NETWORK ENGINES INC - 10-Q Quarterly Report

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

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FORM 10-Q

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(Mark One)

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

For the quarterly period ended June 30, 2002

OR

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

For the transition period from ___________ to ___________

Commission file number: 0-30863

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

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

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

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

---------------------

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

As of August 1, 2002, there were 31,738,561 shares of the registrant's
Common Stock, par value $.01 per share, outstanding.

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NETWORK ENGINES, INC.

INDEX

PAGE
NUMBER
------

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)

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

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION ............................................................... 12

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK .................................................................................. 30

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS ..................................................................... 31

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS ............................................. 31

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ................................... 32

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K ...................................................... 32

SIGNATURES .................................................................................... 33

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

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

June 30, September 30,
2002 2001
----------- -------------
ASSETS (unaudited)

Current assets
Cash and cash equivalents ................................................................. $ 58,593 $ 74,805
Restricted cash ........................................................................... 1,098 1,129
Accounts receivable, net of allowances .................................................... 1,681 1,601
Inventories ............................................................................... 3,227 607
Prepaid expenses and other current assets ................................................. 563 857
Due from contract manufacturer ............................................................ - 380
--------- ---------

Total current assets .................................................................. 65,162 79,379

Property and equipment, net .................................................................... 2,635 3,454
Other assets ................................................................................... 51 171
--------- ---------

Total assets ....................................................................... $ 67,848 $ 83,004
========= =========

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities
Accounts payable .......................................................................... $ 2,486 $ 1,350
Accrued expenses .......................................................................... 1,227 2,518
Accrued restructuring and other charges ................................................... 653 1,368
Due to contract manufacturer .............................................................. - 3,117
Deferred revenue .......................................................................... - 93
Current portion of capital lease obligations and notes payable ............................ 22 60
--------- ---------

Total current liabilities ............................................................. 4,388 8,506

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

Stockholders' equity

Preferred stock ........................................................................... - -
Common stock .............................................................................. 355 352
Additional paid-in capital ................................................................ 174,338 175,288
Accumulated deficit ....................................................................... (105,944) (93,438)
Notes receivable from stockholders ........................................................ (529) (702)
Deferred stock compensation ............................................................... (1,541) (6,813)
Treasury stock, at cost ................................................................... (3,219) (198)
--------- ---------

Total stockholders' equity ............................................................ 63,460 74,489
--------- ---------

Total liabilities and stockholders' equity ......................................... $ 67,848 $ 83,004
========= =========

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

2

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

Three months ended June 30, Nine months ended June 30,
--------------------------- --------------------------
2002 2001 2002 2001
---------- ---------- ---------- -----------

Net revenues .............................................................. $ 4,130 $ 2,380 $ 9,265 $ 11,790

Cost of revenues:
Cost of revenues ...................................................... 3,406 2,160 8,186 10,808
Cost of revenues stock compensation ................................... 1 80 133 251
Inventory write-down (recovery) ...................................... -- (2,837) -- 20,820
-------- -------- -------- --------

Total cost of revenues ................................................ 3,407 (597) 8,319 31,879
-------- -------- -------- --------

Gross profit (loss) ................................................. 723 2,977 946 (20,089)

Operating expenses:
Research and development .............................................. 914 3,067 3,717 10,909
Selling and marketing ................................................. 874 4,156 2,846 16,548
General and administrative ............................................ 1,088 1,238 3,734 5,691
Stock compensation .................................................... 237 2,217 4,072 4,844
Restructuring and other charges ....................................... 353 2,812 353 4,015
Amortization of goodwill and intangible assets ........................ -- 225 -- 600
-------- -------- -------- --------

Total operating expenses ............................................ 3,466 13,715 14,722 42,607
-------- -------- -------- --------

Loss from operations ...................................................... (2,743) (10,738) (13,776) (62,696)
Other income, net ......................................................... 324 1,098 1,270 4,392
-------- -------- -------- --------

Net loss .................................................................. $ (2,419) $ (9,640) $(12,506) $(58,304)
======== ======== ======== ========

Net loss per common share - basic and diluted ............................. $ (0.08) $ (0.28) $ (0.38) $ (1.71)
======== ======== ======== ========

Shares used in computing net loss per common share - basic and diluted .... 32,176 34,436 32,789 34,159

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

3

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

Nine months ended June 30,
--------------------------
2002 2001
--------- ---------

Cash flows from operating activities:
Net loss ....................................................................................... $ (12,506) $ (58,304)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization .............................................................. 1,141 2,957
Provision for inventory reserve, net ....................................................... - 20,820
Provision for doubtful accounts ............................................................ 170 665
Stock compensation ......................................................................... 4,205 5,279
Interest on notes receivable from stockholders ............................................. (28) (13)
Non-cash portion of restructuring and other charges ........................................ - 1,203
Changes in operating assets and liabilities, net of effects of acquisition in 2001:
Accounts receivable .................................................................... (250) 9,222
Inventories ............................................................................ (2,620) (14,953)
Prepaid expenses and other current assets .............................................. 294 595
Due from contract manufacturer ......................................................... 380 6,802
Accounts payable ....................................................................... 1,136 (3,804)
Due to contract manufacturer ........................................................... (3,117) 4,726
Accrued expenses ....................................................................... (2,006) (1,145)
Deferred revenue ....................................................................... (93) (683)
--------- ---------

Net cash used in operating activities ............................................... (13,294) (26,633)

Cash flows from investing activities:
Purchases of property and equipment ............................................................ (322) (2,626)
Change in restricted cash ...................................................................... 31 (1,051)
Changes in other assets ........................................................................ 120 30
Acquisition of business including acquisition expenses ......................................... - (30)
--------- ---------

Net cash used in investing activities ............................................... (171) (3,677)

Cash flows from financing activities:
Payments on capital lease obligations and notes payable ........................................ (47) (64)
Collection of notes receivable from stockholders ............................................... 201 -
Loans to stockholders .......................................................................... - (812)
Acquisition of treasury stock .................................................................. (3,021) -
Proceeds from issuance of common stock ......................................................... 120 476
--------- ---------

Net cash used in financing activities ............................................... (2,747) (400)
--------- ---------

Net decrease in cash and cash equivalents ........................................................... (16,212) (30,710)
Cash and cash equivalents, beginning of period ...................................................... 74,805 112,382
--------- ---------

Cash and cash equivalents, end of period ............................................................ $ 58,593 $ 81,672
========= =========

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

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NETWORK ENGINES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

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

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

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

2. SIGNIFICANT ACCOUNTING POLICIES

Recent Accounting Pronouncements

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

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

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NETWORK ENGINES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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

In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities" ("SFAS No. 146"). This statement addresses
financial accounting and reporting for costs associated with exit or disposal
activities and nullifies EITF Issue No. 94-3, "Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring)" ("EITF 94-3"). SFAS No. 146 requires
that a liability for a cost associated with an exit or disposal activity be
recognized when the liability is incurred. EITF 94-3 allowed for an exit cost
liability to be recognized at the date of an entity's commitment to an exit
plan. SFAS 146 also requires that liabilities recorded in connection with exit
plans be initially measured at fair value. The provisions of SFAS 146 are
effective for exit or disposal activities that are initiated after December 31,
2002, with early adoption encouraged. The Company does not expect the adoption
of SFAS 146 will have a material impact on its financial position or results of
operations.

