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EX-31.2 - EX-31.2 - NETWORK ENGINES INCa11-7092_1ex31d2.htm
EX-10.1 - EX-10.1 - NETWORK ENGINES INCa11-7092_1ex10d1.htm
EX-32.2 - EX-32.2 - NETWORK ENGINES INCa11-7092_1ex32d2.htm

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

(Mark One)

 

x

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

 

For the quarterly period ended March 31, 2011

 

OR

 

o

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

 

For the transition period from              to              

 

Commission file number: 000-30863

 


 

GRAPHIC

 

NETWORK ENGINES, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

04-3064173

(State or other jurisdiction of
incorporation)

 

(I.R.S. Employer
Identification No.)

 

 

 

25 Dan Road, Canton, MA

 

02021

(Address of principal executive offices)

 

(Zip Code)

 

(781) 332-1000

(Registrant’s telephone number, including area code)

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  o  No  o

 

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

 

Large accelerated filer o

 

Accelerated filer x

 

 

 

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

 

Smaller reporting company o

 

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

 

As of May 6, 2011, there were 42,950,065 shares of the registrant’s Common Stock, par value $.01 per share, outstanding.

 

 

 




Table of Contents

 

PART I. FINANCIAL INFORMATION

 

ITEM I. FINANCIAL STATEMENTS

 

NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)

 

 

 

March 31, 
2011

 

September 30,
2010

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

15,108

 

$

15,323

 

Accounts receivable, net of allowances of $96 and $63 at March 31, 2011 and September 30, 2010, respectively

 

38,828

 

34,377

 

Income tax receivable

 

 

125

 

Inventories

 

26,496

 

23,161

 

Prepaid expenses and other current assets

 

4,626

 

2,746

 

 

 

 

 

 

 

Total current assets

 

85,058

 

75,732

 

 

 

 

 

 

 

Property and equipment, net

 

2,028

 

1,570

 

Intangible asset, net

 

5,909

 

6,574

 

Goodwill

 

505

 

 

Other assets

 

217

 

235

 

 

 

 

 

 

 

Total assets

 

$

93,717

 

$

84,111

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

21,300

 

$

16,447

 

Accrued compensation and other related benefits

 

1,961

 

1,829

 

Other accrued expenses

 

3,269

 

2,584

 

Deferred revenue

 

5,092

 

5,101

 

 

 

 

 

 

 

Total current liabilities

 

31,622

 

25,961

 

 

 

 

 

 

 

Deferred revenue, net of current portion

 

3,562

 

2,998

 

 

 

 

 

 

 

Total liabilities

 

35,184

 

28,959

 

 

 

 

 

 

 

Commitments and contingencies (Note 8)

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock, $0.01 par value, 5,000,000 authorized, and no shares issued and outstanding

 

 

 

Common stock, $0.01 par value, 100,000,000 shares authorized; 48,090,500 and 47,991,049 shares issued; 42,947,096 and 42,847,645 shares outstanding at March 31, 2011 and September 30, 2010, respectively

 

481

 

480

 

Additional paid-in capital

 

199,484

 

198,932

 

Accumulated deficit

 

(136,413

)

(139,241

)

Treasury stock, at cost, 5,143,404 shares at March 31, 2011 and September 30, 2010

 

(5,019

)

(5,019

)

Total stockholders’ equity

 

58,533

 

55,152

 

Total liabilities and stockholders’ equity

 

$

93,717

 

$

84,111

 

 

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

 

1



Table of Contents

 

NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

 

 

 

Three months ended
March 31,

 

Six months ended
March 31,

 

 

 

2011

 

2010

 

2011

 

2010

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

64,953

 

$

55,030

 

$

136,659

 

$

99,082

 

 

 

 

 

 

 

 

 

 

 

Cost of revenues

 

57,397

 

48,527

 

121,581

 

86,524

 

 

 

 

 

 

 

 

 

 

 

Gross margin

 

7,556

 

6,503

 

15,078

 

12,558

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research and development

 

1,611

 

1,584

 

3,178

 

3,267

 

Selling and marketing

 

1,951

 

2,060

 

3,861

 

3,818

 

General and administrative

 

2,227

 

2,199

 

4,357

 

4,220

 

Amortization of intangible asset

 

332

 

389

 

665

 

778

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

6,121

 

6,232

 

12,061

 

12,083

 

 

 

 

 

 

 

 

 

 

 

Income from operations

 

1,435

 

271

 

3,017

 

475

 

Interest and other income (expense), net

 

102

 

(26

)

46

 

(8

)

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

1,537

 

245

 

3,063

 

467

 

Provision for income taxes

 

60

 

9

 

234

 

33

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

1,477

 

$

236

 

$

2,829

 

$

434

 

 

 

 

 

 

 

 

 

 

 

Net income per share — basic

 

$

0.03

 

$

0.01

 

$

0.07

 

$

0.01

 

 

 

 

 

 

 

 

 

 

 

Net income per share — diluted

 

$

0.03

 

$

0.01

 

$

0.06

 

$

0.01

 

 

 

 

 

 

 

 

 

 

 

Shares used in computing basic net income per share

 

42,895

 

42,050

 

42,876

 

42,039

 

Shares used in computing diluted net income per share

 

44,438

 

43,566

 

44,153

 

43,199

 

 

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

 

2



Table of Contents

 

NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

 

 

Six months ended
March 31,

 

 

 

2011

 

2010

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

2,829

 

$

434

 

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

 

 

 

 

 

Depreciation and amortization

 

1,107

 

1,241

 

Loss (Gain) on disposal of asset

 

4

 

(9

)

Provision for doubtful accounts

 

36

 

(31

)

Stock-based compensation

 

464

 

594

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(4,489

)

(6,794

)

Income tax receivable

 

125

 

 

Inventories

 

(3,338

)

(10,817

)

Prepaid expenses and other assets

 

(1,860

)

37

 

Accounts payable

 

4,853

 

6,829

 

Accrued expenses

 

847

 

(114

)

Deferred revenue

 

555

 

593

 

 

 

 

 

 

 

Net cash provided by (used in) operating activities

 

1,133

 

(8,037

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Acquisition, net of cash assumed

 

(505

)

 

Refundable acquisition consideration

 

 

3,629

 

Purchases of property and equipment

 

(905

)

(408

)

 

 

 

 

 

 

Net cash (used in) provided by investing activities

 

(1,410

)

3,221

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Purchase of treasury stock

 

 

(177

)

Payment of bank line of credit fees

 

(30

)

(38

)

Proceeds from issuance of common stock

 

92

 

130

 

 

 

 

 

 

 

Net cash provided by (used in) financing activities

 

62

 

(85

)

 

 

 

 

 

 

Net decrease in cash and cash equivalents

 

(215

)

(4,901

)

Cash and cash equivalents, beginning of period

 

15,323

 

21,039

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

15,108

 

$

16,138

 

 

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

 

3



Table of Contents

 

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.  Basis of Presentation

 

The accompanying condensed consolidated financial statements have been prepared by Network Engines, Inc. (“Network Engines” or the “Company”) in accordance with accounting principles generally accepted in the United States of America and pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”).  Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations.  The year-end condensed consolidated balance sheet data was derived from audited financial statements, but does not include all year-end disclosures required by accounting principles generally accepted in the United States of America.  These financial statements should be read in conjunction with the audited financial statements and the accompanying notes included in the Company’s 2010 Annual Report on Form 10-K (the “2010 Form 10-K”) filed by the Company with the SEC.

 

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

 

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

 

2.  Significant Accounting Policies

 

Cash and Cash Equivalents

 

The Company held $15.1 million in cash and cash equivalents as of March 31, 2011.  Cash equivalents consisted of money market funds purchased with original maturities of three months or less.  Cash equivalents are measured at fair value, as described in more detail in Note 3.  The Company held cash totaling $15.3 million as of September 30, 2010.  The following table presents balances of cash and cash equivalents held as of March 31, 2011 and September 30, 2010 (in thousands):

 

 

 

March 31,

 

September 30,

 

 

 

2011

 

2010

 

Cash

 

$

3,104

 

$

15,323

 

Cash equivalents

 

12,004

 

 

 

 

 

 

 

 

Total cash and cash equivalents

 

$

15,108

 

$

15,323

 

 

Comprehensive Income

 

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

 

4



Table of Contents

 

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

Significant Customers

 

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

 

 

 

Net Revenues

 

 

 

 

 

 

 

Three months ended

 

Six months ended

 

Accounts Receivable at

 

 

 

March 31,

 

March 31,

 

March 31,

 

September 30,

 

 

 

2011

 

2010

 

2011

 

2010

 

2011

 

2010

 

EMC Corporation

 

59

%

44

%

59

%

42

%

53

%

51

%

Tektronix, Inc.

 

11

%

25

%

11

%

23

%

13

%

16

%

 

3. Fair Value Measurements

 

The Company records its financial assets and liabilities at fair value, which is defined as the price that would be received to sell an asset or paid to transfer a liability (an “exit price”), in the principal or most advantageous market for the asset or liability, in an orderly transaction between market participants at the measurement date. Valuation techniques used to measure fair value include observable and unobservable inputs. Observable or market inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s assumptions about market participant assumptions based on best information available.

 

Observable inputs are the preferred source of fair values. These two types of inputs create the following fair value hierarchy:

 

·                  Level 1—Valuations are based on unadjusted quoted prices in active markets that are accessible at the measurement date for identical assets or liabilities.

 

·                  Level 2—Valuations are based on quoted prices for similar assets or liabilities in active markets, or quoted prices for identical or similar assets or liabilities in markets that are not active for which significant inputs are observable, either directly or indirectly.

 

·                  Level 3—Valuations are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. Inputs reflect management’s best estimates regarding the assumptions that market participants would use in valuing the asset or liability at the measurement date.

 

As of March 31, 2011, the Company held certain assets that are required to be measured at fair value on a recurring basis, consisting of money market funds, which are classified as cash equivalents. The Company did not hold any money market funds as of September 30, 2010. The following table presents the fair value hierarchy for the Company’s financial assets measured at fair value on a recurring basis as of March 31, 2011 (in thousands):

 

 

 

Fair Value Measurements at March 31, 2011 Using:

 

 

 

Level 1 Inputs

 

Level 2 Inputs

 

Level 3 Inputs

 

Assets:

 

 

 

 

 

 

 

Money market fund

 

$

12,004

 

$

 

$

 

 

The net asset amount recorded in the balance sheet (carrying amount) and the estimated fair values of financial instruments at March 31, 2011 consisted of the following:

 

 

 

Carrying Amount

 

Fair Value

 

Assets:

 

 

 

 

 

Money market fund

 

$

12,004

 

$

12,004

 

 

The fair values of the money market fund were based on the quoted market prices on securities exchanges.

 

4.  Stock-Based Compensation

 

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

 

5



Table of Contents

 

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

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

 

 

 

Three months ended
March 31,

 

Six months ended
March 31,

 

 

 

2011

 

2010

 

2011

 

2010

 

 

 

 

 

 

 

 

 

 

 

Cost of revenues

 

$

34

 

$

39

 

$

71

 

$

77

 

Research and development

 

29

 

43

 

62

 

89

 

Selling and marketing

 

81

 

92

 

153

 

169

 

General and administrative

 

92

 

108

 

178

 

259

 

Total stock-based compensation expense

 

$

236

 

$

282

 

$

464

 

$

594

 

 

The Company estimates the fair value of stock options using the Black-Scholes valuation model.  This valuation model takes into account the exercise price of the award, as well as a variety of significant assumptions.  These assumptions include the expected term, the expected volatility of the Company’s common stock over the expected term, the risk-free interest rate over the expected term, and the Company’s expected annual dividend yield.  The Company believes that the valuation technique and the approach utilized to develop the underlying assumptions are appropriate in calculating the fair values of the Company’s stock options granted during the three and six month periods ended March 31, 2011 and 2010.  Estimates of fair value are not intended to predict the value ultimately realized by persons who receive equity awards.  In determining the amount of expense to be recorded, judgment is also required to estimate forfeitures of the awards based on the probability of employees completing the required service period.  Historical forfeitures are used as a starting point for developing the estimate of future forfeitures.

 

Assumptions used to determine the fair value of options granted during the three and six months ended March 31, 2011 and 2010, using the Black-Scholes valuation model, were:

 

 

 

Three months ended March 31,

 

Six months ended March 31,

 

 

 

2011

 

2010

 

2011

 

2010

 

 

 

 

 

 

 

 

 

 

 

Expected term (1)

 

3.75 to 6.50 years

 

3.75 to 6.50 years

 

3.75 to 6.50 years

 

3.75 to 6.50 years

 

Expected volatility factor (2)

 

72.15% to 77.71%

 

71.56% to 72.09%

 

69.80% to 77.71%

 

71.56% to 74.03%

 

Risk-free interest rate (3)

 

1.65% to 2.42%

 

1.71% to 2.97%

 

0.76% to 2.42%

 

1.45% to 2.97%

 

Expected annual dividend yield

 

 

 

 

 

 


(1)

The expected term for each grant was determined based on analysis of the Company’s historical exercise and post-vesting cancellation activity.

 

 

(2)

The expected volatility for each grant was estimated based on a weighted average of the historical volatility of the Company’s common stock.

 

 

(3)

The risk-free interest rate for each grant was based on the U.S. Treasury yield curve in effect at the time of grant for a period equal to the expected term of the stock option.

 

6



Table of Contents

 

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

A summary of the Company’s stock option activity for the six months ended March 31, 2011 is as follows:

 

 

 

Six months ended March 31, 2011

 

 

 

Number of 
Options

 

Weighted 
Average 
Exercise Price

 

Weighted
Average Remaining
Contractual
Term (in years)

 

 

 

 

 

 

 

 

 

Outstanding at September 30, 2010

 

7,262,112

 

$

1.95

 

 

 

Granted

 

661,000

 

$

1.59

 

 

 

Exercised

 

(99,451

)

$

0.93

 

 

 

Forfeited

 

(19,220

)

$

1.53

 

 

 

Expired

 

(89,470

)

$

2.69

 

 

 

Outstanding at March 31, 2011

 

7,714,971

 

$

1.93

 

5.85

 

Exercisable at March 31, 2011

 

6,029,540

 

$

2.10

 

5.13

 

 

All stock options granted during the six months ended March 31, 2011 were granted with exercise prices equal to the fair market value of the Company’s common stock on the grant date and had a weighted average grant date fair value of $0.98.

 

At March 31, 2011, unrecognized compensation expense related to non-vested stock options was $1,150,000, which is expected to be recognized over a weighted average vesting period of 2.20 years.

 

5.  Net Income Per Share

 

Basic net income per share is computed by dividing the net income for the period by the weighted average number of shares of common stock outstanding during the period.  Diluted net income per share is computed by dividing the net income for the period by the weighted average number of shares of common stock and potential common stock, if dilutive, outstanding during the period.  Potential common stock includes incremental shares of common stock issuable upon the exercise of stock options, calculated using the treasury stock method.  For periods in which the Company incurs a net loss, diluted net loss per share is the same as basic net loss per share because the inclusion of these common stock equivalents would be anti-dilutive.

 

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

 

7



Table of Contents

 

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

 

 

Three months 
ended March 31,

 

Six months ended 
March 31,

 

 

 

2011

 

2010

 

2011

 

2010

 

Numerator:

 

 

 

 

 

 

 

 

 

Net income

 

$

1,477

 

$

236

 

$

2,829

 

$

434

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

Shares used in computing basic net income per share

 

42,895

 

42,050

 

42,876

 

42,039

 

Common stock equivalents from employee stock options

 

1,543

 

1,516

 

1,277

 

1,160

 

 

 

 

 

 

 

 

 

 

 

Shares used in computing diluted net income per share

 

44,438

 

43,566

 

44,153

 

43,199

 

 

 

 

 

 

 

 

 

 

 

Net income per share:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.03

 

$

0.01

 

$

0.07

 

$

0.01

 

Diluted

 

$

0.03

 

$

0.01

 

$

0.06

 

$

0.01

 

 

 

 

 

 

 

 

 

 

 

Anti-dilutive potential common stock equivalents excluded from the calculation of diluted net income per share:

 

 

 

 

 

 

 

 

 

Options to purchase common stock

 

3,794

 

4,313

 

3,967

 

5,247

 

 

6.  Intangible Asset

 

The Company recorded an intangible asset as the result of a business combination in fiscal year 2008. The acquired intangible asset is customer relationships, which is being amortized over the estimated period of economic benefit expected to be received, resulting in a weighted average amortization period of 4.97 years. The following table presents the intangible asset balances as of March 31, 2011 and September 30, 2010 (in thousands):

 

 

 

March 31, 2011

 

September 30, 2010

 

 

 

Gross 
Carrying 
Amount

 

Accumulated
Amortization

 

Net Book 
Value

 

Gross 
Carrying 
Amount

 

Accumulated
Amortization

 

Net Book 
Value

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Customer relationships

 

$

11,775

 

$

5,866

 

$

5,909

 

$

11,775

 

$

5,201

 

$

6,574

 

 

Amortization expense for the three and six months ended March 31, 2011 was $332,000 and $665,000, respectively. The estimated future amortization expense for the intangible asset as of March 31, 2011 by fiscal year is $665,000 for the remainder of 2011, $1,119,000 for 2012, $868,000 for 2013, $678,000 for 2014, $537,000 for 2015, and $2,042,000 thereafter.

 

The Company reviews long-lived assets, including definite-lived intangible assets, to determine if any adverse conditions exist that would indicate impairment.  Factors that could lead to an impairment of acquired customer relationships include a worsening in customer attrition rates compared to historical attrition rates, or lower than initially anticipated cash flows associated with customer relationships.  The Company assesses the recoverability of long-lived assets based on the projected undiscounted future cash flows estimated to be generated over the asset’s remaining life.  The amount of impairment, if any, is measured based on the excess of the carrying value over fair value.  Fair value is generally calculated as the present value of estimated future cash flows using a risk-adjusted discount rate, which requires significant management judgment with respect to revenue and expense growth rates, and the selection and use of an appropriate discount rate.  As of March 31, 2011, there were no triggering events that led to the Company performing an impairment review of the intangible asset.

 

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Table of Contents

 

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

7.  Inventories

 

Inventories consisted of the following (in thousands):

 

 

 

March 31, 2011

 

September 30, 2010

 

 

 

 

 

 

 

Raw materials

 

$

11,160

 

$

8,128

 

Work in process

 

1,964

 

985

 

Finished goods

 

13,372

 

14,048

 

 

 

 

 

 

 

Total

 

$

26,496

 

$

23,161

 

 

8.  Commitments and Contingencies

 

Guarantees and Indemnifications

 

Acquisition-related indemnifications—When, as part of an acquisition, the Company acquires all the stock of a company, the Company assumes liabilities for certain events or circumstances that took place prior to the date of acquisition. The maximum potential amount of future payments the Company could be required to make for such obligations is undeterminable. Although certain provisions of the agreements remain in effect indefinitely, the Company believes that the probability of receiving a claim related to acquisitions other than Alliance Systems, Inc. (“Alliance Systems”) is unlikely. As a result, the Company had not recorded any liabilities for such indemnification clauses as of March 31, 2011. As of March 31, 2011, the Company had received a claim related to a sales and use tax audit of Alliance Systems by the state of Texas. The Company is indemnified by the former shareholders of Alliance Systems, as provided under the terms of the merger agreement, for any resulting liabilities related to the period prior to the date that the Company acquired Alliance Systems.

 

The Company enters into standard indemnification agreements in the ordinary course of its business. Pursuant to these agreements, the Company indemnifies, holds harmless, and agrees to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally its business partners or customers, in connection with any patent, copyright, trademark, trade secret or other intellectual property infringement claim by any third party with respect to its products. The term of these indemnification agreements is generally perpetual. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these indemnifications as of March 31, 2011.

 

Product warranties — The Company offers and fulfills standard warranty services on most of its application platform solutions. Warranty terms vary in duration depending upon the product sold, but generally provide for the repair or replacement of any defective products for periods of up to 36 months after shipment. Based upon historical experience and expectation of future conditions, the Company reserves for the estimated costs to fulfill customer warranty obligations upon the recognition of the related revenue. The following table presents changes in the Company’s product warranty liability for the three and six months ended March 31, 2011 and 2010 (in thousands):

 

 

 

Three months ended 
March 31,

 

Six months ended
March 31,

 

 

 

2011

 

2010

 

2011

 

2010

 

 

 

 

 

 

 

 

 

 

 

Beginning balance

 

$

530

 

$

602

 

$

557

 

$

641

 

Accruals for warranties issued

 

347

 

463

 

769

 

787

 

Fulfillment of warranties during the period

 

(376

)

(472

)

(825

)

(835

)

Ending balance

 

$

501

 

$

593

 

$

501

 

$

593

 

 

9



Table of Contents

 

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

Contingencies

 

Initial Public Offering Lawsuit

 

A putative class action lawsuit was filed on December 3, 2001 in the United States District Court for the Southern District of New York against the Company and several underwriters of the Company’s July 2000 initial public offering (“IPO”), alleging that the defendants violated federal securities laws by issuing and selling securities pursuant to the Company’s IPO without disclosing to investors that the underwriter defendants had solicited and received excessive and undisclosed commissions from certain investors. The suit seeks damages and certification of a plaintiff class consisting of all persons who acquired shares of the Company’s common stock between July 13, 2000 and December 6, 2000.  On July 9, 2003, a Special Committee of our Board of Directors authorized the Company to negotiate a settlement of the pending claims substantially consistent with a memorandum of understanding negotiated among the class plaintiffs, all issuer defendants and their insurers. The parties have negotiated the settlement, which provides, among other things, for a release of the Company and the individual defendants for the conduct alleged in the amended complaint to be wrongful. The Company would agree to undertake other responsibilities under the settlement, including agreeing to assign, or not assert, certain potential claims that the Company may have against the underwriters. Any direct financial impact of the proposed settlement is expected to be borne by the Company’s insurers. Any such settlement would be subject to various contingencies, including approval by the court overseeing the litigation. On February 15, 2005, the District Court issued an Opinion and Order preliminarily approving the settlement, provided that the defendants and plaintiffs agree to a modification narrowing the scope of the bar order set forth in the original settlement agreement. The parties agreed to a modification narrowing the scope of the bar order, and on August 31, 2005, the District Court issued an order preliminarily approving the settlement and setting a public hearing on its fairness, which took place on April 24, 2006. On December 5, 2006, the United States Court of Appeals for the Second Circuit overturned the District Court’s certification of the class of plaintiffs who are pursuing the claims that would be settled in the settlement against the underwriter defendants. Thereafter, the District Court ordered a stay of all proceedings in all of the lawsuits pending the outcome of plaintiffs’ petition to the Second Circuit for rehearing en banc and resolution of the class certification issue. On April 6, 2007, the Second Circuit denied plaintiffs’ petition for rehearing, but clarified that the plaintiffs may seek to certify a more limited class in the District Court. On June 25, 2007, the District Court signed an order terminating the settlement. On October 5, 2009, the District Court issued an opinion granting plaintiffs’ motion for final approval of a proposed settlement, approval of the plan of distribution of the settlement fund, and certification of the settlement classes. An Order and Final Judgment was entered on December 30, 2009. Various notices of appeal of the District Court’s October 5, 2009 order were filed. On October 7, 2010, all but two parties who had filed a notice of appeal filed a stipulation with the District Court withdrawing their appeals with prejudice, and the two remaining objectors filed briefs in support of their appeals. On December 8, 2010, plaintiffs moved to dismiss with prejudice the appeal filed by one of the two appellants based on alleged violations of the Second Circuit’s rules, including failure to serve, falsifying proofs of service, and failure to include citations to the record.  The motion was fully briefed as of December 30, 2010, but the Second Circuit has not yet ruled on the motion.  The filing of plaintiffs’ motion tolled the deadline for appellees to file answering briefs on both appeals. The Company is unable to predict the outcome of this suit and as a result, no amounts have been accrued as of March 31, 2011.

 

9. Line of Credit

 

On October 11, 2007, the Company entered into a Loan and Security Agreement (the “Loan Agreement”) with Silicon Valley Bank (the “Bank”) to establish a line of credit from which the Company could borrow. On August 5, 2008, the Company and the Bank entered into the First Loan Modification Agreement (the “First Modification”). The First Modification amended the Loan Agreement to extend its term to August 5, 2010, and to change the amount of the revolving loan facility to $10 million.

 

On February 5, 2010, the Company and the Bank entered into an Amended and Restated Loan and Security Agreement. This agreement amended the Loan Agreement to extend its term to February 4, 2012, and to change the interest rate on the line to one half of a point (0.50%) above the Prime Rate with interest payable monthly. The Prime Rate is the rate announced from time to time by the Bank. The Company is also required to comply with certain financial covenants relating to liquidity and minimum operating cash flows per quarter. As of May 10, 2011, the Company had not drawn on this line of credit.

 

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Table of Contents

 

NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

10. Business Combination

 

On January 18, 2011, the Company entered into a Purchase and Sales Agreement (the “P&S Agreement”) with Multis Limited (“Multis”) to acquire the integration business of Multis in exchange for a cash payment of approximately $505,000.  Multis is a contract manufacturer, and its integration business had been manufacturing certain of the Company’s products since fiscal year 2006.  This acquisition was accounted for as a business combination under Accounting Standards Codification (“ASC”) 805. As such, the purchase price was allocated to the fair value of the acquired assets. Because the Company was the only customer of Multis’ integration business, there were no acquired customer relationships.  The only asset acquired was an assembled workforce, which does not represent an intangible asset under ASC 805 and there were no acquired liabilities.  As such, the entire purchase price was allocated to Goodwill. The Company expects that the goodwill recorded will be fully deductible for tax purposes. This acquisition enabled the Company to have a turn-key ability to meet its growing international requirements, as well as eliminate the time and expenses associated with trans-Atlantic shipments.  Additionally, this acquisition provided the Company with a cost effective alternative to establishing a similar operation independently.

 

The Company also entered into a lease agreement (the “Lease Agreement”) with Multis on January 18, 2011 to lease approximately 20,000 square feet of manufacturing and warehousing space in Galway, Ireland.  The payments due to Multis under the Lease Agreement are at current market rates for similar properties near Galway, Ireland.  As such, these payments are not additional cash consideration paid in connection with this acquisition.  Both the P&S Agreement and the Lease Agreement were effected through the Company’s newly created and wholly owned Irish subsidiary, NEI Ireland Limited (“NEI Ireland”).

 

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Table of Contents

 

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

 

Special Note Regarding Forward-Looking Statements

 

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

 

The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and the notes thereto included in Item 1 in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal year ended September 30, 2010 filed by us with the SEC.

 

Overview

 

As a system integrator, we design and manufacture application platforms and appliance solutions on which software applications are applied to both enterprise and telecommunications networks. We market our application platform solutions and services to original equipment manufacturers, or OEMs, and independent software vendors, or ISVs, that then deliver their software applications in the form of a network-ready hardware or software platform. We brand these platforms for our customers, who subsequently resell and support these platforms to organizations and enterprises. Application platforms are pre-configured server-based network infrastructure devices, engineered to deliver specific software application functionality, ease deployment challenges, improve integration and manageability, accelerate time-to-market and increase the security of that software application in an end user’s network. We also provide platform management software tools and support services related to solution design, integration control, global logistics, and support and maintenance programs.

 

We are currently focused on the following key factors in evaluating our financial condition and operating results:

 

·                  Revenue growth:  We have recently focused our sales and marketing efforts on pursuing new revenue opportunities with large customers.  As we seek to increase our net revenues and operating income, winning new business from large customers, whether new or existing, is expected to have a more significant impact on our revenues and profitability than pursuing opportunities from smaller prospects.  To enhance our ability to win large business opportunities, during the three months ended March 31, 2011 we have realigned our sales team to focus on the markets where our most promising target opportunities (as well as many of our existing customers) are located.  Also, standard platform designs have become more sophisticated in recent years, reducing the need for platform customization.  Therefore, the larger revenue opportunities that we have pursued (and in some cases have won) are increasingly likely to have their needs met by standard platforms, which yield lower gross margins than customized platforms.  However, we believe that pursuing and winning such opportunities will enhance our operating income despite possibly causing our gross margins as a percentage of revenue to decline as compared to historical levels.

 

·                  Managing operating expenses:  Because our gross margin as a percentage of net revenues is relatively low (11.0% for the six months ended March 31, 2011), we view effective management of our operating expenses as critical to maximizing our net income.  We regularly review and scrutinize our headcount and expenditures to ensure that we are spending in accordance with our established budget and that we are receiving commensurate value from our expenditures, while ensuring that we maintain our ability to meet our customers’ needs.  We believe that by leveraging our existing operating infrastructure, we can support significant growth in net revenues without incurring significant incremental operating expenses.

 

·                  Increasing service revenues:  Our service revenues have historically amounted to less than 5% of our total net revenues.  One of our objectives is to increase the proportion of customers that purchase services from us (our “attach rate”) in order to enhance our net revenues, gross margin, and operating income.  However, the larger customer opportunities which we have been pursuing tend to have lower attach rates, as they are

 

12



Table of Contents

 

more likely than smaller companies to utilize existing in-house service capabilities instead of purchasing services from their system integrator vendors.

 

·                  Customer service:  Because most application platforms can be built using standard, commodity hardware and operating systems, we believe that a key point of differentiation for providers of application platforms is the ability to provide technical expertise and excellent customer service.  We believe that offering a range of support services which many of our customers perceive as valuable enhances our ability to attract and retain customers.

 

·                  Managing working capital:  We regularly monitor our working capital to ensure that we maintain sufficient liquidity to fund our operating and investing needs.  The key components of our working capital management include timely collection of accounts receivable to shorten the cycle of converting our sales to cash, and effective purchasing of inventory to ensure that we obtain materials on a timely basis to fulfill our customers’ needs, while minimizing excess and obsolete inventory and maximizing the annualized rate at which we turn over our inventory.

 

We are also focused on the key risks and challenges which we are currently facing, including the following:

 

·                  Dependence on key customers:  During the six months ended March 31, 2011, our top two customers accounted for 71% of our total net revenues.  We have a contractual agreement with one of these customers, and we rely solely on purchase orders from our other key customer. In both circumstances, these customers are not obligated to purchase any minimum quantity of products from us and they can use alternative suppliers for any portion of these solutions we provide to them.  One of the expected benefits of our strategy of pursuing larger revenue opportunities is to decrease our dependence on two customers for such a large percentage of our revenues.

 

·                  Some of our key components are manufactured in Japan.  As a result of the recent earthquake in the Japan, there have been a limited number of reports of supply chain shortages and interruptions. While we do not expect there to be a material impact on our supply chain, we are actively monitoring the situation to mitigate any risk of supply chain shortages.

 

·                  Technology trends:  Computer hardware and software technologies can change dramatically and rapidly, which can present risks to providers in these markets.  We regularly monitor developments in our target markets and formulate strategies to ensure we are prepared to respond to such developments, and to the possibility that our customers’ needs may change as a result, in a timely manner.  For example, the introduction of next-generation components by key technology developers requires us to manage transitions from one generation to the next and ensure that new technologies are interoperable with our customers’ applications.  Recently, virtualization and “cloud computing” have emerged as trends which are expected to impact our target markets, perhaps significantly, in the coming years.  We have begun efforts to increase our participation in these areas and enhance our ability to offer customers the deployment of their applications in whatever form or forms they desire.

 

·                  Variability of net revenues:  Many of our customers, especially those in the telecommunications market, have project-oriented businesses.  When a given significant project is in process, the volume of our sales to such customers tends to increase.  After such a project is completed, our sales to such customers may decline for varying periods of time, depending on the timing and magnitude of other projects which may be in process.  As a result, the revenues that we generate from sales to such customers can vary significantly from quarter to quarter and, possibly, from year to year.  We obtain forecasts from our customers, generally on a monthly or quarterly basis, in order to enhance our ability to anticipate these revenue trends and plan for the resulting fluctuations in our customers’ needs.

 

Critical Accounting Policies and Estimates

 

Our discussion and analysis of financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America.  In preparing these financial statements, we have made estimates and judgments in determining certain amounts included in the financial statements.  We base our estimates and judgments on historical experience and other assumptions that we believe to be reasonable under the circumstances.  Actual results may differ from these estimates under different assumptions or conditions.  There have been no changes to our critical accounting policies since September 30, 2010.

 

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Table of Contents

 

Results of Operations

 

Three months ended March 31, 2011 compared to the three months ended March 31, 2010

 

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

 

 

 

Three months ended March 31,

 

 

 

2011

 

2010

 

Increase (Decrease)

 

 

 

Dollars

 

% of Net 
Revenues

 

Dollars

 

% of Net 
Revenues

 

Dollars

 

Percentage

 

Net revenues

 

$

64,953

 

100.0

%

$

55,030

 

100.0

%

$

9,923

 

18.0

%

Gross margin

 

7,556

 

11.6

%

6,503

 

11.8

%

1,053

 

16.2

%

Operating expenses

 

6,121

 

9.4

%

6,232

 

11.3

%

(111

)

(1.8

)%

Income from operations

 

1,435

 

2.2

%

271

 

0.5

%

1,164

 

429.5

%

Net income

 

1,477

 

2.3

%

236

 

0.4

%

1,241

 

525.8

%

 

Net Revenues

 

The increase in net revenues during the quarter ended March 31, 2011 as compared to the quarter ended March 31, 2010 was primarily due to increased sales volume to EMC Corporation (“EMC”) during the quarter ended March 31, 2011.  The increase in sales to EMC of $14.0 million was primarily the result of the high volume design win achieved in fiscal year 2009, which was not fully ramped during the quarter ended March 31, 2010.  This increase was partially offset by a $6.6 million decrease in sales to our second largest customer, Tektronix. This decrease was due to their completion of a telecommunications project during fiscal year 2010.  Our sales to Tektronix are largely project-driven and are therefore volatile from period to period.

 

Gross Margin

 

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

 

Gross margin increased in the three months ended March 31, 2011 as compared to the three months ended March 31, 2010, primarily due to increased sales volumes to EMC.  This increase in sales to EMC resulted in a decrease in gross margin as a percentage of net revenues, as our high volume business with EMC carries a lower gross margin than our historical levels. To the extent that our high volume business with EMC increases as a percentage of our net revenues, our gross margin as a percentage of net revenues may decrease.  We have pursued such opportunities in order to increase revenues and leverage those revenues over our existing infrastructure to improve operating margins.

 

Operating Expenses

 

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

 

 

 

Three months ended March 31,

 

 

 

2011

 

2010

 

Increase (Decrease)

 

 

 

Dollars

 

% of Net 
Revenues

 

Dollars

 

% of Net 
Revenues

 

Dollars

 

Percentage

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

$

1,611

 

2.5

%

$

1,584

 

2.9

%

$

27

 

1.7

%

Selling and marketing

 

1,951

 

3.0

%

2,060

 

3.7

%

(109

)

(5.3

)%

General and administrative

 

2,227

 

3.4

%

2,199

 

4.0

%

28

 

1.3

%

Amortization of intangible asset

 

332

 

0.5

%

389

 

0.7

%

(57

)

(14.7

)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

$

6,121

 

9.4

%

$

6,232

 

11.3

%

$

(111

)

(1.8

)%

 

14



Table of Contents

 

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 application platform solutions.  We expense all of our research and development costs as they are incurred.  The following table summarizes the most significant components of research and development expense for the periods indicated, in thousands and as a percentage of total research and development expense, and provides the changes in thousands and percentages:

 

 

 

Three months ended March 31,

 

 

 

2011

 

2010

 

Increase (Decrease)

 

 

 

Dollars

 

% of 
Expense 
Category

 

Dollars

 

% of 
Expense 
Category

 

Dollars

 

Percentage

 

Research and development:

 

 

 

 

 

 

 

 

 

 

 

 

 

Compensation and related expenses

 

$

1,177

 

73.1

%

$

1,227

 

77.5

%

$

(50

)

(4.1

)%

Stock-based compensation

 

29

 

1.8

%

43

 

2.7

%

(14

)

(32.6

)%

Prototype

 

110

 

6.8

%

188

 

11.9

%

(78

)

41.5

%

Consulting and professional services

 

129

 

8.0

%

72

 

4.5

%

57

 

79.2

%

Other

 

166

 

10.3

%

54

 

3.4

%

112

 

207.4

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total research and development

 

$

1,611

 

100

%

$

1,584

 

100

%

$

27

 

1.7

%

 

Research and development expenses slightly increased in the three months ended March 31, 2011, as compared to the three months ended March 31, 2010, primarily due to increases in consulting and other expenses, partially offset by decreases in prototype and compensation and related expenses.  Prototype and consulting and professional services expenses tend to fluctuate based on the status of our development projects which are in process at any given time. Although our application platform development strategy emphasizes the utilization of standard component technologies, which utilize off-the-shelf components, qualification of these platforms still requires prototype and consulting and professional services. As such, we expect that prototype and consulting and professional services costs will continue to be variable and could fluctuate depending on the timing and magnitude of our development projects.  Compensation and related expenses decreased primarily due to a decrease in variable compensation.  Pursuant to our bonus plans for the six months ending March 31, 2010 (the “First Half 2010 Bonus Plan”) and March 31, 2011 (the “First Half 2011 Bonus Plan”), respectively, our executive officers and certain other of our employees (collectively, the “Participants”) had the opportunity to earn cash incentive bonuses based on our performance for the first half of fiscal year 2010 or 2011, as applicable.  Targeted incentive bonuses for the Participants in the plans were equal to 50% of each Participant’s annual incentive bonus target.  Measurement of our performance was based on our net income for the first half of fiscal year 2010 or 2011, as applicable, calculated in accordance with accounting principles generally accepted in the United States (“GAAP”), but prior to calculating the bonus payment.  During the six months ended March 31, 2010, we did not achieve the targeted GAAP profitability (the “Corporate Metric”) under the First Half 2010 Bonus Plan until the second quarter of fiscal 2010, whereas we achieved the Corporate Metric under the First Half 2011 Bonus Plan in the first quarter of fiscal 2011.  As such, less variable compensation expense was accrued in the three months ended March 31, 2011 as compared to the three months ended March 31, 2010.

 

Selling and Marketing

 

Selling and marketing expenses consist primarily of salaries and commissions for personnel engaged in sales and marketing, and costs associated with our marketing programs, which include costs associated with our attendance at trade shows, public relations, product literature costs, web site enhancements, 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:

 

15



Table of Contents

 

 

 

Three months ended March 31,

 

 

 

2011

 

2010

 

Increase (Decrease)

 

 

 

Dollars

 

% of 
Expense 
Category

 

Dollars

 

% of 
Expense 
Category

 

Dollars

 

Percentage

 

Selling and marketing:

 

 

 

 

 

 

 

 

 

 

 

 

 

Compensation and related expenses

 

$

1,446

 

74.1

%

$

1,567

 

76.0

%

$

(121

)

(7.7

)%

Stock-based compensation

 

81

 

4.2

%

92

 

4.5

%

(11

)

(12.0

)%

Marketing programs

 

158

 

8.1

%

150

 

7.3

%

8

 

5.3

%

Travel

 

74

 

3.8

%

70

 

3.4

%

4

 

5.7

%

Other

 

192

 

9.8

%

181

 

8.8

%

11

 

6.1

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total selling and marketing

 

$

1,951

 

100

%

$

2,060

 

100

%

$

(109

)

(5.3

)%

 

Selling and marketing expenses decreased in the three months ended March 31, 2011, as compared to the three months ended March 31, 2010, primarily due to a decrease in compensation and related expenses.  Compensation and related expenses decreased primarily due to a decrease in variable compensation. During the six months ended March 31, 2010, we did not achieve the Corporate Metric under the First Half 2010 Bonus Plan until the second quarter of fiscal 2010, whereas we achieved the Corporate Metric under the First Half 2011 Bonus Plan in the first quarter of fiscal 2011.  As such, less variable compensation expense was accrued in the three months ended March 31, 2011 as compared to the three months ended March 31, 2010.

 

General and Administrative

 

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

 

 

 

Three months ended March 31,

 

 

 

2011

 

2010

 

Increase (Decrease)

 

 

 

Dollars

 

% of 
Expense 
Category

 

Dollars

 

% of 
Expense 
Category

 

Dollars

 

Percentage

 

General and administrative:

 

 

 

 

 

 

 

 

 

 

 

 

 

Compensation and related expenses

 

$

1,170

 

52.5

%

$

1,303

 

59.3

%

$

(133

)

(10.2

)%

Stock-based compensation

 

93

 

4.2

%

108

 

4.9

%

(15

)

(13.9

)%

Consulting and professional services

 

613

 

27.5

%

490

 

22.3

%

123

 

25.1

%

Other

 

351

 

15.8

%

298

 

13.5

%

53

 

17.8

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total general and administrative

 

$

2,227

 

100

%

$

2,199

 

100

%

$

28

 

1.3

%

 

General and administrative expenses increased in the three months ended March 31, 2011, as compared to the three months ended March 31, 2010, primarily due to increases in consulting and professional services and other expenses, partially offset by a decrease in compensation and related expenses.  The increase in consulting and professional services was primarily attributable to increased consulting and outside service fees associated with the acquisition and integration of NEI Ireland during the three months ended March 31, 2011.  The increase in other expenses was primarily related to increased travel expenses incurred during the three months ended March 31, 2011 associated with the integration of NEI Ireland.  Compensation and related expenses decreased primarily due to a decrease in variable compensation. During the six months ended March 31, 2010, we did not achieve the Corporate Metric under the First Half 2010 Bonus Plan until the second quarter of fiscal 2010, whereas we achieved the Corporate Metric under the First Half 2011 Bonus Plan in the first quarter of fiscal 2011.  As such, less variable compensation expense was accrued in the three months ended March 31, 2011 as compared to the three months ended March 31, 2010.

 

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Table of Contents

 

Amortization of Intangible Asset

 

Amortization of the intangible asset decreased by $57,000 in the three months ended March 31, 2011, as compared to the three months ended March 31, 2010.  Amortization expense for the intangible asset decreases annually to reflect the fact that the estimated economic benefit expected to be received from the intangible asset declines over time.

 

Interest and Other Income (Expense), net

 

Interest and other income (expense), net, totaled $102,000 of income for the three months ended March 31, 2011, compared to $(26,000) of expense for the three months ended March 31, 2010.  This change was primarily due to foreign currency exchange gains of $139,000 recorded during the three months ended March 31, 2011 as compared to losses of $(13,000) recorded during the three months ended March 31, 2010.  These foreign currency gains and losses relate to value-added tax (“VAT”) refunds receivable.  The refundable VAT amounts, which we pay on products and services purchased from our vendors in the European Union (“EU”), are denominated in Euros.  While these VAT amounts are refundable to us, we are exposed to foreign currency exchange gains and losses between the time at which we pay the VAT on certain purchases and the time at which we receive the VAT refund from foreign tax authorities.  The foreign currency gains recorded during the three months ended March 31, 2011 increased primarily as a result of the increased volatility in the foreign currency exchange markets, specifically the Euro.  Additionally, we have increased our purchasing of materials from vendors within the EU as a result of our recent acquisition (see Note 10 in the notes to the condensed consolidated financial statements for details regarding the acquisition). These foreign currency gains recorded during the three months ended March 31, 2011 were partially offset by $(39,000) of interest expense, as compared to $(13,000) of interest expense recorded during the three months ended March 31, 2010.

 

Provision for Income Taxes

 

The provision for income taxes for the three months ended March 31, 2011 was $60,000, as compared to $9,000 for the three months ended March 31, 2010.  This increase was related to the increase in taxable income.  Although we have significant net operating loss carryforwards which can be used to offset federal and most state taxable income, we are subject to state taxes in various jurisdictions where we do not have net operating loss carryforwards or where states have suspended the use of net operating loss carryforwards to offset taxable income.

 

Six months ended March 31, 2011 compared to the six months ended March 31, 2010

 

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

 

 

 

Six Months ended March 31,

 

 

 

2011

 

2010

 

Increase (Decrease)

 

 

 

Dollars

 

% of Net 
Revenues

 

Dollars

 

% of Net 
Revenues

 

Dollars

 

Percentage

 

Net revenues

 

$

136,659

 

100.0

%

$

99,082

 

100.0

%

$

37,577

 

37.9

%

Gross profit

 

15,078

 

11.0

%

12,558

 

12.7

%

2,520

 

20.1

%

Operating expenses

 

12,061

 

8.8

%

12,083

 

12.2

%

(22

)

(0.2

)%

Income from operations

 

3,017

 

2.2

%

475

 

0.5

%

2,542

 

535.2

%

Net income

 

2,829

 

2.1

%

434

 

0.4

%

2,395

 

551.8

%

 

Net Revenues

 

The increase in net revenues during the six months ended March 31, 2011 as compared to the six months ended March 31, 2010 was primarily the result of increased sales volume to EMC, which increased by $38.9 million during the six months ended  March 31, 2011.  Shipments related to our high volume design win from 2009 were fully ramped during the six months ended March 31, 2011.  This increase to EMC was partially offset by a decrease of $7.4 million in revenues to Tektronix. Our revenues to other customers increased by $6.1 million during the six months ended March 31, 2011, as compared to the six months ended March 31, 2010.

 

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Table of Contents

 

Gross Margin

 

Gross margin increased in the six months ended March 31, 2011 as compared to the six months ended March 31, 2010, primarily due to increased sales volumes to EMC.  This increase in sales to EMC resulted in a decrease in gross margin as a percentage of net revenues, as our high volume business with EMC carries a lower gross margin than our historical levels.  To the extent that our high volume business with EMC increases as a percentage of our net revenues, our gross margin as a percentage of net revenues may decrease.  We have pursued such opportunities in order to increase revenues and leverage those revenues over our existing infrastructure to improve operating margins.

 

Operating Expenses

 

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

 

 

 

Six months ended March 31,

 

 

 

2011

 

2010

 

Increase (Decrease)

 

 

 

Dollars

 

% of Net 
Revenues

 

Dollars

 

% of Net 
Revenues

 

Dollars

 

Percentage

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

$

3,178

 

2.3

%

$

3,267

 

3.3

%

$

(89

)

(2.7

)%

Selling and marketing

 

3,861

 

2.8

%

3,818

 

3.9

%

43

 

1.1

%

General and administrative

 

4,357

 

3.2

%

4,220

 

4.3

%

137

 

3.2

%

Amortization of intangible asset

 

665

 

0.5

%

778

 

0.8

%

(113

)

(14.5

)%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

$

12,061

 

8.8

%

$

12,083

 

12.2

%

$

(22

)

(0.2

)%

 

Research and Development

 

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

 

 

 

Six months ended March 31,

 

 

 

2011

 

2010

 

Increase (Decrease)

 

 

 

Dollars

 

% of 
Expense 
Category

 

Dollars

 

% of 
Expense 
Category

 

Dollars

 

Percentage

 

Research and development:

 

 

 

 

 

 

 

 

 

 

 

 

 

Compensation and related expenses

 

$

2,346

 

73.8

%

$

2,242

 

68.6

%

$

104

 

4.6

%

Stock-based compensation

 

62

 

2.0

%

89

 

2.7

%

(27

)

(30.3

)%

Prototype

 

282

 

8.9

%

514

 

15.7

%

(232

)

(45.1

)%

Consulting and professional services

 

216

 

6.8

%

214

 

6.6

%

2

 

0.9

%

Other

 

272

 

8.5

%

208

 

6.4

%

64

 

30.8

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total research and development

 

$

3,178

 

100

%

$

3,267

 

100

%

$

(89

)

(2.7

)%

 

Research and development expenses decreased in the six months ended March 31, 2011, as compared to the six months ended March 31, 2010, primarily due to decreases in prototype and stock-based compensation expenses, partially offset against an increase in compensation and related expenses.   Prototype and consulting and professional services expenses tend to fluctuate based on the status of our development projects which are in process at any given time. We expect that prototype and consulting and professional services costs will continue to be variable and could fluctuate depending on the timing and magnitude of our development projects.  The decrease in stock-based compensation was primarily due to the fact that certain stock options granted in prior periods reached the end of their vesting periods during the six months ended March 31, 2011.  Compensation and related expenses increased partially due to an increase in salaries and wages, which was the result of planned salary increases which took effect during the fourth quarter of fiscal 2010, as well as an increase in variable compensation, which was directly related to the improved results of operations.

 

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Table of Contents

 

Selling and Marketing

 

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

 

 

 

Six months ended March 31,

 

 

 

2011

 

2010

 

Increase (Decrease)

 

 

 

Dollars

 

% of 
Expense 
Category

 

Dollars

 

% of 
Expense 
Category

 

Dollars

 

Percentage

 

Selling and marketing:

 

 

 

 

 

 

 

 

 

 

 

 

 

Compensation and related expenses

 

$

2,924

 

75.8

%

$

2,878

 

75.5

%

$

46

 

1.6

%

Stock-based compensation

 

152

 

3.9

%

169

 

4.4

%

(17

)

(10.1

)%

Marketing programs

 

224

 

5.8

%

204

 

5.3

%

20

 

9.8

%

Travel

 

163

 

4.2

%

169

 

4.4

%

(6

)

(3.6

)%

Other

 

398

 

10.3

%

398

 

10.4

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total selling and marketing

 

$

3,861

 

100

%

$

3,818

 

100

%

$

43

 

1.1

%

 

Selling and marketing expenses increased in the six months ended March 31, 2011, as compared to the six months ended March 31, 2010, primarily due to increases in compensation and related expenses and marketing program expenses.  The increase in compensation and related expenses was primarily attributed to an increase in variable compensation in the six months ended March 31, 2011, which was directly related to the improved results of operations.  The increase in marketing programs was primarily attributable to increased advertising expenses incurred during the six months ended March 31, 2011 as compared to the six months ended March 31, 2010.  During the six months ended March 31, 2011, we increased our presence in certain technology industry publications in an effort to explore new business opportunities.

 

General and Administrative

 

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

 

 

 

Six months ended March 31,

 

 

 

2011

 

2010

 

Increase (Decrease)

 

 

 

Dollars

 

% of 
Expense 
Category

 

Dollars

 

% of 
Expense 
Category

 

Dollars

 

Percentage

 

General and administrative:

 

 

 

 

 

 

 

 

 

 

 

 

 

Compensation and related expenses

 

$

2,408

 

55.3

%

$

2,381

 

56.4

%

$

27

 

1.1

%

Stock-based compensation

 

179

 

4.1

%

259

 

6.1

%

(80

)

(30.9

)%

Consulting and professional services

 

1,081

 

24.8

%

930

 

22.1

%

151

 

16.2

%

Other

 

689

 

15.8

%

650

 

15.4

%

39

 

6.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total general and administrative

 

$

4,357

 

100

%

$

4,220

 

100

%

$

137

 

3.2

%

 

General and administrative increased in the six months ended March 31, 2011, as compared to the six months ended March 31, 2010, primarily due to increases in consulting and professional services, partially offset by decreases in stock-based compensation.  The increase in consulting and professional services was primarily attributable to an increase in professional service expenses associated with the acquisition of the integration operations of Multis Limited (see Note 10 in the notes to the condensed consolidated financial statements for details regarding the acquisition).  The decrease in stock-based compensation was primarily due to the fact that certain stock options granted in prior periods reached the end of their vesting periods during the six months ended March 31, 2011.

 

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Table of Contents

 

Amortization of Intangible Asset

 

Amortization of the intangible asset decreased by $113,000 in the six months ended March 31, 2011, as compared to the six months ended March 31, 2010.  Amortization expense for the intangible asset decreases annually over time, to reflect the fact that the estimated economic benefit expected to be received from the intangible asset declines over time.

 

Interest and Other Income (Expense), net

 

Interest and other income (expense), net, increased to $46,000 of income for the six months ended March 31, 2011, as compared to $(8,000) of expense for the six months ended March 31, 2010.  The change was primarily attributed to foreign currency gains of $92,000 recorded during the six months ended March 31, 2011 as compared to foreign currency exchange losses of $18,000 recorded during the six months ended March 31, 2010.  This change was partially offset by increased interest expense of $(53,000) recorded during the six months ended March 31, 2011 as compared to interest income of $11,000 recorded during the six months ended March 31, 2010.

 

Provision for Income Taxes

 

The provision for income taxes for the six months ended March 31, 2011 was $234,000 as compared to $33,000 recorded for the six months ended March 31, 2010. This increase was primarily related to the increase in taxable income.  Although we have significant net operating loss carryforwards which can be used to offset taxable income, we are still subject to state taxes in various jurisdictions where we do not have net operating loss carryforwards or where states have suspended the use of net operating loss carryforwards to offset taxable income.

 

Liquidity and Capital Resources

 

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

 

 

 

Six months ended
March 31,

 

 

 

2011

 

2010

 

 

 

 

 

 

 

Net income

 

$

2,829

 

$

434

 

Non-cash adjustments to net income

 

1,611

 

1,795

 

Changes in working capital

 

(3,307

)

(10,266

)

 

 

 

 

 

 

Net cash provided by (used in) operating activities

 

1,133

 

(8,037

)

 

 

 

 

 

 

Net cash (used in) provided by investing activities

 

(1,410

)

3,221

 

Net cash provided by (used in) financing activities

 

62

 

(85

)

 

 

 

 

 

 

Net decrease in cash and cash equivalents

 

(215

)

(4,901

)

Beginning cash and cash equivalents

 

15,323

 

21,039

 

 

 

 

 

 

 

Ending cash and cash equivalents

 

$

15,108

 

$

16,138

 

 

Operating Activities

 

Cash provided by operating activities of $1.1 million during the six months ended March 31, 2011 was primarily the result of the net income for the period and the impact of non-cash adjustments to net income, partially offset by the net impact of changes in working capital. Non-cash adjustments to net income consisted primarily of depreciation and amortization expense of $1.1 million and stock-based compensation of $464,000. Of the $3.3 million net changes in working capital, $3.3 million was due to an increase in inventories, $4.5 million was the result of an increase in accounts receivable and $2.6 million was due to an increase in VAT receivable, which were partially offset by a $4.9 million increase in accounts payable. The increase in the VAT receivable balance was primarily related to an increase in purchasing during the six months ended March 31, 2011 from vendors which are located within the EU in support of our new manufacturing facility in Galway, Ireland.  Changes in working capital

 

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Table of Contents

 

in all periods are also impacted by variations in the timing and magnitude of cash receipts, cash disbursements, inventory receipts and invoicing to customers.

 

Cash used in operating activities of $8.0 million during the six months ended March 31, 2010 was primarily the result of net cash used in changes in working capital, partially offset by net income and the impact of non-cash adjustments to net income.  The changes in working capital were partially the result of an increase in accounts receivable, which was primarily related to higher net revenues in the three months ended March 31, 2010 compared to the three months ended September 30, 2009.  The changes in working capital were also partially the result of an increase in inventories, which was primarily due to increased purchasing to meet expected future customer demand, in particular as a result of the ramping up of new business relating to our fiscal year 2009 design wins.

 

Investing Activities

 

Cash used in investing activities during the six months ended March 31, 2011 was due to the use of $905,000 of cash for purchases of property and equipment and the use of $505,000 related to our acquisition of the integration operations of Multis Limited (see Note 10 in the notes to the condensed consolidated financial statements for details regarding the acquisition).  Cash provided by investing activities during the six months ended March 31, 2010 was primarily the result of the receipt of the $3.6 million in refundable acquisition consideration, which was a return of cash we originally paid in connection with a business combination in fiscal year 2008. This increase in cash was partially offset by the use of $408,000 of cash for purchases of property and equipment.

 

Financing Activities

 

Cash provided by financing activities during the six months ended March 31, 2011 consisted of the receipt of $92,000 as a result of employee stock option exercises, partially offset by $30,000 used to pay fees associated with our bank line of credit.  Cash used in financing activities during the six months ended March 31, 2010 consisted primarily of $177,000 used to repurchase shares of our common stock and $38,000 used to pay fees associated with our bank line of credit, partially offset by the receipt of $130,000 as the result of employee stock option exercises (see Note 9 in the notes to the condensed consolidated financial statements for details regarding the line of credit).

 

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

 

·                  the timing and size of orders from our customers;

 

·                  the timeliness of receipts of payments from our customers;

 

·                  the timing and size of our purchase of inventories;

 

·                  our ability to enter into partnerships with OEMs and ISVs;

 

·                  the level of success of our customers in selling systems that include our application platform solutions;

 

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

 

·                  market developments.

 

We believe that our available cash resources, cash that we expect to generate from sales of our products and services, and cash available through the Silicon Valley Bank line of credit will be sufficient to meet our operating and capital requirements through at least the next twelve months.

 

In the event that our available cash resources and the Silicon Valley Bank line of credit are not sufficient, or if an event of default occurs, such as failure to achieve certain financial covenants, that limits our ability to borrow under the line of credit, we may need to raise additional funds. We may in the future seek to raise additional funds through borrowings, public or private equity financings or from other sources. On April 28, 2010, we filed a Shelf Registration Statement on Form S-3 (the “Shelf Registration Statement”), pursuant to which we may sell, from time to time, any combination of securities under the prospectus included in the Shelf Registration Statement, for an

 

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Table of Contents

 

aggregate offering price of up to $40,000,000. Under the Shelf Registration Statement, we may offer, from time to time, common stock, preferred stock, debt securities, depository shares, purchase contracts, purchase units, warrants, or any combination of the above securities.

 

There can be no assurance that additional financing will be available at all or, if available, will be on terms acceptable to us. Additional equity financings could result in dilution to our shareholders. If additional financing is needed and is not available on acceptable terms, we may need to reduce our operating expenses and scale back our operations.

 

Contractual Obligations and Commitments

 

On March 31, 2011, we entered into an Eighth Amendment to the Lease Agreement (the “Amendment”) with Great Point Investors, LLC that replaces and extends our previous lease for 52,000 square feet of manufacturing and office space located at 25 Dan Road, Canton, Massachusetts, 02021.

 

The Lease has an initial term of 78 months, with two available extension options of five years, each at our election.  The cumulative base rent under the initial term of the Lease totals $2,590,000, with rent payable monthly.  Under the terms of the Lease, we are responsible for the payment of additional rent items, which include property taxes and operating costs, payable monthly.

 

With the exception of the Amendment executed on March 31, 2011, there were no other material changes to our contractual obligations and commitments during the six months ended March 31, 2011 as disclosed in our Annual Report on Form 10-K for the year ended September 30, 2010.

 

The following table sets forth certain information concerning our obligations and commitments to make certain payments, as of March 31, 2011 (in thousands):

 

 

 

Payments Due by Period

 

 

 

Less than
1 Year

 

1-3 Years

 

3-5 Years

 

After
 5 Years

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating leases

 

$

797

 

$

2,039

 

$

2,160

 

$

1,564

 

$

6,560

 

Capital lease obligation

 

17

 

21

 

 

 

38

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

814

 

$

2,060

 

$

2,160

 

$

1,564

 

$

6,598

 

 

Off-Balance Sheet Arrangements

 

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

 

ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

We engage in certain transactions which are denominated in currencies other than the U.S. dollar (primarily the Euro). These transactions may subject us to exchange rate risk based on fluctuations in currency exchange rates, which occur between the time such a transaction is recognized in our financial statements and the time that the transaction is settled. Historically, our exchange rate risk was not material; however, as a result of the recent acquisition of our manufacturing facility in Galway, Ireland, our purchasing from vendors located within the EU has increased. As these transactions are denominated in Euros, we are subject to exchange rate risk, which may be material.  We do not engage in any foreign currency hedging transactions. We are exposed to market risk related to changes in interest rates. In the past, we have invested excess cash balances in cash equivalents and short-term investments, and if we were to do so in the future, 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 would not be material. In

 

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Table of Contents

 

addition, we believe that a hypothetical 10% increase or decrease in interest rates would not have a material adverse effect on our financial condition.

 

ITEM 4.    CONTROLS AND PROCEDURES

 

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act) as of March 31, 2011.  Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of March 31, 2011, our disclosure controls and procedures (1) were designed to effectively accumulate and communicate information to the Company’s management, as appropriate, to allow timely decisions regarding required disclosure and (2) were effective, in that they provide reasonable assurance that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

 

During the three months ended March 31, 2011, no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

PART II—OTHER INFORMATION

 

ITEM 1.     LEGAL PROCEEDINGS

 

Initial Public Offering Lawsuit

 

A putative class action lawsuit was filed on December 3, 2001 in the United States District Court for the Southern District of New York against us and several underwriters of our July 2000 initial public offering (“IPO”), alleging that the defendants violated federal securities laws by issuing and selling securities pursuant to our IPO without disclosing to investors that the underwriter defendants had solicited and received excessive and undisclosed commissions from certain investors. The suit seeks damages and certification of a plaintiff class consisting of all persons who acquired shares of our common stock between July 13, 2000 and December 6, 2000.  On July 9, 2003, a Special Committee of our Board of Directors authorized us to negotiate a settlement of the pending claims substantially consistent with a memorandum of understanding negotiated among the class plaintiffs, all issuer defendants and their insurers. The parties have negotiated the settlement, which provides, among other things, for a release of us and the individual defendants for the conduct alleged in the amended complaint to be wrongful. We would agree to undertake other responsibilities under the settlement, including agreeing to assign, or not assert, certain potential claims that we may have against the underwriters. Any direct financial impact of the proposed settlement is expected to be borne by the our insurers. Any such settlement would be subject to various contingencies, including approval by the court overseeing the litigation. On February 15, 2005, the District Court issued an Opinion and Order preliminarily approving the settlement, provided that the defendants and plaintiffs agree to a modification narrowing the scope of the bar order set forth in the original settlement agreement. The parties agreed to a modification narrowing the scope of the bar order, and on August 31, 2005, the District Court issued an order preliminarily approving the settlement and setting a public hearing on its fairness, which took place on April 24, 2006. On December 5, 2006, the United States Court of Appeals for the Second Circuit overturned the District Court’s certification of the class of plaintiffs who are pursuing the claims that would be settled in the settlement against the underwriter defendants. Thereafter, the District Court ordered a stay of all proceedings in all of the lawsuits pending the outcome of plaintiffs’ petition to the Second Circuit for rehearing en banc and resolution of the class certification issue. On April 6, 2007, the Second Circuit denied plaintiffs’ petition for rehearing, but clarified that the plaintiffs may seek to certify a more limited class in the District Court. On June 25, 2007, the District Court signed an order terminating the settlement. On October 5, 2009, the District Court issued an opinion granting plaintiffs’ motion for final approval of a proposed settlement, approval of the plan of distribution of the settlement fund, and certification of the settlement classes. An Order and Final Judgment was entered on December 30, 2009. Various notices of appeal of the District Court’s October 5, 2009 order were filed. On October 7, 2010, all but two parties who had filed a notice of appeal filed a stipulation with the District Court withdrawing their appeals with prejudice, and the two remaining objectors filed briefs in support of their appeals. On December 8, 2010, plaintiffs moved to dismiss with prejudice the appeal filed by one of the two appellants based on alleged violations of the Second Circuit’s rules, including failure to serve, falsifying proofs of service, and failure to include citations to the record.  The motion was fully briefed as of December 30, 2010, but the Second Circuit has not yet ruled on the motion.  The filing of plaintiffs’ motion tolled the deadline for appellees to file answering briefs

 

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on both appeals. We are unable to predict the outcome of this suit and as a result, no amounts have been accrued as of March 31, 2011.

 

ITEM 1A. RISK FACTORS

 

The risks and uncertainties described below are not the only ones we are faced with.  Additional risks and uncertainties not presently known to us, or that are currently deemed immaterial, may also impair our business operations.  If any of the following risks actually occur, our financial condition and operating results could be materially adversely affected.  Subsequent to the previous disclosure of risk factors in Item 1A of Part I of our most recent Annual Report on Form 10-K for the fiscal year ended September 30, 2010, other than the removal of the risk associated with our contract manufacturer, there have been no significant changes in our risk factors.

 

Risks of dependence on customers who represent more than 10% of net revenues.

 

We derive a significant portion of our revenues from sales of application platform solutions directly to EMC and Tektronix and our revenues may decline significantly if these customers reduce, cancel or delay purchases of our products, terminate their relationships with us or exercise certain of their contractual rights.

 

For the three month ended March 31, 2011 and 2010, sales directly to EMC, our largest customer, accounted for 59% and 44%, of our total net revenues, respectively.  For the six months ended March 31, 2011 and 2010, sales directly to EMC accounted for 59% and 42%, of our total net revenues, respectively.  These sales are primarily attributable to a limited number of products pursuant to non-exclusive contracts. In the fourth quarter of fiscal year 2009, we won new business to provide additional products to EMC. Gross margins as a percentage of net revenues associated with EMC decreased during the fiscal year ended September 30, 2010 as this new business ramped up. To the extent that our sales associated with EMC increase as a percentage of our total net revenues, our overall gross margin percentage may decrease.

 

EMC may terminate our non-exclusive contracts in the event that we attempt to assign our rights under the agreements to another party without EMC’s prior approval. Furthermore, in the event that we default on certain portions of the agreement, EMC has the right to manufacture certain products in exchange for a mutually agreeable royalty fee.

 

For the three months ended March 31, 2011 and 2010, sales directly to Tektronix, our second largest customer, accounted for 11% and 25% of our total net revenues, respectively. For the six months ended March 31, 2011 and 2010, sales directly to Tektronix accounted for 11% and 23% of our total net revenues, respectively. These sales are primarily attributable to a limited number of products pursuant to a non-exclusive contract. The nature of the products we sell to Tektronix is largely project driven; thus, our sales to Tektronix are subject to volatility from period to period. We have limited visibility into their future projects. Upon completion of their projects, there is no assurance we will sell products to Tektronix for any new projects. If Tektronix does not require our products and services for their future projects, our sales to this customer would decline and our operating results would be harmed. Accordingly, the success of our business will depend, to some degree, on this customer’s willingness to continue to utilize our application platform solutions in its existing and future products.

 

Our financial success is dependent upon the future success of the products we sell to these customers and the continued growth of these customers, whose industries have a history of rapid technological change, short product lifecycles, consolidation and pricing and margin pressures. These customers have the right to enter into agreements with alternative suppliers for the application platform solutions we provide or for portions of those solutions or for similar products, are not obligated to purchase any minimum quantity of products from us and may choose to stop purchasing from us at any time, with or without cause. A significant reduction in sales to these customers, or significant pricing and additional margin pressures exerted on us by these customers, would have a material adverse effect on our results of operations. In addition, if these customers delay or cancel purchases of our products, as a result of dissatisfaction or otherwise, our operating results would be harmed and we may be unable to accurately predict revenues, profitability and cash flows.

 

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Risks related to business strategy.

 

Our future success is dependent upon our ability to generate significant revenues from application platform solution relationships.

 

We believe we must diversify our revenues and a major component of our business strategy is to form application platform design relationships with new OEMs and ISVs. Under this strategy, we work with our customers to design an application platform branded with their name. The customers then perform all of the selling and marketing efforts related to sales of their branded appliance.

 

There are multiple risks associated with this strategy including:

 

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

 

·                  our customers will most likely continue selling their software products as separate products in addition to selling them in the form of an application platform, which will require us to effectively communicate the benefits of delivering their software in the form of an application platform;

 

·                  our reliance on our customers to perform all of the selling and marketing efforts associated with further sales of the application platform solution we develop with them;

 

·                  continued consolidation within the data storage, network security and telecommunications industries that results in existing customers being acquired by other companies;

 

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

 

·                  our ability to provide our customers with high quality application platform solutions at competitive prices; and

 

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

 

·                  the expenditure of significant product design and engineering costs, which if not recovered through application platform sales could negatively affect our operating results;

 

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

 

We have begun to pursue (and in some cases we have won) larger opportunities which we expect to have a more significant impact on our net revenues. We expect that these opportunities will have gross margins as a percentage of revenues which are lower than historical levels, but we believe that such opportunities can be leveraged over our existing infrastructure without requiring us to incur significant additional operating costs. However, if we cannot meet customer demand utilizing our existing infrastructure, we may need to increase our infrastructure and associated operating costs, which would negatively impact our operating results. Also, our revenue growth may be lower than expected if we are unsuccessful in winning large opportunities, which would lead us to pursue smaller opportunities in order to grow revenues.

 

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

 

We believe our success will depend on our ability to license or integrate certain applications from third-parties that would be incorporated in certain of our application platform solutions and services. Because we do not currently know with certainty which of these prospective technologies will be desired in the marketplace, we may incorrectly invest in development or prioritize our efforts to integrate these technologies in our application platform solutions and services. Additionally, even if we correctly focus our efforts, there can be no assurance that we will select the preferred provider of these technologies, the third-party provider will be committed to the relationship and integration of their technology, or that they will license their technology to us without obtaining significant certification or training, which could be costly and time consuming. If we are unable to successfully integrate the correct third-party technologies in a timely manner, our application platform solutions and services may be inferior to other competitive products in the marketplace, which may adversely affect the results of our operations and our ability to grow our business. We believe that our services are a key competitive differentiation point and an important element of the total solution we offer. If our current and prospective customers do not find the services we offer to be of value to them or their end users, they may decide to perform these services in-house or we may lose their business to competitors. If this were to occur, our revenues and operating results would be adversely impacted.

 

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

 

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

 

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

 

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

 

·                  we may incorporate technologies that do not result in the desired improvements to our current and/or future application platform solutions and services;

 

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

 

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

 

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

 

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

 

Risks related to the application platform markets.

 

If application platforms are not increasingly adopted as a solution to meet a significant portion of companies’ software application needs, the market for application platform solutions may not grow, which could negatively impact our revenues.

 

We expect that all of our future revenues will come from sales of application platform solutions and related services. As a result, we are substantially dependent on the growing use of application platforms to meet businesses’

 

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software application needs. Our revenues may not grow and the market price of our common stock could decline if the application platform market does not grow as rapidly as we expect.

 

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

 

To an extent, the application platform market is trending towards virtual application platforms and services and cloud computing. A virtual application platform is a software solution, comprised of one or more virtual machines that is packaged, maintained, updated, and managed as a unit. Cloud computing is a web-based concept, whereby vendors provide customers with a virtual (i.e. web-based) network appliance infrastructure, reducing the customer’s need to purchase appliance hardware. While we currently provide virtual application platform solutions, our revenues and operating results may be negatively impacted if current and prospective customers move toward using virtual or cloud-based platforms provided by other vendors.

 

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

 

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

 

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

 

Risks related to financial results.

 

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

 

In the past, we have incurred significant net losses and could incur net losses in the future. At March 31, 2011 and September 30, 2010, our accumulated deficit was $136 million and $139 million, respectively. If we are successful in winning large opportunities in future periods but cannot meet our customer requirements utilizing our existing infrastructure and production capabilities, we may need to increase our infrastructure. This would increase operating expenses and negatively impact our operating results. Also, our revenue growth may be lower than expected if we are unsuccessful in winning large opportunities, which would lead us to pursue smaller opportunities in order to grow revenues. As a result, we will need to generate significant revenues to achieve and sustain profitability. If we do not achieve and sustain profitability, the market price for our common stock may decline. Even if we achieve sustained profitability there can be no guarantee that our stock price will increase.

 

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

 

Products and services in the data storage, network security, and telecommunications markets may be subject to further commoditization as these industries continue to mature and other businesses introduce additional competing products and services. Our gross margin as a percentage of revenues for our products may decrease in response to changes in our product mix, competitive pricing pressures, or new product introductions into these markets. If we are unable to offset decreases in our gross margins as a percentage of revenues by increasing our sales volumes, or by decreasing our product costs, operating results will decline. We expect that our high volume, low margin products will continue to grow relative to our low volume, high margin products. This change in the mix of sales of our products would adversely affect our gross margin as a percentage of new revenues. To maintain our gross margins, we also must continue to reduce the manufacturing cost of our application platform solutions. Our efforts to produce higher margin application platform solutions, continue to improve our application platform solutions and produce new application platform solutions may make it difficult to reduce our manufacturing cost per product. If we fail to respond adequately to pricing pressures, to competitive products with improved performance or to developments with respect to the other factors on which we compete, we could lose customers or orders and may lose new customer opportunities. If we are unable to offset decreases in the prices we are able to charge our customers and/or our gross margin percentage with increased sales volumes, our business will suffer.

 

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

 

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

 

·                  the degree to which our customers are successful in reselling application platform solutions to their end customers;

 

·                  our customers’ consumption of their existing inventories of our products;

 

·                  the variability of orders we receive from customers who have project-based businesses, especially in the telecommunications market;

 

·                  the loss of key suppliers or customers;

 

·                  the product mix of our sales;

 

·                  the timing of new product introductions by our customers;

 

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

 

·                  price competition;

 

·                  the timing of engineering projects; and

 

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

 

In October 2007, we entered into an agreement with Silicon Valley Bank to provide for a line of credit. We view this line of credit as a source of available liquidity to fund fluctuations in our working capital requirements. This facility contains various conditions, covenants and representations with which we must be in compliance in order to borrow funds. However, if we wish to borrow under this facility in the future, there can be no assurance that we will be in compliance with these conditions, covenants and representations. In addition, this line of credit facility with Silicon Valley Bank expires on February 4, 2012. After that, we may need to secure new financing to continue funding fluctuations in our working capital requirements. However, we may not be able to secure new financing, or financing on favorable terms, if we experience an adverse change in our business. If we experience an increase in order activity from our customers, our cash balance may decrease due to the need to purchase inventories to fulfill those orders. If this occurs, we may have to draw on this facility, or secure other financing, in order to maintain our liquidity. As of May 10, 2011, we have not borrowed on this line of credit.

 

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

 

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

 

·                  collectibility of accounts receivable;

 

·                  inventory write-downs;

 

·                  stock-based compensation;

 

·                  valuation of intangible assets;

 

·                  warranty reserves; and

 

·                  our ability to realize deferred tax assets.

 

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

 

An intangible asset represents a significant portion of our assets, and any impairment of the intangible asset would adversely impact our operating results.

 

At March 31, 2011, the carrying value of our intangible asset, which consists of customer relationships associated with an acquisition we completed in fiscal year 2008, was approximately $5.9 million, net of accumulated amortization. We will continue to incur non-cash charges relating to the amortization of our intangible asset over its remaining useful life. Future determinations of significant write-offs of the intangible asset resulting from an impairment test or any accelerated amortization of the intangible asset could have a significant impact on our operating results and affect our ability to achieve or maintain profitability. Although we do not believe that any impairment of the intangible asset exists at this time, in the event that any indicators of possible impairment exist,

 

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we may record charges which could have a material adverse effect on our results of operations. Such indicators include, but are not limited to, a worsening in customer attrition rates compared to historical attrition rates, or lower than initially anticipated cash flows associated with customer relationships.

 

Risks related to competition.

 

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

 

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

 

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

 

We may begin to compete directly with our technology partners as we continue to pursue higher volume opportunities. If we fail to differentiate ourselves from, and compete with, our technology partners effectively, our growth may be limited.

 

We believe our future success will depend on our ability to win new business with larger customers. Historically, we pursued primarily small to medium-sized companies which may not have had the design, integration, and logistics capabilities that we offer to our customers. The competition for these customers was primarily limited to integrators similar in size and resources to us. As we pursue larger opportunities, we will be competing with companies larger than us and that have more resources. Additionally, as we continue to pursue high volume opportunities, future customers may not require the additional services that we offer and may opt to purchase their platforms directly from our technology partners. In some cases, we may begin to compete with some of our larger technology partners who also perform integration services. These larger technology partners typically have lower costs of materials, which would enable them to provide a buyer with a lower cost alternative than we would be able to offer. If we fail to provide buyers with competitive solutions to those offered by our technology partners or effectively market our service offerings to these larger prospective customers, our growth may be limited.

 

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Risks related to marketing and sales efforts and customer service.

 

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

 

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

 

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

 

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

 

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

 

Risks related to product manufacturing.

 

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

 

We depend upon single source and limited source suppliers for our industry standard processors, main logic boards, telephony boards, certain disk drives, hardware platforms and power supplies as well as certain of our chassis and sheet metal parts. Additionally, we depend on limited sources to supply certain other industry standard and customized components. We have in the past experienced, and may in the future experience, shortages of or difficulties in acquiring components in the quantities and of the quality needed to produce our application platform solutions. Shortages in supply or quality issues related to these key components for an extended time would cause delays in the production of our application platform solutions, prevent us from satisfying our contractual obligations and meeting customer expectations, and result in lost sales and customers. If we are unable to buy components in the quantities and of the quality that we need on a timely basis or at acceptable prices, we will not be able to manufacture and deliver our application platform solutions on a timely or cost effective basis to our customers, and our competitive position, reputation, business, financial condition and results of operations could be seriously harmed. If we are able to secure other sources of supply for such components, our costs to purchase such components could increase, which would negatively impact our gross margins. A significant portion of our components are purchased from suppliers located in China. In recent years, several factories in China have closed without notice. If a factory which supplies parts to us closes with little or no notice, we could experience shortages and difficulties in locating alternative sources of supply.

 

Tighter management of inventories across global supply chains may lead to longer lead times for our purchases of certain inventory components. If we are unable to manage our supply chain and maintain sufficient inventories to meet customer demand, this could result in lost sales and customers.

 

Due largely to the recent economic downturn, we have experienced tighter management of inventories across our supply chain, resulting in longer lead times to obtain inventory components from our vendors. To a significant degree, we plan our purchasing of inventory components based on forecasts of future demand from our customers. If actual order volumes from our customers exceed those forecasts, we may experience supply depletions

 

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or shortages. In some cases, this may lead to delays in our deliveries of products to our customers due to the long lead times required to obtain new supplies of certain inventory components. In other cases, this may cause our customers to cancel their orders with us. These factors could adversely impact our relationships with our customers and could cause certain customers to seek other sources of product supply. Also, we may purchase larger quantities of certain inventory components in order to mitigate the risks described above. Such inventory may later become excess or obsolete, which would result in higher than expected costs to write down inventory to its net realizable value.

 

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

 

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

 

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

 

As application platform solutions are complex, they may contain errors that can be detected at any point in a product’s lifecycle. If flaws in design, production, assembly or testing of our products (by us or our suppliers) were to occur, we could experience a rate of failure in our products that could result in substantial repair, replacement or service costs and potential damage to our reputation. In addition, because our solutions are combined with products from other vendors, should problems occur, it might be difficult to identify the source of the problem.

 

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

 

In the past, we have discovered errors in some of our application platform solutions 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. Errors in our application platform solutions may be found in the future and any of these errors could be significant. Significant errors, including those discussed above, may result in:

 

·                  the loss of or delay in market acceptance and sales of our application platform solutions;

 

·                  diversion of engineering resources;

 

·                  increased manufacturing costs;

 

·                  the loss of customers;

 

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

 

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·                  increased maintenance and warranty costs.

 

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

 

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

 

Other risks related to our business.

 

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

 

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

 

·                  be time consuming for us to address;

 

·                  require us to enter into royalty or licensing agreements;

 

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

 

·                  divert our management’s attention and resources; and

 

·                  cause product shipment delays.

 

In addition, other parties may make claims against our customers related to products that are incorporated into our application platform solutions. Our business could be adversely affected if such claims resulted in the inability of our customers to continue producing the infringing product.

 

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

 

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

 

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

 

Our manufacturing facilities and headquarters are concentrated primarily in three locations. If the operations in either facility were disrupted as a result of a natural disaster, fire, power or other utility outage, work stoppage or other similar event, our business could be seriously harmed for a period of at least one quarter as a result of interruptions or delays in our manufacturing, engineering, or post-sales support operations.

 

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

 

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

 

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

 

The market price of our common stock has been subject to significant fluctuations and may continue to fluctuate or decline. During the six months ended March 31, 2011, the closing price of our common stock ranged from a low of $1.42 to a high of $2.33 and during fiscal year ended September 30, 2010, the closing price of our common stock ranged from a low of $1.07 to a high of $3.45. The market for technology and micro-cap stocks has been extremely volatile and frequently reaches levels that bear no relationship to the past or present operating performance of those companies. General economic conditions, such as recession or interest rate or currency rate fluctuations in the United States or abroad, could negatively affect the market price of our common stock. In addition, our operating results may be below the expectations of securities analysts and investors. If this were to occur, the market price of our common stock may decrease significantly. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against such companies. Such litigation could result in substantial cost and a diversion of management’s attention and resources.

 

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

 

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

 

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

 

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

 

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

 

In December 2001, a class action lawsuit relating to our initial public offering was filed against us, our chairman, one of our executive officers and the underwriters of our initial public offering. For more information on lawsuits, see “Part II, Item 1—Legal Proceedings.” We are currently attempting to settle the lawsuit filed against us related to our initial public offering. We are unable to predict the effects on our financial condition or business of the lawsuit related to our initial public offering or other lawsuits that may arise from time to time. While we maintain certain insurance coverage, there can be no assurance that claims against us will not result in substantial monetary damages in excess of such insurance coverage. This class action lawsuit, or any future lawsuits, could cause our director and officer insurance premiums to increase and could affect our ability to obtain director and officer insurance coverage, which would negatively affect our business. In addition, we have expended, and may in the future expend, significant resources to defend such claims. This class action lawsuit, or other similar lawsuits that may arise from time to time, could negatively impact both our financial condition and the market price of our common stock and could result in management devoting a substantial portion of their time to these lawsuits, which could adversely affect the operation of our business.

 

ITEM 6.     EXHIBITS

 

(a)    Exhibits

 

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

 

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SIGNATURES

 

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

 

 

NETWORK ENGINES, INC.

 

 

Date: May 10, 2011

 

/s/ Gregory A. Shortell

 

 

 

 

 

Gregory A. Shortell

 

 

President and Chief Executive Officer

 

 

(Principal Executive Officer)

 

 

 

 

 

/s/ Douglas G. Bryant

 

 

 

 

 

Douglas G. Bryant

 

 

Chief Financial Officer, Treasurer and Secretary

 

 

(Principal Financial Officer and Principal Accounting Officer)

 

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EXHIBIT INDEX

 

Exhibit No.

 

Exhibit

 

 

 

10.1

 

Seventh Amendment dated March 31, 2011 to Lease for 25 Dan Road, Canton, Massachusetts

 

 

 

10.2

 

Eighth Amendment dated March 31, 2011 to Lease for 25 Dan Road, Canton, Massachusetts

 

 

 

10.3*

 

Amendment Number One, dated August 12, 2003, to the Purchase Agreement for product between the Company and EMC Corporation dated February 5, 2002

 

 

 

10.4*

 

Amendment Number Two, dated February 18, 2011, to the Purchase Agreement for product between the Company and EMC Corporation dated February 5, 2002

 

 

 

31.1

 

Certification of Gregory A. Shortell, the Chief Executive Officer of the Company, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

31.2

 

Certification of Douglas G. Bryant, the Chief Financial Officer of the Company, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

32.1

 

Certification of Gregory A. Shortell, the Chief Executive Officer of the Company, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

32.2

 

Certification of Douglas G. Bryant, the Chief Financial Officer of the Company, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 


* Confidential treatment requested as to certain portions, which portions have been separately filed with the Securities and Exchange Commission

 

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