##### **UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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

 

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**(Mark One)**

 
| **ý**                                             | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|--------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
|                                                   |       |                                                                                                     |
| **For the quarterly period ended June 30,  2005** |
|                                                   |       |                                                                                                     |
| **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: 0-30863**

 

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**NETWORK ENGINES, INC.**

(Exact name of registrant as specified in itscharter)

 
| **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 areacode)

 

Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthan the Registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes  ý** **No  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act.) Yes  ý  No  o

 

As of August 5, 2005, there were 37,765,199 shares of theregistrant’s Common Stock, 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)                                                            |             |
|                                                                                                 |             |
| CONDENSED  CONSOLIDATED BALANCE SHEETS                                                               | 1                |
| CONDENSED  CONSOLIDATED STATEMENTS OF OPERATIONS                                                     | 2                |
| CONDENSED  CONSOLIDATED STATEMENTS OF CASH FLOWS                                                     | 3                |
| NOTES TO  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                                  | 48               |
|                                                                                                 |             |
| ITEM 4. CONTROLS  AND PROCEDURES                                                                     | 48               |
|                                                                                                 |             |
| **PART II. OTHER  INFORMATION**                                                                 | ** **       |
|                                                                                                 |             |
| ITEM 1. LEGAL PROCEEDINGS                                                                            | 49               |
|                                                                                                 |             |
| ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                 | 50               |
|                                                                                                 |             |
| ITEM 6. EXHIBITS                                                                                     | 51               |
|                                                                                                 |             |
| SIGNATURES                                                                                           | 52               |

 

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**PART I. FINANCIAL INFORMATION**

 

**ITEM I. FINANCIAL STATEMENTS (UNAUDITED)**

 

**NETWORK ENGINES, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(in thousands)**

 
| ** **                                                                                                                                                                                                            | ** ** | **June 30,  2005** | ** ** | **September 30,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                                                            | ** ** | **(unaudited)**         | ** ** | ** **                   | ** ** |
| **ASSETS**                                                                                                                                                                                                            |       |                    |       |                         |       |
| **Current assets:**                                                                                                                                                                                                   |       |                    |       |                         |       |
| Cash and cash equivalents                                                                                                                                                                                             |       | $                       | 10,972     |                         | $          | 12,974 |   |
| Short-term investments                                                                                                                                                                                                |       | 29,280                  |       | 26,614                       |       |
| Restricted cash                                                                                                                                                                                                       |       | 47                      |       | 47                           |       |
| Accounts receivable, net of allowances                                                                                                                                                                                |       | 10,160                  |       | 13,222                       |       |
| Inventories                                                                                                                                                                                                           |       | 12,644                  |       | 14,342                       |       |
| Prepaid expenses and other current assets                                                                                                                                                                             |       | 801                     |       | 1,257                        |       |
| Total current assets                                                                                                                                                                                                  |       | 63,904                  |       | 68,456                       |       |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| Property and equipment, net                                                                                                                                                                                           |       | 2,005                   |       | 1,623                        |       |
| Goodwill                                                                                                                                                                                                              |       | 7,769                   |       | 7,769                        |       |
| Other assets                                                                                                                                                                                                          |       | 100                     |       | 173                          |       |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| Total assets                                                                                                                                                                                                          |       | $                       | 73,778     |                         | $          | 78,021 |   |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                         | ** ** | ** **              | ** ** | ** **                   | ** ** |
| **Current liabilities:**                                                                                                                                                                                              | ** ** | ** **              | ** ** | ** **                   | ** ** |
| Accounts payable                                                                                                                                                                                                      |       | $                       | 5,952      |                         | $          | 9,312 |   |
| Accrued compensation and other related  benefits                                                                                                                                                                      |       | 1,338                   |       | 1,248                        |       |
| Other accrued expenses                                                                                                                                                                                                |       | 1,603                   |       | 2,295                        |       |
| Current maturities of capital lease  obligations                                                                                                                                                                      |       | 22                      |       | —                       |       |
| Deferred revenue                                                                                                                                                                                                      |       | 3,858                   |       | 493                          |       |
| Total current liabilities                                                                                                                                                                                             |       | 12,773                  |       | 13,348                       |       |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| Capital lease obligations, net of current  portion                                                                                                                                                                    |       | 79                      |       | —                       |       |
| Commitments and contingencies (Note 7)                                                                                                                                                                                |       |                    |       |                         |       |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| **Stockholders’ equity:**                                                                                                                                                                                        | ** ** | ** **              | ** ** | ** **                   | ** ** |
| Common stock, $.01 par value, 100,000,000  shares authorized; 40,327,057 and 39,678,844 shares issued; 37,765,199 and  37,116,986 shares outstanding at June 30, 2005 and September 30,  2004, respectively |       | 403                     |       | 397                          |       |
| Additional paid-in capital                                                                                                                                                                                            |       | 178,390                 |       | 177,688                      |       |
| Accumulated deficit                                                                                                                                                                                                   |       | (115,029                | )          | (110,567                     | )          |
| Deferred stock compensation                                                                                                                                                                                           |       | —                  |       | (7                           | )          |
| Treasury stock, at cost, 2,561,858 shares at  June 30, 2005 and September 30, 2004                                                                                                                          |       | (2,838                  | )          | (2,838                       | )          |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| Total stockholders’ equity                                                                                                                                                                                       |       | 60,926                  |       | 64,673                       |       |
|                                                                                                                                                                                                                  |       |                    |       |                         |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                       |       | $                       | 73,778     |                         | $          | 78,021 |   |

 

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

 

1

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**NETWORK ENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS**

**(in thousands, except per share data)**

**(unaudited)**

 
| ** **                                                    | ** ** | **Three months ended  June 30,** | ** ** | **Nine months  ended  June 30,** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                              | ** ** | **2004**                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                    | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues                                                  |       | $                                     | 24,305     |                                  | $          | 34,381 |   | $ | 74,937 |   | $ | 105,851 |   |
|                                                          |       |                                  |       |                                  |       |   |   |   |   |
| Cost of revenues                                              |       | 20,220                                |       | 28,609                                |       | 60,688 |   | 86,686 |   |
|                                                          |       |                                  |       |                                  |       |   |   |   |   |
| Gross profit                                                  |       | 4,085                                 |       | 5,772                                 |       | 14,249 |   | 19,165 |   |
|                                                          |       |                                  |       |                                  |       |   |   |   |   |
| Operating expenses:                                           |       |                                  |       |                                  |       |   |   |   |   |
| Research and development                                      |       | 1,702                                 |       | 1,492                                 |       | 5,670 |   | 4,207 |   |
| Selling and marketing                                         |       | 2,535                                 |       | 2,177                                 |       | 7,312 |   | 6,570 |   |
| General and administrative                                    |       | 1,935                                 |       | 1,497                                 |       | 6,033 |   | 4,837 |   |
| Stock compensation                                            |       | —                                |       | 28                                    |       | 16 |   | 366 |   |
| Amortization of intangible assets                             |       | —                                |       | 31                                    |       | — |   | 265 |   |
| Impairment of intangible assets                               |       | —                                |       | —                                |       | — |   | 3,614 |   |
| Restructuring charge                                          |       | —                                |       | (107                                  | )          | 366 |   | (107 | ) |
|                                                          |       |                                  |       |                                  |       |   |   |   |   |
| Total operating expenses                                      |       | 6,172                                 |       | 5,118                                 |       | 19,397 |   | 19,752 |   |
|                                                          |       |                                  |       |                                  |       |   |   |   |   |
| Income (loss) from operations                                 |       | (2,087                                | )          | 654                                   |       | (5,148 | ) | (587 | ) |
| Interest and other income, net                                |       | 286                                   |       | 72                                    |       | 686 |   | 216 |   |
|                                                          |       |                                  |       |                                  |       |   |   |   |   |
| Net income (loss)                                             |       | $                                     | (1,801     | )                                     | $          | 726 |   | $ | (4,462 | ) | $ | (371 | ) |
|                                                          |       |                                  |       |                                  |       |   |   |   |   |
| Net income (loss) per share - basic                           |       | $                                     | (0.05      | )                                     | $          | 0.02 |   | $ | (0.12 | ) | $ | (0.01 | ) |
|                                                          |       |                                  |       |                                  |       |   |   |   |   |
| Net income (loss) per share - diluted                         |       | $                                     | (0.05      | )                                     | $          | 0.02 |   | $ | (0.12 | ) | $ | (0.01 | ) |
|                                                          |       |                                  |       |                                  |       |   |   |   |   |
| Shares used in computing basic net income  (loss) per share   |       | 37,582                                |       | 36,886                                |       | 37,357 |   | 36,445 |   |
| Shares used in computing diluted net income  (loss) per share |       | 37,582                                |       | 40,042                                |       | 37,357 |   | 36,445 |   |

 

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

 

2

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**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inthousands)**

**(unaudited)**

 
| ** **                                                                       | ** ** | **Nine months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                       | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| ** **                                                                       | ** ** | ** **                          | ** ** | ** ** | ** ** |
| Cash flows from operating activities:                                            |       |                                |       |   |   |
| Net loss                                                                         |       | $                                   | (4,462     | ) | $ | (371 | ) |
| Adjustments to reconcile net loss to net  cash provided by operating activities: |       |                                |       |   |   |
| Depreciation and amortization                                                    |       | 875                                 |       | 1,191 |   |
| Provision for doubtful accounts                                                  |       | (30                                 | )          | 12 |   |
| Stock compensation                                                               |       | 16                                  |       | 406 |   |
| Impairment of intangible assets                                                  |       | —                              |       | 3,614 |   |
| Impairment of long lived assets                                                  |       | 40                                  |       | — |   |
| Reversal of restructuring charge                                                 |       | —                              |       | (107 | ) |
| Changes in operating assets and liabilities:                                     |       |                                |       |   |   |
| Accounts receivable                                                              |       | 3,092                               |       | (457 | ) |
| Inventories                                                                      |       | 1,698                               |       | (1,630 | ) |
| Prepaid expenses and other current assets                                        |       | 456                                 |       | 1,107 |   |
| Accounts payable                                                                 |       | (3,360                              | )          | (4,033 | ) |
| Accrued expenses                                                                 |       | (602                                | )          | 534 |   |
| Deferred revenue                                                                 |       | 3,365                               |       | (77 | ) |
|                                                                             |       |                                |       |   |   |
| Net cash provided by operating activities                                        |       | 1,088                               |       | 189 |   |
|                                                                             |       |                                |       |   |   |
| Cash flows from investing activities:                                            |       |                                |       |   |   |
| Purchases of property and equipment                                              |       | (1,196                              | )          | (709 | ) |
| Purchases of short-term investments                                              |       | (44,167                             | )          | (8,381 | ) |
| Proceeds from sales and maturities of short-term  investments                    |       | 41,501                              |       | 15,400 |   |
| Changes in other assets                                                          |       | 73                                  |       | (44 | ) |
|                                                                             |       |                                |       |   |   |
| Net cash provided by (used in) investing  activities                             |       | (3,789                              | )          | 6,266 |   |
|                                                                             |       |                                |       |   |   |
| Cash flows from financing activities:                                            |       |                                |       |   |   |
| Proceeds from issuance of common stock                                           |       | 699                                 |       | 1,133 |   |
| Net proceeds from settlement of lawsuit                                          |       | —                              |       | 415 |   |
|                                                                             |       |                                |       |   |   |
| Net cash provided by financing activities                                        |       | 699                                 |       | 1,548 |   |
|                                                                             |       |                                |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                            |       | (2,002                              | )          | 8,003 |   |
| Cash and cash equivalents, beginning of  period                                  |       | 12,974                              |       | 9,227 |   |
|                                                                             |       |                                |       |   |   |
| Cash and cash equivalents, end of period                                         |       | $                                   | 10,972     |   | $ | 17,230 |   |
|                                                                             |       |                                |       |   |   |
| Supplemental disclosure  of non-cash investing and financing activities:         |       |                                |       |   |   |
| Acquisition of  equipment under capital lease obligation                         |       | $                                   | 101        |   | $ | — |   |

 

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

 

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.  BASIS OF PRESENTATION**

 

Theaccompanying condensed consolidated financial statements have been prepared byNetwork Engines, Inc. (“Network Engines” or the “Company”) in accordancewith generally accepted accounting principles and pursuant to the rules andregulations of the Securities and Exchange Commission. Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted pursuant to such rules and regulations. These financial statementsshould be read in conjunction with the audited financial statements and theaccompanying notes included in the Company’s 2004 Annual Report on Form 10-Kfiled by the Company with the Securities and Exchange Commission.

 

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

 

Thepreparation of these condensed consolidated financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosures of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period. The most significant estimates reflected inthese financial statements include accounts receivable and sales allowances,inventory valuation, valuation of goodwill, valuation of deferred tax assets,warranty reserves and stock compensation. Actual results could differ fromthose estimates.

 

Certain previously reported amounts have been reclassified to conform tothe current period presentation.  At March 31,2005, the Company reclassified certain auction rate securities from cash andcash equivalents to short-term investments as of March 31, 2005 and forall prior periods. These reclassifications had no impact on the results of theoperations of the Company.  The followingtable summarizes the balances as previously reported and as reclassified as ofthe period ending dates for each of the past six quarters (in thousands):

 
| ** **              | ** ** | **As Reported**                | ** ** | **As Reclassified**            | ** ** |
|-------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **              | ** ** | **Cash and Cash  Equivalents** | ** ** | **Cash and Cash  Equivalents** | ** ** | **Short-term  Investments** | ** ** |
|                    |       |                           |       |                           |       |   |   |
| December 31, 2004  |       | $                              | 41,305     |                           | $          | 14,519 |   | $ | 26,786 |   |
| September 30, 2004 |       | 37,093                         |       | 12,974                         |       | 26,614 |   |
| June 30, 2004      |       | 35,290                         |       | 17,230                         |       | 20,545 |   |
| March 31, 2004     |       | 35,084                         |       | 14,674                         |       | 20,410 |   |
| December 31, 2003  |       | 35,055                         |       | 15,742                         |       | 19,313 |   |
| September 30, 2003 |       | 36,788                         |       | 9,227                          |       | 27,561 |   |
|                         |            |                                |            |                                |            |  |  |  |  |  |

 

**2.  SIGNIFICANT ACCOUNTINGPOLICIES**

 

**Recent Accounting Pronouncements**

 

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123(revised 2004), “Share-Based Payment” (“SFAS 123(R)”). SFAS 123(R) is arevision of FASB Statement No. 123, “Accounting for Stock-BasedCompensation”, supersedes Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees”, and amends FASB Statement No. 95, “Statementof Cash Flows”. SFAS 123(R) requires all share-based payments to employees,including grants of employee stock options and stock purchases under employeestock purchase plans, to be recognized in the financial statements based ontheir fair values. In March 2005, the Securities and Exchange Commission(SEC) issued Staff Accounting Bulletin No. 107 (SAB 107), which providesthe Staff’s views regarding interactions between FAS 123(R) and certain SEC rules andregulations and provides interpretations of the valuation of share-basedpayments for public companies. In April 2005, the

 

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SEC adopted a new rule amendingthe compliance dates for SFAS 123(R). In accordance with the new rule, theaccounting provisions of SFAS 123(R) will be effective for the Company for thefiscal year beginning October 1, 2005. Although the Company has not yetdetermined whether the adoption of SFAS 123(R) and SAB 107 will result inamounts that are similar to the current pro forma disclosures under SFAS 123,it expects the adoption to have an adverse impact on its consolidatedstatements of operations and net loss per share.

 

In November 2004, the Financial AccountingStandards Board (FASB) issued Statement of Financial Accounting Standards(SFAS) No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter4” (SFAS 151).  SFAS 151 clarifies thatabnormal inventory costs such as costs of idle facilities, excess freight andhandling costs, and wasted materials (spoilage) are required to be recognizedas current period charges.  Theprovisions of SFAS 151 are effective for the fiscal year beginning October 1,2005.  The Company’s early adoption ofthe provisions of SFAS 151 during the three months ended June 30, 2005 didnot affect the Company’s consolidated financial position or results ofoperations.

 

***Accounting forStock-Based Compensation***

 

Stock options and restricted stock issued to employees and members ofthe Company’s board of directors are accounted for in accordance withAccounting Principles Board Opinion No. 25, “Accounting for Stock Issuedto Employees,” and related interpretations (“APB 25”). Accordingly,compensation expense is recorded for options and restricted stock awarded toemployees and directors to the extent that the exercise or purchase prices areless than the fair market value of the Company’s common stock on the date ofgrant, where the number of shares and exercise or purchase price are fixed. Thedifference between the fair value of the Company’s common stock and theexercise or purchase price of the stock option or restricted stock award isrecorded as deferred stock compensation. Deferred stock compensation is amortizedto compensation expense over the vesting period of the underlying stock optionor restricted stock. Upon cancellation of options with residual deferredcompensation balances at the date of cancellation, the remaining amount ofunrecognized deferred compensation is reversed as an adjustment to additionalpaid-in capital. The Company follows the disclosure requirements of Statementof Financial Accounting Standards No. 123, “Accounting for Stock-BasedCompensation” (“SFAS 123”), as amended by SFAS 148 “Accounting for Stock-BasedCompensation — Transition and Disclosure”. Stock-based awards to non-employeesare accounted for at their fair value in accordance with SFAS 123.

 

Prior to the Company’s initial public offering in July 2000, theCompany recorded deferred stock compensation of approximately $15.5 million forrestricted stock and stock options granted at prices deemed to be below fairmarket value for financial reporting purposes. In connection with the Company’sacquisition of TidalWire Inc. (“TidalWire”) in the quarter ended December 31,2002, the Company replaced all outstanding TidalWire common stock options withoptions for the purchase of 1,035,033 shares of the Company’s common stock withan average exercise price of $0.36. The value of these options, based on theBlack-Scholes valuation model was $578,000. Related to the unvested portion ofthe replaced stock options, the Company recorded $304,000 as deferred stockcompensation expense based on the intrinsic value of those employee stock options.

 

5

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The following table illustrates the effect on net loss and net loss pershare as if the Company had applied the fair value recognition provisions ofSFAS 123 to stock-based employee awards. The fair value of the stock compensation used to calculate the pro formanet loss and net loss per share amounts was estimated using the Black-Scholesoption pricing model.

 
| ** **                                                                    | ** ** | **Three Months ended  June 30,**     | ** ** | **Nine months ended  June 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                    | ** ** | **2005**                                  | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                    | ** ** | **(in thousands, except per share data)** | ** ** |
|                                                                          |       |                                      |       |                                 |       |   |   |   |   |
| Net income (loss) - as reported                                               |       | $                                         | (1,801     | )                                    | $          | 726 |   | $ | (4,462 | ) | $ | (371 | ) |
| Add: Stock-based employee compensation  expense included in net income (loss) |       | —                                    |       | 41                                   |       | 8 |   | 406 |   |
| Deduct: Total stock-based employee  compensation expense                      |       | (726                                      | )          | (956                                 | )          | (2,387 | ) | (2,791 | ) |
| Net (loss) - pro forma                                                        |       | $                                         | (2,527     | )                                    | $          | (189 | ) | $ | (6,841 | ) | $ | (2,756 | ) |
|                                                                          |       |                                      |       |                                 |       |   |   |   |   |
| Net income (loss) per share:                                                  |       |                                      |       |                                 |       |   |   |   |   |
| Basic - as reported                                                           |       | $                                         | (0.05      | )                                    | $          | 0.02 |   | $ | (0.12 | ) | $ | (0.01 | ) |
| Basic - pro forma                                                             |       | $                                         | (0.07      | )                                    | $          | — |   | $ | (0.18 | ) | $ | (0.08 | ) |
| Diluted - as reported                                                         |       | $                                         | (0.05      | )                                    | $          | 0.02 |   | $ | (0.12 | ) | $ | (0.01 | ) |
| Diluted - pro forma                                                           |       | $                                         | (0.07      | )                                    | $          | — |   | $ | (0.18 | ) | $ | (0.08 | ) |
|                                                                          |       |                                      |       |                                 |       |   |   |   |   |
| Assumptions used in determination of option  fair value:                      |       |                                      |       |                                 |       |   |   |   |   |
| Expected term:                                                                |       |                                      |       |                                 |       |   |   |   |   |
| Stock options                                                                 |       | 5 years                                   |       | 5 years                              |       | 5 years |   | 5 years |   |
| Employee stock purchase plan                                                  |       | 1 year                                    |       | 1 year                               |       | 1 year |   | 1 year |   |
| Risk free interest rate:                                                      |       |                                      |       |                                 |       |   |   |   |   |
| Stock options                                                                 |       | 3.93                                      | %          | 3.27                                 | %          | 3.72 | % | 3.21 | % |
| Employee stock purchase plan                                                  |       | 3.13                                      | %          | 1.29                                 | %          | 2.86 | % | 1.18 | % |
| Volatility                                                                    |       | 114                                       | %          | 133                                  | %          | 120 | % | 134 | % |
| Dividend rate                                                                 |       | 0                                         | %          | 0                                    | %          | 0 | % | 0 | % |

 

6

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

 

Cash equivalents consists principally of money market funds, commercialpaper, and other marketable securities purchased with an original maturity ofthree months or less.  These investmentsare carried at cost, which approximates market value. The Company also investsexcess cash in auction rate securities. These securities have long-term underlying maturities, however themarket is highly liquid and the interest rates reset every 7, 28 or 35days.  The Company’s intent is not tohold these securities to maturity, but rather to use the interest rate resetfeature to sell securities to provide liquidity as needed.  The Company’s short-term investments areclassified as available for sale and are carried at fair value, with unrealizedgains and losses included in other comprehensive income or loss, which is aseparate component of stockholders’ equity, until realized. At June 30,2005 and September 30, 2004 there were no unrealized gains or losses.Details of the Company’s cash, cash equivalents and short-term investments areas follows (in thousands):

 
| ** **                          | ** ** | **June 30,  2005** | ** ** | **September 30,  2004** | ** ** |
|-------------------------------------|------------|-------------------------|------------|------------------------------|------------|
| **Cash and cash equivalents:**      |       |                    |       |                         |       |
| Cash                                |       | $                       | 5,913      |                         | $          | 7,912 |   |
| Money market funds                  |       | 5,059                   |       | 5,062                        |       |
|                                |       |                    |       |                         |       |
| **Total cash and cash equivalents** |       | $                       | 10,972     |                         | $          | 12,974 |   |
|                                |       |                    |       |                         |       |
| **Short-term investments:**         |       |                    |       |                         |       |
| Commercial paper                    |       | $                       | —     |                         | $          | 2,495 |   |
| Municipal auction rate securities   |       | 29,280                  |       | 24,119                       |       |
|                                |       |                    |       |                         |       |
| **Total short-term investments**    |       | $                       | 29,280     |                         | $          | 26,614 |   |

 

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

 

During each period presented, comprehensive income (loss) was equal tonet income (loss).

 

#### ***Segment Reporting***

 

TheCompany is organized into two reportable business segments: OEM Appliance andDistribution. The Company’s segments have been determined based upon thechannels through which the segments sell products. Sales of server appliancesto the Company’s network equipment and Independent Software Vendors (“ISV”)partners are included in the Company’s OEM Appliance segment. Sales of serverappliances and third-party data storage networking products to distributors,value added resellers (“VARs”) and systems integrators are included in theCompany’s Distribution segment. The accounting policies of these segments arethe same as those described in the Company’s summary of significant accountingpolicies in its Annual Report on Form 10-K for the year ended September 30,2004. The Company evaluates its segments’ performance based on revenues andgross profit, and the Company’s management regularly evaluates the Company’ssegments in deciding how to allocate resources and assess performance. Thereare no inter-segment sales or transfers. Management does not review assets aspart of the assessment of segment performance; as such, segment assetinformation is not available.

 

7

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

 
| ** **          | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|---------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **          | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| OEM Appliance:      |       |                                  |       |                                 |       |   |   |   |   |
| Net revenues        |       | $                                     | 24,096     |                                 | $          | 20,571 |   | $ | 69,986 |   | $ | 62,448 |   |
|                |       |                                  |       |                                 |       |   |   |   |   |
| Gross profit        |       | $                                     | 4,288      |                                 | $          | 4,270 |   | $ | 14,129 |   | $ | 12,919 |   |
|                |       |                                  |       |                                 |       |   |   |   |   |
| Distribution:       |       |                                  |       |                                 |       |   |   |   |   |
| Net revenues        |       | $                                     | 209        |                                 | $          | 13,810 |   | $ | 4,951 |   | $ | 43,403 |   |
|                |       |                                  |       |                                 |       |   |   |   |   |
| Gross profit (loss) |       | $                                     | (203       | )                                    | $          | 1,502 |   | $ | 120 |   | $ | 6,246 |   |
|                |       |                                  |       |                                 |       |   |   |   |   |
| Combined Segments:  |       |                                  |       |                                 |       |   |   |   |   |
| Net revenues        |       | $                                     | 24,305     |                                 | $          | 34,381 |   | $ | 74,937 |   | $ | 105,851 |   |
|                |       |                                  |       |                                 |       |   |   |   |   |
| Gross profit        |       | $                                     | 4,085      |                                 | $          | 5,772 |   | $ | 14,249 |   | $ | 19,165 |   |

 

All of the Company’s long-lived assets were located in the United Statesas of June 30, 2005 and September 30, 2004.

 

***Significant Customers***

 

The following table summarizes those customerswho accounted for greater than 10% of the Company’s net revenues or accountsreceivable:

 
| ** ** | ** ** | **Net Revenues**                      | ** ** | ** **                           | ** ** | ** **                                | ** ** |
|------------|------------|---------------------------------------|------------|--------------------------------------|------------|-------------------------------------------|------------|
| ** ** | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** | **Accounts Receivable  at June 30,** | ** ** |
| ** ** | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Customer A |       | 83                                    | %          | 49                                   | %          | 79                                        | %          | 50 | % | 70 | % | 40 | % |

 

**3.  VALUATION OF GOODWILL ANDINTANGIBLE ASSETS AND RELATED IMPAIRMENT**

 

On December 10, 2003, the Company amended its agreement with EMCregardingthe distribution of EMC-approved Fibre Channel host bus adaptors (“HBAs”). Thisamendment required the Company to pay a royalty to EMC for each EMC-approvedHBA sold by the Company. As a result of the negative effect of this amendmenton the Company’s gross profits related to sales of EMC-approved Fibre ChannelHBAs, the Company’s Distribution segment gross profits and the Company’sconsolidated gross profits and operating results, the Company considered thisamendment to be a triggering event requiring examination for potentialimpairment of its goodwill, in accordance with Statement of FinancialAccounting Standard No. 142, and intangible assets, in accordance withStatement of Financial Accounting Standard No. 144. As a result, theCompany conducted a detailed analysis of its goodwill and intangible assets asof December 10, 2003. This analysis resulted in the determination that thefair value of the reporting unit exceeded the carrying value and thereforegoodwill was not impaired by this amendment. The Company’s impairment analysisof its intangible assets resulted in the determination that the fair value ofthe intangible assets was less than the carrying amount of its intangibleassets, which resulted in a charge to operations of approximately $3,614,000 inthe quarter ended December 31, 2003. At June 30, 2005 and September 30,2004, the Company’s goodwill was carried at $7,769,000.

 

8

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**4.  NET INCOME (LOSS) PER SHARE**

** **

Basicnet income (loss) per share is computed by dividing the net income (loss) forthe period by the weighted average number of shares of common stock outstandingduring the period, excluding shares of common stock subject to repurchase bythe Company (“restricted shares”). Diluted net income (loss) per share iscomputed by dividing the net income (loss) for the period by the weightedaverage number of shares of common stock and potential common stock outstandingduring the period, if dilutive. Potential common stock includes incremental sharesof common stock issuable upon the exercise of stock options.

 

Thefollowing table sets forth the computation of basic and diluted net income(loss) per share as well as the weighted average potential common stockexcluded from the calculation of net loss per share because their inclusionwould be anti-dilutive (in thousands):

 
| ** **                                                                                                      | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                      | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Numerator:                                                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Net income (loss)                                                                                               |       | $                                     | (1,801     | )                                    | $          | 726 |   | $ | (4,462 | ) | $ | (371 | ) |
|                                                                                                            |       |                                  |       |                                 |       |   |   |   |   |
| Denominator:                                                                                                    |       |                                  |       |                                 |       |   |   |   |   |
| Shares used in computing basic net income  (loss) per share                                                     |       | 37,582                                |       | 36,886                               |       | 37,357 |   | 36,445 |   |
| Employee stock options and restricted stock                                                                     |       | —                                |       | 3,156                                |       | — |   | — |   |
|                                                                                                            |       |                                  |       |                                 |       |   |   |   |   |
| Shares used in computing diluted net income  (loss) per share                                                   |       | 37,582                                |       | 40,042                               |       | 37,357 |   | 36,445 |   |
|                                                                                                            |       |                                  |       |                                 |       |   |   |   |   |
| Net income (loss) per share:                                                                                    |       |                                  |       |                                 |       |   |   |   |   |
| Basic                                                                                                           |       | $                                     | (0.05      | )                                    | $          | 0.02 |   | $ | (0.12 | ) | $ | (0.01 | ) |
| Diluted                                                                                                         |       | $                                     | (0.05      | )                                    | $          | 0.02 |   | $ | (0.12 | ) | $ | (0.01 | ) |
|                                                                                                            |       |                                  |       |                                 |       |   |   |   |   |
| Anti-dilutive potential common stock  equivalents excluded from the calculation of net income (loss) per share: |       |                                  |       |                                 |       |   |   |   |   |
| Options to purchase common stock                                                                                |       | 4,674                                 |       | 1,531                                |       | 4,537 |   | 4,681 |   |
| Restricted common stock                                                                                         |       | —                                |       | —                               |       | — |   | 9 |   |
| Total                                                                                                           |       | 4,674                                 |       | 1,531                                |       | 4,537 |   | 4,690 |   |

 

**5.  INVENTORIES**

 

Inventories consisted of the following (inthousands):

 

| ** **      | ** ** | **June 30, 2005** | ** ** | **September 30, 2004** | ** ** |
|-----------------|------------|------------------------|------------|-----------------------------|------------|
| ** **      | ** ** | ** **             | ** ** | ** **                  | ** ** |
| Raw materials   |       | $                      | 5,011      |                        | $          | 4,909 |   |
| Work in process |       | 814                    |       | 1,579                       |       |
| Finished goods  |       | 6,819                  |       | 7,854                       |       |
|            |       |                   |       |                        |       |
|            |       | $                      | 12,644     |                        | $          | 14,342 |   |

 

9

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**6.  CAPITAL LEASE AGREEMENT**

** **

During the three months ended June 30, 2005,the Company entered into a lease agreement for certain office equipment that isaccounted for as a capital lease. The Company has assets acquired under capitallease obligations amounting to $101,000 at June 30, 2005.  Accumulated amortization was not material at June 30,2005.  Amortization of such equipment isincluded in depreciation and amortization expense.

 

At June 30, 2005, the minimal annual rentalcommitments, under this capital lease agreement are as follows (in thousands):

 

| 2005                                              |   | $      | 6      |   |
|---------------------------------------------------|--------|--------|--------|--------|
| 2006                                              |   | 24     |   |
| 2007                                              |   | 24     |   |
| 2008                                              |   | 24     |   |
| 2009                                              |   | 24     |   |
| Thereafter                                        |   | 18     |   |
|                                              |   |   |   |
| Total minimum lease payments                      |   | 120    |   |
| Less amount representing interest                 |   | 19     |   |
| Present value of minimum lease payments           |   | 101    |   |
| Less current portion                              |   | 22     |   |
| Capital lease obligation, net of current  portion |   | $      | 79     |   |

 

**7.  CONTINGENCIES**

 

  ***Guarantees andIndemnifications***

 

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. While the provisions of the agreements remain in effect indefinitely,the Company believes that the probability of receiving a claim is unlikely.  As a result, the Company has not recorded aliability for these indemnification clauses as of June 30, 2005.

 

The Company enters into standard indemnification agreements in theordinary course of its business. Pursuant to these agreements, the Companyindemnifies, holds harmless, and agrees to reimburse the indemnified party forlosses suffered or incurred by the indemnified party, generally its businesspartners or customers, in connection with any patent, copyright, trademark,trade secret or other intellectual property infringement claim by any thirdparty with respect to its products. The term of these indemnificationagreements is generally perpetual. The Company has never incurred costs todefend lawsuits or settle claims related to these indemnification agreements.As a result, the Company believes the estimated fair value of these agreementsis minimal. Accordingly, the Company has no liabilities recorded for theseindemnifications as of June 30, 2005.

 

Productwarranties – The Company offers and fulfills warranty services on certain ofits server appliances. In addition, while the Company was selling third-partydata storage networking products it contracted with a third party to providewarranty services for these products. The Company’s agreement with thisthird-party warranty provider expired in March 2005 as scheduled.  However, the terms of the agreement requirethe third-party warranty provider to service these products for the entirewarranty period. Warranty terms vary in duration depending upon the productsold but generally provide for the repair or replacement of any defectiveproducts for periods of up to 36 months after shipment. Based upon historicalexperience and expectation of future conditions, the Company reserves for theestimated costs to fulfill

 

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customer warranty obligations upon the recognition ofthe related revenue. For warranties related to third-party data storagenetworking products, the Company recorded warranty expense based on itsagreement with its third-party warranty fulfillment provider, whose fees weredetermined based on fixed periodic amounts as well as activity-based charges.

 

Thefollowing table presents changes in the Company’s product warranty liabilityfor the three and nine months ended June 30, 2005 and 2004, respectively (inthousands):

 
| ** **                                   | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                   | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                         |       |                                  |       |                                 |       |   |   |   |   |
| Beginning balance                            |       | $                                     | 427        |                                 | $          | 513 |   | $ | 433 |   | $ | 605 |   |
| Accruals for warranties issued               |       | 219                                   |       | 376                                  |       | 762 |   | 978 |   |
| Cost of warranties honored during the period |       | (260                                  | )          | (361                                 | )          | (809 | ) | (1,055 | ) |
| Ending balance                               |       | $                                     | 386        |                                 | $          | 528 |   | $ | 386 |   | $ | 528 |   |

 

***Contingencies***

 

*AnnouncementTiming Lawsuit*

* *

On March 17, 2004, the United States District Court for theDistrict of Massachusetts (the “Court”) consolidated a number of purportedclass action lawsuits filed against Network Engines, Inc. and certainindividual Network Engines defendants (collectively the “Defendants”). These suits generally concern the timing of the announcement of anamendment to Network Engines’ agreement with EMC Corporation regarding theresale of EMC-approved Fibre Channel HBAs.  The Plaintiffs filed anamended consolidated complaint on June 4, 2004.  The Defendants on August 13,2004 filed a motion to dismiss the amended consolidated complaint.  ThePlaintiffs on October 12, 2004 filed an opposition to the Defendants’motion to dismiss and the Defendants filed a reply to the Plaintiff’sopposition on November 12, 2004. The Court on November 22, 2004 denied the Defendant’s motion todismiss the amended consolidated complaint. On December 23, 2004, theDefendants filed an answer to the amended consolidated complaint.

 

Since that time the parties have engaged in some informal discovery and,more recently, have exchanged formal discovery requests.  Pursuant to the Court-approved schedule inthe case, the plaintiffs’ class certification motion is due on August 5,2005 and any opposition is due on October 5, 2005.  Discovery is to conclude on or before March 31,2006.  Network Engines believes that thePlaintiffs’ allegations are without merit, and it intends to pursue a vigorousdefense.  The Company is unable to predict the outcome of this suit andits ultimate effect, if any, on the Company’s financial condition; however, theCompany’s defense against this suit may result in the expenditure ofsignificant financial and managerial resources.  No amounts have beenaccrued for this matter.

 

*TidalWireAcquisition Lawsuit*

* *

Apurported class action and derivative lawsuit was filed on January 7, 2003in the Court of Chancery in the State of Delaware against the Company, andcertain members of its Board of Directors relating to the acquisition ofTidalWire Inc.  The plaintiffs in thecomplaint alleged that the Company and the named directors of its Board ofDirectors breached their fiduciary duties by, among other things, paying anexcessive amount in the acquisition of TidalWire Inc. and purportedly failingto disclose material facts in the Company’s Joint Proxy Statement/InformationStatement distributed to stockholders for approval of the issuance of shares ofthe Company’s Common Stock in the merger. The plaintiffs sought damages, rescission of the merger and otherrelief. On October 30, 2003, the court approved a settlement of the actionnegotiated by the parties, and that settlement became final on December 1,2003.  Under the settlement, all claimsagainst the Company and its individual board members were dismissed withprejudice, and (a) the

 

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defendants in the lawsuit paid $600,000 to theCompany, (b) plaintiff’s attorney fees of $185,000 were paid out of that$600,000 amount and (c) in the disclosure for the Company’s next annualmeeting, the Company was required to detail certain information concerningrelationships among its board members, which the Company has complied with.Payments to the Company under this settlement, net of payments of plaintiff’sattorney fees, were recorded as an increase of $415,000 to additional paid-incapital during the quarter ended December 31, 2003.

 

*InitialPublic Offering Lawsuit*

* *

On orabout December 3, 2001, a putative class action lawsuit was filed in theUnited States District Court for the Southern District of New York against theCompany, Lawrence A. Genovesi (the Company’s Chairman and former ChiefExecutive Officer), Douglas G. Bryant (the Company’s Chief Financial Officerand Vice President of Finance and Administration), and the followingunderwriters of the Company’s initial public offering: FleetBoston RobertsonStephens, Inc., Credit Suisse First Boston Corp., Goldman Sachs &Co., Lehman Brothers Inc. and Salomon Smith Barney, Inc. (collectively,the “Underwriter Defendants”). An amended class action complaint, captioned Inre Network Engines, Inc. Initial Public Offering Securities Litigation, 01Civ. 10894 (SAS), was filed on April 20, 2002.

 

The suit alleges that the defendants violated thefederal securities laws by issuing and selling securities pursuant to 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 alsoalleges that the Underwriter Defendants entered into agreements with certaincustomers whereby the Underwriter Defendants agreed to allocate to thosecustomers shares of the Company’s common stock in the offering, in exchange forwhich the customers agreed to purchase additional shares of the Company’scommon stock in the aftermarket at pre-determined prices. The suit alleges thatsuch tie-in arrangements were designed to and did maintain, distort and/orinflate the price of the Company’s common stock in the aftermarket. The suitfurther alleges that the Underwriter Defendants received undisclosed andexcessive brokerage commissions and that, as a consequence, the UnderwriterDefendants successfully increased investor interest in the manipulated IPOsecurities and increased the Underwriter Defendants’ individual and collectiveunderwritings, compensation and revenues. The suit seeks damages and certificationof a plaintiff class consisting of all persons who acquired shares of theCompany’s common stock between July 13, 2000 and December 6, 2000.

 

In July 2002,the Company, Lawrence A. Genovesi and Douglas G. Bryant joined in an omnibusmotion to dismiss the suit challenging the legal sufficiency of plaintiffs’claims. The motion was filed on behalf of hundreds of issuer and individualdefendants named in similar lawsuits. Plaintiffs opposed the motion, and theCourt heard oral argument on the motion in November 2002. On February 19,2003, the Court issued an opinion and order denying the motion as to theCompany. However, in October 2002, Lawrence A. Genovesi and Douglas G.Bryant were dismissed from this case without prejudice.

 

On July 9, 2003, a Special Committee of theCompany’s Board of Directors authorized the Company to negotiate a settlementof the pending claims substantially consistent with a memorandum ofunderstanding negotiated among class plaintiffs, all issuer defendants andtheir insurers.  The parties havenegotiated the settlement, which provides, among other things, for a release ofthe Company and the Individual Defendants for the conduct alleged in theamended complaint to be wrongful.  TheCompany would agree to undertake other responsibilities under the settlement,including agreeing to assign, or not assert, certain potential claims that itmay have against its underwriters.  Anydirect financial impact of the proposed settlement is expected to be borne bythe Company’s insurers.  Any suchsettlement would be subject to various contingencies, including approval by theCourt overseeing the litigation. On February 15, 2005, the Court issued an Opinion and Order preliminarilyapproving the settlement, provided that the defendants and plaintiffs agree toa modification narrowing the scope of the bar order set forth in the originalsettlement agreement.

 

12

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TheCompany is unable to predict the outcome of this suit and its ultimate effect,if any, on the Company’s financial condition; however, the Company’s defenseagainst this suit has and may continue to result in the expenditure ofsignificant financial and managerial resources. No amounts have been accruedfor this matter.

 

**8.  RESTRUCTURING CHARGE**

 

Duringthe quarter ended December 31, 2004, the Company discontinued sales ofthird-party data storage networking products based on a review of that portionof the business and its prospects.  Thecommoditization of Fibre Channel HBA technology and increasing competition inthe market resulted in the Company experiencing declining gross profits relatedto its distribution of HBAs. As a result, the Company recorded a restructuringcharge of $366,000 during the quarter ended December 31, 2004.  Approximately $283,000 of the charge relatedto one-time termination benefits associated with terminating eleven employeesin this portion of the business during the quarter. The Company also incurred$83,000 for a fixed payment related to its warranty fulfillment contract withan external service provider. The Company completed its sales of its remainingthird-party data storage networking products during the quarter ended December 31,2004.  The Company completed its paymentsunder this restructuring obligation during the quarter ended March 31,2005.

 

Thefollowing table sets forth restructuring charge accrual activity during thenine months ended June 30, 2005 (in thousands):

 
| ** **                                                       | ** ** | **Employee  Related** | ** ** | **Other** | ** ** | **Total** | ** ** |
|------------------------------------------------------------------|------------|-----------------------|------------|-----------|------------|-----------|------------|
|                                                             |       |                  |       |      |       |      |       |
| Restructuring charge accrual balance at  September 30, 2004 |       | $                     | —     |      | $          | —    |       | $ | — |   |
|                                                             |       |                  |       |      |       |      |       |
| Restructuring charge                                             |       | 283                   |       | 83        |       | 366       |       |
|                                                             |       |                  |       |      |       |      |       |
| Cash payments                                                    |       | (116                  | )          | —    |       | (116      | )          |
| Restructuring charge accrual balance at December 31,  2004  |       | 167                   |       | 83        |       | 250       |       |
| Cash payments                                                    |       | (167                  | )          | (83       | )          | (250      | )          |
| Restructuring charge accrual balance at  June 30, 2005      |       | $                     | —     |      | $          | —    |       | $ | — |   |

 

**9.  RELATED PARTY TRANSACTIONS**

 

Robert M. Wadsworth, one of the Company’s directors,is a managing director of the limited liability corporation that controlsHarbourVest Partners (and its affiliates), one of the Company’s significantstockholders. Mr. Wadsworth,is also a director of PSI Holding Group, Inc. (“PSI”), the parent companyof Akibia, Inc. (“Akibia”). During the three and nine months ended June 30,2005 and 2004, HarbourVest owned greater than 5% of the outstanding stock ofthe Company and greater than 5% of the outstanding stock of PSI. While theCompany was selling third-party data storage networking products it engagedAkibia to provide certain customer support and warranty fulfillment servicesrelated to the Company’s sales of HBAs. The Company’s agreement with Akibiaexpired in March 2005 as scheduled. However, the terms of the agreement required Akibia fulfill the warrantyservices for the entire warranty period. Akibia charged the Company a quarterly fixed fee of $83,000 and avariable fee based upon the Company’s sales of HBAs, which ended in December 2004.In the three months ended June 30, 2005 and 2004, the Company recognized$0 and $191,000, respectively, of expense as a result of this warrantyfulfillment services agreement with Akibia.  In the nine months ended June 30,2005 and 2004 the Company recognized $201,000 and $604,000, respectively, ofexpense for these services.  In connection with this customer supportand warranty fulfillment services agreement, the Company also sold product toAkibia to allow Akibia to fulfill the Company’s warranty obligations for theseproducts. In the three months ended June 30, 2005 and 2004, the Companyrecorded revenues of approximately $0 and $27,000, respectively, from sales ofHBAs to Akibia. In the nine months ended June 30, 2005 and 2004, theCompany recorded revenues of approximately $40,000 and $54,000, respectively,from sales of HBAs to Akibia. The

 

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Company also purchased certain products sold throughits Distribution segment from Akibia to fulfill customer orders. In the ninemonths ended June 30, 2004, the Company purchased approximately $19,000 ofinventory from Akibia for resale to the Company’s Distribution segmentcustomers.  No such purchases were madeduring the three and nine months ended June 30, 2005.

 

Inaddition, during the three and nine months ended June 30, 2004, theCompany sold approximately $17,000 and $60,000, respectively, of serverappliance products to Akibia for resale. The Company had no sales of server appliance products to Akibia duringthe three and nine months ended June 30, 2005.  In addition, the Company engaged Akibia toprovide certain customer support and warranty fulfillment services to certainof its server appliance customers in both its OEM Appliance and Distributionsegments. Under the terms of this agreement, the Company was obligated to payAkibia certain fixed fees and certain activity-based fees based on actualwarranty experience. The Company no longer engages Akibia for these supportservices.  As a result, there were noexpenses recorded for the three and nine months ended June 30, 2005. Inthe three and nine months ended June 30, 2004, the Company recordedexpenses totaling approximately $10,200 and $50,500, respectively, related tothis agreement.  At June 30, 2005and September 30, 2004, the Company had amounts payable to Akibia ofapproximately $0 and $143,000, respectively, and amounts receivable from Akibiaof $0 and $51,000, respectively.

 

Mr. Wadsworthalso serves as a director of Innoveer Solutions, Inc. (“Innoveer”),formerly Akibia Consulting, a subsidiary of Akibia.  The Company previously engaged Innoveer toperform certain professional services related to an upgrade of its customerresource management (“CRM”) software system that was completed during fiscalyear 2004. The Company incurred approximately $243,000 related to this upgradeproject in the three and nine months ended June 30, 2004. The Company alsoengages Innoveer to provide professional services related to modifications ofits CRM software system.  During the ninemonths ended June 30, 2005, the Company incurred approximately $14,300related to these services.  The Companyhad no amounts outstanding to Innoveer at June 30, 2005.

 

Several of the Company’s directors haverelationships outside of their positions on the Company’s board of directors.John A. Blaeser, one of the Company’s directors, was the president and CEO ofthe public company Concord Communications, Inc. prior to its acquisitionby Computer Associates, Inc. on June 7, 2005, and served on its boardof directors. Robert M. Wadsworth, also one of the Company’s directors, is amanaging director of the limited liability corporation that controlsHarbourVest Partners (and its affiliates), one of the Company’s significantstockholders. Mr. Wadsworth was also a director of Concord Communications,where he was the chairman of the compensation committee of its board ofdirectors, which determined the compensation and benefits of ConcordCommunications’ executive officers, including the compensation of Mr. Blaeser.Further, Gary E. Haroian, one of the Company’s directors, was formerly ChiefFinancial Officer of Concord Communications while Mr. Blaeser was theChief Executive Officer of that organization, and was formerly the Controllerof Stratus Computer while John H. Curtis, our President and Chief ExecutiveOfficer, was Chief Financial Officer of that organization.

 

Mr. Polestra,a director of the Company, was a managing director of Ascent VenturePartners.  Both Mr. Polestra and Mr. Blaeserare limited partners in one of Ascent Venture Partner’s funds, which ownsgreater than 5% of the outstanding capital stock of Network IntelligenceCorporation.  Network IntelligenceCorporation has a contract with the Company to purchase certain of itsproducts.  In the three months ended June 30,2005 and 2004, sales to Network Intelligence Corporation were approximately$890,000 and $660,000, respectively.   Sales toNetwork Intelligence Corporation for the nine months ended June 30, 2005and 2004 were $2,962,000 and $2,460,000, respectively.  At June 30, 2005 and September 30,2004, the Company had $664,000 and $474,000, respectively, of receivables fromNetwork Intelligence Corporation.

 

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

 

**Special Note Regarding 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 of historical information provided hereinare forward-looking statements and may contain information about financialresults, economic conditions, trends and 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 elsewhere in this report and the risks discussed in ourother filings with the Securities and Exchange Commission. Readers arecautioned not to place undue reliance on these forward-looking statements,which reflect management’s analysis, judgment, belief or expectation only as ofthe date hereof. We undertake no obligation to publicly reissue theseforward-looking statements to reflect events or circumstances that arise afterthe date hereof.

 

The following discussion and analysis shouldbe read in conjunction with the condensed consolidated financial statements andthe notes thereto included in Item 1 in this Quarterly Report on Form 10-Qand our Annual Report on Form 10-K for the fiscal year ended September 30,2004 filed by the Company with the Securities and Exchange Commission.

 

**Overview**

** **

We develop, manufacture and distribute serverappliance solutions that enable network equipment providers and independentsoftware vendors, or ISVs, to deliver data storage and security networkingapplications on server appliances. Server appliances are pre-configured network infrastructure devicesdesigned to deliver specific application functionality. The server appliance issold and supported by the network equipment or ISV partner in our OEM Appliancesegment, or by us through our Distribution segment.

 

We also distributed third-party data storagenetworking products, primarily Fibre Channel host bus adapters, or HBAs, andnetwork security products to our customer base of value-added resellers, orVARs, and systems integrators.  Duringthe quarter ended December 31, 2004, we decided to discontinue sellingthese third-party data storage networking products.  This decision was based on a review of thisportion of the business and its prospects. As a result of the commoditization of the Fibre Channel HBA technologyand increasing competition in the distribution of HBAs, we experienceddeclining gross profits from sales of these products.  Furthermore, future net revenues and grossprofits in this portion of our Distribution segment were expected to deteriorate.  We believe this decision enables us to focusour remaining distribution sales, marketing, and support infrastructure on thesale of our NS Series Security Appliances powered by Microsoft InternetSecurity and Acceleration (ISA) Server 2004. Our first product in our line of NS Series Security Appliancesbecame available for sale during the quarter ended December 31, 2004.

 

We are currently organized into two reportablesegments: OEM Appliance and Distribution.

 

**OEM Appliance segment**

 

Our OEM Appliance segment leverages our serverappliance development, manufacturing and supply chain services. We design,produce and fulfill devices branded for our network equipment and ISV partners,and we derive our revenues from the sale of the value-added hardware platformsand certain services to these partners. These partners subsequently sell andsupport the server appliance under their own brands to their customer base.During the three and nine months ended June 30, 2005, sales to EMCrepresented 84% of our OEM Appliance segment revenues.

 

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**Distribution segment**

** **

Revenues from our Distribution segment have beenderived from two activities: first is the revenue derived from the distributionof third-party products and components, primarily related to data storage areanetworking; second is the distribution of our NS Series SecurityAppliances that we develop, manufacture, sell and support.

 

*Third-party data storage productrevenues*.  To date,substantially all of our Distribution segment revenues have been derived fromthe sale of third-party data storage networking components and products,predominantly EMC-approved Fibre Channel HBAs. We had been one of two authorized distributors in North America forFibre Channel HBAs that had been approved by EMC, although other companies werepermitted by EMC to sell such HBAs and EMC sells such HBAs itself. We were alsoa distributor of standard Fibre Channel HBAs, network switches, other storagearea networking products.

 

During the quarter ended December 31, 2004, wediscontinued sales of these third-party data storage networking products.  As a result, during the three months ended June 30,2005 we generated no revenues from the sale of these products.  During the nine months ended June 30,2005, sales of these third-party data storage networking products represented94% of our Distribution segment revenues.

 

Based on our decision to discontinue sales ofthird-party data storage networking products, and because our NS Series lineof security appliances is an emerging opportunity, we expect that Distributionnet revenues for fiscal 2005 will decline significantly from the prior fiscalyear. Prospectively, we expect our Distribution segment revenues will consistprimarily of sales of our NS Series Security Appliances.

 

*Server appliance revenues*.  Server appliance revenues are derived fromthe sale and support of server appliances we developed in conjunction withcertain of our ISV partners. In this case, we are acting as a value-addeddistributor for the ISV, distributing the ISV’s software in the form of aserver appliance, and acting as the point of sale and support for the device.To date, server appliance sales have represented a small portion of ourDistribution segment revenues.  In October 2004,we began to sell our new NS6300 Security Appliance, which has been developed bylicensing Microsoft’s Internet Security and Acceleration (“ISA”) Server 2004software application. In February 2005, we announced the introduction oftwo new products in our line of NS Series Security Appliances, the NS6200and NS6400. We expect that the sale of our NS Series Security Applianceswill be the primary source of our future Distribution segment revenues, howeverwe expect that it will take several quarters for revenues from sales of theseserver appliances to become significant.

* *

## **CriticalAccounting Policies And Estimates**

## ** **

Our discussion and analysis of financial condition andresults of operations are based upon our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States. In preparing these financial statements, we havemade estimates and judgments in determining certain amounts included in thefinancial statements. We base our estimates and judgments on historicalexperience and other various assumptions that we believe to be reasonable underthe circumstances.  Actual results maydiffer from these estimates under different assumptions or conditions. Webelieve the following critical accounting policies affect our more significantjudgments and estimates used in the preparation of our financial statements.

 

***Revenuerecognition***

*** ***

Revenues from products are generally recognized upondelivery to customers if persuasive evidence of an arrangement exists, the feeis fixed or determinable, collectibility is reasonably assured and title andrisk of loss have passed to the customer. In the event we have unfulfilled future obligations, revenue and relatedcosts are deferred until those future obligations are met. We have an inventoryconsignment agreement with our largest customer related to certain serverappliances sold through our OEM Appliance segment. This customer notifies uswhen it utilizes inventory and we recognize revenues from sales to thiscustomer based upon these notifications.

 

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Maintenance revenues are derived from customer supportagreements 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, hardware repairs, 24-hour customer support, andadvanced replacement of server appliances. Maintenance revenues are recognizedratably over the term of the maintenance period. Payments for maintenance feesare generally made in advance and are included in deferred revenue.

 

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 assess whether the sales price is fixed ordeterminable based on the payment terms associated with the transaction andwhether the sales price is subject to refund or adjustment. We assesscollectibility based primarily on the creditworthiness of the customer asdetermined by credit checks and analysis, as well as the customer’s paymenthistory.

 

For revenue arrangements that contain multipleelements, such as the sale of both the product and post-sales support, in whichsoftware is not incidental to the product, such as our sales of serverappliances through our Distribution segment, we determine fair value based uponvendor specific objective evidence, which is typically established throughcontractual post-sales support renewal rates whereby the residual fair value isallocated to the server appliance.  Forrevenue arrangements that contain multiple elements, in which software is notincluded or is incidental to the product, such as our sales of serverappliances through our OEM Appliance segment, we determine fair value based onobjective and reliable evidence of fair value, which is typically determinedthrough contractual refund rates for cancellations, stand-alone sales of postsales support, and competitive market analyses whereby the residual fair valueis allocated to the server appliance.

 

We recognize revenue when the revenue recognitioncriteria for each element of the sale is met. If we are not able to derive the fair value of each element of the sale,all revenues from the arrangement are deferred and recognized ratably over theperiod of the support arrangement, which is typically one to three years.

 

***Allowances forDoubtful Accounts and Sales Returns***

*** ***

Our allowance for doubtful accounts is based on ourassessment of the collectibility of customer accounts. We regularly review theallowance by considering factors such as historical experience, credit quality,age of the accounts receivable balances, and current economic conditions thatmay affect a customer’s ability to pay. If a major customer’s creditworthinessdeteriorates, or if actual defaults are higher than our historical experience,or if other circumstances arise, our estimates of the recoverability of amountsdue to us could be overstated, and additional allowances could be required,which could have an adverse impact on our results of operations.

 

Historically, our Distribution segment customers wereoffered a thirty-day right of return on “un-opened” third-party data storagenetworking products.   A reserve forsales returns was established based on historical trends in product returnrates. The reserve for sales returns was recorded as a reduction of ourrevenues and accounts receivable. All rights of return related to sales ofthese products expired at December 31, 2004.  We record sales returns reserves related tosales of server appliances for certain customers based on contractual terms.

 

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***Inventories***

*** ***

We value inventory at the lower of cost or estimatedmarket, and determine cost on a first-in, first-out basis. We regularly reviewinventory quantities on hand and record a write-down for excess or obsoleteinventory based primarily on our estimated forecast of product demand andanticipated production requirements in the near future. Any rapid technologicalchanges and future product development could result in an increase in theamount of obsolete inventory quantities on hand. Agreements with certain of ourOEM Appliance customers include inventory protection provisions, however, theseprovisions may not provide us with complete protection from loss due to excessor obsolete inventory.

 

***ProductWarranty Obligations***

*** ***

We offer a warranty on certain of our products thatgenerally provide for us to repair or replace any defective products for aperiod of up to 36 months after shipment. We reserve for the estimated costs tofulfill customer warranty obligations upon the recognition of the relatedrevenue and record warranty expense as a component of cost of sales.

 

*OEM Server appliance products*– Costs included in our server appliance product warranty obligation includeshipping, materials, internal and external labor, and travel. Significantjudgment and estimates are involved in estimating our warranty reserve on ourOEM server appliance products. Although our current OEM server applianceproducts use more standards-based technologies than in the past, certain of ourserver appliance products incorporate proprietary technologies, which mayincrease our risks related to product warranty obligations. In the past we haveexperienced unexpected component failures in certain of our server applianceproducts, which have required us to increase our product warranty accruals. Atthe time any unexpected component failure arises, we assess the costs to repairany defects and record what we believe to be an appropriate warranty obligationbased on the available information at the time. To the extent we may experienceincreased warranty claim activity, increased costs associated with servicingthose claims, or use estimates that prove to be materially different fromactual claims, our product warranty obligations may need to be increased,resulting in decreased gross profits.

 

*NS Series security applianceproducts-* Our NS Series Security Appliances typically donot include a general warranty, but instead customers typically are required topurchase an annual maintenance program at the time of the appliance purchase.Our NS Series Security Appliances sold in Europe are sold with athirteen-month hardware warranty.

 

*HBA products*- OurHBA warranty expense was determined based upon contractual rates with athird-party warranty provider who we paid to perform substantially allactivities related to the fulfillment of our HBA product warranty obligations.As such, the warranty expense that we recognized for past shipments is fixedand is not subject to change.

 

***Goodwilland long-lived assets***

*** ***

Goodwill represents the excess purchase price over thefair value of the net tangible and intangible assets acquired.  We review long-lived assets at least annuallyto determine if any adverse conditions exist that would indicate impairment.  Conditions that would trigger a more frequentimpairment assessment include, but are not limited to, a significant adversechange in certain agreements, or business climate that could affect the valueof an asset. We assess the recoverability of long-lived assets based on theprojected undiscounted future cash flows over the asset’s remaining life. Theamount of impairment, if any, is measured based on the excess of the carryingvalue over fair value.  Fair value isgenerally calculated as the present value of estimated future cash flows usinga risk-adjusted discount rate, which requires significant management judgmentwith respect to revenue and expense growth rates, and the selection and use ofan appropriate discount rate.

 

Goodwill is reviewed each year in the fourth quarterfor impairment, or more frequently if certain indicators are present.  Examples of such indicators that would causeus to test goodwill for impairment between annual tests include, but are notlimited to a significant adverse change in the business climate, unanticipatedcompetition, or a loss of key personnel. When conducting our impairmentevaluation, we

 

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compare the carrying value of the reporting unit, as defined, to thefair value of the reporting unit. 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 as the present valueof estimated future cash flows using a risk-adjusted discount rate, andincludes significant judgments by management. We believe that the mostsignificant judgments involved in the determination of the fair value of ourgoodwill is our expectation of future revenues and gross profits from our salesof server appliances through our Distribution segment. We have a limitedhistory selling server appliances through our Distribution segment. Differentassumptions utilized in the determination of the fair value of our goodwillcould yield materially different results.

 

***Incometax asset valuation***

 

We record deferred tax assets and liabilities based onthe net tax effects of tax credits, operating loss carryforwards and temporarydifferences between the carrying amounts of assets and liabilities forfinancial reporting purposes and the amounts used for income tax purposes. Wethen assess the likelihood that our deferred tax assets will be recovered fromfuture taxable income and, to the extent we believe that recovery is notlikely, we establish a valuation allowance. The valuation allowance is based onour estimate of future taxable income and the period over which our deferredtax assets will be recoverable. At June 30, 2005, we believe that it ismore likely than not that all of our deferred tax assets will not be realized,and, accordingly, we have recorded a valuation allowance against all of ourdeferred tax assets. If results of operations in the future indicate that someor all of the deferred tax assets will be recovered, the reduction of thevaluation allowance will be recorded as a tax benefit.  To the extent that net operating losses, whenrealized, relate to stock options deductions of approximately $1.1 million, theresulting benefits will be credited to additional paid-in capital.

 

**Results of Operations**

 

## **Three monthsended June 30, 2005 compared to the three months ended June 30, 2004**

 

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

 
| ** **           | ** ** | **Three Months Ended June 30,** | ** ** |
|----------------------|------------|--------------------------------------|------------|
| ** **           | ** ** | **2005**                             | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **           | ** ** | **Dollars**                          | ** ** | **%****of Net  Revenues** | ** ** | **Dollars** | ** ** | **%****of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues         |       | $                                    | 24,305     |   | 100.0 | % | $ | 34,381 |   | 100.0 | % | $ | (10,076 | ) | (29 | )% |
| Gross profit         |       | 4,085                                |       | 16.8 | % | 5,772 |   | 16.8 | % | (1,687 | ) | (29 | )% |
| Operating expenses   |       | 6,172                                |       | 25.4 | % | 5,118 |   | 14.9 | % | 1,054 |   | 21 | % |
| Loss from operations |       | (2,087                               | )          | (8.6 | )% | 654 |   | 1.9 | % | (2,741 | ) | (419 | )% |
| Net loss             |       | (1,801                               | )          | (7.4 | )% | 726 |   | 2.1 | % | (2,527 | ) | (348 | )% |
|                      |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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# ***NetRevenues and Gross Profit***

 

The following table summarizes our net revenues and gross profit byreportable segment, in thousands and as a percentage of net revenues andprovides the changes in thousands and percentages:

 
| ** **             | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------|------------|--------------------------------------|------------|
| ** **             | ** ** | **2005**                             | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **             | ** ** | **Dollars**                          | ** ** | **%****of Net Revenues** | ** ** | **Dollars** | ** ** | **%****of Net Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| **OEM Appliance:**     |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net revenues           |       | $                                    | 24,096     |   | 100.0 | % | $ | 20,571 |   | 100.0 | % | $ | 3,525 |   | 17 | % |
| Gross profit           |       | 4,288                                |       | 17.8 | % | 4,270 |   | 20.8 | % | 18 |   | 0 | % |
|                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| **Distribution:**      |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net revenues           |       | 209                                  |       | 100.0 | % | 13,810 |   | 100.0 | % | (13,601 | ) | (98 | )% |
| Gross profit (loss)    |       | (203                                 | )          | (97.1 | )% | 1,502 |   | 10.9 | % | (1,705 | ) | (114 | )% |
|                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| **Total net revenues** |       | 24,305                               |       | 100.0 | % | 34,381 |   | 100.0 | % | (10,076 | ) | (29 | )% |
| **Total gross profit** |       | 4,085                                |       | 16.8 | % | 5,772 |   | 16.8 | % | (1,687 | ) | (29 | )% |
|                        |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Net Revenues***

 

Our revenues are derived from sales of serverappliances primarily to our OEM network equipment and ISV partners.  We also derived revenues from thedistribution of third-party data storage networking products, until wecompleted our exit from this portion of our Distribution business during thequarter ended December 31, 2004.

 

Our OEM Appliance segment net revenues increased inthe three months ended June 30, 2005 primarily due to an increase in salesvolumes to EMC, which represented 83% of OEM Appliance net revenues in thethree months ended June 30, 2005 versus 81% in the three months ended June 30,2004. Net revenues to other OEM Appliance partners for the three months ended June 30,2005 increased to $4 million from $3.8 million for the three months ended June 30,2004.

 

Our Distribution segment net revenues during the threemonths ended June 30, 2005 decreased significantly compared to netrevenues of $13.8 million in the three months ended June 30, 2004.  Net revenues for the three months ended June 30,2004 were primarily attributable to sales of third-party data storagenetworking products, which we no longer sell. As a result of discontinuing thesale these products, we expect that Distribution segment net revenues for thefiscal year 2005 will also decline significantly. We expect that in the futureour Distribution segment revenues will consist primarily of sales of our NS Series SecurityAppliances.

 

Our first NS Series Security Appliance, theNS6300, became available in October 2004 and our NS6200 and NS6400 wereintroduced during February 2005. Because the market penetration of these security appliances is in theearly stages, we have not experienced significant sales from these serverappliances during the three months ended June 30, 2005.  Additionally, we expect that it will takeseveral quarters before revenues from these server appliances becomesignificant.

 

***Gross Profit (Loss)***

*** ***

Gross profit (loss) represents net revenues recognizedless the cost of revenues. Cost of revenues includes cost of materials,warranty costs, inventory obsolescence charges, shipping and handling costs,customer support costs, and manufacturing costs, which are primarily comprisedof compensation, contract labor costs and, when applicable, contract manufacturingcosts.

 

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Gross profit in our OEM Appliance segment remainedconsistent for the three months ended June 30, 2005 compared to the threemonths ended June 30, 2004.  Grossprofit as a percentage of net revenues in our OEM Appliance segment decreasedfor the three months ended June 30, 2005 compared to the three monthsended June 30, 2004. This is due primarily to changes in product mix,which was partially offset by higher volumes. The decrease in gross profits andgross profits as a percentage of net revenues in our Distribution segment wassubstantially attributable to our exit from distributing third-party datastorage networking products.

 

Our gross profit is affected by the product mix withinour OEM Appliance business, our OEM Appliance segment product pricing as wellas the timing, size and configuration of server appliance orders. OEM Appliancegross profit is also affected by the mix of product manufactured internallycompared to product manufactured by our contract manufacturer, which carrieshigher manufacturing costs.  As volumescontinue to increase for a given OEM partner, we expect gross profits as apercentage of net revenues to decline due to higher discounting.  In addition, we expect gross profits to alsodecline in the fourth quarter of fiscal 2005 based on anticipated changes tothe OEM product mix, competitive pricing pressure, and higher costs ofmaterials related to early life cycle products. We expect gross profit to continue to be affected by these factors inboth the OEM Appliance and Distribution segments.  We expect that the gross margins as apercentage of revenue on our security appliances will initially besignificantly influenced by promotional activities targeted at achieving marketacceptance of these products.

 

***Operating Expenses***

** **

Themost significant components of our operating expenses are research anddevelopment, selling and marketing, and general and administrative expenses.The following table presents operating expenses during the periods indicated,in thousands and as a percentage of net revenues:

 
| ** **                        | ** ** | **Three Months Ended June 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|
| ** **                        | ** ** | **2005**                             | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| **Operating  Expenses:**          | ** ** | **Dollars**                          | ** ** | **%****of Net Revenues** | ** ** | **Dollars** | ** ** | **%****of Net Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and development          |       | $                                    | 1,702      |   | 7.0 | % | $ | 1,492 |   | 4.3 | % | $ | 210 |   | 14 | % |
| Selling and marketing             |       | 2,535                                |       | 10.4 | % | 2,177 |   | 6.3 | % | 358 |   | 16 | % |
| General and administrative        |       | 1,935                                |       | 8.0 | % | 1,497 |   | 4.4 | % | 438 |   | 29 | % |
| Stock compensation                |       | —                               |       | 0.0 | % | 28 |   | 0.1 | % | (28 | ) | (100 | )% |
| Amortization of intangible assets |       | —                               |       | 0.0 | % | 31 |   | 0.1 | % | (31 | ) | (100 | )% |
| Restructuring  charge             |       | —                               |       | 0.0 | % | (107 | ) | (0.3 | )% | 107 |   | (100 | )% |
|                              |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total operating expenses          |       | $                                    | 6,172      |   | 25.4 | % | $ | 5,118 |   | 14.9 | % | $ | 1,054 |   | 21 | % |

 

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*Research and development*

 

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

 
| ** **                      | ** ** | **Three Months Ended June 30,** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **2005**                             | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                      | ** ** | **Dollars**                          | ** ** | **%****of  Expense  Category** | ** ** | **Dollars** | ** ** | **%****of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and development        |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related        |       | $                                    | 1,201      |   | 71 | % | $ | 842 |   | 56 | % | $ | 359 |   | 43 | % |
| Prototype                       |       | 84                                   |       | 5 | % | 171 |   | 11 | % | (87 | ) | (51 | )% |
| Consulting and outside services |       | 210                                  |       | 12 | % | 247 |   | 17 | % | (37 | ) | (15 | )% |
| Other                           |       | 207                                  |       | 12 | % | 232 |   | 16 | % | (25 | ) | (11 | )% |
|                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total research and development  |       | $                                    | 1,702      |   | 100 | % | $ | 1,492 |   | 100 | % | $ | 210 |   | 14 | % |

 

Overall our server appliance development expenses haveincreased as a result of an increase in the development and sustainingengineering efforts related to existing, new and prospective ISV and networkequipment partners and increased software development activities related to ourNS Series Security Appliances. To support these development activities, wehave increased our research and development personnel from 30 at June 30,2004 to 42 at June 30, 2005, which has resulted in increased compensationcosts. Conversely, we have decreased the number of consultants used tosupplement our research and development personnel levels, which has resulted indecreased consulting and outside service costs. In addition, our prototype expenses for the three months ended June 30,2005 decreased from the three months ended June 30, 2004 as a result ofthe timing of certain engineering projects in our OEM Appliance segment.

 

Our server appliance development strategy emphasizesthe utilization of standard, off-the-shelf components in our server applianceplatforms. However, we expect that in some cases significant developmentefforts will be required to fulfill our current and potential ISV and networkequipment partners’ needs. In addition, for our NS Series SecurityAppliances, we intend to focus our software development in areas that improvethe ease of server appliance implementation and use, which we believe willenhance our value proposition.  We expectthat research and development costs will increase in the fourth quarter offiscal 2005 primarily due to the timing of certain development projects forboth our OEM Appliance segment and NS Series Security Appliances.

 

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*Selling and marketing*

 

Selling and marketing expenses consist primarily ofsalaries and commissions for personnel engaged in sales and marketing; costsassociated with our marketing programs, which include costs associated with ourattendance at trade shows, public relations, advertising, product literaturecosts, web site enhancements and product evaluation costs; recruiting andtravel. 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:

 
| ** **                  | ** ** | **Three Months Ended June 30,** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|
| ** **                  | ** ** | **2005**                             | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                  | ** ** | **Dollars**                          | ** ** | **%****of  Expense  Category** | ** ** | **Dollars** | ** ** | **%****of Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing       |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related    |       | $                                    | 1,389      |   | 55 | % | $ | 1,509 |   | 69 | % | $ | (120 | ) | (8 | )% |
| Marketing programs          |       | 618                                  |       | 24 | % | 231 |   | 11 | % | 387 |   | 168 | % |
| Travel                      |       | 268                                  |       | 11 | % | 167 |   | 8 | % | 101 |   | 60 | % |
| Other                       |       | 260                                  |       | 10 | % | 270 |   | 12 | % | (10 | ) | (4 | )% |
|                        |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and marketing |       | $                                    | 2,535      |   | 100 | % | $ | 2,177 |   | 100 | % | $ | 358 |   | 16 | % |

 

Our Distribution segment by its nature incurs more ofthe marketing and sales burden of the products that it sells and must engage ina higher level of marketing program activities than our OEM Appliance segment.Sales in our OEM Appliance segment are to our ISV and network equipmentpartners who market and sell their products, which incorporate our serverappliances. As a result, our OEM Appliance segment engages in a limited levelof marketing programs.

 

As indicated in the table above, the primary componentof the increase in selling and marketing expenses are marketing program costsoffset in part by a decrease in compensation costs. We have increased the levelof marketing programs during the quarter ended June 30, 2005 as a resultof the release of our NS Series Security Appliances. Our selling andmarketing personnel decreased, in the aggregate, from 44 at June 30, 2004to 40 at June 30, 2005. This net decrease represents decreases fromterminations and attrition related to our exit from the distribution ofthird-party data storage networking products, partially offset by increasedhiring related to our NS Series Security Appliance initiative. As aresult, compensation and related expenses decreased in the aggregate during thethree months ended June 30, 2005 as compared to the three months ended June 30,2004.  In addition, our travel expenseshave increased from the three months ended June 30, 2004 as a result ofour continued effort to build our channel of resellers and distributors for ourNS Series of security appliances. In particular we commenced our European sales operations during thequarter ended June 30, 2005, with our initial focus being in the UnitedKingdom.

 

We believe that we must continue our selling and marketingefforts in order to enhance our position as a leading provider of serverappliance products and to establish ourselves as a leader in network securityappliances. Variable marketing costs, such as marketing programs, are somewhatdependent on the timing and magnitude of new product introductions and willfluctuate depending on the level of this activity. We expect selling andmarketing expenses to increase in the fourth quarter of fiscal 2005 as wecontinue to develop our sales force in Europe.

 

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*General and administrative*

 

General and administrative expenses consist primarilyof salaries and other related costs for executive, accounting, internal audit,information technology and human resources personnel; professional services,which include legal, accounting, audit and tax fees, and consultants forSarbanes-Oxley compliance; director and officer insurance; and bad debtexpenses. The following table summarizes the most significant components ofgeneral and administrative expense for the periods indicated in thousands andas a percentage of total general and administrative expense and provides thechanges in thousands and percentages:

 
| ** **                           | ** ** | **Three Months Ended June 30,** | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|
| ** **                           | ** ** | **2005**                             | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                          | ** ** | **%****of Expense  Category** | ** ** | **Dollars** | ** ** | **%****of Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and administrative           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation                         |       | $                                    | 682        |   | 36 | % | $ | 656 |   | 44 | % | $ | 26 |   | 4 | % |
| Consulting and professional services |       | 835                                  |       | 44 | % | 441 |   | 29 | % | 394 |   | 89 | % |
| Director and officer insurance       |       | 246                                  |       | 13 | % | 238 |   | 16 | % | 8 |   | 3 | % |
| Bad debts                            |       | (30                                  | )          | (2 | )% | (34 | ) | (2 | )% | 4 |   | (12 | )% |
| Other                                |       | 202                                  |       | 10 | % | 196 |   | 13 | % | 6 |   | 3 | % |
|                                 |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total general and administrative     |       | $                                    | 1,935      |   | 100 | % | $ | 1,497 |   | 100 | % | $ | 438 |   | 29 | % |

 

As indicated in the table above, the primary componentof the increase in general and administrative expenses is increased consultingand professional services.  The increasein consulting and professional services is due primarily to increased costsrelated to our compliance with the Sarbanes-Oxley Act of 2002.

 

We expect general and administrative expenses toincrease in the fourth quarter of fiscal 2005 depending on costs associatedwith ongoing litigation and increased costs related to operating as a publiccompany, including compliance with the requirements of the Sarbanes-Oxley Actof 2002.

 

*Stock compensation*

 

Stock compensation for the three months ended June 30,2004 relates to the issuance of stock options with exercise prices below thedeemed fair value of the Company’s common stock on the date of issuance. Weamortized stock compensation over the vesting period of the related options.The decrease in stock compensation is due to the completed amortization of thedeferred stock compensation related to these options as scheduled.

 

*Amortization and impairment ofintangible assets*

 

In connection with our acquisition of TidalWire in December 2002,we recorded a definite-lived intangible asset attributable to TidalWire’sexisting customer relationships. This asset was being amortized on astraight-line basis over its estimated useful life. In December 2003, weamended our agreement with EMC regarding distribution of EMC-approvedHBAs.  This amendment required us to paya royalty to EMC for each EMC-approved HBA we sold.  As a result of the negative effect of thisamendment on our gross profits, we considered this amendment to be a triggeringevent requiring assessment for impairment. As a result, during the quarterended December 31, 2003 we conducted a detailed impairment analysis of ourintangible assets. This analysis resulted in the determination that the fairvalue of our intangible assets was less than its carrying amount, whichresulted in a charge to operations of approximately $3.6 million in the quarterended December 31, 2003. We also performed an impairment evaluation of theremaining carrying value of these intangible assets at September 30,2004.  This analysis resulted in theremaining carrying value of these intangible assets being written-off.  As a result of this reduction in the carryingvalue of the assets, there was no amortization expense for the three monthsended June 30, 2005.

 

24

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***Interestand Other Income (Expense), net***

*** ***

Interest and other income (expense), net hasincreased to $286,000 for the three months ended June 30, 2005 from$72,000 for the three months ended June 30, 2004. This increase is due tohigher interest rates earned combined with our higher cash, cash equivalents,and short-term investments.

 

**Results of Operations**

** **

**Nine months ended June 30, 2005 compared to the nine months ended June 30,2004**

** **

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

 
| ** **           | ** ** | **Nine Months Ended June 30,** | ** ** |
|----------------------|------------|-------------------------------------|------------|
| ** **           | ** ** | **2005**                            | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **           | ** ** | **Dollars**                         | ** ** | **%****of Net  Revenues** | ** ** | **Dollars** | ** ** | **%****of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues         |       | $                                   | 74,937     |   | 100.0 | % | $ | 105,851 |   | 100.0 | % | $ | (30,914 | ) | (29 | )% |
| Gross profit         |       | 14,249                              |       | 19.0 | % | 19,165 |   | 18.1 | % | (4,916 | ) | (26 | )% |
| Operating expenses   |       | 19,397                              |       | 25.9 | % | 19,752 |   | 18.7 | % | (355 | ) | (2 | )% |
| Loss from operations |       | (5,148                              | )          | (6.9 | )% | (587 | ) | (0.6 | )% | (4,561 | ) | 777 | % |
| Net loss             |       | $                                   | (4,462     | ) | (6.0 | )% | $ | (371 | ) | (0.4 | )% | $ | (4,091 | ) | 1103 | % |

 

# ***NetRevenues and Gross Profit***

 

The following table summarizes our net revenues and gross profit byreportable segment, in thousands and as a percentage of net revenues andprovides the changes in thousands and percentages:

 
| ** **             | ** ** | **Nine Months Ended June 30,** | ** ** |
|------------------------|------------|-------------------------------------|------------|
| ** **             | ** ** | **2005**                            | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **             | ** ** | **Dollars**                         | ** ** | **%****of Net  Revenues** | ** ** | **Dollars** | ** ** | **%****of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| **OEM Appliance:**     |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Net revenues           |       | $                                   | 69,986     |   | 100.0 | % | $ | 62,448 |   | 100.0 | % | $ | 7,538 |   | 12 | % |
| Gross profit           |       | 14,129                              |       | 20.2 | % | 12,919 |   | 20.7 | % | 1,210 |   | 9 | % |
|                   |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| **Distribution:**      |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Net revenues           |       | 4,951                               |       | 100.0 | % | 43,403 |   | 100.0 | % | (38,452 | ) | (89 | )% |
| Gross profit           |       | 120                                 |       | 2.4 | % | 6,246 |   | 14.4 | % | (6,126 | ) | (98 | )% |
|                   |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| **Total net revenues** |       | 74,937                              |       | 100.0 | % | 105,851 |   | 100.0 | % | (30,914 | ) | (29 | )% |
| **Total gross profit** |       | 14,249                              |       | 19.0 | % | 19,165 |   | 18.1 | % | (4,916 | ) | (26 | )% |
|                        |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

# ***Net Revenues***

# *** ***

OurOEM Appliance segment net revenues increased in the nine months ended June 30,2005 primarily due to an increase in sales volumes to EMC, which represented84% of OEM Appliance net revenues in the nine months ended June 30, 2005and 2004. In addition, net revenues to other OEM Appliance partners for thenine months ended June 30, 2005 increased to $11 million from $9.7 millionfor the nine months ended June 30, 2004.

 

OurDistribution segment net revenues during the nine months ended June 30,2005 decreased significantly compared to net revenues in the nine months ended June 30,2004.  Net revenues for the nine monthsended June 30, 2004 were primarily attributable to sales of third-partydata storage networking products, which we discontinued selling in the quarterended December 31, 2004.

 

25

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# ***Gross Profit***

 

Gross profit in our OEM Appliance segment increasedslightly for the nine months ended June 30, 2005 compared to the ninemonths ended June 30, 2004. Gross profit as a percentage of net revenuesin our OEM Appliance segment decreased for the nine months ended June 30,2005 compared to the nine months ended June 30, 2004. This is dueprimarily to product mix, which was partially offset by higher volumes. Thedecrease in gross profits and gross profits as a percentage of net revenues inour Distribution segment was attributable primarily to our decision todiscontinue sales of third-party data storage networking products.

 

***Operating Expenses***

*** ***

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

 
| ** **                        | ** ** | **Nine Months Ended June 30,** | ** ** |
|-----------------------------------|------------|-------------------------------------|------------|
| ** **                        | ** ** | **2005**                            | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                         | ** ** | **%****of Net  Revenues** | ** ** | **Dollars** | ** ** | **%****of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating Expenses:               | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Research and development          |       | $                                   | 5,670      |   | 7.6 | % | $ | 4,207 |   | 4.0 | % | $ | 1,463 |   | 35 | % |
| Selling and marketing             |       | 7,312                               |       | 9.8 | % | 6,570 |   | 6.2 | % | 742 |   | 11 | % |
| General and administrative        |       | 6,033                               |       | 8.1 | % | 4,837 |   | 4.6 | % | 1,196 |   | 25 | % |
| Stock compensation                |       | 16                                  |       | 0.0 | % | 366 |   | 0.3 | % | (350 | ) | (96 | )% |
| Amortization of intangible assets |       | —                              |       | 0.0 | % | 265 |   | 0.3 | % | (265 | ) | (100 | )% |
| Impairment of intangible assets   |       | —                              |       | 0.0 | % | 3,614 |   | 3.4 | % | (3,614 | ) | 100 | % |
| Restructuring charge              |       | 366                                 |       | 0.5 | % | (107 | ) | (0.1 | )% | 473 |   | (442 | )% |
|                              |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total operating expenses          |       | $                                   | 19,397     |   | 25.9 | % | $ | 19,752 |   | 18.7 | % | $ | (355 | ) | (2 | )% |

 

*Research and development*

 

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

 
| ** **                      | ** ** | **Nine Months Ended June 30,** | ** ** |
|---------------------------------|------------|-------------------------------------|------------|
| ** **                      | ** ** | **2005**                            | ** ** | **2004** | ** ** | **Increase** | ** ** |
| ** **                      | ** ** | **Dollars**                         | ** ** | **%****of  Expense  Category** | ** ** | **Dollars** | ** ** | **%****of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and development        |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related        |       | $                                   | 3,455      |   | 61 | % | $ | 2,314 |   | 55 | % | $ | 1,141 |   | 49 | % |
| Prototype                       |       | 685                                 |       | 12 | % | 671 |   | 16 | % | 14 |   | 2 | % |
| Consulting and outside services |       | 885                                 |       | 16 | % | 647 |   | 15 | % | 238 |   | 37 | % |
| Other                           |       | 645                                 |       | 11 | % | 575 |   | 14 | % | 70 |   | 12 | % |
|                            |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total research and development  |       | $                                   | 5,670      |   | 100 | % | $ | 4,207 |   | 100 | % | $ | 1,463 |   | 35 | % |

 

Our server appliance development expenses haveincreased as a result of an increase in the development and sustainingengineering efforts related to existing, new and prospective ISV and networkequipment partners and increased software development activities related to ourNS Series Security Appliances. To support these development activities, weincreased the number of our research and development personnel during the ninemonths ended June 30, 2005 from the nine months ended June 30, 2004,which has resulted in increased compensation costs. We have also increased thenumber of consultants used to supplement our research and development personnellevels, primarily in the area of software development, which has resulted inincreased consulting and outside service costs.

 

26

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*Selling and marketing*

 

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

 
| ** **                  | ** ** | **Nine Months Ended June 30,** | ** ** |
|-----------------------------|------------|-------------------------------------|------------|
| ** **                  | ** ** | **2005**                            | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                  | ** ** | **Dollars**                         | ** ** | **%****of  Expense  Category** | ** ** | **Dollars** | ** ** | **%****of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing       |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related    |       | $                                   | 4,381      |   | 60 | % | $ | 4,696 |   | 71 | % | $ | (315 | ) | (7 | )% |
| Marketing programs          |       | 1,573                               |       | 22 | % | 732 |   | 11 | % | 841 |   | 115 | % |
| Travel                      |       | 622                                 |       | 9 | % | 430 |   | 7 | % | 192 |   | 45 | % |
| Other                       |       | 736                                 |       | 10 | % | 712 |   | 11 | % | 24 |   | 3 | % |
|                        |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and marketing |       | $                                   | 7,312      |   | 100 | % | $ | 6,570 |   | 100 | % | $ | 742 |   | 11 | % |

 

The primary component of the increase in selling andmarketing expenses are marketing program costs offset in part by a decrease incompensation costs. We have increased the level of marketing programs duringthe nine months ended June 30, 2005 as a result of the release of our NS Series SecurityAppliances. Our selling and marketing personnel decreased, in the aggregate,for the nine months ended June 30, 2005 compared to the nine months ended June 30,2004. This net decrease represents decreases from terminations and attritionrelated to our exit from the distribution of third-party data storagenetworking products, partially offset by increased hiring related to our NS Series SecurityAppliance initiative. As a result, compensation and related expenses decreasedin the aggregate.

 

*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,** |       |
|--------------------------------------|--------|-------------------------------------|------------|
|                                 |   | **2005**                            | ** ** | **2004** | ** ** | **Increase (Decrease)** |   |
|                                 |   | **Dollars**                         | ** ** | **%****of Expense  Category** | ** ** | **Dollars** | ** ** | **%****of Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** |   |
| General and administrative           |   |                                |       |   |   |   |   |   |   |   |   |   |   |
| Compensation                         |   | $                                   | 2,177      |   | 36 | % | $ | 1,929 |   | 40 | % | $ | 248 |   | 13 | % |
| Consulting and professional services |   | 2,418                               |       | 40 | % | 1,519 |   | 31 | % | 899 |   | 59 | % |
| Director and officer insurance       |   | 722                                 |       | 12 | % | 713 |   | 15 | % | 9 |   | 1 | % |
| Bad debts                            |   | —                              |       | 0 | % | 12 |   | 0 | % | (12 | ) | (100 | )% |
| Other                                |   | 716                                 |       | 12 | % | 664 |   | 14 | % | 52 |   | 8 | % |
|                                 |   |                                |       |   |   |   |   |   |   |   |   |   |   |
| Total general and administrative     |   | $                                   | 6,033      |   | 100 | % | $ | 4,837 |   | 100 | % | $ | 1,196 |   | 25 | % |

 

The primary components of the increase in general andadministrative expenses are increased consulting and professional services andincreased compensation.  The increase inconsulting and professional services is due primarily to increased costsrelated to our compliance with the Sarbanes-Oxley Act of 2002. For the ninemonths ended June 30, 2005, we also had more personnel than during thenine month period ended June 30, 2004.

 

27

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*Stock compensation*

 

Stock compensation relates to the issuance of stockoptions with exercise prices below the deemed fair value of the Company’scommon stock on the date of issuance. We amortized stock compensation over thevesting period of the related options, which is attributable for approximately$8,000 of stock compensation in the nine months ended June 30, 2005.  In addition, approximately $8,000 of stockcompensation in the nine months ended June 30, 2005 relates to stockoptions granted to a certain non-employee. The decrease in stock compensationin the nine months ended June 30, 2005 compared to the nine months ended June 30,2004 is due to the completed amortization of the deferred stock compensationrelated to these options as scheduled.

 

*Amortization and impairment ofintangible assets*

 

In connection with our acquisition of TidalWire in December 2002,we recorded a definite-lived intangible asset attributable to TidalWire’sexisting customer relationships. This asset was being amortized on a straight-linebasis over its estimated useful life.  InDecember 2003, we amended our agreement with EMC regarding distribution ofEMC-approved HBAs.  This amendmentrequired us to pay a royalty to EMC for each EMC-approved HBA we sold.  As a result of the negative effect of thisamendment on our gross profits, we considered this amendment to be a triggeringevent requiring assessment for impairment. As a result, during the quarterended December 31, 2003 we conducted a detailed impairment analysis of ourintangible assets. This analysis resulted in the determination that the fairvalue of our intangible assets was less than its carrying amount, whichresulted in a charge to operations of approximately $3.6 million in the quarterended December 31, 2003. We also performed an impairment evaluation of theremaining carrying value of these intangible assets at September 30,2004.  This analysis resulted in theremaining carrying value of these intangible assets being written-off.  As a result of this reduction in the carryingvalue of the assets, there was no amortization expense for the nine monthsended June 30, 2005.

 

*Restructuring charge*

 

During the three months ended December 31, 2004,we recorded a restructuring charge of approximately $366,000 related to ourexit from that portion of the business related to the distribution ofthird-party data storage networking products. Approximately $283,000 of the charge related to one-time employeebenefits associated with terminating certain employees in this portion of thebusiness during the quarter. We also incurred $83,000 for a fixed paymentrelated to our warranty fulfillment contract with an external service provider.

 

***Interestand Other Income (Expense), net***

*** ***

Interest and other income (expense), net hasincreased to $686,000 for the nine months ended June 30, 2005 from$216,000 for the nine months ended June 30, 2004. This increase is due tohigher interest rates earned combined with our higher cash, cash equivalents,and short-term investments.

 

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**Liquidityand Capital Resources**

** **

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

 
| ** **                                        | ** ** | **Nine Months Ended June 30,** | ** ** |
|---------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                        | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| ** **                                        | ** ** | ** **                          | ** ** | ** ** | ** ** |
| Net loss                                          |       | $                                   | (4,462     | ) | $ | (371 | ) |
| Non-cash adjustments to net loss                  |       | 901                                 |       | 5,116 |   |
| Changes in working capital                        |       | 4,649                               |       | (4,556 | ) |
|                                              |       |                                |       |   |   |
| Cash provided by operating activities             |       | 1,088                               |       | 189 |   |
|                                              |       |                                |       |   |   |
| Cash provided by (used in) investing  activities  |       | (3,789                              | )          | 6,266 |   |
| Cash provided by financing activities             |       | 699                                 |       | 1,548 |   |
|                                              |       |                                |       |   |   |
| Increase (decrease) in cash and cash  equivalents |       | (2,002                              | )          | 8,003 |   |
| Cash at beginning of period                       |       | 12,974                              |       | 9,227 |   |
|                                              |       |                                |       |   |   |
| Cash at end of period                             |       | $                                   | 10,972     |   | $ | 17,230 |   |

 

***OperatingActivities***

 

Cash flows provided by operating activities of $1.1million for the nine months ended June 30, 2005 were attributable to a netloss of $4.5 million offset by non-cash adjustments to net loss of $901,000 andchanges in working capital of $4.7 million. Non-cash adjustments to net lossconsisted substantially of depreciation expense. Significant cash flow effectsfrom changes in working capital for the nine months ended June 30, 2005included an increased cash flow of $3.1 million from the collection of accountsreceivable, $1.7 million from a reduction of inventory, and $3.4 million fromincreased deferred revenue.  Theseincreases in cash flow were partially offset by decreased cash flow from adecrease in accounts payable of $3.4 million.

 

The higher collections of accounts receivable, and theassociated reduction in inventory and accounts payable are primarily the resultof our exit from the distribution of third-party storage networkingproducts.  In the first quarter of fiscal2005 we sold our remaining inventory related to this portion of our business,which has entirely been converted to cash as of June 30, 2005. Our dayssales outstanding was 37 days in the nine months ended June 30, 2005 and2004.  The increase in deferred revenueis primarily attributable to certain product deliveries in our OEM Appliancesegment where our fee was not fixed or determinable due to uncertaintiesregarding potential future hardware upgrades. We do not expect further future increases in deferred revenue related tothese potential hardware upgrades.

 

***InvestingActivities***

*** ***

 Cash flows usedin investing activities during the nine months ended June 30, 2005resulted from net purchases of $2.7 million of short-term available for saleinvestments combined with $1.2 million of investments in property andequipment. Cash flows provided by investing activities for the nine monthsended June 30, 2004 consisted mainly of net sales of short-term availablefor sale investments of $7 million, offset by purchases of property andequipment of $709,000.

 

***FinancingActivities***

*** ***

Cash flows provided by financing activities consistedof cash received as a result of employee stock option and stock purchase planactivity of $699,000 in the nine months ended June 30, 2005. Cash flowsprovided by financing activities of $1.1 million for the nine months ended June 30,2004 were primarily related to stock option and stock purchase plan activity,combined with the receipt of certain legal settlement proceeds of approximately$415,000. We expect employee stock option activity to continue in fiscal 2005,however we cannot predict its level given the volatility of our stock price.

 

29

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***ContractualObligations and Commitments***

* *

The following table sets forth certain informationconcerning our obligations and commitments to make certain payments (inthousands).

 
| ** **           | ** ** | **Payments Due by Period** | ** ** |
|----------------------|------------|----------------------------|------------|
| ** **           | ** ** | **Less than  1 Year**      | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **After  5 Years** | ** ** | **Total** | ** ** |
|                 |       |                       |       |   |   |   |   |   |   |   |   |
| Operating leases     |       | $                          | 610        |   | $ | 458 |   | $ | — |   | $ | — |   | $ | 1,068 |   |
| Capital lease        |       | 6                          |       | 72 |   | 42 |   | — |   | 120 |   |
| Purchase obligations |       | 95                         |       | 195 |   | — |   | — |   | 290 |   |
|                 |       |                       |       |   |   |   |   |   |   |   |   |
| Total                |       | $                          | 711        |   | $ | 725 |   | $ | 42 |   | $ | — |   | $ | 1,478 |   |

 

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

 

•                  the timing and size of orders from our largest customer;

 

•                  the level of investment required for development and sales andmarketing related to our NS Series Security Appliances;

 

•                  Microsoft’s continued commitment to ISA Server 2004;

 

•                  our ability to enter into partnerships with distributors, value addedresellers and system integrators and their ability to sell our NS Series SecurityAppliances;

 

•                  our ability to market and sell our NS Series Security Appliances;

 

•                  our ability to form an adequate number of partnerships with network equipmentproviders and ISVs;

 

•                  the level of success of our OEM Appliance partners in selling serverappliance solutions that include our server appliance hardware platforms;

 

•                  the costs and timing of product engineering efforts and the success ofthese efforts;

 

•                  the outcome of pending litigation; and

 

•                  market developments.