Comprehensive Loss

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

Segment Reporting

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

Significant Customers

During the three and nine-month periods ended June 30, 2002, one customer
accounted for approximately 84% ($3.5 million) and 79% ($7.3 million) of the
Company's net revenues, respectively; this same customer accounted for
approximately 75% ($1.7 million) of the Company's gross accounts receivable at
June 30, 2002. During the three months ended June 30, 2001, two customers each
accounted for approximately 11% ($250,000) of the Company's net revenues. During
the nine months ended June 30, 2001, no single customer accounted for greater
than 10% of the Company's net revenues. One customer accounted for approximately
21% ($543,000) of the Company's gross accounts receivable at September 30, 2001.

3. NET LOSS PER SHARE

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

6

NETWORK ENGINES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

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

As of
June 30,
--------------------
2002 2001
--------- ---------

Options to purchase common stock .............................. 4,399 6,034
Warrants to purchase common stock ............................. 1,625 1,625
Unvested restricted common stock .............................. 210 458
--------- ---------

6,234 8,117
========= =========

4. INVENTORIES

Inventories consisted of the following (in thousands):

June 30, September 30,
2002 2001
------------- ----------------

Raw materials .................................... $ 1,216 $ 226
Work in process .................................. 528 235
Finished goods ................................... 1,483 146
------------- ----------------

$ 3,227 $ 607
============= ================

In November 2001, the Company entered into an agreement to engage a third
party to provide long-term product support for the Company's discontinued
product lines. Under the terms of this agreement, the Company agreed to provide
the third party with training, documentation and access to qualified employees
of the Company. The Company also transferred certain inventory with a book value
of zero on hand at the time of the agreement to this third party in exchange for
the third party's agreement to assume all warranty support services to previous
purchasers of the Company's discontinued products. This transaction had an
immaterial impact on the Company's financial position and results from
operations.

5. COMMITMENTS AND CONTINGENCIES

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

On or about December 3, 2001, Margaret Vojnovich filed a lawsuit in the United
States District Court for the Southern District of New York against Network
Engines, Inc., Lawrence A. Genovesi, the Company's current Chairman and former
Chief Executive Officer, and Douglas G. Bryant, the Company's Chief Financial
Officer and Vice President of Administration (collectively, the "Executive
Officers"), FleetBoston Robertson Stephens, Inc. Credit Suisse First Boston
Corp., Goldman Sachs & Co., Lehman Brothers Inc. and Salomon Smith Barney, Inc.
underwriters of the Company's initial public offering in July 2000 (the "IPO")
(collectively, the "Underwriter Defendants"). The suit generally alleges that
the Underwriter Defendants violated the federal securities laws by conspiring to
increase the compensation

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NETWORK ENGINES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

received by the Underwriter Defendants by agreeing with some recipients of an
allocation of IPO stock that the recipients would purchase shares of securities
in the after-market of the IPO at pre-determined price levels designed to
maintain, distort and/or inflate the price of the Company's common stock in the
aftermarket. The suit also alleges that the Underwriter Defendants received
undisclosed and excessive brokerage commissions and that, as a consequence, the
Underwriter Defendants successfully increased investor interest in the
manipulated IPO securities and increased the Underwriter Defendants' individual
and collective underwritings, compensation and revenues. The suit further
alleges that the defendants violated the federal securities laws by issuing and
selling securities pursuant to the IPO without disclosing to investors that the
Underwriter Defendants in the offering, including the lead underwriters, had
solicited and received excessive and undisclosed commissions from certain
investors. The suit seeks damages, rescission of the purchase prices paid by
purchasers of shares of the Company's common stock and certification of a
plaintiff class consisting of all persons who acquired shares of the Company's
common stock between July 13, 2000 and December 6, 2000. An amended Class Action
Complaint was filed on April 20, 2002 (the "Amended Complaint"). The Amended
Complaint, captioned, In re Network Engines, Inc. Initial Public Offering
Securities Litigation, 01 Civ. 10894 (SAS) alleges violations of the federal
securities laws in connection with the Company's IPO conducted on or about July
13, 2000, and the trading of the Company's common stock in the aftermarket from
the date of the IPO through December 6, 2000. The Company is in the process of
reviewing this suit and intends to respond in a timely manner. The Company is
unable to predict the outcome of this suit and its ultimate effect, if any, on
the Company's financial condition, however the Company's defense against these
claims could result in the expenditure of significant financial and managerial
resources.

On August 14, 2001, the Company announced that its Board of Directors had
approved the repurchase of up to $5.0 million of the Company's common stock in
the open market or in non-solicited privately negotiated transactions. The
Company plans to use any repurchased shares for its employee stock plans. During
the year ended September 30, 2001 and the nine months ended June 30, 2002, the
Company repurchased 300,900 and 3,191,082 shares of common stock at a cost of
approximately $198,000 and $3,021,000, respectively. The nine-month activity
includes the repurchase of 1,023,210 shares at a cost of approximately
$1,037,000 during the three months ended June 30, 2002.

6. ACQUISITION OF IP PERFORMANCE

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

In July 2001, the Company completed an intensive review of its business, which
resulted in its implementation of a restructuring plan. This restructuring plan
included a discontinuation of much of the customized hardware and software that
had previously been a part of the Company's product development process. As a
result of this restructuring and an assessment of expected future cash flows,
the Company determined that the recoverability of the IP Performance-related
intangible assets was unlikely. Accordingly, the Company recognized an
impairment charge for the full amount of the remaining un-amortized intangible
assets, approximately $2,023,000, during the fourth quarter of fiscal 2001.
Prior to the impairment, the Company had been amortizing the goodwill and
intangible assets over a three-year period, resulting in approximately $225,000
and $600,000 of amortization expense during the three and nine-month periods
ended June 30, 2001, respectively.

8

NETWORK ENGINES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

The Company also issued 321,756 shares of restricted common stock to key
employee shareholders of IP Performance. Under the terms of the restricted stock
agreements, these shares were restricted as to sale and such restrictions lapsed
in three equal annual installments, beginning on November 8, 2001, contingent
upon continued employment of the holder. In connection with the issuance of
these restricted shares, the Company recorded approximately $6,351,000 of
deferred compensation, which was being recognized as stock compensation expense
ratably over the vesting period. During the nine months ended June 30, 2002, the
Company terminated the employment of all of the former IP Performance employees.
In accordance with the restricted stock agreements with these individuals, all
of the remaining unvested restricted stock vested upon termination. As a result,
during the nine months ended June 30, 2002, the Company recognized the remaining
deferred stock compensation of approximately $3,461,000.

7. INVENTORY WRITE-DOWN

During the nine months ended June 30, 2001, the Company recorded a net
inventory write-down of approximately $20,820,000 for excess and obsolete
inventory related to the Company's WebEngine Blazer, WebEngine Sierra and
StorageEngine Voyager products. This excess and obsolete inventory was due to an
unanticipated shortfall in sales of these products and the resulting reduction
in expected future sales of these products. The net write-down included
inventory held at the Company's contract manufacturer, inventory on-hand and
firm purchase commitments as of June 30, 2001. During the three months ended
June 30, 2001, the Company reversed approximately $2,837,000 of inventory
reserves recorded during the six months ended March 31, 2001. The reversal was
the result of the Company's better-than-expected sales of products and
components during the quarter ended June 30, 2001, as well as more favorable
negotiations with vendors on inventory commitments, which had been included in
the previously recorded inventory write-down.

8. RESTRUCTURING AND OTHER CHARGES

During the year ended September 30, 2001, the Company undertook two
restructurings of its operations, the first of these restructurings occurred in
April 2001 and the second in July 2001. Through the April 2001 restructuring,
the Company sought to better align the Company's operating expenses with reduced
revenues, and as a result of its implementation, the Company recorded a charge
to operations of $2,812,000. This charge was due to a reduction in workforce
from 243 employees to 170 employees, the curtailment of a planned expansion into
leased facilities and other items. This charge included approximately $951,000
for employee related costs including severance payments to terminated employees
and stock option compensation expense related to modifications of certain stock
options held by terminated employees, approximately $1,331,000 to write off
certain assets related to facilities that the Company will not be occupying and
approximately $530,000 primarily related to non-refundable deposits on
tradeshows the Company would not be attending as well as certain other sales and
marketing commitments. The Company's July 2001 restructuring was the result of
an intensive review of its business, which resulted in a refocus of the
Company's sales strategy toward strategic partnerships with independent software
vendors (ISVs) and original equipment manufacturers (OEMs) and a discontinuation
of much of the customized hardware and software that was previously included in
the Company's products. As a result of the implementation of the July 2001
restructuring, the Company recorded a charge to operations of approximately
$6,871,000. This charge included approximately $1,643,000 of employee related
costs as the Company reduced its workforce by 65 employees, approximately
$2,224,000 as a result of the Company's disposal of certain property and
equipment, approximately $2,023,000 to write off goodwill and intangible assets
which were deemed to be impaired, approximately $618,000 of facility costs
associated with non-cancelable operating leases for space which will not be
occupied and approximately $363,000 of other charges. In addition to the April
2001 and July 2001 restructurings, in March 2001 the Company recorded a charge
due to the retirement of fixed assets related to its WebEngine Blazer product
line. These fixed assets had a total net book value of approximately $1,203,000
and consisted primarily of computer equipment previously utilized in the
production and sales of the WebEngine Blazer, the Company's previous generation
web content server appliance product. The total of the restructuring and other
charges detailed above was approximately $10,886,000 recorded for the year ended
September 30, 2001. The reduction in the Company's workforce implemented during
the year ended September 30, 2001 impacted employees in

9

NETWORK ENGINES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

all of the Company's groups, including manufacturing, research and development,
selling and marketing and general and administrative.

During the three months ended June 30, 2002, the Company implemented an
additional restructuring. In an effort to further streamline its operations the
Company reduced its workforce by 13 employees, which impacted employees in all
of the Company's groups. The implementation of this reduction in workforce
resulted in a charge of $353,000 to operations, which is comprised entirely of
employee related charges, including severance payments to terminated employees.

The following table sets forth restructuring accrual activity during the nine
months ended June 30, 2002:

Employee Facility
Related Related Other Total
----------- --------- --------- ---------

Restructuring accrual balance at September 30, 2001 $ 491 $ 559 $ 318 $ 1,368

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

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

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

----------- --------- --------- ---------
Restructuring accrual balance at March 31, 2002 118 400 76 594

Restructuring charge 353 - - 353

Cash payments (213) (56) (25) (294)

----------- --------- --------- ---------
Restructuring accrual balance at June 30, 2002 $ 258 $ 344 $ 51 $ 653
=========== ========= ========= =========

The Company expects the remaining restructuring accrual balance to be
substantially utilized by June 30, 2003, including cash payments of
approximately $650,000.

9. RELATED PARTY TRANSACTIONS

In January 2001, the Company entered into a series of related agreements with
Lawrence A. Genovesi, the Company's current Chairman and former President, Chief
Executive Officer and Chief Technology Officer. These agreements were entered
into to avoid significant sales of the Company's stock by Mr. Genovesi as a
result of a margin call on a personal loan collateralized by Mr. Genovesi's
holdings of the Company's common stock. The Company agreed to guarantee a
personal loan obtained by Mr. Genovesi from a financial institution (the "Bank")
through a deposit of $1,051,850 of the Company's cash with the Bank (the
"Guarantee"). The Guarantee period ended on January 9, 2002 and the Company
extended the Guarantee to January 9, 2003, at which time the balance of the
amount deposited with the Bank, which is not required to satisfy any obligations
under the Guarantee, will be returned to the Company. Mr. Genovesi and the
Company also entered into an agreement whereby Mr. Genovesi has agreed to
reimburse the Company for any obligations incurred by the Company under the
Guarantee (the "Reimbursement Agreement"). Any unpaid balances under the
Reimbursement Agreement bear interest at a rate of 10% per annum. In the event
of a default under the Reimbursement Agreement by Mr. Genovesi, the Company has
the right to apply any and all compensation due to Mr. Genovesi against all of
Mr. Genovesi's obligations outstanding under the Reimbursement Agreement. In
addition, the Company and Mr. Genovesi entered into a revolving promissory note
of up to $210,000 (the "Note"). The Note bore interest at a rate of 5.9% per
annum and was due and payable in full upon the earlier of January 9, 2002 or 30
days following the date Mr. Genovesi ceased to be an employee of the Company.
Mr. Genovesi borrowed approximately $75,000

10

NETWORK ENGINES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

under the Note, which was re-paid in full in November 2001, plus accrued
interest of approximately $2,000.

In conjunction with the Guarantee, the Reimbursement Agreement and the Note,
the Company and Mr. Genovesi entered into a pledge agreement whereby Mr.
Genovesi pledged to the Company all shares of the Company's common stock owned
by Mr. Genovesi as of the date of the agreement or subsequently acquired, and
all options and other rights to acquire shares of the Company's common stock
owned by Mr. Genovesi as of the date of the agreement or subsequently acquired
(collectively, the "Pledged Securities"). Additionally, Mr. Genovesi pledged to
the Company all additional securities or other consideration from time to time
acquired by Mr. Genovesi in substitution for, or in respect of, the Pledged
Securities. If Mr. Genovesi elects to sell any of the Pledged Securities during
the term of the agreement, all proceeds of such sale will be applied to any
amounts payable under the Reimbursement Agreement. In addition to the Pledged
Securities, Mr. Genovesi's obligations under the Reimbursement Agreement are
collateralized by a second mortgage on certain real property owned by Mr.
Genovesi. As of June 30, 2002, no amounts were required to be reimbursed to the
Company under the Reimbursement Agreement. In November 2001, the Company
repurchased 234,822 shares of the Company's common stock from Mr. Genovesi for
$225,195 in a private transaction. The purchase price was determined based on
the average closing price of the Company's common stock over the ten trading
days prior to the purchase date. Mr. Genovesi used the proceeds to pay all
amounts outstanding under the Note, to pay down a recourse note payable to the
Company and to pay taxes incurred in connection with the Company's repurchase of
its common stock from Mr. Genovesi. The Company recorded the repurchased shares
as treasury stock at the cost paid to Mr. Genovesi.

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

In April 2002, one former officer's loan was repaid in full, including accrued
interest of approximately $2,500, through a payment to the Company of $29,727 of
cash and a sale to the Company of 30,000 shares of the Company's common stock in
exchange for the retirement of $27,000 of the former officer's note payable. The
price per share of the Company's common stock was based on the market price as
of the close of business on the date of the repurchase. The common stock
repurchased was recorded as treasury stock at the cost to repurchase. Because
the amounts outstanding under certain of the Loan Agreements exceeded the value
of the Company's common stock pledged as collateral, in January 2002 the Company
extended the repayment dates to September 2002 for loans with an aggregate
principal amount of $226,996 due from one of its current officers and one of its
former officers and in March 2002 the Company extended the repayment dates to
July 2002 for the remaining loans with an aggregate principal amount of
$456,126. Subsequently, in early July 2002, the Company also extended the
repayment dates for these remaining loans to September 2002.

11

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

Special Note Regarding Forward-Looking Statements

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

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

Overview

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

Over time, much of the hardware components of server appliances have become
commoditized and a significant number of companies entered the server appliance
marketplace. In response to competitive pressures combined with the effects of a
downturn in the economy, which had a significant negative impact on our "new
economy" customers, we implemented a restructuring plan in the quarter ended
June 30, 2001, to better align our operating expenses with our reduced revenues.
This restructuring plan resulted in a $2.8 million charge to operations in April
2001, a 73-employee reduction in our workforce, as well as the curtailment of
planned facility expansion and other cost cutting measures. We further undertook
an extensive review of our business strategy and, in July 2001, we implemented a
second restructuring of our business, which de-emphasized much of our customized
hardware and software development and focused our resources on what we believe
to be our core competencies of hardware packaging, software integration and
supply chain management. In addition, this restructuring of our business
included a transition from primarily direct sales channels to partnerships with
ISVs and OEMs in order to allow them to offer "turn-key" server appliance
solutions to enterprise customers. Our current server appliance hardware
platforms continue to combine creative hardware packaging, cooling and software
integration to provide high-density, server appliances. In addition, the
implementation of our July 2001 restructuring plan included a reduction in our
workforce from 160 employees to 95 employees. We incurred a charge to operations
of approximately $6.9 million in the fourth quarter ended September 30, 2001 as
we executed our July 2001 restructuring plan. In an effort to further streamline
our operations we reduced our workforce by 13

12

employees during the three months ended June 30, 2002. As a result of this
workforce reduction, we recorded a charge to operations of $353,000 during the
three months ended June 30, 2002. At June 30, 2002, we had an accumulated
deficit of approximately $105.9 million.

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

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

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

Research and development expenses consist primarily of salaries and related
expenses for personnel engaged in research and development, fees paid to
consultants and outside service providers, material costs for prototype and test
units and other expenses related to the design, development, testing and
enhancements of our products. We expense all of our research and development
costs as they are incurred. We believe that a significant level of investment in
product development is required to remain competitive. We expect to continue to
devote substantial resources to product development. As a result, we expect
research and development expenses to remain constant in absolute dollars during
the remainder of fiscal 2002 as we continue our transition away from the
internal development of significant proprietary hardware and software. At June
30, 2002, there were 20 employees in research and development.

Selling and marketing expenses consist primarily of salaries, commissions and
related expenses for personnel engaged in sales, marketing and customer support
functions, as well as costs associated with advertising, trade shows, public
relations and marketing materials. We expect selling and marketing expenses to
increase in absolute dollars during the remainder of fiscal 2002 as we expand
our sales and marketing efforts to increase our market presence. At June 30,
2002, there were 10 employees in sales, marketing and customer support.

General and administrative expenses consist primarily of salaries and other
related costs for executive, finance, accounting, information technology,
facilities and human resources personnel, as well as accounting, legal, other
professional fees, administrative expenses associated with operating as a public
company and allowance for doubtful accounts. We expect general and
administrative expenses to increase slightly during the remainder of fiscal 2002
due to the rising costs associated with operating as a public company. There
were 13 general and administrative employees at June 30, 2002.

We recorded deferred stock compensation on our balance sheet of $15.5 million
in connection with stock option and restricted stock grants to our employees and
directors that were granted between February 1, 1999 and June 30, 2000. This
amount represents the difference between the exercise price and the deemed fair
value of our common stock for financial reporting purposes at the date of grant.
We are amortizing this stock compensation over the vesting period of the related
options. All options granted subsequent to June 30, 2000 have been issued with
exercise prices equal to the fair market value of our common stock and,
accordingly, no additional deferred compensation has been recorded. Through June
30, 2002, we amortized $7.0 million to stock compensation expense and $7.0
million of deferred stock compensation has been reversed due to the cancellation
of options for terminated employees.

We recorded $6.4 million of deferred compensation on our balance sheet as a
result of restricted stock issued to the former employees of IP Performance,
Inc. ("IP Performance") who were retained as our employees in connection with
our acquisition of IP Performance in November 2000. The restricted stock

13

was to vest annually through November 2003 contingent upon continued employment.
During fiscal 2002, we terminated the employment of all of the former IP
Performance employees. In accordance with the restricted stock agreements, all
of the remaining unvested restricted stock vested upon termination. As a result,
during the nine months ended June 30, 2002, the Company recognized the remaining
deferred stock compensation of approximately $3.5 million.

We expect quarterly stock compensation amortization of approximately $220,000
during the remainder of fiscal 2002 and 2003 and an aggregate of approximately
$441,000 thereafter. The amount of stock compensation expense to be recorded in
future periods could change if restricted stock or options for accrued but
unvested compensation are forfeited.

Critical Accounting Policies And Estimates

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

We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our condensed
consolidated financial statements. We maintain allowances for doubtful accounts
for estimated losses resulting from the inability of our customers to make
required payments. If the financial condition of our customers were to
deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required. We assess the collectibility of revenue
at the point of each sale based upon all available information. We recognize
revenues upon shipment of our products to our customers. Our customers are not
granted rights to return our products to us after the purchase has been made.
However, in certain circumstances, we have accepted returns although we were not
contractually obligated to. We record a provision for potential returns based on
our historical return information. Estimates of collectibility are affected by
our customers' financial condition at the point of sale and these estimates may
differ from actual results. We write down our inventory for estimated
obsolescence or unmarketable inventory equal to the difference between the cost
of inventory and the estimated market value based upon assumptions about future
demand and market conditions. If actual market conditions are less favorable
than those projected by management, additional inventory write-downs may be
required.

Results of Operations

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

14

Three months ended June Nine months ended June
30, 30,
----------------------- ----------------------
2002 2001 2002 2001
--------- ------------ ----------- ---------

Net revenues ............................................... 100% 100% 100% 100%

Cost of revenues:
Cost of revenues ...................................... 82 91 88 92
Cost of revenues stock compensation ................... - 3 2 2
Inventory write-down (recovery) ...................... - (119) - 176
--------- --------- --------- ---------

Total cost of revenues ................................ 82 (25) 90 270
--------- --------- --------- ---------

Gross profit (loss) ................................ 18 125 10 (170)

Operating expenses:
Research and development .............................. 22 129 40 93
Selling and marketing ................................. 21 175 31 140
General and administrative ............................ 26 52 40 48
Stock compensation .................................... 6 93 44 41
Restructuring and other charges ....................... 9 118 4 34
Amortization of goodwill and intangible assets ........ - 9 - 5
--------- --------- --------- ---------

Total operating expenses ........................... 84 576 159 361
--------- --------- --------- ---------

Loss from operations ....................................... (66) (451) (149) (531)
Other income ............................................... 7 46 14 37
--------- --------- --------- ---------

Net loss.................................................... (59%) (405%) (135%) (494%)
========= ========= ========= =========

Three Months Ended June 30, 2002 and June 30, 2001

Net Revenues

Net revenues increased to $4.1 million in the three months ended June 30, 2002
from $2.4 million in the three months ended June 30, 2001. This increase is due
to higher sales volumes as a result of sales to a large OEM customer in the
three months ended June 30, 2002 for which there was no comparable customer
during the three months ended June 30, 2001. This customer accounted for 84% of
our net revenues during the three months ended June 30, 2002. The increase in
net revenues in the three months ended June 30, 2002 was offset somewhat by a
decrease in license revenues in the three months ended June 30, 2002 as compared
to the three months ended June 30, 2001. License revenues in the three months
ended June 30, 2002 were immaterial and we do not expect significant future
license revenues.

Gross Profit

In the three months ended June 30, 2002, we had a gross profit of $723,000, a
decrease from a gross profit of $3.0 million in the three months ended June 30,
2001. This decline in gross profit was due primarily to the reversal of $2.8
million of inventory reserves during the three months ended June 30, 2001 for
which there was no comparable amount during the three months ended June 30,
2002. Excluding the reversal of inventory reserves and stock compensation, gross
profit increased to $724,000, or 17.5% of net revenues, in the three months
ended June 30, 2002 from a gross profit of $220,000, or 9.2% of net revenues, in
the three months ended June 30, 2001. This increase is the result of an increase
in product sales volumes in the three months ended June 30, 2002 and lower
manufacturing costs in the three months ended June 30, 2002 as a result of the
restructurings that we implemented in fiscal 2001. The increase in gross profit
was partially offset by a decrease in license revenues during the three months
ended June 30, 2002 as compared to the three months ended June 30, 2001. License
revenues in the three months ended June 30, 2002 were immaterial and we do not
expect significant future license revenues.

