UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2008

OR

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

For the transition period from to

Commission file number: 000-30863

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 that 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, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o		Accelerated filer x

Non-accelerated filer o		Smaller reporting company o
(Do not check if a smaller reporting company)

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 May 6, 2008, there were 44,008,643 shares of the registrant’s Common Stock, par value $.01 per share, outstanding.

PART I. FINANCIAL INFORMATION

ITEM I. FINANCIAL STATEMENTS

NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)

	March 31, 2008			September 30, 2007
ASSETS
Current assets:
Cash and cash equivalents	$	11,838		$	44,403
Restricted cash	47			247
Accounts receivable, net of allowances of $68 and $32 at March 31, 2008 and September 30, 2007, respectively	29,581			17,511
Income tax receivable	2,820			—
Inventories	17,824			10,175
Prepaid expenses and other current assets	2,180			1,077

Total current assets	64,290			73,413

Property and equipment, net	1,937			1,128
Intangible assets, net	10,854			—
Goodwill	8,333			—
Contingently returnable acquisition consideration	4,022			—
Other assets	321			281

Total assets	$	89,757		$	74,822

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	12,277		$	10,189
Accrued compensation and other related benefits	2,792			1,773
Accrued warranty	968			1,046
Other accrued expenses	2,034			2,182
Deferred revenue	5,136			2,839

Total current liabilities	23,207			18,029

Deferred revenue, net of current portion	2,353			1,285

Total liabilities	25,560			19,314

Commitments and contingencies (Note 8)

Stockholders’ equity:
Preferred stock, $0.01 par value, 5,000,000 authorized, and no shares issued and outstanding	—			—
Common stock, $0.01 par value, 100,000,000 shares authorized; 46,570,501 and 43,590,883 shares issued; 44,008,643 and 41,029,025 shares outstanding at March 31, 2008 and September 30, 2007, respectively	465			436
Additional paid-in capital	194,124			187,005
Accumulated deficit	(127,554		)	(129,095		)
Treasury stock, at cost, 2,561,858 shares at March 31, 2008 and September 30, 2007, respectively	(2,838		)	(2,838		)
Total stockholders’ equity	64,197			55,508
Total liabilities and stockholders’ equity	$	89,757		$	74,822

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

NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

	Three months ended March 31,					Six months ended March 31,
	2008		2007			2008		2007

Net revenues	$	55,174	$	29,305		$	109,514	$	56,543

Cost of revenues	46,275		23,215			90,875		45,220

Gross profit	8,899		6,090			18,639		11,323

Operating expenses:
Research and development	2,318		2,410			4,688		4,403
Selling and marketing	2,948		1,810			6,065		3,540
General and administrative	2,935		1,954			5,580		4,015
Amortization of intangible assets	501		—			921		—

Total operating expenses	8,702		6,174			17,254		11,958

Income (loss) from operations	197		(84		)	1,385		(635		)
Interest and other income, net	142		462			266		909

Income before income taxes	339		378			1,651		274
Provision for income taxes	39		13			110		23

Net income	$	300	$	365		$	1,541	$	251

Net income per share – basic	$	0.01	$	0.01		$	0.04	$	0.01

Net income per share – diluted	$	0.01	$	0.01		$	0.03	$	0.01

Shares used in computing basic net income per share	44,009		40,735			43,833		40,339
Shares used in computing diluted net income per share	44,306		41,438			44,169		41,251

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

NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Six months ended March 31,
	2008			2007

Cash flows from operating activities:
Net income	$	1,541		$	251
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	1,650			407
Provision for doubtful accounts	51			(11		)
Loss on disposal of long-lived assets	—			7
Stock-based compensation	1,043			1,260
Changes in operating assets and liabilities, net of effects of acquisition:
Accounts receivable	1,175			475
Inventories	5,112			(2,044		)
Prepaid expenses and other current assets	(234		)	317
Accounts payable	(5,821		)	1,740
Accrued expenses	(3,195		)	349
Deferred revenue	277			1,804

Net cash provided by operating activities	1,599			4,555

Cash flows from investing activities:
Acquisition, net of cash assumed	(29,802		)	—
Contingently returnable acquisition payment	(4,022		)	—
Payment for disposition of subsidiary	(231		)	—
Purchases of property and equipment	(185		)	(495		)
Purchases of short-term investments	—			(9,541		)
Proceeds from sales and maturities of short-term investments	—			9,800
Changes in other assets				(43		)

Net cash used in investing activities	(34,240		)	(279		)

Cash flows from financing activities:
Proceeds from issuance of common stock	115			1,835
Payments on capital lease obligation	(10		)	(10		)

Net cash provided by financing activities	105			1,825

Effect of exchange rate differences on cash	(29		)	—
Net (decrease) increase in cash and cash equivalents	(32,565		)	6,101
Cash and cash equivalents, beginning of period	44,403			8,014

Cash and cash equivalents, end of period	$	11,838		$	14,115

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

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 (the “SEC”). 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 consolidated 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 2007 Annual Report on Form 10-K (the “2007 Form 10-K”) filed by the Company with the SEC.

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 allowance for doubtful accounts, inventory valuation, valuation of deferred tax assets, valuation of intangible 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 Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard No. 157, “Fair Value Measurements” (“FAS 157”). This statement addresses 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 of America. In February 2008, the FASB issued FASB Staff Position 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13” (“FSP 157-1”). FSP 157-1 amends FAS 157 to remove certain leasing transactions from its scope. In February 2008, the FASB issued FASB Staff Position 157-2, “Effective Date of FASB Statement No. 157” (“FSP 157-2”). FSP 157-2 defers the effective date of FAS 157 for certain non-financial assets and liabilities to the beginning of the Company’s fiscal year that begins after November 15, 2008. FAS 157 is effective for financial assets and liabilities 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 157 will have a material impact on the Company’s financial position, results of operations or cash flows.

In February 2007, the 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. FAS 159 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 impact on the Company’s financial position, results of operations or cash flows.

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

In December 2007, the FASB issued Statement of Financial Accounting Standard No. 141(R), “Business Combinations” (“FAS 141R”). This Statement replaced Statement of Financial Accounting Standard No. 141 to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. FAS 141R establishes principles and requirements for how the acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree, recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. FAS 141R is effective for business combinations on a prospective basis for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The adoption of FAS 141R will not have a material impact on the Company’s financial position, results of operations or cash flows.

