordsen.  TheAlliance Systems selling stockholders have agreed with the Company to undertakethe defense of the action insofar as it relates to activities that occurredprincipally before the Company acquired Alliance Systems, and have agreed tobear any costs associated with this action. The Company believes this claim is without merit.  The Company is unable to predict the ultimateoutcome of this claim and is unable to estimate the amount of any potentialloss it might incur as a result of this claim, and therefore no amounts havebeen accrued relating to this claim as of December 31, 2009.  With regard to any claims which the Companyhas received or may receive in the future related to the Alliance Systemsacquisition, the Company intends to pursue reimbursement from the formershareholders of Alliance Systems for any losses incurred by the Company as aresult of such claims, pursuant to the terms of the Alliance Systems mergeragreement.

 

TheCompany enters into standard indemnification agreements in the ordinary courseof its business.  Pursuant to theseagreements, the Company indemnifies, holds harmless, and agrees to reimbursethe indemnified party for losses suffered or incurred by the indemnified party,generally its business partners or customers, in connection with any patent,copyright, trademark, trade secret or other intellectual property infringementclaim by any third party with respect to its products.  The term of these indemnification agreementsis generally perpetual.  The Company hasnever incurred costs to defend lawsuits or settle claims related to theseindemnification agreements.  As a result,the Company believes the estimated fair value of these agreements isminimal.  Accordingly, the Company has noliabilities recorded for these indemnifications as of December 31, 2009.

 

Product warranties — The Company offers and fulfills standard warranty services on itsapplication platform solutions.  Warrantyterms vary in duration depending upon the product sold, but generally providefor the repair or replacement of any defective products for periods of up to 36months after shipment.  Based uponhistorical experience and expectation of future conditions, the Companyreserves for the estimated costs to fulfill customer warranty obligations uponthe recognition of the related revenue. The following table presents changes in the Company’s product warrantyliability for the three months ended December 31, 2009 and 2008 (inthousands):

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 
| ** **                                  | ** ** | **Three months ended   December 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2009**                                   | ** ** | **2008** | ** ** |
|                                        |       |                                       |       |   |   |
| Beginning balance                           |       | $                                          | 641        |   | $ | 931 |   |
| Accruals for warranties issued              |       | 324                                        |       | 334 |   |
| Fulfillment of warranties during the period |       | (363                                       | )          | (388 | ) |
| Ending balance                              |       | $                                          | 602        |   | $ | 877 |   |

 

***Contingencies***

 

*Initial Public Offering Lawsuit*

 

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

 

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

 

**11. Lineof Credit**

 

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

 

On February 5,2010, the Company and the Bank entered into an Amended and Restated Loan andSecurity Agreement.  This agreementamended the Loan Agreement to extend its term to February 4, 2012, and tochange the interest rate on the line to one half of a point (0.50%) above thecurrent prime rate with interest payable monthly.  The Company is also required to comply withcertain financial covenants relating to liquidity and minimum operating cashflows per quarter.

 

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**ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Special Note RegardingForward-Looking Statements**

** **

This Quarterly Report on Form 10-Qcontains forward-looking statements within the meaning of Section 21E ofthe Securities Exchange Act of 1934, as amended, that involve risks anduncertainties.  All statementsother than statements of historical information provided herein areforward-looking statements and may contain projections related to financialresults, economic conditions, trends and known uncertainties.  Our actual results could differ materiallyfrom those discussed in the forward-looking statements as a result of a numberof factors, which include those discussed in this section and in Part II,Item 1A, Risk Factors, of this report and the risks discussed in our otherfilings with the Securities and Exchange Commission (the “SEC”).  Readers are cautioned not to place unduereliance on these forward-looking statements, which reflect management’sanalysis, judgment, belief or expectation only as of the date hereof.  We undertake no obligation to publiclyreissue these forward-looking statements to reflect events or circumstancesthat arise after the date hereof.

 

Thefollowing discussion and analysis should be read in conjunction with thecondensed consolidated financial statements and the notes thereto included inItem 1 in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2009 filed by us with the SEC.

 

**Overview**

** **

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

 

**CriticalAccounting Policies and Estimates**

 

Ourdiscussion and analysis of financial condition and results of operations arebased upon our condensed consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States of America.  In preparingthese financial statements, we have made estimates and judgments in determiningcertain amounts included in the financial statements.  We base our estimates and judgments onhistorical experience and other assumptions that we believe to be reasonableunder the circumstances.  Actual resultsmay differ from these estimates under different assumptions or conditions.  There have been no changes to our criticalaccounting policies since September 30, 2009.

 

**Resultsof Operations**

 

**Threemonths ended December 31, 2009 compared to the three months ended December 31,2008**

 

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

 
| ** **                     | ** ** | **Three months ended****December 31****,** | ** ** |
|--------------------------------|------------|-------------------------------------------------|------------|
| ** **                     | ** ** | **2009**                                        | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                     | ** ** | **Dollars**                                     | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues                   |       | $                                               | 43,878     |   | 100.0 | % | $ | 37,235 |   | 100.0 | % | $ | 6,643 |   | 17.8 | % |
| Gross profit                   |       | 5,996                                           |       | 13.7 | % | 5,608 |   | 15.1 | % | 388 |   | 6.9 | % |
| Operating expenses             |       | 5,851                                           |       | 13.3 | % | 6,133 |   | 16.5 | % | (282 | ) | (4.6 | )% |
| Income (loss) from  operations |       | 145                                             |       | 0.3 | % | (525 | ) | (1.4 | )% | 670 |   | — |   |
| Net income (loss)              |       | 139                                             |       | 0.3 | % | (466 | ) | (1.3 | )% | 605 |   | — |   |
|                                |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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***Net Revenues***

 

Our revenues are derived primarily from sales of application platformsolutions to our OEM and ISV customers. The increase in net revenues during the three months ended December 31,2009 as compared to the three months ended December 31, 2008 was primarilythe result of increased sales volume with some of our larger customers, as thethree months ended December 31, 2008 was more heavily impacted by theglobal economic downturn than the three months ended December 31,2009.  These increases were alsopartially the result of new revenues earned from our design wins achievedduring fiscal year 2009, in particular a design win achieved in the fourthquarter of fiscal year 2009 with our largest customer.  We began shipping products associated withthis design win during the three months ended December 31, 2009. Theseincreases were partially offset by a decrease in net revenues related to thefact that we have been transitioning away from some of our non-strategic,transactional revenues to projects that are more in line with our businessmodel.

 

***Gross Profit***

 

Gross profit representsnet revenues recognized less the cost of revenues. Cost of revenues includescost of materials, manufacturing costs, warranty costs, inventory write-downs,shipping and handling costs and customer support costs. Manufacturing costs areprimarily comprised of compensation, contract labor costs and, when applicable,contract manufacturing costs.

 

Gross profit as apercentage of net revenues decreased for the three months ended December 31,2009, as compared to the three months ended December 31, 2008. Thedecrease from the prior year was primarily due to changes in customer andproduct mix, which were impacted by certain new business opportunities won inrecent quarters, which have gross margins that are lower than historicallevels.  The first shipments of productrelated to some of these opportunities occurred (and the related revenues wererecognized) during the three months ended December 31, 2009.  We have pursued such opportunities in orderto increase revenues and leverage those revenues over our existinginfrastructure to improve operating margins. In addition, certain planned price decreases took effect during thethree months ended December 31, 2009 in connection with the design winachieved in the fourth quarter of fiscal year 2009 with our largest customer.

 

Gross profit as apercentage of net revenues is affected by customer and product mix, componentmaterial costs, pricing and the volume of orders as well as by the mix ofproduct manufactured internally compared to product manufactured by a contractmanufacturer, which carries higher manufacturing costs. There could bevariability with regard to our gross profit percentage in future periods;however, we expect our gross profit percentage will be in the range of 11% to12.5% in the near term as our revenues related to recent design winsincrease.  We may also continue to seekhigher volume revenue opportunities which have gross profit percentages that arelower than historical levels.

 

***Operating Expenses***

 

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

 
| ** **                        | ** ** | **Three months ended****December 31****,** | ** ** |
|-----------------------------------|------------|-------------------------------------------------|------------|
| ** **                        | ** ** | **2009**                                        | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                     | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating  expenses:              |       |                                            |       |   |   |   |   |   |   |   |   |   |   |
| Research and  development         |       | $                                               | 1,683      |   | 3.8 | % | $ | 1,442 |   | 3.9 | % | $ | 241 |   | 16.7 | % |
| Selling and marketing             |       | 1,758                                           |       | 4.0 | % | 2,177 |   | 5.8 | % | (419 | ) | (19.2 | )% |
| General and  administrative       |       | 2,021                                           |       | 4.6 | % | 2,075 |   | 5.6 | % | (54 | ) | (2.6 | )% |
| Amortization of  intangible asset |       | 389                                             |       | 0.9 | % | 439 |   | 1.2 | % | (50 | ) | (11.4 | )% |
|                              |       |                                            |       |   |   |   |   |   |   |   |   |   |   |
| Total operating  expenses         |       | $                                               | 5,851      |   | 13.3 | % | $ | 6,133 |   | 16.5 | % | $ | (282 | ) | (4.6 | )% |

 

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***Research and Development***

 

Research and development expenses consist primarily of salaries andrelated expenses for personnel engaged in research and development, fees paidto consultants and outside service providers, material costs for prototype andtest units and other expenses related to the design, development, testing andenhancements of our application platform solutions.  We expense all of our research anddevelopment costs as they are incurred. The following table summarizes the most significant components ofresearch and development expense for the periods indicated, in thousands and asa percentage of total research and development expense, and provides thechanges in thousands and percentages:

 
| ** **                            | ** ** | **Three months ended****December 31****,** | ** ** |
|---------------------------------------|------------|-------------------------------------------------|------------|
| ** **                            | ** ** | **2009**                                        | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                                     | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research  and development:            |       |                                            |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and  related expenses    |       | $                                               | 1,015      |   | 60.3 | % | $ | 970 |   | 67.3 | % | $ | 45 |   | 4.6 | % |
| Stock-based  compensation             |       | 46                                              |       | 2.7 | % | 84 |   | 5.8 | % | (38 | ) | (45.2 | )% |
| Prototype                             |       | 326                                             |       | 19.4 | % | 140 |   | 9.7 | % | 186 |   | 132.9 | % |
| Consulting and  professional services |       | 142                                             |       | 8.4 | % | 92 |   | 6.4 | % | 50 |   | 54.3 | % |
| Other                                 |       | 154                                             |       | 9.2 | % | 156 |   | 10.8 | % | (2 | ) | (1.3 | )% |
|                                  |       |                                            |       |   |   |   |   |   |   |   |   |   |   |
| Total research and  development       |       | $                                               | 1,683      |   | 100 | % | $ | 1,442 |   | 100 | % | $ | 241 |   | 16.7 | % |

 

Research and development expenses increased in the three months ended December 31,2009, as compared to the three months ended December 31, 2008, primarilydue to increases in prototype and consulting and professional servicesexpenses.  These costs often tend tofluctuate based on the status of our development projects which are in processat any given time.  Although ourapplication platform development strategy emphasizes the utilization ofstandard component technologies, which utilize off-the-shelf components, someof our design wins from fiscal year 2009 required customized platforms which haveresulted in additional prototype and consulting and professional services.  We expect that prototype and consulting andprofessional services costs will continue to be variable and could fluctuatedepending on the timing and magnitude of our development projects.

 

***Selling and Marketing***

 

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

 
| ** **                         | ** ** | **Three months ended****December 31****,** | ** ** |
|------------------------------------|------------|-------------------------------------------------|------------|
| ** **                         | ** ** | **2009**                                        | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                         | ** ** | **Dollars**                                     | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling  and marketing:            |       |                                            |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and  related expenses |       | $                                               | 1,311      |   | 74.6 | % | $ | 1,565 |   | 71.9 | % | $ | (254 | ) | (16.2 | )% |
| Stock-based  compensation          |       | 77                                              |       | 4.4 | % | 61 |   | 2.8 | % | 16 |   | 26.2 | % |
| Marketing programs                 |       | 54                                              |       | 3.1 | % | 171 |   | 7.8 | % | (117 | ) | (68.4 | )% |
| Travel                             |       | 99                                              |       | 5.6 | % | 109 |   | 5.0 | % | (10 | ) | (9.2 | )% |
| Other                              |       | 217                                             |       | 12.3 | % | 271 |   | 12.5 | % | (54 | ) | (19.9 | )% |
|                               |       |                                            |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and  marketing       |       | $                                               | 1,758      |   | 100 | % | $ | 2,177 |   | 100 | % | $ | (419 | ) | (19.2 | )% |

 

Selling and marketing expenses decreased in the threemonths ended December 31, 2009, as compared to the three months ended December 31,2008, primarily due to decreases in compensation and related expenses and

 

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marketing programs.  Compensation and related expenses decreasedprimarily due to a decrease in selling and marketing headcount from 46 as of December 31,2008, to 41 as of December 31, 2009. The decrease in marketing programs was primarily attributable to effortsundertaken by the Company to manage expenses.

 

***General and Administrative***

 

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

 
| ** **                            | ** ** | **Three months ended****December 31****,** | ** **         |
|---------------------------------------|------------|-------------------------------------------------|--------------------|
| ** **                            | ** ** | **2009**                                        | ** **         | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                                     | ** **         | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General  and administrative:          |       |                                            |               |   |   |   |   |   |   |   |   |   |   |
| Compensation and  related expenses    |       | $                                               | 1,078              |   | 53.3 | % | $ | 1,062 |   | 51.2 | % | $ | 16 |   | 1.5 | % |
| Stock-based  compensation             |       | 151                                             |               | 7.5 | % | 159 |   | 7.7 | % | (8 | ) | (5.0 | )% |
| Consulting and  professional services |       | 440                                             |               | 21.7 | % | 465 |   | 22.4 | % | (25 | ) | (5.4 | )% |
| Director and officer  insurance       |       | 38                                              |               | 1.9 | % | 55 |   | 2.6 | % | (17 | ) | (30.9 | )% |
| Other                                 |       | 314                                             |               | 15.6 | % | 334 |   | 16.1 | % | (20 | ) | (6.0 | )% |
|                                  |       |                                            |               |   |   |   |   |   |   |   |   |   |   |
| Total general and  administrative     |       | $                                               |    2,021 |   | 100 | % | $ | 2,075 |   | 100 | % | $ | (54 | ) | (2.6 | )% |

 

General and administrative expenses decreased in the three months endedDecember 31, 2009, as compared to the three months ended December 31,2008, primarily due to decreases in consulting and professional services.  The decrease in consulting and professionalservices was primarily due to lower costs for legal services.

 

***Amortization of Intangible Asset***

 

Amortization of the intangible asset decreased by $50,000 in the threemonths ended December 31, 2009, as compared to the three months ended December 31,2008.  Amortization expense for theintangible asset decreases annually over its life of 17 years, to reflect thefact that the estimated economic benefit expected to be received from theintangible asset declines over time.

 

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

* *

Interest and otherincome, net, decreased to $18,000 for the three months ended December 31,2009, compared to $59,000 for the three months ended December 31,2008.  This decrease was primarily due toa $38,000 decrease in interest income, attributable to lower interest rates onthe cash balances held by us during the three months ended December 31,2009, as compared to the three months ended December 31, 2008.

 

***Provision for Income Taxes***

 

The provision forincome taxes for the three months ended December 31, 2009 was$24,000.  There was no provision forincome taxes during the three months ended December 31, 2008.  Although we have significant net operatingloss carryforwards which can be used to offset taxable income, we are stillsubject to federal alternative minimum tax. In addition, we will be subject to state taxes in various jurisdictionswhere we do not have net operating loss carryforwards or where states havesuspended the use of net operating loss carryforwards to offset taxable income.

 

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**Liquidityand Capital Resources**

 

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

 
| ** **                                           | ** ** | **Three months ended********December 31****,** | ** **                                                 |
|------------------------------------------------------|------------|-----------------------------------------------------|------------------------------------------------------------|
| ** **                                           | ** ** | **2009**                                            | ** **                                                 | **2008** | ** ** |
|                                                 | ** ** | ** **                                          | ** **                                                 | ** ** | ** ** |
| Net  income (loss)                                   |       | $                                                   |           139 |   | $ |        (466 | ) |
| Non-cash  adjustments to net income (loss)           |       | 931                                                 |                                                       | 1,036 |   |
| Changes  in working capital                          |       | (4,338                                              | )                                                          | 2,850 |   |
|                                                 |       |                                                |                                                       |   |   |
| Net  cash (used in) provided by operating activities |       | (3,268                                              | )                                                          | 3,420 |   |
|                                                 |       |                                                |                                                       |   |   |
| Net  cash provided by (used in) investing activities |       | 3,506                                               |                                                       | (178 | ) |
| Net  cash used in financing activities               |       | (176                                                | )                                                          | (85 | ) |
|                                                 |       |                                                |                                                       |   |   |
| Net  increase in cash and cash equivalents           |       | 62                                                  |                                                       | 3,157 |   |
| Beginning  cash and cash equivalents                 |       | 21,039                                              |                                                       | 10,003 |   |
|                                                 |       |                                                |                                                       |   |   |
| Ending  cash and cash equivalents                    |       | $                                                   |      21,101                            |   | $ |       13,160 |   |

 

***OperatingActivities***

 

Cash used in operating activities during the three months ended December 31,2009 was primarily the result of net cash used in changes in working capital,partially offset by net income and the impact of non-cash adjustments to netincome.  Changes in working capital were primarily driven by differencesin the timing and magnitude of cash receipts, cash disbursements, inventoryreceipts and shipments to customers.  The changes in working capital werepartially the result of an increase in accounts receivable, which was primarilyrelated to higher net revenues in the three months ended December 31, 2009compared to the three months ended September 30, 2009 and the timing ofthese revenues.  During the three monthsended December 31, 2009, our shipments to customers were heavilyconcentrated toward the end of the period as compared to the three months endedSeptember 30, 2009.  The changes inworking capital were also partially the result of an increase in inventories,which was primarily due to increased purchasing to meet expected futurecustomer demand, in particular as a result of the ramping up of new businessrelating to our fiscal year 2009 design wins.

 

Cash provided by operating activities during the three months ended December 31,2008 was primarily the result of net cash provided by changes in workingcapital and the impact of non-cash adjustments to net loss, partially offset bythe net loss for the period.  Changes in working capital were primarilydriven by differences in the timing and magnitude of cash receipts, cashdisbursements, inventory receipts and invoicing to customers.  The changein accounts receivable was also related to collections of payments fromcustomers, as well as the fact that revenues for the three months ended December 31,2008 were lower than revenues for the three months ended September 30,2008.  The change in inventories was also related to the depletion ofinventories on hand and lower purchases during the three months ended December 31,2008 compared to the three months ended September 30, 2008, which was alsorelated to the downward trend in revenues.  Changes in working capitalduring the three months ended December 31, 2008 also included the receiptof $1.9 million of income tax refunds related to taxes paid by Alliance Systemsin prior years.

 

***InvestingActivities***

 

Cash provided byinvesting activities during the three months ended December 31, 2009 wasprimarily the result of the receipt of the $3.6 million in refundableacquisition consideration, which was a return of cash we originally paid inconnection with our acquisition of Alliance Systems (See Note 4 in thenotes to the condensed consolidated financial statements for details regardingthe acquisition).  This increase in cashwas partially offset by the use of $123,000 of cash for purchases of propertyand equipment.  Cash used in investing activities during the three monthsended December 31, 2008 related to the use of $178,000 of cash forpurchases of property and equipment.

 

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***FinancingActivities***

 

Cash used in financingactivities during the three months ended December 31, 2009 consistedprimarily of $177,000 used to repurchase shares of our common stock.  Cashused in financing activities during the three months ended December 31,2008 consisted primarily of $166,000 used to repurchase shares of our commonstock, partially offset by the receipt of $89,000 as the result of purchasesunder the Employee Stock Purchase Plan.

 

On June 12,2008, our Board of Directors authorized the repurchase of up to $5 million ofour common stock through a share repurchase program.  As authorized by the program, shares may bepurchased in the open market or through privately negotiated transactions, in amanner consistent with applicable securities laws and regulations.  This stock repurchase program does notobligate us to acquire any specific number of shares, does not have anexpiration date, and may be terminated at any time by our Board of Directors.  All repurchases are expected to be fundedfrom our current cash balances or from cash generated from operations.  Tofacilitate repurchases of shares under this program, we have established Rule 10b5-1plans intended to comply with the requirements of Rule 10b5-1 and Rule 10b-18under the Securities Exchange Act of 1934.  A Rule 10b5-1 planpermits the repurchase of shares by a company at times when it otherwise mightbe prevented from doing so under insider trading laws or because of companyblackout periods, provided that the plan is adopted when the company is notaware of material non-public information.  Pursuant to the plan, a brokerdesignated by us has the authority to repurchase shares, in accordance with theterms of the plan, without further direction from us.  The amount andtiming of specific repurchases are subject to the terms of the plan and marketconditions.  Upon the expirationof the first 10b5-1 plan on November 7, 2008, we suspended repurchases ofour common stock.  We resumed the stockrepurchase program on March 16, 2009 under a new 10b5-1 plan, asauthorized by the Board of Directors. During the three months ended December 31, 2009, we repurchased158,200 shares of our common stock at an average cost of $1.12 per share.  From the inception of the share repurchaseprogram through December 31, 2009, we had repurchased 2,581,546 shares ofour common stock at an average cost of $0.84 per share.  As of December 31, 2009, the maximumdollar value that may yet be used for purchases under the program was$2,820,000.

 

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

 

·                  the timing and size oforders from our customers;

 

·                  the timeliness of receiptsof payments from our customers;

 

·                  the timing and size of ourpurchases of inventories;

 

·                  our ability to enter intopartnerships with OEMs and ISVs;

 

·                  the level of success ofour customers in selling systems that include our application platformsolutions;

 

·                  the costs and timing ofproduct engineering efforts and the success of these efforts; and

 

·                  market developments.

 

Webelieve that our available cash resources, cash that we expect to generate fromsales of our products, and borrowings available to us will be sufficient tomeet our operating and capital requirements through at least the next twelvemonths.

 

Inthe event that our available cash resources and our Silicon Valley Bank line ofcredit are not sufficient, or if an event of default occurs, such as failure toachieve certain financial covenants, that limits our ability to borrow underthe line of credit, we may need to raise additional funds. We may in the futureseek to raise additional funds through borrowings, public or private equityfinancings or from other sources. There can be no assurance that additionalfinancing will be available at all or, if available, will be on termsacceptable to us. Additional equity financings could result in dilution to ourshareholders. If additional financing is needed and is not available onacceptable terms, we may need to reduce our operating expenses and scale backour operations.

 

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***ContractualObligations and Commitments***

 

During the three months ended December 31, 2009, there were nomaterial changes to our contractual obligations and commitments as disclosed inour annual report on Form 10-K for the year ended September 30, 2009.

 

**Off-Balance Sheet Arrangements**

 

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

 

**RecentAccounting Pronouncements**

** **

**In September 2006, the Financial AccountingStandards Board (“FASB”) issued authoritative guidance which defines fairvalue, establishes a framework for measuring fair value in accordance withgenerally accepted accounting principles, and expands disclosures about fairvalue measurements. This guidance was effective for fiscal years beginningafter November 15, 2007; however, the FASB delayed the effective date tofiscal years beginning after November 15, 2008 for nonfinancial assets andnonfinancial liabilities, except those items recognized or disclosed at fairvalue on an annual or more frequent basis. We adopted this guidance, as itapplies to our financial assets and liabilities which are recognized ordisclosed at fair value on a recurring basis (at least annually), as of October 1,2008. We adopted this guidance, as it applies to our nonfinancial assets andliabilities, as of October 1, 2009. The adoption of this guidance did not have an impact on our financialposition, results of operations, or cash flows.**

** **

**In December 2007, the FASB issued authoritativeguidance related to business combinations. This guidance establishes principlesand requirements for how the acquirer recognizes and measures in its financialstatements the identifiable assets acquired, the liabilities assumed, and anynoncontrolling interest in the acquiree, recognizes and measures the goodwillacquired in the business combination or a gain from a bargain purchase anddetermines what information to disclose to enable users of the financialstatements to evaluate the nature and financial effects of the businesscombination. This guidance is effective for business combinations on aprospective basis for which the acquisition date is on or after the beginningof our first annual reporting period beginning on or after December 15,2008. We adopted this guidance on October 1, 2009 and the adoption did nothave a material impact on our financial position, results of operations, orcash flows.**

** **

**In April 2008, the FASB issued authoritativeguidance used to determine the useful life of intangible assets. This guidanceamends the factors that should be considered in developing renewal or extensionassumptions used to determine the useful life of a recognized intangible asset.This change is intended to improve the consistency between the useful life of arecognized intangible asset and the period of expected cash flows used tomeasure the fair value of the asset. The requirement for determining usefullives must be applied prospectively to intangible assets acquired after theeffective date and the disclosure requirements must be applied prospectively toall intangible assets recognized as of, and subsequent to, the effective date.This guidance is effective as of the beginning of our fiscal year that beginsafter December 15, 2008. We adopted this guidance on October 1, 2009and the adoption did not have a material impact on our financial position,results of operations, or cash flows.**

** **

**In October 2009, the FASB issued authoritativeguidance for multiple-deliverable revenue arrangements, which amends previouslyissued guidance to require an entity to use an estimated selling price whenvendor specific objective evidence or acceptable third party evidence does notexist for any products or services included in a multiple element arrangement.The arrangement consideration should be allocated among the products andservices based upon their relative selling prices, thus eliminating the use ofthe residual method of allocation. This standard also requires expandedqualitative and quantitative disclosures regarding significant judgments madeand changes in applying this guidance. This standard is effective on aprospective basis for revenue arrangements entered into or materially modifiedin fiscal years beginning on or after June 15, 2010. Early adoption andretrospective application are also permitted. We are in the process of evaluatingwhether the adoption will have a material impact on our financial position,results of operations, or cash flows.**

 

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**In October 2009, the FASB issued authoritativeguidance for certain revenue arrangements that include software elements. Underthis guidance, tangible products containing software elements that functiontogether to deliver the product’s essential functionality are no longer withinthe scope of software revenue guidance. Entities that sell joint hardware andsoftware products that meet this scope exception will be required to follow theguidance for multiple-deliverable revenue arrangements. This standard iseffective on a prospective basis for revenue arrangements entered into ormaterially modified in fiscal years beginning on or after June 15, 2010.Early adoption and retrospective application are also permitted. We are in theprocess of evaluating whether the adoption will have a material impact on ourfinancial position, results of operations, or cash flows.**

** **

In January 2010,the FASB issued authoritative guidance requiring additional disclosure relatedto fair value measurements that are made on a recurring and non-recurringbasis.  This guidance updates theguidance previously issued by the FASB related to fair value measurementdisclosures.  Under this guidance,entities will be required to provide disclosures for transfers in and out of Level1 and Level 2 fair value inputs.  Inaddition, entities will be required to provide disclosures for activity withinthe Level 3 fair value input tier, including purchases, sales, issuances, andsettlements during the reporting period. This guidance is effective for interim and annual reporting periodsbeginning after December 15, 2009, except for the Level 3 disclosurerequirements, which will be effective for fiscal years beginning after December 15,2010.  We do not expect the adoption ofthis guidance to have a material impact on our financial position, results ofoperations, or cash flows.

 

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

 

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

 

**ITEM 4.    CONTROLS AND PROCEDURES**

 

Our management,with the participation of our Chief Executive Officer and Chief FinancialOfficer, evaluated the effectiveness of our disclosure controls and procedures(as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act) as of December 31, 2009.  Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer concluded that, as of December 31,2009, our disclosure controls and procedures (1) were designed toeffectively accumulate and communicate information to the Company’s management,as appropriate, to allow timely decisions regarding required disclosure and (2) wereeffective, in that they provide reasonable assurance that information requiredto be disclosed by the Company in the reports that it files or submits underthe Securities Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’s rules andforms.

 

During the threemonths ended December 31, 2009, no change in ourinternal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) occurred that has materially affected,or is reasonably likely to materially affect, our internal control overfinancial reporting.

 

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**PART II—OTHER INFORMATION**

 

**ITEM 1.     LEGAL PROCEEDINGS**

 

*InitialPublic Offering Lawsuit*

 

On or about December 3,2001, a putative class action lawsuit was filed in the United States DistrictCourt for the Southern District of New York against us, Lawrence A. Genovesi(our former Chairman and Chief Executive Officer), Douglas G. Bryant (our ChiefFinancial Officer), and several underwriters of our initial public offering.The suit alleges, *inter alia*,that the defendants violated the federal securities laws by issuing and sellingsecurities pursuant to our initial public offering in July 2000 (“IPO”)without disclosing to investors that the underwriter defendants had solicitedand received excessive and undisclosed commissions from certain investors. Thesuit seeks damages and certification of a plaintiff class consisting of allpersons who acquired shares of our common stock between July 13, 2000 and December 6,2000.

 

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

 

*CustomerClaim*

 

On January 20,2009, a lawsuit was filed in the United States District Court for the EasternDistrict of Texas against us and several other co-defendants. The suit, filedby Cordsen Engineering GmbH (“Cordsen”), a former customer of AllianceSystems, alleges breach of contract and other claims with regard to certainproducts that Cordsen purchased from Alliance Systems (prior to our acquisitionof Alliance Systems) and which Cordsen alleges did not meet its desiredspecifications. (See Note 3 in the notes to the consolidated financialstatements for details regarding the acquisition.) Cordsen alleges that byvirtue of our acquisition of Alliance Systems in October 2007, we became theassignee of Alliance Systems’ agreement with Cordsen. The Alliance Systemsselling stockholders have agreed with us to undertake the defense of the actioninsofar as it relates to activities that occurred principally before weacquired Alliance Systems, and have agreed to bear any costs associated withthis action. We believe this claim is without merit. We are unable to predictthe ultimate outcome of this claim and are unable to estimate the amount of anypotential loss we might incur as a result of this claim, and therefore noamounts have been accrued relating to this claim as of December 31, 2009.With regard to this claim, we intend to pursue reimbursement from the formershareholders of Alliance Systems for any losses incurred by us, pursuant to theterms of the Alliance Systems merger agreement.

 

**ITEM 1A. RISK FACTORS**

 

The risks anduncertainties described below are not the only ones we are faced with. Additional risks and uncertainties not presently known to us, or that arecurrently deemed immaterial, may also impair our businessoperations.  If any of the following risks actually occur, our financialcondition and operating results could be materially adversely affected. Subsequent to the previous disclosure of risk factors in Item 1A of Part Iof our most recent Annual Report on Form 10-K for the fiscal year ended September 30,2009, there have been no significant changes in our risk factors.

 

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

 

**We derive a significant portionof our revenues from sales of application platform solutions directly to EMCand our revenues may decline significantly if this customer reduces, cancels ordelays purchases of our products, terminates its relationship with us orexercises certain of its contractual rights.**

 

For the three monthsended December 31, 2009 and 2008, sales directly to EMC, our largestcustomer, accounted for 40% and 33%, of our total net revenues,respectively.  These sales are primarilyattributable to a limited number of products pursuant to non-exclusivecontracts. We anticipate that our future operating results will continue todepend heavily on sales to, and our relationship with, this customer.Accordingly, the success of our business will depend, in large part, on thiscustomer’s willingness to continue to utilize our application platformsolutions in its existing and future products. In the fourth quarter of fiscalyear 2009, we won new business to provide additional products to this customer.As this business ramps up, we expect our revenues from this customer toincrease during the remainder of fiscal year 2010. However, gross marginsassociated with this customer have decreased and may continue to decrease, dueto the nature of the new business that we have begun providing to thiscustomer.

 

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

 

Under the terms ofour non-exclusive contracts, this customer has the right to enter intoagreements with third parties for similar products, is not obligated topurchase any minimum quantity of products from us and may choose to stoppurchasing from us at any time, with or without cause. In addition, this customermay terminate the agreements in the event that we attempt to assign our rightsunder the agreements to another party without this customer’s prior approval.Furthermore, in the event that we default on certain portions of the agreement,this customer has the right to manufacture certain products in exchange for amutually agreeable royalty fee. If any of these events were to occur, or ifthis customer were to delay or discontinue purchases of our products as aresult of dissatisfaction or otherwise, our revenues and operating resultswould be materially adversely affected, our reputation in the industry mightsuffer, and we may be unable to accurately predict revenues, profitability andcash flows.

 

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

 

**Our future success is dependentupon our ability to generate significant revenues from application platformdesign relationships.**

 

Webelieve we must diversify our revenues and a major component of our businessstrategy is to form application platform design relationships with newOEMs and ISVs. Under this strategy, we work with our customers to designan application platform branded with their name. The customers then perform allof the selling and marketing efforts related to sales of their brandedappliance.

 

Thereare multiple risks associated with this strategy including:

 

·                  the expenditure ofsignificant product design and engineering costs, which if not recoveredthrough application platform sales could negatively affect our operatingresults;

 

·                  a significant reliance onour customers’ application software products, which could be technologicallyinferior to competitive products and result in limitations on our applicationplatform sales, causing our revenues and operating results to suffer;

 

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·                  our customers will mostlikely continue selling their software products as separate products inaddition to selling them in the form of an application platform, which willrequire us to effectively communicate the benefits of delivering their softwarein the form of an application platform;

 

·                  our reliance on ourcustomers to perform all of the selling and marketing efforts associated withfurther sales of the application platform solution we develop with them;

 

·                  continued consolidationwithin the data storage, network security, carrier communications andenterprise communications industries that results in existing customers beingacquired by other companies;

 

·                  our ability to leveragestrategic relationships to obtain new sales leads;

 

·                  our ability to provide ourcustomers with high quality application platform solutions at competitiveprices; and

 

·                  there is no guarantee thatdesign wins will result in actual orders or sales. A “design win” occurs when anew customer or a separate division within an existing customer notifies usthat we have been selected to integrate the customer’s application. There canbe delays of several months or more between the design win and when a customerinitiates actual orders. The design win may never result in actual orders orsales. Further, if the customer’s plans change, we may commit significantresources to design wins that do not result in actual orders.

 

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

 

We have begun topursue (and in some cases we have won) larger opportunities which we expect tohave a more significant impact on our net revenues. We expect that theseopportunities will have gross margins which are lower than historical levels,but we believe that such opportunities can be leveraged over our existinginfrastructure without requiring us to incur significant additional operatingcosts. However, if we cannot meet customer demand utilizing our existinginfrastructure, we may need to increase our infrastructure and associatedoperating costs, which would negatively impact our operating results. Also, ourrevenue growth may be lower than expected if we are unsuccessful in winninglarge opportunities, which would lead us to pursue smaller opportunities inorder to grow revenues.

 

**We may not be able to effectivelycommercialize our application platform solutions and services or may be at acompetitive disadvantage if we cannot license or integrate third-partyapplications that are essential for the functionality of certain platforms.**

 

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

 

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**Our business could be harmed ifwe fail to adequately integrate new technologies into our application platformsolutions or if we invest in technologies that do not result in the desiredeffects on our current and/or future product offerings.**

 

Aspart of our strategy, we review opportunities to incorporate products andtechnologies that could be required in order to add new customers, retainexisting customers, expand the breadth of product offerings or enhance ourtechnical capabilities. Investing in new technologies presents numerous risks,including:

 

·                  we may experiencedifficulties integrating new technologies into our current or future products;

 

·                  our new products may bedelayed because selected new technologies themselves are delayed or havedefects and/or performance limitations;

 

·                  we may incorporatetechnologies that do not result in the desired improvements to our currentand/or future application platform products;

 

·                  we may incorporate newtechnologies that either may not be desired by our customers or may not becompatible with our customers’ existing technology;

 

·                  new technologies areunproven and could contain latent defects, which could result in high productfailure rates; and

 

·                  we could find that the newproducts and/or technologies that we choose to incorporate into our productsare technologically inferior to those utilized by our competitors.

 

Ifwe are unable to adequately integrate new technologies into our applicationplatform products or if we invest in technologies that do not result in thedesired effects on our current and/or future product offerings, our businesscould be harmed and operating results could suffer.

 

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

 

**If application platforms are notincreasingly adopted as a solution to meet a significant portion of companies’software application needs, the market for application platform solutions maynot grow, which could negatively impact our revenues.**

 

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

 

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

 

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

 

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

 

The markets we serve arecharacterized by rapid technological change, frequent new product introductionsand enhancements, potentially short product lifecycles, changes in customerdemands and evolving industry standards. In the application platform market, weattempt to mitigate these risks by utilizing standards-based hardware platformsand by maintaining an adequate knowledge base of available technologies.However, the application platform solutions that we sell could be renderedobsolete if products based on new technologies are introduced or new industrystandards emerge and we are not able to incorporate these technological changesinto our products. In addition, we depend on third parties for the basehardware of our application platforms and we are at risk if these third partiesdo not integrate new technologies. Releasing new products and servicesprematurely may result in quality problems, and delays may result in loss ofcustomer confidence and market share. We may be unable to design new productsand services or achieve and maintain market acceptance of them once they havecome to market. Furthermore, when we do release new or enhanced products andservices, we may be unable to manage the transition from the older products andservices to minimize disruption in customer ordering patterns, avoid excessiveinventories of older products and deliver enough new products and services tomeet customer demand.

 

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

 

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

 

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

 

In the past, we haveincurred significant net losses and could incur net losses in the future. At December 31,2009 and September 30, 2009, our accumulated deficit was$141 million. If we are successful in winning large opportunities infuture periods but cannot meet our customer requirements utilizing our existinginfrastructure and production capabilities, we may need to increase ourinfrastructure. This would increase operating expenses and negatively impactour operating results. Also, our revenue growth may be lower than expected ifwe are unsuccessful in winning large opportunities, which would lead us topursue smaller opportunities in order to grow revenues. As a result, we willneed to generate significant revenues to achieve and sustain profitability. Ifwe do not achieve and sustain profitability, the market price for our commonstock may decline. Even if we achieve sustained profitability there can be noguarantee that our stock price will increase.

 

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

 

In October 2007, weentered into an agreement with Silicon Valley Bank to provide for a line ofcredit. We view this line of credit as a source of available liquidity to fundfluctuations in our working capital requirements. This facility containsvarious conditions, covenants and representations with which we must be incompliance in order to borrow funds. However, if we wish to borrow under thisfacility in the future, there can be no assurance that we will be in compliancewith these conditions, covenants and representations. In addition, this line ofcredit facility with Silicon Valley Bank expires on February 4, 2012.After that, we may need to secure new financing to continue fundingfluctuations in our working capital requirements. However, we may not be ableto secure new financing, or financing on favorable terms, if we experience anadverse change in our business. If we experience an increase in order activityfrom our customers, our cash balance may decrease due to the need to purchaseinventories to fulfill those orders. If this occurs, we may have to draw onthis facility, or secure other financing, in order to maintain our liquidity.As of February 9, 2010, we have not borrowed on this line of credit.

 

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

 

Our discussion andanalysis of financial condition and results of operations is based on ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the

 

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United States. Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the amounts reported in the consolidated financial statements andaccompanying notes. On an ongoing basis, we evaluate significant estimates usedin preparing our consolidated financial statements, including those related to:

 

·                  revenue recognition;

 

·                  collectibility of accountsreceivable;

 

·                  inventory write-downs;

 

·                  stock-based compensation;

 

·                  valuation of intangibleassets;

 

·                  warranty reserves; and

 

·                  realization of deferredtax assets.

 

We base our estimates onhistorical experience and on various other assumptions that we believe to bereasonable under the circumstances, as provided in our discussion and analysisof financial condition and results of operations, the results of which form thebasis for making judgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources. Actual results may differfrom these and other estimates if our assumptions change or if actualcircumstances differ from those in our assumptions, which could cause ouroperating results to fall below the expectations of securities analysts andinvestors, resulting in a decline in our stock price.

 

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

 

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

 

·                  the degree to which ourcustomers are successful in reselling application platform solutions to theirend customers;

 

·                  our customers’ consumptionof their existing inventories of our products;

 

·                  the variability of orderswe receive from customers who have project-based businesses;

 

·                  the loss of key suppliersor customers;

 

·                  the product mix of oursales;

 

·                  the timing of new productintroductions by our customers;

 

·                  the availability and/orprice of products from suppliers;

 

·                  price competition;

 

·                  costs associated with ourintroduction of new application platform solutions and the market acceptance ofthose products; and

 

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

 

**If the products and services thatwe sell become more commoditized and competition in the data storage, networksecurity, carrier communications and enterprise communications marketscontinues to increase, then our gross profit as a percentage of net revenuesmay decrease and our operating results may suffer.**

 

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

 

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

 

At December 31,2009, the carrying value of our intangible asset, which consists of customerrelationships associated with our acquisition of Alliance Systems, Inc. (“AllianceSystems”), was approximately $7.7 million, net of accumulatedamortization. We will continue to incur non-cash charges relating to theamortization of our intangible asset over its remaining useful life. Futuredeterminations of significant write-offs of the intangible asset resulting froman impairment test or any accelerated amortization of the intangible assetcould have a significant impact on our operating results and affect our abilityto achieve or maintain profitability. Although we do not believe that anyimpairment of the intangible asset exists at this time, in the event that anyindicators of possible impairment exist, we may record charges which could havea material adverse effect on our results of operations. Such indicatorsinclude, but are not limited to, a worsening in customer attrition ratescompared to historical attrition rates, or lower than initially anticipated cashflows associated with customer relationships.

 

***Risks related to competition.***

 

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

 

In the applicationplatform market, we face significant competition from a number of differenttypes of companies. Our competitors include companies who marketgeneral-purpose servers, server virtualization software, specific-purposeservers and application platforms as well as companies that sell customintegration services utilizing hardware produced by other companies. Many ofthese companies are larger than we are and have greater financial resources andname recognition than we do, as well as significant distribution capabilitiesand larger, more established service organizations to support their products.Our larger competitors may be able to leverage their existing resources,including their extensive distribution capabilities and service organizations,to provide a wider offering of products and services and higher levels ofsupport on a more cost-effective basis than we can. We expect competition inthe application platform market to increase significantly as more companiesenter the market and as our existing competitors continue to improve theperformance of their current products and to introduce new products andtechnologies. Such increased competition could adversely affect sales of ourcurrent and future products. In addition, competing companies may be able toundertake more extensive promotional activities, adopt more aggressive pricingpolicies and offer more attractive terms to their customers than we can. If ourcompetitors provide lower cost products with greater functionality or supportthan our application platform solutions, or if some

 

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of their products arecomparable to ours and are offered as part of a range of products that is broaderthan ours, our application platform solutions could become undesirable.

 

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

 

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

 

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

 

Although we currentlyhave a relatively small sales and marketing organization, we must continue toincrease market awareness and sales of our products and services and promoteour brand in the marketplace. We believe that to compete successfully we willneed OEMs and ISVs to recognize us as a top-tier provider of applicationplatform solutions and services. If we are unable to increase market awarenessand promote ourselves as a leading provider of application platform solutionswith our available resources, we may be unable to develop new customerrelationships or expand our product and service offerings at existingcustomers.

 

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

 

We need to effectivelymanage our customer support operations to ensure that we maintain goodrelationships with our customers. We believe that providing a level of highquality customer support will be a key differentiator for our product offeringsand may require more technically qualified staff which could be more costly. Ifwe are unable to provide this higher level of service we may be unable tosuccessfully attract and retain customers.

 

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

 

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

 

**Our dependence on sole source andlimited source suppliers for key application platform components makes ussusceptible to supply shortages and potential quality issues that could preventus from shipping customer orders on time, or at all, and could result in lostsales and customers.**

 

We depend upon singlesource and limited source suppliers for our industry standard processors, mainlogic boards, telephony boards, certain disk drives, hardware platforms andpower supplies as well as certain of our chassis and sheet metal parts.Additionally, we depend on limited sources to supply certain other industrystandard and customized components. We have in the past experienced, and may inthe future experience, shortages of or difficulties in acquiring components inthe quantities and of the quality needed to produce our application platformsolutions. Shortages in supply or quality issues related to these keycomponents for an extended time would cause delays in the production of ourapplication platform solutions, prevent us from satisfying our contractualobligations and meeting customer expectations, and result in lost sales andcustomers. If we are unable to buy components in the quantities and of the qualitythat we need on a timely basis or at acceptable prices, we will not be able tomanufacture and deliver our application platform solutions on a timely or costeffective basis to our customers, and our competitive position, reputation,business, financial condition and results of operations could be seriouslyharmed. If we are able to secure other sources of supply for such components,our costs to purchase such components could increase, which would negativelyimpact our gross margins. A significant portion of our components are purchasedfrom suppliers located in China. During the past year, several factories inChina have

 

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closed without notice. Ifa factory which supplies parts to us closes with little or no notice, we couldexperience shortages and difficulties in locating alternative sources ofsupply.

 

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

 

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

 

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

 

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

 

Inthe past, we have discovered errors in some of our application platformsolutions and have experienced delays in the shipment of our products duringthe period required to correct these errors or we have had to replace defectiveproducts that were already shipped. Errors in our application platformsolutions may be found in the future and any of these errors could besignificant. Significant errors, including those discussed above, may resultin:

 

·                  the loss of or delay inmarket acceptance and sales of our application platform solutions;

 

·                  diversion of engineeringresources;

 

·                  increased manufacturingcosts;

 

·                  the loss of customers;

 

·                  injury to our reputationand other customer relations problems; and

 

·                  increased maintenance andwarranty costs.

 

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

 

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

 

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

 

We use rolling forecastsbased on anticipated product orders to determine our application platform componentrequirements. Lead times for materials and components that we order may changesignificantly depending on variables such as specific supplier requirements,contract terms and current market demand for those components. In addition, avariety of factors, including the timing of product releases, potential delaysor cancellations of orders, the timing of large orders and the unprovenacceptance of new products in the market make it difficult to predict productorders. As a result, our materials requirement forecasts may not be accurate.If we overestimate our materials requirements, we may have excess inventory,which would increase costs and negatively impact our cash position. Ouragreements with certain customers provide us with protections related toinventory purchased in accordance with the terms of these agreements; however,these protections may not be sufficient to prevent certain losses as a resultof excess or obsolete inventory. If we underestimate our materialsrequirements, we may have inadequate inventory which could interrupt ourmanufacturing and delay delivery of our application platform solutions tocustomers, resulting in a loss of sales or customers. Any of these occurrenceswould negatively impact our business and operating results.

 

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

 

**Our operating results wouldsuffer if we or our customers were subject to an infringement claim thatresulted in protracted litigation, the award of significant damages against usor the payment of substantial ongoing royalties.**

 

Substantiallitigation regarding intellectual property rights exists in the technologyindustry. We expect that application platform solutions may be subject tothird-party infringement claims as the number of competitors in the industrysegment grows and the functionality of products in different industry segmentsoverlap. In the past we have received claims from third parties that ourapplication platform solutions infringed their intellectual property rights. Wedo not believe that our application platform solutions employ technology thatinfringes the proprietary rights of any third parties. We are also not aware ofany claims made against any of our customers related to their infringement ofthe proprietary rights of other parties in relation to products that includeour application platform solutions. Other parties may make claims against us orour customers that, with or without merit, could:

 

·                  be time consuming for usto address;

 

·                  require us to enter intoroyalty or licensing agreements;

 

·                  result in costlylitigation, including potential liability for damages;

 

·                  divert our management’sattention and resources; and

 

·                  cause product shipmentdelays.

 

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

 

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

 

Our success depends inlarge part on our ability to retain and attract highly skilled engineering,sales, marketing, customer service and managerial personnel. If we are unableto attract a sufficient number of qualified

 

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personnel, we may not beable to meet key objectives such as developing, upgrading, or enhancing ourproducts in a timely manner, which could negatively impact our business andcould hinder any future growth.

 

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

 

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

 

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

 

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

 

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

 

The market priceof our common stock has been subject to significant fluctuations and maycontinue to fluctuate or decline. During the fiscal year ended September 30,2009, the closing price of our common stock ranged from a low of $0.29 to ahigh of $1.32, and during the three months ended December 31, 2009, from alow of $1.07 to a high of $1.66.  The market for technology and micro-capstocks has been extremely volatile and frequently reaches levels that bear norelationship to the past or present operating performance of those companies.General economic conditions, such as recession or interest rate or currencyrate fluctuations in the United States or abroad, could negatively affect themarket price of our common stock. In addition, our operating results may bebelow the expectations of securities analysts and investors. If this were tooccur, the market price of our common stock may decrease significantly. In thepast, following periods of volatility in the market price of a company’ssecurities, securities class action litigation has often been institutedagainst such companies. Such litigation could result in substantial cost and adiversion of management’s attention and resources.

 

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

 

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

 

At certain times in thepast, the market price of our common stock has been less than $1.00 per share.If we are unable to meet the stock price listing requirements of NASDAQ, ourcommon stock could be de-listed from the NASDAQ Global Market. If our commonstock were de-listed from the NASDAQ Global Market, among other things, thiscould result in a number of negative implications, including reduced liquidityin our common stock as a result of the loss of market efficiencies associatedwith NASDAQ and the loss of federal preemption of state securities laws, aswell as the potential loss of confidence by suppliers, customers and employees,the loss of institutional investor interest, fewer business developmentopportunities and greater difficulty in obtaining financing. As of February 9,2010, we were in compliance with all applicable requirements for continuedlisting on the NASDAQ Global Market.

 

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

 

The current downturn inthe economy, and any further slowdown in future periods, could adversely affectour business in ways that we are unable to fully anticipate. Tightened creditmarkets may negatively impact operations by affecting solvency of customers,suppliers and other business partners, or the ability of our customers toobtain credit to finance purchases of our products and services, which in turncould lead to increased difficulty in collecting accounts receivable. Tightenedcredit markets may also negatively impact our ability to borrow funds, ifneeded, either under our line of credit with Silicon Valley Bank or from othersources. In addition, government responses to the disruptions in the financialmarkets may not stabilize the markets or increase liquidity or the availabilityof credit for us or our customers. A widespread reduction of global businessactivity could cause customers to reduce capital expenditures, put increasedpricing pressure on our products and services, and subject us, our suppliersand our customers to interest rate risks and tax changes that could impact ourfinancial strength. These and other economic factors could have a materialadverse effect on our financial condition, operating results and liquidity.

 

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

 

Our Board of Directorshas 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, todetermine the price, rights, preferences, privileges and restrictions of thepreferred stock. This preferred stock, if issued, might have preference overthe rights of the holders of common stock and could adversely affect the marketprice of our common stock. The issuance of this preferred stock may make itmore difficult for a third party to acquire us or to acquire a majority of ouroutstanding voting stock. We currently have no plans to issue preferred stock.

 

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

 

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

 

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

 

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**ITEM 2.     UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

 

Thefollowing table presents information regarding the Company’s repurchases of itscommon stock during the three months ended December 31, 2009.

 

Issuer Purchases of Equity Securities

 
| **Month**          | ** ** | **Number of  Shares  Purchased as  Part of Publicly  Announced  Program (1)** | ** ** | **Average  Price Paid  Per Share** | ** ** | **Maximum Dollar Value  that May Yet Be Used  for Purchases Under the  Program** | ** ** |
|--------------------|------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------|------------|
| October 2009  |       | 133,000                                                                                                |       | $                                            | 1.12       |                                                                                                                          | $          | 2,848,000 |   |
| November 2009 |       | 25,200                                                                                                 |       | $                                            | 1.12       |                                                                                                                          | $          | 2,820,000 |   |
| December 2009 |       | —                                                                                                 |       | —                                       |       | $                                                                                                                             | 2,820,000  |   |
| Total              |       | 158,200                                                                                      |       | $                                            | 1.12       |                                                                                                                          |       |   |

 

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(1)   All of the shares of common stock set forth inthis column were purchased pursuant to the program publicly announced on June 12,2008. On this date, we announced that our Board of Directors had authorized therepurchase of up to $5 million of common stock through a share repurchaseprogram. The program does not have an expiration date. All repurchasesdescribed in the table above were effected pursuant to written Rule 10b5-1trading plans. Upon the expiration of the first 10b5-1 plan on November 7,2008, we suspended repurchases of common stock. On March 16, 2009, weannounced that we would resume the repurchase of common stock under a new10b5-1 plan as part of the share repurchase program previously authorized byour Board of Directors. From the program’s inception through December 31,2009, we repurchased 2,581,546 shares at an average cost of $0.84 per share.

 

**ITEM 5.     OTHERINFORMATION**

 

On February 5,2010, we entered into an Amended and Restated Loan and Security Agreement (the“Amended Loan Agreement”) with Silicon Valley Bank (“SVB”).  Thisagreement amends the Loan and Security Agreement dated October 11, 2007,by and among us and SVB, as amended by the First Loan Modification Agreementdated August 5, 2008.  The Amended Loan Agreement provides us with arevolving line of credit in an amount not to exceed $10,000,000 (the “Line ofCredit”).  The Line of Credit matures and the principal balance is payablein full on February 4, 2012, which is 24 months from the date of the AmendedLoan Agreement.

 

Under the AmendedLoan Agreement, we may borrow up to $10,000,000 minus the amount of anyoutstanding letters of credit, the amount of a certain reserve that may beestablished by SVB, and the outstanding principal balance of any advances madeby SVB under the Line of Credit.

 

Amounts borrowedunder the Line of Credit bear interest at a floating per annum rate equal to0.50% above the Prime Rate.  The “Prime Rate” is the rate announced fromtime to time by SVB as its “prime rate.”  We are also subject to an unusedline of credit fee of 0.30% per annum, payable monthly, and to financialcovenants which require us to maintain specified liquidity and minimumoperating cash flows per quarter.

 

The Amended LoanAgreement contains customary events of default, including failure to pay anyprincipal, interest or other amount when due, violation of specified covenants,or a change in control.  Upon the occurrence of an event of default, thepayment of all obligations under the Amended Loan Agreement may be acceleratedand the lending commitments under the Amended Loan Agreement may be terminated.

 

The foregoingdescription of the Amended Loan Agreement is not complete and is qualified inits entirety by reference to the Amended Loan Agreement, which is filed as Exhibit 10.1hereto and is incorporated herein by reference.

 

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**ITEM 6.     EXHIBITS**

 

(a)    Exhibits

 

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

 

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**SIGNATURES**

 

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

 
|                         | **NETWORK  ENGINES, INC.** |
|------------------------------|----------------------------|
|                         |                       |
| Date: February 9,  2010 |                       | /s/  Gregory A. Shortell |
|                         |                       |   |
|                         |                       | Gregory  A. Shortell |
|                         |                       | President and Chief  Executive Officer |
|                         |                       | (Principal Executive  Officer) |
|                         |                       |   |
|                         |                       | /s/  Douglas G. Bryant |
|                         |                       |   |
|                         |                       | Douglas G. Bryant |
|                         |                       | Chief Financial  Officer, Treasurer and Secretary |
|                         |                       | (Principal Financial  Officer and Principal Accounting Officer) |

 

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Exhibit**                                                                                                                                             |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                 |       | Amended  and Restated Loan and Security Agreement, dated as of February 5, 2010,  by and among Network Engines, Inc., and Silicon Valley Bank |
|                 |       |                                                                                                                                                    |
| 31.1                 |       | Certification  of Gregory A. Shortell, the Chief Executive Officer of the Company, pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002.     |
|                 |       |                                                                                                                                                    |
| 31.2                 |       | Certification  of Douglas G. Bryant, the Chief Financial Officer of the Company, pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.       |
|                 |       |                                                                                                                                                    |
| 32.1                 |       | Certification  of Gregory A. Shortell, the Chief Executive Officer of the Company, pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002.     |
|                 |       |                                                                                                                                                    |
| 32.2                 |       | Certification  of Douglas G. Bryant, the Chief Financial Officer of the Company, pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.       |

 

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