Operating Expenses

15

Research and Development. Research and development expenses decreased to
$914,000 in the three months ended June 30, 2002 from $3.1 million in the three
months ended June 30, 2001. This decrease was due primarily to decreased
compensation costs as research and development personnel decreased from 81
employees at June 30, 2001 to 20 employees at June 30, 2002.

Selling and Marketing. Selling and marketing expenses decreased to $874,000 in
the three months ended June 30, 2002 from $4.2 million in the three months ended
June 30, 2001. This decrease was due to decreased compensation costs as sales,
marketing and customer support personnel decreased from 49 employees at June 30,
2001 to 10 employees at June 30, 2002. The decrease was also due to a
significant reduction in spending on marketing programs, as we did not have any
trade show or advertising expenditures in the three months ended June 30, 2002.
To a lesser extent, decreased travel costs also contributed to the decrease in
selling and marketing expenses during the three months ended June 30, 2002 as a
result of the decrease in sales, marketing and customer support personnel.

General and Administrative. General and administrative expenses decreased to
$1.1 million in the three months ended June 30, 2002 from $1.2 million in the
three months ended June 30, 2001. The decrease in general and administrative
expenses is primarily attributable to decreased compensation costs as general
and administrative personnel decreased from 19 employees as of June 30, 2001 to
13 employees as of June 30, 2002.

Stock Compensation. We recognized stock compensation expense of $238,000 and
$2.3 million in the three months ended June 30, 2002 and 2001, respectively,
related to the grant of options and restricted stock to employees and directors
prior to our initial public offering in fiscal 2000 and in connection with
restricted stock issued to employees as a result of our acquisition of IP
Performance, Inc. in November 2000. The decrease in stock compensation expense
in the three months ended June 30, 2002 is the result of forfeitures of unvested
options and restricted stock with unrecognized compensation previously held by
terminated employees.

Restructuring and other charges. In the three months ended June 30, 2001, we
recorded a charge to operations of $2.8 million. This charge was due to a
reduction in our workforce from 243 employees to 170 employees, the curtailment
of a planned expansion into leased facilities and other items. This
restructuring was to better align our operating expenses with reduced revenues.
This charge included approximately $951,000 for employee termination related
costs, approximately $1.3 million to write off certain assets related to
facilities that we will not be occupying and approximately $530,000 primarily
related to non-refundable deposits on tradeshows we would not be attending as
well as certain other sales and marketing commitments. In the three months ended
June 30, 2002, we further streamlined our operations by reducing our workforce
by 13 employees. As a result of this workforce reduction, we recorded a
restructuring charge of $353,000, which is comprised entirely of employee
termination related charges.

Amortization of Goodwill and Intangible Assets. In connection with our
acquisition of IP Performance, Inc. in November 2000, we recorded goodwill and
intangible assets of $2.7 million, of which we amortized $225,000 in the three
months ended June 30, 2001. During fiscal 2001, we completed an intensive review
of our business, which resulted in our implementation of a restructuring plan.
As a result of this restructuring and an assessment of expected future cash
flows, we determined that the recoverability of intangible assets resulting from
our purchase of IP Performance, Inc. was unlikely. Accordingly, we recognized an
impairment charge for the full amount of the remaining unamortized intangible
assets, approximately $2.0 million during the fourth quarter of fiscal 2001.

Other income, net

Other income, net decreased to $324,000 in the three months ended June 30,
2002 from $1.1 million in the three months ended June 30, 2001. This decrease
was due to lower average interest rates earned on our cash equivalents and a
lower average cash and cash equivalents balance during the three months ended
June 30, 2002 as a result of utilizing cash and cash equivalents to fund net
operating losses incurred since our initial public offering in July 2000.

16

Nine Months Ended June 30, 2002 and June 30, 2001

Net Revenues

Net revenues decreased to $9.3 million in the nine months ended June 30, 2002
from $11.8 million in the nine months ended June 30, 2001. This decrease is
primarily due to lower average unit sell prices offset to some extent by an
increase in the number of units sold as a result of a high concentration of OEM
revenues in the nine months ended June 30, 2002. During the nine months ended
June 30, 2002 one OEM customer accounted for 79% of our net revenues. To a
lesser extent, the decrease in net revenues is due to a decrease in license
revenues during the nine months ended June 30, 2002 as compared to the nine
months ended June 30, 2001. License revenues in the nine months ended June 30,
2002 were immaterial and we do not expect significant future license revenues.

Gross Profit (Loss)

In the nine months ended June 30, 2002, we had a gross profit of $946,000, an
improvement from a gross loss of $20.1 million in the nine months ended June 30,
2001. During the nine months ended June 30, 2001, we recorded a net inventory
write-down of approximately $20.8 million for which there was no corresponding
charge in the nine months ended June 30, 2002. The inventory write-down resulted
from an unanticipated decline in sales during the nine months ended June 30,
2001, as well as a high level of inventory and firm inventory commitments
compared to the Company's reduced expectations for future product sales at that
time. Excluding the inventory write-down and stock compensation, gross profit
increased to $1.1 million, or 11.6% of net revenues, in the nine months ended
June 30, 2002 from a gross profit of $982,000, or 8.3% of net revenues, in the
nine months ended June 30, 2001. This increase is primarily due to lower
manufacturing costs as a result of the restructurings that we implemented in
fiscal 2001 and a decrease in component costs, which is due to our increased use
of standard off-the-shelf components in our products and the general economic
slowdown of the past year. A decrease in license revenues during the nine months
ended June 30, 2002 partially offset the increase in gross profit. License
revenues in the nine months ended June 30, 2002 were immaterial and we do not
expect significant future license revenues.

Operating Expenses

Research and Development. Research and development expenses decreased to $3.7
million in the nine months ended June 30, 2002 from $10.9 million in the nine
months ended June 30, 2001. This decrease was due primarily to decreased
compensation and recruiting costs as research and development personnel
decreased from 81 employees at June 30, 2001 to 20 employees at June 30, 2002.
The decrease in research and development expenses is also due to decreases in
consulting, prototype and test unit costs as we have increased the use of
standard off-the-shelf components in our products, which has reduced our need to
build prototype and test units and has allowed us to utilize fewer consultants
in our product development process.

Selling and Marketing. Selling and marketing expenses decreased to $2.8
million in the nine months ended June 30, 2002 from $16.5 million in the nine
months ended June 30, 2001. This decrease was due primarily to decreased
compensation and recruiting costs as sales, marketing and customer support
personnel decreased from 49 employees at June 30, 2001 to 10 employees at June
30, 2002. The decrease was also due to a significant reduction in spending on
marketing programs, as we did not have any trade show or advertising
expenditures in the three months ended June 30, 2002. To a lesser extent,
decreased travel costs also contributed to the decrease in selling and marketing
expenses during the nine months ended June 30, 2002 as a result of the decrease
in sales, marketing and customer support personnel.

General and Administrative. General and administrative expenses decreased to
$3.7 million in the nine months ended June 30, 2002 from $5.7 million in the
nine months ended June 30, 2001. The decrease in general and administrative
expenses is attributable to lower compensation and recruiting costs as general
and administrative personnel decreased from 19 employees as of June 30, 2001 to
13 employees as of June 30, 2002. The decrease in general and administrative
expenses is also due to lower bad debt expenses during the nine months ended
June 30, 2002. During the nine months ended June 30, 2001 we recognized a
significant bad debt expense as a result of the economic down-turn during that
time period and the

17

concentration of our customers in the "dot com" sector, which was significantly
affected by the overall economy. In addition, the decrease in general and
administrative expenses is also due to lower consulting and professional service
fees. The decrease in general and administrative expenses was somewhat offset by
a charge recorded during the nine months ended June 30, 2002 to settle a
lawsuit, which was previously filed against us December 29, 1999 by a former
employee.

Stock Compensation. We recognized stock compensation expense of $4.2 million
and $5.1 million in the nine months ended June 30, 2002 and 2001, respectively,
related to the grant of options and restricted stock to employees and directors
prior to our initial public offering in fiscal 2000 and in connection with
restricted stock issued to employees as a result of our acquisition of IP
Performance, Inc., in November 2000. The decrease in stock compensation expense
in the nine months ended June 30, 2002 is the result of forfeitures of unvested
options and restricted stock with unrecognized compensation previously held by
terminated employees. During the nine months ended June 30, 2002, we terminated
the employment of all of the remaining employees of IP Performance, Inc. In
accordance with the restricted stock agreements with these individuals, all of
the related restricted stock vested upon termination and all of the remaining
deferred stock compensation of $3.5 million was accelerated and recorded in the
nine months ended June 30, 2002, which partially offset the decrease in stock
compensation.

Restructuring and other charges. In the nine months ended June 30, 2001, we
recorded a charge to operations of $4.0 million. This charge was due to a
reduction in our workforce from 243 employees to 170 employees, the curtailment
of a planned expansion into leased facilities and other items. This
restructuring was to better align our operating expenses with reduced revenues.
This charge included approximately $951,000 for employee related costs including
severance payments to terminated employees and stock option compensation expense
related to modifications of certain stock options held by terminated employees,
approximately $1.3 million to write off certain assets related to facilities
that we will not be occupying and approximately $530,000 primarily related to
non-refundable deposits on tradeshows we would not be attending as well as
certain other sales and marketing commitments. Also included in our $4.0 million
restructuring charge during the nine months ended June 30, 2001 was a charge of
$1.2 million for the retirement of fixed assets related to our discontinued
WebEngine Blazer product line. These fixed assets consisted primarily of
computer equipment previously utilized in the production and sales of the
WebEngine Blazer. In the nine months ended June 30, 2002, we further streamlined
our operations by reducing our workforce by 13 employees. As a result of this
workforce reduction, we recorded a restructuring charge of $353,000, which is
comprised entirely of employee termination related charges.

Amortization of Goodwill and Intangible Assets. In connection with our
acquisition of IP Performance, Inc. in November 2000, we recorded goodwill and
intangible assets of $2.7 million, of which we amortized $600,000 in the nine
months ended June 30, 2001. During fiscal 2001, we completed an intensive review
of our business, which resulted in our implementation of a restructuring plan.
As a result of this restructuring and an assessment of expected future cash
flows, we determined that the recoverability of intangible assets resulting from
our purchase of IP Performance, Inc. was unlikely. Accordingly, we recognized an
impairment charge for the full amount of the remaining un-amortized intangible
assets, approximately $2.0 million, during the fourth quarter of fiscal 2001.

Other income, net

Other income, net decreased to $1.3 million in the nine months ended June 30,
2002 from $4.4 million in the nine months ended June 30, 2001. This decrease was
due to lower average interest rates earned on our cash equivalents and a lower
average cash and cash equivalents balance during the nine months ended June 30,
2002 as a result of utilizing cash and cash equivalents to fund our net
operating losses incurred since our initial public offering in July 2000.

Liquidity and Capital Resources

Since fiscal 1997, we have financed our operations primarily through the sale
of equity securities, borrowings and the sale of our products. On July 18, 2000,
we completed our initial public offering by selling 7,475,000 shares of our
common stock, including the exercise of the underwriters' overallotment

18

option of 975,000 shares, at $17 per share and raised approximately $116.9
million, net of offering costs and underwriting fees totaling approximately
$10.2 million. Prior to our initial public offering, we raised approximately
$37.3 million, net of offering costs, from the issuance of preferred stock. As
of June 30, 2002, we had $58.6 million in cash and cash equivalents, excluding
restricted cash of $1.1 million.

Cash used in operating activities was $13.3 million and $26.6 million in the
nine months ended June 30, 2002 and 2001, respectively. Cash used in operating
activities during the nine months ended June 30, 2002 was primarily due to a net
loss of $12.5 million and decreases in the amount due to our contract
manufacturer and accrued expenses and an increase in inventories and is offset
by adjustments for non-cash charges for stock compensation, depreciation and
amortization. Cash used in operating activities in the nine months ended June
30, 2001 was primarily due to a net loss of $58.3 million, an increase in
inventories and decreases in accounts payable and accrued expenses, offset in
part by a net increase in the amount due to our contract manufacturer, a
decrease in accounts receivable and adjustments for non-cash charges for
inventory reserves, stock compensation, depreciation and amortization.

Cash used in investing activities was $171,000 and $3.7 million in the nine
months ended June 30, 2002 and 2001, respectively. Cash used in investing
activities was primarily for purchases of property and equipment and other
assets during the nine months ended June 30, 2002. Cash used in investing
activities was primarily for purchases of property and equipment and other
assets and a deposit of restricted cash for an executive loan guarantee during
the nine months ended June 30, 2001.

Cash used in financing activities was $2.7 million and $400,000 during the
nine months ended June 30, 2002 and 2001, respectively. Cash used in financing
activities in the nine months ended June 30, 2002 was primarily for the
acquisition of treasury stock, offset in part by cash received upon the
repayment of stockholder notes receivable and the proceeds from employee stock
option and stock purchase plan activity. Cash used in financing activities in
the nine months ended June 30, 2001 was primarily from the issuance of
stockholder notes receivable, which was offset by the proceeds from employee
stock option and stock purchase plan activity.

On August 14, 2001, we announced that our Board of Directors had approved the
repurchase of up to $5 million of our common stock in the open market or in
non-solicited privately negotiated transactions. We plan to use repurchased
shares for our employee stock plans. During the year ended September 30, 2001
and nine months ended June 30, 2002, the Company repurchased 300,900 and
3,191,082 shares of common stock at a cost of approximately $198,000 and
$3,021,000, respectively.

As a result of restructurings implemented in fiscal 2001 and 2002, as of June
30, 2002 we are obligated to make additional cash payments of approximately
$650,000, the majority of which will be made over the next twelve months. We
anticipate that funds required to make all restructuring payments will be
available from our current working capital.

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

The following table sets forth future payments that we are obligated to make
under capital and operating lease commitments as of June 30, 2002 (in
thousands):

19

Fiscal year
-------------------------------
Contractual obligations 2002 2003 2004 2005 Total
- ----------------------- ---- ---- ---- ---- ------
Operating leases $212 $892 $916 $356 $2,376
Capital leases 22 - - - 22
---- ---- ---- ---- ------
Total contractual cash obligations $234 $892 $916 $356 $2,398

During the nine month period ended June 30, 2002, we did not engage in:

. material off-balance sheet activities, including the use of structured
finance or specific purpose entities;

. trading activities in non-exchange traded contracts; nor

. transactions with persons or entities that benefit from their
non-independent relationship with us, other than transactions
disclosed in footnote 9 to our condensed consolidated financial
statements.

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

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

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

. the level of success of our strategic ISV and OEM partners in selling
server appliance solutions that include our server appliance hardware
platforms;

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

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

. market developments.

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

Recent Accounting Pronouncements

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

In August 2001, the FASB issued Statement of Financial Accounting Standards
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS
144"). The objectives of SFAS 144 are to

20

address significant issues relating to the implementation of FASB Statement No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of" ("SFAS 121"), and to develop a single accounting
model, based on the framework established in SFAS 121, for long-lived assets to
be disposed of by sale, whether previously held and used or newly acquired. SFAS
144 supersedes SFAS 121; however, it retains the fundamental provisions of SFAS
121 for (1) the recognition and measurement of the impairment of long-lived
assets to be held and used and (2) the measurement of long-lived assets to be
disposed of by sale. SFAS 144 supersedes the accounting and reporting provisions
of Accounting Principles Board No. 30, "Reporting the Results of Operations -
Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary,
Unusual and Infrequently Occurring Events and Transactions" ("APB 30"), for
segments of a business to be disposed of. However, SFAS 144 retains APB 30's
requirement that entities report discontinued operations separately from
continuing operations and extends that reporting requirement to "a component of
an entity" that either has been disposed of or is classified as "held for sale."
SFAS 144 also amends the guidance of Accounting Research Bulletin No. 51,
"Consolidated Financial Statements," to eliminate the exception to consolidation
for a temporarily controlled subsidiary. SFAS 144 is effective for financial
statements issued for fiscal years beginning after December 15, 2001, including
interim periods, and, generally, its provisions are to be applied prospectively.
We do not expect SFAS 144 to have a material impact on our financial position or
the results of our operations.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities," or SFAS 146. This statement addresses
financial accounting and reporting for costs associated with exit or disposal
activities and nullifies EITF Issue 94-3, "Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring)," or EITF 94-3. SFAS 146 requires
that a liability for a cost associated with an exit or disposal activity be
recognized when the liability is incurred. EITF 94-3 allowed for an exit cost
liability to be recognized at the date of an entity's commitment to an exit
plan. SFAS 146 also requires that liabilities recorded in connection with exit
plans be initially measured at fair value. The provisions of SFAS 146 are
effective for exit or disposal activities that are initiated after December 31,
2002, with early adoption encouraged. We do not expect the adoption of SFAS 146
will have a material impact on our financial position or results of operations.

FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

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

Risk Related to Revenue Concentration

We derive a substantial portion of our revenues from one OEM customer, and our
revenues may decline significantly if this customer cancels or delays purchases
of our products, terminates their contract with us, or exercises certain of
their other rights under the terms of the contract.

In the nine months ended June 30, 2002, one customer accounted for 79% of our
net revenues. Under the terms of our non-exclusive contract with this customer
they have the right to enter into agreements with other parties for similar
products, they are not obligated to purchase any minimum quantity of products
from us and they may choose to stop purchasing from us at any time. In addition,
they may terminate the agreement in the event that we attempt to assign our
rights under the agreement to another party without their prior approval.
Furthermore, in the event that we default on certain portions of the agreement
and do not cure during the prescribed cure period, they may obtain the right to
manufacture the products defined in the agreement in exchange for a mutually
agreeable royalty fee. If any of these events were to occur, or if this customer
delays purchase of our products, our revenues and operating results would be
adversely affected, our reputation in the industry may suffer and our ability to
predict cash flow accurately would decrease. Accordingly, unless and until we
expand and diversify our revenue base, our future success will depend upon the
timing and size of future purchase orders, if any, from this customer.

21

Risks Related to Restructuring

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

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

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

During the fiscal year ended September 30, 2001, we restructured our business.
Our restructuring included a considerable reduction in our workforce and our
future operating expenses and an adjustment to our business strategy to
concentrate our resources on our core competencies, which we believe to be
hardware platform packaging and the ability to integrate our hardware platforms
with various operating systems, management systems and application software
systems. Our restructuring also includes a transition from primarily direct
sales channels to partnerships with independent software vendors and original
equipment manufacturers in order to offer "turn-key" solutions for enterprise
customers. In addition, our restructuring includes the termination of a number
of our product lines and a transformation of our product development process
from one requiring significant proprietary hardware development to one utilizing
standard hardware. We continue to evaluate our business model and our
organization and we will continue to make the changes that we believe are
necessary to ensure the highest possible shareholder value. However, there can
be no assurance that our restructuring efforts will have a positive effect on
our operations, our market share, the market price of our common stock or public
perception of us in the server appliance marketplace, or that we will ever
achieve substantial revenues or profitability, any one of which could cause
further decline in the market price of our common stock.

Risks Related to the Server Appliance Market

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

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

We believe that our expectations for the growth of the server appliance market
may not be fulfilled if customers continue to use general-purpose servers. The
role of our products could, for example, be limited if general-purpose servers
become better at performing functions currently being performed by server

22

appliances or are offered at a lower cost. This could force us to further lower
the prices of our products or result in fewer sales of our products.

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

The server appliance market is characterized by rapid technological change,
frequent new product introductions and enhancements, potentially short product
life cycles, changes in customer demands and evolving industry standards. Our
products could be rendered obsolete if products based on new technologies are
introduced or new industry standards emerge.

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

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

Risks Related to Competition

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

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, 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 large competitors may be able to
leverage their existing resources, including their extensive distribution
capabilities and their service organizations, to provide a wider offering of
products and services as well as higher levels of support on a more
cost-effective basis than we can. In addition, competing companies may be able
to undertake more extensive promotional activities, adopt more aggressive
pricing policies and offer more attractive terms to their customers than we can.
If our competitors provide lower cost solutions with greater functionality or
support than our products, or if some of their products are comparable to ours
and are offered as part of a range of products that is broader than ours, our
products could become undesirable. Even if the functionality of competing
products is equivalent to ours, we face a substantial risk that a significant
number of customers would elect to pay a premium for similar functionality
rather than purchase products from a less-established vendor. We attempt to
differentiate ourselves from our competition by offering a wide variety of
software integration, branding and supply-chain management services. If we are
unable to effectively differentiate our products from those of our competition,
our revenues will not increase and may decline. Furthermore, increased
competition could negatively affect our business and future operating results by
leading to price reductions, higher selling expenses or a reduction in our
market share.

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

Large server manufacturers may not only develop their own server appliance
solutions, but they may also acquire or establish cooperative relationships with
our smaller competitors, including smaller private companies. Because large
server manufacturers have significant financial and organizational resources

23

available, they may be able to quickly penetrate the server appliance market by
leveraging the technology and expertise of smaller companies and utilizing their
own extensive distribution channels. We expect that the server industry will
experience further consolidation. It is possible that new competitors or
alliances among competitors may emerge and rapidly acquire significant market
share through consolidation. Consolidation within the server marketplace could
adversely affect our revenues.

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

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

Risks Related to Our Financial Results

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

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

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

. the growth and changing requirements of the server appliance market;
. the performance, quality, price and total cost of ownership of our
products;
. the perceived value add of our server appliance integration services
by prospective ISV's; and
. the availability, price, quality and performance of competing products
and technologies.

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

Since our inception, we have incurred significant net losses, including net
losses of $5.8 million, $12.5 million and $69.5 million in fiscal 1999, 2000 and
2001, respectively, as well as a net loss of $12.5 million in the nine months
ended June 30, 2002. We expect to continue to have net losses in the future. In
addition, we had an accumulated deficit of $105.9 million as of June 30, 2002.
We believe that our future growth depends upon the success of our new product
development and selling and marketing efforts, which will require us to incur
significant product development, selling and marketing and administrative
expenses. As a result, we will need to generate significant revenues to achieve
profitability. We cannot be certain that we will achieve profitability in the
future or, if we achieve profitability, that we will be able to sustain it. If
we do not achieve and maintain profitability, the market price for our common
stock may decline.

