NETWORK ENGINES INC - 10-K Annual Report

25 Dan Road, Canton, MA		02021
(Address of principal executive offices)		(Zip 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 than the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statement incorporated by reference in part III of this Form 10-K or any amendment to this Form 10-K. ¨

Portions of the registrant’s definitive Proxy Statement for its Annual Meeting of Stockholders for the year ended September 30, 2000, which will be filed with the Securities and Exchange Commission within 120 days after the end of the Company’s fiscal year, are incorporated by reference into Part III hereof.

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

Network Engines develops, markets and provides integrated and powerful server appliances that allow organizations to provide information and applications over the Internet. Server appliances are a new category of computer network infrastructure devices that deliver specific functionality through a combination of pre-packaged hardware and software. Unlike general-purpose servers, our server appliances are high-powered, compact products that can be used with either Windows or Linux operating systems and a range of applications and computing power. Our customers may select the number and type of each server that they need, utilize them separately or combine them into groups, or clusters, and locate them geographically as needed. Our server appliances can be managed from a single location without the support of on-site technicians. Our server appliances are designed to meet the complex needs and requirements of e-commerce and Internet-based organizations, including web hosting and service providers, content infrastructure providers, application service providers and larger enterprises. Our server appliances are easy to install and configure and are designed to meet our customers’ needs by combining specific application functionality within small physical packaging.

The emergence of the Internet as a global communications medium for e-commerce and information delivery is now well accepted. The openness and accessibility of the Internet enable large and small organizations, either new or established, to enter this competitive environment by creating Internet sites and establishing their own network infrastructures. New and emerging organizations hoping to grow, and well-financed organizations hoping to increase market share, typically seek to reduce “time-to-revenue,” the length of time between developing their on-line ideas and the availability of their web sites to their potential customers.

Organizations seek to appeal to a wide range of users and to generate large volumes of activity at their web sites, resulting in significant Internet traffic. The growth and complexity in Internet use and functionality, including streaming media, dynamic content and e-commerce transactions, have led to increased demand for greater bandwidth and processing power. The increase in Internet traffic and demand for greater bandwidth has resulted in more utilization of remote server facilities, which house servers for Internet-related businesses. These facilities, often known as co-location facilities, provide strategically located secure data center space with high-speed network connections to the Internet and can improve network performance to end users by reducing the distance between end users and Internet servers.

Traditionally, organizations have built their Internet solutions with general-purpose servers. This method requires extensive time and technical resources and capabilities, which increases overall cost of ownership, including time and cost of implementation. To extend the power and features of a general-purpose server, organizations must integrate numerous discrete hardware and software elements, including operating systems, applications, security systems, load balancers and management tools, which increases overall costs and time-to-revenue. This approach is not well-suited for use in remote server facilities because it typically creates large, complex systems that require substantial facility space. In addition, most vendors’ offerings include limited management and few vendors, if any, provide remote lights-out management capabilities, which increases the need for dedicated attention of on-site information technology professionals. When organizations use general-purpose servers to handle Internet traffic, they typically face a higher total cost of ownership since equipment costs, facility costs and operating expenses are high and time-to-revenue is increased.

To address the shortcomings of general-purpose servers, many organizations are seeking well-designed solutions for Internet applications that meet a common set of requirements. These organizations include web hosting and service providers, content infrastructure providers, application service providers and larger enterprises. Their requirements include:

The server appliance, which is a combination of computing hardware and software that is designed to deliver a single application function, was developed to address the shortcomings of general-purpose servers. International Data Corporation estimates that the worldwide market for server appliances will grow to $11.5 billion in 2004 from approximately $214.6 million in 1999, a compounded annual growth rate of approximately 222%. As market acceptance of server appliances grows, we expect that users will increasingly demand products that meet specific functional requirements and reduce total cost of ownership, including time-to-revenue, packaging density, installation and management functionality. In addition, specific customer preferences for operating systems, applications and computing power play important roles in customer selection of server appliances. Therefore, server appliance vendors who offer a choice in these areas will have a broader market opportunity.

We develop, market and provide a selection of server appliances that enable organizations to provide information and applications over the Internet to meet the requirements of e-commerce and Internet-based organizations. Our server appliances are high-powered, compact products with a choice of operating systems, applications and computing power. Key elements of our solution include:

High Performance in a Small Package. Our products integrate high performance components in a small package, enabling our customers to minimize hosting or co-location costs for servers. All of our current products are 1.75 inches in height, also known as one rack unit, which is typically one-half to one-third the height of the leading, currently available general-purpose servers with the same processing power. This is important because our customers typically use multiple server appliances and must pay for the amount of rack space the servers require. Our server appliances minimize the space requirements for our customers without loss of computing power, thereby reducing the rental costs for rack space at co-location facilities.

Ease of Installation and Use. Each of our server appliances is pre-configured and is capable of performing its assigned application when it is unpacked and connected. The typical installation consists of the user entering one or sometimes a few configuration parameters, including the network address, either through the front-panel liquid crystal display or an Internet browser. Customers do not need to integrate other hardware, operating systems, applications or management software. Each appliance has built-in management for installation, configuration and error reporting, as well as application management capabilities specific to the appliance type. With these features, we believe our servers enable our customers to decrease time-to-revenue and reduce cost of ownership.

Integrated Remote Management. Our server appliances contain integrated hardware and software components that allow lights-out management capable of monitoring and operating our server appliances even if a server’s operating system is not functioning. Each of our server appliances is designed with a dedicated embedded processor and extensive, embedded software for system management and communications. Customers can monitor and control our appliances in dispersed, remote locations using an Internet connection and an Internet browser. In addition, our management system enables customers to develop rules-based decision-making, whereby errors or performance conditions in a remote cluster can trigger actions ranging from simple notification to a complex series of automatic responses. This remote management capability enables customers to customize and centralize system administration and scale their Internet solutions without hiring a proportionate number of technicians.

Dynamic Scalability. Our solution is scalable because our customers can increase the power and capacity of their server clusters simply by adding more servers. Our server appliances can be easily connected to form a group, or cluster, or to augment an existing cluster, to meet both varied and rapidly changing management and performance requirements, thereby reducing costs. The scalability of our solution is dynamic because the performance of individual networking applications operating on our servers can be increased rapidly and without interruption by increasing the number of server appliances in a cluster of our servers devoted to that application. Our proprietary connection technology automatically recognizes new Network Engines’ appliances and assigns addresses without interruption, instantly establishing communication with, and control of, any of our server appliances that are added to a working cluster.

Selection of Operating Systems, Applications and Computing Power. We offer customers appliances with a choice of operating systems, a range of applications and varying degrees of computing power and functionality. Our customers have differing requirements for operating systems, either Windows or Linux, applications and computing power. By offering these choices, our products appeal to a broad range of customers.

Broadening Our Server Appliance Product Line. We believe that each medium-to large-scale Internet server appliance customer has specific application and appliance requirements that result in the need for a variety of server appliances. To increase our appeal to the server appliance market, we are seeking to broaden our product line beyond our current web content, storage and management appliances to include products designed specifically for streaming content, database management, system security and other purposes. In addition, we intend to continue to meet the evolving needs of our customers by offering a product line with varying levels of performance and a choice of operating systems.

Continuing Hardware and Software Innovation. With our technology expertise, we seek to continue to develop hardware and software innovations for the server appliance market. Utilizing our software expertise, we intend to ensure that our products have intuitive user interfaces and that they may be easily installed, configured and remotely managed. We also intend to continue to enhance the performance of our hardware platforms and their remote manageability, while maintaining our leadership in compact packaging. In addition, we intend to continue to enhance the combinations of hardware and software in our server appliances to address the evolving needs of the Internet.

Expanding Research and Development. We will continue our research and development efforts, including the hiring of qualified technical personnel, in an effort to enhance existing products and develop new products. In order to offer our customers the best possible products and to accommodate their future software and hardware choices as well as their legacy technology equipment, we will seek to continue to develop relationships with key technology vendors that enhance our total product offerings. With our expanded research and development capabilities, we intend to integrate new technologies into our products and to enhance the management and interoperability of our products within our customers’ installations.

Building Multi-tier Distribution Capability. We sell our products through a direct sales force, through systems integrators acting as resellers, and to OEMs and licensed manufacturers. We intend to expand and utilize a direct sales organization to build our relationships with large end-user customers and to maintain a good understanding of their changing and expanding market requirements. In addition, we intend to continue building relationships with network systems integrators to provide our products more effectively to this and other market segments. We are expanding our distribution network to include several international equipment distributors and an Internet-based channel fulfillment program. We expect to continue to license our technology and sell our products to licensed manufacturers and OEMs. We believe these relationships will assist us in establishing market presence and increasing our product sales.

Establishing Strong Brand Identity. We seek to increase company name recognition and identification in our targeted market to enhance our sales efforts. We employ an aggressive public relations campaign as well as creative marketing strategies to enhance market awareness of our products. We intend to continue to incorporate innovative hardware designs with easy-to-use, stylish web management interfaces to reinforce our brand name and establish a strong competitive advantage.

Investing in Businesses, Products and Technologies. We intend to pursue strategic acquisitions of, or investments in, businesses, products and technologies that will provide us with additional industry expertise, enhance our range of product offerings, expand our development and production capacity, broaden our client base and expand our geographical presence.

Network Engines’ Internet Appliance Architecture is our approach to building high-performance, high-density appliances for use by e-commerce and Internet-based organizations, including web hosting and service providers, content infrastructure providers, application service providers and larger enterprises. This architecture enables us to combine the hardware and software needed to install, manage, optimize and expand our customers’ Internet-based applications.

Inherent in our architecture is the concept that simple, comprehensive management of customer installations is as important as ease of set up. All of our products can be managed from any location using a standard web browser, enabling network managers to operate more efficiently without sacrificing site performance and availability. All of our products are designed within this Internet Appliance Architecture framework. Each of our server appliances has the following common characteristics:

The WebEngine family of products includes the WebEngine Roadster NT, WebEngine Roadster LX, WebEngine Viper NT, WebEngine Viper LX and WebEngine Blazer. Each WebEngine server appliance may be easily and rapidly deployed to distribute Internet-based content. Each member of the WebEngine family has distinct features developed to provide a customized solution for the range of organizations that provide information over the Internet, from entry-level businesses to large-scale, rapid-growth Internet businesses.

We have committed significant research and development resources to offer our WebEngine products with either Windows or Linux operating systems in the NT and LX versions of the Roadster and Viper. This choice accommodates customer preferences for operating systems and applications. The software in each of the NT and LX products is as follows:

WebEngine Roadster and WebEngine Viper. The WebEngine Roadster and Viper products incorporate Intel processing components in a rack mountable device that is one rack unit in height. The Roadster and Viper products can be used as standalone servers, if a customer needs to dedicate an affordable server appliance to individual web sites or end users. These products can also be grouped into a cluster of servers containing up to 256 of our appliances. Setup is easy and management of the Roadsters and Vipers can be handled through the front-panel liquid crystal display or an Internet browser.

The WebEngine Roadster NT and LX products are our entry-priced server appliances. The WebEngine Viper NT and LX products have either one or two Intel Pentium III processors, allowing for higher performance and speed. We commenced commercial shipment of the WebEngine Roadster and the WebEngine Viper in the third quarter of fiscal 2000. We charge between $2,500 and $5,500 per unit for our WebEngine Roadster appliances and between $5,000 and $14,000 per unit for our WebEngine Viper appliances, depending upon specific product configurations.

WebEngine Blazer. The WebEngine Blazer uses the same hardware platform as the Viper products. Blazers are available without an operating system to allow for complete customer configuration or they may be ordered with Windows or Linux operating systems already installed. Like our other products, the Blazer includes a backup management network connection and an industry-standard network connection to give our customers a powerful hardware platform with our standard management features that can be easily expanded. We commenced commercial shipment of the WebEngine Blazer in June 1999. We charge between $3,500 and $12,500 per unit for our WebEngine Blazer appliances, depending upon specific product configurations.

The AdminEngine enables the management of up to 256 Network Engines appliances that are grouped in a cluster, from any location, through any standard web browser or standards-based network management application. AdminEngine enables a customer to quickly and easily solve a variety of problems that otherwise would require a technician to travel to the customer’s server room, which is often located in a remote facility. Using an Internet browser, customers can restart any Network Engines server from a network drive, reset it for a local restart, and power it up or down. AdminEngine also allows our customers to closely monitor performance of their appliances and to establish rules that will enable our servers to notify the customer of unusual events. We commenced commercial shipment of the AdminEngine in February 2000. We charge approximately $5,000 per unit for our AdminEngine.

The StorageEngine Voyager is the first of our network attached storage appliance products. The StorageEngine Voyager is a 1U high, 4 disk network attached storage controller with up to 144 gigabytes of storage and the ability to expand up to 432 gigabytes. The StorageEngine Voyager is specifically designed for e-commerce and hosting providers seeking a storage solution for small Internet clusters in co-located environments. The StorageEngine Voyager allows customers to quickly add capacity to extend their web presence by clustering StorageEngine Voyagers with any of our WebEngine server appliances. The manageability of the StorageEngine can be increased by grouping it with our WebEngine server appliances in a cluster with our AdminEngine. We released the StorageEngine Voyager in November 2000 and expect to commence commercial shipment of the StorageEngine Voyager by the second quarter of fiscal 2001. We expect to charge between $15,000 and $37,000 per unit for our StorageEngine, depending upon specific product configurations.

A key benefit of our server appliances is the integration of hardware and software technologies to provide a complete solution for our users. Our server appliance hardware and software technology is integrated with many industry-standard technologies to create server appliance solutions.

High-density packaging. We believe that we have been a leader in the development of server hardware utilizing standard Intel Pentium III processors in a rack mountable device that is one rack unit in height. We have developed significant expertise in cooling and monitoring temperatures to maintain operating conditions within specifications for the included components.

Management. The processing board of each of our server appliances contains hardware and software dedicated to the management of that particular appliance and contributes to our ability to achieve lights-out management. This management section of the processing board is connected to our management appliance by a network connection, as well as a backup management connection, known as a cluster management bus. Although our management appliance normally uses the principal network connection to communicate with each of our appliances, it is able to switch to the cluster management bus when communications through the network connection are not available.

Our software is incorporated at three levels: standard appliance management software in all of our WebEngine and StorageEngine products; specific appliance management software in each of our WebEngine and StorageEngine products; and appliance cluster management software in our AdminEngine management server appliance.

Standard Appliance Management. Each of our WebEngine and StorageEngine products includes software that allows the appliance to be managed as a standalone device. In addition, each of these server appliances includes software to enable enhanced management communications using our AdminEngine if that appliance is added to a cluster of our appliances that are managed together. This built-in software reports on hardware conditions, including temperatures, voltage measurements, fan rotation and similar operating conditions. It also provides performance statistics, including numbers of transactions, processor utilization, disk and memory utilization and related measurements. This software reports on the presence and working condition of application and system software components. Each server appliance incorporates software that can execute management instructions. For example, the software can restart the operating system or reset the power supply.

Specific Appliance Management. Management software is also included in each appliance for normal application management functions, depending on the level of management provided by the application builder. For example, Roadster NT and Viper NT provide a simple interface to the management features of Microsoft’s Internet Information Server. Roadster LX and Viper LX include proprietary software for the creation and management of web site partitions—functionality that is not included with the Apache application.

Our customers include companies with e-commerce web sites and high-traffic Internet web sites, as well as web hosting providers, including application service providers and Internet service providers. These customers include providers of streaming video service, web content services, television-based web services, e-commerce, web portals and emerging web technologies. Customers also include OEMs and parties that are licensed to build products based on our product designs. In the fiscal year ended September 30, 1999, sales to Akamai, IBM and Microsoft (WebTV) accounted for 46%, 28% and 14% of net revenues, respectively. For the year ended September 30, 2000, sales to IBM and Akamai accounted for 16% and 12% of our net revenues, respectively.

We sell our products through a direct sales organization and through a network of channels that includes systems integrators, distributors and licensed manufacturers. We are continuing to expand our relationships with channel partners and establish an Internet channel. As of November 15, 2000, we employed 55 people in sales.

Our direct sales organization sells to medium to large users of Internet-based applications and Internet infrastructure companies and focuses on organizations who require multiple numbers of our internet server appliances to meet the demands of their applications. We have regional sales managers and systems engineers that are located in and serve strategic metropolitan areas, including Atlanta, Boston, Dallas, Denver, Los Angeles, New York, Phoenix, San Francisco, Seattle and Washington D.C. Our sales managers and sales engineers work in teams to analyze our prospective customers’ requirements and propose solutions that meet their needs. Our sales teams maintain close relationships with our customers after our products have been installed to ensure our customers remain satisfied. Our sales managers are compensated with a base salary and commissions, which are based on their attainment of sales quotas. In addition to a base salary, our systems engineers receive bonus payments based on the sales revenues generated by their assigned customers.

Our indirect sales efforts in the United States are primarily focused on enhancing our network of domestic systems integrators and resellers who have significant experience with networking applications. We are also focusing on developing additional indirect sales channels sales activities outside the United States, primarily in Europe and Asia.

We have entered into strategic OEM and licensed manufacturer agreements under which our WebEngine Blazer product, manufactured either by us or another company, is branded and sold under another company’s label. While we expect sales to OEM and licensed manufacturers to continue, none of them has any obligation to purchase any quantity of our products in the future. We will continue to seek to license our technology to broaden our sales capacity.

Our marketing objectives include building market awareness and acceptance of Network Engines and our products, as well as generating qualified customer leads. We attend trade shows, send out direct mail, and provide information about our company and our products on our web site. We also conduct public relations activities utilizing the services of Beaupre & Co., a division of Brodeur Worldwide. Our executives speak at industry events and provide briefings to industry analysts and trade press. We have begun advertising in local and trade publications to promote our products to our target markets.

We believe that our ability to consistently provide high-quality customer service and support will be a key factor in attracting and retaining customers. We provide support for our products through our customer support staff based in our Canton, Massachusetts facility, field support technicians and technical sales engineers, who are located in key market areas. Our support activities include direct support to our customers through our web site, which offers technical information designed to assist in answering frequently asked questions and in problem diagnosis and resolution. We also provide 24 hour per day telephone support via a help desk, e-mail support, and remote control support that provides direct access from our support personnel to our customers’ systems for diagnosis and problem resolution. We have also engaged third party service providers to augment our own on-site support in U.S. locations where we do not have our own service personnel. These service arrangements enable us to offer broader next-day, on-site customer support visits, installation and project services.

We provide a warranty program for all of our products, which ranges from one year to 15 months in duration for all parts replacement. Our standard terms and conditions provide that a customer may return a defective product for repair or replacement during the warranty period. In addition, during the warranty period, it has been our practice to send our customers a replacement unit in advance of their returning a unit experiencing problems. The customer then swaps units, returning the damaged unit to our depot repair facility in Canton, Massachusetts. We plan to add additional repair facilities as we build our distribution capability to be able to provide this level of service on a worldwide basis. As of November 15, 2000, we employed 12 people in support services.

We use a contract manufacturer to produce most of our products. We also have our own manufacturing employees and manufacturing facilities to build prototypes and initial units of our new server appliance hardware products. Our in-house capability is also currently used to perform final assembly, testing and quality assurance processes, although many of these activities have recently been transferred to our manufacturer, SCI Systems. SCI Systems currently utilizes two of their facilities to build our server appliances—one in Hookset, New Hampshire and the other in Augusta, Maine.

Some of our sub-assemblies, including chassis, central processing unit motherboards, and power supplies, are manufactured to our specifications while other sub-assemblies, for example disk drives, are commodity items. This approach allows us to maintain design control in areas where we add significant value and to benefit from market economies with respect to commodity items.

We believe that our future success depends on our ability to build upon our current technology platforms, expand the features and functionality of our suite of server appliances, and develop additional products that maintain our technological advantages. We have assembled a team of highly skilled engineers with significant industry experience in high-density packaging, server appliance design, embedded system and cluster management, networking, software, quality assurance and technical documentation. As of November 15, 2000, we employed 85 people in this group.

We will continue to integrate our own hardware and software designs with industry-standard components, including operating systems and processor technologies. We also intend to combine technology from other industry sources into our server appliances where appropriate in order to meet functionality and time-to-market objectives. We currently have new server appliances and new hardware platforms under development that are intended to increase the choices of server appliances we offer to our customers. Development work underway encompasses projects for network attached storage, Internet caching, load balancing and streaming video. These research and development activities range from feasibility studies to active development efforts. It is possible that we may choose to abandon any or all of these activities without bringing them to market.

Our product development expenses for fiscal 1998, 1999 and 2000, were $923,000, $2.6 million and $8.2 million, respectively. We expect our product development expenses to increase as we hire additional research and development personnel to develop new products and enhance our existing products.

We have developed, and will continue to seek to develop, relationships with key technology vendors that enhance our product offerings. We believe the use of industry standard technologies can reduce the cost of our development activities and the cost of our products to our customers. We also believe that the integration of emerging technologies from new vendors can allow us to bring products to market more quickly and to reduce the costs that would result from developing the capability ourselves. Finally, we believe that extending the management capabilities of our products to other vendors’ products will assist us in meeting the needs of our customers to effectively administer heterogeneous Internet systems and services.

Our principal competitors are general-purpose server manufacturers, including Compaq, Dell, Hewlett-Packard, IBM and Sun Microsystems. These competitors have begun manufacturing special versions of their general-purpose server products for sale as server appliances. We also compete with server appliance vendors such as Cobalt Networks, which was recently acquired by Sun Microsystems, Network Appliance and CacheFlow. These other competitors are expanding their product lines to include several types of server appliances. In addition, we compete with computer companies that specialize in building very compact rack-mounted server products, but who do not typically include software in their offerings. Examples of these competitors are VA Linux, Penguin Computing and Qsol.com.

We believe that we compete favorably on factors that are important to our target market, including packaging density, ease of installation and configuration, clustering capability to build large configurations of our server appliances, management capabilities for co-located servers and a wide range of appliance choices.

We expect competition in the server appliance market to increase significantly as more companies enter the market and current competitors expand their product lines. Many of these potential competitors may have significant competitive advantages, including greater name recognition, more resources to apply to the development, marketing and sales of their products, and more established sales channels.

We have invested significantly in the development of proprietary technology for our products and our operations frequently incorporate proprietary and confidential information. We rely upon a combination of copyright and trademark laws and non-disclosure and other intellectual property contractual arrangements to protect our proprietary rights. We protect our software, documentation and other written materials under trade secret and copyright laws, which only provide limited protection. We have patent applications pending but do not currently hold any patents. We also enter into confidentiality or license agreements with our employees, consultants and corporate partners, and control access to and distribution of our software, documentation and other proprietary information.

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. Monitoring unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. In addition, our competitors might independently develop similar technology or duplicate our product or circumvent any patents or our other intellectual property rights. Due to rapid technological changes in our market, we believe the various legal protections available for our intellectual property are of limited value. Instead, we seek to establish and maintain a technology leadership position by leveraging technological and creative skills of our personnel, new product developments and enhancements to existing products.

Our success in recruiting, hiring, training and retaining large numbers of full-time and skilled employees and, if the need arises, obtaining large numbers of temporary employees during periods of increased product demand, is critical to our ability to produce high quality products on a timely basis. As of November 15, 2000, we had 232 employees. In addition, we may hire temporary employees during the year depending on market acceptance of our products. We believe that the demographics surrounding our headquarters, and our reputation and compensation package, should allow us to continue to attract and retain qualified employees.

In May 2000, we moved our corporate headquarters to a facility in Canton, Massachusetts, consisting of approximately 52,000 square feet of leased manufacturing and office space. In August 2000, we expanded our corporate headquarters into an additional 23,000 square feet located at the Canton facility. We believe that the Canton facility and additional or alternative available spaces will be adequate to meet our requirements for the foreseeable future. In addition, we have leased regional sales office facilities in the following strategic metropolitan areas: Los Angeles, New York, San Francisco and Washington, D.C. We also maintain international sales offices in Paris, Amsterdam and London as well as a development office in Austin, Texas.

On December 29, 1999, a former employee, George Flate, commenced a lawsuit against us, a current officer and director and a former officer and director, in Suffolk Superior Court, a Massachusetts state court. Mr. Flate alleges that he was unlawfully terminated as Vice President of OEM Sales in an effort to deprive him of commission payments. He is seeking undisclosed damages based on two contractual claims relating to his employment. We anticipate that Mr. Flate will claim damages in excess of one million dollars. Specifically, he is alleging that Network Engines breached its implied covenant of good faith and fair dealing and that current and former officers of the company named in the lawsuit intentionally interfered with contractual relations. Both of these claims are based on Mr. Flate’s allegations that he is entitled to commissions from several transactions that were negotiated after Mr. Flate was no longer with the company. Mr. Flate was employed by Network Engines for approximately one year. Currently, the matter is in the early stages of discovery. Although we believe these claims are without merit and we intend to vigorously defend against each claim asserted in the complaint, an adverse resolution of either of these claims could require the payment of substantial monetary damages. Moreover, our defense against these claims might result in the expenditure of significant financial and managerial resources.

Lawrence A. Genovesi is our founder and has served as our Chairman of the Board, President, Chief Executive Officer and Chief Technology Officer since October 1989. Mr. Genovesi also founded and served as Chief Executive Officer of New England Interconnection Devices, Inc., a contract manufacturer, from May 1985 to July 1988. From October 1982 to January 1983, Mr. Genovesi served as Vice President of Engineering for Microsystems International, Inc., a computer manufacturer. From June 1981 to December 1982, Mr. Genovesi served as Director of Engineering for CPU Systems Corp., a computer manufacturer and reseller.

Douglas G. Bryant has served as our Secretary and Vice President of Administration since March 2000, our Treasurer since January 1998 and our Chief Financial Officer since September 1997. Prior to joining Network Engines, Mr. Bryant served as Chief Financial Officer of CrossComm Corporation, a manufacturer of internetworking products including routers and switches, from July 1996 to June 1997, and as Corporate Controller from September 1989 to June 1996.

Timothy J. Dalton has served as Vice President of Manufacturing since November 1997. From November 1996 to November 1997, Mr. Dalton served as Operations Manager of Axil Computer Corporation, a privately-held designer and manufacturer of eight-way SMP servers. From January 1994 to July 1996, Mr. Dalton served as Director of Manufacturing Engineering of Concurrent Computer Corporation, a designer and manufacturer of Real Time Fault Tolerant servers for the financial and telecommunications industries.

William B. Elliott has served as Vice President of Marketing since December 1997. Previously, Mr. Elliott served as Vice President of Operations for Dynaflo, Inc. from May 1997 to December 1997. From October 1996 to May 1997, Mr. Elliott served as Vice President of Sales and Marketing for Anysoft, Inc., a producer of utility software that enhances the interchange of information between legacy and modern Windows-based applications. Mr. Elliott served as Vice President of Telecommunications at Stratus Computer from November 1993 to April 1996, and as Vice President of International Sales for Stratus’ telecommunications division from October 1990 to November 1993.

Rene E. Thibault has been Vice President of Sales since July 1999. Prior to joining Network Engines, Mr. Thibault served as Vice President of Sales and Marketing for Voice Request Corporation, a developer of speech-enabled call routing systems, from January 1997 to June 1999. From October 1995 to December 1996, Mr. Thibault served as Vice President of Sales for Centigram Communications Corporation, a manufacturer of multimedia messaging and personal assistant servers. Mr. Thibault also served as Director of Sales for Centigram from September 1990 to September 1995.

Gregory A. Baryza has been Vice President of Engineering since November 2000. Prior to joining Network Engines, Mr. Baryza served as Vice President of Engineering for Incentive Systems, a compensation management solutions provider,, from September 1999 to November 2000. From September 1998 to September 1999 Mr. Baryza served as Sr. Vice President of Engineering at VenturCom, a provider of software and services for developers of Win32-based intelligent connected equipment. Mr. Baryza also served as Vice President of Engineering for Object Design (now Excelon Corporation) from August 1995 to July 1998 and Director of Engineering Operations from August 1993 to August 1995. Mr. Baryza also held senior-level positions in product development, customer service, marketing operations, and engineering at Stratus Computer from July 1985 to August 1993.

Robert F. Wambach has served as Vice President of Strategic Technology Relationships since May 2000 and served as Vice President of Engineering from May 1999 to May 2000. Prior to joining Network Engines, Mr. Wambach served as Senior Director of VPN Programs at Shiva Corporation, a manufacturer of hardware and software to enable the connectivity of enterprise networks, which was ultimately acquired by a subsidiary of Intel and renamed Intel Network Systems, from February 1999 to May 1999, Senior Director of Platform Engineering from June 1998 to February 1999, and Director of Hardware Engineering from June 1997 to June 1998. Mr. Wambach held various engineering management positions with Fujitsu-Nexion (formerly Nexion) from May 1993 to June 1997.

Network Engine’s common stock began trading on the Nasdaq National Market on July 13, 2000 under the symbol “NENG”. Prior to that time there had been no market for our common stock. The following table sets forth the high and low closing sales prices per share for our common stock on the Nasdaq National Market for the period indicated:

		High		Low
Fourth Quarter (from July 13, 2000)		$45.375		$24.875

Through its initial public offering in July 2000, the Company sold 7,475,000 shares of common stock, inclusive of the underwriters’ over allotment, at an initial public offering price of $17 per share. Net proceeds received by the Company in its initial public offering were approximately $116.9 million reflecting gross proceeds of $127.1 million net of underwriting fees of approximately $8.9 million and other offering costs of approximately $1.3 million. From the date of receipt of the proceeds from the initial public offering through September 30, 2000, approximately $4.8 million was used to fund the operations of the Company, approximately $761,000 was used for the acquisition of sales demonstration equipment, approximately $360,000 was used for the expansion of information technology infrastructure and approximately $204,000 was used for the acquisition of engineering, production and other equipment. None of the net proceeds of the initial public offering were paid by the Company, directly or indirectly, to any director, officer or general partner of the Company or any of their associates, or to any persons owning ten percent or more of any class of the Company’s equity securities, or any affiliates of the Company.

The following selected consolidated financial data are derived from the financial statements of Network Engines, Inc. The historical results presented are not necessarily indicative of future results. The selected consolidated financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Network Engines’ Consolidated Financial Statements and the Related Notes.

Delaware		04-3064173
(State or other jurisdiction of incorporation)		(I.R.S. Employer Identification No.)

		Page
PART I

ITEM 1.	BUSINESS	1

ITEM 2.	PROPERTIES	13

ITEM 3.	LEGAL PROCEEDINGS	13

ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS	14

PART II

ITEM 5.	MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS	17

ITEM 6.	SELECTED CONSOLIDATED FINANCIAL DATA	18

ITEM 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	19

ITEM 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	39

ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA	40

ITEM 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE	63

PART III

ITEM 10.	DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT	63

ITEM 11.	EXECUTIVE COMPENSATION	63

ITEM 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT	63

ITEM 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS	63

PART IV

ITEM 14.	EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K	64

SIGNATURES		65

	Year ended September 30,
	1996	1997	1998	1999	2000
Net product revenues	$1,515	$ 609	$ 1,102	$ 6,031	$ 38,216
Net license revenues	—	—	—	—	4,858

Total net revenues	1,515	609	1,102	6,031	43,074
Cost of product revenues	718	465	1,591	4,733	26,695
Cost of license revenues	—	—	—	—	34

Name	Age	Position

Lawrence A. Genovesi	42	Chairman of the Board of Directors, President, Chief Executive Officer and Chief Technology Officer

Douglas G. Bryant	43	Vice President of Administration, Chief Financial Officer, Treasurer and Secretary

Timothy J. Dalton	49	Vice President of Manufacturing

William B. Elliott	56	Vice President of Marketing

Rene E. Thibault	49	Vice President of Sales

Gregory A. Baryza	53	Vice President of Engineering

Robert F. Wambach	40	Vice President of Strategic Technology Relationships