##### **UNITEDSTATES**

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

**Washington,D.C. 20549**

** **

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** **

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

##### ** **

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**(Mark One)**

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

 

**For the quarterly period ended March 31,2008**

 

###### **OR**

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

 

**Forthe transition period from                      to**

 

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

######  

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**NETWORK ENGINES, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**(781) 332-1000**

(Registrant’s telephone number, including areacode)

 

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

 

Indicate bycheck mark whether the registrant is a large accelerated filer, an acceleratedfiler, a non-accelerated filer, or a smaller reporting company. See definitionsof “large accelerated filer,” “accelerated filer,” and “smaller reportingcompany” in Rule 12b-2 of the Exchange Act. (Check one):

 

| Large  accelerated filer o                     |   | Accelerated  filer x         |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| Non-accelerated  filer o                       |   | Smaller  reporting company o |
| (Do  not check if a smaller reporting company) |   |                              |

 

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

 

As of May 6, 2008, there were 44,008,643 shares of the registrant’sCommon Stock, par value $.01 per share, outstanding.

 

 

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**NETWORK ENGINES, INC.**

 

**INDEX**

 
| ** ** | ** **                                                                                           | **PAGE  NUMBER** |
|------------|------------------------------------------------------------------------------------------------------|------------------|
| ** ** | **PART I.  FINANCIAL INFORMATION**                                                              | ** **       |
| ** ** | ** **                                                                                           | ** **       |
|       | ITEM 1. FINANCIAL  STATEMENTS (UNAUDITED)                                                            | 1                |
|       | CONDENSED  CONSOLIDATED BALANCE SHEETS                                                               | 1                |
|       | CONDENSED  CONSOLIDATED STATEMENTS OF OPERATIONS                                                     | 2                |
|       | CONDENSED  CONSOLIDATED STATEMENTS OF CASH FLOWS                                                     | 3                |
|       | NOTES TO  UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                      | 4                |
|       |                                                                                                 |             |
|       | ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF  OPERATIONS | 15               |
|       |                                                                                                 |             |
|       | ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                  | 26               |
|       |                                                                                                 |             |
|       | ITEM 4. CONTROLS  AND PROCEDURES                                                                     | 26               |
|       |                                                                                                 |             |
| ** ** | **PART II. OTHER INFORMATION**                                                                  | ** **       |
| ** ** | ** **                                                                                           | ** **       |
|       | ITEM 1. LEGAL PROCEEDINGS                                                                            | 27               |
|       |                                                                                                 |             |
|       | ITEM 1A. RISK FACTORS                                                                                | 28               |
|       |                                                                                                 |             |
|       | ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                         | 38               |
|       |                                                                                                 |             |
|       | ITEM 6. EXHIBITS                                                                                     | 39               |
|       |                                                                                                 |             |
|       | SIGNATURES                                                                                           | 40               |

 

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**PART I. FINANCIAL INFORMATION**

 

**ITEM I. FINANCIAL STATEMENTS**

 

**NETWORK ENGINES, INC.**

**CONDENSED CONSOLIDATED BALANCESHEETS**

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

**(unaudited)**

 
| ** **                                                                                                                                                                                                              | ** ** | **March 31,  2008** | ** ** | **September 30,  2007** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|
| **ASSETS**                                                                                                                                                                                                              | ** ** | ** **               | ** ** | ** **                   | ** ** |
| **Current assets:**                                                                                                                                                                                                     | ** ** | ** **               | ** ** | ** **                   | ** ** |
| Cash and cash equivalents                                                                                                                                                                                               |       | $                        | 11,838     |                         | $          | 44,403 |   |
| Restricted cash                                                                                                                                                                                                         |       | 47                       |       | 247                          |       |
| Accounts receivable, net of allowances of  $68 and $32 at March 31, 2008 and September 30, 2007, respectively                                                                                                 |       | 29,581                   |       | 17,511                       |       |
| Income tax receivable                                                                                                                                                                                                   |       | 2,820                    |       | —                       |       |
| Inventories                                                                                                                                                                                                             |       | 17,824                   |       | 10,175                       |       |
| Prepaid expenses and other current assets                                                                                                                                                                               |       | 2,180                    |       | 1,077                        |       |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| Total current assets                                                                                                                                                                                                    |       | 64,290                   |       | 73,413                       |       |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| Property and equipment, net                                                                                                                                                                                             |       | 1,937                    |       | 1,128                        |       |
| Intangible assets, net                                                                                                                                                                                                  |       | 10,854                   |       | —                       |       |
| Goodwill                                                                                                                                                                                                                |       | 8,333                    |       | —                       |       |
| Contingently returnable acquisition  consideration                                                                                                                                                                      |       | 4,022                    |       | —                       |       |
| Other assets                                                                                                                                                                                                            |       | 321                      |       | 281                          |       |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| Total assets                                                                                                                                                                                                            |       | $                        | 89,757     |                         | $          | 74,822 |   |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                           | ** ** | ** **               | ** ** | ** **                   | ** ** |
| **Current liabilities:**                                                                                                                                                                                                | ** ** | ** **               | ** ** | ** **                   | ** ** |
| Accounts payable                                                                                                                                                                                                        |       | $                        | 12,277     |                         | $          | 10,189 |   |
| Accrued compensation and other related  benefits                                                                                                                                                                        |       | 2,792                    |       | 1,773                        |       |
| Accrued warranty                                                                                                                                                                                                        |       | 968                      |       | 1,046                        |       |
| Other accrued expenses                                                                                                                                                                                                  |       | 2,034                    |       | 2,182                        |       |
| Deferred revenue                                                                                                                                                                                                        |       | 5,136                    |       | 2,839                        |       |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| Total current liabilities                                                                                                                                                                                               |       | 23,207                   |       | 18,029                       |       |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| Deferred revenue, net of current portion                                                                                                                                                                                |       | 2,353                    |       | 1,285                        |       |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| Total liabilities                                                                                                                                                                                                       |       | 25,560                   |       | 19,314                       |       |
|                                                                                                                                                                                                                    |       |                     |       |                         |       |
| Commitments and contingencies (Note 8)                                                                                                                                                                                  |       |                     |       |                         |       |
| ** **                                                                                                                                                                                                              | ** ** | ** **               | ** ** | ** **                   | ** ** |
| **Stockholders’ equity:**                                                                                                                                                                                          | ** ** | ** **               | ** ** | ** **                   | ** ** |
| Preferred stock, $0.01 par value, 5,000,000  authorized, and no shares issued and outstanding                                                                                                                           | ** ** | **—**               | ** ** | **—**                   | ** ** |
| Common stock, $0.01 par value, 100,000,000  shares authorized; 46,570,501 and 43,590,883 shares issued; 44,008,643 and  41,029,025 shares outstanding at March 31, 2008 and September 30,  2007, respectively |       | 465                      |       | 436                          |       |
| Additional paid-in capital                                                                                                                                                                                              |       | 194,124                  |       | 187,005                      |       |
| Accumulated deficit                                                                                                                                                                                                     |       | (127,554                 | )          | (129,095                     | )          |
| Treasury stock, at cost, 2,561,858 shares at  March 31, 2008 and September 30, 2007, respectively                                                                                                             |       | (2,838                   | )          | (2,838                       | )          |
| Total stockholders’ equity                                                                                                                                                                                         |       | 64,197                   |       | 55,508                       |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                         |       | $                        | 89,757     |                         | $          | 74,822 |   |

 

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

 

1

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**NETWORK ENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

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

**(unaudited)**

 
| ** **                                             | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                             | ** ** | **2008**                                         | ** ** | **2007**                                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                             | ** ** | ** **                                       | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues                                           |       | $                                                | 55,174     |                                           | $          | 29,305 |   | $ | 109,514 |   | $ | 56,543 |   |
|                                                   |       |                                             |       |                                           |       |   |   |   |   |
| Cost of revenues                                       |       | 46,275                                           |       | 23,215                                         |       | 90,875 |   | 45,220 |   |
|                                                   |       |                                             |       |                                           |       |   |   |   |   |
| Gross profit                                           |       | 8,899                                            |       | 6,090                                          |       | 18,639 |   | 11,323 |   |
|                                                   |       |                                             |       |                                           |       |   |   |   |   |
| Operating expenses:                                    |       |                                             |       |                                           |       |   |   |   |   |
| Research and development                               |       | 2,318                                            |       | 2,410                                          |       | 4,688 |   | 4,403 |   |
| Selling and marketing                                  |       | 2,948                                            |       | 1,810                                          |       | 6,065 |   | 3,540 |   |
| General and administrative                             |       | 2,935                                            |       | 1,954                                          |       | 5,580 |   | 4,015 |   |
| Amortization of intangible assets                      |       | 501                                              |       | —                                         |       | 921 |   | — |   |
|                                                   |       |                                             |       |                                           |       |   |   |   |   |
| Total operating expenses                               |       | 8,702                                            |       | 6,174                                          |       | 17,254 |   | 11,958 |   |
|                                                   |       |                                             |       |                                           |       |   |   |   |   |
| Income (loss) from operations                          |       | 197                                              |       | (84                                            | )          | 1,385 |   | (635 | ) |
| Interest and other income, net                         |       | 142                                              |       | 462                                            |       | 266 |   | 909 |   |
|                                                   |       |                                             |       |                                           |       |   |   |   |   |
| Income before  income taxes                            |       | 339                                              |       | 378                                            |       | 1,651 |   | 274 |   |
| Provision for  income taxes                            |       | 39                                               |       | 13                                             |       | 110 |   | 23 |   |
|                                                   |       |                                             |       |                                           |       |   |   |   |   |
| Net income                                             |       | $                                                | 300        |                                           | $          | 365 |   | $ | 1,541 |   | $ | 251 |   |
|                                                   |       |                                             |       |                                           |       |   |   |   |   |
| Net income per share – basic                      |       | $                                                | 0.01       |                                           | $          | 0.01 |   | $ | 0.04 |   | $ | 0.01 |   |
|                                                   |       |                                             |       |                                           |       |   |   |   |   |
| Net income per share – diluted                    |       | $                                                | 0.01       |                                           | $          | 0.01 |   | $ | 0.03 |   | $ | 0.01 |   |
|                                                   |       |                                             |       |                                           |       |   |   |   |   |
| Shares used in computing basic net income  per share   |       | 44,009                                           |       | 40,735                                         |       | 43,833 |   | 40,339 |   |
| Shares used in computing diluted net income  per share |       | 44,306                                           |       | 41,438                                         |       | 44,169 |   | 41,251 |   |

 

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

 

2

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**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(inthousands)**

**(unaudited)**

 
| ** **                                                                         | ** ** | **Six months ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2008**                                       | ** ** | **2007** | ** ** |
| ** **                                                                         | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Cash flows from operating activities:                                              |       |                                           |       |   |   |
| Net income                                                                         |       | $                                              | 1,541      |   | $ | 251 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                                           |       |   |   |
| Depreciation and amortization                                                      |       | 1,650                                          |       | 407 |   |
| Provision for doubtful accounts                                                    |       | 51                                             |       | (11 | ) |
| Loss on disposal of long-lived assets                                              |       | —                                         |       | 7 |   |
| Stock-based compensation                                                           |       | 1,043                                          |       | 1,260 |   |
| Changes in operating assets and liabilities,  net of effects of acquisition:       |       |                                           |       |   |   |
| Accounts receivable                                                                |       | 1,175                                          |       | 475 |   |
| Inventories                                                                        |       | 5,112                                          |       | (2,044 | ) |
| Prepaid expenses and other current assets                                          |       | (234                                           | )          | 317 |   |
| Accounts payable                                                                   |       | (5,821                                         | )          | 1,740 |   |
| Accrued expenses                                                                   |       | (3,195                                         | )          | 349 |   |
| Deferred revenue                                                                   |       | 277                                            |       | 1,804 |   |
|                                                                               |       |                                           |       |   |   |
| Net cash provided by operating activities                                          |       | 1,599                                          |       | 4,555 |   |
|                                                                               |       |                                           |       |   |   |
| Cash flows from investing activities:                                              |       |                                           |       |   |   |
| Acquisition, net of cash assumed                                                   |       | (29,802                                        | )          | — |   |
| Contingently returnable acquisition payment                                        |       | (4,022                                         | )          | — |   |
| Payment for disposition of subsidiary                                              |       | (231                                           | )          | — |   |
| Purchases of property and equipment                                                |       | (185                                           | )          | (495 | ) |
| Purchases of short-term investments                                                |       | —                                         |       | (9,541 | ) |
| Proceeds from sales and maturities of  short-term investments                      |       | —                                         |       | 9,800 |   |
| Changes in other assets                                                            |       |                                           |       | (43 | ) |
|                                                                               |       |                                           |       |   |   |
| Net cash used in investing activities                                              |       | (34,240                                        | )          | (279 | ) |
|                                                                               |       |                                           |       |   |   |
| Cash flows from financing activities:                                              |       |                                           |       |   |   |
| Proceeds from issuance of common stock                                             |       | 115                                            |       | 1,835 |   |
| Payments on capital lease obligation                                               |       | (10                                            | )          | (10 | ) |
|                                                                               |       |                                           |       |   |   |
| Net cash provided by financing activities                                          |       | 105                                            |       | 1,825 |   |
|                                                                               |       |                                           |       |   |   |
| Effect of exchange rate differences on cash                                        |       | (29                                            | )          | — |   |
| Net (decrease) increase in cash and cash  equivalents                              |       | (32,565                                        | )          | 6,101 |   |
| Cash and cash equivalents, beginning of  period                                    |       | 44,403                                         |       | 8,014 |   |
|                                                                               |       |                                           |       |   |   |
| Cash and cash equivalents, end of period                                           |       | $                                              | 11,838     |   | $ | 14,115 |   |

 

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

 

3

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

**1.  Basis of Presentation**

 

Theaccompanying condensed consolidated financial statements have been prepared byNetwork Engines, Inc. (“Network Engines” or the “Company”) in accordancewith accounting principles generally accepted in the United States of Americaand pursuant to the rules and regulations of the Securities and ExchangeCommission (the “SEC”).  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to such rules and regulations.  The year-end condensed consolidated balancesheet data was derived from audited financial statements, but does not includeall year-end disclosures required by accounting principles generally acceptedin the United States of America.  Thesefinancial statements should be read in conjunction with the audited financialstatements and the accompanying notes included in the Company’s 2007 AnnualReport on Form 10-K (the “2007 Form 10-K”) filed by the Company withthe SEC.

 

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

 

Thepreparation of these condensed consolidated financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosures of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period.  Themost significant estimates reflected in these financial statements includeallowance for doubtful accounts, inventory valuation, valuation of deferred taxassets, valuation of intangible assets, warranty reserves and stock-basedcompensation.  Actual results coulddiffer from those estimates.

 

**2.  Significant AccountingPolicies**

 

***Recent Accounting Pronouncements***

 

In September 2006, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standard No. 157,“Fair Value Measurements” (“FAS 157”).  This statement addresses howcompanies should measure fair value when they are required to use a fair valuemeasure for recognition or disclosure purposes under accounting principlesgenerally accepted in the United States of America.  In February 2008, the FASB issued FASB Staff Position 157-1, “Applicationof FASB Statement No. 157 to FASB Statement No. 13 and OtherAccounting Pronouncements That Address Fair Value Measurements for Purposes ofLease Classification or Measurement under Statement 13” (“FSP 157-1”).  FSP 157-1 amends FAS 157 to remove certainleasing transactions from its scope. In February 2008, the FASB issued FASB Staff Position 157-2, “EffectiveDate of FASB Statement No. 157” (“FSP 157-2”).  FSP 157-2 defers the effective date of FAS157 for certain non-financial assets and liabilities to the beginning ofthe Company’s fiscal year that begins after November 15, 2008.  FAS 157 is effective for financial assets andliabilities as of the beginning of the Company’s fiscal year that begins after November 15,2007.  The Company is in the process ofevaluating whether the adoption of FAS 157 will have a material impact on theCompany’s financial position, results of operations or cash flows.

 

In February 2007, the FASB issued Statementof Financial Accounting Standard No. 159, “The Fair Value Option forFinancial Assets and Financial Liabilities — Including an amendment of FASBStatement No. 115” (“FAS 159”).  This statement permits entities tochoose to measure many financial instruments and certain other items at fairvalue at specified election dates. Subsequent unrealized gains and losses on items for which the fair valueoption has been elected will be reported in earnings.  FAS 159 is effective as of the beginning ofthe Company’s fiscal year that begins after November 15, 2007.  TheCompany is in the process of evaluating whether the adoption of FAS 159 willhave a material impact on the Company’s financial position, results ofoperations or cash flows.

 

4

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

In December 2007, theFASB issued Statement of Financial Accounting Standard No. 141(R), “BusinessCombinations” (“FAS 141R”).  ThisStatement replaced Statement of Financial Accounting Standard No. 141 to improve therelevance, representational faithfulness, and comparability of the informationthat a reporting entity provides in its financial reports about a businesscombination and its effects.  FAS 141Restablishes principles and requirements for how the acquirer recognizes andmeasures in its financial statements the identifiable assets acquired, theliabilities assumed, and any noncontrolling interest in the acquiree,recognizes and measures the goodwill acquired in the business combination or again from a bargain purchase and determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination.  FAS141R is effective for business combinations on a prospective basis for which theacquisition date is on or afterthe beginning of the first annual reporting period beginning on or after December 15,2008.  The adoption of FAS 141R will nothave a material impact on the Company’s financial position, results of operationsor cash flows.

 

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

 

The Company has an unrecognized tax benefit ofapproximately $540,000 related to the validity of certain credits.  As discussed in Note 12 to the consolidatedfinancial statements in the 2007 Form 10-K, the Company has a valuationallowance against the full amount of its net deferred tax asset.  The Company currently provides a valuationallowance against deferred tax assets when it is more likely than not that someportion, or all of its deferred tax assets, will not be realized.  Because the Company has a full valuationallowance against its deferred tax assets, the adoption of FIN 48 had no impacton the Company’s retained earnings or reported liabilities.  Because the Company has significant operatingloss carryforwards to offset future taxable income, the Company does not expectto utilize any of these credits in the near term, and as a result, the Companydoes not expect that the unrecognized tax benefit will change significantlywithin the next twelve months.

 

The Company files its tax returns as prescribed bythe tax laws of the jurisdictions in which it operates.  The Company’s tax years from 2001 to 2007 arestill subject to examination.  Variousstate and foreign jurisdiction tax years remain open to examination as well,though the Company believes any additional assessment will be immaterial to itsconsolidated financial statements.

 

#### ***RevenueRecognition***

#### *** ***

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

 

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

 

Contracts and/or customer purchase orders aregenerally used to determine the existence of an arrangement. Shipping documentsand consignment usage notifications are used to verify shipment or transfer ofownership, as applicable. The Company assesses whether the sales price is fixedor determinable based on the payment terms associated with the transaction andwhether the sales price is subject to refund 

 

5

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**NETWORK ENGINES, INC.**

**NOTES TOTHE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

or adjustment. The Companyassesses collectibility based primarily on the creditworthiness of the customeras determined by credit checks and analysis, as well as the customer’s paymenthistory.

 

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

 

The Company recognizes revenue when the revenuerecognition criteria for each element of the sale are met. If the Company isnot able to derive the fair value of the undelivered element of the sale (i.e.maintenance), all revenues from the arrangement are deferred and recognizedratably over the period of the support arrangement, which is typically one tothree years. The Company includes shipping and handling costs, if any,reimbursed by its customers as net revenues and cost of revenues.

 

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

#### *** ***

The Company did not hold any cash equivalents as of March 31,2008.  As of September 30, 2007,cash equivalents consisted principally of money market funds and commercialpaper purchased with an original maturity of three months or less.  At March 31, 2008 and September 30,2007, $47,000 and $247,000, respectively, of cash was restricted and pledged ascollateral for letters of credit.  TheCompany did not hold any short-term investments as of March 31, 2008 or September 30,2007.  Details of the Company’s cash andcash equivalents are as follows (in thousands):

 
| ** **                          | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|-------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                          | ** ** | **2008**           | ** ** | **2007**               | ** ** |
| **Cash and cash equivalents:**      |       |               |       |                   |       |
| Cash                                |       | $                  | 11,838     |                   | $          | 3,836 |   |
| Money market funds                  |       | —             |       | 37,941                 |       |
| Commercial paper                    |       | —             |       | 2,626                  |       |
|                                |       |               |       |                   |       |
| **Total cash and cash equivalents** |       | $                  | 11,838     |                   | $          | 44,403 |   |

 

#### ***Comprehensive Income***

#### *** ***

During each period presented, comprehensive income was equal to netincome.

 

***Significant Customers***

 

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

 
| ** **     | ** ** | **Net Revenues**                  | ** ** | ** **                     | ** ** | ** **                           | ** ** |
|----------------|------------|----------------------------------------|------------|--------------------------------|------------|--------------------------------------|------------|
| ** **     | ** ** | **Three months ended ** | ** ** | **Six months ended** | ** ** | **Accounts Receivable at** | ** ** |
| ** **     | ** ** | **March 31,**                     | ** ** | **March 31,**             | ** ** | **March 31,**                   | ** ** | **September 30,** | ** ** |
| ** **     | ** ** | **2008**                               | ** ** | **2007**                       | ** ** | **2008**                             | ** ** | **2007** | ** ** | **2008** | ** ** | **2007** | ** ** |
| Customer A     |       | 49                                     | %          | 80                             | %          | 44                                   | %          | 81 | % | 42 | % | 81 | % |
| Customer B (1) |       | 11                                     | %          | —                         |       | 12                                   | %          | — |   | 12 | % | — |   |

 

6

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**NETWORK ENGINES, INC.**

**NOTES TOTHE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

----

(1) CustomerB became a customer as a result of the Company’s acquisition of AllianceSystems, Inc. on October 11, 2007.

 

**3. Business Combination**

 

On October 11, 2007, inorder to increase the Company’s presence in the server appliance marketplace,the Company acquired all of the equity of Alliance Systems, Inc. (“AllianceSystems”), a privately held corporation located in Plano, Texas, which providesserver appliances and computer infrastructure supporting telecommunications andenterprise communications solutions.  Theaggregate purchase price of approximately $40,879,000 was funded through a cashpayment of $32,820,000 and the issuance of 2.9 million shares of the Company’scommon stock valued at approximately $5,994,000, which was based on the averagemarket price of the Company’s common stock over the period of two days beforeand after the terms of the acquisition were announced.  The Company also incurred acquisition-relatedfees and expenses of approximately $1,071,000, and approximately $994,000 ofcosts related to certain exit activities of the acquired business.  The Company’s cash payment included repaymentof Alliance Systems’ working capital line of credit of approximately$6,727,000, and $800,000 due under a note payable to Alliance Systems’ majoritystockholder.

 

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

 

7

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** **

**NETWORK ENGINES, INC.**

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

 

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

 
| **Net assets acquired**          |   |   |   |
|----------------------------------|--------|--------|--------|
| Cash                             |   | $      | 362    |   |
| Accounts receivable              |   | 13,617 |   |
| Income tax receivable            |   | 2,820  |   |
| Inventory                        |   | 12,799 |   |
| Prepaid and other current assets |   | 923    |   |
| Property, plant, and equipment   |   | 1,388  |   |
| Deferred tax asset               |   | 5,170  |   |
| Intangible asset                 |   | 11,775 |   |
| Goodwill                         |   | 8,333  |   |
| Other assets                     |   | 127    |   |
| Accounts payable                 |   | (7,836 | )      |
| Income tax payable               |   | (127   | )      |
| Deferred tax liability           |   | (5,170 | )      |
| Other accrued expenses           |   | (4,144 | )      |
| Deferred revenue                 |   | (3,180 | )      |
|                             |   |   |   |
| **Total net assets acquired**    |   | $      | 36,857 |   |

 

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

 

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

 

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

 
| ** **                                           | ** ** | **Severance** | ** ** | **Disposition of  subsidiary** | ** ** | **Total** | ** ** |
|------------------------------------------------------|------------|---------------|------------|-------------------------------------|------------|-----------|------------|
| Accruals established upon acquisition |       | $             | 548        |                                | $          | 446       |       | $ | 994 |   |
| Payments                                             |       | (106          | )          | —                              |       | (106      | )          |
| Balance at December 31, 2007                    |       | 442           |       | 446                                 |       | 888       |       |
| Payments                                             |       | (191          | )          | (446                                | )          | (637      | )          |
| Balance at March 31, 2008                       |       | $             | 251        |                                | $          | —    |       | $ | 251 |   |

 

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

 

8

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

TheCompany has included as a component of the net assets acquired an estimatedliability for approximately $123,000 for uncertain tax positions, as determinedin accordance with FIN 48.  Theseuncertain tax positions related to state tax filing requirements.  This liability, which included an estimatefor interest and penalties, was based on the known facts at the time of thepurchase price allocation.

