<PAGE>


================================================================================

                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
                                   ----------

                                    FORM 10-Q

                                   ----------

(Mark One)

[X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
     ACT OF 1934

                  For the quarterly period ended March 31, 2002

                                       OR

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

For the transition period from             to
                               -----------    ------------

                         Commission file number: 0-30863

                                   ----------

                              NETWORK ENGINES, INC.
             (Exact name of registrant as specified in its charter)

                Delaware                                     04-3064173
    (State or other jurisdiction of                       (I.R.S. Employer
             incorporation)                             Identification No.)

        25 Dan Road, Canton, MA                                02021
(Address of principal executive offices)                     (Zip Code)

                                 (781) 332-1000
              (Registrant's telephone number, including area code)

                                   ----------

     Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period than the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

     As of May 1, 2002, there were 32,770,547 shares of the registrant's Common
Stock, par value $.01 per share, outstanding.

================================================================================

<PAGE>

                              NETWORK ENGINES, INC.

                                      INDEX

                                                                           PAGE
                                                                          NUMBER
                                                                          ------

                          PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)

        CONDENSED CONSOLIDATED BALANCE SHEETS..........................      2
        CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS................      3
        CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS................      4
        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS...........      5

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
          AND FINANCIAL CONDITION......................................     11

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
          RISK.........................................................     28

                           PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS..............................................     29

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS......................     29

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............     30

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K...............................     30

SIGNATURES.............................................................     31

EXHIBIT INDEX..........................................................     32


<PAGE>

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

                              NETWORK ENGINES, INC.
                      CONDENSED CONSOLIDATED BALANCE SHEETS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                              March 31,    September 30,
                                                                                2002           2001
                                                                              ---------    -------------
                                                                             (unaudited)
<S>                                                                           <C>            <C>
                                     ASSETS
Current assets
     Cash and cash equivalents ...........................................    $  62,603      $ 74,805
     Restricted cash .....................................................        1,098         1,129
     Accounts receivable, net of allowances ..............................        1,620         1,601
     Inventories .........................................................        1,315           607
     Prepaid expenses and  other current assets ..........................          635           857
     Due from contract manufacturer ......................................           --           380
                                                                              ---------      --------

        Total  current assets ............................................       67,271        79,379

Property and equipment, net ..............................................        2,790         3,454
Other assets .............................................................          256           171
                                                                              ---------      --------

            Total assets .................................................    $  70,317      $ 83,004
                                                                              =========      ========

                      LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities
     Accounts payable ....................................................    $   1,263      $  1,350
     Accrued expenses ....................................................        1,867         2,518
     Accrued restructuring and other charges .............................          594         1,368
     Due to contract manufacturer ........................................           --         3,117
     Deferred revenue ....................................................           --            93
     Current portion of capital lease obligations and notes payable ......           36            60
                                                                              ---------      --------

        Total current liabilities ........................................        3,760         8,506

     Capital lease obligations and notes payable, net of current portion..           --             9
     Commitments and contingencies (Note 5)

Stockholders' equity

     Common stock ........................................................          353           352
     Additional paid-in capital ..........................................      174,498       175,288
     Accumulated deficit .................................................     (103,525)      (93,438)
     Notes receivable from stockholders ..................................         (582)         (702)
     Deferred stock compensation .........................................       (2,005)       (6,813)
     Treasury stock, at cost .............................................       (2,182)         (198)
                                                                              ---------      --------

        Total stockholders' equity .......................................       66,557        74,489
                                                                              ---------      --------

            Total liabilities and stockholders' equity ...................    $  70,317      $ 83,004
                                                                              =========      ========
</TABLE>

    The accompanying notes are an integral part of the condensed consolidated
                             financial statements.

                                       2

<PAGE>

                              NETWORK ENGINES, INC.
                 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                      (in thousands, except per share data)
                                   (unaudited)

<TABLE>
<CAPTION>
                                                                Three months ended March 31,   Six months ended March 31,
                                                                ----------------------------   --------------------------
                                                                       2002      2001               2002       2001
                                                                     -------   --------           --------   --------
<S>                                                                  <C>       <C>                <C>        <C>
Net revenues ................................................        $ 3,034   $  2,516           $  5,135   $  9,410

Cost of revenues:
   Cost of revenues .........................................          2,708      3,452              4,780      8,648
   Cost of revenues stock compensation ......................             59         80                132        171
   Inventory write-down .....................................             --      8,692                 --     23,657
                                                                     -------   --------           --------   --------

   Total cost of revenues ...................................          2,767     12,224              4,912     32,476
                                                                     -------   --------           --------   --------

     Gross profit (loss) ....................................            267     (9,708)               223    (23,066)

Operating expenses:
   Research and development .................................          1,258      3,968              2,803      7,842
   Selling and marketing ....................................            790      5,891              1,972     12,392
   General and administrative ...............................          1,469      1,876              2,646      4,453
   Stock compensation .......................................            168      1,373              3,835      2,627
   Restructuring and other charges ..........................             --      1,203                 --      1,203
   Amortization of goodwill and intangible assets ...........             --        225                 --        375
                                                                     -------   --------           --------   --------

     Total operating expenses ...............................          3,685     14,536             11,256     28,892
                                                                     -------   --------           --------   --------

Loss from operations ........................................         (3,418)   (24,244)           (11,033)   (51,958)
Other income ................................................            522      1,442                946      3,294
                                                                     -------   --------           --------   --------

Net loss ....................................................        $(2,896)  $(22,802)          $(10,087)  $(48,664)
                                                                     =======   ========           ========   ========

Net loss per common share - basic and diluted ...............        $ (0.09)  $  (0.67)          $  (0.30)  $  (1.43)
                                                                     =======   ========           ========   ========

Shares used in computing net loss per common
   share - basic and diluted.................................         32,847     34,219             33,180     34,040
</TABLE>

   The accompanying notes are an integral part of the condensed consolidated
                             financial statements.

                                       3

<PAGE>

                              NETWORK ENGINES, INC.
                 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)
                                   (unaudited)

<TABLE>
<CAPTION>
                                                                                    Six months ended March 31,
                                                                                    --------------------------
                                                                                         2002       2001
                                                                                       --------   --------
<S>                                                                                    <C>        <C>
Cash flows from operating activities:
   Net loss .....................................................................      $(10,087)  $(48,664)
   Adjustments to reconcile net loss to net cash used in
    operating activities:
      Depreciation and amortization .............................................           750      1,911
      Provision for inventory reserve, net ......................................            --     23,835
      Provision for doubtful accounts ...........................................           125        620
      Stock compensation ........................................................         3,967      2,798
      Interest on notes receivable from stockholders ............................           (19)        (4)
      Non-cash portion of restructuring and other charges .......................            --      1,203
      Changes in operating assets and liabilities, net of effects of acquisition:
         Accounts receivable ....................................................          (144)     9,184
         Inventories ............................................................          (708)   (21,310)
         Prepaid expenses and other current assets ..............................           222       (262)
         Due from contract manufacturer .........................................           380      6,056
         Accounts payable .......................................................           (87)    (1,740)
         Due to contract manufacturer ...........................................        (3,117)    12,653
         Accrued expenses .......................................................        (1,425)      (999)
         Deferred revenue .......................................................           (93)      (217)
                                                                                       --------   --------

            Net cash used in operating activities ...............................       (10,236)   (14,936)

Cash flows from investing activities:
   Purchases of property and equipment ..........................................           (86)    (2,522)
   Change in restricted cash ....................................................            31     (1,051)
   Change in other assets .......................................................           (85)    (1,070)
   Acquisition of business including acquisition expenses .......................            --        (30)
                                                                                       --------   --------

            Net cash used in investing activities ...............................          (140)    (4,673)

Cash flows from financing activities:
   Payments on capital lease obligations and notes payable ......................           (33)       (53)
   Proceeds received on notes receivable from stockholders ......................           139         --
   Acquisition of treasury stock ................................................        (1,984)        --
   Proceeds from issuance of common stock .......................................            52        384
                                                                                       --------   --------

            Net cash provided by (used in) financing activities .................        (1,826)       331
                                                                                       --------   --------

Net decrease in cash and cash equivalents .......................................       (12,202)   (19,278)
Cash and cash equivalents, beginning of period ..................................        74,805    112,382
                                                                                       --------   --------

Cash and cash equivalents, end of period ........................................      $ 62,603   $ 93,104
                                                                                       ========   ========
</TABLE>

    The accompanying notes are an integral part of the condensed consolidated
                              financial statements.

                                       4

<PAGE>

                              NETWORK ENGINES, INC.

              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

     The accompanying condensed consolidated financial statements have been
prepared by Network Engines, Inc. ("Network Engines" or the "Company") in
accordance with generally accepted accounting principles and pursuant to the
rules and regulations of the Securities and Exchange Commission. Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with generally accepted accounting principles have been
condensed or omitted pursuant to such rules and regulations. These financial
statements should be read in conjunction with the audited financial statements
and the accompanying notes included in the Company's 2001 Annual Report on Form
10-K filed by the Company with the Securities and Exchange Commission.

     The information furnished reflects all adjustments, which, in the opinion
of management, are of a normal recurring nature and are considered necessary for
a fair presentation of results for the interim periods. Certain
reclassifications of prior period amounts have been made to conform with current
period presentation. It should also be noted that results for the interim
periods are not necessarily indicative of the results expected for the full year
or any future period.

     The preparation of these condensed consolidated financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. The most significant estimates included in the
financial statements are accounts receivable and sales allowances and inventory
valuation. Actual results could differ from those estimates.

2. SIGNIFICANT ACCOUNTING POLICIES

Recent Accounting Pronouncements

     In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 141 ("SFAS 141"), "Business Combinations" and SFAS No. 142 ("SFAS 142"),
"Goodwill and Other Intangible Assets." SFAS 141 requires that all business
combinations be accounted for under the purchase method of accounting only and
that certain acquired intangible assets in a business combination be recognized
as assets apart from goodwill. SFAS 142 requires, among other things, the
cessation of the amortization of goodwill. In addition, the standard includes
provisions for the reclassification of certain existing recognized intangibles
as goodwill, reassessment of the useful lives of existing recognized
intangibles, reclassification of certain intangibles out of previously reported
goodwill and the identification of reporting units for purposes of assessing
potential future impairments of goodwill. SFAS 142 also requires the completion
of a transitional goodwill impairment test six months from the date of adoption.
SFAS 141 is effective for all business combinations initiated after June 30,
2001. SFAS 142 is effective for the Company's fiscal quarters beginning on
October 1, 2002; early adoption is not permitted. The Company does not expect
SFAS 142 to have a material impact on its financial position and results of
operations.

     In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS 144"). The objectives of
SFAS 144 are to address significant issues relating to the implementation of
FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to Be Disposed Of" ("SFAS 121"), and to develop a single
accounting model, based on the framework established in SFAS 121, for long-lived
assets to be disposed of by sale, whether previously held and used or newly
acquired. SFAS 144 supersedes SFAS 121; however, it retains the fundamental
provisions of SFAS 121 for (1) the recognition and measurement of the impairment
of long-lived assets to be held and used and (2) the measurement of long-lived
assets to be disposed of by sale. SFAS 144 supersedes the accounting and
reporting provisions of Accounting Principles Board No. 30, "Reporting the
Results of Operations - Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions" ("APB 30"), for segments of

                                       5

<PAGE>

                              NETWORK ENGINES, INC.

       NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

a business to be disposed of. However, SFAS 144 retains APB 30's requirement
that entities report discontinued operations separately from continuing
operations and extends that reporting requirement to "a component of an entity"
that either has been disposed of or is classified as "held for sale." SFAS 144
also amends the guidance of Accounting Research Bulletin No. 51, "Consolidated
Financial Statements," to eliminate the exception to consolidation for a
temporarily controlled subsidiary. SFAS 144 is effective for financial
statements issued for fiscal years beginning after December 15, 2001, including
interim periods, and, generally, its provisions are to be applied prospectively.
The Company does not expect SFAS 144 to have a material impact on the Company's
financial position or results of operations.

Comprehensive Loss

     During each period presented, comprehensive loss was equal to net loss.

Segment Reporting

     The Company organizes itself as a single business segment and conducts its
operations primarily in the United States.

Significant Customers

     During the three and six month periods ended March 31, 2002, one customer
accounted for approximately 76% ($2.3 million) and 75% ($3.8 million) of the
Company's net revenues, respectively; this same customer accounts for
approximately 56% ($1.5 million) of the Company's accounts receivable at March
31, 2002. During the three months ended March 31, 2001, two customers each
accounted for approximately 11% ($275,000) of the Company's net revenues. During
the six months ended March 31, 2001, one customer accounted for 12% ($1.1
million) of the Company's net revenues. No customer accounted for greater than
10% of the Company's accounts receivable at March 31, 2001.

3. NET LOSS PER SHARE

     Basic net loss per share is computed by dividing the net loss attributable
to common stockholders for the period by the weighted average number of shares
of common stock outstanding during the period, excluding shares of common stock
subject to repurchase by the Company ("restricted shares"). Diluted net loss per
share is computed by dividing the net loss attributable to common stockholders
for the period by the weighted average number of shares of common stock and
potential common stock outstanding during the period, if dilutive. Potential
common stock includes restricted shares and incremental shares of common stock
issuable upon the exercise of stock options and warrants. Because the inclusion
of potential common stock would be anti-dilutive for all periods presented,
diluted net loss per share is the same as basic net loss per share.

     The following table sets forth the potential common stock excluded from the
calculation of net loss per common share because their inclusion would be
anti-dilutive (in thousands):

                                                           As of
                                                         March 31,
                                                       -------------
                                                       2002    2001
                                                       -----   -----
Options to purchase common stock ...................   4,622   6,364
Warrants to purchase common stock ..................   1,625   1,625
Unvested restricted common stock ...................     310     438
                                                       -----   -----

                                                       6,557   8,427
                                                       =====   =====

                                       6

<PAGE>

                              NETWORK ENGINES, INC.

       NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

4. INVENTORIES

Inventories consisted of the following (in thousands):

                                               March 31,   September 30,
                                                 2002          2001
                                               ---------   -------------
Raw materials ..............................    $1,024         $226
Work in process ............................       157          235
Finished goods .............................       134          146
                                                ------         ----

                                                $1,315         $607
                                                ======         ====

     In November 2001, the Company entered into an agreement to engage a third
party to provide long-term product support for the Company's discontinued
product lines. Under the terms of this agreement, the Company agreed to provide
the third party with training, documentation and access to qualified employees
of the Company. The Company also transferred certain fully reserved inventory on
hand at the time of the agreement to this third party in exchange for the third
party's agreement to assume all warranty support services to previous purchasers
of the Company's discontinued products.

5. CONTINGENCIES

     On December 29, 1999, a former employee, George Flate, commenced a lawsuit
against the Company and two former officers and directors of the Company in
Suffolk Superior Court, a Massachusetts state court. Mr. Flate alleged that the
Company unlawfully terminated him in an effort to deprive him of commission
payments. Specifically, he alleged a breach of the implied covenant of good
faith and fair dealing against the Company and a claim of intentional
interference with contractual relations against the former officers of the
Company named in the lawsuit. Mr. Flate was employed by the Company as its Vice
President of OEM Sales for approximately one year. In April 2002, the Company
completed a settlement with Mr. Flate for less than $350,000. The Company
accounted for the settlement as a charge to general and administrative expenses
during the three months ended March 31, 2002.

     On or about December 3, 2001, Margaret Vojnovich filed in the United States
District Court for the Southern District of New York a lawsuit against Network
Engines, Inc., Lawrence A. Genovesi, the Company's current Chairman and former
Chief Executive Officer, and Douglas G. Bryant, the Company's Chief Financial
Officer and Vice President of Administration (collectively, the "Executive
Officers"), FleetBoston Robertson Stephens, Inc., an underwriter of the
Company's initial public offering in July 2000 (the "IPO" ), Credit Suisse First
Boston Corp., Goldman Sachs & Co., Lehman Brothers Inc. and Salomon Smith
Barney, Inc. (collectively, the "Underwriter Defendants"). The suit generally
alleges that the Underwriter Defendants violated the federal securities laws by
conspiring and agreeing to raise and increase the compensation received by the
Underwriter Defendants by agreeing with some recipients of an allocation of IPO
stock that the recipients would purchase shares of securities in the
after-market of the IPO at pre-determined price levels designed to maintain,
distort and/or inflate the price of the Company's common stock in the
aftermarket. The suit also alleges that the Underwriter Defendants received
undisclosed and excessive brokerage commissions and that, as a consequence, the
Underwriter Defendants successfully increased investor interest in the
manipulated IPO securities and increased the Underwriter Defendants' individual
and collective underwritings, compensation and revenues. The suit further
alleges that the defendants violated the federal securities laws by issuing and
selling securities pursuant to the IPO without disclosing to investors that the
Underwriter Defendants in the offering, including the lead underwriters, had
solicited and received excessive and undisclosed commissions from certain
investors. The suit seeks damages, rescission of the purchase prices paid by
purchasers of shares of the Company's common stock and certification of a
plaintiff class consisting of all persons who acquired shares of the Company's
common stock between July 13, 2000 and December 6, 2000. On April 19, 2002, the
plaintiffs filed an amended class action complaint captioned, In Re Network
Engines, Inc. Initial Public Offering Securities Litigation, 01 Civ. 10894
(SAS). The Company is in the process of reviewing this suit and intends to
respond in a timely manner. The Company is unable to predict the outcome of this
suit and its ultimate effect, if any, on the Company's financial condition,
however the Company's defense against these

                                       7

<PAGE>

                              NETWORK ENGINES, INC.

        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

claims could result in the expenditure of significant financial and managerial
resources.

     On August 14, 2001, the Company announced that its Board of Directors had
approved the repurchase of up to $5.0 million of the Company's common stock in
the open market or in non-solicited privately negotiated transactions. The
Company plans to use any repurchased shares for its employee stock plans. During
the year ended September 30, 2001 and the six months ended March 31, 2002, the
Company repurchased 300,900 and 2,167,872 shares of common stock at a cost of
approximately $198,000 and $1,984,000, respectively.

6. ACQUISITION OF IP PERFORMANCE

     On November 8, 2000, the Company completed its acquisition of IP
Performance, Inc. ("IP Performance"), a developer of network acceleration
technology, through the exchange of 128,693 shares of Network Engines common
stock for all outstanding shares of IP Performance capital stock. The
acquisition was accounted for using the purchase method of accounting.
Accordingly, the fair market value of the acquired assets and assumed
liabilities have been included in the Company's financial statements as of the
acquisition date and the results of IP Performance operations have been included
in the Company's financial statements thereafter. The purchase price of
approximately $2,540,000, plus assumed net liabilities of approximately $95,000
and acquisition expenses of approximately $63,000, resulted in goodwill and
intangible assets of approximately $2,698,000. The Company's pro forma
statements of operations prior to the acquisition would not differ materially
from reported results.

     In July 2001, the Company completed an intensive review of its business,
which resulted in its implementation of a restructuring plan. This restructuring
plan included a discontinuation of much of the customized hardware and software
that had previously been a part of the Company's product development process. As
a result of this restructuring and an assessment of expected future cash flows,
the Company determined that the recoverability of the IP Performance-related
intangible assets was unlikely. Accordingly, the Company recognized an
impairment charge for the full amount of the remaining un-amortized intangible
assets, approximately $2,023,000, during the fourth quarter of fiscal 2001.
Prior to the impairment, the Company had been amortizing the goodwill and
intangible assets over a three-year period resulting in approximately $225,000
and $375,000 of amortization expense during the three months and six months
ended March 31, 2001, respectively.

     The Company also issued 321,756 shares of restricted common stock to key
employee shareholders of IP Performance. Under the terms of the restricted stock
agreements, these shares were restricted as to sale and such restrictions lapsed
in three equal annual installments, beginning on November 8, 2001, contingent
upon continued employment of the holder. In connection with the issuance of
these restricted shares, the Company recorded approximately $6,351,000 of
deferred compensation, which was being recognized as stock compensation expense
ratably over the vesting period. In December 2001, the Company terminated all
but one of the former IP Performance employees. In accordance with the
restricted stock agreements with these individuals, all of the remaining
un-vested restricted stock vested upon termination. As a result, during the
three months ended December 31, 2001, the Company recognized the remaining
deferred stock compensation of approximately $3,461,000.

7. INVENTORY WRITE-DOWN

     In the first and second quarters of fiscal 2001, the Company recorded
inventory write-downs of approximately $14,965,000 and $8,692,000, respectively,
for excess and obsolete inventory related to the Company's WebEngine Blazer,
WebEngine Sierra and StorageEngine Voyager product lines. This excess and
obsolete inventory was due to an unanticipated shortfall in sales of these
products as well as the discontinuation of the Company's WebEngine Blazer and
StorageEngine Voyager products. These write-downs included inventory held at the
Company's contract manufacturer, inventory on hand and firm purchase
commitments.

8. RESTRUCTURING AND OTHER CHARGES

                                       8

<PAGE>

                              NETWORK ENGINES, INC.

        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

     During the year ended September 30, 2001, the Company undertook two
restructurings of its operations, the first of these restructurings occurred in
April 2001 and the second in July 2001. Through the April 2001 restructuring,
the Company sought to better align the Company's operating expenses with reduced
revenues, and as a result of its implementation, the Company recorded a charge
to operations of $2,812,000. This charge was due to a reduction in workforce
from 243 employees to 170 employees, the curtailment of a planned expansion into
leased facilities and other items. This charge included approximately $951,000
for employee related costs including severance payments to terminated employees
and stock option compensation expense related to modifications of certain stock
options held by terminated employees, approximately $1,331,000 to write off
certain assets related to facilities that the Company will not be occupying and
approximately $530,000 primarily related to non-refundable deposits on
tradeshows the Company would not be attending as well as certain other sales and
marketing commitments. The Company's July 2001 restructuring was the result of
an intensive review of its business, which resulted in a re-focus of the
Company's sales strategy toward strategic partnerships with independent software
vendors (ISVs) and original equipment manufacturers (OEMs) and a discontinuation
of much of the customized hardware and software that was previously included in
the Company's products. As a result of the implementation of the July 2001
restructuring, the Company recorded a charge to operations of approximately
$6,871,000. This charge included approximately $1,643,000 of employee related
costs as the Company reduced its workforce by 70 employees, approximately
$2,224,000 as a result of the Company's disposal of certain property and
equipment, approximately $2,023,000 to write off goodwill and intangible assets
which were deemed to be impaired, approximately $618,000 of facility costs
associated with non-cancelable operating leases for space which will not be
occupied and approximately $363,000 of other charges. In addition to the April
2001 and July 2001 restructurings, in March 2001 the Company recorded a charge
due to the retirement of fixed assets related to its WebEngine Blazer product
line. These fixed assets had a total net book value of approximately $1,203,000
and consisted primarily of computer equipment previously utilized in the
production and sales of the WebEngine Blazer, the Company's previous generation
web content server appliance product. The total of the restructuring and other
charges detailed above was approximately $10,886,000. The reduction in the
Company's workforce implemented during the year ended September 30, 2001,
impacted employees in all of the Company's groups, including manufacturing,
research and development, selling and marketing and general and administrative.

