##### **Table ofContents**

 

 

 

##### **UNITED STATES**

##### **SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

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

##### ** **

----

 

**(MarkOne)**

 

| **x**                                                                                                                                                                                                                                                                                                             | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                              |       |                                                                                                    |
| **For the quarterly period ended June 30, 2009**                                                                                                                                                                                                                                                             |
|                                                                                                                                                                                                                                                                                                              |
| **OR**                                                                                                                                                                                                                                                                                                            |
|                                                                                                                                                                                                                                                                                                              |       |                                                                                                    |
| **o**                                                                                                                                                                                                                                                                                                             |       | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                                                              |       |                                                                                                    |
| **For the transition period from                          to                       ** |

 

###### **Commission file number:000-30863**

###### ** **

----

 

 

**NETWORKENGINES, INC.**

(Exact name of registrant as specified in its charter)

** **

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

 

**(781) 332-1000**

(Registrant’s telephone number, including area code)

 

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

 

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

 

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

 

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

 

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

 

Asof August 6, 2009, there were 42,145,194 shares of the registrant’s CommonStock, par value $.01 per share, outstanding.

 

 

 

 

----

Table ofContents

 

**NETWORK ENGINES, INC.**

 

**INDEX**

 
| ** **                                                                                           | **PAGE  NUMBER** |
|------------------------------------------------------------------------------------------------------|------------------|
|                                                                                                 |             |
| **PART I. FINANCIAL INFORMATION**                                                               | ** **       |
|                                                                                                 |             |
| ITEM 1. FINANCIAL STATEMENTS  (UNAUDITED)                                                            | 1                |
|                                                                                                 |             |
| CONDENSED CONSOLIDATED  BALANCE SHEETS                                                               | 1                |
| CONDENSED CONSOLIDATED  STATEMENTS OF OPERATIONS                                                     | 2                |
| CONDENSED CONSOLIDATED  STATEMENTS OF CASH FLOWS                                                     | 3                |
| NOTES TO  UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                      | 4                |
|                                                                                                 |             |
| ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF  OPERATIONS | 14               |
|                                                                                                 |             |
| ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                  | 25               |
|                                                                                                 |             |
| ITEM 4. CONTROLS AND  PROCEDURES                                                                     | 25               |
|                                                                                                 |             |
| **PART II. OTHER  INFORMATION**                                                                 | ** **       |
|                                                                                                 |             |
| ITEM 1. LEGAL PROCEEDINGS                                                                            | 25               |
|                                                                                                 |             |
| ITEM 1A. RISK FACTORS                                                                                | 26               |
|                                                                                                 |             |
| ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                 | 37               |
|                                                                                                 |             |
| ITEM 6. EXHIBITS                                                                                     | 37               |
|                                                                                                 |             |
| SIGNATURES                                                                                           | 38               |

 

----

Table ofContents

 

**PART I. FINANCIAL INFORMATION**

 

**ITEM I. FINANCIAL STATEMENTS**

 

**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(inthousands, except share data)**

**(unaudited)**

 
| ** **                                                                                                                                                                                                             | ** ** | **June 30, 2009** | ** ** | **September 30,  2008** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------------|------------|
| **ASSETS**                                                                                                                                                                                                             |       |                   |       |                         |       |
| **Current assets:**                                                                                                                                                                                                    | ** ** | ** **             | ** ** | ** **                   | ** ** |
| Cash and cash equivalents                                                                                                                                                                                              |       | $                      | 19,720     |                         | $          | 10,003 |   |
| Restricted cash                                                                                                                                                                                                        |       | —                 |       | 47                           |       |
| Accounts receivable, net of allowances of $224 and  $122 at June 30, 2009 and September 30, 2008, respectively                                                                                               |       | 22,146                 |       | 26,403                       |       |
| Income tax receivable                                                                                                                                                                                                  |       | 44                     |       | 2,585                        |       |
| Inventories                                                                                                                                                                                                            |       | 12,252                 |       | 21,380                       |       |
| Prepaid expenses and other current assets                                                                                                                                                                              |       | 1,809                  |       | 2,009                        |       |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| Total current assets                                                                                                                                                                                                   |       | 55,971                 |       | 62,427                       |       |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| Property and equipment, net                                                                                                                                                                                            |       | 1,701                  |       | 1,549                        |       |
| Intangible asset, net                                                                                                                                                                                                  |       | 8,567                  |       | 9,884                        |       |
| Contingently returnable acquisition consideration                                                                                                                                                                      |       | 4,022                  |       | 4,022                        |       |
| Other assets                                                                                                                                                                                                           |       | 165                    |       | 183                          |       |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| Total assets                                                                                                                                                                                                           |       | $                      | 70,426     |                         | $          | 78,065 |   |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                         | ** ** | ** **             | ** ** | ** **                   | ** ** |
| **Current liabilities:**                                                                                                                                                                                               | ** ** | ** **             | ** ** | ** **                   | ** ** |
| Accounts payable                                                                                                                                                                                                       |       | $                      | 7,321      |                         | $          | 11,745 |   |
| Accrued compensation and other related benefits                                                                                                                                                                        |       | 1,642                  |       | 1,327                        |       |
| Other accrued expenses                                                                                                                                                                                                 |       | 2,370                  |       | 3,222                        |       |
| Deferred revenue                                                                                                                                                                                                       |       | 4,222                  |       | 5,173                        |       |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| Total current liabilities                                                                                                                                                                                              |       | 15,555                 |       | 21,467                       |       |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| Deferred revenue, net of current portion                                                                                                                                                                               |       | 2,538                  |       | 2,246                        |       |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| Total liabilities                                                                                                                                                                                                      |       | 18,093                 |       | 23,713                       |       |
|                                                                                                                                                                                                                   |       |                   |       |                         |       |
| Commitments and contingencies (Note 9)                                                                                                                                                                                 |       |                   |       |                         |       |
| ** **                                                                                                                                                                                                             | ** ** | ** **             | ** ** | ** **                   | ** ** |
| **Stockholders’ equity:**                                                                                                                                                                                         | ** ** | ** **             | ** ** | ** **                   | ** ** |
| Preferred stock, $0.01 par value, 5,000,000 authorized,  and no shares issued and outstanding                                                                                                                          | ** ** | **—**             | ** ** | **—**                   | ** ** |
| Common stock, $0.01 par value, 100,000,000 shares  authorized; 47,117,898 and 46,753,826 shares issued; 42,430,236 and  43,285,167 shares outstanding at June 30, 2009 and September 30,  2008, respectively |       | 471                    |       | 468                          |       |
| Additional paid-in capital                                                                                                                                                                                             |       | 196,388                |       | 195,228                      |       |
| Accumulated deficit                                                                                                                                                                                                    |       | (139,951               | )          | (137,572                     | )          |
| Treasury stock, at cost, 4,687,662 and 3,468,659  shares at June 30, 2009 and September 30, 2008, respectively                                                                                               |       | (4,575                 | )          | (3,772                       | )          |
| Total stockholders’ equity                                                                                                                                                                                        |       | 52,333                 |       | 54,352                       |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                        |       | $                      | 70,426     |                         | $          | 78,065 |   |

 

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

 

1

----

Table ofContents

 

**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

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

**(unaudited)**

 
| ** **                                                    | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                    | ** ** | **2009**                                        | ** ** | **2008**                                       | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Net revenues                                                  |       | $                                               | 33,329     |                                           | $          | 47,046 |   | $ | 108,025 |   | $ | 156,560 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Cost of revenues                                              |       | 28,292                                          |       | 39,396                                         |       | 91,612 |   | 130,271 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Gross profit                                                  |       | 5,037                                           |       | 7,650                                          |       | 16,413 |   | 26,289 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Operating expenses:                                           |       |                                            |       |                                           |       |   |   |   |   |
| Research and development                                      |       | 1,644                                           |       | 2,135                                          |       | 4,739 |   | 6,823 |   |
| Selling and marketing                                         |       | 2,039                                           |       | 2,761                                          |       | 6,240 |   | 8,826 |   |
| General and administrative                                    |       | 2,222                                           |       | 2,639                                          |       | 6,572 |   | 8,219 |   |
| Amortization of intangible asset                              |       | 439                                             |       | 485                                            |       | 1,317 |   | 1,406 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Total operating expenses                                      |       | 6,344                                           |       | 8,020                                          |       | 18,868 |   | 25,274 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| (Loss) income from operations                                 |       | (1,307                                          | )          | (370                                           | )          | (2,455 | ) | 1,015 |   |
| Interest and other income, net                                |       | 64                                              |       | 110                                            |       | 76 |   | 376 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| (Loss) income before income taxes                             |       | (1,243                                          | )          | (260                                           | )          | (2,379 | ) | 1,391 |   |
| Provision for income taxes                                    |       | —                                          |       | 23                                             |       | — |   | 133 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Net (loss) income                                             |       | $                                               | (1,243     | )                                              | $          | (283 | ) | $ | (2,379 | ) | $ | 1,258 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Net (loss) income per share – basic                      |       | $                                               | (0.03      | )                                              | $          | (0.01 | ) | $ | (0.06 | ) | $ | 0.03 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Net (loss) income per share – diluted                    |       | $                                               | (0.03      | )                                              | $          | (0.01 | ) | $ | (0.06 | ) | $ | 0.03 |   |
|                                                          |       |                                            |       |                                           |       |   |   |   |   |
| Shares used in computing basic net (loss) income  per share   |       | 42,764                                          |       | 44,090                                         |       | 43,026 |   | 43,918 |   |
| Shares used in computing diluted net (loss)  income per share |       | 42,764                                          |       | 44,090                                         |       | 43,026 |   | 44,248 |   |

 

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

 

2

----

Table ofContents

 

**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(inthousands)**

**(unaudited)**

 
| ** **                                                                                | ** ** | **Nine  months ended********June 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                | ** ** | **2009**                                    | ** ** | **2008** | ** ** |
| ** **                                                                                | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Cash flows from operating activities:                                                     |       |                                        |       |   |   |
| Net (loss) income                                                                         |       | $                                           | (2,379     | ) | $ | 1,258 |   |
| Adjustments to reconcile net (loss) income to net  cash provided by operating activities: |       |                                        |       |   |   |
| Depreciation and amortization                                                             |       | 1,997                                       |       | 2,489 |   |
| Loss on disposal of property and equipment                                                |       | 22                                          |       | 10 |   |
| Provision for doubtful accounts                                                           |       | 143                                         |       | 93 |   |
| Stock-based compensation                                                                  |       | 999                                         |       | 1,510 |   |
| Changes in operating assets and liabilities, net of  effects of acquisition:              |       |                                        |       |   |   |
| Accounts receivable                                                                       |       | 4,114                                       |       | (290 | ) |
| Income tax receivable                                                                     |       | 2,541                                       |       | — |   |
| Inventories                                                                               |       | 9,125                                       |       | 3,533 |   |
| Prepaid expenses and other assets                                                         |       | 264                                         |       | (355 | ) |
| Accounts payable                                                                          |       | (4,423                                      | )          | (2,059 | ) |
| Accrued expenses                                                                          |       | (518                                        | )          | (3,638 | ) |
| Deferred revenue                                                                          |       | (660                                        | )          | (215 | ) |
|                                                                                      |       |                                        |       |   |   |
| Net cash provided by operating activities                                                 |       | 11,225                                      |       | 2,336 |   |
|                                                                                      |       |                                        |       |   |   |
| Cash flows from investing activities:                                                     |       |                                        |       |   |   |
| Acquisition and related costs, net of cash assumed                                        |       | —                                      |       | (30,039 | ) |
| Contingently returnable acquisition payment                                               |       | —                                      |       | (4,022 | ) |
| Payment for disposition of subsidiary                                                     |       | —                                      |       | (231 | ) |
| Purchases of property and equipment                                                       |       | (853                                        | )          | (337 | ) |
|                                                                                      |       |                                        |       |   |   |
| Net cash used in investing activities                                                     |       | (853                                        | )          | (34,629 | ) |
|                                                                                      |       |                                        |       |   |   |
| Cash flows from financing activities:                                                     |       |                                        |       |   |   |
| Purchase of treasury stock                                                                |       | (803                                        | )          | (172 | ) |
| Proceeds from issuance of common stock                                                    |       | 168                                         |       | 319 |   |
| Payments on capital lease obligation                                                      |       | (20                                         | )          | (15 | ) |
|                                                                                      |       |                                        |       |   |   |
| Net cash (used in) provided by financing activities                                       |       | (655                                        | )          | 132 |   |
|                                                                                      |       |                                        |       |   |   |
| Effect of exchange rate differences on cash                                               |       | —                                      |       | (29 | ) |
| Net increase (decrease) in cash and cash  equivalents                                     |       | 9,717                                       |       | (32,190 | ) |
| Cash and cash equivalents, beginning of period                                            |       | 10,003                                      |       | 44,403 |   |
|                                                                                      |       |                                        |       |   |   |
| Cash and cash equivalents, end of period                                                  |       | $                                           | 19,720     |   | $ | 12,213 |   |

 

**The accompanying notes arean integral part of the condensed consolidated financial statements.**

 

3

----

Table of Contents

** **

**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.  Basis of Presentation**

 

Theaccompanying condensed consolidated financial statements have been prepared byNetwork Engines, Inc. (“Network Engines” or the “Company”) in accordancewith accounting principles generally accepted in the United States of Americaand pursuant to the rules and regulations of the Securities and ExchangeCommission (the “SEC”).  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to such rules and regulations.  The year-end condensed consolidated 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.  Thesefinancial statements should be read in conjunction with the audited financialstatements and the accompanying notes included in the Company’s 2008 AnnualReport on Form 10-K (the “2008 Form 10-K”) filed by the Company withthe SEC.

 

Theinformation furnished reflects all adjustments, which, in the opinion ofmanagement, are of a normal recurring nature and are considered necessary for afair statement of results for the interim periods.  It should also be noted that results for theinterim periods are not necessarily indicative of the results expected for thefull year or any future period.

 

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

 

**2.  Significant Accounting Policies**

 

***Recent Accounting Pronouncements***

 

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standard No. 157, “Fair ValueMeasurements” (“FAS 157”).  This statement addresses how companies shouldmeasure fair value when they are required to use a fair value measure forrecognition or disclosure purposes under accounting principles generallyaccepted in the United States of America. The FASB has also issued the following related FASB Staff Positions:

 

·         FASB StaffPosition No. FAS 157-1, “Application of FASB Statement No. 157 toFASB Statement No. 13 and Other Accounting Pronouncements That AddressFair Value Measurements for Purposes of Lease Classification or Measurementunder Statement 13” (“FSP 157-1”), issued in February 2008, amends FAS 157to remove certain leasing transactions from its scope.

 

·         FASB StaffPosition No. FAS 157-2, “Effective Date of FASB Statement No. 157”(“FSP 157-2”), issued in February 2008, defers the effective date ofFAS 157 for non-financial assets and liabilities, except for items thatare recognized or disclosed at fair value on a recurring basis (at leastannually), to the beginning of the Company’s fiscal year that begins after November 15,2008.  The Company is in the process of evaluating whetherthe adoption of FSP 157-2 (as it relates to the effective date of FAS 157 fornon-financial assets and liabilities which are recognized or disclosed at fairvalue on a non-recurring basis) will have a material impact on its financialposition, results of operations or cash flows.

 

·         FASB Staff Position No. FAS157-4, “Determining Fair Value When the Volume and Level of Activity for theAsset or Liability Have Significantly Decreased and Identifying TransactionsThat Are Not Orderly” (“FSP 157-4”), issued in April 2009, providesadditional guidance in applying FAS 157 when market volume and level ofactivity for the asset or liability have significantly decreased, and alsoincludes guidance on identifying distressed or forced (that is, not orderly)transactions that do not represent fair value. FSP 157-4 is effective for interim reporting periods ending after June 15,2009.  The Company adopted FSP 157-4 forthe interim reporting period ended June 30, 2009, and this adoption did nothave a material impact on its financial position, results of operations, orcash flows.

 

4

----

Table of Contents

 

**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

FAS157 defines fair value as the price that would be received to sell an asset orpaid to transfer a liability (“exit price”) in an orderly transaction betweenmarket participants at the measurement date. FAS 157 requires disclosures that categorize assets and liabilitieswhich are recognized or disclosed at fair value into one of three differentlevels depending on the assumptions (“inputs”) used in the valuation.  In the fair value hierarchy, Level 1 providesthe most reliable measure of fair value, while Level 3 generally requiressignificant management judgment. Financial assets and liabilities are classified in their entirety basedon the lowest level of input significant to the fair value measurement.

 

TheCompany adopted FAS 157, as it applies to financial assets and liabilities andnonfinancial assets and liabilities which are recognized or disclosed at fairvalue on a recurring basis (at least annually), as of October 1, 2008, andthis adoption did not have any impact on the Company’s financial position,results of operations or cash flows.  See Note 11 foradditional details regarding fair value measurements.

 

TheCompany adopted FASB Statement of Financial Accounting Standard No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities — including anamendment of FASB Statement No. 115” (“FAS 159”) as of October 1,2008.  This statement permits entities to choose to measure many financialinstruments and certain other items at fair value at specified electiondates.  The decision to measure specifiedinstruments at fair value is done so on an instrument-by-instrument basis andis irrevocable.  Subsequent unrealizedgains and losses as well as upfront costs and fees on items for which the fairvalue option has been elected are reported in earnings.  The adoption of FAS 159 did not have any impact on theCompany’s financial position, results of operations or cash flows, as theCompany did not elect to measure any items at fair value as of the adoptiondate.

 

In December 2007, the FASB issued Statement ofFinancial Accounting Standard No. 141(R), “Business Combinations” (“FAS141R”).  This Statement replacedStatement of Financial Accounting Standard No. 141 to improvethe relevance, representational faithfulness, and comparability of theinformation that a reporting entity provides in its financial reports about abusiness combination and its effects. FAS 141R establishes principles and requirements for how the acquirerrecognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, and any noncontrolling interest in theacquiree, recognizes and measures the goodwill acquired in the businesscombination or a gain from a bargain purchase and determines what informationto disclose to enable users of the financial statements to evaluate the natureand financial effects of the business combination.  FAS 141R is effective for businesscombinations on a prospective basis for which the acquisition date is on or after the beginning of the Company’sfirst annual reporting period beginning on or after December 15, 2008.  The Company does not expect the adoption ofFAS 141R to have a material impact on its financial position, results ofoperations, or cash flows.

 

In April 2008, theFASB issued FASB Staff Position No. FAS 142-3, “Determination of theUseful Life of Intangible Assets” (“FSP 142-3”).  FSP 142-3 amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of a recognized intangible asset under Statement of FinancialAccounting Standard No. 142, “Goodwill and Other Intangible Assets” (“FAS142”).  This change is intended toimprove the consistency between the useful life of a recognized intangibleasset under FAS 142 and the period of expected cash flows used to measure thefair value of the asset under FAS 141R and other generally accepted accountingprinciples.  The requirement fordetermining useful lives must be applied prospectively to intangible assetsacquired after the effective date and the disclosure requirements must beapplied prospectively to all intangible assets recognized as of, and subsequentto, the effective date.  FSP 142-3 iseffective as of the beginning of the Company’s fiscal year that begins after December 15,2008.  The Company is in the process of evaluating whetherthe adoption of FSP 142-3 will have a material impact on its financialposition, results of operations, or cash flows.

 

In April 2009, the FASB issued FASB StaffPosition No. FAS 115-2 and 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” (“FSPFAS 115-2 and FAS 124-2”) and FASB Staff Position No. FAS 107-1 and APB28-1, “Interim Disclosures about FairValue of Financial Instruments” (“FSP FAS 107-1 and APB 28-1”).  These Staff Positions impact certain aspectsof fair value measurement and related disclosures.  The provisions of these Staff Positions areeffective for interim periods ending after June 15, 2009.  The Company adopted FSPFAS 115-2 and FAS 124-2 and FSP FAS 107-1 and APB 28-1 for the interim reportingperiod ended June 30, 2009.  The adoption of these Staff Positions didnot have a material impact on the Company’s financial position, results ofoperations, or cash flows.

 

5

----

Table of Contents

 

**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

In May 2009,the FASB issued Statement of Financial Accounting Standard No. 165, “Subsequent Events” (“FAS 165”). Thisstandard is intended to establish general standards of accounting for anddisclosure of events that occur after the balance sheet date but beforefinancial statements are issued or are available to be issued. Specifically,this standard sets forth the period after the balance sheet date during whichmanagement of a reporting entity should evaluate events or transactions thatmay occur for potential recognition or disclosure in the financial statements,the circumstances under which an entity should recognize events or transactionsoccurring after the balance sheet date in its financial statements, and thedisclosures that an entity should make about events or transactions thatoccurred after the balance sheet date.  FAS 165 is effective for fiscalyears and interim periods ending after June 15, 2009 and will be appliedprospectively. The Company adopted FAS 165 for the interim reporting periodended June 30, 2009, and this adoption did not have a material impact onthe Company’s financial position, results of operations, or cash flows.  In accordance with FAS 165, the Companyevaluated subsequent events through August 10, 2009, the date of issuanceof the unaudited consolidated financial statements.  During this period, no material recognizablesubsequent events occurred.

 

In June 2009, the FASB issued Statement ofFinancial Accounting Standard No. 168, “The FASB Accounting Standards Codification and the Hierarchy ofGenerally Accepted Accounting Principles” (“FAS 168”). This standard isa replacement of FAS 162, and establishes two levels of U.S. generally acceptedaccounting principles (“GAAP”), authoritative and nonauthoritative. The FASBAccounting Standards Codification (the “Codification”) will become the sourceof authoritative, nongovernmental GAAP, except for rules and interpretivereleases of the Securities and Exchange Commission (“SEC”), which are sourcesof authoritative GAAP for SEC registrants. All other nongrandfathered, non-SECaccounting literature not included in the Codification will becomenonauthoritative. This standard is effective for financial statements forinterim or annual reporting periods ending after September 15, 2009. The Company will begin to use the new guidelines and numbering systemprescribed by the Codification when referring to GAAP for the fourth quarter ofits fiscal year ending September 30, 2009.  As the Codification wasnot intended to change or alter existing GAAP, the Company does not expect theadoption to have any impact on its financial position, results of operations,or cash flows.

 

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

#### *** ***

The Company held$19,720,000 in cash and cash equivalents as of June 30, 2009.  Cash equivalents consisted of money marketfunds purchased with an original maturity of three months or less.  Cash equivalents are measured at fair value,as described in more detail in Note 11. The Company did not hold any cash equivalents or short-term investmentsas of September 30, 2008, and did not hold any short-term investments asof June 30, 2009.  As of June 30,2009, the Company held no restricted cash. As of September 30, 2008, $47,000 in restricted cash was pledged ascollateral for a letter of credit related to the lease of one of the Company’soffice facilities.  The restriction ofthis amount was released during the quarter ended June 30, 2009, as theletter of credit is now supported by the Company’s bank line of credit (seeNote 10).  The following table presentsbalances of cash and cash equivalents held as of June 30, 2009 and September 30,2008 (in thousands):

 

| ** **                          | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|-------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                          | ** ** | **2009**          | ** ** | **2008**               | ** ** |
| **Cash**                            |       | $                 | 2,695      |                   | $          | 10,003 |   |
| **Cash equivalents:**               |       |              |       |                   |       |
| Money market funds                  |       | 17,025            |       | —                 |       |
|                                |       |              |       |                   |       |
| **Total cash and cash equivalents** |       | $                 | 19,720     |                   | $          | 10,003 |   |

 

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

#### *** ***

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

 

6

----

Table of Contents

 

**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

***Significant Customers***

 

The followingtables summarize those customers which accounted for greater than 10% of theCompany’s net revenues or accounts receivable:

 
| ** **           | ** ** | **Net Revenues**                           | ** ** |
|----------------------|------------|-------------------------------------------------|------------|
| ** **           | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
| ** **           | ** ** | **2009**                                        | ** ** | **2008** | ** ** | **2009** | ** ** | **2008** | ** ** |
| EMC Corporation      |       | 35                                              | %          | 41 | % | 35 | % | 43 | % |
| Tektronix, Inc. |       | 11                                              | %          | 12 | % | 11 | % | 12 | % |

 
| ** **           | ** ** | **Accounts Receivable at** | ** ** |
|----------------------|------------|----------------------------|------------|
| ** **           | ** ** | **June 30, 2009**     | ** ** | **September 30, 2008** | ** ** |
| EMC  Corporation     | ** ** | 24                         | %          | 30 | % |
| Tektronix, Inc. | ** ** | 12                         | %          | 17 | % |
| Tekelec              | ** ** | 12                         | %          | 2 | % |

 

**3.Business Combination**

 

On October 11,2007, in order to increase the Company’s presence in the application platformmarketplace, the Company acquired all of the equity of Alliance Systems, Inc.(“Alliance Systems”), a privately held corporation located in Plano, Texas,which provided application platforms and related equipment supporting carriercommunications and enterprise communications solutions.  For further information on the acquisition,refer to the Company’s Annual Report on Form 10-K for the year ended September 30,2008.

 

The acquisition wasstructured to include a downward adjustment to the purchase price based on thenet working capital of Alliance Systems as of October 11, 2007, as definedin the merger agreement, and therefore approximately $4.0 million of the cashpaid is contingently returnable to the Company upon resolution of thisprovision.  As a result, the amount ofcontingently returnable consideration has been excluded from the allocation ofthe purchase price to the net assets acquired until such time that this amount isno longer contingently returnable.  Whenthe contingencies are resolved, any portion of the $4.0 million which isnot returned to the Company will be reclassified as goodwill.  If goodwill is recorded in a future period,it will then be subject to review for impairment annually as of the fiscal yearend date, and more frequently if certain indicators are present.  The Company has been pursuingsettlement of this contingency through negotiations with the formershareholders of Alliance Systems; however, no final resolution has been reachedas of June 30, 2009.  During July 2009,the Company and the former Alliance Systems shareholders agreed to proceed toarbitration to resolve the disputed claims as provided for in the mergeragreement.

 

**4.  Stock-Based Compensation**

 

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

 

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

 
| ** **                             | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|----------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                             | ** ** | **2009**                                        | ** ** | **2008**                                       | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                   |       |                                            |       |                                           |       |   |   |   |   |
| Cost of revenues                       |       | $                                               | 34         |                                           | $          | 41 |   | $ | 109 |   | $ | 141 |   |
| Research and development               |       | 58                                              |       | 161                                            |       | 200 |   | 573 |   |
| Selling and marketing                  |       | 75                                              |       | 92                                             |       | 213 |   | 253 |   |
| General and administrative             |       | 152                                             |       | 173                                            |       | 477 |   | 543 |   |
| Total stock-based compensation expense |       | $                                               | 319        |                                           | $          | 467 |   | $ | 999 |   | $ | 1,510 |   |

 

7

----

Table ofContents

 

**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

The Company estimates thefair value of stock options using the Black-Scholes valuation model.  This valuation model takes into account theexercise price of the award, as well as a variety of significantassumptions.  These assumptions includethe expected term, the expected volatility of the Company’s common stock overthe expected term, the risk-free interest rate over the expected term, and theCompany’s expected annual dividend yield. The Company believes that the valuation technique and the approachutilized to develop the underlying assumptions are appropriate in calculatingthe fair values of the Company’s stock options granted during the three andnine month periods ended June 30, 2009 and 2008.  Estimates of fair value are not intended topredict the value ultimately realized by persons who receive equity awards.  In determining the amount of expense to berecorded, judgment is also required to estimate forfeitures of the awards basedon the probability of employees completing the required service period. Historical forfeitures are used as a starting point for developing the estimateof future forfeitures.

 

Assumptionsused to determine the fair value of options granted during the three and ninemonths ended June 30, 2009 and 2008, using the Black-Scholes valuationmodel, were:

 
| ** **                      | ** ** | **Three months ended June 30,** | ** ** | **Nine months ended June 30,** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                      | ** ** | **2009**                             | ** ** | **2008**                            | ** ** | **2009** | ** ** | **2008** | ** ** |
|                            |       |                                 |       |                                |       |   |   |   |   |
| Expected term (1)               |       | 3.50 years                           |       | 6.06 to 6.25 years                  |       | 3.50 to 6.00 years |   | 5.50 to 6.25 years |   |
| Expected volatility  factor (2) |       | 79.74%                               |       | 56.69% to 57.71%                    |       | 66.82% to 80.11% |   | 54.89% to 59.05% |   |
| Risk-free interest rate  (3)    |       | 1.54%                                |       | 3.51%                               |       | 1.28% to 2.21% |   | 2.70% to 4.13% |   |
| Expected annual  dividend yield |       | —                               |       | —                              |       | — |   | — |   |

 

----

| (1)    | For  grants issued prior to January 1, 2008, expected term was determined as the midpoint between  the vesting date and the end of the contractual term, also known as the  “simplified method” for estimating expected term described by Staff  Accounting Bulletin No. 107 (“SAB 107”). For grants issued on or  after January 1, 2008, expected term was determined based on analysis of  the Company’s historical exercise and post-vesting cancellation activity. |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| (2)    | The  expected volatility for each grant was estimated based on a weighted average  of the historical volatility of the Company’s common stock.                                                                                                                                                                                                                                                                                                                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| (3)    | The  risk-free interest rate for each grant was based on the U.S. Treasury yield  curve in effect at the time of grant for a period equal to the expected term  of the stock option.                                                                                                                                                                                                                                                                                                                                |

 

Stock-based compensationexpense related to the Company’s Employee Stock Purchase Plan is determinedbased on the discount of 15% from the per share market price on the close ofthe purchase period.

 

A summary of the Company’sstock option activity for the nine months ended June 30, 2009 is asfollows:

 

| ** **                              | ** ** | **Nine months ended June 30, 2009** | ** ** |
|-----------------------------------------|------------|------------------------------------------|------------|
| ** **                              | ** ** | **Number of  Options**                   | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted********Average Remaining  Contractual  Term (in years)** | ** ** |
|                                    |       |                                     |       |   |   |   |   |
| Outstanding  at September 30, 2008 |       | 7,483,042                                |       | $ | 2.35 |   |   |   |
| Granted                                 |       | 1,165,500                                |       | $ | 0.39 |   |   |   |
| Exercised                               |       | —                                   |       | $ | — |   |   |   |
| Forfeited                               |       | (238,983                                 | )          | $ | 1.89 |   |   |   |
| Expired                                 |       | (410,432                                 | )          | $ | 2.32 |   |   |   |
| Outstanding  at June 30, 2009      |       | 7,999,127                                |       | $ | 2.08 |   | 6.69 |   |
| Exercisable  at June 30, 2009      |       | 5,228,441                                |       | $ | 2.49 |   | 5.73 |   |

 

All stock options grantedduring the nine months ended June 30, 2009 were granted with exerciseprices equal to the fair market value of the Company’s common stock on thegrant date and had a weighted average grant date fair value of $0.23.

 

8

----

Table ofContents

 

**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

AtJune 30, 2009,unrecognized compensation expense related to non-vested stock options was$1,671,000, which is expected to be recognized over a weighted average periodof 2.33 years.

 

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

** **

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

 

The following table sets forth the computation of basic and diluted net (loss) income per share as well asthe weighted average potential common stock excluded from the calculation ofnet (loss) income per sharebecause their inclusion would be anti-dilutive (in thousands, except per sharedata):

 

| ** **                                                                                                      | ** ** | **Three months  ended June 30,** | ** ** | **Nine  months ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                      | ** ** | **2009**                              | ** ** | **2008**                              | ** ** | **2009** | ** ** | **2008** | ** ** |
| Numerator:                                                                                                      |       |                                  |       |                                  |       |   |   |   |   |
| Net  (loss) income                                                                                              |       | $                                     | (1,243     | )                                     | $          | (283 | ) | $ | (2,379 | ) | $ | 1,258 |   |
|                                                                                                            |       |                                  |       |                                  |       |   |   |   |   |
| Denominator:                                                                                                    |       |                                  |       |                                  |       |   |   |   |   |
| Shares  used in computing basic net (loss) income per share                                                     |       | 42,764                                |       | 44,090                                |       | 43,026 |   | 43,918 |   |
| Common  stock equivalents from employee stock options                                                           |       | —                                |       | —                                |       | — |   | 330 |   |
|                                                                                                            |       |                                  |       |                                  |       |   |   |   |   |
| Shares  used in computing diluted net (loss) income per share                                                   |       | 42,764                                |       | 44,090                                |       | 43,026 |   | 44,248 |   |
|                                                                                                            |       |                                  |       |                                  |       |   |   |   |   |
| Net  (loss) income per share:                                                                                   |       |                                  |       |                                  |       |   |   |   |   |
| Basic                                                                                                           |       | $                                     | (0.03      | )                                     | $          | (0.01 | ) | $ | (0.06 | ) | $ | 0.03 |   |
| Diluted                                                                                                         |       | $                                     | (0.03      | )                                     | $          | (0.01 | ) | $ | (0.06 | ) | $ | 0.03 |   |
|                                                                                                            |       |                                  |       |                                  |       |   |   |   |   |
| Anti-dilutive  potential common stock equivalents excludedfrom the calculation of net (loss)  income per share: |       |                                  |       |                                  |       |   |   |   |   |
| Options  to purchase common stock                                                                               |       | 6,830                                 |       | 7,703                                 |       | 7,834 |   | 7,107 |   |

 

**6.  Intangible Asset**

 

The Company recorded anintangible asset as the result of its acquisition of Alliance Systems (see Note3 above).  The acquired intangible assetis customer relationships, which is being amortized over 17 years, which is theestimated period of economic benefit expected to be received, resulting in aweighted average amortization period of 4.97 years.  Thefollowing table presents the intangible asset balances as of June 30, 2009 andSeptember 30, 2008 (in thousands):

 

| ** **              | ** ** | **June 30, 2009**      | ** ** | **September 30, 2008**   | ** ** |
|-------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **              | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Book  Value** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Book  Value** | ** ** |
| ** **              | ** ** | ** **                  | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Customer  relationships |       | $                           | 11,775     |                          | $          | 3,208 |   | $ | 8,567 |   | $ | 11,775 |   | $ | 1,891 |   | $ | 9,884 |   |
|                         |            |                             |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

9

----

Table of Contents

 

**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

Amortizationexpense for the three and nine months ended June 30, 2009 was $439,000 and$1,317,000, respectively.  The estimatedfuture amortization expense for the intangible asset as of June 30, 2009by fiscal year is $439,000 for the remainder of 2009, $1,554,000 for 2010,$1,330,000 for 2011, $1,119,000 for 2012, $868,000 for 2013 and $3,257,000thereafter.

 

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

 

**7.  Inventories**

 

Inventoriesconsisted of the following (in thousands):

 

| ** **       | ** ** | **June 30,  2009** | ** ** | **September 30, 2008** | ** ** |
|------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **       | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Raw  materials   |       | $                       | 6,106      |                        | $          | 13,402 |   |
| Work  in process |       | 1,093                   |       | 1,442                       |       |
| Finished  goods  |       | 5,053                   |       | 6,536                       |       |
|             |       |                    |       |                        |       |
| Total            |       | $                       | 12,252     |                        | $          | 21,380 |   |

 

**8.  Equity**

 

On June 12,2008, the Board of Directors of the Company authorized the repurchase of up to$5 million of its common stock through a share repurchase program.  As authorized by the program, shares may bepurchased in the open market or through privately negotiated transactions, in amanner consistent with applicable securities laws and regulations.  This stock repurchase program does notobligate the Company to acquire any specific number of shares, does not have anexpiration date, and may be terminated at any time by the Company’s Board ofDirectors.  All repurchases are expected tobe funded from the Company’s current cash balances or from cash generated fromoperations.  To facilitate repurchases of shares under this program, the Company hasestablished Rule 10b5-1 plans intended to comply with the requirements of Rule 10b5-1and Rule 10b-18 under the Securities Exchange Act of 1934.  A Rule 10b5-1plan permits the repurchase of shares by a company at times when it otherwisemight be prevented from doing so under insider trading laws or because ofcompany blackout periods, provided that the plan is adopted when the company isnot aware of material non-public information.  Pursuant to the plan, abroker designated by the Company has the authority to repurchase shares, inaccordance with the terms of the plan, without further direction from theCompany.  The amount and timing of specific repurchases are subjectto the terms of the plan and market conditions.  Upon the expiration of the first 10b5-1 planon November 7, 2008, the Company suspended repurchases of its commonstock.  The Company resumed the stockrepurchase program on March 16, 2009 under a new 10b5-1 plan, asauthorized by the Board of Directors. During the three months ended June 30, 2009, the Companyrepurchased 772,957 shares of its common stock at an average cost of $0.76 pershare.  During the nine months ended June 30,2009, the Company repurchased 1,219,003 shares of its common stock at anaverage cost of $0.66 per share.  Fromthe inception of the share repurchase program through June 30, 2009, theCompany had repurchased 2,125,804 shares of its common stock at an average costof $0.82 per share.  As of June 30,2009, the maximum dollar value that may yet be used for purchases under theprogram was $3,264,000.

 

10

----

Table of Contents

** **

**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**9.  Commitments andContingencies**

 

***Guarantees and Indemnifications***

 

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

 

TheCompany enters into standard indemnification agreements in the ordinary courseof its business.  Pursuant to theseagreements, the Company indemnifies, holds harmless, and agrees to reimbursethe indemnified party for losses suffered or incurred by the indemnified party,generally its business partners or customers, in connection with any patent,copyright, trademark, trade secret or other intellectual property infringementclaim by any third party with respect to its products.  The term of these indemnification agreementsis generally perpetual.  The Company hasnever incurred costs to defend lawsuits or settle claims related to these indemnificationagreements.  As a result, the Companybelieves the estimated fair value of these agreements is minimal.  Accordingly, the Company has no liabilitiesrecorded for these indemnifications as of June 30, 2009.

 

Product warranties — The Company offers and fulfills standard warrantyservices on its application platform solutions. Warranty terms vary in duration depending upon the product sold, butgenerally provide for the repair or replacement of any defective products forperiods of up to 36 months after shipment. Based upon historical experience and expectation of future conditions,the Company reserves for the estimated costs to fulfill customer warrantyobligations upon the recognition of the related revenue.  The following table presents changes in theCompany’s product warranty liability for the three and nine months ended June 30,2009 and 2008 (in thousands):

 

| ** **                                  | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended********June 30,** | ** ** |
|---------------------------------------------|------------|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2009**                              | ** ** | **2008**                                   | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                        |       |                                  |       |                                       |       |   |   |   |   |
| Beginning balance                           |       | $                                     | 796        |                                       | $          | 968 |   | $ | 931 |   | $ | 1,046 |   |
| Acquisitions                                |       | —                                |       | —                                     |       | — |   | 70 |   |
| Accruals for warranties issued              |       | 159                                   |       | 564                                        |       | 741 |   | 1,561 |   |
| Fulfillment of warranties during the period |       | (293                                  | )          | (563                                       | )          | (1,010 | ) | (1,708 | ) |
| Ending balance                              |       | $                                     | 662        |                                       | $          | 969 |   | $ | 662 |   | $ | 969 |   |

 

11

----

Table of Contents

 

**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

***Contingencies***

 

*Initial Public Offering Lawsuit*

 

Onor about December 3, 2001, a putative class action lawsuit was filed inthe United States District Court for the Southern District of New York againstthe Company, Lawrence A. Genovesi (the Company’s former Chairman and ChiefExecutive Officer), Douglas G. Bryant (the Company’s Chief Financial Officer),and several underwriters of the Company’s initial public offering.  The suit alleges, *inter alia*,that the defendants violated the federal securities laws by issuing and sellingsecurities pursuant to the Company’s initial public offering in July 2000(“IPO”) without disclosing to investors that the underwriter defendants hadsolicited and received excessive and undisclosed commissions from certaininvestors.  The suit seeks damages andcertification of a plaintiff class consisting of all persons who acquiredshares of the Company’s common stock between July 13, 2000 and December 6,2000.

 

InOctober 2002, Lawrence A. Genovesi and Douglas G. Bryant were dismissedfrom this case without prejudice.  On December 5,2006, the United States Court of Appeals for the Second Circuit overturned theDistrict Court’s certification of a plaintiff class.  On April 6, 2007, the Second Circuitdenied plaintiffs’ petition for rehearing, but clarified that the plaintiffsmay seek to certify a more limited class in the District Court.  On September 27, 2007,plaintiffs filed a motion for class certification in certain designated “focuscases” in the District Court.  That motion has since beenwithdrawn.  On November 13, 2007,the issuer defendants in certain designated “focus cases” filed a motion todismiss the second consolidated amended class action complaints that were filedin those cases.  On March 26, 2008, theDistrict Court issued an Opinion and Order denying, in large part, the motionsto dismiss theamendedcomplaintsin the “focuscases.”  On April 2, 2009, theplaintiffs filed a motion for preliminary approval of a new proposed settlementbetween plaintiffs, the underwriter defendants, the issuer defendants and theinsurers for the issuer defendants.  On June 10,2009, the Court issued an opinion preliminarily approving the proposedsettlement, and scheduling a settlement fairness hearing for September 10,2009.  The Company is unable topredict the outcome of this suit and as a result, no amounts have been accruedas of June 30, 2009.

 

**10. Lineof Credit**

 

On October 11,2007, the Company entered into a Loan and Security Agreement with SiliconValley Bank (the “Bank”).  On August 5,2008, the Company and the Bank entered into the First Loan ModificationAgreement (the “Modification Agreement”). The Modification Agreement amended the Loan Agreement to extend its termto August 5, 2010, and to change the amount of the revolving loan facilityto $10 million.  The ModificationAgreement did not change the interest rate on the line, which is equal to onequarter of a point (0.25%), below the current prime rate with interest payablemonthly.  As of August 10, 2009, theCompany had not drawn on this line of credit.

 

**11. FairValue Measurements**

 

On October 1,2008, the Company adopted the effective portions of FAS 157 as describedin Note 2.  The adoption did nothave a material impact on the Company’s financial statements and did not resultin any adjustments to the opening balance of accumulated deficit as of October 1,2008.

 

FAS 157establishes a new framework for measuring fair value and expands relateddisclosures.  The FAS 157 frameworkrequires fair value to be determined based on the exchange price that would bereceived to sell an asset or paid to transfer a liability (an “exit price”) inthe principal or most advantageous market for the asset or liability in anorderly transaction between market participants.

 

Thevaluation techniques required by FAS 157 are based upon observable andunobservable inputs.  Observable ormarket inputs reflect market data obtained from independent sources, whileunobservable inputs reflect the Company’s assumptions about market participantassumptions based on best information available.  Observable inputs are the preferred source offair values.  In accordance withFAS 157, these two types of inputs create the following fair valuehierarchy:

 

·                  Level 1 – Valuations are based on unadjusted quotedprices in active markets that are accessible at the measurement date foridentical assets or liabilities.

 

12

----

Table of Contents

 

**NETWORK ENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

·                  Level 2 – Valuations are based on quoted prices forsimilar assets or liabilities in active markets, or quoted prices for identicalor similar assets or liabilities in markets that are not active for whichsignificant inputs are observable, either directly or indirectly.

 

·                  Level 3 – Valuations are based on prices or valuationtechniques that require inputs that are both unobservable and significant tothe overall fair value measurement. Inputs reflect management’s best estimates regarding the assumptionsthat market participants would use in valuing the asset or liability at themeasurement date.

 

As of June 30,2009, the Company held certain assets that are required to be measured at fairvalue on a recurring basis, consisting of money market funds, which areclassified as cash equivalents.  In accordance with FAS 157, the followingtable presents the fair value hierarchy for the Company’s financial assetsmeasured at fair value on a recurring basis as of June 30, 2009 (inthousands):

 
| ** **         | ** ** | **Fair Value  Measurements at June 30, 2009 Using:** | ** ** |
|--------------------|------------|-----------------------------------------------------------|------------|
| ** **         | ** ** | **Level 1  Inputs**                                       | ** ** | **Level 2  Inputs** | ** ** | **Level 3  Inputs** | ** ** |
| Assets:            |       |                                                      |       |   |   |   |   |
| Money market funds |       | $                                                         | 17,025     |   | $ | — |   | $ | — |   |
|                    |            |                                                           |            |  |  |  |  |  |  |  |

 

Effective October 1, 2008, the Company also adopted FAS 159,which allows an entity to choose to measure certain financial instruments andliabilities at fair value on an investment-by-investment basis.  Subsequent fair value measurement for thefinancial instruments and liabilities an entity chooses to measure at fairvalue will be recognized in earnings.  Asof June 30, 2009, the Company had not elected this option for any eligiblefinancial instrument.

 

The net assetamount recorded in the balance sheet (carrying amount) and the estimated fairvalues of financial instruments at June 30, 2009 consisted of thefollowing:

 
| ** **         | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** |
|--------------------|------------|----------------------|------------|----------------|------------|
| Assets:            |       |                 |       |           |       |
| Money market funds |       | $                    | 17,025     |           | $          | 17,025 |   |
|                    |            |                      |            |                |            |  |  |

 

The methods andassumptions used to estimate fair value are as follows:

 

Money market funds - Thefair values of these instruments were based on the quoted market prices onsecurities exchanges.

 

13

----

Tableof Contents

** **

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

 

**Special Note RegardingForward-Looking Statements**

** **

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

 

The following discussion and analysis should be read in conjunction withthe condensed consolidated financial statements and the notes thereto includedin Item 1 in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2008 filed by us with the SEC.

 

**Overview**

** **

We develop andmanufacture application platform solutions that enable leading originalequipment manufacturers, or OEMs, independent software vendors, or ISVs, andservice providers to deliver their software applications in the form of anetwork-ready device.  Applicationplatforms are pre-configured network infrastructure devices designed tooptimally deliver specific software application functionality, ease deployment,improve integration and manageability, accelerate time to market and increasethe security of that software application in a customer’s network.  We offer application platform customers anextensive suite of services associated with the design, development,manufacturing, brand fulfillment and post-sale support of these devices.  We produce, brand and fulfill devices brandedfor our customers, and derive our revenues primarily from the sale ofvalue-added hardware platforms to these customers. Our customers subsequentlyresell and support the platforms under their own brands to their customerbases.

 

**CriticalAccounting Policies and Estimates**

 

Ourdiscussion and analysis of financial condition and results of operations arebased upon our condensed consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States of America.  In preparingthese financial statements, we have made estimates and judgments in determiningcertain amounts included in the financial statements.  We base our estimates and judgments onhistorical experience and other assumptions that we believe to be reasonableunder the circumstances.  Actual resultsmay differ from these estimates under different assumptions or conditions.  There have been no changes to our criticalaccounting policies since September 30, 2008.

 

**Resultsof Operations**

 

**Threemonths ended June 30, 2009 compared to the three months ended June 30,2008**

 

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

 
| ** **           | ** ** | **Three months ended****June 30****,** | ** ** |
|----------------------|------------|---------------------------------------------|------------|
| ** **           | ** ** | **2009**                                    | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **           | ** ** | **Dollars**                                 | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues         |       | $                                           | 33,329     |   | 100.0 | % | $ | 47,046 |   | 100.0 | % | $ | (13,717 | ) | (29.2 | )% |
| Gross profit         |       | 5,037                                       |       | 15.1 | % | 7,650 |   | 16.3 | % | (2,613 | ) | (34.2 | )% |
| Operating expenses   |       | 6,344                                       |       | 19.0 | % | 8,020 |   | 17.1 | % | (1,676 | ) | (20.9 | )% |
| Loss from operations |       | (1,307                                      | )          | (3.9 | )% | (370 | ) | (0.8 | )% | (937 | ) | 253.2 | % |
| Net loss             |       | (1,243                                      | )          | (3.7 | )% | (283 | ) | (0.6 | )% | (960 | ) | 339.2 | % |
|                      |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

14

----

Table of Contents

 

***Net Revenues***

 

Our revenues are derived primarily from sales ofapplication platform solutions and related maintenance services to our OEM, ISVand service provider customers.

 

Ournet revenues decreased for the three months ended June 30, 2009, ascompared to the three months ended June 30, 2008, primarily due todecreases in sales volumes, which were significantly impacted by the globaleconomic downturn.  These decreases werepartially offset by revenues generated from new customer wins secured in recentperiods.  Also, some of our storagecustomers are using larger hard disk drives, enabling them to provide theircustomers with the same storage capacity with fewer appliances, resulting in adecrease in sales volume compared to the prior period.  In addition, we are transitioning away fromsome of our non-strategic, transactional revenues to projects that are more inline with our business model.

 

***Gross Profit***

 

Grossprofit represents net revenues recognized less the cost of revenues.  Cost of revenues includes cost of materials,manufacturing costs, warranty costs, inventory write-downs, shipping andhandling costs and customer support costs. Manufacturing costs are primarily comprised of compensation, contractlabor costs and, when applicable, contract manufacturing costs.

 

Grossprofit as a percentage of net revenue decreased for the three months ended June 30,2009, as compared to the three months ended June 30, 2008.  The decrease from the prior year wasprimarily due to an increase in inventory write-downs, customer and productmix, and manufacturing costs remaining fairly constant from the prior yearrelative to the decrease in net revenues.

 

Grossprofit is affected by customer and product mix, component material costs,pricing and the volume of orders as well as by the mix of product manufacturedinternally compared to product manufactured by a contract manufacturer, whichcarries higher manufacturing costs.  Inaddition, we have won some new business which will have gross margins that arelower than current levels, in order to increase revenues and leverage thoserevenues over a fixed infrastructure to improve operating margins.  We may seek opportunities to win additionalnew business with gross margins which are lower than current levels.

 

***Operating Expenses***

 

Thefollowing table presents operating expenses during the periods indicated, inthousands and as a percentage of net revenues, and provides the changes inthousands and percentages:

 
| ** **                        | ** ** | **Three months ended****June 30****,** | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|
| ** **                        | ** ** | **2009**                                    | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                 | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating  expenses:              |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Research and  development         |       | $                                           | 1,644      |   | 4.9 | % | $ | 2,135 |   | 4.6 | % | $ | (491 | ) | (23.0 | )% |
| Selling and marketing             |       | 2,039                                       |       | 6.1 | % | 2,761 |   | 5.9 | % | (722 | ) | (26.1 | )% |
| General and  administrative       |       | 2,222                                       |       | 6.7 | % | 2,639 |   | 5.6 | % | (417 | ) | (15.8 | )% |
| Amortization of  intangible asset |       | 439                                         |       | 1.3 | % | 485 |   | 1.0 | % | (46 | ) | (9.5 | )% |
|                              |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Total operating  expenses         |       | $                                           | 6,344      |   | 19.0 | % | $ | 8,020 |   | 17.1 | % | $ | (1,676 | ) | (20.9 | )% |

 

***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 application platformsolutions.  We expense all of ourresearch and development costs as they are incurred.  The following table summarizes the mostsignificant components of research and development expense for the periodsindicated, in thousands and as a percentage of total research and developmentexpense, and provides the changes in thousands and percentages:

 

15

----

Table of Contents

 
| ** **                            | ** ** | **Three months ended****June 30****,** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|
| ** **                            | ** ** | **2009**                                    | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                                 | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research  and development:            |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and  related expenses    |       | $                                           | 1,052      |   | 64.0 | % | $ | 1,369 |   | 64.1 | % | $ | (317 | ) | (23.2 | )% |
| Stock-based  compensation             |       | 58                                          |       | 3.5 | % | 161 |   | 7.5 | % | (103 | ) | (64.0 | )% |
| Prototype                             |       | 247                                         |       | 15.0 | % | 247 |   | 11.6 | % | — |   | 0.0 | % |
| Consulting and  professional services |       | 147                                         |       | 9.0 | % | 189 |   | 8.9 | % | (42 | ) | (22.2 | )% |
| Other                                 |       | 140                                         |       | 8.5 | % | 169 |   | 7.9 | % | (29 | ) | (17.2 | )% |
|                                  |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Total research and  development       |       | $                                           | 1,644      |   | 100 | % | $ | 2,135 |   | 100 | % | $ | (491 | ) | (23.0 | )% |

 

Research and development expenses decreased in thethree months ended June 30, 2009, as compared to the three months ended June 30,2008, primarily due to decreases in compensation and related expenses andstock-based compensation.  Compensationand related expenses and stock-based compensation expenses decreased primarilydue to a decrease in headcount from 44 at June 30, 2008 to 36 at June 30,2009, and lower variable compensation, which was directly related to thedecrease in net revenues and results of operations.

 

Our application platform development strategy emphasizesthe utilization of standard component technologies, which utilize off-the-shelfcomponents.  However, we expect that insome cases, significant development efforts will be required to fulfill ourcurrent and potential customers’ needs using customized platforms.  We expect that prototype and consulting andprofessional services costs will be variable and could fluctuate depending onthe timing and magnitude of our development projects.

 

***Selling and Marketing***

 

Selling and marketing expenses consist primarily ofsalaries and commissions for personnel engaged in sales and marketing, andcosts associated with our marketing programs, which include costs associatedwith our attendance at trade shows, public relations, product literature costs,web site enhancements, and travel.  Thefollowing table summarizes the most significant components of selling andmarketing expense for the periods indicated, in thousands and as a percentageof total selling and marketing expense, and provides the changes in thousands andpercentages:

 
| ** **                         | ** ** | **Three months ended****June 30****,** | ** ** |
|------------------------------------|------------|---------------------------------------------|------------|
| ** **                         | ** ** | **2009**                                    | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                         | ** ** | **Dollars**                                 | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling  and marketing:            |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and  related expenses |       | $                                           | 1,506      |   | 73.9 | % | $ | 1,899 |   | 68.8 | % | $ | (393 | ) | (20.7 | )% |
| Stock-based  compensation          |       | 76                                          |       | 3.7 | % | 92 |   | 3.3 | % | (16 | ) | (17.4 | )% |
| Marketing programs                 |       | 195                                         |       | 9.5 | % | 311 |   | 11.3 | % | (116 | ) | (37.3 | )% |
| Travel                             |       | 83                                          |       | 4.1 | % | 169 |   | 6.1 | % | (86 | ) | (50.9 | )% |
| Other                              |       | 179                                         |       | 8.8 | % | 290 |   | 10.5 | % | (111 | ) | (38.3 | )% |
|                               |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and  marketing       |       | $                                           | 2,039      |   | 100 | % | $ | 2,761 |   | 100 | % | $ | (722 | ) | (26.1 | )% |

 

Selling and marketingexpenses decreased in the three months ended June 30, 2009, as compared tothe three months ended June 30, 2008, primarily due to decreases incompensation and related expenses, marketing programs, and other expenses.  Compensation and related expenses decreasedprimarily due to a decrease in headcount from 56 as of June 30, 2008, to42 as of June 30, 2009, and lower variable compensation, which wasdirectly related to the decrease in net revenues and results ofoperations.  The decrease in marketingprograms was mostly attributable to rebranding costs that were incurred in theprior year which did not recur in the current year.

 

16

----

Table of Contents

 

***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 director and officer insurance.  The following table summarizes the mostsignificant components of general and administrative expense for the periodsindicated, in thousands and as a percentage of total general and administrativeexpense, and provides the changes in thousands and percentages:

 
| ** **                            | ** ** | **Three months ended****June 30****,** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|
| ** **                            | ** ** | **2009**                                    | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                                 | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General  and administrative:          |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and  related expenses    |       | $                                           | 1,103      |   | 49.6 | % | $ | 1,313 |   | 49.8 | % | $ | (210 | ) | (16.0 | )% |
| Stock-based  compensation             |       | 152                                         |       | 6.9 | % | 173 |   | 6.6 | % | (21 | ) | (12.1 | )% |
| Consulting and  professional services |       | 504                                         |       | 22.7 | % | 754 |   | 28.5 | % | (250 | ) | (33.2 | )% |
| Director and officer  insurance       |       | 56                                          |       | 2.5 | % | 66 |   | 2.5 | % | (10 | ) | (15.2 | )% |
| Other                                 |       | 407                                         |       | 18.3 | % | 333 |   | 12.6 | % | 74 |   | 22.2 | % |
|                                  |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Total general and  administrative     |       | $                                           | 2,222      |   | 100 | % | $ | 2,639 |   | 100 | % | $ | (417 | ) | (15.8 | )% |

 

General and administrative expenses decreased in thethree months ended June 30, 2009, as compared to the three months ended June 30,2008, primarily due to decreases in compensation and related expenses andconsulting and professional services expenses. The decrease in compensation and related expenses was attributable tolower headcount and lower variable compensation, which was directly related tothe decrease in net revenues and results of operations.  The decrease in consulting and professionalservices expenses was primarily due to costs related to the integration ofAlliance Systems incurred during the three months ended June 30, 2008,which did not recur during the three months ended June 30, 2009.

 

***Amortization of Intangible Asset***

 

Amortization of the intangible asset decreased by$46,000 in the three months ended June 30, 2009, as compared to the threemonths ended June 30, 2008. Amortization expense for the intangible asset decreases annually overits life of 17 years, to reflect the fact that the estimated economic benefitexpected to be received from the intangible asset declines over time.

 

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

* *

Interestand other income, net, decreased to $64,000 for the three months ended June 30,2009, compared to $110,000 for the three months ended June 30, 2008.  This decrease was primarily due to lowerinterest income, attributable to lower interest rates on the cash balances heldby us during the three months ended June 30, 2009, as compared to thethree months ended June 30, 2008.

 

**Ninemonths ended June 30, 2009 compared to the nine months ended June 30,2008**

 

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

 
| ** **                     | ** ** | **Nine months ended****June 30****,** | ** ** |
|--------------------------------|------------|--------------------------------------------|------------|
| ** **                     | ** ** | **2009**                                   | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                     | ** ** | **Dollars**                                | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues                   |       | $                                          | 108,025    |   | 100.0 | % | $ | 156,560 |   | 100.0 | % | $ | (48,535 | ) | (31.0 | )% |
| Gross profit                   |       | 16,413                                     |       | 15.2 | % | 26,289 |   | 16.8 | % | (9,876 | ) | (37.6 | )% |
| Operating expenses             |       | 18,868                                     |       | 17.5 | % | 25,274 |   | 16.1 | % | (6,406 | ) | (25.3 | )% |
| (Loss) income from  operations |       | (2,455                                     | )          | (2.3 | )% | 1,015 |   | 0.7 | % | (3,470 | ) | — |   |
| Net (loss) income              |       | (2,379                                     | )          | (2.2 | )% | 1,258 |   | 0.8 | % | (3,637 | ) | — |   |
|                                |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

17

----

Table ofContents

 

***Net Revenues***

 

Ournet revenues decreased for the nine months ended June 30, 2009, ascompared to the nine months ended June 30, 2008, primarily due to decreases insales volumes, which were significantly impacted by the global economicdownturn.  These decreases were partiallyoffset by revenues generated from new customer wins secured in recentperiods.  Sales volumes have decreased inpart due to the fact that some of our storage customers are using larger harddisk drives, enabling them to provide their customers with the same storagecapacity with fewer appliances.  Inaddition, we are transitioning away from some of our non-strategic,transactional revenues to projects that are more in line with our businessmodel.  In addition, two customers whohave reduced or ceased their purchases from us, one because it was acquired bya larger company and one because it changed its business model, accounted forapproximately $7.4 million of the decrease in net revenues.  Also contributing to the decrease was thefact that the nine month period ended June 30, 2008 included the resultsof operations of the former German subsidiary of Alliance Systems, which wesold in February 2008.  Furthermore,we ceased sales of military and government products during the three monthperiod ended June 30, 2008.  Netrevenues from the German subsidiary and from sales of military and governmentproducts totaled approximately $3.0 million during the nine month period ended June 30,2008.

 

***Gross Profit***

 

Grossprofit as a percentage of net revenue decreased for the nine months ended June 30,2009, as compared to the nine months ended June 30, 2008.  The decrease from the prior year wasprimarily due to increased inventory write-downs, customer and product mix, andmanufacturing costs remaining fairly constant from the prior year relative tothe decrease in net revenues.

 

***Operating Expenses***

 

Thefollowing table presents operating expenses during the periods indicated, inthousands and as a percentage of net revenues, and provides the changes inthousands and percentages:

 
| ** **                        | ** ** | **Nine months ended****June 30****,** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|
| ** **                        | ** ** | **2009**                                   | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating  expenses:              |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Research and  development         |       | $                                          | 4,739      |   | 4.4 | % | $ | 6,823 |   | 4.4 | % | $ | (2,084 | ) | (30.5 | )% |
| Selling and marketing             |       | 6,240                                      |       | 5.8 | % | 8,826 |   | 5.6 | % | (2,586 | ) | (29.3 | )% |
| General and  administrative       |       | 6,572                                      |       | 6.1 | % | 8,219 |   | 5.2 | % | (1,647 | ) | (20.0 | )% |
| Amortization of  intangible asset |       | 1,317                                      |       | 1.2 | % | 1,406 |   | 0.9 | % | (89 | ) | (6.3 | )% |
|                              |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Total operating  expenses         |       | $                                          | 18,868     |   | 17.5 | % | $ | 25,274 |   | 16.1 | % | $ | (6,406 | ) | (25.3 | )% |

 

18

----

Table of Contents

 

***Research and Development***

 

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 inthousands and percentages:

 
| ** **                            | ** ** | **Nine months ended****June 30****,** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                            | ** ** | **2009**                                   | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                                | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research  and development:            |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and  related expenses    |       | $                                          | 3,057      |   | 64.5 | % | $ | 4,397 |   | 64.4 | % | $ | (1,340 | ) | (30.5 | )% |
| Stock-based  compensation             |       | 200                                        |       | 4.2 | % | 573 |   | 8.4 | % | (373 | ) | (65.1 | )% |
| Prototype                             |       | 631                                        |       | 13.3 | % | 596 |   | 8.7 | % | 35 |   | 5.9 | % |
| Consulting and  professional services |       | 436                                        |       | 9.2 | % | 648 |   | 9.5 | % | (212 | ) | (32.7 | )% |
| Other                                 |       | 415                                        |       | 8.8 | % | 609 |   | 9.0 | % | (194 | ) | (31.9 | )% |
|                                  |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Total research and  development       |       | $                                          | 4,739      |   | 100 | % | $ | 6,823 |   | 100 | % | $ | (2,084 | ) | (30.5 | )% |

 

Researchand development expenses decreased in the nine months ended June 30, 2009,as compared to the nine months ended June 30, 2008, primarily dueto decreases in compensation and related expenses, stock-based compensation,consulting and professional services and other expenses.  Compensation and related expenses andstock-based compensation expenses decreased primarily due to a decrease inheadcount from 44 at June 30, 2008 to 36 at June 30, 2009, and lowervariable compensation, which was directly related to the decrease in netrevenues and results of operations. Consulting and professional services decreased due to the variations inthe timing and magnitude of ongoing projects during the current and prioryears.

 

***Selling and Marketing***

 

Thefollowing table summarizes the most significant components of selling andmarketing expense for the periods indicated, in thousands and as a percentageof total selling and marketing expense, and provides the changes in thousandsand percentages:

 
| ** **                         | ** ** | **Nine months ended****June 30****,** | ** ** |
|------------------------------------|------------|--------------------------------------------|------------|
| ** **                         | ** ** | **2009**                                   | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                         | ** ** | **Dollars**                                | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling  and marketing:            |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and  related expenses |       | $                                          | 4,641      |   | 74.4 | % | $ | 6,344 |   | 71.9 | % | $ | (1,703 | ) | (26.8 | )% |
| Stock-based  compensation          |       | 214                                        |       | 3.4 | % | 253 |   | 2.8 | % | (39 | ) | (15.4 | )% |
| Marketing programs                 |       | 482                                        |       | 7.7 | % | 638 |   | 7.2 | % | (156 | ) | (24.5 | )% |
| Travel                             |       | 268                                        |       | 4.3 | % | 575 |   | 6.5 | % | (307 | ) | (53.4 | )% |
| Other                              |       | 635                                        |       | 10.2 | % | 1,016 |   | 11.6 | % | (381 | ) | (37.5 | )% |
|                               |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and  marketing       |       | $                                          | 6,240      |   | 100 | % | $ | 8,826 |   | 100 | % | $ | (2,586 | ) | (29.3 | )% |

 

Sellingand marketing expenses decreased in the nine months ended June 30, 2009,as compared to the nine months ended June 30, 2008, primarily due todecreases in compensation and related expenses, travel, and otherexpenses.  Compensation and relatedexpenses decreased primarily due to a decrease in headcount from 56 as of June 30,2008, to 42 as of June 30, 2009, and lower variable compensation, whichwas directly related to the decreases in net revenues and results ofoperations.  Travel expenses decreasedprimarily due to the decrease in headcount and efforts undertaken during thecurrent fiscal year to reduce non-essential employee travel.  Other expenses decreased as we incurredexpenses associated with market research, rebranding, and trade shows for theintegration of Alliance Systems in the nine months ended June 30, 2008that did not recur in the nine months ended June 30, 2009.

 

19

----

Table ofContents

 

***General and Administrative***

 

Thefollowing table summarizes the most significant components of general andadministrative expense for the periods indicated, in thousands and as apercentage of total general and administrative expense, and provides thechanges in thousands and percentages:

 
| ** **                            | ** ** | **Nine months ended****June 30****,** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                            | ** ** | **2009**                                   | ** ** | **2008** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Dollars**                                | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General  and administrative:          |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and  related expenses    |       | $                                          | 3,261      |   | 49.6 | % | $ | 4,137 |   | 50.3 | % | $ | (876 | ) | (21.2 | )% |
| Stock-based  compensation             |       | 477                                        |       | 7.3 | % | 543 |   | 6.6 | % | (66 | ) | (12.2 | )% |
| Consulting and  professional services |       | 1,629                                      |       | 24.8 | % | 2,309 |   | 28.1 | % | (680 | ) | (29.4 | )% |
| Director and officer  insurance       |       | 167                                        |       | 2.5 | % | 200 |   | 2.4 | % | (33 | ) | (16.5 | )% |
| Other                                 |       | 1,038                                      |       | 15.8 | % | 1,030 |   | 12.6 | % | 8 |   | 0.8 | % |
|                                  |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Total general and  administrative     |       | $                                          | 6,572      |   | 100 | % | $ | 8,219 |   | 100 | % | $ | (1,647 | ) | (20.0 | )% |

 

General and administrative expenses decreased in thenine months ended June 30, 2009, as compared to the nine months ended June 30,2008, primarily due to decreases in compensation and related expenses and consultingand professional services expenses.  Thedecrease in compensation and related expenses was primarily due to lowerheadcount and lower variable compensation, which was directly related to thedecreases in net revenues and results of operations.   The reduction in headcount was primarilyrelated to the integration of Alliance Systems during the nine months ended June 30,2008.  Also, the Company incurred$175,000 in severance charges during the nine months ended June 30, 2008,which did not recur in the current period. The decrease in consulting and professional services expenses wasprimarily due to costs related to the acquisition and integration of AllianceSystems incurred during the nine months ended June 30, 2008, which did notrecur during the nine months ended June 30, 2009.

 

***Amortization of Intangible Asset***

 

Amortization of the intangible asset decreased by$89,000 in the nine months ended June 30, 2009, as compared to the ninemonths ended June 30, 2008. Amortization expense for the intangible asset decreases annually overits life of 17 years, to reflect the fact that the estimated economic benefitexpected to be received from the intangible asset declines over time.

 

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

 

Interest and other income,net, decreased to $76,000 for the nine months ended June 30, 2009, ascompared to $376,000 for the nine months ended June 30, 2008. Interest income decreased to $177,000 for the nine months ended June 30,2009, compared to $350,000 for the nine months ended June 30, 2008.  This decrease was primarily attributable to lowerinterest rates on the cash balances held by us during the nine months ended June 30,2009, as compared to the nine months ended June 30, 2008.  Also, a foreign currencyexchange loss of $57,000 was recorded for the nine months ended June 30,2009, compared to a foreign currency exchange gain of $105,000 recorded duringthe nine months ended June 30, 2008. These gains and losses relateprimarily to VAT refunds receivable. The refundable VAT amounts, which we payon products and services purchased from our contract manufacturer located inIreland, are denominated in Euros.

 

20

----

Table of Contents

 

**Liquidityand Capital Resources**

 

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

 
| ** **                                        | ** ** | **Nine months ended********June 30****,** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                        | ** ** | **2009**                                       | ** ** | **2008** | ** ** |
|                                              | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Net  (loss) income                                |       | $                                              | (2,379     | ) | $ | 1,258 |   |
| Non-cash  adjustments to net (loss) income        |       | 3,161                                          |       | 4,102 |   |
| Changes  in working capital                       |       | 10,443                                         |       | (3,024 | ) |
|                                              |       |                                           |       |   |   |
| Cash  provided by operating activities            |       | 11,225                                         |       | 2,336 |   |
|                                              |       |                                           |       |   |   |
| Cash  used in investing activities                |       | (853                                           | )          | (34,629 | ) |
| Cash  (used in) provided by financing activities  |       | (655                                           | )          | 132 |   |
| Effect  of exchange rate differences on cash      |       | —                                         |       | (29 | ) |
|                                              |       |                                           |       |   |   |
| Increase  (decrease) in cash and cash equivalents |       | 9,717                                          |       | (32,190 | ) |
| Beginning  cash and cash equivalents              |       | 10,003                                         |       | 44,403 |   |
|                                              |       |                                           |       |   |   |
| Ending  cash and cash equivalents                 |       | $                                              | 19,720     |   | $ | 12,213 |   |

 

***OperatingActivities***

 

Cash provided by operating activities of $11.2 millionduring the nine months ended June 30, 2009 was primarily the result of netcash provided by changes in working capital and the impact of non-cashadjustments to net loss, partially offset by the net loss for the period.  The change in accounts receivable was relatedto collections of payments from customers, as well as the fact that revenuesfor the nine months ended June 30, 2009 were lower than revenues for thenine month period ended June 30, 2008. The change in inventories was related to the depletion of inventories onhand and lower purchases during the nine months ended June 30, 2009, whichwas related to the downward trend in revenues and efforts we undertook tominimize inventory quantities on hand. Changes in working capital during the nine months ended June 30,2009 also included the receipt of $2.5 million of income tax refunds related totaxes paid by Alliance Systems in prior years.

 

Cash provided by operating activities of $2.3 millionduring the nine months ended June 30, 2008 was primarily the result of netincome and the impact of non-cash adjustments to net income, partially offsetby net cash used by changes in working capital. The changes in working capital were primarily related to the use of cashto settle accounts payable and accrued expenses, partially offset by the impactof cash provided by the decrease in inventories.

 

***InvestingActivities***

 

Cash used in investing activities during the ninemonths ended June 30, 2009 consisted of the use of approximately $853,000of cash for purchases of property and equipment.  Cash used in investing activities during thenine months ended June 30, 2008 primarily related to the use of $34million of cash for the acquisition of Alliance Systems and related costs.

 

***FinancingActivities***

 

Cashused in financing activities during the nine months ended June 30, 2009consisted primarily of $803,000 used to repurchase shares of our common stock,partially offset by the receipt of $168,000 as the result of purchases underthe Employee Stock Purchase Plan.  Cashprovided by financing activities during the nine months ended June 30,2008 consisted primarily of the receipt of $319,000 as the result of employeestock option exercises and purchases under the Employee Stock Purchase Plan,partially offset by the use of $172,000 to repurchase shares of our commonstock.  Cash inflows from stock option exercises may occur inthe future; however, we cannot predict the magnitude of any such cash inflows,given the volatility of capital markets. As of June 30, 2009, offerings under the Employee Stock PurchasePlan had ceased due to a lack of sufficient shares remaining in the Plan.  Although additional shares may be proposedfor shareholder authorization in the future, there are no current plans topropose any additional shares.

 

21

----

Table of Contents

 

On June 12,2008, our Board of Directors authorized the repurchase of up to $5 million ofour common stock through a share repurchase program.  As authorized by the program, shares may bepurchased in the open market or through privately negotiated transactions, in amanner consistent with applicable securities laws and regulations.  This stock repurchase program does not obligateus to acquire any specific number of shares, does not have an expiration date,and may be terminated at any time by our Board of Directors.  All repurchases are expected to be fundedfrom our current cash balances or from cash generated from operations.  Tofacilitate repurchases of shares under this program, we have established Rule 10b5-1plans intended to comply with the requirements of Rule 10b5-1 and Rule 10b-18under the Securities Exchange Act of 1934.  A Rule 10b5-1 planpermits the repurchase of shares by a company at times when it otherwise mightbe prevented from doing so under insider trading laws or because of companyblackout periods, provided that the plan is adopted when the company is notaware of material non-public information.  Pursuant to the plan, a brokerdesignated by us has the authority to repurchase shares, in accordance with theterms of the plan, without further direction from us.  The amount andtiming of specific repurchases are subject to the terms of the plan and marketconditions.  Upon the expirationof the first 10b5-1 plan on November 7, 2008, we suspended repurchases ofour common stock.  We resumed the stockrepurchase program on March 16, 2009 under a new 10b5-1 plan, asauthorized by the Board of Directors. During the three months ended June 30, 2009, we repurchased 772,957shares of our common stock at an average cost of $0.76 per share.  During the nine months ended June 30,2009, we repurchased 1,219,003 shares of our common stock at an average cost of$0.66 per share.  From the inception ofthe share repurchase program through June 30, 2009, we had repurchased2,215,804 shares of our common stock at an average cost of $0.82 pershare.  As of June 30, 2009, themaximum dollar value that may yet be used for purchases under the program was$3,264,000.

 

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

 

·      the timing and size of orders from our customers;

 

·      the timeliness of receipts of payments from ourcustomers;

 

·      our ability to enter into partnerships with OEMs, ISVsand service providers;

 

·      the level of success of our customers in sellingsystems that include our application platform solutions;

 

·      the costs and timing of product engineering effortsand the success of these efforts; and

 

·      market developments.

 

We believe that our available cash resources and cashthat we expect to generate from sales of our products and services will besufficient to meet our operating and capital requirements through at least thenext twelve months.

 

In the event that our available cash resources and theSilicon Valley Bank line of credit are not sufficient, or if an event ofdefault occurs, such as failure to achieve certain financial covenants, thatlimits our ability to borrow under the line of credit, we may need to raiseadditional funds.  We may in the futureseek to raise additional funds through borrowings, public or private equityfinancings or from other sources.  Therecan be no assurance that additional financing will be available at all or, ifavailable, will be on terms acceptable to us. Additional equity financings could result in dilution to our shareholders.  If additional financing is needed and is notavailable on acceptable terms, we may need to reduce our operating expenses andscale back our operations.

 

***ContractualObligations and Commitments***

 

During the nine months ended June 30, 2009, therewere no material changes to our contractual obligations and commitments asdisclosed in our annual report on Form 10-K for the year ended September 30,2008.

 

**Off-Balance Sheet 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 any transactions with unconsolidated entitieswhereby the Company has 

 

22

----

Table of Contents

 

subordinated retained interests, derivativeinstruments or other contingent arrangements that expose the Company tomaterial continuing risks, contingent liabilities, or any other obligationunder a variable interest in an unconsolidated entity that provides financing,liquidity, market risk or credit risk support to the Company.

 

**RecentAccounting Pronouncements**

** **

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standard No. 157, “Fair ValueMeasurements” (“FAS 157”).  This statement addresses how companies shouldmeasure fair value when they are required to use a fair value measure forrecognition or disclosure purposes under accounting principles generallyaccepted in the United States of America. The FASB has also issued the following related FASB Staff Positions:

 

·         FASB StaffPosition No. FAS 157-1, “Application of FASB Statement No. 157 toFASB Statement No. 13 and Other Accounting Pronouncements That AddressFair Value Measurements for Purposes of Lease Classification or Measurementunder Statement 13” (“FSP 157-1”), issued in February 2008, amends FAS 157to remove certain leasing transactions from its scope.

 

·         FASB StaffPosition No. FAS 157-2, “Effective Date of FASB Statement No. 157”(“FSP 157-2”), issued in February 2008, defers the effective date ofFAS 157 for non-financial assets and liabilities, except for items thatare recognized or disclosed at fair value on a recurring basis (at leastannually), to the beginning of our fiscal year that begins after November 15,2008.  We are in the process of evaluating whether theadoption of FSP 157-2 (as it relates to the effective date of FAS 157 fornon-financial assets and liabilities which are recognized or disclosed at fairvalue on a non-recurring basis) will have a material impact on our financialposition, results of operations, or cash flows.

 

·         FASB StaffPosition No. FAS 157-4, “Determining Fair Value When the Volume and Levelof Activity for the Asset or Liability Have Significantly Decreased andIdentifying Transactions That Are Not Orderly” (“FSP 157-4”), issued in April 2009,provides additional guidance in applying FAS 157 when market volume and levelof activity for the asset or liability have significantly decreased, and alsoincludes guidance on identifying distressed or forced (that is, not orderly)transactions that do not represent fair value. FSP 157-4 is effective for interim reporting periods ending after June 15,2009.  We adopted FSP 157-4 for theinterim reporting period ended June 30, 2009, and this adoption did nothave a material impact on our financial position, results of operations, orcash flows.

 

FAS 157 defines fairvalue as the price that would be received to sell an asset or paid to transfera liability (“exit price”) in an orderly transaction between marketparticipants at the measurement date. FAS 157 requires disclosures that categorize assets and liabilitieswhich are recognized or disclosed at fair value into one of three differentlevels depending on the assumptions (“inputs”) used in the valuation.  In the fair value hierarchy, Level 1 providesthe most reliable measure of fair value, while Level 3 generally requiressignificant management judgment. Financial assets and liabilities are classified in their entirety basedon the lowest level of input significant to the fair value measurement.

 

Weadopted FAS 157, as it applies to our financial assets and liabilities andnonfinancial assets and liabilities which are recognized or disclosed at fairvalue on a recurring basis (at least annually), as of October 1, 2008, andthis adoption did not have any impact on our financial position, results ofoperations or cash flows.

 

Weadopted FASB Statement of Financial Accounting Standard No. 159, “The FairValue Option for Financial Assets and Financial Liabilities — including anamendment of FASB Statement No. 115” (“FAS 159”) as of October 1,2008.  This statement permits entities to choose to measure many financialinstruments and certain other items at fair value at specified electiondates.  The decision to measure specifiedinstruments at fair value is done so on an instrument-by-instrument basis andis irrevocable.  Subsequent unrealizedgains and losses as well as upfront costs and fees on items for which the fairvalue option has been elected are reported in earnings.  The adoption of FAS 159 did not have any impact on ourfinancial position, results of operations or cash flows, as we did not elect tomeasure any items at fair value as of the adoption date.

 

In December 2007, the FASB issued Statement ofFinancial Accounting Standard No. 141(R), “Business Combinations” (“FAS141R”).  This Statement replacedStatement of Financial Accounting Standard No. 141 to improvethe relevance, representational faithfulness, and comparability of theinformation that a reporting entity 

 

23

----

Table of Contents

 

provides in its financialreports about a business combination and its effects.  FAS 141R establishes principles andrequirements for how the acquirer recognizes and measures in its financialstatements the identifiable assets acquired, the liabilities assumed, and anynoncontrolling interest in the acquiree, recognizes and measures the goodwillacquired in the business combination or a gain from a bargain purchase anddetermines what information to disclose to enable users of the financialstatements to evaluate the nature and financial effects of the businesscombination.  FAS 141R is effective forbusiness combinations on a prospective basis for which the acquisition date is on or after the beginning of our firstannual reporting period beginning on or after December 15, 2008.  We do not expect the adoption of FAS 141R tohave a material impact on our financial position, results of operations, orcash flows.

 

In April 2008, theFASB issued FASB Staff Position No. FAS 142-3, “Determination of theUseful Life of Intangible Assets” (“FSP 142-3”).  FSP 142-3 amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of a recognized intangible asset under Statement of FinancialAccounting Standard No. 142, “Goodwill and Other Intangible Assets” (“FAS142”).  This change is intended toimprove the consistency between the useful life of a recognized intangibleasset under FAS 142 and the period of expected cash flows used to measure thefair value of the asset under FAS 141R and other generally accepted accountingprinciples.  The requirement fordetermining useful lives must be applied prospectively to intangible assetsacquired after the effective date and the disclosure requirements must beapplied prospectively to all intangible assets recognized as of, and subsequentto, the effective date.  FSP 142-3 iseffective as of the beginning of our fiscal year that begins after December 15,2008.  We are in the process of evaluating whether theadoption of FSP 142-3 will have a material impact on our financial position,results of operations, or cash flow.

 

In April 2009, the FASB issued FASB StaffPosition No. FAS 115-2 and 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” (“FSPFAS 115-2 and FAS 124-2”) and FASB Staff Position No. FAS 107-1 and APB28-1, “Interim Disclosures about FairValue of Financial Instruments” (“FSP FAS 107-1 and APB 28-1”).  These Staff Positions impact certain aspectsof fair value measurement and related disclosures.  The provisions of these Staff Positions areeffective for interim periods ending after June 15, 2009.  We adopted FSP FAS 115-2 and FAS 124-2 andFSP FAS 107-1 and APB 28-1 for the interim reporting period ended June 30,2009.  The adoption of these Staff Positions didnot have a material impact on our financial position, results of operations, orcash flows.

 

In May 2009,the FASB issued Statement of Financial Accounting Standard No. 165, “Subsequent Events” (“FAS 165”). Thisstandard is intended to establish general standards of accounting for anddisclosure of events that occur after the balance sheet date but beforefinancial statements are issued or are available to be issued. Specifically,this standard sets forth the period after the balance sheet date during whichmanagement of a reporting entity should evaluate events or transactions thatmay occur for potential recognition or disclosure in the financial statements,the circumstances under which an entity should recognize events or transactionsoccurring after the balance sheet date in its financial statements, and thedisclosures that an entity should make about events or transactions thatoccurred after the balance sheet date.  FAS 165 is effective for fiscalyears and interim periods ending after June 15, 2009 and will be appliedprospectively. We adopted FAS 165 for the interim reporting period ended June 30,2009, and this adoption did not have a material impact on our financialposition, results of operations, or cash flows. In accordance with FAS 165, we evaluated subsequent events through August 10,2009, the date of issuance of our unaudited consolidated financialstatements.  During this period, nomaterial recognizable subsequent events occurred.

 

In June 2009, the FASB issued Statement ofFinancial Accounting Standard No. 168, “The FASB Accounting Standards Codification and the Hierarchy ofGenerally Accepted Accounting Principles” (“FAS 168”). This standard isa replacement of FAS 162, and establishes two levels of U.S. generally acceptedaccounting principles (“GAAP”), authoritative and nonauthoritative. The FASBAccounting Standards Codification (the “Codification”) will become the sourceof authoritative, nongovernmental GAAP, except for rules and interpretivereleases of the Securities and Exchange Commission (“SEC”), which are sourcesof authoritative GAAP for SEC registrants. All other nongrandfathered, non-SECaccounting literature not included in the Codification will becomenonauthoritative. This standard is effective for financial statements forinterim or annual reporting periods ending after September 15, 2009. We will begin to use the new guidelines and numbering system prescribed by theCodification when referring to GAAP for the fourth quarter of our fiscal yearending September 30, 2009.  As the Codification was not intended tochange or alter existing GAAP, we do not expect the adoption to have any impacton our financial position, results of operations, or cash flows.

 

24

----

Table ofContents

 

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

 

We donot engage in any foreign currency hedging transactions and therefore do notbelieve we are subject to material exchange rate risk.  We are not currently exposed to market riskrelated to changes in interest rates.  Inthe past, we have invested excess cash balances in cash equivalents andshort-term investments, and if we were to do so in the future, we believe thatthe effect, if any, of reasonably possible near-term changes in interest rateson our financial position, results of operations and cash flows would not bematerial.  In addition, a hypothetical10% increase or decrease in interest rates would not have a material adverseeffect on our financial condition.

 

**ITEM 4.    CONTROLS AND PROCEDURES**

 

Ourmanagement, with the participation of our Chief Executive Officer and ChiefFinancial Officer, evaluated the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act) as of June 30, 2009.  Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer concluded that, as of June 30, 2009,our disclosure controls and procedures (1) were designed to effectivelyaccumulate and communicate information to the Company’s management, asappropriate, to allow timely decisions regarding required disclosure and (2) wereeffective, in that they provide reasonable assurance that information requiredto be disclosed by the Company in the reports that it files or submits underthe Securities Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’s rules andforms.

 

Duringthe three months ended June 30,2009, no change in our internal control overfinancial reporting (as defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) occurred that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

**PART II—OTHERINFORMATION**

 

**ITEM 1.     LEGAL PROCEEDINGS**

 

*InitialPublic Offering Lawsuit*

 

Onor about December 3, 2001, a putative class action lawsuit was filed inthe United States District Court for the Southern District of New York againstus, Lawrence A. Genovesi (our former Chairman and Chief Executive Officer),Douglas G. Bryant (our Chief Financial Officer), and several underwriters ofour initial public offering.  The suitalleges, *inter alia*, that the defendants violatedthe federal 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 seeks damages and certification of aplaintiff class consisting of all persons who acquired shares of our commonstock between July 13, 2000 and December 6, 2000.

 

In October 2002,Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this casewithout prejudice.  On December 5,2006, the United States Court of Appeals for the Second Circuit overturned theDistrict Court’s certification of a plaintiff class.  On April 6, 2007, the Second Circuitdenied plaintiffs’ petition for rehearing, but clarified that the plaintiffsmay seek to certify a more limited class in the District Court.  On September 27, 2007, plaintiffs fileda motion for class certification in certain designated “focus cases” in theDistrict Court.  That motion has sincebeen withdrawn.  On November 13,2007, the issuer defendants in certain designated “focus cases” filed a motionto dismiss the second consolidated amended class action complaints that werefiled in those cases.  On March 26,2008, the District Court issued an Opinion and Order denying, in large part,the motions to dismiss the amended complaints in the “focus cases.”  On April 2, 2009, the plaintiffs filed amotion for preliminary approval of a new proposed settlement betweenplaintiffs, the underwriter defendants, the issuer defendants and the insurersfor the issuer defendants.  On June 10,2009, the Court issued an opinion preliminarily approving the proposedsettlement, and scheduling a settlement fairness hearing for September 10,2009.  We are unable to predict theoutcome of this suit and as a result, no amounts have been accrued as of June 30,2009.

 

25

----

Table of Contents

 

*CustomerClaim*

 

OnJanuary 20, 2009, a lawsuit was filed in the United States District Courtfor the Eastern District of Texas against us and several otherco-defendants.  The suit, filed byCordsen Engineering GmbH (“Cordsen”), a former customer of Alliance Systems,alleges breach of contract and other claims with regard to certain productsthat Cordsen purchased from Alliance Systems (prior to our acquisition ofAlliance Systems) and which Cordsen alleges did not meet its desiredspecifications.  Cordsen alleges that byvirtue of our acquisition of Alliance Systems in October 2007, we becamethe assignee of Alliance Systems’ agreement with Cordsen.  The Alliance Systems selling stockholdershave agreed with us to undertake the defense of the action insofar as itrelates to activities that occurred principally before we acquired AllianceSystems, and have agreed to bear any costs associated with this action.  We believe this claim is without merit.  We are unable to predict the ultimate outcomeof this claim and are unable to estimate the amount of any potential loss wemight incur as a result of this claim, and therefore no amounts have beenaccrued relating to this claim as of June 30, 2009.  With regard to this claim, we intend topursue reimbursement from the former shareholders of Alliance Systems for anylosses incurred by us, pursuant to the terms of the Alliance Systems mergeragreement.

 

**ITEM 1A. RISK FACTORS**

 

Therisks and uncertainties described below are not the only ones we are facedwith.  Additional risks and uncertaintiesnot presently known to us, or that are currently deemed immaterial,may also impair our business operations. If any of the following risks actually occur, our financial conditionand operating results could be materially adversely affected.  Subsequent to the previous disclosure of riskfactors in Item 1A of Part I of our most recent Annual Report on Form 10-Kfor the fiscal year ended September 30, 2008, there have been nosignificant changes in our risk factors, except for the following:

 

·                  The risk factortitled “If the market price of our common stock isnot quoted on a national exchange, our ability to raise future capital may behindered and the market price of our common stock may be negatively impacted”has been updated to reflect the further extension by NASDAQ of its suspensionof enforcement of the minimum bid price rule.

 

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

 

**Wederive a significant portion of our revenues from sales of application platformsolutions directly to EMC and our revenues may decline significantly ifthis customer reduces, cancels or delays purchases of our products, terminatesits relationship with us or exercises certain of its contractual rights.**

 

Forthe three months ended June 30, 2009 and 2008,sales directly to EMC, our largest customer, accounted for 35% and 41%, of ourtotal net revenues, respectively.  Forthe nine months ended June 30, 2009 and 2008,sales directly to EMC accounted for 35% and 43%, of our total net revenues,respectively.  These sales are primarilyattributable to one product pursuant to a non-exclusive contract.  Although this concentration has decreased asa result of our acquisition of Alliance Systems, we anticipate that our futureoperating results will continue to depend heavily on sales to, and ourrelationship with, this customer. Accordingly, the success of our business will depend, in large part, onthis customer’s willingness to continue to utilize our application platformsolutions in its existing and future products. Further, our financial success is dependent upon the future success ofthe products we sell to this customer and the continued growth of thiscustomer, whose industry has a history of rapid technological change, shortproduct lifecycles, consolidation and pricing and margin pressures.  As we have experienced in recent periods, advances in hard drive storage capacitycould also result in lower sales volumes to this customer.  A significant reduction insales to this customer, or significant pricing and additional margin pressuresexerted on us by this customer, would have a material adverse effect on ourresults of operations.  In addition, ifthis customer delays or cancels purchases of our products, our operatingresults would be harmed and we may be unable to accurately predict revenues,profitability and cash flows.

 

Underthe terms of our non-exclusive contract, this customer has the right to enterinto agreements with third parties for similar products, is not obligated topurchase any minimum quantity of products from us and may choose to stoppurchasing from us at any time, with or without cause.  In addition, this customer may terminatethe agreement in the event that we attempt to assign our rights under theagreement to another party without this customer’s prior approval.  Furthermore, in the event that we default oncertain portions of the agreement, this customer has the right to manufacturecertain products in exchange for a mutually agreeable royalty fee.  If any of 

 

26

----

Table ofContents

 

theseevents were to occur, or if this customer were to delay or discontinuepurchases of our products as a result of dissatisfaction or otherwise, ourrevenues and operating results would be materially adversely affected, ourreputation in the industry might suffer, and we may be unable to accuratelypredict revenues, profitability and cash flows.

 

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

 

**Ourfuture success is dependent upon our ability to generate significant revenuesfrom application platform development relationships.**

 

Webelieve we must diversify our revenues and a major component of our businessstrategy is to form application platform development relationships withnew OEMs, ISVs and service providers. Under this strategy, we work with our customers to develop anapplication platform branded with their name. The customers then perform all of the selling and marketing effortsrelated to sales of their branded appliance.

 

Thereare multiple risks associated with this strategy including:

 

·         the expenditure ofsignificant product development costs, which if not recovered throughapplication platform sales could negatively affect our operating results;

 

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

 

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

 

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

 

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

 

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

 

·         there is no guarantee thatdesign wins will become actual orders and sales.  A “design win’’ occurs when a customer orprospective customer notifies us that we have been selected to integrate thecustomer’s application.  There can bedelays of several months or more between the design win and when a customerinitiates actual orders.  The design winmay never become an actual order or sale. Further, if the customer’s plans change, we may commit significantresources to design wins that do not result in actual orders.

 

Additionally,our future success will depend on our ability to establish relationships withnew customers while expanding sales of application platform solutions to ourexisting customers.  If these customersare unsuccessful in their marketing and sales efforts, or if we are unable toexpand our sales to existing customers and develop relationships with newcustomers, our revenues and operating results could suffer.

 

**Wemay not be able to effectively commercialize our application platformsolutions or may be at a competitive disadvantage if we cannot license or integratethird-party applications that are essential for the functionality of certainplatforms.**

 

Webelieve our success will depend on our ability to license or integrate certainapplications from third-parties that would be incorporated in certain of ourapplication platform solutions.  Becausewe do not currently know with certainty which of these prospective technologieswill be desired in the marketplace, we may incorrectly invest indevelopment or prioritize our efforts to integrate these technologies in ourapplication platforms.  Additionally,even if we correctly focus our efforts, there can be no assurance that we willselect the preferred provider of these technologies, the third-party providerwill be committed to the relationship and integration of their technology, orthat they will license their technology to us without obtaining significantcertification or training, 

 

27

----

Table ofContents

 

whichcould be costly and time consuming.  Ifwe are unable to successfully integrate the correct third-party technologies ina timely manner, our application platform solutions may be inferior toother competitive products in the marketplace, which may adversely affectthe results of our operations and our ability to grow our business.

 

**Ourbusiness could be harmed if we fail to adequately integrate new technologiesinto our application platform solutions or if we invest in technologies that donot result in the desired effects on our current and/or future productofferings.**

 

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

 

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

 

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

 

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

 

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

 

·         new technologies are unprovenand could contain latent defects, which could result in high product failures;and

 

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

 

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

 

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

 

**Ifapplication platforms are not increasingly adopted as a solution to meet asignificant portion of companies’ software application needs, the market forapplication platform solutions may not grow, which could negatively impactour revenues.**

 

Weexpect that all of our future revenues will come from sales of applicationplatform solutions and related services. As a result, we are substantially dependent on the growing use ofapplication platforms to meet businesses’ software application needs.  Our revenues may not grow and the marketprice of our common stock could decline if the application platform market doesnot grow as rapidly as we expect.

 

Ourexpectations for the growth of the application platform market may not befulfilled if customers continue to use general-purpose servers or proprietaryplatforms.  The role of our productscould, for example, be limited if general-purpose serversout-perform application platforms, provide more capabilities and/orflexibility than application platforms or are offered at a lower cost.  This could force us to lower the prices ofour application platform solutions or could result in fewer sales of theseproducts, which would negatively impact our revenues and decrease our grossprofits.

 

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

 

Themarkets we serve are characterized by rapid technological change, frequent newproduct introductions and enhancements, potentially short product lifecycles,changes in customer demands and evolving industry standards.  In the application platform market, weattempt to mitigate these risks by utilizing standards-based hardware platformsand by maintaining an adequate knowledge base of available technologies.  However, the application platform solutions thatwe sell could be rendered obsolete if products based on new technologies are 

 

28

----

Table ofContents

 

introducedor new industry standards emerge and we are not able to incorporate thesetechnological changes into our products. In addition, we depend on third parties for the base hardware of ourapplication platforms and we are at risk if these third parties do notintegrate new technologies.  Releasingnew products and services prematurely may result in quality problems, anddelays may result in loss of customer confidence and market share.  We may be unable to develop new products andservices or achieve and maintain market acceptance of them once they have cometo market.  Furthermore, when we dointroduce new or enhanced products and services, we may be unable to manage thetransition from the older products and services to minimize disruption incustomer ordering patterns, avoid excessive inventories of older products anddeliver enough new products and services to meet customer demand.  Moreover, due to advances in technology, suchas increases in hard drive storage capacity and processor speed, there is arisk that customer demand may decrease. Such a decrease may result if our customers require fewer units of ourproducts in order to meet their technical demands.

 

To remain competitive inthe application platform market, we must successfully identify new productopportunities and partners and develop and bring new products to market in atimely and cost-effective manner.  Ourfailure to select the appropriate partners and keep pace with rapid industry,technology or market changes could have a material adverse effect on our business,results of operations or financial condition.

 

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

 

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

 

Inthe past, we have incurred significant net losses and could incur net losses inthe future.  At June 30, 2009 and September 30,2008, our accumulated deficit was $140 million and $138 million,respectively.  We believe that any futuregrowth will require us to incur significant engineering, selling and marketingand administrative expenses.  As aresult, we will need to generate significant revenues to achieve and sustainprofitability.  If we do not achieve andsustain profitability, the market price for our common stockmay decline.  Even if we achievesustained profitability there can be no guarantee that our stock price willincrease.

 

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

 

In connection with our October 2007acquisition of Alliance Systems, we entered into an agreement with SiliconValley Bank to provide for a line of credit. We view this line of credit as a source of available liquidity to fundfluctuations in our working capital requirements.  This facility contains various conditions,covenants and representations with which we must be in compliance in order toborrow funds.  However, if we wish toborrow under this facility in the future, there can be no assurance that wewill be in compliance with these conditions, covenants andrepresentations.  In addition, this lineof credit facility with Silicon Valley Bank expires on August 5,2010.  After that, we may need to securenew financing to continue funding fluctuations in our working capital requirements.  However, we may not be able to secure newfinancing, or financing on favorable terms, if we experience a significantadverse change in our business.  As of August 10,2009, we had not drawn on this line of credit.

 

**If ourestimates or judgments relating to our critical accounting policies are basedon assumptions that change or prove to be incorrect, our operating resultscould fall below expectations of securities analysts and investors, resultingin a decline in our stock price.**

 

Ourdiscussion and analysis of financial condition and results of operations isbased on our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America.  The preparation of financialstatements in conformity with generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the amounts reportedin the consolidated financial statements and accompanying notes.  On an ongoing basis, we evaluate significantestimates used in preparing our consolidated financial statements, includingthose related to:

 

·         revenue recognition;

 

·         collectibility of accounts receivable;

 

·         inventory write-downs;

 

29

----

Tableof Contents

 

·         stock-based compensation;

 

·         valuation of intangible assets;

·         warranty reserves; and

 

·         realization of deferred tax assets.

 

Webase our estimates on historical experience and on various other assumptionsthat we believe to be reasonable under the circumstances, as provided in ourdiscussion and analysis of financial condition and results of operations, theresults of which form the basis for making judgments about the carryingvalues of assets and liabilities that are not readily apparent from othersources.  Actual results may differfrom these and other estimates if our assumptions change or if actualcircumstances differ from those in our assumptions, which could cause ouroperating results to fall below the expectations of securities analysts andinvestors, resulting in a decline in our stock price.

 

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

 

Ourquarterly revenues and operating results are difficult to predict andmay fluctuate significantly 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 based in part on expectations offuture revenues and gross profits, which are partially dependent on ourcustomers’ ability to accurately forecast and communicate their future productneeds.  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 quarterly operating resultsinclude:

 

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

 

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

 

·         the variability of orders wereceive from customers who do not provide us with sales forecasts;

 

·         the availability and/or price of products fromsuppliers;

 

·         the product mix of our sales;

 

·         the timing of new product introductions by ourcustomers;

 

·         the loss of key suppliers or customers;

·         price competition;

 

·         costs associated with our introduction of new applicationplatform solutions and the market acceptance of those products; and

 

·         the mix of product manufactured internally and by ourcontract manufacturer.

 

**If theproducts and services that we sell become more commoditized and competition inthe data storage, network security, carrier communications and enterprisecommunications markets continues to increase, then our gross profit as apercentage of net revenues may decrease and our operating resultsmay suffer.**

 

Productsand services in the data storage, network security, carrier communications andenterprise communications markets may be subject to furthercommoditization as these industries continue to mature and other businessesintroduce additional competing products and services.  Our gross profit as a percentage of revenuesfor our products may decrease in response to changes in our product mix,competitive pricing pressures, or new product introductions into thesemarkets.  If we are unable to offset decreasesin our gross profits as a percentage of revenues by increasing our salesvolumes, or by decreasing our product costs, or by maintaining relativelyconsistent levels of

 

30

----

Table ofContents

 

operatingexpenses, our operating results will decline. Changes in the mix of sales of our products, including the mix of highermargin products sold in smaller quantities and lower margin products sold inlarger quantities, could adversely affect our operating results for futurequarters.  To maintain our gross profits,we also must continue to reduce the manufacturing cost of our applicationplatform solutions.  Our efforts toproduce higher margin application platform solutions, continue to improve ourapplication platform solutions and produce new application platform solutionsmay make it difficult to reduce our manufacturing cost per product.  Further, utilization of a contractmanufacturer to produce a portion of our customer requirements for certainapplication platform solutions may not allow us to reduce our cost perproduct.  If we fail to respondadequately to pricing pressures, to competitive products with improvedperformance or to developments with respect to the other factors on which wecompete, we could lose customers or orders. If we are unable to offset decreases in the prices we are able to chargeour customers and/or our gross margin percentage with increased sales volumes,our business willsuffer.

 

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

 

AtJune 30, 2009, the carrying value of our intangible asset, which consistsof customer relationships associated with our acquisition of Alliance Systems,was approximately $8.6 million, net of accumulated amortization.  We will continue to incur non-cash chargesrelating to the amortization of our intangible asset over its remaining usefullife.  Future determinations ofsignificant write-offs of the intangible asset resulting from an impairmenttest or any accelerated amortization of the intangible asset could have asignificant impact on our operating results and affect our ability to achieveor maintain profitability.  Although wedo not believe that any impairment of the intangible asset exists at this time,in the event that any indicators of possible impairment exist, we may recordcharges which could have a material adverse effect on our results ofoperations.  Such indicators include, butare not limited to, a worsening in customer attrition rates compared tohistorical attrition rates, or lower than initially anticipated cash flowsassociated with customer relationships.

 

Ouracquisition of Alliance Systems was structured to include a downward adjustmentto the purchase price based on the net working capital of Alliance Systems asof October 11, 2007, as defined in the merger agreement, and thereforeapproximately $4.0 million of the cash paid is contingently returnable tous upon resolution of this provision.  Asa result, the amount of contingently returnable consideration has been excludedfrom the allocation of the purchase price to the net assets acquired until suchtime that this amount is no longer contingently returnable.  When the contingencies are resolved, anyportion of the $4.0 million which is not returned to us will bereclassified as goodwill.  If goodwill isrecorded in a future period, it will then be subject to review for impairmentannually as of the fiscal year end date, and more frequently if certainindicators are present.  We have beenpursuing settlement of this contingency through negotiations with the formershareholders of Alliance Systems; however, no final resolution has been reachedas of June 30, 2009.  During July 2009,we and the former Alliance Systems shareholders agreed to proceed toarbitration to resolve the disputed claims as provided for in the merger agreement.  If an impairment charge is recorded in thefuture, it would negatively impact our operating results.

 

***Risks related to competition.***

 

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

 

Inthe application platform market, we face significant competition from a numberof different types of companies.  Ourcompetitors include companies who market general-purpose servers, servervirtualization software, specific-purpose servers and application platforms aswell as companies that sell custom integration services utilizing hardwareproduced by other companies.  Many ofthese companies are larger than we are and have greater financial resources andname recognition than we do, as well as significant distribution capabilitiesand larger, more established service organizations to support theirproducts.  Our larger competitorsmay be able to leverage their existing resources, including theirextensive distribution capabilities and service organizations, to provide awider offering of products and services and higher levels of support on a morecost-effective basis than we can.  Weexpect competition in the application platform market to increase significantlyas more companies enter the market and as our existing competitors continue toimprove the performance of their current products and to introduce new productsand technologies.  Such increasedcompetition could adversely affect sales of our 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 wecan.  If our competitors provide lowercost products with greater functionality or support than our applicationplatform solutions, or if some of their products are comparable to ours and areoffered as part of a range of products that is broader than ours, ourapplication platform solutions could become undesirable.

 

31

----

Table of Contents

 

Evenif the functionality of competing products is equivalent to ours, we face arisk that a significant number of customers would elect to pay a premium forsimilar functionality from a larger vendor rather than purchase products fromus.  We attempt to differentiateourselves from our competition by offering a wide variety of softwareintegration, branding, supply-chain management, engineering, support, logisticsand fulfillment services.  If we areunable to effectively differentiate ourselves from our competition, wemay be forced to offer price reductions to maintain relationships withcertain customers.  As a result, ourrevenues may not increase and may decline, and our gross marginsmay decline.  Furthermore, increasedcompetition could lead to higher selling expenses which would negatively affectour business and future operating results.

 

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

 

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

 

Althoughwe currently have a relatively small sales and marketing organization, we mustcontinue to increase market awareness and sales of our products and promote ourbrand in the marketplace.  We believethat to compete successfully we will need OEMs, ISVs and service providers torecognize us as a top-tier provider of application platform solutions andservices.  If we are unable to increasemarket awareness and promote ourselves as a leading provider of applicationplatform solutions with our available resources, we may be unable to developnew customer relationships or expand our product and service offerings withexisting customers.