 

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

 
| ** **                                   | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended March  31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                   | ** ** | **2008**                                         | ** ** | **2007**                                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net revenues                                 |       | $                                                | 55,174     |                                           | $          | 54,019 |   | $ | 111,801 |   | $ | 108,472 |   |
|                                         |       |                                             |       |                                           |       |   |   |   |   |
| Income (loss) from continuing operations (a) |       | $                                                | (63        | )                                              | $          | (870 | ) | $ | 1,385 |   | $ | (617 | ) |
|                                         |       |                                             |       |                                           |       |   |   |   |   |
| Net income (loss)                            |       | $                                                | (63        | )                                              | $          | (668 | ) | $ | 1,385 |   | $ | (510 | ) |
|                                         |       |                                             |       |                                           |       |   |   |   |   |
| Net income (loss) per share                  |       |                                             |       |                                           |       |   |   |   |   |
| Basic                                        |       | $                                                | (0.00      | )                                              | $          | (0.02 | ) | $ | 0.03 |   | $ | (0.01 | ) |
| Diluted                                      |       | $                                                | (0.00      | )                                              | $          | (0.02 | ) | $ | 0.03 |   | $ | (0.01 | ) |

 

----

(a) Includes$485,000 of amortization of intangible assets and $388,000 of additional costsrelated to the fair value adjustment of inventory in each of the three monthperiods ended March 31, 2008 and 2007, and includes $970,000 ofamortization of intangible assets and $388,000 of additional costs related tothe fair value adjustment of inventory in each of the six month periods ended March 31,2008 and 2007.

 

**4.  Stock-Based Compensation**

 

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

 

Thefollowing table presents stock-based employee compensation expense included inthe Company’s unaudited condensed consolidated statements of operations (inthousands):

 
| ** **                             | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|----------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                             | ** ** | **2008**                                         | ** ** | **2007**                                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                   |       |                                             |       |                                           |       |   |   |   |   |
| Cost of revenues                       |       | $                                                | 46         |                                           | $          | 40 |   | $ | 100 |   | $ | 80 |   |
| Research and development               |       | 162                                              |       | 300                                            |       | 412 |   | 580 |   |
| Selling and marketing                  |       | 66                                               |       | 67                                             |       | 161 |   | 167 |   |
| General and administrative             |       | 182                                              |       | 241                                            |       | 370 |   | 433 |   |
| Total stock-based compensation expense |       | $                                                | 456        |                                           | $          | 648 |   | $ | 1,043 |   | $ | 1,260 |   |

 

TheCompany estimates the fair value of stock options using the Black-Scholesvaluation model.  This valuation modeltakes into account the exercise price of the award, as well as a variety ofsignificant assumptions.  Theseassumptions include the expected term, the expected volatility of the Company’scommon stock over the expected term, the risk-free interest rate over theexpected term, and the Company’s expected 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 

 

9

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

Company’s stock options grantedduring the three and six months ended March 31, 2008 and 2007.  Estimates of fair value are not intended topredict the value ultimately realized by persons who receive equityawards.  In determining the amount ofexpense to be recorded, judgment is also required to estimate forfeitures ofthe awards based on the probability of employees completing the requiredservice period.  Historical forfeitures are used as a starting point fordeveloping the estimate of future forfeitures.

 

Assumptions used to determine the fair value of options granted duringthe three and six months ended March 31, 2008 and 2007, using theBlack-Scholes valuation model, were:

 
| ** **                     | ** ** | **Three months ended March 31,** | ** ** | **Six months ended March 31,** | ** ** |
|--------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                     | ** ** | **2008**                                             | ** ** | **2007**                                           | ** ** | **2008** | ** ** | **2007** | ** ** |
|                           |       |                                                 |       |                                               |       |   |   |   |   |
| Expected term (1)              |       | 5.50 to 6.25 years                                   |       | 5.50 to 6.25 years                                 |       | 5.50 to 6.25 years |   | 5.50 to 6.25 years |   |
| Expected volatility factor (2) |       | 54.89% to 58.75%                                     |       | 65.77% to 72.67%                                   |       | 54.89% to 59.05% |   | 65.77% to 72.67% |   |
| Risk-free interest rate (3)    |       | 2.70%                                                |       | 4.44% to 4.65 %                                    |       | 2.70% to 4.13% |   | 4.44% to 4.65% |   |
| Expected annual dividend yield |       | —                                               |       | —                                             |       | — |   | — |   |

 

----

| (1)    |   | The expected term for each grant was determined as the midpoint  between the vesting date and the end of the contractual term, also known as  the “simplified method” for estimating expected term, as described by Staff  Accounting Bulletin No. 107 (“SAB 107”). |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                         |
| (2)    |   | The expected volatility for each grant is estimated based on a weighted  average of historical volatility.                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                         |
| (3)    |   | The risk-free interest rate for each grant is based on the U.S.  Treasury yield curve in effect at the time of grant for a period equal to the  expected term of the stock option.                                                                                                           |

 

Stock-based compensation expense related to the Company’s Employee StockPurchase Plan is determined based on the discount of 15% from the per sharemarket price on the close of the purchase period.

 

A summary of the Company’s stock option activity for the six monthsended March 31, 2008 is as follows:

 
| ** **                           | ** ** | **Six months ended March 31, 2008** | ** ** |
|--------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                           | ** ** | **Number of  Options**                                  | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  years)** | ** ** |
|                                 |       |                                                         |       |   |   |   |   |
| Outstanding, September 30, 2007 |       | 6,091,355                                                    |       | $ | 2.51 |   |   |   |
| Granted                              |       | 2,571,000                                                    |       | 1.89 |   |   |   |
| Exercised                            |       | (9,187                                                       | )          | 1.75 |   |   |   |
| Forfeited                            |       | (291,779                                                     | )          | 2.05 |   |   |   |
| Expired                              |       | (108,450                                                     | )          | 3.24 |   |   |   |
| Outstanding, March 31, 2008     |       | 8,252,939                                                    |       | $ | 2.33 |   | 7.64 |   |
| Exercisable at March 31, 2008   |       | 3,905,447                                                    |       | $ | 2.85 |   | 6.22 |   |

 

All stock options granted during the six months ended March 31,2008 were granted with exercise prices equal to the fair market value of theCompany’s common stock on the grant date and had a weighted average grant datefair value of $1.12.

 

10

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

At March 31, 2008, unrecognized compensation expense related tonon-vested stock options was $3,324,000, which is expected to be recognizedover a weighted average period of 2.84 years.

 

**5.  Net Income Per Share**

** **

Basic net income per share iscomputed by dividing the net income for the period by the weighted averagenumber of shares of common stock outstanding during the period.  Diluted net income per share is computed bydividing the net income for the period by the weighted average number of sharesof common stock and potential common stock, if dilutive, outstanding during theperiod.  Potential common stock includesincremental shares of common stock issuable upon the exercise of stock options.

 

The following tablesets forth the computation of basic and diluted net income per share as well asthe weighted average potential common stock excluded from the calculation ofnet income per share because their inclusion would be anti-dilutive (inthousands, except per share data):

 
| ** **                                                                                               | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                                               | ** ** | **2008**                                         | ** ** | **2007**                                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Numerator:                                                                                               |       |                                             |       |                                           |       |   |   |   |   |
| Net income                                                                                               |       | $                                                | 300        |                                           | $          | 365 |   | $ | 1,541 |   | $ | 251 |   |
|                                                                                                     |       |                                             |       |                                           |       |   |   |   |   |
| Denominator:                                                                                             |       |                                             |       |                                           |       |   |   |   |   |
| Shares used in computing basic net income  per share                                                     |       | 44,009                                           |       | 40,735                                         |       | 43,833 |   | 40,339 |   |
| Common stock equivalents from employee stock  options                                                    |       | 297                                              |       | 703                                            |       | 336 |   | 912 |   |
|                                                                                                     |       |                                             |       |                                           |       |   |   |   |   |
| Shares used in computing diluted net income  per share                                                   |       | 44,306                                           |       | 41,438                                         |       | 44,169 |   | 41,251 |   |
|                                                                                                     |       |                                             |       |                                           |       |   |   |   |   |
| Net income per share:                                                                                    |       |                                             |       |                                           |       |   |   |   |   |
| Basic                                                                                                    |       | $                                                | 0.01       |                                           | $          | 0.01 |   | $ | 0.04 |   | $ | 0.01 |   |
| Diluted                                                                                                  |       | $                                                | 0.01       |                                           | $          | 0.01 |   | $ | 0.03 |   | $ | 0.01 |   |
|                                                                                                     |       |                                             |       |                                           |       |   |   |   |   |
| Anti-dilutive potential common stock  equivalents excluded from the calculation of net income per share: |       |                                             |       |                                           |       |   |   |   |   |
| Options to purchase common stock                                                                         |       | 7,331                                            |       | 3,273                                          |       | 6,974 |   | 3,131 |   |

 

**6.  Goodwill and Intangible Assets**

 

The Company recorded goodwill and intangible assets as the result of itsacquisition of Alliance Systems.  The acquired intangible asset iscustomer relationships, which will be amortized over the period of economicbenefit expected to be received.  The following table presents the intangibleasset balances as of March 31, 2008 (in thousands):

 
| ** **             | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Book  Value** | ** ** |
|------------------------|------------|---------------------------------|------------|-------------------------------|------------|--------------------------|------------|
| ** **             | ** ** | ** **                      | ** ** | ** **                    | ** ** | ** **               | ** ** |
| Customer relationships |       | $                               | 11,775     |                          | $          | 921                      |       | $ | 10,854 |   |
|                        |            |                                 |            |                               |            |                          |            |  |  |  |

 

The estimated futureamortization expense for the intangible asset as of March 31, 2008 byfiscal year is $960,000 for the remainder of 2008, $1,766,000 for 2009,$1,554,000 for 2010, $1,330,000 for 2011, $1,119,000 for 2012 and $4,125,000thereafter.

 

Goodwillrepresents the excess purchase price over the fair value of the net tangibleand intangible assets acquired.  TheCompany reviews long-lived assets, including definite-lived intangible assets,to determine if any adverse conditions exist that would indicateimpairment.  Goodwill is reviewed eachyear 

 

11

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

in the fourth quarter forimpairment, or more frequently if certain indicators are present.  When conducting an impairment evaluation, theCompany compares the carrying value of the reporting unit to the fair value ofthe reporting unit.  Management hasdetermined that the reporting unit is the Company as a whole.  If the carrying amount of the reporting unitexceeds its fair value, then the carrying value of that reporting unit’sgoodwill is compared to the implied fair value of the goodwill and animpairment loss is recorded in an amount equal to that excess, if any.  Fair value is calculated as the present valueof estimated future cash flows using a risk-adjusted discount rate, and includessignificant judgments by management.

 

Conditionsthat could trigger a more frequent impairment assessment include, but are notlimited to, a significant adverse change in certain agreements, an economicdownturn in customers’ industries, increased competition, or other informationregarding the Company’s market value, such as a reduction in its stockprice.  For example, a reduction in thestock price to a price at or near the book value of the Company for a period oftime could indicate a triggering event and a possible impairment of goodwill.

 

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

 

**7.  Inventories**

 

Inventories consistedof the following (in thousands):

 
| ** **      | ** ** | **March 31, 2008** | ** ** | **September 30, 2007** | ** ** |
|-----------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **      | ** ** | ** **                   | ** ** | ** **                       | ** ** |
| Raw materials   |       | $                            | 11,393     |                             | $          | 5,764 |   |
| Work in process |       | 383                          |       | 445                              |       |
| Finished goods  |       | 6,048                        |       | 3,966                            |       |
|            |       |                         |       |                             |       |
| Total           |       | $                            | 17,824     |                             | $          | 10,175 |   |

 

**8.  Commitments and Contingencies**

 

  ***Guarantees andIndemnifications***

 

Acquisition-related indemnifications – When, as part of an acquisition,the Company acquires all the stock of a company, the Company assumesliabilities for certain events or circumstances that took place prior to thedate of acquisition.  The maximumpotential amount of future payments the Company could be required to make forsuch obligations is undeterminable.  TheCompany has received one claim related to the Alliance Systems acquisition, forwhich the Company has recorded a liability of $85,000 as of March 31,2008.  While the provisions of theagreements remain in effect indefinitely, the Company believes that theprobability of receiving a claim related to acquisitions other than AllianceSystems is unlikely.  As a result, theCompany has not recorded any other liabilities for such indemnification clausesas of March 31, 2008.

 

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

 

12

----

 

**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

value of these agreements isminimal.  Accordingly, the Company has noliabilities recorded for these indemnifications as of March 31, 2008.

 

Product warranties – The Company offers and fulfills warranty services oncertain of its server appliances. Warranty terms vary in duration depending upon the product sold, butgenerally provide for the repair or replacement of any defective products forperiods of up to 36 months after shipment. Based upon historical experience and expectation of future conditions,the Company reserves for the estimated costs to fulfill customer warrantyobligations upon the recognition of the related revenue.  The following table presents changes in theCompany’s product warranty liability for the three and six months ended March 31,2008 and 2007 (in thousands):

 
| ** **                                  | ** ** | **Three months ended  March 31,** | ** ** | **Six months ended  March 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                  | ** ** | **2008**                                         | ** ** | **2007**                                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                        |       |                                             |       |                                           |       |   |   |   |   |
| Beginning balance                           |       | $                                                | 1,017      |                                           | $          | 702 |   | $ | 1,046 |   | $ | 559 |   |
| Acquisitions                                |       | —                                           |       | —                                         |       | 70 |   | — |   |
| Accruals for warranties issued              |       | 475                                              |       | 598                                            |       | 997 |   | 919 |   |
| Fulfillment of warranties during the period |       | (524                                             | )          | (283                                           | )          | (1,145 | ) | (461 | ) |
| Ending balance                              |       | $                                                | 968        |                                           | $          | 1,017 |   | $ | 968 |   | $ | 1,017 |   |

 

***Contingencies***

 

*Initial Public Offering Lawsuit*

 

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

 

In October 2002, Lawrence A. Genovesi and Douglas G. Bryant weredismissed from this case without prejudice. On December 5, 2006, the United States Court of Appeals for the SecondCircuit overturned the District Court’s certification of a plaintiff class.  On April 6, 2007, the Second Circuit denied plaintiffs’petition for rehearing, but clarified that the plaintiffs may seek to certify amore limited class in the District Court. The Company is unable to predict the outcome of this suit and as aresult, no amounts have been accrued as of March 31, 2008.

 

13

----

 

**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**9.  Line of Credit**

 

On October 11,2007, the Company entered into a Loan and Security Agreement with SiliconValley Bank (the “Bank”).  The term ofthis agreement is for one year, ending on October 9, 2008.  The Loan Agreement provides the Company witha $15 million revolving loan facility. The interest rate on this line is equal to one quarter of a point (.25%)below the current prime rate with interest payable monthly.  As of March 31, 2008, the Company hasnot drawn on this line of credit.

 

14

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Special NoteRegarding Forward-Looking Statements**

** **

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

 

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

 

**Overview**

** **

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

 

            As mentionedpreviously in the notes to our financial statements, we acquired AllianceSystems, Inc. (“Alliance Systems”) on October 11, 2007.  With this acquisition, many of our assets andliabilities increased between September 30, 2007 and March 31, 2008.

 

**Critical Accounting Policies and Estimates**

 

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

 

*Revenue Recognition*

 

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

 

15

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

 

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

 

For revenue arrangements that contain multipleelements, such as the sale of both the product and post sales support and/orextended warranty and related services element, in which software is not incidentalto the product, we determine fair value based upon vendor specific objectiveevidence, which is typically established through contractual post-sales supportrenewal rates whereby the residual fair value is allocated to the serverappliance. For revenue arrangements that contain multiple elements, in whichsoftware is not included or is incidental to the product, we allocate revenueto the extended warranty and related services element based on separatelypriced contractual rates for those elements.

 

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

 

*Goodwill and Other Intangible Assets*

 

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

 

Conditionsthat could trigger a more frequent impairment assessment include, but are notlimited to, a significant adverse change in certain agreements, an economicdownturn in our customers’ industries, increased competition, or otherinformation regarding our market value, such as a reduction in our stockprice.  For example, a reduction in ourstock price to a price at or near the book value of the Company for a period oftime could indicate a triggering event and a possible impairment of goodwill.

 

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

 

16

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**Results of Operations**

 

**Three months ended March 31, 2008 compared to the three monthsended March 31, 2007**

 

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

 
| ** **                    | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------------|------------|------------------------------------------------------|------------|
| ** **                    | ** ** | **2008**                                             | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                    | ** ** | **Dollars**                                          | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues                  |       | $                                                    | 55,174     |   | 100.0 | % | $ | 29,305 |   | 100.0 | % | $ | 25,869 |   | 88.3 | % |
| Gross profit                  |       | 8,899                                                |       | 16.1 | % | 6,090 |   | 20.8 | % | 2,809 |   | 46.1 | % |
| Operating expenses            |       | 8,702                                                |       | 15.8 | % | 6,174 |   | 21.1 | % | 2,528 |   | 40.9 | % |
| Income (loss) from operations |       | 197                                                  |       | 0.3 | % | (84 | ) | (0.3 | )% | 281 |   | — |   |
| Net income                    |       | $                                                    | 300        |   | 0.5 | % | $ | 365 |   | 1.2 | % | $ | (65 | ) | (17.8 | )% |

 

***Net Revenues***

 

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

 

Our net revenues increased for the three months ended March 31,2008, as compared to the three months ended March 31, 2007, primarily dueto the acquisition of Alliance Systems on October 11, 2007.  If the acquisition had occurred at thebeginning of fiscal year 2007, net revenues, on a pro forma basis, would haveincreased by approximately $1.2 million. The pro forma increase would have been attributable primarily toincreased sales volumes.

 

***Gross Profit***

 

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

 

Gross profit as a percentage of net revenue decreased for the threemonths ended March 31, 2008, as compared to the three months ended March 31,2007.  The decrease from the prior yearwas primarily due to higher inventory write-downs, a decrease in averageselling prices based on the customer and product mix combined with consistentmanufacturing costs, and lower gross margins associated with the AllianceSystems business.  In addition, grossprofit in the prior year included the cost recovery of previously written-downinventory.

 

Gross profit is affected by customer and product mix, pricing and thevolume of orders as well as by the mix of product manufactured internallycompared to product manufactured by a contract manufacturer, which results inhigher manufacturing costs.  We expectthat gross profit as a percentage of net revenue for the three months ended June 30,2008 will decrease, as compared to the three months ended March 31, 2008.

 

***Operating Expenses***

 

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

 
| ** **                        | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|
| ** **                        | ** ** | **2008**                                             | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                          | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating expenses:               |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Research and development          |       | $                                                    | 2,318      |   | 4.2 | % | $ | 2,410 |   | 8.2 | % | $ | (92 | ) | (3.8 | )% |
| Selling and marketing             |       | 2,948                                                |       | 5.4 | % | 1,810 |   | 6.2 | % | 1,138 |   | 62.9 | % |
| General and administrative        |       | 2,935                                                |       | 5.3 | % | 1,954 |   | 6.7 | % | 981 |   | 50.2 | % |
| Amortization of intangible assets |       | 501                                                  |       | 0.9 | % | — |   | — |   | 501 |   | — |   |
|                              |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total operating expenses          |       | $                                                    | 8,702      |   | 15.8 | % | $ | 6,174 |   | 21.1 | % | $ | 2,528 |   | 40.9 | % |

 

17

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*** ***

***Research and Development***

 

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

 
| ** **                           | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                             | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and development:            |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                    | 1,507      |   | 65.0 | % | $ | 1,388 |   | 57.6 | % | $ | 119 |   | 8.6 | % |
| Stock-based compensation             |       | 162                                                  |       | 7.0 | % | 300 |   | 12.4 | % | (138 | ) | (46.0 | )% |
| Prototype                            |       | 128                                                  |       | 5.5 | % | 270 |   | 11.2 | % | (142 | ) | (52.6 | )% |
| Consulting and professional services |       | 194                                                  |       | 8.4 | % | 257 |   | 10.7 | % | (63 | ) | (24.5 | )% |
| Other                                |       | 327                                                  |       | 14.1 | % | 195 |   | 8.1 | % | 132 |   | 67.7 | % |
|                                 |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total research and development       |       | $                                                    | 2,318      |   | 100 | % | $ | 2,410 |   | 100 | % | $ | (92 | ) | (3.8 | )% |

 

Research and development expenses decreased in thethree months ended March 31, 2008, as compared to the three months ended March 31,2007, primarily due to decreases in stock-based compensation and prototypeexpenses, partially offset by increases related to the acquisition of AllianceSystems.  Because our research anddevelopment expenses are project driven, the timing of these expenditures canvary.  If the acquisition had occurred atthe beginning of fiscal year 2007, research and development expenses would havedecreased by approximately $550,000, when comparing the pro forma research anddevelopment expenses for the three months ended March 31, 2007 to ouractual results for the three months ended March 31, 2008.  On a pro forma basis, there would have beendecreases in compensation, primarily due to lower headcount, stock-basedcompensation, and prototype and consulting costs, based on the timing ofprojects being worked on.

 

Our server appliance development strategy emphasizesthe utilization of standard server appliance platforms, which utilizeoff-the-shelf components.  However, weexpect that in some cases, significant development efforts will be required tofulfill our current and potential customers’ needs using customizedplatforms.  In addition, we intend tofocus our software development in areas that improve the ease of serverappliance implementation and use, which we believe will enhance our valueproposition.  We expect that prototypeand consulting costs will be variable and could fluctuate depending on thetiming and magnitude of our development projects.  However, we expect our research anddevelopment costs to decrease during the three months ended June 30, 2008,as compared to the three months ended March 31, 2008.

 

***Selling and Marketing***

 

Selling and marketing expenses consist primarily ofsalaries and commissions for personnel engaged in sales and marketing, andcosts associated with our marketing programs, which include costs associatedwith our attendance at trade shows, product literature costs, web siteenhancements, product evaluation costs, and travel.  The following table summarizes the mostsignificant components of selling and marketing expense for the periodsindicated, in thousands and as a percentage of total selling and marketingexpense, and provides the changes in thousands and percentages:

 

18

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| ** **                        | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------|------------|------------------------------------------------------|------------|
| ** **                        | ** ** | **2008**                                             | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:            |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                    | 2,109      |   | 71.6 | % | $ | 1,182 |   | 65.3 | % | $ | 927 |   | 78.4 | % |
| Stock-based compensation          |       | 66                                                   |       | 2.2 | % | 67 |   | 3.7 | % | (1 | ) | (1.5 | )% |
| Marketing programs                |       | 215                                                  |       | 7.3 | % | 226 |   | 12.5 | % | (11 | ) | (4.9 | )% |
| Travel                            |       | 209                                                  |       | 7.1 | % | 144 |   | 8.0 | % | 65 |   | 45.1 | % |
| Other                             |       | 349                                                  |       | 11.8 | % | 191 |   | 10.5 | % | 158 |   | 82.7 | % |
|                              |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and marketing       |       | $                                                    | 2,948      |   | 100 | % | $ | 1,810 |   | 100 | % | $ | 1,138 |   | 62.9 | % |

 

Selling and marketingexpenses increased in the three months ended March 31, 2008, as comparedto the three months ended March 31, 2007, primarily due to the acquisitionof Alliance Systems.  Selling andmarketing headcount increased from 22 as of March 31, 2007, to 58 as of March 31,2008.  If the acquisition had occurred atthe beginning of fiscal year 2007, selling and marketing expenses would havedecreased by approximately $700,000, when comparing the pro forma selling andmarketing expenses for the three months ended March 31, 2007 to our actualresults for the three months ended March 31, 2008.  On a pro forma basis, there would have beenlower compensation and related expenses, because Alliance Systems had decreasedits selling and marketing headcount.

 

We believe that we must target our selling andmarketing efforts on network equipment providers, independent software vendors(“ISVs”) and telecom equipment manufacturers in order to enhance our positionas a leading provider of server appliance products.  We expect selling and marketing expenses toremain consistent during the three months ended June 30, 2008, as comparedto the three months ended March 31, 2008.

