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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 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

NETWORK ENGINES, INC.

(Exact name of registrant as specified in its charter)

(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 x  No o

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

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

As of August 5, 2011, there were 42,738,044 shares of the registrant’s Common Stock, par value $.01 per share, outstanding.

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NETWORK ENGINES, INC.

INDEX

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PART I. FINANCIAL INFORMATION

ITEM I. FINANCIAL STATEMENTS

NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)

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

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NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

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

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NETWORK ENGINES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

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

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.  Basis of Presentation

The accompanying condensed consolidated financial statements have been prepared by Network Engines, Inc. (“Network Engines” or the “Company”) in accordance with accounting principles generally accepted in the United States of America and pursuant to the rules and regulations of the Securities and Exchange Commission (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 $15.0 million in cash and cash equivalents as of June 30, 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 June 30, 2011 and September 30, 2010 (in thousands):

Comprehensive Income

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

Significant Customers

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

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(1) On April 1, 2011, EMC Corporation acquired Netwitness Corporation (“Netwitness”), which was also previously one of the Company’s customers. As a result, the Company has included revenues from sales to Netwitness after April 1, 2011 in determining net revenues from EMC Corporation. The Company has also included accounts receivable from Netwitness in determining EMC Corporation’s receivable balance as of June 30, 2011.

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 June 30, 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 June 30, 2011 (in thousands):

The net asset amount recorded in the balance sheet (carrying amount) and the estimated fair values of financial instruments at June 30, 2011 consisted of the following:

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

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

4.  Stock-Based Compensation

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

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

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 nine month periods ended June 30, 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 nine months ended June 30, 2011 and 2010, using the Black-Scholes valuation model, were:

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

A summary of the Company’s stock option activity for the nine months ended June 30, 2011 is as follows:

All stock options granted during the nine months ended June 30, 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 $0.97.

At June 30, 2011, unrecognized compensation expense related to non-vested stock options was $943,000, which is expected to be recognized over a weighted average vesting period of 2.12 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):

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

6. 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”).

7.  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 June 30, 2011 and September 30, 2010 (in thousands):

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Amortization expense for the three and nine months ended June 30, 2011 was $332,000 and $997,000, respectively. The estimated future amortization expense for the intangible asset as of June 30, 2011 by fiscal year is $332,000 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 June 30, 2011, there were no triggering events that led to the Company performing an impairment review of the intangible asset.

8.  Inventories

Inventories consisted of the following (in thousands):

9.  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 June 30, 2011. As of June 30, 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

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these indemnifications as of June 30, 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 product revenue.  The following table presents changes in the Company’s product warranty liability for the three and nine months ended June 30, 2011 and 2010 (in thousands):

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

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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.  On May 17, 2011, the Second Circuit dismissed one of the appeals and remanded the one remaining appeal to the District Court for further proceedings to determine whether the remaining objector has stand.  The District Court has not yet made such a determination.  The Company is unable to predict the outcome of this suit and as a result, no amounts have been accrued as of June 30, 2011.

10. 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 August 9, 2011, the Company had not drawn on this line of credit.

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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, 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 (11.3% for the nine months ended June 30, 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

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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 nine months ended June 30, 2011, our top two customers accounted for 70% 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.  For example, EMC Corporation (“EMC”) notified us on May 19, 2011 that it would begin dual sourcing the integration of one of its product lines during the quarter ended September 30, 2011.  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.

·                  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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Results of Operations

Three months ended June 30, 2011 compared to the three months ended June 30, 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:

Net Revenues

The increase in net revenues during the quarter ended June 30, 2011 as compared to the quarter ended June 30, 2010 was primarily due to increased sales volumes with EMC, which increased by $6.0 million during the quarter ended June 30, 2011.  Revenues from all other customers increased by $5.2 million during the quarter ended June 30, 2011, as compared to the quarter ended June 30, 2010. These increases were partially offset by a $6.7 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, and contract labor costs.

Gross margin increased in the three months ended June 30, 2011 as compared to the three months ended June 30, 2010, primarily due to increased sales volumes.  The increase in the gross margin as a percentage of net revenues was partially attributable to customer and product mix as well as increased gross margin percentages associated with our high volume business with EMC.  The increase in the gross margin percentages associated with our high volume business with EMC was the result of these platforms having fixed integration fees, which were applied to lower average selling prices during three months ended June 30, 2011 as compared to the three months ended June 30, 2010.

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:

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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:

Research and development expenses decreased in the three months ended June 30, 2011, as compared to the three months ended June 30, 2010, primarily due to decreases in prototype expenses, partially offset by increases in consulting and professional service expenses 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.  The increase in compensation and related expenses was primarily attributable to increases in variable compensation which was directly related to the results of operations.  Additionally, the increase in compensation and related expenses was also attributable to certain planned salary increases that went into effect during the fourth quarter of fiscal year 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: