##### **Table of Contents**

 

 

 

##### **UNITEDSTATES**

##### **SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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

##### ** **

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**(MarkOne)**

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

 

**For the quarterly period ended June 30, 2008**

 

###### **OR**

######  

| **o**** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|-----------------|----------------------------------------------------------------------------------------------------------|

 

**Forthe transition period from                      to**

 

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

######  

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**NETWORK ENGINES, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**(781) 332-1000**

(Registrant’s telephone number, including area code)

 

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

 

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

 

Largeaccelerated 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 7, 2008, there were 43,741,468 shares of the registrant’s CommonStock, par value $.01 per share, outstanding.

 

 

 

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**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 |       | 15               |
|                                                                                                 |       |             |
| ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISK                                  |       | 27               |
|                                                                                                 |       |             |
| ITEM 4. CONTROLS AND PROCEDURES                                                                      |       | 27               |
|                                                                                                 |       |             |
| **PART II.  OTHER INFORMATION**                                                                 |
|                                                                                                 |       |             |
| ITEM  1. LEGAL PROCEEDINGS                                                                           |       | 28               |
|                                                                                                 |       |             |
| ITEM  1A. RISK FACTORS                                                                               |       | 28               |
|                                                                                                 |       |             |
| ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND  USE OF PROCEEDS                                 |       | 39               |
|                                                                                                 |       |             |
| ITEM  5. OTHER INFORMATION                                                                           |       | 40               |
|                                                                                                 |       |             |
| ITEM 6.  EXHIBITS                                                                                    |       | 40               |
|                                                                                                 |       |             |
| SIGNATURES                                                                                           |       | 41               |

 

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Table ofContents

 

**PART I. FINANCIAL INFORMATION**

 

**ITEM I. FINANCIAL STATEMENTS**

 

**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(inthousands, except share data)**

**(unaudited)**

 
| ** **                                                                                                                                                                                                            | ** ** | **June 30,  2008** | ** ** | **September 30,  2007** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------------|------------|
| **ASSETS**                                                                                                                                                                                                            | ** ** | ** **              | ** ** | ** **                   | ** ** |
| **Current assets:**                                                                                                                                                                                                   | ** ** | ** **              | ** ** | ** **                   | ** ** |
| Cash and cash equivalents                                                                                                                                                                                             |       | $                       | 12,213     |                         | $          | 44,403 |   |
| Restricted cash                                                                                                                                                                                                       |       | 47                      |       | 247                          |       |
| Accounts receivable, net of allowances of $106 and $32 at  June 30, 2008 and September 30, 2007, respectively                                                                                               |       | 31,005                  |       | 17,511                       |       |
| Income tax receivable                                                                                                                                                                                                 |       | 2,585                   |       | —                       |       |
| Inventories                                                                                                                                                                                                           |       | 19,404                  |       | 10,175                       |       |
| Prepaid expenses and other current assets                                                                                                                                                                             |       | 2,360                   |       | 1,077                        |       |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| Total current assets                                                                                                                                                                                                  |       | 67,614                  |       | 73,413                       |       |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| Property and equipment, net                                                                                                                                                                                           |       | 1,685                   |       | 1,128                        |       |
| Intangible assets, net                                                                                                                                                                                                |       | 10,369                  |       | —                       |       |
| Goodwill                                                                                                                                                                                                              |       | 8,676                   |       | —                       |       |
| Contingently returnable acquisition consideration                                                                                                                                                                     |       | 4,022                   |       | —                       |       |
| Other assets                                                                                                                                                                                                          |       | 263                     |       | 281                          |       |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| Total assets                                                                                                                                                                                                          |       | $                       | 92,629     |                         | $          | 74,822 |   |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                        | ** ** | ** **              | ** ** | ** **                   | ** ** |
| **Current liabilities:**                                                                                                                                                                                              | ** ** | ** **              | ** ** | ** **                   | ** ** |
| Accounts payable                                                                                                                                                                                                      |       | $                       | 16,056     |                         | $          | 10,189 |   |
| Accrued compensation and other related benefits                                                                                                                                                                       |       | 2,228                   |       | 1,773                        |       |
| Other accrued expenses                                                                                                                                                                                                |       | 2,934                   |       | 3,228                        |       |
| Deferred revenue                                                                                                                                                                                                      |       | 4,575                   |       | 2,839                        |       |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| Total current liabilities                                                                                                                                                                                             |       | 25,793                  |       | 18,029                       |       |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| Deferred revenue, net of current portion                                                                                                                                                                              |       | 2,422                   |       | 1,285                        |       |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| Total liabilities                                                                                                                                                                                                     |       | 28,215                  |       | 19,314                       |       |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| 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;  46,753,826 and 43,590,883 shares issued; 44,053,468 and 41,029,025 shares  outstanding at June 30, 2008 and September 30, 2007, respectively |       | 468                     |       | 436                          |       |
| Additional paid-in capital                                                                                                                                                                                            |       | 194,793                 |       | 187,005                      |       |
| Accumulated deficit                                                                                                                                                                                                   |       | (127,837                | )          | (129,095                     | )          |
| Treasury stock, at cost, 2,700,358 and 2,561,858 shares at  June 30, 2008 and September 30, 2007, respectively                                                                                              |       | (3,010                  | )          | (2,838                       | )          |
| Total stockholders’ equity                                                                                                                                                                                       |       | 64,414                  |       | 55,508                       |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                       |       | $                       | 92,629     |                         | $          | 74,822 |   |

 

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

 

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**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(unaudited)**

 
| ** **                                                   | ** ** | **Three months ended  June 30,** | ** ** | **Nine months  ended  June 30,** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| ** **                                                   | ** ** | **2008**                              | ** ** | **2007**                              | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                   | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues                                                 |       | $                                     | 47,046     |                                  | $          | 27,998 |   | $ | 156,560 |   | $ | 84,541 |   |
|                                                         |       |                                  |       |                                  |       |   |   |   |   |
| Cost of revenues                                             |       | 39,396                                |       | 22,683                                |       | 130,271 |   | 67,902 |   |
|                                                         |       |                                  |       |                                  |       |   |   |   |   |
| Gross profit                                                 |       | 7,650                                 |       | 5,315                                 |       | 26,289 |   | 16,639 |   |
|                                                         |       |                                  |       |                                  |       |   |   |   |   |
| Operating expenses:                                          |       |                                  |       |                                  |       |   |   |   |   |
| Research and development                                     |       | 2,135                                 |       | 2,226                                 |       | 6,823 |   | 6,629 |   |
| Selling and marketing                                        |       | 2,761                                 |       | 1,323                                 |       | 8,826 |   | 4,863 |   |
| General and administrative                                   |       | 2,639                                 |       | 1,858                                 |       | 8,219 |   | 5,873 |   |
| Amortization of intangible assets                            |       | 485                                   |       | —                                |       | 1,406 |   | — |   |
|                                                         |       |                                  |       |                                  |       |   |   |   |   |
| Total operating expenses                                     |       | 8,020                                 |       | 5,407                                 |       | 25,274 |   | 17,365 |   |
|                                                         |       |                                  |       |                                  |       |   |   |   |   |
| (Loss) income from operations                                |       | (370                                  | )          | (92                                   | )          | 1,015 |   | (726 | ) |
| Interest and other income, net                               |       | 110                                   |       | 524                                   |       | 376 |   | 1,433 |   |
|                                                         |       |                                  |       |                                  |       |   |   |   |   |
| (Loss) income before income  taxes                           |       | (260                                  | )          | 432                                   |       | 1,391 |   | 707 |   |
| Provision for income taxes                                   |       | 23                                    |       | 16                                    |       | 133 |   | 39 |   |
|                                                         |       |                                  |       |                                  |       |   |   |   |   |
| Net (loss) income                                            |       | $                                     | (283       | )                                     | $          | 416 |   | $ | 1,258 |   | $ | 668 |   |
|                                                         |       |                                  |       |                                  |       |   |   |   |   |
| Net (loss) income per share – basic and diluted         |       | $                                     | (0.01      | )                                     | $          | 0.01 |   | $ | 0.03 |   | $ | 0.02 |   |
|                                                         |       |                                  |       |                                  |       |   |   |   |   |
| Shares used in computing basic net (loss) income per share   |       | 44,090                                |       | 40,871                                |       | 43,918 |   | 40,517 |   |
| Shares used in computing diluted net (loss) income per share |       | 44,090                                |       | 41,270                                |       | 44,248 |   | 41,208 |   |

 

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

 

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**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(inthousands)**

**(unaudited)**

 
| ** **                                                                         | ** ** | **Nine months ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                         | ** ** | **2008**                             | ** ** | **2007** | ** ** |
| ** **                                                                         | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Cash flows from operating activities:                                              |       |                                 |       |   |   |
| Net income                                                                         |       | $                                    | 1,258      |   | $ | 668 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                                 |       |   |   |
| Depreciation and amortization                                                      |       | 2,489                                |       | 622 |   |
| Provision for doubtful accounts                                                    |       | 93                                   |       | 6 |   |
| Loss on disposal of long-lived assets                                              |       | 10                                   |       | 7 |   |
| Stock-based compensation                                                           |       | 1,510                                |       | 1,864 |   |
| Changes in operating assets and liabilities, net of effects of  acquisition:       |       |                                 |       |   |   |
| Accounts receivable                                                                |       | (290                                 | )          | 779 |   |
| Inventories                                                                        |       | 3,533                                |       | (3,714 | ) |
| Prepaid expenses and other current assets                                          |       | (355                                 | )          | 274 |   |
| Accounts payable                                                                   |       | (2,059                               | )          | 1,734 |   |
| Accrued expenses                                                                   |       | (3,638                               | )          | 953 |   |
| Deferred revenue                                                                   |       | (215                                 | )          | 2,869 |   |
|                                                                               |       |                                 |       |   |   |
| Net cash provided by operating activities                                          |       | 2,336                                |       | 6,062 |   |
|                                                                               |       |                                 |       |   |   |
| Cash flows from investing activities:                                              |       |                                 |       |   |   |
| Acquisition, net of cash assumed                                                   |       | (30,039                              | )          | — |   |
| Contingently returnable acquisition payment                                        |       | (4,022                               | )          | — |   |
| Payment for disposition of subsidiary                                              |       | (231                                 | )          | — |   |
| Purchases of property and equipment                                                |       | (337                                 | )          | (665 | ) |
| Purchases of short-term investments                                                |       | —                               |       | (17,500 | ) |
| Proceeds from sales and maturities of short-term investments                       |       | —                               |       | 16,902 |   |
| Changes in other assets                                                            |       | —                               |       | (82 | ) |
|                                                                               |       |                                 |       |   |   |
| Net cash used in investing activities                                              |       | (34,629                              | )          | (1,345 | ) |
|                                                                               |       |                                 |       |   |   |
| Cash flows from financing activities:                                              |       |                                 |       |   |   |
| Purchase of treasury stock                                                         |       | (172                                 | )          | — |   |
| Proceeds from issuance of common stock                                             |       | 319                                  |       | 1,979 |   |
| Payments on capital lease obligation                                               |       | (15                                  | )          | (14 | ) |
|                                                                               |       |                                 |       |   |   |
| Net cash provided by financing activities                                          |       | 132                                  |       | 1,965 |   |
|                                                                               |       |                                 |       |   |   |
| Effect of exchange rate differences on cash                                        |       | (29                                  | )          | — |   |
| Net (decrease) increase in cash and cash equivalents                               |       | (32,190                              | )          | 6,682 |   |
| Cash and cash equivalents, beginning of period                                     |       | 44,403                               |       | 8,014 |   |
|                                                                               |       |                                 |       |   |   |
| Cash and cash equivalents, end of period                                           |       | $                                    | 12,213     |   | $ | 14,696 |   |

 

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

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED 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 2007 AnnualReport on Form 10-K (the “2007 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. In February 2008,the FASB issued FASB Staff Position 157-1, “Application of FASB Statement No. 157to FASB Statement No. 13 and Other Accounting Pronouncements That AddressFair Value Measurements for Purposes of Lease Classification or Measurementunder Statement 13” (“FSP 157-1”).  FSP157-1 amends FAS 157 to remove certain leasing transactions from its scope.In February 2008, the FASB issuedFASB Staff Position 157-2, “Effective Date of FASB Statement No. 157” (“FSP157-2”).  FSP 157-2 defers the effectivedate of FAS 157 for certain non-financial assets and liabilities to the beginningof the Company’s fiscal year that begins after November 15, 2008.  FAS 157 is effective for financial assets andliabilities as of the beginning of the Company’s fiscal year that begins after November 15,2007.  The Company is in the process ofevaluating whether the adoption of FAS 157 will have a material impact on theCompany’s financial position, results of operations or cash flows.

 

InFebruary 2007, the FASB issued Statement of Financial Accounting Standard No. 159,“The Fair Value Option for Financial Assets and Financial Liabilities —Including an amendment of FASB Statement No. 115” (“FAS 159”).  Thisstatement permits entities to choose to measure many financial instruments and certainother items at fair value at specified election dates.  Subsequent unrealized gains and losses onitems for which the fair value option has been elected will be reported inearnings.  FAS 159 is effective as of thebeginning of the Company’s fiscal year that begins after November 15,2007.  The Company is in the process of evaluating whether the adoption ofFAS 159 will have a material impact on the Company’s financial position,results of operations or cash flows.

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

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 firstannual reporting period beginning on or after December 15, 2008.  The adoption of FAS 141R will not have amaterial impact on the Company’s financial position,results of operations 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 the fairvalue 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 ofevaluating whether the adoption of FSP 142-3 will have a material impact on theCompany’s financial position, results of operations or cash flows.

 

On October 1, 2007,the Company adopted FASB Interpretation No. 48, “Accounting forUncertainty in Income Taxes” (“FIN 48”). FIN 48 prescribes a recognition threshold that a tax position isrequired to meet before being recognized in the financial statements andprovides guidance on derecognition, measurement, classification, interest andpenalties, accounting in interim periods, disclosure and transition issues.

 

TheCompany has an unrecognized tax benefit of approximately $540,000 related tothe validity of certain credits.  Asdiscussed in Note 12 to the consolidated financial statements in the 2007 Form 10-K,the Company has a valuation allowance against the full amount of its netdeferred tax asset.  The Companycurrently provides a valuation allowance against deferred tax assets when it ismore likely than not that some portion, or all of its deferred tax assets, willnot be realized.  Because the Company hasa full valuation allowance against its deferred tax assets, the adoption of FIN48 had no impact on the Company’s retained earnings or reportedliabilities.  Because the Company hassignificant operating loss carryforwards to offset future taxable income, theCompany does not expect to utilize any of these credits in the near term, andas a result, the Company does not expect that the unrecognized tax benefit willchange significantly within the next twelve months.

 

TheCompany files its tax returns as prescribed by the tax laws of thejurisdictions in which it operates.  TheCompany’s tax years from 2001 to 2007 are still subject to examination.  Various state and foreign jurisdiction taxyears remain open to examination as well, though the Company believes anyadditional assessment will be immaterial to its consolidated financialstatements.

 

#### ***RevenueRecognition***

#### *** ***

Revenuesfrom productsare generally recognized upon delivery to customers if persuasiveevidence of an arrangement exists, the fee is fixed or determinable,collectibility is reasonably assured and title and risk of loss have passed tothe customer. In the event the Company has unfulfilled future obligations,revenue and related costs are deferred until those future obligations are met.The Company has an inventory consignment agreement with its largest customerrelated to certain server appliances. This customer notifies 

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

the Company when itutilizes inventory and the Company recognizes revenues from sales to this customerbased upon these notifications.

 

Maintenancerevenues are derived from customer support agreements generally entered into inconnection with the initial server appliance sales and subsequent renewals.Maintenance fees are typically for one to three year renewable periods andinclude the right to unspecified software updates when and if available forcertain agreements, hardware repairs, 24-hour customer support, and advancedreplacement of server appliances. Maintenance revenues are recognized ratably overthe term of the maintenance period. Payments for maintenance fees are generallymade in advance and are included in deferred revenue. The associatedmaintenance expenses are expensed in the same period as incurred.

 

Contractsand/or customer purchase orders are generally used to determine the existenceof an arrangement. Shipping documents and consignment usage notifications areused to verify shipment or transfer of ownership, as applicable. The Companyassesses whether the sales price is fixed or determinable based on the paymentterms associated with the transaction and whether the sales price is subject torefund or adjustment. The Company assesses collectibility based primarily onthe creditworthiness of the customer as determined by credit checks andanalysis, as well as the customer’s payment history.

 

Forrevenue arrangements that contain multiple elements, such as the sale of boththe product and post sales support and/or extended warranty and relatedservices element, in which software is not incidental to the product, theCompany determines fair value based upon vendor specific objective evidence,which is typically established through contractual post-sales support renewalrates whereby the residual fair value is allocated to the server appliance. Forrevenue arrangements that contain multiple elements, in which software is notincluded or is incidental to the product, the Company allocates revenue to theextended warranty and related services element based on separately pricedcontractual rates for those elements.

 

TheCompany recognizes revenue when the revenue recognition criteria for eachelement of the sale are met. If the Company is not able to derive the fairvalue of the undelivered element of the sale (i.e. maintenance), all revenuesfrom the arrangement are deferred and recognized ratably over the period of thesupport arrangement, which is typically one to three years. The Companyincludes shipping and handling costs, if any, reimbursed by its customers asnet revenues and cost of revenues.

 

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

#### *** ***

TheCompany did not hold any cash equivalents as of June 30, 2008.  As of September 30, 2007, cashequivalents consisted principally of money market funds and commercial paperpurchased with an original maturity of three months or less.  At June 30, 2008 and September 30,2007, $47,000 and $247,000, respectively, of cash was restricted and pledged ascollateral for letters of credit.  TheCompany did not hold any short-term investments as of June 30, 2008 or September 30,2007.  Details of the Company’s cash andcash equivalents are as follows (in thousands):

 

| ** **                          | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|-------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                          | ** ** | **2008**          | ** ** | **2007**               | ** ** |
| **Cash and cash equivalents:**      | ** ** | ** **        | ** ** | ** **             | ** ** |
| Cash                                |       | $                 | 12,213     |                   | $          | 3,836 |   |
| Money market funds                  |       | —            |       | 37,941                 |       |
| Commercial paper                    |       | —            |       | 2,626                  |       |
|                                |       |              |       |                   |       |
| **Total cash and cash equivalents** |       | $                 | 12,213     |                   | $          | 44,403 |   |

 

#### ***Comprehensive Income (Loss)***

#### *** ***

Duringeach period presented, comprehensive income (loss) was equal to net income(loss).

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

***Significant Customers***

 

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

 
| ** **     | ** ** | **Net Revenues**       | ** ** | ** **            | ** ** |
|----------------|------------|------------------------|------------|-----------------------|------------|
| ** **     | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** | **Accounts Receivable at** | ** ** |
| ** **     | ** ** | **June 30,**      | ** ** | **June 30,**     | ** ** | ** ** | ** ** | **September 30,** | ** ** |
| ** **     | ** ** | **2008**               | ** ** | **2007**              | ** ** | **2008** | ** ** | **2007** | ** ** | **June 30, 2008** | ** ** | **2007** | ** ** |
| Customer A     |       | 40                     | %          | 81                    | %          | 43 | % | 81 | % | 42 | % | 81 | % |
| Customer B (1) |       | 12                     | %          | —                |       | 12 | % | — |   | 14 | % | — |   |

 

----

(1) Customer Bbecame a customer as a result of the Company’s acquisition of Alliance Systems, Inc.on October 11, 2007 (see Note 3).

 

**3.Business Combination**

 

On October 11, 2007, inorder to increase the Company’s presence in the server appliance marketplace,the Company acquired all of the equity of Alliance Systems, Inc. (“AllianceSystems”), a privately held corporation located in Plano, Texas, which providesserver appliances and computer infrastructure supporting telecommunications andenterprise communications solutions.  Theaggregate purchase price of approximately $40,947,000 was funded through a cashpayment of $32,820,000 and the issuance of 2.9 million shares of the Company’scommon stock valued at approximately $5,994,000, which was based on the averagemarket price of the Company’s common stock over the period of two days beforeand after the terms of the acquisition were announced.  The Company also incurred acquisition-relatedfees and expenses of approximately $1,139,000, and approximately $994,000 ofcosts related to certain exit activities of the acquired business.  The Company’s cash payment included repaymentof Alliance Systems’ working capital line of credit of approximately$6,727,000, and $800,000 due under a note payable to Alliance Systems’ majoritystockholder.

 

The acquisition was structuredto include a downward adjustment to the purchase price based on the net workingcapital of Alliance Systems as of October 11, 2007, as defined in themerger agreement, and therefore approximately $4.0 million of the cash paid iscontingently returnable to the Company upon resolution of this provision.  As a result, the amount of contingentlyreturnable consideration has been excluded from the allocation of the purchaseprice to the net assets acquired until such time that this amount is no longercontingently returnable.

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

The components of thepurchase price allocation for Alliance Systems are as follows (in thousands):

 

| **Net assets acquired**          | ** ** | ** ** | ** ** |
|----------------------------------|------------|------------|------------|
| Cash                             |       | $          | 362        |   |
| Accounts receivable              |       | 13,619     |       |
| Income tax receivable            |       | 2,585      |       |
| Inventory                        |       | 12,799     |       |
| Prepaid and other current assets |       | 923        |       |
| Property, plant, and equipment   |       | 1,347      |       |
| Deferred tax asset               |       | 5,170      |       |
| Intangible asset                 |       | 11,775     |       |
| Goodwill                         |       | 8,676      |       |
| Other assets                     |       | 127        |       |
| Accounts payable                 |       | (7,836     | )          |
| Income tax payable               |       | (127       | )          |
| Deferred tax liability           |       | (5,170     | )          |
| Other accrued expenses           |       | (4,145     | )          |
| Deferred revenue                 |       | (3,180     | )          |
| ** **                       | ** ** | ** ** | ** ** |
| **Total net assets acquired**    |       | $          | 36,925     |   |

 

The acquired intangible asset is customerrelationships, which will be amortized over the period of economic benefitexpected to be received, resulting in a weighted average amortization period of4.97 years.  The transaction, which wasnontaxable to the Company, resulted in the Company recording deferred taxliabilities of $5,170,000 related to the differences between the financialstatement and the tax bases of the acquired assets and liabilities.  As a result of the recorded deferred taxliabilities, the Company determined it would more likely than not realize thetax benefits from certain of its historical deferred tax assets, and thereforereduced its valuation allowance accordingly. Substantially all of the goodwill recorded will not be deductible fortax purposes; however, fees and expenses incurred by the Company will result intax goodwill that will be deductible in the future.  Additionally, fees and expenses incurred byAlliance Systems that have not been included in the purchase price allocationmay be deductible in the future, in the event that the Company sells theAlliance Systems business.

 

During the three month period ended December 31,2007, the Company was in the process of executing certain restructuringactivities with respect to portions of the acquired business.  These activities, which were accounted for inaccordance with Emerging Issues Task Force (“EITF”) Issue No. 95-3, “Recognitionof Liabilities in Connection with a Purchase Business Combination” (“EITF 95-3”),primarily consisted of severance costs for reductions in staffing levels andthe disposition of Alliance Systems’ German subsidiary.  In connection with these exit activities theCompany recorded the estimated liabilities as part of the cost of theacquisition.  In accordance with EITF95-3, upon finalization of the exit plans or settlement of the estimatedobligations for less than the expected amount, any excess will result in acorresponding decrease in goodwill.

 

The changes in accrued exit activity expensesrelated to the acquisition of Alliance Systems are as follows (in thousands):

 

| ** **                            | ** ** | **Severance** | ** ** | **Disposition of   subsidiary** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|---------------|------------|---------------------------------|------------|-----------|------------|
| Accruals established upon acquisition |       | $             | 548        |                            | $          | 446       |       | $ | 994 |   |
| Payments                              |       | (392          | )          | (446                            | )          | (838      | )          |
| Balance at June 30, 2008         |       | $             | 156        |                            | $          | —    |       | $ | 156 |   |

 

TheCompany disposed of Alliance Systems’ German subsidiary on February 12,2008.

 

TheCompany has included as a component of the net assets acquired an estimatedliability for approximately $123,000 for uncertain tax positions, as determinedin accordance with FIN 48.  These 

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

uncertaintax positions related to state tax filing requirements.  This liability, which included an estimatefor interest and penalties, was based on the known facts at the time of thepurchase price allocation.

 

TheCompany’s condensed consolidated financial statements include Alliance Systems’operating results from the date of acquisition. The following unaudited pro forma information presents a summary ofconsolidated results of operations of the Company and Alliance Systems as ifthe acquisition had occurred at the beginning of each period presented, withpro forma adjustments to give effect to amortization of intangible assets, andcertain other adjustments together with related tax effects (in thousands,except per share amounts):

 
| ** **                                   | ** ** | **Three months ended   June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|----------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                                   | ** ** | **2008**                               | ** ** | **2007**                             | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net revenues                                 |       | $                                      | 47,046     |                                 | $          | 54,865 |   | $ | 158,847 |   | $ | 163,337 |   |
|                                         |       |                                   |       |                                 |       |   |   |   |   |
| (Loss) income from continuing operations (a) |       | $                                      | (662       | )                                    | $          | (180 | ) | $ | 1,490 |   | $ | (419 | ) |
|                                         |       |                                   |       |                                 |       |   |   |   |   |
| Net (loss) income                            |       | $                                      | (662       | )                                    | $          | 389 |   | $ | 1,490 |   | $ | 257 |   |
|                                         |       |                                   |       |                                 |       |   |   |   |   |
| Net (loss) income per share                  |       |                                   |       |                                 |       |   |   |   |   |
| Basic                                        |       | $                                      | (0.02      | )                                    | $          | 0.01 |   | $ | 0.03 |   | $ | 0.01 |   |
| Diluted                                      |       | $                                      | (0.02      | )                                    | $          | 0.01 |   | $ | 0.03 |   | $ | 0.01 |   |

 

----

(a) Includes$485,000 of amortization of intangible assets and $388,000 of additional costsrelated to the fair value adjustment of inventory in each of the three monthperiods ended June 30, 2008 and 2007, and includes $1,455,000 ofamortization of intangible assets and $388,000 of additional costs related tothe fair value adjustment of inventory in each of the nine month periods ended June 30,2008 and 2007.

 

**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 requisite serviceperiod (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,** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                             | ** ** | **2008**                              | ** ** | **2007**                             | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                   |       |                                  |       |                                 |       |   |   |   |   |
| Cost of revenues                       |       | $                                     | 41         |                                 | $          | 44 |   | $ | 141 |   | $ | 124 |   |
| Research and development               |       | 161                                   |       | 297                                  |       | 573 |   | 877 |   |
| Selling and marketing                  |       | 92                                    |       | 76                                   |       | 253 |   | 243 |   |
| General and administrative             |       | 173                                   |       | 187                                  |       | 543 |   | 620 |   |
| Total stock-based compensation expense |       | $                                     | 467        |                                 | $          | 604 |   | $ | 1,510 |   | $ | 1,864 |   |

 

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 months ended June 30, 2008 and 2007. Estimates of fair value are not intended to predict the value ultimatelyrealized by persons who receive 

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

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, 2008 and 2007, using the Black-Scholes valuationmodel, were:

 
| ** **                     | ** ** | **Three months ended June 30,** | ** ** | **Nine months ended June 30,** | ** ** |
|--------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                     | ** ** | **2008**                             | ** ** | **2007**                            | ** ** | **2008** | ** ** | **2007** | ** ** |
|                           |       |                                 |       |                                |       |   |   |   |   |
| Expected term (1)              |       | 6.06  to 6.25 years                  |       | 5.50  to 6.25 years                 |       | 5.50  to 6.25 years |   | 5.50  to 6.25 years |   |
| Expected volatility factor (2) |       | 56.69%  to 57.71%                    |       | 65.77%  to 72.67%                   |       | 54.89%  to 59.05% |   | 65.77%  to 72.67% |   |
| Risk-free interest rate (3)    |       | 3.51%                                |       | 4.44%  to 4.70%                     |       | 2.70%  to 4.13% |   | 4.44%  to 4.70% |   |
| Expected annual dividend yield |       | —                               |       | —                              |       | — |   | — |   |

 

----

| (1)    |   | The  expected term is estimated based on historical option activity.                                                                                                 |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                 |
| (2)    |   | The  expected volatility is estimated based on a weighted average of historical  volatility.                                                                         |
|   |   |                                                                                                                                                                 |
| (3)    |   | The  risk-free interest rate is 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-basedcompensation expense related to the Company’s Employee Stock Purchase Plan isdetermined based on the discount of 15% from the per share market price on theclose of the purchase period.

 

Asummary of the Company’s stock option activity for the nine months ended June 30,2008 is as follows:

 

| ** **                           | ** ** | **Nine months ended June 30, 2008** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|
| ** **                           | ** ** | **Number of  Options**                   | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average   Remaining  Contractual   Term (in  years)** | ** ** |
|                                 |       |                                     |       |   |   |   |   |
| Outstanding, September 30, 2007 |       | 6,091,355                                |       | $ | 2.51 |   |   |   |
| Granted                              |       | 2,589,000                                |       | 1.89 |   |   |   |
| Exercised                            |       | (9,500                                   | )          | 1.73 |   |   |   |
| Forfeited                            |       | (486,366                                 | )          | 2.05 |   |   |   |
| Expired                              |       | (127,386                                 | )          | 3.11 |   |   |   |
| Outstanding, June 30, 2008      |       | 8,057,103                                |       | $ | 2.33 |   | 7.29 |   |
| Exercisable at June 30, 2008    |       | 4,183,065                                |       | $ | 2.77 |   | 5.96 |   |

 

Allstock options granted during the nine months ended June 30, 2008 weregranted with exercise prices equal to the fair market value of the Company’scommon stock on the grant date and had a weighted average grant date fair valueof $1.12.

 

AtJune 30, 2008, unrecognized compensation expense related to non-vestedstock options was $2,865,000, which is expected to be recognized over aweighted average period of 2.65 years.

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

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

** **

Basic net income (loss) pershare is computed by dividing the net income (loss) for the period by theweighted average number of shares of common stock outstanding during theperiod.  Diluted net income (loss) pershare is computed by dividing the net income (loss) for the period by theweighted average number of shares of common stock and potential common stock,if dilutive, outstanding during the period. Potential common stock includes incremental shares of common stockissuable upon the exercise of stock options, calculated using the treasurystock method.

 

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

 
| ** **                                                                                                             | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                             | ** ** | **2008**                              | ** ** | **2007**                             | ** ** | **2008** | ** ** | **2007** | ** ** |
| Numerator:                                                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| Net (loss) income                                                                                                      |       | $                                     | (283       | )                                    | $          | 416 |   | $ | 1,258 |   | $ | 668 |   |
|                                                                                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Denominator:                                                                                                           |       |                                  |       |                                 |       |   |   |   |   |
| Shares used in computing basic net (loss)  income per share                                                            |       | 44,090                                |       | 40,871                               |       | 43,918 |   | 40,517 |   |
| Common stock equivalents from employee stock  options                                                                  |       | —                                |       | 399                                  |       | 330 |   | 691 |   |
|                                                                                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Shares used in computing diluted net (loss)  income per share                                                          |       | 44,090                                |       | 41,270                               |       | 44,248 |   | 41,208 |   |
|                                                                                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Net (loss) income per share:                                                                                           |       |                                  |       |                                 |       |   |   |   |   |
| Basic                                                                                                                  |       | $                                     | (0.01      | )                                    | $          | 0.01 |   | $ | 0.03 |   | $ | 0.02 |   |
| Diluted                                                                                                                |       | $                                     | (0.01      | )                                    | $          | 0.01 |   | $ | 0.03 |   | $ | 0.02 |   |
|                                                                                                                   |       |                                  |       |                                 |       |   |   |   |   |
| Anti-dilutive potential common stock  equivalents excluded  from the  calculation of net (loss) income per share: |       |                                  |       |                                 |       |   |   |   |   |
| Options to purchase common stock                                                                                       |       | 7,703                                 |       | 5,338                                |       | 7,107 |   | 3,898 |   |

 

**6. Goodwill andIntangible Assets**

 

The Company recorded goodwill and intangible assets as the result of itsacquisition of Alliance Systems.  The acquired intangible asset iscustomer relationships, which will be amortized over the period of economicbenefit expected to be received.  The following table presents the intangibleasset balances as of June 30, 2008 (in thousands):

 
| ** **             | ** ** | **Gross Carrying   Amount** | ** ** | **Accumulated   Amortization** | ** ** | **Net Book   Value** | ** ** |
|------------------------|------------|-----------------------------|------------|--------------------------------|------------|----------------------|------------|
| ** **             | ** ** | ** **                  | ** ** | ** **                     | ** ** | ** **           | ** ** |
| Customer relationships |       | $                           | 11,775     |                           | $          | 1,406                |       | $ | 10,369 |   |
|                        |            |                             |            |                                |            |                      |            |  |  |  |

 

The estimated futureamortization expense for the intangible asset as of June 30, 2008 byfiscal year is $485,000 for the remainder of 2008, $1,765,000 for 2009,$1,554,000 for 2010, $1,330,000 for 2011, $1,119,000 for 2012 and $4,125,000thereafter.

 

Goodwillrepresents the excess purchase price over the fair value of the net tangibleand intangible assets acquired.  TheCompany reviews long-lived assets, including definite-lived intangible assets,to determine if any adverse conditions exist that would indicateimpairment.  Goodwill is reviewed eachyear in the fourth quarter for impairment, or more frequently if certain indicatorsare present.  When conducting animpairment evaluation, the Company compares the carrying value of the reportingunit to the fair value 

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

of the reportingunit.  Management has determined that thereporting unit is the Company as a whole. If the carrying amount of the reporting unit exceeds its fair value,then the carrying value of that reporting unit’s goodwill is compared to theimplied fair value of the goodwill and an impairment loss is recorded in anamount equal to that excess, if any. Fair value is calculated using widely accepted valuation techniques,including the present value of estimated future cash flows using arisk-adjusted discount rate, and market multiple analyses.  These types of analyses include significantjudgments by management.

 

Conditionsthat could trigger a more frequent impairment assessment include, but are notlimited to, a significant adverse change in certain agreements, an economicdownturn in customers’ industries, increased competition, or other informationregarding the Company’s market value, such as a reduction in its stock price.

 

During the quarter ended June 30, 2008, certain conditions existedthat caused management to determine that a triggering event had occurredrequiring an assessment of goodwill for impairment.  These indicators included a decline in the price of the Company’scommon stock to a price that was below its carrying value for an extendedperiod of time during the quarter, and revenues for the quarter ended June 30,2008 that were lower than the Company’s expectations, resulting in a net lossfor the quarter ended June 30, 2008.

 

The Company’s assessment for impairment was conducted in accordance withFAS 142, which required the Company to determine the fair value of the Company as awhole since it is considered the reporting unit to which all goodwill isallocated.  The Company estimated thefair value of the reporting unit utilizing industry accepted valuation techniques that included the present valueof estimated future cash flows using a risk-adjusted discount rate, and amarket multiple approach, which considered the Company’s market capitalizationadjusted for a control premium.  Thesevaluation techniques include significant judgments by management, includingestimates and assumptions about the Company’s projected future operatingresults, discount rates, and long-term growth rates.  The Company’s forecasts of future revenuewere based on expected future growth from new as well as existing customers,and historical trends.  In addition, theCompany considered the expected gross margins attainable in the future and therequired level of operating expenses needed to conduct its business.

 

The Company’s impairment assessment resulted in theimplied fair value of the reporting unit exceeding the carrying value, andtherefore goodwill was not impaired as of June 30, 2008.  The Company’s estimates used in determining the fairvalue were based on available information at the time it performed theimpairment assessment and consequently modifications in the Company’s estimatesor assumptions could yield a different result.

 

Factors thatcould lead to an impairment of acquired customer relationships (recorded as aresult of the Alliance Systems acquisition) include a worsening in customerattrition rates compared to historical attrition rates, or lower than initiallyanticipated cash flows associated with customer relationships.  The Company assesses the recoverability oflong-lived assets based on the projected undiscounted future cash flows overthe asset’s remaining life.  The amountof impairment, if any, is measured based on the excess of the carrying valueover fair value.  Fair value is generallycalculated as the present value of estimated future cash flows using arisk-adjusted discount rate, which requires significant management judgmentwith respect to revenue and expense growth rates, and the selection and use ofan appropriate discount rate.

 

**7.  Inventories**

 

Inventories consistedof the following (in thousands):

 
| ** **      | ** ** | **June 30, 2008** | ** ** | **September 30, 2007** | ** ** |
|-----------------|------------|------------------------|------------|-----------------------------|------------|
| ** **      | ** ** | ** **             | ** ** | ** **                  | ** ** |
| Raw materials   |       | $                      | 12,358     |                        | $          | 5,764 |   |
| Work in process |       | 1,073                  |       | 445                         |       |
| Finished goods  |       | 5,973                  |       | 3,966                       |       |
|            |       |                   |       |                        |       |
| Total           |       | $                      | 19,404     |                        | $          | 10,175 |   |

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**8.  Equity**

 

On June 12, 2008, the Boardof Directors of the Company authorized the repurchase of up to $5 million ofits common stock through a share repurchase program.  As authorized by the program, shares may bepurchased in the open market or through privately negotiated transactions, in amanner consistent with applicable securities laws and regulations.  This stock repurchase program does notobligate the Company to acquire any specific number of shares, does not have anexpiration date, and may be terminated at any time by the Company’s Board ofDirectors.  All repurchases are expectedto be funded from the Company’s current cash balances or from cash generatedfrom operations.  To facilitate repurchases of shares under this program, the Companyestablished a Rule 10b5-1 plan intended to comply with the requirements ofRule 10b5-1 and Rule 10b-18 under the Securities Exchange Act of1934.  A Rule 10b5-1 plan permits the repurchase of shares by acompany at times when it otherwise might be prevented from doing so underinsider trading laws or because of company blackout periods, provided that theplan is adopted when the company is not aware of material non-publicinformation.  Pursuant to the plan, a broker designated by the Company hasthe authority to repurchase shares, in accordance with the terms of the plan,without further direction from the Company.  The amount and timing ofspecific repurchases are subject to the terms of the plan and marketconditions.  During the threemonths ended June 30, 2008, the Company repurchased 138,500 shares of itscommon stock at an average price of $1.25 per share.  As of June 30, 2008, the maximum dollarvalue that may yet be used for purchases under the program was $4,827,000.

 

**9.  Commitments and Contingencies**

 

***Guarantees and Indemnifications***

 

Acquisition-related indemnifications – When, as part of an acquisition,the Company acquires all the stock of a company, the Company assumesliabilities for certain events or circumstances that took place prior to thedate of acquisition.  The maximumpotential amount of future payments the Company could be required to make forsuch obligations is undeterminable.  Asof June 30, 2008, the Company has received one claim related to theAlliance Systems acquisition, for which the Company has paid a settlement of$88,000.  While the provisions of theagreements remain in effect indefinitely, the Company believes that the probabilityof receiving a claim related to acquisitions other than Alliance Systems isunlikely.  As a result, the Company hasnot recorded any other liabilities for such indemnification clauses as of June 30,2008.

 

The Company enters into standard indemnification agreements in theordinary course of its business. Pursuant to these agreements, the Company indemnifies, holds harmless,and agrees to reimburse the indemnified party for losses suffered or incurredby the indemnified party, generally its business partners or customers, inconnection with any patent, copyright, trademark, trade secret or otherintellectual property infringement claim by any third party with respect to itsproducts.  The term of theseindemnification agreements is generally perpetual.  The Company has never incurred costs todefend 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, 2008.

 

Product warranties – The Company offers and fulfills warranty services oncertain of its server appliances. 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 warranty obligationsupon the recognition of the related revenue. The following table presents changes in the Company’s product warrantyliability for the three and nine months ended June 30, 2008 and 2007 (inthousands):

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 
| ** **                                  | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|---------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                  | ** ** | **2008**                              | ** ** | **2007**                             | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                        |       |                                  |       |                                 |       |   |   |   |   |
| Beginning balance                           |       | $                                     | 968        |                                 | $          | 1,017 |   | $ | 1,046 |   | $ | 559 |   |
| Acquisitions                                |       | —                                |       | —                               |       | 70 |   | — |   |
| Accruals for warranties issued              |       | 564                                   |       | 766                                  |       | 1,561 |   | 1,684 |   |
| Fulfillment of warranties during the period |       | (563                                  | )          | (445                                 | )          | (1,708 | ) | (905 | ) |
| Ending balance                              |       | $                                     | 969        |                                 | $          | 1,338 |   | $ | 969 |   | $ | 1,338 |   |

 

***Contingencies***

 

*Initial Public Offering Lawsuit*

 

On or about December 3, 2001, a putativeclass action lawsuit was filed in the United States District Court for theSouthern District of New York against the Company, Lawrence A. Genovesi (theCompany’s former Chairman and Chief Executive Officer), Douglas G. Bryant (theCompany’s Chief Financial Officer), and several underwriters of the Company’sinitial public offering.  The suitalleges, *inter alia*, that the defendants violatedthe federal securities laws by issuing and selling securities pursuant to theCompany’s initial public offering in July 2000 (“IPO”) without disclosingto investors that the underwriter defendants had solicited and receivedexcessive and undisclosed commissions from certain investors.  The suit seeks damages and certification of aplaintiff class consisting of all persons who acquired shares of the Company’scommon stock between July 13, 2000 and December 6, 2000.