During the year ended September 30, 2001, we implemented restructuring plans
to curtail discretionary selling, general and administrative expenses,
consolidate our international operations, implement new business strategies to
efficiently maximize our resources and utilize other cost saving methods. If
these, or

24

other cost control measures that we may employ, are unsuccessful, our expenses
could increase and our losses could be greater than expected, which could
negatively impact the market price for our common stock.

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

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

If the commodification of products and competition in the server appliance
market increases, then our gross profit as a percentage of net revenues may
decrease and our operating results may suffer.

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

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

Our quarterly revenues and operating results are difficult to predict and may
fluctuate significantly from quarter to quarter due to the timing and size of
orders from our customers, particularly our largest customer, and because server
appliances generally, and our current products in particular, are relatively new
and the future growth of the market for our products is uncertain. We also
expect to rely on additional new products for growth in our net revenues in the
future. In addition, none of our customers are obligated to purchase any
quantity of our products in the future. If the timing or size of orders from our
customers, particularly our largest customer, differs from expectations, the
server appliance market in general fails to grow as expected or our products
fail to achieve market acceptance, our quarterly net revenues and operating
results may fall below the expectations of investors and public market research
analysts. In this event, the price of our common stock could decline.

Risks Related to Our Marketing and Sales Efforts

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

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

25

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

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

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

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

Risks Related to Our Product Manufacturing

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

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

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

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

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

Our existing manufacturing facility is limited in its production capacity. For
us to be successful our product sales volumes must increase significantly. Our
production capacity must increase to support significant increases in product
sales volumes. In order to increase our production capacity, we may have to
utilize the services of a contract manufacturer to produce our products at high
volumes. We may have

26

difficulties in identifying and engaging a contract manufacturer to produce our
products with terms that are favorable to us. Using a contract manufacturer may
increase the cost of producing our products and we could experience transitional
difficulties including production delays and quality control issues, which could
cause customer relationships to suffer and result in lost sales. Also, the use
of a contract manufacturer may not guarantee us production levels, manufacturing
line space or manufacturing prices, which could interrupt our business
operations and have a negative effect on operating results.

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

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

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

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

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

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

. be time-consuming to defend;

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

. divert our management's attention and resources;

. cause product shipment delays; or

. require us to enter into royalty or licensing agreements.

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

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Other Risks Related to Our Business

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

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

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

The market price for our common stock has declined since our fiscal 2000 and
at times was less than $1.00 per share. If we are unable to meet the stock price
listing requirements of NASDAQ, our common stock could be de-listed from the
NASDAQ National Market. If our common stock were de-listed from NASDAQ, among
other things, this could result in a number of negative implications, including
reduced liquidity in our common stock as a result of the loss of market
efficiencies associated with NASDAQ and the loss of federal preemption of state
securities laws as well as the potential loss of confidence by suppliers,
customers and employees, the loss of analyst coverage and institutional investor
interest, fewer business development opportunities and greater difficulty in
obtaining financing.

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

We require the services of qualified technical personnel. We have experienced
the negative effects of an economic slowdown. Our revenues have declined
significantly since our fiscal year ended September 30, 2000 and the market
price of our common stock has decreased significantly. As a result, we have
implemented various personnel reductions, which have placed added pressure on
the remaining employees and management of the Company. These and other factors
may make it difficult for us to retain the qualified employees and management
that we need to effectively manage our business operations, including key
research and development activities. If we are unable to retain a sufficient
number of technical personnel we may not be able to complete development of, or
upgrade or enhance, our products in a timely manner, which could negatively
impact our business and could hinder any future growth.

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

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

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

. diversion of development resources;

. injury to our reputation; or

. increased maintenance and warranty costs.

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

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

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

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

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

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

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

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

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

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

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

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

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

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

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PART II--OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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

On or about December 3, 2001, Margaret Vojnovich filed in the United States
District Court for the Southern District of New York a lawsuit against Network
Engines, Inc., Lawrence A. Genovesi, the Company's current Chairman and former
Chief Executive Officer, and Douglas G. Bryant, the Company's Chief Financial
Officer and Vice President of Administration (collectively, the "Executive
Officers"), FleetBoston Robertson Stephens, Inc., Credit Suisse First Boston
Corp., Goldman Sachs & Co., Lehman Brothers Inc. and Salomon Smith Barney, Inc.
underwriters of the Company's initial public offering in July 2000 (the "IPO")
(collectively, the "Underwriter Defendants"). The suit generally alleges that
the Underwriter Defendants violated the federal securities laws by conspiring to
increase the compensation received by the Underwriter Defendants by agreeing
with some recipients of an allocation of IPO stock that the recipients would
purchase shares of securities in the after-market of the IPO at pre-determined
price levels designed to maintain, distort and/or inflate the price of the
Company's common stock in the aftermarket. The suit also alleges that the
Underwriter Defendants received undisclosed and excessive brokerage commissions
and that, as a consequence, the Underwriter Defendants successfully increased
investor interest in the manipulated IPO securities and increased the
Underwriter Defendants' individual and collective underwritings, compensation
and revenues. The suit further alleges that the defendants violated the federal
securities laws by issuing and selling securities pursuant to the IPO without
disclosing to investors that the Underwriter Defendants in the offering,
including the lead underwriters, had solicited and received excessive and
undisclosed commissions from certain investors. The suit seeks damages,
rescission of the purchase prices paid by purchasers of shares of the Company's
common stock and certification of a plaintiff class consisting of all persons
who acquired shares of the Company's common stock between July 13, 2000 and
December 6, 2000. An amended class action complaint was filed on April 20, 2002
(the "Amended Complaint"). The Amended Complaint, captioned, In re Network
Engines, Inc. Initial Public Offering Securities Litigation, 01 Civ. 10894 (SAS)
alleges violations of the federal securities laws in connection with the
Company's IPO conducted on or about July 13, 2000, and the trading of the
Company's common stock in the aftermarket from the date of the IPO through
December 6, 2000. The Company is in the process of reviewing this suit and
intends to respond in a timely manner. The Company is unable to predict the
outcome of this suit and its ultimate effect, if any, on the Company's financial
condition, however the Company's defense against these claims could result in
the expenditure of significant financial and managerial resources.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

(d) Use of Proceeds from Sales of Registered Securities

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

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outstanding stock, or to any of our affiliates. During the period from the
offering to June 30, 2002, we have used the proceeds as follows: approximately
$50.7 million was used to fund the operations of the Company, approximately $5.0
million was used for the purchase of property and equipment and approximately
$3.2 million was used to repurchase the Company's common stock under a stock
repurchase plan.

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

No matters were submitted to a vote of security holders during the three
months ended June 30, 2002.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

There are no exhibits filed with this report or which are incorporated by
reference hereto.

(b) Reports on Form 8-K

We did not file any reports on Form 8-K during the three months ended June
30, 2002.

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SIGNATURES

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

NETWORK ENGINES, INC.

Date: August 13, 2002

/s/ John H. Curtis

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

/s/ Douglas G. Bryant

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

STATEMENT PURSUANT TO 18 U.S.C.(S)1350

Pursuant to 18 U.S.C. (S)1350, each of the undersigned certifies that this
Quarterly Report on Form 10-Q for the period ended June 30, 2002 fully complies
with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act
of 1934 and that the information contained in this report fairly presents, in
all material respects, the financial condition and results of operations of
Network Engines, Inc.

Date: August 13, 2002

/s/ John H. Curtis

----------------------------------------------
John H. Curtis
President and Chief Executive Officer

/s/ Douglas G. Bryant

----------------------------------------------
Douglas G. Bryant
Vice President of Administration, Chief
Financial Officer, Treasurer and Secretary

33