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

The Company has an unrecognized tax benefit of approximately $540,000 related to the validity of certain credits. As discussed in Note 12 to the consolidated financial statements in the 2007 Form 10-K, the Company has a valuation allowance against the full amount of its net deferred tax asset. The Company currently provides a valuation allowance against deferred tax assets when it is more likely than not that some portion, or all of its deferred tax assets, will not be realized. Because the Company has a full valuation allowance against its deferred tax assets, the adoption of FIN 48 had no impact on the Company’s retained earnings or reported liabilities. Because the Company has significant operating loss carryforwards to offset future taxable income, the Company does not expect to utilize any of these credits in the near term, and as a result, the Company does not expect that the unrecognized tax benefit will change significantly within the next twelve months.

The Company files its tax returns as prescribed by the tax laws of the jurisdictions in which it operates. The Company’s tax years from 2001 to 2007 are still subject to examination. Various state and foreign jurisdiction tax years remain open to examination as well, though the Company believes any additional assessment will be immaterial to its consolidated financial statements.

Revenue Recognition

Revenues from products are generally recognized upon delivery to customers if persuasive evidence of an arrangement exists, the fee is fixed or determinable, collectibility is reasonably assured and title and risk of loss have passed to the customer. In the event the Company has unfulfilled future obligations, revenue and related costs are deferred until those future obligations are met. The Company has an inventory consignment agreement with its largest customer related to certain server appliances. This customer notifies the Company when it utilizes inventory and the Company recognizes revenues from sales to this customer based upon these notifications.

Maintenance revenues are derived from customer support agreements generally entered into in connection with the initial server appliance sales and subsequent renewals. Maintenance fees are typically for one to three year renewable periods and include the right to unspecified software updates when and if available for certain agreements, hardware repairs, 24-hour customer support, and advanced replacement of server appliances. Maintenance revenues are recognized ratably over the term of the maintenance period. Payments for maintenance fees are generally made in advance and are included in deferred revenue. The associated maintenance expenses are expensed in the same period as incurred.

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

or adjustment. The Company assesses collectibility based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer’s payment history.

For revenue arrangements that contain multiple elements, such as the sale of both the product and post sales support and/or extended warranty and related services element, in which software is not incidental to the product, the Company determines fair value based upon vendor specific objective evidence, which is typically established through contractual post-sales support renewal rates whereby the residual fair value is allocated to the server appliance. For revenue arrangements that contain multiple elements, in which software is not included or is incidental to the product, the Company allocates revenue to the extended warranty and related services element based on separately priced contractual rates for those elements.

The Company recognizes revenue when the revenue recognition criteria for each element of the sale are met. If the Company is not able to derive the fair value of the undelivered element of the sale (i.e. maintenance), all revenues from the arrangement are deferred and recognized ratably over the period of the support arrangement, which is typically one to three years. The Company includes shipping and handling costs, if any, reimbursed by its customers as net revenues and cost of revenues.

Cash, Cash Equivalents, Short-Term Investments and Restricted Cash

The Company did not hold any cash equivalents as of March 31, 2008. As of September 30, 2007, cash equivalents consisted principally of money market funds and commercial paper purchased with an original maturity of three months or less. At March 31, 2008 and September 30, 2007, $47,000 and $247,000, respectively, of cash was restricted and pledged as collateral for letters of credit. The Company did not hold any short-term investments as of March 31, 2008 or September 30, 2007. Details of the Company’s cash and cash equivalents are as follows (in thousands):

	March 31,		September 30,
	2008		2007
Cash and cash equivalents:
Cash	$	11,838	$	3,836
Money market funds	—		37,941
Commercial paper	—		2,626

Total cash and cash equivalents	$	11,838	$	44,403

Comprehensive Income

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

Significant Customers

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

	Net Revenues
	Three months ended				Six months ended				Accounts Receivable at
	March 31,				March 31,				March 31,		September 30,
	2008		2007		2008		2007		2008		2007
Customer A	49	%	80	%	44	%	81	%	42	%	81	%
Customer B (1)	11	%	—		12	%	—		12	%	—

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The components of the purchase price allocation for Alliance Systems are as follows (in thousands):

Net assets acquired
Cash	$	362
Accounts receivable	13,617
Income tax receivable	2,820
Inventory	12,799
Prepaid and other current assets	923
Property, plant, and equipment	1,388
Deferred tax asset	5,170
Intangible asset	11,775
Goodwill	8,333
Other assets	127
Accounts payable	(7,836		)
Income tax payable	(127		)
Deferred tax liability	(5,170		)
Other accrued expenses	(4,144		)
Deferred revenue	(3,180		)

Total net assets acquired	$	36,857

The acquired intangible asset is customer relationships, which will be amortized over the period of economic benefit expected to be received, resulting in a weighted average amortization period of 4.97 years. The transaction, which was nontaxable to the Company, resulted in the Company recording deferred tax liabilities of $5,170,000 related to the differences between the financial statement and the tax bases of the acquired assets and liabilities. As a result of the recorded deferred tax liabilities, the Company determined it would more likely than not realize the tax benefits from certain of its historical deferred tax assets, and therefore reduced its valuation allowance accordingly. Substantially all of the goodwill recorded will not be deductible for tax purposes; however, fees and expenses incurred by the Company will result in tax goodwill that will be deductible in the future. Additionally, fees and expenses incurred by Alliance Systems that have not been included in the purchase price allocation may be deductible in the future, in the event that the Company sells the Alliance Systems business.

During the three month period ended December 31, 2007, the Company was in the process of executing certain restructuring activities with respect to portions of the acquired business. These activities, which were accounted for in accordance with Emerging Issues Task Force (“EITF”) Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination” (“EITF 95-3”), primarily consisted of severance costs for reductions in staffing levels and the disposition of Alliance Systems’ German subsidiary. In connection with these exit activities the Company recorded the estimated liabilities as part of the cost of the acquisition. In accordance with EITF 95-3, upon finalization of the exit plans or settlement of the estimated obligations for less than the expected amount, any excess will result in a corresponding decrease in goodwill.

The changes in accrued exit activity expenses related to the acquisition of Alliance Systems are as follows (in thousands):

	Severance			Disposition of subsidiary			Total
Accruals established upon acquisition	$	548		$	446		$	994
Payments	(106		)	—			(106		)
Balance at December 31, 2007	442			446			888
Payments	(191		)	(446		)	(637		)
Balance at March 31, 2008	$	251		$	—		$	251

The Company disposed of Alliance Systems’ German subsidiary on February 12, 2008.

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The Company has included as a component of the net assets acquired an estimated liability for approximately $123,000 for uncertain tax positions, as determined in accordance with FIN 48. These uncertain tax positions related to state tax filing requirements. This liability, which included an estimate for interest and penalties, was based on the known facts at the time of the purchase price allocation.

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

	Three months ended March 31,						Six months ended March 31,
	2008			2007			2008		2007
Net revenues	$	55,174		$	54,019		$	111,801	$	108,472

Income (loss) from continuing operations (a)	$	(63	)	$	(870	)	$	1,385	$	(617	)

Net income (loss)	$	(63	)	$	(668	)	$	1,385	$	(510	)

Net income (loss) per share
Basic	$	(0.00	)	$	(0.02	)	$	0.03	$	(0.01	)
Diluted	$	(0.00	)	$	(0.02	)	$	0.03	$	(0.01	)

(a) Includes $485,000 of amortization of intangible assets and $388,000 of additional costs related to the fair value adjustment of inventory in each of the three month periods ended March 31, 2008 and 2007, and includes $970,000 of amortization of intangible assets and $388,000 of additional costs related to the fair value adjustment of inventory in each of the six month periods ended March 31, 2008 and 2007.

4. 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 March 31,				Six months ended March 31,
	2008		2007		2008		2007

Cost of revenues	$	46	$	40	$	100	$	80
Research and development	162		300		412		580
Selling and marketing	66		67		161		167
General and administrative	182		241		370		433
Total stock-based compensation expense	$	456	$	648	$	1,043	$	1,260

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 common 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

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Company’s stock options granted during the three and six months ended March 31, 2008 and 2007. 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.

Assumptions used to determine the fair value of options granted during the three and six months ended March 31, 2008 and 2007, using the Black-Scholes valuation model, were:

	Three months ended March 31,		Six months ended March 31,
	2008	2007	2008	2007

Expected term (1)	5.50 to 6.25 years	5.50 to 6.25 years	5.50 to 6.25 years	5.50 to 6.25 years
Expected volatility factor (2)	54.89% to 58.75%	65.77% to 72.67%	54.89% to 59.05%	65.77% to 72.67%
Risk-free interest rate (3)	2.70%	4.44% to 4.65 %	2.70% to 4.13%	4.44% to 4.65%
Expected annual dividend yield	—	—	—	—

(1)		The 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, as 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 is 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 six months ended March 31, 2008 is as follows:

	Six months ended March 31, 2008
	Number of Options		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (in years)

Outstanding, September 30, 2007	6,091,355		$	2.51
Granted	2,571,000		1.89
Exercised	(9,187	)	1.75
Forfeited	(291,779	)	2.05
Expired	(108,450	)	3.24
Outstanding, March 31, 2008	8,252,939		$	2.33	7.64
Exercisable at March 31, 2008	3,905,447		$	2.85	6.22

All stock options granted during the six months ended March 31, 2008 were granted with exercise prices equal to the fair market value of the Company’s common stock on the grant date and had a weighted average grant date fair value of $1.12.

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

At March 31, 2008, unrecognized compensation expense related to non-vested stock options was $3,324,000, which is expected to be recognized over a weighted average period of 2.84 years.

5. Net Income Per Share

Basic net income per share is computed by dividing the net income for the period by the weighted average number of shares of common stock outstanding during the period. Diluted net income per share is computed by dividing the net income for the period by the weighted average number of shares of common stock and potential common stock, if dilutive, outstanding during the period. 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 per share as well as the weighted average potential common stock excluded from the calculation of net income per share because their inclusion would be anti-dilutive (in thousands, except per share data):

	Three months ended March 31,				Six months ended March 31,
	2008		2007		2008		2007
Numerator:
Net income	$	300	$	365	$	1,541	$	251

Denominator:
Shares used in computing basic net income per share	44,009		40,735		43,833		40,339
Common stock equivalents from employee stock options	297		703		336		912

Shares used in computing diluted net income per share	44,306		41,438		44,169		41,251

Net income per share:
Basic	$	0.01	$	0.01	$	0.04	$	0.01
Diluted	$	0.01	$	0.01	$	0.03	$	0.01

Anti-dilutive potential common stock equivalents excluded from the calculation of net income per share:
Options to purchase common stock	7,331		3,273		6,974		3,131

6. Goodwill and Intangible Assets

The Company recorded goodwill and intangible assets as the result of its acquisition of Alliance Systems. The acquired intangible asset is customer relationships, which will be amortized over the period of economic benefit expected to be received. The following table presents the intangible asset balances as of March 31, 2008 (in thousands):

	Gross Carrying Amount		Accumulated Amortization		Net Book Value

Customer relationships	$	11,775	$	921	$	10,854

The estimated future amortization expense for the intangible asset as of March 31, 2008 by fiscal year is $960,000 for the remainder of 2008, $1,766,000 for 2009, $1,554,000 for 2010, $1,330,000 for 2011, $1,119,000 for 2012 and $4,125,000 thereafter.

Goodwill represents the excess purchase price over the fair value of the net tangible and intangible assets acquired. The Company reviews long-lived assets, including definite-lived intangible assets, to determine if any adverse conditions exist that would indicate impairment. Goodwill is reviewed each year

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

in the fourth quarter for impairment, or more frequently if certain indicators are present. When conducting an impairment evaluation, the Company compares the carrying value of the reporting unit to the fair value of the reporting unit. Management has determined that the reporting unit is the Company as a whole. If the carrying amount of the reporting unit exceeds its fair value, then the carrying value of that reporting unit’s goodwill is compared to the implied fair value of the goodwill and an impairment loss is recorded in an amount equal to that excess, if any. Fair value is calculated as the present value of estimated future cash flows using a risk-adjusted discount rate, and includes significant judgments by management.

Conditions that could trigger a more frequent impairment assessment include, but are not limited to, a significant adverse change in certain agreements, an economic downturn in customers’ industries, increased competition, or other information regarding the Company’s market value, such as a reduction in its stock price. For example, a reduction in the stock price to a price at or near the book value of the Company for a period of time could indicate a triggering event and a possible impairment of goodwill.

Factors that could lead to an impairment of acquired customer relationships (recorded as a result of the Alliance Systems acquisition) include a worsening in customer attrition rates compared to historical attrition rates, or lower than initially anticipated cash flows associated with customer relationships. The Company assesses the recoverability of long-lived assets based on the projected undiscounted future cash flows over the asset’s remaining life. The amount of impairment, if any, is measured based on the excess of the carrying value over fair value. Fair value is generally calculated as the present value of estimated future cash flows using a risk-adjusted discount rate, which requires significant management judgment with respect to revenue and expense growth rates, and the selection and use of an appropriate discount rate.

7. Inventories

Inventories consisted of the following (in thousands):

	March 31, 2008		September 30, 2007

Raw materials	$	11,393	$	5,764
Work in process	383		445
Finished goods	6,048		3,966

Total	$	17,824	$	10,175

8. 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. The Company has received one claim related to the Alliance Systems acquisition, for which the Company has recorded a liability of $85,000 as of March 31, 2008. While the provisions of the agreements remain in effect indefinitely, the Company believes that the probability of receiving a claim related to acquisitions other than Alliance Systems is unlikely. As a result, the Company has not recorded any other liabilities for such indemnification clauses as of March 31, 2008.

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

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these indemnifications as of March 31, 2008.

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 six months ended March 31, 2008 and 2007 (in thousands):

	Three months ended March 31,						Six months ended March 31,
	2008			2007			2008			2007

Beginning balance	$	1,017		$	702		$	1,046		$	559
Acquisitions	—			—			70			—
Accruals for warranties issued	475			598			997			919
Fulfillment of warranties during the period	(524		)	(283		)	(1,145		)	(461		)
Ending balance	$	968		$	1,017		$	968		$	1,017

Contingencies

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 former Chairman and Chief Executive Officer), Douglas G. Bryant (the Company’s Chief Financial Officer), and several underwriters of the Company’s initial public offering. The suit alleges, inter alia, 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 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 October 2002, Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this case without prejudice. On December 5, 2006, the United States Court of Appeals for the Second Circuit overturned the District Court’s certification of a plaintiff class. 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. The Company is unable to predict the outcome of this suit and as a result, no amounts have been accrued as of March 31, 2008.

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

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 (the “SEC”). 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, 2007 filed by us with the SEC.

Overview

We develop and manufacture server appliance solutions that deliver software applications on server appliances. Currently, a large portion of our revenues is derived from the sale of server appliances to customers in the data storage, network security, telecommunications and enterprise communications markets. Server appliances are pre-configured network infrastructure devices designed to optimally deliver specific software application functionality while facilitating ease of deployment, improved manageability and increased security of that software application in a customer’s network. A server appliance deployment is intended to reduce the total cost of ownership associated with the deployment and ongoing maintenance of software applications within a customer’s IT infrastructure

As mentioned previously in the notes to our financial statements, we acquired Alliance Systems, Inc. (“Alliance Systems”) on October 11, 2007. With this acquisition, many of our assets and liabilities increased between September 30, 2007 and March 31, 2008.

Critical Accounting Policies and Estimates

Our discussion and analysis of financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States 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 assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Other than adding our goodwill and long-lived assets policy, there were no other changes to our critical accounting policies since September 30, 2007.

Revenue Recognition

Revenues from products are generally recognized upon delivery to customers if persuasive evidence of an arrangement exists, the fee is fixed or determinable, collectibility is reasonably assured and title and risk of loss have passed to the customer. In the event we have unfulfilled future obligations, revenue and related costs are deferred until those future obligations are met. We have an inventory consignment agreement with our largest customer related to certain server appliances. This customer notifies us when it utilizes inventory and we recognize revenues from sales to this customer based upon these notifications.

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

For revenue arrangements that contain multiple elements, such as the sale of both the product and post sales support and/or extended warranty and related services element, in which software is not incidental to the product, we determine fair value based upon vendor specific objective evidence, which is typically established through contractual post-sales support renewal rates whereby the residual fair value is allocated to the server appliance. For revenue arrangements that contain multiple elements, in which software is not included or is incidental to the product, we allocate revenue to the extended warranty and related services element based on separately priced contractual rates for those elements.

We recognize revenue when the revenue recognition criteria for each element of the sale are met. If we are not able to derive the fair value of the undelivered element of the sale (i.e. maintenance), all revenues from the arrangement are deferred and recognized ratably over the period of the support arrangement, which is typically one to three years. We include shipping and handling costs, if any, reimbursed by our customers as net revenues and cost of revenues.

Goodwill and Other Intangible Assets

Goodwill represents the excess purchase price over the fair value of the net tangible and intangible assets acquired. We review long-lived assets, including definite-lived intangible assets, to determine if any adverse conditions exist that would indicate impairment. Goodwill is reviewed each year in the fourth quarter for impairment, or more frequently if certain indicators are present. When conducting our impairment evaluation, we compare the carrying value of the reporting unit to the fair value of the reporting unit. We have determined that the reporting unit is the Company as a whole. If the carrying amount of the reporting unit exceeds its fair value, then the carrying value of that reporting unit’s goodwill is compared to the implied fair value of the goodwill and an impairment loss is recorded in an amount equal to that excess, if any. Fair value is calculated as the present value of estimated future cash flows using a risk-adjusted discount rate, and includes significant judgments by management.

Conditions that could trigger a more frequent impairment assessment include, but are not limited to, a significant adverse change in certain agreements, an economic downturn in our customers’ industries, increased competition, or other information regarding our market value, such as a reduction in our stock price. For example, a reduction in our stock price to a price at or near the book value of the Company for a period of time could indicate a triggering event and a possible impairment of goodwill.

Factors that could lead to an impairment of acquired customer relationships (recorded as a result of the Alliance Systems acquisition) include a worsening in customer attrition rates compared to historical attrition rates, or lower than initially anticipated cash flows associated with customer relationships. We assess the recoverability of long-lived assets based on the projected undiscounted future cash flows over the asset’s remaining life. The amount of impairment, if any, is measured based on the excess of the carrying value over fair value. Fair value is generally calculated as the present value of estimated future cash flows using a risk-adjusted discount rate, which requires significant management judgment with respect to revenue and expense growth rates, and the selection and use of an appropriate discount rate.

Results of Operations

Three months ended March 31, 2008 compared to the three months ended March 31, 2007

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 March 31,
	2008				2007					Increase (Decrease)
	Dollars		% of Net Revenues		Dollars			% of Net Revenues		Dollars			Percentage
Net revenues	$	55,174	100.0	%	$	29,305		100.0	%	$	25,869		88.3	%
Gross profit	8,899		16.1	%	6,090			20.8	%	2,809			46.1	%
Operating expenses	8,702		15.8	%	6,174			21.1	%	2,528			40.9	%
Income (loss) from operations	197		0.3	%	(84		)	(0.3	)%	281			—
Net income	$	300	0.5	%	$	365		1.2	%	$	(65	)	(17.8	)%

Net Revenues

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

Our net revenues increased for the three months ended March 31, 2008, as compared to the three months ended March 31, 2007, primarily due to the acquisition of Alliance Systems on October 11, 2007. If the acquisition had occurred at the beginning of fiscal year 2007, net revenues, on a pro forma basis, would have increased by approximately $1.2 million. The pro forma increase would have been attributable primarily to increased sales volumes.

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 decreased for the three months ended March 31, 2008, as compared to the three months ended March 31, 2007. The decrease from the prior year was primarily due to higher inventory write-downs, a decrease in average selling prices based on the customer and product mix combined with consistent manufacturing costs, and lower gross margins associated with the Alliance Systems business. In addition, gross profit in the prior year included the cost recovery of previously written-down inventory.

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 June 30, 2008 will decrease, as compared to the three months ended March 31, 2008.

Operating Expenses

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

	Three Months Ended March 31,
	2008				2007				Increase (Decrease)
	Dollars		% of Net Revenues		Dollars		% of Net Revenues		Dollars			Percentage
Operating expenses:
Research and development	$	2,318	4.2	%	$	2,410	8.2	%	$	(92	)	(3.8	)%
Selling and marketing	2,948		5.4	%	1,810		6.2	%	1,138			62.9	%
General and administrative	2,935		5.3	%	1,954		6.7	%	981			50.2	%
Amortization of intangible assets	501		0.9	%	—		—		501			—

Total operating expenses	$	8,702	15.8	%	$	6,174	21.1	%	$	2,528		40.9	%

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 March 31,
	2008				2007				Increase (Decrease)
	Dollars		% of Expense Category		Dollars		% of Expense Category		Dollars			Percentage
Research and development:
Compensation and related expenses	$	1,507	65.0	%	$	1,388	57.6	%	$	119		8.6	%
Stock-based compensation	162		7.0	%	300		12.4	%	(138		)	(46.0	)%
Prototype	128		5.5	%	270		11.2	%	(142		)	(52.6	)%
Consulting and professional services	194		8.4	%	257		10.7	%	(63		)	(24.5	)%
Other	327		14.1	%	195		8.1	%	132			67.7	%

Total research and development	$	2,318	100	%	$	2,410	100	%	$	(92	)	(3.8	)%

Research and development expenses decreased in the three months ended March 31, 2008, as compared to the three months ended March 31, 2007, primarily due to decreases in stock-based compensation and prototype expenses, partially offset by increases related to the acquisition of Alliance Systems. Because our research and development expenses are project driven, the timing of these expenditures can vary. If the acquisition had occurred at the beginning of fiscal year 2007, research and development expenses would have decreased by approximately $550,000, when comparing the pro forma research and development expenses for the three months ended March 31, 2007 to our actual results for the three months ended March 31, 2008. On a pro forma basis, there would have been decreases in compensation, primarily due to lower headcount, stock-based compensation, and prototype and consulting costs, based on the timing of projects being worked on.

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 decrease during the three months ended June 30, 2008, as compared to the three months ended March 31, 2008.

Selling and Marketing

Selling and marketing expenses consist primarily of salaries and commissions for personnel engaged in sales and marketing, and costs associated with our marketing programs, which include costs associated with our attendance at trade shows, product literature costs, web site enhancements, product evaluation 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 March 31,
	2008				2007				Increase (Decrease)
	Dollars		% of Expense Category		Dollars		% of Expense Category		Dollars			Percentage
Selling and marketing:
Compensation and related expenses	$	2,109	71.6	%	$	1,182	65.3	%	$	927		78.4	%
Stock-based compensation	66		2.2	%	67		3.7	%	(1		)	(1.5	)%
Marketing programs	215		7.3	%	226		12.5	%	(11		)	(4.9	)%
Travel	209		7.1	%	144		8.0	%	65			45.1	%
Other	349		11.8	%	191		10.5	%	158			82.7	%

Total selling and marketing	$	2,948	100	%	$	1,810	100	%	$	1,138		62.9	%

Selling and marketing expenses increased in the three months ended March 31, 2008, as compared to the three months ended March 31, 2007, primarily due to the acquisition of Alliance Systems. Selling and marketing headcount increased from 22 as of March 31, 2007, to 58 as of March 31, 2008. If the acquisition had occurred at the beginning of fiscal year 2007, selling and marketing expenses would have decreased by approximately $700,000, when comparing the pro forma selling and marketing expenses for the three months ended March 31, 2007 to our actual results for the three months ended March 31, 2008. On a pro forma basis, there would have been lower compensation and related expenses, because Alliance Systems had decreased its selling and marketing headcount.

We believe that we must target our selling and marketing efforts on network equipment providers, independent software vendors (“ISVs”) and telecom equipment manufacturers in order to enhance our position as a leading provider of server appliance products. We expect selling and marketing expenses to remain consistent during the three months ended June 30, 2008, as compared to the three months ended March 31, 2008.

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 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 March 31,
	2008				2007				Increase (Decrease)
	Dollars		% of Expense Category		Dollars		% of Expense Category		Dollars			Percentage
General and administrative:
Compensation and related expenses	$	1,505	51.3	%	$	956	48.9	%	$	549		57.4	%
Stock-based compensation	182		6.2	%	241		12.3	%	(59		)	(24.5	)%
Consulting and professional services	900		30.6	%	519		26.6	%	381			73.4	%
Director and officer insurance	70		2.4	%	83		4.3	%	(13		)	(15.7	)%
Other	278		9.5	%	155		7.9	%	123			79.4	%

Total general and administrative	$	2,935	100	%	$	1,954	100	%	$	981		50.2	%

General and administrative expenses increased in the three months ended March 31, 2008, as compared to the three months ended March 31, 2007, primarily due to the acquisition of Alliance Systems. General and administrative headcount increased from 27 as of March 31, 2007, to 44 as of March 31, 2008. If the acquisition had occurred at the beginning of fiscal year 2007, general and administrative expenses would have decreased by approximately $280,000, when comparing the pro forma general and administrative expenses for the three months ended March 31, 2007 to our actual results for the three months ended March 31, 2008. The pro forma decrease would have been attributable to decreases in compensation and stock-based compensation expenses and other expenses, offset by an increase in consulting and professional services. The pro forma decrease in compensation and related expenses would have been primarily due to lower headcount during the current year period as compared to the same period in the prior year. The pro forma increase in consulting and professional services is primarily related to additional costs associated with our integration of Alliance Systems.

We expect general and administrative expenses to decrease during the three months ended June 30, 2008, as compared to the three months ended March 31, 2008.

Amortization of Intangible Assets

The amortization of intangible assets increased by $501,000 for the three months ended March 31, 2008, as compared to the three months ended March 31, 2007. The increase was due to the amortization of intangible assets related to the acquisition of Alliance Systems, which occurred on October 11, 2007.

Interest and Other Income, net

Interest and other income, net, decreased to $141,000 for the three months ended March 31, 2008 from $462,000 for the three months ended March 31, 2007. This decrease was primarily due to lower interest income, attributable to lower cash and short-term investment balances held by the Company during the three months ended March 31, 2008, as compared to the three months ended March 31, 2007.

Six months ended March 31, 2008 compared to the six months ended March 31, 2007

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:

	Six Months Ended March 31,
	2008				2007					Increase (Decrease)
	Dollars		% of Net Revenues		Dollars			% of Net Revenues		Dollars		Percentage
Net revenues	$	109,514	100.0	%	$	56,543		100.0	%	$	52,971	93.4	%
Gross profit	18,639		17.0	%	11,323			20.0	%	7,316		64.6	%
Operating expenses	17,254		15.7	%	11,958			21.1	%	5,296		44.3	%
Income (loss) from operations	1,385		1.3	%	(635		)	(1.1	)%	2,020		—
Net income	$	1,541	1.4	%	$	251		0.4	%	$	1,290	513.9	%

Net Revenues

Our net revenues increased for the six months ended March 31, 2008, as compared to the six months ended March 31, 2007, primarily due to the acquisition of Alliance Systems on October 11, 2007. If the acquisition had occurred at the beginning of fiscal year 2007, net revenues, on a pro forma basis, would have increased by approximately $3.3 million. The pro forma increase would have been attributable primarily to increased sales volumes.

Gross Profit

Gross profit as a percentage of net revenue decreased for the six months ended March 31, 2008, as compared to the six months ended March 31, 2007, primarily due to higher inventory write-downs, a decrease in average selling prices based on the customer and product mix combined with consistent manufacturing costs, and lower gross margins associated with the Alliance Systems business.

Operating Expenses

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

	Six Months Ended March 31,
	2008				2007				Increase (Decrease)
	Dollars		% of Net Revenues		Dollars		% of Net Revenues		Dollars		Percentage
Operating Expenses:
Research and development	$	4,688	4.3	%	$	4,403	7.8	%	$	285	6.5	%
Selling and marketing	6,065		5.5	%	3,540		6.2	%	2,525		71.3	%
General and administrative	5,580		5.1	%	4,015		7.1	%	1,565		39.0	%
Amortization of intangible assets	921		0.8	%	—		—		921		—

Total operating expenses	$	17,254	15.7	%	$	11,958	21.1	%	$	5,296	44.3	%

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:

	Six Months Ended March 31,
	2008				2007				Increase (Decrease)
	Dollars		% of Expense Category		Dollars		% of Expense Category		Dollars			Percentage
Research and development:
Compensation and related expenses	$	3,028	64.6	%	$	2,607	59.2	%	$	421		16.1	%
Stock-based compensation	412		8.8	%	580		13.2	%	(168		)	(29.0	)%
Prototype	250		5.3	%	411		9.3	%	(161		)	(39.1	)%
Consulting and professional services	459		9.8	%	399		9.1	%	60			15.0	%
Other	539		11.5	%	406		9.2	%	133			32.8	%

Total research and development	$	4,688	100	%	$	4,403	100	%	$	285		6.5	%

Research and development expenses increased in the six months ended March 31, 2008, as compared to the six months ended March 31, 2007, primarily due to the acquisition of Alliance Systems. If the acquisition had occurred at the beginning of fiscal year 2007, research and development expenses would have decreased by approximately $510,000, when comparing the pro forma research and development expenses for the six month periods ended March 31, 2008 and 2007. Because our research and development expenses are project driven, the timing of these expenditures can vary. On a pro forma basis, there would have been decreases in compensation and stock-based compensation as a result of lower headcount and the scheduled vesting of stock options, and a decrease in prototype expenses based on the timing of projects being worked on.

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:

	Six Months Ended March 31,
	2008				2007				Increase (Decrease)
	Dollars		% of Expense Category		Dollars		% of Expense Category		Dollars			Percentage
Selling and marketing:
Compensation and related expenses	$	4,445	73.3	%	$	2,407	68.0	%	$	2,038		84.7	%
Stock-based compensation	161		2.6	%	167		4.7	%	(6		)	(3.6	)%
Marketing programs	327		5.4	%	395		11.2	%	(68		)	(17.2	)%
Travel	406		6.7	%	256		7.2	%	150			58.6	%
Other	726		12.0	%	315		8.9	%	411			130.5	%

Total selling and marketing	$	6,065	100	%	$	3,540	100	%	$	2,525		71.3	%

Selling and marketing expenses increased in the six months ended March 31, 2008, as compared to the six months ended March 31, 2007, primarily due to the acquisition of Alliance Systems. Selling and marketing headcount increased from 22 as of March 31, 2007, to 58 as of March 31, 2008. If the acquisition had occurred at the beginning of fiscal year 2007, selling and marketing expenses would have decreased by approximately $950,000, when comparing the pro forma selling and marketing expenses for the six month periods ended March 31, 2008 and 2007. On a pro forma basis, there would have been lower compensation and related expenses, attributable to the fact that Alliance Systems had decreased its selling and marketing headcount.

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:

	Six Months Ended March 31,
	2008				2007				Increase (Decrease)
	Dollars		% of Expense Category		Dollars		% of Expense Category		Dollars				Percentage
General and administrative:
Compensation and related expenses	$	2,824	50.6	%	$	1,730	43.1	%		$	1,094		63.2	%
Stock-based compensation	370		6.6	%	433		10.8	%		(63		)	(14.5	)%
Consulting and professional services	1,555		27.9	%	1,362		33.9	%		193			14.2	%
Director and officer insurance	134		2.4	%	166		4.1	%		(32		)	(19.3	)%
Other	697		12.5	%	324		8.1	%		373			115.1	%

Total general and administrative	$	5,580	100	%	$	4,015	100	%		$	1,565		39.0	%

General and administrative expenses increased in the six months ended March 31, 2008, as compared to the six months ended March 31, 2007, primarily due to the acquisition of Alliance Systems. General and administrative headcount increased from 27 as of March 31, 2007, to 44 as of March 31, 2008. If the acquisition had occurred at the beginning of fiscal year 2007, general and administrative expenses would have decreased by approximately $837,000, when comparing the pro forma general and administrative expenses for the six month periods ended March 31, 2008 and 2007. The pro forma decrease would have been attributable to decreases in compensation and related expenses and in other costs, primarily bad debt expense. The pro forma decrease in compensation and related expenses would have been primarily due to lower headcount within the administrative departments as well as lower bonus expense during the current year period as compared to the same period in the prior year.

Amortization of Intangible Assets

The amortization of intangible assets increased by $921,000 for the six months ended March 31, 2008, as compared to the six months ended March 31, 2007. The increase was due to the amortization of intangible assets related to the acquisition of Alliance Systems, which occurred on October 11, 2007.

Interest and Other Income, net

Interest and other income, net, decreased to $265,000 for the six months ended March 31, 2008 from $909,000 for the six months ended March 31, 2007. This decrease was primarily due to lower interest income, attributable to lower cash and short-term investment balances held by the Company during the six months ended March 31, 2008, as compared to the six months ended March 31, 2007.

Liquidity and Capital Resources

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

	Six Months Ended March 31,
	2008			2007

Net income	$	1,541		$	251
Non-cash adjustments to net income	2,744			1,663
Changes in working capital	(2,686		)	2,641

Cash provided by operating activities	1,599			4,555

Cash (used in) investing activities	(34,240		)	(279		)
Cash provided by financing activities	105			1,825
Effect of exchange rate differences on cash	(29		)	—

(Decrease) increase in cash and cash equivalents	(32,565		)	6,101
Beginning cash and cash equivalents	44,403			8,014

Ending cash and cash equivalents	$	11,838		$	14,115

Operating Activities

Cash provided by operating activities during the six months ended March 31, 2008 was primarily the result of net income and the impact of non-cash adjustments to net income, partially offset by a net use of

cash from changes in working capital. The changes in working capital primarily related to the use of cash to settle accounts payable and accrued expenses, partially offset by the impact of cash provided by decreases in accounts receivable and inventories. Changes in working capital for the six months ended March 31, 2007 included an increase in deferred revenue of $1.8 million related to the transfer of support obligations of the previously installed Whale appliances from Microsoft.

Investing Activities

Cash used in investing activities during the six months ended March 31, 2008 primarily related to the use of approximately $34 million of cash for the acquisition of Alliance Systems.

Financing Activities

Cash provided by financing activities during the six months ended March 31, 2008 consisted primarily of $115,000 of cash received as the result of employee stock option exercises and purchases under the Employee Stock Purchase Plan. We expect these activities to continue for the remainder of fiscal year 2008; however, we cannot predict the magnitude of the cash inflows, 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 larger customers;

· our ability to enter into partnerships with network equipment providers, ISVs and telecom equipment manufacturers;

· 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 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.

In the event that our available cash resources and the Silicon Valley Bank line of credit are not sufficient, after the line of credit matures on October 9, 2008, we would need to raise additional funds. We may in the future seek 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. Additional equity financings could result in dilution to our shareholders. If additional financing is needed and is not available on acceptable terms, we may need to reduce our operating expenses and scale back our operations.

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, 2007, during the six months ended March 31, 2008, we incurred an additional contractual obligation related to the facility leased by Alliance Systems. The remaining obligation under this lease as of March 31, 2008 is as follows:

	Payments Due by Fiscal Period
	Less than 1 Year		1-3 Years		3-5 Years		After 5 Years		Total

Operating lease	$	369	$	2,161	$	—	$	—	$	2,530

Total	$	369	$	2,161	$	—	$	—	$	2,530

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.

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard No. 157, “Fair Value Measurements” (“FAS 157”). This statement addresses 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 of America. In February 2008, the FASB issued FASB Staff Position 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13” (“FSP 157-1”). FSP 157-1 amends FAS 157 to remove certain leasing transactions from its scope. In February 2008, the FASB issued FASB Staff Position 157-2, “Effective Date of FASB Statement No. 157” (“FSP 157-2”). FSP 157-2 defers the effective date of FAS 157 for certain non-financial assets and liabilities to the beginning of the Company’s fiscal year that begins after November 15, 2008. FAS 157 is effective for financial assets and liabilities 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 157 will have a material impact on our financial position, results of operations or cash flows.

In February 2007, the 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. FAS 159 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 impact on our financial position, results of operations or cash flows.

In December 2007, the FASB issued Statement of Financial Accounting Standard No. 141(R), “Business Combinations” (“FAS 141R”). This Statement replaced Statement of Financial Accounting Standard No. 141 to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. FAS 141R establishes principles and requirements for how the acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree, recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. FAS 141R is effective for business combinations on a prospective basis for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The adoption of FAS 141R will not have a material impact on our financial position, results of operations or cash flows.

ITEM 1A. RISK FACTORS

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

Risks 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.

For the three months ended March 31, 2008 and 2007, sales directly to EMC, our largest customer, accounted for 49% and 80%, of our total net revenues, respectively. For the six months ended March 31, 2008 and 2007, sales directly to EMC accounted for 44% and 81%, of our total net revenues, respectively. These sales are primarily attributable to one product pursuant to a non-exclusive contract. Although this concentration has decreased as a result of our acquisition of Alliance Systems, 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 we may be unable to accurately predict revenues, profitability and cash flows.

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 we may be unable to accurately predict revenues, profitability and cash flows.

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 telecom equipment manufacturers. Under this strategy, we work with our customers to develop a server appliance branded with their name. These customers then perform 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 which sell their software products as separate products in addition to selling them in the form of a server appliance will most likely continue to do so, which will require us to effectively communicate the benefits of delivering their software in the form of a server appliance;

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

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

· our ability to leverage strategic relationships to obtain new sales leads;

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

· there is no guarantee that design wins will become actual orders and sales. A “design win’’ occurs when a customer or prospective customer notifies us that we have been selected to integrate the customer’s application. There can be delays of several months or more between the design win and when a customer initiates actual orders. The design win may never become an actual order or sale. Further, if the customer’s plans change, we may commit significant resources to design wins that do not result in actual orders.

Additionally, our future success will depend on our ability to 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.

