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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

Commission file number: 0-30863

NETWORK ENGINES, INC.
(Exact name of registrant as specified in its charter)

Registrant's telephone number, including area code (781) 332-1000

Securities registered pursuant to Section 12 (b) of the Act: None

Securities registered pursuant to Section 12 (g) of the Act: Common Stock, $0.01 par value

        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 ý    No o

        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. ý

        Indicate by checkmark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes ý    No o

        The aggregate market value of the voting Common Stock held by non-affiliates of the registrant on March 31, 2004 was approximately $112,178,325.

        The number of shares outstanding of the registrant's Common Stock as of December 10, 2004: 37,245,014 shares.

DOCUMENTS INCORPORATED BY REFERENCE

        Portions of our proxy statement relating to the 2005 Annual Meeting of Shareholders are incorporated by reference into Part III of this Form 10-K.

NETWORK ENGINES, INC.
ANNUAL REPORT ON FORM 10-K
For the Fiscal Year Ended September 30, 2004

TABLE OF CONTENTS

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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.

PART I

ITEM 1. BUSINESS

Overview

        Network Engines develops, manufactures and distributes server appliance solutions that enable network equipment providers and independent software vendors, or ISVs, to deliver data storage and security networking applications on server appliances. We previously also distributed third-party data storage networking connectivity products for the leading Fibre Channel host bus adapter, or HBA, and storage switch manufacturers in the data storage industry to a customer base of value-added resellers, or VARs, and systems integrators. We believe we are a leading provider of server appliance solutions and distribution services by virtue of our ability to offer a wide range of engineering, manufacturing, supply-chain and support services to network equipment providers and ISVs.

        Server appliances are pre-configured network infrastructure devices designed to optimally deliver specific software application functionality and facilitate ease of deployment and support of a software application in a customer's network. We offer our server appliance partners a comprehensive suite of services, including development, manufacturing, fulfillment, distribution and post-sale support. Our server appliances are sold and supported either by the application provider or alternatively by us through our Distribution operation. Our OEM Appliance customers include, but are not limited to: Borderware, Inc., Computer Associates Inc., EMC Corporation, Network Intelligence Corporation, Nortel Networks Corp., and Surf Control Inc.

        During fiscal 2004 we were organized into two reportable segments: OEM Appliance and Distribution. Our OEM Appliance operation leverages our server appliance development, manufacturing and supply chain support services. We produce and fulfill devices branded for our network equipment and ISV partners, and we derive our revenues from the sale of value-added hardware platforms to these partners. These partners subsequently sell and support the device under their own brands to their customer base. Revenues from our Distribution operations during fiscal 2004 were derived from two activities: first was the revenue derived from the distribution of third-party data storage networking products; second was the distribution of server appliances that we develop, manufacture, sell and support on behalf of our ISV partners. Substantially all of the revenue during fiscal 2004 associated with our Distribution operations was derived from the sale of third-party data storage networking products.

        In early fiscal 2005, we decided to discontinue selling third-party data storage networking products after a review of that portion of the business and its future prospects. As a result of the commoditization of Fibre Channel HBA technology and increasing competition in the market, we had experienced declining gross profits in that portion of the Distribution business. Furthermore, we expected future net revenues and gross profits in this portion of the business to deteriorate. We expect sales of these third-party data storage networking products will cease by December 31, 2004.

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        As a result of the decision to discontinue selling third-party data storage networking products, we believe we have transformed the company into a "pure-play" appliance company, dedicated to delivering security and storage solutions. During fiscal 2004 we entered a relationship with Microsoft Corporation to license their Internet Security and Acceleration (ISA) Server 2004. We intend to integrate that software with server appliance platforms and our proprietary software to sell our NS Series firewall appliances primarily to Microsoft-certified value added resellers and system integrators.

        Microsoft's ISA Server 2004 is a third generation firewall technology with advanced virtual private network (VPN) and web caching functionality. Unlike most earlier generation firewall technology, Microsoft's ISA Server 2004 will provide critical application inspection and content filtering functionality required to secure critical business applications, specifically Microsoft applications. Our NS Series firewall appliances also include our own software intellectual property, Network Engines Web Server, or NEWS™ technology. NEWS™ is a secure, web-based appliance management sub-system that enables deployment and maintenance tasks such as provisioning and remote system updates. NEWS™ is our key technology differentiator and enabler for all NS Series appliance management and update tasks.

        We expect that total revenue for fiscal year 2005 will be derived primarily from OEM Appliance sales. After we discontinue the distribution of third-party data storage networking products, Distribution revenue in fiscal 2005 will be derived primarily from the sale of our NS Series firewall appliances. The first NS Series firewall appliance, the NS6300, became generally available in October of 2004, therefore we expect that it will take several quarters before revenues from these appliances would become significant.

