NEI Network Engines, (MM)

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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, 2012

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 7, 2012, there were 42,667,031 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 COMPREHENSIVE INCOME

(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

Cash and Cash Equivalents

The Company held $14.3 million in cash and cash equivalents as of June 30, 2012.  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 June 30, 2012 and September 30, 2011 (in thousands):

Comprehensive Income

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

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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:

(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, 2012 and September 30, 2011.

Intangible Assets and Long-lived Assets

Other intangible and long-lived assets primarily consist of property and equipment and an intangible asset with a definite life.  Guidance provided by the Financial Accounting Standards Board (“FASB”) requires impairment losses to be recorded on long-lived assets used in operations when indicators of impairment are present and the projected undiscounted cash flows estimated to be generated by those assets are less than the assets’ carrying value.  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. Long-lived assets are reviewed periodically for impairment or whenever events or changes in circumstances indicated that full recoverability of net asset balances through future cash flows is in question.  In connection with the signing of the Merger Agreement with UNICOM Systems, Inc., as discussed in Note 10, the Company assessed the intangible assets and long-lived assets for impairment utilizing the guidance provided by the FASB noted above and determined that no impairment existed as of June 30, 2012.

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 require the Company to make judgments 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

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

estimates regarding the assumptions that market participants would use in valuing the asset or liability at the measurement date.

As of June 30, 2012, 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 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 2 to 3 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 $4.4 million as of June 30, 2012. The fair value of these contracts resulted in an asset of $89,000 as of June 30, 2012.  Gains of $201,000 related to these contracts were recognized as a component of other income (expense) for the quarter ended June 30, 2012. During the nine months ended June 30, 2012, gains of $341,000 were recognized as a component of other income (expense).There were no outstanding foreign exchange forward contracts as of September 30, 2011 or for the quarter ending June 30, 2011.

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, 2012 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 June 30, 2012 and are included in level 2 inputs.

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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):

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 nine month periods ended June 30, 2012 and 2011.  No options were granted during the three months ended June 30, 2012.  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, 2012 and 2011, using the Black-Scholes valuation model, were:

(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.

A summary of the Company’s stock option activity for the nine months ended June 30, 2012 is as follows:

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

All stock options granted during the nine months ended June 30, 2012 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 $0.64.

At June 30, 2012, unrecognized compensation expense related to non-vested stock options was $617,000, which is expected to be recognized over a weighted-average period of 2.40 years.

Restricted Stock Awards

The following table summarizes our restricted stock award activity for the nine months ended June 30, 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. During the nine months ended June 30, 2012, 113,500 shares of restricted stock were granted with an aggregate fair value of $111,000.  At June 30, 2012, unrecognized compensation expense related to unvested restricted stock awards was $83,000, 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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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 June 30, 2012 and September 30, 2011 (in thousands):

Amortization expense for the three months ended June 30, 2012 and 2011 was $280,000 and $332,000, respectively.  Amortization expense for the nine months ended June 30, 2012 and 2011 was $840,000 and $997,000, respectively.  The estimated future amortization expense for the intangible asset as of June 30, 2012 by fiscal year is $279,000 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.

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

7.  Inventories

Inventories consisted of the following (in thousands):

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 June 30, 2012 and 2011.

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 39 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, 2012 and 2011 (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

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 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 June 30, 2012.

Litigation related to the merger with UNICOM Systems, Inc.

On June 25, 2012, a purported class action lawsuit was filed in the Court of Chancery of the State of Delaware, by Terry Hull, an alleged stockholder of the Company ( Hull v. Network Engines, Inc. et al. , Transaction ID 44992327, C.A. No. 7650). The lawsuit sets forth several allegations related to that certain Agreement and Plan of Merger, dated as of June 18, 2012, by and among UNICOM Systems, Inc., a California corporation (“ UNICOM ”), Unicom Sub Two, Inc., a Delaware corporation and wholly-owned subsidiary of UNICOM (“ Merger Sub ”), and the Company (the “ Merger Agreement ”), pursuant to which UNICOM will acquire all of the outstanding shares of the Company for $1.45 per share in cash, without interest, and pursuant to which Merger Sub will be merged with and into the Company with the Company continuing as the surviving corporation and a wholly owned subsidiary of UNICOM (the “ Merger ”).  These allegations include:  (i) that the members of our board of directors breached fiduciary duties they allegedly owed in negotiating and approving the Merger Agreement, that the members of our board of directors breached fiduciary duties they allegedly owed in approving the potential transaction bonuses payable by the Company to Mr. Shortell and Mr. Bryant (the “Transaction Bonus Agreements”), that the Merger consideration negotiated in the Merger Agreement improperly values the Company, that the Company’s stockholders will not likely receive adequate or fair value for their Network Engines’ common stock in the Merger, and that the terms of the Merger Agreement impose improper deal protection devices that will preclude competing offers, and (ii) that UNICOM and Merger Sub aided and abetted the purported breaches of fiduciary duty. The lawsuit seeks, among other things, an injunction against the consummation of the Merger and rescission in the event that the Merger has already been consummated prior to the entry of the court’s final judgment, an award of damages and costs and expenses, including attorneys’ and experts’ fees and expenses.

On June 25, 2012, a purported class action lawsuit was filed in the Court of Chancery of the State of Delaware, by Matt Lefever, an alleged stockholder of the Company ( Lefever v. Network Engines, Inc. et al. , Transaction ID 44996002, C.A. No. 7653). The lawsuit alleges: (i) that the members of our board of directors

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NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

breached fiduciary duties they allegedly owed in negotiating and approving the Merger Agreement, that the members of our board of directors breached fiduciary duties they allegedly owed in approving the Transaction Bonus Agreements with Mr. Shortell and Mr. Bryant, that the Merger consideration negotiated in the Merger Agreement improperly values the Company, that the Company’s stockholders will not likely receive adequate or fair value for their Network Engines’ common stock in the Merger, and that the terms of the Merger Agreement impose improper deal protection devices that will preclude competing offers, and (ii) that UNICOM and Merger Sub aided and abetted the purported breaches of fiduciary duty. The lawsuit seeks, among other things, an injunction against the consummation of the Merger and rescission in the event that the Merger has already been consummated prior to the entry of the court’s final judgment, an award of damages and costs and expenses, including attorneys’ and experts’ fees and expenses.

On June 25, 2012, a purported class action lawsuit was filed in the Court of Chancery of the State of Delaware, by Rajinder Bansal, an alleged stockholder of the Company ( Bansal v. Network Engines, Inc. et al. , Transaction ID 44993557, C.A. No. 7654). The lawsuit alleges: (i) that the members of our board of directors breached fiduciary duties they allegedly owed in negotiating and approving the Merger Agreement, that the members of our board of directors breached fiduciary duties they allegedly owed in approving the Transaction Bonus Agreements with Mr. Shortell and Mr. Bryant, that the Merger consideration negotiated in the Merger Agreement improperly values the Company, that the Company’s stockholders will not likely receive adequate or fair value for their Network Engines’ common stock in the Merger, and that the terms of the Merger Agreement impose improper deal protection devices that will preclude competing offers, and (ii) that UNICOM and Merger Sub aided and abetted the purported breaches of fiduciary duty. The lawsuit seeks, among other things, an injunction against the consummation of the Merger and rescission in the event that the Merger has already been consummated prior to the entry of the court’s final judgment, an award of damages and costs and expenses, including attorneys’ and experts’ fees and expenses.

On June 26, 2012, a purported class action lawsuit was filed in Suffolk County Superior Court in the Commonwealth of Massachusetts, by Sajjan G. Shiva, an alleged stockholder of the Company ( Shiva v. Network Engines, Inc. et al. , Civil Action No. 12-2392). The lawsuit alleges: (i) that the members of our board of directors breached fiduciary duties they allegedly owed in negotiating and approving the Merger Agreement, that the members of our board of directors breached fiduciary duties they allegedly owed in approving the Transaction Bonus Agreements with Mr. Shortell and Mr. Bryant, that the Merger consideration negotiated in the Merger Agreement improperly values the Company, that the Company’s stockholders will not likely receive adequate or fair value for their Network Engines’ common stock in the Merger, and that the terms of the Merger Agreement impose improper deal protection devices that will preclude competing offers, and (ii) that UNICOM and Merger Sub aided and abetted the purported breaches of fiduciary duty. The lawsuit seeks, among other things, an injunction against the consummation of the Merger and rescission in the event that the Merger has already been consummated prior to the entry of the court’s final judgment, an award of damages and costs and expenses, including attorneys’ and experts’ fees and expenses.

On June 28, 2012, a purported class action lawsuit was filed in the Court of Chancery of the State of Delaware, by Joseph Yud, an alleged stockholder of the Company ( Yud v. Network Engines, Inc. et al. , Transaction ID 45065809, C.A. No. 7661). The lawsuit alleges: (i) that the members of our board of directors breached fiduciary duties they allegedly owed in negotiating and approving the Merger Agreement, that the members of our board of directors breached fiduciary duties they allegedly owed in approving the Transaction Bonus Agreements with Mr. Shortell and Mr. Bryant, that the Merger consideration negotiated in the Merger Agreement improperly values the Company, that the Company’s stockholders will not likely receive adequate or fair value for their Network Engines’ common stock in the Merger, and that the terms of the Merger Agreement impose improper deal protection devices that will preclude competing offers, and (ii) that UNICOM and Merger Sub aided and abetted the purported breaches of fiduciary duty. The lawsuit seeks, among other things, an injunction against the consummation of the Merger and rescission in the event that the Merger has already been consummated prior to the entry of the court’s final judgment, an award of damages and costs and expenses, including attorneys’ and experts’ fees and expenses.

Except as discussed above, as of the date of this filing, the Company is not aware of any other lawsuits that have been filed against us relating to the Merger. Additional lawsuits pertaining to the Merger could be filed in the future. The Company is unable to determine the outcome of these suits or the estimated range of liability, if any, and as a result, no amounts have been accrued as of June 30, 2012.

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NETWORK ENGINES, INC.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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” or “SVB”) to establish a line of credit from which the Company could borrow.

On February 5, 2010, the Company and the Bank entered into an Amended and Restated Loan and Security Agreement (“Loan and Security Agreement”). This agreement replaced in its entirety the Loan Agreement and had an initial term through February 4, 2012. It also had an interest rate on the line of 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 reduced the amount available under its existing line of credit and as a result, on December 13, 2011, the Company entered into the Second Loan Modification Agreement (the “Second Modification Agreement”) that amended the Loan and Security Agreement 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.  Upon expiration of the letter of credit on February 24, 2012, the existing line of credit was reduced to $10 million.

On March 28, 2012, the Company entered into the Third Loan Modification Agreement (the “Third Modification Agreement”) with the Bank.  The Third Modification Agreement, effective March 31, 2012, amended the Loan and Security Agreement, as amended by the First Loan Modification Agreement dated January 18, 2011 and further amended by the Second Modification Agreement by extending its term until June 30, 2012 and decreasing the unused line of credit fee from 0.30% to 0.25% per annum.

On June 22, 2012, the Company entered into the Fourth Loan Modification Agreement (the “Fourth Modification Agreement”) with the Bank.  The Fourth Modification Agreement amends the Loan and Security Agreement, as amended by the First Loan Modification Agreement, Second Modification Agreement and Third Modification Agreement, to extend its term until September 30, 2012, and keeps the amount available under the line of credit facility at $10 million. 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 0.25% per annum, payable monthly, and to certain financial covenants relating to liquidity and minimum operating cash flows per quarter. As of June 30, 2012, there were no amounts outstanding under the line of credit.

On July 12, 2012, the Company issued a letter of credit for $20 million with one of its largest suppliers to supplement its existing credit limit with this supplier.  This letter of credit was issued to support the Company’s last time purchases of certain end-of-life platforms, as a result of the EMC transition discussed in the Company’s press release dated April 12, 2012.  This letter of credit expires on September 30, 2012, and may be reduced from time to time based on the amounts outstanding that we owe our supplier.

10. Merger Agreement

On June 18, 2012, the Company entered into a Merger Agreement, pursuant to which UNICOM will acquire all of the outstanding shares of the Company for $1.45 per share, in cash, without interest, in the Merger.

On the terms and subject to the conditions set forth in the Merger Agreement, which has been unanimously approved by the Board of Directors of the Company, at the effective time of the Merger (the “ Effective Time ”), and as a result thereof, each share of common stock, par value $0.01 per share, of the Company (“ Network Engines Common Stock ”) that is issued and outstanding immediately prior to the Effective Time (other than Network Engines Common Stock held in the treasury of the Company or owned directly or indirectly by UNICOM or any subsidiary of the Company, which will be canceled without payment of any consideration, and the Network Engines Common Stock for which dissenters’ rights have been validly exercised and not withdrawn) will be converted at the Effective Time into the right to receive $1.45 in cash, without interest (the “ Merger Consideration ”), subject to adjustment under certain conditions as described in the Merger Agreement.  Each option to purchase the Network Engines Common Stock that is outstanding as of the Effective Time will become fully vested and will be canceled

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NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

in exchange for the right to receive in cash the amount by which the Merger Consideration exceeds the exercise price, multiplied by the number of shares of the Network Engines Common Stock subject to such option.

UNICOM and the Company have made customary representations, warranties and covenants in the Merger Agreement, including, among others, covenants that: (i) the Company will conduct its business in the ordinary course consistent with past practice during the interim period between the execution of the Merger Agreement and the effective time of the Merger, (ii) the Company will not engage in certain kinds of transactions during such period without the consent of UNICOM, (iii) the Company will cause a meeting of the Company’s stockholders to be held to consider approval of the Merger Agreement, and (iv) subject to certain customary exceptions, the Board of Directors of the Company will recommend approval by its stockholders of the Merger Agreement.

The Merger Agreement provided that the Company was permitted to solicit alternative acquisition proposals from third parties through July 18, 2012 (the “ Go-Shop Period ”).  Following the Go-Shop Period, the Company has made a covenant not to: (a) solicit proposals relating to alternative business combination transactions or (b) subject to certain exceptions designed to allow the Board of Directors to fulfill its fiduciary duties to stockholders of the Company, enter into discussions concerning, or provide confidential information in connection with any proposals for alternative business combination transactions.

Consummation of the Merger is subject to customary conditions, including (i) approval of the holders of a majority of the outstanding shares of the Company Common Stock (the “ Stockholder Approval ”), (ii) the absence of any law or order prohibiting the consummation of the Merger and (iii) the absence of a material adverse effect with respect to the Company.

Following the Go-Shop Period, the Merger Agreement prohibits the Company from knowingly initiating, soliciting or encouraging or facilitating the submission of any Acquisition Proposal (as defined in the Merger Agreement); provided, however, that at any time prior to the receipt of the Stockholder Approval, the Company may, subject to the terms and conditions set forth in the Merger Agreement, furnish information to, and engage in discussions and negotiations with, a third party that makes an unsolicited Acquisition Proposal that the Board of Directors of the Company (the “ Network Engines Board ”) determines constitutes or may reasonably be expected to lead to a Superior Proposal (as defined in the Merger Agreement).  In the event that the Network Engines Board determines that an Acquisition Proposal constitutes a Superior Proposal, the Company may either (i) terminate the Merger Agreement to enter into a definitive agreement with respect to such Superior Proposal and pay a termination fee of either $1,250,000 if such Superior Proposal was a proposal received by the Company during the Go-Shop Period or $2,500,000 if such Superior Proposal was a proposal received by the Company at any time following the Go-Shop Period, or (ii) effect a Change of Company Board Recommendation (as defined in the Merger Agreement).

On June 18, 2012, the Company entered into separate agreements with each of Gregory A. Shortell, its Chief Executive Officer and President, and Douglas G. Bryant, its Chief Financial Officer, Treasurer and Secretary, regarding potential transaction bonuses payable by the Company. The Transaction Bonus Agreements with Mr. Shortell and Mr. Bryant provide that, in order to incentivize Mr. Shortell and Mr. Bryant to work towards the successful consummation of the Merger, subject to conditions set forth in the Transaction Bonus Agreements with Mr. Shortell and Mr. Bryant, the Company shall pay Mr. Shortell and Mr. Bryant a bonus in lump sum cash payments equal to $950,000 and $475,000 to Mr. Shortell and Mr. Bryant, respectively, which shall be paid with the Company’s first payroll on or following the consummation of the transaction. The Company is unable to determine whether the Merger will be completed due to the uncertainties of the pending shareholder approval and the outstanding litigation described in Note 8, and therefore, no amounts have been accrued as of June 30, 2012 with respect to the Transaction Bonus Agreements.

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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, who 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.

On June 18, 2012, we entered into a definitive merger agreement with UNICOM Systems, Inc. (“UNICOM”), whereby UNICOM will acquire all outstanding shares of common stock of the Company for $1.45 per common share in cash.  This transaction is subject to negotiated conditions as well as the approval of our shareholders.  If the merger is consummated, we will become a private company, wholly owned by UNICOM.

On April 12, 2012, EMC Corporation (“EMC”) notified us that EMC will begin to transition the integration of certain EMC standard platform products away from its system integrators, including us, during the December 2012 and March 2013 quarters.  During the quarter ended June 30, 2012, these products represented approximately $20.2 million in quarterly revenues, or 31% of our total revenues.  We will continue to integrate EMC’s Centera product line which we have been integrating since 2002 as well as certain other product lines.  As a result of this announcement, we are focusing on replacing this level of revenue through the expansion of revenues with existing customers, the addition of new customers and the expansion of our market opportunities.

One of the opportunities we are pursuing relates to the development of more efficient power solutions, particularly for data centers.  Increasing demands within these centers are creating both higher infrastructure costs and power usage which in turn is driving the industry to seek new ways to increase efficiency and decrease operating costs.  Converting the power distribution configuration from alternating current (AC) to direct current (DC) within the data center is increasingly seen as an ideal solution, and we believe 380v DC can become the power standard of the future, as it is more energy-efficient than traditional AC technology and is also less complex, which requires less space and infrastructure cost.  We believe that our early entry into this market coupled with our expertise in power usage and provisioning will help to open new opportunities for us to generate new revenues.

In addition, we are exploring other opportunities in the data center space, with the potential to provide service, logistics and integration capabilities for existing enterprise data center companies.  Specifically, we believe existing data centers, seeking to benefit from newer technology including the 380v DC power systems and solutions built on open system architecture with commercial off the shelf (“COTS”) products will experience upgrade cycles, and we believe that we have the potential to generate new revenues from this process.

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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 replace the net revenues that we will lose as a result of the EMC transition, 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 (11.2% for the quarter ended June 30, 2012), 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 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 June 30, 2012, our top three customers accounted for 79% 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.  On April 12, 2012, EMC notified us that they will begin to transition the integration of certain EMC standard platform products away from its system integrators, including us, during the December 2012 and March 2013 quarters. During the quarter ended June 30, 2012, these products represented approximately $20.2 million in quarterly revenues for us.  We will continue to integrate EMC’s Centera product line which we have been integrating since 2002 as well as certain other product lines. 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.

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·                   Inventory management: In support of the final transition of the EMC standard platforms, we will make certain last time buys of certain end-of-life platforms to bridge the changeover to the new products.  These last time buys will take place in the fourth quarter of fiscal year 2012, which will be sold in subsequent fiscal periods.  These last time buys of inventory will cause our inventory levels to significantly increase during the fourth quarter of the current fiscal year and the first quarter of fiscal year 2013, which will have a negative impact on our cash balance.  On July 12, 2012, we issued a letter of credit for $20 million with one of our largest suppliers to supplement our existing credit limit with this supplier.  This letter of credit was issued to support the Company’s last time buys of certain platforms.  This letter of credit expires on September 30, 2012, and may be reduced from time to time based on the amounts outstanding that we owe our supplier.  We believe our cash resources, cash that we expect to generate from revenues, and cash available through our line of credit and letter of credit will be sufficient to meet our operating and capital requirements for the next twelve months.

·                   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.  Most recently, a next generation micro-processor architecture has been released and may impact our target markets during the fourth quarter 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.  This is evidenced by the relatively weak June 2012 quarter as well as a relatively weak forecasted fourth fiscal 2012 quarter for customers who sell into the communications vertical compared to revenues from the first half of fiscal 2012.  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 nine months ended June 30, 2012.

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.

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Results of Operations

Three months ended June 30, 2012 compared to the three months ended June 30, 2011

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 decrease in net revenues during the quarter ended June 30, 2012 as compared to the quarter ended June 30, 2011 was primarily due to decreased sales volumes with EMC and one of our customers in the communications vertical market, partially offset by increased sales volumes with Symantec.  Revenues associated with sales to EMC decreased by $6.8 million, which was primarily due to decreased sales volumes as a 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 $7.0 million in the quarter ended June 30, 2012 as compared to the quarter ended June 30, 2011.  Sales to one of our customers that serves the communications vertical market decreased by $3.9 million during the quarter ended June 30, 2012 as compared to the quarter ended June 30, 2011 due to the project-oriented nature of the communications vertical market.  Revenues associated with sales to Symantec increased by $10.6 million during the quarter ended June 30, 2012 as compared to the quarter ended June 30, 2011.  Sales to Symantec commenced towards the end of the quarter ended June 30, 2011.  Revenues derived from all other customers decreased by $1.5 million during the quarter ended June 30, 2012 as compared to the quarter ended June 30, 2011.

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 decreased in the quarter ended June 30, 2012 as compared to the quarter ended June 30, 2011, primarily due to decreased revenues and changes in 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: