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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended December 31, 2003

OR

For the transition period from              to             

Commission file number: 0-30863

NETWORK ENGINES, INC.

(Exact name of registrant as specified in its charter)

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  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.)    Yes  x    No  ¨

As of December 31, 2003, there were 36,457,606 shares of the registrant’s Common Stock, par value $.01 per share, outstanding.

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NETWORK ENGINES, INC.

INDEX

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PART I. FINANCIAL INFORMATION

ITEM I. FINANCIAL STATEMENTS

NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)

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

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NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS

(in thousands, except per share data)

(unaudited)

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

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NETWORK ENGINES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

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

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

The accompanying condensed consolidated financial statements have been prepared by Network Engines, Inc. (“Network Engines” or the “Company”) in accordance with 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 2003 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, unless otherwise disclosed, and are considered necessary for a fair presentation of results for the interim periods. It should also be noted that results for the interim periods are not necessarily indicative of the results expected for the full year or any future period.

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

2. SIGNIFICANT ACCOUNTING POLICIES

Recent Accounting Pronouncements

In November 2002, the Emerging Issues Task Force of the FASB reached a consensus on Issue 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). EITF 00-21 requires that for revenue arrangements with multiple deliverables, those deliverables be divided into separate units of accounting if the deliverables meet certain criteria as defined by EITF 00-21. Arrangement consideration is to be allocated among the separate units of accounting based on their relative fair values and revenue recognition decisions should be considered separately for each separate unit of accounting. EITF 00-21 is effective for all arrangements entered into in fiscal periods beginning after June 15, 2003, with early adoption permitted. The adoption of EITF 00-21 did not have a material impact on the Company’s financial position or its results of operations.

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” FIN 46 requires that if an entity has a controlling financial interest in a variable interest entity, the assets, liabilities and results of activities of the variable interest entity should be included in the consolidated financial statements of the entity. FIN 46 requires that its provisions are effective immediately for all arrangements entered into after January 31, 2003. For those arrangements entered into prior to January 31, 2003, FIN 46, as amended by FIN 46R, provisions are required to be adopted by the Company in the second quarter of fiscal 2004. The Company does not have any financial interests in variable interest entities created after January 31, 2003. The adoption of FIN 46R is not expected to have a material impact on the Company’s financial position or its results of operations.

In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 establishes standards for how an issuer of equity classifies and measures on its balance sheet certain financial instruments with characteristics of both liabilities and equity. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003 and for existing financial instruments after October 1, 2003. The adoption of SFAS 150 did not have an impact on the Company’s financial position or its results of operation.

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NETWORK ENGINES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

In December 2003, the Staff of the Securities and Exchange Commission (SEC or the Staff) issued Staff Accounting Bulletin No. 104 (SAB 104), Revenue Recognition, which supercedes SAB 101, Revenue Recognition in Financial Statements. SAB 104’s primary purpose is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, superceded as a result of the issuance of EITF 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” While the wording of the SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The adoption of this bulletin did not have a material impact on the Company’s financial position or its results of operations.

Accounting for Stock-Based Compensation

Stock options and restricted stock issued to employees and members of the Company’s board of directors are accounted for in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations (“APB 25”). Accordingly, compensation expense is recorded for options and restricted stock awarded to employees and directors to the extent that the exercise or purchase prices are less than the fair market value of the Company’s common stock on the date of grant, where the number of shares and exercise or purchase price are fixed. The difference between the fair value of the Company’s common stock and the exercise or purchase price of the stock option or restricted stock award is recorded as deferred stock compensation. Deferred stock compensation is amortized to compensation expense over the vesting period of the underlying stock option or restricted stock. Upon cancellation of options with residual deferred compensation balances at the date of cancellation, the remaining amount of unrecognized deferred compensation is reversed as an adjustment to additional paid-in capital. The Company follows the disclosure requirements of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by SFAS 148 “Accounting for Stock-Based Compensation — Transition and Disclosure”. Stock-based awards to non-employees are accounted for at their fair value in accordance with SFAS 123.

Prior to the Company’s initial public offering in July 2000, the Company recorded deferred stock compensation of approximately $15.5 million for restricted stock and stock options granted at prices deemed to be below fair market value for financial reporting purposes. In connection with the Company’s acquisition of TidalWire Inc. (“TidalWire”) in the quarter ended December 31, 2002, the Company replaced all outstanding TidalWire common stock options with options for the purchase of 1,035,033 shares of the Company’s common stock with an average exercise price of $0.36. The value of these options, based on the Black-Scholes valuation model was $578,000. Related to the unvested portion of the replaced stock options, the Company recorded $304,000 as deferred stock compensation expense based on the intrinsic value of those employee stock options. The Company recognized stock compensation expense of approximately $225,000 and $206,000 for the quarters ended December 31, 2003 and 2002, respectively. During the quarters ended December 31, 2003 and 2002, the Company reversed approximately $3,000 and $11,000, respectively, of deferred stock compensation due to the cancellation of unvested options held by terminated employees.

The following table illustrates the effect on net loss and net loss per share as if the Company had applied the fair value recognition provisions of SFAS 123, to stock-based employee awards for the quarters ended December 31, 2003 and 2002:

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NETWORK ENGINES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

All options granted during the quarters ended December 31, 2003 and 2002 were granted with exercise prices equal to the fair market value of the Company’s common stock on the grant date and had weighted average grant prices of $6.07 and $0.97 per share, respectively.

Comprehensive Loss

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

Segment Reporting

Prior to the acquisition of TidalWire, the Company organized itself as a single business segment. As a result of the acquisition of TidalWire, the Company now organizes itself into two reportable business segments: OEM Appliance and Distribution. The Company’s segments have been determined based upon the channels through which the segments sell products. Sales of server appliances to the Company’s network equipment and independent software vendor (“ISV”) partners are included in the Company’s OEM Appliance segment. Sales of server appliances and data storage products to value added resellers (“VARs”) and systems integrators are included in the Company’s Distribution segment. The accounting policies of these segments are the same as those described in the Company’s summary of significant accounting policies in its Annual Report on Form 10-K for the year ended September 30, 2003. The Company evaluates its segments’ performance based on revenues and gross profit, and the Company’s management regularly evaluates the Company’s segments in deciding how to allocate resources and assess performance. There are no inter-segment sales or transfers. Management does not review assets as part of the assessment of segment performance; as such, segment asset information is not available.

The following is a summary of the Company’s operations by reporting segment (in thousands):

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NETWORK ENGINES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

Significant Customers

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

3. ACQUISITION OF TIDALWIRE INC.

On December 27, 2002, the Company acquired all of the outstanding capital stock of TidalWire Inc. (“TidalWire”), a privately held corporation previously located in Westborough, Massachusetts dedicated to the distribution and support of data storage networking products. The estimated fair values of the acquired assets and assumed liabilities were included in the Company’s financial statements as of the acquisition date, and the results of the operations of TidalWire have been included in the financial statements since that date.

The aggregate purchase price of $17,544,000 included a net cash payment of approximately $9,320,000, representing gross cash payments of approximately $9,910,000 less amounts due to TidalWire by a stockholder under a note of approximately $590,000, and the issuance of 3,331,043 shares of the Company’s common stock that were held by the Company as treasury stock (valued at approximately $3,331,000, based on the average market price of the Company’s common stock over the period three days before and after the terms of the acquisition were agreed to and announced). In addition, the Company assumed approximately $1,878,000 outstanding under TidalWire’s working capital line of credit, which the Company repaid and cancelled on December 27, 2002. As part of the acquisition, the Company also replaced all outstanding TidalWire common stock options with options for the purchase of 1,035,033 shares of the Company’s common stock with an average exercise price of $0.36. The value of these options, based on the Black-Scholes valuation model was $578,000. Related to the unvested portion of the replaced stock options, the Company recorded $304,000 as deferred stock compensation expense based on the intrinsic value of those employee stock options. The Company also incurred fees and expenses of approximately $2,133,000 in connection with this acquisition. The aggregate purchase price included cash payments of $3,350,443 and the issuance of 1,407,092 shares of the Company’s common stock (valued at approximately $1,407,000) to related parties (See Note 9).

The Company acquired TidalWire primarily because TidalWire had historically been a profitable company with customer management, marketing, logistics and support systems in place to support a growing channel of value added resellers (“VARs”) and systems integrators. The Company distributes certain of its ISV partners’ server appliances through TidalWire’s channel of VARs and systems integrators thereby allowing the Company’s current and potential ISV partners to eliminate the cost of sales associated with the hardware component of the server appliance sale. The Company also utilizes TidalWire’s existing infrastructure to diversify its sources of revenues beyond the server appliance market and plans to expand TidalWire’s data storage product offerings to include products involved in network security.

A summary of the assets acquired and liabilities assumed in the acquisition and the fair values recorded for each is as follows (in thousands):

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NETWORK ENGINES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

All goodwill has been assigned to the Company’s Distribution segment. The Company does not expect goodwill to be deductible for tax purposes.

As a result of the Company’s amended agreement with EMC regarding the Company’s sales of EMC-approved HBAs (see Note 4) in the quarter ended December 31, 2003, the Company recorded an asset impairment charge of $3.6 million related to intangible assets acquired in its acquisition of TidalWire. The Company expects to recognize quarterly amortization expense associated with customer relationships of $31,250 through September 30, 2007 and $24,112 in the quarter ending December 31, 2007. The Company recorded amortization expense of approximately $203,000 during the quarter ended December 31, 2003.

The following unaudited pro forma results of the Company for the quarter ended December 31, 2002 give effect to the acquisition of TidalWire as if it had occurred on October 1, 2002 (in thousands, except per share data):

These unaudited pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the results of operations that actually would have resulted had the acquisition occurred on the date indicated and are not necessarily indicative of future results.

4. VALUATION OF GOODWILL AND INTANGIBLE ASSETS AND RELATED IMPAIRMENT

On December 10, 2003, the Company amended its agreement with EMC regarding the distribution of EMC-approved Fibre Channel host bus adaptors (“HBAs”), effective January 1, 2004. This amendment extends the term of the agreement through December 2005 and provides for increased costs to the Company relating to sales of EMC-approved HBAs. In the quarter ended December 31, 2003, sales of EMC-approved HBAs represented 30% of the Company’s total net revenues and 67% of the Company’s Distribution segment revenues. Because of this amendment, the Company will be required to pay a royalty to EMC for each EMC-approved HBA sold by the Company beginning in the quarter ending March 31, 2004. As a result, there will be a decline in the Company’s gross profits related to sales of EMC-approved HBAs, which will in turn have a negative impact on the Company’s Distribution segment gross profits as well as the Company’s consolidated gross profits and operating results, beginning in the quarter ending March 31, 2004.

The Company’s goodwill and intangible assets are the result of the Company’s acquisition of TidalWire and are allocated to the Company’s Distribution segment (see Note 3). Because of the negative impact that this amendment will have on the Company’s future results, the Company considered this to be a triggering event requiring examination for potential impairment of its goodwill, in accordance with the Statement of Financial Accounting Standard (“SFAS”) No. 142, and intangible assets, in accordance with SFAS No. 144. As a result, the Company conducted a detailed analysis of its goodwill and intangible assets as of December 10, 2003.

The fair value of the Company’s goodwill is attributable to synergies the Company expects to realize from sales of server appliances through the distribution infrastructure acquired in its acquisition of TidalWire, now the Company’s Distribution segment. To assess the Company’s goodwill for impairment under SFAS No. 142, the Company performed an assessment of the carrying value of the goodwill to determine if the fair value of the goodwill was below its carrying value. This assessment included a determination of the fair value of the Company’s Distribution segment through internal analysis and a valuation performed by an independent third-party appraiser, primarily using the discounted cash flow approach. This valuation was based on a number of estimates and assumptions, including the projected future operating results of the Company’s Distribution segment, the discount rate, and the long-term growth rate. This analysis resulted in the determination that the fair value of the Company’s goodwill exceeded the carrying amount of its goodwill and therefore goodwill was not impaired by this amendment.

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NETWORK ENGINES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

The fair value of the Company’s intangible assets is primarily attributable to its distribution agreement with EMC regarding the sale of EMC-approved HBAs. To assess the fair value of the Company’s intangible assets under SFAS No. 144, the Company estimated the undiscounted future cash flows from these assets. The Company estimated the future cash flows from its intangible assets based on internal analysis and valuation work performed by an independent third-party appraiser. This valuation was based on a number of estimates and assumptions, including the projected results of the Company’s sales of EMC-approved HBAs and the related gross profit. This analysis resulted in the determination that the fair value of the Company’s intangible assets, based on the estimated future discounted cash flows from these assets, was less than the carrying amount of its intangible assets, which resulted in a charge to operations of approximately $3.6 million in the quarter ended December 31, 2003. As of December 31, 2003, the Company’s goodwill and intangible assets were carried at $7.8 million and $493,000, respectively.

5. 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.

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):

6. INVENTORIES

Inventories consisted of the following (in thousands):

7. CONTINGENCIES

Guarantees and Indemnifications

Director and officer indemnifications – Pursuant to the Company’s Second Amended and Restated Certificate of Incorporation, as permitted under Delaware law, the Company indemnifies its officers and directors for certain events or occurrences while the officer or director is, or was serving in his capacity as a

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NETWORK ENGINES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

director or officer of the Company or as a director, officer or trustee of a different entity, at the Company’s request. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum potential amount of future payments the Company could be required to make under these indemnifications is unlimited; however, the Company has a director and officer insurance policy that limits its exposure and enables it to recover a portion of any future amounts paid. As a result of the Company’s insurance policy coverage, the Company believes the estimated fair value of these indemnifications is minimal. Accordingly, the Company has no liabilities recorded for these indemnifications as of December 31, 2003.

Acquisition-related indemnifications - When, as part of an acquisition, the Company acquires all the stock of a company, the Company assumes liabilities for certain events or circumstances that took place prior to the date of acquisition. The maximum potential amount of future payments the Company could be required to make for such obligations is undeterminable. While the provisions of the agreements remain in effect indefinitely, the Company believes that the probability of receiving a claim is unlikely. As a result, the Company has not recorded a liability for these indemnification clauses as of December 31, 2003.

The Company enters into standard indemnification agreements in the ordinary course of its business. Pursuant to these agreements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally its business partners or customers, in connection with any patent, copyright, trademark, trade secret or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these indemnifications as of December 31, 2003.

Product warranties – The Company offers a warranty on certain of the products that it sells. Depending on the product sold, warranty obligations are fulfilled by the Company, a third-party contracted by the Company or the product manufacturer. Warranty terms vary in duration depending upon the product sold but generally provide for the repair or replacement of any defective products for periods of up to 36 months after shipment. Based upon historical experience and expectation of future conditions, the Company reserves for the estimated costs to fulfill customer warranty obligations upon the recognition of the related revenue. In addition, the Company records warranty expense based on its agreements with its third-party warranty fulfillment provider, whose fees are determined based on fixed periodic amounts as well as activity-based charges.

The following table presents changes in the Company’s product warranty liability for the quarters ended December 31, 2003 and 2002, respectively (in thousands):

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NETWORK ENGINES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

Contingencies

Announcement Timing Lawsuit

Commencing on December 16, 2003, a number of purported class action lawsuits have been filed in the United States District Court for the District of Massachusetts against Network Engines, Inc. and certain individual Network Engines defendants relating to the timing of the announcement of an amendment to Network Engines’ agreement with EMC Corporation regarding the resale of EMC-approved host bus adapters (HBAs). The plaintiffs in the complaints allege, among other things, that Network Engines and the individual defendants allegedly failed to disclose that Network Engines was in the process of renegotiating its distribution contract with EMC while issuing positive statements highlighting Network Engines financial performance. The plaintiffs seek unspecified damages. Network Engines has received indication that other plaintiffs have planned to file similar complaints. Network Engines believes that the actions are without merit, and it intends to vigorously defend against these suits.

TidalWire Acquisition Lawsuit

A purported class action and derivative lawsuit was filed on January 7, 2003 in the Court of Chancery in the State of Delaware against the Company, Robert M. Wadsworth, Frank M. Polestra, John H. Curtis, Lawrence A. Genovesi, John A. Blaeser and Fontaine K. Richardson relating to the acquisition of TidalWire Inc. The plaintiffs in the complaint alleged that the Company and the named directors of its Board of Directors breached their fiduciary duties by, among other things, paying an excessive amount in the acquisition of TidalWire and purportedly failing to disclose material facts in the Company’s Joint Proxy Statement/Information Statement distributed to stockholders for approval of the issuance of shares of the Company’s Common Stock in the merger. The plaintiffs sought damages, rescission of the merger and other relief. As of September 30, 2003, no liability was recorded in connection with this litigation. On October 30, 2003, the court approved a settlement of the action negotiated by the parties, and that settlement became final on December 1, 2003. Under the settlement, all claims against the Company and its individual board members were dismissed with prejudice, and (a) the defendants in the lawsuit paid $600,000 to the Company, (b) plaintiff’s attorney fees of $185,000 were paid out of that $600,000 amount and (c) in the disclosure for the Company’s next annual meeting, the Company will detail certain information concerning relationships among its board members. Payments to the Company under this settlement, net of payments of plaintiff’s attorney fees, were recorded as an increase to additional paid-in capital in the quarter ended December 31, 2003.

Initial Public Offering Lawsuit

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

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

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NETWORK ENGINES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

In July 2002, the Company, Lawrence A. Genovesi and Douglas G. Bryant joined in an omnibus motion to dismiss challenging the legal sufficiency of plaintiffs’ claims. The motion was filed on behalf of hundreds of issuer and individual defendants named in similar lawsuits. Plaintiffs opposed the motion, and the Court heard oral argument on the motion in November 2002. On February 19, 2003, the Court issued an opinion and order denying the motion as to the Company. In addition, in October 2002, Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this case without prejudice. On July 9, 2003, a Special Committee of the Company’s Board of Directors authorized the Company to negotiate a settlement of the pending claims substantially consistent with a memorandum of understanding negotiated among class plaintiffs, all issuer defendants and their insurers. The settlement would provide, among other things, for a release of the Company and the Individual Defendants for the conduct alleged in the amended complaint to be wrongful. The Company would agree to undertake other responsibilities under the settlement, including agreeing to assign, or not assert, certain potential claims that we may have against our underwriters. Any direct financial impact of the proposed settlement is expected to be borne by our insurers. Any such settlement would be subject to various contingencies, including approval by the Court overseeing the litigation.

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 this suit has and may continue to result in the expenditure of significant financial and managerial resources. No amounts have been accrued for this matter.

8. RESTRUCTURING AND OTHER CHARGES

In the first quarter of fiscal 2003, the Company recorded a charge to operations of $914,000. This charge was comprised entirely of future lease and lease-related payments and resulted from the continued vacancy, and the expected future vacancy, of certain leased facilities. When the Company restructured its operations during fiscal 2001, a portion of the charges that were recorded were based on the curtailment of a planned expansion into leased facilities of approximately 24,000 square feet as well as vacating approximately 17,000 square feet of leased space. In December 2002, based on the real estate market in the area of these facilities, the lack of interest in the spaces that the Company had been actively marketing to sublease and the deteriorating financial condition of the sub-tenant, the Company revised its estimates as to the duration of an expected sublease of these facilities and the estimated sublease income. These revised estimates assumed no sublease income from the Company’s vacant 17,000 square foot space through the end of the Company’s original lease term, March 2005, and approximately $126,000 of sublease income during the final nine months through March 2005 of its lease on the 24,000 square foot space. As a result, the Company recorded a charge to operations of $914,000. In the second quarter of fiscal 2003, the Company received $30,000 of sublease income not previously anticipated and, as a result, reversed $30,000 of its restructuring accrual. In October 2003, the Company further amended its lease, which extended the lease term on its primary office and manufacturing space and eliminated the remaining lease on the 24,000 square foot space as of October 31, 2003. This lease amendment required the Company to pay a termination charge of $54,000. In addition, the Company revised its estimate as to the expected future vacancy of the 17,000 square foot space and determined that approximately 8,500 square feet of this space would be occupied by the Company beginning in October of fiscal 2004. As a result of the Company’s lease amendment and revised estimates, the Company reversed approximately $377,000 of its restructuring accrual in the fourth quarter of fiscal 2003. Beginning in April 2005, the Company expects to utilize all of its leased space through the end of its amended lease term, March 2007.

The following table sets forth restructuring and other charges accrual activity during the quarter ended December 31, 2003 and 2002 (in thousands):

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NETWORK ENGINES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

The Company expects the remaining restructuring accrual balance to be substantially utilized by March 31, 2005, comprising cash payments of approximately $117,000 in fiscal 2004 and $60,000 in fiscal 2005.

9. RELATED PARTY TRANSACTIONS

In connection with the Company’s acquisition of TidalWire, the Company paid $1,144,615 to Ascent Venture Partners (together with its affiliated entities, “Ascent”) and $2,205,828 to HarbourVest Partners (together with its affiliated entities, “HarbourVest”), two substantial stockholders of the Company. At the time of the acquisition, Ascent and HarbourVest owned approximately 18.1% and 16.3% of the outstanding common stock of the Company, respectively. Ascent and HarbourVest also owned 12.9% and 24.9% of the outstanding common stock of TidalWire, respectively. Pursuant to the terms of the merger agreement, the Company also issued 480,706 shares and 926,386 shares of its common stock previously held as treasury stock to Ascent and HarbourVest, respectively, and made the aforementioned cash payments to Ascent and HarbourVest in exchange for all of the TidalWire common stock held by Ascent and HarbourVest. The consideration paid to Ascent and HarbourVest may be deemed to have been indirectly paid to Frank M. Polestra and Robert M. Wadsworth, two of the Company’s directors. As a managing member or general partner of each of the general partners that control Ascent, Mr. Polestra may be deemed to have indirectly received the $1,144,615 of cash paid to Ascent as well as beneficial ownership of 480,706 shares of the Company’s common stock issued to Ascent. As a managing director of the limited liability corporation that controls HarbourVest, Mr. Wadsworth may be deemed to have indirectly received the $2,205,828 of cash paid to HarbourVest as well as beneficial ownership of 926,386 shares of the Company’s common stock issued to HarbourVest.

Mr. Wadsworth, a director of the Company, is also a director of PSI Holding Group, Inc. (“PSI”), the parent company of Akibia, Inc. (“Akibia”). During the quarter ended December 31, 2003, HarbourVest owned greater than 5% of the outstanding stock of the Company and greater than 5% of the outstanding stock of PSI. In connection with the TidalWire acquisition, the Company has engaged Akibia to provide certain customer support and warranty fulfillment services related to the Company’s sales of fibre channel host bus adaptors (“HBAs”). Akibia charges the Company a fee for these services based upon the Company’s sales of HBAs. In the quarter ended December 31, 2003, the Company recognized $220,000 of expense as a result of its customer support and warranty fulfillment services agreements with Akibia. In connection with this customer support and warranty fulfillment services agreement, the Company sells product to Akibia to allow Akibia to fulfill the Company’s warranty obligations for these products. In the quarter ended December 31, 2003, the Company recorded revenues of approximately $18,000 from sales of HBAs to Akibia. The Company also purchases certain products sold through its Distribution segment from Akibia to fulfill customer orders. In the quarter ended December 31, 2003, the Company purchased approximately $19,000 of inventory from Akibia for resale to the Company’s Distribution segment customers. In addition, during the quarter ended December 31, 2003, the Company sold approximately $37,000 of server appliance products to Akibia for resale. The Company is amortizing the revenues from these sales over the applicable service period until it has established vendor-specific objective evidence of the fair value of the elements of these sales and, as such, recorded approximately $600 of revenues from these sales in the quarter ended December 31, 2003. In addition, the Company has engaged Akibia to provide certain customer support and warranty fulfillment services to certain of its server appliance

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NETWORK ENGINES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(CONTINUED)

customers in both its OEM Appliance and Distribution Segments. Under the terms of this agreement, the Company is obligated to pay Akibia certain fixed fees and certain activity-based fees based on actual warranty experience. In the quarter ended December 31, 2003, the Company recorded expenses totaling approximately $19,000 related to this agreement. The Company has also engaged Akibia to perform certain professional services related to an upgrade of the Company’s customer resource management software system (“CRM”) and may engage Akibia to perform other professional services in future periods. The estimated cost of this CRM upgrade is approximately $225,000. No costs were incurred related to the CRM upgrade project or any other professional services in the quarter ended December 31, 2003. At December 31, 2003, the Company had amounts payable to Akibia of approximately $138,000.

Several of the Company’s directors have relationships outside of their positions on the Company’s board of directors. John A. Blaeser, one of the Company’s directors, is the president and CEO of Concord Communications, Inc., a public company, and serves on its board of directors. Robert M. Wadsworth, also one of the Company’s directors, is a managing director of the limited liability corporation that controls HarbourVest Partners (and its affiliates), one of the Company’s significant stockholders. Mr. Wadsworth is also a director of Concord Communications, where he is the chairman of the compensation committee of its board of directors, which determines the compensation and benefits of Concord Communications’ executive officers, including the compensation of Mr. Blaeser. In addition, two of the Company’s directors, Mr. Wadsworth and Fontaine K. Richardson, are also directors of ePrescence Inc., a public company in which HarbourVest Partners and/or its affiliates own approximately 11.6% of the outstanding common stock. Further, Gary E. Haroian, one of the Company’s directors, was formerly Chief Financial Officer of Concord Communications while Mr. Blaeser was the Chief Executive Officer of that organization, and was formerly the Controller of Stratus Computer while John H. Curtis, our President and Chief Executive Officer, was Chief Financial Officer of that organization.

Mr. Polestra, a director of the Company, is a managing member of the general partner of Ascent Venture Partners III, L.P., which owns greater than 5% of the outstanding capital stock of Network Intelligence Corporation. Network Intelligence Corporation has a contract with the Company to purchase certain of its products. In the quarter ended December 31, 2003 and 2002, sales to Network Intelligence Corporation were approximately $1.2 million and $576,000, respectively.

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

Special Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, that involve risks and uncertainties. All statements other than statements of historical information provided herein are forward-looking statements and may contain 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, 2003 filed by the Company with the Securities and Exchange Commission.

Overview

We develop, manufacture and distribute server appliance solutions that enable network equipment providers and independent software vendors, or ISVs, to deliver data storage and security networking applications to their customers. Server appliances are pre-configured network infrastructure devices designed to deliver specific application functionality. The server appliance is sold and supported either by the network equipment or ISV partner or alternatively by us through our Distribution operation. We also distribute third party data storage networking products to our customer base of over 400 value-added resellers, or VARs, and systems integrators.

On December 27, 2002, we acquired TidalWire Inc., a value-added distributor specializing in the distribution of data storage networking products, primarily Fibre Channel host bus adapters, or HBAs. In addition to the revenue associated with our TidalWire Distribution business, the acquisition provided us with a sophisticated logistics system, relationships with over 400 VARs and systems integrators and expanded post-sales support capabilities. The acquisition of TidalWire enables us to offer these distribution capabilities to current and future ISV partners and thereby gives us the ability to expand our server appliance business.

We are currently organized into two reportable segments: OEM Appliance and Distribution.

OEM Appliance operations

Our OEM Appliance operation leverages our server appliance development, manufacturing and logistics services. We produce and fulfill devices branded for our network equipment and ISV partners, and we derive our revenues from the sale of the value-added hardware platform to these partners. These partners subsequently sell and support the device under their own brands to their customer base. During the quarters ended December 31, 2003 and 2002, sales to EMC represented 84% and 86% of our OEM Appliance segment revenues, respectively.

Distribution operations

Revenues from our Distribution operations are derived from two activities; first is the revenue derived from the distribution of third party products and components, primarily related to data storage area networking; second is the distribution of server appliances that we develop, manufacture, sell and support on behalf of our ISV partners.

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Complementary product and component Distribution revenues. To date, substantially all of our Distribution operations’ revenue has been derived from the distribution of third party data storage components and products, predominantly EMC-approved Fibre Channel HBAs. We are one of two authorized distributors in North America for Fibre Channel HBAs that have been approved by EMC. We are also a distributor of standard Fibre Channel HBAs, network switches and other storage area networking products. During the quarter ended December 31, 2003, sales of Fibre Channel HBAs represented 91% of our Distribution segment revenues.

In December 2003, we amended our distribution agreement with EMC regarding our sales of EMC-approved Fibre Channel HBAs. This amendment is effective January 1, 2004 and requires that we pay a royalty to EMC for each EMC-approved Fibre Channel HBA that we sell. As a result of this amendment, there will be a decline in our gross profits related to sales of EMC-approved HBAs, which will in turn have a negative impact on our Distribution segment gross profits as well as our consolidated gross profits and operating results, beginning in the quarter ending March 31, 2004. In the quarter ended December 31, 2003, sales of EMC-approved HBAs represented 67% of our Distribution segment revenues.

Server Appliance Distribution revenues. We have recently begun to recognize revenue derived from the sale and support of server appliances we have developed and manufactured in conjunction with our ISV partners. In this case, we are acting as a highly value-added distributor for the ISV, distributing the ISV’s software in the form of a co-branded appliance, and acting as the point of sale and support for the device.

To date, server appliance sales have represented a small portion of our Distribution revenues. This is due in part to the length of time it takes to bring a server appliance product to market and experience significant revenues from that product. After signing an agreement with a new server appliance partner, we expect it will take a quarter to develop the server appliance, another quarter to introduce the server appliance and educate and train our sales team and the channel partners, and only by the third quarter do we expect revenue to begin to ramp up. We expect there to be exceptions to this model as we will be dependent on the timing of our ISV partner software releases, beta customer feedback, and other unforeseen factors. Most of our current ISV partners were announced during the fourth quarter of fiscal 2003 and the first quarter of fiscal 2004, therefore we expect that revenue from the sales of these products will not begin to ramp up until our fiscal third and fourth quarters of 2004. As a result, we expect that the sale of server appliances through our Distribution segment will be an important source of our future revenues. In addition, we expect sales of HBAs and other storage networking products to remain an important component of our business strategy because by offering these products we are able to stay in contact with VARs and systems integrators who are potential server appliance customers. We also expect that, over time, the gross profit from our sales of server appliances through our Distribution segment will be between 25% and 30%.

Critical Accounting Policies And Estimates

Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. 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 and judgments, including those related to: revenue recognition; allowances for doubtful accounts and sales returns; inventory valuation; product warranty obligations; acquisition accounting; goodwill, intangible assets and long-lived assets; restructuring and other charges; stock compensation expense; and income tax asset valuation. We base our estimates and judgments 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 financial statements.

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Revenue recognition

We generally recognize revenues from sales of our products upon shipment to customers provided persuasive evidence of the arrangement has been received, the sales price is fixed or determinable, collectibility of the related receivable is reasonably assured and title and risk of loss have passed to the customer. We have an inventory consignment agreement with our largest customer related to server appliances sold through our OEM Appliance segment. This customer notifies us when it utilizes inventory and we recognize revenues from sales to this customer based upon these notifications.

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

When we enter into revenue arrangements containing multiple elements, the sale of both the product and post-sales support, we allocate the total revenue to be earned under the arrangement among the various elements based on vendor-specific objective evidence of the fair value of each element and revenue is recognized when the revenue recognition criteria for each element is met. If we are not able to derive vendor-specific objective evidence of each component, revenues are deferred and recognized ratably over the period of the support arrangement, which is typically one year. For post-sales support services, revenue is recognized ratably over the period the services are performed.

Allowances for Doubtful Accounts and Sales Returns

Our allowance for doubtful accounts as of December 31, 2003 was $475,000, compared with $419,000 as of September 30, 2003. The allowance is based on our assessment of the collectibility of customer accounts. We regularly review the allowance by considering factors such as historical experience, credit quality, age of the accounts receivable balances, and current economic conditions that may affect a customer’s ability to pay. If a major customer’s creditworthiness deteriorates, or if actual defaults are higher than our historical experience, or if other circumstances arise, our estimates of the recoverability of amounts due to us could be overstated, and additional allowances could be required, which could have an adverse impact on our results of operations. As of December 31, 2003 and September 30, 2003, receivables from EMC represented 41% and 42% of our accounts receivable, respectively.

Our Distribution segment customers are offered a thirty-day right of return on “un-opened” products. A reserve for sales returns is established based on historical trends in product return rates. The reserve for sales returns as of December 31, 2003 and September 30, 2003 was $319,000 and $245,000, respectively, for estimated future returns that were recorded as a reduction of our revenues and accounts receivable. If the actual future returns were to deviate from the historical data on which the reserve had been established, our revenues could be adversely affected.

Inventories

We value our inventory at the lower of cost (first-in, first-out method) or market. We regularly review inventory quantities on hand and record a reserve for excess and obsolete inventory based primarily on our estimated forecast of product demand and anticipated production requirements in the near future. Our inventory reserve balances as of December 31, 2003 were $1.7 million, compared with $1.6 million as of September 30, 2003. Any rapid technological changes and future product development could result in an increase in the amount of obsolete inventory quantities on hand. Agreements with certain suppliers to our Distribution business include stock rotation provisions and agreements with certain of our OEM Appliance customers include inventory protection provisions, however, these provisions may not provide us with complete protection from loss due to excess or obsolete inventory. In the past, we have had substantial write-offs due to excess and obsolete inventory, which was primarily related to internally developed products. Our current products include more standards-based technologies, which may help to mitigate our inventory obsolescence risk. However, if there were to be a sudden and significant decrease in demand for

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our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to increase our inventory reserves and our gross profit could be adversely affected. Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels to ensure competitive lead times versus the risk of inventory obsolescence because of rapidly changing technology and customer requirements.

Product Warranty Obligations

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

Server appliance products – As of December 31, 2003, our server appliance product warranty obligations were $437,000 versus $524,000 as of September 30, 2003. Costs included in our server appliance product warranty obligation include shipping, materials, internal and external labor, external testing costs and travel. Significant judgment and estimates are involved in estimating our warranty reserve on our server appliance products. Although our current server appliance products use more standards-based technologies than in the past, certain of our server appliance products incorporate proprietary technologies, which may increase our risks related to product warranty obligations. In the past we have experienced unexpected component failures in certain of our server appliance products, which have required us to increase our product warranty accruals. At the time any unexpected component failure arises, we assess the costs to repair any defects and record what we believe to be an appropriate warranty obligation based on the available information at the time. To the extent we may experience increased warranty claim activity, increased costs associated with servicing those claims, or use estimates that prove to be materially different from actual claims, our product warranty obligations may need to be increased, resulting in decreased gross profits.

HBA products - As of December 31, 2003, our HBA product warranty obligations were $93,000 versus $81,000 as of September 30, 2003. Our HBA warranty expense is determined based upon contractual rates with a third party warranty provider who we pay to perform substantially all activities related to the fulfillment of our HBA product warranty obligations. As such, the warranty expense recognized for current and past shipments are fixed and not subject to change. Our agreement with this third party warranty provider renews annually, therefore the fees that we pay under this agreement could change in the future.

Acquisition accounting

In December 2002, we acquired TidalWire for total consideration of $17.5 million, which was allocated to net tangible assets and liabilities acquired of $4.3 million, deferred stock compensation of $304,000, intangible assets of $5.1 million and goodwill of $7.8 million. The fair value of the intangible assets as of the date of the acquisition was determined based on the discounted estimated future cash flows from sales resulting primarily from our distribution agreement with EMC. We have estimated that the useful life of these intangible assets would be five years. Significant judgments and estimates are involved in determining the fair value of assets acquired and their useful lives. Different assumptions could yield materially different results.

Goodwill, intangible assets and long-lived assets

Goodwill and intangible assets are a result of our acquisition of TidalWire. As of December 31, 2003 our goodwill was $7.8 million and our intangible assets were $493,000. Goodwill, which is attributable to synergies we expect to realize through our sales of server appliances through the distribution infrastructure acquired in our acquisition of TidalWire, is not amortized but is tested for impairment at least annually or when events or circumstances occur indicating possible impairment. Intangible assets, which are primarily attributable to our distribution agreement with EMC regarding our sales of EMC-approved HBAs, are amortized over their estimated useful life of five years and are assessed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Any

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impairment loss is charged to operations in the period of the loss (see Note 4 to our condensed consolidated financial statements). We assess the recoverability of long-lived assets, including intangible assets, based on the projected undiscounted future cash flows over the asset’s remaining life. The amount of impairment, if any, is measured based on the excess of the carrying value over fair value, determined using projected discounted future operating cash flows. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. For goodwill recovery, we compare the carrying value of the segment to which the goodwill is allocated with the segment’s fair value. If the carrying value of the segment exceeds its fair value, then the carrying value of that segment’s goodwill is compared to the implied fair value of the goodwill and an impairment loss is recorded in an amount equal to that excess, if any. Determining the fair value of individual assets and goodwill may include significant judgments by management. We believe that the most significant judgment involved in the determination of the fair value of our goodwill is our expectation of future revenues and gross profits from our sales of server appliances through our Distribution segment. We have a limited history selling server appliances through our Distribution segment. Different assumptions utilized in the determination of the fair value of our goodwill and intangible assets could yield materially different results.

Restructuring and other charges

Charges taken for vacant facilities are recognized when the available information indicates that a loss is probable and estimable. In the first quarter of fiscal 2003 we recorded a charge to operations of $914,000 related to the vacancy of certain leased office space. In the fourth quarter of fiscal 2003 we revised this charge to $507,000 based on an amendment to our lease agreement and revised estimates of the future vacancy of certain leased facilities. If actual results related to any of these assumptions or estimates were to exceed or not meet our expectations in the future, we may need to adjust certain restructuring and other charges in future reporting periods, resulting in increased or decreased operating expenses. As of December 31, 2003, our accrual for restructuring and other charges totaled $178,000 versus $278,000 as of September 30, 2003.

Stock compensation

In connection with the grant of certain options and restricted stock awards to employees issued prior to our initial public offering in July 2000, we recorded deferred stock compensation within stockholders’ equity of $15.5 million, representing the difference between the estimated fair value of the common stock for accounting purposes and the option exercise price of these options or restricted stock awards at the date of grant. Such amount is presented as a reduction of stockholders’ equity and is being amortized over the vesting period of the applicable options. Significant judgments and estimates were involved in determining the proper valuation of deferred stock compensation because at the time of grant there was no available market for our common stock. Different assumptions could have yielded materially different results.

Income tax asset valuation

We record deferred tax assets and liabilities based on the net tax effects of tax credits, operating loss carryforwards and temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. We then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we establish a valuation allowance. The valuation allowance is based on our estimate of future taxable income and the period over which our deferred tax assets will be recoverable. Through December 31, 2003, we believe that it is more likely than not that all of our deferred tax assets will not be realized, and, accordingly, we have recorded a valuation allowance against all of our deferred tax assets. If results of operations in the future indicate that some or all of the deferred tax assets will be recovered, the reduction of the valuation allowance will be recorded as a tax benefit during one period or over several periods.

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Comparability of Financial Information

On December 27, 2002, we completed our acquisition of TidalWire. As a result, the quarter ended March 31, 2003 was the first quarter that included the TidalWire operations in our consolidated results for an entire quarter. Our financial results only include TidalWire financial results for periods subsequent to December 27, 2002. As such, the presentation of historical financial information and any discussion regarding the comparison of historical financial information to financial information does not include any financial information for TidalWire prior to December 28, 2002, unless otherwise indicated. Forward-looking statements made regarding our expected future operating results include the expected results of both Network Engines and TidalWire on a combined basis.

Results of Operations

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

Net Revenues and Gross Profit

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

Net Revenues

Prior to our acquisition of TidalWire on December 27, 2002, our revenues were derived from sales of server appliance hardware platforms and related pre-sales integration and supply-chain management services in North America. In April 2002, our largest OEM Appliance customer, EMC, announced the availability of a product that incorporates one of our customized platforms. Since then, sales of that product have been a major portion of our net revenues. As a result of our acquisition of TidalWire, we also distribute data storage networking products, consisting primarily of Fibre Channel HBAs, through a channel of VARs and systems integrators. We intend to increase the number of data storage networking and network security products that we distribute, including server appliances developed with our network equipment and ISV partners.

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Our OEM Appliance segment revenues increased due to an increase in sales volumes to EMC, which represented 84% of our OEM Appliance revenues in the first quarter of fiscal 2004 and 86% of our OEM Appliance revenues in the first quarter of fiscal 2003. Additionally, we have added OEM Appliance partners over the past year and our revenues to OEM Appliance customers other than EMC have grown from $813,000 in the first quarter of 2003 to $3.2 million in the first quarter of 2004. Approximately $1.8 million of this increase is attributable to revenues from three OEM Appliance customers added in the past year while the remainder of the increase is the result of net revenue growth among pre-existing OEM Appliance customers.

Our Distribution segment revenues increased due to our acquisition of TidalWire in December 2002. Prior to the TidalWire acquisition, there were no Distribution revenues. Distribution revenues are primarily attributable to sales of Fibre Channel HBAs, which represented 91% of Distribution revenues and include sales of other data storage networking products.

Based on current forecasts from certain partners, the expected impact of the amended EMC HBA distribution agreement and historical and seasonal trends, we expect that revenues in the second quarter of fiscal 2004 will decline slightly. In the data storage industry, the quarter ending March 31 is typically the weakest quarter of the calendar year, which could contribute to a decline in our net revenues. In addition, our amended agreement with EMC related to our sales of EMC-approved HBAs requires us to pay EMC a royalty for each EMC-approved HBA sold, which increases our cost per HBA and may limit our Distribution segment’s ability to offer discounted pricing on these products. This cost increase may make it more difficult for us to compete in larger sales transactions and could contribute to a decline in our Distribution segment revenues.

Gross Profit

Gross profit represents net revenues recognized less the cost of revenues. Cost of revenues includes cost of materials, warranty costs, inventory obsolescence charges and shipping and handling costs. For server appliance products, cost of revenues also includes manufacturing costs, which are primarily comprised of compensation and, when applicable, contract manufacturing costs.

The increase in gross profit in our OEM Appliance segment is due to the growth we have experienced over the past year in our OEM Appliance sales volumes. As a percentage of net revenues, gross profit in our OEM Appliance segment has declined versus the first quarter of 2003 due primarily to a lower average selling price per unit as a result of price decreases to certain OEM Appliance segment customers as a result of volume increases. The decrease in our gross profit as a percentage of OEM Appliance net revenues was offset in part by lower manufacturing costs per unit sold due to volume efficiencies and related manufacturing process improvements.

The increase in gross profit in our Distribution segment is due to the addition of a full quarter of revenues from this segment, which was created as a result of our acquisition of TidalWire on December 27, 2002. The increase in gross profit as a percentage of net revenues in our Distribution segment is due to changes in customer mix versus the first quarter of 2003, which only included revenues subsequent to December 27, 2002. We don’t believe this comparison of gross profit as a percentage of net revenues is meaningful due to the small amount of revenues in the first quarter of fiscal 2003.

Our gross profit is affected by the product mix within our OEM Appliance business, our OEM Appliance product pricing as well as the timing, size and configuration of server appliance orders. OEM Appliance gross profit is also affected by the mix of product manufactured internally compared to product manufactured by our contract manufacturer, which carries higher manufacturing costs. Our gross profit is also affected by the relative size of Distribution revenues to OEM Appliance revenues as well as the mix of products sold through our Distribution business as each of these products carries a different gross profit as a percentage of revenues. We expect gross profit to continue to be affected by these factors as well as volume price decreases in our OEM Appliance segment and competitive pricing pressure in both our OEM Appliance and Distribution segments and, most significantly, increased costs associated with our recently amended distribution agreement with EMC related to EMC-approved HBAs. Additionally, certain of our vendors have increased the price of certain products that they sell to us. To date, we have been able to

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offset these price increases through certain volume purchase discounts offered to us by these vendors. Our Distribution segment gross profits will be affected by the extent to which future volume purchase discounts are offered to us. In the second quarter of fiscal 2004 we expect OEM Appliance gross profit to be between 19% and 21% of OEM Appliance net revenues, Distribution gross profit to be between 7% and 12% of Distribution net revenues and total gross profit to be between 16% and 18% of total net revenues.

Operating Expenses

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

Research and Development

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

During the past year, our server appliance development projects have increased as a result of an increase in the development and sustaining engineering efforts related to existing, new and prospective ISV and network equipment partners and increased software development activities. To support these activities we have increased our research and development personnel from 17 at December 31, 2002 to 24 at December 31, 2003, which resulted in increased compensation costs. We have also developed additional prototypes of new and existing server appliance products and increased the number of consultants used to supplement our research and development personnel levels. Prototype and consulting costs are variable and fluctuate depending on the timing and magnitude of our server appliance development projects. Our server appliance development strategy also

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emphasizes the utilization of standard, off-the-shelf components in our server appliance platforms, however, we expect that in some cases significant development efforts will be required to fulfill our current and potential ISV and network equipment partners’ needs. In addition, we intend to focus our software development in areas that improve the ease of server appliance implementation and use, which we believe will enhance our value proposition. We expect that quarterly research and development expenses will increase during the remainder of fiscal 2004, depending on the timing and costs of actual server appliance development project activity. We also expect research and development expenses to remain relatively consistent with the first quarter as a percentage of revenues over the remainder of fiscal 2004, depending on actual revenue results.

Selling and marketing

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

The increase in compensation costs is primarily the result of the addition of personnel engaged in selling and marketing, which increased from 12 prior to our acquisition of TidalWire on December 27, 2002 to 41 at December 31, 2003. In addition, our marketing program activities have increased over the past year due to our acquisition of TidalWire, now our Distribution segment, which by its nature, engages in more marketing program activities than our OEM Appliance segment. Our Distribution segment incurs more of the marketing and sales burden of the products that it sells and must engage in a higher level of marketing program activities than our OEM Appliance segment. Sales in our OEM Appliance segment are to our ISV and network equipment partners who market and sell their products, which incorporate our server appliances. As a result, our OEM Appliance segment engages in a limited level of marketing programs. We have also increased our marketing program activities in an effort to further establish our presence in the server appliance market. We believe that we must continue our marketing efforts in order to establish ourselves as the leading providing of server appliance products and to maintain our market presence in the distribution of storage networking products. In addition, our travel costs have also increased, which is due to our increased selling and marketing personnel. Variable marketing costs, such as marketing programs, are somewhat dependent on the timing and magnitude of new product introductions and will fluctuate depending on the level of this activity. We expect quarterly selling and marketing expenses to increase in absolute dollars during the remainder of 2004, but remain relatively constant with the first quarter as a percentage of net revenues, depending on actual revenue results.

General and administrative

General and administrative expenses consist primarily of salaries and other related costs for executive, finance, accounting, information technology, facilities and human resources personnel; professional services, which include legal, accounting, audit and tax fees; and director and officer insurance; administrative expenses associated with operating as a public company and bad debt expenses.

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