UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

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

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

Large accelerated filer o  Accelerated filer x  Non-accelerated filer o

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

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

NETWORK ENGINES, INC.

INDEX

PART I. FINANCIAL INFORMATION

ITEM I. FINANCIAL STATEMENTS

NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)

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

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

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NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

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

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

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NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

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

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

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.  BASIS OF PRESENTATION

The accompanying condensed consolidated financial statements have been prepared by Network Engines, Inc. (“Network Engines” or the “Company”) in accordance with accounting principles generally accepted in the United States of America and pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. The year-end condensed balance sheet data was derived from audited financial statements, but does not include all year-end disclosures required by accounting principles generally accepted in the United States of America.  These financial statements should be read in conjunction with the audited financial statements and the accompanying notes included in the Company’s 2006 Annual Report on Form 10-K filed by the Company with the Securities and Exchange Commission.

The information furnished reflects all adjustments, which, in the opinion of management, are of a normal recurring nature and are considered necessary for a fair statement of results for the interim periods. It should also be noted that results for the interim periods are not necessarily indicative of the results expected for the full year or any future period.

The preparation of these condensed consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates reflected in these financial statements include inventory valuation, valuation of deferred tax assets, warranty reserves and stock-based compensation. Actual results could differ from those estimates.

2.  SIGNIFICANT ACCOUNTING POLICIES

Recent Accounting Pronouncements

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

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

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In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, “Fair Value Measurements” (“FAS 157”).  This statement address how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under accounting principles generally accepted in the United States.  This Statement is effective as of the beginning of the Company’s fiscal year that begins after November 15, 2007.  The Company is in the process of evaluating whether the adoption of this statement will have a material impact on the Company’s financial position, results of operations or cash flows.

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

Cash, Cash Equivalents, and Short-term Investments

Cash equivalents consist principally of money market funds, commercial paper, and other marketable securities purchased with an original maturity of three months or less.  These investments are carried at cost, which approximates market value. The Company also invests excess cash in auction rate securities.  These securities have long-term underlying maturities, however the market is highly liquid and the interest rates reset every 7, 28 or 35 days.  The Company’s intent is not to hold these securities to maturity, but rather to use the interest rate reset feature to sell securities to provide liquidity as needed.  The Company’s short-term investments are classified as available for sale and are carried at fair value, with unrealized gains and losses included in other comprehensive income or loss, which is a separate component of stockholders’ equity, until realized. At June 30, 2007 and September 30, 2006, there were no unrealized gains or losses.  At June 30, 2007 and September 30, 2006, $247,000 and $47,000, respectively, of cash was restricted and pledged as collateral for letters of credit.  Details of the Company’s cash, cash equivalents and short-term investments are as follows (in thousands):

	June 30, 2007		September 30, 2006
Cash and cash equivalents:
Cash	$	1,549	$	718
Money market funds	5,158		5,105
Commercial paper	7,989		2,191
Total cash and cash equivalents	$	14,696	$	8,014
Short-term investments:
Municipal auction rate securities	$	25,402	$	24,804

Comprehensive Income (Loss)

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

Segment Reporting

During the quarter ended December 31, 2006, the Company changed the manner in which management viewed information regarding results of the Company’s operations for purposes of making decisions affecting the business. This resulted from changes in the operations of the Company, including consolidation of financial and operational information reviewed by management to evaluate the Company’s

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operations, discontinuing market demand creation for its NS Series Security Appliances and using certain of those products as reference platforms for developing and selling appliances to system integrators and Independent Software Vendors (“ISVs”), and the consolidation of the Company’s sales force. Therefore, the Company now has one reportable segment, which represents how management now evaluates the Company’s operations.  Substantially all of the Company’s long-lived assets were located in the United States as of June 30, 2007 and September 30, 2006.

Significant Customers

The following table summarizes those customers who accounted for greater than 10% of the Company’s net revenues or accounts receivable:

	Net Revenues
	Three months ended				Nine months ended				Accounts Receivable at
	June 30,				June 30,				June 30,		September 30,
	2007		2006		2007		2006		2007		2006
EMC Corporation	81	%	81	%	81	%	81	%	81	%	85	%

3.  STOCK-BASED COMPENSATION

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

The following table presents stock-based employee compensation expense included in the Company’s unaudited condensed consolidated statements of operations (in thousands):

	Three months ended June 30,				Nine months ended June 30,
	2007		2006		2007		2006
Cost of revenues	$	44	$	55	$	124	$	141
Research and development	297		297		877		835
Selling and marketing	76		205		243		614
General and administrative	187		214		620		553
Stock-based compensation expense	$	604	$	771	$	1,864	$	2,143

The Company estimates the fair value of stock options using the Black-Scholes valuation model. This valuation model takes into account the exercise price of the award, as well as a variety of significant assumptions. These assumptions include the expected term, the expected volatility of the Company’s stock over the expected term, the risk-free interest rate over the expected term, and the Company’s expected annual dividend yield. The Company believes that the valuation technique and the approach utilized to develop the underlying assumptions are appropriate in calculating the fair values of the Company’s stock options granted in the three and nine months ended June 30, 2007 and 2006. Estimates of fair value are not intended to predict the value ultimately realized by persons who receive equity awards. In determining the amount of expense to be recorded, judgment is also required to estimate forfeitures of the awards based on the probability of employees completing the required service period.   Historical forfeitures are used as a starting point for developing the estimate of future forfeitures.

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Assumptions used to determine the fair value of options granted during the three and nine months ended June 30, 2007, using the Black-Scholes valuation model were:

	Expected Term (1)	Expected Volatility Factor (2)	Risk Free Interest Rate (3)	Expected Annual Dividend Yield
Three and nine months ended June 30, 2007	5.50 - 6.25 years	65.77% - 72.67%	4.44% - 4.70%	—
Three and nine months ended June 30, 2006	5.50 – 6.25 years	77.00% - 78.21%	4.39% - 5.15%	—

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

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

A summary of the Company’s stock option activity for the nine months ended June 30, 2007 is as follows:

	Nine months ended June 30, 2007
	Number of Options		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (in years)
Outstanding, September 30, 2006	7,366,964		$	2.29
Granted	1,180,150		2.20
Exercised	(1,625,246	)	1.10
Cancelled	(579,749	)	3.23
Outstanding, June 30, 2007	6,342,119		$	2.49	7.61
Exercisable at June 30, 2007	3,230,757		$	3.00	6.56

All options granted during the nine months ended June 30, 2007 and 2006 were granted with exercise prices equal to the fair market value of the Company’s common stock on the grant date and had weighted average grant date fair values of $1.46 and $1.12, respectively.

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At June 30, 2007, unrecognized compensation expense related to non-vested stock options was $3,153,491 which is expected to be recognized over a weighted average period of 2.58 years.

4.  NET INCOME (LOSS) PER SHARE

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

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

	Three months ended June 30,					Nine months ended June 30,
	2007		2006			2007		2006
Numerator:
Net income (loss)	$	416	$	(1,105	)	$	668	$	(5,189	)
Denominator:
Shares used in computing basic net income (loss) per share	40,871		38,218			40,517		38,023
Common stock equivalents from employee stock options	399		—			691		—
Shares used in computing diluted net income (loss) per share	41,270		38,218			41,208		38,023
Net income (loss) per share:
Basic	$	0.01	$	(0.03	)	$	0.02	$	(0.14	)
Diluted	$	0.01	$	(0.03	)	$	0.02	$	(0.14	)
Anti-dilutive potential common stock equivalents excluded from the calculation of net income (loss) per share:	5,338		4,979			3,898		4,572
Options to purchase common stock

5.  INVENTORIES

Inventories consisted of the following (in thousands):

	June 30, 2007		September 30, 2006
Raw materials	$	6,392	$	4,628
Work in process	771		432
Finished goods	4,997		3,385
	$	12,160	$	8,445

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6.  COMMITMENTS AND CONTINGENCIES

Guarantees and Indemnifications

Acquisition-related indemnifications - When, as part of an acquisition, the Company acquires all the stock of a company, the Company assumes liabilities for certain events or circumstances that took place prior to the date of acquisition.  The maximum potential amount of future payments the Company could be required to make for such obligations is undeterminable.  While the provisions of the agreements remain in effect indefinitely, the Company believes that the probability of receiving a claim is unlikely.  As a result, the Company has not recorded a liability for these indemnification clauses as of June 30, 2007.

The Company enters into standard indemnification agreements in the ordinary course of its business. Pursuant to these agreements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally its business partners or customers, in connection with any patent, copyright, trademark, trade secret or other intellectual property infringement claim by any third party with respect to its products. The term of these indemnification agreements is generally perpetual. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these indemnifications as of June 30, 2007.

Product warranties – The Company offers and fulfills warranty services on certain of its server appliances. Warranty terms vary in duration depending upon the product sold but generally provide for the repair or replacement of any defective products for periods of up to 36 months after shipment. Based upon historical experience and expectation of future conditions, the Company reserves for the estimated costs to fulfill customer warranty obligations upon the recognition of the related revenue. The following table presents changes in the Company’s product warranty liability for the three and nine months ended June 30, 2007 and 2006 (in thousands):

	Three months ended June 30,						Nine months ended June 30,
	2007			2006			2007			2006
Beginning balance	$	1,017		$	515		$	559		$	455
Accruals for warranties issued	766			222			1,684			835
Fulfillment of warranties during the period	(445		)	(216		)	(905		)	(769		)
Ending balance	$	1,338		$	521		$	1,338		$	521

Contingencies

Announcement Timing Lawsuit

On March 17, 2004, the United States District Court for the District of Massachusetts (the “Court”) consolidated a number of purported class action lawsuits filed against Network Engines, Inc. and certain individual Network Engines defendants (collectively the “Defendants”).  These suits generally concern the timing of the announcement of an amendment to Network Engines’ agreement with EMC Corporation regarding the resale of EMC-approved Fibre Channel HBAs.  The Plaintiffs filed an amended consolidated complaint on June 4, 2004.  The Defendants on August 13, 2004 filed a motion to dismiss the amended consolidated complaint.  The Plaintiffs on October 12, 2004 filed an opposition to the Defendants’ motion to dismiss and the Defendants filed a reply to the Plaintiffs’ opposition on November 12, 2004.  The Court on November 22, 2004 denied the Defendants’ motion to dismiss the amended consolidated complaint. On December 9, 2004, the Defendants’ filed an answer to the amended consolidated complaint.

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

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

Initial Public Offering Lawsuit

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

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

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

On July 9, 2003, a Special Committee of the Company’s Board of Directors authorized the Company to negotiate a settlement of the pending claims substantially consistent with a memorandum of understanding negotiated among class 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 the individual defendants for the conduct alleged in the amended complaint to be wrongful.  The Company would agree to undertake other responsibilities under the settlement, including agreeing to assign, or not assert, certain potential claims that it may have against its underwriters.  Any direct financial impact of the proposed settlement is expected to be borne by the Company’s insurers.  Any such settlement would be subject to various contingencies, including approval by the Court overseeing the litigation. On February 15, 2005, the Court issued an Opinion and Order preliminarily approving the settlement, provided that the defendants and plaintiffs agree to a modification narrowing the scope of the bar order set forth in the original settlement agreement.  The parties agreed to a modification narrowing the scope of the bar order, and on August 31, 2005, the Court issued an order preliminarily approving the settlement and setting a public hearing on its fairness, which took place on April 24, 2006.  On December 5, 2006, the United States Court of Appeals for the Second Circuit overturned the District Court’s certification of the class of

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plaintiffs who are pursuing the claims that would be settled in the settlement against the underwriter defendants. Thereafter, the District Court ordered a stay of all proceedings in all of the lawsuits pending the outcome of plaintiffs’ petition to the Second Circuit for rehearing en banc and resolution of the class certification issue.  On April 6, 2007, the Second Circuit denied plaintiffs’ petition for rehearing, but clarified that the plaintiffs may seek to certify a more limited class in the District Court.  On June 25, 2007, the District Court signed an order terminating the settlement. The Company is unable to predict the outcome of this suit and as a result, no amounts have been accrued as of June 30, 2007.

7.  RELATED PARTY TRANSACTIONS

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

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

Special Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, that involve risks and uncertainties. All statements other than statements of historical information provided herein are forward-looking statements and may contain projections related to financial results, economic conditions, trends and known uncertainties. Our actual results could differ materially from those discussed in the forward-looking statements as a result of a number of factors, which include those discussed in this section and in Part II, Item 1A, Risk Factors, of this report and the risks discussed in our other filings with the Securities and Exchange Commission. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis, judgment, belief or expectation only as of the date hereof. We undertake no obligation to publicly reissue these forward-looking statements to reflect events or circumstances that arise after the date hereof.

The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and the notes thereto included in Item 1 in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended September 30, 2006 filed by the Company with the Securities and Exchange Commission.

Overview

We develop and manufacture server appliance solutions that deliver data storage and network security applications on server appliances. Server appliances are pre-configured network infrastructure devices designed to optimally deliver specific software application functionality and facilitate ease of deployment and support of a software application in a customer’s network.

During the quarter ended December 31, 2006, we changed the manner in which we view information regarding results of our operations for purposes of making decisions affecting the business. These changes included consolidation of financial and operational information reviewed to evaluate our operations, discontinuing market demand creation for our NS Series Security Appliances and using certain of those products as reference platforms for developing and selling appliances to system integrators and Independent Software Vendors (“ISVs”), and the consolidation of our sales force. Therefore, we now have one reportable segment, which represents how we evaluate our operations.

Critical Accounting Policies and Estimates

Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. In preparing these financial statements, we have made estimates and judgments in determining certain amounts included in the financial statements. We base our estimates and judgments on historical experience and other various assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. No changes to our critical accounting policies have taken place since September 30, 2006.

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Results of Operations

Three months ended June 30, 2007 compared to the three months ended June 30, 2006

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

	Three Months Ended June 30,
	2007					2006					Increase (Decrease)
	Dollars			% of Net Revenues		Dollars			% of Net Revenues		Dollars			Percentage
Net revenues	$	27,998		100.0	%	$	32,048		100.0	%	$	(4,050	)	(12.6	)%
Gross profit	5,315			19.0	%	5,384			16.8	%	(69		)	(1.3	)%
Operating expenses	5,407			19.3	%	6,914			21.6	%	(1,507		)	(21.8	)%
Loss from operations	(92		)	(0.3	)%	(1,530		)	(4.8	)%	1,438			93.9	%
Net income (loss)	416			1.5	%	(1,105		)	(3.4	)%	1,521			137.6	%

Net Revenues

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

Our net revenues for the three months ended June 30, 2007 declined versus the same period in fiscal 2006 primarily due to both lower average selling prices related to the natural evolution of product life-cycles and lower sales volume.  Net revenues from sales to EMC represented 81% of net revenues in the three months ended June 30, 2007 versus 81% in the three months ended June 30, 2006. Net revenues from other customers for the three months ended June 30, 2007 were $5.3 million compared to $4.8 million in the three months ended June 30, 2006, after excluding revenues from Network Intelligence Corporation due to its acquisition by EMC on September 18, 2006.   This growth was attributable to an increase in revenue from existing customers, revenue for servicing Microsoft Whale customers and revenue from new customers in the first half of fiscal 2007.

Gross profit

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

Gross profit as a percentage of net revenue increased for the quarter ended June 30, 2007 compared to the quarter ended June 30, 2006.  The increase from the prior year was primarily due to increased service revenue which carries higher gross margins, the timing of cost reductions relative to price reductions to customers and the effect of lower appliance average selling prices in relation to consistent per unit gross margin dollars.   These increases were partially offset by higher warranty expenses.

Gross profit is affected by customer and product mix, pricing and the volume of orders as well as by the mix of product manufactured internally compared to product manufactured by a contract manufacturer, which results in higher manufacturing costs.  We expect that gross profit as a percentage of net revenue for the three months ended September 30, 2007 will be similar when compared to the three months ended June 30, 2007.

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Operating Expenses

The following table presents operating expenses during the periods indicated, in thousands and as a percentage of net revenues:

	Three Months Ended June 30,
	2007				2006				Increase (Decrease)
	Dollars		% of Net Revenues		Dollars		% of Net Revenues		Dollars			Percentage
Operating expenses:
Research and development	$	2,226	8	%	$	1,986	6	%	$	240		12	%
Selling and marketing	1,323		5	%	2,949		9	%	(1,626		)	(55	)%
General and administrative	1,858		7	%	1,979		6	%	(121		)	(6	)%
Total operating expenses	$	5,407	19	%	$	6,914	22	%	$	(1,507	)	(22	)%

Research and development

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

	Three Months Ended June 30,
	2007				2006				Increase (Decrease)
	Dollars		% of Expense Category		Dollars		% of Expense Category		Dollars			Percentage
Research and development:
Compensation and related expenses	$	1,382	62	%	$	1,279	64	%	$	103		8	%
Stock-based compensation	296		13	%	297		15	%	(1		)	—
Prototype	141		6	%	45		2	%	96			213	%
Consulting and outside services	271		12	%	110		6	%	161			146	%
Other	136		6	%	255		13	%	(119		)	(46	)%
Total research and development	$	2,226	100	%	$	1,986	100	%	$	240		12	%

Our research and development expenses have increased this quarter as compared to the same period last fiscal year. Because our research and development expenses are project driven, the timing of these expenditures can vary.  The increase in compensation and related expenses is attributable to an increase in headcount.  The increase in consulting costs as well as prototype costs relates to the timing of certain development projects.

Our server appliance development strategy emphasizes the utilization of standard server appliance platforms, which utilize off-the-shelf components. However, we expect that in some cases significant development efforts will be required to fulfill our current and potential customers’ needs using customized platforms. In addition, we intend to focus our software development in areas that improve the ease of server appliance implementation and use, which we believe will enhance our value proposition.  We expect that prototype and consulting costs will be variable and could fluctuate depending on the timing and magnitude of our development projects. However, we expect our research and development costs to remain consistent during our quarter ended September 30, 2007.

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Selling and marketing

Selling and marketing expenses consist primarily of salaries and commissions for personnel engaged in sales and marketing; costs associated with our marketing programs, which include costs associated with our attendance at trade shows, advertising, web site enhancements and product evaluation costs; consulting and outside services costs and travel. The following table summarizes the most significant components of selling and marketing expense for the periods indicated in thousands and as a percentage of total selling and marketing expense and provides the changes in thousands and percentages:

	Three Months Ended June 30,
	2007				2006				Increase (Decrease)
	Dollars		% of Expense Category		Dollars		% of Expense Category		Dollars			Percentage
Selling and marketing:
Compensation and related expenses	$	906	69	%	$	1,861	63	%	$	(955	)	(51	)%
Stock-based compensation	76		6	%	204		7	%	(128		)	(63	)%
Marketing programs	109		8	%	386		13	%	(277		)	(72	)%
Travel	103		8	%	254		9	%	(151		)	(59	)%
Other	129		9	%	244		8	%	(115		)	(47	)%
Total selling and marketing	$	1,323	100	%	$	2,949	100	%	$	(1,626	)	(55	)%

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

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

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General and administrative

General and administrative expenses consist primarily of salaries and other related costs for executive, finance, information technology and human resources personnel; professional services, which include legal, accounting, audit and tax fees, and costs of compliance with the Sarbanes-Oxley Act; and director and officer insurance. The following table summarizes the most significant components of general and administrative expense for the periods indicated in thousands and as a percentage of total general and administrative expense and provides the changes in thousands and percentages:

	Three Months Ended June 30,
	2007				2006				Increase (Decrease)
	Dollars		% of Expense Category		Dollars		% of Expense Category		Dollars			Percentage
General and administrative:
Compensation and related expenses	$	903	49	%	$	783	40	%	$	120		15	%
Stock-based compensation	187		10	%	214		11	%	(27		)	(13	)%
Consulting and professional services	511		28	%	561		28	%	(50		)	(9	)%
Director and officer insurance	83		4	%	226		11	%	(143		)	(63	)%
Other	174		9	%	195		10	%	(21		)	(11	)%
Total general and administrative	$	1,858	100	%	$	1,979	100	%	$	(121	)	(6	)%

As indicated in the table above, general and administrative expenses decreased in the three months ended June 30, 2007 versus the three months ended June 30, 2006.   This was primarily a result of decreases in director and officer insurance, other expenses and consulting and professional services partially offset by an increase in compensation and related expenses.   The decrease in consulting and professional services is due primarily to a decrease in consultant expenses attributable to the timing of certain MIS projects.  The decreases in other expenses primarily relates to higher recruiting and relocation expenses incurred in the prior year as a result of our change in our Chief Executive Officer.  We expect general and administrative expenses to remain consistent during our quarter ended September 30, 2007.

Interest and Other Income, net

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

Nine months ended June 30, 2007 compared to the nine months ended June 30, 2006

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

	Nine Months Ended June 30,
	2007					2006					Increase (Decrease)
	Dollars			% of Net Revenues		Dollars			% of Net Revenues		Dollars			Percentage
Net revenues	$	84,541		100.0	%	$	87,353		100.0	%	$	(2,812	)	(3.2	)%
Gross profit	16,639			19.7	%	14,376			16.5	%	2,263			15.7	%
Operating expenses	17,365			20.5	%	20,700			23.7	%	(3,335		)	(16.1	)%
Loss from operations	(726		)	(0.9	)%	(6,324		)	(7.2	)%	5,598			88.5	%
Net income (loss)	668			0.8	%	(5,189		)	(5.9	)%	5,857			112.9	%

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Net Revenues

Our net revenues decreased slightly for the nine months ended June 30, 2007 versus the same period in fiscal 2006. This was primarily due to both lower average selling prices related to the natural evolution of product life-cycles and lower sales volume.  Net revenues from sales to EMC represented 81% of net revenues in the nine months ended June 30, 2007 and 2006. In addition, net revenues from other customers for the nine months ended June 30, 2007 increased to $15.9 million from $11.7 million (excluding Network Intelligence) for the nine months ended June 30, 2006.  This growth was attributable to an increase in revenue from existing customers, revenue for servicing Microsoft Whale customers and revenue from new customers in the first half of fiscal 2007.

Gross profit

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

Operating Expenses

The following table presents operating expenses during the periods indicated, in thousands and as a percentage of net revenues:

	Nine Months Ended June 30,
	2007				2006				Increase (Decrease)
	Dollars		% of Net Revenues		Dollars		% of Net Revenues		Dollars			Percentage
Operating expenses:
Research and development	$	6,629	8	%	$	6,188	7	%	$	441		7	%
Selling and marketing	4,863		6	%	8,539		10	%	(3,676		)	(43	)%
General and administrative	5,873		7	%	5,973		7	%	(100		)	(2	)%
Total operating expenses	$	17,365	21	%	$	20,700	24	%	$	(3,335	)	(16	)%

Research and development

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

	Nine Months Ended June 30,
	2007				2006				Increase (Decrease)
	Dollars		% of Expense Category		Dollars		% of Expense Category		Dollars			Percentage
Research and development:
Compensation and related expenses	$	3,989	60	%	$	3,769	61	%	$	220		6	%
Stock-based compensation	877		13	%	835		13	%	42			5	%
Prototype	551		8	%	434		7	%	117			27	%
Consulting and outside services	670		10	%	486		8	%	184			38	%
Other	542		8	%	664		11	%	(122		)	(18	)%
Total research and development	$	6,629	100	%	$	6,188	100	%	$	441		7	%

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

Selling and marketing

The following table summarizes the most significant components of selling and marketing expense for the periods indicated in thousands and as a percentage of total selling and marketing expense and provides the changes in thousands and percentages:

	Nine Months Ended June 30,
	2007				2006				Increase (Decrease)
	Dollars		% of Expense Category		Dollars		% of Expense Category		Dollars			Percentage
Selling and marketing:
Compensation and related expenses	$	3,313	68	%	$	5,075	59	%	$	(1,762	)	(35	)%
Stock-based compensation	243		5	%	614		7	%	(371		)	(60	)%
Marketing programs	504		10	%	1,318		15	%	(814		)	(62	)%
Travel	360		7	%	783		9	%	(423		)	(54	)%
Consulting	59		1	%	366		4	%	(307		)	(84	)%
Other	384		8	%	383		5	%	1			—	%
Total selling and marketing	$	4,863	100	%	$	8,539	100	%	$	(3,676	)	(43	)%

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

General and administrative

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

	Nine Months Ended June 30,
	2007				2006				Increase (Decrease)
	Dollars		% of Expense Category		Dollars		% of Expense Category		Dollars			Percentage
General and administrative:
Compensation and related expenses	$	2,634	45	%	$	2,283	38	%	$	351		15	%
Stock-based compensation	620		11	%	553		9	%	67			12	%
Consulting and professional services	1,873		32	%	1,741		29	%	132			8	%
Director and officer insurance	248		4	%	688		12	%	(440		)	(64	)%
Other	498		8	%	708		12	%	(210		)	(30	)%
Total general and administrative	$	5,873	100	%	$	5,973	100	%	$	(100	)	(2	)%

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

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related expenses, which were related to changes in our senior management, and consulting and professional services, were offset by larger decreases in the cost of director and officer insurance and other expenses.   The increase in consulting and professional services is due primarily to costs associated with the investigation of embezzlement by a former non-management employee which was detected during the fourth quarter of fiscal 2006 and was completed during the first quarter of fiscal 2007.

Interest and Other Income, net

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

Liquidity and Capital Resources

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

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

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

	June 30, 2007		September 30, 2006
Short-term investments	$	25,402	$	24,804

Operating Activities

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

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Investing Activities

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

Financing Activities

Cash flows provided by financing activities primarily consisted of cash received as a result of employee stock option and stock purchase plan activity of $2.0 million in the nine months ended June 30, 2007 primarily as a result of exercises by former officers. We expect employee stock option and stock purchase plan activity to continue in fiscal 2007; however, we cannot predict its level given the volatility of capital markets.

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

·the timing and size of orders from our largest customer;

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

·the level of success of our customers in selling server appliance solutions that include our server appliance hardware platforms;

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

·market developments.

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

Contractual Obligations and Commitments

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

Off-Balance Sheet Arrangements

We have not created, and are not party to, any special-purpose or off-balance sheet entities for the purpose of raising capital, incurring debt or operating parts of our business that are not consolidated into our financial statements.  We have not entered into any transactions with unconsolidated entities whereby the Company has subordinated retained interests, derivative instruments or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the Company.

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Related Party Transactions

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

Recent Accounting Pronouncements

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements” (“SAB 108”).  SAB 108 addresses how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in current-year financial statements. SAB 108 requires us to quantify misstatements using a balance sheet and income statement approach and to evaluate whether either approach results in an error that is material in light of relevant quantitative and qualitative factors. The requirements of SAB 108 are effective for fiscal years ending after November 15, 2006. The adoption of SAB 108 is not expected to have an impact on our financial position, results of operations or cash flows.

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

In September 2006, the FASB issued Statement of Financial Accounting Standard No. 157, “Fair Value Measurements”, (“FAS 157”).  This statement address how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under accounting principles generally accepted in the United States.  This Statement is effective as of the beginning of the our fiscal year that begins after November 15, 2007. We are in the process of evaluating whether the adoption of this statement will have a material impact on our financial position, results of operations and cash flows.

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

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ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

ITEM 4.    CONTROLS AND PROCEDURES

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

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

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PART II—OTHER INFORMATION

ITEM 1.     LEGAL PROCEEDINGS

Initial Public Offering Lawsuit

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

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

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

On July 9, 2003, a Special Committee of our Board of Directors authorized us to negotiate a settlement of the pending claims substantially consistent with a memorandum of understanding negotiated among class plaintiffs, all issuer defendants and their insurers.  The parties have negotiated the settlement, which provides, among other things, for a release of us and the individual defendants for the conduct alleged in the amended complaint to be wrongful.  We would agree to undertake other responsibilities under the settlement, including agreeing to assign, or not assert, certain potential claims that we may have against the underwriters.  Any direct financial impact of the proposed settlement is expected to be borne by our insurers.  Any such settlement would be subject to various contingencies, including approval by the Court overseeing the litigation. On February 15, 2005, the Court issued an Opinion and Order preliminarily approving the settlement, provided that the defendants and plaintiffs agree to a modification narrowing the scope of the bar order set forth in the original settlement agreement.   The parties agreed to a modification narrowing the scope of the bar order, and on August 31, 2005, the Court issued an order preliminarily approving the settlement and setting a public hearing on its fairness, which took place on April 24, 2006.  On December 5, 2006, the United States Court of Appeals for the Second Circuit overturned the District Court’s certification of the class of plaintiffs who are pursuing the claims that would be settled in the settlement against the underwriter defendants. Thereafter, the District Court ordered a stay of all proceedings in all of the lawsuits pending the outcome of plaintiffs’ petition to the Second Circuit for rehearing en banc and resolution of the class certification issue.  On April 6, 2007, the Second Circuit denied plaintiffs’ petition for rehearing, but clarified that the plaintiffs may seek to certify a more limited class in the District Court. On June 25, 2007, the District Court signed an order terminating the settlement.

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

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ITEM 1A. RISK FACTORS

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

The following discussion includes two revised risk factors (“We may not be able to effectively commercialize our appliances or may be at a competitive disadvantage if we cannot license or integrate third-party applications that are essential for the functionality of certain appliances” and  “If we are unable to effectively manage our customer service and support activities, we may not be able to retain our existing customers or attract new customers”) .  Two other risk factors (“Market acceptance and demand of Microsoft’s ISA Server software will depend on Microsoft’s decision to prioritize and concentrate its marketing efforts for this software, and on the success of Microsoft’s ISA Server software “ and  “If we are unable to effectively leverage our relationship with Microsoft to establish new relationships with independent software vendors and other systems integrators our revenues and operating results may be adversely affected”) that were included in our most recent Annual Report on Form 10-K, have been removed from our discussion of risk factors.

Risks of dependence on one strategic partner.

We derive a significant portion of our revenues from sales of server appliances directly to EMC and our revenues may decline significantly if this customer cancels or delays purchases of our products, terminates its relationship with us or exercises certain of its contractual rights.

In the three months ended June 30, 2007 and 2006, sales directly to EMC, our largest customer, accounted for 81% of our total net revenues. These sales are primarily attributable to one product pursuant to a non-exclusive contract.  We anticipate that our future operating results will continue to depend heavily on sales to, and our relationship with, this customer. Accordingly, the success of our business will depend, in large part, on this customer’s willingness to continue to utilize our server appliance solutions in its existing and future products. Further, our financial success is dependent upon the future success of the products we sell to this customer and the continued growth of this customer, whose industry has a history of rapid technological change, short product life cycles, consolidation and pricing and margin pressures. A significant reduction in sales to this customer, or significant pricing and additional margin pressures exerted on us by this customer, would have a material adverse effect on our results of operations. In addition, if this customer delays or cancels purchases of our products, our operating results would be harmed and our ability to accurately predict revenues, profitability and cash flows would decrease.

Under the terms of our non-exclusive contract, this customer has the right to enter into agreements with third parties for similar products, is not obligated to purchase any minimum quantity of products from us and may choose to stop purchasing from us at any time, with or without cause. In addition, this customer may terminate the agreement in the event that we attempt to assign our rights under the agreement to another party without this customer’s prior approval. Furthermore, in the event that we default on certain portions of the agreement, this customer has the right to manufacture certain products in exchange for a mutually agreeable royalty fee. If any of these events were to occur, or if this customer were to delay or discontinue purchases of our products as a result of dissatisfaction or otherwise, our revenues and operating results would be materially adversely affected, our reputation in the industry might suffer, and our ability to accurately predict revenues, profitability and cash flows would decrease.

Risks related to business strategy.

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

We believe we must diversify our revenues and a major component of our business strategy is to form server appliance development relationships with new network equipment providers, ISVs and systems integrators. Under this strategy, we work with our customers to develop a server appliance branded with

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

There are multiple risks associated with this strategy including:

·the expenditure of significant product development costs, which if not recovered through server appliance sales could negatively affect our operating results;

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

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

·our reliance on our customers to perform all of the selling and marketing efforts associated with further sales of the server appliance product we develop with them;

·continued consolidation within the network equipment and software industries that results in existing customers being acquired by other companies; and

·our ability to provide our customers with high quality server appliances at competitive prices.

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

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

We believe our success will depend on our ability to license or integrate certain applications from third-parties that would be incorporated in certain of our server appliance solutions. Because we do not currently know with certainty which of these prospective technologies will be desired in the marketplace, we may incorrectly invest in development or prioritize our efforts to integrate these technologies in our appliances. Additionally, even if we correctly focus our efforts, there can be no assurance that we will select the preferred provider of these technologies, the third-party provider will be committed to the relationship and integration of their technology, or that they will license their technology to us without obtaining significant certification or training, which could be costly and time consuming. If we are unable to successfully integrate the correct third-party technologies in a timely manner, our appliances may be inferior with other competitive products in the marketplace, which may adversely affect the results of our operations and our ability to grow our business.

If we are unable to grow our international revenues and successfully overcome the risks inherent in international business activities, the growth of our business may be limited.

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

·cost of customizing products for foreign countries;

·export and import restrictions, such as those affecting encryption commodities and software or those requiring local content;

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·difficulties in providing customer support;

·reduced protection of intellectual property rights and increased liability exposure;

·regional economic and political conditions; and

·unique product requirements of certain foreign countries which may limit sales and/or require significant additional research and development investments.

The majority of our international sales currently are U.S. dollar-denominated. As a result, any increase in the value of the U.S. dollar relative to foreign currencies makes our products less competitive in international markets. Because of this our revenues may be adversely affected, or we may be required to denominate more of our sales in foreign currencies at some point in the future to remain competitive. In addition, because certain of our operating expenses related to our international sales are denominated in foreign currency, we may have difficulty controlling expenses in the event of significant currency fluctuations.

Our business could be harmed if we fail to adequately integrate new technologies into our server appliance products or if we invest in technologies that do not result in the desired effects on our current and/or future product offerings.

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

·we may experience difficulties integrating new technologies into our current or future products;

·our new products may be delayed because selected new technologies themselves are delayed or have defects and/or performance limitations;

·we may incorporate technologies that do not result in the desired improvements to our current and/or future server appliance products;

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

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

·we could find that the new products and/or technologies that we choose to incorporate into our products are technologically inferior to those utilized by our competitors.

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

Risks related to the server appliance, data storage and network security markets.

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

We expect that all of our future revenues will come from sales of server appliances and related maintenance. As a result, we are substantially dependent on the growing use of server appliances to meet businesses’ data storage and network security application needs. Our revenues may not grow and the market price of our common stock could decline if the server appliance market does not grow as rapidly as we expect.

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Our expectations for the growth of the server appliance market may not be fulfilled if customers continue to use general-purpose servers. The role of our products could, for example, be limited if general-purpose servers out-perform server appliances, provide more capabilities and/or flexibility than server appliances or are offered at a lower cost. This could force us to lower the prices of our server appliance products or could result in fewer sales of these products, which would negatively impact our revenues and decrease our gross profits.

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

The markets we serve are characterized by rapid technological change, frequent new product introductions and enhancements, potentially short product life cycles, changes in customer demands and evolving industry standards. In the server appliance market, we attempt to mitigate these risks by utilizing standards-based hardware platforms and by maintaining an adequate knowledge base of available technologies. However, the server appliance products that we sell could be rendered obsolete if products based on new technologies are introduced or new industry standards emerge and we are not able to incorporate these technological changes into our products. In addition, we depend on third parties for the base platforms of our server appliances and we are at risk if these third parties do not integrate new technologies. Releasing new products and services prematurely may result in quality problems, and delays may result in loss of customer confidence and market share. We may be unable to develop new products and services or achieve and maintain 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 to manage the transition from the older products and services to minimize disruption in customer ordering patterns, avoid excessive inventories of older products and deliver enough new products and services to meet customer demand.

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

Risks related to financial results.

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

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

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

Our discussion and analysis of financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our consolidated financial statements, including those related to:

·revenue recognition;

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·inventory write-downs;

·stock-based compensation; and

·warranty reserves.

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

Our quarterly revenues and operating results may fluctuate seasonally, which could result in decreased revenue from quarter to quarter, which in turn could cause the market price of our common stock to decline.

Seasonal fluctuations in revenues and operating results in the data storage industry are common. In particular, this industry typically experiences increased orders and resulting revenues in the quarter ended December 31, and a subsequent decline in orders and resulting revenues during the quarter ended March 31. With a substantial amount of our revenues currently derived from data storage products, we may experience significant quarter-to-quarter fluctuations in revenues and operating results due to customers timing their orders based on their own quarterly financial and/or operational considerations, which we have no influence over. In addition, to the extent that revenues from international sales become significant, we may experience seasonal fluctuations during the quarter ending September 30 as a result of European holiday patterns.

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

Our quarterly revenues and operating results may also fluctuate for reasons other than seasonality, which could cause our operating results to fall below expectations and thus impact the market price of our common stock.

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

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

·the product mix of our sales;

·the timing of new product introductions by our customers;

·the availability and/or price of products from suppliers;

·the loss of key suppliers or customers;

·price competition;

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

·the mix of product manufactured internally and by our contract manufacturer.

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

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

Risks related to competition.

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

In the server appliance market, we face significant competition from a number of different types of companies. Our competitors include companies who market general-purpose servers, server virtualization software, specific-purpose servers and server appliances as well as companies that sell custom integration services utilizing hardware produced by other companies. Many of these companies are larger than we are and have greater financial resources and name recognition than we do, as well as significant distribution capabilities and larger, more established service organizations to support their products. Our larger competitors may be able to leverage their existing resources, including their extensive distribution capabilities and service organizations, to provide a wider offering of products and services and higher levels of support on a more cost-effective basis than we can. We expect competition in the server appliance market to increase significantly as more companies enter the market and as our existing competitors continue to improve the performance of their current products and to introduce new products and technologies. Such increased competition could adversely affect sales of our current and future products. In addition, competing companies may be able to undertake more extensive promotional activities, adopt more aggressive pricing policies and offer more attractive terms to their customers than we can. If our competitors provide lower cost products with greater functionality or support than our server appliance solutions, or if some of their products are comparable to ours and are offered as part of a range of products that is broader than ours, our server appliance solutions could become undesirable.

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

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Risks related to marketing and sales efforts and customer service.

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

Although we currently have a relatively small sales and marketing organization, we must continue to increase market awareness and sales of our products and promote our brand in the marketplace. We believe that to compete successfully we will need network equipment providers, ISVs and systems integrators to recognize Network Engines as a top-tier provider of server appliance platforms and custom integration services.  If we are unable to increase market awareness and promote ourselves as a leading provider of server appliance solutions with our available resources, we may be unable to develop new customer relationships or expand our product and service offerings at existing customers.

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

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

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

Risks related to product manufacturing.

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

We depend upon single source and limited source suppliers for our industry-standard processors, main logic boards, certain disk drives, hardware platforms and power supplies as well as certain of our chassis and sheet metal parts. Additionally, we depend on limited sources to supply certain other industry-standard and customized components. We have in the past experienced, and may in the future experience, shortages of or difficulties in acquiring components in the quantities and of the quality needed to produce our server appliance products. Shortages in supply or quality issues related to these key components for an extended time would cause delays in the production of our server appliance products, prevent us from satisfying our contractual obligations and meeting customer expectations, and result in lost sales and customers. If we are unable to buy components in the quantities and of the quality that we need on a timely basis or at acceptable prices, we will not be able to manufacture and deliver our server appliance products on a timely or cost-effective basis to our customers, and our competitive position, reputation, business, financial condition and results of operations could be seriously harmed.

If our server appliance products fail to perform properly and conform to specifications, our customers may demand refunds, assert claims for damages or terminate existing relationships with us, and our reputation and operating results may suffer materially.

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

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our solutions are combined with products from other vendors, should problems occur, it might be difficult to identify the source of the problem. Continued improvement in manufacturing capabilities, control of material and manufacturing quality and costs, and product testing are critical factors in our future growth. There can be no assurance that our efforts to monitor, develop, modify and implement appropriate test and manufacturing processes for our products will be sufficient to permit us to avoid a rate of failure in our products that results in substantial delays in shipment, significant repair or replacement costs or potential damage to our reputation, any of which could have a material adverse effect on our business, results of operations or financial condition.

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

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

·diversion of engineering resources;

·increased manufacturing costs;

·the loss of new or existing server appliance customers;

·injury to our reputation and other customer relations problems; and

·increased maintenance and warranty costs.

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

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

Our future server appliance revenue growth may be limited by our ability to expand production capacity.

Our existing manufacturing facility is limited in its production capacity. For us to achieve significant server appliance revenue growth, our server appliance sales volumes must increase significantly and our production capacity must increase to support such sales volumes.

To supplement our current production capacity, to provide for increased capacity for “production spikes” and to provide disaster backup capabilities, we currently utilize the services of a contract manufacturer for certain server appliance products on a limited basis. However, our contract manufacturer is not obligated to supply products to us for any specific period, or in any specific quantity, except as may be provided in an accepted purchase order. Using a contract manufacturer increases our cost of producing server appliance products and could decrease our gross profits. In the event that we need to change contract manufacturers or require significantly increased production levels, we could experience transitional difficulties, including production delays and quality control issues, that could prevent us from satisfying our production requirements on a timely basis, cause customer relationships to suffer and result in lost sales. Also, the use of a contract manufacturer does not guarantee us production levels,

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manufacturing line space or manufacturing prices, the lack of which could interrupt our business operations and have a negative effect on operating results.

In the past, we expanded our internal production capacity through expansion and reorganization of our current production facilities. Although we believe that our current facility, along with our use of a contract manufacturer to supplement production, is sufficient to support our business for the foreseeable future, we may need additional production capacity. We believe that we could expand production levels in our existing facility by increasing the number of manufacturing shifts, but we are currently utilizing all available manufacturing space in our existing facility and have limited opportunity to expand further.  We would have difficulties expanding this facility beyond this limited ability, and therefore, significant further expansion of the production capacity would require additional facilities.  Expansion of our existing facilities or additional facilities could require substantial investments, which could detract from our ability to invest in other areas of our business and may not result in the desired return on investment, which could negatively affect our operating results.

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

We use rolling forecasts based on anticipated product orders to determine our server appliance component requirements. Lead times for materials and components that we order vary significantly depending on variables such as specific supplier requirements, contract terms and current market demand for those components. In addition, a variety of factors, including the timing of product releases, potential delays or cancellations of orders, the timing of large orders and the unproven acceptance of new products in the market make it difficult to predict product orders. As a result, our materials requirement forecasts may not be accurate. If we overestimate our materials requirements, we may have excess inventory, which would increase costs and negatively impact our cash position. Our agreements with certain customers provide us with protections related to inventory purchased in accordance with the terms of these agreements; however, these protections may not be sufficient to prevent certain losses as a result of excess or obsolete inventory. If we underestimate our materials requirements, we may have inadequate inventory, which could interrupt our manufacturing and delay delivery of our server appliance products to customers, resulting in a loss of sales or customers. Any of these occurrences would negatively impact our business and operating results.

Risks related to product dependence on intellectual property.

Our reliance upon contractual provisions, domestic patent, copyright and trade secret laws and applied-for patents to protect our proprietary rights may not be sufficient to protect our intellectual property.

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

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

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Our operating results would suffer if we, our ISV or network equipment customers, or other third-party software providers from whom we license technology, were subject to an infringement claim that resulted in protracted litigation, the award of significant damages against us or the payment of substantial ongoing royalties.

Substantial litigation regarding intellectual property rights exists in the technology industry. We expect that server appliance products may be subject to third-party infringement claims as the number of competitors in the industry segment grows and the functionality of products in different industry segments overlap. In the past we have received claims from third parties that our server appliance products infringed their intellectual property rights. We do not believe that our server appliance products employ technology that infringes the proprietary rights of any third parties. We are also not aware of any claims made against any of our ISV or network equipment provider customers related to their infringement of the proprietary rights of other parties in relation to products that include our server appliance products. Other parties may make claims against us that, with or without merit, could:

·be time-consuming for us to address;

·require us to enter into royalty or licensing agreements;

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

·divert our management’s attention and resources; and

·cause product shipment delays.

In addition, other parties may make claims against our ISV or network equipment customers, or third-party software providers related to products that are incorporated into our server appliance products. Our business could be adversely affected if such claims resulted in the inability of our customers to continue producing the infringing product, or if we are unable to cost effectively continue licensing the third-party software.

Other risks related to our business.

If we fail to retain and attract appropriate levels of qualified employees and members of senior management, we may not be able to successfully execute our business strategy.

Our success depends in large part on our ability to retain and attract highly skilled engineering, sales, marketing, customer service and managerial personnel. If we are unable to attract a sufficient number of qualified personnel, particularly personnel knowledgeable in software engineering and product management, we may not be able to meet key objectives such as developing, upgrading, or enhancing our products in a timely manner, which could negatively impact our business and could hinder any future growth.

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

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

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

In December 2001, a class action lawsuit relating to our initial public offering was filed against us, our chairman, one of our executive officers and the underwriters of our initial public offering. For more information on lawsuits, see “Part II, Item 1 – Legal Proceedings.”  We are currently attempting to settle the lawsuit filed against us related to our initial public offering. We are unable to predict the effects on our financial condition or business of the lawsuit related to our initial public offering or other 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 substantial monetary damages in excess of such insurance coverage. This class action lawsuit, or any future lawsuits, could cause our director and officer insurance premiums to increase and could affect our ability to obtain director and officer insurance coverage, which would negatively affect our business. In addition, we have expended, and may in the future expend, significant resources to defend such claims. This class action lawsuit, or other similar lawsuits that may arise from time to time, could negatively impact both our financial condition and the market price of our common stock and could result in management devoting a substantial portion of their time to these lawsuits, which could adversely affect the operation of our business.

If the site of our manufacturing operations were to experience a significant disruption in its operations, it would have a material adverse effect on our financial condition and results of our operations.

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

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

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

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

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

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

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

ITEM 6.     EXHIBITS

(a)    Exhibits

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

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SIGNATURES

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

	NETWORK ENGINES, INC.
Date: August 9, 2007		/s/ Gregory A. Shortell
		Gregory A. Shortell
		President and Chief
		Executive Officer
		(Principal Executive
		Officer)
		/s/ Douglas G. Bryant
		Douglas G. Bryant
		Vice President of Finance
		and Administration, Chief
		Financial Officer, Treasurer
		and Secretary
		(Principal Financial Officer
		and Principal
		Accounting Officer)

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EXHIBIT INDEX

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

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