        Headquartered in Canton, Massachusetts, we were incorporated in 1989, and began developing custom server hardware platforms in 1997 for internet-based organizations, content infrastructure providers and larger enterprises. In 1999, we achieved an important milestone by introducing a one-rack unit Intel-based server, representing a server only 1.75 inches in height. At that time, we designed most of the hardware components that went into our servers and, as a result, we invested significant resources in the development of our products. Subsequently, a significant number of companies entered the one rack unit server marketplace, much of the hardware components of server appliances became commoditized and, at the same time, the demand of internet-based organizations declined precipitously. As a result, we restructured our operations in fiscal 2001, which among other things de-emphasized the use of proprietary components in server hardware platforms. Our purchase of TidalWire in December 2002 enhanced our supply chain capabilities. TidalWire was a specialty distributor of third-party data storage networking products. This acquisition provided us with the ability to partner with ISVs to develop, manufacture, and distribute the ISV's applications in the form of server appliances. Throughout fiscal years 2003 and 2004, we established relationships with several ISV partners, including Microsoft. Today, we are leveraging our engineering and manufacturing infrastructure to supply OEM appliances to our partners and plan to leverage our distribution infrastructure and capabilities to focus on distributing our Network Engines NS Series firewall appliances.

Industry Background

        Traditionally, networking solutions were built utilizing custom-designed hardware and proprietary operating systems. Vendors developed custom components and systems in an effort to meet the high performance demands of their customers, such as increasing networking speeds, packet processing requirements and internal storage capabilities. Standard components that could meet these performance demands were not commercially available, requiring networking equipment companies to invest considerable capital in hardware and system-level research and development. While these highly integrated systems were designed to address the performance demands of the customer, they were expensive due to the cost of research and development related to the requisite customization.

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Networking solution vendors generally maintained internal research, development, manufacturing and integration expertise in both hardware and software, as both were critical aspects of a networking solution and viewed as essential to maintaining a competitive advantage.

        Over time, much of the networking solutions market has evolved toward the development and manufacture of systems, which are built using commercially available standardized components and standardized operating system platforms. Networking solutions vendors are driven by continuous market demand for lower priced systems and a desire to utilize ubiquitous processing and operating system platforms, which promote standard- based solutions. The speed and processing power of standard Intel-based processors has reached a level where these processors can adequately meet the demands of many networking applications. Operating system platforms, such as Windows and Linux, have also increased in power and sophistication and can now be used as the "embedded' operating system environment for many of today's networking applications.

        This evolution in the development and manufacturing of systems built with commercially-available, standardized components has allowed networking equipment vendors to refocus development efforts and resources on the application software and system integration aspects of their solutions. Vendors recognize that custom hardware development in many cases is no longer critical in meeting their customers' performance requirements. Competing systems are being integrated and packaged on standardized hardware platforms and, therefore, hardware alone no longer differentiates a system in the marketplace. As a result, network equipment providers have begun outsourcing components of hardware integration, test, manufacturing and logistics to partners that specialize in these skills.

        The ability of standard server hardware and operating systems to meet the demands of networking applications served as a catalyst in the emergence of an ISV industry focused on delivering enterprise class networking application software. However, these servers often require hardware customization and software "tuning" to optimize the performance of the application. Manufacturers of general-purpose servers, such as Dell Corporation, IBM Corporation and Hewlett-Packard Co., generally do not provide specific customization of their products for most networking application vendors. ISVs using general purpose servers must invest considerable development resources in order to facilitate the deployment of their applications across multiple general-purpose servers and operating system environments, and must also invest in the post-sales support of the application in varied deployment scenarios and changing network environments. In addition, the deployment of some application software on general-purpose servers and operating system environments is not ideal for the end-user customer due to the time and cost of implementation, the expertise required to optimize performance and challenges relating to on-going support and migration. The server appliance market has recently developed in response to these shortcomings and to reduce the total cost of ownership to the end-user customer. Server appliances are pre-configured network infrastructure devices designed to optimally deliver specific software application functionality and facilitate ease of deployment and support of a software application in a customer's network.

        While there are many applications for which a server appliance may ultimately be used, early adoption of the technology is most prevalent in the data storage and security networking markets. These markets are significant in size and have exhibited robust growth in recent years. The security applications that we believe are most likely to benefit from a server appliance solution include firewalls, authentication, anti-virus, anti-spam, instant messaging or IM security, web content filtering, intrusion detection and prevention, device relationship management, digital rights management, and web services security management. The storage applications that we believe are most likely to benefit from deployment in the form of a server appliance include storage security, backup and recovery, virtual tape libraries, storage resource management and storage virtualization.

        Another significant trend driving the growth of the data storage and security markets is the decentralization of storage management applications and security applications. Enterprises are

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deploying applications both in data centers and at departmental and remote office locations. As a result, there is an increased need for applications that can be deployed quickly and efficiently without the need for extensive internal IT resources. Furthermore, remote deployment, monitoring and upgrades have become a critical aspect of managing the IT network of an enterprise.

        Finally, the storage and security needs of small to medium size enterprises continue to grow and, given the limited resources of these smaller businesses, we believe vendors must provide turnkey solutions that are cost-effective, easy to install and deploy and require minimal human maintenance and management resources.

Network Engines' Solution

        We develop, manufacture and distribute server appliance solutions that enable our network equipment and ISV partners to deliver data storage and security networking applications as a server appliance. We focus on developing cost-effective server appliance solutions to meet the performance requirements of our partners' software applications in order to address the deployment and cost of ownership needs of their and our customers. Key elements of our solution include:

        Appliance development expertise.    One of our core businesses is developing and manufacturing high quality server appliance solutions in conjunction with our network equipment and ISV partners. We have developed a structured appliance development process, which takes into account all major aspects of a product's design, from performance requirements to branding, packaging and quality assurance. We strive to engage with our partners at multiple levels of their organization, including engineering and product management, to optimize the product or suite of products by focusing on the integration of the hardware, operating system, utilities and application software. We make use of in-house server platform designs and third-party server platforms, depending on the configuration, application and volume requirements.

        Flexible, high-quality manufacturing services.    We have a sophisticated manufacturing facility at our headquarters in Canton, Massachusetts, which is ISO 9001:2000 certified. Our advanced control processes and systems, and comprehensive system tests that we develop with our partners, are designed to ensure quality and trace-ability at every key step of the manufacturing process. We believe our core strengths include our flexibility and ability to react quickly to accommodate changes in customer demands, including increasing order volumes, engineering changes to existing products and new product introductions. For certain high-volume products, we supplement our production capacity and make provision to maintain continuity of supply through a relationship with a contract manufacturer.

        Custom design services.    We believe our expertise in developing customized hardware platforms is a significant competitive advantage with respect to partners with high volume requirements for whom commercially available platforms are not appropriate solutions. This capability is based on our heritage of designing and optimizing custom server platforms, and is generally driven by our customers' specific requirements for features including density, performance or cost optimization. Our customization skills include hardware, firmware and software integration and packaging. Our team of skilled engineers, augmented by third-party contractors, has significant industry experience in high-density packaging, server design, testing, quality assurance and technical documentation.

        Appliance life cycle management.    We operate in a technology environment in which platforms, operating systems, components and software applications are constantly evolving. We pro-actively analyze these developments in order to maintain the operation of our partners' software applications despite changes in the underlying technologies. We also adapt the appliance solutions to meet emerging requirements and capabilities of new versions of our partners' software applications. We believe our expertise in life cycle management has become a critical factor in attracting new partners and retaining our existing partners.

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        Distribution infrastructure and support capabilities.    We believe our distribution infrastructure is a critical part of our capability. We believe that this infrastructure was a critical component in establishing a relationship with Microsoft Corporation. With the NS Series firewall appliance, we have begun to sell and market a Network Engines branded firewall appliance powered by Microsoft ISA Server 2004. We are responsible for developing, manufacturing, marketing and selling our NS Series firewall appliances as well as supplying logistics and post-sales support for our devices.

        NEWS™ technology.    Our NS Series firewall appliances include our proprietary software intellectual property, Network Engines Web Server, or NEWS™ technology. NEWS™ is a secure, web-based appliance management sub-system that enables deployment and maintenance tasks such as provisioning and remote system updates. NEWS™ is our key technology differentiator and enabler for all NS Series firewall appliance management and update tasks.

Business Strategy

        Our objective is to become a leading global provider of server appliance solutions and services for the storage and network security markets. The key elements of our strategy include:

        Strengthen existing relationships and engage with new network equipment and ISV partners to sell server appliance solutions.    We believe that our full service supply chain capabilities are a competitive advantage in the marketplace today. We intend to leverage this advantage to develop additional business within our existing OEM customer base and to identify and attract new OEM partners. We are targeting partners in the data storage and network security markets where initial adoption of the server appliance solution has been most prevalent.