 

We believe that our available cash resources,including cash equivalents and short-term investments, and cash that we expectto generate from sales of our products will be sufficient to meet our operatingand capital requirements through at least the next twelve months.

 

**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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**Related Party Transactions**

 

Robert M. Wadsworth, one of our directors, is amanaging director of the limited liability corporation that controlsHarbourVest Partners (and its affiliates), one of our significant stockholders.Mr. Wadsworth isalso a director of PSI Holding Group, Inc. (“PSI”), the parent company ofAkibia, Inc. (“Akibia”). During the nine months ended June 30, 2005and 2004, HarbourVest owned greater than 5% of our outstanding stock andgreater than 5% of the outstanding stock of PSI. While we were sellingthird-party data storage networking products we engaged Akibia to providecertain customer support and warranty fulfillment services, primarily relatedto our sales of HBAs. Our agreement with Akibia expired in March 2005 asscheduled. However, the terms of the agreement required Akibia to fulfill thewarranty services for the entire warranty period of the HBA. Akibia charged usa quarterly fixed fee of $83,000 and a variable fee based upon our sales ofHBAs, which ended in December 2004. In the three months ended June 30,2005 and 2004, we recognized $0 and $191,000, respectively, of expense as aresult of this warranty fulfillment services agreement with Akibia.  In the nine months ended June 30, 2005and 2004, we recognized $201,000 and $604,000, respectively.In connection with this customer supportand warranty fulfillment services agreement, we also sold product to Akibia toallow Akibia to fulfill our warranty obligations for these products. In thenine months ended June 30, 2005 and 2004, we recorded revenues ofapproximately $40,000 and $54,000, respectively, from sales of HBAs to Akibia.We also purchased certain products sold through our Distribution segment from Akibiato fulfill customer orders. In the nine months ended March 31, 2004, wepurchased approximately $19,000 of inventory from Akibia for resale to ourDistribution segment customers.  No suchpurchases were made during the nine months ended June 30, 2005. Inaddition, during the three and nine months ended June 30, 2004, we soldapproximately $17,000 and $60,000, respectively, of server appliance productsto Akibia for resale. We had no sales of server appliance products to Akibiaduring the three and nine months ended June 30, 2005.  In addition, we engaged Akibia to providecertain customer support and warranty fulfillment services to certain of ourserver appliance customers in both our OEM Appliance and Distribution segments.Under the terms of this agreement, we were obligated to pay Akibia certainfixed fees and certain activity-based fees based on actual warranty experience.We no longer engage Akibia for these support services. In the three and sixmonths ended June 30, 2004, we recorded expenses totaling approximately$10,200 and $50,500, respectively, related to this agreement. At June 30,2005 and September 30, 2004, we had amounts payable to Akibia ofapproximately $0 and $143,000, respectively, and amounts receivable from Akibiaof $0 and $51,000, respectively.

 

Mr. Wadsworthalso serves as a director of Innoveer Solutions, Inc. (“Innoveer”),formerly Akibia Consulting, a subsidiary of Akibia.  We previously engaged Innoveer to performcertain professional services related to an upgrade of our customer resourcemanagement (“CRM”) software system that was completed during fiscal year 2004.We incurred approximately $243,000 related to this upgrade project in the threeand nine months ended June 30, 2004. We also engage Innoveer to provideprofessional services related to modifications of our CRM software system.  During the nine months ended June 30,2005, we incurred approximately $14,300 related to these services.  We had no amounts outstanding to Innoveer at June 30,2005.

 

Several of our directors have relationships outsideof their positions on our board of directors. John A. Blaeser, one of ourdirectors, was the president and CEO of the public company ConcordCommunications, Inc. prior to its acquisition by Computer Associates Inc.on June 7, 2005, and served on its board of directors. Robert M.Wadsworth, also one of our directors, is a managing director of the limitedliability corporation that controls HarbourVest Partners (and its affiliates),one of our significant stockholders. Mr. Wadsworth was also a director ofConcord Communications, where he was the chairman of the compensation committeeof its board of directors, which determined the compensation and benefits ofConcord Communications’ executive officers, including the compensation of Mr. Blaeser.Further, Gary E. Haroian, one of our directors, was formerly Chief FinancialOfficer of Concord Communications while Mr. Blaeser was the ChiefExecutive Officer of that organization, and was formerly the Controller ofStratus Computer while John H. Curtis, our President and Chief ExecutiveOfficer, was Chief Financial Officer of that organization.

 

Mr. Polestra,one of our directors, was a managing director of Ascent VenturePartners.  Both Mr. Polestra and Mr. Blaeserare limited partners in one of Ascent Venture Partners’ funds, which ownsgreater

 

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than 5% of the outstandingcapital stock of Network Intelligence Corporation.  Network Intelligence Corporation has acontract with us to purchase certain of our products.  In the three months ended June 30,2005 and 2004, sales to Network Intelligence Corporation were approximately$890,000 and $660,000, respectively.  Sales to Network Intelligence Corporation for the nine months ended June 30,2005 and 2004 were $2,962,000 and $2,460,000, respectively. At June 30,2005 and September 30, 2004, the Company had $664,000 and $474,000,respectively, of receivables from Network Intelligence Corporation.

 

**Recent AccountingPronouncements**

 

In December 2004, the Financial Accounting Standards Board (“FASB”)issued Statement of Financial Accounting Standards No. 123 (revised 2004),“Share-Based Payment” (“SFAS 123(R)”). SFAS 123(R) is a revision of FASBStatement No. 123, “Accounting for Stock-Based Compensation”, supersedesAccounting Principles Board Opinion No. 25, “Accounting for Stock Issuedto Employees”, and amends FASB Statement No. 95, “Statement of Cash Flows”.SFAS 123(R) requires all share-based payments to employees, including grants ofemployee stock options and stock purchases under employee stock purchase plans,to be recognized in the financial statements based on their fair values. In March 2005,the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 107(SAB 107), which provides the Staff’s views regarding interactions between FAS123(R) and certain SEC rules and regulations and provides interpretationsof the valuation of share-based payments for public companies.  In April  2005, the SEC adopted a new rule amendingthe compliance dates for SFAS 123(R). In accordance with the new rule, theaccounting provisions of SFAS 123(R) will be effective for us in our fiscalyear beginning October 1, 2005.

 

We are currently evaluating which method we will useto adopt the requirements of SFAS 123(R), and have not yet determined whetherthe adoption of SFAS 123(R) and SAB 107 will result in amounts that are similarto the current pro forma disclosures under SFAS 123, however we expect theadoption to have an adverse impact on our consolidated statements of operationsand net loss per share.

 

In November 2004, the Financial Accounting Standards Board (FASB)issued Statement of Financial Accounting Standards (SFAS) No. 151, “InventoryCosts, an amendment of ARB No. 43, Chapter 4” (SFAS 151).  SFAS 151 clarifies that abnormal inventorycosts such as costs of idle facilities, excess freight and handling costs, andwasted materials (spoilage) are required to be recognized as current periodcharges.  The provisions of SFAS 151 areeffective for the fiscal year beginning October 1, 2005.  Our early adoption of the provisions of SFAS151 in the three months ended June 30, 2005, did not affect ourconsolidated financial position or results of operations.

 

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**FACTORS THAT MAY AFFECT FUTUREOPERATING RESULTS**

 

Therisks and uncertainties described below are not the only ones we are facedwith. Additional risks and uncertainties not presently known to us, or that arecurrently deemed immaterial, may also impair our business operations. If any ofthe following risks actually occur, our financial condition and operatingresults could be materially adversely affected.

 

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

*** ***

**We derive asignificant portion of our revenues from sales of server appliances directly toEMC through our OEM Appliance segment and our revenues may declinesignificantly if this customer cancels or delays purchases of our products,terminates its relationship with us, or exercises certain of its contractualrights.**

** **

In the three and nine months ended June 30, 2005,sales directly to EMC, our largest customer, accounted for 83% and 79% of ourtotal net revenues, respectively, and 84% of our OEM Appliance revenues.  Primarily all of these sales are attributableto one OEM Appliance product pursuant to a non-exclusive contract. Weanticipate that our future operating results will continue to depend heavily onsales to, and our relationship with, this customer.  Accordingly, the success of our business willdepend, in large part, on this customer’s willingness to continue to utilizeour server appliance solutions in its existing and future products.  Further, our financial success is dependentupon the future success of the products we sell to this customer and thecontinued growth, viability and financial stability of this customer, whoseindustry has experienced rapid technological change, short product life cycles,consolidation and pricing and margin pressures. A significant reduction in sales to this customer, or significantpricing and additional margin pressures exerted on us by this customer, wouldhave a material adverse effect on our results of operations.  In addition, if this customer delays orcancels purchases of our products, our operating results would be harmed andour ability to accurately predict revenues, profitability and cash flows woulddecrease.

 

Under the terms of our non-exclusive contract, thiscustomer has the right to enter into agreements with third parties for similarproducts, is not obligated to purchase any minimum quantity of products from usand may choose to stop purchasing from us at any time, with or withoutcause.  In addition, this customer mayterminate the agreement in the event that we attempt to assign our rights underthe agreement to another party without this customer’s prior approval.  Furthermore, in the event that we default oncertain portions of the agreement, this customer has the right to manufacturecertain products in exchange for a mutually agreeable royalty fee.  If any of these events were to occur, or ifthis customer were to delay or discontinue purchases of our products as aresult of dissatisfaction or otherwise, our revenues and operating resultswould be materially adversely affected and our reputation in the industry mightsuffer and our ability to accurately predict revenues, profitability and cashflows would decrease.

 

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***Risks related to businessstrategy.***

*** ***

**Our future successis dependent upon our ability to generate significant revenues from serverappliance development relationships in our OEM Appliance segment.**

** **

A major component of our business strategy is to formserver appliance development relationships with network equipment providers andISVs in our OEM Appliance segment.  Underthis strategy, we work with our partners to develop a server appliance, whichis branded with the applicable partner’s name and is sold through our OEMAppliance segment to the partner, who then performs all of the selling andmarketing efforts related to further sales.

 

There are multiple risks associated with this strategyincluding:

 

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

 

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

 

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

 

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

 

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

 

Additionally, our future success will depend on ourability to expand sales of server appliances to our existing partners, as wellas establishing relationships with new partners. If these partners areunsuccessful in their marketing and sales efforts, or if we are unable to expandour sales to existing partners and develop relationships with new partners, ourrevenues and operating results could suffer.

 

**If potentialcustomers do not accept our NS Series Security Appliances as a solution tocertain of their network security needs, our business could be adverselyaffected.**

** **

We currently expect that future Distribution segmentrevenues will be primarily generated through sales of our NS Series SecurityAppliances and the related maintenance service, and we will not succeed if themarket does not accept these products and services as a viable solution tocertain network security needs. Our NS Series Security Appliances arepowered by Microsoft’s Internet Server Acceleration (“ISA”) Server 2004software application.  If customers don’tperceive this application to be technically superior to other competitivesecurity products or if customers don’t believe that our security appliancewill provide increased security for Microsoft applications, then our revenuesand operating results will suffer. The initial member of NS Series line ofsecurity appliance products has been available since October 2004, and wemay not be successful in marketing and selling this type of product. If we areunable to educate and train customers on our new product line, we may not besuccessful in marketing and selling these new products.

 

Sales of NS Series Security Appliances throughour Distribution segment requires a greater selling and marketing burden thanany of our other server appliance products. We may find the selling andmarketing burden to be greater than was originally planned. We have investedand plan to continue to invest in a significant level of engineering resourcesfor the development of our NS Series Security Appliances. If we are unableto generate sufficient revenues to recover these costs and achieve anappropriate gross profit, our operating results will suffer. In addition, wehave limited experience in selling any server appliances through ourDistribution segment’s sales channel of VARs and systems integrators. To date,we have been unable to achieve substantial sales of server appliances throughour Distribution segment and there is no guarantee that we will be able toachieve substantial amounts of such sales in the

 

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future. If we are unable to generate sufficient revenues by leveragingour Distribution operation to increase sales of server appliances in a costeffective and timely manner, our operating results may suffer and we may determinethat we need to increase our investment in this business, thereby increasingour costs and lowering our profits, or we may determine that we mustdiscontinue this component of our business strategy, any of which couldnegatively affect our business and result in an impairment of our goodwill.

 

**Market acceptanceand demand of Microsoft’s ISA Server 2004 software will depend largely onMicrosoft’s decision to prioritize and concentrate its marketing efforts forthis software.**

** **

**Because our NS Series line ofsecurity appliances are powered by Microsoft’s ISA Server 2004, our successwill depend on the extent the market place perceives this software as superiorto other forms of security protection. This perception will be determined substantially as a result ofmarketing efforts undertaken by Microsoft directly.  In order to achieve wide reaching recognitionthat ISA Server 2004 provides necessary protection of specific Microsoftapplications better than other competing products, we will rely to a significantextent on Microsoft’s financial and technical resources to educate its channelof certified resellers and, as equally important, the ultimate end-users.  If Microsoft does not prioritize thesemarketing and promotional campaigns, or delays the timing of such programs,then we may not achieve significant sales of our NS Series SecurityAppliances, which may adversely affect our business.**

** **

**If we fail toenter into partnerships with a significant number of new resellers and systemsintegrators capable of selling our NS Series Security Appliances, ourrevenues and operating results may be adversely affected.**

** **

A key component of our business strategy is to focusour Distribution business on our NS Series Security Appliances. Toaccomplish this, among other things, we must establish a network of qualityVARs and systems integrators that are familiar with Microsoft products and/orthe network security market and are committed to sell our securityappliances.  Our strategy is to partnerwith Microsoft-certified VARs and system integrators.  Because we expect that these newrelationships with Microsoft-certified VARs and system integrators will bederived through working closely with Microsoft’s sales and marketing team,signing resellers will depend principally on our relationship with Microsoft,and our ability to leverage that relationship to gain access to these VARs andsystem integrators.  Therefore, we willneed to further establish and strengthen our relationship with Microsoft inorder to be considered a preferred provider of Microsoft ISA Server 2004 in theform of an appliance.  If we fail tostrengthen our relationship with Microsoft enabling us to enter intopartnerships with a significant number of new resellers and systemsintegrators, our revenues and operating results may be adversely affected.

 

In addition, because our channel of VARs and systemintegrators have the ability to sell products and services that are competitivewith ours, to devote more resources to those competitive products or to ceaseselling our products and services altogether, we will need to train ourreseller partners on the benefits of Microsoft ISA Server 2004 and the addedvalue of selling this application in the form of our NS Series SecurityAppliance.  If we are not successful intraining our resellers, or if these resellers are not committed to sell oursecurity appliances, our revenue growth may be limited and our operatingresults may be adversely affected. Further, to entice these resellers to sellour security appliances we may be required to offer certain financialincentives that would result in a reduction of revenues or an increase inoperating expenses, which would adversely affect our operating results.

 

**We may be unableto deliver our products and services if we cannot continue to licensethird-party technology that is essential for the functionality of our securityappliances.**

** **

Our success will significantly depend on our continuedability to license technology that is essential for the functionality of oursecurity appliances. A material adverse change in our relationship withMicrosoft or the functionality of its software could delay our development andsales until we can find, license and integrate suitable technology. This coulddamage our brand and result in loss of current and potential customers. Wedepend on Microsoft to deliver reliable, high-quality software, develop newsoftware on a timely and cost-effective basis and respond to evolvingtechnology and changes in industry standards. In the future, we believe we will need to license technology fromadditional third-parties that would be incorporated in our NS Series SecurityAppliances.

 

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**Both our OEMAppliance and Distribution segments could be harmed if we fail to adequatelyintegrate new technologies into our server appliance products or if we investin technologies that do not result in the desired effects on our current and/orfuture product offerings.**

** **

As part of our strategy, we review opportunities toincorporate 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 new technologies into ourcurrent or future products;

 

•                  our new products may be delayed because selected new technologiesthemselves are delayed or have defects and/or performance limitations;

 

•                  we may incorporate technologies that do not result in the desiredimprovements to our current and/or future server appliance products;

 

•                  we may incorporate new technologies that either may not be desired byour customers or may not be compatible with our customer’s existing technology;

 

•                  new technologies are unproven and could contain latent defects, whichcould result in high product failures;

 

•                  we could find that the new products and/or technologies that we chooseto incorporate into our products are technologically inferior to those utilizedby our competitors; and

 

•                  our security appliances based on Microsoft ISA Server 2004 will requirea significant investment in our Network Engines Web Services (“NEWS”) softwarethat could be expended inefficiently because of our limited history in the typeof software development required for this product.

 

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.

 

**If we do notexpand our international operations and successfully overcome the risksinherent in international business activities, the growth of our business maybe limited.**

** **

Our ability to grow will depend in part on theexpansion of our international sales.  Wecurrently have a one-year agreement with a distributor headquartered in theUnited Kingdom for exclusive distribution of our NS Series SecurityAppliances throughout Europe. The failure of our distributor to sell ourproducts across Europe would limit our ability to increase our revenues in thatregion. In addition, our international sales are subject to the risks inherentin international business activities, including:

 

•                  cost of customizing products for foreign countries;

 

•                  export and import restrictions, such as those affecting encryptioncommodities and software or those requiring local content;

 

•                  difficulties in providing customer support;

 

•                  reduced protection of intellectual property rights and increasedliability exposure;

 

•                  regional economic and political conditions; and

 

•                  unique product requirements of certain foreign countries which maylimit sales and/or require significant additional research and developmentinvestments.

 

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Our international sales currently are U.S.dollar-denominated. As a result, any increase in the value of the U.S. dollarrelative to foreign currencies makes our products less competitive ininternational markets. Because of this our revenues may be adversely affected,or we may be required to denominate our sales in foreign currencies at somepoint in the future to remain competitive. In addition, because certain of ouroperating expenses related to our international sales are denominated inforeign currency, we may have difficulty controlling expenses in the event ofsignificant currency fluctuations.

 

**If we fail toretain and attract appropriate levels of qualified employees, we may not beable meet key objectives.**

** **

Our success depends in large part on our ability toretain, and attract highly skilled engineering, sales, marketing, customerservice, and managerial personnel.  If weare unable to attract a sufficient number of qualified personnel, particularlypersonnel knowledgeable in software engineering and channel sales andmarketing, experienced in the security market, we may not be able to meet keyobjectives such as developing, upgrading, or enhancing our products in a timelymanner, and effectively marketing our products to customers, any of which couldnegatively impact our business and could hinder any future growth.

 

***Risks related tofinancial results.***

*** ***

**We have a historyof losses and may continue to experience losses in the future, which couldcause the market price of our common stock to decline.**

** **

Since our inception, we have incurred significant netlosses and could incur net losses in the future and at June 30, 2005 ouraccumulated deficit was $115 million.  Webelieve that any future growth will require us to incur significantengineering, selling and marketing and administrative expenses, includingmeeting new regulatory and corporate governance requirements. As a result, wewill need to generate significant revenues to achieve and sustainprofitability.  If we do not achieve andsustain profitability, the market price for our common stock may decline.

 

**If our estimatesor judgments relating to our critical accounting policies are based onassumptions that change or prove to be incorrect, our operating results couldfall below expectations of securities analysts and investors, resulting in adecline in our stock price.**

** **

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

 

•                  revenue recognition, including sales returns and allowances;

 

•                  provision for doubtful accounts;

 

•                  inventory write-downs;

 

•                  warranty reserves;

 

•                  analysis of impairment of goodwill; and

 

•                  realization of deferred tax assets.

 

We base our estimates on historical experience and onvarious other assumptions that we believe to be reasonable under thecircumstances, as provided in our discussion and analysis of financialcondition

 

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and results of operations, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these and other estimates if ourassumptions change or if actual circumstances differ from those in ourassumptions, which could cause our operating results to fall below theexpectations of securities analysts and investors, resulting in a decline inour stock price.

 

**Our quarterlyrevenues and operating results may fluctuate seasonally, which could result indecreased revenue from quarter to quarter, which in turn could cause the marketprice of our common stock to decline.**

** **

Seasonal fluctuations in revenues and operatingresults in the data storage industry are common.  In particular, this industry typicallyexperiences increased orders and resulting revenues in the quarter ended December 31,and a subsequent decline in orders and resulting revenues during the quarterended March 31.  With a substantialamount of our revenues currently derived from data storage products, we mayexperience significant quarter-to-quarter fluctuations in revenues andoperating results due to customers timing their orders based on their ownquarterly financial and/or operational considerations, which we have noinfluence over.  In addition, to theextent that revenues in our Distribution segment from international salesbecome significant, we may experience seasonal fluctuations during the quarterended September 30, as a result of European holiday patterns.

 

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

 

**Our quarterlyrevenues and operating results may also fluctuate for reasons other thanseasonality, which could cause our operating results to fall below expectationsand thus impact the market price of our common stock.**

** **

In addition to seasonality issues, our quarterlyrevenues and operating results are difficult to predict and may fluctuatesignificantly from quarter to quarter. Additionally, none of our customers areobligated to purchase any quantity of our products in the future nor are theyobligated to meet forecasts of their product needs. Our operating expenselevels are based in part on expectations of future revenues and gross profits,which are partially dependent on our customer’s ability to accurately forecastand communicate their future product needs. If revenues or gross profits in aparticular quarter do not meet expectations, operating results could suffer andthe market price of our common stock could decline. Factors affecting quarterlyoperating results include:

 

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

 

•                  the product mix within our OEM Appliance segment;

 

•                  the loss of key suppliers or customers;

 

•                  the availability and/or price of products from suppliers;

 

•                  price competition;

 

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

 

•                  the timing of new product introductions by our OEM Appliance partners;

 

•                  the timing of expenditures in anticipation of increased revenues;

 

•                  the mix of product manufactured internally and by our contractmanufacturer;

 

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•                  changing global economic or political conditions.

 

**If the productsand services that we sell become more commoditized and competition in theserver appliance, data storage and network security markets continues toincrease, then our gross profit as a percentage of net revenues may decreaseand our operating results may suffer.**

** **

Products and services in the server appliance, datastorage and network security markets may be subject to further commoditizationas these industries continue to mature and other businesses introduce additionalcompeting products and services.  Thegross profit as a percentage of revenues of our products may decrease, inresponse to changes in our product mix, competitive pricing pressures, or newproduct introductions into the server appliance and data storage markets.  If we are unable to offset decreases in ourgross profits as a percentage of revenues by increasing our sales volumes, orby decreasing our product costs, operating results will decline. Changes in themix of sales of our products, including the mix of higher margin sales ofproducts sold in smaller quantities and lower margin sales of products sold inlarger quantities, could adversely affect our operating results for futurequarters.  To maintain our gross profits,we also must continue to reduce the manufacturing cost of our server applianceproducts.  Our efforts to produce highermargin server appliance products, continue to improve our server applianceproducts and produce new server appliance products may make it difficult toreduce our manufacturing cost per product. Further, utilization of a contractmanufacturer to produce a portion of our customer requirements for certain ofour server appliance products may not allow us to reduce our cost perproduct.  If we fail to respondadequately to pricing pressures, to competitive products with improvedperformance or to developments with respect to the other factors on which wecompete, we could lose customers or orders. If we are unable to compete effectively, our business would suffer.

 

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

*** ***

**If serverappliances are not increasingly adopted as a solution to meet a significantportion of companies’ security and storage application needs, the market forserver appliances may not grow, which could negatively impact our revenues.**

** **

We expect that a substantial portion of our futurerevenues will come from sales of server appliances. As a result, we aresubstantially dependent on the growing use of server appliances to meetbusinesses’ storage and security networking application needs.  Our revenues may not grow and the marketprice of our common stock could decline if the server appliance market does notgrow as rapidly as we expect.

 

Our expectations for the growth of the serverappliance market may not be fulfilled if customers continue to usegeneral-purpose servers.  The role of ourproducts could, for example, be limited if general-purpose servers out-performserver appliances, provide more capabilities and/or flexibility than serverappliances or are offered at a lower cost. This could force us to lower the prices of our server appliance productsor could result in fewer sales of these products, which would negatively impactour revenues and decrease our gross profits.

 

**The products thatwe sell are subject to rapid technological change and our sales will suffer ifthese products are rendered obsolete by new technologies.**

** **

The markets we serve are characterized by rapidtechnological change, frequent new product introductions and enhancements,potentially short product life cycles, changes in customer demands and evolvingindustry standards.  In the serverappliance market, we attempt to mitigate these risks by utilizing standards-basedhardware platforms and by maintaining an adequate knowledge base of availabletechnologies.  However, the serverappliance products that we sell could be rendered obsolete if products based onnew technologies are introduced or new industry standards emerge and we are notable to incorporate these technological changes into our products.  In addition, we depend on third parties forthe base platforms of our server appliances for many of our OEM Appliancesegment customers and our NS Series Security Appliances, and we are atrisk if these third parties do not integrate new technologies.

 

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Specifically, product development for network securityappliances requires considerable engineering time and testing. Releasing newproducts and services prematurely may result in quality problems, and delaysmay result in loss of customer confidence and market share.  We may be unable to develop new products andservices or achieve and maintain market acceptance of them once they have cometo market. Furthermore, when we do introduce new or enhanced products andservices, we may be unable to manage the transition from the older products andservices to minimize disruption in customer ordering patterns, avoid excessiveinventories of older products and deliver enough new products and services tomeet customer demand.

 

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

 

***Risks related tocompetition.***

*** ***

**Competition in theserver appliance market is significant and if we fail to compete effectively,our financial results will suffer.**

** **

In the server appliance market, we face significantcompetition from a number of different types of companies. Our competitorsinclude companies who market general-purpose servers, specific-purpose serversand server appliances as well as companies that sell custom integrationservices utilizing hardware produced by other companies.  Many of these companies are larger than weare and have greater financial resources and name recognition than we do, aswell as significant distribution capabilities and larger, more establishedservice organizations to support their products.  Our large competitors may be able to leveragetheir existing resources, including their extensive distribution capabilitiesas well as their 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 be ableto 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 server appliancesolutions could become undesirable.

 

Even if the functionality of competing products isequivalent to ours, we face a risk that a significant number of customers wouldelect to pay a premium for similar functionality from an established vendorrather than purchase products from a less-established vendor.  We attempt to differentiate ourselves fromour competition by offering a wide variety of software integration, branding,supply-chain management, engineering, support, distribution, logistics andfulfillment services. If we are unable to effectively differentiate ourselvesfrom our competition, we may be forced to offer price reductions to maintaincertain customers.  As a result, ourrevenues may not increase and may decline, and our gross margins maydecline.  Furthermore, increasedcompetition could negatively affect our business and future operating resultsby leading to higher selling expenses and a reduction in our market share.

 

**If we are unableto compete successfully in the highly competitive market for network securityappliances and services for any reason, such as current or potentialcompetitors gaining competitive advantage through partnering or acquisition,our business could be adversely affected.**

** **

The market for security appliances is intenselycompetitive and we expect competition to intensify in the future. An increasein competitive pressures in our market or our failure to compete effectivelymay result in pricing reductions, reduced gross margins and loss of marketshare. Currently, the primary competitors in our industry relating to securityappliances with Microsoft ISA Server 2004 include Hewlett-Packard Company,Celestix Networks, Inc. and Pyramid Computer GmbH.  However, because our

 

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agreement with Microsoft to license ISA Server 2004 is not exclusive,Microsoft may enter into similar license agreements with additionalcompetitors.  Such competitors may havesignificantly greater resources and experience than us, which may negativelyaffect our business.

 

Competitors in the security industry with appliancesusing technology other than Microsoft ISA Server 2004 include Cisco Systems, Inc.,Nokia Corporation, Juniper Networks, Inc, Watchguard Technologies, Inc.and SonicWALL, Inc.  Substantiallyall of our competitors have longer operating histories, greater namerecognition, larger customer bases and significantly greater financial,technical, marketing and other resources than we do. Our current and potentialcompetitors may establish cooperative relationships among themselves or withthird parties that may further enhance their resources. In addition, current orpotential competitors may be acquired by third parties with greater availableresources.  As a result of such potentialacquisitions, our current or potential competitors might be able to adapt morequickly to new technologies and customer needs, devote greater resources to thepromotion or sale of their products and services, initiate or withstandsubstantial price competition, take advantage of acquisition or otheropportunities more readily or develop and expand their product and serviceofferings more quickly. In addition, our competitors may bundle productscompetitive with ours with other products that they may sell to our current orpotential customers. These customers may accept these bundled products ratherthan separately purchasing our products.

 

**Our revenues couldbe negatively affected if our larger competitors consolidate their extensivedistribution capabilities with our smaller competitors’ products.**

** **

Large server manufacturers may not only develop theirown server appliance solutions, but they may also acquire or establishcooperative relationships with our smaller competitors, developing serverappliance products and related technologies. Because large server manufacturers have significant financial andorganizational resources available, they may be able to quickly penetrate theserver appliance market by leveraging the technology and expertise of smallercompanies with their own extensive distribution channels.  We expect that the server industry willexperience further consolidation.  It ispossible that new competitors or alliances among competitors may emerge andrapidly acquire significant market share through consolidation.  Consolidation within the server marketplacecould adversely affect our revenues.

 

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

*** ***

**We need toeffectively manage our sales and marketing operations to increase marketawareness and sales of our products and to promote our brand recognition. If wefail to do so, our growth will be limited.**

** **

Although we currently have a relatively small salesand marketing organization, we must continue to increase market awareness andsales of our products and promote our brand in the marketplace.  In our OEM Appliance segment, we believe thatto compete successfully we will need network equipment providers and ISVs torecognize Network Engines as a top-tier provider of server appliance platforms,and custom integration services.

 

We must also effectively market to VARs, systemsintegrators, and their end customers our NS Series Security Appliances.This marketing effort requires a significant investment in personnel and otherareas, and an appropriate level of technical knowledge about the securitymarket, Microsoft applications such as Exchange, and other softwareapplications included in these server appliance products.  It also requires substantial understanding ofthe targeted market into which these products are sold and may require theexpenditure of a material amount of managerial and financial resources. We havelimited experience marketing and selling security appliance products throughdistribution channels and therefore, may not be successful in these efforts. Ifwe are unable to design and implement marketing campaigns that are effective inpromoting our security appliances, or if we fail to promote and maintain theNetwork Engines brand, we may not increase or maintain sales and our businessmay be adversely affected.  Our businesswould also suffer if we incur excessive expenses in these marketing campaignsbut fail to achieve the expected or desired increase in revenues.

 

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**If we are unableto effectively manage our customer service and support activities, we may notbe able to retain our existing customers or attract new customers.**

** **

We need to effectively manage our customer supportoperations to ensure that we maintain good relationships with ourcustomers.  Because our NS Series SecurityAppliances provide critical protection for certain applications, managingsoftware updates to the appliance, when and if they are available, will beessential to the performance of the appliance. Managing any such updates released by Microsoft will require carefulconsideration to determine the sensitivity and impact on the function of ourappliance.  Additionally, any updatesdesignated as vital to the function of our appliance will require rapiddeployment to ensure the customers’ applications are properly protected.  We expect that providing this increasedcustomer service for our NS Series Security Appliances will require moretechnically qualified staff either within the Company or from third parties andif we are unable to provide this higher level of service we may be unable tosuccessfully sell such security appliances.

 

Our channel partners in some cases will providesupport for the end-user customers.  Wemay be unable to provide these channel partners with the necessary training andback-up support. Therefore they may be unable to provide end-user customerswith the necessary level of support, which may be detrimental to our reputationand ability to sell our products.  Also someof our channel partners may choose not to provide this service, which wouldrequire us to hire more support staff to provide the first level support to enduser customers, which would increase our costs and lower our margins.

 

If our customer support organization is unsuccessfulin maintaining good customer relationships, we may lose customers to ourcompetitors and our reputation in the market could be damaged.  As a result, we may lose revenues and ourbusiness could suffer. Furthermore, the costs of this service could be higherthan we expect, which could adversely affect our operating results.

 

**A breach ofsecurity could harm public perception of our products and services.**

** **

 We will notsucceed unless the marketplace is confident that we provide effective securityapplication protection. Even applications protected by our appliances usingMicrosoft’s ISA Server 2004 software may be vulnerable to electronic break-insand computer viruses. If an actual or perceived breach of security occurs in anend-user’s systems, regardless of whether the breach is attributable to us, themarket perception of the efficacy of our products and services could be harmed.This could cause us or our reseller partners to lose current and potentialcustomers, or cause us to lose potential resellers. Because the techniques usedby computer hackers to access or sabotage networks change frequently andgenerally are not recognized until launched against a target, we may be unableto anticipate these techniques.

 

***Risks related to productmanufacturing.***

*** ***

**Our dependence onsole source and limited source suppliers for key server appliance componentsmakes us susceptible to supply shortages and potential quality issues thatcould prevent us from shipping customer orders on time, if at all, and couldresult in lost sales and customers.**

** **

We depend upon single source and limited sourcesuppliers for our industry-standard processors, main logic boards, certain diskdrives, hardware platforms and power supplies as well as certain of our coolingsystems, chassis and sheet metal parts. We also rely upon a single sourcesupplier to provide the hardware platform for our NS Series SecurityAppliances. Additionally, we depend on limited sources to supply certain otherindustry-standard and customized components. We have in the past experienced, and may in the future experience,shortages of or difficulties in acquiring components in the quantities and ofthe quality needed 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 to buy components in the quantities andof the quality that we need on a timely basis or at acceptable prices, we willnot be able to manufacture and deliver our server appliance products on atimely or cost-effective basis to our customers, and our competitive position,reputation, business, financial condition and results of operations could beseriously harmed.

 

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

** **

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

 

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

 

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

 

•                  diversion of engineering resources;

 

•                  increased manufacturing costs;

 

•                  the loss of new or existing server appliance partners;

 

•                  injury to our reputation and other customer relations problems; and

 

•                  increased maintenance and warranty costs.

 

Any of these problems could harm our business andfuture operating results. Product errors or delays could be material, includingany product errors or delays associated with the introduction of new productsor versions of existing products. If our server appliance solutions fail toconform to warranted specifications, customers could demand a refund for thepurchase price and assert claims for damages.

 

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

 

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**Our future serverappliance revenue growth is dependent on our ability to expand productioncapacity.**

 

Our existing manufacturing facility is limited in itsproduction capacity.  For us to achievesignificant server appliance revenue growth our server appliance sales volumesmust increase significantly and our production capacity must increase tosupport such sales volumes.

 

  To supplementour current production capacity, to provide for increased capacity for “productionspikes” and to provide disaster backup capabilities, we currently utilize theservices of a contract manufacturer for certain server appliance products.  However, our contract manufacturer is notobligated to supply products to us for any specific period, or in any specificquantity, except as may be provided in a particular purchase order.  Using a contract manufacturer increases ourcost of producing server appliance products and could decrease our grossprofits.  In the event that we need tochange contract manufacturers or require significantly increased productionlevels, we could experience transitional difficulties, including productiondelays and quality control issues, that could prevent us from satisfying ourproduction requirements on a timely basis, cause customer relationships tosuffer and result in lost sales.  Also,the use of a contract manufacturer does not guarantee us production levels,manufacturing line space or manufacturing prices, the lack of which couldinterrupt our business operations and have a negative effect on operatingresults.

 

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

 

**If we do not accuratelyforecast our server appliance materials requirements, our business andoperating results could be adversely affected.**

** **

We use rolling forecasts based on anticipated productorders to determine our server appliance component requirements.  Lead times for materials and components thatwe order vary significantly, depending among other things, on specific supplierrequirements, contract terms and current market demand for thosecomponents.  In addition, a variety offactors, including the timing of product releases, potential delays orcancellations of orders, the timing of large orders, and the unprovenacceptance of new products in the market make it difficult to predict productorders.  As a result, our materialsrequirement forecasts may not be accurate. If we overestimate our materials requirements, we may have excessinventory, which would increase costs and negatively impact our cashposition.  Our agreements with certaincustomers provide us with protections related to inventory purchased in accordancewith the terms of these agreements; however, these protections may not besufficient to prevent certain losses as a result of excess or obsoleteinventory. If we underestimate our materials requirements, we may haveinadequate inventory, which could interrupt our manufacturing and delaydelivery of our server appliance products to customers resulting in a loss ofsales or customers.  Any of theseoccurrences would negatively impact our business and operating results.

 

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

*** ***

**Our reliance uponcontractual provisions, domestic patent, copyright and trademark laws andapplied-for patents to protect our proprietary rights may not be sufficient toprotect our intellectual property.**

** **

Certain of our server appliance solutions aredifferentiated from the products of our competitors by our internally developedsoftware and hardware and the manner in which they are integrated into ourserver

 

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appliance solutions. If we fail to protect our intellectual property,other vendors could sell products with features similar to ours, which couldreduce demand for our solutions.  We havetaken what we believe to be the necessary and appropriate steps to safeguardour intellectual property. However, these steps may afford us only limitedprotection.  Others may developtechnologies that are similar or superior to our technology or design aroundthe patents we own.  Despite theprecautions we have taken, laws and contractual restrictions may not besufficient to prevent misappropriation of our technology or deter others fromdeveloping 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.

 

In addition, the laws of the countries in which we maydecide to market our services and solutions may offer little or no effectiveprotection of our proprietary technology. Reverse engineering, unauthorized copying or other misappropriation ofour proprietary technology could enable third parties to benefit from ourtechnology without paying us for it, which would significantly harm ourbusiness. In addition, our U.S. patents have no effect in foreign jurisdictionsand obtaining patent protection in foreign countries is expensive and timeconsuming.

 

**Our operatingresults would suffer if we, or our ISV or network equipment provider partners,were subject to an infringement claim that resulted in protracted litigation,the award of significant damages against us or the payment of substantialongoing royalties.**

** **

Substantial litigation regarding intellectual propertyrights exists in the technology industry. We expect that server appliance products may be subject to third-partyinfringement claims as the number of competitors in the industry segment growsand the functionality of products in different industry segments overlap.  From time to time we receive claims fromthird parties that our server appliance products have infringed theirintellectual property rights. We do not believe that our server applianceproducts employ technology that infringes the proprietary rights of any thirdparties. We are also not aware of any claims made against any of our ISV ornetwork equipment provider partners related to their infringement of theproprietary rights of other parties in relation to products that include ourserver appliance products. Other parties may make claims against us that, withor without merit, could:

 

•                  be time-consuming for us to address;

 

•                  require us to enter into royalty or licensing agreements;

 

•                  result in costly litigation, including potential liability for damages;

 

•                  divert our management’s attention and resources; and

 

•                  cause product shipment delays.

 

In addition, other parties may make claims against ourISV or network equipment provider partners related to products that areincorporated into our server appliance products. Our business could beadversely affected if such claims resulted in the inability of our ISV ornetwork equipment provider partners’ to continue to produce the infringingproduct or if these claims prohibited us from licensing the softwareapplications of our ISV partners.

 

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

*** ***

** **We may have difficultyimplementing in a timely manner the internal controls necessary to allow ourmanagement to report on the effectiveness of our internal controls, and thesereports may not reveal all material weaknesses or significant deficiencies withour internal controls.

** **

Pursuant to Section 404 of the Sarbanes-Oxley Actof 2002, or Section 404, we will be required to furnish an internalcontrols report of management’s assessment of the design and effectiveness ofour internal controls as part of our Annual Report on Form 10-K beginningwith the fiscal year ending September 30, 2005. Our auditors will then berequired to attest to, and report on, management’s

 

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assessment. In order to issue our report, our management must documentboth the design for our internal controls and the testing processes thatsupport management’s evaluation and conclusion. Our management has started thenecessary processes and procedures for issuing its report on our internalcontrols. However, the evaluation and attestation processes required by Section 404are arduous. Accordingly, we may encounter problems or delays in completing thereview and evaluation, the implementation of improvements required to addressany material weaknesses or significant deficiencies identified in our internalcontrols, and the receipt of a positive attestation, or any attestation at all,by our independent registered public accounting firm. We are still performingthe system and process documentation and evaluation needed to comply with Section 404,which is both costly and challenging. During this process, if our managementidentifies one or more material weaknesses in our internal control overfinancial reporting, we will be unable to assert such internal control iseffective. If we are unable to assert that our internal control over financialreporting is effective as of September 30, 2005 (or if our auditors areunable to attest that our management’s report is fairly stated or they areunable to express an opinion on the effectiveness of our internal controls), wecould lose investor confidence in the accuracy and completeness of ourfinancial reports, which could have an adverse effect on our stock price. Uponcompletion of our testing, we may identify material weaknesses or significantdeficiencies in our internal controls. In addition to adversely affecting ourability to receive a positive attestation or any attestation at all, suchmaterial weaknesses or significant deficiencies in our internal controls couldhave a material adverse effect on our results of operations. Additionally, uponthe completion of our testing and documentation, certain deficiencies may bediscovered that will require remediation. This remediation may require implementingadditional controls, the costs of which could have a material adverse effect onour results of operations.

 

**Class actionlawsuits have been filed against us, our board of directors, our chairman andcertain of our executive officers and other lawsuits may be instituted againstus from time to time.**

** **

**In December 2001, a classaction lawsuit relating to our initial public offering was filed against us,our chairman, one of our executive officers and the underwriters of our initialpublic offering. In addition, in January 2003, a purported class actionlawsuit was filed against us and our Board of Directors relating to theacquisition of TidalWire Inc.  Morerecently, commencing on December 16, 2003, a number of purported classaction lawsuits were filed against us and John H. Curtis, our President andCEO, Douglas G. Bryant, our CFO, Vice President of Finance and Administration,Treasurer and Secretary, and Lawrence Genovesi, our Chairman of the Boardrelating to the timing of our announcement of the amendment of our HBAdistribution agreement with EMC. For more information on these lawsuits, see “Part II,Item 1 – Legal Proceedings.” In December 2003, we settled the class actionlawsuit filed against us relating to the acquisition of TidalWire Inc. and weare currently attempting to settle the lawsuit filed against us related to ourinitial public offering. We are unable to predict the effects on our financialcondition, or our business, of the lawsuit related to our initial publicoffering, the lawsuit related to our announcement of the amendment of our HBAdistribution agreement with EMC or other lawsuits that may arise from time totime.  While we maintain certaininsurance coverage, there can be no assurance that claims against us will notresult in substantial monetary damages in excess of such insurance coverage.These class action lawsuits, or any future lawsuits, could cause our directorand officer insurance premiums to increase and could affect our ability toobtain director and officer insurance coverage, which would negatively affectour business. In addition, we have expended, and may in the future expend,significant resources to defend such claims. These class action lawsuits, orother similar lawsuits that may arise from time to time, could negativelyimpact both our financial condition and the market price of our common stockand could result in management devoting a substantial portion of their time tothese lawsuits, which could adversely affect the operation of our business.**

** **

**If the site of ourmanufacturing operations were to experience a significant disruption in itsoperations, it would have a material adverse effect on our financial conditionand results of our operations.**

** **

Our manufacturing facility and headquarters areconcentrated in one location.   If theoperations in this facility were disrupted as a result of a natural disaster,fire, power or other utility outage, work stoppage or other similar event,our business could be seriously harmed as a result of interruptions or delaysin our manufacturing, engineering, distribution or post-sales supportoperations.

 

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**We havediscontinued selling third-party data storage networking products, and arerelying on a third party to fulfill the warranty obligations related to theseproducts.**

** **

**Because we have outsourced customersupport activities of these third-party data storage networking products to athird party, we will continue to depend on this third party to successfullyaddress our former customers’ needs for the remaining outstanding warrantyperiod.  Although we have paid the thirdparty in full for this service, if it does not fulfill its obligation we may berequired to incur additional costs to satisfy those customers’ needs, which maynegatively affect our business.**

** **

**If we do notretain our senior management, we may not be able to successfully execute ourbusiness strategy.**

** **

The loss of key members of our management team couldharm us. Our success is substantially dependent on the ability, experience andperformance of our senior management team. Because of their ability andexperience, we may not be able to successfully execute our business strategy ifwe were to lose one or more of these individuals. If we are unable tosuccessfully execute our business strategy, our operating results would suffer.

 

**The market pricefor our common stock may be particularly volatile, and our stockholders may beunable to resell their shares at a profit.**

** **

The market price of our common stock has been subjectto significant fluctuations and may continue to fluctuate or decline. Duringfiscal 2004, the price of our common stock ranged from a low of $1.29 to a highof $11.00 and in the nine months ended June 30, 2005 from a low of $1.61to a high of $3.16. The stock markets have experienced significant price andtrading volume fluctuations. The market for technology stocks has beenextremely volatile and frequently reaches levels that bear no relationship tothe past or present operating performance of those companies. General economicconditions, such as recession or interest rate or currency rate fluctuations inthe United States or abroad, could negatively affect the market price of ourcommon stock. In addition, our operating results may be below the expectationsof securities analysts and investors. If this were to occur, the market priceof our common stock may decrease significantly. In the past, following periods of volatility in the market price of acompany’s securities, securities class action litigation has often beeninstituted against such companies.  Suchlitigation could result in substantial cost and a diversion of management’sattention and resources.

 

The market price of our common stock may fluctuate inresponse to various factors, some of which are beyond our control. Thesefactors include, but are not limited to, the following:

 

•                  changes in our relationship or contracts with EMC;

 

•                  changes in our relationship with Microsoft;

 

•                  market acceptance of our NS Series Security Appliance;

 

•                  actual or anticipated fluctuations in our operating results;

 

•                  changes in financial estimates or investment recommendations bysecurities analysts who follow our business;

 

•                  technological advances or introduction of new products by us or ourcompetitors;

 

•                  the loss of key personnel;

 

•                  our sale of common stock or other securities in the future;

 

•                  significant sales of our common stock by existing stockholders,affiliates and insiders;

 

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•                  intellectual property or litigation developments;

 

•                  changes in market valuations or earnings of our competitors or othertechnology companies;

 

•                  changes in business or regulatory conditions;

 

•                  the trading volume of our common stock; and

 

•                  disruptions in the geopolitical environment, including war in theMiddle East or elsewhere or acts of terrorism in the United States orelsewhere.

 

**Any decline in the market price ofour common stock or negative market conditions could adversely affect ourability to raise additional capital, to complete future acquisitions of orinvestments in other businesses and to attract and retain qualified technicaland sales and marketing personnel.**

** **

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

** **

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

 

Inaddition, provisions of our second amended and restated certificate ofincorporation, second amended and restated by-laws may deter an unsolicitedoffer to purchase us. These provisions, coupled with the provisions of theDelaware General Corporation Law, may delay or impede a merger, tender offer orproxy contest involving us. For example, our Board of Directors is divided intothree classes, only one of which is elected at each annual meeting. Thesefactors may further delay or prevent a change of control of our business.

 

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

** **

We donot engage in any foreign currency hedging transactions and therefore, do notbelieve we are subject to material exchange rate risk. We are exposed to marketrisk related to changes in interest rates. We invest excess cash balances incash equivalents and short-term investments and as a result, we believe thatthe effect, if any, of reasonably possible near-term changes in interest rateson our financial position, results of operations and cash flows will not bematerial. In addition, a hypothetical 10% increase or decrease in interestrates would not have a material adverse effect on our financial 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 of 1934) as of June 30,2005.  Based on this evaluation, ourchief executive officer and chief financial officer concluded that, as of June 30,2005, our disclosure controls and procedures were (1) designed to ensurethat material information relating us, including our consolidated subsidiaries,is made known to our chief executive officer and chief financial officer byothers within those entities, particularly during the period in which thisreport was being prepared and (2) effective, in that they providereasonable assurance that information required to be disclosed by us in thereports that we file or submit under the Securities Exchange Act is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms. There were nochanges in our internal controls over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Securities Exchange Act) during the fiscal quarterended June 30, 2005 that have

 

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materially affected, or arereasonably likely to materially affect, our internal controls over financialreporting.

 

**PART II—OTHER INFORMATION**

** **

**ITEM1.     LEGAL PROCEEDINGS**

 

*Announcement Timing Lawsuit*

 

On March 17, 2004, the United States DistrictCourt for the District of Massachusetts consolidated a number of purportedclass action lawsuits filed against Network Engines, Inc. and certainindividual Network Engines defendants, collectively the defendants.  Thesesuits generally concern the timing of the announcement of an amendment toNetwork Engines’ agreement with EMC Corporation regarding the resale ofEMC-approved Fibre Channel HBAs.  In its March 17, 2004 order, thecourt selected Wing Kam Yu, Blake Kunkel, and Thomas Cunningham as leadplaintiffs and appointed Milberg Weiss Bershad Hynes & Lerach LLP (nowMilberg Weiss Bershad & Schulman LLP) as plaintiffs’ lead counsel. The lead plaintiffs filed an amended consolidated complaint on June 4,2004.  The defendants on August 13, 2004 filed a motion to dismissthe amended consolidated complaint.  The plaintiffs on October 12,2004 filed an opposition to the defendants’ motion to dismiss and thedefendants filed a reply to the plaintiff’s opposition on November 12,2004.  The court on November 22,2004 denied the defendant’s motion to dismiss the amended consolidatedcomplaint. On December 23, 2004 the defendants filed an answer to theamended consolidated complaint.

 

Since that time the parties have engaged in someinformal discovery and, more recently, have exchanged formal discoveryrequests.  Pursuant to the Court-approvedschedule in the case, the plaintiffs’ class certification motion is due onAugust 5, 2005 and any opposition is due on October 5, 2005.  Discovery is to conclude on or before March 31,2006.  Network Engines believes that theplaintiffs’ allegations are without merit, and it intends to pursue a vigorousdefense.  We are unable to predict the outcome of this suit and itsultimate effect, if any, on the Company’s financial condition; however, ourdefense against this suit may result in the expenditure of significantfinancial and managerial resources.  No amounts have been accrued for thismatter.

 

 *TidalWire AcquisitionLawsuit*

 

A purported class action andderivative lawsuit was filed on January 7, 2003 in the Court of Chanceryin the State of Delaware against Network Engines, Inc., Robert M.Wadsworth, Frank M. Polestra, John H. Curtis, Lawrence A. Genovesi, John A.Blaeser and Fontaine K. Richardson relating to the acquisition of TidalWireInc.  The plaintiffs in the complaint alleged that Network Engines and thenamed directors of its Board of Directors breached their fiduciary duties by,among other things, paying an excessive amount in the acquisition of TidalWireand purportedly failing to disclose material facts in our Joint ProxyStatement/Information Statement distributed to stockholders for approval of theissuance of shares of our common stock in the merger.  The plaintiffssought damages, rescission of the merger and other relief. On October 30,2003, the court approved a settlement of the action negotiated by the parties,and that settlement became final on December 1, 2003.  Under thesettlement, all claims against us and our individual board members weredismissed with prejudice, and (a) the defendants in the lawsuit paid $600,000to us, (b) plaintiff’s attorney fees of $185,000 were paid out of that$600,000 amount and (c) in the disclosure for our next annual meeting, wewere required to detail certain information concerning relationships among itsboard members, which we have complied with. Payments to us under thissettlement, net of payments of plaintiff’s attorney fees, were recorded as anincrease of $415,000 to additional paid-in capital in the three months ended December 31,2003.

 

 *Initial Public OfferingLawsuit*

 

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 the Company, Lawrence A. Genovesi (the Company’sChairman and former Chief Executive Officer), Douglas G. Bryant (the Company’sChief

 

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Financial Officer and Vice President of Finance and Administration),and the following underwriters of our initial public offering: FleetBostonRobertson Stephens, Inc., Credit Suisse First Boston Corp., Goldman Sachs &Co., Lehman Brothers Inc. and Salomon Smith Barney, Inc. collectively, theunderwriter defendants.  An amended class action complaint, captioned Inre Network Engines, Inc. Initial Public Offering Securities Litigation, 01Civ. 10894 (SAS), was filed on April 20, 2002.

 

The suit alleges that the defendants violated thefederal securities laws by issuing and selling securities pursuant to ourinitial public offering in July 2000, or IPO, without disclosing to investorsthat the underwriter defendants had solicited and received excessive andundisclosed commissions from certain investors.  The suit also allegesthat the underwriter defendants entered into agreements with certain customerswhereby the underwriter defendants agreed to allocate to those customers sharesof our common stock in the offering, in exchange for which the customers agreedto purchase additional shares of our common stock in the aftermarket atpre-determined prices.  The suit alleges that such tie-in arrangementswere designed to and did maintain, distort and/or inflate the price of ourcommon stock in the aftermarket.  The suit further alleges that theunderwriter defendants received undisclosed and excessive brokerage commissionsand that, as a consequence, the underwriter defendants successfully increasedinvestor interest in the manipulated IPO securities and increased theunderwriter defendants’ individual and collective underwritings, compensationand revenues.  The suit seeks damages and certification of a plaintiffclass consisting of all persons who acquired shares of our common stock betweenJuly 13, 2000 and December 6, 2000.

 

In July 2002, Network Engines, Lawrence A.Genovesi and Douglas G. Bryant joined in an omnibus motion to dismisschallenging the legal sufficiency of plaintiffs’ claims.  The motion wasfiled on behalf of hundreds of issuer and individual defendants named insimilar lawsuits.  Plaintiffs opposed the motion, and the court heard oralargument on the motion in November 2002. On February 19, 2003, thecourt issued an opinion and order denying the motion as to Network Engines. In addition, in October 2002, Lawrence A. Genovesi and Douglas G.Bryant were dismissed from this case without prejudice.

 

On July 9, 2003, a Special Committee of our Boardof Directors authorized Network Engines to negotiate a settlement of thepending claims substantially consistent with a memorandum of understandingnegotiated among class plaintiffs, all issuer defendants and their insurers. We have negotiated the settlement, which provides, among other things,for a release of Network Engines and the individual defendants for the conductalleged in the amended complaint to be wrongful.  We would agree toundertake other responsibilities under the settlement, including agreeing toassign, or not assert, certain potential claims that we may have against theunderwriters.  Any direct financial impact of the proposed settlement isexpected to be borne by our insurers.  The settlement is subject tovarious contingencies, including approval by the Court overseeing thelitigation. On February 15, 2005, the Court issued an Opinion and Orderpreliminarily approving the settlement, provided that the defendants andplaintiffs agree to a modification narrowing the scope of the bar order setforth in the original settlement agreement.

 

We are unable to predict the outcome of this suit andits ultimate effect, if any, on our financial condition; however, our defenseagainst this suit has and may continue to result in the expenditure ofsignificant financial and managerial resources.  No amounts have beenaccrued for this matter.

 

**ITEM2.     UNREGISTERED SALES OF EQUITY SECURITIES AND USE OFPROCEEDS**

** **

*Recent Sales of Unregistered Securities*

* *

During the quarter ended June 30, 2005, we didnot issue any unregistered shares of our common stock.

 

*Use of Proceeds from Sales of RegisteredSecurities*

* *

On July 18, 2000, the Company sold 7,475,000shares of common stock in an initial public offering at a price of $17.00 pershare pursuant to a Registration Statement on Form S-1 (Registration No. 333-34286),which was declared effective by the Securities and Exchange Commission on July 12,2000.

 

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The aggregate proceeds to usfrom the offering were approximately $116.9 million reflecting gross proceedsof $127.0 million net of underwriting fees of approximately $8.9 million andother offering costs of approximately $1.3 million.  During the period from the offering through June 30,2005, we used the proceeds from our initial public offering as follows:approximately $49.4 million to fund our operations, approximately $9.5 millionfor the purchase of property and equipment, approximately $4.6 million torepurchase our common stock under a stock repurchase plan and approximately$13.2 million for our acquisition of TidalWire Inc.

 

**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 9,  2005 |                       | /s/ John H. Curtis |   |
|                       |                       |   |
|                       |                       | John H. Curtis |
|                       |                       | President and Chief  Executive Officer |
|                       |                       | (Principal Executive  Officer) |
|                       |                       |   |
|                       |                       | /s/ Douglas G. Bryant |   |
|                       |                       |   |
|                       |                       | Douglas G. Bryant |
|                       |                       | Vice President of  Finance  and Administration, Chief  Financial Officer, Treasurer  and Secretary |
|                       |                       | (Principal Financial  Officer  and Principal |
|                       |                       | Accounting Officer) |
|                            |                            |  |  |  |

 

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Exhibit**                                                                                                                                       |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                              |
| 31.1                 |       | Certification  of John H. Curtis, 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 John H. Curtis, 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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