 

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

 

Weneed to effectively manage our customer support operations to ensure that wemaintain good relationships with our customers. We believe that providing a level of high quality customer support willbe a key differentiator for our product offerings and may require moretechnically qualified staff which could be more costly.  If we are unable to provide this higher levelof service we may be unable to successfully attract and retain customers.

 

Ifour customer support organization is unsuccessful in maintaining good customerrelationships, we may lose customers to our competitors and our reputationin the market could be damaged.  As aresult, we may lose revenues and our business could suffer.  Furthermore, the costs of providing thisservice could be higher than we expect, which could adversely affect ouroperating results.

 

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

 

**Ourdependence on sole source and limited source suppliers for key applicationplatform components makes us susceptible to supply shortages and potentialquality issues that could prevent us from shipping customer orders on time, orat all, and could result in lost sales and customers.**

 

Wedepend upon single source and limited source suppliers for our industrystandard processors, main logic boards, telephony boards, certain disk drives,hardware platforms and power supplies as well as certain of our chassis andsheet metal parts.  Additionally, wedepend on limited sources to supply certain other industry standard andcustomized components.  We have in thepast experienced, and may in the future experience, shortages of ordifficulties in acquiring components in the quantities and of the quality neededto produce our application platform solutions. Shortages in supply or quality issues related to these key componentsfor an extended time would cause delays in the production of our applicationplatform solutions, prevent us from satisfying our contractual obligations andmeeting customer expectations, and result in lost sales and customers.  If we are unable to buy components in thequantities and of the quality that we need on a timely basis or at acceptableprices, we will not be able to manufacture and deliver our application platformsolutions on a timely or cost effective basis to our customers, and ourcompetitive position, reputation, business, financial condition and results ofoperations could be seriously harmed.  If we are able to secure other sources ofsupply for such components, our costs to purchase such components couldincrease, which would negatively impact our gross margins.  A significant portion of our components arepurchased from suppliers located in China. Recently, several factories in China have closed without notice.  If a factory which supplies parts to uscloses with little or no notice, we could experience shortages and difficultiesin locating alternative sources of supply.

 

32

----

Table ofContents

 

**If ourapplication platform solutions fail to perform properly andconform to specifications, our customers may demand refunds, assertclaims for damages or terminate existing relationships with us, and ourreputation and operating results may suffer materially.**

 

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

 

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

 

·         the loss of or delay in market acceptance and salesof our application platform solutions;

 

·         diversion of engineering resources;

 

·         increased manufacturing costs;

 

·         the loss of customers;

 

·         injury to our reputation and other customer relationsproblems; and

 

·         increased maintenance and warranty costs.

 

Anyof these problems could harm our business and future operating results.  Product errors or delays could be material,including any product errors or delays associated with the introduction of newproducts or versions of existing products. If our application platform solutions fail to conform to warrantedspecifications, customers could demand a refund for the purchase price andassert claims for damages.

 

Moreover,because our application platform solutions may be used in connection withcritical computing systems services, including providing security to protectvaluable information, we may receive significant liability claims if theydo not work properly.  While ouragreements with customers typically contain provisions intended to limit ourexposure to liability claims, these limitations do not preclude all potentialclaims.  Liability claims could exceedour insurance coverage and require us to spend significant time and money inlitigation or to pay significant damages. Any claims for damages, even if unsuccessful, could seriously damage ourreputation and business.

 

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

 

Weuse rolling forecasts based on anticipated product orders to determine ourapplication platform component requirements. Lead times for materials and components that we order vary significantlydepending on variables such as specific supplier requirements, contract termsand current market demand for those components. In addition, a variety of factors, including the timing of productreleases, potential delays or cancellations of orders, the timing of largeorders and the unproven acceptance of new products in the market make itdifficult to predict product 

 

33

----

Table ofContents

 

orders.  As a result, our materials requirementforecasts may not be accurate.  Ifwe overestimate our materials requirements, we may have excess inventory,which would increase costs and negatively impact our cash position.  Our agreements with certain customers provideus with protections related to inventory purchased in accordance with the termsof these agreements; however, these protections may not be sufficient toprevent certain losses as a result of excess or obsolete inventory.  If we underestimate our materialsrequirements, we may have inadequate inventory, which could interrupt ourmanufacturing and delay delivery of our application platform solutions tocustomers, resulting in a loss of sales or customers.  Any of these occurrences would negativelyimpact our business and operating results.

 

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

 

**Ouroperating results would suffer if we, our customers, or other third-partysoftware providers from whom we license technology, were subject to aninfringement claim that resulted in protracted litigation, the award ofsignificant damages against us or the payment of substantial ongoing royalties.**

 

Substantiallitigation regarding intellectual property rights exists in the technologyindustry.  We expect that applicationplatform solutions may be subject to third-party infringement claims asthe number of competitors in the industry segment grows and the functionalityof products in different industry segments overlap.  In the past we have received claims fromthird parties that our application platform solutions infringed theirintellectual property rights.  We do notbelieve that our application platform solutions employ technology thatinfringes the proprietary rights of any third parties.  We are also not aware of any claims madeagainst any of our customers related to their infringement of the proprietaryrights of other parties in relation to products that include our applicationplatform solutions.  Other partiesmay 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.

 

Inaddition, other parties may make claims against our customers, orthird-party software providers related to products that are incorporated intoour application platform solutions.  Ourbusiness could be adversely affected if such claims resulted in the inabilityof our customers to continue producing the infringing product, or if we areunable to cost effectively continue licensing the third-party software.

 

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

 

Oursuccess depends in large part on our ability to retain and attract highlyskilled engineering, sales, marketing, customer service and managerialpersonnel.  If we are unable to attract asufficient number of qualified personnel, we may not be able to meet keyobjectives such as developing, upgrading, or enhancing our products in a timelymanner, which could negatively impact our business and could hinder any future growth.

 

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

 

Section 404of the Sarbanes-Oxley Act of 2002 requires our management to report on, and ourindependent registered public accounting firm to attest to, the effectivenessof our internal control over financial reporting.  We have an ongoing program toperform the system and process evaluation and testing necessary to complywith these requirements.  As a result, wehave incurred expenses and have devoted additional management resources to Section 404compliance.  Effective internal controlsare necessary for us to provide reliable financial reports.  If we cannot provide reliable financialreports, our business and operating results could be harmed.

 

34

----

Table ofContents

 

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

 

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

 

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

 

Ourmanufacturing facilities and headquarters are concentrated in twolocations.  If the operations in eitherfacility were disrupted as a result of a natural disaster, fire, power or otherutility outage, work stoppage or other similar event, our business couldbe seriously harmed for a period of at least one quarter as a result ofinterruptions or delays in our manufacturing, engineering, or post-salessupport operations.

 

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

 

Themarket price of our common stock has been subject to significant fluctuationsand may continue to fluctuate or decline. During the three month period ended June 30, 2009, the closingprice of our common stock ranged from a low of $0.56 to a high of $0.85, andduring the nine months ended June 30, 2009, from a low of $0.29 to a highof $0.85.  The market for technologystocks has been extremely volatile and frequently reaches levels that bear norelationship to the past or present operating performance of those companies.  General economic conditions, such asrecession or interest rate or currency rate fluctuations in the United Statesor abroad, could negatively affect the market price of our common stock.  For example, the recent uncertainty related todeteriorating global economic conditions has negatively impacted the marketprice of our common stock.  In addition, ouroperating results may be below the expectations of securities analysts andinvestors.  If this were to occur, themarket price of our common stock may decrease significantly.  In the past, following periods of volatilityin the market price of a company’s securities, securities class actionlitigation has often been instituted against such companies.  Such litigation could result in substantialcost and a diversion of management’s attention 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.

 

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

 

Subsequent to June 30,2008, at certain times, the market price of our common stock has been less than$1.00 per share.  If we are unable tomeet the stock price listing requirements of NASDAQ, our common stock could bede-listed from the NASDAQ Global Market. On September 29, 2008, we received notification from NASDAQ thatduring the preceding 30 consecutive trading days, the closing bid price of ourcommon stock was below the $1.00 minimum bid price per share required forcontinued listing on the NASDAQ Global Market under NASDAQ Marketplace Rule 5450(a)(1).  In accordance with NASDAQ Marketplace Rule 5810(c)(3)(A),NASDAQ provides issuers 180 calendar days to regain compliance with the minimumbid price requirement by maintaining a closing bid price of $1.00 per share orhigher for a minimum of 10 consecutive trading days.  On October 22, 2008, NASDAQ notified usthat it had suspended enforcement of the minimum bid price rule for threemonths.  On December 23, 2008,NASDAQ notified us that it had further suspended enforcement of the minimum bidprice rule and that this rule was scheduled to be reinstated on April 20,2009.  On March 23, 2009, NASDAQnotified us that it 

 

35

----

Table of Contents

 

had further suspendedenforcement of the minimum bid price rule and that this rule wasscheduled to be reinstated on July 20, 2009.  On July 13, 2009,we were notified by NASDAQ that NASDAQ had further suspended the enforcement ofthe minimum closing bid price rule for an additional two weeks.  Theminimum closing bid price rule was reinstated on August 3,2009.  As a result, we will have until January 13, 2010 to regaincompliance.  NASDAQ also stated that it does not expect any furtherextensions of the suspension of the minimum bid price requirement.  NASDAQ may, in its discretion, require thatour common stock maintain a bid price in excess of $1.00 for a period in excessof 10 business days, but generally no more than 20 business days, beforedetermining that we have demonstrated the ability to maintain long-termcompliance.  If we are unsuccessful inmeeting the minimum bid price requirement during the compliance period, NASDAQwill provide notice to us that our common stock will be delisted from theNASDAQ Global Market.  If we receive sucha notice, we may appeal the staff determination to the NASDAQ ListingQualifications Panel.  We may also applyto transfer our common stock to the NASDAQ Capital Market if we satisfy allcriteria for initial listing on the NASDAQ Capital Market, other thancompliance with the minimum bid price requirement.  If such application to the NASDAQ CapitalMarket is approved, then we will have an additional 180-day compliance period inorder to regain compliance with the minimum bid price requirement while listedon the NASDAQ Capital Market.

 

If our common stock werede-listed from the NASDAQ Global Market, among other things, this could resultin a number of negative implications, including reduced liquidity in our commonstock as a result of the loss of market efficiencies associated with NASDAQ andthe loss of federal preemption of state securities laws, as well as thepotential loss of confidence by suppliers, customers and employees, the loss ofinstitutional investor interest, fewer business development opportunities andgreater difficulty in obtaining financing.

 

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

 

Thecurrent downturn in the economy, and any further slowdown in future periods,could adversely affect our business in ways that we are unable to fullyanticipate.  Tightening credit marketsmay negatively impact operations by affecting solvency of customers, suppliersand other business partners, or the ability of our customers to obtain creditto finance purchases of our products and services, which in turn could lead toincreased difficulty in collecting accounts receivable.  Tightening credit markets may also negativelyimpact our ability to borrow funds, if needed, either under our line of creditwith Silicon Valley Bank or from other sources. In addition, government responses to the disruptions in the financialmarkets may not stabilize the markets or increase liquidity or the availabilityof credit for us or our customers.  Awidespread reduction of global business activity could cause customers toreduce capital expenditures, put increased pricing pressure on our products andservices, and subject us, our suppliers and our customers to interest raterisks and tax changes that could impact our financial strength.  These and other economic factors could have amaterial adverse effect on our financial condition, operating results andliquidity.

 

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

 

OurBoard of Directors has the authority to issue up to 5,000,000 shares ofpreferred stock and, without any further vote or action on the part of thestockholders, to determine the price, rights, preferences, privileges andrestrictions of the preferred stock. This preferred stock, if issued, might have preference over the rightsof the holders of common stock and could adversely affect the market price ofour common stock.  The issuance of thispreferred stock may make it more difficult for a third party to acquire usor to acquire a majority of our outstanding voting stock.  We currently have no plans to issue preferredstock.

 

Inaddition, provisions of our second amended and restated certificate ofincorporation and our second amended and restated by-laws may deter anunsolicited offer to purchase us.  Theseprovisions, coupled with the provisions of the Delaware General CorporationLaw, may delay or impede a merger, tender offer or proxy contest involvingus.  For example, our Board of Directorsis divided into three classes, only one of which is elected at each annualmeeting.  These factors may furtherdelay or prevent a change of control of our business.

 

36

----

Table of Contents

 

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

 

Thefollowing table presents information regarding the Company’s repurchases of itscommon stock during the three months ended June 30, 2009.

 

Issuer Purchases of Equity Securities

 

| **Month**       | ** ** | **Number of  Shares  Purchased as  Part of Publicly  Announced  Program (1)** | ** ** | **Average   Price Paid   Per Share** | ** ** | **Maximum Dollar Value  that May Yet Be Used  for Purchases Under the  Program** | ** ** |
|-----------------|------------|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------|------------|
| April 2009 |       | 248,900                                                                                                |       | $                                                        | 0.63       |                                                                                                                          | $          | 3,691,000 |   |
| May 2009   |       | 249,457                                                                                                |       | $                                                        | 0.80       |                                                                                                                          | $          | 3,491,000 |   |
| June 2009  |       | 274,600                                                                                                |       | $                                                        | 0.83       |                                                                                                                          | $          | 3,264,000 |   |
| Total           |       | 772,957                                                                                                |       | $                                                        | 0.76       |                                                                                                                          | $          | 3,264,000 |   |

 

----

(1)          All of theshares of common stock set forth in this column were purchased pursuant to apublicly announced program as described in footnote 2 below.

 

(2)          On June 12,2008, we announced that our Board of Directors had authorized the repurchase ofup to $5 million of our common stock through a share repurchase program. The program does not have an expiration date.  All repurchases describedin the table above were effected pursuant to written Rule 10b5-1 tradingplans.  From the program’s inception through June 30, 2009, we hadrepurchased 2,125,804 shares at an average cost of $0.82 per share.  Uponthe expiration of the first 10b5-1 plan on November 7, 2008, we suspendedrepurchases of our common stock.  On March 16, 2009, we announcedthat we would resume the repurchase of our common stock under a new 10b5-1 planpreviously authorized by the Board of Directors.

 

**ITEM 6.     EXHIBITS**

 

(a)    Exhibits

 

Theexhibits which are filed with this report or which are incorporated byreference are set forth in the Exhibit Index hereto.

 

37

----

Table of Contents

 

**SIGNATURES**

 

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

 
|                        | **NETWORK  ENGINES, INC.** |
|-----------------------------|----------------------------|
|                        |                       |   |
| Date: August 10,  2009 | ** **                 | /s/  Gregory A. Shortell |
|                        |                       |   |
|                        |                       | Gregory  A. Shortell |
|                        |                       | President and Chief  Executive Officer |
|                        |                       | (Principal Executive  Officer) |
|                        |                       |   |
|                        |                       | /s/  Douglas G. Bryant |
|                        |                       |   |
|                        |                       | Douglas G. Bryant |
|                        |                       | Chief Financial  Officer, Treasurer and Secretary |
|                        |                       | (Principal Financial  Officer and Principal Accounting Officer) |

 

38

----

Table ofContents

 

**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Exhibit**                                                                                                                                         |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
| 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.   |

 

----