##### **UNITED STATES**

##### **SECURITIES ANDEXCHANGE 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) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended December 31,2007**

 

###### **OR**

######  

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

 

**Forthe transition period from                      to**

 

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

######  

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**NETWORKENGINES, INC.**

(Exact name of registrant as specified in itscharter)

 

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

 

**(781) 332-1000**

(Registrant’s telephone number, including areacode)

 

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

 

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

 

Large accelerated filer oAccelerated filer x Non-acceleratedfiler o

 

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 February 6, 2008, there were 44,008,612 shares of theregistrant’s Common Stock, par value $.01 per share, outstanding.

 

 

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**NETWORK ENGINES, INC.**

 

**INDEX**

 
| ** **                                                                                          | ** ** | **PAGE   NUMBER** |
|-----------------------------------------------------------------------------------------------------|------------|-------------------|
|                                                                                                |       |              |
| **PART I.  FINANCIAL INFORMATION**                                                             | ** ** | ** **        |
|                                                                                                |       |              |
| ITEM 1.  FINANCIAL STATEMENTS (UNAUDITED)                                                           |       | 1                 |
|                                                                                                |       |              |
| CONDENSED  CONSOLIDATED BALANCE SHEETS                                                              |       | 1                 |
| CONDENSED  CONSOLIDATED STATEMENTS OF OPERATIONS                                                    |       | 2                 |
| CONDENSED  CONSOLIDATED STATEMENTS OF CASH FLOWS                                                    |       | 3                 |
| NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                                |       | 4                 |
|                                                                                                |       |              |
| ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF  RESULTS OF OPERATIONS AND FINANCIAL CONDITION |       | 13                |
|                                                                                                |       |              |
| ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISK                                 |       | 21                |
|                                                                                                |       |              |
| ITEM  4. CONTROLS AND PROCEDURES                                                                    |       | 21                |
|                                                                                                |       |              |
| **PART II.  OTHER INFORMATION**                                                                | ** ** | ** **        |
|                                                                                                |       |              |
| ITEM  1. LEGAL PROCEEDINGS                                                                          |       | 22                |
|                                                                                                |       |              |
| ITEM  1A. RISK FACTORS                                                                              |       | 23                |
|                                                                                                |       |              |
| ITEM 2. UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                |       | 33                |
|                                                                                                |       |              |
| ITEM 6.  EXHIBITS                                                                                   |       | 33                |
|                                                                                                |       |              |
| SIGNATURES                                                                                          |       | 34                |

 

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**PART I. FINANCIAL INFORMATION**

 

**ITEM I. FINANCIAL STATEMENTS**

 

**NETWORK ENGINES, INC.**

**CONDENSED CONSOLIDATED BALANCESHEETS**

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

**(unaudited)**

** **
| ** **                                                                                                                                                                                                          | ** ** | **December 31,  2007** | ** ** | **September 30,  2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                                                          | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| **ASSETS**                                                                                                                                                                                                          | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| **Current assets:**                                                                                                                                                                                                 | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| Cash and cash equivalents                                                                                                                                                                                           |       | $                           | 8,186      |                         | $          | 44,403 |   |
| Restricted cash                                                                                                                                                                                                     |       | 47                          |       | 247                          |       |
| Accounts receivable, net of allowances of  $338 and $32 at December 31 and September 30, 2007, respectively                                                                                               |       | 30,347                      |       | 17,511                       |       |
| Income tax receivable                                                                                                                                                                                               |       | 2,820                       |       | —                       |       |
| Inventories                                                                                                                                                                                                         |       | 25,553                      |       | 10,175                       |       |
| Prepaid expenses and other current assets                                                                                                                                                                           |       | 2,653                       |       | 1,077                        |       |
|                                                                                                                                                                                                                |       |                        |       |                         |       |
| Total current assets                                                                                                                                                                                                |       | 69,606                      |       | 73,413                       |       |
|                                                                                                                                                                                                                |       |                        |       |                         |       |
| Property and equipment, net                                                                                                                                                                                         |       | 2,228                       |       | 1,128                        |       |
| Intangible assets, net                                                                                                                                                                                              |       | 11,355                      |       | —                       |       |
| Goodwill                                                                                                                                                                                                            |       | 8,210                       |       | —                       |       |
| Contingently returnable acquisition  consideration                                                                                                                                                                  |       | 4,220                       |       | —                       |       |
| Other assets                                                                                                                                                                                                        |       | 266                         |       | 281                          |       |
|                                                                                                                                                                                                                |       |                        |       |                         |       |
| Total assets                                                                                                                                                                                                        |       | $                           | 95,885     |                         | $          | 74,822 |   |
|                                                                                                                                                                                                                |       |                        |       |                         |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                       | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| **Current liabilities:**                                                                                                                                                                                            | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| Accounts payable                                                                                                                                                                                                    |       | $                           | 17,067     |                         | $          | 10,189 |   |
| Accrued compensation and other related  benefits                                                                                                                                                                    |       | 2,931                       |       | 1,773                        |       |
| Accrued warranty                                                                                                                                                                                                    |       | 1,017                       |       | 1,046                        |       |
| Other accrued expenses                                                                                                                                                                                              |       | 3,235                       |       | 2,182                        |       |
| Deferred revenue                                                                                                                                                                                                    |       | 5,735                       |       | 2,839                        |       |
|                                                                                                                                                                                                                |       |                        |       |                         |       |
| Total current liabilities                                                                                                                                                                                           |       | 29,985                      |       | 18,029                       |       |
|                                                                                                                                                                                                                |       |                        |       |                         |       |
| Deferred revenue, net of current portion                                                                                                                                                                            |       | 2,456                       |       | 1,285                        |       |
|                                                                                                                                                                                                                |       |                        |       |                         |       |
| Total liabilities                                                                                                                                                                                                   |       | 32,441                      |       | 19,314                       |       |
|                                                                                                                                                                                                                |       |                        |       |                         |       |
| Commitments and contingencies (Note 7)                                                                                                                                                                              |       |                        |       |                         |       |
| ** **                                                                                                                                                                                                          | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| **Stockholders’ equity:**                                                                                                                                                                                      | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| Preferred stock, $.01 par value, 5,000,000  authorized, and no shares issued and outstanding                                                                                                                        | ** ** | **—**                  | ** ** | **—**                   | ** ** |
| Common stock, $.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 December 31 and September 30,  2007, respectively |       | 465                         |       | 436                          |       |
| Additional paid-in capital                                                                                                                                                                                          |       | 193,671                     |       | 187,005                      |       |
| Accumulated deficit                                                                                                                                                                                                 |       | (127,854                    | )          | (129,095                     | )          |
| Treasury stock, at cost, 2,561,858 shares at  December 31 and September 30, 2007, respectively                                                                                                            |       | (2,838                      | )          | (2,838                       | )          |
| Total stockholders’ equity                                                                                                                                                                                     |       | 63,444                      |       | 55,508                       |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                     |       | $                           | 95,885     |                         | $          | 74,822 |   |

** **

**The accompanying notes are an integral part of thecondensed 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   December 31,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                    | ** ** | **2007**                                                  | ** ** | **2006** | ** ** |
| ** **                                                    | ** ** | ** **                                                | ** ** | ** ** | ** ** |
| Net revenues                                                  |       | $                                                         | 54,340     |   | $ | 27,238 |   |
|                                                          |       |                                                      |       |   |   |
| Cost of revenues                                              |       | 44,600                                                    |       | 22,005 |   |
|                                                          |       |                                                      |       |   |   |
| Gross profit                                                  |       | 9,740                                                     |       | 5,233 |   |
|                                                          |       |                                                      |       |   |   |
| Operating expenses:                                           |       |                                                      |       |   |   |
| Research and development                                      |       | 2,370                                                     |       | 1,993 |   |
| Selling and marketing                                         |       | 3,117                                                     |       | 1,730 |   |
| General and administrative                                    |       | 2,645                                                     |       | 2,061 |   |
| Amortization of intangible assets                             |       | 420                                                       |       | — |   |
|                                                          |       |                                                      |       |   |   |
| Total operating expenses                                      |       | 8,552                                                     |       | 5,784 |   |
|                                                          |       |                                                      |       |   |   |
| Income (loss) from operations                                 |       | 1,188                                                     |       | (551 | ) |
| Interest and other income, net                                |       | 124                                                       |       | 447 |   |
|                                                          |       |                                                      |       |   |   |
| Income (loss)  before income taxes                            |       | 1,312                                                     |       | (104 | ) |
| Provision for  income taxes                                   |       | 71                                                        |       | 10 |   |
|                                                          |       |                                                      |       |   |   |
| Net income (loss)                                             |       | $                                                         | 1,241      |   | $ | (114 | ) |
|                                                          |       |                                                      |       |   |   |
| Net income (loss) per share – basic and  diluted         |       | $                                                         | 0.03       |   | $ | — |   |
|                                                          |       |                                                      |       |   |   |
| Shares used in computing basic net income  (loss) per share   |       | 43,656                                                    |       | 39,947 |   |
| Shares used in computing diluted net income  (loss) per share |       | 44,021                                                    |       | 39,947 |   |

** **

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

 

2

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**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(inthousands)**

**(unaudited)**

** **
| ** **                                                                                          | ** ** | **Three months ended   December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2007**                                                  | ** ** | **2006** | ** ** |
|                                                                                                |       |                                                      |       |   |   |
| Cash flows from operating activities:                                                               |       |                                                      |       |   |   |
| Net income (loss)                                                                                   |       | $                                                         | 1,241      |   | $ | (114 | ) |
| Adjustments to reconcile net income (loss)  to net cash (used in) provided by operating activities: |       |                                                      |       |   |   |
| Depreciation and amortization                                                                       |       | 773                                                       |       | 204 |   |
| Provision for doubtful accounts                                                                     |       | 89                                                        |       | (11 | ) |
| Stock-based compensation                                                                            |       | 587                                                       |       | 614 |   |
| Changes in operating assets and liabilities,  net of effects of acquisition:                        |       |                                                      |       |   |   |
| Accounts receivable                                                                                 |       | 540                                                       |       | 4,860 |   |
| Inventories                                                                                         |       | (2,563                                                    | )          | (2,612 | ) |
| Prepaid expenses and other current assets                                                           |       | (644                                                      | )          | 572 |   |
| Accounts payable                                                                                    |       | (1,079                                                    | )          | 1,598 |   |
| Accrued expenses                                                                                    |       | (2,567                                                    | )          | (392 | ) |
| Deferred revenue                                                                                    |       | 880                                                       |       | (48 | ) |
|                                                                                                |       |                                                      |       |   |   |
| Net cash (used in) provided by operating  activities                                                |       | (2,743                                                    | )          | 4,671 |   |
|                                                                                                |       |                                                      |       |   |   |
| Cash flows from investing activities:                                                               |       |                                                      |       |   |   |
| Acquisition, net of cash assumed                                                                    |       | (29,413                                                   | )          | — |   |
| Contingently returnable acquisition payment                                                         |       | (4,220                                                    | )          | — |   |
| Purchases of property and equipment                                                                 |       | (62                                                       | )          | (197 | ) |
| Purchases of short-term investments                                                                 |       | —                                                    |       | (7,102 | ) |
| Proceeds from sales and maturities of  short-term investments                                       |       | —                                                    |       | 3,750 |   |
| Changes in other assets                                                                             |       | 140                                                       |       | (7 | ) |
|                                                                                                |       |                                                      |       |   |   |
| Net cash used in investing activities                                                               |       | (33,555                                                   | )          | (3,556 | ) |
|                                                                                                |       |                                                      |       |   |   |
| Cash flows from financing activities:                                                               |       |                                                      |       |   |   |
| Proceeds from issuance of common stock                                                              |       | 115                                                       |       | 1,609 |   |
| Payments on capital lease obligation                                                                |       | (5                                                        | )          | (5 | ) |
|                                                                                                |       |                                                      |       |   |   |
| Net cash provided by financing activities                                                           |       | 110                                                       |       | 1,604 |   |
|                                                                                                |       |                                                      |       |   |   |
| Effect of exchange rate differences on cash                                                         |       | (29                                                       | )          | — |   |
| Net (decrease) increase in cash and cash  equivalents                                               |       | (36,217                                                   | )          | 2,719 |   |
| Cash and cash equivalents, beginning of  period                                                     |       | 44,403                                                    |       | 8,014 |   |
|                                                                                                |       |                                                      |       |   |   |
| Cash and cash equivalents, end of period                                                            |       | $                                                         | 8,186      |   | $ | 10,733 |   |

 

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

 

3

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**Continued**

 

**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”). Certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with generally acceptedaccounting principles have been condensed or omitted pursuant to such rules andregulations. The year-end condensed balance sheet data was derived from auditedfinancial statements, but does not include all year-end disclosures required byaccounting principles generally accepted in the United States of America.  These financial statements should be read inconjunction with the audited financial statements and the accompanying notesincluded in the Company’s 2007 Annual Report on Form 10-K (the “2007 Form 10-K”)filed by the Company with the Securities and Exchange Commission.

 

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

 

Thepreparation of these condensed consolidated financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosures of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period. The most significant estimates reflected inthese financial statements include allowance for doubtful accounts, inventoryvaluation, valuation of deferred tax assets, valuation of intangible assets,warranty reserves and stock-based compensation. Actual results could differfrom 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.  This Statement is effective asof the beginning of the Company’s fiscal year that begins after November 15,2008 for certain non financial assets and liabilities and November 15,2007 for other assets and liabilities. The Company is in the process of evaluating whether the adoption of thisstatement will have a material impact on the Company’s financial position,results of operations or cash flows.

 

In February 2007, FASB issued Statement ofFinancial Accounting Standard No. 159, “The Fair Value Option forFinancial Assets and Financial Liabilities — Including an amendment of FASBStatement No. 115” (“FAS 159”).  This Statement permits entities tochoose to measure many financial instruments and certain other items at fairvalue at specified election dates. Subsequent unrealized gains and losses onitems for which the fair value option has been elected will be reported inearnings. This Statement is effective as of the beginning of the Company’sfiscal year that begins after November 15, 2007.  The Company is inthe process of evaluating whether the adoption of FAS 159 will have a materialeffect on the Company’s financial position, results of operations, or cashflows.

 

In December 2007, the SEC issued StaffAccounting Bulletin 110 (“SAB 110”).  SAB110 allows companies, under certain circumstances to continue using asimplified method to calculate the expected term relating to the valuation ofstock options under the Black Scholes method. SAB 110 becomes effective for any option grants issued after January 1,2008.  The Company is in the process of evaluatingwhether SAB 110 will have a material effect on the financial position, resultsof operations and cash flows of the Company.

 

4

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**Continued**

 

InDecember 2007, 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. This Statement establishes principles and requirements for how theacquirer recognizes and measures in its financial statements the identifiableassets acquired,the liabilities assumed, and any noncontrolling interest in the acquiree, recognizes andmeasures the goodwill acquired in the business combination or a gain from abargain purchase and determines what information to disclose to enable users ofthe financial statements to evaluate the nature and financial effects of thebusiness combination.  This Statement iseffective for business combinations on a prospective basis for which theacquisition date is on or after the beginning of the first annualreporting period beginning on or after December 15, 2008.  The adoption of will not have a materialimpact on the Company’s financial position, results of operations or cash flows

 

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

 

    TheCompany has an unrecognized tax benefit of approximately $540,000 related tothe validity of certain credits.   Asdiscussed in Note 12 to the consolidated financial statements in the 2007 Form 10-K,the Company has a valuation allowance against the full amount of its netdeferred tax asset.  The Companycurrently provides a valuation allowance against deferred tax assets when it ismore likely than not that some portion, or all of its deferred tax assets, willnot be realized.  Because the Company hasa full valuation allowance against its deferred tax assets, the adoption of FIN48 had no impact on the Company’s retained earnings or 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 2007are still subject to examination. Various state and foreign jurisdiction taxyears remain open to examination as well, though the Company believes anyadditional assessment will be immaterial to its consolidated financialstatements.

 

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

#### *** ***

The Company did not have any cash equivalents as of December 31,2007.  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 December 31, 2007 and September 30,2007, $47,000 and $247,000, respectively, of cash was restricted and pledged ascollateral for letters of credit. Details of the Company’s cash, cash equivalents and short-terminvestments are as follows (in thousands):

 
| ** **                          | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                          | ** ** | **2007**              | ** ** | **2007**               | ** ** |
| **Cash and cash equivalents:**      |       |                  |       |                   |       |
| Cash                                |       | $                     | 8,186      |                   | $          | 3,836 |   |
| Money market funds                  |       | —                |       | 37,941                 |       |
| Commercial paper                    |       | —                |       | 2,626                  |       |
|                                |       |                  |       |                   |       |
| **Total cash and cash equivalents** |       | $                     | 8,186      |                   | $          | 44,403 |   |

 

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

#### *** ***

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

 

5

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**Continued**

 

***Significant Customers***

 

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

 
| ** **     | ** ** | **Net Revenues for the three   months ended December 31,** | ** ** | **Accounts Receivable at December 31,  September 30,** | ** ** |
|----------------|------------|----------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **     | ** ** | **2007**                                                                                           | ** ** | **2006**                                                                   | ** ** | **2007** | ** ** | **2007** | ** ** |
| Customer A     |       | 38                                                                                                 | %          | 82                                                                         | %          | 28 | % | 81 | % |
| Customer B (1) |       | 13                                                                                                 | %          | 0                                                                          | %          | 15 | % | 0 | % |

 

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 (1) Customer B became a customer as aresult of the Company’s acquisition of Alliance Systems, 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 fully diluted equity of Alliance Systems, Inc.(“Alliance Systems”), a privately held corporation located in Plano, Texas, andprovider of server appliances and computer infrastructure supportingtelecommunications and enterprise communications solutions. The aggregatepurchase price of approximately $40,879,000 was funded through a cash paymentof $32,820,000 and the issuance of 2.9 million shares of the Company’s commonstock valued at approximately $5,994,000, which was based on the average marketprice of the Company’s common stock over the period of two days before andafter the terms of the acquisition were announced.  The Company also incurred fees and expensesof approximately $1,071,000, and approximately $994,000 related to certain exitactivities of the acquired business. The Company’s cash payment includedrepayment of Alliance Systems’ working capital line of credit of approximately$6.8 million, and $800,000 due under a note payable to Alliance Systems’majority stockholder.

 

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 $4.2 million of the cash paid iscontingently returnable to the Company upon resolution of this provision.  As a result, the amount of contingentlyreturnable consideration has been excluded from the allocation of the purchaseprice to the net assets acquired until such time that this amount is no longercontingently returnable.

 

6

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**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**Continued**

 

The components of thepurchase price allocation for Alliance Systems, Inc. are as follows (inthousands):

 
| **Net assets acquired** | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------|------------|
| Cash                              |       | $          | 362        |   |
| Accounts receivable               |       | 13,439     |       |
| 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                          |       | 8,210      |       |
| Other assets                      |       | 127        |       |
| Accounts payable                  |       | (7,836     | )          |
| Income tax payable                |       | (127       | )          |
| Deferred tax liability            |       | (5,170     | )          |
| Other accrued expenses            |       | (4,041     | )          |
| Deferred revenue                  |       | (3,180     | )          |
|                              |       |       |       |
| **Total net assets acquired**     |       | $          | 36,659     |   |

 

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 was nontaxable, resulted in the Companyrecording deferred tax liabilities of $5,170,000 related to the differencesbetween the financial statement and the tax bases of the acquired assets andliabilities.  As a result of the recordeddeferred tax liabilities, the Company determined it would more-likely-than-notrealize the tax benefits from certain of its historical deferred tax assets, andtherefore reduced its valuation allowance accordingly.  Substantially all of the goodwill recordedwill not be deductible for tax purposes, however, fees and expenses incurred bythe Company will result in tax 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.

 

The Company is in the process of executingcertain restructuring activities with respect to portions of the acquiredbusiness. These activities, which were accounted for in accordance withEmerging Issues Task Force Issue (EITF) No. 95-3, “Recognition ofLiabilities in Connection with a Purchase Business Combination,” (“EITF No. 95-3”)primarily consist of severance costs for reductions in staffing levels and thedisposition 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 EITF No. 95-3,upon finalization of the exit plans or settlement of the estimated obligationsfor less than the expected amount, any excess will result in a correspondingdecrease in goodwill.

 

The changes in accrued acquisition expensesfor the acquisition of Alliance Systems are as follows (in thousands):

 
| ** **                        | ** ** | **Severance** | ** ** | **Disposition   of subsidiary** | ** ** | **Total** | ** ** |
|-----------------------------------|------------|---------------|------------|-------------------------------------------|------------|-----------|------------|
| Accruals established              |       | $             | 548        |                                      | $          | 446       |       | $ | 994 |   |
| Payments                          |       | 106           |       | —                                    |       | 106       |       |
| Balance at December 31, 2007 |       | $             | 442        |                                      | $          | 446       |       | $ | 888 |   |

 

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 relate to state tax filing requirements. This liability,which included an estimate for interest and penalties, was based on the knownfacts at the time of the purchase price allocation.

 

7

----

 

**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**Continued**

 

TheCompany’s condensed consolidated financial statements include Alliance Systems’operating results from the date of acquisition. The following unaudited proforma information presents a summary of consolidated results of operations ofthe Company and Alliance Systems as if the acquisition had occurred at thebeginning of each period, with pro forma adjustments to give effect toamortization of intangible assets, and certain other adjustments together withrelated tax effects (in thousands, except per share amounts):

 
| ** **                                   | ** ** | **Three months ended   December 31, 2007** | ** ** | **Three months ended   December 31, 2006** | ** ** |
|----------------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| Revenues                                     |       | $                                                                   | 56,627     |                                                                | $          | 54,453 |   |
|                                         |       |                                                                |       |                                                                |       |
| Income (loss) from continuing operations (a) |       | $                                                                   | 1,459      |                                                                | $          | (125 | ) |
|                                         |       |                                                                |       |                                                                |       |
| Net income (loss)                            |       | $                                                                   | 1,459      |                                                                | $          | (220 | ) |
|                                         |       |                                                                |       |                                                                |       |
| Earnings per share                           |       |                                                                |       |                                                                |       |
| Basic                                        |       | $                                                                   | 0.03       |                                                                | $          | (0.01 | ) |
| Diluted                                      |       | $                                                                   | 0.03       |                                                                | $          | (0.01 | ) |

 

----

(a) Includes$388,000 of additional costs related to the fair value adjustment of inventoryand $485,000 of amortization of intangible assets in each of the periodspresented.

 

**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 December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                       | ** ** | **2007**                                                | ** ** | **2006** | ** ** |
| ** **                       | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Cost of revenues                 |       | $                                                       | 54         |   | $ | 40 |   |
| Research and development         |       | 250                                                     |       | 280 |   |
| Selling and marketing            |       | 95                                                      |       | 100 |   |
| General and administrative       |       | 188                                                     |       | 192 |   |
| Stock-based compensation expense |       | $                                                       | 587        |   | $ | 612 |   |

 

TheCompany estimates the fair value of stock options using the Black-Scholesvaluation model. This valuation model takes into account the exercise price ofthe award, as well as a variety of significant assumptions. These assumptionsinclude the expected term, the expected volatility of the Company’s stock overthe expected term, the risk-free interest rate over the expected term, and theCompany’s expected annual dividend yield. The Company believes that thevaluation technique and the approach utilized to develop the underlying assumptionsare appropriate in calculating the fair values of the Company’s stock optionsgranted in the three months ended December 31, 2007 and 2006. Estimates offair value are not intended to predict the value ultimately realized by personswho receive equity awards. In determining the amount of expense to be recorded,judgment is also required to estimate forfeitures of the awards based on theprobability of employees completing the required service period.  Historical forfeitures are used as a starting point for developing the estimateof future forfeitures.

 

8

----

 

**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**Continued**

 

Assumptions used to determine the fair value of options granted duringthe three months ended December 31, 2007 and 2006, using the Black-Scholesvaluation model were:

 
| ** **                     | ** ** | **Three Months Ended December 31,** | ** ** |
|--------------------------------|------------|---------------------------------------------------------|------------|
| ** **                     | ** ** | **2007**                                                | ** ** | **2006** | ** ** |
|                           |       |                                                    |       |   |   |
| Expected term(1)               |       | 6.06 to 6.25 years                                      |       | 6.06 to 6.25 years |   |
| Expected volatility factor(2)  |       | 59.05                                                   | %          | 72.67 | % |
| Risk-free interest rate(3)     |       | 4.13                                                    | %          | 4.65 | % |
| Expected annual dividend yield |       | —                                                  |       | — |   |

 

----

| (1)    |   | 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 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 compensationexpense related to the Company’s Employee Stock Purchase Plan was determinedbased on the discount of 15% from the per share market price on the close ofthe purchase period.

 

A summary of the Company’s stock option activity for the three monthsended December 31, 2007 is as follows:

 
| ** **                            | ** ** | **Three months ended December 31, 2007** | ** ** |
|---------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                            | ** ** | **Number of   Options**                                 | ** ** | **Weighted   Average   Exercise Price** | ** ** | **Weighted   Average   Remaining   Contractual   Term (in   years)** | ** ** |
|                                  |       |                                                              |       |   |   |   |   |
| Outstanding, September 30, 2007  |       | 6,091,355                                                         |       | $ | 2.51 |   |   |   |
| Granted                               |       | 2,394,500                                                         |       | 1.92 |   |   |   |
| Exercised                             |       | (9,187                                                            | )          | 1.75 |   |   |   |
| Forfeited                             |       | (226,621                                                          | )          | 2.05 |   |   |   |
| Expired                               |       | (55,508                                                           | )          | 3.74 |   |   |   |
| Outstanding, December 31, 2007   |       | 8,194,539                                                         |       | $ | 2.34 |   | 7.78 |   |
| Exercisable at December 31, 2007 |       | 3,588,669                                                         |       | $ | 2.94 |   | 6.20 |   |

 

All options granted during the three months ended December 31, 2007were granted with exercise prices equal to the fair market value of the Company’scommon stock on the grant date and had weighted average grant date fair valueof $1.14.

 

At December 31, 2007, unrecognized compensation expense related tonon-vested stock options was $3,721,000 which is expected to be recognized overa weighted average period of 3 years.

 

9

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** **

**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**Continued**

** **

**5.  Net Income (Loss) per share**

** **

Basic net income (loss) pershare is computed by dividing the net income (loss) for the period by theweighted average number of shares of common stock outstanding during theperiod. Diluted net income (loss) per share is computed by dividing the netincome (loss) for the period by the weighted average number of shares of commonstock and potential common stock outstanding during the period, if dilutive.Potential common stock includes incremental shares of common stock issuableupon the exercise of stock options.

 

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

 
| ** **                                                                                                       | ** ** | **Three months ended   December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2007**                                                  | ** ** | **2006** | ** ** |
| Numerator:                                                                                                       |       |                                                      |       |   |   |
| Net income (loss)                                                                                                |       | $                                                         | 1,241      |   | $ | (114 | ) |
|                                                                                                             |       |                                                      |       |   |   |
| Denominator:                                                                                                     |       |                                                      |       |   |   |
| Shares used in computing basic net income  (loss) per share                                                      |       | 43,656                                                    |       | 39,947 |   |
| Common stock equivalents from employee stock  options                                                            |       | 365                                                       |       | — |   |
|                                                                                                             |       |                                                      |       |   |   |
| Shares used in computing diluted net income  (loss) per share                                                    |       | 44,021                                                    |       | 39,947 |   |
|                                                                                                             |       |                                                      |       |   |   |
| Net income (loss) per share:                                                                                     |       |                                                      |       |   |   |
| Basic                                                                                                            |       | $                                                         | 0.03       |   | $ | — |   |
| Diluted                                                                                                          |       | $                                                         | 0.03       |   | $ | — |   |
|                                                                                                             |       |                                                      |       |   |   |
| Anti-dilutive potential common stock  equivalents excluded  from the calculation of net income (loss) per share: |       |                                                      |       |   |   |
| Options to purchase common stock                                                                                 |       | 6,547                                                     |       | 4,137 |   |

 

**6.  Inventories**

 

Inventories consisted of the following (inthousands):

 
| ** **      | ** ** | **December 31, 2007** | ** ** | **September 30, 2007** | ** ** |
|-----------------|------------|---------------------------------|------------|----------------------------------|------------|
| ** **      | ** ** | ** **                      | ** ** | ** **                       | ** ** |
| Raw materials   |       | $                               | 16,070     |                             | $          | 5,764 |   |
| Work in process |       | 1,008                           |       | 445                              |       |
| Finished goods  |       | 8,475                           |       | 3,966                            |       |
|            |       |                            |       |                             |       |
|            |       | $                               | 25,553     |                             | $          | 10,175 |   |

 

10

----

 

**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**Continued**

 

**7.  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. While the provisions of the agreements remain in effect indefinitely,the Company believes that the probability of receiving a claim is unlikely.  As a result, the Company has not recorded aliability for these indemnification clauses as of December 31, 2007.

 

The Company enters into standard indemnification agreements in theordinary course of its business. Pursuant to these agreements, the Companyindemnifies, holds harmless, and agrees to reimburse the indemnified party forlosses suffered or incurred by the indemnified party, generally its businesspartners or customers, in connection with any patent, copyright, trademark,trade secret or other intellectual property infringement claim by any thirdparty with respect to its products. The term of these indemnificationagreements is generally perpetual. The Company has never incurred costs todefend lawsuits or settle claims related to these indemnification agreements.As a result, the Company believes the estimated fair value of these agreementsis minimal. Accordingly, the Company has no liabilities recorded for theseindemnifications as of December 31, 2007.

 

Product warranties – The Company offers and fulfills warranty services on certain of itsserver appliances. Warranty terms vary in duration depending upon the productsold but generally provide for the repair or replacement of any defectiveproducts for periods of up to 36 months after shipment. Based upon historicalexperience and expectation of future conditions, the Company reserves for theestimated costs to fulfill customer warranty obligations upon the recognitionof the related revenue. The following table presents changes in the Company’sproduct warranty liability for the three months ended December 31, 2007and 2006 (in thousands):

 
| ** **                                  | ** ** | **Three months ended   December 31,** | ** ** |
|---------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                  | ** ** | **2007**                                                  | ** ** | **2006** | ** ** |
|                                        |       |                                                      |       |   |   |
| Beginning balance                           |       | $                                                         | 1,046      |   | $ | 559 |   |
| Acquisitions                                |       | 70                                                        |       | — |   |
| Accruals for warranties issued              |       | 520                                                       |       | 321 |   |
| Fulfillment of warranties during the period |       | (619                                                      | )          | (178 | ) |
| Ending balance                              |       | $                                                         | 1,017      |   | $ | 702 |   |

 

***Contingencies***

 

*Initial Public Offering Lawsuit*

 

On or about December 3, 2001, a putativeclass action lawsuit was filed in the United States District Court for theSouthern District of New York against the Company, Lawrence A. Genovesi (theCompany’s Chairman and former Chief Executive Officer), Douglas G. Bryant (theCompany’s Chief Financial Officer and Vice President of Finance andAdministration), and the following underwriters of the Company’s initial publicoffering: FleetBoston Robertson Stephens Inc., Credit Suisse First BostonCorp., Goldman Sachs & Co., Lehman Brothers Inc. and Salomon SmithBarney, Inc. (collectively, the “Underwriter Defendants”). An amendedclass action complaint, captioned In re Network Engines, Inc. InitialPublic Offering Securities Litigation, 01 Civ. 10894 (SAS), was filed on April 20,2002.

 

11

----

 

**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**Continued**

 

The suit alleges that the defendants violated thefederal securities laws by issuing and selling securities pursuant to theCompany’s initial public offering in July 2000 (“IPO”) without disclosingto investors that the Underwriter Defendants had solicited and receivedexcessive and undisclosed commissions from certain investors. The suit alsoalleges that the Underwriter Defendants entered into agreements with certaincustomers whereby the Underwriter Defendants agreed to allocate to those customersshares of the Company’s common stock in the offering, in exchange for which thecustomers agreed to purchase additional shares of the Company’s common stock inthe aftermarket at pre-determined prices. The suit alleges that such tie-inarrangements were designed to and did maintain, distort and/or inflate theprice of the Company’s common stock in the aftermarket. The suit furtheralleges that the Underwriter Defendants received undisclosed and excessivebrokerage commissions and that, as a consequence, the Underwriter Defendantssuccessfully increased investor interest in the manipulated IPO securities andincreased the Underwriter Defendants’ individual and collective underwritings,compensation and revenues. The suit seeks damages and certification of aplaintiff class consisting of all persons who acquired shares of the Company’scommon stock between July 13, 2000 and December 6, 2000.

 

In July 2002, the Company, Lawrence A.Genovesi and Douglas G. Bryant joined in an omnibus motion to dismiss the suitchallenging the legal sufficiency of plaintiffs’ claims. The motion was filedon behalf of hundreds of issuer and individual defendants named in similarlawsuits. Plaintiffs opposed the motion, and the Court heard oral argument onthe motion in November 2002. On February 19, 2003, the Court issuedan opinion and order denying the motion as to the Company. However, in October 2002,Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this casewithout prejudice.

 

On July 9, 2003, a Special Committee of theCompany’s Board of Directors authorized the Company to negotiate a settlementof the pending claims substantially consistent with a memorandum ofunderstanding negotiated among class plaintiffs, all issuer defendants andtheir insurers.  The parties have negotiated the settlement, whichprovides, among other things, for a release of the Company and the individualdefendants for the conduct alleged in the amended complaint to bewrongful.  The Company would agree to undertake other responsibilitiesunder the settlement, including agreeing to assign, or not assert, certainpotential claims that it may have against its underwriters.  Any directfinancial impact of the proposed settlement is expected to be borne by theCompany’s insurers.  Any such settlement would be subject to variouscontingencies, including approval by the Court overseeing the litigation. On February 15,2005, the Court issued an Opinion and Order preliminarily approving thesettlement, provided that the defendants and plaintiffs agree to amodification narrowing the scope of the bar order set forth in the originalsettlement agreement.  The parties agreed to a modification narrowing thescope of the bar order, and on August 31, 2005, the Court issued an orderpreliminarily approving the settlement and setting a public hearing on itsfairness, which took place on April 24, 2006.  On December 5,2006, the United States Court of Appeals for the Second Circuit overturned theDistrict Court’s certification of the class of plaintiffs who are pursuing theclaims that would be settled in the settlement against the underwriterdefendants. Thereafter, the District Court ordered a stay of all proceedings inall of the lawsuits pending the outcome of plaintiffs’ petition to the SecondCircuit for rehearing en banc and resolution of the class certificationissue.  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.  On June 25, 2007, theDistrict Court signed an order terminating the settlement. The Company isunable to predict the outcome of this suit and as a result, no amounts havebeen accrued as of December 31, 2007.

 

**8. Lineof Credit**

 

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

 

12

----

 

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

 

**Special NoteRegarding Forward-Looking Statements**

** **

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

 

The following discussion and analysis shouldbe read in conjunction with the condensed consolidated financial statements andthe notes thereto included in Item 1 in this Quarterly Report on Form 10-Qand the Company’s (“we”, “our”, or “us”) Annual Report on Form 10-K forthe fiscal year ended September 30, 2007 filed by us with the SEC.

 

**Overview**

** **

            We develop and manufacture server appliance solutionsthat deliver software applications on server appliances. Currently, a largeportion of our revenues is derived from the sale of server appliances tocustomers in the data storage, network security, telecommunications andenterprise 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 deployment is intended to reduce the total cost ofownership associated with the deployment and ongoing maintenance of softwareapplications within a customer’s IT infrastructure

 

            As mentionedpreviously in our 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 December 31,2007, including any related allowances, such as allowance for doubtful accountsand allowance for sales returns.

 

**Critical Accounting Policies and Estimates**

 

Our discussion and analysis of financial condition and results ofoperations are based upon our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States of America. In preparing these financial statements, we havemade estimates and judgments in determining certain amounts included in thefinancial statements. We base our estimates and judgments on historicalexperience and other various assumptions that we believe to be reasonable underthe circumstances. Actual results may differ from these estimates underdifferent assumptions or conditions. Other than adding our goodwill and longlived assets policy, there were no other changes to our critical accountingpolicies since September 30, 2007.

 

*Goodwill and long lived assets*

 

Goodwillrepresents the excess purchase price over the fair value of the net tangibleand intangible assets acquired. We review long-lived assets, including definitelived intangible assets, to determine if any adverse conditions exist that wouldindicate impairment. Conditions that would trigger a more frequent impairmentassessment include, but are not limited to, a significant adverse change incertain agreements, or business climate that could affect the value of anasset. We assess the recoverability of long-lived assets 

 

13

----

 

based on the projectedundiscounted future cash flows over the asset’s remaining life. The amount ofimpairment, if any, is measured based on the excess of the carrying value overfair value. Fair value is generally calculated as the present value ofestimated future cash flows using a risk-adjusted discount rate, which requiressignificant management judgment with respect to revenue and expense growthrates, and the selection and use of an appropriate discount rate.

 

Goodwill isreviewed each year in the fourth quarter for impairment, or more frequently ifcertain indicators are present. Examples of such indicators that would cause usto test goodwill for impairment between annual tests include, but are notlimited to a significant adverse change in the business climate, unanticipatedcompetition, or a loss of key personnel. When conducting our impairmentevaluation, we compare the carrying value of the reporting unit to the fairvalue of the reporting unit. If the carrying amount of the reporting unitexceeds its fair value, then the carrying value of that reporting unit’sgoodwill is compared to the implied fair value of the goodwill and animpairment loss is recorded in an amount equal to that excess, if any. Fairvalue is calculated as the present value of estimated future cash flows using arisk-adjusted discount rate, and includes significant judgments by management.

 

**Results of Operations**

 

**Three months ended December 31, 2007 compared to the three monthsended December 31, 2006**

 

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 December 31,** | ** ** |
|-------------------------------|------------|---------------------------------------------------------|------------|
| ** **                    | ** ** | **2007**                                                | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                    | ** ** | **Dollars**                                             | ** ** | **% of Net   Revenues** | ** ** | **Dollars** | ** ** | **% of Net   Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues                  |       | $                                                       | 54,340     |   | 100.0 | % | $ | 27,238 |   | 100.0 | % | $ | 27,102 |   | 100.0 | % |
| Gross profit                  |       | 9,740                                                   |       | 17.9 | % | 5,233 |   | 19.2 | % | 4,507 |   | 86.1 | % |
| Operating expenses            |       | 8,552                                                   |       | 15.7 | % | 5,784 |   | 21.2 | % | 2,768 |   | 47.9 | % |
| Income (loss) from operations |       | 1,188                                                   |       | 2.2 | % | (551 | ) | (2.0 | )% | 1,739 |   | 315.6 | % |
| Net income (loss)             |       | $                                                       | 1,241      |   | 2.3 | % | (114 | ) | (0.4 | )% | $ | 1,355 |   | 1188.6 | % |
|                               |            |                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Net Revenues***

 

Our revenues are derived from sales of server appliances and relatedmaintenance services.

 

Our net revenues for the three months ended December 31, 2007increased as compared to the same period in fiscal 2007 primarily due to theacquisition of Alliance Systems on October 11, 2007.  If the acquisition had occurred at thebeginning of fiscal 2007, net revenues, on a proforma basis, would haveincreased by approximately $2.2 million. This increase was mainly attributable to increased sales volumes.

 

***Gross profit***

 

Gross profit represents net revenues recognized less the cost ofrevenues. Cost of revenues includes cost of materials, warranty costs,inventory write-downs, shipping and handling costs, customer support costs andmanufacturing costs. Manufacturing costs are primarily comprised ofcompensation, contract labor costs and, when applicable, contract manufacturingcosts.

 

Gross profit as a percentage of net revenue decreased for the threemonths ended December 31, 2007 compared to the three months ended December 31,2006.  The decrease from the prior yearwas primarily due to the additional costs associated with the increase ofAlliance Systems inventory fair value at October 11, 2007, and customermix, which were offset by the sale of previously written down inventory.

 

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 

 

14

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net revenue for the three months ended March 31, 2008 will besimilar when compared to the three months ended December 31, 2007.

 

***Operating Expenses***

 

The followingtable presents operating expenses during the periods indicated, in thousandsand as a percentage of net revenues:

 
| ** **                        | ** ** | **Three Months Ended December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                                | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                             | ** ** | **% of Net   Revenues** | ** ** | **Dollars** | ** ** | **% of Net   Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating Expenses:               |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Research and development          |       | $                                                       | 2,370      |   | 4.4 | % | $ | 1,993 |   | 7.3 | % | $ | 377 |   | 15.9 | % |
| Selling and marketing             |       | 3,117                                                   |       | 5.7 | % | 1,730 |   | 6.3 | % | 1,387 |   | 80.2 | % |
| General and administrative        |       | 2,645                                                   |       | 4.9 | % | 2,061 |   | 7.6 | % | 584 |   | 28.3 | % |
| Amortization of intangible assets |       | 420                                                     |       | 0.8 | % | — |   | — |   | 420 |   | 100.0 | % |
| Total operating expenses          |       | $                                                       | 8,552      |   | 15.8 | % | $ | 5,784 |   | 21.2 | % | $ | 2,768 |   | 47.9 | % |

 

***Research and development***

 

Research and development expenses consist primarily of salaries andrelated expenses for personnel engaged in research and development, fees paidto consultants and outside service providers, material costs for prototype andtest units and other expenses related to the design, development, testing andenhancements of our server appliance products. We expense all of our researchand development costs as they are incurred. The following table summarizes themost significant components of research and development expense for the periodsindicated, in thousands and as a percentage of total research and developmentexpense and provides the changes in thousands and percentages:

 
| ** **                        | ** ** | **Three Months Ended December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                                | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                             | ** ** | **% of   Expense  Category** | ** ** | **Dollars** | ** ** | **% of   Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and development:         |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                       | 1,521      |   | 64.2 | % | $ | 1,219 |   | 61.1 | % | $ | 302 |   | 24.8 | % |
| Stock-based compensation          |       | 250                                                     |       | 10.6 | % | 280 |   | 14.1 | % | (30 | ) | (10.7 | )% |
| Prototype                         |       | 122                                                     |       | 5.1 | % | 141 |   | 7.1 | % | (19 | ) | (13.5 | )% |
| Consulting and outside services   |       | 265                                                     |       | 11.2 | % | 142 |   | 7.1 | % | 123 |   | 86.7 | % |
| Other                             |       | 212                                                     |       | 8.9 | % | 211 |   | 10.6 | % | 1 |   | 0.5 | % |
|                              |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total research and development    |       | $                                                       | 2,370      |   | 100.0 | % | $ | 1,993 |   | 100 | % | $ | 377 |   | 18.9 | % |

 

Our research and development expenses have increased this quarter ascompared to the same period last fiscal year mainly due to the acquisition ofAlliance Systems.  If the acquisition hadoccurred at the beginning of fiscal 2007, research and development expenseswould have been consistent between the three months ended December 31,2006 and December 31 ,2007.  Becauseour research and development expenses are project driven, the timing of theseexpenditures can vary.  On a proformabasis, there would have been an increase in consulting costs offset by asimilar decrease in prototype and other costs based on the nature of the stageof projects being worked on.

 

Our server appliance development strategy emphasizes the utilization ofstandard server appliance platforms, which utilize off-the-shelf components.However, we expect that in some cases, significant 

 

15

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development efforts will be required to fulfill ourcurrent and potential customers’ needs using customized platforms. In addition,we intend to focus our software development in areas that improve the ease ofserver appliance implementation and use, which we believe will enhance ourvalue proposition.  We expect thatprototype and consulting costs will be variable and could fluctuate dependingon the timing and magnitude of our development projects. However, we expect ourresearch and development costs to increase slightly during the three monthsended March 31, 2008, as compared to the three months ended December 31,2007.

 

***Selling and marketing***

 

Selling and marketing expenses consist primarily of salaries andcommissions for personnel engaged in sales and marketing; costs associated withour marketing programs, which include costs associated with our attendance attrade shows, product literature costs, web site enhancements, productevaluation 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:

 
| ** **                        | ** ** | **Three Months Ended December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                                | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                             | ** ** | **% of   Expense   Category** | ** ** | **Dollars** | ** ** | **% of   Expense   Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:            |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                       | 2,336      |   | 74.9 | % | $ | 1,226 |   | 70.8 | % | $ | 1,109 |   | 90.5 | % |
| Stock-based compensation          |       | 95                                                      |       | 3.1 | % | 100 |   | 5.8 | % | (6 | ) | (6.0 | )% |
| Marketing programs                |       | 112                                                     |       | 3.6 | % | 169 |   | 9.8 | % | (57 | ) | (33.7 | )% |
| Travel                            |       | 197                                                     |       | 6.3 | % | 112 |   | 6.5 | % | 85 |   | 75.9 | % |
| Other                             |       | 377                                                     |       | 12.1 | % | 123 |   | 7.1 | % | 256 |   | 208.1 | % |
|                              |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and marketing       |       | $                                                       | 3,117      |   | 100 | % | $ | 1,730 |   | 100 | % | $ | 1,387 |   | 80.1 | % |

 

As indicated in the table above, our selling andmarketing expenses have significantly increased.  This increase is the result of ouracquisition of Alliance Systems as the headcount grew from 28 to 62employees.  If the acquisition occurredat the beginning of fiscal 2007, selling and marketing expenses would havedecreased approximately $252,000, mainly related to a decrease in compensationand related expenses as Alliance Systems had decreased its selling andmarketing headcount.

 

We believe that we must target our selling and marketing efforts onnetwork equipment providers, independent software vendors (“ISVs”) and telecomservice providers in order to enhance our position as a leading provider ofserver appliance products. We expect selling and marketing expenses to increaseduring the three months ended March 31, 2008, compared to the three monthsended December 31, 2007, primarily as a result of our rebranding of thecombined entity and tradeshow activities.

 

16

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*** ***

***General and administrative***

 

General and administrative expenses consist primarily of salaries andother related costs for executive, finance, information technology and humanresources personnel; professional services, which include legal, accounting,audit and tax fees; and director and officer insurance. The following tablesummarizes the most significant components of general and administrativeexpense for the periods indicated in thousands and as a percentage of totalgeneral and administrative expense and provides the changes in thousands andpercentages:

 
| ** **                           | ** ** | **Three Months Ended December 31,** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                                | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                             | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and administrative:          |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                       | 1,319      |   | 49.9 | % | $ | 774 |   | 37.6 | % | $ | 545 |   | 70.3 | % |
| Stock-based compensation             |       | 188                                                     |       | 7.1 | % | 192 |   | 9.3 | % | (4 | ) | (2.1 | )% |
| Consulting and professional services |       | 655                                                     |       | 24.8 | % | 846 |   | 41.0 | % | (191 | ) | (22.5 | )% |
| Director and officer insurance       |       | 64                                                      |       | 2.4 | % | 83 |   | 4.0 | % | (19 | ) | (22.9 | )% |
| Other                                |       | 419                                                     |       | 15.8 | % | 166 |   | 8.1 | % | 253 |   | 152.4 | % |
|                                 |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total general and administrative     |       | $                                                       | 2,645      |   | 100.0 | % | $ | 2,061 |   | 100.0 | % | $ | 584 |   | 28.3 | % |

 

As indicated in the table above, general and administrative expensesincreased in the three months ended December 31, 2007 as compared to thethree months ended December 31, 2006, mainly due to the acquisition ofAlliance Systems as the headcount increased from 26, as of December 31,2006, to 43 as of December 31, 2007. If the acquisition had occurred as of October 1, 2006, general andadministrative expenses would have decreased by approximately $750,000.  The proforma decrease would have beenattributable to a decrease in compensation and related expenses as well asconsulting and professional services.  The proforma decrease in compensation and related expenses was primarilya result of a decrease in headcount within the administrative departments aswell as relatively lower bonus payments during the current period as comparedto the previous year’s period.  Thedecrease in consulting and professional services is due primarily to a decreasein consultant expenses attributable to the timing of certain MIS projects aswell as decreased legal fees from legal services performed in the prior yearthat did not reoccur in the current period. We expect general and administrative expenses to increase slightlyduring the three months ended March 31, 2008, as compared to the threemonths ended December 31, 2007, as a result of integration activities.

 

***Intangible Asset Amortization***

 

The amortization of intangible assets increased by $420,000 in thethree months ended December 31, 2007 as compared to the three months endedDecember 31, 2006.  The reason forthis increase was attributable to the amortization of intangible assets relatedto the Alliance Systems acquisition on October 11, 2007.

 

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

* *

Interest and other income, net decreased to $124,000 for the threemonths ended December 31, 2007 from $447,000 for the three months ended December 31,2006. This decrease was mainly attributable to the lower cash balances held bythe Company during the three months ended December 31, 2007 as a result ofthe purchase of Alliance Systems.

 

17

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**Liquidityand Capital Resources**

 

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

 
| ** **                                        | ** ** | **Three Months Ended December  31,** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                        | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| ** **                                        | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Net income (loss)                                 |       | $                                                   | 1,241      |   | $ | (114 | ) |
| Non-cash adjustments to net income (loss)         |       | 1,449                                               |       | 807 |   |
| Changes in working capital                        |       | (5,433                                              | )          | 3,978 |   |
|                                              |       |                                                |       |   |   |
| Cash (used in) provided by operating  activities  |       | (2,743                                              | )          | 4,671 |   |
|                                              |       |                                                |       |   |   |
| Cash (used in) investing activities               |       | (33,555                                             | )          | (3,556 | ) |
| Cash provided by financing activities             |       | 110                                                 |       | 1,604 |   |
|                                              |       |                                                |       |   |   |
| Effect of exchange rate differences on cash       |       | (29                                                 | )          | — |   |
| Increase (decrease) in cash and cash  equivalents |       | (36,217                                             | )          | 2,719 |   |
| Beginning cash and cash equivalents               |       | 44,403                                              |       | 8,019 |   |
|                                              |       |                                                |       |   |   |
| Ending cash and cash equivalents                  |       | $                                                   | 8,186      |   | $ | 10,733 |   |

 

***OperatingActivities***

 

Cash flows used by operating activities of $2.7 million for the threemonths ended December 31, 2007 were a result of the decrease related tochanges in working capital from increased purchases of inventory and cash usedto pay down accounts payable and accrued expenses offset by an increase in netincome.

 

***InvestingActivities***

 

Cash flows used in investing activities during the three months ended December 31,2007 primarily related to the purchase of Alliance Systems for approximately$33 million.

 

***FinancingActivities***

 

Cash flows provided by financing activities primarily consisted of cashreceived as a result of employee stock option and stock purchase plan activityof $115,000 in the three months ended December 31, 2007. We expectemployee stock option and stock purchase plan activity to continue in fiscal2008; however, we cannot predict its level given the volatility of capitalmarkets.

 

Our future liquidity and capital requirements will depend upon numerousfactors including:

 
|   | · | the timing and size of orders from our larger customers;                                                                             |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                 |
|   | · | our ability to enter into partnerships with network equipment  providers, independent software vendors and telecom service providers |
|   |   |                                                                                                                                 |
|   | · | the level of success of our customers in selling server appliance  solutions that include our server appliance hardware platforms;   |
|   |   |                                                                                                                                 |
|   | · | the costs and timing of product engineering efforts and the success of  these efforts; and                                           |
|   |   |                                                                                                                                 |
|   | · | market developments.                                                                                                                 |

 

18

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We believe that our available cash resources and cash that we expect togenerate from sales of our products will be sufficient to meet our operatingand capital requirements through at least the next twelve months.

 

In the event that our available cash resources and the Silicon ValleyBank line of credit are not sufficient, after the line of credit matures on October 9,2008, we would need to raise additional funds. We may in the future seek toraise additional funds through borrowings, public or private equity financingsor from other sources. There can be no assurance that additional financing willbe available at all or, if available, will be on terms acceptable to us.Additional equity financings could result in dilution to our shareholders. Ifadditional financing is needed and is not available on acceptable terms, we mayneed to reduce our operating expenses and scale back our operations.

 

***ContractualObligations and Commitments***

 

In conjunction with the acquisition of Alliance Systems, Inc. asof October 11, 2007, we incurred an additional contractual obligationrelated to the Plano, Texas building lease. The obligation of this lease is as follows:

 
| ** **       | ** ** | **Payments Due by Period** | ** ** |
|------------------|------------|-------------------------------------------|------------|
| ** **       | ** ** | **Less than  1 Year**           | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **After  5 Years** | ** ** | **Total** | ** ** |
|             |       |                                      |       |   |   |   |   |   |   |   |   |
| Operating leases |       | $                                         | 555        |   | $ | 2,159 |   | $ | — |   | $ | — |   | $ | 2,714 |   |
|             |       |                                      |       |   |   |   |   |   |   |   |   |
| Total            |       | $                                         | 555        |   | $ | 2,159 |   | $ | — |   | $ | — |   | $ | 2,714 |   |

 

**Off-Balance Sheet Arrangements**

 

We have not created, and are not party to, any special-purpose oroff-balance sheet entities for the purpose of raising capital, incurring debtor operating parts of our business that are not consolidated into our financialstatements.  We have not entered into anytransactions with unconsolidated entities whereby the Company has subordinatedretained interests, derivative instruments or other contingent arrangementsthat expose the Company to material continuing risks, contingent liabilities,or any other obligation under a variable interest in an unconsolidated entitythat provides financing, liquidity, market risk or credit risk support to theCompany.

 

**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.  This Statement is effective as of thebeginning of our fiscal year that begins after November 15, 2008 forcertain non financial assets and liabilities and November 15, 2007 forother assets and liabilites. We are in the process of evaluating whetherthe adoption of this statement will have a material impact on our financialposition, results of operations and cash flows.

 

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

 

19

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In December 2007, the SEC issued StaffAccounting Bulletin 110 (“SAB 110”).  SAB110 allows companies, under certain circumstances to continue using asimplified method to calculate the expected term relating to the valuation ofstock options under the Black Scholes method. SAB 110 becomes effective for any option grants issued after January 1,2008.  We are in the process of evaluating whetherSAB 110 will have a material effect on our financial position, results ofoperations and 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. This Statement establishes principles and requirements for how theacquirer recognizes and measures in its financial statements the identifiableassets acquired,the liabilities assumed, and any noncontrolling interest in the acquiree, recognizes andmeasures the goodwill acquired in the business combination or a gain from abargain purchase and determines what information to disclose to enable users ofthe financial statements to evaluate the nature and financial effects of thebusiness combination.  This Statement iseffective for business combinations on a prospective basis for which theacquisition date is on or after the beginning of the first annualreporting period beginning on or after December 15, 2008.  The adoption of will not have a materialimpact on our financialposition, results of operations or cash flows

 

20

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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 currentlyexposed to market risk related to changes in interest rates. In the past, weinvested excess cash balances in cash equivalents and short-term investmentsand, if we were to do so in the future, we believe that the effect, if any, ofreasonably possible near-term changes in interest rates on our financialposition, results of operations and cash flows will not be material. Inaddition, a hypothetical 10% increase or decrease in interest rates would nothave a material adverse effect on our financial condition.

 

**ITEM 4.    CONTROLS AND PROCEDURES**

 

Our management,with the participation of our Chief Executive Officer and Chief FinancialOfficer, evaluated the effectiveness of our disclosure controls and procedures(as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act) as of December 31, 2007. Based on this evaluation,our Chief Executive Officer and Chief Financial Officer concluded that, as of December 31,2007, our disclosure controls and procedures (1) were designed toeffectively accumulate and communicate information to the Company’s management,as appropriate, to allow timely decisions regarding required disclosure and (2) wereeffective, in that they provide reasonable assurance that information requiredto be disclosed by the Company in the reports that it files or submits underthe Securities Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’s rules andforms.

 

During the three months ended December 31, 2007, we changed ourinternal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) to include internal controls related to ouracquisition of Alliance Systems on October 11, 2007. We implemented internalcontrols to provide reasonable assurance that the acquired assets and liabilities,including the valuation of the intangible asset, were fairly stated in allmaterial respects in accordance with generally accepted accounting principles.

 

 

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**PART II—OTHERINFORMATION**

 

**ITEM 1.     LEGAL PROCEEDINGS**

 

*InitialPublic Offering Lawsuit*

 

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

 

The suit alleges that the defendants violated the federal securitieslaws by issuing and selling securities pursuant to our initial public offeringin July 2000 (“IPO”) without disclosing to investors that the UnderwriterDefendants had solicited and received excessive and undisclosed commissionsfrom certain investors. The suit also alleges that the Underwriter Defendantsentered into agreements with certain customers whereby the UnderwriterDefendants agreed to allocate to those customers shares of our common stock inthe offering, in exchange for which the customers agreed to purchase additionalshares of our common stock in the aftermarket at pre-determined prices. Thesuit alleges that such tie-in arrangements were designed to and did maintain,distort and/or inflate the price of our common stock in the aftermarket. Thesuit further alleges that the Underwriter Defendants received undisclosed andexcessive brokerage commissions and that, as a consequence, the UnderwriterDefendants successfully increased investor interest in the manipulated IPOsecurities and increased the Underwriter Defendants’ individual and collectiveunderwritings, compensation and revenues. The suit seeks damages andcertification of a plaintiff class consisting of all persons who acquiredshares of our common stock between July 13, 2000 and December 6,2000.

 

In July 2002,we, Lawrence A. Genovesi and Douglas G. Bryant joined in an omnibus motion todismiss the suit challenging the legal sufficiency of plaintiffs’ claims. Themotion was filed on behalf of hundreds of issuer and individual defendantsnamed in similar lawsuits. Plaintiffs opposed the motion, and the Court heardoral argument on the motion in November 2002. On February 19, 2003,the Court issued an opinion and order denying the motion as to us. However, in October 2002,Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this casewithout prejudice.

 

On July 9, 2003, a Special Committee of our Board of Directorsauthorized us to negotiate a settlement of the pending claims substantiallyconsistent with a memorandum of understanding negotiated among classplaintiffs, all issuer defendants and their insurers.  The parties have negotiated the settlement,which provides, among other things, for a release of us and the individualdefendants for the conduct alleged in the amended complaint to bewrongful.  We would agree to undertakeother responsibilities under the settlement, including agreeing to assign, ornot assert, certain potential claims that we may have against theunderwriters.  Any direct financialimpact of the proposed settlement is expected to be borne by our insurers.  Any such settlement would be subject tovarious contingencies, including approval by the Court overseeing thelitigation. On February 15, 2005, the Court issued an Opinion and Order preliminarilyapproving the settlement, provided that the defendants and plaintiffs agree toa modification narrowing the scope of the bar order set forth in the originalsettlement agreement.   The partiesagreed to a modification narrowing the scope of the bar order, and on August 31,2005, the Court issued an order preliminarily approving the settlement andsetting a public hearing on its fairness, which took place on April 24,2006.  On December 5, 2006, theUnited States Court of Appeals for the Second Circuit overturned the DistrictCourt’s certification of the class of plaintiffs who are pursuing the claimsthat would be settled in the settlement against the underwriter defendants.Thereafter, the District Court ordered a stay of all proceedings in all of thelawsuits pending the outcome of plaintiffs’ petition to the Second Circuit forrehearing en banc and resolution of the class certification issue.  On April 6, 2007, the Second Circuitdenied plaintiffs’ petition for rehearing, but clarified that the plaintiffsmay seek to certify a more limited class in the District Court. On June 25,2007, the District Court signed an order terminating the settlement. We areunable to predict the outcome of this suit and as a result, no amounts havebeen accrued as of December 31, 2007.

 

22

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**ITEM 1A. RISK FACTORS**

 

The risks and uncertainties described below are not the only ones we arefaced with. Additional risks and uncertainties not presently known to us, orthat are currently deemed immaterial, may also impair our businessoperations. If any of the following risks actually occur, our financialcondition and operating results could be materially adversely affected.

 

***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.**

 

In the quarters ended December 31, 2007 and 2006 sales directly toEMC, our largest customer, accounted for 39% and 82%, of our total netrevenues, respectively. These sales are primarily attributable to one productpursuant 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 will continueto depend heavily on sales to, and our relationship with, this customer.Accordingly, the success of our business will depend, in large part, on thiscustomer’s willingness to continue to utilize our server appliance solutions inits existing and future products. Further, our financial success is dependentupon the future success of the products we sell to this customer and thecontinued growth of this customer, whose industry has a history of rapidtechnological change, short product life cycles, consolidation and pricing andmargin pressures. A significant reduction in sales to this customer, orsignificant pricing and additional margin pressures exerted on us by thiscustomer, would have a material adverse effect on our results of operations. Inaddition, if this customer delays or cancels purchases of our products, ouroperating results would be harmed and our ability to accurately predictrevenues, profitability and cash flows would decrease.

 

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 terminate the agreement in the event thatwe attempt to assign our rights under the agreement to another party withoutthis 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 ofthese events were to occur, or if this customer were to delay or discontinuepurchases of our products as a result of dissatisfaction or otherwise, ourrevenues and operating results would be materially adversely affected, ourreputation in the industry might suffer, and our ability to accurately predictrevenues, profitability and cash flows would decrease.

 

***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 service providers. Underthis strategy, we work with our customers to develop a server appliance brandedwith their name.  Our partner thenperforms all of the selling and marketing efforts related to sales of theirbranded appliance.

 

There are multiple risks associated with this strategy including:

 
|   | · | the expenditure of significant product development costs, which if not  recovered through server appliance sales could negatively affect our  operating results;                                                                                               |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                           |
|   | · | a significant reliance on our customers’ application software  products, which could be technologically inferior to competitive products and  result in limitations on our server appliance sales, causing our revenues and  operating results to suffer; |

 

23

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|   | · | our customers will most likely continue selling their software  products as separate products in addition to selling it in the form of a  server appliance, which will require us to effectively communicate the  benefits of delivering their software in the form of a server appliance;                                                                                                                                                                                                                                                                       |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   | · | our reliance on our customers to perform all of the selling and  marketing efforts associated with further sales of the server appliance  product we develop with them;                                                                                                                                                                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   | · | continued consolidation within the network equipment and software  industries that results in existing customers being acquired by other  companies                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   | · | our ability to leverage strategic relationships to obtain new sales  leads                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   | · | our ability to provide our customers with high quality server  appliances at competitive prices; and                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   | · | there is no guarantee that design wins will become actual orders and  sales. A “design win’’ occurs when a customer or prospective customer  notifies us that we have been selected to integrate the customer’s  application. There can be delays of several months or more between the design  win and when a customer initiates actual orders. The design win may never  become an actual order or sale. Further, if the customer’s plans change, we  may commit significant resources 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 these customers are unsuccessful in their marketingand sales efforts, or if we are unable to expand our sales to existingcustomers and develop relationships with new customers, our revenues andoperating 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 anticipated benefits, Alliance Systems’ business must besuccessfully integrated into our operations by focusing on, manufacturing andsupply chain, sales and marketing operations, and general and administrative.The success of the Alliance Systems acquisition will depend on our ability torealize these anticipated benefits from integrating Alliance Systems’ businessinto our operations. We may fail to realize the anticipated benefits of theacquisition on a timely basis, or at all, for a variety of reasons, includingthe following:

 
|   | · | diversion of management attention and difficulties arising from  managing multiple locations;                           |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                    |
|   | · | potential disruption of ongoing business;                                                                               |
|   |   |                                                                                                                    |
|   | · | failure to effectively coordinate sales and marketing efforts to  communicate the capabilities of the combined Company; |
|   |   |                                                                                                                    |
|   | · | potential difficulties integrating financial 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 cashflows fromoperations.  As a result, we could havedifficulty borrowing under our current credit facility or securing financing tofund operations 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.**

 

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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 knowwith certainty which of these prospective technologies will be desired in themarketplace, we may incorrectly invest in development or prioritize ourefforts to integrate these technologies in our appliances. Additionally, evenif we correctly focus our efforts, there can be no assurance that we willselect the preferred provider of these technologies, the third-party providerwill be committed to the relationship and integration of their technology, orthat they will license their technology to us without obtaining significantcertification or training, which could be costly and time consuming. If we areunable to successfully integrate the correct third-party technologies in atimely manner, our appliances may be inferior to other competitive productsin the marketplace, which may adversely affect the results of ouroperations and our ability to grow our 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 in new technologies presents numerousrisks, including:

 
|   | · | we may experience difficulties integrating new technologies into  our current or future products;                                                                       |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                         |
|   | · | our new products may be delayed because selected new technologies  themselves are delayed or have defects and/or performance limitations;                               |
|   |   |                                                                                                                                                                         |
|   | · | we may incorporate technologies that do not result in the desired  improvements to our current and/or future server appliance products;                                 |
|   |   |                                                                                                                                                                         |
|   | · | we may incorporate new technologies that either may not be  desired by our customers or may not be compatible with our customers’  existing technology;  |
|   |   |                                                                                                                                                                         |
|   | · | new technologies are unproven and could contain latent defects, which  could result in high product failures; and                                                            |
|   |   |                                                                                                                                                                         |
|   | · | we could find that the new products and/or technologies that we choose  to incorporate into our products are technologically 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 a result, we are substantially dependenton the growing use of server appliances to meet businesses’ application needs.Our revenues may not grow and the market price of our common stock coulddecline if the server appliance market 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 of our products could, for example, belimited if general-purpose servers out-perform server appliances, providemore capabilities 

 

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and/or flexibility than server appliances or are offered at a lowercost. This could force us to lower the prices of our server appliance productsor could result in fewer sales of these products, which would negatively impactour revenues and decrease our gross profits.

 

**The products 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. Inthe server appliance market, we attempt to mitigate these risks by utilizingstandards-based hardware platforms and by maintaining an adequate knowledgebase of available technologies. However, the server appliance products that wesell 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 thirdparties for the base platforms of our server appliances and we are at risk ifthese third parties do not integrate new technologies. Releasing new productsand services prematurely may result in quality problems, and delaysmay result in loss of customer confidence and market share. We may beunable to develop new products and services or achieve and maintain marketacceptance of them once they have come to market. Furthermore, when we dointroduce new or enhanced products and services, we may be unable tomanage the transition from the older products and services to minimize disruptionin customer ordering patterns, avoid excessive inventories of older productsand deliver enough new products and services to meet 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 failureto select the appropriate partners and keep pace with rapid industry,technology or market changes could have a material adverse effect on ourbusiness, results of operations or financial condition.

 

***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.**

 

Since our inception, we have incurredsignificant net losses and could continue to incur net losses in the future. AtDecember 31, 2007 and September 30, 2007 our accumulated deficit was$128 million and $129 million, respectively. We believe that any future growthwill require us to incur significant engineering, selling and marketing andadministrative expenses. As a result, we will need to generate significantrevenues to achieve and sustain profitability. If we do not achieve and sustainprofitability, the market price for our common stock may decline.  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 credit facility asa source of available liquidity to fund fluctuations in our working capitalrequirements. This facility contains various conditions, covenants andrepresentations with which we must be in compliance in order to borrow funds.However, if we wish to borrow under this facility in the future, there can beno assurance that 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 financing, or financing on favorable terms, if we experiencea significant adverse change in our business. As of December 31, 2007, we have not drawn on this line of credit.

 

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

 

Ourdiscussion and analysis of financial condition and results of operations isbased on our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United States.The preparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the amounts reported in the consolidated financial statements andaccompanying notes. On an ongoing basis, we evaluate significant estimates usedin preparing our consolidated financial statements, including those related to:

 

·                  revenue recognition;

 

·                  inventory write-downs;

 

·                  stock-based compensation;

 

·                  valuation of intangible assets and goodwill

 

·                  warranty reserves and

 

·                  realization of deferred tax assets.

 

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

 

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

 

Inaddition to seasonality issues, our quarterly revenues and operating resultsare difficult to predict and may fluctuate significantly from quarter toquarter. None of our customers are obligated to purchase any quantity of ourproducts in the future nor are they obligated to meet forecasts of theirproduct needs. Our operating expense levels are based in part onexpectations of future revenues and gross profits, which are partiallydependent on our customers’ ability to accurately forecast and communicatetheir future product needs. If revenues or gross profits in a particularquarter do not meet expectations, operating results could suffer and the marketprice of our common stock could decline. Factors affecting quarterly operatingresults include:

 

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

 

·                  the product mix of our sales;

 

·                  the timing of new product introductions by ourcustomers;

 

·                  the availability and/or price of products fromsuppliers;

 

·                  the loss of key suppliers or customers;

 

·                  price competition;

 

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·                  costs associated with our introduction of newserver appliances and the market acceptance of those products;

 

·                  seasonal fluctuations in the data storageindustry; and

 

·                  the mix of product manufactured internally andby our contract manufacturer.

 

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

 

Productsand services in the server appliance, data storage, network security andtelecom markets may be subject to further commoditization as theseindustries continue to mature and other businesses introduce additionalcompeting products and services. Our gross profit as a percentage of revenuesfor our products may decrease in response to changes in our product mix,competitive pricing pressures, or new product introductions into the serverappliance, data storage, network security and telecom markets. If we are unableto offset decreases in our gross profits as a percentage of revenues byincreasing our sales volumes, or by decreasing our product costs, operatingresults will decline. Changes in the mix of sales of our products, includingthe mix of higher margin products sold in smaller quantities and lower marginproducts sold in larger quantities, could adversely affect our operatingresults for future quarters. To maintain our gross profits, we also mustcontinue to reduce the manufacturing cost of our server appliance products. Ourefforts to produce higher margin server appliance products, continue to improveour server appliance products and produce new server appliance productsmay make it difficult to reduce our manufacturing cost per product.Further, utilization of a contract manufacturer to produce a portion of ourcustomer requirements for certain of our server appliance products may notallow us to reduce our cost per product. If we fail to respond adequately topricing pressures, to competitive products with improved performance or todevelopments with respect to the other factors on which we compete, we couldlose customers or orders. If we are unable to compete effectively, our business will suffer.

 

***Risks related to competition.***

 

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

 

Inthe server appliance market, we face significant competition from a number ofdifferent types of companies. Our competitors include companies who marketgeneral-purpose servers, server virtualization software, specific-purposeservers and server appliances as well as companies that sell custom integrationservices utilizing hardware produced by other companies. Many of thesecompanies are larger than we are and have greater financial resources and namerecognition than we do, as well as significant distribution capabilities andlarger, more established service organizations to support their products. Ourlarger competitors may be able to leverage their existing resources, includingtheir extensive distribution capabilities and service organizations, to providea wider offering of products and services and higher levels of support on amore cost-effective basis than we can. We expect competition in the serverappliance market to increase significantly as more companies enter the marketand as our existing competitors continue to improve the performance of theircurrent products and to introduce new products and technologies. Such increasedcompetition could adversely affect sales of our current and future products. Inaddition, competing companies may be able to undertake more extensivepromotional activities, adopt more aggressive pricing policies and offer moreattractive terms to their customers than we can. If our competitors providelower cost products with greater functionality or support than our serverappliance solutions, or if some of their products are comparable to ours andare offered as part of a range of products that is broader than ours, ourserver appliance solutions could become undesirable.

 

Evenif the functionality of competing products is equivalent to ours, we face arisk that a significant number of customers would elect to pay a premium forsimilar functionality from an established vendor rather than purchase productsfrom a less-established vendor. We attempt to differentiate ourselves from ourcompetition by offering a wide variety of software integration, branding,supply-chain management, engineering, support, logistics and fulfillmentservices. If we are unable to effectively differentiate ourselves from ourcompetition, we may be forced to offer price reductions to maintaincertain 

 

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customers.As a result, our revenues may not increase and may decline, and ourgross 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 efforts and customerservice.***

 

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

 

Althoughwe currently have a relatively small sales and marketing organization, we mustcontinue to increase market awareness and sales of our products and promote ourbrand in the marketplace. We believe that to compete successfully we will neednetwork equipment providers, ISVs and telecom service providers to recognize usas a top-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 weare unable to effectively manage our customer service and support activities,we may not be able to retain our existing customers or attract newcustomers.**

 

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

 

Ifour customer support organization is unsuccessful in maintaining good customerrelationships, we may lose customers to our competitors and our reputationin the market could be damaged. As a result, we may lose revenues and ourbusiness could suffer. Furthermore, the costs of providing this service couldbe higher than we expect, which could adversely affect our operating results.

 

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

 

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

 

Wedepend upon single source and limited source suppliers for our industrystandard processors, main logic boards, certain disk drives, hardware platformsand power supplies as well as certain of our chassis and sheet metal parts.Additionally, we depend on limited sources to supply certain other industrystandard and customized components. We have in the past experienced, andmay in the future experience, shortages of or difficulties in acquiringcomponents in the quantities and of the quality needed to produce our serverappliance products. Shortages in supply or quality issues related to these keycomponents for an extended time would cause delays in the production of ourserver appliance products, prevent us from satisfying our contractualobligations and meeting customer expectations, and result in lost sales andcustomers. If we are unable to buy components in the quantities and of thequality that we need on a timely basis or at acceptable prices, we will not beable to manufacture and deliver our server appliance products on a timely orcost effective basis to our customers, and our competitive position,reputation, business, financial condition and results of operations could beseriously harmed.

 

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

 

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Becauseserver appliance solutions are complex, they could contain errors that can bedetected at any point in a product’s life cycle. If flaws in design,production, assembly or testing of our products (by us or our suppliers) wereto occur, we could experience a rate of failure in our products that couldresult in substantial repair, replacement or service costs and potential damageto our reputation.  In addition, because our solutions are combined withproducts from other vendors, should problems occur, it might be difficult toidentify the source of the problem. Continued improvement in manufacturingcapabilities, control of material and manufacturing quality and costs, andproduct testing are critical factors in our future growth. There can be noassurance that our efforts to monitor, develop, modify and implementappropriate test and manufacturing processes for our products will besufficient to permit us to avoid a rate of failure in our products that resultsin substantial delays in shipment, significant repair or replacement costs orpotential damage to our reputation, any of which could have a material adverseeffect on our business, results of operations or financial condition.

 

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

 

·                  the loss of or delay in market acceptance andsales of our server appliance products;

 

·                  diversion of engineering resources;

 

·                  increased manufacturing costs;

 

·                  the loss of new or existing server appliance customers;

 

·                  injury to our reputation and other customerrelations problems; and

 

·                  increased maintenance and warranty costs.

 

Anyof these problems could harm our business and future operating results. Producterrors or delays could be material, including any product errors or delaysassociated with the introduction of new products or versions of existingproducts. If our server appliance solutions fail to conform to warrantedspecifications, customers could demand a refund for the purchase price andassert claims for damages.

 

Moreover,because our server appliance solutions may be used in connection withcritical computing systems services, including providing security to protectvaluable information, we may receive significant liability claims if theydo not work properly. While our agreements with customers typically containprovisions intended to limit our exposure to liability claims, theselimitations do not preclude all potential claims. Liability claims could exceedour insurance coverage and require us to spend significant time and money inlitigation or to pay significant damages. Any claims for damages, even ifunsuccessful, could seriously damage our reputation and business.

 

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

 

                We use rolling forecasts basedon anticipated product orders to determine our server appliance componentrequirements. 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 offactors, including the timing of product releases, potential delays orcancellations of orders, the timing of large orders and the unproven acceptanceof new products in the market make it difficult to predict product orders. As aresult, our materials requirement forecasts may not be accurate. If weoverestimate our materials requirements, we may have excess inventory,which would increase costs and negatively impact our cash position. Ouragreements with certain customers provide us with protections related toinventory purchased in accordance with the terms of these 

 

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agreements;however, these protections may not be sufficient to prevent certain lossesas a result of excess or obsolete inventory. If we underestimate our materialsrequirements, we may have inadequate inventory, which could interrupt ourmanufacturing and delay delivery of our server appliance products to customers,resulting in a loss of sales or customers. Any of these occurrences wouldnegatively impact our business and operating results.

 

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

 

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

 

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

 

Inaddition, the laws of the countries in which we may decide to market ourservices and solutions may offer little or no effective protection of ourproprietary technology. Reverse engineering, unauthorized copying or othermisappropriation of our proprietary technology could enable third parties tobenefit from our technology without paying us for it, which could harm ourbusiness. In addition, our U.S. patents have no effect in foreign jurisdictionsand obtaining patent protection in foreign countries is expensive and timeconsuming.

 

**Ouroperating results would suffer if we, our ISV, telecom or network equipmentcustomers, 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.**

 

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

 

·                  be time consuming for us to address;

 

·                  require us to enter into royalty or licensingagreements;

 

·                  result in costly litigation, includingpotential liability for damages;

 

·                  divert our management’s attention andresources; and

 

·                  cause product shipment delays.

 

Inaddition, other parties may make claims against our ISV, telecom, ornetwork equipment customers, or third-party software providers related toproducts that are incorporated into our server 

 

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applianceproducts. Our business could be adversely affected if such claims resulted inthe inability of our customers to continue producing the infringing product, orif we are unable to cost effectively continue licensing the third-party software.

 

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

 

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

 

Oursuccess depends in large part on our ability to retain and attract highlyskilled engineering, sales, marketing, customer service and managerialpersonnel. If we are unable to attract a sufficient number of qualifiedpersonnel, particularly personnel knowledgeable in software engineering andproduct management, we may not be able to meet key objectives such asdeveloping, upgrading, or enhancing our products in a timely manner, whichcould negatively impact our business and could hinder any future growth.

 

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

 

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

 

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

 

InDecember 2001, a class action lawsuit relating to our initial publicoffering was filed against us, our chairman, one of our executive officers andthe underwriters of our initial public offering. For more information onlawsuits, see “Part I, Item 3 – Legal Proceedings.”  We are currently attempting to settle thelawsuit filed against us related to our initial 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 maintain certain insurance coverage, there can beno assurance that claims against us will not result in substantial monetarydamages in excess of such insurance coverage. This class action lawsuit,or any future lawsuits, could cause our director and officer insurance premiumsto increase and could affect our ability to obtain director and officerinsurance coverage, which would negatively affect our business. In addition, wehave expended, and may in the future expend, significant resources todefend such claims. This class action lawsuit, or other similar lawsuitsthat may arise from time to time, could negatively impact both ourfinancial condition and the market price of our common stock and could resultin management devoting a substantial portion of their time to these lawsuits,which could adversely affect the operation of our business.

 

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

 

Ourmanufacturing facilities and headquarters are concentrated in two locations. Ifthe operations in either facility were disrupted as a result of a naturaldisaster, fire, power or other utility outage, work stoppage or othersimilar event, our business could be seriously harmed for a period of at leastone quarter as a result of interruptions or delays in our manufacturing,engineering, or post sales support operations.

 

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

 

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Themarket price of our common stock has been subject to significant fluctuationsand may continue to fluctuate or decline. During fiscal 2007, the closingprice of our common stock ranged from a low of $1.73 to a high of $2.81, and inthe three months ended December 31, 2007, from a low of $1.57 to a high of$2.12. The market for technology stocks has been extremely volatile andfrequently reaches levels that bear no relationship to the past or presentoperating performance of those companies. General economic conditions, such asrecession or interest rate or currency rate fluctuations in the United Statesor abroad, could negatively affect the market price of our common stock. Inaddition, our operating results may be below the expectations ofsecurities analysts and investors. If this were to occur, the market price ofour common stock may decrease significantly. In the past, followingperiods of volatility in the market price of a company’s securities, securitiesclass action litigation has often been instituted against such companies.Such litigation could result in substantial cost and a diversion of management’sattention and resources.

 

Anydecline in the market price of our common stock or negative market conditionscould adversely affect our ability to raise additional capital, to completefuture acquisitions of or investments in other businesses and to attract andretain qualified technical and sales and marketing personnel.

 

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

 

OurBoard of Directors has the authority to issue up to 5,000,000 shares ofpreferred stock and, without any further vote or action on the part of thestockholders, to determine the price, rights, preferences, privileges andrestrictions of the preferred stock. This preferred stock, if issued, mighthave preference over the rights of the holders of common stock and couldadversely affect the market price of our common stock. The issuance of thispreferred stock may make it more difficult for a third party to acquire usor to acquire a majority of our outstanding voting stock. We currently have noplans to issue preferred stock.

 

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

 

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

 

                On October 11, 2007, we issued approximately 2.9 million shares ofour Common Stock, valued at approximately $5.9 million, to stockholders ofAlliance Systems, a privately held company, in connection with our acquisitionof Alliance Systems.  The offer and salewas made without any public offering or solicitation, and was exempt under Section 4(2) ofthe Securities Act of 1933, as amended.

 

**ITEM 6.     EXHIBITS**

 

(a)    Exhibits

 

The exhibits whichare filed with this report or which are incorporated by reference are set forthin 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:  February 11, 2008 |                       | /s/ Gregory A. Shortell |   |
|                               |                       |   |
|                               |                       | Gregory A. Shortell |
|                               |                       | President and Chief  Executive Officer |
|                               |                       | (Principal Executive  Officer) |
|                               |                       |   |
|                               |                       |   |
|                               |                       | /s/  Douglas G. Bryant |   |
|                               |                       |   |
|                               |                       | Douglas G. Bryant |
|                               |                       | Chief Financial  Officer,  Treasurer and Secretary |
|                               |                       | (Principal Financial  Officer  and Principal |
|                               |                       | Accounting Officer) |
|                                    |                            |  |  |  |

 

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**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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