The failure to successfully integrate our acquisition of Alliance Systems into our operations in the expected time frame, or at all, may adversely affect our future results.

We believe that the acquisition of Alliance Systems, completed in October 2007, will result in certain benefits, including expanded customer reach, increased product offerings, and certain cost savings from economies of scale. However, to realize these anticipated benefits, Alliance Systems’ business must be successfully integrated into our operations by focusing on, manufacturing and supply chain synergies, sales and marketing operations, and general and administrative efficiencies. The success of the Alliance Systems acquisition will depend on our ability to realize these anticipated benefits from integrating Alliance Systems’ business into our operations. We may fail to realize the anticipated benefits of the acquisition on a timely basis, or at all, for a variety of reasons, including the following:

• diversion of management attention and difficulties arising from managing multiple locations;

• potential disruption of ongoing business;

• failure to effectively coordinate sales and marketing efforts to communicate the capabilities of the combined Company;

• potential difficulties integrating financial reporting or other critical systems; and

• the loss of key employees, customers, or vendors.

If we fail to successfully integrate Alliance Systems and realize the expected benefits of the acquisition, it could have an adverse impact on our results of operations, and our ability to generate cash

from operations. As a result, we could have difficulty borrowing under our current credit facility or securing financing to fund our operations in the future.

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 to other competitive products in the marketplace, which may adversely affect the results of our operations and our ability to grow our business.

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 markets.

If server appliances are not increasingly adopted as a solution to meet a significant portion of companies’ 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’ 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.

Our expectations for the growth of the server appliance market may not be fulfilled if customers continue to use general-purpose servers or proprietary platforms. 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.

In the past, we have incurred significant net losses and could incur net losses in the future. At March 31, 2008 and September 30, 2007, our accumulated deficit was $128 million and $129 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. Even if we achieve sustained profitability there can be no guarantee that our stock price will increase.

We may not be able to borrow funds under our credit facility or secure future financing if there is a material adverse change in our business.

In connection with our October 2007 acquisition of Alliance Systems, we entered into an agreement with Silicon Valley Bank to provide for a line of credit. We view this line of credit as a source of available liquidity to fund fluctuations in our working capital requirements. This facility contains various conditions, covenants and representations with which we must be in compliance in order to borrow funds. However, if we wish to borrow under this facility in the future, there can be no assurance that we will be in compliance with these conditions, covenants and representations. In addition, this line of credit facility with Silicon Valley Bank expires on October 9, 2008. After that, we may need to secure new financing to continue funding fluctuations in our working capital requirements. However, we may not be able to secure new

financing, or financing on favorable terms, if we experience a significant adverse change in our business. As of March 31, 2008, we have not drawn on this line of credit.

If our estimates or judgments relating to our critical accounting policies are based on assumptions that 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 is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. 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;

• inventory write-downs;

• stock-based compensation;

• valuation of intangible assets and goodwill;

• warranty reserves; and

• realization of deferred tax assets.

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 also fluctuate for various reasons, which could cause our operating results to fall below expectations and thus impact the market price of our common stock.

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;

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

• seasonal fluctuations in the data storage and telecom industries; 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, network security and telecom 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, network security and telecom markets may be subject to further commoditization as these industries continue to mature and other businesses introduce additional competing products and services. Our gross profit as a percentage of revenues for 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, network security and telecom 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.

Goodwill and other intangible assets represent a significant portion of our assets, and any impairment of goodwill or other intangible assets would adversely impact our net income.

At March 31, 2008, we had goodwill and intangible assets of approximately $19.2 million, net of accumulated amortization. Our goodwill is subject to an annual impairment test, and both goodwill and other intangible assets are also tested whenever events and circumstances indicate that they may be impaired. Such events or conditions could include an economic downturn in our customers’ industries, increased competition, or other information regarding our market value, such as a reduction in our stock price to a price at or near the book value of the Company for a period of time which could indicate a triggering event and a possible impairment of goodwill. Any excess goodwill resulting from the impairment test must be written off in the period of determination. In addition, we will continue to incur non-cash charges relating to the amortization of our intangible asset other than goodwill, over the remaining useful lives of such asset. Future determinations of significant write-offs of goodwill or intangible assets resulting from an impairment test or any accelerated amortization of intangible assets could have a significant impact on our net income and affect our ability to maintain profitability. Although we do not believe that any impairment of goodwill or other intangible assets exists at this time, in the event that such a condition or event occurs, we may record charges which could have a material adverse effect on our results of operations.

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.

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 telecom equipment manufacturers to recognize us 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 providing 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, or 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 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.

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 patent applications 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.

Our operating results would suffer if we, our ISV, telecom 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, telecom, 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, telecom, 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.

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

Our manufacturing facilities and headquarters are concentrated in two locations. If the operations in either 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 for a period of at least one quarter 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 2007, the closing price of our common stock ranged from a low of $1.73 to a high of $2.81, and during the six months ended March 31, 2008, from a low of $1.36 to a high of $1.64. 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.

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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Our Annual Meeting of Stockholders was held on March 13, 2008. Of the 44,008,612 shares outstanding as of January 18, 2008, 37,115,053 (84.34%) were present or represented by proxy at the meeting. The table below presents the voting results of the matters voted upon by our stockholders at the meeting:

Nominee	Votes For	Votes Withheld
Fontaine K. Richardson	34,083,992	3,031,061
Gregory A. Shortell	34,057,490	3,057,563

For		Against		Abstain		Non Votes
36,575,756		424,731		114,566		—

For		Against		Abstain		Non Votes
14,721,276		2,019,912		29,020		20,344,845

	NETWORK ENGINES, INC.

Date: May 9, 2008		/s/ Gregory A. Shortell

		Gregory A. Shortell
		President and Chief Executive Officer
		(Principal Executive Officer)


		/s/ Douglas G. Bryant

		Douglas G. Bryant
		Chief Financial Officer, Treasurer and Secretary
		(Principal Financial Officer and Principal
		Accounting Officer)

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.

		PAGE NUMBER
	PART I. FINANCIAL INFORMATION

	ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)	1
	CONDENSED CONSOLIDATED BALANCE SHEETS	1
	CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS	2
	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS	3
	NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	4

	ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	15

	ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	26

	ITEM 4. CONTROLS AND PROCEDURES	26

	PART II. OTHER INFORMATION

	ITEM 1. LEGAL PROCEEDINGS	27

	ITEM 1A. RISK FACTORS	28

	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	38

	ITEM 6. EXHIBITS	39

	SIGNATURES	40