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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended December 31, 2011

OR

For the transition period from                to               

Commission file number: 000-30863

NETWORK ENGINES, INC.

(Exact name of registrant as specified in its charter)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period 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 February 5, 2012, there were 42,552,659 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 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 2011 Annual Report on Form 10-K (the “2011 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, stock-based compensation and fair values of financial instruments.  Actual results could differ from those estimates.

2.  Significant Accounting Policies

Recent Accounting Pronouncements

In June 2011, the FASB issued new guidance on the presentation of comprehensive income. While the new guidance changes the presentation of comprehensive income, there are no changes to the components that are recognized in net income or other comprehensive income under current accounting guidance. This new guidance is effective for fiscal years and interim periods beginning after December 15, 2011.  The Company early adopted this guidance during the quarter ended December 31, 2011, however, the adoption did not have an impact on the financial statements, results of operations or cash flows. For all periods presented, comprehensive income was equal to net income.

Cash and Cash Equivalents

The Company held $9.6 million in cash and cash equivalents as of December 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 and cash equivalents totaling $19.9 million as of September 30, 2011.  The following table presents balances of cash and cash equivalents held as of December 31, 2011 and September 30, 2011 (in thousands):

Comprehensive Income

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

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Significant Customers

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

(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 December 31, 2011 and September 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 December 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 and foreign exchange forward contracts, which are classified within prepaid expenses and other current assets.

Due to its manufacturing facility in Galway, Ireland, the Company’s business operations are exposed to changes in certain foreign currency exchange rates. Changes in these rates may have an impact on future cash flows and earnings. The Company manages these risks through normal operating activities and, when deemed appropriate, through the use of derivative financial instruments whereby the Company enters into short-term foreign exchange

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forward contracts to lock in exchange rates associated with forecasted future cash flows. These future cash flows mainly relate to the Company’s value-added-tax (“VAT”) refunds receivable, denominated in Euros.  The Company pays VAT in US Dollars on products and services purchased from its vendors in the European Union (“EU”).  However, these VAT amounts are refundable to the Company in Euros, therefore they are exposed to foreign currency exchange gains and losses between the time at which the Company pays the VAT and the time it receives the refund from foreign tax authorities.  These foreign currency gains and losses are recorded in the statement of operations as other income (expense).  The foreign exchange forward contracts typically have durations of approximately 4 to 6 months.  These financial instruments do not qualify for hedge accounting in accordance with accounting guidance related to hedging activities.  As such, the Company revalues these financial instruments to market rates on a recurring basis and any gains or losses are recorded in the statement of operations as other income (expense).

The Company has policies governing the use of derivative instruments and does not enter into financial instruments for trading or speculative purposes. By using derivative instruments, the Company is subject to credit risk to the extent the counterparty fails to fulfill its performance obligations under a derivative contract.  In such instances, the Company’s credit risk will equal the fair value of the derivative.  The Company minimizes this credit risk by entering into transactions with major banks and financial institutions.

The aggregate notional amount of the Company’s outstanding foreign exchange forward contracts was $3.9 million as of December 31, 2011. The fair value of these contracts resulted in an asset of $199,000 as of December 31, 2011.  Gains of $231,000 related to these contracts were recognized as a component of other income (expense) for the quarter ended December 31, 2011. There were no outstanding foreign exchange forward contracts as of September 30, 2011 or for the quarter ending December 31, 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 December 31, 2011 and September 30, 2011 (in thousands):

The fair values of the money market fund were based on the quoted market prices on securities exchanges.  The fair values of the foreign exchange forward contracts are based on observable market spot and forward rates as of December 31, 2011 and are included in level 2 inputs.

4.  Stock-Based Compensation

Stock Options

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):

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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 quarters ended December 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 months ended December 31, 2011 and 2010, using the Black-Scholes valuation model, were:

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

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All stock options granted during the three months ended December 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 $0.60.

At December 31, 2011, unrecognized compensation expense related to non-vested stock options was $808,000, which is expected to be recognized over a weighted-average period of 2.65 years.

Restricted Stock Awards

The following table summarizes our restricted stock award activity for the three months ended December 31, 2011:

Restricted stock awards are valued based on the Company’s stock price on the grant date, and vest in equal annual installments over four years from the date of grant. As of December 31, 2011, there were 113,500 shares of restricted stock outstanding and unvested, with an aggregate fair value of $111,000.  At December 31, 2011, unrecognized compensation expense related to unvested restricted stock awards was $99,000, which is expected to be recognized over the vesting period through December 2015.

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, potential common stock, if dilutive, and the dilutive impact of restricted stock awards outstanding for the period.  Potential common stock includes incremental shares of common stock issuable upon the exercise of stock options, calculated using the treasury stock method.

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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6.  Intangible Asset

The Company recorded an intangible asset as the result of its acquisition of Alliance Systems, Inc.  The acquired intangible asset is customer relationships, which is being amortized over 17 years, which is 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 December 31, 2011 and September 30, 2011 (in thousands):

Amortization expense for the three months ended December 31, 2011 and 2010 was $280,000 and $333,000, respectively.  The estimated future amortization expense for the intangible asset as of December 31, 2011 by fiscal year is $839,000 for the remainder of 2012, $868,000 for 2013, $678,000 for 2014, $537,000 for 2015, $434,000 for 2016 and $1,608,000 thereafter.

7.  Inventories

Inventories consisted of the following (in thousands):

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8.  Commitments and Contingencies

Guarantees and Indemnifications

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 does not expect to and has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these indemnifications as of December 31, 2011 and 2010.

Product warranties — The Company offers and fulfills standard warranty services on some 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 months ended December 31, 2011 and 2010 (in thousands):

Contingencies

Initial Public Offering Lawsuit

On or about December 3, 2001, a putative class action lawsuit was filed in the United States District Court for the Southern District of New York against the Company, Lawrence A. Genovesi (the Company’s former Chairman and Chief Executive Officer), Douglas G. Bryant (the Company’s Chief Financial Officer), and several underwriters of the Company’s initial public offering. The suit alleges, inter alia, that the defendants violated the federal securities laws by issuing and selling securities pursuant to the Company’s initial public offering in July 2000 (“IPO”) without disclosing to investors that the underwriter defendants had solicited and received excessive and undisclosed commissions from certain investors. The suit seeks damages and certification of a plaintiff class consisting of all persons who acquired shares of the Company’s common stock between July 13, 2000 and December 6, 2000.

In October 2002, Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this case without prejudice. On December 5, 2006, the United States Court of Appeals for the Second Circuit overturned the District Court’s certification of a plaintiff class. On April 6, 2007, the Second Circuit denied plaintiffs’ petition for rehearing, but clarified that the plaintiffs may seek to certify a more limited class in the District Court. On September 27, 2007, plaintiffs filed a motion for class certification in certain designated “focus cases” in the District Court. That motion has since been withdrawn. On November 13, 2007, the issuer defendants in certain designated “focus cases” filed a motion to dismiss the second consolidated amended class action complaints that were filed in those cases. On March 26, 2008, the District Court issued an Opinion and Order denying, in large part, the motions to dismiss the amended complaints in the “focus cases.” On April 2, 2009, the plaintiffs filed a motion for preliminary approval of a new proposed settlement between plaintiffs, the underwriter defendants, the issuer defendants and the insurers for the issuer defendants. On June 10, 2009, the Court issued an opinion preliminarily approving the proposed settlement, and scheduling a settlement fairness hearing for September 10, 2009. On

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October 5, 2009, the Court issued an opinion granting plaintiffs’ motion for final approval of the 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 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 standing.  On August 25, 2011, the District Court concluded that the remaining objector lacks standing to object to the settlement because he was not a class member.  On September 23, 2011, the remaining objector filed a Notice of Appeal of the District Court’s August 25, 2011 Order.  On January 13, 2012, the Second Circuit issued a mandate dismissing the appeal, thereby finalizing the settlement between the plaintiffs and defendants and ending this case.  The settlement required the insurers for the issuer defendants to pay the settlement directly to the plaintiffs, as the Company had no liability in connection with this litigation.  In January 2012, the insurers for the issuer defendants paid the settlement amount directly to the plaintiffs. As the Company did not and will not have any obligation related to this case or settlement, no amounts have been accrued as of December 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.

On October 26, 2011 the Company issued a letter of credit for $8 million to one of its largest suppliers to supplement its credit limit with this supplier as a result of the Company’s increased inventory purchasing as a result of the industry-wide hard drive supply shortage due to the flooding in Thailand. This letter of credit expires on February 24, 2012 and reduces the amount available under its existing line of credit. As a result, on December 13, 2011, the Company entered into an amendment to increase its existing line of credit facility with the Bank from $10 million to $18 million and to extend its term to March 31, 2012. Amounts borrowed under the Line of Credit bear interest at a rate equal to the greater of the floating Prime Rate or 3.25%, payable monthly. The “Prime Rate” is the rate announced from time to time by the Wall Street Journal as its “prime rate.” The Company is also subject to an unused line of credit fee of 0.30% per annum, payable monthly, and to certain financial covenants relating to liquidity and minimum operating cash flows per quarter. As of December 31, 2011, there were no amounts outstanding under the line of credit or letter 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, 2011 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 communications 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 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.

During the quarter ended December 31, 2011, we increased our inventories by $20.3 million in an effort to secure hard drives and, in some cases, server appliance platforms as a result of the Thailand flooding.  These purchases were needed to meet most of our customer demand for the quarter ended March 31, 2012.  Although we believe we have secured inventory to meet most of our customer demand for the quarter ended March 31, 2012, we expect that the hard drive supply chain will be tighter during the quarter ended March 31, 2012, as most of the available inventory in the supply chain has been depleted and the new manufacturing capacity is not yet on line.  We are continuing to work closely with our suppliers to mitigate any risk of meeting our customer commitments and we believe that we have sufficient resources to procure inventory on an accelerated scale, if necessary.

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

·                  Revenue growth:  We have 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.  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 (12.0% for the quarter ended December 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

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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 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 that we currently face, including the following:

·                  Dependence on key customers:  During the quarter ended December 31, 2011, our top three customers accounted for 78% of our total net revenues.  We have a contractual agreement with two of these customers, and we rely solely on purchase orders from our other key customer. In all of these 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”) began dual sourcing the integration of one of its product lines during the quarter ended September 30, 2011.  Our sales associated with the portion of the EMC product being sourced away from us had an annualized run rate of approximately $40 million at the time of the dual-sourcing transition. This dual-sourcing transition was completed during the quarter ended December 31, 2011.  One of the expected benefits of our strategy of pursuing larger revenue opportunities is to decrease our dependence on a limited number of customers for such a large percentage of our revenues.

·                  Sole and limited source suppliers: As a result of the flooding in Thailand, we and many others have experienced hard drive availability issues during the quarter ended December 31, 2011.  We expect that we will continue to see hard drive supply shortages through the remainder of the year, as the hard drive manufacturers ramp their new manufacturing facilities.  We continue to work closely with our hard drive suppliers to maximize the amount of inventory we can procure to satisfy our customers’ forecasts.  Where possible, we have increased our inventory levels to ensure we have adequate hard drive supplies to meet customer demands, particularly for the quarter ended March 31, 2012. This increase in our inventory levels has had an impact on our cash levels, though we expect this to be a temporary issue.  We believe our cash resources, cash that we expect to generate from revenues, and cash available through our line of credit will be sufficient to meet our operating and capital requirements.

·                  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

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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, including virtual appliances.  Most recently, a next generation micro-processor architecture is being released and is expected to impact our target markets when it is available during the second half of our fiscal year 2012.  As we expect that our target markets will begin to transition to this new technology into their products, we have begun to adopt and market this technology to prospective and existing customers.

·                  Variability of net revenues:  Many of our customers, especially those in the communications 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 and estimates since September 30, 2011, with the exception of the foreign exchange forward contracts that the Company entered into during the quarter ended December 31, 2011.

We entered into these contracts to mitigate our risks associated with changes in foreign currency exchange rates.  These financial instruments do not qualify for hedge accounting in accordance with guidance related to hedging activities.  As such, we revalue these financial instruments to market rates on a recurring basis and any gains or losses are recorded in the statement of operations as other income (expense).  We have policies governing the use of derivative instruments and do not enter into financial instruments for trading or speculative purposes. By using derivative instruments, we are subject to credit risk to the extent the counterparty fails to fulfill its performance obligations under a derivative contract.  In such instances, our credit risk will equal the fair value of the derivative.  We minimize this credit risk by entering into transactions with major banks and financial institutions.

Results of Operations

Three months ended December 31, 2011 compared to the three months ended December 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:

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Net Revenues

The decrease in net revenues during the quarter ended December 31, 2011 as compared to the quarter ended December 31, 2010 was primarily due to decreased sales volumes with EMC, partially offset by increased sales volumes with Symantec.  The decrease in sales volumes with EMC was primarily the result of EMC’s strategic initiative to dual source one of its product lines, which took effect during the quarter ended September 30, 2011.  Revenues associated with this product line decreased by $9.5 million in the quarter ended December 31, 2011 as compared to the quarter ended December 31, 2010.  Revenues associated with sales to Symantec, which began during the third quarter of fiscal year 2011, were $7.6 million during the quarter ended December 31, 2011.

Gross Margin

Gross margin increased in the quarter ended December 31, 2011 as compared to the quarter ended December 31, 2010, primarily due to an increase in service revenues, which increased from 3.4% of our net revenues during the quarter ended December 31, 2010 to 5.5% of our net revenues during the quarter ended December 31, 2011.  This increase in service revenues was primarily the result of certain non-recurring engineering (“NRE”) services with certain customers, which were completed during the quarter ended December 31, 2011.  Revenues associated with NRE services are project-driven and are therefore subject to volatility from period to period.  Our service revenue carries higher gross margins as compared to our sales of application platforms.  The gross margin on our application platforms decreased in the quarter ended December 31, 2011 as compared to the quarter ended December 31, 2010.  This decrease was primarily impacted by customer and product mix.

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:

Engineering and Development

Engineering and development expenses consist primarily of salaries and related expenses for personnel engaged in engineering 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 engineering and development costs as they are incurred.  The following table summarizes the most significant components of engineering and development expense for the periods indicated, in thousands and as a percentage of total engineering and development expense, and provides the changes in thousands and percentages:

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Engineering and development expenses increased during the quarter ended December 31, 2011, as compared to the quarter ended December 31, 2010, primarily due to increased compensation and related expenses and consulting and professional services, partially offset by decreases in prototype expenses. Compensation and related expenses increased primarily due to an increase in salaries and wages, which was the result of planned salary increases that took effect during the fourth quarter of fiscal 2011.  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.

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:

Selling and marketing expenses decreased during the quarter ended December 31, 2011, as compared to the quarter ended December 31, 2010, primarily due to decreases in compensation and related expenses and stock based compensation expenses.  Compensation and related expenses decreased primarily due to a decrease in headcount, which decreased from 40 employees as of December 31, 2010 to 34 as of December 31, 2011.  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 quarter ended December 31, 2011.

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General and Administrative

General and administrative expenses consist primarily of salaries and other related costs for executive, finance, information technology and human resources personnel; consulting and professional services, which include legal, accounting, and 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: