##### **UNITED STATES**

##### **SECURITIES ANDEXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

----

 

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

 

----

 
| **(Mark  One)**                                                                                                                                                                                   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                              |   |   |
| **ý**                                                                                                                                                                                        | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES  EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                              |   |   |
| **For the quarterly period ended December 31,  2005**                                                                                                                                             |
|                                                                                                                                                                                              |   |   |
| **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**

 

----

 

**NETWORK ENGINES, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

Indicate bycheck mark whether the registrant: (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period than the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes  ý    No  o

 

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

 

Largeaccelerated file oAccelerated filer ý Non-acceleratedfiler o

 

Indicate bycheck mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).  Yes  o    No  ý

 

As of February6, 2006, there were 37,968,015 shares of the registrant’s Common Stock, parvalue $.01 per share, outstanding.

 

 

----

 

**NETWORK ENGINES, INC.**

 

**INDEX**

 
| ** **                                                                                           | ** **                                            | **PAGE  NUMBER** |
|------------------------------------------------------------------------------------------------------|-------------------------------------------------------|------------------|
|                                                                                                 |                                                  |             |
| **PART I.  FINANCIAL INFORMATION**                                                                   | ** **                                            | ** **       |
|                                                                                                 |                                                  |             |
| ITEM 1. FINANCIAL STATEMENTS  (UNAUDITED)                                                            |                                                  |             |
|                                                                                                 |                                                  |             |
|                                                                                                 | CONDENSED CONSOLIDATED  BALANCE SHEETS                |             | 1 |
|                                                                                                 | CONDENSED CONSOLIDATED  STATEMENTS OF OPERATIONS      |             | 2 |
|                                                                                                 | CONDENSED CONSOLIDATED  STATEMENTS OF CASH FLOWS      |             | 3 |
|                                                                                                 | NOTES TO CONDENSED  CONSOLIDATED FINANCIAL STATEMENTS |             | 4 |
|                                                                                                 |                                                  |             |
| ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL  CONDITION |                                                  | 15               |
|                                                                                                 |                                                  |             |
| ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                  |                                                  | 26               |
|                                                                                                 |                                                  |             |
| ITEM 4. CONTROLS  AND PROCEDURES                                                                     |                                                  | 27               |
|                                                                                                 |                                                  |             |
| **PART  II. OTHER INFORMATION**                                                                      | ** **                                            | ** **       |
|                                                                                                 |                                                  |             |
| ITEM 1. LEGAL  PROCEEDINGS                                                                           |                                                  | 28               |
|                                                                                                 |                                                  |             |
| ITEM 1A. RISK FACTORS                                                                                |                                                  | 29               |
|                                                                                                 |                                                  |             |
| ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                 |                                                  | 45               |
|                                                                                                 |                                                  |             |
| ITEM 6. EXHIBITS                                                                                     |                                                  | 45               |
|                                                                                                 |                                                  |             |
| SIGNATURES                                                                                           |                                                  | 46               |

 

----

 

**PART I. FINANCIAL INFORMATION**

 

**ITEM I. FINANCIAL STATEMENTS**

 

**NETWORKENGINES, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands)**

 
| ** **                                                                                                                                                                                                      | ** ** | **December 31,  2005** | ** ** | **September 30,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                                                      | ** ** | **(unaudited)**        | ** ** | ** **              | ** ** |
| **ASSETS**                                                                                                                                                                                                      |       |                   |       |                    |       |
| **Current assets:**                                                                                                                                                                                             |       |                   |       |                    |       |
| Cash and cash equivalents                                                                                                                                                                                       |       | $                      | 9,789      |                    | $          | 9,468 |   |
| Short-term investments                                                                                                                                                                                          |       | 26,809                 |       | 27,894                  |       |
| Restricted cash                                                                                                                                                                                                 |       | 47                     |       | 47                      |       |
| Accounts receivable, net of allowances                                                                                                                                                                          |       | 13,228                 |       | 10,442                  |       |
| Inventories                                                                                                                                                                                                     |       | 8,602                  |       | 9,227                   |       |
| Prepaid expenses and other current assets                                                                                                                                                                       |       | 1,117                  |       | 905                     |       |
| Total current assets                                                                                                                                                                                            |       | 59,592                 |       | 57,983                  |       |
|                                                                                                                                                                                                            |       |                   |       |                    |       |
| Property and equipment, net                                                                                                                                                                                     |       | 1,591                  |       | 1,699                   |       |
| Other assets                                                                                                                                                                                                    |       | 40                     |       | 122                     |       |
|                                                                                                                                                                                                            |       |                   |       |                    |       |
| Total assets                                                                                                                                                                                                    |       | $                      | 61,223     |                    | $          | 59,804 |   |
|                                                                                                                                                                                                            |       |                   |       |                    |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                   |       |                   |       |                    |       |
| **Current liabilities:**                                                                                                                                                                                        |       |                   |       |                    |       |
| Accounts payable                                                                                                                                                                                                |       | $                      | 8,023      |                    | $          | 5,645 |   |
| Accrued compensation and other related  benefits                                                                                                                                                                |       | 1,427                  |       | 1,276                   |       |
| Other accrued expenses                                                                                                                                                                                          |       | 1,740                  |       | 1,669                   |       |
| Current portion of capital lease obligation                                                                                                                                                                     |       | 18                     |       | 18                      |       |
| Deferred revenue                                                                                                                                                                                                |       | 661                    |       | 891                     |       |
| Total current liabilities                                                                                                                                                                                       |       | 11,869                 |       | 9,499                   |       |
|                                                                                                                                                                                                            |       |                   |       |                    |       |
| Long-term portion of capital lease  obligation                                                                                                                                                                  |       | 75                     |       | 79                      |       |
| Deferred revenue                                                                                                                                                                                                |       | 277                    |       | 365                     |       |
| 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; 40,527,899 and 40,341,890 shares issued; 37,966,041 and  37,780,032 shares outstanding at December 31, 2005 and September 30, 2005,  respectively |       | 405                    |       | 403                     |       |
| Additional paid-in capital                                                                                                                                                                                      |       | 179,209                |       | 178,446                 |       |
| Accumulated deficit                                                                                                                                                                                             |       | (127,774               | )          | (126,150                | )          |
| Treasury stock, at cost, 2,561,858 shares at  December 31, 2005 and September 30, 2005                                                                                                                          |       | (2,838                 | )          | (2,838                  | )          |
|                                                                                                                                                                                                            |       |                   |       |                    |       |
| Total stockholders’ equity                                                                                                                                                                                 |       | 49,002                 |       | 49,861                  |       |
|                                                                                                                                                                                                            |       |                   |       |                    |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                 |       | $                      | 61,223     |                    | $          | 59,804 |   |

 

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

 

1

----

 

**NETWORKENGINES, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(unaudited)**

 
| ** **                                                     | ** ** | **Three months ended December 31,** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| ** **                                                     | ** ** | ** **                          | ** ** | ** ** | ** ** |
| Net revenues                                                   |       | $                                   | 27,269     |   | $ | 26,959 |   |
|                                                           |       |                                |       |   |   |
| Cost of revenues                                               |       | 22,608                              |       | 21,916 |   |
|                                                           |       |                                |       |   |   |
| Gross profit                                                   |       | 4,661                               |       | 5,043 |   |
|                                                           |       |                                |       |   |   |
| Operating expenses:                                            |       |                                |       |   |   |
| Research and development                                       |       | 2,020                               |       | 1,979 |   |
| Selling and marketing                                          |       | 2,778                               |       | 2,425 |   |
| General and administrative                                     |       | 1,807                               |       | 1,984 |   |
| Restructuring charge                                           |       | —                              |       | 366 |   |
|                                                           |       |                                |       |   |   |
| Total operating expenses                                       |       | 6,605                               |       | 6,754 |   |
|                                                           |       |                                |       |   |   |
| Loss from operations                                           |       | (1,944                              | )          | (1,711 | ) |
| Interest and other income, net                                 |       | 320                                 |       | 162 |   |
|                                                           |       |                                |       |   |   |
| Net loss                                                       |       | $                                   | (1,624     | ) | $ | (1,549 | ) |
|                                                           |       |                                |       |   |   |
| Net loss per share - basic and diluted                         |       | $                                   | (0.04      | ) | $ | (0.04 | ) |
|                                                           |       |                                |       |   |   |
| Shares used in computing basic and diluted net  loss per share |       | 37,867                              |       | 37,187 |   |

 

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

 

2

----

 

**NETWORKENGINES, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inthousands)**

**(unaudited)**

 
| ** **                                                                                 | ** ** | **Three months ended  December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                 | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **                                                                                 | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Cash flows from operating activities:                                                      |       |                                 |       |   |   |
| Net loss                                                                                   |       | $                                    | (1,624     | ) | $ | (1,549 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities: |       |                                 |       |   |   |
| Depreciation and amortization                                                              |       | 248                                  |       | 340 |   |
| Provision for doubtful accounts                                                            |       | (23                                  | )          | 32 |   |
| Stock-based compensation                                                                   |       | 584                                  |       | 5 |   |
| Changes in operating assets and liabilities:                                               |       |                                 |       |   |   |
| Accounts receivable                                                                        |       | (2,763                               | )          | 344 |   |
| Inventories                                                                                |       | 625                                  |       | 4,086 |   |
| Prepaid expenses and other current assets                                                  |       | (212                                 | )          | (36 | ) |
| Accounts payable                                                                           |       | 2,378                                |       | (2,454 | ) |
| Accrued expenses                                                                           |       | 222                                  |       | (782 | ) |
| Accrued restructuring charge                                                               |       | —                               |       | 250 |   |
| Deferred revenue                                                                           |       | (318                                 | )          | 1,589 |   |
|                                                                                       |       |                                 |       |   |   |
| Net cash provided by (used in) operating  activities                                       |       | (883                                 | )          | 1,825 |   |
|                                                                                       |       |                                 |       |   |   |
| Cash flows from investing activities:                                                      |       |                                 |       |   |   |
| Purchases of property and equipment                                                        |       | (140                                 | )          | (314 | ) |
| Purchases of short-term investments                                                        |       | (17,415                              | )          | (6,822 | ) |
| Proceeds from sales and maturities of  short-term investments                              |       | 18,500                               |       | 6,650 |   |
| Changes in other assets                                                                    |       | 82                                   |       | 15 |   |
|                                                                                       |       |                                 |       |   |   |
| Net cash provided by (used in) investing  activities                                       |       | 1,027                                |       | (471 | ) |
|                                                                                       |       |                                 |       |   |   |
| Cash flows from financing activities:                                                      |       |                                 |       |   |   |
| Proceeds from issuance of common stock                                                     |       | 181                                  |       | 191 |   |
| Payments on capital lease obligation                                                       |       | (4                                   | )          | — |   |
|                                                                                       |       |                                 |       |   |   |
| Net cash provided by financing activities                                                  |       | 177                                  |       | 191 |   |
|                                                                                       |       |                                 |       |   |   |
| Net increase in cash and cash equivalents                                                  |       | 321                                  |       | 1,545 |   |
| Cash and cash equivalents, beginning of  period                                            |       | 9,468                                |       | 12,974 |   |
|                                                                                       |       |                                 |       |   |   |
| Cash and cash equivalents, end of period                                                   |       | $                                    | 9,789      |   | $ | 14,519 |   |

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

 

3

----

 

**NETWORK ENGINES, INC.**

**NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

 

**1.  BASIS OF PRESENTATION**

 

The accompanyingcondensed consolidated financial statements have been prepared by NetworkEngines, Inc. (“Network Engines” or the “Company”) in accordance with generallyaccepted accounting principles 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. These financial statements should beread in conjunction with the audited financial statements and the accompanyingnotes included in the Company’s 2005 Annual Report on Form 10-K filed by theCompany with the Securities and Exchange Commission.

 

The information furnishedreflects all adjustments, which, in the opinion of management, are of a normalrecurring nature and are considered necessary for a fair presentation ofresults for the interim periods. It should also be noted that results for theinterim periods are not necessarily indicative of the results expected for thefull year or any future period.

 

Thepreparation of these condensed consolidated financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosures of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period. The most significant estimates reflected inthese financial statements include allowance for doubtful accounts, inventoryvaluation, valuation of deferred tax assets, warranty reserves and stock-basedcompensation. Actual results could differ from those estimates.

 

**2.  SIGNIFICANT ACCOUNTING POLICIES**

 

***Recent Accounting Pronouncements***

 

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards No. 123 (revised 2004), *“Share-Based Payment”* (“SFAS 123(R)”). SFAS 123(R) is arevision of FASB Statement No. 123, *“Accounting forStock-Based Compensation”*, supersedes Accounting Principles BoardOpinion No. 25, *“Accounting for Stock Issued to Employees”*,and amends FASB Statement No. 95, *“Statement of Cash Flows”*.SFAS 123(R) requires all share-based payments to employees, including grants ofemployee stock options and stock purchases under employee stock purchase plans,to be recognized in the financial statements based on their fair values. TheCompany adopted SFAS 123(R) using the modified prospective method during thequarter ended December 31, 2005. As noted in footnote 3 below, the adoption ofSFAS 123(R) had a material impact on the Company’s condensed consolidatedstatements of operations and net loss per share.

 

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

 

The Company considers all highly liquid investments purchased with anoriginal maturity of three months or less to be cash equivalents; cashequivalents are carried at cost plus accrued interest, which approximates fairmarket value.  All securities purchasedwith an original maturity of greater than three months and that mature within12 months from the balance sheet date are considered short-term investments.All investments are classified as available for sale and are carried at fairvalue, with unrealized gains and losses included in other comprehensive incomeor loss, which is a separate component of stockholders’ equity, until realized.The Company invests excess cash primarily in municipal bonds and auction ratesecurities, money market funds and government agency securities. Details of theCompany’s cash, cash equivalents and short-term investments are as follows (inthousands):

 

4

----

 
| ** **                          | ** ** | **December 31,  2005** | ** ** | **September 30,  2005** | ** ** |
|-------------------------------------|------------|------------------------|------------|-------------------------|------------|
| **Cash and cash equivalents:**      |       |                   |       |                    |       |
| Cash                                |       | $                      | 4,632      |                    | $          | 2,722 |   |
| Money market funds                  |       | 5,157                  |       | 5,018                   |       |
| Municipal bonds                     |       | —                 |       | 1,728                   |       |
|                                |       |                   |       |                    |       |
| **Total cash and cash equivalents** |       | $                      | 9,789      |                    | $          | 9,468 |   |
|                                |       |                   |       |                    |       |
| **Short-term investments:**         |       |                   |       |                    |       |
| Municipal auction rate securities   |       | $                      | 26,809     |                    | $          | 27,894 |   |

 

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

 

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

 

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

 

The Company is organizedinto two reportable segments: OEM Appliance and Distribution. The Company’ssegments have been determined based upon the channels through which thesegments sell products. Sales of server appliances to the Company’s networkequipment and ISV partners are included in the Company’s OEM Appliance segment.Sales of server appliances and data storage products to VARs and systemsintegrators are included in the Company’s Distribution segment. The accountingpolicies of these segments are the same as those described in the Company’ssummary of significant accounting policies in its Annual Report on Form 10-Kfor the year ended September 30, 2005. The Company evaluates its segments’performance based on net revenues, gross profit and segment operating income (loss),and the Company’s management regularly evaluates the Company’s segments indeciding how to allocate resources and assess performance. There are nointer-segment sales or transfers. Management does not review assets as part ofthe assessment of segment performance.

 

The following is a summary ofthe Company’s operations by reporting segment for the three months ended (inthousands):

 
| ** **                      | ** ** | **OEM** | ** ** | **Distribution** | ** ** | **Total** | ** ** |
|---------------------------------|------------|---------|------------|------------------|------------|-----------|------------|
| **December 31, 2005**      |       |    |       |             |       |      |       |
| Net revenues                    |       | $       | 27,012     |             | $          | 257       |       | $ | 27,269 |   |
| Segment operating income (loss) |       | $       | 3,710      |             | $          | (3,387    | )          | $ | 323 |   |
|                            |       |    |       |             |       |      |       |
| **December 31, 2004**           |       |    |       |             |       |      |       |
| Net revenues                    |       | $       | 22,302     |             | $          | 4,657     |       | $ | 26,959 |   |
| Segment operating income (loss) |       | $       | 2,651      |             | $          | (2,378    | )(a)       | $ | 273 |   |
|                                 |            |         |            |                  |            |           |            |  |  |  |  |

 

----

(a)   Includes $366 of restructuring charges

 

5

----

 

The Company does not allocategeneral and administrative expenses to its reportable segments, because theseactivities are managed separately from the reportable segments. The Company doesnot allocate the costs of stock-based compensation to its reportable segments,because these expenses pertain to grants of awards that are managed andmeasured at the corporate level.   Additionally,management excludes these expenses when planning or measuring the periodic financialperformance of the Company’s segments since they are unrelated to its coreoperating metrics.  A reconciliation ofthe totals reported for the reportable segments to the loss from operations inthe consolidated financial statements is as follows, in thousands:

 
| ** **                                                             | ** ** | **Three months ended  December 31,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                             | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| Total segment operating income                                         |       | $                                    | 323        |   | $ | 273 |   |
| General and administrative                                             |       | 1,807                                |       | 1,984 |   |
| Stock-based compensation (not included in  general and administrative) |       | 460                                  |       | — |   |
| Loss from operations                                                   |       | $                                    | (1,944     | ) | $ | (1,711 | ) |

 

All of the Company’s long-lived assets were located in the United Statesas of December 31, 2005 and 2004.

 

***SignificantCustomers***

 

The following table summarizes those customerswho accounted for greater than 10% of the Company’s net revenues or accountsreceivable:

 
| ** ** | ** ** | **Net Revenues for the three** | ** ** | ** **                 | ** ** |
|------------|------------|--------------------------------|------------|----------------------------|------------|
| ** ** | ** ** | **months ended December 31,**  | ** ** | **Accounts Receivable at** | ** ** |
| ** ** | ** ** | ** **                     | ** ** | **December 31,**           | ** ** | **September 30,** | ** ** |
| ** ** | ** ** | **2005**                       | ** ** | **2004**                   | ** ** | **2005** | ** ** | **2005** | ** ** |
| Customer A |       | 83%                            |       | 69%                        |       | 77% |   | 67% |   |

 

**3.  STOCK-BASED COMPENSATION**

 

Effective October 1, 2005, the Company adopted the provisions ofStatement of Financial Accounting Standards 123(R), *“Share-Based Payment,”* (“SFAS 123(R)”),**which establishes accounting for equityinstruments exchanged for employee services. Under the provisions ofSFAS 123(R), stock-based compensation cost is measured at the grant date,based on the fair value of the award, and is recognized as an expense over theemployee’s requisite service period (generally the vesting period of the equityaward). Prior to October 1, 2005, the Company accounted for share-basedcompensation to employees in accordance with Accounting Principles BoardOpinion No. 25,*“Accounting for StockIssued to Employees,”* (“APB 25”) and related interpretations. TheCompany also followed the disclosure requirements of Statement of FinancialAccounting Standards No. 123,*“Accountingfor Stock-Based Compensation”* (“SFAS 123”). The Company electedto adopt the modified prospective transition method as provided bySFAS 123(R) and, accordingly, financial statement amounts for the priorperiods presented in this Form 10-Q have not been restated to reflect thefair value method of expensing stock-based compensation.

 

**StockIncentive Plans**

 

In October 1999, the Company’s shareholders approved the 1999 StockIncentive Plan (the “1999 Plan”). Under the 1999 Plan, stock option andrestricted stock or other stock-based awards for up to 4,747,902 shares ofcommon stock may be issued to employees, officers, directors, consultants andadvisors of the Company. Options are granted for terms of up to ten years andvest over varying periods. Option grants to new employees generally vest 25% onthe first anniversary of the grant date and thereafter in equal quarterlyinstallments over the next three years. Subsequent grants to existing employeesgenerally

 

6

----

 

vest in equal quarterlyinstallments over four years. The option price per share is determined by theboard of directors on the grant date.

 

In May 2000, the Company’s shareholders approved an increase of3,300,000 in the number of shares authorized under the 1999 Plan and anautomatic annual increase in the number of shares authorized under the 1999Plan. The automatic annual increase is equal to the lesser of: 5% of theoutstanding shares on the first day of each fiscal year; 4,000,000 shares; oran amount determined by the board of directors, which is subject to a maximumof 20,047,902 authorized shares under the plan. As of December 31, 2005, theCompany is authorized to grant options, restricted stock or other awards of upto 13,807,273 shares of common stock.

 

In May 2000, the Company’s shareholders approved the 2000 DirectorOption Plan (the “Director Plan”). Under the Director Plan, the Company maymake formula grants of stock options to non-employee directors of up to 500,000shares of common stock.  New directors tothe Company’s board are granted an initial grant of 50,000 shares, which vest25% on the first anniversary of the grant date and thereafter in equalquarterly installments over the next three years.  Subsequent annual grants of 15,000 shares todirectors vest 100% upon the first anniversary of the grant date.  In March 2004, the Company’s shareholdersapproved an increase of an additional 325,000 shares of common stock authorizedto be issued under this plan, resulting in a total of 825,000 optionsauthorized to be issued. Under the Director Plan, options to purchase 520,000shares have been granted, options to purchase 45,000 shares have been exercisedand options to purchase 30,000 shares have been cancelled through December 31,2005.

 

In May 2000, the Company’s shareholders approved the 2000 Employee StockPurchase Plan (the “Purchase Plan”). Under the Purchase Plan, the Company mayissue up to an aggregate of 750,000 shares of common stock to eligibleemployees.  In March 2004, the Company’sshareholders approved an increase of an additional 500,000 shares of commonstock authorized to be issued under the Purchase Plan, resulting in a total of 1,250,000shares authorized to be issued.  Eligibleemployees must be employed by the Company for more than 20 hours per week andmore than five months in a fiscal year. Under the Purchase Plan, the Companymakes two offerings each fiscal year, at the end of which employees maypurchase shares of common stock through payroll deductions made over the termof each offering. The per-share purchase price for offerings prior to May 15,2005, was equal to the lesser of 85% of the closing price of the common stockat the beginning or end of the offering period. During the year ended September30, 2005, the board of directors amended the Purchase Plan to limit theper-share purchase price for offerings to 85% of the closing price at the endof the offering period, beginning with the offering period ended May 15, 2005.Offering periods begin on the 15th day of November and May eachyear. During the three months ended December 31, 2005, 163,883 shares of commonstock, were issued under the Purchase Plan. The Company had 214,000 shares available for issuance under its PurchasePlan as of December 31, 2005.

 

The following table presents stock-based employee compensation expensesincluded in the Company’s unaudited condensed consolidated statements ofoperations (in thousands):

 
| ** **                       | ** ** | **Three Months Ended  December 31, 2005** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| ** **                       | ** ** | ** **                                | ** ** |
| Cost of revenues                 |       | $                                         | 40         |   |
| Research and development         |       | 254                                       |       |
| Selling and marketing            |       | 166                                       |       |
| General and administrative       |       | 124                                       |       |
| Stock-based compensation expense |       | $                                         | 584        |   |

 

As a result of adopting SFAS 123(R), the Company’s net loss for thequarter ended December 31, 2005, is $584,000 greater than if it hadcontinued to account for stock-based compensation under APB 25. Basic anddiluted loss per share for the quarter ended December 31, 2005 was also greaterby $0.01 due to the adoption of SFAS 123(R).

 

7

----

 

The Company estimates the fair value of stock options using theBlack-Scholes valuation model. This valuation model takes into account theexercise price of the award, as well as a variety of significant assumptions.These assumptions used to estimate the fair value of stock options include theexpected term, the expected volatility of the Company’s stock over the expectedterm, the risk-free interest rate over the expected term, and the Company’sexpected annual dividend yield. The Company believes that the valuationtechnique and the approach utilized to develop the underlying assumptions areappropriate in calculating the fair values of the Company’s stock optionsgranted in the three months ended December 31, 2005. Estimates of fairvalue are not intended to predict actual future events or the value ultimatelyrealized by persons who receive equity awards.

 

Assumptions used to determine the fair value of options granted duringthe three months ended December 31, 2005, using the Black-Scholes valuation modelwere:

 
| ** **                     | ** ** | **Three Months Ended  December 31, 2005** | ** ** |
|--------------------------------|------------|-------------------------------------------|------------|
|                           |       |                                      |       |
| Expected term(1)               |       | 6.06 to 6.25 years                        |       |
| Expected volatility factor(2)  |       | 77.00                                     | %          |
| Risk-free interest rate(3)     |       | 4.39                                      | %          |
| Expected annual dividend yield |       | —                                    |       |

 

----

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

 

(2)   Theexpected volatility for each grant is estimated based on a weighted average ofhistorical volatility. The Company excluded the volatility during the periodfollowing the Company’s Initial Public Offering from its calculation as it isnot indicative of future volatility. .

 

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

 

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

 

Prior to October 1, 2005, the Company accounted for stock-basedcompensation to employees in accordance with APB 25. The Company also hadpreviously adopted the provisions of SFAS 123,which required disclosureonly of stock-based compensation and its impact on net loss and net loss pershare.  The following table illustratesthe effects on net loss and net loss per share for the three months ended December31, 2004 as if the Company had applied the fair value recognition provisions ofSFAS 123 to stock-based employee awards.

 
| ** **                                                                                     | ** ** | **Three Months Ended   December 31, 2004** | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                     | ** ** | ** **                                 | ** ** |
| Net loss as  reported                                                                          |       | $                                          | (1,549     | ) |
| Add:  Stock-based employee compensation expense included in net loss                           |       | —                                     |       |
| Less: Total  stock-based employee compensation expense determined under the fair value  method |       | (758                                       | )          |
| Pro forma net  loss                                                                            |       | $                                          | (2,307     | ) |
| Net loss per  share:                                                                           |       |                                       |       |
| Basic and Diluted — as reported                                                      |       | $                                          | (0.04      | ) |
| Basic and Diluted — pro-forma                                                        |       | $                                          | (0.06      | ) |

 

8

----

 

In determiningthe stock-based compensation expense to be disclosed under SFAS 123, theCompany was required to estimate the fair value of stock awards granted toemployees using a Black-Scholes valuation model.  However, differences between the requirementsof SFAS 123(R) and SFAS 123 resulted in a different set assumptions determinedby the Company to be used in its valuation model.  Assumptions used to determine the fair valueof options granted under SFAS 123 during the three months ended December 31,2004 were:

 
| ** **               | ** ** | **Three Months Ended  December 31, 2004** | ** ** |
|--------------------------|------------|------------------------------------------------|------------|
|                     |       |                                           |       |
| Expected term            |       | 5 years                                   |       |
| Volatility               |       | 130                                            | %          |
| Risk-free  interest rate |       | 3.61                                           | %          |
| Dividend  yield          |       | —                                         |       |

 

The Company issues common stock from previously authorized but unissuedshares to satisfy option exercises and purchases under the Company’s PurchasePlan.

 

A summary of the Company’s stock option activity for the three monthsended December 31, 2005 is as follows:  

 
| ** **                       | ** ** | **Number of  Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  years)** | ** ** |
|----------------------------------|------------|------------------------|------------|---------------------------------------|------------|----------------------------------------------------------------------|------------|
|                             |       |                   |       |                                  |       |                                                                 |       |
| Outstanding, September 30, 2005  |       | 6,701,268              |       | $                                     | 2.41       |                                                                 |       |   |
| Granted                          |       | 846,250                |       | 1.43                                  |       |                                                                 |       |
| Exercised                        |       | (22,126                | )          | 0.96                                  |       |                                                                 |       |
| Cancelled                        |       | (164,185               | )          | 4.31                                  |       |                                                                 |       |
| Outstanding, December 31, 2005   |       | 7,361,207              |       | $                                     | 2.26       |                                                                 | 7.35       |   |
| Exercisable at December 31, 2005 |       | 4,158,529              |       | $                                     | 2.13       |                                                                 | 6.21       |   |

 

All options granted during the three months ended December 31, 2005 and2004 were granted with exercise prices equal to the fair market value of theCompany’s common stock on the grant date and had weighted average grant datefair values of $1.02 and $2.53, respectively.

 

At December 31, 2005, the aggregate intrinsic value of optionsoutstanding and options exercisable was $1,353,000 and $1,234,000,respectively.  The intrinsic value of astock option is the amount by which the market value of the underlying stockexceeds the exercise price of the option.

 

The aggregate intrinsic value of options exercised during the threemonths ended December 31, 2005 was $8,000.

 

9

----

 

The following table summarizes the stock options outstanding at December31, 2005:

 
| ** **                 | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                | ** ** |
|----------------------------|------------|-------------------------|------------|----------------------------------------|------------|
| **Exercise  Price  Range** | ** ** | **Number**              | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted Average  Remaining  Contractual  Term (in years)** | ** ** | **Number** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                       |       |                    |       |                                   |       |   |   |   |   |   |   |
| $0.07 - $0.92              |       | 1,487,353               |       | $                                      | 0.62       |   | 5.60 |   | 1,362,352 |   | $ | 0.60 |   |
| $0.95 - $1.19              |       | 1,741,235               |       |                                   | 1.08       |   | 6.14 |   | 1,481,668 |   |   | 1.10 |   |
| $1.20 - $1.63              |       | 1,099,981               |       |                                   | 1.45       |   | 9.24 |   | 191,165 |   |   | 1.45 |   |
| $1.65- $2.58               |       | 1,063,500               |       |                                   | 2.01       |   | 8.42 |   | 241,936 |   |   | 2.19 |   |
| $2.61 - $4.40              |       | 1,406,466               |       |                                   | 3.39       |   | 8.58 |   | 521,364 |   |   | 3.76 |   |
| $4.58 - $35.44             |       | 556,422                 |       |                                   | 9.10       |   | 6.98 |   | 353,794 |   |   | 9.65 |   |
| $39.81                     |       | 6,250                   |       |                                   | 39.81      |   | 4.68 |   | 6,250 |   |   | 39.81 |   |
|                       |       | 7,361,207               |       |                                   | 2.26       |   | 7.35 |   | 4,158,529 |   |   | 2.13 |   |

 

The Company’s non-vested stock option activity for the three monthsended December 31, 2005 was as follows:

 
| ** **                               | ** ** | **Number of  Options** | ** ** | **Weighted  Average Fair  Value** | ** ** |
|------------------------------------------|------------|------------------------|------------|-----------------------------------|------------|
|                                     |       |                   |       |                              |       |
| Non-vested options at September 30, 2005 |       | 2,721,275              |       | $                                 | 2.39       |   |
| Granted                                  |       | 846,250                |       |                              | 1.02       |   |
| Vested                                   |       | (248,907               | )          |                              | 2.32       |   |
| Forfeited                                |       | (115,940               | )          |                              | 2.47       |   |
| Non-vested options at December 31, 2005  |       | 3,202,678              |       |                              | 2.02       |   |

 

At December 31, 2005, unrecognized compensation expense related tonon-vested stock options was $4,503,000, which is expected to be recognizedover a weighted average period of 2.68 years.

 

**4.  NETLOSS PER SHARE**

 

Basic net loss per shareis computed by dividing the net loss for the period by the weighted averagenumber of shares of common stock outstanding during the period. Diluted netloss per share is computed by dividing the net loss for the period by theweighted average number of shares of common stock and potential common stockoutstanding during the period, if dilutive. Potential common stock includesincremental shares of common stock issuable upon the exercise of stock options. For the three month periods endedDecember 31, 2005 and 2004, stock options totaling 4,628,000 and 4,125,000shares respectively, were excluded from the calculation of net loss per sharebecause their inclusion would be anti-dilutive.

 

10

----

 

**5. INVENTORIES**

 

Inventories consisted of the following (inthousands):

 
| ** **       | ** ** | **December 31,  2005** | ** ** | **September 30,  2005** | ** ** |
|------------------|------------|------------------------|------------|-------------------------|------------|
| ** **       | ** ** | ** **             | ** ** | ** **              | ** ** |
| Raw materials    |       | $                      | 4,641      |                    | $          | 3,972 |   |
| Work in  process |       | 663                    |       | 302                     |       |
| Finished  goods  |       | 3,298                  |       | 4,953                   |       |
|             |       |                   |       |                    |       |
|             |       | $                      | 8,602      |                    | $          | 9,227 |   |

 

**6. CONTINGENCIES**

 

***Guarantees and Indemnifications***

 

Acquisition-related indemnifications - When, as part of an acquisition,the Company acquires all the stock of a company, the Company assumesliabilities for certain events or circumstances that took place prior to thedate of acquisition.  The maximumpotential amount of future payments the Company could be required to make forsuch obligations is undeterminable. While the provisions of the agreements remain in effect indefinitely,the Company believes that the probability of receiving a claim isunlikely.  As a result, the Company hasnot recorded a liability for these indemnification clauses as of December 31,2005.

 

The Company enters into standard indemnification agreements in theordinary course of its business. Pursuant to these agreements, the Companyindemnifies, holds harmless, and agrees to reimburse the indemnified party forlosses suffered or incurred by the indemnified party, generally its businesspartners or customers, in connection with any patent, copyright, trademark,trade secret or other intellectual property infringement claim by any thirdparty with respect to its products. The term of these indemnificationagreements is generally perpetual. The Company has never incurred costs todefend lawsuits or settle claims related to these indemnification agreements.As a result, the Company believes the estimated fair value of these agreementsis minimal. Accordingly, the Company has no liabilities recorded for theseindemnifications as of December 31, 2005.

 

Product warranties – The Company offers and fulfills warrantyservices on certain of its server appliances. In addition, while the Companywas selling third-party data storage networking products it contracted with athird party to provide warranty services for these products. The Company’sagreement with this third-party warranty provider expired in March 2005 asscheduled. However, the terms of the agreement require the third-party warrantyprovider to service these products for the entire warranty period. Warrantyterms vary in duration depending upon the product sold but generally providefor the repair or replacement of any defective products for periods of up to 36months after shipment. Based upon historical experience and expectation offuture conditions, the Company reserves for the estimated costs to fulfillcustomer warranty obligations upon the recognition of the related revenue. Forwarranties related to third-party data storage networking products, the Companyrecorded warranty expense based on its agreement with its third-party warrantyfulfillment provider, whose fees were determined based on fixed periodicamounts as well as activity-based charges. The following table presents changesin the Company’s product warranty liability for the three months ended December31, 2005 and 2004 (in thousands):

 

11

----

 

| ** **                                   | ** ** | **Three months ended  December 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------|------------|
| ** **                                   | ** ** | **2005**                             | ** ** | **2004** | ** ** |
|                                         |       |                                 |       |   |   |
| Beginning balance                            |       | $                                    | 455        |   | $ | 433 |   |
| Accruals for warranties issued               |       | 390                                  |       | 342 |   |
| Cost of warranties honored during the period |       | (358                                 | )          | (386 | ) |
| Ending balance                               |       | $                                    | 487        |   | $ | 389 |   |

 

***Contingencies***

 

*AnnouncementTiming 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 Defendantsfiled a reply to the Plaintiff’s opposition on November 12, 2004.  The Court on November 22, 2004 denied theDefendant’s motion to dismiss the amended consolidated complaint. On December23, 2004, the Defendants filed an answer to the amended consolidated complaint.

 

Since that time the parties have engaged in some informal discovery and,more recently, have exchanged formal discovery requests.  Discovery is to conclude on or before March31, 2006.  The parties are currentlyactively pursuing settlement.  No amountshave been accrued for this matter, since the anticipated settlement is expectedto be covered in its entirety by the Company’s insurance provider.

 

*InitialPublic Offering Lawsuit*

 

Onor about December 3, 2001, a putative class action lawsuit was filed in theUnited States District Court for the Southern District of New York against theCompany, Lawrence A. Genovesi (the Company’s Chairman and former ChiefExecutive Officer), Douglas G. Bryant (the Company’s Chief Financial Officerand 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 Network Engines,Inc. Initial Public Offering Securities Litigation, 01 Civ. 10894 (SAS), wasfiled on April 20, 2002.

 

The suit alleges that the defendants violated the federal securitieslaws by 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,

 

12

----

 

compensation and revenues. Thesuit seeks damages and certification of a plaintiff class consisting of allpersons who acquired shares of the Company’s common stock between July 13, 2000and December 6, 2000.

 

InJuly 2002, the Company, Lawrence A. Genovesi and Douglas G. Bryant joined in anomnibus motion to dismiss the suit challenging the legal sufficiency ofplaintiffs’ claims. The motion was filed on behalf of hundreds of issuer andindividual defendants named in similar lawsuits. Plaintiffs opposed the motion,and the Court heard oral argument on the motion in November 2002. On February19, 2003, the Court issued an opinion and order denying the motion as to theCompany. However, in October 2002, Lawrence A. Genovesi and Douglas G. Bryantwere 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 parties have negotiated the settlement,which provides, among other things, for a release of the Company and theIndividual Defendants for the conduct alleged in the amended complaint to bewrongful.  The Company would agree toundertake other responsibilities under the settlement, including agreeing toassign, or not assert, certain potential claims that it may have against itsunderwriters.  Any direct financialimpact of the proposed settlement is expected to be borne by the Company’sinsurers.  Any such settlement would besubject to various contingencies, including approval by the Court overseeingthe litigation. On February 15, 2005, the Court issued an Opinion andOrder preliminarily approving the settlement, provided that the defendants andplaintiffs agree to a modification narrowing the scope of the bar order setforth in the original settlement agreement.  The parties agreed to a modification narrowing the scope of thebar order, and on August 31, 2005, the Court issued an order preliminarilyapproving the settlement.  No amountshave been accrued for this matter, since the anticipated settlement is expectedto be covered in its entirety by the Company’s insurance provider.

 

**7. RELATED PARTY TRANSACTIONS**

 

Robert M. Wadsworth, one of the Company’s directors, is a managingdirector of the limited liability corporation that controls HarbourVest Partners(and its affiliates), one of the Company’s significant stockholders. Mr.Wadsworth, is also a director of PSI Holding Group, Inc. (“PSI”), the parentcompany of Akibia, Inc. (“Akibia”). During the quarters ended December 31, 2005and 2004, HarbourVest owned greater than 5% of the outstanding stock of theCompany and greater than 5% of the outstanding stock of PSI. While the Companywas selling third-party data storage networking products it engaged Akibia toprovide certain customer support and warranty fulfillment services related tothe Company’s sales of HBAs. The Company’s agreement with Akibia expired inMarch 2005 as scheduled.  However, theterms of the agreement required Akibia fulfill the warranty services for theentire warranty period.  Akibia chargedthe Company a quarterly fixed fee of $83,000 and a variable fee based upon theCompany’s sales of HBAs which ended December 2004. In the quarter endedDecember 31, 2004, the Company recognized $201,000 of expense as a result ofits HBA customer support and warranty fulfillment services agreements withAkibia. The Company recognized no such expense in the quarter endedDecember 31, 2005. In connectionwith this customer support and warranty fulfillment services agreement, theCompany also sold product to Akibia to allow Akibia to fulfill the Company’swarranty obligations for these products. In the quarter ended December 31, 2004,the Company recorded revenues of approximately $40,000, from sales of HBAs toAkibia. The Company recorded no such revenues in the quarter ended December 31,2005.  There were no amounts receivablefrom or payable to Akibia at December 31, 2005 or September 30, 2005.  In November 2005, Mr. John A. Blaeser, one ofthe Company’s directors, also joined the board of directors of Akibia.

 

13

----

 

Mr. Wadsworth also serves as a director of Innoveer Solutions, Inc.(“Innoveer”), formerly Akibia Consulting, and previously a subsidiary ofAkibia. The Company engages Innoveer to provide professional services relatedto modifications of its Customer Resource Management (“CRM”) software system.During the three months ended December 31, 2005 and 2004, the Company incurredapproximately $29,000 and $14,300, respectively, related to these services. TheCompany owed Innoveer $26,000 at December 31, 2005.  There were no amounts outstanding to Innoveerat September 30, 2005.

 

During the year ended September 30, 2005 the Company engaged theconsulting services of Mapleworks Technologies (“Mapleworks”), a softwaredevelopment services provider. Both Mr. Blaeser and Mr. Wadsworth areinvestors in Mapleworks and are members of its board of advisors. For the threemonths ended December 31, 2005 the Company incurred $45,000 in fees for theseconsulting services.  The Company had noamounts outstanding to Mapleworks at December 31, 2005 and September 30, 2005.

 

14

----

 

**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS ANDFINANCIAL CONDITION**

 

**Special NoteRegarding Forward-Looking Statements**

 

ThisQuarterly Report on Form 10-Q contains forward-looking statements within themeaning of Section 21E of the Securities Exchange Act of 1934, as amended, thatinvolve risks and uncertainties. All statements other than statements ofhistorical information provided herein are forward-looking statements and maycontain projections related to financial results, economic conditions, trendsand known uncertainties. Our actual results could differ materially from thosediscussed in the forward-looking statements as a result of a number of factors,which include those discussed in this section and in Part II, Item 1A, RiskFactors, of this report and the risks discussed in our other filings with theSecurities and Exchange Commission. Readers are cautioned not to place unduereliance on these forward-looking statements, which reflect management’sanalysis, judgment, belief or expectation only as of the date hereof. Weundertake no obligation to publicly reissue these forward-looking statements toreflect events or circumstances that arise after the date hereof.

 

The following discussion and analysis should be read in conjunction withthe condensed consolidated financial statements and the notes thereto includedin Item 1 in this Quarterly Report on Form 10-Q and our Annual Report on Form10-K for the fiscal year ended September 30, 2005 filed by the Company with theSecurities and Exchange Commission.

 

**Overview**

 

We develop and manufacture server appliance solutions that deliver datastorage and network security applications on server appliances. Serverappliances are pre-configured network infrastructure devices designed tooptimally deliver specific software application functionality and facilitateease of deployment and support of a software application in a customer’snetwork. We are organized into two reportable segments: OEM Appliance andDistribution.

 

**OEMAppliance segment**

 

In our OEM Appliance segment, we develop and manufacture serverappliance solutions that enable network equipment providers and independentsoftware vendors, or ISVs, to deliver their data storage and network securityapplications in the form of a server appliance. We offer our server appliancepartners a comprehensive suite of services, including development,manufacturing, fulfillment and post-sale support. We produce and fulfilldevices branded for our network equipment and ISV partners, and derive ourrevenues from the sale of value-added hardware platforms to these partners.These partners subsequently sell and support the device under their own brandsto their customer base. During the three months ended December 31, 2005and 2004, sales to EMC represented 84% and 83%, respectively, of our OEMAppliance segment revenues.

 

For the three months ended December 31, 2005 and 2004 our OEM Appliancesegment had segment operating income of $3.7 million and $2.7 million,respectively. Refer to footnote 2 of our Condensed Consolidated FinancialStatements contained in Item I of this report for purposes of determiningsegment operating income.

 

**Distributionsegment**

 

Currently in our Distribution segment, we develop, manufacture, sell,market and support our NS Series Security Appliances that are basedon Microsoft’s Internet Security and Acceleration (ISA) Server 2004. We licenseand integrate this software with server appliance platforms and our proprietarysoftware to sell our own branded server appliances primarily toMicrosoft-certified or network security value added resellers and systemintegrators. However sales of these servers did not commence until fiscal year2005 and, as a result, sales of these server appliances have represented asmall portion of our Distribution segment revenues. We expect that the sale ofour NS Series Security Appliances will be the

 

15

----

 

primary source of our futureDistribution segment revenues. However, we believe that it may take severalquarters more before revenues from sales of these server appliances becomesignificant.

 

Previously in our Distribution segment we also distributed third-partydata storage networking connectivity products for the leading Fibre Channelhost bus adapter, or HBA, and storage switch manufacturers in the data storageindustry to a customer base of value-added resellers and systems integrators. Forthe three months ended December 31, 2004, 98% of our Distribution segment’srevenue had been derived from the sale of third-party data storage networkingcomponents and products, predominantly EMC-approved Fibre Channel HBAs. As aresult of an amendment to a key distribution agreement, there was a decline inour gross profits related to sales of EMC-approved Fibre Channel HBAs, which inturn had a negative impact on our Distribution segment gross profits as well asour consolidated gross profits and operating results. In addition, as a resultof the higher costs per EMC-approved Fibre Channel HBA that this amendmentimposed upon us, our Distribution segment’s ability to compete in large salestransactions involving EMC-approved Fibre Channel HBAs was negatively affected.This amendment, the commoditization of Fibre Channel HBA technology, and theincreasing competition in the market resulted in declining gross profitsrelated to our distribution of HBAs. During the quarter ended December 31,2004, we discontinued sales of these third-party data storage networkingproducts, as a result of these factors and the future prospects of this portionof our segment.

 

For the three months ended December 31, 2005 and 2004 our Distributionsegment had segment operating losses of $3.4 million and $2.4 million,respectively. Refer to footnote 2 of our Condensed Consolidated FinancialStatements contained in Item I of this report for purposes of determiningsegment operating loss.

 

**CriticalAccounting Policies and Estimates**

 

Our discussion and analysis of financial condition and results ofoperations are based upon our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States of America. In preparing these financial statements, we havemade estimates and judgments in determining certain amounts included in thefinancial statements. We base our estimates and judgments on historicalexperience and other various assumptions that we believe to be reasonable underthe circumstances. Actual results may differ from these estimates underdifferent assumptions or conditions. We believe the following criticalaccounting policies affect our more significant judgments and estimates used inthe preparation of our financial statements.

 

***Revenue recognition***

 

Revenues from products are generally recognized upon delivery tocustomers if persuasive evidence of an arrangement exists, the fee is fixed ordeterminable, collectibility is reasonably assured and title and risk of losshave passed to the customer. In the event we have unfulfilled futureobligations, revenue and related costs are deferred until those futureobligations are met. We have an inventory consignment agreement with ourlargest customer related to certain server appliances sold through our OEMAppliance segment. This customer notifies us when it utilizes inventory and werecognize revenues from sales to this customer based upon these notifications.

 

Maintenance revenues are derived from customer support agreementsgenerally entered into in connection with the initial server appliance salesand subsequent renewals. Maintenance fees are typically for one to three yearrenewable periods and include the right to unspecified software updateswhen-and-if-available, hardware repairs, 24-hour customer support, and advancedreplacement of server appliances. Maintenance revenues are recognized ratablyover the term of the maintenance period. Payments for maintenance fees aregenerally made in advance and are included in deferred revenue.

 

16

----

 

Contracts and/or customer purchase orders are generally used todetermine the existence of an arrangement. Shipping documents and consignmentusage notifications are used to verify shipment or transfer of ownership, asapplicable. We assess whether the sales price is fixed or determinable based onthe payment terms associated with the transaction and whether the sales price issubject to refund or adjustment. We assess collectibility based primarily onthe creditworthiness of the customer as determined by credit checks andanalysis, as well as the customer’s payment history.

 

For revenue arrangements that contain multiple elements, such as thesale of both the product and post-sales support, in which software is notincidental to the product, such as our sales of server appliances through ourDistribution segment, we determine fair value based upon vendor specificobjective evidence, which is typically established through contractualpost-sales support renewal rates whereby the residual fair value is allocatedto the server appliance. For revenue arrangements that contain multipleelements, in which software is not included or is incidental to the product,such as our sales of server appliances through our OEM Appliance segment, wedetermine fair value based on objective and reliable evidence of fair value,which is typically determined through contractual refund rates for cancellations,and stand-alone sales of post sales support, whereby the residual fair value isallocated to the server appliance.

 

We recognize revenue when the revenue recognition criteria for eachelement of the sale is met. If we are not able to derive the fair value of theundelivered element of the sale (maintenance), all revenues from thearrangement are deferred and recognized ratably over the period of the supportarrangement, which is typically one to three years.

 

***Allowances for Doubtful Accounts and Sales Returns***

 

Our allowance for doubtful accounts is based on our assessment of thecollectibility of customer accounts. We regularly review the allowance byconsidering factors such as historical experience, credit quality, age of theaccounts receivable balances, and current economic conditions that may affect acustomer’s ability to pay. If a major customer’s creditworthiness deteriorates,or if actual defaults are higher than our historical experience, or if othercircumstances arise, our estimates of the recoverability of amounts due to uscould be overstated, and additional allowances could be required, which couldhave an adverse impact on our results of operations.

 

***Inventories***

 

We value inventory at the lower of cost or estimated market, anddetermine cost on a first-in, first-out basis. We regularly review inventoryquantities on hand and record a write-down for excess or obsolete inventorybased primarily on our estimated forecast of product demand and anticipatedproduction requirements in the near future. Any rapid technological changes,regulatory changes or future product development could result in an increase inthe amount of obsolete inventory quantities on hand. Agreements with certain ofour OEM Appliance customers include inventory protection provisions, however,these provisions may not provide us with complete protection from loss due toexcess or obsolete inventory.

 

***Product Warranty Obligations***

 

We offer a warranty on certain of our products that generally providefor us to repair or replace any defective products for a period of up to 36months after shipment. We reserve for the estimated costs to fulfill customerwarranty obligations upon the recognition of the related revenue and recordwarranty expense as a component of cost of sales.

 

*OEM Server appliance products—*Costs included in our serverappliance product warranty obligation include shipping, materials, internal andexternal labor, and travel. Significant judgment and estimates are involved inestimating our warranty reserve on our OEM server appliance products. Althoughour current OEM server appliance products use more standards-based technologiesthan in the past, certain of our server appliance products incorporate customizedcomponents, which may increase our risks related to product warrantyobligations. In the past we have experienced unexpected component failures incertain of our server appliance products, which have required us to increaseour product warranty accruals. At the

 

17

----

 

time any unexpected componentfailure arises, we assess the costs to repair any defects and record what webelieve to be an appropriate warranty obligation based on the availableinformation at the time. To the extent we may experience increased warrantyclaim activity, increased costs associated with servicing those claims, or useestimates that prove to be materially different from actual claims, our productwarranty obligations may need to be increased, resulting in decreased grossprofits.

 

*NS Series Security Appliance products—*OurNS Series Security Appliances typically do not include a general warranty,but instead customers typically are required to purchase an annual maintenanceprogram at the time of the appliance purchase. Our NS Series SecurityAppliances sold in Europe are sold with a thirteen-month hardware warranty.

 

*HBA products—* Our HBAwarranty expense was determined based upon contractual rates with a third-partywarranty provider who we paid to perform substantially all activities relatedto the fulfillment of our HBA product warranty obligations. As such, thewarranty expense that we recognized for past shipments is fixed and is notsubject to change.

 

***Long-lived assets***

 

We review long-lived assets at least annually to determine if anyadverse conditions exist that would indicate impairment. Conditions that wouldtrigger a more frequent impairment assessment include, but are not limited to,a significant adverse change in certain agreements, or business climate thatcould affect the value of an asset. We assess the recoverability of long-livedassets based on the projected undiscounted future cash flows over the asset’sremaining life. The amount of impairment, if any, is measured based on theexcess of the carrying value over fair value. Fair value is generallycalculated as the present value of estimated future cash flows using arisk-adjusted discount rate, which requires significant management judgmentwith respect to revenue and expense growth rates, and the selection and use ofan appropriate discount rate.

 

***Income tax asset valuation***

 

We record deferred tax assets and liabilities based on the net taxeffects of tax credits, operating loss carryforwards and temporary differencesbetween the carrying amounts of assets and liabilities for financial reportingpurposes and the amounts used for income tax purposes. We then assess thelikelihood that our deferred tax assets will be recovered from future taxableincome and, to the extent we believe that recovery is not likely, we establish avaluation allowance. The valuation allowance is based on our estimate of futuretaxable income and the period over which our deferred tax assets will berecoverable. At December 31, 2005, we believe that it is more likely than notthat all of our deferred tax assets will not be realized, and, accordingly, wehave recorded a valuation allowance against all of our deferred tax assets. Ifresults of operations in the future indicate that some or all of the deferredtax assets will be recovered, the reduction of the valuation allowance will berecorded as a tax benefit.

 

***Stock-based compensation***

 

We adopted the provisions of Statement of Financial AccountingStandards 123(R), *“Share-Based Payment,”*(“SFAS 123(R)”),**on October 1, 2005 which requires usto measure compensation cost at the grant date, based on the fair value of theaward, and to recognize that cost as an expense over the employee’s requisiteservice period (generally the vesting period of the equity award). Prior toOctober 1, 2005, we accounted for stock-based compensation to employees inaccordance with Accounting Principles Board Opinion No. 25,*“Accounting for Stock Issued to Employees,”*(“APB 25”) and related interpretations. We also followed the disclosurerequirements of Statement of Financial Accounting Standards No. 123,*“Accounting for Stock-Based Compensation”*(“SFAS 123”). We elected to adopt the modified prospective transitionmethod as provided by SFAS 123(R) and, accordingly, financial statementamounts for the prior periods presented in this Form 10-Q have not beenrestated to reflect the fair value method of expensing stock-basedcompensation.

 

Under SFAS 123(R), we determine the fair value of stock options awardedbased on the grant-date fair value of the award using an option pricing model.  Such an option pricing model requires us tomake

 

18

----

 

judgments for certainassumptions used, in particular, the expected term of the option and theexpected volatility over that term.  Wehave determined the expected term using the midpoint between the vesting dateand the end of the contractual term for our options, also known as the “simplifiedmethod” described under Staff Accounting Bulletin No. 107, (“SAB 107”). We havedetermined our expected volatility based primarily on our historical volatility,however we have assigned a higher weighting to more recent periods.  In addition, we have excluded the volatilityof our stock for the period following our Initial Public Offering (“IPO”) inJuly 2000 to December 31, 2000, because we believe this period to be anabnormality directly related to our IPO and therefore would not expect it torecur.

 

In determining the amount of expense to be recorded, judgment is also requiredto estimate forfeitures of the awards based on the probability of employeescompleting the required service period. If actual forfeitures differ significantlyfrom our estimates, our results of operations could be materially impacted.

 

**Results ofOperations**

 

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

 
| ** **           | ** ** | **Three Months Ended December 31,** | ** ** |
|----------------------|------------|-------------------------------------|------------|
| ** **           | ** ** | **2005**                            | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **           | ** ** | **Dollars**                         | ** ** | **%****of Net  Revenues** | ** ** | **Dollars** | ** ** | **%****of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Net revenues         |       | $                                   | 27,269     |   | 100.0 | % | $ | 26,959 |   | 100.0 | % | $ | 310 |   | 1.1 | % |
| Gross profit         |       | 4,661                               |       | 17.1 | % | 5,043 |   | 18.7 | % | (382 | ) | (7.6 | )% |
| Operating expenses   |       | 6,605                               |       | 24.2 | % | 6,754 |   | 25.1 | % | (149 | ) | (2.2 | )% |
| Loss from operations |       | (1,944                              | )          | (7.1 | )% | (1,711 | ) | (6.3 | )% | (233 | ) | (13.6 | )% |
| Net loss             |       | (1,624                              | )          | (6.0 | )% | (1,549 | ) | (5.7 | )% | (75 | ) | (4.8 | )% |
|                      |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

# ***Net Revenues and GrossProfit (Loss)***

 

The following table summarizes our net revenues and gross profit (loss)by reportable segment, in thousands and as a percentage of net revenues andprovides the changes in thousands and percentages:

 
| ** **             | ** ** | **Three Months Ended December 31,** | ** ** |
|------------------------|------------|-------------------------------------|------------|
| ** **             | ** ** | **2005**                            | ** ** | **2004** | ** ** | **Increase (Decrease)** | ** ** |
| ** **             | ** ** | **Dollars**                         | ** ** | **%****of Net  Revenues** | ** ** | **Dollars** | ** ** | **%****of Net  Revenues** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| **OEM Appliance:**     |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Net revenues           |       | $                                   | 27,012     |   | 100.0 | % | $ | 22,302 |   | 100.0 | % | $ | 4,710 |   | 21.1 | % |
| Gross profit           |       | 4,972                               |       | 18.4 | % | 4,657 |   | 20.9 | % | 315 |   | 6.8 | % |
|                   |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| **Distribution:**      |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Net revenues           |       | 257                                 |       | 100.0 | % | 4,657 |   | 100.0 | % | (4,400 | ) | (94.5 | )% |
| Gross profit (loss)    |       | (311                                | )          | (121 | )% | 386 |   | 8.3 | % | (697 | ) | (180.6 | )% |
|                   |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| **Total net revenues** |       | $                                   | 27,269     |   | 100.0 | % | $ | 26,959 |   | 100.0 | % | $ | 310 |   | 1.1 | % |
| **Total gross profit** |       | $                                   | 4,661      |   | 17.1 | % | $ | 5,043 |   | 18.7 | % | $ | (382 | ) | (7.6 | )% |

 

***Net******Revenues***

 

Ourrevenues are derived from sales of server appliances primarily to our OEMnetwork equipment and ISV partners.  Wealso derived revenues from the distribution of third-party data storage 

 

19

----

 

networking products, until wecompleted our exit from this portion of our Distribution business during thequarter ended December 31, 2004.

 

Our OEM Appliance segment net revenues increased in the three monthsended December 31, 2005 primarily due to an increase in sales volumes to EMC,partially offset by lower average selling prices.  Net revenues from sales to EMC represented 84%of OEM Appliance net revenues in the three months ended December 31, 2005versus 83% in the three months ended December 31, 2004. In addition, netrevenues to other OEM Appliance partners for the three months ended December31, 2005 increased to $4.4 million from $3.7 million for the three months endedDecember 31, 2004. This increase was broad based and included both new customersand increased sales to existing customers, partially offset by decreases among othercustomers.

 

Our Distribution segment net revenues for the three months endedDecember 31, 2005 were attributable to sales of NS Series Security Appliances. Becausethe market penetration of these security appliances is in the early stages, weexpect that it will take several quarters before revenues from our NS SeriesSecurity Appliances become significant. In the quarter ended December 31, 2004,we discontinued sales of third-party data storage networking products.  Our net revenues in the three months endedDecember 31, 2004 from these products were primarily the result of our focus ondisposing of existing on-hand inventories and represented our final sales ofthese products.

 

***Gross profit (loss)***

 

Gross profit (loss) represents net revenues recognized less the cost ofrevenues. Cost of revenues includes cost of materials, warranty costs,inventory write-downs, shipping and handling costs, customer support costs, andmanufacturing costs, which are primarily comprised of compensation, contractlabor costs and, when applicable, contract manufacturing costs.

 

Gross profit in our OEM Appliance segment increased for the quarterended December 31, 2005, compared to the quarter ended December 31, 2004,primarily as a result of increased sales volumes. Gross profit as a percentageof net revenues in our OEM Appliance segment decreased for 2005 compared to 2004.This is due primarily to changes in product mix and competitive pricingpressure, which was partially offset by higher sales volumes and the sale ofinventory that was previously written-down.  The decrease in gross profits and grossprofits as a percentage of net revenues in our Distribution segment wasattributable to our exit from distributing third-party data storage networkingproducts combined with lower than expected sales of our NS Series SecurityAppliances during the quarter ended December 31, 2005.

 

Our gross profit is affected by the product mix within our OEM Appliancebusiness, our OEM Appliance segment product pricing as well as the timing, sizeand configuration of server appliance orders. OEM Appliance gross profit isalso affected by the mix of product manufactured internally compared to productmanufactured by our contract manufacturer, which carries higher manufacturingcosts. As volumes continue to increase for some OEM partners, we expect grossprofits as a percentage of net revenues to decline due to higher discounting. Inaddition, we also expect gross profits as a percentage of net revenues todecline in the three months ended March 31, 2006 based on changes in ourproduct mix, and no significant sales of inventory previously written-down. Becauseour NS Series Security Appliances are still an emerging product, untilsales volumes become significant, our gross profits in our Distribution segmentwill not be contributory.

 

We expect gross profit to continue to be affected by these factors inboth the OEM Appliance and Distribution segments. We expect that the gross profitsas a percentage of revenue on our NS Series Security Appliances willcontinue to be significantly influenced by promotional activities targeted atachieving market acceptance of these products.

 

***Operating Expenses***

 

Themost significant components of our operating expenses are research anddevelopment, selling and marketing, and general and administrative expenses.The following table presents operating expenses during the periods indicated,in thousands and as a percentage of net revenues:

 

20

----

 
| ** **                 | ** ** | **Three  Months  Ended December 31,** | ** ** |
|----------------------------|------------|--------------------------------------------|------------|
| ** **                 | ** ** | **2005**                                   | ** ** | **2004** |   | **Increase  (Decrease)** | ** ** |
|                       | ** ** | **Dollars**                                | ** ** | **% of Net  Revenues** | ** ** | **Dollars** | ** ** | **% of Net  Revenues** |   | **Dollars** | ** ** | **Percentage** | ** ** |
| Operating Expenses:        |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Research and development   |       | $                                          | 2,020      |   | 7.4 | % | $ | 1,979 |   | 7.3 | % | $ | 41 |   | 2.1 | % |
| Selling and marketing      |       | 2,778                                      |       | 10.2 | % | 2,425 |   | 9.0 | % | 353 |   | 14.6 | % |
| General and administrative |       | 1,807                                      |       | 6.6 | % | 1,984 |   | 7.4 | % | (177 | ) | (8.9 | )% |
| Restructuring charge       |       | —                                     |       | — |   | 366 |   | 1.4 | % | (366 | ) | (100.0 | )% |
|                       |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Total operating expenses   |       | $                                          | 6,605      |   | 24.2 | % | $ | 6,754 |   | 25.1 | % | $ | (149 | ) | (2.2 | )% |

* *

*Research and development.*

 

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

 
| ** **                        | ** ** | **Three  Months Ended December 31,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|
| ** **                        | ** ** | **2005**                             | ** ** | **2004** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                          | ** ** | **%****of  Expense  Category** | ** ** | **Dollars** | ** ** | **%****of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| Research and development          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                    | 1,217      |   | 60 | % | $ | 1,077 |   | 54 | % | $ | 140 |   | 13 | % |
| Stock-based compensation          |       | 255                                  |       | 13 | % | — |   | — |   | 255 |   | 100 | % |
| Prototype                         |       | 97                                   |       | 5 | % | 318 |   | 16 | % | (221 | ) | (69 | )% |
| Consulting and outside services   |       | 228                                  |       | 11 | % | 343 |   | 17 | % | (115 | ) | (34 | )% |
| Other                             |       | 223                                  |       | 11 | % | 241 |   | 12 | % | (18 | ) | (7 | )% |
|                              |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total research and development    |       | $                                    | 2,020      |   | 100 | % | $ | 1,979 |   | 100 | % | $ | 41 |   | 2 | % |

 

Our server appliance development expenses have increased as a result of recognizingstock-based compensation and an increase in compensation and related costspartially off-set by decreases in prototype development and consulting andoutside services. The increase in compensation and related expenses isattributable to increased headcount.  Wehave increased our research and development personnel to 42 at December 31, 2005from 37 at December 31, 2004. The decreases in prototype and consulting costsrelate to the timing of certain development projects specifically with ourlargest OEM customer.

 

Our server appliance development strategy emphasizes the utilization ofstandard, off-the-shelf components in our server appliance platforms. However,we expect that in some cases significant development efforts will be requiredto fulfill our current and potential ISV and network equipment partners’ needsusing customized platforms. In addition, we intend to focus our softwaredevelopment in areas that improve the ease of server appliance implementationand use, which we believe will enhance our value proposition.  We expect that prototype and consulting costswill be variable and could fluctuate depending on the timing and magnitude ofour server appliance development projects. We expect that research anddevelopment costs will continue to increase in the remainder of fiscal 2006primarily due to certain development projects for both our OEM Appliancesegment and NS Series Security Appliances.

* *

*Selling and marketing.*

 

Selling and marketing expenses consist primarily of salaries andcommissions for personnel engaged in sales and marketing; costs associated withour marketing programs, which include costs

 

21

----

 

associated with our attendanceat trade shows, advertising, web site enhancements and product evaluationcosts; consulting and outside services costs and travel. The following tablesummarizes the most significant components of selling and marketing expense forthe periods indicated in thousands and as a percentage of total selling andmarketing expense and provides the changes in thousands and percentages:

 
| ** **                        | ** ** | **Three  Months Ended December 31,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|
| ** **                        | ** ** | **2005**                             | ** ** | **2004** |   | **Increase  (Decrease)** | ** ** |
| ** **                        | ** ** | **Dollars**                          |       | **% of  Expense  Category** |   | **Dollars** |   | **% of  Expense  Category** |   | **Dollars** |   | **Percentage** | ** ** |
| Selling and marketing             |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses |       | $                                    | 1,507      |   | 54 | % | $ | 1,609 |   | 66 | % | $ | (102 | ) | (6 | )% |
| Stock-based compensation          |       | 166                                  |       | 6 | % | — |   | — |   | 166 |   | 100 | % |
| Marketing programs                |       | 437                                  |       | 16 | % | 381 |   | 16 | % | 56 |   | 15 | % |
| Consulting and outside services   |       | 241                                  |       | 9 | % | 104 |   | 4 | % | 137 |   | 132 | % |
| Travel                            |       | 266                                  |       | 10 | % | 124 |   | 5 | % | 142 |   | 115 | % |
| Other                             |       | 161                                  |       | 5 | % | 207 |   | 9 | % | (46 | ) | (22 | )% |
|                              |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total selling and marketing       |       | $                                    | 2,778      |   | 100 | % | $ | 2,425 |   | 100 | % | $ | 353 |   | 15 | % |

 

Currently our Distribution segment by its nature incurs more of themarketing and sales burden of the products that it sells and must engage in ahigher level of marketing program activities than our OEM Appliance segment.Sales in our OEM Appliance segment are to our ISV and network equipmentpartners who market and sell their products, which incorporate our serverappliances. As a result, our OEM Appliance segment engages in a limited levelof marketing programs.

 

As indicated in the table above, the primary components of the increasein selling and marketing expenses are stock-based compensation, travel, consultingand outside services. Our consulting and outside services and travel expenseshave increased significantly as a result of our continued expansion of ourEuropean sales presence during the quarter ended December 31, 2005.  For the quarter ended December 31, 2004, wehad not yet established our sales operations in Europe.  Our selling and marketing personnelincreased, in the aggregate, from 30 at December 31, 2004 to 32 at December 31,2005. This net increase represents increased hiring related to our NS SeriesSecurity Appliance initiative, offset by decreases from terminations andattrition related to our distribution of third-party data storage networkingproducts. Compensation and related expenses decreased in the aggregate duringthe three months ended December 31, 2005 as compared to the three months endedDecember 31, 2004, as a result of lower bonuses and commissions in the quarterended December 31, 2005 related to sales of our NS Series Security Appliances.

 

We believe that we must continue our selling and marketing efforts inorder to enhance our position as a leading provider of server applianceproducts and to establish ourselves as a leader in network security appliances.Variable marketing costs, such as marketing programs, are somewhat dependent onthe timing and magnitude of new product introductions and will fluctuatedepending on the level of this activity. We expect increases in selling andmarketing expenses in the remainder of fiscal 2006 in an effort to gainrecognition in the market for our NS Series Security Appliances and continue toexpand our sales and marketing efforts to further increase our market presenceand grow our revenues.

 

22

----

 

*General and administrative*.

 

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

 
| ** **                           | ** ** | **Three  Months Ended December 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|
| ** **                           | ** ** | **2005**                             | ** ** | **2004** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                           | ** ** | **Dollars**                          | ** ** | **%****of  Expense  Category** | ** ** | **Dollars** | ** ** | **%****of  Expense  Category** | ** ** | **Dollars** | ** ** | **Percentage** | ** ** |
| General and administrative           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Compensation and related expenses    |       | $                                    | 688        |   | 38 | % | $ | 760 |   | 38 | % | $ | (72 | ) | (9 | )% |
| Stock-based compensation             |       | 124                                  |       | 7 | % | 5 |   | — |   | 119 |   | 2380 | % |
| Consulting and professional services |       | 545                                  |       | 30 | % | 629 |   | 32 | % | (84 | ) | (13 | )% |
| Director and officer insurance       |       | 231                                  |       | 13 | % | 238 |   | 12 | % | (7 | ) | (3 | )% |
| Bad debts                            |       | (23                                  | )          | (1 | )% | 32 |   | 2 | % | (55 | ) | (172 | )% |
| Other                                |       | 242                                  |       | 13 | % | 320 |   | 16 | % | (78 | ) | (24 | )% |
|                                 |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total general and administrative     |       | $                                    | 1,807      |   | 100 | % | $ | 1,984 |   | 100 | % | $ | (177 | ) | (9 | )% |

 

As indicated in the table above, the primary components of the decreasein general and administrative expenses are compensation and related expenses, consultingand professional services, and bad debt expense partially off-set by theaddition of stock-based compensation.  AtDecember 31, 2005, we had 23 employees in our general and administrativedepartment compared to 26 employees at December 31, 2004. The decrease inconsulting and professional services is due primarily to a decrease in legalcosts associated with the timing of certain litigation activities. The decreasein our bad debt expense is attributable to better than expected collections ofolder accounts receivable.

 

We expect general and administrative expenses to increase over theremainder of fiscal 2006 depending on costs associated with ongoing litigationand increased costs related to operating as a public company, includingcompliance with the requirements of the Sarbanes-Oxley Act.

* *

*Restructuring charge*.

 

During the three months ended December 31, 2004, we recorded arestructuring of approximately $366,000 related to our exit from that portionof the business related to the distribution of third-party data storagenetworking products.  Approximately$283,000 of the charge related to one-time employee benefits associated withterminating certain employees in that portion of the business during thequarter. We also incurred $83,000 for a fixed payment related to our warrantyfulfillment contract with an external service provider.

 

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

 

Interest and other income, net has increased to $320,000 for the threemonths ended December 31, 2005 from $162,000 for the three months endedDecember 31, 2004. This increase is primarily due to higher interest ratesearned on our cash, cash equivalents, and short-term investments.

 

23

----

 

**Liquidityand Capital Resources**

 

Thefollowing table summarizes cash flow activities, in thousands, for the periodsindicated:

 
| ** **                                       | ** ** | **Three Months Ended  December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                       | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Net loss                                         |       | $                                    | (1,624     | ) | $ | (1,549 | ) |
| Non-cash adjustments to net loss                 |       | 809                                  |       | 377 |   |
| Changes in working capital                       |       | (68                                  | )          | 2,997 |   |
|                                             |       |                                 |       |   |   |
| Cash (used in) provided by operating  activities |       | (883                                 | )          | 1,825 |   |
|                                             |       |                                 |       |   |   |
| Cash provided by (used in) investing  activities |       | 1,027                                |       | (471 | ) |
| Cash provided by financing activities            |       | 177                                  |       | 191 |   |
|                                             |       |                                 |       |   |   |
| Increase in cash and cash equivalents            |       | 321                                  |       | 1,545 |   |
| Beginning cash and cash equivalents              |       | 9,468                                |       | 12,974 |   |
|                                             |       |                                 |       |   |   |
| Ending cash and cash equivalents                 |       | $                                    | 9,789      |   | $ | 14,519 |   |

 

The following table presentsour short-term investments as of the periods indicated (in thousands):

 
| ** **             | ** ** | **Three Months Ended  December 31,** | ** ** |
|------------------------|------------|--------------------------------------|------------|
| ** **             | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **             | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Short-term investments |       | $                                    | 26,809     |   | $ | 26,786 |   |
|                        |            |                                      |            |  |  |  |  |

 

***Operating Activities***

 

Cash flows used  in operatingactivities for the three months ended December 31, 2005 is primarily a resultof the net loss of $1.6 million for the period partially off-set by non-cashadjustments to the net loss of $809,000. The most significant non-cash adjustment to net loss for the threemonths ended December 31, 2005 was $584,000 of stock-based compensationexpense, which we were not required to record in the three months endedDecember 31, 2004.  Net changes in workingcapital for the three months ended December 31, 2005 did not significantlyaffect the cash used in operations.  Cashflows provided by operations for the three months ended December 31, 2004,included significant cash flows from the changes in working capital as a resultof our exit from the distribution of third-party storage networking products.

 

***Investing Activities***

 

Cash flows provided by investing activities during the quarter endedDecember 31, 2005 consisted of net proceeds received from the maturity of ourshort-term investments of approximately $1.1 million.  This increased cash flows was offset by thepurchase of property and equipment of approximately $140,000.

*** ***

***Financing Activities***

 

Cash flows provided by financing activities consisted of cash receivedas a result of employee stock option and stock purchase plan activity of $181,000in the first quarter of fiscal 2006. We expect employee stock option and stockpurchase plan activity to continue in fiscal 2006, however we cannot predictits level given the volatility of capital markets.

 

24

----

 

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

 

•                  the timing andsize of orders from our largest customer;

•                  the level ofinvestment required for development and sales and marketing related to our NSSeries Security Appliances;

•                  our ability toenter into partnerships with value added resellers and system integrators andtheir ability to sell our NS Series Security Appliances;

•                  our ability tomarket and sell our NS Series Security Appliances;

•                  our ability toform an adequate number of OEM partnerships with network equipment providersand ISVs;

•                  the level ofsuccess of our OEM Appliance partners in selling server appliance solutionsthat include our server appliance hardware platforms;

•                  the costs andtiming of product engineering efforts and the success of these efforts;

•                  the outcome ofpending litigation; and

•                  marketdevelopments.

 

We believe that our available cash resources, including cash, cashequivalents and short term investments, and cash that we expect to generatefrom sales of our products will be sufficient to meet our operating and capitalrequirements through at least the next twelve months. After that, we may needto raise additional funds. We may in the future seek to raise additional fundsthrough borrowings, public or private equity financings or from other sources.There can be no assurance that additional financing will be available at allor, if available, will be on terms acceptable to us. If additional financing isneeded and is not available on acceptable terms, we may need to reduce ouroperating expenses.

 

***Contractual Obligations and Commitments***

 

The following table sets forth certain information concerning ourobligations and commitments to make certain payments (in thousands).

 
| ** **           | ** ** | **Payments  Due by Period** | ** ** |
|----------------------|------------|-----------------------------|------------|
| ** **           | ** ** | **Less  than  1 Year**      | ** ** | **1-3  Years** | ** ** | **4-5  Years** | ** ** | **After 5 Years** | ** ** | **Total** | ** ** |
|                 |       |                        |       |   |   |   |   |   |   |   |   |
| Operating lease      |       | $                           | 610        |   | $ | 153 |   | $ | — |   | $ | — |   | $ | 763 |   |
| Capital lease        |       | 24                          |       | 48 |   | 36 |   | — |   | 108 |   |
| Purchase obligations |       | 89                          |       |   |   | — |   | — |   | 89 |   |
|                 |       |                        |       |   |   |   |   |   |   |   |   |
| Total                |       | $                           | 723        |   | $ | 201 |   | $ | 36 |   | $ | — |   | $ | 960 |   |

 

**Off-Balance Sheet Arrangements**

 

We have not created, and are not party to, any special-purpose or offbalance sheet entities for the purpose of raising capital, incurring debt oroperating parts of our business that are not consolidated into our financialstatements.  We have not entered into anytransactions with unconsolidated entities whereby the Company has subordinatedretained interests, derivative instruments or other contingent arrangements thatexpose the Company to material continuing risks, contingent liabilities, or anyother obligation under a variable interest in an unconsolidated entity thatprovides financing, liquidity, market risk or credit risk support to theCompany.

 

25

----

 

**Related Party Transactions**

 

Robert M. Wadsworth, one of our directors, is a managing director of thelimited liability corporation that controls HarbourVest Partners (and itsaffiliates), one of our significant stockholders. Mr. Wadsworth, is alsoa director of PSI Holding Group, Inc. (“PSI”), the parent company of Akibia,Inc. (“Akibia”). During the quarters ended December 31, 2005 and 2004,HarbourVest owned greater than 5% of our outstanding stock and greater than 5%of the outstanding stock of PSI. While we were selling third-party data storagenetworking products we engaged Akibia to provide certain customer support andwarranty fulfillment services related to our sales of HBAs. Our agreement withAkibia expired in March 2005 as scheduled. However, the terms of the agreement required Akibia fulfill the warrantyservices for the entire warranty period. Akibia charged us a quarterly fixed fee of $83,000 and a variable feebased upon our sales of HBAs which ended December 2004. In the quarter endedDecember 31, 2004, we recognized $201,000 of expense as a result of our HBAcustomer support and warranty fulfillment services agreements with Akibia.We recognized no such expense in the quarter ended December 31, 2005. In connection with this customer support andwarranty fulfillment services agreement, we also sold product to Akibia toallow Akibia to fulfill our warranty obligations for these products. In thequarter ended December 31, 2004, we recorded revenues of approximately $40,000,from sales of HBAs to Akibia. We recorded no such revenues in the quarter endedDecember 31, 2005.  There were no amountsreceivable from or payable to Akibia at December 31, 2005 or September 30,2005.  In November 2005, Mr. John A.Blaeser, one of our directors, also joined the board of directors of Akibia.

 

Mr.  Wadsworth also serves as a director of InnoveerSolutions, Inc. (“Innoveer”), formerly Akibia Consulting, and previously asubsidiary of Akibia. We engage Innoveer to provide professional servicesrelated to modifications of our Customer Resource Management (“CRM”) softwaresystem. During the three months ended December 31, 2005 and 2004, we incurredapproximately $29,000 and $14,300, respectively, related to these services. AtDecember 31, 2005, we had amounts outstanding payable to Innoveer ofapproximately $26,000. We had no amounts outstanding to Innoveer atSeptember 30, 2005.

 

During the year ended September 30, 2005 we engaged the consultingservices of Mapleworks Technologies (“Mapleworks”), a software developmentservices provider. Both Mr. Blaeser and Mr. Wadsworth are investorsin Mapleworks and are members of its board of advisors. For the three monthsended December 31, 2005 we incurred $45,000 in fees for these consultingservices.  We had no amounts outstandingpayable to Mapleworks at December 31, 2005 and September 30, 2005.

 

**Recent AccountingPronouncements**

 

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards 123 (revised 2004), “Share-BasedPayment” (“SFAS 123(R)”). SFAS 123(R) is a revision of FASB Statement No. 123, “Accountingfor Stock-Based Compensation”, supersedes Accounting Principles Board OpinionNo. 25, “Accounting for Stock Issued to Employees”, and amends FASB StatementNo. 95, “Statement of Cash Flows”. SFAS 123(R) requires all share-basedpayments to employees, including grants of employee stock options and stockpurchases under employee stock purchase plans, to be recognized in thefinancial statements based on their fair values. We adopted SFAS 123(R) usingthe modified prospective method during the quarter ended December 31, 2005. Asnoted in footnote 3 to our Condensed Consolidated Financial Statements, theadoption of SFAS 123(R) had a material impact on our consolidated statements ofoperations and net loss per share.

 

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

 

We do not engage in anyforeign currency hedging transactions and therefore, do not believe we aresubject to material exchange rate risk. We are exposed to market risk relatedto changes in interest rates. We invest excess cash balances in cashequivalents and short-term investments and as a result, we believe that theeffect, if any, of reasonably possible near-term changes in interest rates onour financial position, results of operations and cash flows will not bematerial. In addition, a hypothetical 10% increase or decrease in interestrates would not have a material adverse effect on our financial condition.

 

26

----

 

**ITEM4.    CONTROLS AND PROCEDURES**

 

Our management, with the participation of ourchief executive officer and chief financial officer, evaluated theeffectiveness of our disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) under the Securities Exchange Act) as ofDecember 31, 2005. Based on this evaluation, our chief executive officer andchief financial officer concluded that, as of December 31, 2005, our disclosurecontrols and procedures (1)  were designed to effectively accumulate andcommunicate information to the Company’s management, as appropriate, to allowtimely decisions regarding required disclosure  (2) were effective, in that they providereasonable assurance that information required to be disclosed by the Companyin the reports that it files or submits under the Securities Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms.

 

Nochange in our internal control over financial reporting (as defined in Rules13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the threemonths ended December 31, 2005 that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

27

----

 

**PARTII—OTHER INFORMATION**

 

**ITEM 1.     LEGALPROCEEDINGS**

 

*Announcement Timing Lawsuit*

 

On March 17, 2004, the United States District Court for the District ofMassachusetts consolidated a number of purported class action lawsuits filedagainst Network Engines, Inc. and certain individual Network Enginesdefendants, collectively the defendants.  These suits generally concernthe timing of the announcement of an amendment to Network Engines’ agreementwith EMC Corporation regarding the resale of EMC-approved Fibre Channel HBAs. In its March 17, 2004 order, the court selected Wing Kam Yu, BlakeKunkel, and Thomas Cunningham as lead plaintiffs and appointed Milberg WeissBershad Hynes & Lerach LLP (now Milberg Weiss Bershad & Schulman LLP)as plaintiffs’ lead counsel.  The lead plaintiffs filed an amendedconsolidated complaint on June 4, 2004.  The defendants on August 13, 2004filed a motion to dismiss the amended consolidated complaint.  The plaintiffson October 12, 2004 filed an opposition to the defendants’ motion to dismissand the defendants filed a reply to the plaintiff’s opposition on November 12,2004.  The court on November 22, 2004denied the defendants’ motion to dismiss the amended consolidated complaint. OnDecember 9, 2004 the defendants filed an answer to the amended consolidatedcomplaint.  Since that time the partieshave engaged in some informal discovery and, more recently, have exchanged formaldiscovery requests.  Discovery is toconclude on or before March 31, 2006. The parties are currently actively pursuing settlement.  Network Engines believes that the plaintiffs’allegations are without merit, and it intends to pursue a vigorous defense.

 

We are unable to predict the outcome of this suit and its ultimateeffect, if any, on the Company’s financial condition; however, our defenseagainst this suit may result in the expenditure of significant financial andmanagerial resources.  No amounts have been accrued for this matter, sincethe anticipated settlement is expected to be covered in its entirety by ourinsurance provider.

 

*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 our initial public offering: FleetBoston Robertson Stephens,Inc., Credit Suisse First Boston Corp., Goldman Sachs & Co., LehmanBrothers Inc. and Salomon Smith Barney, Inc. collectively, the underwriterdefendants.  An amended class action complaint, captioned In re NetworkEngines, Inc. Initial Public Offering Securities Litigation, 01 Civ. 10894(SAS), was filed on April 20, 2002.

 

The suit alleges that the defendants violated the federal securitieslaws by issuing and selling securities pursuant to our initial public offeringin July 2000, or IPO, without disclosing to investors that the underwriterdefendants had solicited and received excessive and undisclosed commissionsfrom certain investors.  The suit also alleges that the underwriter defendantsentered into agreements with certain customers whereby the underwriterdefendants agreed to allocate to those customers shares of our common stock inthe offering, in exchange for which the customers agreed to purchase additionalshares of our common stock in the aftermarket at pre-determined prices. The suit alleges that such tie-in arrangements were designed to and didmaintain, distort and/or inflate the price of our common stock in theaftermarket.  The suit further alleges that the underwriter defendantsreceived undisclosed and excessive brokerage commissions and that, as aconsequence, 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 consistingof all persons who acquired shares of our common stock between July 13, 2000and December 6, 2000.

 

28

----

 

In July 2002, Network Engines, Lawrence A. Genovesi and Douglas G.Bryant joined in an omnibus motion to dismiss challenging the legal sufficiencyof plaintiffs’ claims.  The motion was filed on behalf of hundreds ofissuer 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 Network Engines.  In addition, in October 2002, Lawrence A.Genovesi and Douglas G. Bryant were dismissed from this case without prejudice.

 

On July 9, 2003, a Special Committee of our Board of Directorsauthorized Network Engines to negotiate a settlement of the pending claims substantiallyconsistent with a memorandum of understanding negotiated among classplaintiffs, all issuer defendants and their insurers.  We have negotiatedthe settlement, which provides, among other things, for a release of NetworkEngines and the individual defendants for the conduct alleged in the amendedcomplaint to be wrongful.  We would agree to undertake otherresponsibilities under the settlement, including agreeing to assign, or notassert, certain potential claims that we may have against the underwriters. Any direct financial impact of the proposed settlement is expected to beborne by our insurers.  The settlement is subject to variouscontingencies, including approval by the Court overseeing the litigation. OnFebruary 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 parties agreed to a modification narrowingthe scope of the bar order, and on August 31, 2005, the Court issued an orderpreliminarily approving the settlement.

 

We are unable to predict the outcome of this suit and its ultimateeffect, if any, on our financial condition; however, our defense against thissuit has and may continue to result in the expenditure of significant financialand managerial resources.  No amounts have been accrued for this matter,since the anticipated settlement is expected to be covered in its entirety byour insurance provider.

 

**ITEM 1A. RISK FACTORS**

 

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

 

***Risksof dependence on one strategic partner.***

 

**We derive a significantportion of our revenues from sales of server appliances directly to EMC throughour OEM Appliance segment 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 quarters ended December 31, 2005 and 2004, sales directly to EMC,our largest customer, accounted for 83% and 69% of our total net revenues and84% and 83% of our OEM Appliance revenues, respectively.  Primarily all of these sales are attributableto one OEM Appliance product pursuant to a non-exclusive contract. Weanticipate that our future operating results will continue to depend heavily onsales to, and our relationship 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 dependentupon the future success of the products we sell to this customer and the continuedgrowth, viability and financial stability of this customer, whose industry hasexperienced rapid technological change, short product life cycles,consolidation and pricing and margin pressures. A significant reduction in sales to this customer, or significantpricing and additional margin pressures exerted on us by this customer, wouldhave a material adverse effect on our results of operations.  In addition, if this customer delays orcancels purchases of our products, our operating results would be harmed andour ability to accurately predict revenues, profitability and cash flows woulddecrease.

 

29

----

 

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

 

***Risksrelated to business strategy.***

 

**If potential customers donot accept our NS Series Security Appliances as a solution to certain of theirnetwork security needs, our business will be adversely affected.**

 

We currently expect that future Distribution segment revenues will beprimarily generated through sales of our NS Series Security Appliances and therelated maintenance service, and we will not succeed if the market does notaccept these products and services as a viable solution to certain networksecurity needs. Our NS Series Security Appliances are powered by Microsoft’sInternet Server Acceleration (“ISA”) Server 2004 software application.  If customers don’t perceive this applicationto be technically superior to other competitive security products or ifcustomers don’t believe that our security appliance will provide increased securityfor Microsoft applications, then our future revenues and operating results willsuffer. We also may not be successful in marketing and selling these productsin the future if we are unable to educate and train channel customers on ourproduct line, or if we are unable to gain market acceptance of these products.

 

Sales of NS Series Security Appliances through our Distribution segmentrequires a greater selling and marketing burden than any of our other serverappliance products. We may find the selling and marketing burden to be greaterthan was originally planned. We have invested and plan to continue to invest ina significant level of sales and marketing resources and programs along withengineering resources for the continued development of our NS Series SecurityAppliances. If we are unable to generate sufficient revenues to recover thesecosts and achieve an appropriate gross profit, our operating results willsuffer. To date, we have been unable to achieve substantial sales of serverappliances through our Distribution segment and there is no guarantee that wewill be able to achieve substantial amounts of such sales in the future. If weare unable to generate sufficient revenues by leveraging our Distributionoperation to increase sales of server appliances in a cost effective and timelymanner, our operating results may suffer and we may determine that we need toincrease our investment in this business, thereby increasing our costs andincreasing our losses, or we may determine that we must discontinue thiscomponent of our business strategy, any of which could negatively affect ourbusiness.

 

**Market acceptance anddemand of Microsoft’s ISA Server 2004 software will depend on Microsoft’sdecision to prioritize and concentrate its marketing efforts for this software.**

 

**Because our NS Series line ofsecurity appliances are powered by Microsoft’s ISA Server 2004, our successwill depend on the extent the marketplace perceives this software as superiorto other forms of security protection. We believe, this perception will be determined substantially as a resultof marketing efforts undertaken by Microsoft directly.  In order to achieve broad recognition thatISA Server 2004 provides necessary protection of specific Microsoftapplications better than other competing products, we will rely to asignificant extent on Microsoft’s financial and technical resources to educateits channel of certified resellers and, equally as important, the ultimateend-users.  If Microsoft does notprioritize these marketing and promotional campaigns, or delays the timing ofsuch programs, then we may not achieve significant sales of our NS SeriesSecurity Appliances, which may adversely affect our business.**

 

Even if Microsoft’s ISA Server 2004 software is widely accepted as thebest protection of Microsoft applications, customers may choose to purchase ISAServer 2004 in the form of software instead of a server appliance.  Although many network security applicationsare sold in the form of an appliance to 

 

30

----

 

allow for better deployment,management and security, Microsoft could continue to sell and/or customers mayelect to purchase ISA Server 2004 in the form of software only or may choose topurchase appliances from other vendors. If Microsoft does not promote the advantages of ISA Server 2004 in theform of a server appliance, this would have a negative impact on our business.

 

**If we fail to engage witha significant number of new resellers and systems integrators capable ofselling our NS Series Security Appliances, our revenues and operating resultsmay be adversely affected.**

 

In order for our NS Series Security Appliances to be successful webelieve we must establish a network of quality VARs and systems integratorsthat are familiar with Microsoft products or the network security market andare committed to sell our security appliances. To date, we have engaged with approximately 83 resellers in NorthAmerica and 50 resellers in Europe.  Manyof the North American reseller relationships were derived through workingclosely with Microsoft’s sales and marketing team.  All of our European reseller relationshipsare the result of our distribution agreement with InTechnology.  Microsoft was instrumental in our enteringthis European distribution agreement.  Assuch, we believe that signing additional resellers will continue to depend onour relationship with Microsoft, and our ability to leverage that relationshipto gain access to quality VARs and system integrators.  Therefore, we will need to further establishand strengthen our relationship with Microsoft in order to be considered apreferred provider of Microsoft ISA Server 2004 in the form of anappliance.  We believe to grow and furtherdevelop our indirect channel of resellers in the future we must establish atwo-tiered distribution channel in North America.  We also believe that we will need Microsoft’sassistance in establishing such a channel. Additionally, we must effectively manage this relationship to gainaccess to the distributor’s resellers, direct marketers and marketing programs.If we fail to strengthen our relationship with Microsoft enabling us to enterinto partnerships with a significant number of new resellers and systemsintegrators, or are unable to establish a two-tiered distribution channel ourrevenues and operating results may be adversely affected.

 

In addition, because our channel of distributors, VARs and systemintegrators have the ability to sell products and services that are competitivewith ours, to devote more resources to those competitive products or to ceaseselling our products and services altogether, we will need to educate and trainour reseller partners on the benefits of Microsoft ISA Server 2004 and theadded value of selling this application in the form of our NS Series SecurityAppliances.  Additionally, we will needto effectively market to end-users of our NS Series Security Appliances toeducate them on the value of deploying ISA Server 2004 in the form of anappliance in order to stimulate demand in the distribution channel.

 

If we are not successful in marketing to resellers and end-users,training our resellers, or if these resellers are not committed to sell oursecurity appliances, our revenue growth may be limited and our operatingresults may be adversely affected. Further, to entice these resellers to sellour security appliances we may be required to offer certain financialincentives that would result in a reduction of revenues or an increase inoperating expenses, which would adversely affect our operating results.

 

**A breach of securitycould harm public perception of our products and services.**

 

We will not succeed unless the marketplace is confident that we provideeffective security application protection. Even applications protected by ourappliances using Microsoft’s ISA Server 2004 software may be vulnerable toelectronic break-ins and computer viruses. If an actual or perceived breach ofsecurity occurs in an end-user’s systems, regardless of whether the breach is attributableto us, the market perception of the efficacy of our products and services couldbe harmed. This could cause us or our reseller partners to lose current andpotential customers, or cause us to lose potential resellers. Because thetechniques used by computer hackers to access or sabotage networks changefrequently and generally are not recognized until launched against a target, wemay be unable to anticipate these techniques.

** **

 

31

----

 

**We may be unable todeliver our products and services if we cannot continue to license or integratethird-party technology that is essential for the functionality of our securityappliances.**

 

Our success will significantly depend on our continued ability tolicense or integrate technology that is essential for the functionality of oursecurity appliances. A material adverse change in our relationship withMicrosoft or the functionality of its software would have a significant adverseresult on our Distribution segment operations. We depend on Microsoft todeliver reliable, high-quality software, develop new software on a timely andcost-effective basis and respond to evolving technology and changes in industrystandards. Further,if Microsoft does not continue to make ISA Server 2004 available to OEMcustomers on a favorable basis, our ability to sell our NS Series SecurityAppliances may be substantially reduced.

 

We believe we also need to license or integrate technology fromadditional third-parties that would be incorporated in our NS Series SecurityAppliances.  Because we do not currentlyknow with certainty which of these prospective technologies will be desired inthe marketplace, we may incorrectly invest in development or prioritize ourefforts to integrate these technologies in our NS Series SecurityAppliances.    Additionally, even if wecorrectly focus our efforts, there can be no assurance that we will select thepreferred provider of these technologies, or that the third-party provider willbe committed to the relationship and integration of their technology.  If we are unable to successfully integratethese third-party technologies, our NS Series Security Appliances may beinferior with other competitive products, which may adversely affect theresults of our operations and our ability to grow our Distribution segmentbusiness.

 

**If we do not expand ourinternational operations and successfully overcome the risks inherent ininternational business activities, the growth of our business may be limited.**

 

Our ability to grow will depend in part on the expansion of ourinternational sales.  We currently haveagreements with distributors headquartered outside the United States for the distributionof our NS Series Security Appliances throughout Europe and the Middle East. Thefailure of our distributors to sell our products across these regions, or theirde-emphasizing their support of our products would limit our ability toincrease our revenues in those regions. In addition, our international salesare subject to the risks inherent in international business activities,including:

 

•        costof customizing products for foreign countries;

 

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

 

•        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 sales and/orrequire significant additional research and development investments, such asbeing able to comply with European Union directive Restriction of HazardousSubstances (RoHS) which restricts the use of hazardous substances in electricaland electronic equipment, by July 1, 2006.

 

Our international sales currently are U.S. dollar-denominated. As aresult, any increase in the value of the U.S. dollar relative to foreigncurrencies makes our products less competitive in international markets.Because of this our revenues may be adversely affected, or we may be requiredto denominate our sales in foreign currencies at some point in the future toremain competitive. In addition, because certain of our operating expensesrelated to our international sales are denominated in foreign currency, we mayhave difficulty controlling expenses in the event of significant currencyfluctuations.

** **

 

32

----

 

**Our future success isdependent upon our ability to generate significant revenues from serverappliance development relationships in our OEM Appliance segment.**

 

A major component of our business strategy is to form server appliancedevelopment relationships with network equipment providers and ISVs in our OEMAppliance segment.  Under this strategy,we work with our partners to develop a server appliance, which is branded withthe applicable partner’s name and is sold through our OEM Appliance segment tothe partner, who then performs all of the selling and marketing efforts relatedto further sales.

 

There are multiple risks associated with this strategy including:

 

•        the expenditure of significant productdevelopment costs, which if not recovered through server appliance sales couldnegatively affect our operating results;

 

•        a significant reliance on our partners’application software products, which could be technologically inferior tocompetitive products and result in limitations on our server appliance sales,causing our revenues and operating results to suffer;

 

•        the possibility that our partners will continueselling their application software products as separate products in addition toselling it in the form of a server appliance;

 

•        our reliance on our partners to perform all ofthe selling and marketing efforts associated with further sales of the serverappliance product we develop with them; and

 

•        our ability to provide our partners with highquality server appliances at competitive prices.

 

**Additionally, our future successwill depend on our ability to expand sales of server appliances to our existingpartners, as well as establishing relationships with new partners. If thesepartners are unsuccessful in their marketing and sales efforts, or if we areunable to expand our sales to existing partners and develop relationships withnew partners, our revenues and operating results could suffer.**

 

**Both our OEM Applianceand Distribution segments could be harmed if we fail to adequately integratenew technologies into our server appliance products or if we invest in technologiesthat do not result in the desired effects on our current and/or future productofferings.**

 

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

 

•        oursecurity appliances based on Microsoft ISA Server 2004 will require asignificant investment in our Network Engines Web Services (“NEWS”) softwarethat could be expended inefficiently because of our limited history in the typeof software development required for this product.

 

•        wemay experience difficulties integrating new technologies into our current orfuture products;

 

•        ournew products may be delayed because selected new technologies themselves aredelayed or have defects and/or performance limitations;

 

•        wemay incorporate technologies that do not result in the desired improvements toour current and/or future server appliance products;

 

•        wemay incorporate new technologies that either may not be desired by ourcustomers or may not be compatible with our customer’s existing technology;

 

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

 

33

----

 

•        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 unable to adequatelyintegrate new technologies into our server appliance products or if we investin technologies that do not result in the desired effects on our current and/orfuture product offerings, our business could be harmed and operating resultscould suffer.**

 

**If we fail to retain andattract appropriate levels of qualified employees, we may not be able meet keyobjectives.**

 

Our success depends in large part on our ability to retain, and attracthighly skilled engineering, sales, marketing, customer service, and managerialpersonnel.  If we are unable to attract asufficient number of qualified personnel, particularly personnel knowledgeablein software engineering and channel sales and marketing, experienced in thenetwork security market, we may not be able to meet key objectives such asdeveloping, upgrading, or enhancing our products in a timely manner, andeffectively marketing our products to customers, any of which could negativelyimpact our business and could hinder any future growth.

 

**Some OEM Appliance partners may view our NS Seriesfamily of security appliances as competitive to their applications and couldchoose not to do business with us.**

 

As part of our OEM Appliance segment, we partner withnetwork equipment providers and ISVs to deliver network security applicationsin the form of a server appliance.  Someof our existing partners or potential future partners may view our NS SeriesSecurity Appliances as competitive to their applications and may chose not todo business with us.  We believe that wehave policies and procedures in place to protect the proprietary nature of ourOEM Appliance partners’ applications and business plans.  However, if our NS Series Security Appliancesachieve greater acceptance in the market, some of these partners or potentialpartners may elect not to utilize our service appliance services, which wouldhave a negative impact on our business.

 

***Risksrelated to financial results.***

 

**We have a history oflosses and may continue to experience losses in the future, which could causethe market price of our common stock to decline.**

 

Since our inception, we have incurred significant net losses and couldincur net losses in the future and at December 31, 2005 and September 30, 2005our accumulated deficit was $128 million and $126 million, respectively.  We believe that any future growth willrequire us to incur significant engineering, selling and marketing andadministrative expenses, including meeting new regulatory and corporategovernance requirements. As a result, we will need to generate significantrevenues to achieve and sustain profitability. If we do not achieve and sustain profitability, the market price for ourcommon stock may decline.

 

**If our estimates orjudgments relating to our critical accounting policies are based on assumptionsthat change or prove to be incorrect, our operating results could fall belowexpectations of securities analysts and investors, resulting in a decline inour stock price.**

 

Our discussion and analysis of financial condition and results ofoperations are based on our consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States. The preparation of financial statements in conformity withgenerally accepted accounting principles requires management to make estimatesand assumptions that affect the amounts reported in the consolidated financialstatements and accompanying notes. On an ongoing basis, we evaluate significantestimates used in preparing our consolidated financial statements, includingthose related to:

 

•        revenuerecognition, including sales returns and allowances;

 

34

----

 

•        provisionfor doubtful accounts;

 

•        inventorywrite-downs;

 

•        stock-basedcompensation;

 

•        warrantyreserves; and

 

•        realizationof deferred tax assets.

 

We base our estimates on historical experience and on various otherassumptions that we believe to be reasonable under the circumstances, asprovided in our discussion and analysis of financial condition and results ofoperations, the results of which form the basis for making judgments about thecarrying values of assets and liabilities that are not readily apparent fromother sources.  Actual results may differfrom these and other estimates if our assumptions change or if actualcircumstances differ from those in our assumptions, which could cause ouroperating results to fall below the expectations of securities analysts and investors,resulting in a decline in our stock price.

 

**Our quarterly revenuesand operating results may fluctuate seasonally, which could result in decreasedrevenue from quarter to quarter, which in turn could cause the market price ofour common stock to decline.**

 

Seasonal fluctuations in revenues and operating results in the datastorage industry are common.  Inparticular, this industry typically experiences increased orders and resultingrevenues in the quarter ended December 31, and a subsequent decline in ordersand resulting revenues during the quarter ended March 31.  With a substantial amount of our revenuescurrently derived from data storage products, we may experience significantquarter-to-quarter fluctuations in revenues and operating results due tocustomers timing their orders based on their own quarterly financial and/oroperational considerations, which we have no influence over.  In addition, to the extent that revenues inour Distribution segment from international sales become significant, we mayexperience seasonal fluctuations during the quarter ended September 30, as aresult of European holiday patterns.

 

Accordingly, we believe that quarter-to-quarter comparisons of resultsof operations are not necessarily meaningful and should not be relied upon asan indication of future performance. Nonetheless, the market price of our common stock could decline inresponse to these variations.

 

**Our quarterly revenuesand operating results may also fluctuate for reasons other than seasonality, whichcould cause our operating results to fall below expectations and thus impactthe market price of our common stock.**

 

In addition to seasonality issues, our quarterly revenues and operatingresults are difficult to predict and may fluctuate significantly from quarterto quarter. None of our customers are obligated to purchase any quantity of ourproducts in the future nor are they obligated to meet forecasts of theirproduct needs. Our operating expense levels are based in part on expectationsof future revenues and gross profits, which are partially dependent on ourcustomers’ ability to accurately forecast and communicate their future productneeds. If revenues or gross profits in a particular quarter do not meetexpectations, operating results could suffer and the market price of our commonstock could decline. Factors affecting quarterly operating results include:

 

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

 

•        theproduct mix within our OEM Appliance segment;

 

•        thetiming of new product introductions by our OEM Appliance partners;

 

•        theavailability and/or price of products from suppliers;

 

35

----

 

•        theloss of key suppliers or customers;

 

•        pricecompetition;

 

•        costsassociated with our introduction of our NS Series Security Appliances and themarket acceptance of those products;

 

•        thetiming of expenditures in anticipation of increased revenues;

 

•        themix of product manufactured internally and by our contract manufacturer;

 

•        changingglobal economic or political conditions.

 

**If the products andservices that we sell become more commoditized and competition in the serverappliance, data storage and network security markets continues to increase,then our gross profit as a percentage of net revenues may decrease and ouroperating results may suffer.**

 

Products and services in the server appliance, data storage and networksecurity markets may be subject to further commoditization as these industriescontinue to mature and other businesses introduce additional competing productsand services.  The gross profit as apercentage of revenues of our products may decrease, in response to changes inour product mix, competitive pricing pressures, or new product introductions intothe server appliance and data storage markets. If we are unable to offset decreases in our gross profits as apercentage of revenues by increasing our sales volumes, or by decreasing ourproduct costs, operating results will decline. Changes in the mix of sales ofour products, including the mix of higher margin sales of products sold insmaller quantities and lower margin sales of products sold in largerquantities, could adversely affect our operating results for future quarters.  To maintain our gross profits, we also mustcontinue to reduce the manufacturing cost of our server applianceproducts.  Our efforts to produce highermargin server appliance products, continue to improve our server applianceproducts and produce new server appliance products may make it difficult toreduce our manufacturing cost per product. Further, utilization of a contractmanufacturer to produce a portion of our customer requirements for certain ofour server appliance products may not allow us to reduce our cost per product.  If we fail to respond adequately to pricingpressures, to competitive products with improved performance or to developmentswith respect to the other factors on which we compete, we could lose customersor orders.  If we are unable to competeeffectively, our business will suffer.

 

***Risksrelated to the server appliance, data storage and network security markets.***

 

**If server appliances arenot increasingly adopted as a solution to meet a significant portion ofcompanies’ network security and data storage application needs, the market forserver appliances may not grow, which could negatively impact our revenues.**

 

We expect that a substantial portion of our future revenues will comefrom sales of server appliances. As a result, we are substantially dependent onthe growing use of server appliances to meet businesses’ data storage andnetwork security application needs.  Ourrevenues may not grow and the market price of our common stock could decline ifthe server appliance market does not grow as rapidly as we expect.

 

Our expectations for the growth of the server appliance market may notbe fulfilled if customers continue to use general-purpose servers.  The role of our products could, for example,be limited if general-purpose servers out-perform server appliances, providemore capabilities and/or flexibility than server appliances or are offered at alower cost.  This could force us to lowerthe prices of our server appliance products or could result in fewer sales ofthese products, which would negatively impact our revenues and decrease ourgross profits.

 

36

----

 

**The products that we sellare subject to rapid technological change and our sales will suffer if theseproducts are rendered obsolete by new technologies.**

 

The markets we serve are characterized by rapid technological change,frequent new product introductions and enhancements, potentially short productlife cycles, changes in customer demands and evolving industry standards.  In the server appliance market, we attempt tomitigate these risks by utilizing standards-based hardware platforms and bymaintaining an adequate knowledge base of available technologies.  However, the server appliance products thatwe sell could be rendered obsolete if products based on new technologies areintroduced or new industry standards emerge and we are not able to incorporatethese technological changes into our products. In addition, we depend on third parties for the base platforms of ourserver appliances for many of our OEM Appliance segment customers and our NSSeries Security Appliances, and we are at risk if these third parties do notintegrate new technologies. Specifically, product development for network security appliancesrequires considerable engineering time and testing. Releasing new products andservices prematurely may result in quality problems, and delays may result inloss of customer confidence and market share. We may be unable to develop new products and services or achieve andmaintain market acceptance of them once they have come to market. Furthermore,when we do introduce 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 remain competitive in the server appliance market, we mustsuccessfully identify new product opportunities and partners and develop andbring new products to market in a timely and cost-effective manner. Our failureto select the appropriate partners and keep pace with rapid industry,technological or market changes could have a material adverse effect on ourbusiness, results of operations or financial condition.

 

***Risksrelated to competition.***

 

**Competition in the serverappliance market is significant and if we fail to compete effectively, ourfinancial results will suffer.**

 

In the server appliance market, we face significant competition from anumber of different types of companies. Our competitors include companies whomarket general-purpose servers, specific-purpose servers and server appliancesas well as companies that sell custom integration services utilizing hardwareproduced by other companies.  Many ofthese companies are larger than we are and have greater financial resources andname recognition than we do, as well as significant distribution capabilitiesand larger, more established service organizations to support their products.  Our larger competitors may be able to leveragetheir existing resources, including their extensive distribution capabilitiesand service organizations, to provide a wider offering of products and servicesand higher levels of support on a more cost-effective basis than we can.  We expect competition in the server appliancemarket to increase significantly as more companies enter the market and as ourexisting competitors continue to improve the performance of their currentproducts and to introduce new products and technologies.  Such increased competition could adverselyaffect sales of our current and future products.  In addition, competing companies may be ableto undertake more extensive promotional activities, adopt more aggressivepricing policies and offer more attractive terms to their customers than wecan.  If our competitors provide lowercost products with greater functionality or support than our server appliancesolutions, or if some of their products are comparable to ours and are offeredas part of a range of products that is broader than ours, our server appliancesolutions could become undesirable.

 

Even if the functionality of competing products is equivalent to ours,we face a risk that a significant number of customers would elect to pay apremium for similar functionality from an established vendor rather thanpurchase products from a less-established vendor.  We attempt to differentiate ourselves fromour competition by offering a wide variety of software integration, branding,supply-chain management, engineering, support, logistics and fulfillmentservices. If we are unable to effectively differentiate ourselves from ourcompetition, we may be forced to offer price reductions to maintain certaincustomers.  As a result, our revenues maynot increase and may 

 

37

----

 

decline, and our gross margins may decline.  Furthermore, increased competition could leadto higher selling expenses which would negatively affect our business andfuture operating results.

 

**If we are unable tocompete successfully in the highly competitive market for network securityappliances and services for any reason, such as current or potentialcompetitors gaining competitive advantage through partnering or acquisition, ourbusiness could be adversely affected.**

 

The market for network security appliances is intensely competitive andwe expect competition to intensify in the future. An increase in competitivepressures in our market or our failure to compete effectively may result inpricing reductions, reduced gross margins and loss of market share. Currently,the primary competitors relating to network security appliances with MicrosoftISA Server 2004 include Hewlett-Packard Company, Celestix Networks, Inc. andPyramid Computer GmbH.  However, becauseour agreement with Microsoft to license ISA Server 2004 is not exclusive,Microsoft may enter into similar license agreements with additionalcompetitors.  Such competitors may belarger and have significantly greater resources and experience than us, whichmay negatively affect our business.

 

Competitors in the security industry with appliances using technologyother than Microsoft ISA Server 2004 include Cisco Systems, Inc., NokiaCorporation, Juniper Networks, Inc, Watchguard Technologies, Inc. andSonicWALL, Inc.  Substantially all of ourcompetitors have longer operating histories, greater name recognition, largercustomer bases and significantly greater financial, technical, marketing andother resources than we do. Our current and potential competitors may establishcooperative relationships among themselves or with third parties that mayfurther enhance their resources. In addition, current or potential competitorsmay be acquired by third parties with greater available resources.  As a result of such potential acquisitions,our current or potential competitors might be able to adapt more quickly to newtechnologies and customer needs, devote greater resources to the promotion orsale of their products and services, initiate or withstand substantial pricecompetition, take advantage of acquisition or other opportunities more readilyor develop and expand their product and service offerings more quickly. Inaddition, our competitors may bundle products competitive with ours with otherproducts that they may sell to our current or potential customers. Thesecustomers may accept these bundled products rather than separately purchasingour products.

 

**Our revenues could benegatively affected if our larger competitors consolidate their extensivedistribution capabilities with our smaller competitors’ products.**

 

Large server manufacturers may not only develop their own serverappliance solutions, but they may also acquire or establish cooperativerelationships with our smaller competitors, developing server applianceproducts and related technologies. Because large server manufacturers have significant financial andorganizational resources available, they may be able to quickly penetrate theserver appliance market by leveraging the technology and expertise of smallercompanies with their own extensive distribution channels.  We expect that the server industry willexperience further consolidation.  It ispossible that new competitors or alliances among competitors may emerge and rapidlyacquire significant market share through consolidation.  Consolidation within the server marketplacecould adversely affect our revenues.

 

***Risksrelated to marketing and sales efforts and customer service.***

 

**We need to effectivelymanage our sales and marketing operations to increase market awareness andsales of our products and to promote our brand recognition. If we fail to doso, our growth will be limited.**

 

Although we currently have a relatively small sales and marketingorganization, we must continue to increase market awareness and sales of ourproducts and promote our brand in the marketplace.  In our OEM Appliance segment, we believe thatto compete successfully we will need network equipment providers and ISVs torecognize Network Engines as a top-tier provider of server appliance platformsand custom integration services.

 

We must also effectively market to VARs, systems integrators, and theirend customers our NS Series Security Appliances. This marketing effort requiresa significant investment in personnel and other 

 

38

----

 

areas, and an appropriate level of technical knowledge about thesecurity market, Microsoft applications such as Exchange, and other softwareapplications included in these server appliance products.  It also requires substantial understanding ofthe targeted market into which these products are sold and may require theexpenditure of a material amount of managerial and financial resources. We havelimited experience marketing and selling security appliance products throughindirect channels and therefore, may not be successful in these efforts. If weare unable to design and implement marketing campaigns that are effective inpromoting our network security appliances, or if we fail to promote andmaintain the Network Engines brand, we may not increase or maintain sales andour business may be adversely affected. Our business would also suffer if we incur excessive expenses in thesemarketing campaigns but fail to achieve the expected or desired increase inrevenues.

 

**If we are unable toeffectively manage our customer service and support activities, we may not beable to retain our existing customers or attract new customers.**

 

We need to effectively manage our customer support operations to ensurethat we maintain good relationships with our customers.  Because our NS Series Security Appliancesprovide critical protection for certain applications, managing software updatesto the appliance, when and if they are available, will be essential to theperformance of the appliance.  Managingany such updates released by Microsoft will require careful consideration todetermine the sensitivity and impact on the function of our appliance.  Additionally, any updates designated as vitalto the function of our appliance will require rapid deployment to ensure thecustomers’ applications are properly protected. We expect that providing this increased customer service for our NSSeries Security Appliances will require more technically qualified staff eitherwithin the Company or from third parties and if we are unable to provide thishigher level of service we may be unable to successfully sell such securityappliances.

 

Our channel partners in some cases will provide support for theend-user customers.  We may be unable toprovide these channel partners with the necessary training and back-up support.Therefore they may be unable to provide end-user customers with the necessarylevel of support, which may be detrimental to our reputation and ability tosell our products.  Also, some of ourchannel partners may choose not to provide this service, which would require usto hire more support staff to provide the first level support to end usercustomers, which would increase our costs and lower our margins.

 

If our customer support organization is unsuccessful in maintaininggood customer relationships, we may lose customers to our competitors and ourreputation in the market could be damaged. As a result, we may lose revenues and our business could suffer.Furthermore, the costs of this service could be higher than we expect, whichcould adversely affect our operating results.

 

***Risksrelated to product manufacturing.***

** **

**Our dependence on solesource and limited source suppliers for key server appliance components makesus susceptible to supply shortages and potential quality issues that couldprevent us from shipping customer orders on time, if at all, and could resultin lost sales and customers.**

 

We depend upon single source and limited source suppliers for ourindustry-standard processors, main logic boards, certain disk drives, hardwareplatforms and power supplies as well as certain of our cooling systems, chassisand sheet metal parts. We also rely upon a single source supplier to providethe hardware platform for our NS Series Security Appliances. Additionally, wedepend on limited sources to supply certain other industry-standard andcustomized components.  We are relying onour suppliers to be compliant with the European Union directive on RoHS by July1, 2006 for products that we ship into the European Union.  We have in the past experienced, and may inthe future experience, shortages of or difficulties in acquiring components inthe quantities and of the quality needed to produce our server applianceproducts.  Shortages in supply or qualityissues related to these key components for an extended time would cause delaysin the production of our server appliance products, prevent us from satisfyingour contractual obligations and meeting customer expectations, and result inlost sales and customers. If we are unable to buy components in the quantitiesand of the quality that we need on a timely basis or at acceptable prices, wewill not be able to manufacture and deliver our server appliance products on atimely

 

39

----

 

or cost-effective basis to our customers, and our competitive position,reputation, business, financial condition and results of operations could beseriously harmed.

 

**If our server applianceproducts fail to perform properly and conform to specifications, our customersmay demand refunds, assert claims for damages or terminate existingrelationships with us and our reputation and operating results may suffermaterially.**

 

Because server appliance solutions are complex, they could containerrors that can be detected at any point in a product’s life cycle.  If flaws in design, production, assembly ortesting of our products (by us or our suppliers) were to occur, we couldexperience a rate of failure in our products that could result in substantialrepair, replacement or service costs and potential damage to ourreputation.   In addition, becauseour solutions are combined with products from other vendors, should problemsoccur, it might be difficult to identify the source of the problem. Continuedimprovement in manufacturing capabilities, control of material andmanufacturing quality and costs, and product testing are critical factors inour future growth.  There can be no assurance that our efforts to monitor,develop, modify and implement appropriate test and manufacturing processes forour products will be sufficient to permit us to avoid a rate of failure in ourproducts that results in substantial delays in shipment, significant repair orreplacement costs or potential damage to our reputation, any of which couldhave a material adverse effect on our business, results of operations orfinancial condition.

 

In the past, we have discovered errors in some of our server appliancesolutions and have experienced delays in the shipment of our server applianceproducts during the period required to correct these errors or we have had toreplace defective products that were already shipped.  Errors in our server appliance solutions maybe found in the future and any of these errors could be significant.  Significant errors, including those discussedabove, may result in:

 

•        theloss of or delay in market acceptance and sales of our server applianceproducts;

 

•        diversionof engineering resources;

 

•        increasedmanufacturing costs;

 

•        theloss of new or existing server appliance partners;

 

•        injuryto our reputation and other customer relations problems; and

 

•        increasedmaintenance and warranty costs.

 

Any of these problems could harm our business and future operatingresults. Product errors or delays could be material, including any producterrors or delays associated with the introduction of new products or versionsof existing products. If our server appliance solutions fail to conform towarranted specifications, customers could demand a refund for the purchaseprice and assert claims for damages.

 

Moreover, because our server appliance solutions may be used inconnection with critical computing systems services, including providingsecurity to protect valuable information, we may receive significant liabilityclaims if they do not work properly. While our agreements with customerstypically contain provisions intended to limit our exposure to liabilityclaims, these limitations do not preclude all potential claims. Liabilityclaims could exceed our insurance coverage and require us to spend significanttime and money in litigation or to pay significant damages. Any claims fordamages, even if unsuccessful, could seriously damage our reputation and business.

 

40

----

 

**Our future serverappliance revenue growth is dependent on our ability to expand productioncapacity.**

 

Our existing manufacturing facility is limited in its productioncapacity.  For us to achieve significantserver appliance revenue growth our server appliance sales volumes mustincrease significantly and our production capacity must increase to supportsuch sales volumes.

 

To supplement our current production capacity, to provide for increasedcapacity for “production spikes” and to provide disaster backup capabilities,we currently utilize the services of a contract manufacturer for certain serverappliance products on a limited basis. However, our contract manufacturer is not obligated to supply productsto us for any specific period, or in any specific quantity, except as may beprovided in an accepted purchase order. Using a contract manufacturer increases our cost of producing serverappliance products and could 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 acontract manufacturer does not guarantee us production levels, manufacturingline space or manufacturing prices, the lack of which could interrupt ourbusiness operations and have a negative effect on operating results.

 

In the past, we expanded our internal production capacity throughexpansion and reorganization of our current production facilities. Although webelieve that our current facility, along with our use of a contractmanufacturer to supplement production, is sufficient to support our businessfor the foreseeable future, we may need additional production capacity. Webelieve that we could expand production levels in our existing facility, but weare currently utilizing all available manufacturing space in our existingfacility and we may have difficulties expanding this facility any further.Therefore, significant further expansion of the production capacity either inour existing facilities or by expanding into additional facilities couldrequire substantial investments, which could detract from our ability to investin other areas of our business and may not result in the desired return oninvestment, which could negatively affect our operating results.

 

**If we do not accuratelyforecast our server appliance materials requirements, our business andoperating results could be adversely affected.**

 

We use rolling forecasts based on anticipated product orders todetermine our server appliance component requirements.  Lead times for materials and components thatwe order vary significantly, depending among other things, on specific supplierrequirements, contract terms and current market demand for thosecomponents.  In addition, a variety offactors, including the timing of product releases, potential delays orcancellations 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 materialsrequirement forecasts may not be accurate. If we overestimate our materials requirements, we may have excessinventory, which would increase costs and negatively impact our cash position.  Our agreements with certain customers provideus with protections related to inventory purchased in accordance with the termsof these agreements; however, these protections may not be sufficient toprevent certain losses as a result of excess or obsolete inventory. If weunderestimate our materials requirements, we may have inadequate inventory,which could interrupt our manufacturing and delay delivery of our serverappliance products to customers resulting in a loss of sales or customers.  Any of these occurrences would negativelyimpact our business and operating results.

 

***Risksrelated to product dependence on intellectual property.***

 

**Our reliance uponcontractual provisions, domestic patent, copyright and trade secret laws andapplied-for patents to protect our proprietary rights may not be sufficient toprotect our intellectual property.**

 

Certain of our server appliance solutions are differentiated from theproducts of our competitors by our internally developed software and hardwareand the manner in which they are integrated into our server appliancesolutions. If we fail to protect our intellectual property, other vendors couldsell products with 

 

41

----

 

features similar to ours, which could reduce demand for oursolutions.  We have taken what we believeto be the necessary and appropriate steps to safeguard our intellectualproperty. However, these steps may afford us only limited protection.  Others may develop technologies that aresimilar or superior to our technology or design around the patents we own.  Despite the precautions we have taken, lawsand contractual restrictions may not be sufficient to prevent misappropriationof our technology or deter others from developing similar technologies. Inaddition, there can be no guarantee that any of our patent applications willresult in patents, or that any such patents would provide effective protectionof our technology.

 

In addition, the laws of the countries in which we may decide to marketour services and solutions may offer little or no effective protection of ourproprietary technology.  Reverseengineering, unauthorized copying or other misappropriation of our proprietarytechnology could enable third parties to benefit from our technology withoutpaying us for it, which would significantly harm our business. In addition, ourU.S. patents have no effect in foreign jurisdictions and obtaining patentprotection in foreign countries is expensive and time consuming.

 

**Our operating resultswould suffer if we, or our ISV or network equipment provider partners, weresubject to an infringement claim that resulted in protracted litigation, theaward of significant damages against us or the payment of substantial ongoingroyalties.**

 

Substantial litigation regarding intellectual property rights exists inthe technology industry.  We expect thatserver appliance products may be subject to third-party infringement claims asthe number of competitors in the industry segment grows and the functionalityof products in different industry segments overlap.  In the past we have received claims fromthird parties that our server appliance products infringed their intellectualproperty rights. We do not believe that our server appliance products employtechnology that infringes the proprietary rights of any third parties. We arealso not aware of any claims made against any of our ISV or network equipmentprovider partners related to their infringement of the proprietary rights ofother parties in relation to products that include our server applianceproducts. Other parties may 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, other parties may make claims against our ISV or networkequipment provider partners related to products that are incorporated into ourserver appliance products. Our business could be adversely affected if suchclaims resulted in the inability of our ISV or network equipment providerpartners’ to continue to produce the infringing product.

 

***Otherrisks related to our business.***

** **

**If we fail to maintain aneffective system of internal controls, we may not be able to accurately reportour financial results.  As a result,current and potential stockholders could lose confidence in our financialreporting, which could have a negative market reaction.**

 

Section 404 of the Sarbanes-Oxley Act of 2002 requires our managementto report on, and our independent registered public accounting firm to attestto, the effectiveness of our internal control over financial reporting.  We have an ongoing program to perform thesystem and process evaluation and testing necessary to comply with theserequirements.  As a result, we haveincurred increased expense and have devoted additional management resources toSection 404 compliance.  Effectiveinternal controls are 

 

42

----

 

necessary for us to provide reliable financial reports.  If we cannot provide reliable financialreports, our business and operating results could be harmed.

 

**Class action lawsuitshave been filed against us, our board of directors, our chairman and certain ofour executive officers and other lawsuits may be instituted against us fromtime to time.**

 

**In December 2001, a class actionlawsuit relating to our initial public offering was filed against us, ourchairman, one of our executive officers and the underwriters of our initialpublic offering. In addition, in January 2003, a purported class action lawsuitwas filed against us and our Board of Directors relating to the acquisition ofTidalWire Inc. and on December 16, 2003, a number of purported class actionlawsuits were filed against us and John H. Curtis, our former President andCEO, Douglas G. Bryant, our CFO, Vice President of Finance and Administration,Treasurer and Secretary, and Lawrence Genovesi, our Chairman of the Boardrelating to the timing of our announcement of the amendment of our HBAdistribution agreement with EMC. For more information on these lawsuits, see “PartII, Item 1 – Legal Proceedings.” In December 2003, we settled the class actionlawsuit filed against us relating to the acquisition of TidalWire Inc. and weare currently attempting to settle the lawsuit filed against us related to ourinitial public offering and the lawsuit related to the timing of ourannouncement of the amendment of our HBA distribution agreement with EMC. Weare unable to predict the effects on our financial condition or business of thelawsuit related to our initial public offering, the lawsuit related to ourannouncement of the amendment of our HBA distribution agreement with EMC orother lawsuits that may arise from time to time.  While we maintain certain insurance coverage,there can be no assurance that claims against us will not result in substantialmonetary damages in excess of such insurance coverage. These class action lawsuits,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 to defendsuch claims. These class action lawsuits, or other similar lawsuits that mayarise from time to time, could negatively impact both our financial conditionand the market price of our common stock and could result in managementdevoting a substantial portion of their time to these lawsuits, which couldadversely affect the operation of our business.**

 

**If the site of ourmanufacturing operations were to experience a significant disruption in itsoperations, it would have a material adverse effect on our financial conditionand results of our operations.**

 

Our manufacturing facility and headquarters are concentrated in onelocation.   If the operations in thisfacility were disrupted as a result of a natural disaster, fire, power or otherutility outage, work stoppage or other similar event, our business could beseriously harmed as a result of interruptions or delays in our manufacturing,engineering, distribution or post-sales support operations.

 

**We have discontinuedselling third-party data storage networking products, and are relying on athird party to fulfill the warranty obligations related to these products.**

 

**Because we have outsourced customersupport activities of these third-party data storage networking products to athird party, we will continue to depend on this third party to successfullyaddress our former customers’ needs for the remaining outstanding warrantyperiod.  Although we have paid the thirdparty in full for this service, if it does not fulfill its obligation we may berequired to incur additional costs to satisfy those customers’ needs, which maynegatively affect our business.**

 

**If we can not attract andretain key members of senior management, we may not be able to successfully executeour business strategy.**

 

The loss of key members of our management team could harm us. Oursuccess is substantially dependent on the ability, experience and performanceof our senior management team. Because of their ability and experience, we maynot be able to successfully execute our business strategy if we were to loseone or more of these individuals, without obtaining a replacement with theequivalent or more experience. If we are unable to successfully execute ourbusiness strategy, our operating results would suffer.

 

43

----

 

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

 

The market price of our common stock has been subject to significantfluctuations and may continue to fluctuate or decline. During fiscal 2005, theprice of our common stock ranged from a low of $1.37 to a high of $3.16 and inthe three months ended December 31, 2005 from a low of $1.12 to a high of$1.52. The market for technology stocks has been extremely volatile andfrequently reaches levels that bear no relationship to the past or presentoperating performance of those companies. General economic conditions, such asrecession or interest rate or currency rate fluctuations in the United Statesor abroad, could negatively affect the market price of our common stock. Inaddition, our operating results may be below the expectations of securitiesanalysts and investors. If this were to occur, the market price of our commonstock may decrease significantly.  In thepast, following periods of volatility in the market price of a company’ssecurities, securities class action litigation has often been institutedagainst such companies.  Such litigationcould result in substantial cost and a diversion of management’s attention andresources.

 

The market price of our common stock may fluctuate in response tovarious factors, some of which are beyond our control. These factors include,but are not limited to, the following:

 

•        changesin our relationship or contract with EMC;

 

•        changesin our relationship with Microsoft;

 

•        marketacceptance of our NS Series Security Appliances;

 

•        actualor anticipated fluctuations in our operating results;

 

•        changesin financial estimates or investment recommendations by securities analysts whofollow our business;

 

•        technologicaladvances or introduction of new products by us or our competitors;

 

•        theloss of key personnel;

 

•        oursale of common stock or other securities in the future;

 

•        significantsales of our common stock by existing stockholders, affiliates and insiders;

 

•        intellectualproperty or litigation developments;

 

•        changesin market valuations or earnings of our competitors or other technology companies;

 

•        changesin business or regulatory conditions;

 

•        thetrading volume of our common stock; and

 

•        disruptionsin the geopolitical environment, including war in the Middle East or elsewhereor acts of terrorism in the United States or elsewhere.

** **

**Any decline in the market price ofour common stock or negative market conditions could adversely affect ourability to raise additional capital, to complete future acquisitions of orinvestments in other businesses and to attract and retain qualified technicaland sales and marketing personnel.**

 

44

----

 

**We have anti-takeoverdefenses that could delay or prevent an acquisition and could adversely affectthe market price of our common stock.**

 

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

 

In addition, provisions ofour second amended and restated certificate of incorporation and our secondamended and restated by-laws may deter an unsolicited offer to purchase us.These provisions, coupled with the provisions of the Delaware GeneralCorporation Law, may delay or impede a merger, tender offer or proxy contestinvolving us. For example, our Board of Directors is divided into threeclasses, only one of which is elected at each annual meeting. These factors mayfurther delay or prevent a change of control of our business.

 

**ITEM2.     UNREGISTERED SALES OF EQUITY SECURITIES AND USE OFPROCEEDS**

 

*Recent Sales of Unregistered Securities*

 

During the quarter ended December 31, 2005, we did not issue anyunregistered shares of our common stock.

* *

*Use of Proceeds from Sales of Registered Securities*

 

On July 18, 2000, the Company sold 7,475,000 shares of common stock inan initial public offering at a price of $17.00 per share pursuant to aRegistration Statement on Form S-1 (Registration No. 333-34286), which wasdeclared effective by the Securities and Exchange Commission on July 12,2000.  The aggregate proceeds to us fromthe offering were approximately $116.9 million reflecting gross proceeds of$127.0 million net of underwriting fees of approximately $8.9 million and otheroffering costs of approximately $1.3 million. During the period from the offering through December 31, 2005, we usedthe proceeds from its initial public offering as follows: approximately $60.2 millionto fund our operations, approximately $8.8 million for the purchase of propertyand equipment, approximately $4.6 million to repurchase our common stock undera stock repurchase plan and approximately $13.2 million for our acquisition ofTidalWire Inc.

 

**ITEM 6.    EXHIBITS**

 

(a)    Exhibits

 

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

 

45

----

 

**SIGNATURES**

 

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

 
|                   | **NETWORK  ENGINES, INC.**                                                                        |
|------------------------|---------------------------------------------------------------------------------------------------|
|                   |                                                                                              |
| Date: February 9, 2006 | /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)                                                                               |
|                        |                                                                                                   |  |  |

 

46

----

 

**EXHIBITINDEX**

 
| **Exhibit No.** | ** ** | **Exhibit**                                                                                                                                    |
|----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                 |       | Severance Terms  Agreement, dated January 9, 2006, between the Company and Gregory A.  Shortell.                                               |
|                 |       |                                                                                                                                           |
| 10.2                 |       | Letter  Agreement, dated January 6, 2006, between the Company and Gregory A.  Shortell.                                                        |
|                 |       |                                                                                                                                           |
| 10.3                 |       | 2006  Executive Bonus Program.                                                                                                                 |
|                 |       |                                                                                                                                           |
| 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.   |

 

47

----