The following table sets forth restructuring accrual activity during the six
months ended March 31, 2002:

<TABLE>
<CAPTION>
                                                      Employee   Facility
                                                      Related    Related    Other   Total
                                                      --------   --------   -----   ------
<S>                                                    <C>         <C>      <C>     <C>
Restructuring accrual balance at September 30, 2001    $ 491       $559     $ 318   $1,368

Cash payments                                           (247)       (87)     (147)    (481)

                                                       -----       ----     -----   ------
Restructuring accrual balance at December 31, 2001     $ 244       $472     $ 171   $  887
                                                       -----       ----     -----   ------

Cash payments                                           (126)       (72)      (95)    (293)

                                                       -----       ----     -----   ------
Restructuring accrual balance at March 31, 2002        $ 118       $400     $  76   $  594
                                                       =====       ====     =====   ======
</TABLE>

The Company expects the remaining restructuring accrual balance to be
substantially utilized by December 31, 2002, including cash payments of
approximately $544,000.

9. RELATED PARTY TRANSACTIONS

     In January 2001, the Company entered into a series of related agreements
with Lawrence A. Genovesi, the Company's current Chairman and former President,
Chief Executive Officer and Chief Technology Officer. These agreements were
entered into to avoid significant sales of the Company's stock by Mr. Genovesi
as a result of a margin call on a personal loan collateralized by Mr. Genovesi's
holdings of the

                                       9

<PAGE>

                              NETWORK ENGINES, INC.

        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

Company's common stock. The Company agreed to guarantee a personal loan obtained
by Mr. Genovesi from a financial institution (the "Bank") through a deposit of
$1,051,850 of the Company's cash with the Bank (the "Guarantee"). The Guarantee
period ended on January 9, 2002 and the Company extended the Guarantee to
January 9, 2003, at which time the balance of the amount deposited with the
Bank, which is not required to satisfy any obligations under the Guarantee, will
be returned to the Company. Mr. Genovesi and the Company also entered into an
agreement whereby Mr. Genovesi has agreed to reimburse the Company for any
obligations incurred by the Company under the Guarantee (the "Reimbursement
Agreement"). Any unpaid balances under the Reimbursement Agreement bear interest
at a rate of 10% per annum. In the event of a default under the Reimbursement
Agreement by Mr. Genovesi, the Company has the right to apply any and all
compensation due to Mr. Genovesi against all of Mr. Genovesi's obligations
outstanding under the Reimbursement Agreement. In addition, the Company and Mr.
Genovesi entered into a revolving promissory note of up to $210,000 (the
"Note"). The Note bore interest at a rate of 5.9% per annum and was due and
payable in full upon the earlier of January 9, 2002 or 30 days following the
date Mr. Genovesi ceased to be an employee of the Company. The Note was paid in
full in November 2001.

     In conjunction with the Guarantee, the Reimbursement Agreement and the
Note, the Company and Mr. Genovesi entered into a pledge agreement whereby Mr.
Genovesi pledged to the Company all shares of the Company's common stock owned
by Mr. Genovesi as of the date of the agreement or subsequently acquired, and
all options and other rights to acquire shares of the Company's common stock
owned by Mr. Genovesi as of the date of the agreement or subsequently acquired
(collectively, the "Pledged Securities"). Additionally, Mr. Genovesi pledged to
the Company all additional securities or other consideration from time to time
acquired by Mr. Genovesi in substitution for, or in respect of, the Pledged
Securities. If Mr. Genovesi elects to sell any of the Pledged Securities during
the term of the agreement, all proceeds of such sale will be applied to any
amounts payable under the Reimbursement Agreement. In addition to the Pledged
Securities, Mr. Genovesi's obligations under the Reimbursement Agreement are
collateralized by a second mortgage on certain real property owned by Mr.
Genovesi. As of March 31, 2002, no amounts were required to be reimbursed to the
Company under the Reimbursement Agreement. In November 2001, the Company
repurchased 234,822 shares of the Company's common stock from Mr. Genovesi for
$225,195 in a private transaction. The purchase price was determined based on
the average closing price of the Company's common stock over the ten trading
days prior to the purchase date. Mr. Genovesi used the proceeds to pay all
amounts outstanding under the Note, to pay down a recourse note payable to the
Company and to pay taxes incurred in connection with the Company's repurchase of
its common stock from Mr. Genovesi.

     In April 2001, the Company entered into full recourse loan agreements with
certain former employees and certain current and former officers of the Company
(the "Loan Agreements"). These loan agreements were entered into to avoid
substantial sales of the Company's common stock by these employees and officers
as a result of alternative minimum tax obligations incurred by these employees
and officers in connection with their exercise of options to purchase shares of
the Company's common stock. The net amount loaned to the employees and officers
under the Loan Agreements was approximately $508,000. Outstanding amounts under
the Loan Agreements accrue interest at a rate of 4.63% per annum and are due and
payable in full upon the earlier of one year from the date of each individual
agreement or thirty days after termination of employment with the Company,
unless termination is involuntary and without cause. In conjunction with the
Loan Agreements, each employee and officer pledged all shares of capital stock,
and options to purchase capital stock, of the Company now owned, or acquired in
the future (the "Pledged Stock"), and any distributions on the Pledged Stock or
proceeds from their sale. Amounts due under these Loan Agreements have been
included in the balance sheet as notes receivable from stockholders. In November
2001, the Company extended the repayment dates to September 2002 for loans with
an aggregate principal amount of $226,996 due from two of its current officers.
In April 2002, one former officer's loan was repaid in full through a payment to
the Company of $29,727 of cash and a sale to the Company of 30,000 shares of the
Company's common stock in exchange for the retirement of $27,000 of the former
officer's note payable. The Company also extended the repayment dates to
September 2002 for the remaining loans in April 2002.

                                       10

<PAGE>

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION

Special Note Regarding Forward-Looking Statements

     This Form 10-Q contains forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934, as amended, that involve
risks and uncertainties. All statements other than statements of historical
information provided herein are forward-looking statements and may contain
information about financial results, economic conditions, trends and known
uncertainties. Our actual results could differ materially from those discussed
in the forward-looking statements as a result of a number of factors, which
include those discussed in this section and elsewhere in this report and the
risks discussed in our other filings with the Securities and Exchange
Commission. Readers are cautioned not to place undue reliance on these
forward-looking statements, which reflect management's analysis, judgment,
belief or expectation only as of the date hereof. We undertake no obligation to
publicly reissue these forward-looking statements to reflect events or
circumstances that arise after the date hereof.

     The following discussion and analysis should be read in conjunction with
the condensed consolidated financial statements and the notes thereto included
in Item 1 in this Quarterly Report on Form 10-Q and our Annual Report on Form
10-K for the fiscal year ended September 30, 2001 filed by the Company with the
Securities and Exchange Commission.

Overview

     We are a provider of high-density, server appliance hardware platforms and
custom integration services. Server appliances are pre-configured computer
network infrastructure devices designed to deliver specific application
functionality. We are focused on partnering with independent software vendors
("ISVs") and original equipment manufacturers ("OEMs") to provide these
strategic partners with dense server appliance hardware, integration services
and appliance development, deployment and support to allow these strategic
partners to deliver "turn-key" solutions to their end-user customers. When we
first entered the server appliance market, we focused our business primarily on
providing scalable web content servers to Internet-based organizations, content
infrastructure providers and larger enterprises. It was necessary for us to
design most of the hardware components that went into our servers and, as a
result, we invested significant resources in the development of our products. In
June 1999, we introduced the first "1U" (1.75 inch tall) server, the WebEngine
Blazer. After the introduction of our WebEngine Blazer product, we experienced
significant growth as we invested in the development of our technology and
products, the recruitment and training of personnel for our engineering, sales
and marketing and technical support departments, and the establishment of an
administrative organization. As a result, our employee base grew from 39 as of
June 30, 1999 to 244 as of March 31, 2001, and our operating expenses grew
significantly.

     Over time, much of the hardware components of server appliances have become
commoditized and a significant number of companies entered the server appliance
marketplace. In response to competitive pressures combined with the effects of a
downturn in the economy, which had a significant negative impact on our "new
economy" customers, we implemented a restructuring plan in the quarter ended
June 30, 2001, to better align our operating expenses with our reduced revenues.
This restructuring plan resulted in a $2.8 million charge to operations in April
2001, a 73-employee reduction in our workforce, as well as the curtailment of
planned facility expansion and other cost cutting measures. We further undertook
an extensive review of our business strategy and, in July 2001, we implemented a
second restructuring of our business, which de-emphasized much of our customized
hardware and software development and focused our resources on what we believe
to be our core competencies of hardware packaging, software integration and
supply chain management. In addition, this restructuring of our business
included a transition from primarily direct sales channels to partnerships with
ISVs and OEMs in order to offer "turn-key" server appliance hardware platforms
to enterprise customers. Our current server appliance hardware platforms
continue to combine creative hardware packaging, cooling and software
integration to provide high-density, server appliances. In addition, the
implementation of our July 2001 restructuring plan included a reduction in our
workforce from 160 employees to 95 employees. We incurred a charge to operations
of approximately $6.9 million in the fourth quarter ended September 30, 2001 as
we executed our July 2001 restructuring plan. At March 31, 2002, we had an
accumulated deficit of approximately $103.5 million.

                                       11

<PAGE>

     Our revenues are derived from sales of our server appliance hardware
platforms. We recognize revenues upon shipment, provided evidence of an
arrangement has been received, no obligations remain outstanding and
collectibility is reasonably assured. The majority of our sales to date have
been to customers in the United States.

In the past, we generated a portion of our net revenues from license
arrangements, which allowed certain customers to sell our WebEngine Blazer
product under their name in exchange for per unit fees. We recognized license
revenues upon the licensee's sale to its customers. We do not anticipate future
revenues from existing license revenue arrangements.

     Gross profit (loss) represents net revenues recognized less the cost of
revenues. Cost of revenues includes cost of materials, manufacturing costs,
manufacturing personnel expenses, obsolescence charges, packaging, license fees
and shipping and warranty costs. Our gross profit (loss) is affected by the mix
of our product revenues and our product pricing and the timing, size and
configuration of customer orders.

     Research and development expenses consist primarily of salaries and related
expenses for personnel engaged in research and development, fees paid to
consultants and outside service providers, material costs for prototype and test
units and other expenses related to the design, development, testing and
enhancements of our products. We expense all of our research and development
costs as they are incurred. We believe that a significant level of investment in
product development is required to remain competitive. We expect to continue to
devote substantial resources to product development. However, we expect research
and development expenses to decrease in absolute dollars during the remainder of
fiscal 2002 due to our transition away from the internal development of
significant proprietary hardware and software. At March 31, 2002, there were 22
employees in research and development.

     Selling and marketing expenses consist primarily of salaries, commissions
and related expenses for personnel engaged in sales, marketing and customer
support functions, as well as costs associated with advertising, trade shows,
public relations and marketing materials. We expect selling and marketing
expenses to increase in absolute dollars during the remainder of fiscal 2002 as
we expand our sales and marketing efforts to increase our market presence. At
March 31, 2002, there were 14 employees in sales, marketing and customer
support.

     General and administrative expenses consist primarily of salaries and other
related costs for executive, finance, accounting, information technology,
facilities and human resources personnel, as well as accounting, legal, other
professional fees and allowance for doubtful accounts. We expect general and
administrative expenses to decrease during the remainder of fiscal 2002 as we
recorded a charge to settle litigation during the three months ended March 31,
2002 for which we do not expect comparable charges during the remainder of
fiscal 2002. There were 14 general and administrative employees at March 31,
2002.

     We recorded deferred stock compensation on our balance sheet of $15.5
million in connection with stock option and restricted stock grants to our
employees and directors that were granted between February 1, 1999 and June 30,
2000. This amount represents the difference between the exercise price and the
deemed fair value of our common stock for financial reporting purposes at the
date of grant. We are amortizing this stock compensation over the vesting period
of the related options. All options granted subsequent to June 30, 2000 have
been issued with exercise prices equal to the fair market value of our common
stock and, accordingly, no additional deferred compensation has been recorded.
Through March 31, 2002, we amortized $6.8 million to stock compensation expense
and $6.7 million of deferred stock compensation has been reversed due to the
cancellation of options for terminated employees.

     We recorded $6.4 million of deferred compensation on our balance sheet as a
result of restricted stock issued to the former employees of IP Performance,
Inc. ("IP Performance") who were retained as our employees in connection with
our acquisition of IP Performance in November 2000. The restricted stock was to
vest annually through November 2003 contingent upon continued employment. In
December 2001, we terminated all but one of the former IP Performance employees.
In accordance with the restricted stock agreements, all of the remaining
un-vested restricted stock vested upon termination. As a result, during the

                                       12

<PAGE>

three months ended December 31, 2001, the Company recognized the remaining
deferred stock compensation of approximately $3.5 million.

During the next twelve months, we expect to amortize stock compensation of:

                                                      Expected
                                                   Amortization of
                                                       Stock
Fiscal Quarter Ending                               Compensation
---------------------                              ---------------
                                                   (in thousands)
June 30, 2002 ..................................        $217
September 30, 2002 .............................         217
December 31, 2002 ..............................         217
March 31, 2003 .................................         217

     We then expect aggregate per quarter stock compensation amortization of
approximately $200,000 during the remainder of fiscal 2003 and an aggregate of
approximately $400,000 thereafter. The amount of stock compensation expense to
be recorded in future periods could change if restricted stock or options for
accrued but unvested compensation are forfeited.

Critical Accounting Policies And Estimates

     Our discussion and analysis of our financial condition and results of
operations are based upon our condensed consolidated financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. On an on-going basis, we evaluate our estimates, including
those related to accounts receivable and sales allowances and inventory
valuation. We base our estimates on historical experience and on various other
assumptions that we believe to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities that are not readily apparent from other sources.
Actual results may differ from these estimates under different assumptions or
conditions.

     We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our condensed
consolidated financial statements. We maintain allowances for doubtful accounts
for estimated losses resulting from the inability of our customers to make
required payments. If the financial condition of our customers were to
deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required. We assess the collectibility of revenue
at the point of each sale based upon all available information. We maintain
sales allowances for revenue transactions where collectibility is not reasonably
assured. Estimates of collectibility are affected by our customers' financial
condition at the point of sale and these estimates may differ from actual
results. We write down our inventory for estimated obsolescence or unmarketable
inventory equal to the difference between the cost of inventory and the
estimated market value based upon assumptions about future demand and market
conditions. If actual market conditions are less favorable than those projected
by management, additional inventory write-downs may be required.

Results of Operations

     The following table sets forth financial data for the periods indicated as
a percentage of net revenues:

                                       13

<PAGE>

<TABLE>
<CAPTION>
                                                               Three months ended   Six months ended
                                                                    March 31,           March 31,
                                                               ------------------   ----------------
                                                                  2002    2001        2002    2001
                                                                  ----    ----        ----    ----
<S>                                                               <C>     <C>         <C>     <C>
Net revenues ...............................................       100%    100%        100%    100%

Cost of revenues:
   Cost of revenues ........................................        89     137          93      92
   Cost of revenues stock compensation .....................         2       3           3       2
   Inventory write-down (benefit) ..........................        --     346          --     251
                                                                  ----    ----        ----    ----

   Total cost of revenues ..................................        91     486          96     345
                                                                  ----    ----        ----    ----

      Gross profit (loss) ..................................         9    (386)          4    (245)

Operating expenses:
   Research and development ................................        41     158          55      83
   Selling and marketing ...................................        26     234          38     132
   General and administrative ..............................        48      75          51      47
   Stock compensation ......................................         6      55          75      28
   Restructuring and other charges .........................        --      48          --      13
   Amortization of goodwill and intangible assets ..........        --       8          --       4
                                                                  ----    ----        ----    ----

      Total operating expenses .............................       121     578         219     307
                                                                  ----    ----        ----    ----

Loss from operations .......................................      (112)   (964)       (215)   (552)
Other income ...............................................        17      57          19      35
                                                                  ----    ----        ----    ----

Net loss....................................................       (95%)  (907%)      (196%)  (517%)
                                                                  ====    ====        ====    ====
</TABLE>

Three Months Ended March 31, 2002 and March 31, 2001

Net Revenues

     Net revenues increased to $3.0 million in the three months ended March 31,
2002 from $2.5 million in the three months ended March 31, 2001. This increase
is due to higher sales volumes as a result of sales to a large OEM customer in
the three months ended March 31, 2002 for which there was no comparable customer
during the three months ended March 31, 2001. This customer accounted for 76% of
our net revenues during the three months ended March 31, 2002. The increase in
net revenues in the three months ended March 31, 2002 was offset somewhat by a
lower average selling price of our products as compared to that of the three
months ended March 31, 2001. The decrease in the average selling price of our
products during the three months ended March 31, 2002 was due to the high
concentration of OEM revenues, which have a lower sales price per unit.

Gross Profit (Loss)

     In the three months ended March 31, 2002, we had a gross profit of
$267,000, an improvement from a gross loss of $9.7 million in the three months
ended March 31, 2001. During the three months ended March 31, 2001, we recorded
an inventory write-down of approximately $8.7 million for which there was no
corresponding charge in the three months ended March 31, 2002. The inventory
write-down resulted from an unanticipated decline in sales during the three
months ended March 31, 2001, as well as a high level of inventory and firm
inventory commitments compared to the Company's reduced expectations for future
product sales at that time. Excluding the inventory write-down and stock
compensation, gross profit increased to $326,000, or 10.7% of net revenues, in
the three months ended March 31, 2002 from a gross loss of ($936,000), or
(37.2%) of net revenues, in the three months ended March 31, 2001. This increase
is primarily the result of decreased component costs due to our increased use of
standard off-the-shelf components in our products and the general economic
slowdown of the past year, an increase in product sales volumes and decreased
manufacturing costs as a result of restructurings that we undertook during the

                                       14

<PAGE>

third and fourth quarters of our fiscal 2001. The increase in gross profit was
offset by a lower average selling price of our products in the three months
ended March 31, 2002, which is due to the high concentration of OEM revenues.

Operating Expenses

     Research and Development. Research and development expenses decreased to
$1.3 million in the three months ended March 31, 2002 from $4.0 million in the
three months ended March 31, 2001. This decrease was due primarily to decreased
compensation costs as research and development personnel decreased from 85
employees at March 31, 2001 to 22 employees at March 31, 2002. The decrease in
research and development expenses is also due to decreases in prototype and test
unit costs and consulting costs as we have increased the use of standard
off-the-shelf components in our products, which has reduced our need to build
prototype and test units and has allowed us to utilize fewer consultants in our
product development process.

     Selling and Marketing. Selling and marketing expenses decreased to $790,000
in the three months ended March 31, 2002 from $5.9 million in the three months
ended March 31, 2001. This decrease was due primarily to decreased compensation
costs as sales, marketing and customer support personnel decreased from 98
employees at March 31, 2001 to 14 employees at March 31, 2002. To a lesser
extent, the decrease in selling and marketing expenses is also attributable to
lower advertising and trade show expenses as we reduced our discretionary
selling and marketing expenditures during the three months ended March 31, 2002
and decreased travel costs as a result of the decrease in sales, marketing and
customer support personnel.

     General and Administrative. General and administrative expenses decreased
to $1.5 million in the three months ended March 31, 2002 from $1.9 million in
the three months ended March 31, 2001. The decrease in general and
administrative expenses is primarily attributable to decreased compensation
costs as general and administrative personnel decreased from 30 employees as of
March 31, 2001 to 14 employees as of March 31, 2002. To a lesser extent, the
decrease in general and administrative expenses is attributed to lower
consulting and professional service fees and a decrease in recruiting costs. The
decrease in general and administrative expenses was somewhat offset by a charge
of less than $350,000 recorded during the three months ended March 31, 2002 to
settle a lawsuit filed against us December 29, 1999 by a former employee.

     Stock Compensation. We recognized stock compensation expense of $227,000
and $1.5 million in the three months ended March 31, 2002 and 2001,
respectively, related to the grant of options and restricted stock to employees
and directors prior to our initial public offering in fiscal 2000 and in
connection with restricted stock issued to employees as a result of our
acquisition of IP Performance, Inc. in November 2000. The decrease in stock
compensation expense in the three months ended March 31, 2002 is the result of
the forfeiture of options and restricted stock with accrued but unvested
compensation by terminated employees.

     Restructuring and other charges. In the three months ended March 31, 2001,
we retired fixed assets related to our WebEngine Blazer product line. These
fixed assets had a total net book value of approximately $1,203,000 and
consisted primarily of computer equipment previously utilized in the production
and sales of the WebEngine Blazer, our previous generation web content server
appliance product.

     Amortization of Goodwill and Intangible Assets. In connection with our
acquisition of IP Performance, Inc. in November 2000, we recorded goodwill and
intangible assets of $2.7 million, of which we amortized $225,000 in the three
months ended March 31, 2001. During fiscal 2001, we completed an intensive
review of our business, which resulted in our implementation of a restructuring
plan. As a result of this restructuring and an assessment of expected future
cash flows, we determined that the recoverability of intangible assets resulting
from our purchase of IP Performance, Inc. was uncertain. Accordingly, we
recognized an impairment charge for the full amount of the remaining
un-amortized intangible assets, approximately $2.0 million during the fourth
quarter of fiscal 2001.

                                       15

<PAGE>

Other income

     Other income decreased to $522,000 in the three months ended March 31, 2002
from $1.4 million in the three months ended March 31, 2001. This decrease was
due to lower average interest rates earned on our cash equivalents and a lower
average cash and cash equivalents balance during the three months ended March
31, 2002 as a result of net operating losses incurred since our initial public
offering in July 2000.

Six Months Ended March 31, 2002 and March 31, 2001

Net Revenues

     Net revenues decreased to $5.1 million in the six months ended March 31,
2002 from $9.4 million in the six months ended March 31, 2001. This decrease is
due to a lower average selling price of our products as compared to that of the
six months ended March 31, 2001, which is due to the high concentration of OEM
revenues, which have a lower average selling price per unit. During the six
months ended March 31, 2002 one customer accounted for 75% of our net revenues.
To a lesser extent, the decrease in net revenues is due to a decrease in license
revenues during the six months ended March 31, 2002. We do not expect
significant future license revenues.

Gross Profit (Loss)

     In the six months ended March 31, 2002, we had a gross profit of $223,000,
an improvement from a gross loss of $23.1 million in the six months ended March
31, 2001. During the six months ended March 31, 2001, we recorded an inventory
write-down of approximately $23.7 million for which there was no corresponding
charge in the three months ended March 31, 2002. The inventory write-down
resulted from an unanticipated decline in sales during the six months ended
March 31, 2001, as well as a high level of inventory and firm inventory
commitments compared to the Company's reduced expectations for future product
sales at that time. Excluding the inventory write-down and stock compensation,
gross profit decreased to $355,000, or 6.9% of net revenues, in the six months
ended March 31, 2002 from a gross profit of $762,000, or 8.1% of net revenues,
in the six months ended March 31, 2001. This decrease is primarily the result of
a lower average selling price of our products in the six months ended March 31,
2002, which is due to the high concentration of OEM revenues. To a lesser
extent, the decrease in gross profit is due to a decrease in license revenues
during the six months ended March 31, 2002. The decrease in gross profit was
offset in part by decreases in component costs, which is due to our increased
use of standard off-the-shelf components in our products and the general
economic slowdown of the past year.

Operating Expenses

     Research and Development. Research and development expenses decreased to
$2.8 million in the six months ended March 31, 2002 from $7.8 million in the six
months ended March 31, 2001. This decrease was due primarily to decreased
compensation costs as research and development personnel decreased from 85
employees at March 31, 2001 to 22 employees at March 31, 2002. The decrease in
research and development expenses is also due to decreases in prototype and test
unit costs and consulting costs as we have increased the use of standard
off-the-shelf components in our products, which has reduced our need to build
prototype and test units and has allowed us to utilize fewer consultants in our
product development process.

     Selling and Marketing. Selling and marketing expenses decreased to $2.0
million in the six months ended March 31, 2002 from $12.4 million in the six
months ended March 31, 2001. This decrease was due primarily to decreased
compensation costs as sales, marketing and customer support personnel decreased
from 98 employees at March 31, 2001 to 14 employees at March 31, 2002. To a
lesser extent, the decrease in selling and marketing expenses is also
attributable to lower advertising and trade show expenses as we reduced our
discretionary selling and marketing expenditures during the six months ended
March 31, 2002 and decreased travel costs as a result of the decrease in sales,
marketing and customer support personnel.

     General and Administrative. General and administrative expenses decreased
to $2.6 million in the six months ended March 31, 2002 from $4.5 million in the
six months ended March 31, 2001. The decrease in

                                       16

<PAGE>

general and administrative expenses is attributable to decreased bad debt
expense and lower compensation costs as general and administrative personnel
decreased from 30 employees as of March 31, 2001 to 14 employees as of March 31,
2002. The decrease in general and administrative expenses is also attributed to
lower consulting and professional service fees and a decrease in recruiting
costs. The decrease in general and administrative expenses was somewhat offset
by a charge of less than $350,000 recorded during the six months ended March 31,
2002 to settle a lawsuit, which was filed against us December 29, 1999 by a
former employee.

     Stock Compensation. We recognized stock compensation expense of $4.0
million and $2.8 million in the six months ended March 31, 2002 and 2001,
respectively, related to the grant of options and restricted stock to employees
and directors prior to our initial public offering in fiscal 2000 and in
connection with restricted stock issued to employees as a result of our
acquisition of IP Performance, Inc., in November 2000. In December 2001, we
terminated substantially all of the remaining employees of IP Performance, Inc.
In accordance with the restricted stock agreements with these individuals, all
of the related restricted stock vested upon termination and all of the remaining
deferred stock compensation of $3.5 million was accelerated and recorded in the
three months ended December 31, 2001.

     Restructuring and other charges. In the six months ended March 31, 2001, we
retired fixed assets related to our WebEngine Blazer product line. These fixed
assets had a total net book value of approximately $1,203,000 and consisted
primarily of computer equipment previously utilized in the production and sales
of the WebEngine Blazer, our previous generation web content server appliance
product.

     Amortization of Goodwill and Intangible Assets. In connection with our
acquisition of IP Performance, Inc. in November 2000, we recorded goodwill and
intangible assets of $2.7 million, of which we amortized $375,000 in the six
months ended March 31, 2001. During fiscal 2001, we completed an intensive
review of our business, which resulted in our implementation of a restructuring
plan. As a result of this restructuring and an assessment of expected future
cash flows, we determined that the recoverability of intangible assets resulting
from our purchase of IP Performance, Inc. was uncertain. Accordingly, we
recognized an impairment charge for the full amount of the remaining
un-amortized intangible assets, approximately $2.0 million during the fourth
quarter of fiscal 2001.

Other income

     Other income decreased to $946,000 in the six months ended March 31, 2002
from $3.3 million in the six months ended March 31, 2001. This decrease was due
to lower average interest rates earned on our cash equivalents and a lower
average cash and cash equivalents balance during the six months ended March 31,
2002 as a result of net operating losses incurred since our initial public
offering in July 2000.

Liquidity and Capital Resources

     Since fiscal 1997, we have financed our operations primarily through the
sale of equity securities, borrowings and the sale of our products. On July 18,
2000, we completed our initial public offering by selling 7,475,000 shares of
our common stock, including the exercise of the underwriters' overallotment
option of 975,000 shares, at $17 per share and raised approximately $116.9
million, net of offering costs and underwriting fees totaling approximately
$10.2 million. Prior to our initial public offering, we raised approximately
$37.3 million, net of offering costs, from the issuance of preferred stock. As
of March 31, 2002, we had $62.6 million in cash and cash equivalents, excluding
restricted cash of $1.1 million.

     Cash used in operating activities was $10.2 million and $14.9 million in
the six months ended March 31, 2002 and March 31, 2001, respectively. Cash used
in operating activities during the six months ended March 31, 2002 was primarily
due to a net loss of $10.1 million and decreases in the amount due to our
contract manufacturer and accrued expenses and is offset by adjustments for
non-cash charges for stock compensation, depreciation and amortization. Cash
used in operating activities in the six months ended March 31, 2001 was
primarily due to a net loss of $48.7 million, an increase in inventories and
decreases in accounts payable and accrued expenses, offset in part by a net
increase in the amount due to our contract

                                       17

<PAGE>

manufacturer, a decrease in accounts receivable and adjustments for non-cash
charges for inventory reserves, stock compensation, depreciation and
amortization.

     Cash used in investing activities was $140,000 and $4.7 million in the six
months ended March 31, 2002 and 2001, respectively. Cash used in investing
activities was primarily for purchases of property and equipment and other
assets during the six months ended March 31, 2002. Cash used in investing
activities was primarily for purchases of property and equipment and other
assets and a deposit of restricted cash for an executive loan guarantee during
the six months ended March 31, 2001.

     Cash from financing activities was a cash outflow of $1.8 million during
the six months ended March 31, 2002 and a cash inflow of $331,000 during the six
months ended December 31, 2000. Cash used in financing activities in the three
months ended March 31, 2002 was primarily for the acquisition of treasury stock,
offset in part by cash received upon the repayment of stockholder notes
receivable. Cash provided by financing activities in the six months ended March
31, 2001 was primarily from the exercise of stock options and warrants.

     On August 14, 2001, we announced that our Board of Directors had approved
the repurchase of up to $5 million of our common stock in the open market or in
non-solicited privately negotiated transactions. We plan to use repurchased
shares for our employee stock plans. During the year ended September 30, 2001
and six months ended March 31, 2002, the Company repurchased 300,900 and
2,167,872 shares of common stock at a cost of approximately $198,000 and
$1,984,000, respectively.

     As a result of restructurings implemented in fiscal 2001, we are obligated
to make additional cash payments of approximately $544,000, the majority of
which will be made over the next nine months. We anticipate that funds required
to make all restructuring payments will be available from our current working
capital.

     On January 9, 2001, we deposited $1.1 million of cash with a bank to
guarantee a personal loan of Lawrence A. Genovesi, our current Chairman and
former President, Chief Executive Officer and Chief Technology Officer. The
guarantee period, as amended, ends on January 9, 2003, at which time the balance
of the amount deposited with the bank, which is not required to satisfy any
obligations under the guarantee, will be returned to us. The bank may draw down
against this deposited amount in the event that Mr. Genovesi does not make
required payments as due under the personal loan agreement. In conjunction with
our guarantee of this loan, we entered into a pledge agreement with Mr. Genovesi
whereby he pledged to us as collateral all shares of Network Engines stock
currently held by him, all shares of Network Engines stock aquired by him at any
future time and a second mortgage on certain real property owned by Mr.
Genovesi.

The following table sets forth future payments that we are obligated to make
under capital and operating lease commitments as of March 31, 2002 (in
thousands):

                                                 Payments Due by Period
                                                        Fiscal year
                                                 -------------------------
Contractual obligation                   Total   2002   2003   2004   2005
----------------------                  ------   ----   ----   ----   ----
Operating leases                        $2,588   $424   $892   $916   $356
Capital leases                              36     36     --     --     --
                                        ------   ----   ----   ----   ----
   Total contractual cash obligations   $2,624   $460   $892   $916   $356

During the three month period ended March 31, 2002, we did not engage in:

     .    material off-balance sheet activities, including the use of structured
          finance or specific purpose entities;
     .    trading activities in non-exchange traded contracts; nor
     .    transactions with persons or entities that benefit from their
          non-independent relationship with us, other than transactions
          disclosed in footnote 9 to our condensed consolidated financial
          statements.

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

                                       18

<PAGE>

     .    our ability to form an adequate number of strategic partnerships with
          ISVs and OEMs;

     .    the level of success of our strategic ISV and OEM partners 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;

     .    the costs involved in obtaining, maintaining and enforcing
          intellectual property rights; and

     .    market developments.

     We believe that our available cash resources, including cash and cash
equivalents, together with cash we expect to generate from sales of our
products, will be sufficient to meet our debt service and our operating and
capital requirements through at least the next 12 months. After that, we may
need to raise additional funds. We may seek to raise additional funds through
borrowings, public or private equity financings or from other sources. There can
be no assurance that additional financing will be available at all or, if
available, will be on terms acceptable to us. If additional financing is needed
and is not available on acceptable terms, we may need to reduce our operating
expenses or discontinue one or more components of our new business strategy.

Recent Accounting Pronouncements

     In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 141 ("SFAS 141"), "Business Combinations" and SFAS No. 142 ("SFAS 142"),
"Goodwill and Other Intangible Assets." SFAS 141 requires that all business
combinations be accounted for under the purchase method only and that certain
acquired intangible assets in a business combination be recognized as assets
apart from goodwill. SFAS 142 requires, among other things, the cessation of the
amortization of goodwill. In addition, the standard includes provisions for the
reclassification of certain existing recognized intangibles as goodwill,
reassessment of the useful lives of existing recognized intangibles,
reclassification of certain intangibles out of previously reported goodwill and
the identification of reporting units for purposes of assessing potential future
impairments of goodwill. SFAS 142 also requires the completion of a transitional
goodwill impairment test six months from the date of adoption. SFAS 141 is
effective for all business combinations initiated after June 30, 2001. SFAS 142
is effective for the Company's fiscal quarters beginning on October 1, 2002;
early adoption is not permitted. We do not expect SFAS 142 to have a material
impact on our financial position or the results of our operations.

     In October 2001, the FASB issued Statement of Financial Accounting
Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets" ("SFAS 144"). The objectives of SFAS 144 are to address significant
issues relating to the implementation of FASB Statement No. 121, "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of"
("SFAS 121"), and to develop a single accounting model, based on the framework
established in SFAS 121, for long-lived assets to be disposed of by sale,
whether previously held and used or newly acquired. SFAS 144 supersedes SFAS
121; however, it retains the fundamental provisions of SFAS 121 for (1) the
recognition and measurement of the impairment of long-lived assets to be held
and used and (2) the measurement of long-lived assets to be disposed of by sale.
SFAS 144 supersedes the accounting and reporting provisions of Accounting
Principles Board No. 30, "Reporting the Results of Operations - Reporting the
Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions" ("APB 30"), for segments of a
business to be disposed of. However, SFAS 144 retains APB 30's requirement that
entities report discontinued operations separately from continuing operations
and extends that reporting requirement to "a component of an entity" that either
has been disposed of or is classified as "held for sale." SFAS 144 also amends
the guidance of Accounting Research Bulletin No. 51, "Consolidated Financial
Statements," to eliminate the exception to consolidation for a temporarily
controlled subsidiary. SFAS 144 is effective for financial statements issued for
fiscal years beginning after December 15, 2001, including interim periods, and,
generally, its provisions are to be applied

                                       19

<PAGE>

prospectively. We do not expect SFAS 144 to have a material impact on our
financial position or the results of our operations.

                FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

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

                         Risks Related to Restructuring

We have recently restructured our business. There can be no assurance that our
restructuring will have the intended effect on our business.

     During the fiscal year ended September 30, 2001, we restructured our
business. Our restructuring included a considerable reduction in our workforce
and our future operating expenses and an adjustment to our business strategy to
concentrate our resources on our core competencies, which we believe to be
hardware platform packaging and the ability to integrate our hardware platforms
with various operating systems, management systems and application software
systems. Our restructuring also includes a transition from primarily direct
sales channels to partnerships with independent software vendors and original
equipment manufacturers in order to offer "turn-key" solutions for enterprise
customers. In addition, our restructuring includes the termination of sales of
our WebEngine Blazer, WebEngine Roadster, WebEngine Viper, AdminEngine and
StorageEngine Voyager products. There can be no assurance that our
restructuring, even if fully implemented, will have a positive effect on our
operations, our market share, the market price of our common stock or public
perception of us in the server appliance marketplace, or that we will ever
achieve substantial revenues or profitability, any one of which could cause
further decline in the market price of our common stock.

If we fail to generate significant revenues from strategic partnerships with
independent software vendors and original equipment manufacturers, our
operations could be materially adversely affected and as a result, we may choose
to discontinue one or more of the components of our new business strategy.

     Previously, our revenues were principally derived from direct sales to
companies in the Internet marketplace, otherwise known as "new economy"
customers. A major component of our restructuring is a business strategy change
to focus our sales and marketing efforts on indirect sales through strategic
partnerships with ISVs and OEMs. To date, we have not entered into a significant
number of definitive agreements with ISVs and OEMs. We may not be able to
develop a significant number of strategic partnerships with ISVs and OEMs and,
even if we are successful in developing strategic partnerships with ISVs and
OEMs, this strategy may fail to generate sufficient revenues to offset the
demands that this strategy will place on our business. A failure to generate
significant revenues from strategic partnerships could materially adversely
affect our operations and, as a result, we may choose to discontinue one or more
of the components of our new business strategy.

                Risks Related to Competition Within Our Industry

If we are not able to effectively compete against providers of general-purpose
servers, specific-purpose servers or other server appliance providers, our
revenues will not increase and may decrease further.

     In the market for server appliance hardware platforms, we face significant
competition from larger companies who market general-purpose servers,
specific-purpose servers and server appliances and have greater financial
resources and name recognition than we do. Many of these companies have
significant distribution capabilities as well as larger more established service
organizations to support their products. Our large competitors may be able to
leverage their existing resources, including their extensive

                                       20

<PAGE>

distribution capabilities and their service organizations, to provide a wider
offering of products and services as well as higher levels of support on a more
cost-effective basis than we can. In addition, competing companies may be able
to undertake more extensive promotional activities, adopt more aggressive
pricing policies and offer more attractive terms to their customers than we can.
If these large competitors provide lower cost server appliance hardware
platforms with greater functionality or support than our products, or if some of
their products are comparable to ours and are offered as part of a range of
products that is broader than ours, our products could become undesirable. Even
if the functionality of competing products is equivalent to ours, we face a
substantial risk that a significant number of customers would elect to pay a
premium for similar functionality rather than purchase products from a
less-established vendor. Increased competition may continue to negatively affect
our business and future operating results by leading to price reductions, higher
selling expenses or a reduction in our market share.

If server appliances are not increasingly adopted as a solution to meet
companies' computer application needs, the market for our products may not grow
and the market price of our common stock could decline as a result of lower
revenues or reduced investor expectations.

     We expect that substantially all of our revenues will come from sales of
our newest and future server appliance hardware platforms. As a result, we
depend on the growing use of server appliances to meet businesses' computer
application needs. The market for server appliance products has only recently
begun to develop and it is evolving rapidly. Because this market is new, we
cannot predict its potential size or future growth rate with a high degree of
certainty. Our revenues may not grow and the market price of our common stock
could decline if the server appliance market does not grow rapidly.

     We believe that our expectations for the growth of the server appliance
market may not be fulfilled if customers continue to use general-purpose
servers. The role of our products could, for example, be limited if
general-purpose servers become better at performing functions currently being
performed by server appliances or are offered at a lower cost. This could force
us to further lower the prices of our products or result in fewer sales of our
products.

Our revenues could be reduced further if our larger competitors make
acquisitions in order to join their extensive distribution capabilities with our
smaller competitors' products.

     Large server manufacturers may not only develop their own server appliance
solutions, but they may also acquire or establish cooperative relationships with
our smaller competitors, including smaller private companies. Because large
server manufacturers have significant financial and organizational resources
available, they may be able to quickly penetrate the server appliance market by
leveraging the technology and expertise of smaller companies and utilizing their
own extensive distribution channels. We expect that the server industry will
experience further consolidation. It is possible that new competitors or
alliances among competitors may emerge and rapidly acquire significant market
share through consolidation. Consolidation within the server marketplace could
adversely affect our revenues.

We may sell fewer products if other vendors' products are no longer compatible
with ours or other vendors bundle their products with those of our competitors
and sell them at lower prices.

     Our ability to sell our products depends in part on the compatibility of
our products with other vendors' software and hardware products. Developers of
these products may change their products so that they will no longer be
compatible with our products. These other vendors may also decide to bundle
their products with other server appliances for promotional purposes and
discount the sales price of the bundle. If that were to happen, our business and
future operating results could suffer if we were no longer able to offer
commercially viable products.

Server appliance products are subject to rapid technological change due to
changing operating system software and network hardware and software
configurations, and our sales will suffer if our products are rendered obsolete
by new technologies.

     The server appliance market is characterized by rapid technological change,
frequent new product introductions and enhancements, potentially short product
life cycles, changes in customer demands and

                                       21

<PAGE>

evolving industry standards. Our products could be rendered obsolete if products
based on new technologies are introduced or new industry standards emerge.

     New products and product enhancements can require long development and
testing periods, which require us to retain, and may require us to hire
additional, technically competent personnel. Significant delays in new product
releases or significant problems in installing or implementing new products
could seriously damage our business. We have on occasion experienced delays in
the scheduled introduction of new and enhanced products and cannot be certain
that we will avoid similar delays in the future.

     Our future success depends upon our ability to utilize our creative
packaging and hardware and software integration skills to combine
industry-standard hardware and software to produce low-cost, high-performance
products that satisfy our strategic partners' requirements and achieve market
acceptance. We cannot be certain that we will successfully identify new product
opportunities and develop and bring new products to market in a timely and
cost-effective manner.

                     Risks Related to Our Financial Results

We derive a substantial portion of our revenues from one customer, and our
revenues may decline significantly if this customer cancels or delays a purchase
of our products.

     In the six months ended March 31, 2002, one customer accounted for 75% of
our net revenues. None of our customers are obligated to purchase any quantity
of our products in the future. If our largest customer stops purchasing from us,
delays future purchases or discontinues use of our technology, our revenues and
operating results will be adversely affected, our reputation in the industry may
suffer and our ability to predict cash flow accurately will decrease.
Accordingly, unless and until we expand and diversify our customer base, our
future success will depend upon the timing and size of future purchase orders,
if any, from this customer.

We are an early-stage company in the evolving market for server appliances and
have recently released key new products, which have not yet obtained significant
market acceptance.

     Because of our limited operating history in the server appliance market, it
is difficult to discern trends that may emerge and affect our business. In
November 2001, we introduced our ApplianceEngine 1000 product and in February
2002 we introduced our ApplianceEngine 3000 product. We cannot be sure whether
these, or additional new product offerings, will obtain significant market
acceptance, whether they will capture adequate market share or whether we will
be able to recognize significant revenue from them. Our limited historical
financial performance may make it difficult for you to evaluate the success of
our business to date and to assess its future viability.

     If our new and enhanced products do not gain market acceptance, we may not
be able to attract and engage strategic ISV and OEM partners. If we are unable
to attract and engage ISV and OEM partners, our revenues and operating results
will be adversely affected. Factors that may affect the market acceptance of our
products, some of which are beyond our control, include the following:

     .    the growth and changing requirements of the server appliance market;
     .    the performance, quality, price and total cost of ownership of our
          products; and
     .    the availability, price, quality and performance of competing products
          and technologies.

We have a history of losses and expect to experience losses in the future, which
could result in the market price of our common stock declining further.

     Since our inception, we have incurred significant net losses, including net
losses of $5.8 million, $12.5 million and $69.5 million in fiscal 1999, 2000 and
2001, respectively, as well as a net loss of $10.1 million in the six months
ended March 31, 2002. We expect to continue to have net losses in the future. In
addition, we had an accumulated deficit of $103.5 million as of March 31, 2002.
We believe that our future

                                       22

<PAGE>

growth depends upon the success of our new product development and selling and
marketing efforts, which will require us to incur significant product
development, selling and marketing and administrative expenses. As a result, we
will need to generate significant revenues to achieve profitability. We cannot
be certain that we will achieve profitability in the future or, if we achieve
profitability, that we will be able to sustain it. If we do not achieve and
maintain profitability, the market price for our common stock may decline.

     During the year ended September 30, 2001, we implemented restructuring
plans to curtail discretionary selling, general and administrative expenses,
consolidate our international operations, implement new business strategies to
efficiently maximize our resources and utilize other cost saving methods. If
these, or other cost control measures that we may employ, are unsuccessful, our
expenses could increase and our losses could be greater than expected, which
could negatively impact the market price for our common stock.

Our revenues fell sharply in fiscal 2001 and we may not be able to return to our
historical revenue growth rates, which could cause our stock price to decline.

     Our revenues grew rapidly in fiscal 1999 and fiscal 2000 and fell sharply
in fiscal 2001. We are unable to predict whether or not we will be able to
return to the rate of revenue growth achieved in fiscal 1999 and fiscal 2000
because of uncertain economic conditions, competition and our inexperience in
identifying and engaging ISV and OEM partners. If we are unable to return to the
rate of revenue growth we experienced in fiscal 2000, our stock price could
decline.

If the commodification of products and competition in the server appliance
market increases, then the average unit price of our products may decrease and
our operating results may suffer.

     Products in the appliance server market may be subject to further
commodification as the industry matures and other businesses introduce more
competing products. The average unit price of our products has already
decreased, and may continue to decrease, in response to changes in our product
mix, competitive pricing pressures, or new product introductions into the server
appliance marketplace. If we are unable to offset decreases in our average
selling prices by increasing our sales volumes, our revenues will decline.
Changes in the mix of sales of our products, including the mix of higher margin
sales of products sold in smaller quantities and somewhat lower margin sales of
products sold in larger quantities, could adversely affect our operating results
for future quarters. To maintain our gross margins, we also must continue to
reduce the manufacturing cost of our products. Our efforts to produce higher
margin products, continue to improve our products and produce new products may
make it difficult to reduce our manufacturing cost per product. Further, our
utilization of a contract manufacturer may not allow us to reduce our cost per
product.

Our quarterly revenues and operating results may fluctuate due to a lack of
growth of the server appliance market in general or failure of our products to
achieve market acceptance.

     Our quarterly revenues and operating results are difficult to predict and
may fluctuate significantly from quarter to quarter because server appliances
generally, and our current products in particular, are relatively new and the
future growth of the market for our products is uncertain. In addition, we
expect to rely on additional new products for growth in our net revenues in the
future. If the server appliance market in general fails to grow as expected or
our products fail to achieve market acceptance, our quarterly net revenues and
operating results may fall below the expectations of investors and public market
research analysts. In this event, the price of our common stock could decline
further.

                Risks Related to Our Marketing and Sales Efforts

We need to effectively manage our sales and marketing operations to increase
market awareness and sales of our products. If we fail to do so, our growth, if
any, will be limited.

                                       23

<PAGE>

     Through our recent restructuring plans, we significantly reduced our
selling and marketing personnel in an attempt to reduce operating expenses and
to conserve cash. Although we have fewer selling and marketing personnel, we
must continue to increase market awareness and sales of our products. If we fail
in this endeavor, our growth, if any, will be limited.

     Our efforts to promote our brand may not result in the desired brand
recognition by existing or potential ISV and OEM customers or in increased
sales.

     In the fast growing market for server appliance hardware platforms, we
believe we need a strong brand to compete successfully. In order to attract and
retain ISV and OEM customers, we believe that our brand must be recognized and
viewed favorably by ISVs and OEMs. As part of our recent restructuring plans, we
reduced our marketing programs. If we are unable to design and implement
effective marketing campaigns or otherwise fail to promote and maintain our
brand, our sales may not increase and our business may be adversely affected.
Our business may also suffer if we incur excessive expenses promoting and
maintaining our brand but fail to achieve the expected or desired increase in
revenues.

If we are unable to effectively manage our customer service and support
activities, we may not be able to retain our existing ISV and OEM customers and
attract new ISV and OEM customers.

     We have a small customer service and support organization. We need to
effectively manage our customer support operations to ensure that we maintain
good relationships with our customers. If our customer support organization is
unsuccessful in maintaining good customer relationships, we may lose customers
to our competitors and our reputation in the market could be damaged. As a
result, we may lose revenue and incur losses greater than expected.

                   Risks Related to Our Product Manufacturing

If we do not accurately forecast our component requirements, our business and
operating results could be adversely affected.

     We use rolling forecasts based on anticipated product orders to determine
our component requirements. Lead times for materials and components that we
order vary significantly and depend on factors including specific supplier
requirements, contract terms and current market demand for those components. In
addition, a variety of factors, including the timing of product releases,
potential delays or cancellations of orders and the timing of large orders, make
it difficult to predict product orders. As a result, our component requirement
forecasts may not be accurate. If we overestimate our component requirements, we
may have excess inventory, which would increase our costs and negatively impact
our cash position. If we underestimate our component requirements, we may have
inadequate inventory, which could interrupt our manufacturing and delay delivery
of our products to our customers. Any of these occurrences would negatively
impact our business and operating results.

Our dependence on sole source and limited source suppliers for key components
makes us susceptible to supply shortages that could prevent us from shipping
customer orders on time, if at all, and could result in lost sales or customers.

     We depend upon single source and limited source suppliers for our
industry-standard processors, main logic boards, certain disk drives, and power
supplies as well as our internally developed heat-pipe, chassis and sheet metal
parts. We also depend on limited sources to supply several other
industry-standard components. We have in the past experienced, and may in the
future experience, shortages of, or difficulties in acquiring, components needed
to produce our products. Shortages have been of limited duration and have not
yet caused delays in production of our products. However, shortages in supply of
these key components for an extended time would cause delays in the production
of our products, prevent us from satisfying our contractual obligations and
meeting customer expectations, and result in lost sales or customers. If we are
unable to buy components we need or if we are unable to buy components at
acceptable prices, we will not be able to manufacture and deliver our products
on a timely or cost-effective basis to our customers.

                                       24

<PAGE>

Our future success is dependent on our ability to expand our production
capacity.

     Our existing manufacturing facility is limited in its production capacity.
For us to be successful our product sales volumes must increase significantly.
Our production capacity must increase to support significant increases in
product sales volumes. In order to increase our production capacity, we may have
to utilize the services of a contract manufacturer to produce our products at
high volumes. We may have difficulties in identifying and engaging a contract
manufacturer to produce our products with terms that are favorable to us. Using
a contract manufacturer may increase the cost of producing our products and we
could experience transitional difficulties including production delays and
quality control issues, which could cause customer relationships to suffer and
result in lost sales. Also, the use of a contract manufacturer may not guarantee
us production levels, manufacturing line space or manufacturing prices, which
could interrupt our business operations and have a negative effect on operating
results.

            Risks Related to Our Products' Dependence on Intellectual
                        Property and Our Use of Our Brand

Our reliance upon contractual provisions, domestic copyright and trademark laws
and our applied-for patents to protect our proprietary rights may not be
sufficient to protect our intellectual property from others who may sell similar
products.

     Our products are differentiated from those of our competitors by our
internally developed software and hardware and the manner in which they are
integrated into our products. If we fail to protect our intellectual property,
other vendors could sell products with features similar to ours, and this could
reduce demand for our products. We believe that the steps we have taken to
safeguard our intellectual property afford only limited protection. Others may
develop technologies that are similar or superior to our technology or design
around the copyrights and trade secrets we own. Despite the precautions we have
taken, laws and contractual restrictions may not be sufficient to prevent
misappropriation of our technology or deter others from developing similar
technologies. In addition, there can be no guarantee that any of our patent
applications will result in patents, or that any such patents would provide
effective protection of our technology.

     In addition, the laws of the countries in which we decide to market our
services and solutions may offer little or no effective protection of our
proprietary technology. Reverse engineering, unauthorized copying or other
misappropriation of our proprietary technology could enable third-parties to
benefit from our technology without paying us for it, which would significantly
harm our business.

We have invested substantial resources in developing our products and our brand,
and our operating results would suffer if we were subject to a protracted
infringement claim or one with a significant damages award.

     Substantial litigation regarding intellectual property rights and brand
names exists in our industry. We expect that server appliance products may be
increasingly subject to third-party infringement claims as the number of
competitors in our industry segment grows and the functionality of products in
different industry segments overlaps. We are not aware that our products employ
technology that infringes any proprietary rights of third parties. However,
third parties may claim that we infringe their intellectual property rights. Any
claims, with or without merit, could:

     .    be time-consuming to defend;

     .    result in costly litigation;

     .    divert our management's attention and resources;

     .    cause product shipment delays; or

     .    require us to enter into royalty or licensing agreements.

                                       25

<PAGE>

     Royalty or licensing agreements may not be available on terms acceptable to
us, if at all. A successful claim of product infringement against us or our
failure or inability to license the infringed or similar technology could
adversely affect our business because we would not be able to sell the impacted
product without redeveloping it or incurring significant additional expenses.

                       Other Risks Related to Our Business

A class action lawsuit has been filed against us, our chairman and one of our
executive officers.

     On or about December 3, 2001, a class action lawsuit was filed against us,
our chairman, one of our executive officers and the underwriters of our initial
public offering. We are unable to predict the effects of this suit, or other
similar suits, on our financial condition and our business and, although we
maintain certain insurance coverage, there can be no assurance that this claim
will not result in substantial monetary damages in excess of our insurance
coverage. In addition, we may expend significant resources to defend this case.
This class action lawsuit, or other similar suits, could negatively impact both
our financial condition and the market price for our common stock.

If the market price of our common stock is not quoted on a national exchange,
our ability to raise future capital may be hindered and the market price of our
common stock may be negatively impacted.

     The market price for our common stock has declined during the past year. If
we are unable to meet the stock price listing requirements of NASDAQ, our common
stock could be de-listed from the NASDAQ National Market. If our common stock
were de-listed from NASDAQ, among other things, this could result in a number of
negative implications, including reduced liquidity in our common stock as a
result of the loss of market efficiencies associated with NASDAQ and the loss of
federal preemption of state securities laws as well as the potential loss of
confidence by suppliers, customers and employees, the loss of analyst coverage
and institutional investor interest, fewer business development opportunities
and greater difficulty in obtaining financing.

If we fail to retain appropriate levels of qualified technical personnel, we may
not be able to develop and introduce our products on a timely basis.

     We require the services of qualified technical personnel. We have
experienced the negative effects of an economic slowdown. Our revenues have
declined significantly during the past year and the market price of our common
stock has decreased significantly. As a result, we have implemented plans to
substantially reduce our operating expenditures, including a reduction in the
number of personnel in our organization. This reduction in personnel places
added pressure on the remaining employees and management of the Company. These
and other factors may make it difficult for us to retain the qualified employees
and management that we need to effectively manage our business operations,
including key research and development activities. If we are unable to retain a
sufficient number of technical personnel we may not be able to complete
development of, or upgrade or enhance, our products in a timely manner, which
could negatively impact our business and could hinder any future growth.

If our products fail to perform properly and conform to our specifications, our
customers may demand refunds or assert claims for damages and our reputation and
operating results may suffer.

     Because our server appliance hardware platforms are complex, they could
contain errors that can be detected at any point in a product's life cycle. In
the past we have discovered errors in some of our products and have experienced
delays in the shipment of our products during the period required to correct
these errors or we have had to replace defective products that were already
shipped. These delays and replacements have principally related to new product
releases. Errors in our products may be found in the future and any of these
errors could be significant. Detection of any significant errors may result in:

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

     .    diversion of development resources;

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<PAGE>

     .    injury to our reputation; or

     .    increased maintenance and warranty costs.

     These problems could harm our business and future operating results.
Product errors or delays could be material, including any product errors or
delays associated with the introduction of new products or the versions of our
products that support Windows or UNIX-based operating systems. While we attempt
to limit our risk contractually, if our products fail to conform to warranted
specifications, customers could demand a refund for the purchase price or assert
claims for damages.

     Moreover, because our products may be used in connection with critical
distributed computing systems services, we may receive significant liability
claims if our products do not work properly. Our agreements with customers
typically contain provisions intended to limit our exposure to liability claims.
However, these limitations may not preclude all potential claims. Liability
claims could exceed our insurance coverage and require us to spend significant
time and money in litigation or to pay significant damages. Any claims for
damages, even if unsuccessful, could seriously damage our reputation and our
business.

Our stock may be subject to substantial price and volume fluctuations due to a
number of factors, many of which will be beyond our control that may prevent our
stockholders from reselling our common stock at a profit.

     The securities markets have experienced significant price and volume
fluctuations in the past and the market prices of the securities of technology
companies have been especially volatile. This market volatility, as well as
general economic, market or political conditions, could reduce the market price
of our common stock in spite of our operating performance. In addition, our
operating results could be below the expectations of public market analysts and
investors, and in response the market price of our common stock could decrease
significantly. Investors may be unable to resell their shares of our common
stock for a profit. In the past, companies that have experienced volatility in
the market price of their stock have been the object of securities class action
litigation. If we were the object of securities class action litigation, it
could result in substantial costs and a diversion of management's attention and
resources. The decline in the market price of our common stock and market
conditions generally could adversely affect our ability to raise additional
capital, to complete future acquisitions of or investments in other businesses
and to attract and retain qualified technical and sales and marketing personnel.

Future sales by existing stockholders could depress the market price of our
common stock.

     Sales of a substantial number of shares of our common stock by existing
stockholders could depress the market price of our common stock and impair our
ability to raise capital through the sale of additional equity securities.

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

     Our board of directors has the authority to issue up to 5,000,000 shares of
preferred stock and, without any further vote or action on the part of the
stockholders, will have the authority to determine the price, rights,
preferences, privileges and restrictions of the preferred stock. This preferred
stock, if issued, might have preference over the rights of the holders of common
stock and could adversely affect the price of our common stock. The issuance of
this preferred stock may make it more difficult for a third party to acquire us
or to acquire a majority of our outstanding voting stock. We currently have no
plans to issue preferred stock.

     In addition, provisions of our second amended and restated certificate of
incorporation, second amended and restated by-laws and equity compensation plans
may deter an unsolicited offer to purchase Network Engines. These provisions,
coupled with the provisions of the Delaware General Corporation Law, may delay
or impede a merger, tender offer or proxy contest involving Network Engines. For
example, our

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board of directors will be divided into three classes, only one of which will be
elected at each annual meeting. These factors may further delay or prevent a
change of control of our business.

If we do not retain our senior management, we may not be able to successfully
execute our business plan.

     As a result of our recent restructurings we have lost members of our
management team. The loss of key members of our current management team could
harm us. Our success is substantially dependent on the ability, experience and
performance of our senior management team. Because of their ability and
experience, we may not be able to implement successfully our business strategy
if we lose one or more of these individuals.

We may need additional capital that may not be available to us and, if raised,
may dilute our existing investors' ownership interest in us.

     We may need to raise additional funds to develop or enhance our services
and solutions, to fund expansion, to respond to competitive pressures or to
acquire complementary products, businesses or technologies. Additional financing
may not be available on terms that are acceptable to us. If we raise additional
funds through the issuance of equity or convertible debt securities, the
percentage ownership of our stockholders would be reduced and these securities
might have rights, preferences and privileges senior to those of our current
stockholders. If adequate funds are not available on acceptable terms, our
ability to fund our expansion, take advantage of unanticipated opportunities,
develop or enhance products or services, or otherwise respond to competitive
pressures would be significantly limited.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     We do not engage in any foreign currency hedging transactions and
therefore, do not believe we are subject to material exchange rate risk. We are
exposed to market risk related to changes in interest rates. We invest excess
cash balances in cash equivalents and as a result, we believe that the effect,
if any, of reasonably possible near-term changes in interest rates on our
financial position, results of operations and cash flows will not be material.

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PART II--OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

     On December 29, 1999, a former employee, George Flate, commenced a lawsuit
against the Company and two former officers and directors of the Company in
Suffolk Superior Court, a Massachusetts state court. Mr. Flate alleged that the
Company him in an effort to deprive him of commission payments. Specifically, he
alleged a breach of the implied covenant of good faith and fair dealing against
the Company and a claim of intentional interference with contractual relations
against the former officers of the Company named in the lawsuit. Mr. Flate was
employed by the Company as its Vice President of OEM Sales for approximately one
year. In April 2002, the Company completed a settlement with Mr. Flate for less
than $350,000. The Company accounted for the settlement as a charge to general
and administrative expenses during the three months ended March 31, 2002.

     On or about December 3, 2001, Margaret Vojnovich filed in the United States
District Court for the Southern District of New York a lawsuit against Network
Engines, Inc., Lawrence A. Genovesi, the Company's current Chairman and former
Chief Executive Officer, and Douglas G. Bryant, the Company's Chief Financial
Officer and Vice President of Administration (collectively, the "Executive
Officers"), FleetBoston Robertson Stephens, Inc., an underwriter of the
Company's initial public offering in July 2000 (the "IPO" ), Credit Suisse First
Boston Corp., Goldman Sachs & Co., Lehman Brothers Inc. and Salomon Smith
Barney, Inc. (collectively, the "Underwriter Defendants"). The suit generally
alleges that the Underwriter Defendants violated the federal securities laws by
conspiring and agreeing to raise and increase the compensation received by the
Underwriter Defendants by agreeing with some recipients of an allocation of IPO
stock that the recipients would purchase shares of securities in the
after-market of the IPO at pre-determined price levels designed to maintain,
distort and/or inflate the price of the Company's common stock in the
aftermarket. The suit also alleges that the Underwriter Defendants received
undisclosed and excessive brokerage commissions and that, as a consequence, the
Underwriter Defendants successfully increased investor interest in the
manipulated IPO securities and increased the Underwriter Defendants' individual
and collective underwritings, compensation and revenues. The suit further
alleges that the defendants violated the federal securities laws by issuing and
selling securities pursuant to the IPO without disclosing to investors that the
Underwriter Defendants in the offering, including the lead underwriters, had
solicited and received excessive and undisclosed commissions from certain
investors. The suit seeks damages, rescission of the purchase prices paid by
purchasers of shares of the Company's common stock and certification of a
plaintiff class consisting of all persons who acquired shares of the Company's
common stock between July 13, 2000 and December 6, 2000. On April 19, 2002, the
plaintiffs filed an amended class action complaint captioned, In Re Network
Engines, Inc. Initial Public Offering Securities Litigation, 01 Civ. 10894
(SAS). The Company is in the process of reviewing this suit and intends to
respond in a timely manner. The Company is unable to predict the outcome of this
suit and its ultimate effect, if any, on the Company's financial condition,
however the Company's defense against these claims could result in the
expenditure of significant financial and managerial resources.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

     (d) Use of Proceeds from Sales of Registered Securities

     On July 18, 2000, we sold 7,475,000 shares of our common stock in an
initial public offering at a price of $17.00 per share pursuant to a
Registration Statement on Form S-1 (the "Registration Statement") (Registration
No. 333-34286), which was declared effective by the Securities and Exchange
Commission on July 12, 2000. The managing underwriters of our initial public
offering were Donaldson, Lufkin & Jenrette, Dain Rauscher Wessels, Robertson
Stephens and DLJdirect Inc. The aggregate proceeds to us from the offering were
approximately $116.9 million reflecting gross proceeds of $127.0 million net of
underwriting fees of approximately $8.9 million and other offering costs of
approximately $1.3 million. None of the proceeds of the offering was paid by us,
directly or indirectly, to any director, officer or general partner of ours or
any of their associates, to any persons owning ten percent or more of our
outstanding stock, or to any of our affiliates. During the period from the
offering to March 31, 2002, we have used the proceeds as follows: approximately
$47.8 million was used to fund the operations of the Company, approximately $4.8
million was used for the purchase of property and equipment and

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approximately $2.0 million was used to repurchase the Company's common stock
under a stock repurchase plan.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     The Company's Annual Meeting of Stockholders was held on March 14, 2002 at
the Courtyard Marriott Hotel, 200 Technology Center Drive, Stoughton,
Massachusetts, 02072. Of the 33,246,060 shares outstanding as of January 18,
2002 (the record date), 28,985,318 shares (87.2%) were present or represented by
proxy at the meeting.

     1. The table below presents the results of the election to the Company's
board of directors.

        Frank M. Polestra           28,508,736  For           476,582  Against

     The terms of Lawrence A. Genovesi, John A. Blaeser, Robert M. Wadsworth,
Dennis A. Kirshy and John H. Curtis, as directors of the Company, continued
after this meeting.

     2. The stockholders ratified the appointment of PricewaterhouseCoopers LLP
as the Company's independent accountants for the fiscal year ended September 30,
2002. This proposal received 28,940,462 shares voted for and 24,203 shares voted
against, with 20,653 shares abstaining.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

     (a)  Exhibits

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

     (b)  Reports on Form 8-K

     We did not file any reports on Form 8-K during the three months ended March
     31, 2002.

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SIGNATURES

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

                                      NETWORK ENGINES, INC.

Date: May 14, 2002


                                      /s/ John H. Curtis
                                      ------------------------------------------
                                      John H. Curtis
                                      President and Chief Executive Officer
                                      (Principal Executive Officer)


                                      /s/ Douglas G. Bryant
                                      ------------------------------------------
                                      Douglas G. Bryant
                                      Vice President of Administration, Chief
                                      Financial Officer, Treasurer and Secretary
                                      (Principal Financial Officer and Principal
                                      Accounting Officer)

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                                  EXHIBIT INDEX

Exhibit No.    Exhibit
10.36+         Purchase Agreement for product between the Registrant and EMC
               Corporation, dated February 5, 2002.

+ Confidential treatment requested as to certain portions, which portions have
been separately filed with the Securities and Exchange Commission.

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