 

In October 2002, Lawrence A. Genovesi andDouglas G. Bryant were dismissed from this case without prejudice.  On December 5, 2006, the United StatesCourt of Appeals for the Second Circuit overturned the District Court’scertification of a plaintiff class.  On April 6,2007, the Second Circuit denied plaintiffs’ petition for rehearing, butclarified that the plaintiffs may seek to certify a more limited class in theDistrict Court.  On September 27,2007, plaintiffs filed a motion for class certification in certain designated “focuscases” in the District Court, and the motion is currently pending before theDistrict Court.  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 DistrictCourt issued an Opinion and Order denying, in large part, the motions todismiss the amended complaints in the “focus cases.”  The Company is unable to predict the outcome ofthis suit and as a result, no amounts have been accrued as of June 30,2008.

 

**10. Lineof Credit**

 

On October 11,2007, the Company entered into a Loan and Security Agreement with SiliconValley Bank (the “Bank”).  The term ofthis agreement was for one year, ending on October 9, 2008.  The Loan Agreement provided the Company witha $15 million revolving loan facility. The interest rate on this line was equal to one quarter of a point(.25%) below the current prime rate with interest payable monthly.

 

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.  As of June 30, 2008, the Company has notdrawn on this line of credit.

 

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**ITEM2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

 

**Special NoteRegarding Forward-Looking Statements**

** **

This Quarterly Report on Form 10-Qcontains forward-looking statements within the meaning of Section 21E ofthe Securities Exchange Act of 1934, as amended, that involve risks anduncertainties.  All statements other than statements ofhistorical information provided herein are forward-looking statements and maycontain projections related to financial results, economic conditions, trendsand known uncertainties.  Our actualresults could differ materially from those discussed in the forward-lookingstatements as a result of a number of factors, which include those discussed inthis section and in Part II, Item 1A, Risk Factors, of this report and therisks discussed in our other filings with the Securities and ExchangeCommission (the “SEC”).  Readers arecautioned not to place undue reliance on these forward-looking statements,which reflect management’s analysis, judgment, belief or expectation only as ofthe date hereof.  We undertake noobligation to publicly reissue these forward-looking statements to reflectevents or circumstances that arise after the date hereof.

 

The followingdiscussion and analysis should be read in conjunction with the condensedconsolidated financial statements and the notes thereto included in Item 1 inthis Quarterly Report on Form 10-Q and our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2007 filed by us with the SEC.

 

**Overview**

** **

We develop and manufacture server appliance solutions that deliversoftware applications on server appliances. Currently, a large portion of our revenues is derived from the sale ofserver appliances to customers in the data storage, network security,telecommunications and enterprise communications markets.  Server appliances are pre-configured networkinfrastructure devices designed to optimally deliver specific softwareapplication functionality while facilitating ease of deployment, improvedmanageability and increased security of that software application in a customer’snetwork.  A server appliance deploymentis intended to reduce the total cost of ownership associated with thedeployment and ongoing maintenance of software applications within a customer’sIT infrastructure

 

As mentioned previously in thenotes to our financial statements, we acquired Alliance Systems, Inc. (“AllianceSystems”) on October 11, 2007.  Withthis acquisition, many of our assets and liabilities increased between September 30,2007 and June 30, 2008.

 

**Critical Accounting Policies and Estimates**

 

Our discussion and analysis of financial condition and results ofoperations are based upon our condensed consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. In preparing these financial statements, we have made estimates andjudgments in determining certain amounts included in the financialstatements.  We base our estimates andjudgments on historical experience and other assumptions that we believe to bereasonable under the circumstances. Actual results may differ from these estimates under differentassumptions or conditions.  Other thanadding our goodwill and long-lived assets policy, there were no other changesto our critical accounting policies since September 30, 2007.

 

*Revenue Recognition*

 

Revenuesfrom productsare generally recognized upon delivery to customers if persuasiveevidence of an arrangement exists, the fee is fixed or determinable,collectibility is reasonably assured and title and risk of loss have passed tothe customer. In the event we have unfulfilled future obligations, revenue andrelated costs are deferred until those future obligations are met. We have aninventory consignment agreement with our largest customer related to certainserver appliances. This customer notifies us when it utilizes inventory and werecognize revenues from sales to this customer based upon these notifications.

 

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Maintenance revenues are derived from customersupport agreements generally entered into in connection with the initial serverappliance sales and subsequent renewals. Maintenance fees are typically for oneto three year renewable periods and include the right to unspecified softwareupdates when and if available for certain agreements, hardware repairs, 24-hourcustomer support, and advanced replacement of server appliances. Maintenancerevenues are recognized ratably over the term of the maintenance period.Payments for maintenance fees are generally made in advance and are included indeferred revenue. The associated maintenance expenses are expensed in the sameperiod as incurred.

 

Contracts and/or customer purchase orders aregenerally used to determine the existence of an arrangement. Shipping documentsand consignment usage notifications are used to verify shipment or transfer ofownership, as applicable.  We assesswhether the sales price is fixed or determinable based on the payment termsassociated with the transaction and whether the sales price is subject to refundor adjustment.  We assess collectibilitybased primarily on the creditworthiness of the customer as determined by creditchecks and analysis, as well as the customer’s payment history.

 

For revenue arrangements that contain multipleelements, such as the sale of both the product and post sales support and/orextended warranty and related services element, in which software is notincidental to the product, we determine fair value based upon vendor specificobjective evidence, which is typically established through contractualpost-sales support renewal rates whereby the residual fair value is allocatedto the server appliance. For revenue arrangements that contain multipleelements, in which software is not included or is incidental to the product, weallocate revenue to the extended warranty and related services element based onseparately priced contractual rates for those elements.

 

We recognize revenue when the revenue recognitioncriteria for each element of the sale are met. If we are not able to derive thefair value of the undelivered element of the sale (i.e. maintenance), allrevenues from the arrangement are deferred and recognized ratably over theperiod of the support arrangement, which is typically one to three years.  We include shipping and handling costs, ifany, reimbursed by our customers as net revenues and cost of revenues.

 

*Goodwill and Other Intangible Assets*

 

Goodwillrepresents the excess purchase price over the fair value of the net tangibleand intangible assets acquired.  Wereview long-lived assets, including definite-lived intangible assets, todetermine if any adverse conditions exist that would indicate impairment.  Goodwill is reviewed each year in the fourthquarter for impairment, or more frequently if certain indicators arepresent.  When conducting our impairmentevaluation, we compare the carrying value of the reporting unit to the fairvalue of the reporting unit.  We havedetermined that the reporting unit is the Company as a whole.  If the carrying amount of the reporting unitexceeds its fair value, then the carrying value of that reporting unit’sgoodwill is compared to the implied fair value of the goodwill and animpairment loss is recorded in an amount equal to that excess, if any.  Fair value is calculated using widelyaccepted valuation techniques, including the present value of estimated futurecash flows using a risk-adjusted discount rate, and market multipleanalyses.  These types of analysesinclude significant judgments by management.

 

Conditionsthat could trigger a more frequent impairment assessment include, but are notlimited to, a significant adverse change in certain agreements, an economicdownturn in our customers’ industries, increased competition, or otherinformation regarding our market value, such as a reduction in our stock price.

 

During the quarter ended June 30, 2008, certain conditions existedthat caused management to determine that a triggering event had occurredrequiring an assessment of goodwill for impairment.  These indicators included a decline in the price of our common stock toa price that was below our carrying value for an extended period of time duringthe quarter, and revenues for the quarter ended June 30, 2008 that werelower than our expectations, resulting in a net loss for the quarter ended June 30,2008.

 

Our assessment for impairment was conducted in accordance with Statementof Financial Accounting Standard No. 142, “Goodwill and Other IntangibleAssets” (“FAS 142”), which required us to determine the fair value of the Company as awhole since it is considered the reporting unit to which all goodwill isallocated.  We estimated the fair valueof the reporting unit utilizing industryaccepted valuation 

 

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techniquesthat included the present value of estimated future cash flows using arisk-adjusted discount rate, and a market multiple approach, which consideredour market capitalization adjusted for a control premium.  These valuation techniques includesignificant judgments by management, including estimates and assumptions aboutour projected future operating results, discount rates, and long-term growthrates.  Our forecasts of future revenuewere based on expected future growth from new as well as existing customers,and historical trends.  In addition, weconsidered the expected gross margins attainable in the future and the requiredlevel of operating expenses needed to conduct our business.

 

Our impairment assessment resulted in the impliedfair value of the reporting unit exceeding the carrying value, and thereforegoodwill was not impaired as of June 30, 2008.  Our estimates used in determining the fair value were based onavailable information at the time we performed the impairment assessment andconsequently modifications in our estimates or assumptions could yield adifferent result.

 

Factorsthat could lead to an impairment of acquired customer relationships (recordedas a result of the Alliance Systems acquisition) include a worsening incustomer attrition rates compared to historical attrition rates, or lower thaninitially anticipated cash flows associated with customer relationships.  We assess the recoverability of long-livedassets based on the projected undiscounted future cash flows over the asset’sremaining life.  The amount ofimpairment, if any, is measured based on the excess of the carrying value overfair value.  Fair value is generallycalculated as the present value of estimated future cash flows using arisk-adjusted discount rate, which requires significant management judgmentwith respect to revenue and expense growth rates, and the selection and use ofan appropriate discount rate.

 

**Results of Operations**

 

**Three months ended June 30, 2008 compared to the three months endedJune 30, 2007**

 

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

 
| ** **           | ** ** | **Three Months Ended June 30,** | ** **   |
|----------------------|------------|--------------------------------------|--------------|
| ** **           | ** ** | **2008**                             | ** **   | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **           | ** ** | **Dollars**                          | ** **   | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues         |       | $                                    |  47,046 |   | 100.0 | % | $ |  27,998 |   | 100.0 | % | $ |  19,048 |   | 68.0 | % |
| Gross profit         |       | 7,650                                |         | 16.3 | % | 5,315 |   | 19.0 | % | 2,335 |   | 43.9 | % |
| Operating expenses   |       | 8,020                                |         | 17.1 | % | 5,407 |   | 19.3 | % | 2,613 |   | 48.3 | % |
| Loss from operations |       | (370                                 | )            | (0.8 | )% | (92 | ) | (0.3 | )% | (278 | ) | 302.2 | % |
| Net (loss) income    |       | $                                    |  (283   | ) | (0.6 | )% | $ |  416 |   | 1.5 | % | $ |  (699 | ) | — |   |

 

***Net Revenues***

 

Our revenues are derived primarily from sales ofserver appliances and related maintenance services.

 

Our net revenues increased for the three months ended June 30,2008, as compared to the three months ended June 30, 2007, primarily dueto the acquisition of Alliance Systems on October 11, 2007.  If the acquisition had occurred at thebeginning of fiscal year 2007, net revenues would have decreased byapproximately $7.8 million, when comparing the pro forma net revenues for thethree months ended June 30, 2007 to our actual results for the threemonths ended June 30, 2008.  The proforma decrease would have been attributable primarily to lower sales volumes.

 

***Gross Profit***

 

Gross profit represents net revenues recognized less the cost ofrevenues.  Cost of revenues includes costof materials, warranty costs, inventory write-downs, shipping and handlingcosts, customer support costs and manufacturing costs.  Manufacturing costs are primarily comprisedof compensation, contract labor costs and, when applicable, contract manufacturingcosts.

 

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Gross profit as a percentage of net revenue decreased for the threemonths ended June 30, 2008, as compared to the three months ended June 30,2007.  The decrease from the prior yearwas primarily due to lower gross margins associated with the Alliance Systemsbusiness and customer and product mix, partially offset by the impact in thecurrent year of the cost recovery of previously written-down inventory.

 

Gross profit is affected by customer and product mix, component materialcosts, pricing and the volume of orders as well as by the mix of productmanufactured internally compared to product manufactured by a contractmanufacturer, which results in higher manufacturing costs.  We expect that gross profit as a percentageof net revenue for the three months ending September 30, 2008 willdecrease as compared to the three months ended June 30, 2008.

 

***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,** | ** **  |
|-----------------------------------|------------|--------------------------------------|-------------|
| ** **                        | ** ** | **2008**                             | ** **  | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                          | ** **  | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating expenses:               |       |                                 |        |   |   |   |   |   |   |   |   |   |   |
| Research and development          |       | $                                    |  2,135 |   | 4.6 | % | $ |  2,226 |   | 8.0 | % | $ |  (91 | ) | (4.1 | )% |
| Selling and marketing             |       | 2,761                                |        | 5.9 | % | 1,323 |   | 4.7 | % | 1,438 |   | 108.7 | % |
| General and administrative        |       | 2,639                                |        | 5.6 | % | 1,858 |   | 6.6 | % | 781 |   | 42.0 | % |
| Amortization of intangible assets |       | 485                                  |        | 1.0 | % | — |   | — |   | 485 |   | — |   |
|                              |       |                                 |        |   |   |   |   |   |   |   |   |   |   |
| Total operating expenses          |       | $                                    |  8,020 |   | 17.1 | % | $ |  5,407 |   | 19.3 | % | $ |  2,613 |   | 48.3 | % |

 

***Research and Development***

 

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

 
| ** **                           | ** ** | **Three Months Ended June 30,** | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|
| ** **                           | ** ** | **2008**                             | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                          | ** ** | **% of   Expense  Category** | ** ** | **Dollars** | ** ** | **% of   Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and development:            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                    | 1,369      |   | 64.1 | % | $ | 1,382 |   | 62.1 | % | $ | (13 | ) | (0.9 | )% |
| Stock-based compensation             |       | 161                                  |       | 7.5 | % | 296 |   | 13.3 | % | (135 | ) | (45.6 | )% |
| Prototype                            |       | 247                                  |       | 11.6 | % | 141 |   | 6.3 | % | 106 |   | 75.2 | % |
| Consulting and professional services |       | 189                                  |       | 8.9 | % | 271 |   | 12.2 | % | (82 | ) | (30.3 | )% |
| Other                                |       | 169                                  |       | 7.9 | % | 136 |   | 6.1 | % | 33 |   | 24.3 | % |
|                                 |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total research and development       |       | $                                    | 2,135      |   | 100 | % | $ | 2,226 |   | 100 | % | $ | (91 | ) | (4.1 | )% |

 

Research and development expenses decreased in thethree months ended June 30, 2008, as compared to the three months ended June 30,2007, primarily due to decreases in stock-based compensation and prototypeexpenses, partially offset by increases related to the acquisition of AllianceSystems.  Because our research anddevelopment expenses are project driven, the timing of these expenditures canvary.  If the acquisition had occurred atthe beginning of fiscal year 2007, research and development 

 

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expenses would have decreased by approximately$656,000, when comparing the pro forma research and development expenses forthe three months ended June 30, 2007 to our actual results for the threemonths ended June 30, 2008.  On apro forma basis, there would have been decreases in compensation, primarily dueto lower headcount, stock-based compensation, and consulting costs.

 

Our server appliance development strategy emphasizesthe utilization of standard server appliance platforms, which utilizeoff-the-shelf components.  However, weexpect that in some cases, significant development efforts will be required tofulfill our current and potential customers’ needs using customizedplatforms.  In addition, we intend tofocus our software development in areas that improve the ease of serverappliance implementation and use, which we believe will enhance our valueproposition.  We expect that prototypeand consulting costs will be variable and could fluctuate depending on thetiming and magnitude of our development projects.  However, we expect our research anddevelopment costs to decrease during the three months ending September 30,2008, as compared to the three months ended June 30, 2008.

 

***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, product literature costs, web siteenhancements, product evaluation costs, and travel.  The following table summarizes the mostsignificant components of selling and marketing expense for the periods indicated,in thousands and as a percentage of total selling and marketing expense, andprovides the changes in thousands and percentages:

 
| ** **                        | ** ** | **Three Months Ended June 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|
| ** **                        | ** ** | **2008**                             | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                          | ** ** | **% of   Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                    | 1,899      |   | 68.8 | % | $ | 906 |   | 68.5 | % | $ | 993 |   | 109.6 | % |
| Stock-based compensation          |       | 92                                   |       | 3.3 | % | 76 |   | 5.7 | % | 16 |   | 21.1 | % |
| Marketing programs                |       | 311                                  |       | 11.3 | % | 109 |   | 8.2 | % | 202 |   | 185.3 | % |
| Travel                            |       | 169                                  |       | 6.1 | % | 103 |   | 7.8 | % | 66 |   | 64.1 | % |
| Other                             |       | 290                                  |       | 10.5 | % | 129 |   | 9.8 | % | 161 |   | 124.8 | % |
|                              |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and marketing       |       | $                                    | 2,761      |   | 100 | % | $ | 1,323 |   | 100 | % | $ | 1,438 |   | 108.7 | % |

 

Selling and marketingexpenses increased in the three months ended June 30, 2008, as compared tothe three months ended June 30, 2007, primarily due to the acquisition ofAlliance Systems.  Selling and marketingheadcount increased from 24 as of June 30, 2007, to 56 as of June 30,2008.  If the acquisition had occurred atthe beginning of fiscal year 2007, selling and marketing expenses would havedecreased by approximately $394,000, when comparing the pro forma selling andmarketing expenses for the three months ended June 30, 2007 to our actualresults for the three months ended June 30, 2008.  On a pro forma basis, there would have beenlower compensation and related expenses, because Alliance Systems had decreasedits selling and marketing headcount. There also would have been an increase in marketing program costs, primarilydue to attendance at more trade shows.

 

We believe that we must target our selling andmarketing efforts on network equipment providers, independent software vendors(“ISVs”) and telecom equipment manufacturers in order to enhance our positionas a leading provider of server appliance products.  We expect selling and marketing expenses todecrease during the three months ending September 30, 2008, as compared tothe three months ended June 30, 2008.

 

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***General and Administrative***

** **

General and administrative expenses consist primarily of salaries andother related costs for executive, finance, information technology and humanresources personnel; professional services, which include legal, accounting,audit and tax fees; and director and officer insurance.  The following table summarizes the mostsignificant components of general and administrative expense for the 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,** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **2008**                        | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                     | ** ** | **% of   Expense  Category** | ** ** | **Dollars** | ** ** | **% of   Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and administrative:          |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                               | 1,313      |   | 49.8 | % | $ | 903 |   | 48.6 | % | $ | 410 |   | 45.4 | % |
| Stock-based compensation             |       | 173                             |       | 6.6 | % | 187 |   | 10.0 | % | (14 | ) | (7.5 | )% |
| Consulting and professional services |       | 754                             |       | 28.5 | % | 511 |   | 27.5 | % | 243 |   | 47.6 | % |
| Director and officer insurance       |       | 66                              |       | 2.5 | % | 83 |   | 4.5 | % | (17 | ) | (20.5 | )% |
| Other                                |       | 333                             |       | 12.6 | % | 174 |   | 9.4 | % | 159 |   | 91.4 | % |
|                                 |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Total general and administrative     |       | $                               | 2,639      |   | 100 | % | $ | 1,858 |   | 100 | % | $ | 781 |   | 42.0 | % |

 

General and administrative expenses increased in the three months endedJune 30, 2008, as compared to the three months ended June 30, 2007, primarilydue to the acquisition of Alliance Systems. General and administrative headcount increased from 27 as of June 30,2007, to 41 as of June 30, 2008.  If theacquisition had occurred at the beginning of fiscal year 2007, general andadministrative expenses would have decreased by approximately $578,000, whencomparing the pro forma general and administrative expenses for the threemonths ended June 30, 2007 to our actual results for the three months endedJune 30, 2008.  The pro forma decreasewould have been attributable to decreases in compensation and stock-basedcompensation expenses and other expenses, offset by an increase in consultingand professional services.  The pro formadecrease in compensation and related expenses would have been primarily due tolower headcount during the current year period as compared to the same periodin the prior year.  The pro formaincrease in consulting and professional services is primarily related toadditional costs associated with our integration of Alliance Systems.

 

We expect general and administrative expenses to decrease during thethree months ending September 30, 2008, as compared to the three months endedJune 30, 2008.

 

***Amortization of Intangible Assets***

*** ***

The amortization of intangible assets increased by $485,000 for thethree months ended June 30, 2008, as compared to the three months ended June 30,2007.  The increase was due to theamortization of intangible assets related to the acquisition of AllianceSystems, which occurred on October 11, 2007.

 

***Interestand Other Income, net***

*** ***

Interestand other income, net, decreased to $110,000 for the three months ended June30, 2008 from $524,000 for the three months ended June 30, 2007.  This decrease was primarily due to lowerinterest income, attributable to lower cash and short-term investment balancesheld by us during the three months ended June 30, 2008, as compared to thethree months ended June 30, 2007.

 

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**Nine months ended June 30, 2008 compared tothe nine months ended June 30, 2007**

** **

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

 
| ** **                    | ** ** | **Nine Months Ended June 30,** | ** ** |
|-------------------------------|------------|--------------------------------|------------|
| ** **                    | ** ** | **2008**                       | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                    | ** ** | **Dollars**                    | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues                  |       | $                              | 156,560    |   | 100.0 | % | $ | 84,541 |   | 100.0 | % | $ | 72,019 |   | 85.2 | % |
| Gross profit                  |       | 26,289                         |       | 16.8 | % | 16,639 |   | 19.7 | % | 9,650 |   | 58.0 | % |
| Operating expenses            |       | 25,274                         |       | 16.1 | % | 17,365 |   | 20.5 | % | 7,909 |   | 45.5 | % |
| Income (loss) from operations |       | 1,015                          |       | 0.7 | % | (726 | ) | (0.8 | )% | 1,741 |   | — |   |
| Net income                    |       | $                              | 1,258      |   | 0.8 | % | $ | 668 |   | 0.8 | % | $ | 590 |   | 88.3 | % |

 

***Net Revenues***

*** ***

Our net revenues increased for the nine months ended June 30, 2008, ascompared to the nine months ended June 30, 2007, primarily due to theacquisition of Alliance Systems on October 11, 2007.  If the acquisition had occurred at thebeginning of fiscal year 2007, net revenues would have decreased byapproximately $4.5 million, when comparing the pro forma net revenues for thenine month periods ended June 30, 2008 and 2007.  The pro forma decrease would have beenattributable primarily to lower sales volumes.

 

***Gross Profit***

 

Gross profit as a percentage of net revenuedecreased for the nine months ended June 30, 2008, as compared to the ninemonths ended June 30, 2007.  The decreasefrom the prior year was primarily due to higher inventory write-downs, adecrease in average selling prices based on the customer and product mixcombined with consistent manufacturing costs, and lower gross marginsassociated with the Alliance Systems business. In addition, gross profit in the prior year included the cost recoveryof previously written-down inventory.

 

***Operating Expenses***** **

 

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

 
| ** **                        | ** ** | **Nine Months Ended June 30,** | ** ** |
|-----------------------------------|------------|--------------------------------|------------|
| ** **                        | ** ** | **2008**                       | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                    | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| **Operating Expenses:**           |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Research and development          |       | $                              | 6,823      |   | 4.4 | % | $ | 6,629 |   | 7.8 | % | $ | 194 |   | 2.9 | % |
| Selling and marketing             |       | 8,826                          |       | 5.6 | % | 4,863 |   | 5.8 | % | 3,963 |   | 81.5 | % |
| General and administrative        |       | 8,219                          |       | 5.2 | % | 5,873 |   | 6.9 | % | 2,346 |   | 39.9 | % |
| Amortization of intangible assets |       | 1,406                          |       | 0.9 | % | — |   | — |   | 1,406 |   | — |   |
|                              |       |                           |       |   |   |   |   |   |   |   |   |   |   |
| Total operating expenses          |       | $                              | 25,274     |   | 16.1 | % | $ | 17,365 |   | 20.5 | % | $ | 7,909 |   | 45.5 | % |

*** ***

***Research andDevelopment***

** **

The following table summarizes the most significant components ofresearch and development expense for the periods indicated, in thousands and asa percentage of total research and development expense, and provides thechanges in thousands and percentages: 

 

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| ** **                           | ** ** | **Nine Months Ended June 30,** | ** ** |
|--------------------------------------|------------|--------------------------------|------------|
| ** **                           | ** ** | **2008**                       | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                    | ** ** | **% of   Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and development:            |       |                           |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                              | 4,397      |   | 64.4 | % | $ | 3,989 |   | 60.2 | % | $ | 408 |   | 10.2 | % |
| Stock-based compensation             |       | 573                            |       | 8.4 | % | 877 |   | 13.2 | % | (304 | ) | (34.7 | )% |
| Prototype                            |       | 596                            |       | 8.7 | % | 551 |   | 8.3 | % | 45 |   | 8.2 | % |
| Consulting and professional services |       | 648                            |       | 9.5 | % | 670 |   | 10.1 | % | (22 | ) | (3.3 | )% |
| Other                                |       | 609                            |       | 9.0 | % | 542 |   | 8.2 | % | 67 |   | 12.4 | % |
|                                 |       |                           |       |   |   |   |   |   |   |   |   |   |   |
| Total research and development       |       | $                              | 6,823      |   | 100 | % | $ | 6,629 |   | 100 | % | $ | 194 |   | 2.9 | % |

 

Research and development expenses increased in the nine months endedJune 30, 2008, as compared to the nine months ended June 30, 2007, primarilydue to the acquisition of Alliance Systems. If the acquisition had occurred at the beginning of fiscal year 2007,research and development expenses would have decreased by approximately$1,165,000, when comparing the pro forma research and development expenses forthe nine month periods ended June 30, 2008 and 2007.  Because our research and development expensesare project driven, the timing of these expenditures can vary.  On a pro forma basis, there would have beendecreases in compensation and stock-based compensation as a result of lowerheadcount and the scheduled vesting of stock options, and a decrease inprototype expenses based on the timing of projects being worked on.

 

***Selling and Marketing***

** **

The following table summarizes the most significant components ofselling and marketing expense for the periods indicated, in thousands and as apercentage of total selling and marketing expense, and provides the changes inthousands and percentages:

 
| ** **                        | ** ** | **Nine Months Ended June 30,** | ** ** |
|-----------------------------------|------------|--------------------------------|------------|
| ** **                        | ** ** | **2008**                       | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                    | ** ** | **% of Expense Category** | ** ** | **Dollars** | ** ** | **% of Expense Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:            |       |                           |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                              | 6,344      |   | 71.9 | % | $ | 3,313 |   | 68.1 | % | $ | 3,031 |   | 91.5 | % |
| Stock-based compensation          |       | 253                            |       | 2.8 | % | 243 |   | 5.0 | % | 10 |   | 4.1 | % |
| Marketing programs                |       | 638                            |       | 7.2 | % | 504 |   | 10.4 | % | 134 |   | 26.6 | % |
| Travel                            |       | 575                            |       | 6.5 | % | 360 |   | 7.4 | % | 215 |   | 59.7 | % |
| Other                             |       | 1,016                          |       | 11.6 | % | 443 |   | 9.1 | % | 573 |   | 129.3 | % |
|                              |       |                           |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and marketing       |       | $                              | 8,826      |   | 100 | % | $ | 4,863 |   | 100 | % | $ | 3,963 |   | 81.5 | % |

 

Selling and marketing expenses increased in the nine months ended June30, 2008, as compared to the nine months ended June 30, 2007, primarily due tothe acquisition of Alliance Systems. Selling and marketing headcount increased from 24 as of June 30, 2007,to 56 as of June 30, 2008.  If theacquisition had occurred at the beginning of fiscal year 2007, selling andmarketing expenses would have decreased by approximately $1,349,000, whencomparing the pro forma selling and marketing expenses for the nine monthperiods ended June 30, 2008 and 2007.  Ona pro forma basis, there would have been lower compensation and related expenses,attributable to the fact that Alliance Systems had decreased its selling andmarketing headcount.  There also wouldhave been decreases in travel and other expenses, as well as an increase inmarketing program costs, primarily due to attendance at more trade shows.

 

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***General and Administrative***

 

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

 
| ** **                           | ** ** | **Nine Months Ended June 30,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                           | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                        | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and administrative:          |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                  | 4,137      |   | 50.3 | % | $ | 2,634 |   | 44.8 | % | $ | 1,503 |   | 57.1 | % |
| Stock-based compensation             |       | 543                                                |       | 6.6 | % | 620 |   | 10.6 | % | (77 | ) | (12.4 | )% |
| Consulting and professional services |       | 2,309                                              |       | 28.1 | % | 1,873 |   | 31.9 | % | 436 |   | 23.3 | % |
| Director and officer insurance       |       | 200                                                |       | 2.5 | % | 248 |   | 4.2 | % | (48 | ) | (19.4 | )% |
| Travel                               |       | 173                                                |       | 2.1 | % | 65 |   | 1.1 | % | 108 |   | 166.2 | % |
| Other                                |       | 857                                                |       | 10.4 | % | 433 |   | 7.4 | % | 424 |   | 97.9 | % |
|                                 |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total general and administrative     |       | $                                                  | 8,219      |   | 100 | % | $ | 5,873 |   | 100 | % | $ | 2,346 |   | 39.9 | % |

 

General and administrative expenses increased in thenine months ended June 30, 2008, as compared to the nine months ended June 30,2007, primarily due to the acquisition of Alliance Systems.  General and administrative headcountincreased from 27 as of June 30, 2007, to 41 as of June 30,2008.  If the acquisition had occurred atthe beginning of fiscal year 2007, general and administrative expenses wouldhave decreased by approximately $1,416,000, when comparing the pro formageneral and administrative expenses for the nine month periods ended June 30,2008 and 2007.  The pro forma decreasewould have been attributable to decreases in compensation and related expensesand in other costs.  The pro formadecrease in compensation and related expenses would have been primarily due tolower headcount within the administrative departments as well as lower bonusexpense during the current year period as compared to the same period in theprior year.

 

***Amortization ofIntangible Assets***

 

The amortization of intangible assets increased by$1,406,000 for the nine months ended June 30, 2008, as compared to thenine months ended June 30, 2007. The increase was due to the amortization of intangible assets related tothe acquisition of Alliance Systems, which occurred on October 11, 2007.

 

***Interest andOther Income, net***

 

Interest and other income, net, decreased to $376,000for the nine months ended June 30, 2008 from $1,433,000 for the ninemonths ended June 30, 2007.  Thisdecrease was primarily due to lower interest income, attributable to lower cashand short-term investment balances held by us during the nine months ended June 30,2008, as compared to the nine months ended June 30, 2007.

 

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**Liquidity and Capital Resources**

 

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

 
| ** **                                       | ** ** | **Nine Months Ended June 30,** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                       | ** ** | **2008**                                           | ** ** | **2007** | ** ** |
|                                             |       |                                               |       |   |   |
| Net income                                       |       | $                                                  | 1,258      |   | $ | 668 |   |
| Non-cash adjustments to net income               |       | 4,102                                              |       | 2,499 |   |
| Changes in working capital                       |       | (3,024                                             | )          | 2,895 |   |
|                                             |       |                                               |       |   |   |
| Cash provided by operating activities            |       | 2,336                                              |       | 6,062 |   |
|                                             |       |                                               |       |   |   |
| Cash used in investing activities                |       | (34,629                                            | )          | (1,345 | ) |
| Cash provided by financing activities            |       | 132                                                |       | 1,965 |   |
| Effect of exchange rate differences on cash      |       | (29                                                | )          | — |   |
|                                             |       |                                               |       |   |   |
| (Decrease) increase in cash and cash equivalents |       | (32,190                                            | )          | 6,682 |   |
| Beginning cash and cash equivalents              |       | 44,403                                             |       | 8,014 |   |
|                                             |       |                                               |       |   |   |
| Ending cash and cash equivalents                 |       | $                                                  | 12,213     |   | $ | 14,696 |   |

 

***OperatingActivities***

 

Cash provided by operating activities during the ninemonths ended June 30, 2008 was primarily the result of net income and theimpact of non-cash adjustments to net income, partially offset by a net use ofcash from changes in working capital. The changes in working capital primarily related to the use of cash tosettle accounts payable and accrued expenses, partially offset by the impact ofcash provided by decreases in inventories. Changes in working capital for the nine months ended June 30, 2007included an increase in deferred revenue of $2.9 million, primarily related tothe transfer of support obligations of the previously installed Whaleappliances from Microsoft.

 

***InvestingActivities***

 

Cash used in investing activities during the ninemonths ended June 30, 2008 primarily related to the use of approximately$34 million of cash for the acquisition of Alliance Systems.

 

***FinancingActivities***

 

Cash provided by financing activities during the ninemonths ended June 30, 2008 consisted primarily of $319,000 received as theresult of employee stock option exercises and purchases under the EmployeeStock Purchase Plan, partially offset by the use of $172,000 to repurchaseshares of our common stock.  We expectstock option exercise activity to continue for the remainder of fiscal year2008; however, we cannot predict the magnitude of the cash inflows, given thevolatility of capital markets.

 

On June 12, 2008, our Board of Directorsauthorized the repurchase of up to $5 million of our common stock through ashare repurchase program.  As authorizedby the program, shares may be purchased in the open market or through privatelynegotiated transactions, in a manner consistent with applicable securities lawsand regulations.  This stock repurchaseprogram does not obligate us to acquire any specific number of shares and maybe terminated at any time.  Allrepurchases are expected to be funded from our current cash balances or fromcash generated from operations.  Tofacilitate repurchases of shares under this program, we established a Rule 10b5-1plan 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  insidertrading laws or because of company blackout periods, provided that the plan isadopted when the company is not aware of material non-public information. Pursuant to the plan, a broker designated by us has the authority to repurchaseshares, in accordance with the terms of the plan, without further directionfrom us.  The amount and timing of specific repurchases are subjectto the terms of the plan and market

 

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conditions.  As of June 30,2008, 138,500 shares of our common stock had been purchased under therepurchase program at an average price of $1.25 per share including transactioncosts.

 

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

 

·                  the timing and size of orders from our largercustomers;

 

·                  our ability to enter into partnerships with networkequipment providers, ISVs and telecom equipment manufacturers;

 

·                  the level of success of our customers in sellingserver appliance solutions that include our server appliance hardwareplatforms;

 

·                  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 will be sufficient tomeet our operating and capital requirements through at least the next twelvemonths.

 

In the event that our available cash resources and theSilicon Valley Bank line of credit are not sufficient, or if an event of defaultoccurs, such as failure to achieve certain financial covenants, that limits ourability to borrow under the line of credit, we may need to raise additionalfunds.  We may in the future seek toraise additional funds through borrowings, public or private equity financingsor from other sources.  There can be noassurance that additional financing will be available at all or, if available,will be on terms acceptable to us.  Additionalequity 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***

 

In addition to our contractual obligations disclosedin our Annual Report on Form 10-K for the year ended September 30,2007, during the nine months ended June 30, 2008, we incurred anadditional contractual obligation related to the facility leased by AllianceSystems.  The remaining obligation underthis lease as of June 30, 2008 is as follows:

 
| ** **      | ** ** | **Payments Due by Fiscal Period** | ** ** |
|-----------------|------------|-------------------------------------------------------|------------|
| ** **      | ** ** | **Less than  1 Year**                       | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **After 5 Years** | ** ** | **Total** | ** ** |
|            |       |                                                  |       |   |   |   |   |   |   |   |   |
| Operating lease |       | $                                                     | 186        |   | $ | 2,161 |   | $ | — |   | $ | — |   | $ | 2,347 |   |
|            |       |                                                  |       |   |   |   |   |   |   |   |   |
| Total           |       | $                                                     | 186        |   | $ | 2,161 |   | $ | — |   | $ | — |   | $ | 2,347 |   |

 

**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 subordinated retained interests, derivative instrumentsor other contingent arrangements that expose the Company to material continuingrisks, contingent liabilities, or any other obligation under a variableinterest in an unconsolidated entity that provides financing, liquidity, marketrisk or credit risk support to the Company.

 

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**Recent Accounting Pronouncements**

 

In September 2006, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standard No. 157,“Fair Value Measurements” (“FAS 157”). This statement addresses how companies should measure fair value whenthey are required to use a fair value measure for recognition or disclosurepurposes under accounting principles generally accepted in the United States ofAmerica.  In February 2008, the FASBissued FASB Staff Position 157-1, “Application of FASB Statement No. 157to FASB Statement No. 13 and Other Accounting Pronouncements That AddressFair Value Measurements for Purposes of Lease Classification or Measurementunder Statement 13” (“FSP 157-1”).  FSP157-1 amends FAS 157 to remove certain leasing transactions from itsscope.  In February 2008, the FASBissued FASB Staff Position 157-2, “Effective Date of FASB Statement No. 157”(“FSP 157-2”).  FSP 157-2 defers theeffective date of FAS 157 for certain non-financial assets and liabilities tothe beginning of our fiscal year that begins after November 15, 2008.  FAS 157 is effective for financial assets andliabilities as of the beginning of our fiscal year that begins after November 15,2007.  We are in the process ofevaluating whether the adoption of FAS 157 will have a material impact on ourfinancial position, results of operations or cash flows.

 

In February 2007, the FASB issued Statement ofFinancial Accounting Standard No. 159, “The Fair Value Option forFinancial Assets and Financial Liabilities – Including an amendment of FASBStatement No. 115” (“FAS 159”). This statement permits entities to choose to measure many financialinstruments and certain other items at fair value at specified electiondates.  Subsequent unrealized gains andlosses on items for which the fair value option has been elected will bereported in earnings.  FAS 159 iseffective as of the beginning of our fiscal year that begins after November 15,2007.  We are in the process ofevaluating whether the adoption of FAS 159 will have a material impact on ourfinancial position, results of operations or cash flows.

 

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 improve therelevance, representational faithfulness, and comparability of the informationthat a reporting entity provides in its financial reports about a businesscombination and its effects.  FAS 141Restablishes principles and requirements for how the acquirer recognizes andmeasures in its financial statements the identifiable assets acquired, theliabilities assumed, and any noncontrolling interest in the acquiree,recognizes and measures the goodwill acquired in the business combination or again from a bargain purchase and determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination.  FAS141R is effective for business combinations on a prospective basis for whichthe acquisition date is on or after the beginning of the first annual reportingperiod beginning on or after December 15, 2008.  The adoption of FAS 141R will not have amaterial impact on our financial position, results of operations or cash flows.

 

In April 2008, the FASB issued FASB StaffPosition No. FAS 142-3, “Determination of the Useful Life of IntangibleAssets” (“FSP 142-3”).  FSP 142-3 amendsthe factors that should be considered in developing renewal or extensionassumptions used to determine the useful life of a recognized intangible assetunder FAS 142.  This change is intendedto improve 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 ofevaluating whether the adoption of FSP 142-3 will have a material impact on ourfinancial position, results of operations or cash flows.

 

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

 

We do not engage in any foreign currency hedgingtransactions and therefore do not believe we are subject to material exchangerate risk.  We are not currently exposedto market risk related to changes in interest rates.  In the past, we have invested excess cashbalances in cash equivalents and short-term investments, and if we were to doso in the future, we believe that the effect, if any, of reasonably possiblenear-term changes in interest rates on our financial position, results ofoperations and cash flows would not be material.  In addition, a hypothetical 10% increase ordecrease in interest rates would not have a material adverse effect on ourfinancial condition.

 

**ITEM4.    CONTROLS AND PROCEDURES**

 

Our management, with the participation of our ChiefExecutive Officer and Chief Financial Officer, evaluated the effectiveness ofour disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act) as of June 30,2008.  Based on this evaluation, ourChief Executive Officer and Chief Financial Officer concluded that, as of June 30,2008, our disclosure controls and procedures (1) were designed toeffectively accumulate and communicate information to the Company’s management,as appropriate, to allow timely decisions regarding required disclosure and (2) wereeffective, in that they provide reasonable assurance that information requiredto be disclosed by the Company in the reports that it files or submits underthe Securities Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’s rules andforms.

 

During the three months ended June 30, 2008, nochange in our internal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) occurred that has materially affected,or is reasonably likely to materially affect, our internal control overfinancial reporting.

 

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**PART II—OTHERINFORMATION**

 

**ITEM1.     LEGAL PROCEEDINGS**

 

*Initial Public Offering Lawsuit*

 

On or about December 3, 2001, a putative classaction lawsuit was filed in the United States District Court for the SouthernDistrict of New York against us, Lawrence A. Genovesi (our former Chairman andChief Executive Officer), Douglas G. Bryant (our Chief Financial Officer), andseveral underwriters of our initial public offering.  The suit alleges, *inter alia*,that the defendants violated the federal securities laws by issuing and sellingsecurities pursuant to our initial public offering in July 2000 (“IPO”)without disclosing to investors that the underwriter defendants had solicitedand received excessive and undisclosed commissions from certain investors.  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 DouglasG. Bryant were dismissed from this case without prejudice.  On December 5, 2006, the United StatesCourt of Appeals for the Second Circuit overturned the District Court’scertification of a plaintiff class.  On April 6,2007, the Second Circuit denied plaintiffs’ petition for rehearing, butclarified that the plaintiffs may seek to certify a more limited class in theDistrict Court.  On September 27,2007, plaintiffs filed a motion for class certification in certain designated “focuscases” in the District Court, and the motion is currently pending before theDistrict Court.  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.”  We are unable to predict the outcome of thissuit and as a result, no amounts have been accrued as of June 30, 2008.

 

**ITEM 1A.RISK FACTORS**

 

The risks and uncertainties described below are notthe only ones we are faced with. Additional risks and uncertainties not presently known to us, or thatare currently deemed immaterial, may also impair our businessoperations.  If any of the followingrisks actually occur, our financial condition and operating results could bematerially adversely affected. Subsequent to the previous disclosure of risk factors in Item 1A of Part Iof our most recent Annual Report on Form 10-K for the fiscal year ended September 30,2007, we have added the following two risk factors:

 

·                                          Goodwill and other intangible assetsrepresent a significant portion of our assets, and any impairment of goodwillor other intangible assets would adversely impact our net income.

·                                          If the market price of our common stockis not quoted on a national exchange, our ability to raise future capital maybe hindered and the market price of our common stock may be negativelyimpacted.

 

***Risks of dependence on onestrategic partner.***

 

**We derive a significant portion ofour revenues from sales of server appliances directly to EMC and our revenuesmay decline significantly if this customer cancels or delays purchases ofour products, terminates its relationship with us or exercises certain of itscontractual rights.**

 

For the three months ended June 30, 2008 and2007, sales directly to EMC, our largest customer, accounted for 40% and 81%,of our total net revenues, respectively. For the nine months ended June 30, 2008 and 2007, sales directly toEMC accounted for 43% and 81%, of our total net revenues, respectively.  These sales are primarily attributable to oneproduct pursuant to a non-exclusive contract. Although this concentration has decreased as a result of our acquisitionof Alliance Systems, we anticipate that our future operating results willcontinue to depend heavily on sales to, and our relationship with, thiscustomer.  Accordingly, the success ofour business will depend, in large part, on this customer’s willingness tocontinue to utilize our server appliance solutions in its existing and futureproducts.  Further, our financial successis dependent upon the future success of the products we sell to this customer andthe continued growth of this customer, whose industry has a history of rapidtechnological change, short product life 

 

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cycles, consolidation and pricing and margin pressures.  A significant reduction in sales to thiscustomer, or significant pricing and additional margin pressures exerted on usby this customer, would have a material adverse effect on our results ofoperations.  In addition, if thiscustomer delays or cancels purchases of our products, our operating resultswould be harmed and we may be unable to accurately predict revenues,profitability and cash flows.

 

Under the terms of our non-exclusive contract, thiscustomer has the right to enter into agreements with third parties for similarproducts, is not obligated to purchase any minimum quantity of products from usand may choose to stop purchasing from us at any time, with or withoutcause.  In addition, this customermay terminate the agreement in the event that we attempt to assign ourrights under the agreement to another party without this customer’s priorapproval.  Furthermore, in the event thatwe default on certain portions of the agreement, this customer has the right tomanufacture certain products in exchange for a mutually agreeable royaltyfee.  If any of these events were tooccur, or if this customer were to delay or discontinue purchases of ourproducts as a result of dissatisfaction or otherwise, our revenues and operatingresults would be materially adversely affected, our reputation in the industrymight suffer, and we may be unable to accurately predict revenues,profitability and cash flows.

 

***Risks related to businessstrategy.***

 

**Our future success is dependent uponour ability to generate significant revenues from server appliance developmentrelationships.**

 

We believe we must diversify our revenues and a majorcomponent of our business strategy is to form server appliance developmentrelationships with new network equipment providers, ISVs and telecom equipmentmanufacturers.  Under this strategy, wework with our customers to develop a server appliance branded with theirname.  These customers then perform allof the selling and marketing efforts related to sales of their brandedappliance.

 

There are multiple risks associated with this strategyincluding:

 

·                                          the expenditure of significant productdevelopment costs, which if not recovered through server appliance sales couldnegatively affect our operating results;

 

·                                          a significant reliance on our customers’application software products, which could be technologically inferior tocompetitive products and result in limitations on our server appliance sales,causing our revenues and operating results to suffer;

 

·                                          our customers which sell their softwareproducts as separate products in addition to selling them in the form of aserver appliance will most likely continue to do so, which will require us toeffectively communicate the benefits of delivering their software in the formof a server appliance;

 

·                                          our reliance on our customers toperform all of the selling and marketing efforts associated with furthersales of the server appliance product we develop with them;

 

·                                          continued consolidation within thenetwork equipment and software industries that results in existing customersbeing acquired by other companies;

 

·                                          our ability to leverage strategicrelationships to obtain new sales leads;

 

·                                          our ability to provide our customers withhigh quality server appliances at competitive prices; and

 

·                                          there is no guarantee that design winswill become actual orders and sales.  A “designwin’’ occurs when a customer or prospective customer notifies us that we havebeen selected to integrate the customer’s application.  There can be delays of several months or morebetween the design win and when a customer initiates actual orders.  The design win may never

 

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become an actual order or sale.  Further, if the customer’s plans change, wemay commit significant resources to design wins that do not result in actualorders.

 

Additionally, our future success will depend on ourability to establish relationships with new customers while expanding sales ofserver appliances to our existing customers. If these customers are unsuccessful in their marketing and salesefforts, or if we are unable to expand our sales to existing customers anddevelop relationships with new customers, our revenues and operating resultscould suffer.

 

**The failure to successfully integrateour acquisition of Alliance Systems into our operations in the expected timeframe, or at all, may adversely affect our future results.**

 

We believe that the acquisition of Alliance Systems,completed in October 2007, will result in certain benefits, includingexpanded customer reach, increased product offerings, and certain cost savingsfrom economies of scale.  However, torealize these anticipated benefits, Alliance Systems’ business must besuccessfully integrated into our operations by focusing on, manufacturing andsupply chain synergies, sales and marketing operations, and general andadministrative efficiencies.  The successof the Alliance Systems acquisition will depend on our ability to realize theseanticipated benefits from integrating Alliance Systems’ business into ouroperations.  We may fail to realize theanticipated benefits of the acquisition on a timely basis, or at all, for avariety of reasons, including the following:

 

·                  diversion of management attention and difficultiesarising from managing multiple locations;

 

·                  potential disruption of ongoing business;

 

·                  failure to effectively coordinate salesand marketing efforts to communicate the capabilities of the combined Company;

 

·                  potential difficulties integratingfinancial reporting or other critical systems; and

 

·                  the loss of key employees, customers, orvendors.

 

If we fail to successfully integrate Alliance Systemsand realize the expected benefits of the acquisition, it could have an adverseimpact on our results of operations, and our ability to generate cash fromoperations.  As a result, we could havedifficulty borrowing under our current credit facility or securing financing tofund our operations in the future.

 

**We may not be able toeffectively commercialize our appliances or may be at a competitivedisadvantage if we cannot license or integrate third-party applications thatare essential for the functionality of certain appliances.**

 

We believe our success will depend on our ability tolicense or integrate certain applications from third-parties that would beincorporated in certain of our server appliance solutions.  Because we do not currently know withcertainty which of these prospective technologies will be desired in themarketplace, we may incorrectly invest in development or prioritize ourefforts to integrate these technologies in our appliances.  Additionally, even if we correctly focus ourefforts, there can be no assurance that we will select the preferred providerof these technologies, the third-party provider will be committed to therelationship and integration of their technology, or that they will licensetheir technology to us without obtaining significant certification or training,which could be costly and time consuming. If we are unable to successfully integrate the correct third-partytechnologies in a timely manner, our appliances may be inferior to othercompetitive products in the marketplace, which may adversely affect theresults of our operations and our ability to grow our business.

 

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

 

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

 

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

 

·                  our new products may be delayedbecause selected new technologies themselves are delayed or have defects and/orperformance limitations;

 

·                  we may incorporate technologies thatdo not result in the desired improvements to our current and/or future serverappliance products;

 

·                  we may incorporate new technologiesthat either may not be desired by our customers or may not be compatiblewith our customers’ existing technology;

 

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

 

·                  we could find that the new productsand/or technologies that we choose to incorporate into our products aretechnologically inferior to those utilized by our competitors.

 

If we are unable to adequately integrate newtechnologies into our server appliance products or if we invest in technologiesthat do not result in the desired effects on our current and/or future productofferings, our business could be harmed and operating results could suffer.

 

***Risks related to the serverappliance markets.***

 

**If server appliances are notincreasingly adopted as a solution to meet a significant portion of companies’application needs, the market for server appliances may not grow, whichcould negatively impact our revenues.**

 

We expect that all of our future revenues will comefrom sales of server appliances and related services.  As a result, we are substantially dependenton the growing use of server appliances to meet businesses’ applicationneeds.  Our revenues may not growand the market price of our common stock could decline if the server appliancemarket does not grow as rapidly as we expect.

 

Our expectations for the growth of the serverappliance market may not be fulfilled if customers continue to usegeneral-purpose servers or proprietary platforms.  The role of our products could, for example,be limited if general-purpose servers out-perform server appliances,provide more capabilities and/or flexibility than server appliances or areoffered at a lower cost.  This couldforce us to lower the prices of our server appliance products or could resultin fewer sales of these products, which would negatively impact our revenuesand decrease our gross profits.

 

**The products that we sell are subjectto rapid technological change and our sales will suffer if these products arerendered obsolete by new technologies.**

 

The markets we serve are characterized by rapidtechnological change, frequent new product introductions and enhancements,potentially short product life cycles, changes in customer demands and evolvingindustry standards.  In the serverappliance market, we attempt to mitigate these risks by utilizingstandards-based hardware platforms and by maintaining an adequate knowledgebase of available technologies.  However,the server appliance products that we sell could be rendered obsolete ifproducts based on new technologies are introduced or new industry standardsemerge and we are not able to incorporate these technological changes into ourproducts.  In addition, we depend onthird parties for the base platforms of our server appliances and we are atrisk if these third parties do not integrate new technologies.  Releasing new products and servicesprematurely may result in quality problems, and delays may result inloss of customer confidence and market share. We may be unable to develop new products and services or achieveand maintain market acceptance of them once they have come to market.

 

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Furthermore, when we do introduce new or enhanced products andservices, we may be unable to manage the transition from the olderproducts and services to minimize disruption in customer ordering patterns,avoid excessive inventories of older products and deliver enough new productsand services to meet customer demand.

 

Toremain competitive in the server appliance market, we must successfullyidentify new product opportunities and partners and develop and bring newproducts to market in a timely and cost-effective manner.  Our failure to select the appropriatepartners and keep pace with rapid industry, technology or market changes couldhave a material adverse effect on our business, results of operations orfinancial 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, 2008 and September 30,2007, our accumulated deficit was $128 million and $129 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 capitalrequirements.  However, we may not beable to secure new financing, or financing on favorable terms, if we experiencea significant adverse change in our business. As of June 30, 2008, we have not drawn on this line of credit.

 

**If ourestimates or judgments relating to our critical accounting policies are basedon assumptions that prove to be incorrect, our operating results could fallbelow expectations of securities analysts and investors, resulting in a declinein 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;

 

·        inventory write-downs;

 

·        stock-based compensation;

 

·        valuation of intangible assets and goodwill;

 

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·        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 of futurerevenues and gross profits, which are partially dependent on our customers’ability to accurately forecast and communicate their future product needs.  If revenues or gross profits in a particularquarter do not meet expectations, operating results could suffer and the marketprice of our common stock could decline. Factors affecting quarterly operating results include:

 

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

 

·        the product mix of our sales;

 

·        the timing of new product introductions by ourcustomers;

 

·        the availability and/or price of products fromsuppliers;

 

·        the loss of key suppliers or customers;

 

·        price competition;

 

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

 

·        seasonal fluctuations in the data storage and telecomindustries; and

 

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

 

**If theproducts and services that we sell become more commoditized and competition inthe server appliance, data storage, network security and telecom marketscontinues to increase, then our gross profit as a percentage of net revenuesmay decrease and our operating results may suffer.**

 

Productsand services in the server appliance, data storage, network security and telecommarkets may be subject to further commoditization as these industriescontinue to mature and other businesses introduce additional competing productsand services.  Our gross profit as apercentage of revenues for our products may decrease in response tochanges in our product mix, competitive pricing pressures, or new productintroductions into the server appliance, data storage, network security andtelecom markets.  If we are unable tooffset decreases in our gross profits as a percentage of revenues by increasingour sales volumes, or by decreasing our product costs, operating results willdecline.  Changes in the mix of sales ofour products, including the mix of higher margin products sold in smallerquantities and lower margin products sold in larger quantities, could adverselyaffect our operating results for future quarters.  To maintain our gross profits, we also mustcontinue to reduce the manufacturing cost of our server applianceproducts.  Our efforts to produce highermargin server appliance products, continue to improve our server 

 

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applianceproducts and produce new server appliance products may make it difficultto reduce our manufacturing cost per product. Further, utilization of a contract manufacturer to produce a portion ofour customer requirements for certain of our server appliance productsmay not allow us to reduce our cost per product.  If we fail to respond adequately to pricingpressures, to competitive products with improved performance or to developmentswith respect to the other factors on which we compete, we could lose customersor orders.  If we are unable to competeeffectively, our businesswill suffer.

 

**Goodwilland other intangible assets represent a significant portion of our assets, andany impairment of goodwill or other intangible assets would adversely impactour net income.**

 

At June 30, 2008, wehad goodwill and intangible assets of approximately $19.0 million, net ofaccumulated amortization.  Our goodwillis subject to an annual impairment test, and both goodwill and other intangibleassets are also tested whenever events and circumstances indicate that they maybe impaired.  Such events or conditionscould include an economic downturn in our customers’ industries, increasedcompetition, or other information regarding our market value, such as areduction in our stock price to a price at, near or below our book value for aperiod of time which could indicate a triggering event and a possibleimpairment of goodwill.  Any excessgoodwill resulting from the impairment test must be written off in the periodof determination.  During the quarterended June 30, 2008, we performed an interim impairment test of ourgoodwill.  We determined that ourgoodwill was not impaired based on this test. In addition, we will continue to incur non-cash charges relating to theamortization of our intangible asset other than goodwill, over the remaininguseful lives of such asset.  Futuredeterminations of significant write-offs of goodwill or intangible assetsresulting from an impairment test or any accelerated amortization of intangibleassets could have a significant impact on our net income and affect our abilityto maintain profitability.  Although wedo not believe that any impairment of goodwill or other intangible assetsexists at this time, in the event that such a condition or event occurs, we mayrecord charges which could have a material adverse effect on our results ofoperations.

 

***Risks related to competition.***

 

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

 

Inthe server appliance market, we face significant competition from a number ofdifferent types of companies.  Ourcompetitors include companies who market general-purpose servers, servervirtualization software, specific-purpose servers and server appliances as wellas companies that sell custom integration services utilizing hardware producedby other companies.  Many of thesecompanies are larger than we are and have greater financial resources and namerecognition than we do, as well as significant distribution capabilities andlarger, more established service organizations to support their products.  Our larger competitors may be able toleverage their existing resources, including their extensive distributioncapabilities and service organizations, to provide a wider offering of productsand services and higher levels of support on a more cost-effective basis thanwe can.  We expect competition in theserver appliance market to increase significantly as more companies enter themarket and as our existing competitors continue to improve the performance oftheir current products and to introduce new products and technologies.  Such increased competition could adverselyaffect 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 server appliancesolutions, or if some of their products are comparable to ours and are offeredas part of a range of products that is broader than ours, our serverappliance solutions could become undesirable.

 

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 an established vendor rather than purchase productsfrom a less-established vendor.  Weattempt to differentiate ourselves from our competition by offering a widevariety of software integration, branding, supply-chain management,engineering, support, logistics and fulfillment services.  If we are unable to effectively differentiateourselves from our competition, we may be forced to offer price reductionsto maintain certain customers.  As aresult, our revenues may not increase and may decline, and our grossmargins may decline.  Furthermore,increased competition could lead to higher selling expenses which wouldnegatively affect our business and future operating results.

 

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***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 network equipment providers, ISVs andtelecom equipment manufacturers to recognize us as a top-tier provider ofserver appliance platforms and custom integration services.  If we are unable to increase market awarenessand promote ourselves as a leading provider of server appliance solutions withour available resources, we may be unable to develop new customer relationshipsor expand our product and service offerings at existing 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 server appliancecomponents makes us susceptible to supply shortages and potential qualityissues that could prevent us from shipping customer orders on time, or at all,and could result in lost sales and customers.**

 

Wedepend upon single source and limited source suppliers for our industrystandard processors, main logic boards, certain disk drives, hardware platformsand power supplies as well as certain of our chassis and sheet metalparts.  Additionally, we depend onlimited sources to supply certain other industry standard and customizedcomponents.  We have in the pastexperienced, and may in the future experience, shortages of ordifficulties in acquiring components in the quantities and of the qualityneeded to produce our server appliance products.  Shortages in supply or quality issues relatedto these key components for an extended time would cause delays in theproduction of our server appliance products, prevent us from satisfying ourcontractual obligations and meeting customer expectations, and result in lostsales and customers.  If we are unable tobuy components in the quantities and of the quality that we need on a timelybasis or at acceptable prices, we will not be able to manufacture and deliverour server appliance products on a timely or cost effective basis to ourcustomers, and our competitive position, reputation, business, financialcondition and results of operations could be seriously harmed.

 

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

 

Becauseserver appliance solutions are complex, they could contain errors that can bedetected at any point in a product’s life cycle.  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.

 

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Therecan be no assurance that our efforts to monitor, develop, modify and implementappropriate test and manufacturing processes for our products will besufficient to permit us to avoid a rate of failure in our products that resultsin substantial delays in shipment, significant repair or replacement costs orpotential damage to our reputation, any of which could have a material adverseeffect on our business, results of operations or financial condition.

 

Inthe past, we have discovered errors in some of our server appliance solutionsand have experienced delays in the shipment of our server appliance productsduring the period required to correct these errors or we have had to replacedefective products that were already shipped. Errors in our server appliance solutions may be found in the futureand any of these errors could be significant. Significant errors, including those discussed above, may result in:

 

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

 

·        diversion of engineering resources;

 

·        increased manufacturing costs;

 

·        the loss of new or existing server appliancecustomers;

 

·        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 server appliance solutions fail to conform to warrantedspecifications, customers could demand a refund for the purchase price andassert claims for damages.

 

Moreover,because our server appliance 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 server appliance materials requirements, ourbusiness and operating results could be adversely affected.**

 

Weuse rolling forecasts based on anticipated product orders to determine ourserver appliance 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 orders.  Asa result, our materials requirement forecasts may not be accurate.  If we overestimate our materialsrequirements, we may have excess inventory, which would increase costs andnegatively impact our cash position.  Ouragreements with certain customers provide us with protections related toinventory purchased in accordance with the terms of these agreements; however,these protections may not be sufficient to prevent certain losses as aresult of excess or obsolete inventory. If we underestimate our materials requirements, we may haveinadequate inventory, which could interrupt our manufacturing and delaydelivery of our server appliance products to customers, resulting in a loss ofsales or customers.  Any of these occurrenceswould negatively impact our business and operating results.

 

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***Risks related to product dependence on intellectualproperty.***

 

**Ourreliance upon contractual provisions, domestic patent, copyright and tradesecret laws and patent applications to protect our proprietary rightsmay not be sufficient to protect our intellectual property.**

 

Certainof our server appliance solutions are differentiated from the products of ourcompetitors by our internally developed software and hardware and the manner inwhich they are integrated into our server appliance solutions.  If we fail to protect our intellectualproperty, other vendors could sell products with features similar to ours,which could reduce demand for our solutions. We have taken what we believe to be the necessary and appropriate stepsto safeguard our intellectual property. However, these steps may afford us only limited protection.  Others may develop technologies that aresimilar or superior to our technology or design around the patents we own.  Despite the precautions we have taken, lawsand contractual restrictions may not be sufficient to prevent misappropriationof our technology or deter others from developing similar technologies.  In addition, there can be no guarantee thatany of our patent applications will result in patents, or that any such patentswould provide effective protection of our technology.

 

Inaddition, the laws of the countries in which we may decide to market ourservices and solutions may offer little or no effective protection of ourproprietary technology.  Reverseengineering, unauthorized copying or other misappropriation of our proprietarytechnology could enable third parties to benefit from our technology withoutpaying us for it, which could harm our business.  In addition, our U.S. patents have no effectin foreign jurisdictions and obtaining patent protection in foreign countries isexpensive and time consuming.

 

**Our operatingresults would suffer if we, our ISV, telecom or network equipment customers, orother third-party software providers from whom we license technology, weresubject to an infringement claim that resulted in protracted litigation, theaward of significant damages against us or the payment of substantial ongoingroyalties.**

 

Substantiallitigation regarding intellectual property rights exists in the technologyindustry.  We expect that serverappliance products 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 server appliance products infringed their intellectualproperty rights.  We do not believe thatour server appliance products employ technology that infringes the proprietaryrights of any third parties.  We are alsonot aware of any claims made against any of our ISV, telecom, or networkequipment provider customers related to their infringement of the proprietaryrights of other parties in relation to products that include our serverappliance products.  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 ISV, telecom, ornetwork equipment customers, or third-party software providers related toproducts that are incorporated into our server appliance products.  Our business could be adversely affected ifsuch claims resulted in the inability of our customers to continue producingthe infringing product, or if we are unable to cost effectively continuelicensing the third-party software.

 

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

 

**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, particularly personnel knowledgeablein software engineering and product management, we may not be able to meetkey objectives such as developing, upgrading, or enhancing our products in atimely manner, which could negatively impact our business and could hinder anyfuture 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 increased expense and have devoted additional managementresources to Section 404 compliance. Effective internal controls are necessary for us to provide reliablefinancial reports.  If we cannot providereliable financial reports, our business and operating results could be harmed.

 

**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 ourcommon stock and could result in management devoting a substantial portion oftheir time 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 their 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 fiscal 2007, the closing price of our common stock ranged from alow of $1.73 to a high of $2.81, and during the nine months ended June 30,2008, from a low of $1.10 to a high of $2.12. The market for technology stocks has been extremely volatile andfrequently reaches levels that bear no relationship to the past or presentoperating performance of those companies. General economic conditions, such as recession or interest rate orcurrency rate fluctuations in the United States or abroad, could negativelyaffect the market price of our common stock. In addition, our operating results may be below the expectations ofsecurities analysts and investors.  Ifthis were to occur, the market price of our common stock may decreasesignificantly.  In the past, followingperiods of volatility in the market price of

 

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acompany’s securities, securities class action litigation has often beeninstituted against such companies.  Such litigationcould result in substantial cost and a diversion of management’s attention andresources.

 

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.**

 

Subsequentto June 30, 2008, at certain times, the market price of our common stockhas been less than $1.00 per share.  Ifwe are unable to meet the stock price listing requirements of NASDAQ, ourcommon stock could be de-listed from the NASDAQ Global Market.  If our common stock were de-listed from theNASDAQ Global Market, among other things, this could result in a number of negativeimplications, including reduced liquidity in our common stock as a result ofthe loss of market efficiencies associated with NASDAQ and the loss of federalpreemption of state securities laws, as well as the potential loss ofconfidence by suppliers, customers and employees, the loss of institutionalinvestor interest, fewer business development opportunities and greaterdifficulty in obtaining financing.

 

**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.

 

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

 

Thefollowing table presents information regarding the Company’s repurchases of itscommon stock during the quarter ended June 30, 2008.

 

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** | ** ** |
|----------------|------------|------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------|------------|
| June 2008 |       | 138,500                                                                                                    |       | $                                            | 1.25       |                                                                                                                          | $          | 4,827,217 |   |
|                |            |                                                                                                            |            |                                              |            |                                                                                                                               |            |  |  |

 

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(1)   All of the shares of common stock set forth in this column werepurchased pursuant to a publicly announced program as described in footnote 2below.

(2)   On June 12, 2008, the Company announced that its Board ofDirectors had authorized the repurchase of up to $5 million of its common stockthrough a share repurchase program.  Theprogram does not have an expiration date. All repurchases described in the table above were effected pursuant to a written Rule 10b5-1trading plan.

 

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**ITEM 5.     OTHERINFORMATION**

 

On August 5,2008, Network Engines, Inc. (the “Borrower”) entered into the First LoanModification Agreement with Silicon Valley Bank (“SVB”).  The First Loan Modification Agreement amendsthe Loan and Security Agreement (the “Loan Agreement”), dated October 11,2007, by and among the Borrower and SVB. The amended Loan Agreement provides Borrower with a revolving line ofcredit in an amount not to exceed $10,000,000 (the “Line of Credit”).  The Line of Credit matures and the principalbalance is payable in full on August 5, 2010, which is 24 months from thedate of the First Loan Modification Agreement.

 

Underthe amended Loan Agreement, Borrower may borrow up to $10,000,000 minus theamount of any outstanding letters of credit, the amount of a certain reservethat may be established by SVB, and the outstanding principal balance of anyadvances made by SVB under the Line of Credit.

 

Amountsborrowed under the Line of Credit bear interest at a floating per annum rateequal to 0.25% below the Prime Rate.  The“Prime Rate” is the rate announced from time to time by SVB as its “prime rate.” Borrower is also subject to an unused line of credit fee of 0.25% per annum,payable quarterly, and to financial covenants which require it to maintaincertain liquidity and minimum operating cash flows per quarter.

 

TheLoan Agreement contains customary events of default, including Borrower’sfailure to pay any principal, interest or other amount when due, Borrower’sviolation of certain covenants, or a change in control of Borrower.  Upon the occurrence of an event of default,the payment of all obligations under the Loan Agreement may be accelerated andthe lending commitments under the Loan Agreement may be terminated.

 

Theforegoing description of the First Loan Modification Agreement is not completeand is qualified in its entirety by reference to the First Loan ModificationAgreement, which is filed as Exhibit 10.1 hereto and is incorporatedherein by reference.

 

**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.

 

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**SIGNATURES**

 

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

 
|                        | **NETWORK  ENGINES, INC.**                         |
|-----------------------------|----------------------------------------------------|
|                        |                                               |
| Date: August 11,  2008 | /s/ Gregory A. Shortell                            |
|                        |                                               |
|                        | Gregory A. Shortell                                |
|                        | President and Chief  Executive Officer             |
|                        | (Principal Executive  Officer)                     |
|                        |                                               |
|                        |                                               |
|                        | /s/  Douglas G. Bryant                             |
|                        |                                               |
|                        | Douglas G. Bryant                                  |
|                        | Chief Financial  Officer,  Treasurer and Secretary |
|                        | (Principal Financial  Officer  and Principal       |
|                        | Accounting Officer)                                |
|                             |                                                    |  |

 

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**EXHIBITINDEX**

 
| **Exhibit No.** | ** ** | **Exhibit**                                                                                                                                         |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                |
| 10.1                 |       | First Loan Modification  Agreement, dated as of August 5, 2008, by and among Network  Engines, Inc., and Silicon Valley Bank              |
|                 |       |                                                                                                                                                |
| 31.1                 |       | Certification  of Gregory A. Shortell, the Chief Executive Officer of the Company, pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002. |
|                 |       |                                                                                                                                                |
| 31.2                 |       | Certification  of Douglas G. Bryant, the Chief Financial Officer of the Company, pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.   |
|                 |       |                                                                                                                                                |
| 32.1                 |       | Certification  of Gregory A. Shortell, the Chief Executive Officer of the Company, pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                 |       |                                                                                                                                                |
| 32.2                 |       | Certification  of Douglas G. Bryant, the Chief Financial Officer of the Company, pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.   |

 

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