##### **UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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##### **FORM10-Q**

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**(MarkOne)**

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

**For thequarterly period ended December 31, 2006**

###### **OR**

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

**For the transition period from                     to                     **

###### **Commission file number: 0-30863**

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**NETWORKENGINES, INC.**

(Exact name ofregistrant as specified in its charter)

| **Delaware**                                               | ** ** | **04-3064173**                        |
|------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation)           |       | (I.R.S. Employer  Identification No.) |
|                                                       |       |                                  |
| **25 Dan  Road, Canton, MA**                               | ** ** | **02021**                             |
| (Address of  principal executive  offices)                 |       | (Zip Code)                            |
|                                                       |       |                                  |
| **(781)  332-1000**                                        |
| (Registrant’s  telephone number, including area code) |

 

Indicate by checkmark whether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. Yes x  No o

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

Large acceleratedfiler o  Acceleratedfiler x  Non-accelerated filer o

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o  No x

As of February 5,2007, there were 40,681,285 shares of the registrant’s Common Stock, par value$.01 per share, outstanding.

 

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

 

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**PARTI. FINANCIAL INFORMATION**

**ITEM I.FINANCIAL STATEMENTS**

**NETWORK ENGINES, INC. CONDENSED CONSOLIDATED BALANCE SHEETS(in thousands)(unaudited)**
| ** **                                                                                                                                                                                                      | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                      | ** ** | **2006**              | ** ** | **2006**               | ** ** |
| **ASSETS**                                                                                                                                                                                                      | ** ** | ** **            | ** ** | ** **             | ** ** |
| **Current assets:**                                                                                                                                                                                             | ** ** | ** **            | ** ** | ** **             | ** ** |
| Cash and cash  equivalents                                                                                                                                                                                      |       | $                     | 10,733     |                   | $          | 8,014 |   |
| Short-term  investments                                                                                                                                                                                         |       | 28,156                |       | 24,804                 |       |
| Restricted cash                                                                                                                                                                                                 |       | 47                    |       | 47                     |       |
| Accounts  receivable, net of allowances                                                                                                                                                                         |       | 12,329                |       | 17,178                 |       |
| Inventories                                                                                                                                                                                                     |       | 11,059                |       | 8,445                  |       |
| Prepaid expenses  and other current assets                                                                                                                                                                      |       | 888                   |       | 1,460                  |       |
| Total current  assets                                                                                                                                                                                           |       | 63,212                |       | 59,948                 |       |
|                                                                                                                                                                                                            |       |                  |       |                   |       |
| Property and  equipment, net                                                                                                                                                                                    |       | 1,086                 |       | 1,093                  |       |
| Other assets                                                                                                                                                                                                    |       | 27                    |       | 20                     |       |
|                                                                                                                                                                                                            |       |                  |       |                   |       |
| Total assets                                                                                                                                                                                                    |       | $                     | 64,325     |                   | $          | 61,061 |   |
|                                                                                                                                                                                                            |       |                  |       |                   |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                  | ** ** | ** **            | ** ** | ** **             | ** ** |
| **Current liabilities:**                                                                                                                                                                                        | ** ** | ** **            | ** ** | ** **             | ** ** |
| Accounts payable                                                                                                                                                                                                |       | $                     | 8,645      |                   | $          | 7,047 |   |
| Accrued compensation  and other related benefits                                                                                                                                                                |       | 1,502                 |       | 1,762                  |       |
| Other accrued  expenses                                                                                                                                                                                         |       | 2,048                 |       | 2,180                  |       |
| Current portion  of capital lease obligation                                                                                                                                                                    |       | 19                    |       | 19                     |       |
| Deferred revenue                                                                                                                                                                                                |       | 941                   |       | 1,049                  |       |
| Total current  liabilities                                                                                                                                                                                      |       | 13,155                |       | 12,057                 |       |
|                                                                                                                                                                                                            |       |                  |       |                   |       |
| Long-term  portion of capital lease obligation                                                                                                                                                                  |       | 55                    |       | 60                     |       |
| Deferred revenue                                                                                                                                                                                                |       | 601                   |       | 541                    |       |
|                                                                                                                                                                                                            |       |                  |       |                   |       |
| Total  liabilities                                                                                                                                                                                              |       | 13,811                |       | 12,658                 |       |
|                                                                                                                                                                                                            |       |                  |       |                   |       |
| Commitments and  contingencies (Note 6)                                                                                                                                                                         |       |                  |       |                   |       |
|                                                                                                                                                                                                            |       |                  |       |                   |       |
| **Stockholders’ equity:**                                                                                                                                                                                  | ** ** | ** **            | ** ** | ** **             | ** ** |
| Preferred stock,  $.01 par value, 5,000,000 authorized, no shares issued or outstanding                                                                                                                         |       | —                |       | —                 |       |
| Common stock,  $.01 par value, 100,000,000 shares authorized; 43,189,827 and 41,751,304  shares issued; 40,627,969 and 39,189,446 shares outstanding at December 31,  2006 and September 30, 2006, respectively |       | 432                   |       | 418                    |       |
| Additional paid-in  capital                                                                                                                                                                                     |       | 184,631               |       | 182,420                |       |
| Accumulated  deficit                                                                                                                                                                                            |       | (131,711              | )          | (131,597               | )          |
| Treasury stock,  at cost, 2,561,858 shares at December 31, 2006 and September 30, 2006                                                                                                                          |       | (2,838                | )          | (2,838                 | )          |
|                                                                                                                                                                                                            |       |                  |       |                   |       |
| Total  stockholders’ equity                                                                                                                                                                                |       | 50,514                |       | 48,403                 |       |
|                                                                                                                                                                                                            |       |                  |       |                   |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                |       | $                     | 64,325     |                   | $          | 61,061 |   |

 

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

1

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**NETWORK ENGINES, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except per share data)****(unaudited)**
| ** **                                                     | ** ** | **Three months ended  December 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                                                     | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Net revenues                                                   |       | $                                                   | 27,238     |   | $ | 27,269 |   |
|                                                           |       |                                                |       |   |   |
| Cost of revenues                                               |       | 22,005                                              |       | 22,608 |   |
|                                                           |       |                                                |       |   |   |
| Gross profit                                                   |       | 5,233                                               |       | 4,661 |   |
|                                                           |       |                                                |       |   |   |
| Operating  expenses:                                           |       |                                                |       |   |   |
| Research and development                                       |       | 1,993                                               |       | 2,020 |   |
| Selling and marketing                                          |       | 1,730                                               |       | 2,778 |   |
| General and administrative                                     |       | 2,061                                               |       | 1,807 |   |
|                                                           |       |                                                |       |   |   |
| Total operating expenses                                       |       | 5,784                                               |       | 6,605 |   |
|                                                           |       |                                                |       |   |   |
| Loss from  operations                                          |       | (551                                                | )          | (1,944 | ) |
| Interest and  other income, net                                |       | 447                                                 |       | 320 |   |
|                                                           |       |                                                |       |   |   |
| Net loss before income taxes                                   |       | (104                                                | )          | (1,624 | ) |
| Provision for income taxes                                     |       | 10                                                  |       | — |   |
|                                                           |       |                                                |       |   |   |
| Net loss                                                       |       | $                                                   | (114       | ) | $ | (1,624 | ) |
|                                                           |       |                                                |       |   |   |
| Net loss per  share – basic and diluted                   |       | $                                                   | —     |   | $ | (0.04 | ) |
|                                                           |       |                                                |       |   |   |
| Shares used in  computing basic and diluted net loss per share |       | 39,947                                              |       | 37,867 |   |

 

**The accompanying notes are an integral part of the condensedconsolidated financial statements.**

2

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**NETWORK ENGINES, INC.CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS****(in thousands)****(unaudited)**
| ** **                                                                                 | ** ** | **Three months ended  December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                                                                                 | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Cash flows from  operating activities:                                                     |       |                                                |       |   |   |
| Net loss                                                                                   |       | $                                                   | (114       | ) | $ | (1,624 | ) |
| Adjustments to reconcile net loss to net cash  provided by (used in) operating activities: |       |                                                |       |   |   |
| Depreciation and amortization                                                              |       | 204                                                 |       | 248 |   |
| Provision for doubtful accounts                                                            |       | (11                                                 | )          | (23 | ) |
| Stock-based compensation                                                                   |       | 614                                                 |       | 584 |   |
| Changes in operating assets and liabilities:                                               |       |                                                |       |   |   |
| Accounts receivable                                                                        |       | 4,860                                               |       | (2,763 | ) |
| Inventories                                                                                |       | (2,612                                              | )          | 625 |   |
| Prepaid expenses and other current assets                                                  |       | 572                                                 |       | (212 | ) |
| Accounts payable                                                                           |       | 1,598                                               |       | 2,378 |   |
| Accrued expenses                                                                           |       | (392                                                | )          | 222 |   |
| Deferred revenue                                                                           |       | (48                                                 | )          | (318 | ) |
|                                                                                       |       |                                                |       |   |   |
| Net cash provided by (used in) operating activities                                        |       | 4,671                                               |       | (883 | ) |
|                                                                                       |       |                                                |       |   |   |
| Cash flows from  investing activities:                                                     |       |                                                |       |   |   |
| Purchases of property and equipment                                                        |       | (197                                                | )          | (140 | ) |
| Purchases of short-term investments                                                        |       | (7,102                                              | )          | (17,415 | ) |
| Proceeds from sales and maturities of short-term  investments                              |       | 3,750                                               |       | 18,500 |   |
| Changes in other assets                                                                    |       | (7                                                  | )          | 82 |   |
|                                                                                       |       |                                                |       |   |   |
| Net cash (used in) provided by investing activities                                        |       | (3,556                                              | )          | 1,027 |   |
|                                                                                       |       |                                                |       |   |   |
| Cash flows from  financing activities:                                                     |       |                                                |       |   |   |
| Proceeds from issuance of common stock                                                     |       | 1,609                                               |       | 181 |   |
| Payments on capital lease obligation                                                       |       | (5                                                  | )          | (4 | ) |
|                                                                                       |       |                                                |       |   |   |
| Net cash provided by financing activities                                                  |       | 1,604                                               |       | 177 |   |
|                                                                                       |       |                                                |       |   |   |
| Net increase in  cash and cash equivalents                                                 |       | 2,719                                               |       | 321 |   |
| Cash and cash  equivalents, beginning of period                                            |       | 8,014                                               |       | 9,468 |   |
|                                                                                       |       |                                                |       |   |   |
| Cash and cash  equivalents, end of period                                                  |       | $                                                   | 10,733     |   | $ | 9,789 |   |

 

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

3

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**NETWORKENGINES, INC.NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**1.BASIS OF PRESENTATION**

The accompanying condensed consolidated financialstatements have been prepared by Network Engines, Inc. (“Network Engines” orthe “Company”) in accordance with accounting principles generally accepted inthe United States of America and pursuant to the rules and regulations of theSecurities and Exchange Commission. Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith generally accepted accounting principles have been condensed or omittedpursuant to such rules and regulations. The year-end condensed balance sheetdata was derived from audited financial statements, but does not include allyear-end disclosures required by accounting principles generally accepted inthe United States of America. These financial statements should be read inconjunction with the audited financial statements and the accompanying notesincluded in the Company’s 2006 Annual Report on Form 10-K filed by the Companywith the Securities and Exchange Commission.

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

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

**2.SIGNIFICANT ACCOUNTING POLICIES**

***Recent Accounting Pronouncements***

In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin No.108, “Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in the Current YearFinancial Statements” (“SAB 108”). SAB 108 addresses how the effects ofprior-year uncorrected misstatements should be considered when quantifying misstatementsin current-year financial statements. SAB 108 requires an entity to quantifymisstatements using a balance sheet and income statement approach and toevaluate whether either approach results in an error that is material in lightof relevant quantitative and qualitative factors. The requirements of SAB 108are effective for fiscal years ending after November 15, 2006. Theadoption of SAB 108 is not expected to have an impact on the Company’sfinancial position, results of operations, or cash flows.

#### ***Cash, Cash Equivalents, Short-termInvestments and Restricted Cash***

Cash equivalentsconsist principally of money market funds, commercial paper, and othermarketable securities purchased with an original maturity of three months orless. These investments are carried at cost, which approximates market value.The Company also invests excess cash in auction rate securities. Thesesecurities have long-term underlying maturities, however the market is highlyliquid and the interest rates reset every 7, 28 or 35 days. The Company’sintent is not to hold these securities to maturity, but rather to use theinterest rate reset feature to sell securities to provide liquidity as needed. TheCompany’s short-term investments are classified as available for sale and arecarried at fair value, with unrealized gains and losses included in othercomprehensive income or loss, which is a separate component of stockholders’equity, until realized. At December 31, 2006 and September 30, 2006, there wereno unrealized gains or losses. At December 31, 2006 and September 30, 2006,$47,000 of cash was restricted and pledged as collateral for a letter of creditrelated to the lease of the Company’s facilities. Details of the Company’scash, cash equivalents and short-term investments are as follows (inthousands):

4

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|                                      | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|--------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                           | ** ** | **2006**              | ** ** | **2006**               | ** ** |
| **Cash  and cash equivalents:**      |       |                  |       |                   |       |
| Cash                                 |       | $                     | 2,843      |                   | $          | 718 |   |
| Money market funds                   |       | 5,128                 |       | 5,105                  |       |
| Commercial paper                     |       | 2,762                 |       | 2,191                  |       |
|                                 |       |                  |       |                   |       |
| **Total  cash and cash equivalents** |       | $                     | 10,733     |                   | $          | 8,014 |   |
|                                 |       |                  |       |                   |       |
| **Short-term  investments:**         |       |                  |       |                   |       |
| Municipal  auction rate securities   |       | $                     | 28,156     |                   | $          | 24,804 |   |

 

#### ***Comprehensive Loss***

During each periodpresented, comprehensive loss was equal to net loss.

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

Duringthe quarter ended December 31, 2006, the Company changed the manner in whichmanagement viewed information regarding results of the Company’s operations forpurposes of making decisions affecting the business. This resulted from changesin the operations of the Company, including consolidation of financial andoperational information reviewed by management to evaluate the Company’soperations, discontinuing market demand creation for its NS Series SecurityAppliances and using certain of those products as reference platforms fordeveloping and selling appliances to system integrators and IndependentSoftware Vendors (“ISVs”), and the consolidation of the Company’s sales force.Therefore, the Company now has one reportable segment, which represents howmanagement now evaluates the Company’s operations. Substantially all of theCompany’s long-lived assets were located in the United States as of December31, 2006 and September 30, 2006.

#### ***Significant******Customers***

#### The followingtable summarizes those customers who accounted for greater than 10% of theCompany’s net revenues or accounts receivable:

|                 | ** ** | **Net Revenues for the three** | ** ** | **Accounts Receivable at** | ** ** |
|-----------------|------------|----------------------------------------------------|------------|--------------------------------------|------------|
| ** **      | ** ** | **months ended December 31,**       | ** ** | **December 31,**                | ** ** | **September 30,** | ** ** |
| ** **      | ** ** | **2006**                                           | ** ** | **2005**                             | ** ** | **2006** | ** ** | **2006** | ** ** |
| EMC Corporation |       | 82                                                 | %          | 83                                   | %          | 77 | % | 85 | % |

 

**3.STOCK-BASED COMPENSATION**

Stock-based compensation expense is measured at the grant date, based onthe fair value of the award, and is recognized as an expense over the employee’srequisite service period (generally the vesting period of the equity award).

5

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The followingtable presents stock-based employee compensation expense included in theCompany’s unaudited condensed consolidated statements of operations (inthousands):
|                                   | ** ** | **Three Months Ended December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
|                              |       |                                                    |       |   |   |
| Cost of revenues                  |       | $                                                       | 40         |   | $ | 40 |   |
| Research and  development         |       | 280                                                     |       | 254 |   |
| Selling and  marketing            |       | 100                                                     |       | 166 |   |
| General and  administrative       |       | 192                                                     |       | 124 |   |
| Stock-based  compensation expense |       | $                                                       | 612        |   | $ | 584 |   |

 

The Companyestimates the fair value of stock options using the Black-Scholes valuationmodel. This valuation model takes into account the exercise price of the award,as well as a variety of significant assumptions. These assumptions include theexpected term, the expected volatility of the Company’s stock over the expectedterm, the risk-free interest rate over the expected term, and the Company’sexpected annual dividend yield. The Company believes that the valuationtechnique and the approach utilized to develop the underlying assumptions areappropriate in calculating the fair values of the Company’s stock optionsgranted in the three months ended December 31, 2006. Estimates of fair valueare not intended to predict the value ultimately realized by persons whoreceive equity awards. In determining the amount of expense to be recorded,judgment is also required to estimate forfeitures of the awards based on theprobability of employees completing the required service period. Historicalforfeitures are used as a starting point for developing our estimate of futureforfeitures.

Assumptions usedto determine the fair value of options granted using the Black-Scholesvaluation model were:
|                                 | ** ** | **Three Months Ended December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
|                            |       |                                                    |       |   |   |
| Expected term(1)                |       | 6.06 to 6.25 years                                      |       | 6.06 to 6.25 years |   |
| Expected  volatility factor(2)  |       | 72.67                                                   | %          | 77.00 | % |
| Risk-free  interest rate(3)     |       | 4.65                                                    | %          | 4.39 | % |
| Expected annual  dividend yield |       | —                                                  | %          | — |   |

 

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(1)          Expectedterm for each grant was determined as the midpoint between the vesting date andthe end of the contractual term, also known as the “simplified method” forestimating expected term described by Staff Accounting Bulletin No. 107 (“SAB107”).

(2)          Theexpected volatility for each grant is estimated based on a weighted average ofhistorical volatility.

(3)          Therisk-free interest rate for each grant is based on the U.S. Treasury yieldcurve in effect at the time of grant for a period equal to the expected term ofthe stock option.

Stock-basedcompensation expense related to the Company’s Employee Stock Purchase Plan wasdetermined based on the discount of 15% from the per share market price on theclose of the purchase period.

6

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A summary of theCompany’s stock option activity for the three months ended December 31, 2006 isas follows: 
|                                   | ** ** | **Number of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  years)** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|----------------------------------------------------------------------|------------|
|                              |       |                        |       |                                   |       |                                                                 |       |
| Outstanding,  September 30, 2006  |       | 7,366,964                   |       | $                                      | 2.29       |                                                                 |       |   |
| Granted                           |       | 713,900                     |       | 2.28                                   |       |                                                                 |       |
| Exercised                         |       | (1,388,049                  | )          | 1.09                                   |       |                                                                 |       |
| Cancelled                         |       | (275,779                    | )          | 3.04                                   |       |                                                                 |       |
| Outstanding,  December 31, 2006   |       | 6,417,036                   |       | $                                      | 2.51       |                                                                 | 7.62       |   |
| Exercisable at  December 31, 2006 |       | 2,601,547                   |       | $                                      | 3.23       |                                                                 | 5.77       |   |

 

All optionsgranted during the three months ended December 31, 2006 and 2005 were grantedwith exercise prices equal to the fair market value of the Company’s commonstock on the grant date and had weighted average grant date fair values of$1.55 and $1.02, respectively.

At December 31,2006, unrecognized compensation expense related to non-vested stock options was$3,985,000, which is expected to be recognized over a weighted average periodof 2.84 years.

**4.NET LOSS PER SHARE**

Basic net loss per share is computed by dividing thenet loss for the period by the weighted average number of shares of commonstock outstanding during the period. Diluted net loss per share is computed bydividing the net loss for the period by the weighted average number of sharesof common stock and potential common stock outstanding during the period, ifdilutive. Potential common stock includes incremental shares of common stockissuable upon the exercise of stock options. For the three month periods endedDecember 31, 2006 and 2005, stock options totaling 4,137,000 and 4,628,000shares, respectively were excluded from the calculation of net loss per sharebecause their inclusion would be anti-dilutive.

**5. INVENTORIES**

Inventories consisted ofthe following (in thousands):
|                 | ** ** | **December 31,  2006** | ** ** | **September 30,  2006** | ** ** |
|-----------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **      | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| Raw materials   |       | $                           | 6,934      |                         | $          | 4,628 |   |
| Work in process |       | 434                         |       | 432                          |       |
| Finished goods  |       | 3,691                       |       | 3,385                        |       |
|            |       |                        |       |                         |       |
|            |       | $                           | 11,059     |                         | $          | 8,445 |   |

7

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**6. COMMITMENTS AND CONTINGENCIES**

***Guaranteesand Indemnifications***

Acquisition-relatedindemnifications – When, as part of an acquisition, the Company acquires allthe stock of a company, the Company assumes liabilities for certain events orcircumstances that took place prior to the date of acquisition. The maximumpotential amount of future payments the Company could be required to make forsuch obligations is undeterminable. While the provisions of the agreementsremain in effect indefinitely, the Company believes that the probability ofreceiving a claim is unlikely. As a result, the Company has not recorded aliability for these indemnification clauses as of December 31, 2006.

The Company entersinto standard indemnification agreements in the ordinary course of itsbusiness. Pursuant to these agreements, the Company indemnifies, holdsharmless, and agrees to reimburse the indemnified party for losses suffered orincurred by the indemnified party, generally its business partners orcustomers, in connection with any patent, copyright, trademark, trade secret orother intellectual property infringement claim by any third party with respectto its products. The term of these indemnification agreements is generallyperpetual. The Company has never incurred costs to defend lawsuits or settleclaims related to these indemnification agreements. As a result, the Companybelieves the estimated fair value of these agreements is minimal. Accordingly,the Company has no liabilities recorded for these indemnifications as ofDecember 31, 2006.

Product warranties – The Company offers and fulfills warrantyservices on certain of its server appliances. Warranty terms vary in durationdepending upon the product sold but generally provide for the repair orreplacement of any defective products for periods of up to 36 months aftershipment. Based upon historical experience and expectation of futureconditions, the Company reserves for the estimated costs to fulfill customerwarranty obligations upon the recognition of the related revenue. The followingtable presents changes in the Company’s product warranty liability for thethree months ended December 31, 2006 and 2005 (in thousands):
|                                              | ** ** | **Three months ended  December 31,** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
|                                         |       |                                                |       |   |   |
| Beginning  balance                           |       | $                                                   | 559        |   | $ | 455 |   |
| Accruals for  warranties issued              |       | 321                                                 |       | 390 |   |
| Fulfillment of  warranties during the period |       | (178                                                | )          | (358 | ) |
| Ending balance                               |       | $                                                   | 702        |   | $ | 487 |   |

 

***Contingencies***

*Initial Public Offering Lawsuit*

On or about December 3, 2001, a putative class actionlawsuit was filed in the United States District Court for the Southern Districtof New York against the Company, Lawrence A. Genovesi (the Company’s Chairmanand former Chief Executive Officer), Douglas G. Bryant (the Company’s ChiefFinancial Officer and Vice President of Finance and Administration), and thefollowing underwriters of the Company’s initial public offering: FleetBostonRobertson Stephens Inc., Credit Suisse First Boston Corp., Goldman Sachs &Co., Lehman Brothers Inc. and Salomon Smith Barney, Inc. (collectively, the “UnderwriterDefendants”). An amended class action complaint, captioned In re NetworkEngines, Inc. Initial Public Offering Securities Litigation, 01 Civ. 10894(SAS), was filed on April 20, 2002.

The suit alleges that the defendants violated thefederal securities laws by issuing and selling securities pursuant to theCompany’s initial public offering in July 2000 (“IPO”) without disclosing to

8

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investors that theUnderwriter Defendants had solicited and received excessive and undisclosedcommissions from certain investors. The suit also alleges that the UnderwriterDefendants entered into agreements with certain customers whereby theUnderwriter Defendants agreed to allocate to those customers shares of theCompany’s common stock in the offering, in exchange for which the customersagreed to purchase additional shares of the Company’s common stock in theaftermarket at pre-determined prices. The suit alleges that such tie-inarrangements were designed to and did maintain, distort and/or inflate theprice of the Company’s common stock in the aftermarket. The suit furtheralleges that the Underwriter Defendants received undisclosed and excessivebrokerage commissions and that, as a consequence, the Underwriter Defendantssuccessfully increased investor interest in the manipulated IPO securities andincreased the Underwriter Defendants’ individual and collective underwritings,compensation and revenues. The suit seeks damages and certification of aplaintiff class consisting of all persons who acquired shares of the Company’scommon stock between July 13, 2000 and December 6, 2000.

In July 2002, the Company, Lawrence A. Genovesi andDouglas G. Bryant joined in an omnibus motion to dismiss the suit challengingthe legal sufficiency of plaintiffs’ claims. The motion was filed on behalf ofhundreds of issuer and individual defendants named in similar lawsuits.Plaintiffs opposed the motion, and the Court heard oral argument on the motionin November 2002. On February 19, 2003, the Court issued an opinion and orderdenying the motion as to the Company. However, in October 2002, Lawrence A.Genovesi and Douglas G. Bryant were dismissed from this case without prejudice.

On July 9, 2003, a SpecialCommittee of the Company’s Board of Directors authorized the Company tonegotiate a settlement of the pending claims substantially consistent with amemorandum of understanding negotiated among class plaintiffs, all issuerdefendants and their insurers. The parties have negotiated the settlement,which provides, among other things, for a release of the Company and theIndividual Defendants for the conduct alleged in the amended complaint to bewrongful. The Company would agree to undertake other responsibilities under thesettlement, including agreeing to assign, or not assert, certain potentialclaims that it may have against its underwriters. Any direct financial impactof the proposed settlement is expected to be borne by the Company’s insurers. Anysuch settlement would be subject to various contingencies, including approvalby the Court overseeing the litigation. On February 15, 2005, the Court issuedan 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. The parties agreed to amodification narrowing the scope of the bar order, and on August 31, 2005, theCourt issued an order preliminarily approving the settlement and setting apublic hearing on its fairness, which took place on April 24, 2006. On December5, 2006, the United States Court of Appeals for the Second Circuit overturnedthe District Court’s certification of the class of plaintiffs who are pursuingthe claims that would be settled in the settlement against the underwriterdefendants. Plaintiffs filed a Petition for Rehearing and Rehearing *En Banc* with the Second Circuit on January5, 2007 in response to the Second Circuit’s decision and have informed theDistrict Court that they would like to be heard as to whether the settlementmay still be approved even if the decision of the Court of Appeals is notreversed. The District Court indicated that it would defer consideration offinal approval of the settlement pending plaintiffs’ request for furtherappellate review. The Company is unable to predict the outcome of this suit andas a result, no amounts have been accrued as of December 31, 2006.

**7. RELATED PARTY TRANSACTIONS**

Robert M. Wadsworth, one ofthe Company’s directors, also serves as a director of Innoveer Solutions, Inc. (“Innoveer”). TheCompany engages Innoveer to provide professional services related tomodifications of its customer resource management (“CRM”) software system. Duringthe three months ended December 31, 2006 and 2005, the Company incurredapproximately $11,000 and $29,000, respectively, related to these services. TheCompany had $11,000 and $7,000 payable to Innoveer at December 31, 2006 and September30, 2006, respectively.

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**ITEM 2. MANAGEMENT’S DISCUSSIONAND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION**

**Special Note RegardingForward-Looking Statements**

This Quarterly Report on Form10-Q contains 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 projections related to 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 in Part II, Item 1A, Risk Factors, of this report and therisks discussed in our other filings with the Securities and ExchangeCommission. Readers are cautioned not to place undue reliance on theseforward-looking statements, which reflect management’s analysis, judgment,belief or expectation only as of the date hereof. We undertake no obligation topublicly reissue these forward-looking statements to reflect events orcircumstances that arise after the date hereof.

The followingdiscussion and analysis should be read in conjunction with the condensedconsolidated financial statements and the notes thereto included in Item 1 inthis Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for thefiscal year ended September 30, 2006 filed by the Company with the Securitiesand Exchange Commission.

**Overview**

We develop and manufacture server appliance solutionsthat deliver data storage and network security applications on serverappliances. Server appliances are pre-configured network infrastructure devicesdesigned to optimally deliver specific software application functionality andfacilitate ease of deployment and support of a software application in acustomer’s network.

During the quarter, we changed the manner in which weview information regarding results of our operations for purposes of makingdecisions affecting the business. These changes included consolidation offinancial and operational information reviewed to evaluate our operations,discontinuing market demand creation for our NS Series Security Appliances andusing certain of those products as reference platforms for developing andselling appliances to system integrators and Independent Software Vendors (“ISVs”),and the consolidation of our sales force. Therefore, we now have one reportablesegment, which represents how we evaluate our operations.

**CriticalAccounting Policies and Estimates**

Our discussion andanalysis of financial condition and results of operations are based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America. Inpreparing these financial statements, we have made estimates and judgments indetermining certain amounts included in the financial statements. We base ourestimates and judgments on historical experience and other various assumptionsthat we believe to be reasonable under the circumstances. Actual results maydiffer from these estimates under different assumptions or conditions. Nochanges to our critical accounting policies have taken place since September30, 2006.

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**Resultsof Operations**

**Threemonths ended December 31, 2006 compared to the three months ended December 31,2005**

Thefollowing table summarizes financial data for the periods indicated inthousands and as a percentage of net revenues and provides the changes inthousands and percentages:
| ** **            | ** ** | **Three Months Ended December 31,** | ** ** |
|-----------------------|------------|---------------------------------------------------------|------------|
| ** **            | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **            | ** ** | **Dollars**                                             | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues          |       | $                                                       | 27,238     |   | 100.0 | % | $ | 27,269 |   | 100.0 | % | $ | (31 | ) | (0.1 | )% |
| Gross profit          |       | 5,233                                                   |       | 19.2 | % | 4,661 |   | 17.1 | % | 572 |   | 12.3 | % |
| Operating  expenses   |       | 5,784                                                   |       | 21.2 | % | 6,605 |   | 24.2 | % | (821 | ) | (12.4 | )% |
| Loss from  operations |       | (551                                                    | )          | (2.0 | )% | (1,944 | ) | (7.1 | )% | 1,393 |   | 71.7 | % |
| Net loss              |       | (114                                                    | )          | (0.4 | )% | (1,624 | ) | (6.0 | )% | 1,510 |   | 93.0 | % |
|                       |            |                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Net Revenues***

Our revenues are derived from sales of serverappliances and related maintenance services.

Our net revenues remained relatively consistent forthe three months ended December 31, 2006 versus the same period in fiscal 2006.This was primarily due to a decrease in sales volumes, offset by higher averageselling prices. Net revenues from sales to EMC represented 82% of net revenuesin the three months ended December 31, 2006 versus 83% in the three monthsended December 31, 2005. In addition, net revenues from other customers for thethree months ended December 31, 2006 increased to $4.8 million from $3.1million for the three months ended December 31, 2005. This increase was broadbased and included increased sales to existing customers, as well as revenuefrom new customers.

***Gross profit***

Gross profitrepresents net revenues recognized less the cost of revenues. Cost of revenuesincludes cost of materials, warranty costs, inventory write-downs, shipping andhandling costs, customer support costs, and manufacturing costs. Manufacturingcosts are primarily comprised of compensation, contract labor costs and, whenapplicable, contract manufacturing costs.

Gross profit andgross profit as a percentage of net revenue increased for the quarter endedDecember 31, 2006, compared to the quarter ended December 31, 2005, primarilyas a result of changes in customer and product mix and the timing of costreductions from our suppliers relative to price reductions to customers.

Gross profit isaffected by customer and product mix, pricing and the volume of orders as wellas by the mix of product manufactured internally compared to productmanufactured by a contract manufacturer, which results in higher manufacturingcosts. We expect that gross profit as a percentage of net revenue for the threemonths ended March 31, 2007 will be comparable to the three months endedDecember 31, 2006.

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***Operating Expenses***

The following table presents operating expenses duringthe periods indicated, in thousands and as a percentage of net revenues:
| ** **                 | ** ** | **Three Months Ended December 31,** | ** ** |
|----------------------------|------------|---------------------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                 | ** ** | **Dollars**                                             | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating  Expenses:       |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Research and development   |       | $                                                       | 1,993      |   | 7 | % | $ | 2,020 |   | 7 | % | $ | (27 | ) | (1 | )% |
| Selling and marketing      |       | 1,730                                                   |       | 6 | % | 2,778 |   | 10 | % | (1,048 | ) | (38 | )% |
| General and administrative |       | 2,061                                                   |       | 8 | % | 1,807 |   | 7 | % | 254 |   | 14 | % |
|                       |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total operating  expenses  |       | $                                                       | 5,784      |   | 21 | % | $ | 6,605 |   | 24 | % | $ | (821 | ) | (12 | )% |

 

***Research anddevelopment***

Research and development expenses consist primarily ofsalaries and related expenses for personnel engaged in research anddevelopment, fees paid to consultants and outside service providers, material costsfor 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 December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                             | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:        |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                       | 1,219      |   | 61 | % | $ | 1,217 |   | 60 | % | $ | 2 |   | — |   |
| Stock-based compensation          |       | 280                                                     |       | 14 | % | 255 |   | 13 | % | 25 |   | 10 | % |
| Prototype                         |       | 141                                                     |       | 7 | % | 97 |   | 5 | % | 44 |   | 45 | % |
| Consulting and outside services   |       | 142                                                     |       | 7 | % | 228 |   | 11 | % | (86 | ) | (38 | )% |
| Other                             |       | 211                                                     |       | 11 | % | 223 |   | 11 | % | (12 | ) | (5 | )% |
|                              |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total research  and development   |       | $                                                       | 1,993      |   | 100 | % | $ | 2,020 |   | 100 | % | $ | (27 | ) | (1 | )% |

 

Our research anddevelopment expenses have remained relatively consistent this quarter ascompared to the same period last fiscal year. Because our research anddevelopment expenses are project driven, the timing of these expenditures canvary. The increase in prototype expenses is attributable to increaseddevelopment on our server appliances for both new and existing customers. Thedecrease in consulting costs also relates to the timing of certain developmentprojects.

Our server appliancedevelopment strategy emphasizes the utilization of standard server applianceplatforms, which utilize off-the-shelf components. However, we expect that insome cases significant development efforts will be required to fulfill ourcurrent and potential customers’ needs using customized platforms. In addition,we intend to focus our software development in areas that improve the ease ofserver appliance implementation and use, which we believe will enhance ourvalue proposition. We expect that prototype and consulting costs will bevariable and could fluctuate depending on the timing and magnitude of ourdevelopment projects. We expect our research and development costs to increaseduring our quarter ended March 31, 2007.

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***Selling andmarketing***

Selling and marketing expenses consist primarily ofsalaries and commissions for personnel engaged in sales and marketing; costsassociated with our marketing programs, which include costs associated with ourattendance at trade shows, advertising, web site enhancements and productevaluation costs; consulting and outside services costs and travel. Thefollowing table summarizes the most significant components of selling andmarketing expense for the periods indicated in thousands and as a percentage oftotal selling and marketing expense and provides the changes in thousands andpercentages:
| ** **                        | ** ** | **Three Months Ended December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                             | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and  marketing:           |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                       | 1,226      |   | 71 | % | $ | 1,507 |   | 54 | % | $ | (281 | ) | (19 | )% |
| Stock-based compensation          |       | 100                                                     |       | 6 | % | 166 |   | 6 | % | (66 | ) | (40 | )% |
| Marketing programs                |       | 169                                                     |       | 10 | % | 437 |   | 16 | % | (268 | ) | (61 | )% |
| Consulting and outside services   |       | 29                                                      |       | 2 | % | 241 |   | 9 | % | (212 | ) | (88 | )% |
| Travel                            |       | 112                                                     |       | 6 | % | 266 |   | 10 | % | (154 | ) | (58 | )% |
| Other                             |       | 94                                                      |       | 5 | % | 161 |   | 5 | % | (67 | ) | (42 | )% |
|                              |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total selling  and marketing      |       | $                                                       | 1,730      |   | 100 | % | $ | 2,778 |   | 100 | % | $ | (1,048 | ) | (38 | )% |

 

As indicated in the table above, the primarycomponents of the decrease in selling and marketing expenses are compensationand related expenses, marketing programs, consulting and outside services, andtravel. The decrease in compensation and related expense primarily relates to areduction in headcount from 37 at December 31, 2005 to 28 at December 31, 2006.The reduction in marketing expenses, consulting and outside services, andtravel is a result of reduced spending on end user lead generation programs forour NS Series products.

We believe that we must target our selling andmarketing efforts on network equipment providers, system integrators andindependent software vendors (“ISVs”) in order to enhance our position as aleading provider of server appliance products. We expect selling and marketingexpenses to increase slightly during our quarter ended March 31, 2007.

***General andadministrative***

General and administrative expenses consist primarilyof salaries and other related costs for executive, finance, informationtechnology and human resources personnel; professional services, which includelegal, accounting, audit and tax fees, and costs of compliance with theSarbanes-Oxley Act; and director and officer insurance. The following tablesummarizes the most significant components of general and administrative expensefor the periods indicated in thousands and as a percentage of total general andadministrative expense and provides the changes in thousands and percentages:
| ** **                           | ** ** | **Three Months Ended December 31,** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                             | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and  administrative:         |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                       | 774        |   | 38 | % | $ | 688 |   | 38 | % | $ | 86 |   | 13 | % |
| Stock-based compensation             |       | 192                                                     |       | 9 | % | 124 |   | 7 | % | 68 |   | 55 | % |
| Consulting and professional services |       | 846                                                     |       | 41 | % | 545 |   | 30 | % | 301 |   | 55 | % |
| Director and officer insurance       |       | 83                                                      |       | 4 | % | 231 |   | 13 | % | (148 | ) | (64 | )% |
| Other                                |       | 166                                                     |       | 8 | % | 219 |   | 12 | % | (53 | ) | (24 | )% |
|                                 |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total general  and administrative    |       | $                                                       | 2,061      |   | 100 | % | $ | 1,807 |   | 100 | % | $ | 254 |   | 14 | % |

 

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As indicated in the table above, general andadministrative expenses increased in the three months ended December 31, 2006versus the three months ended December 31, 2005. This was primarily a result ofincreases in consulting and professional services and compensation and relatedexpenses partially offset by a decrease in the cost of director and officerinsurance. At December 31, 2005, we had 24 employees in our general andadministrative department compared to 26 employees at December 31, 2006. Theincrease in consulting and professional services is due primarily to costsassociated with the investigation of embezzlement by a former non-managementemployee which was detected during the fourth quarter of fiscal 2006 and wascompleted during this quarter. We expect general and administrative expenses todecline slightly during our quarter ended March 31, 2007.

***Interestand Other Income, net***

Interest and other income,net increased to $447,000 for the three months ended December 31, 2006 from$320,000 for the three months ended December 31, 2005. This increase isprimarily due to increased interest rates and higher balances of our cash, cashequivalents, and short-term investments.

**Liquidityand Capital Resources**

The following tablesummarizes cash flow activities, in thousands, for the periods indicated:
|                                                  | ** ** | **Three Months Ended  December 31,** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
|                                             |       |                                                |       |   |   |
| Net loss                                         |       | $                                                   | (114       | ) | $ | (1,624 | ) |
| Non-cash  adjustments to net loss                |       | 807                                                 |       | 809 |   |
| Changes in  working capital                      |       | 3,978                                               |       | (68 | ) |
|                                             |       |                                                |       |   |   |
| Cash provided by  (used in) operating activities |       | 4,671                                               |       | (883 | ) |
|                                             |       |                                                |       |   |   |
| Cash (used in)  provided by investing activities |       | (3,556                                              | )          | 1,027 |   |
| Cash provided by  financing activities           |       | 1,604                                               |       | 177 |   |
|                                             |       |                                                |       |   |   |
| Increase in cash  and cash equivalents           |       | 2,719                                               |       | 321 |   |
| Beginning cash  and cash equivalents             |       | 8,014                                               |       | 9,468 |   |
|                                             |       |                                                |       |   |   |
| Ending cash and cash  equivalents                |       | $                                                   | 10,733     |   | $ | 9,789 |   |

 

The following table presents our short-terminvestments as of the periods indicated (in thousands):
|                        | ** ** | **December 31,  2006** | ** ** | **September 30,  2006** | ** ** |
|------------------------|------------|-----------------------------|------------|------------------------------|------------|
|                   |       |                        |       |                         |       |
| Short-term investments |       | $                           | 28,156     |                         | $          | 24,804 |   |
|                        |            |                             |            |                              |            |  |  |

 

***Operating Activities***

Cash flows provided by operating activities of $4.7million for the three months ended December 31, 2006 were primarily a result ofchanges in working capital. The most significant changes were a decrease inaccounts receivable of $4.9 million due to the timing of shipments during thequarter and an increase in accounts payable of $1.6 million. These werepartially offset by an increase in the inventory balances of $2.6 million dueto lower than expected sales to our largest customer.

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***Investing Activities***

Cash flows used in investing activities during thethree months ended December 31, 2006 consisted of net investments in short-termsecurities of approximately $3.4 million and the purchase of property andequipment of approximately $197,000.

***Financing Activities***

Cash flows provided by financing activities primarilyconsisted of cash received as a result of employee stock option and stockpurchase plan activity of $1.6 million in the three months ended December 31,2006 primarily as a result of exercises by former officers. We expect employeestock option and stock purchase plan activity to continue in fiscal 2007;however, we cannot predict its level given the volatility of capital markets.

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

·                  the timing and size of orders from ourlargest customer;

·                  our ability to enter into partnershipswith network equipment providers, systems integrators and independent softwarevendors;

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

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

·                  market developments.

We believe that our available cash resources,including cash, cash equivalents and short-term investments, and cash that weexpect to generate from sales of our products will be sufficient to meet ouroperating and capital requirements through at least the next twelve months.After that, we may need to raise additional funds. We may in the future seek toraise additional funds through borrowings, public or private equity financingsor from other sources. There can be no assurance that additional financing willbe available at all or, if available, will be on terms acceptable to us. Ifadditional financing is needed and is not available on acceptable terms, we mayneed to reduce our operating expenses.

***Contractual Obligations and Commitments***

As of December 31, 2006, there have been no materialchanges to our contractual obligations disclosure in our annual report onForm 10-K for the year ended September 30, 2006.

**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 anytransactions with unconsolidated entities whereby the Company has subordinatedretained interests, derivative instruments or other contingent arrangementsthat expose the Company to material continuing risks, contingent liabilities,or any other obligation under a variable interest in an unconsolidated entitythat provides financing, liquidity, market risk or credit risk support to theCompany.

**Related Party Transactions**

Robert M. Wadsworth, one ofour directors, alsoserves as a director of Innoveer Solutions, Inc. (“Innoveer”). We engageInnoveer to provide professional services related to modifications of itscustomer resource management (“CRM”) software system. During the three monthsended December 31, 2006 and 2005, we incurred approximately $11,000 and$29,000, respectively, related to these services. We had $11,000 and $7,000payable to Innoveer at December 31, 2006 and September 30, 2006, respectively.

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**Recent AccountingPronouncements**

In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin No.108, “Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in the Current YearFinancial Statements” (“SAB 108”). SAB 108 addresses how the effects ofprior-year uncorrected misstatements should be considered when quantifying misstatementsin current-year financial statements. SAB 108 requires us to quantifymisstatements using a balance sheet and income statement approach and toevaluate whether either approach results in an error that is material in lightof relevant quantitative and qualitative factors. The requirements of SAB 108are effective for fiscal years ending after November 15, 2006. Theadoption of SAB 108 is not expected to have an impact on our financialposition, results of operations, or cash flows.

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

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

**ITEM 4. CONTROLS AND PROCEDURES**

Our management, with the participation of our chiefexecutive officer and chief financial officer, evaluated the effectiveness ofour disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act) as of December 31, 2006. Based onthis evaluation, our chief executive officer and chief financial officerconcluded that, as of December 31, 2006, our disclosure controls and procedures(1) were designed to effectively accumulate and communicate information to theCompany’s management, as appropriate, to allow timely decisions regardingrequired disclosure and (2) were effective, in that they providereasonable assurance that information required to be disclosed by the Companyin the reports that it files or submits under the Securities Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms.

No change in our internal control over financial reporting (as defined inRules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the threemonths ended December 31, 2006 that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

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**PARTII—OTHER INFORMATION**

**ITEM 1. LEGAL PROCEEDINGS**

*Initial Public Offering Lawsuit*

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

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

In July 2002, we, Lawrence A. Genovesi and Douglas G.Bryant joined in an omnibus motion to dismiss the suit challenging the legalsufficiency of plaintiffs’ claims. The motion was filed on behalf of hundredsof issuer and individual defendants named in similar lawsuits. Plaintiffsopposed the motion, and the Court heard oral argument on the motion in November2002. On February 19, 2003, the Court issued an opinion and order denying themotion as to us. However, in October 2002, Lawrence A. Genovesi and Douglas G.Bryant were dismissed from this case without prejudice.

On July 9, 2003, a SpecialCommittee of our Board of Directors authorized us to negotiate a settlement ofthe pending claims substantially consistent with a memorandum of understandingnegotiated among class plaintiffs, all issuer defendants and their insurers. Theparties have negotiated the settlement, which provides, among other things, fora release of us and the Individual Defendants for the conduct alleged in theamended complaint to be wrongful. We would agree to undertake otherresponsibilities under the settlement, including agreeing to assign, or notassert, certain potential claims that we may have against the underwriters. Anydirect financial impact of the proposed settlement is expected to be borne byour insurers. Any such settlement would be subject to various contingencies,including approval by the Court overseeing the litigation. On February 15,2005, the Court issued an Opinion and Order preliminarily approving the settlement, providedthat the defendants and plaintiffs agree to a modification narrowing the scopeof the bar order set forth in the original settlement agreement. The partiesagreed to a modification narrowing the scope of the bar order, and on August31, 2005, the Court issued an order preliminarily approving the settlement andsetting a public hearing on its fairness, which took place on April 24, 2006. OnDecember 5, 2006, the United States Court of Appeals for the Second Circuitoverturned the District Court’s certification of the class of plaintiffs whoare pursuing the claims that would be settled in the settlement against theunderwriter defendants. Plaintiffs filed a Petition for Rehearing and Rehearing*En Banc* with the Second Circuiton January 5, 2007 in response to the Second Circuit’s decision and haveinformed the District Court that they would like to be heard as to whether thesettlement may still be approved even if the decision of the Court of Appealsis not reversed. The District Court indicated that it would defer considerationof final approval of the settlement pending plaintiffs’ request for furtherappellate review. We are unable to predict the outcome of this suit and as aresult, no amounts have been accrued as of December 31, 2006.

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**ITEM 1A. RISK FACTORS**

The risks anduncertainties described below are not the only ones we may face. Additionalrisks and uncertainties not presently known to us, or that are currently deemedimmaterial, may also impair our business operations. If any of thefollowing risks actually occur, our financial condition and operating resultscould be materially adversely affected.

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

**Wederive a significant portion of our revenues from sales of server appliancesdirectly to EMC and our revenues may decline significantly if thiscustomer cancels or delays purchases of our products, terminates itsrelationship with us, or exercises certain of its contractual rights.**

In the threemonths ended December 31, 2006 and 2005, sales directly to EMC, our largestcustomer, accounted for 82% and 83% of our total net revenues. Primarily all ofthese sales are attributable to one product pursuant to a non-exclusivecontract. In addition, during September 2006 EMC acquired Network Intelligence,Inc., one of our other sizeable customers, and as a result, the concentrationof our sales with EMC will increase in the near term. Our concentration ofrevenues with EMC would also increase in the future in the event of furtheracquisitions of existing customers by EMC. We anticipate that our futureoperating results will continue to depend heavily on sales to, and ourrelationship with, this customer. Accordingly, the success of our business 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 dependent upon the future success of the products wesell to this customer and the continued growth of this customer, whose industryhas a history of rapid technological change, short product life cycles,consolidation and pricing and margin pressures. A significant reduction insales to this customer, or significant pricing and additional margin pressuresexerted on us by this customer, would have a material adverse effect on ourresults of operations. In addition, if this customer delays or cancels purchasesof our products, our operating results would be harmed and our ability toaccurately predict revenues, profitability and cash flows would decrease.

Under the terms ofour non-exclusive contract, this customer has the right to enter into agreementswith third parties for similar products, is not obligated to purchase anyminimum quantity of products from us and may choose to stop purchasingfrom us at any time, with or without cause. In addition, this customermay terminate the agreement in the event that we attempt to assign ourrights under the agreement to another party without this customer’s priorapproval. Furthermore, in the event that we default on certain portions of theagreement, this customer has the right to manufacture certain products inexchange for a mutually agreeable royalty fee. If any of these events were tooccur, or if this customer were to delay or discontinue purchases of ourproducts as a result of dissatisfaction or otherwise, our revenues andoperating results would be materially adversely affected, our reputation in theindustry might suffer, and our ability to accurately predict revenues,profitability and cash flows would decrease.

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

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

We believe we mustdiversify our revenues and a major component of our business strategy is toform server appliance development relationships with new network equipmentproviders, ISVs, and systems integrators. Under this strategy, we work with ourcustomers to develop a server appliance branded with their name. Our partnerthen performs all of the selling and marketing efforts related to sales oftheir branded appliance.

There are multiplerisks associated with this strategy including:

·                  the expenditureof significant product development costs, which if not recovered through serverappliance sales could negatively affect our operating results;

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·                  a significantreliance on our customers’ application software products, which could betechnologically inferior to competitive products and result in limitations onour server appliance sales, causing our revenues and operating results tosuffer;

·                  our customerswill most likely continue selling their software products as separate productsin addition to selling it in the form of a server appliance, which willrequire us to effectively communicate the benefits of delivering their softwarein the form of a server appliance;

·                  our reliance onour customers to perform all of the selling and marketing effortsassociated with further sales of the server appliance product we develop withthem;

·                  continuedconsolidation within the network equipment and software industries that resultsin existing customers being acquired by other companies; and

·                  our ability toprovide our customers with high quality server appliances at competitiveprices.

Additionally, ourfuture success will depend on our ability to establish relationships with newcustomers, as well as expanding sales of server appliances to our existingcustomers. If these customers are unsuccessful in their marketing and salesefforts, or if we are unable to expand our sales to existing customers anddevelop relationships with new customers, our revenues and operating resultscould suffer.

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

Because certain ofour server appliance solutions utilize Microsoft’s ISA Server, our success withthese solutions will depend on the extent the marketplace perceives thissoftware as superior to other forms of VPN, firewalling, caching, and securityprotection. We believe this perception will be determined substantially as aresult of marketing efforts undertaken by Microsoft directly. In order toachieve broad recognition that ISA Server provides these features better thanother competing products, we will rely to a significant extent on Microsoft’sfinancial and technical resources to educate the marketplace. If Microsoft doesnot prioritize these marketing and promotional campaigns, or delays the timingof such programs, then we may not achieve significant sales of ourMicrosoft ISA Server based server appliance solutions, which may adverselyaffect our business.

Even if Microsoft’sISA Server software is widely accepted, customers may choose to purchaseISA Server in the form of software instead of a server appliance. Althoughmany network security applications are sold in the form of an appliance toallow for better deployment, management and security, Microsoft could continueto sell and/or customers may elect to purchase ISA Server in theform of software only or may choose to purchase appliances from othervendors. In this event, sales of our Microsoft ISA Server based serverappliance solutions will be adversely affected.

**If weare unable to effectively leverage our relationship with Microsoft to establishnew relationships with independent software vendors and other systemsintegrators our revenues and operating results may be adversely affected.**

In order for ouroffering of Microsoft ISA based server appliance solutions to be successful webelieve we must establish relationships with independent software vendors whoseapplications would also benefit from the advantages of ISA Server in the formof an appliance, and systems integrators that currently have significant salesand marketing resources. To date, we have engaged with a limited number of ISVsand Systems Integrators, and Microsoft has been instrumental in our enteringthese relationships. As such, we believe that building other relationships withISVs and systems integrators will continue to depend, in part, on ourrelationship with Microsoft, and our ability to leverage that relationship togain access to quality systems integrators, as well as other independentsoftware vendors in order to market our ISA Server based appliances includingour managed branch appliance to them. Therefore, we will need to furtherestablish and strengthen our relationship with Microsoft in order to beconsidered a preferred provider of ISA Server in the form of an appliance.If we fail to strengthen our relationship with Microsoft

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and to enter intopartnerships with key systems integrators and independent software vendors, ourrevenues and operating results may be adversely affected.

**Wemay not be able to effectively commercialize our appliances if we cannotcontinue to license or integrate third-party applications that are essentialfor the functionality of these appliances.**

We believe oursuccess will significantly depend on our ability to license or integratecertain applications from additional third-parties that would be incorporatedin our server appliance solutions. Because we do not currently know withcertainty which of these prospective technologies will be desired in themarketplace, we may incorrectly invest in development or prioritize ourefforts to integrate these technologies in our appliances. Additionally, evenif we correctly focus our efforts, there can be no assurance that we willselect the preferred provider of these technologies, or that the third-partyprovider will be committed to the relationship and integration of theirtechnology or that we will be able to integrate these technologies in a timelymanner. If we are unable to successfully integrate these third-partytechnologies in a timely manner, our appliances may be inferior with othercompetitive products in the marketplace, which may adversely affect theresults of our operations and our ability to grow our business.

We also believeour success will depend on our continued ability to license or integratetechnology from Microsoft that is essential for the functionality of certain ofour appliances. A material adverse change in our relationship with Microsoft orthe functionality of its software would have a significant adverse result onour operations. We depend on Microsoft to deliver reliable, high-qualitysoftware, develop new software on a timely and cost-effective basis and respondto evolving technology and changes in industry standards. Further, if Microsoftdoes not continue to make ISA Server available to OEM customers on a favorablebasis, our ability to sell our appliances may be substantially reduced.

**If weare unable to grow our international revenues and successfully overcome therisks inherent in international business activities, the growth of our businessmay be limited.**

Our ability togrow will depend in part on the growth of our international revenues. Ifour server appliance solutions are not accepted across this region, our abilityto increase our revenues in this region would be limited. In addition, ourinternational sales are subject to the risks inherent in international businessactivities, including:

·                  cost ofcustomizing products for foreign countries;

·                  export andimport restrictions, such as those affecting encryption commodities andsoftware or those requiring local content;

·                  difficulties inproviding customer support;

·                  reducedprotection of intellectual property rights and increased liability exposure;

·                  regionaleconomic and political conditions; and

·                  unique productrequirements of certain foreign countries which may limit sales and/orrequire significant additional research and development investments.

The majority of ourinternational sales currently are U.S. dollar-denominated. As a result, anyincrease in the value of the U.S. dollar relative to foreign currencies makesour products less competitive in international markets. Because of this ourrevenues may be adversely affected, or we may be required todenominate more of our sales in foreign currencies at some point in the futureto remain competitive. In addition, because certain of our operating expensesrelated to our international sales are denominated in foreign currency, wemay have difficulty controlling expenses in the event of significantcurrency fluctuations.

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**Ourbusiness could be harmed if we fail to adequately integrate new technologiesinto our server appliance products or if we invest in technologies that do notresult in the desired effects on our current and/or future product offerings.**

As part ofour strategy, we review opportunities to incorporate products and technologiesthat could be required in order to add new customers, retain existingcustomers, expand the breadth of product offerings or enhance our technicalcapabilities. Investing in new technologies presents numerous risks, including:

·                  wemay experience difficulties integrating new technologies into our currentor future products;

·                  our new productsmay be delayed because selected new technologies themselves are delayed orhave defects and/or performance limitations;

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

·                  wemay incorporate new technologies that either may not be desired byour customers or may not be compatible with our customers’ existingtechnology;

·                  new technologiesare unproven and could contain latent defects, which could result in highproduct failures; and

·                  we could findthat the new products and/or technologies that we choose to incorporate intoour products are technologically inferior to those utilized by our competitors.

If we are unableto adequately integrate new technologies into our server appliance products orif we invest in technologies that do not result in the desired effects on ourcurrent and/or future product offerings, our business could be harmed andoperating results could suffer.

***Risks related to the server appliance, data storage andnetwork security markets.***

**Ifserver appliances are not increasingly adopted as a solution to meet a significantportion of companies’ network security and data storage application needs, themarket for server appliances may not grow, which could negatively impactour revenues.**

We expect that allof our future revenues will come from sales of server appliances and relatedmaintenance. As a result, we are substantially dependent on the growing use ofserver appliances to meet businesses’ data storage and network securityapplication needs. Our revenues may not grow and the market price of ourcommon stock could decline if the server appliance market does not grow asrapidly as we expect.

Our expectationsfor the growth of the server appliance market may not be fulfilled ifcustomers continue to use general-purpose servers. The role of our productscould, for example, be limited if general-purpose serversout-perform server appliances, provide more capabilities and/orflexibility than server appliances or are offered at a lower cost. This couldforce us to lower the prices of our server appliance products or could resultin fewer sales of these products, which would negatively impact our revenuesand decrease our gross profits.

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

The markets weserve are characterized by rapid technological change, frequent new productintroductions and enhancements, potentially short product life cycles, changesin customer demands and evolving industry standards. In the server appliancemarket, we attempt to mitigate these risks by utilizing standards-basedhardware platforms and by maintaining an adequate knowledge base of availabletechnologies. However, the server appliance products that we sell could berendered obsolete if products based on new technologies are introduced or newindustry standards emerge and we are not able to

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incorporate thesetechnological changes into our products. In addition, we depend on thirdparties for the base platforms of our server appliances and we are at risk ifthese third parties do not integrate new technologies. Releasing new productsand services prematurely may result in quality problems, and delaysmay result in loss of customer confidence and market share. We may beunable to develop new products and services or achieve and maintain marketacceptance of them once they have come to market. Furthermore, when we dointroduce new or enhanced products and services, we may be unable tomanage the transition from the older products and services to minimizedisruption in customer ordering patterns, avoid excessive inventories of olderproducts and deliver enough new products and services to meet customer demand.

To remaincompetitive in the server appliance market, we must successfully identify new productopportunities and partners and develop and bring new products to market in atimely and cost-effective manner. Our failure to select the appropriatepartners and keep pace with rapid industry, technology or market changes couldhave a material adverse effect on our business, results of operations orfinancial condition.

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

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

Since ourinception, we have incurred significant net losses and could continue to incurnet losses in the future. At December 31, 2006 and September 30, 2006 ouraccumulated deficit was $132 million. We believe that any future growth willrequire us to incur significant engineering, selling and marketing andadministrative expenses. As a result, we will need to generate significantrevenues to achieve and sustain profitability. If we do not achieve and sustainprofitability, the market price for our common stock may decline.

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

Our discussion andanalysis of financial condition and results of operations are based on ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States. The preparationof financial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the consolidated financial statements and accompanyingnotes. On an ongoing basis, we evaluate significant estimates used in preparingour consolidated financial statements, including those related to:

·                  revenuerecognition;

·                  inventorywrite-downs;

·                  stock-basedcompensation; and

·                  warrantyreserves.

We base ourestimates on historical experience and on various other assumptions that webelieve to be reasonable under the circumstances, as provided in our discussionand analysis of financial condition and results of operations, the results ofwhich form the basis for making judgments about the carrying values ofassets and liabilities that are not readily apparent from other sources. Actualresults may differ from these and other estimates if our assumptionschange or if actual circumstances differ from those in our assumptions, whichcould cause our operating results to fall below the expectations of securitiesanalysts and investors, resulting in a decline in our stock price.

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

Seasonalfluctuations in revenues and operating results in the data storage industry arecommon. In particular, this industry typically experiences increased orders andresulting revenues in the quarter ended December 31, and a subsequentdecline in orders and resulting revenues during the quarter endedMarch 31. With a substantial amount of our revenues currently derived fromdata storage products, we may experience significant quarter-to-quarterfluctuations in revenues and operating results due to customers timing theirorders based on their own quarterly financial and/or operationalconsiderations, which we have no influence over. In addition, to the extentthat revenues from international sales become significant, wemay experience seasonal fluctuations during the quarter endingSeptember 30 as a result of European holiday patterns.

Accordingly, webelieve that quarter-to-quarter comparisons of results of operations are notnecessarily meaningful and should not be relied upon as an indication of futureperformance. Nonetheless, the market price of our common stock could decline inresponse to these variations.

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

In addition toseasonality issues, our quarterly revenues and operating results are difficultto predict and may fluctuate significantly from quarter to quarter. Noneof our customers are obligated to purchase any quantity of our products in thefuture nor are they obligated to meet forecasts of their product needs. Ouroperating expense levels are based in part on expectations of futurerevenues and gross profits, which are partially dependent on our customers’ability to accurately forecast and communicate their future product needs. Ifrevenues or gross profits in a particular quarter do not meet expectations,operating results could suffer and the market price of our common stock coulddecline. Factors affecting quarterly operating results include:

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

·                  the product mixof our sales;

·                  the timing ofnew product introductions by our OEM customers;

·                  the availabilityand/or price of products from suppliers;

·                  the loss of keysuppliers or customers;

·                  pricecompetition;

·                  costs associatedwith our introduction of new server appliances and the market acceptance ofthose products; and

·                  the mix ofproduct manufactured internally and by our contract manufacturer.

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

Products andservices in the server appliance, data storage and network security marketsmay be subject to further commoditization as these industries continue tomature and other businesses introduce additional competing products andservices. The gross profit as a percentage of revenues of our productsmay decrease in response to changes in our product mix, competitivepricing pressures, or new product introductions into the server appliance, datastorage and network security markets. If we are unable to offset decreases inour gross profits as a percentage of revenues by increasing our sales volumes,or by

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decreasing our productcosts, operating results will decline. Changes in the mix of sales of ourproducts, including the mix of higher margin sales of products sold in smallerquantities and lower margin sales of products sold in larger quantities, couldadversely affect our operating results for future quarters. To maintain ourgross profits, we also must continue to reduce the manufacturing cost of ourserver appliance products. Our efforts to produce higher margin serverappliance products, continue to improve our server appliance products andproduce new server appliance products may make it difficult to reduce ourmanufacturing cost per product. Further, utilization of a contract manufacturerto produce a portion of our customer requirements for certain of our serverappliance products may not allow us to reduce our cost per product. If wefail to respond adequately to pricing pressures, to competitive products withimproved performance or to developments with respect to the other factors onwhich we compete, we could lose customers or orders. If we are unable tocompete effectively, our business will suffer.

***Risks related to competition.***

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

In the serverappliance market, we face significant competition from a number of differenttypes of companies. Our competitors include companies who marketgeneral-purpose servers, server virtualization software, specific-purposeservers and server appliances as well as companies that sell custom integrationservices utilizing hardware produced by other companies. Many of thesecompanies are larger than we are and have greater financial resources and namerecognition than we do, as well as significant distribution capabilities andlarger, more established service organizations to support their products. Ourlarger competitors may be able to leverage their existing resources,including their extensive distribution capabilities and service organizations,to provide a wider offering of products and services and higher levels ofsupport on a more cost-effective basis than we can. We expect competition inthe server appliance market to increase significantly as more companies enterthe market and as our existing competitors continue to improve the performanceof their current products and to introduce new products and technologies. Suchincreased competition could adversely affect sales of our current and futureproducts. In addition, competing companies may be able to undertake moreextensive promotional activities, adopt more aggressive pricing policies andoffer more attractive terms to their customers than we can. If our competitorsprovide lower cost products with greater functionality or support than ourserver appliance solutions, or if some of their products are comparable to oursand are offered as part of a range of products that is broader than ours,our server appliance solutions could become undesirable.

Even if thefunctionality of competing products is equivalent to ours, we face a risk thata significant number of customers would elect to pay a premium for similarfunctionality from an established vendor rather than purchase products from aless-established vendor. We attempt to differentiate ourselves from ourcompetition by offering a wide variety of software integration, branding,supply-chain management, engineering, support, logistics and fulfillmentservices. If we are unable to effectively differentiate ourselves from ourcompetition, we may be forced to offer price reductions to maintaincertain customers. As a result, our revenues may not increase andmay decline, and our gross margins may decline. Furthermore,increased competition could lead to higher selling expenses which wouldnegatively affect our business and future operating results.

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

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

Although wecurrently have a relatively small sales and marketing organization, we mustcontinue to increase market awareness and sales of our products and promote ourbrand in the marketplace. We believe that to compete successfully we will neednetwork equipment providers, ISVs and systems integrators to recognize NetworkEngines as a top-tier provider of server appliance platforms and customintegration services. If we are unable to increase market awareness and promoteourselves as a leading

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provider of serverappliance solutions with our available resources, we may be unable to developnew customer relationships or expand our product and service offerings atexisting customers.

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

We need toeffectively manage our customer support operations to ensure that we maintaingood relationships with our customers. Because our Microsoft ISA Server basedappliances provide critical services for certain applications, managingsoftware updates to the appliance, when and if they are available, will beessential to the performance of the appliance. In addition, as we integratemore third party software applications our appliances will become increasinglycomplex to maintain and support. As a result, managing any updates released byMicrosoft, or the third party software vendor will require carefulconsideration to determine the sensitivity and impact on the function of ourappliance. Additionally, any updates designated as vital to the function of ourappliance will require rapid deployment to ensure the customers’ applicationsare properly maintained. We expect that providing this increased customerservice for our appliances will require more technically qualified staff eitherwithin the Company or from third parties, which could be more costly, and if weare unable to provide this higher level of service we may be unable tosuccessfully sell our appliances.

Our customers insome cases will provide support for the end-user customers. We may beunable to provide these customers with the necessary training and back-upsupport. Therefore they may be unable to provide end-user customers withthe necessary level of support, which may be detrimental to our reputationand ability to sell our products.

If our customersupport organization is unsuccessful in maintaining good customerrelationships, we may lose customers to our competitors and our reputationin 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.

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

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

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

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

Because serverappliance solutions are complex, they could contain errors that can be detectedat any point in a product’s life cycle. If flaws in design, production,assembly or testing of our products (by us or our suppliers) were to occur, wecould experience a rate of failure in our products that could result insubstantial repair, replacement or service costs and potential damage to ourreputation. In addition, because our solutions are combined with products fromother vendors, should problems occur, it might be difficult

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to identify the source ofthe problem. Continued improvement in manufacturing capabilities, control ofmaterial and manufacturing quality and costs, and product testing are criticalfactors in our future growth. There can be no assurance that our efforts tomonitor, develop, modify and implement appropriate test and manufacturingprocesses for our products will be sufficient to permit us to avoid a rate offailure in our products that results in substantial delays in shipment,significant repair or replacement costs or potential damage to our reputation,any of which could have a material adverse effect on our business, results ofoperations or financial condition.

In the past, wehave discovered errors in some of our server appliance solutions and haveexperienced delays in the shipment of our server appliance products during theperiod required to correct these errors or we have had to replace defectiveproducts that were already shipped. Errors in our server appliance solutionsmay be found in the future and any of these errors could be significant.Significant errors, including those discussed above, may result in:

·                  the loss of ordelay in market acceptance and sales of our server appliance products;

·                  diversion ofengineering resources;

·                  increasedmanufacturing costs;

·                  the loss of newor existing server appliance customers;

·                  injury to ourreputation and other customer relations problems; and

·                  increasedmaintenance and warranty costs.

Any of these problemscould harm our business and future operating results. Product errors or delayscould be material, including any product errors or delays associated with theintroduction of new products or versions of existing products. If our serverappliance solutions fail to conform to warranted specifications, customerscould demand a refund for the purchase price and assert claims for damages.

Moreover, becauseour server appliance solutions may be used in connection with criticalcomputing systems services, including providing security to protect valuableinformation, we may receive significant liability claims if they do notwork properly. While our agreements with customers typically contain provisionsintended to limit our exposure to liability claims, these limitations do notpreclude all potential claims. Liability claims could exceed our insurancecoverage and require us to spend significant time and money in litigation or topay significant damages. Any claims for damages, even if unsuccessful, couldseriously damage our reputation and business.

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

Our existingmanufacturing facility is limited in its production 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 supplement ourcurrent 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 on alimited basis. However, our contract manufacturer is not obligated to supplyproducts to us for any specific period, or in any specific quantity, except asmay be provided in an accepted purchase order. Using a contractmanufacturer increases our cost of producing server appliance products andcould decrease our gross profits. In the event that we need to change contractmanufacturers or require significantly increased production levels, we couldexperience transitional difficulties, including production delays and qualitycontrol issues, that could prevent us from satisfying our productionrequirements on a timely basis, cause customer relationships to suffer andresult in lost sales. Also, the use of a contract manufacturer does notguarantee us production levels, manufacturing line space or manufacturingprices, the lack of which could interrupt our business operations and have anegative effect on operating results.

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In the past, weexpanded our internal production capacity through expansion and reorganizationof our current production facilities. Although we believe that our currentfacility, along with our use of a contract manufacturer to supplementproduction, is sufficient to support our business for the foreseeable future,we may need additional production capacity. We believe that we couldexpand production levels in our existing facility by increasing the number ofmanufacturing shifts, but we are currently utilizing all availablemanufacturing space in our existing facility and have limited opportunity toexpand further. We would have difficulties expanding this facility beyond thislimited ability, and therefore, significant further expansion of the productioncapacity would require additional facilities. Expansion of our existingfacilities or additional facilities could require substantial investments,which could detract from our ability to invest in other areas of our businessand may not result in the desired return on investment, which couldnegatively affect our operating results.

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

We use rolling forecastsbased on anticipated product orders to determine our server appliance componentrequirements. Lead times for materials and components that we order varysignificantly, depending among other things, on specific supplier requirements,contract terms and current market demand for those components. In addition, avariety of factors, including the timing of product releases, potential delaysor cancellations 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 materials requirement forecasts may not beaccurate. If we overestimate our materials requirements, we may haveexcess inventory, which would increase costs and negatively impact our cashposition. Our agreements with certain customers provide us with protectionsrelated to inventory purchased in accordance with the terms of theseagreements; however, these protections may not be sufficient to preventcertain losses as a result of excess or obsolete inventory. If we underestimateour materials requirements, we may have inadequate inventory, which couldinterrupt our manufacturing and delay delivery of our server appliance productsto customers resulting in a loss of sales or customers. Any of theseoccurrences would negatively impact our business and operating results.

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

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

Certain of ourserver appliance solutions are differentiated from the products of ourcompetitors by our internally developed software and hardware and the manner inwhich they are integrated into our server appliance solutions. If we fail toprotect our intellectual property, other vendors could sell products withfeatures similar to ours, which could reduce 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 develop technologies that are similar or superiorto our technology or design around the patents we own. Despite the precautionswe have taken, laws and contractual restrictions may not be sufficient toprevent misappropriation of our technology or deter others from developingsimilar technologies. In addition, there can be no guarantee that any of ourpatent applications will result in patents, or that any such patents wouldprovide effective protection of our technology.

In addition, thelaws of the countries in which we may decide to market our services andsolutions may offer little or no effective protection of our proprietarytechnology. Reverse engineering, unauthorized copying or other misappropriationof our proprietary technology could enable third parties to benefit from ourtechnology without paying us for it, which could harm our business. Inaddition, our U.S. patents have no effect in foreign jurisdictions andobtaining patent protection in foreign countries is expensive and time consuming.

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

Substantiallitigation regarding intellectual property rights exists in the technologyindustry. We expect that server appliance products may be subject tothird-party infringement claims as the number of competitors in the industrysegment grows and the functionality of products in different industry segmentsoverlap. In the past we have received claims from third parties that our serverappliance products infringed their intellectual property rights. We do notbelieve that our server appliance products employ technology that infringes theproprietary rights of any third parties. We are also not aware of any claimsmade against any of our ISV or network equipment provider customers related totheir infringement of the proprietary rights of other parties in relation toproducts that include our server appliance products. Other partiesmay make claims against us that, with or without merit, could:

·                  betime-consuming for us to address;

·                  require us toenter into royalty or licensing agreements;

·                  result in costlylitigation, including potential liability for damages;

·                  divert ourmanagement’s attention and resources; and

·                  cause productshipment delays.

In addition, otherparties may make claims against our ISV or network equipment customers, orthird-party software providers related to products that are incorporated intoour server appliance products. Our business could be adversely affected if suchclaims resulted in the inability of our customers to continue producing theinfringing product, or if we are unable to cost effectively continue licensingthe third-party software.

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

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

Our successdepends in large part on our ability to retain and attract highly skilledengineering, sales, marketing, customer service, and managerial personnel. Ifwe are unable to attract a sufficient number of qualified personnel,particularly personnel knowledgeable in software engineering and productmanagement, we may not be able to meet key objectives such as developing,upgrading, or enhancing our products in a timely manner, which could negativelyimpact our business and could hinder any future growth.

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

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

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

InDecember 2001, a class action lawsuit relating to our initial publicoffering was filed against us, our chairman, one of our executive officers andthe underwriters of our initial public offering. For more information onlawsuits, see “Part II, Item 1 – Legal Proceedings.” We are currently attemptingto settle the lawsuit filed against us related to our initial public offering.We are unable to predict the effects on our financial condition or business ofthe lawsuit related to our initial public offering or other lawsuits thatmay arise from time to time. While we maintain certain insurance coverage,there can be no assurance that claims against us will not result in substantialmonetary damages in excess of such insurance coverage. This class actionlawsuit, or any future lawsuits, could cause our director and officer insurancepremiums to increase and could affect our ability to obtain director andofficer insurance coverage, which would negatively affect our business. Inaddition, we have expended, and may in the future expend, significantresources to defend such claims. This class action lawsuit, or othersimilar lawsuits that may arise from time to time, could negatively impactboth our financial condition and the market price of our common stock and couldresult in management devoting a substantial portion of their time to theselawsuits, which could adversely affect the operation of our business.

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

Our manufacturingfacility and headquarters are concentrated in one location. If the operationsin this facility were disrupted as a result of a natural disaster, fire, poweror other utility outage, work stoppage or other similar event, ourbusiness could be seriously harmed as a result of interruptions or delays inour manufacturing, engineering, or post-sales support operations.

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

The market priceof our common stock has been subject to significant fluctuations andmay continue to fluctuate or decline. During fiscal 2006, the closingprice of our common stock ranged from a low of $1.12 to a high of $3.17, and inthe three months ended December 31, 2006, from a low of $1.94 to a high of$2.81. The market for technology stocks has been extremely volatile andfrequently reaches levels that bear no relationship to the past or presentoperating performance of those companies. General economic conditions, such asrecession or interest rate or currency rate fluctuations in the United Statesor abroad, could negatively affect the market price of our common stock. In addition,our operating results may be below the expectations of securities analystsand investors. If this were to occur, the market price of our common stockmay decrease significantly. In the past, following periods of volatilityin the market price of a company’s securities, securities class actionlitigation has often been instituted against such companies. Such litigationcould result in substantial cost and a diversion of management’s attention andresources.

Any decline in themarket price of our common stock or negative market conditions could adverselyaffect our ability to raise additional capital, to complete future acquisitionsof or investments in other businesses and to attract and retain qualifiedtechnical and 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 ofDirectors has the authority to issue up to 5,000,000 shares of preferred stockand, without any further vote or action on the part of the stockholders,will have the authority to determine the price, rights, preferences, privilegesand restrictions of the preferred stock. This preferred stock, if issued, mighthave preference over the rights of the holders of common stock and couldadversely affect the market price of our common stock. The issuance of thispreferred stock may make it more difficult for a third party to acquire usor to acquire a majority of our outstanding voting stock. We currently have noplans to issue preferred stock.

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In addition,provisions of our second amended and restated certificate of incorporation andour second amended and restated by-laws may deter an unsolicited offer topurchase us. These provisions, coupled with the provisions of the DelawareGeneral 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.

**ITEM 6.EXHIBITS**

(a)          Exhibits

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

 

**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, as amended, the Registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.
|                        | **NETWORK ENGINES, INC.**                          |
|------------------------|----------------------------------------------------|
| ** **             | ** **                                         |
| Date: February 8, 2007 | /s/ Gregory A. Shortell                            |   |
|                   |                                               |
|                   | Gregory A. Shortell                                |
|                   | President and  Chief  Executive Officer            |
|                   | (Principal  Executive  Officer)                    |
|                   |                                               |
|                   |                                               |
|                   | /s/ Douglas G. Bryant                              |   |
|                   |                                               |
|                   | Douglas G. Bryant                                  |
|                   | Chief Financial  Officer,  Treasurer and Secretary |
|                   | (Principal  Financial Officer  and Principal       |
|                   | Accounting Officer)                                |

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**EXHIBIT INDEX**
| Exhibit No. | ** ** | **Exhibit**                                                                                                                                    |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                           |
| 31.1             |       | Certification of Gregory A. Shortell, the Chief  Executive Officer of the Company, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|             |       |                                                                                                                                           |
| 31.2             |       | Certification of Douglas G. Bryant, the Chief  Financial Officer of the Company, pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.   |
|             |       |                                                                                                                                           |
| 32.1             |       | Certification of Gregory A. Shortell, the Chief  Executive Officer of the Company, pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
|             |       |                                                                                                                                           |
| 32.2             |       | Certification of Douglas G. Bryant, the Chief  Financial Officer of the Company, pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.   |

 

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