##### **UNITEDSTATES**

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

**Washington,D.C. 20549**

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

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| **(Mark One)**                                                                                                                                                                                                                             |                                                                                          |       |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------|------------|
|                                                                                                                                                                                                                                       |
| **x**                                                                                                                                                                                                                                      | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
| ** **                                                                                                                                                                                                                                 |                                                                                          | ** ** |
| **For the  quarterly period ended June 30, 2007**                                                                                                                                                                                          |
| ** **                                                                                                                                                                                                                                 |
| **OR**                                                                                                                                                                                                                                     |
|                                                                                                                                                                                                                                       |                                                                                          | ** ** |
| **o**                                                                                                                                                                                                                                      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                                                 |                                                                                          | ** ** |
| **For the transition period from                    to                  ** |
|                                                                                                                                                                                                                                       |
| **Commission  file number: 0-30863**                                                                                                                                                                                                       |
|                                                                                                                                                                                                                                            |                                                                                               |            |  |

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**NETWORKENGINES, INC.**

(Exact name ofregistrant as specified in its charter)

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

 

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

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

Large acceleratedfiler o  Acceleratedfiler x  Non-accelerated filer o

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

As of August 6, 2007,there were 43,567,480 shares of the registrant’s Common Stock, par value $.01per share, outstanding.

 

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**NETWORKENGINES, INC.**

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

 

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**PART I. FINANCIAL INFORMATION**

**ITEM I.FINANCIAL STATEMENTS**

**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(in thousands)**

**(unaudited)**
| ** **                                                                                                                                                                                                  | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                  | ** ** | **2007**          | ** ** | **2006**               | ** ** |
| **ASSETS**                                                                                                                                                                                                  | ** ** | ** **        | ** ** | ** **             | ** ** |
| **Current assets:**                                                                                                                                                                                         | ** ** | ** **        | ** ** | ** **             | ** ** |
| Cash and cash  equivalents                                                                                                                                                                                  |       | $                 | 14,696     |                   | $          | 8,014 |   |
| Short-term  investments                                                                                                                                                                                     |       | 25,402            |       | 24,804                 |       |
| Restricted cash                                                                                                                                                                                             |       | 247               |       | 47                     |       |
| Accounts  receivable, net of allowances                                                                                                                                                                     |       | 16,393            |       | 17,178                 |       |
| Inventories                                                                                                                                                                                                 |       | 12,160            |       | 8,445                  |       |
| Prepaid expenses  and other current assets                                                                                                                                                                  |       | 986               |       | 1,460                  |       |
| Total current  assets                                                                                                                                                                                       |       | 69,884            |       | 59,948                 |       |
|                                                                                                                                                                                                        |       |              |       |                   |       |
| Property and  equipment, net                                                                                                                                                                                |       | 1,129             |       | 1,093                  |       |
| Other assets                                                                                                                                                                                                |       | 102               |       | 20                     |       |
|                                                                                                                                                                                                        |       |              |       |                   |       |
| Total assets                                                                                                                                                                                                |       | $                 | 71,115     |                   | $          | 61,061 |   |
|                                                                                                                                                                                                        |       |              |       |                   |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                              | ** ** | ** **        | ** ** | ** **             | ** ** |
| **Current liabilities:**                                                                                                                                                                                    | ** ** | ** **        | ** ** | ** **             | ** ** |
| Accounts payable                                                                                                                                                                                            |       | $                 | 8,782      |                   | $          | 7,047 |   |
| Accrued  compensation and other related benefits                                                                                                                                                            |       | 1,629             |       | 1,762                  |       |
| Other accrued  expenses                                                                                                                                                                                     |       | 3,266             |       | 2,180                  |       |
| Current portion  of capital lease obligation                                                                                                                                                                |       | 20                |       | 19                     |       |
| Deferred revenue                                                                                                                                                                                            |       | 3,204             |       | 1,049                  |       |
| Total current  liabilities                                                                                                                                                                                  |       | 16,901            |       | 12,057                 |       |
|                                                                                                                                                                                                        |       |              |       |                   |       |
| Long-term  portion of capital lease obligation                                                                                                                                                              |       | 45                |       | 60                     |       |
| Deferred revenue                                                                                                                                                                                            |       | 1,255             |       | 541                    |       |
|                                                                                                                                                                                                        |       |              |       |                   |       |
| Total  liabilities                                                                                                                                                                                          |       | 18,201            |       | 12,658                 |       |
|                                                                                                                                                                                                        |       |              |       |                   |       |
| Commitments and  contingencies (Note 6)                                                                                                                                                                     |       |              |       |                   |       |
|                                                                                                                                                                                                        |       |              |       |                   |       |
| **Stockholders’ equity:**                                                                                                                                                                              | ** ** | ** **        | ** ** | ** **             | ** ** |
| Preferred stock,  $.01 par value, 5,000,000 authorized, no shares issued or outstanding                                                                                                                     |       | —            |       | —                 |       |
| Common stock,  $.01 par value, 100,000,000 shares authorized; 43,482,851 and 41,751,304  shares issued; 40,920,993 and 39,189,446 shares outstanding at June 30, 2007  and September 30, 2006, respectively |       | 435               |       | 418                    |       |
| Additional  paid-in capital                                                                                                                                                                                 |       | 186,246           |       | 182,420                |       |
| Accumulated  deficit                                                                                                                                                                                        |       | (130,929          | )          | (131,597               | )          |
| Treasury stock,  at cost, 2,561,858 shares at June 30, 2007 and September 30, 2006                                                                                                                          |       | (2,838            | )          | (2,838                 | )          |
|                                                                                                                                                                                                        |       |              |       |                   |       |
| Total  stockholders’ equity                                                                                                                                                                            |       | 52,914            |       | 48,403                 |       |
|                                                                                                                                                                                                        |       |              |       |                   |       |
| Total liabilities and stockholders’  equity                                                                                                                                                            |       | $                 | 71,115     |                   | $          | 61,061 |   |

**The accompanying notes are anintegral part of the condensed consolidated financial statements.**

1

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**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(inthousands, except per share data)**

**(unaudited)**

 
| ** **                                                    | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended   June 30,** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                    | ** ** | **2007**                                        | ** ** | **2006**                                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                    | ** ** | ** **                                      | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues                                                  |       | $                                               | 27,998     |                                                 | $          | 32,048 |   | $ | 84,541 |   | $ | 87,353 |   |
|                                                          |       |                                            |       |                                                 |       |   |   |   |   |
| Cost of revenues                                              |       | 22,683                                          |       | 26,664                                               |       | 67,902 |   | 72,977 |   |
|                                                          |       |                                            |       |                                                 |       |   |   |   |   |
| Gross profit                                                  |       | 5,315                                           |       | 5,384                                                |       | 16,639 |   | 14,376 |   |
|                                                          |       |                                            |       |                                                 |       |   |   |   |   |
| Operating  expenses:                                          |       |                                            |       |                                                 |       |   |   |   |   |
| Research and development                                      |       | 2,226                                           |       | 1,986                                                |       | 6,629 |   | 6,188 |   |
| Selling and marketing                                         |       | 1,323                                           |       | 2,949                                                |       | 4,863 |   | 8,539 |   |
| General and administrative                                    |       | 1,858                                           |       | 1,979                                                |       | 5,873 |   | 5,973 |   |
|                                                          |       |                                            |       |                                                 |       |   |   |   |   |
| Total operating expenses                                      |       | 5,407                                           |       | 6,914                                                |       | 17,365 |   | 20,700 |   |
|                                                          |       |                                            |       |                                                 |       |   |   |   |   |
| Income (loss)  from operations                                |       | (92                                             | )          | (1,530                                               | )          | (726 | ) | (6,324 | ) |
| Interest and  other income, net                               |       | 524                                             |       | 425                                                  |       | 1,433 |   | 1,135 |   |
|                                                          |       |                                            |       |                                                 |       |   |   |   |   |
| Income (loss) before income taxes                             |       | 432                                             |       | (1,105                                               | )          | 707 |   | (5,189 | ) |
| Provision for income taxes                                    |       | 16                                              |       | —                                               |       | 39 |   | — |   |
|                                                          |       |                                            |       |                                                 |       |   |   |   |   |
| Net income  (loss)                                            |       | $                                               | 416        |                                                 | $          | (1,105 | ) | 668 |   | $ | (5,189 | ) |
|                                                          |       |                                            |       |                                                 |       |   |   |   |   |
| Net income  (loss) per share – basic and diluted         |       | $                                               | 0.01       |                                                 | $          | (0.03 | ) | $ | 0.02 |   | $ | (0.14 | ) |
|                                                          |       |                                            |       |                                                 |       |   |   |   |   |
| Shares used in  computing basic net income (loss) per share   |       | 40,871                                          |       | 38,218                                               |       | 40,517 |   | 38,023 |   |
|                                                          |       |                                            |       |                                                 |       |   |   |   |   |
| Shares used in  computing diluted net income (loss) per share |       | 41,270                                          |       | 38,218                                               |       | 41,208 |   | 38,023 |   |

 

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

2

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**NETWORKENGINES, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(inthousands)**

