NETWORK ENGINES INC - 10-K Annual Report

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. [X]

Portions of the registrant’s definitive Proxy Statement for its Annual Meeting of Stockholders for the year ended September 30, 2002, 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 projections relating 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, including the factors 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, Inc. (“Network Engines or the “Company”) is a provider of server appliance hardware and custom integration services. Server appliances are pre-configured network infrastructure devices designed to deliver specific application functionality. We are focused on partnering with independent software vendors (“ISVs”) and original equipment manufacturers (“OEMs”) to provide these strategic partners with server appliance hardware, integration services and appliance development, deployment and support to allow these strategic partners to deliver “turn-key” solutions to their end-user customers.

On November 11, 2002, we entered into a definitive agreement to acquire TidalWire Inc. (“TidalWire”), a privately held corporation dedicated to the distribution and support of storage networking products. The acquisition will be effected through a merger of our wholly owned subsidiary into TidalWire. The merger is subject to customary closing conditions, including the approval of our stockholders and the stockholders of TidalWire. A special meeting of our stockholders is scheduled to take place on December 27, 2002 and we expect to close this acquisition as soon as practicable thereafter and after the satisfaction of the other conditions to closing, which we expect to occur by the end of December 2002. Accordingly, any forward-looking statements we make in this Annual Report on Form 10-K do not reflect the impact the acquisition of TidalWire will have on our business and operations if the acquisition is consummated.

We were incorporated in Delaware on September 17, 1999. When we first entered the server appliance market, we focused our business primarily on providing scalable web content servers to Internet-based organizations, content infrastructure providers and larger enterprises. It was necessary for us to design most of the hardware components that went into our servers and, as a result, we

invested significant resources in the development of our products. Over time, much of the hardware components of server appliances have become commoditized and a significant number of companies have entered the server appliance marketplace.

In response to competitive pressures, combined with the effects of a downturn in the economy, we commenced a restructuring plan in the quarter ended June 30, 2001 to better align operating expenses with reduced revenues. We further undertook an extensive review of our business strategy and, in July 2001, implemented a second restructuring of our business, which de-emphasized much of our customized hardware and software development and focused our resources on what we believe to be our core competencies of hardware packaging and software integration. In addition, this restructuring of our business included a transition from primarily direct sales channels to partnerships with ISVs and OEMs in order to offer “turn-key” server appliance solutions to enterprise customers. As of September 30, 2002, we had an accumulated deficit of approximately $107.6 million.

Traditionally, organizations built their network infrastructure 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 further increases overall cost of ownership and time-to-revenue. The server appliance evolved to address these shortcomings of general-purpose servers and provide a well-designed solution to perform a single dedicated service right out of the box at a low cost of ownership. As market acceptance of server appliances continues to grow, we believe that users will increasingly demand products that meet specific functional requirements and reduce total cost of ownership and, as a result, server appliance vendors who are able to package and integrate standards-based platforms with various operating, management and application software will have a broader market opportunity.

We provide standards-based server appliance hardware platforms, software integration services, supply-chain management and fulfillment services that enable our strategic partners to deliver “turn-key” server appliance solutions that are easy to use, install and manage. Key elements of our solution include:

Value-Add Integration and Engineering Services. We have significant hardware and software integration skills and specialized technical resources to help our partners to expand their server appliance product offerings while reducing technical resource and support costs by providing one access point for hardware platforms, appliance and system development, deployment and support.

Supply-Chain Management and Fulfillment Services. We have extensive manufacturing and inventory management capabilities, which give us the ability to manage all of the hardware and manufacturing needs of our partners. We provide our partners with a “turn-key” solution for the hardware component of their server appliances. Once the appliance is manufactured, we can drop-ship the product to our partners’ customers.

Re-focusing Product Development. During fiscal 2001, we undertook an extensive review of our operations, including our product development process. As a result, we determined that we could both lower the cost of development of our products and decrease development time through a significant increase in the usage of “off-the-shelf” or “industry-standard” components in our products. With our re-focused product development process, we believe that the integration of new “off-the-shelf” technologies into our products will improve our products’ functionality, capacity and reliability and reduce development time, thereby lowering development costs.

Broadening Our Server Appliance Hardware Platforms. We believe that ISVs and OEMs will often have a specific set of requirements for creating “turn-key” appliance solutions and, as a result, there will be a need for a variety of server appliance hardware platforms and appliance development services. To increase our appeal to ISVs and OEMs, we are seeking to broaden our current line of server appliance hardware platforms to expand their technological capabilities while reducing our cost. We will purchase hardware platforms from other manufacturers both to reduce our costs and to increase the range of our product offerings.

Creating Exceptional Service and Appliance Development Support Practices. As a part of our business strategy, we assist our ISV partners to develop an appliance product through the integration of their software and our standards-based hardware platforms. The focus of our integration services is the development, execution, and completion of a comprehensive project plan, schedules and deliverables that are focused on the goal of reducing the time to market of our ISV partners’ appliance solutions. Starting with the initial engagement, our project relationship extends through the product development process, general release and throughout the entire support lifecycle. Once an ISV’s appliance is released, our focus shifts to provide ongoing technical, logistic and escalation management support.

Investing in Businesses, Products and Technologies. Our primary goal is to increase shareholder value. We intend to continue 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, expand our geographical presence and ultimately enhance shareholder value.

Network Engines’ Appliance Alliance Program is our approach to build high-performance server appliances for use by ISVs and leading OEM technology partners. This program enables us to combine hardware platforms, custom integration and support services with mission critical software applications to create “turn-key” server appliance solutions for enterprise customers. Creating appliance solutions allows ISVs and OEMs to take advantage of greater market opportunities, faster time to revenue and increased customer satisfaction.

Custom hardware platforms—We build appliances based on each Appliance Alliance member’s specified configuration. Standard components are used to create unique branded appliances for each partner. Modifications to the standard platforms include the addition of unique interface devices, BIOS modifications and systems tuning.

Prior to July 31, 2001, we sold our products primarily through direct sales channels to end-users whose businesses were related to the Internet, otherwise known as “new-economy” businesses. The economic slow-down during fiscal 2001 had a drastic effect on these “new-economy” businesses, which resulted in a significant decline in our net revenues during fiscal 2001. On July 31, 2001, we began a process of re-focusing our business strategy on selling our server appliance hardware platforms and related services through indirect sales channels by forming strategic partnerships with ISVs and OEMs. As a result, our customers now include ISVs and OEMs that build server appliance solutions using our hardware platforms and services as a component of their solutions. For the year ended September 30, 2002, sales to EMC Corporation were significantly greater than 10% of our total net revenues. The loss of this customer would have a material adverse effect on our business.

provided by us under their own label. Our regional sales managers and systems engineers work in teams to analyze our prospective ISV and OEM customers’ requirements and propose server appliance or customized hardware platform solutions that meet their needs and their customers’ needs. Our engineering organization provides substantial advice and assistance to our sales organization for major sales opportunities. As of November 12, 2002, we employed 10 people in sales.

We believe that our ability to consistently provide high-quality support is a key factor in attracting and retaining ISV and OEM partners. In line with our decision to focus our core business on products for the ISV and OEM markets, we engaged a third party services company to assume the services requirements for all of our discontinued products. As a key component of our re-focused business strategy, we will provide support to our ISV and OEM partners through our customer support staff, engineering staff, manufacturing staff and sales systems engineers based in our Canton, Massachusetts facility. As of November 12, 2002, we employed two people in support services.

We use a combination of in-house production and third-party suppliers to produce our server appliance hardware platforms. As of November 12, 2002, we employed 14 people in our manufacturing group. We also make use of contract employees in production and certain other areas.

We believe that our future success depends on our ability to customize standard components and platforms acquired from third party suppliers. This customization includes both hardware and software modifications and enhancements to the standard platforms. We have assembled a team of highly skilled engineers with significant industry experience in high-density packaging, server appliance design, software, quality assurance and technical documentation. As of November 12, 2002, we employed 17 people in this group.

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.

Our principal competitors are general-purpose server manufacturers, including Dell, Hewlett-Packard, IBM and Sun Microsystems. We also compete with major distributors such as Tech Data or Bell Micro that also offer customized integration services to their customers. In addition, we compete with smaller companies that specialize in building server products, and providing some level of integration services. Examples of these competitors include SteelCloud and Advantech.

We expect competition in the server appliance market to increase significantly as more companies enter the market and current competitors expand their product offerings. 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 initial products and operations. We expect to have two patents issued by March 31, 2003 that will remain in effect until 2020. We believe that these patents will provide us with additional protection of proprietary information included in certain of our products. In addition, we have several patent applications pending. We have trademarks for the use of Network Engines, the Network Engines logo, ApplianceEngine 1000, ApplianceEngine 3000, ApplianceEngine 5000, and Appliance Alliance. We believe these trademarks provide us with additional protection over the use of these names and descriptions. 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. Subsequent to the restructuring of July 31, 2001, we reduced our dependence on intellectual property and proprietary technology.

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. Due to rapid technological changes in our market, we believe the various legal protections available for our intellectual property are of limited value. In addition to such intellectual property, we seek to establish and maintain an extensive knowledge of leading technologies and to incorporate these technologies into our appliance platforms by leveraging the technological knowledge and creative skills of our personnel.

Our success in training and retaining skilled employees and, if the need arises, obtaining 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 12, 2002, we had 57 employees. We believe that the demographics surrounding our headquarters, and our reputation and compensation package, should allow us to retain qualified employees.

Our principal business operations are conducted in our corporate headquarters in Canton, Massachusetts where we lease approximately 75,000 square feet of manufacturing and office space. Included in our leased space is 23,000 square feet of office space that we have sub-leased to a third party for the remainder of our lease term. We believe that our Canton facility will be adequate to meet our requirements for the foreseeable future.

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 Network Engines, Lawrence A. Genovesi (our Chairman and former Chief Executive Officer), Douglas G. Bryant (our Chief Financial Officer and Vice President of Administration), and the following underwriters of our initial public offering: FleetBoston Robertson Stephens, Inc., Credit Suisse First Boston Corp., Goldman Sachs & Co., Lehman Brothers Inc. and Salomon Smith Barney, Inc. (collectively, the “Underwriter Defendants”). An amended class action complaint, captioned In re Network Engines, Inc. Initial Public Offering Securities Litigation, 01 Civ. 10894 (SAS), was filed on April 20, 2002.

The suit alleges that the defendants violated the federal securities laws by issuing and selling securities pursuant to the Company’s initial public offering in July 2000 (“IPO”) without disclosing to investors that the Underwriter Defendants had solicited and received excessive and undisclosed commissions from certain investors. The suit also alleges that the Underwriter Defendants entered into agreements with certain customers whereby the Underwriter Defendants agreed to allocate to those customers shares of the Company’s stock in the offering, in exchange for which the customers agreed to purchase additional shares of the Company’s shares in the aftermarket at pre-determined prices. The suit alleges that such tie-in arrangements were designed to and did maintain, distort and/or inflate the

price of the Company’s common stock in the aftermarket. The suit further alleges that the Underwriter Defendants received undisclosed and excessive brokerage commissions and that, as a consequence, the Underwriter Defendants successfully increased investor interest in the manipulated IPO securities and increased the Underwriter Defendants’ individual and collective underwritings, compensation and revenues. The suit seeks damages and certification of a plaintiff class consisting of all persons who acquired shares of Network Engines’ common stock between July 13, 2000 and December 6, 2000.

In July 2002, Network Engines, Lawrence A. Genovesi and Douglas G. Bryant joined in an omnibus motion to dismiss, challenging the legal sufficiency of plaintiffs’ claims. The motion was filed on behalf of hundreds of issuer and individual defendants named in similar lawsuits. Plaintiffs opposed the motion, and the Court heard oral argument on the motion in November 2002. In addition, in October 2002, Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this case without prejudice.

Name	Age	Position

John H. Curtis	60	President and Chief Executive Officer

Douglas G. Bryant	45	Vice President of Administration, Chief Financial Officer, Treasurer and Secretary

J. Donald Oldham	60	Vice President of Sales

Michael D. Riley	38	Vice President of Marketing

John H. Curtis joined Network Engines in March 2001 as President and CEO. He joined Network Engines from Artel, Inc., where he was Vice President of Worldwide Sales. Prior to Artel, Mr. Curtis served as Senior Vice President of Worldwide Operations at Banyan and was Vice President of Worldwide Sales at Intellution Inc. From 1980 to 1992, Mr. Curtis held several senior-level management positions at Stratus Computer, Inc., including Chief Operating Officer, Vice President of Finance and Vice President of International Sales.

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.

J. Donald Oldham joined Network Engines in October 2002 as Vice President of Sales. Prior to joining Network Engines, Mr. Oldham was Vice President of Sales and Program Management at Manufacturers Servicers, Inc., a full-service global electronic manufacturing services and supply-chain company. From 1985 to 1998, Mr. Oldham held multiple senior management positions with Stratus Computer, including Senior Vice President of Worldwide Sales from 1994 to 1998. Mr. Oldham held a variety of sales management positions at IBM, from 1969 to 1985. Prior to IBM, Mr. Oldham was with Westinghouse.

Michael D. Riley joined Network Engines in July 2002 as Vice President of Marketing. Prior to joining Network Engines, Mr. Riley was the Chief Marketing Officer at Sonexis, Inc., a provider of collaboration solutions. Prior to Sonexis, Mr. Riley held a variety of senior management positions with Artel Video Systems from 1998 to 2001, including Senior Vice President of Marketing and Worldwide Sales and Vice President of Marketing. Prior to Artel, Mr. Riley held senior sales and marketing positions at Premisys Communications from 1994 to 1997 and Newbridge Networks Corporation from 1988 to 1993.

Network Engines’ 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:

Fiscal Year Ended September 30:	Fiscal 2002				Fiscal 2001
	High		Low		High		Low
First Quarter	$	1.11	$	0.58	$	44.00	$	1.63
Second Quarter		1.21		0.87		3.44		0.97
Third Quarter		1.35		0.86		1.40		0.61
Fourth Quarter		1.15		0.95		0.87		0.54

As of November 14, 2002, there were approximately 6,000 holders of record of our common stock. Because many of such shares are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders.

On July 18, 2000, the Company sold 7,475,000 shares of common stock in an initial public offering at a price of $17.00 per share pursuant to a Registration Statement on Form S-1 (the “Registration Statement”) (Registration No. 333-34286), which was declared effective by the Securities and Exchange Commission on July 12, 2000. The managing underwriters of the Company’s initial public offering were Donaldson, Lufkin & Jenrette, Dain Rauscher Wessels, Robertson Stephens and DLJdirect Inc. The aggregate proceeds to the Company from the offering were approximately $116.9 million reflecting gross proceeds of $127.0 million net of underwriting fees of approximately $8.9 million and other offering costs of approximately $1.3 million. None of the proceeds of the offering was paid by the Company, directly or indirectly, to any director, officer or general partner of

the Company or any of their associates, to any persons owning ten percent or more of our outstanding stock, or to any of the Company’s affiliates. During the period from the offering to September 30, 2002, the Company has used the proceeds as follows: approximately $53.2 million was used to fund the operations of the Company, approximately $4.9 million was used for the purchase of property and equipment and approximately $4.3 million was used to repurchase the Company’s common stock under a stock repurchase plan.

The following selected consolidated financial data are derived from the financial statements of Network Engines. The historical results presented are not necessarily indicative of future results. The consolidated statement of operations data for the years ended September 30, 2000, 2001 and 2002 and the consolidated balance sheet data as of September 30, 2001 and 2002 have been derived from our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. The consolidated statement of operations data for the years ended September 30, 1998 and 1999 and the consolidated balance sheet data as of September 30, 1998, 1999 and 2000 are derived from our audited consolidated financial statements not included in this Annual Report on Form 10-K. 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 “Financial Statements and Supplementary Data” and the related Notes included elsewhere in this Annual Report on Form 10-K.

On November 12, 1999, Network Engines completed a three-for-one split of its common stock, which was effected through a stock dividend. On May 17, 2000, Network Engines completed a 2.5- for-1 split of its common stock, which was effected through a stock dividend. All share and per share data included in the selected financial data have been restated to reflect both of these splits.

	Year ended September 30
	1998			1999		2000		2001			2002
Net product revenues	$	1,102		$	6,031	$	38,216	$	12,850		$	14,534
Net license revenues		—			—		4,858		665			—

Total net revenues		1,102			6,031		43,074		13,515			14,534
Cost of product revenues		1,591			4,733		26,695		12,344			12,329
Cost of license revenues		—			—		34		5			—
Cost of revenues stock compensation		—			16		254		332			147
Inventory write-down		—			—		—		20,278			—

Total cost of revenues		1,591			4,749		26,983		32,959			12,476

Gross profit (loss)		(489	)		1,282		16,091		(19,444	)		2,058
Operating expenses:
Research and development		923			2,564		8,219		12,704			4,693
Selling and marketing		1,593			2,920		15,760		18,118			3,836
General and administrative		620			934		3,963		7,047			4,602
Stock compensation		—			111		2,667		5,800			4,291
Restructuring and other charges		—			—		—		10,886			353
Amortization of intangible assets		—			—		—		675			—

Total operating expenses		3,136			6,529

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

25 Dan Road, Canton, MA (Address of principal executive offices)		02021 (Zip Code)

		Page

PART I

ITEM 1.	BUSINESS	1

ITEM 2.	PROPERTIES	7

ITEM 3.	LEGAL PROCEEDINGS	7

ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS	8

PART II

ITEM 5.	MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS	10

ITEM 6.	SELECTED CONSOLIDATED FINANCIAL DATA	11

ITEM 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	13

ITEM 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	38

ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA	39

ITEM 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE	68

PART III

ITEM 10.	DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT	68

ITEM 11.	EXECUTIVE COMPENSATION	68

ITEM 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS	68

ITEM 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS	68

ITEM 14.	CONTROLS AND PROCEDURES	68

PART IV

ITEM 15.	EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K	69

SIGNATURES		70

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents