##### **UNITED STATES**

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

**Washington, D.C. 20549**

 

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

##### ** **

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**(Mark One)**

 

**x****     ****QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**Forthe quarterly period ended June 30, 2006**

 

###### **OR**

######  

**o****        ****TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**Forthe transition period from                       to**

 

###### **Commission filenumber: 0-30863**

 

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**NETWORK ENGINES, INC.**

(Exact name of registrant asspecified in its charter)

 

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

 

**(781)332-1000**

(Registrant’s telephone number,including area code)

 

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

 

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

 

Large accelerated filer o  Acceleratedfiler x  Non-accelerated filer o

 

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

 

As of August 4, 2006, there were 38,585,995shares of the registrant’s Common Stock, par value $.01 per share, outstanding.

 

 

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**NETWORK ENGINES, INC.**

 

**INDEX**

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

 

----

 

**PART I. FINANCIAL INFORMATION**

 

**ITEM I.FINANCIAL STATEMENTS**

 

**NETWORK ENGINES, INC.**

**CONDENSED CONSOLIDATEDBALANCE SHEETS**

**(in thousands)**

 
| ** **                                                                                                                                                                                                            | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                            | ** ** | **2006**          | ** ** | **2005**               | ** ** |
| ** **                                                                                                                                                                                                            | ** ** | **(unaudited)**   | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                                                                                                                            |       |              |       |                   |       |
| **Current assets:**                                                                                                                                                                                                   | ** ** | ** **        | ** ** | ** **             | ** ** |
| Cash and cash  equivalents                                                                                                                                                                                            |       | $                 | 5,147      |                   | $          | 9,468 |   |
| Short-term  investments                                                                                                                                                                                               |       | 26,146            |       | 27,894                 |       |
| Restricted  cash                                                                                                                                                                                                      |       | 47                |       | 47                     |       |
| Accounts  receivable, net of allowances                                                                                                                                                                               |       | 21,029            |       | 10,442                 |       |
| Receivable for  insurance recovery                                                                                                                                                                                    |       | 2,875             |       | —                 |       |
| Inventories                                                                                                                                                                                                           |       | 12,315            |       | 9,227                  |       |
| Prepaid  expenses and other current assets                                                                                                                                                                            |       | 795               |       | 905                    |       |
| Total current  assets                                                                                                                                                                                                 |       | 68,354            |       | 57,983                 |       |
|                                                                                                                                                                                                                  |       |              |       |                   |       |
| Property and  equipment, net                                                                                                                                                                                          |       | 1,305             |       | 1,699                  |       |
| Other assets                                                                                                                                                                                                          |       | 40                |       | 122                    |       |
|                                                                                                                                                                                                                  |       |              |       |                   |       |
| Total assets                                                                                                                                                                                                          |       | $                 | 69,699     |                   | $          | 59,804 |   |
|                                                                                                                                                                                                                  |       |              |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                         | ** ** | ** **        | ** ** | ** **             | ** ** |
| **Current liabilities:**                                                                                                                                                                                              | ** ** | ** **        | ** ** | ** **             | ** ** |
| Accounts  payable                                                                                                                                                                                                     |       | $                 | 13,667     |                   | $          | 5,645 |   |
| Accrued  compensation and other related benefits                                                                                                                                                                      |       | 1,858             |       | 1,276                  |       |
| Accrued  litigation settlement                                                                                                                                                                                        |       | 2,875             |       | —                 |       |
| Other accrued  expenses                                                                                                                                                                                               |       | 1,964             |       | 1,669                  |       |
| Current  portion of capital lease obligation                                                                                                                                                                          |       | 17                |       | 18                     |       |
| Deferred  revenue                                                                                                                                                                                                     |       | 1,278             |       | 891                    |       |
| Total current  liabilities                                                                                                                                                                                            |       | 21,659            |       | 9,499                  |       |
|                                                                                                                                                                                                                  |       |              |       |                   |       |
| Long-term  portion of capital lease obligation                                                                                                                                                                        |       | 66                |       | 79                     |       |
| Deferred  revenue                                                                                                                                                                                                     |       | 445               |       | 365                    |       |
|                                                                                                                                                                                                                  |       |              |       |                   |       |
| Total  liabilities                                                                                                                                                                                                    |       | 22,170            |       | 9,943                  |       |
|                                                                                                                                                                                                                  |       |              |       |                   |       |
| Commitments  and contingencies (Note 6)                                                                                                                                                                               |       |              |       |                   |       |
|                                                                                                                                                                                                                  |       |              |       |                   |       |
| **Stockholders’ equity:**                                                                                                                                                                                        | ** ** | ** **        | ** ** | ** **             | ** ** |
| Preferred  stock, $.01 par value, 5,000,000 authorized, no shares issued or outstanding                                                                                                                               |       | —            |       | —                 |       |
| Common stock,  $.01 par value, 100,000,000 shares authorized; 41,142,874 and 40,341,890  shares issued; 38,581,016 and 37,780,032 shares outstanding at June 30,  2006 and September 30, 2005, respectively |       | 411               |       | 403                    |       |
| Additional  paid-in capital                                                                                                                                                                                           |       | 181,295           |       | 178,446                |       |
| Accumulated  deficit                                                                                                                                                                                                  |       | (131,339          | )          | (126,150               | )          |
| Treasury  stock, at cost, 2,561,858 shares at June 30, 2006 and September 30,  2005                                                                                                                         |       | (2,838            | )          | (2,838                 | )          |
|                                                                                                                                                                                                                  |       |              |       |                   |       |
| Total  stockholders’ equity                                                                                                                                                                                      |       | 47,529            |       | 49,861                 |       |
|                                                                                                                                                                                                                  |       |              |       |                   |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                      |       | $                 | 69,699     |                   | $          | 59,804 |   |

 

**The accompanying notes are an integral part ofthe condensed consolidated financial statements.**

 

1

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**NETWORK ENGINES, INC.**

**CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS**

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

**(unaudited)**

 
| ** **                                                     | ** ** | **Three  months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                               | ** ** | **2005**                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                     | ** ** | ** **                             | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues                                                   |       | $                                      | 32,048     |                                 | $          | 24,305 |   | $ | 87,353 |   | $ | 74,937 |   |
|                                                           |       |                                   |       |                                 |       |   |   |   |   |
| Cost of  revenues                                              |       | 26,664                                 |       | 20,220                               |       | 72,977 |   | 60,688 |   |
|                                                           |       |                                   |       |                                 |       |   |   |   |   |
| Gross profit                                                   |       | 5,384                                  |       | 4,085                                |       | 14,376 |   | 14,249 |   |
|                                                           |       |                                   |       |                                 |       |   |   |   |   |
| Operating  expenses:                                           |       |                                   |       |                                 |       |   |   |   |   |
| Research and  development                                      |       | 1,986                                  |       | 1,702                                |       | 6,188 |   | 5,670 |   |
| Selling and  marketing                                         |       | 2,949                                  |       | 2,535                                |       | 8,539 |   | 7,312 |   |
| General and  administrative                                    |       | 1,979                                  |       | 1,935                                |       | 5,973 |   | 6,049 |   |
| Restructuring  charge                                          |       | —                                 |       | —                               |       | — |   | 366 |   |
|                                                           |       |                                   |       |                                 |       |   |   |   |   |
| Total  operating expenses                                      |       | 6,914                                  |       | 6,172                                |       | 20,700 |   | 19,397 |   |
|                                                           |       |                                   |       |                                 |       |   |   |   |   |
| Loss from  operations                                          |       | (1,530                                 | )          | (2,087                               | )          | (6,324 | ) | (5,148 | ) |
| Interest and  other income, net                                |       | 425                                    |       | 286                                  |       | 1,135 |   | 686 |   |
|                                                           |       |                                   |       |                                 |       |   |   |   |   |
| Net loss                                                       |       | $                                      | (1,105     | )                                    | $          | (1,801 | ) | $ | (5,189 | ) | $ | (4,462 | ) |
|                                                           |       |                                   |       |                                 |       |   |   |   |   |
| Net loss per  share — basic and diluted                   |       | $                                      | (0.03      | )                                    | $          | (0.05 | ) | $ | (0.14 | ) | $ | (0.12 | ) |
|                                                           |       |                                   |       |                                 |       |   |   |   |   |
| Shares used  in computing basic and diluted net loss per share |       | 38,218                                 |       | 37,582                               |       | 38,023 |   | 37,357 |   |

 

**The accompanying notes are an integral part ofthe condensed consolidated financial statements.**

 

2

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**NETWORK ENGINES, INC.**

**CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                                 | ** ** | **Nine months  ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| ** **                                                                                 | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Cash flows  from operating activities:                                                     |       |                                  |       |   |   |
| Net loss                                                                                   |       | $                                     | (5,189     | ) | $ | (4,462 | ) |
| Adjustments  to reconcile net loss to net cash (used in) provided by operating activities: |       |                                  |       |   |   |
| Depreciation  and amortization                                                             |       | 774                                   |       | 875 |   |
| Provision for  doubtful accounts                                                           |       | (33                                   | )          | (30 | ) |
| Stock-based  compensation                                                                  |       | 2,143                                 |       | 16 |   |
| Impairment of  long lived assets                                                           |       | —                                |       | 40 |   |
| Changes in  operating assets and liabilities:                                              |       |                                  |       |   |   |
| Accounts  receivable                                                                       |       | (10,554                               | )          | 3,092 |   |
| Inventories                                                                                |       | (3,078                                | )          | 1,698 |   |
| Prepaid  expenses and other current assets                                                 |       | 110                                   |       | 456 |   |
| Accounts  payable                                                                          |       | 7,570                                 |       | (3,360 | ) |
| Accrued  expenses                                                                          |       | 877                                   |       | (602 | ) |
| Deferred  revenue                                                                          |       | 467                                   |       | 3,365 |   |
| Receivable  for insurance recovery                                                         |       | (2,875                                | )          | — |   |
| Accrued  litigation settlement                                                             |       | 2,875                                 |       | — |   |
|                                                                                       |       |                                  |       |   |   |
| Net cash  (used in) provided by operating activities                                       |       | (6,913                                | )          | 1,088 |   |
|                                                                                       |       |                                  |       |   |   |
| Cash flows  from investing activities:                                                     |       |                                  |       |   |   |
| Purchases of  property and equipment                                                       |       | (380                                  | )          | (1,196 | ) |
| Purchases of  short-term investments                                                       |       | (36,752                               | )          | (44,167 | ) |
| Proceeds from  sales and maturities of short-term investments                              |       | 38,500                                |       | 41,501 |   |
| Changes in  other assets                                                                   |       | 82                                    |       | 73 |   |
|                                                                                       |       |                                  |       |   |   |
| Net cash  provided by (used in) investing activities                                       |       | 1,450                                 |       | (3,789 | ) |
|                                                                                       |       |                                  |       |   |   |
| Cash flows  from financing activities:                                                     |       |                                  |       |   |   |
| Proceeds from  issuance of common stock                                                    |       | 704                                   |       | 699 |   |
| Payments on  capital lease obligation                                                      |       | (14                                   | )          | — |   |
| Borrowings  under cash overdraft                                                           |       | 452                                   |       | — |   |
|                                                                                       |       |                                  |       |   |   |
| Net cash  provided by financing activities                                                 |       | 1,142                                 |       | 699 |   |
|                                                                                       |       |                                  |       |   |   |
| Net decrease  in cash and cash equivalents                                                 |       | (4,321                                | )          | (2,002 | ) |
| Cash and cash  equivalents, beginning of period                                            |       | 9,468                                 |       | 12,974 |   |
|                                                                                       |       |                                  |       |   |   |
| Cash and cash  equivalents, end of period                                                  |       | $                                     | 5,147      |   | $ | 10,972 |   |
|                                                                                       |       |                                  |       |   |   |
| Supplemental  disclosure of non-cash investing and financing activities:                   |       |                                  |       |   |   |
| Acquisition  of equipment under capital lease obligation                                   |       | $                                     | —     |   | $ | 101 |   |

 

**The accompanying notes are an integral part ofthe condensed consolidated financial statements.**

 

3

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1. BASIS OF PRESENTATION**

 

The accompanying condensed consolidated financialstatements have been prepared by Network Engines, Inc. (“Network Engines”or the “Company”) in accordance with accounting principles generally acceptedin the United States of America and pursuant to the rules and regulationsof the Securities and Exchange Commission. Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith generally accepted accounting principles have been condensed or omittedpursuant to such rules and regulations. The year-end condensed balancesheet data was derived from audited financial statements, but does not includeall year-end disclosures required by accounting principles generally acceptedin the United States of America. These financial statements should be read inconjunction with the audited financial statements and the accompanying notesincluded in the Company’s 2005 Annual Report on Form 10-K filed by theCompany with the Securities and Exchange Commission.

 

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

 

The preparation of these condensed consolidatedfinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosures of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. The mostsignificant estimates reflected in these financial statements include inventoryvaluation, valuation of deferred tax assets, warranty reserves and stock-basedcompensation. Actual results could differ from those estimates.

 

**2. SIGNIFICANT ACCOUNTING POLICIES**

 

***RecentAccounting Pronouncements***

 

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 123 (revised 2004), *“Share-BasedPayment”* (“SFAS 123(R)”). SFAS 123(R) is a revision of FASBStatement No. 123, *“Accounting forStock-Based Compensation”*, supersedes Accounting Principles BoardOpinion No. 25, *“Accounting for StockIssued to Employees”*, and amends FASB Statement No. 95, *“Statement of Cash Flows”*. SFAS 123(R) requires allshare-based payments to employees, including grants of employee stock optionsand stock purchases under employee stock purchase plans, to be recognized inthe financial statements based on their fair values. The Company adopted SFAS123(R) using the modified prospective method during the quarter ended December 31,2005. As noted in footnote 3 below, the adoption of SFAS 123(R) had a materialimpact on the Company’s condensed consolidated statements of operations and netloss per share.

 

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

#### *** ***

The Company considers all highly liquidinvestments purchased with an original maturity of three months or less to becash equivalents; cash equivalents are carried at cost plus accrued interest,which approximates fair market value. All securities purchased with an originalmaturity of greater than three months and that mature within 12 months from thebalance sheet date and all auction rate securities are considered short-terminvestments. All investments are classified as available for sale and arecarried at fair value, with unrealized gains and losses included in other comprehensiveincome or loss, which is a separate component of stockholders’ equity, untilrealized. The Company invests excess cash primarily in municipal bonds andauction rate securities, money market funds and government agency securities.Details of the Company’s cash, cash equivalents and short-term investments areas follows (in thousands):

 

4

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| ** **                          | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|-------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                          | ** ** | **2006**          | ** ** | **2005**               | ** ** |
| **Cash and cash equivalents:**      | ** ** | ** **        | ** ** | ** **             | ** ** |
| Cash                                |       | $                 | 101        |                   | $          | 2,722 |   |
| Money market  funds                 |       | 5,046             |       | 5,018                  |       |
| Municipal  bonds                    |       | —            |       | 1,728                  |       |
|                                |       |              |       |                   |       |
| **Total cash and cash equivalents** |       | $                 | 5,147      |                   | $          | 9,468 |   |
|                                |       |              |       |                   |       |
| **Short-term investments:**         | ** ** | ** **        | ** ** | ** **             | ** ** |
| Municipal  auction rate securities  |       | $                 | 26,146     |                   | $          | 27,894 |   |

 

#### ***ComprehensiveLoss***

 

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

 

#### ***SegmentReporting***

#### *** ***

The Company is organized into two reportable segments:OEM Appliance and Distribution. The Company’s segments have been determinedbased upon the channels through which the segments sell products. Sales ofserver appliances to the Company’s network equipment and ISV partners areincluded in the Company’s OEM Appliance segment. Sales of server appliances anddata storage products to distributors, value added resellers (or VARs) and systemsintegrators are included in the Company’s Distribution segment. The accountingpolicies of these segments are the same as those described in the Company’ssummary of significant accounting policies in its Annual Report on Form 10-Kfor the year ended September 30, 2005. The Company evaluates its segments’performance based on net revenues, gross profit and segment operating income(loss), and the Company’s management regularly evaluates the Company’s segmentsin deciding how to allocate resources and assess performance. There are nointer-segment sales or transfers. Management does not review assets as part ofthe assessment of segment performance.

 

The following is a summary of the Company’s operations by reportingsegment (in thousands):

 
| ** **                           | ** ** | **OEM Appliance** | ** ** | **Distribution** | ** ** | **Total**  | ** ** |
|--------------------------------------|------------|-------------------|------------|------------------|------------|------------|------------|
| **Three Months Ended June 30,** | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| **2006**                             |       |              |       |             |       |       |       |
| Net Revenue                          |       | $                 | 31,764     |             | $          | 284        |       | $ | 32,048 |   |
| Segment  Operating Income (Loss)     |       | $                 | 4,230      |             | $          | (3,224     | )          | $ | 1,006 |   |
|                                 |       |              |       |             |       |       |       |
| **2005**                             |       |              |       |             |       |       |       |
| Net Revenue                          |       | $                 | 24,096     |             | $          | 209        |       | $ | 24,305 |   |
| Segment  Operating Income (Loss)     |       | $                 | 2,866      |             | $          | (3,018     | )          | $ | (152 | ) |
|                                 |       |              |       |             |       |       |       |
| **Nine Months Ended June 30,**  | ** ** | ** **        | ** ** | ** **       | ** ** | ** ** | ** ** |
| **2006**                             |       |              |       |             |       |       |       |
| Net Revenue                          |       | $                 | 86,466     |             | $          | 887        |       | $ | 87,353 |   |
| Segment  Operating Income (Loss)     |       | $                 | 11,075     |             | $          | (9,836     | )          | $ | 1,239 |   |
|                                 |       |              |       |             |       |       |       |
| **2005**                             |       |              |       |             |       |       |       |
| Net Revenue                          |       | $                 | 69,986     |             | $          | 4,951      |       | $ | 74,937 |   |
| Segment  Operating Income (Loss)     |       | $                 | 8,812      |             | $          | (7,911     | )(a)       | $ | 901 |   |

 

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(a)                                  Includes$366 of restructuring charges

 

5

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The Company does not allocate general and administrative expenses to itsreportable segments, because these activities are managed separately from thereportable segments. The Company does not allocate the costs of stock-basedcompensation to its reportable segments, because these expenses pertain togrants of awards that are managed and measured at the corporate level. Additionally,management excludes these expenses when planning or measuring the periodicfinancial performance of the Company’s segments since they are not directlyrelated to its segment operating performance. A reconciliation of the totalsreported for the reportable segments to the loss from operations in theconsolidated financial statements is as follows, in thousands:

 
| ** **                                                             | ** ** | **Three  months ended  June 30,** | ** ** | **Nine months  ended  June 30,** | ** ** |
|------------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                               | ** ** | **2005**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Total segment  operating income (loss)                                 |       | $                                      | 1,006      |                                  | $          | (152 | ) | $ | 1,239 |   | $ | 901 |   |
| General and  administrative                                            |       | 1,979                                  |       | 1,935                                 |       | 5,973 |   | 6,049 |   |
| Stock-based  compensation (not included in general and administrative) |       | 557                                    |       | —                                |       | 1,590 |   | — |   |
| Loss from  operations                                                  |       | $                                      | (1,530     | )                                     | $          | (2,087 | ) | $ | (6,324 | ) | $ | (5,148 | ) |

 

Substantially all of the Company’s long-livedassets were located in the United States as of June 30, 2006 and September 30,2005.

 

***Significant Customers***

 

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

 
| ** **      | ** ** | **Net  Revenues**       | ** ** | ** **             | ** ** | ** **                  | ** ** |
|-----------------|------------|-------------------------|------------|------------------------|------------|-----------------------------|------------|
| ** **      | ** ** | **Three  months ended** | ** ** | **Nine months  ended** | ** ** | **Accounts  Receivable at** | ** ** |
| ** **      | ** ** | **June 30,**       | ** ** | **June 30,**      | ** ** | **June 30,**           | ** ** | **September 30,** | ** ** |
| ** **      | ** ** | **2006**                | ** ** | **2005**               | ** ** | **2006**                    | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| EMC Corporation |       | 81                      | %          | 83                     | %          | 81                          | %          | 79 | % | 78 | % | 67 | % |

 

**3. STOCK-BASED COMPENSATION**

 

Effective October 1, 2005, the Companyadopted the provisions of Statement of Financial Accounting Standards 123(R),*“Share-Based Payment,”* (“SFAS 123(R)”),**which establishes accounting for equityinstruments exchanged for employee services. Under the provisions ofSFAS 123(R), stock-based compensation cost is measured at the grant date,based on the fair value of the award, and is recognized as an expense over theemployee’s requisite service period (generally the vesting period of the equityaward). Prior to October 1, 2005, the Company accounted for share-basedcompensation to employees in accordance with Accounting Principles Board OpinionNo. 25,*“Accounting for Stock Issued toEmployees,”* (“APB 25”) and related interpretations. The Company alsofollowed the disclosure requirements of Statement of Financial AccountingStandards No. 123,*“Accounting forStock-Based Compensation”* (“SFAS 123”). The Company elected toadopt the modified prospective transition method as provided bySFAS 123(R) and, accordingly, financial statement amounts for the priorperiods presented in this Form 10-Q have not been retroactively adjusted toreflect the fair value method of expensing stock-based compensation.

 

6

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**Stock Incentive Plans**

 

In October 1999, the Company’sshareholders approved the 1999 Stock Incentive Plan (the “1999 Plan”). Underthe 1999 Plan, stock option and restricted stock or other stock-based awardsfor up to 4,747,902 shares of common stock may be issued to employees,officers, directors, consultants and advisors of the Company. Options aregranted for terms of up to ten years and vest over varying periods. Optiongrants to new employees generally vest 25% on the first anniversary of thegrant date and thereafter in equal quarterly installments over the next threeyears. Subsequent grants to existing employees generally vest in equal quarterlyinstallments over four years. The option price per share is determined by theboard of directors on the grant date.

 

In May 2000, the Company’s shareholdersapproved an increase of 3,300,000 in the number of shares authorized under the1999 Plan and an automatic annual increase in the number of shares authorizedunder the 1999 Plan. The automatic annual increase is equal to the lesser of:5% of the outstanding shares on the first day of each fiscal year; 4,000,000shares; or an amount determined by the board of directors, which is subject toa maximum of 20,047,902 authorized shares under the plan. As of June 30,2006, the Company is authorized to grant options, restricted stock or otherawards of up to 13,807,273 shares of common stock.

 

In May 2000, the Company’s shareholdersapproved the 2000 Director Option Plan (the “Director Plan”). Under theDirector Plan, the Company may make formula grants of stock options tonon-employee directors of up to 500,000 shares of common stock. New directorsto the Company’s board are granted an initial grant of 50,000 shares, whichvest 25% on the first anniversary of the grant date and thereafter in equalquarterly installments over the next three years. Subsequent annual grants of15,000 shares to directors vest 100% upon the first anniversary of the grantdate. In March 2004, the Company’s shareholders approved an increase of anadditional 325,000 shares of common stock authorized to be issued under thisplan, resulting in a total of 825,000 options authorized to be issued. Underthe Director Plan, options to purchase 595,000 shares have been granted,options to purchase 45,000 shares have been exercised and options to purchase30,000 shares have been cancelled through June 30, 2006.

 

In May 2000, the Company’s shareholdersapproved the 2000 Employee Stock Purchase Plan (the “Purchase Plan”). Under thePurchase Plan, the Company may issue up to an aggregate of 750,000 sharesof common stock to eligible employees. In March 2004, the Company’sshareholders approved an increase of an additional 500,000 shares of commonstock authorized to be issued under the Purchase Plan, resulting in a total of1,250,000 shares authorized to be issued. Eligible employees must be employedby the Company for more than 20 hours per week and more than five months in afiscal year. Under the Purchase Plan, the Company makes two offerings eachfiscal year, at the end of which employees may purchase shares of commonstock through payroll deductions made over the term of each offering. Theper-share purchase price for offerings prior to May 15, 2005, was equal tothe lesser of 85% of the closing price of the common stock at the beginning orend of the offering period. During the year ended September 30, 2005, theboard of directors amended the Purchase Plan to limit the per-share purchaseprice for offerings to 85% of the closing price at the end of the offeringperiod, beginning with the offering period ended May 15, 2005. Offeringperiods begin on the 15th day of November and May each year. During the ninemonths ended June 30, 2006, 257,000 shares of common stock were issuedunder the Purchase Plan. The Company had 121,000 shares available for issuanceunder its Purchase Plan as of June 30, 2006.

 

7

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The following table presents stock-based employeecompensation expenses included in the Company’s unaudited condensed consolidatedstatements of operations (in thousands):

 
| ** **                        | ** ** | **Three  Months Ended** | ** ** | **Nine Months  Ended**  | ** ** |
|-----------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                        | ** ** | **June 30,  2006** | ** ** | **June 30,  2006** | ** ** |
|                              |       |                    |       |                    |       |
| Cost of revenues                  |       | $                       | 55         |                    | $          | 141 |   |
| Research and development          |       | 297                     |       | 835                     |       |
| Selling and marketing             |       | 205                     |       | 614                     |       |
| General and administrative        |       | 214                     |       | 553                     |       |
| Stock-based  compensation expense |       | $                       | 771        |                    | $          | 2,143 |   |

 

As a result of adopting SFAS 123(R), theCompany’s net loss for the three and nine months ended June 30, 2006, is $771,000and $2,143,000 greater, respectively, than if it had continued to account for stock-basedcompensation under APB 25. Basic and diluted net loss per share for the threeand nine months ended June 30, 2006 was also greater by $0.02 and $0.06,respectively, due to the adoption of SFAS 123(R).

 

The Company estimates the fair value of stockoptions using the Black-Scholes valuation model. This valuation model takesinto account the exercise price of the award, as well as a variety ofsignificant assumptions. These assumptions used to estimate the fair value ofstock options include the expected term, the expected volatility of the Company’sstock over the expected term, the risk-free interest rate over the expectedterm, and the Company’s expected annual dividend yield. The Company believesthat the valuation technique and the approach utilized to develop theunderlying assumptions are appropriate in calculating the fair values of theCompany’s stock options granted in the three and nine months ended June 30,2006. Estimates of fair value are not intended to predict actual future eventsor the value ultimately realized by persons who receive equity awards.

 

Assumptions used to determine the fair value ofoptions granted during the three and nine months ended June 30, 2006, usingthe Black-Scholes valuation model were:

 
| ** **                     | ** ** | **Three  Months Ended** | ** ** | **Nine Months  Ended**  | ** ** |
|--------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                     | ** ** | **June 30,  2006** | ** ** | **June 30,  2006** | ** ** |
|                           |       |                    |       |                    |       |
| Expected term(1)               |       | 6.25 years              |       | 5.50 to 6.25 years      |       |
| Expected volatility factor(2)  |       | 78.21                   | %          | 77.00% to  78.21        | %          |
| Risk-free interest rate(3)     |       | 5.15                    | %          | 4.39% to 5.15           | %          |
| Expected annual dividend yield |       | —                  | %          | —                  | %          |

 

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(1)          Expected term for eachgrant was determined as the midpoint between the vesting date and the end ofthe contractual term, also known as the “simplified method” for estimatingexpected term described by Staff Accounting Bulletin No. 107 (“SAB 107”).

 

(2)          The expected volatilityfor each grant is estimated based on a weighted average of historicalvolatility.

 

(3)          The risk-free interestrate for each grant is based on the U.S. Treasury yield curve in effect at thetime of grant for a period equal to the expected term of the stock option.

 

Stock-based compensation expense related tothe Company’s Employee Stock Purchase Plan was determined based on the discountof 15% from the per share market price on the close of the purchase period.

 

8

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Prior to October 1, 2005, the Companyaccounted for stock-based compensation to employees in accordance with APB 25. TheCompany also had previously adopted the provisions of SFAS 123, whichrequired disclosure only of stock-based compensation and its impact on net lossand net loss per share. The following table illustrates the effects on net lossand net loss per share for the three and nine months ended June 30, 2005as if the Company had applied the fair value recognition provisions ofSFAS 123 to stock-based employee awards.

 
| ** **                                                                                     | ** ** | **Three  Months  Ended  June 30,  2005** | ** ** | **Nine  Months  Ended  June 30,  2005** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
|                                                                                           |       |                                          |       |                                         |       |
| Net loss as  reported                                                                          |       | $                                             | (1,801     | )                                            | $          | (4,462 | ) |
| Add:  Stock-based employee compensation expense included in net loss                           |       | —                                        |       | 8                                            |       |
| Less: Total  stock-based employee compensation expense determined under the fair value  method |       | (726                                          | )          | (2,387                                       | )          |
| Pro forma net  loss                                                                            |       | $                                             | (2,527     | )                                            | $          | (6,841 | ) |
| Net loss per  share:                                                                           |       |                                          |       |                                         |       |
| Basic and  Diluted — as reported                                                     |       | $                                             | (0.05      | )                                            | $          | (0.12 | ) |
| Basic and  Diluted — pro-forma                                                       |       | $                                             | (0.07      | )                                            | $          | (0.18 | ) |

 

Assumptions used to determine the fair valueof options granted under SFAS 123 during the three and nine months ended June 30,2005 were:

 
| ** **              | ** ** | **Three  Months Ended** | ** ** | **Nine Months  Ended**  | ** ** |
|-------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **              | ** ** | **June 30,  2005** | ** ** | **June 30,  2005** | ** ** |
|                    |       |                    |       |                    |       |
| Expected term           |       | 5 years            |       | 5 years            |       |
| Volatility              |       | 114                     | %          | 120                     | %          |
| Risk-free interest rate |       | 3.93                    | %          | 3.72                    | %          |
| Dividend yield          |       | —                  | %          | —                  | %          |

 

The Company issues common stock frompreviously authorized but unissued shares to satisfy option exercises andpurchases under the Company’s Purchase Plan.

 

A summary of the Company’s stock optionactivity for the nine months ended June 30, 2006 is as follows:

 
| ** **                            | ** ** | **Nine Months  ended June 30, 2006** | ** ** |
|---------------------------------------|------------|-------------------------------------------|------------|
| ** **                            | ** ** | **Number  of  Options**                   | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  years)** | ** ** |
|                                  |       |                                      |       |   |   |   |   |
| Outstanding, September 30,  2005 |       | 6,701,268                                 |       | $ | 2.41 |   |   |   |
| Granted                               |       | 2,807,532                                 |       | 1.57 |   |   |   |
| Exercised                             |       | (543,994                                  | )          | 0.75 |   |   |   |
| Cancelled                             |       | (744,768                                  | )          | 2.88 |   |   |   |
| Outstanding, June 30,  2006      |       | 8,220,038                                 |       | $ | 2.19 |   | 7.54 |   |
| Exercisable  at June 30, 2006    |       | 4,335,933                                 |       | $ | 2.29 |   | 6.21 |   |

 

9

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All options granted during the three and nine monthsended June 30, 2006 and 2005 were granted with exercise prices equal tothe fair market value of the Company’s common stock on the grant date. Optionsgranted during the three and nine months ended June 30, 2006 had weightedaverage grant date fair values of $1.52 and $1.12, respectively. Optionsgranted during the three and nine months ended June 30, 2005 had weightedaverage grant date fair values of $1.43 and $1.94, respectively.

 

At June 30, 2006, the aggregate intrinsicvalue of options outstanding and options exercisable was $3,902,000 and $2,615,000,respectively. The intrinsic value of a stock option is the amount by which themarket value of the underlying stock exceeds the exercise price of the option.

 

The aggregate intrinsic value of optionsexercised during the three and nine months ended June 30, 2006 was $568,000and $648,000, respectively.

 

The following table summarizes the stockoptions outstanding at June 30, 2006:

 
| ** **                | ** ** | **Options  Outstanding** | ** ** | **Options  Exercisable**               | ** ** |
|---------------------------|------------|--------------------------|------------|----------------------------------------|------------|
| **Exercise Price  Range** | ** ** | **Number**               | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted Average  Remaining  Contractual  Term (in years)** | ** ** | **Number** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                      |       |                     |       |                                   |       |   |   |   |   |   |   |   |   |
| $0.07 - $0.92             |       | 1,102,232                |       | $                                      | 0.75       |   | 5.68 |   | 1,039,731 |   | $ | 0.74 |   |
| $0.95 - $1.06             |       | 964,294                  |       | 1.01                                   |       | 6.24 |   | 859,694 |   | 1.01 |   |
| $1.07 - $1.35             |       | 804,368                  |       | 1.19                                   |       | 5.01 |   | 765,178 |   | 1.19 |   |
| $1.36 - $1.36             |       | 1,469,282                |       | 1.36                                   |       | 9.52 |   | — |   | — |   |
| $1.38 - $1.65             |       | 902,977                  |       | 1.46                                   |       | 8.79 |   | 239,114 |   | 1.48 |   |
| $1.66 - $2.61             |       | 1,355,229                |       | 2.15                                   |       | 8.37 |   | 535,632 |   | 2.11 |   |
| $2.65 - $4.40             |       | 1,105,406                |       | 3.65                                   |       | 8.22 |   | 520,399 |   | 3.97 |   |
| $4.66 - $39.81            |       | 516,250                  |       | 9.65                                   |       | 6.41 |   | 376,185 |   | 10.16 |   |
|                      |       | 8,220,038                |       | $                                      | 2.19       |   | 7.54 |   | 4,335,933 |   | 2.29 |   |

 

The Company’s non-vested stock option activityfor the nine months ended June 30, 2006 was as follows:

 
| ** **                                     | ** ** | **Number of  Options** | ** ** | **Weighted  Average Grant  Date Fair Value** | ** ** |
|------------------------------------------------|------------|------------------------|------------|----------------------------------------------|------------|
|                                           |       |                   |       |                                         |       |
| Non-vested options at September 30,  2005 |       | 2,721,275              |       | $                                            | 2.39       |   |
| Granted                                        |       | 2,807,532              |       | 1.12                                         |       |
| Vested                                         |       | (992,115               | )          | 2.05                                         |       |
| Forfeited                                      |       | (652,587               | )          | 1.92                                         |       |
| Non-vested options at June 30, 2006       |       | 3,884,105              |       | 1.66                                         |       |
|                                                |            |                        |            |                                              |            |  |

 

At June 30, 2006, unrecognizedcompensation expense related to non-vested stock options was $4,457,000, whichis expected to be recognized over a weighted average period of 2.50 years.

 

10

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**4.NET LOSS PER SHARE**

** **

Basic net loss per share is computed by dividing thenet loss for the period by the weighted average number of shares of commonstock outstanding during the period. Diluted net loss per share is computed bydividing the net loss for the period by the weighted average number of sharesof common stock and potential common stock outstanding during the period, ifdilutive. Potential common stock includes incremental shares of common stockissuable upon the exercise of stock options. For the three month periods ended June 30,2006 and 2005, stock options totaling 2,247,000 and 4,674,000 sharesrespectively, and for the nine month periods ended June 30, 2006 and 2005,stock options totaling 2,401,000 and 4,537,000 shares respectively, were excludedfrom the calculation of net loss per share because their inclusion would beanti-dilutive.

 

**5. INVENTORIES**

 

Inventoriesconsisted of the following (in thousands):

 
| ** **      | ** ** | **June 30,  2006** | ** ** | **September 30,  2005** | ** ** |
|-----------------|------------|-------------------------|------------|------------------------------|------------|
| ** **      | ** ** | ** **              | ** ** | ** **                   | ** ** |
| Raw materials   |       | $                       | 6,695      |                         | $          | 3,972 |   |
| Work in process |       | 605                     |       | 302                          |       |
| Finished goods  |       | 5,015                   |       | 4,953                        |       |
|            |       |                    |       |                         |       |
|            |       | $                       | 12,315     |                         | $          | 9,227 |   |

 

**6. COMMITMENTS AND CONTINGENCIES**

 

***Guarantees and Indemnifications***

 

Acquisition-related indemnifications - When,as part of an acquisition, the Company acquires all the stock of acompany, the Company assumes liabilities for certain events or circumstancesthat took place prior to the date of acquisition. The maximum potential amountof future payments the Company could be required to make for such obligationsis undeterminable. While the provisions of the agreements remain in effectindefinitely, the Company believes that the probability of receiving a claim isunlikely. As a result, the Company has not recorded a liability for theseindemnification clauses as of June 30, 2006.

 

The Company enters into standardindemnification agreements in the ordinary course of its business. Pursuant tothese agreements, the Company indemnifies, holds harmless, and agrees toreimburse the indemnified party for losses suffered or incurred by theindemnified party, generally its business partners or customers, in connectionwith any patent, copyright, trademark, trade secret or other intellectualproperty infringement claim by any third party with respect to its products.The term of these indemnification agreements is generally perpetual. TheCompany has never incurred costs to defend lawsuits or settle claims related tothese indemnification agreements. As a result, the Company believes theestimated fair value of these agreements is minimal. Accordingly, the Companyhas no liabilities recorded for these indemnifications as of June 30, 2006.

 

Product warranties – The Company offers and fulfills warrantyservices on certain of its server appliances. In addition, while the Companywas selling third-party data storage networking products it contracted with athird party to provide warranty services for these products. The Company’sagreement with this third-party warranty provider expired in March 2005 asscheduled. However, the terms of the agreement require the third-party warrantyprovider to service these products for the entire warranty period. Warrantyterms vary in duration depending upon the product sold but generally providefor the repair or replacement of any defective products for periods of up to 36months after shipment. Based upon historical experience and expectation offuture conditions, the Company reserves for the estimated costs to fulfill

 

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customerwarranty obligations upon the recognition of the related revenue. Forwarranties related to third-party data storage networking products, the Companyrecorded warranty expense based on its agreement with its third-party warrantyfulfillment provider, whose fees were determined based on fixed periodicamounts as well as activity-based charges. The following table presents changesin the Company’s product warranty liability for the three months and ninemonths ended June 30, 2006 and 2005 (in thousands):

 
| ** **                                  | ** ** | **Three  months ended  June 30,** | ** ** | **Nine months  ended  June 30,** | ** ** |
|---------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                  | ** ** | **2006**                               | ** ** | **2005**                              | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                        |       |                                   |       |                                  |       |   |   |   |   |
| Beginning balance                           |       | $                                      | 515        |                                  | $          | 427 |   | $ | 455 |   | $ | 433 |   |
| Accruals for warranties issued              |       | 222                                    |       | 219                                   |       | 835 |   | 762 |   |
| Fulfillment of warranties during the period |       | (216                                   | )          | (260                                  | )          | (769 | ) | (809 | ) |
| Ending balance                              |       | $                                      | 521        |                                  | $          | 386 |   | $ | 521 |   | $ | 386 |   |

 

***Contingencies***

 

*Announcement Timing Lawsuit*

 

On March 17, 2004, the United StatesDistrict Court for the District of Massachusetts (the “Court”) consolidated anumber of purported class action lawsuits filed against Network Engines, Inc.and certain individual Network Engines defendants (collectively the “Defendants”).These suits generally concern the timing of the announcement of an amendment toNetwork Engines’ agreement with EMC Corporation regarding the resale ofEMC-approved Fibre Channel HBAs. The Plaintiffs filed an amended consolidatedcomplaint on June 4, 2004. The Defendants on August 13, 2004 filed amotion to dismiss the amended consolidated complaint. The Plaintiffs on October 12,2004 filed an opposition to the Defendants’ motion to dismiss and theDefendants filed a reply to the Plaintiff’s opposition on November 12,2004. The Court on November 22, 2004 denied the Defendant’s motion todismiss the amended consolidated complaint. On December 9, 2004, theDefendants filed an answer to the amended consolidated complaint.

 

Sincethat time the parties engaged in some informal discovery, have exchanged formaldiscovery requests, and then pursued active settlement discussions. On March 31,2006, the parties filed a motion for preliminary approval of a class actionsettlement. On April 4, 2006, the Court entered an Order preliminarilyapproving the settlement and scheduled deadlines for the settlement approvalprocess. The settlement was subject to a notice and comment period, duringwhich class members could object, opt out of the settlement, or fileclaims under the settlement. No class members objected to the settlementor opted out of the class. On July 25, 2006, the Court approved thesettlement. The Court entered an Order and Final Judgment approving the termsof the settlement in its entirety. The Order and Final Judgment is subject toany appeal within the next 30 days. The terms of the settlement require theCompany’s insurance provider to pay $2,875,000 in full settlement of the claimsasserted by the class. At June 30, 2006, the Company recorded accruedlitigation settlement and a receivable for insurance recovery in the amount of$2,875,000.

 

*Initial Public Offering Lawsuit*

 

On or about December 3, 2001, a putative class actionlawsuit was filed in the United States District Court for the Southern Districtof New York against the Company, Lawrence A. Genovesi (the Company’s Chairmanand former Chief Executive Officer), Douglas G. Bryant (the Company’s ChiefFinancial Officer and Vice President of Finance and Administration), and thefollowing underwriters of the Company’s initial public offering: FleetBostonRobertson Stephens, Inc., Credit Suisse First Boston Corp., Goldman Sachs &Co., Lehman Brothers Inc. and Salomon Smith Barney, Inc. (collectively,the

 

12

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“UnderwriterDefendants”). An amended class action complaint, captioned in re NetworkEngines, Inc. Initial Public Offering Securities Litigation, 01 Civ. 10894(SAS), was filed on April 20, 2002.

 

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

 

In July 2002, the Company, Lawrence A. Genovesiand Douglas G. Bryant joined in an omnibus motion to dismiss the suitchallenging the legal sufficiency of plaintiffs’ claims. The motion was filedon behalf of hundreds of issuer and individual defendants named in similarlawsuits. Plaintiffs opposed the motion, and the Court heard oral argument onthe motion in November 2002. On February 19, 2003, the Court issuedan opinion and order denying the motion as to the Company. However, in October 2002,Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this casewithout prejudice.

 

On July 9, 2003, aSpecial Committee of the Company’s Board of Directors authorized the Company tonegotiate a settlement of the pending claims substantially consistent with amemorandum of understanding negotiated among class plaintiffs, all issuerdefendants and their insurers. The parties have negotiated the settlement,which provides, among other things, for a release of the Company and theIndividual Defendants for the conduct alleged in the amended complaint to bewrongful. The Company would agree to undertake other responsibilities under thesettlement, including agreeing to assign, or not assert, certain potentialclaims that it may have against its underwriters. Any direct financialimpact of the proposed settlement is expected to be borne by the Company’sinsurers. Any such settlement would be subject to various contingencies,including approval by the Court overseeing the litigation. On February 15,2005, the Court issued an Opinion and Order preliminarily approving the settlement, providedthat the defendants and plaintiffs agree to a modification narrowing the scopeof the bar order set forth in the original settlement agreement. The partiesagreed to a modification narrowing the scope of the bar order, and on August 31,2005, the Court issued an order preliminarily approving the settlement. TheCompany is unable to predict the outcome of this suit and as a result, noamounts have been accrued as of June 30, 2006.

 

**7. RELATED PARTY TRANSACTIONS**

 

Robert M. Wadsworth, one ofthe Company’s directors, is a managing director of the limited liabilitycorporation that controls HarbourVest Partners (and its affiliates), one of theCompany’s significant stockholders. Mr. Wadsworth, is also a director of PSI HoldingGroup, Inc. (“PSI”), the parent company of Akibia, Inc. (“Akibia”).During the three and six months ended March 31, 2006 and 2005, HarbourVestowned greater than 5% of the outstanding stock of the Company and greater than5% of the outstanding stock of PSI. While the Company was selling third-partydata storage networking products it engaged Akibia to provide certain customersupport and warranty fulfillment services related to the Company’s sales ofHBAs. The Company’s agreement with Akibia expired in March 2005 asscheduled. However, the terms of the agreement required Akibia fulfill thewarranty services for the entire warranty period. Akibia

 

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chargedthe Company a quarterly fixed fee of $83,000 and a variable fee based upon theCompany’s sales of HBAs which ended December 2004. In the three and ninemonths ended June 30, 2005, the Company recognized $0 and $201,000,respectively, of expense as a result of its HBA customer support and warrantyfulfillment services agreements with Akibia. The Company recognized nosuch expense in the three or nine months ended June 30, 2006. In connection with this customer supportand warranty fulfillment services agreement, the Company also sold HBA’s toAkibia to allow Akibia to fulfill the Company’s warranty obligations for theseproducts. In the three and nine months ended June 30, 2005, the Companyrecorded revenues of approximately $0 and $40,000, respectively, from sales ofHBAs to Akibia. The Company recorded no such revenues in the three or ninemonths ended June 30, 2006. There were no amounts receivable from orpayable to Akibia at June 30, 2006 or September 30, 2005. In November 2005,Mr. John A. Blaeser, one of the Company’s directors, also joined the boardof directors of Akibia.

 

Mr. Wadsworth also serves as a directorof Innoveer Solutions, Inc. (“Innoveer”), formerly Akibia Consulting, andpreviously a subsidiary of Akibia. The Company engages Innoveer to provide professionalservices related to modifications of its Customer Resource Management (“CRM”) softwaresystem. During the three and nine months ended June 30, 2006, the Companyincurred approximately $6,000 and $55,000, respectively, related to theseservices. During the three and nine months ended June 30, 2005, theCompany incurred approximately $2,000 and $14,000, respectively, related tothese services. At June 30, 2006, the Company had $5,000 outstanding toInnoveer. The Company had no amounts outstanding to Innoveer at September 30,2005.

 

Additionally, in September 2005, theCompany engaged the consulting services of Mapleworks Technologies (“Mapleworks”),a software development services provider. Both Mr. Blaeser and Mr. Wadsworthare investors in Mapleworks and are members of its board of advisors. For the threeand nine months ended June 30, 2006 the Company incurred $0 and $83,000,respectively, in fees for these consulting services. The Company had no amountsoutstanding to Mapleworks at June 30, 2006 and September 30, 2005.

 

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

 

**Special Note Regarding Forward-LookingStatements**

 

ThisQuarterly Report on Form 10-Q contains forward-looking statements withinthe meaning of Section 21E of the Securities Exchange Act of 1934, asamended, that involve risks and uncertainties. All statements other thanstatements of historical information provided herein are forward-lookingstatements and may contain projections related to financial results,economic conditions, trends and known uncertainties. Our actual results coulddiffer materially from those discussed in the forward-looking statements as aresult of a number of factors, which include those discussed in this section andin Part II, Item 1A, Risk Factors, of this report and the risks discussedin our other filings with the Securities and Exchange Commission. Readers arecautioned not to place undue reliance on these forward-looking statements,which reflect management’s analysis, judgment, belief or expectation only as ofthe date hereof. We undertake no obligation to publicly reissue theseforward-looking statements to reflect events or circumstances that arise after thedate hereof.

 

Thefollowing discussion and analysis should be read in conjunction with thecondensed consolidated financial statements and the notes thereto included inItem 1 in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2005 filed by the Company with theSecurities and Exchange Commission.

 

**Overview**

** **

We develop and manufacture server appliancesolutions that deliver data storage and network security applications on serverappliances. Server appliances are pre-configured network infrastructure devicesdesigned to optimally deliver specific software application functionality andfacilitate ease of deployment and support of a software application in acustomer’s network. We are organized into two reportable segments: OEMAppliance and Distribution.

 

**OEM Appliance segment**

 

In our OEM Appliance segment, we develop andmanufacture server appliance solutions that enable network equipment providersand independent software vendors, or ISVs, to deliver their data storage andnetwork security applications in the form of a server appliance. We offerour server appliance partners a comprehensive suite of services, includingdevelopment, manufacturing, fulfillment and post-sale support. We produce andfulfill devices branded for our network equipment and ISV partners, and deriveour revenues from the sale of value-added hardware platforms to these partners.These partners subsequently sell and support the device under their own brandsto their customer base. During the three and nine months ended June 30,2006, sales to EMC represented 81% of our OEM Appliance segment revenues, comparedto 84% for the three and nine months ended June 30, 2005.

 

For the three and nine months ended June 30,2006 our OEM Appliance segment had segment operating income of $4.2 million and$11.1 million, respectively, compared to segment operating income of $2.9million and $8.8 million for the three and nine months ended June 30,2005, respectively. Refer to footnote 2 of our Condensed Consolidated FinancialStatements contained in Item I of this report for purposes of determiningsegment operating income.

 

**Distribution segment**

 

Currently in our Distribution segment, wedevelop, manufacture, sell, market and support our NS Series SecurityAppliances that are based on Microsoft’s Internet Security and Acceleration(ISA) Server. We license and integrate this software with server applianceplatforms and our proprietary software to sell our own branded serverappliances primarily to value added distributors, Microsoft-certified ornetwork security value added resellers and global system integrators. Sales ofthese servers commenced in the first quarter of fiscal year 2005.

 

15

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During the three months ended June 30,2006, we released our first NS Series Appliance based on the EnterpriseEdition of Microsoft’s ISA Server, the NS 9200. We believe the release of theNS9200, integrated with a third-party anti-virus application and web contentfiltering application enables us to deliver an appliance with enterprise-class security.

 

Previously in our Distribution segment we alsodistributed third-party data storage networking connectivity products for theleading Fibre Channel host bus adapter, or HBA, and storage switchmanufacturers in the data storage industry to a customer base of value-addedresellers and systems integrators. For the three months ended December 31,2004, 98% of our Distribution segment’s revenue had been derived from the saleof third-party data storage networking components and products, predominantlyEMC-approved Fibre Channel HBAs. As a result of an amendment to a keydistribution agreement, there was a decline in our gross profits related tosales of EMC-approved Fibre Channel HBAs, which in turn had a negative impacton our Distribution segment gross profits as well as our consolidated grossprofits and operating results. In addition, as a result of the higher costs perEMC-approved Fibre Channel HBA that this amendment imposed upon us, ourDistribution segment’s ability to compete in large sales transactions involvingEMC-approved Fibre Channel HBAs was negatively affected. This amendment, thecommoditization of Fibre Channel HBA technology, and the increasing competitionin the market resulted in declining gross profits related to our distributionof HBAs. During the quarter ended December 31, 2004, we discontinued salesof these third-party data storage networking products, as a result of thesefactors and the future prospects of this portion of our segment.

 

For the three and nine months ended June 30,2006 our Distribution segment had segment operating losses of $3.2 million and$9.8 million, respectively, compared to segment operating losses of $3.0million and $7.9 million for the three and nine months ended June 30,2005, respectively. Refer to footnote 2 of our Condensed Consolidated FinancialStatements contained in Item I of this report for purposes of determiningsegment operating income.

 

**Critical Accounting Policies and Estimates**

 

Our discussion and analysis of financialcondition and results of operations are based upon our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America. In preparing thesefinancial statements, we have made estimates and judgments in determiningcertain amounts included in the financial statements. We base our estimates andjudgments on historical experience and other various assumptions that webelieve to be reasonable under the circumstances. Actual results may differfrom these estimates under different assumptions or conditions. Other than theadoption of Statement of Financial Accounting Standards 123 (revised 2004), “Share-BasedPayment” (“SFAS 123(R)”), no changes to our critical accounting policies havetaken place since September 30, 2005.

 

***Stock-basedcompensation***

 

We adopted the provisions of Statement ofFinancial Accounting Standards 123(R), *“Share-BasedPayment,”* (“SFAS 123(R)”),**on October 1, 2005 whichrequires us to measure compensation cost at the grant date, based on the fairvalue of the award, and to recognize that cost as an expense over the employee’srequisite service period (generally the vesting period of the equity award).Prior to October 1, 2005, we accounted for stock-based compensation toemployees in accordance with Accounting Principles Board Opinion No. 25,*“Accounting for Stock Issued to Employees,”*(“APB 25”) and related interpretations. We also followed the disclosurerequirements of Statement of Financial Accounting Standards No. 123,*“Accounting for Stock-Based Compensation”*(“SFAS 123”). We elected to adopt the modified prospective transitionmethod as provided by SFAS 123(R) and, accordingly, financial statementamounts for the prior periods presented in this Form 10-Q have not been retroactivelyadjusted to reflect the fair value method of expensing stock-basedcompensation.

 

Under SFAS 123(R), we determine the fair valueof stock options awarded based on the grant-date fair value of the award usingan option pricing model. Such an option pricing model requires us to make judgmentsfor certain assumptions used, in particular, the expected term of the optionand the expected volatility over that term. We have determined the expectedterm using the midpoint between the vesting date and the end of the contractualterm for our options, also known as the “simplified method” described

 

16

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under Staff Accounting Bulletin No. 107, (“SAB 107”). We havedetermined our expected volatility based on a weighted average of historicalvolatility.

 

 Indetermining the amount of expense to be recorded, judgment is also required toestimate forfeitures of the awards based on the probability of employeescompleting the required service period. If actual forfeitures differ significantlyfrom our estimates, our results of operations could be materially impacted.

 

17

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**Results of Operations**

 

**Three months ended June 30, 2006 comparedto the three months ended June 30, 2005**

 

The following table summarizes financial datafor the periods indicated in thousands and as a percentage of net revenues andprovides the changes in thousands and percentages:

 
| ** **           | ** ** | **Three  Months Ended June 30,** | ** ** |
|----------------------|------------|---------------------------------------|------------|
| ** **           | ** ** | **2006**                              | ** ** | **2005** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **           | ** ** | **Dollars**                           | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues         |       | $                                     | 32,048     |   | 100 | % | $ | 24,305 |   | 100.0 | % | $ | 7,743 |   | 32 | % |
| Gross profit         |       | 5,384                                 |       | 17 | % | 4,085 |   | 17 | % | 1,299 |   | 32 | % |
| Operating expenses   |       | 6,914                                 |       | 22 | % | 6,172 |   | 25 | % | 742 |   | 12 | % |
| Loss from operations |       | (1,530                                | )          | (5 | )% | (2,087 | ) | (9 | )% | 557 |   | (27 | )% |
| Net loss             |       | (1,105                                | )          | (3 | )% | (1,801 | ) | (7 | )% | 696 |   | (39 | )% |
|                      |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

# ***Net Revenues and Gross Profit (Loss)***

# ** **

The following table summarizes our netrevenues and gross profit (loss) by reportable segment, in thousands and as apercentage of net revenues and provides the changes in thousands andpercentages:

 
| ** **             | ** ** | **Three  Months Ended June 30,** | ** ** |
|------------------------|------------|---------------------------------------|------------|
| ** **             | ** ** | **2006**                              | ** ** | **2005** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **             | ** ** | **Dollars**                           | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| **OEM Appliance:**     |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Net revenues           |       | $                                     | 31,764     |   | 100 | % | $ | 24,096 |   | 100 | % | $ | 7,668 |   | 32 | % |
| Gross profit           |       | 5,758                                 |       | 18 | % | 4,288 |   | 18 | % | 1,470 |   | 34 | % |
|                   |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| **Distribution:**      | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues           |       | 284                                   |       | 100 | % | 209 |   | 100 | % | 75 |   | 36 | % |
| Gross loss             |       | (374                                  | )          | (132 | )% | (203 | ) | (97 | )% | (171 | ) | 84 | % |
|                   |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| **Total net revenues** |       | 32,048                                |       | 100 | % | 24,305 |   | 100 | % | 7,743 |   | 32 | % |
| **Total gross profit** |       | 5,384                                 |       | 17 | % | 4,085 |   | 17 | % | 1,299 |   | 32 | % |
|                        |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

18

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***Net Revenues***

 

Our revenues are derived from sales of serverappliances primarily to our OEM network equipment and ISV partners.

 

Our OEM Appliance segment net revenues increased inthe three months ended June 30, 2006 primarily due to an increase in salesvolumes to EMC, partially offset by lower average selling prices. Net revenuesfrom sales to EMC represented 81% of OEM Appliance net revenues in the threemonths ended June 30, 2006 versus 84% in the three months ended June 30,2005. In addition, net revenues from other OEM Appliance partners for the threemonths ended June 30, 2006 increased to $5.9 million from $4.0 million forthe three months ended June 30, 2005. This increase was broad based andincluded increased sales to existing customers, partially offset by decreasesamong other customers.

 

Our Distribution segment net revenues for the threemonths ended June 30, 2006 were attributable to sales of NS Series SecurityAppliances which to date have not been significant.

 

***Gross profit (loss)***

 

Gross profit (loss) represents net revenuesrecognized less the cost of revenues. Cost of revenues includes cost ofmaterials, warranty costs, inventory write-downs, shipping and handling costs,customer support costs, and manufacturing costs, which are primarily comprisedof compensation, contract labor costs and, when applicable, contractmanufacturing costs.

 

Gross profit in our OEM Appliance segment increasedfor the quarter ended June 30, 2006, compared to the quarter ended June 30,2005, primarily as a result of increased sales volumes. Gross profit as apercentage of net revenues in our OEM Appliance segment remained consistent in2006 compared to 2005. The increase in gross loss and gross loss as apercentage of net revenues in our Distribution segment was attributable to increasedsales discounts and promotional activities in an attempt to raise awareness of ourNS Series Security Appliances during the quarter ended June 30, 2006.

 

Gross profit in our OEM Appliance segment isaffected by customer and product mix, pricing and the volume of orders. OEMAppliance gross profit is also affected by the mix of product manufacturedinternally compared to product manufactured by a contract manufacturer, which resultsin higher manufacturing costs. We expect that gross profit as a percentage ofnet revenue in our OEM segment for the three months ended September 30,2006 will be comparable to the three months ended June 30, 2006. Untilsales volumes of our NS Series Security Appliances become significant, wedo not expect our Distribution segment to generate gross profit.

 

We expect gross profit to continue to beaffected by these factors in both the OEM Appliance and Distribution segments.We expect that the gross profits as a percentage of revenue on our NS Series SecurityAppliances will continue to be significantly influenced by promotional pricing activitiestargeted at achieving market acceptance of these products.

 

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***Operating Expenses***

 

The most significant components of our operatingexpenses are research and development, selling and marketing, and general andadministrative expenses. The following table presents operating expenses duringthe periods indicated, in thousands and as a percentage of net revenues:

 
| ** **                  | ** ** | **Three  Months Ended June 30,** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|
| ** **                  | ** ** | **2006**                              | ** ** | **2005** | ** ** | **Increase** | ** ** |
| ** **                  | ** ** | **Dollars**                           | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating Expenses:         |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and  development   |       | $                                     | 1,986      |   | 6 | % | $ | 1,702 |   | 7 | % | $ | 284 |   | 17 | % |
| Selling and  marketing      |       | 2,949                                 |       | 9 | % | 2,535 |   | 10 | % | 414 |   | 16 | % |
| General and  administrative |       | 1,979                                 |       | 6 | % | 1,935 |   | 8 | % | 44 |   | 2 | % |
|                        |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Total  operating expenses   |       | $                                     | 6,914      |   | 22 | % | $ | 6,172 |   | 25 | % | $ | 742 |   | 12 | % |

 

***Research and development***

 

Research and development expenses consist primarily ofsalaries and related expenses for personnel engaged in research anddevelopment, fees paid to consultants and outside service providers, materialcosts for prototype and test units and other expenses related to the design,development, testing and enhancements of our server appliance products. Weexpense all of our research and development costs as they are incurred. Thefollowing table summarizes the most significant components of research anddevelopment expense for the periods indicated, in thousands and as a percentageof total research and development expense and provides the changes in thousandsand percentages: 

 
| ** **                         | ** ** | **Three  Months Ended June 30,** | ** ** |
|------------------------------------|------------|---------------------------------------|------------|
| ** **                         | ** ** | **2006**                              | ** ** | **2005** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                         | ** ** | **Dollars**                           | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:         |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Compensation  and related expenses |       | $                                     | 1,279      |   | 64 | % | $ | 1,200 |   | 71 | % | $ | 79 |   | 7 | % |
| Stock-based  compensation          |       | 297                                   |       | 15 | % | — |   | — |   | 297 |   | — |   |
| Prototype                          |       | 45                                    |       | 2 | % | 84 |   | 5 | % | (39 | ) | (46 | )% |
| Consulting  and outside services   |       | 110                                   |       | 6 | % | 210 |   | 12 | % | (100 | ) | (48 | )% |
| Other                              |       | 255                                   |       | 13 | % | 208 |   | 12 | % | 47 |   | 23 | % |
|                               |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Total  research and development    |       | $                                     | 1,986      |   | 100 | % | $ | 1,702 |   | 100 | % | $ | 284 |   | 17 | % |

 

Our research and development expenses have increasedas a result of recognizing stock-based compensation and an increase in compensationand related costs partially offset by a decrease in consulting and outsideservices. The increase in compensation and related expenses is attributable toincreased average headcount. The decrease in consulting costs relates to thetiming of certain development projects.

 

Our server appliance development strategy emphasizesthe utilization of standard server appliance platforms, which utilizeoff-the-shelf components. However, we expect that in some cases significantdevelopment efforts will be required to fulfill our current and potential ISVand network equipment partners’ needs using customized platforms. In addition,we intend to focus our software development in areas that improve the ease ofserver appliance implementation and use, which we believe will enhance ourvalue proposition. We expect that prototype and consulting costs will bevariable and could fluctuate depending on the timing and magnitude of ourserver appliance development projects. We expect our research and developmentcosts to increase over the remainder of fiscal 2006.

 

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***Selling and marketing***

 

Selling and marketing expenses consist primarily ofsalaries and commissions for personnel engaged in sales and marketing; costsassociated with our marketing programs, which include costs associated with ourattendance at trade shows, advertising, web site enhancements and productevaluation costs; consulting and outside services costs and travel. Thefollowing table summarizes the most significant components of selling andmarketing expense for the periods indicated in thousands and as a percentage oftotal selling and marketing expense and provides the changes in thousands andpercentages:

 
| ** **                         | ** ** | **Three  Months Ended June 30,** | ** ** |
|------------------------------------|------------|---------------------------------------|------------|
| ** **                         | ** ** | **2006**                              | ** ** | **2005** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                         | ** ** | **Dollars**                           | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and  marketing:            |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Compensation  and related expenses |       | $                                     | 1,861      |   | 63 | % | $ | 1,389 |   | 55 | % | $ | 472 |   | 34 | % |
| Stock-based  compensation          |       | 204                                   |       | 7 | % | — |   | — |   | 204 |   | — |   |
| Marketing  programs                |       | 386                                   |       | 13 | % | 618 |   | 24 | % | (232 | ) | (38 | )% |
| Consulting  and outside services   |       | 86                                    |       | 3 | % | 86 |   | 3 | % | — |   | — |   |
| Travel                             |       | 254                                   |       | 9 | % | 268 |   | 11 | % | (14 | ) | (5 | )% |
| Other                              |       | 158                                   |       | 5 | % | 174 |   | 7 | % | (16 | ) | (9 | )% |
|                               |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Total selling  and marketing       |       | $                                     | 2,949      |   | 100 | % | $ | 2,535 |   | 100 | % | $ | 414 |   | 16 | % |

 

As indicated in the table above, the primarycomponents of the increase in selling and marketing expenses are compensationand related expenses and stock-based compensation, partially off-set by adecrease in marketing programs. The increase in compensation and relatedexpense primarily relates to approximately $320,000 in severance relatedexpenses for terminated employees. Additionally, we incurred highercompensation and related expenses as a result of our European sales force beingin place for the full three months ended June 30, 2006 compared to only aportion of the three months ended June 30, 2005. These increases have beenpartially off-set by a reduction in average headcount during the three monthperiod ended June 30, 2006 versus the three month period ended June 30,2005 and lower commissions and bonuses due to lower than expected results inour distribution segment. The reduction in marketing expenses is a result of reducedspending on end user lead generation programs for our Distribution segmentsproducts.

 

Currently our Distribution segment by its natureincurs more of the marketing and sales burden of the products that it sells andmust engage in a higher level of marketing program activities than our OEMAppliance segment. Sales in our OEM Appliance segment are to our ISV andnetwork equipment partners who market and sell their products, whichincorporate our server appliances. As a result, our OEM Appliance segmentengages in a limited level of marketing programs.

 

We believe that we must continue our selling andmarketing efforts in order to enhance our position as a leading provider ofserver appliance products and to establish ourselves as a leader in networksecurity appliances. Variable marketing costs, such as marketing programs, aresomewhat dependent on the timing and magnitude of new product introductions andwill fluctuate depending on the level of this activity. We expect selling andmarketing expenses to remain consistent in the remainder of fiscal 2006.

 

***General and administrative***

 

General and administrative expenses consist primarilyof salaries and other related costs for executive, finance, informationtechnology and human resources personnel; professional services, which includelegal, accounting, audit and tax fees, and costs of compliance with theSarbanes-Oxley Act; and director and officer insurance. The following tablesummarizes the most significant components of general and administrativeexpense for the periods indicated in thousands and as a percentage of totalgeneral and administrative expense and provides the changes in thousands andpercentages:

 

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| ** **                            | ** ** | **Three  Months Ended June 30,** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|
| ** **                            | ** ** | **2006**                              | ** ** | **2005** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                           | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and administrative            |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Compensation  and related expenses    |       | $                                     | 783        |   | 40 | % | $ | 682 |   | 35 | % | $ | 101 |   | 15 | % |
| Stock-based  compensation             |       | 214                                   |       | 11 | % | — |   | 0 | % | 214 |   | — |   |
| Consulting  and professional services |       | 561                                   |       | 28 | % | 835 |   | 43 | % | (274 | ) | (33 | )% |
| Director and  officer insurance       |       | 226                                   |       | 11 | % | 246 |   | 13 | % | (20 | ) | (8 | )% |
| Other                                 |       | 195                                   |       | 10 | % | 172 |   | 9 | % | 23 |   | 13 | % |
|                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Total general  and administrative     |       | $                                     | 1,979      |   | 100 | % | $ | 1,935 |   | 100 | % | $ | 44 |   | 2 | % |

 

As indicated in the table above, the general and administrativeexpenses increased in the three months ended June 30, 2006 versus thethree months ended June 30, 2005. This was primarily a result of increasesin compensation and related expenses and stock-based compensation being offsetby a decrease in consulting and professional services. At June 30, 2005,we had 24 employees in our general and administrative department compared to 26employees at June 30, 2006. The decrease in consulting and professionalservices is due primarily to a decrease in costs associated with Sarbanes-Oxleycompliance now that we are in our second year of compliance, and a decrease inlegal costs associated with the timing of certain litigation activities. Weexpect general and administrative expenses to remain consistent over theremainder of fiscal 2006.

 

***Interestand Other Income, net***

* *

Interest and other income, netincreased to $425,000 for the three months ended June 30, 2006 from $286,000for the three months ended June 30, 2005. This increase is primarily dueto higher interest rates earned on our cash, cash equivalents, and short-terminvestments.

 

**Nine months ended June 30, 2006 comparedto the nine months ended June 30, 2005**

 

The following table summarizes financial datafor the periods indicated in thousands and as a percentage of net revenues andprovides the changes in thousands and percentages:

 
| ** **           | ** ** | **Nine Months  Ended June 30,** | ** ** |
|----------------------|------------|--------------------------------------|------------|
| ** **           | ** ** | **2006**                             | ** ** | **2005** | ** ** | **Increase** | ** ** |
| ** **           | ** ** | **Dollars**                          | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues         |       | $                                    | 87,353     |   | 100 | % | $ | 74,937 |   | 100 | % | $ | 12,416 |   | 17 | % |
| Gross profit         |       | 14,376                               |       | 16 | % | 14,249 |   | 19 | % | 127 |   | 1 | % |
| Operating expenses   |       | 20,700                               |       | 24 | % | 19,397 |   | 26 | % | 1,303 |   | 7 | % |
| Loss from operations |       | (6,324                               | )          | (7 | )% | (5,148 | ) | (7 | )% | (1,176 | ) | 23 | % |
| Net loss             |       | (5,189                               | )          | (6 | )% | (4,462 | ) | (6 | )% | (727 | ) | 16 | % |
|                      |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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# ***Net Revenues and Gross Profit (Loss)***

# ** **

The following table summarizes our netrevenues and gross profit (loss) by reportable segment, in thousands and as apercentage of net revenues and provides the changes in thousands andpercentages:

 
| ** **             | ** ** | **Nine Months  Ended June 30,** | ** ** |
|------------------------|------------|--------------------------------------|------------|
| ** **             | ** ** | **2006**                             | ** ** | **2005** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **             | ** ** | **Dollars**                          | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| **OEM Appliance:**     |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net revenues           |       | $                                    | 86,466     |   | 100 | % | $ | 69,986 |   | 100 | % | $ | 16,480 |   | 24 | % |
| Gross profit           |       | 15,368                               |       | 18 | % | 14,129 |   | 20 | % | 1,239 |   | 9 | % |
|                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| **Distribution:**      | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues           |       | 887                                  |       | 100 | % | 4,951 |   | 100 | % | (4,064 | ) | (82 | )% |
| Gross profit  (loss)   |       | (992                                 | )          | (112 | )% | 120 |   | 2 | % | (1,112 | ) | (927 | )% |
|                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| **Total net revenues** |       | 87,353                               |       | 100 | % | 74,937 |   | 100 | % | 12,416 |   | 17 | % |
| **Total gross profit** |       | 14,376                               |       | 16 | % | 14,249 |   | 19 | % | 127 |   | 1 | % |
|                        |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Net Revenues***

 

Our OEM Appliance segment net revenues increased inthe nine months ended June 30, 2006 primarily due to an increase in salesvolumes to EMC, partially offset by lower average selling prices. Net revenuesfrom sales to EMC represented 81% of OEM Appliance net revenues in the ninemonths ended June 30, 2006 versus 84% in the nine months ended June 30,2005. In addition, net revenues to other OEM Appliance partners for the ninemonths ended June 30, 2006 increased to $16.0 million from $11.1 millionfor the nine months ended June 30, 2005. This increase was broad based andincluded increased sales to existing customers, partially offset by decreasesamong other customers.

 

Our Distribution segment net revenues for the ninemonths ended June 30, 2006 were attributable to sales of NS Series SecurityAppliances, which to date have not been significant. In the quarter ended December 31,2004, we discontinued sales of third-party data storage networking products. Ournet revenues in the nine months ended June 30, 2005 from these productswere primarily the result of our focus on disposing of existing on-handinventories and represented our final sales of these products.

 

***Gross profit (loss)***

 

Gross profit in our OEM Appliance segmentincreased for the nine months ended June 30, 2006 versus the same periodin the prior year as a result of higher sales volumes both from EMC as well asfrom other customers. Gross profit as a percentage of net revenue in our OEMAppliance segment decreased for the nine months ended June 30, 2006,compared to the nine months ended June 30, 2005, primarily as a result ofcompetitive pricing pressure resulting in lower average selling pricespartially off-set by higher annual sales volume. The decrease in gross profitsand gross profits as a percentage of net revenues in our Distribution segmentwas attributable to our exit from distributing third-party data storagenetworking products combined with low sales volume of our NS Series SecurityAppliances during the nine months ended June 30, 2006.

 

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***Operating Expenses***

 

The following table presents operating expenses duringthe periods indicated, in thousands and as a percentage of net revenues:

 
| ** **                  | ** ** | **Nine Months  Ended June 30,** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|
| ** **                  | ** ** | **2006**                             | ** ** | **2005** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                  | ** ** | **Dollars**                          | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating Expenses:         | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Research and  development   |       | $                                    | 6,188      |   | 7 | % | $ | 5,670 |   | 8 | % | $ | 518 |   | 9 | % |
| Selling and  marketing      |       | 8,539                                |       | 10 | % | 7,312 |   | 10 | % | 1,227 |   | 17 | % |
| General and  administrative |       | 5,973                                |       | 7 | % | 6,049 |   | 8 | % | (76 | ) | (1 | )% |
| Restructuring  charge       |       | —                               |       | — |   | 366 |   | — |   | (366 | ) | (100 | )% |
|                        |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total  operating expenses   |       | $                                    | 20,700     |   | 24 | % | $ | 19,397 |   | 26 | % | $ | 1,303 |   | 7 | % |

 

***Research and development***

 

The following table summarizes the most significantcomponents of research and development expense for the periods indicated, inthousands and as a percentage of total research and development expense andprovides the changes in thousands and percentages: 

 
| ** **                         | ** ** | **Nine Months  Ended June 30,** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|
| ** **                         | ** ** | **2006**                             | ** ** | **2005** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                         | ** ** | **Dollars**                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:         |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation  and related expenses |       | $                                    | 3,769      |   | 61 | % | $ | 3,455 |   | 61 | % | $ | 314 |   | 9 | % |
| Stock-based  compensation          |       | 835                                  |       | 13 | % | — |   | — |   | 835 |   | — |   |
| Prototype                          |       | 434                                  |       | 7 | % | 685 |   | 12 | % | (251 | ) | (37 | )% |
| Consulting  and outside services   |       | 486                                  |       | 8 | % | 885 |   | 16 | % | (399 | ) | (45 | )% |
| Other                              |       | 664                                  |       | 11 | % | 645 |   | 11 | % | 19 |   | 3 | % |
|                               |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total  research and development    |       | $                                    | 6,188      |   | 100 | % | $ | 5,670 |   | 100 | % | $ | 518 |   | 9 | % |

 

Our research and development expenses have increasedas a result of recognizing stock-based compensation and an increase incompensation and related costs partially offset by decreases in prototypedevelopment and consulting and outside services. The increase in compensationand related expenses is attributable to increased average headcount. Thedecreases in prototype and consulting costs relate to the timing of certaindevelopment projects specifically with our largest OEM customer.

 

***Selling and marketing***

 

The following table summarizes the most significantcomponents of selling and marketing expense for the periods indicated inthousands and as a percentage of total selling and marketing expense andprovides the changes in thousands and percentages:

 

24

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| ** **                         | ** ** | **Nine Months  Ended June 30,** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|
| ** **                         | ** ** | **2006**                             | ** ** | **2005** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                         | ** ** | **Dollars**                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and  marketing:            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation  and related expenses |       | $                                    | 5,075      |   | 59 | % | $ | 4,381 |   | 60 | % | $ | 694 |   | 16 | % |
| Stock-based  compensation          |       | 614                                  |       | 7 | % | — |   | — |   | 614 |   | — |   |
| Marketing  programs                |       | 1,318                                |       | 15 | % | 1,573 |   | 22 | % | (255 | ) | (16 | )% |
| Consulting  and outside services   |       | 366                                  |       | 4 | % | 100 |   | 1 | % | 266 |   | 266 | % |
| Travel                             |       | 783                                  |       | 9 | % | 622 |   | 9 | % | 161 |   | 26 | % |
| Other                              |       | 383                                  |       | 4 | % | 636 |   | 9 | % | (253 | ) | (40 | )% |
|                               |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total selling  and marketing       | .          | $                                    | 8,539      |   | 100 | % | $ | 7,312 |   | 100 | % | $ | 1,227 |   | 17 | % |

 

As indicated in the table above, the primarycomponents of the increase in selling and marketing expenses are compensationand related expenses, stock-based compensation and consulting and outsideservices, partially offset by decreases in marketing programs and other. Our compensationand related expenses, consulting and outside services and our travel expenseshave increased significantly as a result of our continued expansion of ourEuropean sales presence during the nine months ended June 30, 2006. Forthe nine months ended June 30, 2005, we were just beginning to establishour sales operations in Europe. In addition, compensation and related expensesincreased in the nine months ended June 30, 2006, by approximately$320,000 in severance related expenses for terminated employees. These increasesare partially offset by decreases in compensation and related expenses fromterminations and attrition related to our decision to discontinue the distributionof third-party data storage networking products. The reduction in marketingprograms is primarily related to reduced spending on end user lead generationprograms for our Distribution segment products. The decrease in other expensesprimarily relates to decreases in our recruiting expense attributable to thetiming of newly hired employees and lower depreciation expense..

 

***General and administrative***

 

The following table summarizes the most significantcomponents of general and administrative expense for the periods indicated inthousands and as a percentage of total general and administrative expense andprovides the changes in thousands and percentages:

 
| ** **                            | ** ** | **Nine Months  Ended June 30,** | ** ** |
|---------------------------------------|------------|--------------------------------------|------------|
| ** **                            | ** ** | **2006**                             | ** ** | **2005** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and administrative:           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation  and related expenses    |       | $                                    | 2,283      |   | 38 | % | $ | 2,177 |   | 36 | % | $ | 106 |   | 5 | % |
| Stock-based  compensation             |       | 553                                  |       | 9 | % | — |   | 0 | % | 553 |   | — |   |
| Consulting  and professional services |       | 1,741                                |       | 29 | % | 2,418 |   | 40 | % | (677 | ) | (28 | )% |
| Director and  officer insurance       |       | 688                                  |       | 12 | % | 722 |   | 12 | % | (34 | ) | (5 | )% |
| Other                                 |       | 708                                  |       | 12 | % | 732 |   | 12 | % | (24 | ) | (3 | )% |
|                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total general  and administrative     |       | $                                    | 5,973      |   | 100 | % | $ | 6,049 |   | 100 | % | $ | (76 | ) | (1 | )% |

 

As indicated in the table above, the primarycomponents of the decrease in general and administrative expenses areconsulting and professional services. This decrease was partially offset by the

 

25

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addition of stock-basedcompensation. The decrease in consulting and professional services is dueprimarily to a decrease in costs associated with Sarbanes-Oxley compliance nowthat we are in our second year of implementation, and a decrease in legal costsassociated with the timing of certain litigation activities.

 

***Restructuring charge***

 

During the three months ended December 31, 2004,we recorded a restructuring of approximately $366,000 related to our exit fromthat portion of the business related to the distribution of third-party datastorage networking products. Approximately $283,000 of the charge related to one-timeemployee benefits associated with terminating certain employees in that portionof the business during the quarter. We also incurred $83,000 for a fixedpayment related to our warranty fulfillment contract with an external serviceprovider.

 

***Interestand Other Income, net***

* *

Interest and other income,net increased to $1,135,000 for the nine months ended June 30, 2006 from $686,000for the nine months ended June 30, 2005. This increase is primarily due tohigher interest rates earned on our cash, cash equivalents, and short-terminvestments.

 

**Liquidity and Capital Resources**

 

The following tablesummarizes cash flow activities, in thousands, for the periods indicated:

 
| ** **                                       | ** ** | **Nine Months  Ended  June 30,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                       | ** ** | **2006**                              | ** ** | **2005** | ** ** |
|                                             |       |                                  |       |   |   |
| Net loss                                         |       | $                                     | (5,189     | ) | $ | (4,462 | ) |
| Non-cash  adjustments to net loss                |       | 2,884                                 |       | 901 |   |
| Changes in  working capital                      |       | (4,608                                | )          | 4,649 |   |
|                                             |       |                                  |       |   |   |
| Cash (used  in) provided by operating activities |       | (6,913                                | )          | 1,088 |   |
|                                             |       |                                  |       |   |   |
| Cash provided  by (used in) investing activities |       | 1,450                                 |       | (3,789 | ) |
| Cash provided  by financing activities           |       | 1,142                                 |       | 699 |   |
|                                             |       |                                  |       |   |   |
| Decrease in  cash and cash equivalents           |       | (4,321                                | )          | (2,002 | ) |
| Beginning  cash and cash equivalents             |       | 9,468                                 |       | 12,974 |   |
|                                             |       |                                  |       |   |   |
| Ending cash  and cash equivalents                |       | $                                     | 5,147      |   | $ | 10,972 |   |

 

The following table presents our short-terminvestments as of the periods indicated (in thousands):

 
| ** **             | ** ** | **June 30,  2006** | ** ** | **September 31,  2005** | ** ** |
|------------------------|------------|-------------------------|------------|------------------------------|------------|
|                   |       |                    |       |                         |       |
| Short-term investments |       | $                       | 26,146     |                         | $          | 27,894 |   |
|                        |            |                         |            |                              |            |  |  |

 

26

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***Operating Activities***

 

Cash flows used in operating activities for the ninemonths ended June 30, 2006 is primarily a result of the net loss of $5.2million for the period partially offset by non-cash adjustments to the net lossof $2.8 million and a decrease in working capital of $4.6 million. The most significantnon-cash adjustment to net loss for the nine months ended June 30, 2006was $2.1 million of stock-based compensation expense, which we were notrequired to record in the nine months ended June 30, 2005. The mostsignificant changes in working capital for the nine months ended June 30,2006 were increases in the accounts receivable and inventory balances of $10.6million and $3.1 million, respectively, partially offset by an increase in theaccounts payable balance of $8.0 million. The significant changes in workingcapital were primarily a result of a disproportionate amount of sales occurringduring the month of June as well as our overall growth in sales. Cashflows provided by operations for the nine months ended June 30, 2005,included significant cash flows from the changes in working capital as a resultof our exit from the distribution of third-party storage networking products.

 

***Investing Activities***

 

 Cash flowsprovided by investing activities during the nine months ended June 30, 2006consisted of net proceeds received from the maturity of our short-terminvestments of approximately $1.7 million. This increased cash flow was offsetby the purchase of property and equipment of approximately $380,000.

 

***Financing Activities***

 

Cash flows provided by financing activities primarily consistedof cash received as a result of employee stock option and stock purchase planactivity of $704,000 in the nine months ended June 30, 2006. We expectemployee stock option and stock purchase plan activity to continue in fiscal2006, however we cannot predict its level given the volatility of capitalmarkets.

 

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

 

•                  the timing and size of orders fromour largest customer;

•                  the level of success of our OEMAppliance partners in selling server appliance solutions that include ourserver appliance hardware platforms;

•                  the level of investment required fordevelopment and sales and marketing related to our NS Series SecurityAppliances;

•                  our ability to integrate third partysoftware applications on our NS Series appliances that are being demandedby the marketplace

•                  our ability to enter into agreementswith distributors and system integrators and their ability to sell our NS Series SecurityAppliances;

•                  our ability to form an adequatenumber of OEM partnerships with network equipment providers and ISVs;

•                  the costs and timing of productengineering efforts and the success of these efforts;

•                  the outcome of pending litigation;and

•                  market developments.

 

We believe that our available cash resources,including cash, cash equivalents and short term investments, and cash that weexpect to generate from sales of our products will be sufficient to meet ouroperating and capital requirements through at least the next twelve months.After that, we may need to raise additional funds. We may in thefuture seek to raise additional funds through borrowings, public or privateequity financings or from other sources. There can be no assurance thatadditional financing will be available at all or, if available, will be onterms acceptable to us. If additional financing is needed and is not availableon acceptable terms, we may need to reduce our operating expenses.

 

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***Contractual Obligations and Commitments***

 

As of June 30, 2006, our contractual obligationsdisclosed in our annual report on Form 10-K for the year endedSeptember 30, 2005 have not materially changed.

 

**Off-BalanceSheet Arrangements**

 

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

 

**RelatedParty Transactions**

 

Robert M. Wadsworth, one ofthe Company’s directors, is a managing director of the limited liabilitycorporation that controls HarbourVest Partners (and its affiliates), one of theCompany’s significant stockholders. Mr. Wadsworth, is also a director of PSI HoldingGroup, Inc. (“PSI”), the parent company of Akibia, Inc. (“Akibia”).During the three and nine months ended June 30, 2006 and 2005, HarbourVestowned greater than 5% of the outstanding stock of the Company and greater than5% of the outstanding stock of PSI. While the Company was selling third-party datastorage networking products it engaged Akibia to provide certain customersupport and warranty fulfillment services related to the Company’s sales ofHBAs. The Company’s agreement with Akibia expired in March 2005 asscheduled. However, the terms of the agreement required Akibia fulfill thewarranty services for the entire warranty period. Akibia charged the Company aquarterly fixed fee of $83,000 and a variable fee based upon the Company’ssales of HBAs which ended December 2004. In the three and nine monthsended June 30, 2005, the Company recognized $0 and $201,000, respectively,of expense as a result of its HBA customer support and warranty fulfillmentservices agreements with Akibia. The Company recognized nosuch expense in the three or nine months ended June 30, 2006. In connection with this customer supportand warranty fulfillment services agreement, the Company also sold HBA’s toAkibia to allow Akibia to fulfill the Company’s warranty obligations for theseproducts. In the three and nine months ended June 30, 2005, the Companyrecorded revenues of approximately $0 and $40,000, respectively, from sales ofHBAs to Akibia. The Company recorded no such revenues in the three or ninemonths ended June 30, 2006. There were no amounts receivable from orpayable to Akibia at June 30, 2006 or September 30, 2005. In November 2005,Mr. John A. Blaeser, one of the Company’s directors, also joined the boardof directors of Akibia.

 

Mr. Wadsworth also serves as a directorof Innoveer Solutions, Inc. (“Innoveer”), formerly Akibia Consulting, andpreviously a subsidiary of Akibia. The Company engages Innoveer to provideprofessional services related to modifications of its Customer ResourceManagement (“CRM”) software system. During the three and nine months ended June 30,2006, the Company incurred approximately $6,000 and $55,000, respectively,related to these services. During the three and nine months ended June 30,2005, the Company incurred approximately $2,000 and $14,000, respectively, relatedto these services. At June 30, 2006, the company had $5,000 outstanding orInnoveer. The Company had no amounts outstanding to Innoveer September 30,2005.

 

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Additionally, the Company engaged theconsulting services of Mapleworks Technologies (“Mapleworks”), a softwaredevelopment services provider. Both Mr. Blaeser and Mr. Wadsworth areinvestors in Mapleworks and are members of its board of advisors. For the threeand nine months ended June 30, 2006 the Company incurred $0 and $83,000,respectively, in fees for these consulting services. The Company had no amountsoutstanding to Mapleworks at June 30, 2006 and September 30, 2005.

 

**RecentAccounting Pronouncements**

** **

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”).SFAS 123(R) is a revision of FASB Statement No. 123, “Accounting forStock-Based Compensation”, supersedes Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees”, and amends FASB Statement No. 95,“Statement of Cash Flows”. SFAS 123(R) requires all share-based payments toemployees, including grants of employee stock options and stock purchases underemployee stock purchase plans, to be recognized in the financial statementsbased on their fair values. We adopted SFAS 123(R) using the modifiedprospective method during the quarter ended December 31, 2005. As noted infootnote 3 to our Condensed Consolidated Financial Statements, the adoption ofSFAS 123(R) had a material impact on our consolidated statements of operationsand net loss per share.

 

**ITEM 3.   QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

We do not engage in any foreign currency hedgingtransactions and therefore, do not believe we are subject to material exchangerate risk. We are exposed to market risk related to changes in interest rates.We invest excess cash balances in cash equivalents and short-term investmentsand as a result, we believe that the effect, if any, of reasonably possiblenear-term changes in interest rates on our financial position, results ofoperations and cash flows will not be material. In addition, a hypothetical 10%increase or decrease in interest rates would not have a material adverse effecton our financial condition.

 

**ITEM 4.   CONTROLS ANDPROCEDURES**

 

Our management, with the participation of our chiefexecutive officer and chief financial officer, evaluated the effectiveness ofour disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act) as of June 30, 2006.Based on this evaluation, our chief executive officer and chief financialofficer concluded that, as of June 30, 2006, our disclosure controls andprocedures (1)  were designed to effectively accumulate and communicateinformation to the Company’s management, as appropriate, to allow timelydecisions regarding required disclosure and (2) were effective, in thatthey provide reasonable assurance that information required to be disclosed bythe Company in the reports that it files or submits under the SecuritiesExchange Act is recorded, processed, summarized and reported within the timeperiods specified in the SEC’s rules and forms.

 

No change in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) occurred during the nine months ended June 30, 2006 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

29

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**PART II—OTHER INFORMATION**

 

**ITEM 1.    LEGALPROCEEDINGS**

 

*Announcement Timing Lawsuit*

 

On March 17, 2004, the United StatesDistrict Court for the District of Massachusetts (the “Court”) consolidated anumber of purported class action lawsuits filed against us and certainindividual Network Engines defendants (collectively the “Defendants”). Thesesuits generally concern the timing of the announcement of an amendment toNetwork Engines’ agreement with EMC Corporation regarding the resale ofEMC-approved Fibre Channel HBAs. The Plaintiffs filed an amended consolidatedcomplaint on June 4, 2004. The Defendants on August 13, 2004 filed amotion to dismiss the amended consolidated complaint. The Plaintiffs on October 12,2004 filed an opposition to the Defendants’ motion to dismiss and theDefendants filed a reply to the Plaintiff’s opposition on November 12,2004. The Court on November 22, 2004 denied the Defendant’s motion todismiss the amended consolidated complaint. On December 9, 2004, theDefendants filed an answer to the amended consolidated complaint.

 

Sincethat time the parties engaged in some informal discovery, have exchanged formaldiscovery requests, and then pursued active settlement discussions. On March 31,2006, the parties filed a motion for preliminary approval of a class actionsettlement. On April 4, 2006, the Court entered an Order preliminarilyapproving the settlement and scheduled deadlines for the settlement approvalprocess, including scheduling a settlement conference for July 25, 2006. Thesettlement was subject to a notice and comment period, during which class memberscould object, opt out of the settlement, or file claims under the settlement. Noclass members objected to the settlement or opted out of the class. On July 25,2006, the Court approved the settlement. The Court entered an Order and FinalJudgment approving the terms of the settlement in its entirety. The Order andFinal Judgment is subject to any appeal within the next 30 days. The terms ofthe settlement require our insurance provider to pay $2,875,000 in fullsettlement of the claims asserted by the class. At June 30, 2006, werecorded accrued litigation settlement and a receivable for insurance recoveryin the amount of $2,875,000.

 

*Initial Public Offering Lawsuit*

 

On or about December 3, 2001, a putative class actionlawsuit was filed in the United States District Court for the Southern Districtof New York against us, Lawrence A. Genovesi (our former Chairman and ChiefExecutive Officer), Douglas G. Bryant (our Chief Financial Officer and VicePresident of Finance and Administration), and the following underwriters of ourinitial public offering: FleetBoston Robertson Stephens, Inc., CreditSuisse First Boston Corp., Goldman Sachs & Co., Lehman Brothers Inc.and Salomon Smith Barney, Inc. (collectively, the “Underwriter Defendants”).An amended class action complaint, captioned in re Network Engines, Inc.Initial Public Offering Securities Litigation, 01 Civ. 10894 (SAS), was filedon April 20, 2002.

 

The suit alleges that the defendants violated thefederal securities laws by issuing and selling securities pursuant to ourinitial public offering in July 2000 (“IPO”) without disclosing toinvestors that the Underwriter Defendants had solicited and received excessiveand undisclosed commissions from certain investors. The suit also alleges thatthe Underwriter Defendants entered into agreements with certain customerswhereby the Underwriter Defendants agreed to allocate to those customers sharesof our common stock in the offering, in exchange for which the customers agreedto purchase additional shares of our common stock in the aftermarket atpre-determined prices. The suit alleges that such tie-in arrangements weredesigned to and did maintain, distort and/or inflate the price of our commonstock in the aftermarket. The suit further alleges that the UnderwriterDefendants received undisclosed and excessive brokerage commissions and that,as a consequence, the Underwriter Defendants successfully increased investorinterest in the manipulated IPO securities and increased the UnderwriterDefendants’ individual and collective underwritings, compensation and revenues.The suit seeks damages and certification of a plaintiff class consistingof all persons who acquired shares of our common stock between July 13,2000 and December 6, 2000.

 

30

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

 

On July 9, 2003, aSpecial Committee of our Board of Directors authorized us to negotiate asettlement of the pending claims substantially consistent with a memorandum ofunderstanding negotiated among class plaintiffs, all issuer defendants andtheir insurers. The parties have negotiated the settlement, which provides,among other things, for a release of us and the Individual Defendants for theconduct alleged in the amended complaint to be wrongful. We would agree toundertake other responsibilities under the settlement, including agreeing toassign, or not assert, certain potential claims that we may have against theunderwriters. Any direct financial impact of the proposed settlement isexpected to be borne by our insurers. Any such settlement would be subject tovarious contingencies, including approval by the Court overseeing thelitigation. On February 15, 2005, the Court issued an Opinion and Order preliminarilyapproving the settlement, provided that the defendants and plaintiffs agree toa modification narrowing the scope of the bar order set forth in the originalsettlement agreement. The parties agreed to a modification narrowing the scopeof the bar order, and on August 31, 2005, the Court issued an orderpreliminarily approving the settlement. We are unable to predict the outcome ofthis suit and as a result, have not accrued any amounts as of June 30,2006.

 

**ITEM 1A. RISK FACTORS**

 

The risks and uncertainties described below are notthe only ones we are faced with. Additional risks and uncertainties notpresently known to us, or that are currently deemed immaterial, may alsoimpair our business operations. If any of the following risks actually occur,our financial condition and operating results could be materially adversely affected.

 

***Risks of dependence onone strategic partner.***

*** ***

**Wederive a significant portion of our revenues from sales of server appliancesdirectly to EMC through our OEM Appliance segment and our revenues may declinesignificantly if this customer cancels or delays purchases of our products,terminates its relationship with us, or exercises certain of its contractualrights.**

** **

In the nine months ended June 30, 2006 and 2005,sales directly to EMC, our largest customer, accounted for 81% and 79% of ourtotal net revenues and 81% and 84% of our OEM Appliance revenues, respectively.Primarily all of these sales are attributable to one OEM Appliance productpursuant to a non-exclusive contract. We anticipate that our future operatingresults will continue to depend heavily on sales to, and our relationship with,this customer. Accordingly, the success of our business will depend, in largepart, on this customer’s willingness to continue to utilize our serverappliance solutions in its existing and future products. Further, our financialsuccess is dependent upon the future success of the products we sell to thiscustomer and the continued growth, viability and financial stability of thiscustomer, whose industry has experienced rapid technological change, short productlife cycles, consolidation and pricing and margin pressures. A significantreduction in sales to this customer, or significant pricing and additionalmargin pressures exerted on us by this customer, would have a material adverseeffect on our results of operations. In addition, if this customer delays orcancels purchases of our products, our operating results would be harmed andour ability to accurately predict revenues, profitability and cash flows woulddecrease.

 

Under the terms of our non-exclusive contract, thiscustomer has the right to enter into agreements with third parties for similarproducts, is not obligated to purchase any minimum quantity of products from usand may choose to stop purchasing from us at any time, with or withoutcause. In addition, this customer may terminate the agreement in the eventthat we attempt to assign our rights under the agreement to another partywithout this customer’s prior approval. Furthermore, in the event that wedefault on certain portions of the agreement, this customer has the right tomanufacture certain products in exchange

 

31

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for a mutually agreeableroyalty fee. If any of these events were to occur, or if this customer were todelay or discontinue purchases of our products as a result of dissatisfactionor otherwise, our revenues and operating results would be materially adverselyaffected and our reputation in the industry might suffer and our ability toaccurately predict revenues, profitability and cash flows would decrease.

 

***Risks related to businessstrategy.***

*** ***

**Ifpotential customers do not accept our NS Series Security Appliances as asolution to certain of their network security needs, our business will beadversely affected.**

** **

We currently expect that future Distribution segmentrevenues will be primarily generated through sales of our NS Series SecurityAppliances and the related maintenance service, and we will not succeed if themarket does not accept these products and services as a viable solution tocertain network security needs. Our NS Series Security Appliances arepowered by Microsoft’s Internet Server Acceleration (“ISA”) Server softwareapplication. If customers don’t perceive this application to be technicallysuperior to other competitive security products or if customers don’t believethat our security appliance will provide increased security for Microsoftapplications, then our future revenues and operating results will suffer. 

 

Sales of NS Series Security Appliances throughour Distribution segment requires a greater selling and marketing burden thanany of our other server appliance products. We may find the selling andmarketing burden to be greater than was originally planned. We have investedand plan to continue to invest in a significant level of sales and marketingresources along with engineering resources for the continued development of ourNS Series Security Appliances. If we are unable to generate sufficientrevenues to recover these costs and achieve an appropriate gross profit, ouroperating results will suffer. To date, we have been unable to achievesubstantial sales of these server appliances and there is no guarantee that wewill be able to achieve substantial amounts of such sales in the future. If weare unable to generate sufficient revenues by leveraging our Distributionoperation to increase sales of server appliances in a cost effective and timelymanner, our operating results may suffer and we may determine that weneed to increase our investment in this business, thereby increasing our costsand increasing our losses, or we may determine that we must discontinuethis component of our business strategy, any of which could negatively affectour business.

 

**Marketacceptance and demand of Microsoft’s ISA Server software will depend onMicrosoft’s decision to prioritize and concentrate its marketing efforts forthis software.**

** **

**Becauseour NS Series line of security appliances are powered by Microsoft’s ISA Server,our success will depend on the extent the marketplace perceives this softwareas superior to other forms of security protection. We believe this perceptionwill be determined substantially as a result of marketing efforts undertaken byMicrosoft directly. In order to achieve broad recognition that ISA Server providesnecessary protection of specific Microsoft applications better than othercompeting products, we will rely to a significant extent on Microsoft’sfinancial and technical resources to educate its channel of certified resellersand, equally as important, the ultimate end-users. If Microsoft does notprioritize these marketing and promotional campaigns, or delays the timing ofsuch programs, then we may not achieve significant sales of our NS Series SecurityAppliances, which may adversely affect our business.**

** **

Even if Microsoft’s ISA Server software is widelyaccepted as the best protection of Microsoft applications, customers may chooseto purchase ISA Server in the form of software instead of a serverappliance. Although many network security applications are sold in the form ofan appliance to allow for better deployment, management and security, Microsoftcould continue to sell and/or customers may elect to purchase ISA Serverin the form of software only or may choose to purchase appliancesfrom other vendors. If Microsoft does not promote the advantages of ISA Serverin the form of a server appliance, this would have a negative impact onour business.

 

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**Ifwe fail to engage with a significant number of new distributors and systemsintegrators capable of selling our NS Series Security Appliances, ourrevenues and operating results may be adversely affected.**

** **

In order for our NS Series Security Appliances tobe successful we believe we must establish a two tiered distribution channel,backed by quality distributors and systems integrators that are familiar withMicrosoft products or the network security market and are committed to sell oursecurity appliances. To date, we have engaged with distributors in NorthAmerica, Europe, the Middle East and South Africa. Microsoft has beeninstrumental in our entering certain of these distribution agreements. As such,we believe that signing additional distributors and system integrators willcontinue to depend, in part, on our relationship with Microsoft, and ourability to leverage that relationship to gain access to quality distributorsand system integrators. Therefore, we will need to further establish andstrengthen our relationship with Microsoft in order to be considered apreferred provider of Microsoft ISA Server in the form of an appliance. Additionally,we must effectively manage our relationships with our distributors to gainaccess to their resellers, direct marketers and marketing programs. If we failto strengthen our relationship with Microsoft enabling us to enter intopartnerships with key distributors and a significant number of systemsintegrators, or are unable to maintain a two-tiered distribution channel ourrevenues and operating results may be adversely affected.

 

**We may notbe able to effectively commercialize our NS Series Security Appliances ifwe cannot continue to license or integrate third-party security applicationsthat are essential for the functionality of these appliances.**

** **

We believe our success will significantly depend onour ability to license or integrate security applications from additionalthird-parties that would be incorporated in our NS Series SecurityAppliances. Because we do not currently know with certainty which of theseprospective technologies will be desired in the marketplace, we may incorrectlyinvest in development or prioritize our efforts to integrate these technologiesin our NS Series Security Appliances. Additionally, even if we correctlyfocus our efforts, there can be no assurance that we will select the preferredprovider of these technologies, or that the third-party provider will becommitted to the relationship and integration of their technology or that wewill be able to integrate these technologies in a timely manner. If we areunable to successfully integrate these third-party technologies in a timelymanner, our NS Series Security Appliances may be inferior with othercompetitive products in the marketplace, which may adversely affect theresults of our operations and our ability to grow our Distribution segmentbusiness.

 

We also believe our success will depend on ourcontinued ability to license or integrate technology from Microsoft that isessential for the functionality of our security appliances. A material adversechange in our relationship with Microsoft or the functionality of its softwarewould have a significant adverse result on our Distribution segment operations.We depend on Microsoft to deliver reliable, high-quality software, develop newsoftware on a timely and cost-effective basis and respond to evolvingtechnology and changes in industry standards. Further, if Microsoft does not continue to make ISA Server available toOEM customers on a favorable basis, our ability to sell our NS Series SecurityAppliances may be substantially reduced.

 

**Ifwe are unable to leverage the existing customers and sales, channel andmarketing organizations of third-party security application partners for our NSSeries Security Appliances, the growth of our business may belimited.**

** **

**Our salesand marketing organization for our NS Series Security Appliances isrelatively small and we believe that we need to partner with applicationproviders that have existing customers as well as sales, channel and marketingorganizations that we can leverage for the sale of our NS Series SecurityAppliances. For most security applications, there are several companies withwhom we may partner. Because we have not worked with these companiespreviously, we may partner with third-party security application partnersthat have superior technological solutions, but have inferior sales, channeland marketing organizations. Even if we select partners with superior sales,channel and marketing organizations, there can be no assurances as to theircommitment to assist with the sales of their security applications on our NS Series SecurityAppliances. If we are unable to leverage the existing customers and sales,channel and marketing organizations of third-party security applicationpartners for our NS Series Security Appliances, the growth of our businessmay be limited.**

 

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**Ifwe are unable to expand our international operations and successfully overcomethe risks inherent in international business activities, the growth of ourbusiness may be limited.**

** **

Our ability to grow will depend in part on theexpansion of our international sales. We currently have agreements withdistributors headquartered outside the United States for the distribution ofour NS Series Security Appliances throughout Europe, the Middle East andSouth Africa. The failure of our distributors to sell our products across theseregions, or their de-emphasizing their support of our products would limit ourability to increase our revenues in those regions. In addition, ourinternational sales are subject to the risks inherent in international businessactivities, including:

 

•                  cost of customizing products for foreign countries;

 

•                  export and import restrictions, such as thoseaffecting encryption commodities and software or those requiring local content;

 

•                  difficulties in providing customer support;

 

•                  reduced protection of intellectual property rights andincreased liability exposure;

 

•                  regional economic and political conditions; and

 

•                  unique product requirements of certain foreigncountries which may limit sales and/or require significant additionalresearch and development investments, such as being able to comply withEuropean Union directive Restriction of Hazardous Substances (RoHS) whichrestricted the use of hazardous substances in electrical and electronicequipment, on July 1, 2006.

 

Our international sales currently are U.S.dollar-denominated. As a result, any increase in the value of the U.S. dollarrelative to foreign currencies makes our products less competitive ininternational markets. Because of this our revenues may be adverselyaffected, or we may be required to denominate our sales in foreigncurrencies at some point in the future to remain competitive. In addition,because certain of our operating expenses related to our international salesare denominated in foreign currency, we may have difficulty controllingexpenses in the event of significant currency fluctuations.

 

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**Ourfuture success is dependent upon our ability to generate significant revenuesfrom server appliance development relationships in our OEM Appliance segment.**

** **

A major component of our business strategy is to form serverappliance development relationships with new network equipment providers andISVs in our OEM Appliance segment. Under this strategy, we work with ourpartners to develop a server appliance, which is branded with their name, whothen performs all of the selling and marketing efforts related to furthersales.

 

There are multiple risks associated with this strategyincluding:

 

•                  the expenditure of significantproduct development costs, which if not recovered through server appliancesales could negatively affect our operating results;

 

•                  a significant reliance on ourpartners’ application software products, which could be technologicallyinferior to competitive products and result in limitations on our serverappliance sales, causing our revenues and operating results to suffer;

 

•                  the possibility that our partnerswill continue selling their application software products as separate productsin addition to selling it in the form of a server appliance;

 

•                  our reliance on our partners to perform allof the selling and marketing efforts associated with further sales of theserver appliance product we develop with them; and

 

•                  our ability to provide our partnerswith high quality server appliances at competitive prices.

 

**Additionally,our future success will depend on our ability to expand sales of serverappliances to our existing partners, as well as establishing relationships withnew partners. If these partners are unsuccessful in their marketing and salesefforts, or if we are unable to expand our sales to existing partners anddevelop relationships with new partners, our revenues and operating resultscould suffer.**

** **

**Bothour OEM Appliance and Distribution segments could be harmed if we fail toadequately integrate new technologies into our server appliance products or if weinvest in technologies that do not result in the desired effects on our currentand/or future product offerings.**

** **

As part of our strategy, we review opportunitiesto incorporate products and technologies that could be required in order to addnew customers, retain existing customers, expand the breadth of productofferings or enhance our technical capabilities. Investing in new technologiespresents numerous risks, including:

 

•                  we may experience difficulties integrating newtechnologies into our current or future products;

 

•                  our new products may be delayed because selectednew technologies themselves are delayed or have defects and/or performancelimitations;

 

•                  we may incorporate technologies that do notresult in the desired improvements to our current and/or future serverappliance products;

 

•                  we may incorporate new technologies that either may notbe desired by our customers or may not be compatible with our customer’sexisting technology;

 

•                  new technologies are unproven and could contain latentdefects, which could result in high product failures; and

 

•                  we could find that the new products and/ortechnologies that we choose to incorporate into our products aretechnologically inferior to those utilized by our competitors.

 

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**If weare unable to adequately integrate new technologies into our server applianceproducts or if we invest in technologies that do not result in the desiredeffects on our current and/or future product offerings, our business could beharmed and operating results could suffer.**

** **

***Risks related to theserver appliance, data storage and network security markets.***

*** ***

**Ifserver appliances are not increasingly adopted as a solution to meet asignificant portion of companies’ network security and data storage applicationneeds, the market for server appliances may not grow, which couldnegatively impact our revenues.**

** **

We expect that all of our future revenues will comefrom sales of server appliances and related maintenance. As a result, we aresubstantially dependent on the growing use of server appliances to meetbusinesses’ data storage and network security application needs. Our revenues may notgrow and the market price of our common stock could decline if the serverappliance market does not grow as rapidly as we expect.

 

Our expectations for the growth of the serverappliance market may not be fulfilled if customers continue to usegeneral-purpose servers. The role of our products could, for example, belimited if general-purpose servers out-perform server appliances, providemore capabilities and/or flexibility than server appliances or are offered at alower cost. This could force us to lower the prices of our server applianceproducts or could result in fewer sales of these products, which wouldnegatively impact our revenues and decrease our gross profits.

 

**Theproducts that we sell are subject to rapid technological change and our saleswill suffer if these products are rendered obsolete by new technologies.**

** **

The markets we serve are characterized by rapidtechnological change, frequent new product introductions and enhancements,potentially short product life cycles, changes in customer demands and evolvingindustry standards. In the server appliance market, we attempt to mitigate theserisks by utilizing standards-based hardware platforms and by maintaining anadequate knowledge base of available technologies. However, the serverappliance products that we sell could be rendered obsolete if products based onnew technologies are introduced or new industry standards emerge and we are notable to incorporate these technological changes into our products. In addition,we depend on third parties for the base platforms of our server appliances formany of our OEM Appliance segment customers and our NS Series SecurityAppliances, and we are at risk if these third parties do not integrate newtechnologies. Specifically, product development for network security appliancesrequires considerable engineering time and testing. Releasing new products andservices prematurely may result in quality problems, and delays may resultin loss of customer confidence and market share. We may be unable todevelop new products and services or achieve and maintain market acceptance ofthem once they have come to market. Furthermore, when we do introduce new orenhanced products and services, we may be unable to manage the transitionfrom the older products and services to minimize disruption in customerordering patterns, avoid excessive inventories of older products and deliverenough new products and services to meet customer demand.

 

 To remaincompetitive in the server appliance market, we must successfully identify newproduct opportunities and partners and develop and bring new products to marketin a timely and cost-effective manner. Our failure to select the appropriatepartners and keep pace with rapid industry, technological or market changescould have a material adverse effect on our business, results of operations orfinancial condition.

 

***Risks related tofinancial results.***

*** ***

**Wehave a history of losses and may continue to experience losses in thefuture, which could cause the market price of our common stock to decline.**

** **

Since our inception, we have incurred significant netlosses and could continue to incur net losses in the future. At June 30, 2006and September 30, 2005 our accumulated deficit was $131 million and $126million, respectively. We believe that any future growth will require us toincur significant engineering,

 

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selling and marketing andadministrative expenses. As a result, we will need to generate significantrevenues to achieve and sustain profitability. If we do not achieve and sustainprofitability, the market price for our common stock may decline.

 

**Ifour estimates or judgments relating to our critical accounting policies arebased on assumptions that change or prove to be incorrect, our operatingresults could fall below expectations of securities analysts and investors,resulting in a decline in our stock price.**

** **

Our discussion and analysis of financial condition andresults of operations are based on our consolidated financial statements, whichhave been prepared in accordance with accounting principles generally acceptedin the United States. The preparation of financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the amounts reported in the consolidatedfinancial statements and accompanying notes. On an ongoing basis, we evaluatesignificant estimates used in preparing our consolidated financial statements,including those related to:

 

•                  revenue recognition, including sales returns andallowances;

 

•                  inventory write-downs;

 

•                  stock-based compensation; and

 

•                  warranty reserves.

 

We base our estimates on historical experience and onvarious other assumptions that we believe to be reasonable under thecircumstances, as provided in our discussion and analysis of financialcondition and results of operations, the results of which form the basisfor making judgments about the carrying values of assets and liabilities thatare not readily apparent from other sources. Actual results may differfrom these and other estimates if our assumptions change or if actualcircumstances differ from those in our assumptions, which could cause ouroperating results to fall below the expectations of securities analysts andinvestors, resulting in a decline in our stock price.

 

**Ourquarterly revenues and operating results may fluctuate seasonally, whichcould result in decreased revenue from quarter to quarter, which in turn couldcause the market price of our common stock to decline.**

** **

Seasonal fluctuations in revenues and operatingresults in the data storage industry are common. In particular, this industrytypically experiences increased orders and resulting revenues in the quarterended December 31, and a subsequent decline in orders and resultingrevenues during the quarter ended March 31. With a substantial amount ofour revenues currently derived from data storage products, we may experiencesignificant quarter-to-quarter fluctuations in revenues and operating resultsdue to customers timing their orders based on their own quarterly financialand/or operational considerations, which we have no influence over. Inaddition, to the extent that revenues in our Distribution segment frominternational sales become significant, we may experience seasonalfluctuations during the quarter ended September 30, as a result ofEuropean holiday patterns.

 

Accordingly, we believe that quarter-to-quartercomparisons of results of operations are not necessarily meaningful and shouldnot be relied upon as an indication of future performance. Nonetheless, themarket price of our common stock could decline in response to these variations.

 

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**Ourquarterly revenues and operating results may also fluctuate for reasonsother than seasonality, which could cause our operating results to fall belowexpectations and thus impact the market price of our common stock.**

** **

In addition to seasonality issues, our quarterlyrevenues and operating results are difficult to predict and may fluctuatesignificantly from quarter to quarter. None of our customers are obligated topurchase any quantity of our products in the future nor are they obligated tomeet forecasts of their product needs. Our operating expense levels are basedin part on expectations of future revenues and gross profits, which arepartially dependent on our customers’ ability to accurately forecast andcommunicate their future product needs. If revenues or gross profits in aparticular quarter do not meet expectations, operating results could suffer andthe market price of our common stock could decline. Factors affecting quarterlyoperating results include:

 

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

 

•                  the product mix within our OEM Appliance segment;

 

•                  the timing of new product introductions by our OEMAppliance partners;

 

•                  the availability and/or price of products fromsuppliers;

 

•                  the loss of key suppliers or customers;

 

•                  price competition;

 

•                  costs associated with our introduction of our NS Series SecurityAppliances and the market acceptance of those products;

 

•                  the mix of product manufactured internally and by ourcontract manufacturer;

 

**Ifthe products and services that we sell become more commoditized and competitionin the server appliance, data storage and network security markets continues toincrease, then our gross profit as a percentage of net revenues may decreaseand our operating results may suffer.**

** **

Products and services in the server appliance, datastorage and network security markets may be subject to furthercommoditization as these industries continue to mature and other businessesintroduce additional competing products and services. The gross profit as apercentage of revenues of our products may decrease, in response tochanges in our product mix, competitive pricing pressures, or new productintroductions into the server appliance, data storage and network security markets.If we are unable to offset decreases in our gross profits as a percentage ofrevenues by increasing our sales volumes, or by decreasing our product costs,operating results will decline. Changes in the mix of sales of our products,including the mix of higher margin sales of products sold in smaller quantitiesand lower margin sales of products sold in larger quantities, could adverselyaffect our operating results for future quarters. To maintain our grossprofits, we also must continue to reduce the manufacturing cost of our serverappliance products. Our efforts to produce higher margin server applianceproducts, continue to improve our server appliance products and produce newserver appliance products may make it difficult to reduce ourmanufacturing cost per product. Further, utilization of a contract manufacturerto produce a portion of our customer requirements for certain of our serverappliance products may not allow us to reduce our cost per product. If wefail to respond adequately to pricing pressures, to competitive products withimproved performance or to developments with respect to the other factors onwhich we compete, we could lose customers or orders. If we are unable tocompete effectively, our business will suffer.

 

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***Risks related tocompetition.***

*** ***

**Competitionin the server appliance market is significant and if we fail to compete effectively,our financial results will suffer.**

** **

In the server appliance market, we face significantcompetition from a number of different types of companies. Our competitorsinclude companies who market general-purpose servers, server virtualizationsoftware, specific-purpose servers and server appliances as well as companiesthat sell custom integration services utilizing hardware produced by othercompanies. Many of these companies are larger than we are and have greaterfinancial resources and name recognition than we do, as well as significantdistribution capabilities and larger, more established service organizations tosupport their products. Our larger competitors may be able to leveragetheir existing resources, including their extensive distribution capabilitiesand service organizations, to provide a wider offering of products and servicesand higher levels of support on a more cost-effective basis than we can. Weexpect competition in the server appliance market to increase significantly asmore companies enter the market and as our existing competitors continue toimprove the performance of their current products and to introduce new productsand technologies. Such increased competition could adversely affect sales ofour current and future products. In addition, competing companies may beable to undertake more extensive promotional activities, adopt more aggressivepricing policies and offer more attractive terms to their customers than we can.If our competitors provide lower cost products with greater functionality orsupport than our server appliance solutions, or if some of their products arecomparable to ours and are offered as part of a range of products that isbroader than ours, our server appliance solutions could become undesirable.

 

Even if the functionality of competing products isequivalent to ours, we face a risk that a significant number of customers wouldelect to pay a premium for similar functionality from an established vendorrather than purchase products from a less-established vendor. We attempt todifferentiate ourselves from our competition by offering a wide variety ofsoftware integration, branding, supply-chain management, engineering, support,logistics and fulfillment services. If we are unable to effectively differentiateourselves from our competition, we may be forced to offer price reductionsto maintain certain customers. As a result, our revenues may not increaseand may decline, and our gross margins may decline. Furthermore,increased competition could lead to higher selling expenses which wouldnegatively affect our business and future operating results.

 

**Ifwe are unable to compete successfully in the highly competitive market fornetwork security appliances and services for any reason, such as current orpotential competitors gaining competitive advantage through partnering oracquisition, our business could be adversely affected.**

** **

The market for network security appliances isintensely competitive and we expect competition to intensify in the future. Anincrease in competitive pressures in our market or our failure to competeeffectively may result in pricing reductions, reduced gross margins andloss of market share. Currently, the primary competitors relating to networksecurity appliances with Microsoft ISA Server include Hewlett-Packard Company,Celestix Networks, Inc. and Pyramid Computer GmbH. However, because ouragreement with Microsoft to license ISA Server is not exclusive, Microsoft may enterinto similar license agreements with additional competitors. Such competitors may belarger and have significantly greater resources and experience than us, which may negativelyaffect our business.

 

Competitors in the security industry with appliancesusing technology other than Microsoft ISA Server include Cisco Systems, Inc.,Nokia Corporation, Juniper Networks, Inc, Watchguard Technologies, Inc.and SonicWALL, Inc. Substantially all of our competitors have longeroperating histories, greater name recognition, larger customer bases andsignificantly greater financial, technical, marketing and other resources thanwe do. Our current and potential competitors may establish cooperativerelationships among themselves or with third parties that may furtherenhance their resources. In addition, current or potential competitors may beacquired by third parties with greater available resources. As a result of suchpotential acquisitions, our current or potential competitors might be able toadapt more quickly to new technologies and customer needs, devote greaterresources to the promotion or sale of their products and services, initiate orwithstand substantial price competition, take advantage of acquisition or otheropportunities more readily or develop and expand their product and serviceofferings more quickly. In addition, our competitors may bundle productscompetitive with ours with other products that they may sell to our

 

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current or potentialcustomers. These customers may accept these bundled products rather thanseparately purchasing our products.

 

***Risks related tomarketing and sales efforts and customer service.***

*** ***

**Weneed to effectively manage our sales and marketing operations to increasemarket awareness and sales of our products and to promote our brand recognition.If we fail to do so, our growth will be limited.**

** **

Although we currently have a relatively small salesand marketing organization, we must continue to increase market awareness andsales of our products and promote our brand in the marketplace. In our OEMAppliance segment, we believe that to compete successfully we will need networkequipment providers and ISVs to recognize Network Engines as a top-tierprovider of server appliance platforms and custom integration services.

 

We must also effectively market to distributors and systemsintegrators our NS Series Security Appliances. This marketing effortrequires a greater investment in personnel and other areas, and an appropriatelevel of technical knowledge about the security market, Microsoft applicationssuch as Exchange, and other software applications included in these serverappliance products. It also requires substantial understanding of the targetedmarket into which these products are sold and may require the expenditureof a material amount of managerial and financial resources. We have limitedexperience marketing and selling security appliance products through indirectchannels and therefore, may not be successful in these efforts. If we areunable to design and implement marketing campaigns that are effective inpromoting our network security appliances, or if we fail to promote andmaintain the Network Engines brand, we may not increase or maintain salesand our business may be adversely affected. Our business would also sufferif we incur excessive expenses in these marketing campaigns but fail to achievethe expected or desired increase in revenues.

 

**Ifwe are unable to effectively manage our customer service and supportactivities, we may not be able to retain our existing customers or attractnew customers.**

** **

We need to effectively manage our customer supportoperations to ensure that we maintain good relationships with our customers. Becauseour NS Series Security Appliances provide critical protection for certainapplications, managing software updates to the appliance, when and if they areavailable, will be essential to the performance of the appliance. In addition,as we integrate more third party software applications our NS Series SecurityAppliances will become increasingly complex to maintain and support. As aresult, managing any updates released by Microsoft, or the third party softwarevendor will require careful consideration to determine the sensitivity andimpact on the function of our appliance. Additionally, any updates designatedas vital to the function of our appliance will require rapid deployment toensure the customers’ applications are properly protected. We expect thatproviding this increased customer service for our NS Series SecurityAppliances will require more technically qualified staff either within theCompany or from third parties, which could be more costly and if we are unableto provide this higher level of service we may be unable to successfullysell our security appliances.

 

Our channel partners in some cases will providesupport for the end-user customers. We may be unable to provide thesechannel partners with the necessary training and back-up support. Thereforethey may be unable to provide end-user customers with the necessary levelof support, which may be detrimental to our reputation and ability to sellour products. Also, some of our channel partners may choose not to providethis service, which would require us to hire more support staff to provide thefirst level support to end user customers, which would increase our costs andlower our margins.

 

If our customer support organization is unsuccessfulin maintaining good customer relationships, we may lose customers to ourcompetitors and our reputation in the market could be damaged. As a result, we may loserevenues and our business could suffer. Furthermore, the costs of this servicecould be higher than we expect, which could adversely affect our operatingresults.

 

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***Risks related to productmanufacturing.***

*** ***

**Ourdependence on sole source and limited source suppliers for key server appliancecomponents makes us susceptible to supply shortages and potential qualityissues that could prevent us from shipping customer orders on time, if at all,and could result in lost sales and customers.**

** **

We depend upon single source and limited sourcesuppliers for our industry-standard processors, main logic boards, certain diskdrives, hardware platforms and power supplies as well as certain of our coolingsystems, chassis and sheet metal parts. We also rely upon a single sourcesupplier to provide the hardware platform for our NS Series SecurityAppliances. Additionally, we depend on limited sources to supply certain otherindustry-standard and customized components. We have in the past experienced,and may in the future experience, shortages of or difficulties inacquiring components in the quantities and of the quality needed to produce ourserver appliance products. Shortages in supply or quality issues related tothese key components for an extended time would cause delays in the productionof our server appliance products, prevent us from satisfying our contractualobligations and meeting customer expectations, and result in lost sales andcustomers. If we are unable to buy components in the quantities and of thequality that we need on a timely basis or at acceptable prices, we will not beable to manufacture and deliver our server appliance products on a timely orcost-effective basis to our customers, and our competitive position,reputation, business, financial condition and results of operations could beseriously harmed.

 

**Ifour server appliance products fail to perform properly and conform tospecifications, our customers may demand refunds, assert claims fordamages or terminate existing relationships with us and our reputation andoperating results may suffer materially.**

** **

Because server appliancesolutions are complex, they could contain errors that can be detected at anypoint in a product’s life cycle. If flaws in design, production, assembly or testing ofour products (by us or our suppliers) were to occur, we could experience a rateof failure in our products that could result in substantial repair, replacementor service costs and potential damage to our reputation.  In addition, because our solutions arecombined with products from other vendors, should problems occur, it might bedifficult to identify the source of the problem. Continued improvement in manufacturing capabilities,control of material and manufacturing quality and costs, and product testingare critical factors in our future growth. There can be no assurance that ourefforts to monitor, develop, modify and implement appropriate test andmanufacturing processes for our products will be sufficient to permit us toavoid a rate of failure in our products that results in substantial delays inshipment, significant repair or replacement costs or potential damage to ourreputation, any of which could have a material adverse effect on our business,results of operations or financial condition.

 

In the past, we have discovered errors in some of ourserver appliance solutions and have experienced delays in the shipment of ourserver appliance products during the period required to correct these errors orwe have had to replace defective products that were already shipped. Errors inour server appliance solutions may be found in the future and any of theseerrors could be significant. Significant errors, including those discussedabove, may result in:

 

•                  the loss of or delay in market acceptance and sales ofour server appliance products;

 

•                  diversion of engineering resources;

 

•                  increased manufacturing costs;

 

•                  the loss of new or existing server appliance partners;

 

•                  injury to our reputation and other customer relationsproblems; and

 

•                  increased maintenance and warranty costs.

 

Any of these problems could harm our business andfuture operating results. Product errors or delays could be material, includingany product errors or delays associated with the introduction of new

 

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products or versions ofexisting products. If our server appliance solutions fail to conform towarranted specifications, customers could demand a refund for the purchaseprice and assert claims for damages.

 

Moreover, because our server appliance solutions may beused in connection with critical computing systems services, includingproviding security to protect valuable information, we may receivesignificant liability claims if they do not work properly. While our agreementswith customers typically contain provisions intended to limit our exposure toliability claims, these limitations do not preclude all potential claims.Liability claims could exceed our insurance coverage and require us to spendsignificant time and money in litigation or to pay significant damages. Anyclaims for damages, even if unsuccessful, could seriously damage our reputationand business.

 

**Ourfuture server appliance revenue growth may be limited by our ability toexpand production capacity.**

** **

Our existing manufacturing facility is limited in itsproduction capacity. For us to achieve significant server appliance revenuegrowth our server appliance sales volumes must increase significantly and ourproduction capacity must increase to support such sales volumes.

 

To supplement our current production capacity, toprovide for increased capacity for “production spikes” and to provide disasterbackup capabilities, we currently utilize the services of a contractmanufacturer for certain server appliance products on a limited basis. However,our contract manufacturer is not obligated to supply products to us for anyspecific period, or in any specific quantity, except as may be provided inan accepted purchase order. Using a contract manufacturer increases our cost ofproducing server appliance products and could decrease our gross profits. Inthe event that we need to change contract manufacturers or requiresignificantly increased production levels, we could experience transitionaldifficulties, including production delays and quality control issues, thatcould prevent us from satisfying our production requirements on a timely basis,cause customer relationships to suffer and result in lost sales. Also, the useof a contract manufacturer does not guarantee us production levels,manufacturing line space or manufacturing prices, the lack of which couldinterrupt our business operations and have a negative effect on operatingresults.

 

 In the past, weexpanded our internal production capacity through expansion and reorganizationof our current production facilities. Although we believe that our currentfacility, along with our use of a contract manufacturer to supplementproduction, is sufficient to support our business for the foreseeable future,we may need additional production capacity. We believe that we couldexpand production levels in our existing facility, but we are currentlyutilizing all available manufacturing space in our existing facility and we may havedifficulties expanding this facility any further. Therefore, significantfurther expansion of the production capacity either in our existing facilitiesor by expanding into additional facilities could require substantialinvestments, which could detract from our ability to invest in other areas ofour business and may not result in the desired return on investment, whichcould negatively affect our operating results.

 

**Ifwe do not accurately forecast our server appliance materials requirements, ourbusiness and operating results could be adversely affected.**

** **

We use rolling forecasts based on anticipated productorders to determine our server appliance component requirements. Lead times formaterials and components that we order vary significantly, depending amongother things, on specific supplier requirements, contract terms and currentmarket demand for those components. In addition, a variety of factors,including the timing of product releases, potential delays or cancellations oforders, the timing of large orders, and the unproven acceptance of new productsin the market make it difficult to predict product orders. As a result, ourmaterials requirement forecasts may not be accurate. If we overestimateour materials requirements, we may have excess inventory, which wouldincrease costs and negatively impact our cash position. Our agreements withcertain customers provide us with protections related to inventory purchased inaccordance with the terms of these agreements; however, these protections may notbe sufficient to prevent certain losses as a result of excess or obsoleteinventory. If we underestimate our materials requirements, we may haveinadequate inventory, which could interrupt our manufacturing and delaydelivery of our server appliance products to customers resulting in a loss ofsales or customers. Any of these occurrences would negatively impact ourbusiness and operating results.

 

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

*** ***

**Ourreliance upon contractual provisions, domestic patent, copyright and tradesecret laws and applied-for patents to protect our proprietary rights may notbe sufficient to protect our intellectual property.**

** **

Certain of our server appliance solutions aredifferentiated from the products of our competitors by our internally developedsoftware and hardware and the manner in which they are integrated into ourserver appliance solutions. If we fail to protect our intellectual property,other vendors could sell products with features similar to ours, which couldreduce demand for our solutions. We have taken what we believe to be thenecessary and appropriate steps to safeguard our intellectual property.However, these steps may afford us only limited protection. Others may developtechnologies that are similar or superior to our technology or design aroundthe patents we own. Despite the precautions we have taken, laws and contractualrestrictions may not be sufficient to prevent misappropriation of our technologyor deter others from developing similar technologies. In addition, there can beno guarantee that any of our patent applications will result in patents, orthat any such patents would provide effective protection of our technology.

 

In addition, the laws of the countries in which we may decideto market our services and solutions may offer little or no effectiveprotection of our proprietary technology. Reverse engineering, unauthorizedcopying or other misappropriation of our proprietary technology could enablethird parties to benefit from our technology without paying us for it, whichwould significantly harm our business. In addition, our U.S. patents have noeffect in foreign jurisdictions and obtaining patent protection in foreigncountries is expensive and time consuming.

 

**Ouroperating results would suffer if we, or our ISV or network equipment providerpartners, were subject to an infringement claim that resulted in protractedlitigation, the award of significant damages against us or the payment ofsubstantial ongoing royalties.**

** **

Substantial litigation regarding intellectual propertyrights exists in the technology industry. We expect that server applianceproducts may be subject to third-party infringement claims as the numberof competitors in the industry segment grows and the functionality of productsin different industry segments overlap. In the past we have received claimsfrom third parties that our server appliance products infringed theirintellectual property rights. We do not believe that our server applianceproducts employ technology that infringes the proprietary rights of any thirdparties. We are also not aware of any claims made against any of our ISV ornetwork equipment provider partners related to their infringement of theproprietary rights of other parties in relation to products that include ourserver appliance products. Other parties may make claims against us that,with or without merit, could:

 

•                  be time-consuming for us to address;

 

•                  require us to enter into royalty or licensingagreements;

 

•                  result in costly litigation, including potentialliability for damages;

 

•                  divert our management’s attention and resources; and

 

•                  cause product shipment delays.

 

In addition, other parties may make claimsagainst our ISV or network equipment provider partners related to products thatare incorporated into our server appliance products. Our business could beadversely affected if such claims resulted in the inability of our ISV ornetwork equipment provider partners’ to continue to produce the infringingproduct.

 

***Other risks related toour business.***

*** ***

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

** **

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** **

Our success depends in large part on our abilityto retain, and attract highly skilled engineering, sales, marketing, customerservice, and managerial personnel. If we are unable to attract a sufficient numberof qualified personnel, particularly personnel knowledgeable in softwareengineering and channel sales and marketing, experienced in the network storageand security market, we may not be able to meet key objectives such asdeveloping, upgrading, or enhancing our products in a timely manner, andeffectively marketing our products to customers, any of which could negativelyimpact our business and could hinder any future growth.

 

** **If we fail to maintain aneffective system of internal controls, we may not be able to accuratelyreport our financial results. As a result, current and potential stockholderscould lose confidence in our financial reporting, which could have a negativemarket reaction.

** **

Section 404 of the Sarbanes-Oxley Act of 2002requires our management to report on, and our independent registered publicaccounting firm to attest to, the effectiveness of our internal control overfinancial reporting. We have an ongoing program to perform the system andprocess evaluation and testing necessary to comply with these requirements. Asa result, we have incurred increased expense and have devoted additionalmanagement resources to Section 404 compliance. Effective internalcontrols are necessary for us to provide reliable financial reports. If we cannotprovide reliable financial reports, our business and operating results could beharmed.

 

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

** **

**In December 2001,a class action lawsuit relating to our initial public offering was filedagainst us, our chairman, one of our executive officers and the underwriters ofour initial public offering. In addition, in January 2003, a purported class actionlawsuit was filed against us and our Board of Directors relating to theacquisition of TidalWire Inc. and on December 16, 2003, a number ofpurported class action lawsuits were filed against us and John H. Curtis,our former President and CEO, Douglas G. Bryant, our CFO, Vice President ofFinance and Administration, Treasurer and Secretary, and Lawrence Genovesi, ourChairman of the Board relating to the timing of our announcement of theamendment of our HBA distribution agreement with EMC. For more information onthese lawsuits, see “Part II, Item 1 – Legal Proceedings.” In December 2003,we settled the class action lawsuit filed against us relating to theacquisition of TidalWire Inc. and we are currently attempting to settle thelawsuit filed against us related to our initial public offering and the lawsuitrelated to the timing of our announcement of the amendment of our HBAdistribution agreement with EMC. We are unable to predict the effects on ourfinancial condition or business of the lawsuit related to our initial publicoffering, the lawsuit related to our announcement of the amendment of our HBAdistribution agreement with EMC or other lawsuits that may arise from timeto time. While we maintain certain insurance coverage, there can be noassurance that claims against us will not result in substantial monetarydamages in excess of such insurance coverage. These class action lawsuits,or any future lawsuits, could cause our director and officer insurance premiumsto increase and could affect our ability to obtain director and officerinsurance coverage, which would negatively affect our business. In addition, wehave expended, and may in the future expend, significant resources todefend such claims. These class action lawsuits, or other similar lawsuitsthat may arise from time to time, could negatively impact both ourfinancial condition and the market price of our common stock and could resultin management devoting a substantial portion of their time to these lawsuits,which could adversely affect the operation of our business.**

** **

**Ifthe site of our manufacturing operations were to experience a significantdisruption in its operations, it would have a material adverse effect on ourfinancial condition and results of our operations.**

** **

Our manufacturing facility and headquarters areconcentrated in one location. If the operations in this facility were disruptedas a result of a natural disaster, fire, power or other utility outage, workstoppage or other similar event, our business could be seriously harmed asa result of interruptions or delays in our manufacturing, engineering,distribution or post-sales support operations.

 

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

** **

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The market price of our common stock has been subjectto significant fluctuations and may continue to fluctuate or decline.During fiscal 2005, the closing price of our common stock ranged from a low of$1.37 to a high of $3.16 and in the nine months ended June 30, 2006, froma low of $1.12 to a high of $3.17. The market for technology stocks has beenextremely volatile and frequently reaches levels that bear no relationship tothe past or present operating performance of those companies. General economicconditions, such as recession or interest rate or currency rate fluctuations inthe United States or abroad, could negatively affect the market price of our commonstock. In addition, our operating results may be below the expectations ofsecurities analysts and investors. If this were to occur, the market price ofour common stock may decrease significantly. In the past, followingperiods of volatility in the market price of a company’s securities, securitiesclass action litigation has often been instituted against such companies. Suchlitigation could result in substantial cost and a diversion of management’sattention and resources.

 

**Anydecline in the market price of our common stock or negative market conditionscould adversely affect our ability to raise additional capital, to completefuture acquisitions of or investments in other businesses and to attract andretain qualified technical and sales and marketing personnel.**

** **

**Wehave anti-takeover defenses that could delay or prevent an acquisition andcould adversely affect the market price of our common stock.**

** **

Our Board of Directors has the authority to issue upto 5,000,000 shares of preferred stock and, without any further vote or actionon the part of the stockholders, will have the authority to determine theprice, rights, preferences, privileges and restrictions of the preferred stock.This preferred stock, if issued, might have preference over the rights of theholders of common stock and could adversely affect the market price of ourcommon stock. The issuance of this preferred stock may make it moredifficult for a third party to acquire us or to acquire a majority of ouroutstanding voting stock. We currently have no plans to issue preferred stock.

 

In addition, provisions of our second amended andrestated certificate of incorporation and our second amended and restatedby-laws may deter an unsolicited offer to purchase us. These provisions,coupled with the provisions of the Delaware General Corporation Law, may delayor impede a merger, tender offer or proxy contest involving us. For example,our Board of Directors is divided into three classes, only one of which iselected at each annual meeting. These factors may further delay or preventa change of control of our business.

 

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**ITEM 2.    UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

 

*Recent Sales of Unregistered Securities*

 

During the quarter ended June 30, 2006, we didnot issue any unregistered shares of our common stock.

 

*Use of Proceeds from Sales of RegisteredSecurities*

 

On July 18, 2000, theCompany sold 7,475,000 shares of common stock in an initial public offering ata price of $17.00 per share pursuant to a Registration Statement on Form S-1(Registration No. 333-34286), which was declared effective by theSecurities and Exchange Commission on July 12, 2000. The aggregateproceeds to us from the offering were approximately $116.9 million reflectinggross proceeds of $127.0 million net of underwriting fees of approximately $8.9million and other offering costs of approximately $1.3 million. During theperiod from the offering through June 30, 2006, we used the proceeds from ourinitial public offering as follows: approximately $65.8 million to fund ouroperations, approximately $9.1 million for the purchase of property andequipment, approximately $4.6 million to repurchase our common stock under astock repurchase plan and approximately $13.2 million for our acquisition ofTidalWire Inc.

 

**ITEM 6.    EXHIBITS**

 

(a)    Exhibits

 

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

 

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**SIGNATURES**

 

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

 
|                       | **NETWORK ENGINES, INC.**                                                                     |
|----------------------------|----------------------------------------------------------------------------------------------------|
|                       | ** **                                                                                         |
| Date:  August 9, 2006 | /s/ Gregory A. Shortell                                                                            |   |
|                       |                                                                                               |
|                       |                                                                                               |
|                       | Gregory A. Shortell                                                                                |
|                       | President  and Chief  Executive Officer                                                            |
|                       | (Principal  Executive  Officer)                                                                    |
|                       |                                                                                               |
|                       |                                                                                               |
|                       | /s/ Douglas  G. Bryant                                                                             |   |
|                       |                                                                                               |
|                       | Douglas  G. Bryant                                                                                 |
|                       | Vice  President of Finance  and Administration, Chief  Financial Officer, Treasurer  and Secretary |
|                       | (Principal  Financial Officer  and Principal                                                       |
|                       | Accounting  Officer)                                                                               |
|                            |                                                                                                    |  |  |  |

 

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Exhibit**                                                                                                                                                                                                                                    |
|----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                                                                                                           |
| 10.1                 |       | Offer Letter dated March 7,  2006 between Network Engines, Inc. and Kevin Murphy (Filed as Exhibit 10.1  to the Company’s Current Report on Form 8-K dated April 6, 2006 and  incorporated by reference herein). |
|                 |       |                                                                                                                                                                                                                                           |
| 31.1                 |       | Certification of Gregory A. Shortell, the Chief  Executive Officer of the Company, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                            |
|                 |       |                                                                                                                                                                                                                                           |
| 31.2                 |       | Certification of Douglas G. Bryant, the Chief  Financial Officer of the Company, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                              |
|                 |       |                                                                                                                                                                                                                                           |
| 32.1                 |       | Certification of Gregory A. Shortell, the Chief  Executive Officer of the Company, pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                            |
|                 |       |                                                                                                                                                                                                                                           |
| 32.2                 |       | Certification of Douglas G. Bryant, the Chief  Financial Officer of the Company, pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                              |

 

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