 

19

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***General and Administrative***

 

General and administrative expenses consist primarilyof salaries and other related costs for executive, finance, informationtechnology and human resources personnel; professional services, which includelegal, accounting, audit and tax fees; and director and officer insurance.  The following table summarizes the mostsignificant components of general and administrative expense for the periodsindicated, in thousands and as a percentage of total general and administrativeexpense, and provides the changes in thousands and percentages:

 
| ** **                           | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                             | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                          | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and administrative:          |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                    | 1,505      |   | 51.3 | % | $ | 956 |   | 48.9 | % | $ | 549 |   | 57.4 | % |
| Stock-based compensation             |       | 182                                                  |       | 6.2 | % | 241 |   | 12.3 | % | (59 | ) | (24.5 | )% |
| Consulting and professional services |       | 900                                                  |       | 30.6 | % | 519 |   | 26.6 | % | 381 |   | 73.4 | % |
| Director and officer insurance       |       | 70                                                   |       | 2.4 | % | 83 |   | 4.3 | % | (13 | ) | (15.7 | )% |
| Other                                |       | 278                                                  |       | 9.5 | % | 155 |   | 7.9 | % | 123 |   | 79.4 | % |
|                                 |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total general and administrative     |       | $                                                    | 2,935      |   | 100 | % | $ | 1,954 |   | 100 | % | $ | 981 |   | 50.2 | % |

 

General and administrative expenses increased in thethree months ended March 31, 2008, as compared to the three months ended March 31,2007, primarily due to the acquisition of Alliance Systems.  General and administrative headcountincreased from 27 as of March 31, 2007, to 44 as of March 31,2008.  If the acquisition had occurred atthe beginning of fiscal year 2007, general and administrative expenses wouldhave decreased by approximately $280,000, when comparing the pro forma generaland administrative expenses for the three months ended March 31, 2007 to ouractual results for the three months ended March 31, 2008.  The pro forma decrease would have beenattributable to decreases in compensation and stock-based compensation expensesand other expenses, offset by an increase in consulting and professional services.  The pro forma decrease in compensation andrelated expenses would have been primarily due to lower headcount during thecurrent year period as compared to the same period in the prior year.  The pro forma increase in consulting andprofessional services is primarily related to additional costs associated withour integration of Alliance Systems.

 

We expect general and administrative expenses todecrease during the three months ended June 30, 2008, as compared to thethree months ended March 31, 2008.

 

***Amortization of Intangible Assets***

 

The amortization of intangible assets increased by$501,000 for the three months ended March 31, 2008, as compared to thethree months ended March 31, 2007. The increase was due to the amortization of intangible assets related tothe acquisition of Alliance Systems, which occurred on October 11, 2007.

 

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

* *

Interest and other income, net, decreased to$141,000 for the three months ended March 31, 2008 from $462,000 for thethree months ended March 31, 2007. This decrease was primarily due to lower interest income, attributableto lower cash and short-term investment balances held by the Company during thethree months ended March 31, 2008, as compared to the three months ended March 31,2007.

 

**Six months ended March 31, 2008 compared to the six months ended March 31,2007**

 

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

 

20

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| ** **                    | ** ** | **Six Months Ended March 31,** | ** ** |
|-------------------------------|------------|----------------------------------------------------|------------|
| ** **                    | ** ** | **2008**                                           | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                    | ** ** | **Dollars**                                        | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues                  |       | $                                                  | 109,514    |   | 100.0 | % | $ | 56,543 |   | 100.0 | % | $ | 52,971 |   | 93.4 | % |
| Gross profit                  |       | 18,639                                             |       | 17.0 | % | 11,323 |   | 20.0 | % | 7,316 |   | 64.6 | % |
| Operating expenses            |       | 17,254                                             |       | 15.7 | % | 11,958 |   | 21.1 | % | 5,296 |   | 44.3 | % |
| Income (loss) from operations |       | 1,385                                              |       | 1.3 | % | (635 | ) | (1.1 | )% | 2,020 |   | — |   |
| Net income                    |       | $                                                  | 1,541      |   | 1.4 | % | $ | 251 |   | 0.4 | % | $ | 1,290 |   | 513.9 | % |

 

***Net Revenues***

 

Our net revenues increased for the six months ended March 31,2008, as compared to the six months ended March 31, 2007, primarily due tothe acquisition of Alliance Systems on October 11, 2007.  If the acquisition had occurred at thebeginning of fiscal year 2007, net revenues, on a pro forma basis, would haveincreased by approximately $3.3 million. The pro forma increase would have been attributable primarily to increasedsales volumes.

 

***Gross Profit***

 

Gross profit as a percentage of net revenue decreased for the six monthsended March 31, 2008, as compared to the six months ended March 31,2007, primarily due to higher inventory write-downs, a decrease in averageselling prices based on the customer and product mix combined with consistentmanufacturing costs, and lower gross margins associated with the AllianceSystems business.

 

***Operating Expenses***

 

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

 
| ** **                        | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | **2008**                                           | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                        | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating Expenses:          |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Research and development          |       | $                                                  | 4,688      |   | 4.3 | % | $ | 4,403 |   | 7.8 | % | $ | 285 |   | 6.5 | % |
| Selling and marketing             |       | 6,065                                              |       | 5.5 | % | 3,540 |   | 6.2 | % | 2,525 |   | 71.3 | % |
| General and administrative        |       | 5,580                                              |       | 5.1 | % | 4,015 |   | 7.1 | % | 1,565 |   | 39.0 | % |
| Amortization of intangible assets |       | 921                                                |       | 0.8 | % | — |   | — |   | 921 |   | — |   |
|                              |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total operating expenses          |       | $                                                  | 17,254     |   | 15.7 | % | $ | 11,958 |   | 21.1 | % | $ | 5,296 |   | 44.3 | % |

 

***Research and Development***

 

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

 
| ** **                           | ** ** | **Six Months Ended March 31,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                           | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                        | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and development:            |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                  | 3,028      |   | 64.6 | % | $ | 2,607 |   | 59.2 | % | $ | 421 |   | 16.1 | % |
| Stock-based compensation             |       | 412                                                |       | 8.8 | % | 580 |   | 13.2 | % | (168 | ) | (29.0 | )% |
| Prototype                            |       | 250                                                |       | 5.3 | % | 411 |   | 9.3 | % | (161 | ) | (39.1 | )% |
| Consulting and professional services |       | 459                                                |       | 9.8 | % | 399 |   | 9.1 | % | 60 |   | 15.0 | % |
| Other                                |       | 539                                                |       | 11.5 | % | 406 |   | 9.2 | % | 133 |   | 32.8 | % |
|                                 |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total research and development       |       | $                                                  | 4,688      |   | 100 | % | $ | 4,403 |   | 100 | % | $ | 285 |   | 6.5 | % |

 

21

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Research and development expenses increased in the sixmonths ended March 31, 2008, as compared to the six months ended March 31,2007, primarily due to the acquisition of Alliance Systems.  If the acquisition had occurred at thebeginning of fiscal year 2007, research and development expenses would havedecreased by approximately $510,000, when comparing the pro forma research anddevelopment expenses for the six month periods ended March 31, 2008 and2007.  Because our research anddevelopment expenses are project driven, the timing of these expenditures canvary.  On a pro forma basis, there wouldhave been decreases in compensation and stock-based compensation as a result oflower headcount and the scheduled vesting of stock options, and a decrease inprototype expenses based on the timing of projects being worked on.

 

***Selling and Marketing***

 

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

 
| ** **                        | ** ** | **Six Months Ended March 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | **2008**                                           | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                        | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:            |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                  | 4,445      |   | 73.3 | % | $ | 2,407 |   | 68.0 | % | $ | 2,038 |   | 84.7 | % |
| Stock-based compensation          |       | 161                                                |       | 2.6 | % | 167 |   | 4.7 | % | (6 | ) | (3.6 | )% |
| Marketing programs                |       | 327                                                |       | 5.4 | % | 395 |   | 11.2 | % | (68 | ) | (17.2 | )% |
| Travel                            |       | 406                                                |       | 6.7 | % | 256 |   | 7.2 | % | 150 |   | 58.6 | % |
| Other                             |       | 726                                                |       | 12.0 | % | 315 |   | 8.9 | % | 411 |   | 130.5 | % |
|                              |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and marketing       |       | $                                                  | 6,065      |   | 100 | % | $ | 3,540 |   | 100 | % | $ | 2,525 |   | 71.3 | % |

 

Selling and marketing expenses increased in the sixmonths ended March 31, 2008, as compared to the six months ended March 31,2007, primarily due to the acquisition of Alliance Systems.  Selling and marketing headcount increasedfrom 22 as of March 31, 2007, to 58 as of March 31, 2008.  If the acquisition had occurred at thebeginning of fiscal year 2007, selling and marketing expenses would havedecreased by approximately $950,000, when comparing the pro forma selling andmarketing expenses for the six month periods ended March 31, 2008 and2007.  On a pro forma basis, there wouldhave been lower compensation and related expenses, attributable to the factthat Alliance Systems had decreased its selling and marketing headcount.

 

***General and Administrative***

 

The following table summarizes the most significant components ofgeneral and administrative expense for the periods indicated, in thousands andas a percentage of total general and administrative expense, and provides thechanges in thousands and percentages:

 
| ** **                           | ** ** | **Six Months Ended March 31,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                           | ** ** | **2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                        | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and administrative:          |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                  | 2,824      |   | 50.6 | % | $ | 1,730 |   | 43.1 | % | $ | 1,094 |   | 63.2 | % |
| Stock-based compensation             |       | 370                                                |       | 6.6 | % | 433 |   | 10.8 | % | (63 | ) | (14.5 | )% |
| Consulting and professional services |       | 1,555                                              |       | 27.9 | % | 1,362 |   | 33.9 | % | 193 |   | 14.2 | % |
| Director and officer insurance       |       | 134                                                |       | 2.4 | % | 166 |   | 4.1 | % | (32 | ) | (19.3 | )% |
| Other                                |       | 697                                                |       | 12.5 | % | 324 |   | 8.1 | % | 373 |   | 115.1 | % |
|                                 |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total general and administrative     |       | $                                                  | 5,580      |   | 100 | % | $ | 4,015 |   | 100 | % | $ | 1,565 |   | 39.0 | % |
|                                      |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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General and administrative expenses increased in thesix months ended March 31, 2008, as compared to the six months ended March 31,2007, primarily due to the acquisition of Alliance Systems.  General and administrative headcountincreased from 27 as of March 31, 2007, to 44 as of March 31,2008.  If the acquisition had occurred atthe beginning of fiscal year 2007, general and administrative expenses wouldhave decreased by approximately $837,000, when comparing the pro forma generaland administrative expenses for the six month periods ended March 31, 2008and 2007.  The pro forma decrease wouldhave been attributable to decreases in compensation and related expenses and inother costs, primarily bad debt expense. The pro forma decrease in compensation and related expenses would havebeen primarily due to lower headcount within the administrative departments aswell as lower bonus expense during the current year period as compared to thesame period in the prior year.

 

***Amortization of Intangible Assets***

 

The amortization of intangible assets increased by$921,000 for the six months ended March 31, 2008, as compared to the sixmonths ended March 31, 2007.  Theincrease was due to the amortization of intangible assets related to theacquisition of Alliance Systems, which occurred on October 11, 2007.

 

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

* *

Interest and other income, net, decreased to$265,000 for the six months ended March 31, 2008 from $909,000 for the sixmonths ended March 31, 2007.  Thisdecrease was primarily due to lower interest income, attributable to lower cashand short-term investment balances held by the Company during the six monthsended March 31, 2008, as compared to the six months ended March 31,2007.

 

**Liquidityand Capital Resources**

 

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

 
| ** **                                        | ** ** | **Six Months Ended March 31,** | ** ** |
|---------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                        | ** ** | **2008**                                           | ** ** | **2007** | ** ** |
| ** **                                        | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Net income                                        |       | $                                                  | 1,541      |   | $ | 251 |   |
| Non-cash adjustments to net income                |       | 2,744                                              |       | 1,663 |   |
| Changes in working capital                        |       | (2,686                                             | )          | 2,641 |   |
|                                              |       |                                               |       |   |   |
| Cash provided by operating activities             |       | 1,599                                              |       | 4,555 |   |
|                                              |       |                                               |       |   |   |
| Cash (used in) investing activities               |       | (34,240                                            | )          | (279 | ) |
| Cash provided by financing activities             |       | 105                                                |       | 1,825 |   |
| Effect of exchange rate differences on cash       |       | (29                                                | )          | — |   |
|                                              |       |                                               |       |   |   |
| (Decrease) increase in cash and cash  equivalents |       | (32,565                                            | )          | 6,101 |   |
| Beginning cash and cash equivalents               |       | 44,403                                             |       | 8,014 |   |
|                                              |       |                                               |       |   |   |
| Ending cash and cash equivalents                  |       | $                                                  | 11,838     |   | $ | 14,115 |   |

 

***OperatingActivities***

 

Cash provided by operating activities during the sixmonths ended March 31, 2008 was primarily the result of net income and theimpact of non-cash adjustments to net income, partially offset by a net use of 

 

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cash from changes in workingcapital.  The changes in working capitalprimarily related to the use of cash to settle accounts payable and accruedexpenses, partially offset by the impact of cash provided by decreases inaccounts receivable and inventories. Changes in working capital for the six months ended March 31, 2007included an increase in deferred revenue of $1.8 million related to thetransfer of support obligations of the previously installed Whale appliancesfrom Microsoft.

 

***InvestingActivities***

 

Cash used in investing activities during the sixmonths ended March 31, 2008 primarily related to the use of approximately$34 million of cash for the acquisition of Alliance Systems.

 

***FinancingActivities***

 

Cash provided by financing activities during the sixmonths ended March 31, 2008 consisted primarily of $115,000 of cashreceived as the result of employee stock option exercises and purchases underthe Employee Stock Purchase Plan.  Weexpect these activities to continue for the remainder of fiscal year 2008;however, we cannot predict the magnitude of the cash inflows, given thevolatility of capital markets.

 

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

 

·                  the timing and size of orders from our largercustomers;

 

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

 

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

 

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

 

·                  market developments.

 

We believe that our available cash resources and cashthat we expect to generate from sales of our products will be sufficient tomeet our operating and capital requirements through at least the next twelvemonths.

 

In the event that our available cash resources and theSilicon Valley Bank line of credit are not sufficient, after the line of creditmatures on October 9, 2008, we would need to raise additional funds.  We may in the future seek to raise additionalfunds through borrowings, public or private equity financings or from othersources.  There can be no assurance thatadditional financing will be available at all or, if available, will be onterms acceptable to us.  Additionalequity financings could result in dilution to our shareholders.  If additional financing is needed and is notavailable on acceptable terms, we may need to reduce our operating expenses andscale back our operations.

 

***ContractualObligations and Commitments***

 

In addition to our contractual obligations disclosedin our Annual Report on Form 10-K for the year ended September 30,2007, during the six months ended March 31, 2008, we incurred anadditional contractual obligation related to the facility leased by AllianceSystems.  The remaining obligation underthis lease as of March 31, 2008 is as follows:

 
| ** **      | ** ** | **Payments Due by Fiscal Period** | ** ** |
|-----------------|------------|-------------------------------------------------------|------------|
| ** **      | ** ** | **Less than  1 Year**                       | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **After  5 Years** | ** ** | **Total** | ** ** |
|            |       |                                                  |       |   |   |   |   |   |   |   |   |
| Operating lease |       | $                                                     | 369        |   | $ | 2,161 |   | $ | — |   | $ | — |   | $ | 2,530 |   |
|            |       |                                                  |       |   |   |   |   |   |   |   |   |
| Total           |       | $                                                     | 369        |   | $ | 2,161 |   | $ | — |   | $ | — |   | $ | 2,530 |   |

 

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**Off-Balance Sheet Arrangements**

 

We have not created, and are not party to, anyspecial-purpose or off-balance sheet entities for the purpose of raisingcapital, incurring debt or operating parts of our business that are notconsolidated into our financial statements. We have not entered into any transactions with unconsolidated entitieswhereby the Company has subordinated retained interests, derivative instrumentsor other contingent arrangements that expose the Company to material continuingrisks, contingent liabilities, or any other obligation under a variableinterest in an unconsolidated entity that provides financing, liquidity, marketrisk or credit risk support to the Company.

 

**Recent Accounting Pronouncements**

** **

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standard No. 157, “Fair Value Measurements” (“FAS 157”).  This statement addresses how companies shouldmeasure fair value when they are required to use a fair value measure forrecognition or disclosure purposes under accounting principles generallyaccepted in the United States of America. In February 2008, the FASB issued FASB Staff Position 157-1, “Applicationof FASB Statement No. 157 to FASB Statement No. 13 and OtherAccounting Pronouncements That Address Fair Value Measurements for Purposes ofLease Classification or Measurement under Statement 13” (“FSP 157-1”).  FSP 157-1 amends FAS 157 to remove certainleasing transactions from its scope.  In February 2008, the FASB issuedFASB Staff Position 157-2, “Effective Date of FASB Statement No. 157” (“FSP157-2”).  FSP 157-2 defers the effectivedate of FAS 157 for certain non-financial assets and liabilities to the beginning of the Company’s fiscal yearthat begins after November 15, 2008. FAS 157 is effective for financial assets and liabilities as of thebeginning of our fiscal year that begins after November 15, 2007.  We are in the process of evaluating whetherthe adoption of FAS 157 will have a material impact on our financial position,results of operations or cash flows.

 

In February 2007,the FASB issued Statement of Financial Accounting Standard No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities – Including anamendment of FASB Statement No. 115” (“FAS 159”).  This statement permits entities to choose tomeasure many financial instruments and certain other items at fair value atspecified election dates.  Subsequentunrealized gains and losses on items for which the fair value option has beenelected will be reported in earnings.  FAS 159 is effective as of the beginning ofour fiscal year that begins after November 15, 2007.  We are in the process of evaluating whetherthe adoption of FAS 159 will have a material impact on our financial position,results of operations or cash flows.

 

InDecember 2007, the FASB issued Statement of Financial Accounting Standard No. 141(R),“Business Combinations” (“FAS 141R”). This Statement replaced Statement of Financial Accounting Standard No. 141toimprove the relevance, representational faithfulness, and comparability of theinformation that a reporting entity provides in its financial reports about abusiness combination and its effects. FAS 141R establishes principles and requirements for how the acquirerrecognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, and any noncontrolling interest in theacquiree, recognizes and measures the goodwill acquired in the businesscombination or a gain from a bargain purchase and determines what informationto disclose to enable users of the financial statements to evaluate the natureand financial effects of the business combination.  FAS 141R is effective for businesscombinations on a prospective basis for which the acquisition date is on or after the beginning of the first annualreporting period beginning on or after December 15, 2008.  The adoption of FAS 141R will not have amaterial impact on our financial position, results of operations or cashflows.

 

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

 

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

 

**ITEM 4.    CONTROLS AND PROCEDURES**

 

Ourmanagement, with the participation of our Chief Executive Officer and ChiefFinancial Officer, evaluated the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act) as of March 31, 2008.  Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer concluded that, as of March 31, 2008,our disclosure controls and procedures (1) were designed to effectively accumulateand communicate information to the Company’s management, as appropriate, toallow timely decisions regarding required disclosure and (2) wereeffective, in that they provide reasonable assurance that information requiredto be disclosed by the Company in the reports that it files or submits underthe Securities Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’s rules andforms.

 

Duringthe three months ended March 31, 2008, no change in our internal controlover financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) occurred that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

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**PART II—OTHERINFORMATION**

 

**ITEM 1.     LEGAL PROCEEDINGS**

 

*InitialPublic Offering Lawsuit*

 

On or about December 3, 2001, a putative classaction lawsuit was filed in the United States District Court for the SouthernDistrict of New York against us, Lawrence A. Genovesi (our former Chairman andChief Executive Officer), Douglas G. Bryant (our Chief Financial Officer), and severalunderwriters of our initial public offering. The suit alleges, *inter alia*,that the defendants violated the federal securities laws by issuing and sellingsecurities pursuant to our initial public offering in July 2000 (“IPO”) withoutdisclosing to investors that the underwriter defendants had solicited andreceived excessive and undisclosed commissions from certain investors.  The suit seeks damages and certification of aplaintiff class consisting of all persons who acquired shares of our commonstock between July 13, 2000 and December 6, 2000.

 

In October 2002, Lawrence A. Genovesi andDouglas G. Bryant were dismissed from this case without prejudice.  On December 5, 2006, the United States Courtof Appeals for the Second Circuit overturned the District Court’s certificationof a plaintiff class.  On April 6, 2007,the Second Circuit denied plaintiffs’ petition for rehearing, but clarifiedthat the plaintiffs may seek to certify a more limited class in the DistrictCourt.  We are unable to predict theoutcome of this suit and as a result, no amounts have been accrued as of March31, 2008.

 

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**ITEM 1A. RISK FACTORS**

 

The risks and uncertainties described below are not the only ones we arefaced with.  Additional risks anduncertainties not presently known to us, or that are currently deemedimmaterial, may also impair our business operations.  If any of the following risks actually occur,our financial condition and operating results could be materially adverselyaffected.

 

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

 

**We derive a significant portion of our revenues from sales of serverappliances directly to EMC and our revenues may decline significantly ifthis customer cancels or delays purchases of our products, terminates itsrelationship with us or exercises certain of its contractual rights.**

 

For the three months ended March 31, 2008 and 2007, sales directlyto EMC, our largest customer, accounted for 49% and 80%, of our total netrevenues, respectively.  For the sixmonths ended March 31, 2008 and 2007, sales directly to EMC accounted for44% and 81%, of our total net revenues, respectively.  These sales are primarily attributable to oneproduct pursuant to a non-exclusive contract. Although this concentration has decreased as a result of our acquisitionof Alliance Systems, we anticipate that our future operating results willcontinue to depend heavily on sales to, and our relationship with, thiscustomer.  Accordingly, the success ofour business will depend, in large part, on this customer’s willingness tocontinue to utilize our server appliance solutions in its existing and futureproducts.  Further, our financial successis dependent upon the future success of the products we sell to this customerand the continued growth of this customer, whose industry has a history ofrapid technological change, short product life cycles, consolidation andpricing and margin pressures.  Asignificant reduction in sales to this customer, or significant pricing andadditional margin pressures exerted on us by this customer, would have amaterial adverse effect on our results of operations.  In addition, if this customer delays orcancels purchases of our products, our operating results would be harmed and wemay be unable to accurately predict revenues, profitability and cash flows.

 

Under the terms of our non-exclusive contract, this customer has theright to enter into agreements with third parties for similar products, is notobligated to purchase any minimum quantity of products from us andmay choose to stop purchasing from us at any time, with or without cause.  In addition, this customer may terminatethe agreement in the event that we attempt to assign our rights under theagreement to another party without this customer’s prior approval.  Furthermore, in the event that we default oncertain portions of the agreement, this customer has the right to manufacturecertain products in exchange for a mutually agreeable royalty fee.  If any of these events were to occur, or ifthis customer were to delay or discontinue purchases of our products as a resultof dissatisfaction or otherwise, our revenues and operating results would bematerially adversely affected, our reputation in the industry might suffer, andwe may be unable to accurately predict revenues, profitability and cash flows.

 

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

 

**Our future success is dependent upon our ability to generate significantrevenues from server appliance development relationships.**

 

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

 

There are multiple risks associated with this strategy including:

 

·                              theexpenditure of significant product development costs, which if not recoveredthrough server appliance sales could negatively affect our operating results;

 

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·                              asignificant reliance on our customers’ application software products, whichcould be technologically inferior to competitive products and result inlimitations on our server appliance sales, causing our revenues and operatingresults to suffer;

 

·                              ourcustomers which sell their software products as separate products in additionto selling them in the form of a server appliance will most likelycontinue to do so, which will require us to effectively communicate thebenefits of delivering their software in the form of a server appliance;

 

·                              ourreliance on our customers to perform all of the selling and marketingefforts associated with further sales of the server appliance product we developwith them;

 

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

 

·                              ourability to leverage strategic relationships to obtain new sales leads;

 

·                              ourability to provide our customers with high quality server appliances atcompetitive prices; and

 

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

 

Additionally, our future success will depend on our ability to establishrelationships with new customers while expanding sales of server appliances toour existing customers.  If thesecustomers are unsuccessful in their marketing and sales efforts, or if we areunable to expand our sales to existing customers and develop relationships withnew customers, our revenues and operating results could suffer.

