<PAGE>

================================================================================

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

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

                                    FORM 10-Q

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

(Mark One)

[X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
     ACT OF 1934

                For the quarterly period ended December 31, 2001

                                       OR

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
    ACT OF 1934

For the transition period from ___________ to ___________

                         Commission file number: 0-30863

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

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

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

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

                                 (781) 332-1000

              (Registrant's telephone number, including area code)

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

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

     As of February 1, 2002, there were 33,139,963 shares of the registrant's
Common Stock, par value $.01 per share, outstanding.

================================================================================

<PAGE>

                              NETWORK ENGINES, INC.

                                      INDEX

<TABLE>
<CAPTION>
                                                                                       PAGE
                                                                                      NUMBER
                                                                                     --------
<S>                                                                                  <C>
                        PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)

        CONDENSED CONSOLIDATED BALANCE SHEETS ......................................      2
        CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS ............................      3
        CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS ............................      4
        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS .......................      5

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
        AND FINANCIAL CONDITION ....................................................     11

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

                           PART II. OTHER INFORMATION

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

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

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ........................     28

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K ...........................................     28

SIGNATURES .........................................................................     29

EXHIBIT INDEX ......................................................................     30
</TABLE>


<PAGE>

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

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

<TABLE>
<CAPTION>
                                                                                  December 31,  September 30,
                                                                                     2001           2001
                                                                                  ------------  -------------
                                         ASSETS                                   (unaudited)
<S>                                                                               <C>           <C>
Current assets:
     Cash and cash equivalents ..............................................      $  66,951    $  74,805
     Restricted cash ........................................................          1,098        1,129
     Accounts receivable, net of allowances .................................          1,708        1,601
     Inventories ............................................................            799          607
     Prepaid expenses and other current assets ..............................            795          857
     Due from contract manufacturer .........................................             18          380
                                                                                   ---------    ---------

         Total  current assets ..............................................         71,369       79,379

Property and equipment, net .................................................          3,136        3,454
Other assets ................................................................            240          171
                                                                                   ---------    ---------

            Total assets ....................................................      $  74,745    $  83,004
                                                                                   =========    =========

                         LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
     Accounts payable .......................................................      $   1,222    $   1,350
     Accrued expenses .......................................................          2,237        2,518
     Accrued restructuring and other charges ................................            887        1,368
     Due to contract manufacturer ...........................................            403        3,117
     Deferred revenue .......................................................             18           93
     Current portion of capital lease obligations and notes payable .........             52           60
                                                                                   ---------    ---------

         Total current liabilities ..........................................          4,819        8,506

     Capital lease obligations and notes payable, net of current portion ....              -            9
     Commitments and contingencies (Note 5)

Stockholders' equity:

     Common stock ...........................................................            353          352
     Additional paid-in capital .............................................        174,484      175,288
     Accumulated deficit ....................................................       (100,629)     (93,438)
     Notes receivable from stockholders .....................................           (573)        (702)
     Deferred stock compensation ............................................         (2,231)      (6,813)
     Treasury stock, at cost ................................................         (1,478)        (198)
                                                                                   ---------    ---------

         Total stockholders' equity .........................................         69,926       74,489
                                                                                   ---------    ---------

            Total liabilities and stockholders' equity ......................      $  74,745    $  83,004
                                                                                   =========    =========

</TABLE>


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

                                        2

<PAGE>

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


<TABLE>
<CAPTION>
                                                                                   Three months ended December 31,
                                                                                  ---------------------------------
                                                                                        2001            2000
                                                                                  --------------- -----------------
<S>                                                                               <C>            <C>
Net revenues ...................................................................    $    2,101       $    6,894

Cost of revenues:
    Cost of revenues ...........................................................         2,072            5,196
    Cost of revenues stock compensation ........................................            73               91
    Inventory write-down .......................................................            --           14,965
                                                                                    ----------       ----------

    Total cost of revenues .....................................................         2,145           20,252
                                                                                    ----------       ----------

      Gross loss ...............................................................           (44)         (13,358)

Operating expenses:
    Research and development ...................................................         1,545            3,874
    Selling and marketing ......................................................         1,182            6,501
    General and administrative .................................................         1,177            2,577
    Stock compensation .........................................................         3,667            1,254
    Amortization of goodwill and intangible assets .............................            --              150
                                                                                    ----------       ----------

      Total operating expenses .................................................         7,571           14,356
                                                                                    ----------       ----------

Loss from operations ...........................................................        (7,615)         (27,714)
Interest income, net ...........................................................           424            1,852
                                                                                    ----------       ----------

Net loss .......................................................................    $   (7,191)      $  (25,862)
                                                                                    ==========       ==========

Net loss per common share - basic and diluted ..................................    $    (0.21)      $    (0.76)
                                                                                    ==========       ==========

Shares used in computing net loss per common share - basic and diluted .........        33,576           33,862
</TABLE>


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

                                       3

<PAGE>

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


<TABLE>
<CAPTION>
                                                                                                    Three months ended
                                                                                                        December 31,
                                                                                               -------------------------------
                                                                                                  2001               2000
                                                                                               ------------     --------------
<S>                                                                                            <C>              <C>
Cash flows from operating activities:
     Net loss .............................................................................     $  (7,191)       $ (25,862)
     Adjustments to reconcile net loss to net cash used in
      operating activities:
         Depreciation and amortization ....................................................           378            1,242
         Provision for inventory reserve, net .............................................            --           15,055
         Provision for doubtful accounts ..................................................            80              575
         Stock compensation ...............................................................         3,740            1,345
         Interest on notes receivable from stockholders ...................................           (10)              (2)
         Changes in operating assets and liabilities, net of effects of acquisition:
             Accounts receivable ..........................................................          (187)           5,762
             Inventories ..................................................................          (192)         (14,016)
             Prepaid expenses and other current assets ....................................            62             (360)
             Due from contract manufacturer ...............................................           362            5,681
             Accounts payable .............................................................          (128)           9,143
             Due to contract manufacturer .................................................        (2,714)           5,832
             Accrued expenses .............................................................          (762)          (1,318)
             Deferred revenue .............................................................           (75)            (162)
                                                                                                ---------        ---------

                 Net cash provided by (used in) operating activities ......................        (6,637)           2,915

Cash flows from investing activities:
     Purchases of property and equipment ..................................................           (60)          (1,943)
     Change in restricted cash ............................................................            31               --
     Purchases of other assets ............................................................           (69)            (213)
     Acquisition of business including acquisition expenses ...............................            --              (30)
                                                                                                ---------        ---------

                 Net cash used in investing activities ....................................           (98)          (2,186)

Cash flows from financing activities:
     Payments on capital lease obligations and notes payable ..............................           (17)             (26)
     Payments received on notes receivable from stockholders ..............................           139               --
     Acquisition of treasury stock ........................................................        (1,280)              --
     Proceeds from issuance of common stock ...............................................            39              361
                                                                                                ---------        ---------

                 Net cash provided by (used in) financing activities ......................        (1,119)             335
                                                                                                ---------        ---------

Net increase (decrease) in cash and cash equivalents ......................................        (7,854)           1,064
Cash and cash equivalents, beginning of period ............................................        74,805          112,382
                                                                                                ---------        ---------

Cash and cash equivalents, end of period ..................................................     $  66,951        $ 113,446
                                                                                                =========        =========
</TABLE>

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

                                       4

<PAGE>

                              NETWORK ENGINES, INC.

       NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

a business to be disposed of. However, SFAS 144 retains APB 30's requirement
that entities report discontinued operations separately from continuing
operations and extends that reporting requirement to "a component of an entity"
that either has been disposed of or is classified as "held for sale." SFAS 144
also amends the guidance of Accounting Research Bulletin No. 51, "Consolidated
Financial Statements," to eliminate the exception to consolidation for a
temporarily controlled subsidiary. SFAS 144 is effective for financial
statements issued for fiscal years beginning after December 15, 2001, including
interim periods, and, generally, its provisions are to be applied prospectively.
The Company does not expect the application of SFAS 144 to have a material
impact on the Company's financial position or results of operations.

Comprehensive Loss

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

Segment Reporting

  The Company organizes itself as a single business segment and conducts its
operations primarily in the United States.

Significant Customers

  During the three months ended December 31, 2001, one customer accounted for
approximately 73% ($1.5 million) of the Company's net revenues; this same
customer accounts for approximately 89% ($1.7 million) of the Company's accounts
receivable at December 31, 2001. During the three months ended December 31,
2000, one customer accounted for approximately 17% ($1.1 million) of the
Company's net revenues. No customer accounted for greater than 10% of the
Company's accounts receivable at December 31, 2000.

3. NET LOSS PER SHARE

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

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

                                                               As of
                                                            December 31,
                                                          -----------------
                                                           2001       2000
                                                          ------      -----
     Options to purchase common stock ...............      5,558      5,816
     Warrants to purchase common stock ..............      1,625      1,729
     Unvested restricted common stock ...............        387        786
                                                           -----      -----

                                                           7,570      8,331
                                                           =====      =====

4. INVENTORIES

                                       6

<PAGE>

  Inventories consisted of the following (in thousands):

                                                   December 31,   September 30,
                                                      2001             2001
                                                      ----             ----
     Raw materials ..........................         $589             $226
     Work in process ........................           42              235
     Finished goods .........................          168              146
                                                      ----             ----

                                                      $799             $607
                                                      ====             ====

  In November 2001, the Company entered into an agreement to engage a third
party to provide long-term product support for the Company's discontinued
product lines. Under the terms of this agreement, the Company agreed to provide
training, documentation and access to qualified employees of the Company. The
Company also transferred certain fully reserved inventory on hand at the time of
the agreement to this third party in exchange for the third party's agreement to
assume all warranty support services to previous purchasers of the Company's
discontinued products.

5. CONTINGENCIES

    On December 29, 1999, a former employee, George Flate, commenced a lawsuit
against the Company and two former officers and directors of the Company in
Suffolk Superior Court, a Massachusetts state court. Mr. Flate alleges that he
was unlawfully terminated as Vice President of OEM Sales by the Company in an
effort to deprive him of commission payments. He is seeking undisclosed damages
based on two contractual claims relating to his employment, although the Company
anticipates he will claim damages in the multi-million dollar range.
Specifically, he is alleging a breach of the implied covenant of good faith and
fair dealing against the Company and a claim of intentional interference with
contractual relations against the former officers of the Company named in the
lawsuit. Both of these claims are based on Mr. Flate's allegations that he is
entitled to commissions from several transactions that were negotiated after Mr.
Flate was no longer with the Company. Mr. Flate was employed by the Company for
approximately one year. Although the Company believes that these claims are
without merit and intends to vigorously defend against each claim asserted in
the complaint, an adverse resolution of either of these claims could require the
payment of substantial monetary damages. Moreover, the Company's defense against
these claims might result in the expenditure of significant financial and
managerial resources. Costs incurred to date have not been material. The case
has proceeded through discovery and the court has scheduled a trial date of May
20, 2002.

  On or about December 3, 2001, Margaret Vojnovich filed in the United States
District Court for the Southern District of New York a lawsuit against Network
Engines, Inc., Lawrence A. Genovesi, the Company's current Chairman and former
Chief Executive Officer, and Douglas G. Bryant, the Company's Chief Financial
Officer and Vice President of Administration (collectively, the "Executive
Officers"), FleetBoston Robertson Stephens, Inc., an underwriter of the
Company's initial public offering in July 2000 (the "IPO" ), Credit Suisse First
Boston Corp., Goldman Sachs & Co., Lehman Brothers Inc. and Salomon Smith
Barney, Inc. (collectively, the "Underwriter Defendants"). The suit generally
alleges that the Underwriter Defendants violated the federal securities laws by
conspiring and agreeing to raise and increase the compensation received by the
Underwriter Defendants by agreeing with some recipients of an allocation of IPO
stock to agree to purchase shares of manipulated securities in the after-market
of the IPO at pre-determined price levels designed to maintain, distort and/or
inflate the price of the Company's common stock in the aftermarket. The suit
also alleges that the Underwriter Defendants received undisclosed and excessive
brokerage commissions and that, as a consequence, the Underwriter Defendants
successfully increased investor interest in the manipulated IPO securities and
increased the Underwriter Defendants' individual and collective underwritings,
compensation and revenues. The suit further alleges that the defendants violated
the federal securities laws by issuing and selling securities pursuant to the
IPO without disclosing to investors that the Underwriter Defendants in the
offering, including the lead underwriters, had solicited and received excessive
and undisclosed commissions from certain investors. The suit seeks damages,
rescission of the purchase prices paid by purchasers of shares of the Company's
common stock and certification of a plaintiff class consisting of all persons
who acquired shares of the

                                       7

<PAGE>

Company's common stock between July 13, 2000 and December 6, 2000. The Company
is in the process of reviewing this suit and intends to respond in a timely
manner. The Company is unable to predict the outcome of this suit and its
ultimate effect, if any, on the Company's financial condition, however the
Company's defense against these claims could result in the expenditure of
significant financial and managerial resources.

  On August 14, 2001, the Company announced that its Board of Directors had
approved the repurchase of up to $5.0 million of the Company's common stock in
the open market or in non-solicited privately negotiated transactions. The
Company plans to use any repurchased shares for its employee stock plans. During
the year ended September 30, 2001 and quarter ended December 31, 2001, the
Company repurchased 300,900 and 1,548,572 shares of common stock at a cost of
approximately $198,000 and $1,280,000, respectively.

6.  ACQUISITION OF IP PERFORMANCE

On November 8, 2000, the Company completed its acquisition of IP Performance,
Inc. ("IP Performance"), a developer of network acceleration technology, through
the exchange of 128,693 shares of Network Engines common stock for all
outstanding shares of IP Performance capital stock. The acquisition was
accounted for using the purchase method of accounting. Accordingly, the fair
market value of the acquired assets and assumed liabilities have been included
in the Company's financial statements as of the acquisition date and the results
of IP Performance operations have been included in the Company's financial
statements thereafter. The purchase price of approximately $2,540,000, plus
assumed net liabilities of approximately $95,000 and acquisition expenses of
approximately $63,000, resulted in goodwill and intangible assets of
approximately $2,698,000. The Company's pro forma statements of operations prior
to the acquisition would not differ materially from reported results.

  In July 2001, the Company completed an intensive review of its business, which
resulted in its implementation of a restructuring plan. This restructuring plan
included a discontinuation of much of the customized hardware and software that
had previously been a part of the Company's product development process. As a
result of this restructuring and an assessment of expected future cash flows,
the Company determined that the recoverability of the IP Performance-related
intangible assets was unlikely. Accordingly, the Company recognized an
impairment charge for the full amount of the remaining un-amortized intangible
assets, approximately $2,023,000, during the fourth quarter of fiscal 2001.
Prior to the impairment, the Company had been amortizing the goodwill and
intangible assets over a three-year period resulting in approximately $150,000
and $675,000 of amortization expense during the quarter ended December 31, 2000
and the year ended September 30, 2001, respectively.

  The Company also issued 321,756 shares of restricted common stock to key
employee shareholders of IP Performance. Under the terms of the restricted stock
agreements, these shares are restricted as to sale and such restrictions lapse
in three equal annual installments, beginning on November 8, 2001, contingent
upon continued employment of the holder. In connection with the issuance of
these restricted shares, the Company recorded approximately $6,351,000 of
deferred compensation, which was being recognized as stock compensation expense
ratably over the vesting period. In December 2001, the Company terminated all
but one of the former IP Performance employees. In accordance with the
restricted stock agreements with these individuals, all of the remaining
un-vested restricted stock vested upon termination. As a result, during the
three months ended December 31, 2001, the Company recognized the remaining
deferred stock compensation of approximately $3,461,000.

7.  INVENTORY WRITE-DOWN

  In the first quarter of fiscal 2001, the Company recorded an inventory
write-down of $14,965,000 for excess and obsolete inventory related to the
Company's WebEngine Blazer product. This excess and obsolete inventory was due
to an unanticipated shortfall in sales of the WebEngine Blazer product during
the first quarter of fiscal 2001 and the resulting reduction in expected future
sales of this product.

8.  RESTRUCTURING AND OTHER CHARGES

                                       8

<PAGE>

  During the year ended September 30, 2001, the Company undertook two
restructurings of its operations, the first of these restructurings occurred in
April 2001 and the second in July 2001. Through the April 2001 restructuring,
the Company sought to better align the Company's operating expenses with
reduced revenues, and as a result of its implementation, the Company recorded a
charge to operations of $2,812,000. This charge was due to a reduction in
workforce from 243 employees to 170 employees, the curtailment of a planned
expansion into leased facilities and other items. This charge included
approximately $951,000 for employee related costs including severance payments
to terminated employees and stock option compensation expense related to
modifications of certain stock options held by terminated employees,
approximately $1,331,000 to write off certain assets related to facilities that
the Company will not be occupying and approximately $530,000 primarily related
to non-refundable deposits on tradeshows the Company will not be attending as
well as certain other sales and marketing commitments. The Company's July 2001
restructuring was the result of an intensive review of its business, which
resulted in a re-focus of the Company's sales strategy toward strategic
partnerships with independent software vendors (ISVs) and original equipment
manufacturers (OEMs) and a discontinuation of much of the customized hardware
and software that was previously included in the Company's products. As a result
of the implementation of the July 2001 restructuring, the Company recorded a
charge to operations of approximately $6,871,000. This charge included
approximately $1,643,000 of employee related costs as the Company reduced its
workforce by 70 employees, approximately $2,224,000 as a result of the Company's
disposal of certain property and equipment, approximately $2,023,000 to write
off goodwill and intangible assets which were deemed to be impaired,
approximately $618,000 of facility costs associated with non-cancelable
operating leases for space which will not be occupied and approximately $363,000
of other charges. In addition to the April and July restructurings, in March
2001 the Company recorded a charge due to the retirement of fixed assets related
to its WebEngine Blazer product line. These fixed assets had a total net book
value of approximately $1,203,000 and consisted primarily of computer equipment
previously utilized in the production and sales of the WebEngine Blazer, the
Company's previous generation web content server appliance product. The total of
the restructuring and other charges detailed above was approximately
$10,886,000. The reduction in the Company's workforce implemented during the
year ended September 30, 2001, impacted employees in all of the Company's
groups, including manufacturing, research and development, selling and marketing
and general and administrative.

The following table sets forth restructuring accrual activity during the three
months ended December 31, 2001:

<TABLE>
<CAPTION>
                                                                  Employee      Facility
                                                                  Relat         Related          Other          Total
                                                                  --------      --------        --------      --------
<S>                                                               <C>           <C>             <C>           <C>
Restructuring accrual balance at September 30, 2001               $   491        $   559        $   318        $ 1,368

Cash payments                                                        (247)           (87)          (147)          (481)

                                                                  -------        -------        -------        -------
Restructuring accrual balance at December 31, 2001                $   244        $   472        $   171        $   887
                                                                  =======        =======        =======        =======
</TABLE>

The Company expects the remaining restructuring accrual balance to be fully
utilized by December 31, 2002, including cash payments of approximately
$750,000.

9.  RELATED PARTY TRANSACTIONS

  In January 2001, the Company entered into a series of related agreements with
Lawrence A. Genovesi, the Company's current Chairman and former President, Chief
Executive Officer and Chief Technology Officer. These agreements were entered
into to avoid significant sales of the Company's stock by Mr. Genovesi as a
result of a margin call on a personal loan collateralized by Mr. Genovesi's
holdings of the

                                       9

<PAGE>

Company's common stock. The Company agreed to guarantee a personal loan obtained
by Mr. Genovesi from a financial institution (the "Bank") through a deposit of
$1,051,850 of the Company's cash with the Bank (the "Guarantee"). The Guarantee
period ended on January 9, 2002 and the Company extended the Guarantee to
January 9, 2003, at which time the balance of the amount deposited with the
Bank, which is not required to satisfy any obligations under the Guarantee, will
be returned to the Company. Mr. Genovesi and the Company also entered into an
agreement whereby Mr. Genovesi has agreed to reimburse the Company for any
obligations incurred by the Company under the Guarantee (the "Reimbursement
Agreement"). Any unpaid balances under the Reimbursement Agreement bear interest
at a rate of 10% per annum. In the event of a default under the Reimbursement
Agreement by Mr. Genovesi, the Company has the right to apply any and all
compensation due to Mr. Genovesi against all of Mr. Genovesi's obligations
outstanding under the Reimbursement Agreement. In addition, the Company and Mr.
Genovesi entered into a revolving promissory note of up to $210,000 (the
"Note"). The Note bore interest at a rate of 5.9% per annum and was due and
payable in full upon the earlier of January 9, 2002 or 30 days following the
date Mr. Genovesi ceased to be an employee of the Company. The Note was paid in
full in November 2001.

  In conjunction with the Guarantee, the Reimbursement Agreement and the Note,
the Company and Mr. Genovesi entered into a pledge agreement whereby Mr.
Genovesi pledged to the Company all shares of the Company's common stock owned
by Mr. Genovesi as of the date of the agreement or subsequently acquired, and
all options and other rights to acquire shares of the Company's common stock
owned by Mr. Genovesi as of the date of the agreement or subsequently acquired
(collectively, the "Pledged Securities"). Additionally, Mr. Genovesi pledged to
the Company all additional securities or other consideration from time to time
acquired by Mr. Genovesi in substitution for, or in respect of, the Pledged
Securities. If Mr. Genovesi elects to sell any of the Pledged Securities during
the term of the agreement, all proceeds of such sale will be applied first to
any outstanding obligations related to the Note and then to any amounts payable
under the Reimbursement Agreement. In addition to the Pledged Securities, the
Note is collateralized by a second mortgage on certain real property owned by
Mr. Genovesi. As of December 31, 2001, no amounts were required to be reimbursed
to the Company under the Reimbursement Agreement. In November 2001, the Company
repurchased 234,822 shares of the Company's common stock from Mr. Genovesi for
$225,195 in a private transaction. The purchase price was determined based on
the average closing price of the Company's common stock over the ten trading
days prior to the purchase date. Mr. Genovesi used the proceeds to pay all
amounts outstanding under the Note, to pay down a recourse note payable to the
Company and to pay taxes incurred in connection with the Company's repurchase of
its common stock from Mr. Genovesi.

  In April 2001, the Company entered into full recourse loan agreements with
certain former employees and certain current and former officers of the Company
(the "Loan Agreements"). These loan agreements were entered into to avoid
substantial sales of the Company's common stock by these employees and officers
as a result of alternative minimum tax obligations incurred by these employees
and officers in connection with their exercise of options to purchase shares of
the Company's common stock. The net amount loaned to the employees and officers
under the Loan Agreements was approximately $508,000. Outstanding amounts under
the Loan Agreements accrue interest at a rate of 4.63% per annum and are due and
payable in full upon the earlier of one year from the date of each individual
agreement or thirty days after termination of employment with the Company,
unless termination is involuntary and without cause. In conjunction with the
Loan Agreements, each employee and officer pledged all shares of capital stock,
and options to purchase capital stock, of the Company now owned, or acquired in
the future (the "Pledged Stock"), and any distributions on the Pledged Stock or
proceeds from their sale. Amounts due under these Loan Agreements have been
included in the balance sheet as notes receivable from stockholders. In November
2001, the Company extended the repayment dates to September 2002 for loans with
an aggregate principal amount of $226,996 due from two of its current officers.

                                       10

<PAGE>

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

Special Note Regarding Forward-Looking Statements

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

  The following discussion and analysis should be read in conjunction with the
condensed consolidated financial statements and the notes thereto included in
Item 1 in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K
for the fiscal year ended September 30, 2001 filed by the Company with the
Securities and Exchange Commission.

Overview

  We are a provider of high-density, server appliance hardware platforms and
custom integration services. Server appliances are pre-configured computer
network infrastructure devices designed to deliver specific application
functionality. We are focused on partnering with independent software vendors
("ISVs") and original equipment manufacturers ("OEMs") to provide these
strategic partners with dense server appliance hardware, integration services
and appliance development, deployment and support to allow these strategic
partners to deliver "turn-key" solutions to their end-user customers. When we
first entered the server appliance market, we focused our business primarily on
providing scalable web content servers to Internet-based organizations, content
infrastructure providers and larger enterprises. It was necessary for us to
design most of the hardware components that went into our servers and, as a
result, we invested significant resources in the development of our products. In
June 1999, we introduced the first "1U" (1.75 inch tall) server, the WebEngine
Blazer. Since the introduction of our WebEngine Blazer product, we experienced
significant growth as we invested in the development of our technology and
products, the recruitment and training of personnel for our engineering, sales
and marketing and technical support departments, and the establishment of an
administrative organization. As a result, our employee base grew from 39 as of
June 30, 1999 to 244 as of March 31, 2001, and our operating expenses grew
significantly.

  Over time, much of the hardware components of server appliances have become
commoditized and a significant number of companies have entered the server
appliance marketplace. In response to competitive pressures combined with the
effects of a downturn in the economy, which had a significant negative impact on
our "new economy" customers, we implemented a restructuring plan in the quarter
ended June 30, 2001, to better align our operating expenses with our reduced
revenues. This restructuring plan resulted in a $2.8 million charge to
operations in April 2001, a 73-employee reduction in our workforce, as well as
the curtailment of planned facility expansion and other cost cutting measures.
We further undertook an extensive review of our business strategy and, in July
2001, we implemented a second restructuring of our business, which de-emphasized
much of our customized hardware and software development and focused our
resources on what we believe to be our core competencies of hardware packaging
and software integration. In addition, this restructuring of our business
included a transition from primarily direct sales channels to partnerships with
ISVs and OEMs in order to offer "turn-key" server appliance hardware platforms
to enterprise customers. Our current server appliance hardware platforms
continue to combine creative hardware packaging, cooling and software
integration to provide high-density, scalable appliances in a 1U form factor. In
addition, the implementation of our July 2001 restructuring plan included a
reduction in our workforce from approximately 160 employees to approximately 95
employees. We incurred a charge to operations of approximately $6.9 million in
the fourth quarter ended September 30,

                                       11

<PAGE>

2001 as we executed our July 2001 restructuring plan. At December 31, 2001, we
had an accumulated deficit of approximately $100.6 million.

  Our revenues are derived from sales of our server appliance hardware
platforms. We recognize revenues upon shipment, provided evidence of an
arrangement has been received, no obligations remain outstanding and
collectibility is reasonably assured. The majority of our sales to date have
been to customers in the United States.

In the past, we generated a portion of our net revenues from license
arrangements, which allowed certain customers to sell our WebEngine Blazer
product under their name in exchange for per unit fees. We recognized license
revenues upon the licensee's sale to its customers. We do not anticipate future
revenues from existing license revenue arrangements.

  Gross profit (loss) represents net revenues recognized less the cost of
revenues. Cost of revenues includes cost of materials, manufacturing costs,
manufacturing personnel expenses, obsolescence charges, packaging, license fees
and shipping and warranty costs. Our gross profit (loss) is affected by the mix
of our product revenues and our product pricing and the timing, size and
configuration of customer orders.

   Research and development expenses consist primarily of salaries and related
expenses for personnel engaged in research and development, fees paid to
consultants and outside service providers, material costs for prototype and test
units and other expenses related to the design, development, testing and
enhancements of our products. We expense all of our research and development
costs as they are incurred. We believe that a significant level of investment in
product research and development is required to remain competitive. We expect to
continue to devote substantial resources to product development. However, we
expect research and development expenses to decrease in absolute dollars during
the remainder of fiscal 2002 due to our transition away from the internal
development of significant proprietary hardware and software. At December 31,
2001, there were 24 employees in research and development.

  Selling and marketing expenses consist primarily of salaries, commissions and
related expenses for personnel engaged in sales, marketing and customer support
functions, as well as costs associated with advertising, trade shows, public
relations and marketing materials. We expect selling and marketing expenses to
decrease in absolute dollars during the remainder of fiscal 2002 due to our
transition to indirect sales channels and the contraction of our international
sales operations. At December 31, 2001, there were 20 employees in sales,
marketing and customer support.

  General and administrative expenses consist primarily of salaries and other
related costs for executive, finance, accounting, information technology,
facilities and human resources personnel, as well as accounting, legal, other
professional fees and allowance for doubtful accounts. We expect general and
administrative expenses to increase during the remainder of fiscal 2002 due to
legal costs expected to be incurred in our defense of current litigation and any
potential settlements or judgments, which could result in the event that current
litigation is adversely resolved. There were 13 general and administrative
employees at December 31, 2001.

  We recorded deferred stock compensation on our balance sheet of $15.5 million
in connection with stock option and restricted stock grants to our employees and
directors that were granted between February 1, 1999 and June 30, 2000. This
amount represents the difference between the exercise price and the deemed fair
value of our common stock for financial reporting purposes at the date of grant.
We are amortizing this stock compensation over the vesting period of the related
options. All options granted subsequent to June 30, 2000 have been issued with
exercise prices equal to the fair market value of our common stock and,
accordingly, no additional deferred compensation has been recorded. Through
December 31, 2001, we amortized $6.6 million to stock compensation expense and
$6.7 million of deferred stock compensation has been reversed due to the
cancellation of options for terminated employees.

  We recorded $6.4 million of deferred compensation on our balance sheet as a
result of restricted stock issued to the former employees of IP Performance,
Inc. ("IP Performance") who were retained as our employees in connection with
our acquisition of IP Performance in November 2000. The restricted stock was to
vest annually through November 2003 contingent upon continued employment.
In December 2001,

                                       12

<PAGE>

we terminated all but one of the former IP Performance employees. In accordance
with the restricted stock agreements, all of the remaining un-vested restricted
stock vested upon termination. As a result, during the three months ended
December 31, 2001, the Company recognized the remaining deferred stock
compensation of approximately $3.5 million.

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

                                                                    Expected
                                                                 Amortization of
                                                                     Stock
Fiscal Quarter Ending                                             Compensation
---------------------                                             ------------
                                                                 (in thousands)
March 31, 2002 .............................................          $272
June 30, 2002 ..............................................           272
September 30, 2002 .........................................           272
December 31, 2002 ..........................................           269

  We then expect aggregate per quarter stock compensation amortization of
approximately $250,000 during the remainder of fiscal 2003 and an aggregate of
approximately $400,000 thereafter. The amount of stock compensation expense to
be recorded in future periods could change if restricted common stock, or
options, for accrued but unvested compensation are forfeited.

Critical Accounting Policies And Estimates

  Our discussion and analysis of our financial condition and results of
operations are based upon our condensed consolidated financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. On an on-going basis, we evaluate our estimates, including
those related to accounts receivable and sales allowances and inventory
valuation. We base our estimates on historical experience and on various other
assumptions that we believe to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities that are not readily apparent from other sources.
Actual results may differ from these estimates under different assumptions or
conditions.

  We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our condensed
consolidated financial statements. We maintain allowances for doubtful accounts
for estimated losses resulting from the inability of our customers to make
required payments. If the financial condition of our customers were to
deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required. We assess the collectibility of revenue
at the point of each sale based upon all available information. We maintain
sales allowances for revenue transactions where collectibility is not reasonably
assured. Estimates of collectibility are affected by our customers' financial
condition at the point of sale and these estimates may differ from actual
results. We write down our inventory for estimated obsolescence or un-marketable
inventory equal to the difference between the cost of inventory and the
estimated market value based upon assumptions about future demand and market
conditions. We include inventory amounts receivable under non-cancelable
inventory purchase commitments in our analysis of obsolescence or un-marketable
inventory. If actual market conditions are less favorable than those projected
by management, additional inventory write-downs may be required.

 Results of Operations

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

                                       13

<PAGE>

<TABLE>
<CAPTION>
                                                       Three months ended
                                                          December 31,
                                                    ------------------------
                                                       2001         2000
                                                    -----------   ----------
<S>                                                 <C>           <C>
Net revenues ......................................         100%         100%

Cost of revenues
     Cost of revenues .............................          99           76
     Cost of revenues stock compensation ..........           3            1
     Inventory write-down (benefit) ...............           -          217
                                                    -----------   ----------

     Total cost of revenues .......................         102          294
                                                    -----------   ----------

        Gross profit (loss) .......................          (2)        (194)

Operating expenses:
     Research and development .....................          74           56
     Selling and marketing ........................          56           95
     General and administrative ...................          56           37
     Stock compensation ...........................         174           18
     Amortization of goodwill and intangible assets           -            2
                                                    -----------   ----------

        Total operating expenses ..................         360          208
                                                    -----------   ----------

Loss from operations ..............................        (362)        (402)
Interest income, net ..............................          20           27
                                                    -----------   ----------

Net loss ..........................................        (342%)       (375%)
                                                    ===========   ==========
</TABLE>

Three Months Ended December 31, 2001 and December 31, 2000

Net Revenues

  Net revenues decreased to $2.1 million in the three months ended December 31,
2001 from $6.9 million in the three months ended December 31, 2000. During the
three months ended December 31, 2001, one customer accounted for 73% of net
revenues. The decrease is due primarily to a lower average selling price of our
products due to increased competitive pricing pressure as well as a decrease in
product sales volumes as a result of the general economic slowdown, which
significantly impacted the information technology spending of our "new economy"
customer base. To a lesser extent, the decline in net revenues is the result of
a decrease in license revenues. We do not expect significant future license
revenues.

Gross Profit (Loss)

  In the three months ended December 31, 2001, we had a gross loss of $44,000,
an improvement from a gross loss of $13.4 million in the three months ended
December 31, 2000. During the three months ended December 31, 2000, we recorded
an inventory write-down of approximately $15.0 million for which there was no
corresponding charge in the three months ended December 31, 2001. The inventory
write-down resulted from an unanticipated decline in sales during the three
months ended December 31, 2000, as well as a high level of inventory and firm
inventory commitments compared to the Company's reduced expectations for future
product sales. Excluding the inventory write-down and stock compensation, gross
profit decreased to $29,000, or 1.4% of net revenues, in the three months ended
December 31, 2001 from $1.7 million, or 24.6% of net revenues, in the three
months ended December 31, 2000. This decrease was primarily the result of a
lower average selling price of our products in the three months ended December

                                       14

<PAGE>

31, 2001. To a lesser extent, the decrease in gross profit (loss) is due to a
decrease in license revenues and product sales volumes during the three months
ended December 31, 2001.

Operating Expenses

  Research and Development. Research and development expenses decreased to $1.5
million in the three months ended December 31, 2001 from $3.9 million in the
three months ended December 31, 2000. This decrease was due primarily to
decreased compensation costs as research and development personnel decreased
from 83 employees at December 31, 2000 to 24 employees at December 31, 2001. The
decrease in research and development expenses is also due to a decrease in
consulting, which resulted from the development of software associated with our
StorageEngine Voyager during the three months ended December 31, 2000. To a
lesser extent, the decrease in research and development expenses was due to a
decrease in prototype and test unit costs as a result of the significant
development efforts associated with our StorageEngine Voyager and WebEngine
Sierra products incurred during the three months ended December 31, 2000, and a
decrease in recruiting costs.

  Selling and Marketing. Selling and marketing expenses decreased to $1.2
million in the three months ended December 31, 2001 from $6.5 million in the
three months ended December 31, 2000. This decrease was due primarily to
decreased compensation costs as sales, marketing and customer support personnel
decreased from 95 employees at December 31, 2000 to 20 employees at December 31,
2001. The decrease in selling and marketing expenses is also attributable to a
decrease in advertising and trade show expenses as we reduced our discretionary
selling and marketing expenditures during the three months ended December 31,
2001. To a lesser extent, the decrease in selling and marketing expenses is also
attributable to decreased travel and recruiting costs as a result of the
decrease in sales, marketing and customer support personnel.

  General and Administrative. General and administrative expenses decreased to
$1.2 million in the three months ended December 31, 2001 from $2.6 million in
the three months ended December 31, 2000. This decrease resulted from a
significant bad debt expense recorded during the three months ended December 31,
2000 as a result of the downturn in the economy and its effect on our "new
economy" customer base. The decrease in general and administrative expenses is
also attributable to decreased consulting and professional service expenses in
the three months ended December 31, 2001 and decreased compensation costs as
general and administrative personnel decreased from 34 employees as of December
31, 2000 to 13 employees as of December 31, 2001.

  Stock Compensation. We recognized stock compensation expense of $3.7 million
and $1.3 million in the three months ended December 31, 2001 and 2000,
respectively, related to the grant of options and restricted stock to employees
and directors during fiscal 1999 and prior to our initial public offering in
fiscal 2000. In connection with restricted stock issued to employees as a result
of our acquisition of IP Performance, Inc., in November 2000, we recorded
deferred stock compensation of $6.4 million. In December 2001, we terminated
substantially all of the remaining employees of IP Performance, Inc. In
accordance with the restricted stock agreements with these individuals, all of
the related restricted stock vested upon termination and all of the remaining
deferred stock compensation of $3.5 million was accelerated and recorded in the
three months ended December 31, 2001.

  Amortization of Goodwill and Intangible Assets. In connection with our
acquisition of IP Performance, Inc. in November 2000, we recorded goodwill and
intangible assets of $2.7 million, of which we amortized $150,000 in the three
months ended December 31, 2000. During fiscal 2001, we completed an intensive
review of our business, which resulted in our implementation of a restructuring
plan. As a result of this restructuring and an assessment of expected future
cash flows, we determined that the recoverability of intangible assets resulting
from our purchase of IP Performance, Inc. was uncertain. Accordingly, we
recognized an impairment charge for the full amount of the remaining
un-amortized intangible assets, approximately $2.0 million during the fourth
quarter of fiscal 2001.

Interest income, net

                                       15

<PAGE>

  Interest income, net decreased to $424,000 in the three months ended December
31, 2001 from $1.9 million in the three months ended December 31, 2000. This
decrease was due to a lower average cash and cash equivalents balance during the
three months ended December 31, 2001 as a result of net operating losses
incurred since our initial public offering in July 2000.

Liquidity and Capital Resources

  Since fiscal 1997, we have financed our operations primarily through the sale
of equity securities, borrowings and the sale of our products. On July 18, 2000,
we completed our initial public offering by selling 7,475,000 shares of our
common stock, including the exercise of the underwriters' overallotment option
of 975,000 shares, at $17 per share and raised approximately $116.9 million, net
of offering costs and underwriting fees totaling approximately $10.2 million.
Prior to our initial public offering, we raised approximately $37.3 million, net
of offering costs, from the issuance of preferred stock. As of December 31,
2001, we had $67.0 million in cash and cash equivalents, excluding restricted
cash of $1.1 million.

  Cash from operating activities was a cash outflow of $6.6 million in the three
months ended December 31, 2001 and a cash inflow of $2.9 million in the three
months ended December 31, 2000. Cash used in operating activities during the
three months ended December 31, 2001 was primarily due to a net loss of $7.2
million and decreases in the amount due to our contract manufacturer and accrued
expenses. Cash provided by operating activities in the three months ended
December 31, 2000 was primarily due to increases in accounts payable and amounts
due to our contract manufacturer, decreases in accounts receivable and amounts
due from our contract manufacturer.

  Cash used in investing activities was $98,000 and $2.2 million in the three
months ended December 31, 2001 and 2000, respectively. Cash used in investing
activities was primarily for purchases of property and equipment during both
periods.

  Cash from financing activities was a cash outflow of $1.1 million during the
three months ended December 31, 2001 and a cash inflow of $335,000 during the
three months ended December 31, 2000. Cash used in financing activities in the
three months ended December 31, 2001 was primarily for the acquisition of
treasury stock, offset in part by cash received upon the repayment of
stockholder notes receivable. Cash provided by financing activities in the three
months ended December 31, 2000 was primarily from the exercise of stock options
and warrants.

  On August 14, 2001, we announced that our Board of Directors had approved the
repurchase of up to $5 million of our common stock in the open market or in
non-solicited privately negotiated transactions. We plan to use repurchased
shares for our employee stock plans. During the year ended September 30, 2001
and quarter ended December 31, 2001, the Company repurchased 300,900 and
1,548,572 shares of common stock at a cost of approximately $198,000 and
$1,280,000, respectively.

  As a result of restructurings implemented in fiscal 2001, we are obligated to
make additional cash payments of approximately $750,000, the majority of which
will be made over the next twelve months. We anticipate that funds required to
make all restructuring payments will be available from our current working
capital.

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

     .    our ability to form an adequate number of strategic partnerships with
          ISVs and OEMs;

     .    the level of success of our strategic ISV and OEM partners in selling
          server appliance solutions that include our server appliance hardware
          platforms;

     .    the costs and timing of product engineering efforts and the success of
          these efforts;

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

                                       16

<PAGE>

     .    market developments.

  We believe that our available cash resources, including cash and cash
equivalents, together with cash we expect to generate from sales of our
products, will be sufficient to meet our debt service and our operating and
capital requirements through at least the next 12 months. After that, we may
need to raise additional funds. We may seek to raise additional funds through
borrowings, public or private equity financings or from other sources. There can
be no assurance that additional financing will be available at all or, if
available, will be on terms acceptable to us. If additional financing is needed
and is not available on acceptable terms, we may need to reduce our operating
expenses or discontinue one or more components of our new business strategy.

Related Party Transactions

  In January 2001, we entered into a series of related agreements with Lawrence
A. Genovesi, our current Chairman and former President, Chief Executive Officer
and Chief Technology Officer. These agreements were entered into to avoid
significant sales of our stock by Mr. Genovesi as a result of a margin call on a
personal loan collateralized by Mr. Genovesi's holdings of our common stock. We
agreed to guarantee a personal loan obtained by Mr. Genovesi from a financial
institution (the "Bank") through a deposit of $1,051,850 of our cash with the
Bank (the "Guarantee"). The Guarantee period ended on January 9, 2002 and we
extended the Guarantee to January 9, 2003, at which time the balance of the
amount deposited with the Bank, which is not required to satisfy any obligations
under the Guarantee, will be returned to us. We also entered into an agreement
with Mr. Genovesi whereby he has agreed to reimburse us for any obligations
incurred by us under the Guarantee (the "Reimbursement Agreement"). Any unpaid
balances under the Reimbursement Agreement bear interest at a rate of 10% per
annum. In the event of a default under the Reimbursement Agreement by Mr.
Genovesi, we have the right to apply any and all compensation due to Mr.
Genovesi against all of his obligations outstanding under the Reimbursement
Agreement. In addition, we entered into a revolving promissory note agreement
with Mr. Genovesi of up to $210,000 (the "Note"). The Note bore interest at a
rate of 5.9% per annum and was due and payable in full upon the earlier of
January 9, 2002 or 30 days following the date Mr. Genovesi ceased to be an
employee of Network Engines. The Note was paid in full in November 2001.

  In conjunction with the Guarantee, the Reimbursement Agreement and the Note,
we entered into a pledge agreement with Mr. Genovesi whereby he pledged to us
all shares of Network Engines common stock he owned as of the date of the
agreement or subsequently acquired, and all options and other rights to acquire
shares of our common stock he owned as of the date of the agreement or
subsequently acquired (collectively, the "Pledged Securities"). Additionally,
Mr. Genovesi pledged to us all additional securities or other consideration from
time to time acquired by him in substitution for, or in respect of, the Pledged
Securities. If Mr. Genovesi elects to sell any of the Pledged Securities during
the term of the agreement, all proceeds of such sale will be applied first to
any outstanding obligations related to the Note and then to any amounts payable
under the Reimbursement Agreement. In addition to the Pledged Securities, the
Note is collateralized by a second mortgage on certain real property owned by
Mr. Genovesi. As of December 31, 2001, no amounts were required to be reimbursed
to us under the Reimbursement Agreement. In November 2001, we repurchased
234,822 shares of our common stock from Mr. Genovesi for $225,195 in a private
transaction. The purchase price was determined based on the average closing
price of our common stock over the ten trading days prior to the purchase date.
Mr. Genovesi used the proceeds to pay all amounts outstanding under the Note, to
pay down a recourse note payable to us and to pay taxes incurred in connection
with our repurchase of our common stock from Mr. Genovesi.

  In April 2001, we entered into full recourse loan agreements with certain
former employees and certain current and former officers of Network Engines (the
"Loan Agreements"). These loan agreements were entered into in order to avoid
substantial sales of Network Engines common stock by these employees and
officers as a result of alternative minimum tax obligations incurred by them in
connection with their exercise of options to purchase shares of Network Engines
common stock. The net amount loaned to the employees and officers under the Loan
Agreements was approximately $508,000. Outstanding amounts under the Loan
Agreements accrue interest at a rate of 4.63% per annum and are due and payable
in full upon the earlier of one year from the date of each individual agreement
or thirty days after termination of employment with Network Engines, unless
termination is involuntary and without cause. In conjunction with the Loan
Agreements, each employee and officer pledged all shares of capital stock, and
options to purchase capital stock, of Network Engines now owned, or acquired in
the future (the "Pledged Stock"), and any distributions on the Pledged Stock or
proceeds from their sale. Amounts due under these Loan Agreements have been
included in the balance sheet as notes receivable from stockholders. In November
2001, we extended the repayment dates to September 2002 for loans with an
aggregate principal amount of $226,996 due from two of our current officers.

Recent Accounting Pronouncements

  In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 141 ("SFAS 141"), "Business Combinations" and SFAS No. 142 ("SFAS 142"),
"Goodwill and Other Intangible Assets." SFAS 141 requires that all business
combinations be accounted for under the purchase method only and that certain
acquired intangible assets in a business combination be recognized as assets
apart from goodwill. SFAS 142 requires, among other things, the cessation of the
amortization of goodwill. In addition, the standard includes provisions for the
reclassification of certain existing recognized intangibles as goodwill,
reassessment of the useful lives of existing recognized intangibles,
reclassification of certain intangibles out of previously reported goodwill and
the identification of reporting units for purposes of assessing potential future
impairments of goodwill. SFAS 142 also requires the completion of a transitional
goodwill impairment test six months from the date of adoption. SFAS 141 is
effective for all business combinations initiated after June 30, 2001. SFAS 142
is effective for the Company's fiscal quarters beginning on October 1, 2002;
early adoption is not permitted. The Company currently does not expect SFAS 142
to have a material impact on its financial position and results of operations.

  In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment
or Disposal of Long-Lived Assets" ("SFAS 144"). The objectives of SFAS 144 are
to address significant issues relating to the implementation of FASB Statement
No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of" ("SFAS 121"), and to develop a single accounting
model, based on the framework established in SFAS 121, for long-lived assets to
be disposed of by sale, whether previously held and used or newly acquired. SFAS
144 supersedes SFAS 121; however, it retains the fundamental provisions of SFAS
121 for (1) the recognition and measurement of the impairment of long-lived
assets to be held and used and (2) the measurement of long-lived assets to be
disposed of by sale. SFAS 144 supersedes the accounting and reporting provisions
of Accounting Principles Board No. 30, "Reporting the Results of Operations -
Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary,
Unusual and Infrequently Occurring Events and Transactions" ("APB 30"), for
segments of a business to be disposed of. However, SFAS 144 retains APB 30's
requirement that entities report discontinued operations separately from
continuing operations and extends that reporting requirement to "a component of
an entity" that either has been disposed of or is classified as "held for sale."
SFAS 144 also amends the guidance of Accounting Research Bulletin No. 51,
"Consolidated Financial Statements," to eliminate the exception to consolidation
for a temporarily controlled subsidiary. SFAS 144 is effective for financial
statements issued for fiscal years beginning after December 15, 2001, including
interim periods, and, generally, its provisions are to be applied prospectively.
The Company does not expect the application of SFAS 144 to have a material
impact on the Company's financial position or results of operations.

                                       17

<PAGE>

                FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

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

                         Risks Related to Restructuring

We have recently restructured our business. There can be no assurance that our
restructuring will have the intended effect on our business.

  During the fiscal year ended September 30, 2001, we restructured our business.
Our restructuring included a considerable reduction in our workforce and our
future operating expenses and an adjustment to our business strategy to
concentrate our resources on our core competencies, which we believe to be
hardware platform packaging and the ability to integrate our hardware platforms
with various operating systems, management systems and application software
systems. Our restructuring also includes a transition from primarily direct
sales channels to partnerships with independent software vendors and original
equipment manufacturers in order to offer "turn-key" solutions for enterprise
customers. In addition, our restructuring includes the termination of sales of
our WebEngine Blazer, WebEngine Roadster, WebEngine Viper, AdminEngine and
StorageEngine Voyager products. There can be no assurance that our
restructuring, even if fully implemented, will have a positive effect on our
financial results, our operations, our market share, the market price of our
common stock or public perception of us in the server appliance marketplace, or
that we will ever achieve substantial revenues, any one of which could cause
further decline in the market price of our common stock.

If we fail to generate significant revenues from strategic partnerships with
independent software vendors and original equipment manufacturers, our
operations could be materially adversely affected and as a result, we may choose
to discontinue one or more of the components of our new business strategy.

  To date, our revenues have been principally derived from direct sales to
companies in the Internet marketplace, otherwise known as "new economy"
customers. A major component of our restructuring is a business strategy change
to focus our sales and marketing efforts on indirect sales through strategic
partnerships with ISVs and OEMs. To date, we have not entered into a significant
number of definitive agreements with ISVs and OEMs. We may not be able to
develop a significant number of strategic partnerships with ISVs and OEMs and,
even if we are successful in developing strategic partnerships with ISVs and
OEMs, this strategy may fail to generate sufficient revenues to offset the
demands that this strategy will place on our business. A failure to generate
significant revenues from strategic partnerships could materially adversely
affect our operations and, as a result, we may choose to discontinue one or more
of the components of our new business strategy.

                Risks Related to Competition Within Our Industry

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

  In the market for server appliance hardware platforms, we face significant
competition from larger companies who market general-purpose servers,
specific-purpose servers and server appliances and have greater financial
resources and name recognition than we do. Many of these companies have larger
and more established service organizations to support these products. These and
other large competitors may be able to leverage their existing resources,
including their service organizations, and provide a wider offering of products
and higher levels of support on a more cost-effective basis than we can. In
addition, competing companies may be able to undertake more extensive
promotional activities, adopt more aggressive pricing policies and offer more
attractive terms to their customers than we can. If these large competitors
provide lower cost server appliance hardware platforms with greater
functionality or support than our products, or if

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some of their products are comparable to ours and are offered as part of a range
of products that is broader than ours, our products could become undesirable.
Even if the functionality of competing products is equivalent to ours, we face a
substantial risk that a significant number of customers would elect to pay a
premium for similar functionality rather than purchase products from a
less-established vendor. Increased competition may continue to negatively affect
our business and future operating results by leading to price reductions, higher
selling expenses or a reduction in our market share.

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

  We expect that substantially all of our revenues will come from sales of our
newest and future server appliance hardware platforms. As a result, we depend on
the growing use of server appliances to meet businesses' computer application
needs. The market for server appliance products has only recently begun to
develop and it is evolving rapidly. Because this market is new, we cannot
predict its potential size or future growth rate with a high degree of
certainty. Our revenues may not grow and the market price of our common stock
could decline if the server appliance market does not grow rapidly.

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

Our revenues could be reduced further if our larger competitors make
acquisitions in order to join their extensive distribution capabilities with our
smaller competitors' products.

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

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

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

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

  The server appliance market is characterized by rapid technological change,
frequent new product introductions and enhancements, potentially short product
life cycles, changes in customer demands and evolving industry standards. Our
products could be rendered obsolete if products based on new technologies are
introduced or new industry standards emerge.

  New products and product enhancements can require long development and testing
periods, which require us to retain, and may require us to hire additional,
technically competent personnel. Significant delays in

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new product releases or significant problems in installing or implementing new
products could seriously damage our business. We have on occasion experienced
delays in the scheduled introduction of new and enhanced products and cannot be
certain that we will avoid similar delays in the future.

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

                     Risks Related to Our Financial Results

We are an early-stage company in the evolving market for server appliances and
have recently released key new products, which have not yet obtained significant
market acceptance.

  Because of our limited operating history in the server appliance market, it is
difficult to discern trends that may emerge and affect our business. We may
experience negative trends associated with seasonality that, due to our limited
operating history, we have not experienced in the past. In February 2001 we
began shipping our WebEngine Sierra, our next generation server appliance,
designed to replace our discontinued WebEngine Blazer product. To date, the
WebEngine Sierra product has not obtained significant market acceptance and we
cannot be sure whether this product, our recently introduced ApplianceEngine
1000 product, or additional new product offerings, will obtain market
acceptance, whether they will capture adequate market share or whether we will
be able to recognize significant revenue from them. Our limited historical
financial performance may make it difficult for you to evaluate the success of
our business to date and to assess its future viability.

  If our new and enhanced products do not gain market acceptance, we may not be
able to attract and engage strategic ISV and OEM partners. If we are unable to
attract and engage ISV and OEM partners, our revenues and operating results will
be adversely affected. Factors that may affect the market acceptance of our
products, some of which are beyond our control, include the following:

     . the growth and changing requirements of the server appliance market;
     . the performance, quality, price and total cost of ownership of our
       products; and
     . the availability, price, quality and performance of competing products
       and technologies.

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

  Since our inception, we have incurred significant net losses, including net
losses of $5.8 million, $12.2 million and $69.5 million in fiscal 1999, 2000 and
2001, respectively, as well as a net loss of $7.2 million in the three months
ended December 31, 2001. We expect to continue to have net losses in the future.
In addition, we had an accumulated deficit of $100.6 million as of December 31,
2001. We believe that our future growth depends upon the success of our new
product development and selling and marketing efforts, which will require us to
incur significant product development, selling and marketing and administrative
expenses. As a result, we will need to generate significant revenues to achieve
profitability. We cannot be certain that we will achieve profitability in the
future or, if we achieve profitability, that we will be able to sustain it. If
we do not achieve and maintain profitability, the market price for our common
stock may continue to decline.

  During the year ended September 30, 2001, we implemented restructuring plans
to curtail discretionary selling, general and administrative expenses,
consolidate our international operations, implement new business strategies to
efficiently maximize our resources and utilize other cost saving methods. If
these, or other cost control measures that we may employ, are unsuccessful, our
expenses could increase and our losses could be greater than expected, which
could negatively impact the market price for our common stock.

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<PAGE>

Our revenues fell sharply in fiscal 2001 and we may not be able to return to our
historical revenue growth rates, which could cause our stock price to decline
even further.

  Our revenues grew rapidly in fiscal 1999 and fiscal 2000 and fell sharply in
fiscal 2001. We are unable to predict whether or not we will be able to return
to the rate of revenue growth achieved in fiscal 1999 and fiscal 2000 because of
uncertain economic conditions, competition and our inexperience in identifying
and engaging ISV and OEM partners. If we are unable to return to the rate of
revenue growth we experienced in fiscal 2000, our stock price could experience
further declines.

We derive a substantial portion of our revenues from one customer, and our
revenues may decline significantly if this customer cancels or delays a purchase
of our products.

  In the three months ended December 31, 2001, one customer accounted for 73% of
our net revenues. None of our customers are obligated to purchase any quantity
of our products in the future. If our largest customer stops purchasing from us,
delays future purchases or discontinues use of our technology, our revenues and
operating results will be adversely affected, our reputation in the industry may
suffer and our ability to predict cash flow accurately will decrease.
Accordingly, unless and until we expand and diversify our customer base, our
future success will depend upon the timing and size of future purchase orders,
if any, from this customer.

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

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

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

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

                Risks Related to Our Marketing and Sales Efforts

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

  Through our recent restructuring plans, we significantly reduced our selling
and marketing personnel in an attempt to reduce operating expenses and to
conserve cash. Although we have fewer selling and marketing personnel, we must
continue to increase market awareness and sales of our products. If we fail in
this endeavor, our growth, if any, will be limited.

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<PAGE>

Our efforts to promote our brand may not result in the desired brand recognition
by customers or in increased sales.

  In the fast growing market for server appliance hardware platforms, we believe
we need a strong brand to compete successfully. In order to attract and retain
customers, we believe that our brand must be recognized and viewed favorably by
our customers. As part of our recent restructuring plans, we reduced our
marketing programs. If we are unable to design and implement effective marketing
campaigns or otherwise fail to promote and maintain our brand, our sales may not
increase and our business may be adversely affected. Our business may also
suffer if we incur excessive expenses promoting and maintaining our brand but
fail to achieve the expected or desired increase in revenues.

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

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

                   Risks Related to Our Product Manufacturing

We rely on a single contract manufacturer to produce our products at high
volumes, which could have an adverse effect on our operations.

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

  Because the Sanmina Corporation and SCI Systems merger occurred very recently,
there can be no assurance as to the effect, positive or negative, that this
merger will have on the operation of Sanmina-SCI as it relates to our agreement
with them.

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

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

                                       22

<PAGE>

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

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

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

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

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

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

We have invested substantial resources in developing our products and our brand,
and our operating results would suffer if we were subject to a protracted
infringement claim or one with a significant damages award.

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

     .  be time-consuming to defend;

     .  result in costly litigation;

     .  divert our management's attention and resources;

     .  cause product shipment delays; or

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<PAGE>

     .  require us to enter into royalty or licensing agreements.

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

                       Other Risks Related to Our Business

A class action lawsuit has been filed against us, our chairman and one of our
executive officers.

  On or about December 3, 2001, a class action lawsuit was filed against us, our
chairman, one of our executive officers and the underwriters of our initial
public offering. We are unable to predict the effects of this suit, or other
similar suits, on our financial condition and our business and, although we
maintain certain insurance coverage, there can be no assurance that this claim
will not result in substantial monetary damages in excess of our insurance
coverage. In addition, we may expend significant resources to defend this case.
This class action lawsuit, or other similar suits, could negatively impact both
our financial condition and the market price for our common stock.

We are among the defendants in a lawsuit filed against us by a former employee.

On December 29, 1999, a lawsuit was commenced against us, and two former
officers and directors. We believe that the lawsuit is without merit and intend
to engage a vigorous defense. However, an adverse resolution is possible and in
addition, we could expend significant financial and managerial resources during
the course of our defense.

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

  The market price for our common stock has significantly declined during the
past year and our common stock failed to achieve a closing bid price of one
dollar for a period of thirty days. As a result, we received notification from
the NASDAQ stock market that, if our common stock failed to maintain a closing
bid price of one dollar or greater for a period of ten trading days prior to and
including October 29, 2001, then there was the potential that our common stock
could be de-listed from the NASDAQ National Market. However, on September 27,
2001, NASDAQ announced that it had suspended its minimum bid and market value of
public float requirements for continued listing until January 2, 2002. NASDAQ
adopted this measure to help companies remain listed in view of the
extraordinary market conditions following the tragedy of September 11, 2001.
Since the minimum bid price requirement for continued listing on NASDAQ was
reinstated on January 2, 2002, we have not received notice of any new de-listing
proceedings against out common stock. If we are unable to comply with NASDAQ's
requirements, our common stock could be de-listed from trading on the NASDAQ. If
our common stock were de-listed from NASDAQ, among other things, this could
result in a number of negative implications, including reduced liquidity in our
common stock as a result of the loss of market efficiencies associated with
NASDAQ and the loss of federal preemption of state securities laws as well as
the potential loss of confidence by suppliers, customers and employees, the loss
of analyst coverage and institutional investor interest, fewer business
development opportunities and greater difficulty in obtaining financing.

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

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

                                       24

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

  We require the services of qualified technical personnel. We have experienced
the negative effects of an economic slowdown. Our revenues have declined
significantly during the past year and the market price of our common stock has
decreased significantly. As a result, we have implemented plans to substantially
reduce our operating expenditures, including a reduction in the number of
personnel in our organization. This reduction in personnel places added pressure
on the remaining employees and management of the Company. These and other
factors may make it difficult for us to retain the qualified employees and
management that we need to effectively manage our business operations, including
key research and development activities. If we are unable to retain a sufficient
number of technical personnel we may not be able to complete development of, or
upgrade or enhance, our products in a timely manner, which could negatively
impact our business and could hinder any future growth.

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

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

     .  the loss of or delay in market acceptance and sales of our products;

     .  diversion of development resources;

     .  injury to our reputation; or

     .  increased maintenance and warranty costs.

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

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

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

  The securities markets have experienced significant price and volume
fluctuations in the past and the market prices of the securities of technology
companies have been especially volatile. This market volatility, as well as
general economic, market or political conditions, could reduce the market price
of our common stock in spite of our operating performance. In addition, our
operating results could be below the expectations of public market analysts and
investors, and in response the market price of our common stock could decrease
significantly. Investors may be unable to resell their shares of our common
stock for a profit. In the past, companies that have experienced volatility in
the market price of their stock have been

                                       25

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the object of securities class action litigation. If we were the object of
securities class action litigation, it could result in substantial costs and a
diversion of management's attention and resources. The decline in the market
price of our common stock and market conditions generally could adversely affect
our ability to raise additional capital, to complete future acquisitions of or
investments in other businesses and to attract and retain qualified technical
and sales and marketing personnel.

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

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

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

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

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

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

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

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

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PART II--OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

  On December 29, 1999, a former employee, George Flate, commenced a lawsuit
against us, and two individuals who formerly served as both officers and
directors for us, in Suffolk Superior Court, a Massachusetts state court. Mr.
Flate alleges that he was unlawfully terminated as Vice President of OEM Sales
in an effort to deprive him of commission payments. He is seeking undisclosed
damages based on two contractual claims relating to his employment, although we
anticipate he will claim damages in the multi-million dollar range.
Specifically, he is alleging a breach of the implied covenant of good faith and
fair dealing against Network Engines and a claim of intentional interference
with contractual relations against the current and former officers of the
company named in the lawsuit. Both of these claims are based on Mr. Flate's
allegations that he is entitled to commissions from several transactions that
were negotiated after Mr. Flate was no longer with the company. Mr. Flate was
employed by Network Engines for approximately one year. Although we believe
these claims are without merit and we intend to vigorously defend against each
claim asserted in the complaint, an adverse resolution of either of these claims
could require the payment of substantial monetary damages. Moreover, our defense
against these claims might result in the expenditure of significant financial
and managerial resources. Costs incurred to date have not been material. The
case has proceeded through discovery and the court has established a trial date
of May 20, 2002.

  On or about December 3, 2001, Margaret Vojnovich filed in the United States
District Court for the Southern District of New York a lawsuit against Network
Engines, Inc., Lawrence A. Genovesi, the Company's current Chairman and former
Chief Executive Officer, and Douglas G. Bryant, the Company's Chief Financial
Officer and Vice President of Administration (collectively, the "Executive
Officers"), FleetBoston Robertson Stephens, Inc., an underwriter of the
Company's initial public offering in July 2000 (the "IPO" ), Credit Suisse First
Boston Corp., Goldman Sachs & Co., Lehman Brothers Inc. and Salomon Smith
Barney, Inc. (collectively, the "Underwriter Defendants"). The suit generally
alleges that the Underwriter Defendants violated the federal securities laws by
conspiring and agreeing to raise and increase the compensation received by the
Underwriter Defendants by agreeing with some recipients of an allocation of IPO
stock to agree to purchase shares of manipulated securities in the after-market
of the IPO at pre-determined price levels designed to maintain, distort and/or
inflate the price of the Company's common stock in the aftermarket. The suit
also alleges that the Underwriter Defendants received undisclosed and excessive
brokerage commissions and that, as a consequence, the Underwriter Defendants
successfully increased investor interest in the manipulated IPO securities and
increased the Underwriter Defendants' individual and collective underwritings,
compensation and revenues. The suit further alleges that the defendants violated
the federal securities laws by issuing and selling securities pursuant to the
IPO without disclosing to investors that the Underwriter Defendants in the
offering, including the lead underwriters, had solicited and received excessive
and undisclosed commissions from certain investors. The suit seeks damages,
rescission of the purchase prices paid by purchasers of shares of the Company's
common stock and certification of a plaintiff class consisting of all persons
who acquired shares of the Company's common stock between July 13, 2000 and
December 6, 2000. The Company is in the process of reviewing this suit and
intends to respond in a timely manner. The Company is unable to predict the
outcome of this suit and its ultimate effect, if any, on the Company's financial
condition, however the Company's defense against these claims could result in
the expenditure of significant financial and managerial resources.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

  (d) Use of Proceeds from Sales of Registered Securities

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

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underwriting fees of approximately $8.9 million and other offering costs of
approximately $1.3 million. None of the proceeds of the offering was paid by us,
directly or indirectly, to any director, officer or general partner of ours or
any of their associates, to any persons owning ten percent or more of our
outstanding stock, or to any of our affiliates. During the period from the
offering to December 31, 2001, we have used the proceeds as follows:
approximately $44.1 million was used to fund the operations of the Company,
approximately $4.7 million was used for the purchase of property and equipment
and approximately $1.5 million was used to repurchase the Company's common stock
under a stock repurchase plan.

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

  No matters were submitted to a vote of security holders during the three
months ended December 31, 2001.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

  (a)  Exhibits

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

  (b)  Reports on Form 8-K

  We filed a Current Report on Form 8-K, dated November 13, 2001, disclosing the
  repurchase of certain common stock from our Chairman.

  We filed a Current Report on Form 8-K, dated December 12, 2001, disclosing a
  class action lawsuit filed against us and others by Margaret Vojnovich.

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SIGNATURES

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

                                     NETWORK ENGINES, INC.

Date: February 13, 2002

                                     /s/ John H. Curtis
                                     ------------------------------------------
                                     John H. Curtis
                                     President and Chief Executive Officer
                                     (Principal Executive Officer)

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

                                       29

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                                  EXHIBIT INDEX

Exhibit No.   Exhibit
10.35         Form of Retention Agreement, dated November 1, 2001, between the
              Registrant and James D. Murray, Douglas G. Bryant and Timothy J.
              Dalton.