**(unaudited)**
| ** **                                                                                 | ** ** | **Nine months ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                 | ** ** | **June 30,**               | ** ** |
| ** **                                                                                 | ** ** | **2007**                        | ** ** | **2006** | ** ** |
| ** **                                                                                 | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Cash flows from  operating activities:                                                     |       |                            |       |   |   |
| Net income (loss)                                                                          |       | $                               | 668        |   | $ | (5,189 | ) |
| Adjustments to reconcile net loss to net cash  provided by (used in) operating activities: |       |                            |       |   |   |
| Depreciation and amortization                                                              |       | 622                             |       | 774 |   |
| Provision for doubtful accounts                                                            |       | 6                               |       | (33 | ) |
| Stock-based compensation                                                                   |       | 1,864                           |       | 2,143 |   |
| Loss on disposal of fixed asset                                                            |       | 7                               |       | — |   |
| Changes in operating assets and liabilities:                                               |       |                            |       |   |   |
| Accounts receivable                                                                        |       | 779                             |       | (10,554 | ) |
| Inventories                                                                                |       | (3,714                          | )          | (3,078 | ) |
| Prepaid expenses and other current assets                                                  |       | 274                             |       | 110 |   |
| Accounts payable                                                                           |       | 1,734                           |       | 7,570 |   |
| Accrued expenses                                                                           |       | 953                             |       | 877 |   |
| Deferred revenue                                                                           |       | 2,869                           |       | 467 |   |
| Receivable for insurance recovery                                                          |       | —                          |       | (2,875 | ) |
| Accrued litigation settlement                                                              |       | —                          |       | 2,875 |   |
|                                                                                       |       |                            |       |   |   |
| Net cash provided by (used in) operating activities                                        |       | 6,062                           |       | (6,913 | ) |
|                                                                                       |       |                            |       |   |   |
| Cash flows from  investing activities:                                                     |       |                            |       |   |   |
| Purchases of property and equipment                                                        |       | (665                            | )          | (380 | ) |
| Purchases of short-term investments                                                        |       | (17,500                         | )          | (36,752 | ) |
| Proceeds from sales and maturities of short-term  investments                              |       | 16,902                          |       | 38,500 |   |
| Changes in other assets                                                                    |       | (82                             | )          | 82 |   |
|                                                                                       |       |                            |       |   |   |
| Net cash (used in) provided by investing activities                                        |       | (1,345                          | )          | 1,450 |   |
|                                                                                       |       |                            |       |   |   |
| Cash flows from  financing activities:                                                     |       |                            |       |   |   |
| Proceeds from issuance of common stock                                                     |       | 1,979                           |       | 704 |   |
| Payments on capital lease obligation                                                       |       | (14                             | )          | (14 | ) |
| Borrowings under cash overdraft                                                            |       | —                          |       | 452 |   |
|                                                                                       |       |                            |       |   |   |
| Net cash provided by financing activities                                                  |       | 1,965                           |       | 1,142 |   |
|                                                                                       |       |                            |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                      |       | 6,682                           |       | (4,321 | ) |
| Cash and cash  equivalents, beginning of period                                            |       | 8,014                           |       | 9,468 |   |
|                                                                                       |       |                            |       |   |   |
| Cash and cash  equivalents, end of period                                                  |       | $                               | 14,696     |   | $ | 5,147 |   |

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

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**NETWORKENGINES, INC.**

**NOTES TO THEUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**1.  BASIS OF PRESENTATION**

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

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

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

**2.  SIGNIFICANT ACCOUNTING POLICIES**

***Recent Accounting Pronouncements***

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

In September 2006, the Financial Accounting Standards Board (“FASB”)issued FASB Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes—an Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48clarifies the accounting for uncertainty in income taxes recognized incompanies’ financial statements in accordance with FASB Statement No. 109,“Accounting for Income Taxes,” and provides guidance on financial statementrecognition and disclosure for tax positions taken or expected to be taken on atax return. The evaluation of a tax position in accordance with FIN 48 is atwo-step process. The first step is recognition whereby companies mustdetermine whether it is more likely than not that a tax position will besustained upon examination. The second step is measurement whereby a taxposition that meets the more-likely-than-not recognition threshold is measuredto determine the amount of benefit to recognize in the financial statements.FIN 48 also provides guidance on derecognition of recognized tax benefits,classification, interest and penalties, accounting in interim periods,disclosure, and transition. The guidance of FIN 48 is applicable for fiscalyears beginning after December 15, 2006. The Company is in the process ofevaluating whether the adoption of FIN48 will have a material effect on theCompany’s financial position, results of operations, or cash flows.

4

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In September 2006, the FASB issued Statement of Financial AccountingStandard No. 157, “Fair Value Measurements” (“FAS 157”).  This statementaddress how companies should measure fair value when they are required to use afair value measure for recognition or disclosure purposes under accountingprinciples generally accepted in the United States.  This Statement iseffective as of the beginning of the Company’s fiscal year that begins afterNovember 15, 2007.  The Company is in theprocess of evaluating whether the adoption of this statement will have amaterial impact on the Company’s financial position, results of operations orcash flows.

In February 2007, the Financial Accounting Standards Board (“FASB”)issued Statement of Financial Accounting Standard No. 159, “The Fair ValueOption for Financial Assets and Financial Liabilities — Including an amendmentof FASB Statement No. 115” (“FAS 159”).  This Statement permits entitiesto choose to measure many financial instruments and certain other items at fairvalue at specified election dates. Subsequent unrealized gains and losses onitems for which the fair value option has been elected will be reported inearnings. This Statement is effective as of the beginning of the Company’sfiscal year that begins after November 15, 2007.  The Company is in theprocess of evaluating whether the adoption of FAS 159 will have a material effecton the Company’s financial position, results of operations, or cash flows.

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

Cash equivalentsconsist principally of money market funds, commercial paper, and othermarketable securities purchased with an original maturity of three months orless.  These investments are carried atcost, which approximates market value. The Company also invests excess cash inauction rate securities.  Thesesecurities have long-term underlying maturities, however the market is highlyliquid and the interest rates reset every 7, 28 or 35 days.  The Company’s intent is not to hold thesesecurities to maturity, but rather to use the interest rate reset feature tosell securities to provide liquidity as needed. The Company’s short-term investments are classified as available forsale and are carried at fair value, with unrealized gains and losses includedin other comprehensive income or loss, which is a separate component ofstockholders’ equity, until realized. At June 30, 2007 and September 30, 2006,there were no unrealized gains or losses. At June 30, 2007 and September 30, 2006, $247,000 and $47,000,respectively, of cash was restricted and pledged as collateral for letters ofcredit.  Details of the Company’s cash,cash equivalents and short-term investments are as follows (in thousands):
|                                      | ** ** | **June 30,  2007** | ** ** | **September 30,  2006** | ** ** |
|--------------------------------------|------------|-------------------------|------------|------------------------------|------------|
| **Cash  and cash equivalents:**      | ** ** | ** **              | ** ** | ** **                   | ** ** |
| Cash                                 |       | $                       | 1,549      |                         | $          | 718 |   |
| Money market funds                   |       | 5,158                   |       | 5,105                        |       |
| Commercial paper                     |       | 7,989                   |       | 2,191                        |       |
|                                 |       |                    |       |                         |       |
| **Total  cash and cash equivalents** |       | $                       | 14,696     |                         | $          | 8,014 |   |
|                                 |       |                    |       |                         |       |
| **Short-term  investments:**         | ** ** | ** **              | ** ** | ** **                   | ** ** |
| Municipal  auction rate securities   |       | $                       | 25,402     |                         | $          | 24,804 |   |

 

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

During each periodpresented, comprehensive income (loss) was equal to net income (loss).

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

During the quarter endedDecember 31, 2006, the Company changed the manner in which management viewedinformation regarding results of the Company’s operations for purposes ofmaking decisions affecting the business. This resulted from changes in theoperations of the Company, including consolidation of financial and operationalinformation reviewed by management to evaluate the Company’s

5

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operations, discontinuingmarket demand creation for its NS Series Security Appliances and using certainof those products as reference platforms for developing and selling appliancesto system integrators and Independent Software Vendors (“ISVs”), and theconsolidation of the Company’s sales force. Therefore, the Company now has onereportable segment, which represents how management now evaluates the Company’soperations.  Substantially all of the Company’s long-lived assets werelocated in the United States as of June 30, 2007 and September 30, 2006.

***SignificantCustomers***

The following tablesummarizes those customers who accounted for greater than 10% of the Company’snet revenues or accounts receivable:
| ** **      | ** ** | **Net Revenues**            | ** ** | ** **                      | ** ** | ** **                           | ** ** |
|-----------------|------------|----------------------------------|------------|---------------------------------|------------|--------------------------------------|------------|
| ** **      | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** | **Accounts Receivable at** | ** ** |
| ** **      | ** ** | **June 30,**                | ** ** | **June 30,**               | ** ** | **June 30,**                    | ** ** | **September 30,** | ** ** |
| ** **      | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007**                             | ** ** | **2006** | ** ** | **2007** | ** ** | **2006** | ** ** |
| EMC Corporation |       | 81                               | %          | 81                              | %          | 81                                   | %          | 81 | % | 81 | % | 85 | % |

 

**3.  STOCK-BASED COMPENSATION**

Stock-based compensation expense is measured at thegrant date, based on the fair value of the award, and is recognized as anexpense over the employee’s requisite service period (generally the vestingperiod of the equity award).

The followingtable presents stock-based employee compensation expense included in theCompany’s unaudited condensed consolidated statements of operations (in thousands):
| ** **                        | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|-----------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                        | ** ** | **2006**                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
|                              |       |                                            |       |                                           |       |   |   |   |   |
|  Cost of revenues            |       | $                                               | 44         |                                           | $          | 55 |   | $ | 124 |   | $ | 141 |   |
|  Research and development    |       | 297                                             |       | 297                                            |       | 877 |   | 835 |   |
|  Selling and marketing       |       | 76                                              |       | 205                                            |       | 243 |   | 614 |   |
|  General and administrative  |       | 187                                             |       | 214                                            |       | 620 |   | 553 |   |
| Stock-based  compensation expense |       | $                                               | 604        |                                           | $          | 771 |   | $ | 1,864 |   | $ | 2,143 |   |

 

The Companyestimates the fair value of stock options using the Black-Scholes valuationmodel. This valuation model takes into account the exercise price of the award,as well as a variety of significant assumptions. These assumptions include theexpected term, the expected volatility of the Company’s stock over the expectedterm, the risk-free interest rate over the expected term, and the Company’s expectedannual dividend yield. The Company believes that the valuation technique andthe approach utilized to develop the underlying assumptions are appropriate incalculating the fair values of the Company’s stock options granted in the threeand nine months ended June 30, 2007 and 2006. Estimates of fair value are notintended to predict the value ultimately realized by persons who receive equityawards. In determining the amount of expense to be recorded, judgment is alsorequired to estimate forfeitures of the awards based on the probability ofemployees completing the required service period.   Historicalforfeitures are used as a starting point for developing the estimate of futureforfeitures.

6

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Assumptions usedto determine the fair value of options granted during the three and nine monthsended June 30, 2007, using the Black-Scholes valuation model were:
| ** **                                 | ** ** | **Expected Term  (1)** | ** ** | **Expected  Volatility Factor  (2)** | ** ** | **Risk Free  Interest Rate  (3)** | ** ** | **Expected Annual  Dividend Yield** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|-------------------------------------------|------------|---------------------------------------------|------------|-----------------------------------------------|------------|
|                                       |       |                        |       |                                      |       |                                        |       |                                          |       |
| Three and nine  months ended June 30, 2007 |       | 5.50  - 6.25 years          |       | 65.77%  - 72.67%                          |       | 4.44%  - 4.70%                              |       | —                                        |       |
|                                       |       |                        |       |                                      |       |                                        |       |                                          |       |
| Three and nine months  ended June 30, 2006 |       | 5.50 – 6.25 years      |       | 77.00% - 78.21%                           |       | 4.39% - 5.15%                               |       | —                                        |       |

 

----

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

 

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

A summary of theCompany’s stock option activity for the nine months ended June 30, 2007 is asfollows:
|                                  | ** ** | **Nine months ended June 30, 2007** | ** ** |
|----------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                       | ** ** | **Number of  Options**                                  | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  years)** | ** ** |
|                             |       |                                                         |       |   |   |   |   |
| Outstanding,  September 30, 2006 |       | 7,366,964                                                    |       | $ | 2.29 |   |   |   |
| Granted                          |       | 1,180,150                                                    |       | 2.20 |   |   |   |
| Exercised                        |       | (1,625,246                                                   | )          | 1.10 |   |   |   |
| Cancelled                        |       | (579,749                                                     | )          | 3.23 |   |   |   |
| Outstanding,  June 30, 2007      |       | 6,342,119                                                    |       | $ | 2.49 |   | 7.61 |   |
| Exercisable at  June 30, 2007    |       | 3,230,757                                                    |       | $ | 3.00 |   | 6.56 |   |

 

Alloptions granted during the nine months ended June 30, 2007 and 2006 weregranted with exercise prices equal to the fair market value of the Company’scommon stock on the grant date and had weighted average grant date fair valuesof $1.46 and $1.12, respectively.

7

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AtJune 30, 2007, unrecognized compensation expense related to non-vested stockoptions was $3,153,491 which is expected to be recognized over a weightedaverage period of 2.58 years.

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

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

The followingtable sets forth the computation of basic and diluted net income (loss) pershare as well as the weighted average potential common stock excluded from thecalculation of net loss per share because their inclusion would beanti-dilutive (in thousands, except per share data):
| ** **                                                                                                       | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2007**                                        | ** ** | **2006**                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| Numerator:                                                                                                       |       |                                            |       |                                           |       |   |   |   |   |
| Net income (loss)                                                                                                |       | $                                               | 416        |                                           | $          | (1,105 | ) | $ | 668 |   | $ | (5,189 | ) |
|                                                                                                             |       |                                            |       |                                           |       |   |   |   |   |
| Denominator:                                                                                                     |       |                                            |       |                                           |       |   |   |   |   |
| Shares used in computing basic net income (loss) per  share                                                      |       | 40,871                                          |       | 38,218                                         |       | 40,517 |   | 38,023 |   |
| Common stock equivalents from employee stock options                                                             |       | 399                                             |       | —                                         |       | 691 |   | — |   |
|                                                                                                             |       |                                            |       |                                           |       |   |   |   |   |
| Shares used in computing diluted net income (loss)  per share                                                    |       | 41,270                                          |       | 38,218                                         |       | 41,208 |   | 38,023 |   |
|                                                                                                             |       |                                            |       |                                           |       |   |   |   |   |
| Net income  (loss) per share:                                                                                    |       |                                            |       |                                           |       |   |   |   |   |
| Basic                                                                                                            |       | $                                               | 0.01       |                                           | $          | (0.03 | ) | $ | 0.02 |   | $ | (0.14 | ) |
| Diluted                                                                                                          |       | $                                               | 0.01       |                                           | $          | (0.03 | ) | $ | 0.02 |   | $ | (0.14 | ) |
|                                                                                                             |       |                                            |       |                                           |       |   |   |   |   |
| Anti-dilutive  potential common stock equivalents excluded from the calculation of net  income (loss) per share: |       | 5,338                                           |       | 4,979                                          |       | 3,898 |   | 4,572 |   |
| Options to  purchase common stock                                                                                |       |                                            |       |                                           |       |   |   |   |   |

 

**5.  INVENTORIES**

Inventories consisted ofthe following (in thousands):
| ** **      | ** ** | **June 30, 2007** | ** ** | **September 30, 2006** | ** ** |
|-----------------|------------|-----------------------------|------------|----------------------------------|------------|
| ** **      | ** ** | ** **                  | ** ** | ** **                       | ** ** |
| Raw materials   |       | $                           | 6,392      |                             | $          | 4,628 |   |
| Work in process |       | 771                         |       | 432                              |       |
| Finished goods  |       | 4,997                       |       | 3,385                            |       |
|            |       |                        |       |                             |       |
|            |       | $                           | 12,160     |                             | $          | 8,445 |   |

 

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**6.  COMMITMENTS AND CONTINGENCIES**

***Guaranteesand Indemnifications***

Acquisition-relatedindemnifications - When, as part of an acquisition, the Company acquires allthe stock of a company, the Company assumes liabilities for certain events orcircumstances that took place prior to the date of acquisition.  The maximum potential amount of futurepayments the Company could be required to make for such obligations isundeterminable.  While the provisions ofthe agreements remain in effect indefinitely, the Company believes that theprobability of receiving a claim is unlikely. As a result, the Company has not recorded a liability for theseindemnification clauses as of June 30, 2007.

The Company entersinto standard indemnification agreements in the ordinary course of itsbusiness. Pursuant to these agreements, the Company indemnifies, holdsharmless, and agrees to reimburse the indemnified party for losses suffered orincurred by the indemnified party, generally its business partners orcustomers, in connection with any patent, copyright, trademark, trade secret orother intellectual property infringement claim by any third party with respectto its products. The term of these indemnification agreements is generallyperpetual. The Company has never incurred costs to defend lawsuits or settleclaims related to these indemnification agreements. As a result, the Companybelieves the estimated fair value of these agreements is minimal. Accordingly,the Company has no liabilities recorded for these indemnifications as of June30, 2007.

Product warranties – The Company offers and fulfills warrantyservices on certain of its server appliances. Warranty terms vary in durationdepending upon the product sold but generally provide for the repair orreplacement of any defective products for periods of up to 36 months aftershipment. Based upon historical experience and expectation of futureconditions, the Company reserves for the estimated costs to fulfill customerwarranty obligations upon the recognition of the related revenue. The followingtable presents changes in the Company’s product warranty liability for thethree and nine months ended June 30, 2007 and 2006 (in thousands):
| ** **                                   | ** ** | **Three months ended  June 30,** | ** ** | **Nine months ended  June 30,** | ** ** |
|----------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                   | ** ** | **2007**                                        | ** ** | **2006**                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                   | ** ** | ** **                                      | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Beginning  balance                           |       | $                                               | 1,017      |                                           | $          | 515 |   | $ | 559 |   | $ | 455 |   |
| Accruals for  warranties issued              |       | 766                                             |       | 222                                            |       | 1,684 |   | 835 |   |
| Fulfillment of  warranties during the period |       | (445                                            | )          | (216                                           | )          | (905 | ) | (769 | ) |
| Ending balance                               |       | $                                               | 1,338      |                                           | $          | 521 |   | $ | 1,338 |   | $ | 521 |   |

 

***Contingencies***

*Announcement Timing Lawsuit*

On March 17, 2004, the United States District Court for the District ofMassachusetts (the “Court”) consolidated a number of purported class actionlawsuits filed against Network Engines, Inc. and certain individual NetworkEngines defendants (collectively the “Defendants”).  These suits generallyconcern the timing of the announcement of an amendment to Network Engines’agreement with EMC Corporation regarding the resale of EMC-approved FibreChannel HBAs.  The Plaintiffs filed an amended consolidated complaint onJune 4, 2004.  The Defendants on August 13, 2004 filed a motion to dismissthe amended consolidated complaint.  The Plaintiffs on October 12, 2004filed an opposition to the Defendants’ motion to dismiss and the Defendants fileda reply to the Plaintiffs’ opposition on November 12, 2004.  The Court onNovember 22, 2004 denied the Defendants’ motion to dismiss the amendedconsolidated complaint. On December 9, 2004, the Defendants’ filed an answer tothe amended consolidated complaint.

Since that time, the parties engaged in some informal discovery,exchanged formal discovery requests, and then pursued active settlementdiscussions.  On March 31, 2006, the parties filed a motion for

9

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preliminaryapproval of a class action settlement.  On April 4, 2006, the Courtentered an Order preliminarily approving the settlement and scheduled deadlinesfor the settlement approval process. The settlement was subject to a notice andcomment period during which class members could object, opt out of thesettlement, or file claims under the settlement.  No class membersobjected to the settlement or opted out of the class.  On July 25, 2006,the Court approved the settlement.  The Court entered an Order and FinalJudgment approving the terms of the settlement in its entirety.  The termsof the settlement required the Company’s insurance provider to pay $2,875,000in full settlement of the claims asserted by the class.

*Initial Public Offering Lawsuit*

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

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

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

On July 9, 2003, a Special Committee of the Company’s Board of Directorsauthorized the Company to negotiate a settlement of the pending claimssubstantially consistent with a memorandum of understanding negotiated amongclass plaintiffs, all issuer defendants and their insurers.  The partieshave negotiated the settlement, which provides, among other things, for arelease of the Company and the individual defendants for the conduct alleged inthe amended complaint to be wrongful.  The Company would agree toundertake other responsibilities under the settlement, including agreeing toassign, or not assert, certain potential claims that it may have against itsunderwriters.  Any direct financial impact of the proposed settlement isexpected to be borne by the Company’s insurers.  Any such settlement wouldbe subject to various contingencies, including approval by the Court overseeingthe litigation. On February 15, 2005, the Court issued an Opinion and Orderpreliminarily approving the settlement, provided that the defendants and plaintiffs agree to amodification narrowing the scope of the bar order set forth in the originalsettlement agreement.  The parties agreed to a modification narrowing thescope of the bar order, and on August 31, 2005, the Court issued an orderpreliminarily approving the settlement and setting a public hearing on itsfairness, which took place on April 24, 2006.  On December 5, 2006, theUnited States Court of Appeals for the Second Circuit overturned the DistrictCourt’s certification of the class of

10

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plaintiffswho are pursuing the claims that would be settled in the settlement against theunderwriter defendants. Thereafter, the District Court ordered a stay of allproceedings in all of the lawsuits pending the outcome of plaintiffs’ petitionto the Second Circuit for rehearing en banc and resolution of the classcertification issue.  On April 6, 2007, the Second Circuit deniedplaintiffs’ petition for rehearing, but clarified that the plaintiffs may seekto certify a more limited class in the District Court.  On June 25, 2007,the District Court signed an order terminating the settlement. The Company isunable to predict the outcome of this suit and as a result, no amounts havebeen accrued as of June 30, 2007.

**7.  RELATED PARTY TRANSACTIONS**

Robert M. Wadsworth, one ofthe Company’s directors, also serves as a director of Innoveer Solutions, Inc. (“Innoveer”).  The Company engages Innoveer to provideprofessional services related to modifications of its customer resourcemanagement (“CRM”) software system. During the three and nine months ended June 30, 2007, the Companyincurred approximately $7,500 and $49,000, respectively..   During the three and nine months ended June30, 2006, the Company incurred approximately $6,000 and $55,000, respectively.  The Company had $0 and $7,000 payable toInnoveer at June 30, 2007 and September 30, 2006, respectively.

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**ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFRESULTS OF OPERATIONS AND FINANCIAL CONDITION**

**Special Note RegardingForward-Looking Statements**

This Quarterly Report on Form10-Q contains forward-looking statements within the meaning of Section 21E ofthe Securities Exchange Act of 1934, as amended, that involve risks anduncertainties.All statements other than statements of historical information provided hereinare forward-looking statements and may contain projections related to financialresults, economic conditions, trends and known uncertainties. Our actualresults could differ materially from those discussed in the forward-lookingstatements as a result of a number of factors, which include those discussed inthis section and in Part II, Item 1A, Risk Factors, of this report and therisks discussed in our other filings with the Securities and ExchangeCommission. Readers are cautioned not to place undue reliance on theseforward-looking statements, which reflect management’s analysis, judgment,belief or expectation only as of the date hereof. We undertake no obligation topublicly reissue these forward-looking statements to reflect events orcircumstances that arise after the date hereof.

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

**Overview**

Wedevelop and manufacture server appliance solutions that deliver data storageand network security applications on server appliances. Server appliances arepre-configured network infrastructure devices designed to optimally deliverspecific software application functionality and facilitate ease of deploymentand support of a software application in a customer’s network.

Duringthe quarter ended December 31, 2006, we changed the manner in which we viewinformation regarding results of our operations for purposes of makingdecisions affecting the business. These changes included consolidation offinancial and operational information reviewed to evaluate our operations, discontinuingmarket demand creation for our NS Series Security Appliances and using certainof those products as reference platforms for developing and selling appliancesto system integrators and Independent Software Vendors (“ISVs”), and theconsolidation of our sales force. Therefore, we now have one reportablesegment, which represents how we evaluate our operations.

**CriticalAccounting Policies and Estimates**

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

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**Resultsof Operations**

**Threemonths ended June 30, 2007 compared to the three months ended June 30, 2006**

Thefollowing table summarizes financial data for the periods indicated inthousands and as a percentage of net revenues and provides the changes inthousands and percentages:
| ** **            | ** ** | **Three Months Ended June 30,** | ** ** |
|-----------------------|------------|-----------------------------------------------------|------------|
| ** **            | ** ** | **2007**                                            | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **            | ** ** | **Dollars**                                         | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues          |       | $                                                   | 27,998     |   | 100.0 | % | $ | 32,048 |   | 100.0 | % | $ | (4,050 | ) | (12.6 | )% |
| Gross profit          |       | 5,315                                               |       | 19.0 | % | 5,384 |   | 16.8 | % | (69 | ) | (1.3 | )% |
| Operating  expenses   |       | 5,407                                               |       | 19.3 | % | 6,914 |   | 21.6 | % | (1,507 | ) | (21.8 | )% |
| Loss from  operations |       | (92                                                 | )          | (0.3 | )% | (1,530 | ) | (4.8 | )% | 1,438 |   | 93.9 | % |
| Net income (loss)     |       | 416                                                 |       | 1.5 | % | (1,105 | ) | (3.4 | )% | 1,521 |   | 137.6 | % |
|                       |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Net Revenues***

Our revenues are derivedfrom sales of server appliances and related maintenance services.

Our net revenues for the three months ended June 30,2007 declined versus the same period in fiscal 2006 primarily due to both loweraverage selling prices related to the natural evolution of product life-cyclesand lower sales volume.  Net revenuesfrom sales to EMC represented 81% of net revenues in the three months endedJune 30, 2007 versus 81% in the three months ended June 30, 2006. Net revenuesfrom other customers for the three months ended June 30, 2007 were $5.3 millioncompared to $4.8 million in the three months ended June 30, 2006, after excludingrevenues from Network Intelligence Corporation due to its acquisition by EMC onSeptember 18, 2006.   This growth wasattributable to an increase in revenue from existing customers, revenue forservicing Microsoft Whale customers and revenue from new customers in the firsthalf of fiscal 2007.

***Gross profit***

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

Gross profit as apercentage of net revenue increased for the quarter ended June 30, 2007compared to the quarter ended June 30, 2006. The increase from the prior year was primarily due to increased servicerevenue which carries higher gross margins, the timing of cost reductionsrelative to price reductions to customers and the effect of lower applianceaverage selling prices in relation to consistent per unit gross margindollars.   These increases were partiallyoffset by higher warranty expenses.

Gross profit isaffected by customer and product mix, pricing and the volume of orders as wellas by the mix of product manufactured internally compared to productmanufactured by a contract manufacturer, which results in higher manufacturingcosts.  We expect that gross profit as apercentage of net revenue for the three months ended September 30, 2007 will besimilar when compared to the three months ended June 30, 2007.

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***Operating Expenses***

The following table presents operating expenses duringthe periods indicated, in thousands and as a percentage of net revenues:
| ** **                 | ** ** | **Three Months Ended June 30,** | ** ** |
|----------------------------|------------|-----------------------------------------------------|------------|
| ** **                 | ** ** | **2007**                                            | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                 | ** ** | **Dollars**                                         | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating  expenses:       |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Research and development   |       | $                                                   | 2,226      |   | 8 | % | $ | 1,986 |   | 6 | % | $ | 240 |   | 12 | % |
| Selling and marketing      |       | 1,323                                               |       | 5 | % | 2,949 |   | 9 | % | (1,626 | ) | (55 | )% |
| General and administrative |       | 1,858                                               |       | 7 | % | 1,979 |   | 6 | % | (121 | ) | (6 | )% |
|                       |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Total operating  expenses  |       | $                                                   | 5,407      |   | 19 | % | $ | 6,914 |   | 22 | % | $ | (1,507 | ) | (22 | )% |

 

***Research anddevelopment***

Research and development expenses consist primarily ofsalaries and related expenses for personnel engaged in research anddevelopment, fees paid to consultants and outside service providers, materialcosts for prototype and test units and other expenses related to the design,development, testing and enhancements of our server appliance products. Weexpense all of our research and development costs as they are incurred. Thefollowing table summarizes the most significant components of research anddevelopment expense for the periods indicated, in thousands and as a percentageof total research and development expense and provides the changes in thousandsand percentages: 
| ** **                        | ** ** | **Three Months Ended June 30,** | ** ** |
|-----------------------------------|------------|-----------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                            | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                         | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:        |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                   | 1,382      |   | 62 | % | $ | 1,279 |   | 64 | % | $ | 103 |   | 8 | % |
| Stock-based compensation          |       | 296                                                 |       | 13 | % | 297 |   | 15 | % | (1 | ) | — |   |
| Prototype                         |       | 141                                                 |       | 6 | % | 45 |   | 2 | % | 96 |   | 213 | % |
| Consulting and outside services   |       | 271                                                 |       | 12 | % | 110 |   | 6 | % | 161 |   | 146 | % |
| Other                             |       | 136                                                 |       | 6 | % | 255 |   | 13 | % | (119 | ) | (46 | )% |
|                              |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Total research  and development   |       | $                                                   | 2,226      |   | 100 | % | $ | 1,986 |   | 100 | % | $ | 240 |   | 12 | % |

 

Our research and development expenses have increasedthis quarter as compared to the same period last fiscal year. Because ourresearch and development expenses are project driven, the timing of theseexpenditures can vary.  The increase incompensation and related expenses is attributable to an increase inheadcount.  The increase in consultingcosts as well as prototype costs relates to the timing of certain developmentprojects.

Our server appliance development strategy emphasizesthe utilization of standard server appliance platforms, which utilizeoff-the-shelf components. However, we expect that in some cases significantdevelopment efforts will be required to fulfill our current and potentialcustomers’ needs using customized platforms. In addition, we intend to focusour software development in areas that improve the ease of server applianceimplementation and use, which we believe will enhance our valueproposition.  We expect that prototypeand consulting costs will be variable and could fluctuate depending on thetiming and magnitude of our development projects. However, we expect ourresearch and development costs to remain consistent during our quarter endedSeptember 30, 2007.

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***Selling andmarketing***

Selling and marketing expenses consist primarily ofsalaries and commissions for personnel engaged in sales and marketing; costsassociated with our marketing programs, which include costs associated with ourattendance at trade shows, advertising, web site enhancements and productevaluation costs; consulting and outside services costs and travel. Thefollowing table summarizes the most significant components of selling andmarketing expense for the periods indicated in thousands and as a percentage oftotal selling and marketing expense and provides the changes in thousands andpercentages:
| ** **                         | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                         | ** ** | **2007**                                            | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                         | ** ** | **Dollars**                                         | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and marketing:             |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and  related expenses |       | $                                                   | 906        |   | 69 | % | $ | 1,861 |   | 63 | % | $ | (955 | ) | (51 | )% |
| Stock-based  compensation          |       | 76                                                  |       | 6 | % | 204 |   | 7 | % | (128 | ) | (63 | )% |
| Marketing  programs                |       | 109                                                 |       | 8 | % | 386 |   | 13 | % | (277 | ) | (72 | )% |
| Travel                             |       | 103                                                 |       | 8 | % | 254 |   | 9 | % | (151 | ) | (59 | )% |
| Other                              |       | 129                                                 |       | 9 | % | 244 |   | 8 | % | (115 | ) | (47 | )% |
|                               |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and  marketing       |       | $                                                   | 1,323      |   | 100 | % | $ | 2,949 |   | 100 | % | $ | (1,626 | ) | (55 | )% |

 

As indicated in the table above, our selling andmarketing expenses have significantly decreased.  This decrease is the result of our strategicchange to decrease demand creation sales and marketing activities and morefully leverage our customers’ sales and marketing resources.  The primary components of the decrease inselling and marketing expenses are compensation and related expenses, marketingprograms, stock-based compensation and travel. The decrease in compensation andrelated expenses primarily relate to a reduction in headcount from 35 at June30, 2006 to 24 at June 30, 2007, as a result of the evolving sales model.  The decrease in our stock-based compensationrelates to the reduction in headcount. Additionally, the reduction in marketing programs and travel is a resultof reduced spending on end user lead generation programs for our NS Seriessecurity appliances.

We believe that we must target our selling andmarketing efforts on network equipment providers, system integrators andindependent software vendors (“ISVs”) in order to enhance our position as aleading provider of server appliance products. We expect selling and marketingexpenses to increase during our quarter ended September 30, 2007.

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***General andadministrative***

General and administrative expenses consist primarilyof salaries and other related costs for executive, finance, informationtechnology and human resources personnel; professional services, which includelegal, accounting, audit and tax fees, and costs of compliance with theSarbanes-Oxley Act; and director and officer insurance. The following tablesummarizes the most significant components of general and administrativeexpense for the periods indicated in thousands and as a percentage of totalgeneral and administrative expense and provides the changes in thousands andpercentages:
| ** **                           | ** ** | **Three Months Ended June 30,** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                            | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                         | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and  administrative:         |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                   | 903        |   | 49 | % | $ | 783 |   | 40 | % | $ | 120 |   | 15 | % |
| Stock-based compensation             |       | 187                                                 |       | 10 | % | 214 |   | 11 | % | (27 | ) | (13 | )% |
| Consulting and professional services |       | 511                                                 |       | 28 | % | 561 |   | 28 | % | (50 | ) | (9 | )% |
| Director and officer insurance       |       | 83                                                  |       | 4 | % | 226 |   | 11 | % | (143 | ) | (63 | )% |
| Other                                |       | 174                                                 |       | 9 | % | 195 |   | 10 | % | (21 | ) | (11 | )% |
|                                 |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Total general  and administrative    |       | $                                                   | 1,858      |   | 100 | % | $ | 1,979 |   | 100 | % | $ | (121 | ) | (6 | )% |

 

As indicated in the table above, general andadministrative expenses decreased in the three months ended June 30, 2007versus the three months ended June 30, 2006.  This was primarily a result of decreases in director and officerinsurance, other expenses and consulting and professional services partiallyoffset by an increase in compensation and related expenses.   The decrease in consulting and professionalservices is due primarily to a decrease in consultant expenses attributable tothe timing of certain MIS projects.  Thedecreases in other expenses primarily relates to higher recruiting andrelocation expenses incurred in the prior year as a result of our change in ourChief Executive Officer.  We expectgeneral and administrative expenses to remain consistent during our quarterended September 30, 2007.

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

Interest and other income,net increased to $524,000 for the three months ended June 30, 2007 from$425,000 for the three months ended June 30, 2006. This increase is primarilydue to higher interest rates and higher balances of our cash, cash equivalents,and short-term investments.

**Ninemonths ended June 30, 2007 compared to the nine months ended June 30, 2006**

Thefollowing table summarizes financial data for the periods indicated inthousands and as a percentage of net revenues and provides the changes inthousands and percentages:
| ** **            | ** ** | **Nine Months Ended June 30,** | ** ** |
|-----------------------|------------|----------------------------------------------------|------------|
| ** **            | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **            | ** ** | **Dollars**                                        | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues          |       | $                                                  | 84,541     |   | 100.0 | % | $ | 87,353 |   | 100.0 | % | $ | (2,812 | ) | (3.2 | )% |
| Gross profit          |       | 16,639                                             |       | 19.7 | % | 14,376 |   | 16.5 | % | 2,263 |   | 15.7 | % |
| Operating  expenses   |       | 17,365                                             |       | 20.5 | % | 20,700 |   | 23.7 | % | (3,335 | ) | (16.1 | )% |
| Loss from  operations |       | (726                                               | )          | (0.9 | )% | (6,324 | ) | (7.2 | )% | 5,598 |   | 88.5 | % |
| Net income (loss)     |       | 668                                                |       | 0.8 | % | (5,189 | ) | (5.9 | )% | 5,857 |   | 112.9 | % |
|                       |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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***Net Revenues***

Our net revenues decreased slightly for the ninemonths ended June 30, 2007 versus the same period in fiscal 2006. This wasprimarily due to both lower average selling prices related to the naturalevolution of product life-cycles and lower sales volume.  Net revenues from sales to EMC represented81% of net revenues in the nine months ended June 30, 2007 and 2006. Inaddition, net revenues from other customers for the nine months ended June 30,2007 increased to $15.9 million from $11.7 million (excluding NetworkIntelligence) for the nine months ended June 30, 2006.  This growth was attributable to an increasein revenue from existing customers, revenue for servicing Microsoft Whalecustomers and revenue from new customers in the first half of fiscal 2007.

***Gross profit***

Gross profit andgross profit as a percentage of net revenue increased for the nine months endedJune 30, 2007, compared to the nine months ended June 30, 2006.   The increase from the prior year wasprimarily due to increased service revenue which carries higher gross margins,the timing of cost reductions relative to price reductions to customers and theeffect of lower appliance average selling prices in relation to consistent perunit gross margin dollars.   Theseincreases were partially offset by higher warranty expenses.

***Operating Expenses***

The following table presents operating expenses duringthe periods indicated, in thousands and as a percentage of net revenues:
| ** **                 | ** ** | **Nine Months Ended June 30,** | ** ** |
|----------------------------|------------|----------------------------------------------------|------------|
| ** **                 | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                 | ** ** | **Dollars**                                        | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating  expenses:       |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Research and development   |       | $                                                  | 6,629      |   | 8 | % | $ | 6,188 |   | 7 | % | $ | 441 |   | 7 | % |
| Selling and marketing      |       | 4,863                                              |       | 6 | % | 8,539 |   | 10 | % | (3,676 | ) | (43 | )% |
| General and administrative |       | 5,873                                              |       | 7 | % | 5,973 |   | 7 | % | (100 | ) | (2 | )% |
|                       |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total operating  expenses  |       | $                                                  | 17,365     |   | 21 | % | $ | 20,700 |   | 24 | % | $ | (3,335 | ) | (16 | )% |

 

***Research anddevelopment***

The following table summarizes the most significantcomponents of research and development expense for the periods indicated, inthousands and as a percentage of total research and development expense andprovides the changes in thousands and percentages: 
| ** **                        | ** ** | **Nine Months Ended June 30,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                        | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and  development:        |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                  | 3,989      |   | 60 | % | $ | 3,769 |   | 61 | % | $ | 220 |   | 6 | % |
| Stock-based compensation          |       | 877                                                |       | 13 | % | 835 |   | 13 | % | 42 |   | 5 | % |
| Prototype                         |       | 551                                                |       | 8 | % | 434 |   | 7 | % | 117 |   | 27 | % |
| Consulting and outside services   |       | 670                                                |       | 10 | % | 486 |   | 8 | % | 184 |   | 38 | % |
| Other                             |       | 542                                                |       | 8 | % | 664 |   | 11 | % | (122 | ) | (18 | )% |
|                              |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total research  and development   |       | $                                                  | 6,629      |   | 100 | % | $ | 6,188 |   | 100 | % | $ | 441 |   | 7 | % |

 

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Our research and development expenses have increasedin the nine months ended June 30, 2007 as compared to the same period lastfiscal year primarily due to increased compensation and related expenses andprototype and consulting and outside services. The increase in compensation andrelated expenses was the result of increased headcount from 43 at June 30, 2006to 47 at June 30, 2007.  The increase inconsulting costs as well as prototype costs relates to the timing of certaindevelopment projects.

***Selling andmarketing***

The following table summarizes the most significantcomponents of selling and marketing expense for the periods indicated inthousands and as a percentage of total selling and marketing expense andprovides the changes in thousands and percentages:
| ** **                        | ** ** | **Nine Months Ended June 30,** | ** ** |
|-----------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                                        | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Selling and  marketing:           |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                                  | 3,313      |   | 68 | % | $ | 5,075 |   | 59 | % | $ | (1,762 | ) | (35 | )% |
| Stock-based compensation          |       | 243                                                |       | 5 | % | 614 |   | 7 | % | (371 | ) | (60 | )% |
| Marketing programs                |       | 504                                                |       | 10 | % | 1,318 |   | 15 | % | (814 | ) | (62 | )% |
| Travel                            |       | 360                                                |       | 7 | % | 783 |   | 9 | % | (423 | ) | (54 | )% |
| Consulting                        |       | 59                                                 |       | 1 | % | 366 |   | 4 | % | (307 | ) | (84 | )% |
| Other                             |       | 384                                                |       | 8 | % | 383 |   | 5 | % | 1 |   | — | % |
|                              |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total selling  and marketing      |       | $                                                  | 4,863      |   | 100 | % | $ | 8,539 |   | 100 | % | $ | (3,676 | ) | (43 | )% |

 

As indicated in the table above, our selling andmarketing expenses have significantly decreased.  This decrease is the result of our strategicchange to decrease demand creation sales and marketing activities and morefully leverage our customers’ sales and marketing resources.  In particular resulting from this change, wasa decrease in headcount from 35 at June 30, 2006 to 24 at June 30, 2007 therebycausing the compensation and related expenses to decrease.  In addition, the reduction in marketingexpenses and travel is a result of reduced spending on end user lead generationprograms for our NS Series Security Appliances.

***General andadministrative***

The following table summarizes the most significantcomponents of general and administrative expense for the periods indicated inthousands and as a percentage of total general and administrative expense andprovides the changes in thousands and percentages:
| ** **                           | ** ** | **Nine Months Ended June 30,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                           | ** ** | **2006** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                                        | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **% of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and  administrative:         |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                                  | 2,634      |   | 45 | % | $ | 2,283 |   | 38 | % | $ | 351 |   | 15 | % |
| Stock-based compensation             |       | 620                                                |       | 11 | % | 553 |   | 9 | % | 67 |   | 12 | % |
| Consulting and professional services |       | 1,873                                              |       | 32 | % | 1,741 |   | 29 | % | 132 |   | 8 | % |
| Director and officer insurance       |       | 248                                                |       | 4 | % | 688 |   | 12 | % | (440 | ) | (64 | )% |
| Other                                |       | 498                                                |       | 8 | % | 708 |   | 12 | % | (210 | ) | (30 | )% |
|                                 |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Total general  and administrative    |       | $                                                  | 5,873      |   | 100 | % | $ | 5,973 |   | 100 | % | $ | (100 | ) | (2 | )% |

 

As indicated in the table above, general andadministrative expenses decreased slightly in the nine months ended June 30,2007 versus the nine months ended June 30, 2006.   Increases in compensation and

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related expenses, whichwere related to changes in our senior management, and consulting andprofessional services, were offset by larger decreases in the cost of directorand officer insurance and other expenses.  The increase in consulting and professional services is due primarily tocosts associated with the investigation of embezzlement by a formernon-management employee which was detected during the fourth quarter of fiscal2006 and was completed during the first quarter of fiscal 2007.

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

Interest and other income,net increased to $1,433,000 for the nine months ended June 30, 2007 from$1,135,000 for the nine months ended June 30, 2006. This increase is primarilydue to higher interest rates and higher balances of our cash, cash equivalents,and short-term investments.

**Liquidityand Capital Resources**

The following tablesummarizes cash flow activities, in thousands, for the periods indicated:
|                                                   | ** ** | **Nine Months Ended  June 30,** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                        | ** ** | **2007**                                       | ** ** | **2006** | ** ** |
|                                              |       |                                           |       |   |   |
| Net income  (loss)                                |       | $                                              | 668        |   | $ | (5,189 | ) |
| Non-cash  adjustments to net income (loss)        |       | 2,499                                          |       | 2,884 |   |
| Changes in  working capital                       |       | 2,895                                          |       | (4,608 | ) |
|                                              |       |                                           |       |   |   |
| Cash provided by  (used in) operating activities  |       | 6,062                                          |       | (6,913 | ) |
|                                              |       |                                           |       |   |   |
| Cash (used in)  provided by investing activities  |       | (1,345                                         | )          | 1,450 |   |
| Cash provided by  financing activities            |       | 1,965                                          |       | 1,142 |   |
|                                              |       |                                           |       |   |   |
| Increase  (decrease) in cash and cash equivalents |       | 6,682                                          |       | (4,321 | ) |
| Beginning cash  and cash equivalents              |       | 8,014                                          |       | 9,468 |   |
|                                              |       |                                           |       |   |   |
| Ending cash and cash  equivalents                 |       | 14,696                                         |       | 5,147 |   |
|                                                   |            |                                                |            |  |  |  |  |

 

The following table presents our short-terminvestments as of the periods indicated (in thousands):
|                        | ** ** | **June 30,  2007** | ** ** | **September 30,  2006** | ** ** |
|------------------------|------------|-------------------------|------------|------------------------------|------------|
|                   |       |                    |       |                         |       |
| Short-term investments |       | $                       | 25,402     |                         | $          | 24,804 |   |
|                        |            |                         |            |                              |            |  |  |

 

***Operating Activities***

Cash flows provided by operating activities of $6.1million for the nine months ended June 30, 2007 were a result of the increasein net income between the two periods as well as non-cash adjustments to ournet income and changes in our working capital. The most significant changes in our working capital were increases indeferred revenue of $2.9 million primarily related to the transfer of thesupport obligations of the previously installed Whale appliances fromMicrosoft.

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***Investing Activities***

 Cash flows usedin investing activities during the nine months ended June 30, 2007 consisted ofthe purchase of property and equipment of approximately $665,000, and the netpurchase of short-term investments of $598,000.

***Financing Activities***

Cash flows provided by financing activities primarilyconsisted of cash received as a result of employee stock option and stockpurchase plan activity of $2.0 million in the nine months ended June 30, 2007primarily as a result of exercises by former officers. We expect employee stockoption and stock purchase plan activity to continue in fiscal 2007; however, wecannot predict its level given the volatility of capital markets.

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

·                  the timing and size of orders from ourlargest customer;

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

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

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

·                  market developments.

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

***Contractual Obligations andCommitments***

In addition to our contractual obligations disclosedin our Annual Report on Form 10-K for the year ended September 30, 2006,during the quarter ended March 31, 2007, we entered into an agreement thatincludes a minimum purchase commitment that requires us to purchaseapproximately $105,000, $420,000, and $140,000 worth of additional product infiscal 2007, 2008, and 2009 respectively.

**Off-Balance Sheet Arrangements**

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

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**Related Party Transactions**

Robert M. Wadsworth, one ofour directors, alsoserves as a director of Innoveer Solutions, Inc. (“Innoveer”).  We engage Innoveer to provide professionalservices related to modifications of its customer resource management (“CRM”)software system.  During the three andnine months ended June 30, 2007, we incurred approximately $7,500 and $49,000,respectively.  During the three and ninemonths ended June 30, 2006, we incurred approximately $6,000 and $55,000,respectively.   We had $0 and $7,000payable to Innoveer at June 30, 2007 and September 30, 2006, respectively.

**Recent AccountingPronouncements**

In September 2006, the Securities and Exchange Commissionissued Staff Accounting Bulletin No. 108, “Considering the Effects of PriorYear Misstatements when Quantifying Misstatements in the Current Year FinancialStatements” (“SAB 108”).  SAB 108addresses how the effects of prior-year uncorrected misstatements should beconsidered when quantifying misstatements in current-year financial statements.SAB 108 requires us to quantify misstatements using a balance sheet and incomestatement approach and to evaluate whether either approach results in an errorthat is material in light of relevant quantitative and qualitative factors. Therequirements of SAB 108 are effective for fiscal years ending afterNovember 15, 2006. The adoption of SAB 108 is not expected to have animpact on our financial position, results of operations or cash flows.

In September 2006, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation No. 48, “Accounting forUncertainty in Income Taxes—an Interpretation of FASB Statement No. 109” (“FIN48”). FIN 48 clarifies the accounting for uncertainty in income taxesrecognized in companies’ financial statements in accordance with FASB StatementNo. 109, “Accounting for Income Taxes,” and provides guidance on financialstatement recognition and disclosure for tax positions taken or expected to betaken on a tax return. The evaluation of a tax position in accordance with FIN48 is a two-step process. The first step is recognition whereby companies mustdetermine whether it is more likely than not that a tax position will be sustainedupon examination. The second step is measurement whereby a tax position thatmeets the more-likely-than-not recognition threshold is measured to determinethe amount of benefit to recognize in the financial statements. FIN 48 alsoprovides guidance on derecognition of recognized tax benefits, classification,interest and penalties, accounting in interim periods, disclosure andtransition. The guidance of FIN 48 is applicable for fiscal years beginningafter December 15, 2006. We are in the process of evaluatingwhether the adoption of FIN48 will have a material effect on our financialposition, results of operations, or cash flows.

In September 2006, the FASB issued Statement ofFinancial Accounting Standard No. 157, “Fair Value Measurements”, (“FAS 157”).  This statement address how companies shouldmeasure fair value when they are required to use a fair value measure forrecognition or disclosure purposes under accounting principles generallyaccepted in the United States.  ThisStatement is effective as of the beginning of the our fiscal year that beginsafter November 15, 2007.We are in the process of evaluating whether the adoption of this statement willhave a material impact on our financial position, results of operations andcash flows.

In February 2007, the Financial Accounting StandardsBoard (“FASB”) issued FASB Statement No. 159, “The Fair Value Option forFinancial Assets and Financial Liabilities – Including an amendment of FASBStatement No. 115” (“FAS 159”).  ThisStatement permits entities to choose to measure many financial instruments andcertain other items at fair value at specified election dates. Subsequentunrealized gains and losses on items for which the fair value option has beenelected will be reported in earnings. This Statement iseffective as of the beginning of our fiscal year that begins after November 15,2007.  We are in the process of evaluating whetherthe adoption of FAS 159 will have a material effect on our financial position,results of operations and cash flows.

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

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

**ITEM 4.    CONTROLS ANDPROCEDURES**

Our management, with the participation of our ChiefExecutive Officer and Chief Financial Officer, evaluated the effectiveness ofour disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act) as of June 30, 2007. Based on thisevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat, as of June 30, 2007, our disclosure controls and procedures (1) weredesigned to effectively accumulate and communicate information to the Company’smanagement, as appropriate, to allow timely decisions regarding requireddisclosure and (2) were effective, in that they provide reasonableassurance that information required to be disclosed by the Company in thereports that it files or submits under the Securities Exchange Act is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms.

No change in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)occurred during the three months ended June 30, 2007 that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

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**PARTII—OTHER INFORMATION**

**ITEM 1.     LEGAL PROCEEDINGS**

*Initial Public Offering Lawsuit*

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

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

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

On July 9, 2003, a SpecialCommittee of our Board of Directors authorized us to negotiate a settlement ofthe pending claims substantially consistent with a memorandum of understandingnegotiated among class plaintiffs, all issuer defendants and theirinsurers.  The parties have negotiatedthe settlement, which provides, among other things, for a release of us and theindividual defendants for the conduct alleged in the amended complaint to bewrongful.  We would agree to undertakeother responsibilities under the settlement, including agreeing to assign, ornot assert, certain potential claims that we may have against theunderwriters.  Any direct financialimpact of the proposed settlement is expected to be borne by our insurers.  Any such settlement would be subject tovarious contingencies, including approval by the Court overseeing thelitigation. On February 15, 2005, the Court issued an Opinion and Order preliminarilyapproving the settlement, provided that the defendants and plaintiffs agree toa modification narrowing the scope of the bar order set forth in the originalsettlement agreement.   The partiesagreed to a modification narrowing the scope of the bar order, and on August31, 2005, the Court issued an order preliminarily approving the settlement andsetting a public hearing on its fairness, which took place on April 24, 2006.  On December 5, 2006, the United States Courtof Appeals for the Second Circuit overturned the District Court’s certificationof the class of plaintiffs who are pursuing the claims that would be settled inthe settlement against the underwriter defendants. Thereafter, the DistrictCourt ordered a stay of all proceedings in all of the lawsuits pending theoutcome of plaintiffs’ petition to the Second Circuit for rehearing en banc andresolution of the class certification issue. On April 6, 2007, the Second Circuit denied plaintiffs’ petition forrehearing, but clarified that the plaintiffs may seek to certify a more limitedclass in the District Court. On June 25, 2007, the District Court signed anorder terminating the settlement.

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We are unable to predict the outcome of this suit andas a result, no amounts have been accrued as of June 30, 2007.

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**ITEM 1A. RISK FACTORS**

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

The followingdiscussion includes two revised risk factors (“We may not be able to effectively commercialize our appliances ormay be at a competitive disadvantage if we cannot license or integratethird-party applications that are essential for the functionality of certainappliances” and  “If we are unable to effectively manage ourcustomer service and support activities, we may not be able to retain ourexisting customers or attract new customers”) .  Two other risk factors (“Market acceptance and demand of Microsoft’sISA Server software will depend on Microsoft’s decision to prioritize andconcentrate its marketing efforts for this software, and on the success ofMicrosoft’s ISA Server software “ and “If we are unable to effectivelyleverage our relationship with Microsoft to establish new relationships withindependent software vendors and other systems integrators our revenues andoperating results may be adversely affected”) that were included inour most recent Annual Report on Form 10-K, have been removed from ourdiscussion of risk factors.

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

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

In the threemonths ended June 30, 2007 and 2006, sales directly to EMC, our largestcustomer, accounted for 81% of our total net revenues. These sales areprimarily attributable to one product pursuant to a non-exclusivecontract.  We anticipate that our futureoperating results will continue to depend heavily on sales to, and ourrelationship with, this customer. Accordingly, the success of our business willdepend, in large part, on this customer’s willingness to continue to utilizeour server appliance solutions in its existing and future products. Further,our financial success is dependent upon the future success of the products wesell to this customer and the continued growth of this customer, whose industryhas a history of rapid technological change, short product life cycles,consolidation and pricing and margin pressures. A significant reduction insales to this customer, or significant pricing and additional margin pressuresexerted on us by this customer, would have a material adverse effect on ourresults of operations. In addition, if this customer delays or cancelspurchases of our products, our operating results would be harmed and ourability to accurately predict revenues, profitability and cash flows woulddecrease.

Under the terms ofour non-exclusive contract, this customer has the right to enter intoagreements with third parties for similar products, is not obligated topurchase any minimum quantity of products from us and may choose to stoppurchasing from us at any time, with or without cause. In addition, thiscustomer may terminate the agreement in the event that we attempt toassign our rights under the agreement to another party without this customer’sprior approval. Furthermore, in the event that we default on certain portionsof the agreement, this customer has the right to manufacture certain productsin exchange for a mutually agreeable royalty fee. If any of these events wereto occur, or if this customer were to delay or discontinue purchases of ourproducts as a result of dissatisfaction or otherwise, our revenues andoperating results would be materially adversely affected, our reputation in theindustry might suffer, and our ability to accurately predict revenues,profitability and cash flows would decrease.

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

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

We believe we mustdiversify our revenues and a major component of our business strategy is toform server appliance development relationships with new network equipmentproviders, ISVs and systems integrators. Under this strategy, we work with ourcustomers to develop a server appliance branded with

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their name.  Our partner then performs all of the sellingand marketing efforts related to sales of their branded appliance.

There are multiplerisks associated with this strategy including:

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

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

·                              ourcustomers will most likely continue selling their software products as separateproducts in addition to selling it in the form of a server appliance,which will require us to effectively communicate the benefits of deliveringtheir software in the form of a server appliance;

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

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

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

Additionally, ourfuture success will depend on our ability to establish relationships with newcustomers while expanding sales of server appliances to our existing customers.If these customers are unsuccessful in their marketing and sales efforts, or ifwe are unable to expand our sales to existing customers and developrelationships with new customers, our revenues and operating results couldsuffer.

**Wemay not be able to effectively commercialize our appliances or may be at acompetitive disadvantage if we cannot license or integrate third-partyapplications that are essential for the functionality of certain appliances.**

We believe oursuccess will depend on our ability to license or integrate certain applicationsfrom third-parties that would be incorporated in certain of our serverappliance solutions. Because we do not currently know with certainty which ofthese prospective technologies will be desired in the marketplace, wemay incorrectly invest in development or prioritize our efforts tointegrate these technologies in our appliances. Additionally, even if wecorrectly focus our efforts, there can be no assurance that we will select thepreferred provider of these technologies, the third-party provider will becommitted to the relationship and integration of their technology, or that theywill license their technology to us without obtaining significant certificationor training, which could be costly and time consuming. If we are unable tosuccessfully integrate the correct third-party technologies in a timely manner,our appliances may be inferior with other competitive products in themarketplace, which may adversely affect the results of our operations andour ability to grow our business.

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

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

·                              costof customizing products for foreign countries;

·                              exportand import restrictions, such as those affecting encryption commodities andsoftware or those requiring local content;

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·                              difficultiesin providing customer support;

·                              reducedprotection of intellectual property rights and increased liability exposure;

·                              regionaleconomic and political conditions; and

·                              uniqueproduct requirements of certain foreign countries which may limit salesand/or require significant additional research and development investments.

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

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

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

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

·                  ournew products may be delayed because selected new technologies themselvesare delayed or have defects and/or performance limitations;

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

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

·                  newtechnologies are unproven and could contain latent defects, which could resultin high product failures; and

·                  wecould find that the new products and/or technologies that we choose toincorporate into our products are technologically inferior to those utilized byour competitors.

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

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

**Ifserver appliances are not increasingly adopted as a solution to meet asignificant portion of companies’ network security and data storage applicationneeds, the market for server appliances may not grow, which couldnegatively impact our revenues.**

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

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

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

The markets we serveare characterized by rapid technological change, frequent new productintroductions and enhancements, potentially short product life cycles, changesin customer demands and evolving industry standards. In the server appliancemarket, we attempt to mitigate these risks by utilizing standards-basedhardware platforms and by maintaining an adequate knowledge base of availabletechnologies. However, the server appliance products that we sell could berendered obsolete if products based on new technologies are introduced or newindustry standards emerge and we are not able to incorporate thesetechnological changes into our products. In addition, we depend on thirdparties for the base platforms of our server appliances and we are at risk ifthese third parties do not integrate new technologies. Releasing new productsand services prematurely may result in quality problems, and delaysmay result in loss of customer confidence and market share. We may beunable to develop new products and services or achieve and maintain marketacceptance of them once they have come to market. Furthermore, when we dointroduce new or enhanced products and services, we may be unable tomanage the transition from the older products and services to minimizedisruption in customer ordering patterns, avoid excessive inventories of olderproducts and deliver enough new products and services to meet customer demand.

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

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

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

Since our inception, wehave incurred significant net losses and could continue to incur net losses inthe future. During both periods ending June 30, 2007 and September 30,2006 our accumulated deficit was $131 million and $132 million, respectively.We believe that any future growth will require us to incur significantengineering, selling and marketing and administrative expenses. As a result, wewill need to generate significant revenues to achieve and sustainprofitability. If we do not achieve and sustain profitability, the market pricefor our common stock may decline.

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

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

·                              revenuerecognition;

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·                              inventorywrite-downs;

·                              stock-basedcompensation; and

·                              warrantyreserves.

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

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

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

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

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

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

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

·                              theproduct mix of our sales;

·                              thetiming of new product introductions by our customers;

·                              theavailability and/or price of products from suppliers;

·                              theloss of key suppliers or customers;

·                              pricecompetition;

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·                              costsassociated with our introduction of new server appliances and the marketacceptance of those products; and

·                              themix of product manufactured internally and by our contract manufacturer.

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

Products andservices in the server appliance, data storage and network security marketsmay be subject to further commoditization as these industries continue tomature and other businesses introduce additional competing products andservices. The gross profit as a percentage of revenues of our productsmay decrease in response to changes in our product mix, competitivepricing pressures, or new product introductions into the server appliance, datastorage and network security markets. If we are unable to offset decreases inour gross profits as a percentage of revenues by increasing our sales volumes,or by decreasing our product costs, operating results will decline. Changes inthe mix of sales of our products, including the mix of higher margin productssold in smaller quantities and lower margin products sold in larger quantities,could adversely affect our operating results for future quarters. To maintainour gross profits, we also must continue to reduce the manufacturing cost ofour server appliance products. Our efforts to produce higher margin serverappliance products, continue to improve our server appliance products andproduce new server appliance products may make it difficult to reduce ourmanufacturing cost per product. Further, utilization of a contract manufacturerto produce a portion of our customer requirements for certain of our serverappliance products may not allow us to reduce our cost per product. If wefail to respond adequately to pricing pressures, to competitive products withimproved performance or to developments with respect to the other factors onwhich we compete, we could lose customers or orders. If we are unable tocompete effectively, our business will suffer.

***Risks related to competition.***

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

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

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

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

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

Although wecurrently have a relatively small sales and marketing organization, we mustcontinue to increase market awareness and sales of our products and promote ourbrand in the marketplace. We believe that to compete successfully we will neednetwork equipment providers, ISVs and systems integrators to recognize NetworkEngines as a top-tier provider of server appliance platforms and customintegration services.  If we are unableto increase market awareness and promote ourselves as a leading provider ofserver appliance solutions with our available resources, we may be unable to developnew customer relationships or expand our product and service offerings atexisting customers.

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

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

If our customersupport organization is unsuccessful in maintaining good customer relationships,we may lose customers to our competitors and our reputation in the marketcould be damaged. As a result, we may lose revenues and our business couldsuffer. Furthermore, the costs of this service could be higher than we expect,which could adversely affect our operating results.

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

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

We depend uponsingle source and limited source suppliers for our industry-standardprocessors, main logic boards, certain disk drives, hardware platforms and powersupplies as well as certain of our chassis and sheet metal parts. Additionally,we depend on limited sources to supply certain other industry-standard andcustomized components. We have in the past experienced, and may in thefuture experience, shortages of or difficulties in acquiring components in thequantities and of the quality needed to produce our server appliance products.Shortages in supply or quality issues related to these key components for anextended time would cause delays in the production of our server applianceproducts, prevent us from satisfying our contractual obligations and meetingcustomer expectations, and result in lost sales and customers. If we are unableto buy components in the quantities and of the quality that we need on a timelybasis or at acceptable prices, we will not be able to manufacture and deliverour server appliance products on a timely or cost-effective basis to ourcustomers, and our competitive position, reputation, business, financialcondition and results of operations could be seriously harmed.

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

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

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our solutions arecombined with products from other vendors, should problems occur, it might bedifficult to identify the source of the problem. Continued improvement inmanufacturing capabilities, control of material and manufacturing quality andcosts, and product testing are critical factors in our future growth. There canbe no assurance that our efforts to monitor, develop, modify and implementappropriate test and manufacturing processes for our products will besufficient to permit us to avoid a rate of failure in our products that resultsin substantial delays in shipment, significant repair or replacement costs orpotential damage to our reputation, any of which could have a material adverseeffect on our business, results of operations or financial condition.

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

·                              theloss of or delay in market acceptance and sales of our server appliance products;

·                              diversionof engineering resources;

·                              increasedmanufacturing costs;

·                              theloss of new or existing server appliance customers;

·                              injuryto our reputation and other customer relations problems; and

·                              increasedmaintenance and warranty costs.

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

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

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

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

To supplement ourcurrent production capacity, to provide for increased capacity for “productionspikes” and to provide disaster backup capabilities, we currently utilize theservices of a contract manufacturer for certain server appliance products on alimited basis. However, our contract manufacturer is not obligated to supplyproducts to us for any specific period, or in any specific quantity, except asmay be provided in an accepted purchase order. Using a contractmanufacturer increases our cost of producing server appliance products andcould decrease our gross profits. In the event that we need to change contractmanufacturers or require significantly increased production levels, we couldexperience transitional difficulties, including production delays and qualitycontrol issues, that could prevent us from satisfying our productionrequirements on a timely basis, cause customer relationships to suffer andresult in lost sales. Also, the use of a contract manufacturer does notguarantee us production levels, 

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manufacturing line spaceor manufacturing prices, the lack of which could interrupt our businessoperations and have a negative effect on operating results.

In the past, weexpanded our internal production capacity through expansion and reorganizationof our current production facilities. Although we believe that our current facility,along with our use of a contract manufacturer to supplement production, issufficient to support our business for the foreseeable future, we may needadditional production capacity. We believe that we could expand productionlevels in our existing facility by increasing the number of manufacturingshifts, but we are currently utilizing all available manufacturing space in ourexisting facility and have limited opportunity to expand further.  We would have difficulties expanding thisfacility beyond this limited ability, and therefore, significant furtherexpansion of the production capacity would require additional facilities.  Expansion of our existing facilities oradditional facilities could require substantial investments, which coulddetract from our ability to invest in other areas of our business andmay not result in the desired return on investment, which could negativelyaffect our operating results.

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

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

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

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

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

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

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

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

·                              betime-consuming for us to address;

·                              requireus to enter into royalty or licensing agreements;

·                              resultin costly litigation, including potential liability for damages;

·                              divertour management’s attention and resources; and

·                              causeproduct shipment delays.

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

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

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

Our successdepends in large part on our ability to retain and attract highly skilledengineering, sales, marketing, customer service and managerial personnel. If weare unable to attract a sufficient number of qualified personnel, particularlypersonnel knowledgeable in software engineering and product management, wemay not be able to meet key objectives such as developing, upgrading, orenhancing our products in a timely manner, which could negatively impact ourbusiness and could hinder any future growth.

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

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

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

InDecember 2001, a class action lawsuit relating to our initial publicoffering was filed against us, our chairman, one of our executive officers andthe underwriters of our initial public offering. For more information onlawsuits, see “Part II, Item 1 – Legal Proceedings.”  We are currently attempting to settle thelawsuit filed against us related to our initial public offering. We are unableto predict the effects on our financial condition or business of the lawsuitrelated to our initial public offering or other lawsuits that may arisefrom time to time. While we maintain certain insurance coverage, there can beno assurance that claims against us will not result in substantial monetarydamages in excess of such insurance coverage. This class action lawsuit,or any future lawsuits, could cause our director and officer insurance premiumsto increase and could affect our ability to obtain director and officerinsurance coverage, which would negatively affect our business. In addition, wehave expended, and may in the future expend, significant resources todefend such claims. This class action lawsuit, or other similar lawsuitsthat may arise from time to time, could negatively impact both ourfinancial condition and the market price of our common stock and could resultin management devoting a substantial portion of their time to these lawsuits,which could adversely affect the operation of our business.

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

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

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

The market priceof our common stock has been subject to significant fluctuations andmay continue to fluctuate or decline. During fiscal 2006, the closingprice of our common stock ranged from a low of $1.12 to a high of $3.17, and inthe nine months ended June 30, 2007, from a low of $1.75 to a high of $2.81.The market for technology stocks has been extremely volatile and frequentlyreaches levels that bear no relationship to the past or present operatingperformance of those companies. General economic conditions, such as recessionor interest rate or currency rate fluctuations in the United States or abroad,could negatively affect the market price of our common stock. In addition, ouroperating results may be below the expectations of securities analysts andinvestors. If this were to occur, the market price of our common stockmay decrease significantly. In the past, following periods of volatilityin the market price of a company’s securities, securities class actionlitigation has often been instituted against such companies. Such litigationcould result in substantial cost and a diversion of management’s attention andresources.

Any decline in themarket price of our common stock or negative market conditions could adverselyaffect our ability to raise additional capital, to complete future acquisitionsof or investments in other businesses and to attract and retain qualifiedtechnical and sales and marketing personnel.

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

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

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In addition,provisions of our second amended and restated certificate of incorporation andour second amended and restated by-laws may deter an unsolicited offer topurchase us. These provisions, coupled with the provisions of the DelawareGeneral Corporation Law, may delay or impede a merger, tender offer orproxy contest involving us. For example, our Board of Directors is divided intothree classes, only one of which is elected at each annual meeting. Thesefactors may further delay or prevent a change of control of our business.

**ITEM 6.     EXHIBITS**

(a)    Exhibits

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

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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, as amended, the Registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.
|                       | **NETWORK ENGINES, INC.** |
|-----------------------|---------------------------|
| ** **            | ** **                | ** ** |
| Date: August 9,  2007 |                      | /s/ Gregory A. Shortell |   |   |
|                  |                      |   |
|                  |                      | Gregory A.  Shortell |
|                  |                      | President and  Chief |
|                  |                      | Executive Officer |
|                  |                      | (Principal  Executive |
|                  |                      | Officer) |
|                  |                      |   |
|                  |                      |   |
|                  |                      | /s/ Douglas G. Bryant |   |   |
|                  |                      |   |
|                  |                      | Douglas G.  Bryant |
|                  |                      | Vice President  of Finance |
|                  |                      | and  Administration, Chief |
|                  |                      | Financial  Officer, Treasurer |
|                  |                      | and Secretary |
|                  |                      | (Principal  Financial Officer |
|                  |                      | and Principal |
|                  |                      | Accounting  Officer) |
|                       |                           |  |  |  |  |  |

 

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

 

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