 

**The failure to successfully integrate our acquisition of AllianceSystems into our operations in the expected time frame, or at all, mayadversely affect our future results.**

 

We believe that the acquisition of Alliance Systems, completed in October 2007,will result in certain benefits, including expanded customer reach, increasedproduct offerings, and certain cost savings from economies of scale.  However, to realize these anticipatedbenefits, Alliance Systems’ business must be successfully integrated into ouroperations by focusing on, manufacturing and supply chain synergies, sales andmarketing operations, and general and administrative efficiencies.  The success of the Alliance Systemsacquisition will depend on our ability to realize these anticipated benefitsfrom integrating Alliance Systems’ business into our operations.  We may fail to realize the anticipatedbenefits of the acquisition on a timely basis, or at all, for a variety ofreasons, including the following:

 

•                  diversion of management attention anddifficulties arising from managing multiple locations;

 

•                  potential disruption of ongoingbusiness;

 

•                  failure to effectively coordinatesales and marketing efforts to communicate the capabilities of the combinedCompany;

 

•                  potential difficulties integratingfinancial reporting or other critical systems; and

 

•                  the loss of key employees, customers,or vendors.

 

If we fail to successfully integrate Alliance Systems and realize theexpected benefits of the acquisition, it could have an adverse impact on ourresults of operations, and our ability to generate cash 

 

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from operations.  As a result, we could have difficultyborrowing under our current credit facility or securing financing to fund ouroperations in the future.

 

**We may not be able to effectively commercialize our appliances ormay be at a competitive disadvantage if we cannot license or integratethird-party applications that are essential for the functionality of certainappliances.**

 

We believe our success will depend on our ability to license orintegrate certain applications from third-parties that would be incorporated incertain of our server appliance solutions. Because we do not currently know with certainty which of these prospectivetechnologies will be desired in the marketplace, we may incorrectly investin development or prioritize our efforts to integrate these technologies in ourappliances.  Additionally, even if wecorrectly focus our efforts, there can be no assurance that we will select thepreferred provider of these technologies, the third-party provider will becommitted to the relationship and integration of their technology, or that theywill license their technology to us without obtaining significant certificationor training, which could be costly and time consuming.  If we are unable to successfully integratethe correct third-party technologies in a timely manner, our appliancesmay be inferior to other competitive products in the marketplace, whichmay adversely affect the results of our operations and our ability to growour business.

 

**Our business could be harmed if we fail to adequately integrate newtechnologies into our server appliance products or if we invest in technologiesthat do not result in the desired effects on our current and/or future productofferings.**

 

As part of our strategy, we review opportunities to incorporateproducts and technologies that could be required in order to add new customers,retain existing customers, expand the breadth of product offerings or enhanceour technical capabilities.  Investing innew technologies presents numerous risks, including:

 

•                  we may experience difficultiesintegrating new technologies into our current or future products;

 

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

 

•                  we may incorporate technologiesthat do not result in the desired improvements to our current and/or futureserver appliance products;

 

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

 

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

 

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

 

If we are unable to adequately integrate new technologies into ourserver appliance products or if we invest in technologies that do not result inthe desired effects on our current and/or future product offerings, ourbusiness could be harmed and operating results could suffer.

 

***Risks related to the server appliance markets.***

 

**If server appliances are not increasingly adopted as a solution to meeta significant portion of companies’ application needs, the market for serverappliances may not grow, which could negatively impact our revenues.**

 

We expect that all of our future revenues will come from sales of serverappliances and related maintenance.  As aresult, we are substantially dependent on the growing use of server appliancesto meet 

 

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businesses’ applicationneeds.  Our revenues may not growand the market price of our common stock could decline if the server appliancemarket does not grow as rapidly as we expect.

 

Our expectations for the growth of the server appliance marketmay not be fulfilled if customers continue to use general-purpose serversor proprietary platforms.  The role ofour products could, 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 could force us to lower the prices ofour server appliance products or could result in fewer sales of these products,which would negatively impact our revenues and decrease our gross profits.

 

**The products that we sell are subject to rapid technological change andour sales will suffer if these products are rendered obsolete by newtechnologies.**

 

The markets we serve are characterized by rapid technological change,frequent new product introductions and enhancements, potentially short productlife cycles, changes in customer demands and evolving industry standards.  In the server appliance market, we attempt tomitigate these risks by utilizing standards-based hardware platforms and bymaintaining an adequate knowledge base of available technologies.  However, the server appliance products thatwe sell could be rendered obsolete if products based on new technologies areintroduced or new industry standards emerge and we are not able to incorporatethese technological changes into our products.  In addition, we depend on third parties forthe base platforms of our server appliances and we are at risk if these thirdparties do not integrate new technologies. Releasing new products and services prematurely may result inquality problems, and delays may result in loss of customer confidence andmarket share.  We may be unable todevelop new products and services or achieve and maintain market acceptance ofthem once they have come to market. Furthermore, when we do introduce new or enhanced products and services,we may be unable to manage the transition from the older products andservices to minimize disruption in customer ordering patterns, avoid excessiveinventories of older products and deliver enough new products and services tomeet customer demand.

 

To remain competitive in the server appliance market, we mustsuccessfully identify new product opportunities and partners and develop andbring new products to market in a timely and cost-effective manner.  Our failure to select the appropriate partnersand keep pace with rapid industry, technology or market changes could have amaterial adverse effect on our business, results of operations or financialcondition.

 

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

 

**We have a history of losses and may continue to experience lossesin the future, which could cause the market price of our common stock todecline.**

 

In the past, we have incurred significant net losses and could incur netlosses in the future.  At March 31,2008 and September 30, 2007, our accumulated deficit was $128 million and$129 million, respectively.  We believethat any future growth will require us to incur significant engineering,selling and marketing and administrative expenses.  As a result, we will need to generatesignificant revenues to achieve and sustain profitability.  If we do not achieve and sustainprofitability, the market price for our common stock may decline.  Even if we achieve sustained profitabilitythere can be no guarantee that our stock price will increase.

 

**We may not be able to borrow funds under our credit facilityor secure future financing if there is a material adverse change in ourbusiness.**

 

Inconnection with our October 2007 acquisition of Alliance Systems, weentered into an agreement with Silicon Valley Bank to provide for a line ofcredit.  We view this line of credit as asource of available liquidity to fund fluctuations in our working capitalrequirements.  This facility contains variousconditions, covenants and representations with which we must be in compliancein order to borrow funds.  However, if wewish to borrow under this facility in the future, there can be no assurancethat we will be in compliance with these conditions, covenants andrepresentations.  In addition, this lineof credit facility with Silicon Valley Bank expires on October 9,2008.  After that, we may need to securenew financing to continue funding fluctuations in our working capitalrequirements.  However, we may not beable to secure new 

 

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financing, or financing on favorable terms,if we experience a significant adverse change in our business.  As of March 31, 2008, we have not drawnon this line of credit.

 

**If our estimates or judgments relating to our critical accountingpolicies are based on assumptions that prove to be incorrect, our operatingresults could fall below expectations of securities analysts and investors,resulting in a decline in our stock price.**

 

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

 

•                  revenue recognition;

 

•                  inventory write-downs;

 

•                  stock-based compensation;

 

•                  valuation of intangible assets andgoodwill;

 

•                  warranty reserves; and

 

•                  realization of deferred tax assets.

 

We base our estimates on historical experience and on various otherassumptions that we believe to be reasonable under the circumstances, asprovided in our discussion and analysis of financial condition and results ofoperations, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources.  Actual resultsmay differ from these and other estimates if our assumptions change or ifactual circumstances differ from those in our assumptions, which could causeour operating results to fall below the expectations of securities analysts andinvestors, resulting in a decline in our stock price.

 

**Our quarterly revenues and operating results may also fluctuate forvarious reasons, which could cause our operating results to fall belowexpectations and thus impact the market price of our common stock.**

 

Our quarterly revenues and operating results are difficult to predictand may fluctuate significantly from quarter to quarter.  None of our customers are obligated topurchase any quantity of our products in the future nor are they obligated tomeet forecasts of their product needs. Our operating expense levels are based in part on expectations offuture revenues and gross profits, which are partially dependent on ourcustomers’ ability to accurately forecast and communicate their future productneeds.  If revenues or gross profits in aparticular quarter do not meet expectations, operating results could suffer andthe market price of our common stock could decline.  Factors affecting quarterly operating resultsinclude:

 

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

 

•                  the product mix of our sales;

 

•                  the timing of new productintroductions by our customers;

 

•                  the availability and/or price ofproducts from suppliers;

 

•                  the loss of key suppliers orcustomers;

 

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•                  price competition;

 

•                  costs associated with ourintroduction of new server appliances and the market acceptance of thoseproducts;

 

•                  seasonal fluctuations in the datastorage and telecom industries; and

 

•                  the mix of product manufacturedinternally and by our contract manufacturer.

 

**If the products and services that we sell become more commoditized andcompetition in the server appliance, data storage, network security and telecommarkets continues to increase, then our gross profit as a percentage of netrevenues may decrease and our operating results may suffer.**

 

Products and services in the server appliance, data storage, networksecurity and telecom markets may be subject to further commoditization asthese industries continue to mature and other businesses introduce additionalcompeting products and services.  Ourgross profit as a percentage of revenues for our products may decrease inresponse to changes in our product mix, competitive pricing pressures, or newproduct introductions into the server appliance, data storage, network securityand telecom markets.  If we are unable tooffset decreases in our gross profits as a percentage of revenues by increasingour sales volumes, or by decreasing our product costs, operating results willdecline.  Changes in the mix of sales ofour products, including the mix of higher margin products sold in smallerquantities and lower margin products sold in larger quantities, could adverselyaffect our operating results for future quarters.  To maintain our gross profits, we also mustcontinue to reduce the manufacturing cost of our server applianceproducts.  Our efforts to produce highermargin server appliance products, continue to improve our server applianceproducts and produce new server appliance products may make it difficultto reduce our manufacturing cost per product. Further, utilization of a contract manufacturer to produce a portion ofour customer requirements for certain of our server appliance productsmay not allow us to reduce our cost per product.  If we fail to respond adequately to pricingpressures, to competitive products with improved performance or to developmentswith respect to the other factors on which we compete, we could lose customersor orders.  If we are unable to competeeffectively, our business will suffer.

 

**Goodwill and other intangible assets represent a significantportion of our assets, and any impairment of goodwill or other intangibleassets would adversely impact our net income.**

 

AtMarch 31, 2008, we had goodwill and intangible assets of approximately$19.2 million, net of accumulated amortization. Our goodwill is subject to an annual impairment test, and both goodwilland other intangible assets are also tested whenever events and circumstancesindicate that they may be impaired.  Suchevents or conditions could include an economic downturn in our customers’industries, increased competition, or other information regarding our marketvalue, such as a reduction in our stock price to a price at or near the bookvalue of the Company for a period of time which could indicate a triggeringevent and a possible impairment of goodwill. Any excess goodwill resulting from the impairment test must be writtenoff in the period of determination.  Inaddition, we will continue to incur non-cash charges relating to theamortization of our intangible asset other than goodwill, over the remaininguseful lives of such asset.  Futuredeterminations of significant write-offs of goodwill or intangible assetsresulting from an impairment test or any accelerated amortization of intangibleassets could have a significant impact on our net income and affect our abilityto maintain profitability.  Although wedo not believe that any impairment of goodwill or other intangible assetsexists at this time, in the event that such a condition or event occurs, we mayrecord charges which could have a material adverse effect on our results ofoperations.

 

***Risks related to competition.***

 

**Competition in the server appliance market is significant and if we failto compete effectively, our financial results will suffer.**

 

In the server appliance market, we face significant competition from anumber of different types of companies. Our competitors include companies who market general-purpose servers,server virtualization software, specific-purpose servers and server appliancesas well as companies that sell custom integration services utilizing hardwareproduced by other companies.  Many ofthese companies are larger than we are 

 

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and have greater financialresources and name recognition than we do, as well as significant distributioncapabilities and larger, more established service organizations to supporttheir products.  Our larger competitorsmay be able to leverage their existing resources, including theirextensive distribution capabilities and service organizations, to provide awider offering of products and services and higher levels of support on a morecost-effective basis than we can.  Weexpect competition in the server appliance market to increase significantly asmore companies enter the market and as our existing competitors continue toimprove the performance of their current products and to introduce new productsand technologies.  Such increasedcompetition could adversely affect sales of our current and futureproducts.  In addition, competingcompanies may be able to undertake more extensive promotional activities,adopt more aggressive pricing policies and offer more attractive terms to theircustomers 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 the functionality of competing products is equivalent to ours,we face a risk that a significant number of customers would elect to pay apremium for similar functionality from an established vendor rather thanpurchase products from a less-established vendor.  We attempt to differentiate ourselves fromour competition by offering a wide variety of software integration, branding,supply-chain management, engineering, support, logistics and fulfillmentservices.  If we are unable toeffectively differentiate ourselves from our competition, we may be forcedto offer price reductions to maintain certain customers.  As a result, our revenues may notincrease and may decline, and our gross margins may decline.  Furthermore, increased competition could leadto higher selling expenses which would negatively affect our business andfuture operating results.

 

***Risks related to marketing and sales effortsand customer service.***

 

**We need to effectively manage our sales and marketing operations toincrease market awareness and sales of our products and to promote our brandrecognition.  If we fail to do so, ourgrowth will be limited.**

 

Although we currently have a relatively small sales and marketingorganization, we must continue to increase market awareness and sales of our productsand promote our brand in the marketplace. We believe that to compete successfully we will need network equipmentproviders, ISVs and telecom equipment manufacturers to recognize us as atop-tier provider of server appliance platforms and custom integrationservices.  If we are unable to increasemarket awareness and promote ourselves as a leading 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 we are unable to effectively manage our customer service and supportactivities, we may not be able to retain our existing customers or attractnew customers.**

 

We need to effectively manage our customer support operations to ensurethat we maintain good relationships with our customers.  We believe that providing a level of highquality customer support will be a key differentiator for our product offeringsand may require more technically qualified staff which could be morecostly.  If we are unable to provide thishigher level of service we may be unable to successfully attract andretain customers.

 

If our customer support organization is unsuccessful in maintaining goodcustomer relationships, we may lose customers to our competitors and ourreputation in the market could be damaged. As a result, we may lose revenues and our business couldsuffer.  Furthermore, the costs ofproviding this service could be higher than we expect, which could adverselyaffect our operating results.

 

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

 

**Our dependence on sole source and limited source suppliers for keyserver appliance components makes us susceptible to supply shortages andpotential quality issues that could prevent us from shipping customer orders ontime, or at all, and could result in lost sales and customers.**

 

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

 

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

 

Because server appliance solutions are complex, they could containerrors that can be detected at any point in a product’s life cycle.  If flaws in design, production, assembly ortesting of our products (by us or our suppliers) were to occur, we couldexperience a rate of failure in our products that could result in substantialrepair, replacement or service costs and potential damage to our reputation. In addition, because our solutions are combined with products from othervendors, should problems occur, it might be difficult to identify the source ofthe problem.  Continued improvement inmanufacturing capabilities, control of material and manufacturing quality andcosts, and product testing are critical factors in our future growth.  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, we have discovered errors in some of our server appliancesolutions and have experienced delays in the shipment of our server applianceproducts during the period required to correct these errors or we have had toreplace defective products that were already shipped.  Errors in our server appliance solutions may befound in the future and any of these errors could be significant.  Significant errors, including those discussedabove, may result in:

 

•                  the loss of or delay in marketacceptance and sales of our server appliance products;

 

•                  diversion of engineering resources;

 

•                  increased manufacturing costs;

 

•                  the loss of new or existing serverappliance customers;

 

•                  injury to our reputation and othercustomer relations problems; and

 

•                  increased maintenance and warrantycosts.

 

Any of these problems could harm our business and future operatingresults.  Product errors or delays couldbe material, including any product errors or delays associated with theintroduction of new products or versions of existing products.  If our server appliance solutions fail toconform to warranted specifications, customers could demand a refund forthe purchase price and assert claims for damages.

 

Moreover, because our server appliance solutions may be used inconnection with critical computing systems services, including providingsecurity to protect valuable information, we may receive significantliability claims if they do not work properly. While our agreements with customers typically contain provisionsintended to limit our exposure to liability claims, these limitations do notpreclude all potential claims.  Liabilityclaims could exceed our insurance coverage and require us to spend significanttime and 

 

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money in litigation or to paysignificant damages.  Any claims fordamages, even if unsuccessful, could seriously damage our reputation andbusiness.

 

**If we do not accurately forecast our server appliance materialsrequirements, our business and operating results could be adversely affected.**

 

We use rolling forecasts based on anticipated product orders to determineour server appliance component requirements. Lead times for materials and components that we order vary significantlydepending on variables such as specific supplier requirements, contract termsand current market demand for those components. In addition, a variety of factors, including the timing of productreleases, potential delays or cancellations of orders, the timing of largeorders and the unproven acceptance of new products in the market make itdifficult to predict product orders.  Asa result, our materials requirement forecasts may not be accurate.  If we overestimate our materialsrequirements, we may have excess inventory, which would increase costs andnegatively impact our cash position.  Ouragreements with certain customers provide us with protections related toinventory purchased in accordance with the terms of these agreements; however,these protections may not be sufficient to prevent certain losses as aresult of excess or obsolete inventory. If we underestimate our materials requirements, we may haveinadequate inventory, which could interrupt our manufacturing and delaydelivery of our server appliance products to customers, resulting in a loss ofsales or customers.  Any of these occurrenceswould negatively impact our business and operating results.

 

***Risks related to product dependence onintellectual property.***

 

**Our reliance upon contractual provisions, domestic patent, copyright andtrade secret laws and patent applications to protect our proprietary rightsmay not be sufficient to protect our intellectual property.**

 

Certain of our server appliance solutions are differentiated from theproducts of our competitors by our internally developed software and hardwareand the manner in which they are integrated into our server appliancesolutions.  If we fail to protect ourintellectual property, other vendors could sell products with features similarto ours, which could reduce demand for our solutions.  We have taken what we believe to be thenecessary and appropriate steps to safeguard our intellectual property.  However, these steps may afford us onlylimited protection.  Othersmay develop technologies that are similar or superior to our technology ordesign around the patents we own. Despite the precautions we have taken, laws and contractual restrictionsmay not be sufficient to prevent misappropriation of our technology ordeter others from developing similar technologies.  In addition, there can be no guarantee thatany of our patent applications will result in patents, or that any such patentswould provide effective protection of our technology.

 

In addition, the laws of the countries in which we may decide tomarket our services and solutions may offer little or no effectiveprotection of our proprietary technology. Reverse engineering, unauthorized copying or other misappropriation ofour proprietary technology could enable third parties to benefit from ourtechnology without paying us for it, which could harm our business.  In addition, our U.S. patents have no effectin foreign jurisdictions and obtaining patent protection in foreign countriesis expensive and time consuming.

 

**Our operating results would suffer if we, our ISV, telecom or networkequipment customers, or other third-party software providers from whom we licensetechnology, were subject to an infringement claim that resulted in protractedlitigation, the award of significant damages against us or the payment ofsubstantial ongoing royalties.**

 

Substantial litigation regarding intellectual property rights exists inthe technology industry.  We expect thatserver appliance products may be subject to third-party infringementclaims as the number of competitors in the industry segment grows and thefunctionality of products in different industry segments overlap.  In the past we have received claims fromthird parties that our server appliance products infringed their intellectualproperty rights.  We do not believe thatour server appliance products employ technology that infringes the proprietaryrights of any third parties.  We are alsonot aware of any claims made against any of our ISV, telecom, or networkequipment provider customers related to their infringement of the 

 

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proprietary rights of otherparties in relation to products that include our server applianceproducts.  Other parties may makeclaims against us that, with or without merit, could:

 

•                  be time consuming for us to address;

 

•                  require us to enter into royalty orlicensing agreements;

 

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

 

•                  divert our management’s attention andresources; and

 

•                  cause product shipment delays.

 

In addition, other parties may make claims against our ISV,telecom, or network equipment customers, or third-party software providersrelated to products that are incorporated into our server applianceproducts.  Our business could beadversely affected if such claims resulted in the inability of our customers tocontinue producing the infringing product, or if we are unable to costeffectively continue licensing the third-party software.

 

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

 

**If we fail to retain and attract appropriate levels of qualifiedemployees and members of senior management, we may not be able tosuccessfully execute our business strategy.**

 

Our success depends in large part on our ability to retain andattract highly skilled engineering, sales, marketing, customer service andmanagerial personnel.  If we are unableto attract a sufficient number of qualified personnel, particularly personnelknowledgeable in software engineering and product management, we may notbe able to meet key objectives such as developing, upgrading, or enhancing ourproducts in a timely manner, which could negatively impact our business andcould hinder any future growth.

 

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

 

Section 404 of the Sarbanes-Oxley Act of 2002 requires ourmanagement to report on, and our independent registered public accounting firmto attest to, the effectiveness of our internal control over financialreporting.  We have an ongoing program toperform the system and process evaluation and testing necessary to complywith these requirements.  As a result, wehave incurred increased expense and have devoted additional management resourcesto Section 404 compliance. Effective internal controls are necessary for us to provide reliablefinancial reports.  If we cannot providereliable financial reports, our business and operating results could be harmed.

 

**Class action lawsuits have been filed against us, our board ofdirectors, our former chairman and certain of our executive officers and otherlawsuits may be instituted against us from time to time.**

 

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

 

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stock and could result inmanagement devoting a substantial portion of their time to these lawsuits,which could adversely affect the operation of our business.

 

**If either of the sites of our manufacturing operations were toexperience a significant disruption in their operations, it would have amaterial adverse effect on our financial condition and results of ouroperations.**

 

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

 

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

 

The market price of our common stock has been subject to significantfluctuations and may continue to fluctuate or decline.  During fiscal 2007, the closing price of ourcommon stock ranged from a low of $1.73 to a high of $2.81, and during the sixmonths ended March 31, 2008, from a low of $1.36 to a high of $1.64.  The market for technology stocks has beenextremely volatile and frequently reaches levels that bear no relationship tothe past or present operating performance of those companies.  General 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 resultsmay be below the expectations of securities analysts and investors.  If this were to occur, the market price ofour common stock may decrease significantly.  In the past, following periods of volatilityin the market price of a company’s securities, securities class actionlitigation has often been instituted against such companies.  Such litigation could result in substantialcost and a diversion of management’s attention and resources.

 

Any decline in the market price of our common stock or negative marketconditions could adversely affect our ability to raise additional capital, tocomplete future acquisitions of or investments in other businesses and toattract and retain qualified technical and sales and marketing personnel.

 

**We have anti-takeover defenses that could delay or prevent anacquisition and could adversely affect the market price of our common stock.**

 

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

 

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

 

**ITEM4.     SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

Our Annual Meeting ofStockholders was held on March 13, 2008. Of the 44,008,612 shares outstanding as of January 18, 2008,37,115,053 (84.34%) were present or represented by proxy at the meeting.  The table below presents the voting resultsof the matters voted upon by our stockholders at the meeting:

 

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**ProposalI—Election of Directors:**

 
| **Nominee**            | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|------------------------|------------|--------------------|------------|-------------------------|------------|
| Fontaine K. Richardson |       | 34,083,992         |       | 3,031,061               |       |
| Gregory A. Shortell    |       | 34,057,490         |       | 3,057,563               |       |

 

Theterms of Gary E. Haroian, Dennis A. Kirshy, John A. Blaeser, Charles A. Foley,and Robert M. Wadsworth, as directors of the Company, continued after thismeeting.

 

**ProposalII—Ratification of the appointment of PricewaterhouseCoopers LLP as ourIndependent Registered Public Accounting Firm for the fiscal year ending September 30,2008:**

** **
| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Non Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|--------------------|------------|
| 36,575,756 |       | 424,731     |       | 114,566     |       | —             |       |

 

**Proposal III — To approve anamendment to increase the number of shares of common stock reserved forissuance under the 2000 Employee Stock Purchase Plan (the “Employee StockPurchase Plan”) from 1,500,000 to 1,850,000 shares:**

 
| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Non Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|--------------------|------------|
| 14,721,276 |       | 2,019,912   |       | 29,020      |       | 20,344,845         |       |

 

**ITEM 6.     EXHIBITS**

 

(a)    Exhibits

 

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

 

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**SIGNATURES**

 

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

 
|                   | **NETWORK  ENGINES, INC.** |
|------------------------|----------------------------|
|                   | ** **                 |
| Date: May 9, 2008 |                       | /s/ Gregory A. Shortell |
|                   |                       |   |
|                   |                       | Gregory A. Shortell |
|                   |                       | President and Chief  Executive Officer |
|                   |                       | (Principal Executive  Officer) |
|                   |                       |   |
|                   |                       |   |
|                   |                       | /s/ Douglas G. Bryant |
|                   |                       |   |
|                   |                       | Douglas G. Bryant |
|                   |                       | Chief Financial  Officer,   Treasurer and Secretary |
|                   |                       | (Principal Financial  Officer   and Principal |
|                   |                       | Accounting Officer) |

 

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**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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