        Successfully bring to market our NS Series firewall appliances.    We plan to leverage our relationship with Microsoft to sign and train Microsoft certified resellers and system integrators to sell our NS Series firewall appliances, powered by Microsoft's ISA Server 2004. We plan to invest in sales, marketing, customer service and engineering to strengthen our relationship with Microsoft, Microsoft's channel partners, and Microsoft's customer base.

        Establish strong brand identity of Network Engines server appliances.    Network Engines plans to employ a branding strategy that establishes Network Engines as the server appliance development and manufacturing partner of choice. This strategy is designed to establish company name recognition, product brand equity and identification in the data storage and security networking markets.

        Develop technologies that improve the user experience.    We intend to continue to enhance our proprietary technology that we have developed to make truly headless, remotely managed server appliances. Our NEWS™ technology enables end-users to remotely manage the NS Series appliances through a secure web-based management system that enables provisioning and remote system upgrades. NEWS™ is the cornerstone of one of our key differentiators—our ability to enable complete appliance lifecycle management. Today NEWS™ is only deployed with our NS Series firewall appliances. We have filed multiple patents for our server appliance framework technology, including our automated update management system, and we are continuing to work on additional technology that we expect to be patented in the future.

Products and Services

        We develop, manufacture and in some cases distribute optimized server appliance solutions that enable our network equipment and ISV partners to deliver data storage and security networking applications on a server appliance. We have developed a comprehensive suite of products and services, enabling our network equipment and ISV partners to accelerate the time to market for their products, to optimize their server appliance solutions and in some cases enable them to utilize our fulfillment infrastructure to distribute those server appliance solutions. Additionally, in October 2004, we

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announced the general availability of our first product in our family of NS Series firewall appliances, the NS6300. The NS6300 firewall appliance, powered by Microsoft ISA Server 2004, is a third generation application layer firewall with robust VPN and caching capabilities. Our products and services are described below:

Server appliance development

        We have developed a structured approach to server appliance development. We define the customer engagement and ultimate delivery of the product in stages and identify the responsibilities for both the partner and for ourselves. This program is designed to ensure that the engagement with our application partner is well managed and executed and anticipates and includes all aspects of the solution requirements of the customer. The key phases of the process consist of the following:

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Definition: Network Engines and application partner establish project teams and develop product requirements.



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Development: Engineering teams from Network Engines and application partner work together to define a prototype.



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Prototype: Engineering teams develop, build and test prototype.



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Pilot Manufacturing: Network Engines manufacturing builds the First Article unit, a representative sample of the final product.



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First Article: Both parties approve the final product and Network Engines finalizes manufacturing, fulfillment, and post-sale support processes.



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General Availability: The final product is released to Network Engines manufacturing for production.

        We have had a significant amount of experience in developing server appliance solutions and, as such, we believe that our structured approach provides substantial benefits to our partners, including improving the chances for a successful development and speeding the process of bringing a product to market.

Custom server design and integration

        Our design team is well versed in custom server design, generally utilizing standard off-the-shelf components and sub-systems. Such customized hardware requires significant hardware design, packaging, regulatory and thermal profiling skills. Our embedded software design team also performs low-level hardware driver development as well as BIOS modifications and tuning. We leverage these server development skills in order to deliver custom solutions to certain of our partners.

Manufacturing and test services

        We provide internal manufacturing and test services for our server appliance partners. We operate separate manufacturing lines for high volume and low volume manufacturing. Our high volume manufacturing process involves building the chassis, including the integration of the main logic board, memory, disk drive and PCI-board into the chassis and testing of the final product. Our low volume process involves branding of third-party supplied servers, as well as memory, disk drive and PCI board integration and testing. We maintain separate low and high volume lines in order to provide our partners with the appropriate type of manufacturing resources and skill sets to best meet the volume requirements of a particular product. In addition, our low volume line allows us to provide customers with rapid manufacturing turn around time, which provides a significant time to market advantage for new products. Our partners' products undergo system test and burn-in prior to final inspection, packaging and shipment.

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Branding, packaging and fulfillment services

        We brand the server appliance solution for our network equipment or ISV partner. Branding is applied to the server appliance itself as well as to all accompanying documentation, including quick set-up guides, manuals, shipping cartons, shipping labels and paperwork. We retain a full time graphic artist who is responsible for production of branding designs and we work with outside design and production agencies that are highly experienced in equipment packaging and branding approaches.

        We deliver the final product to either our customer or, at their request, directly to their end user customers. In certain cases we also offer to distribute the final product to end users.

NS Series firewall appliance

        Our NS Series firewall appliances combine the power of Microsoft's Internet Security and Acceleration (ISA) Server 2004 software application with our server appliance integration expertise and our internally developed Network Engines Web Server (NEWS™). Our first product in this family, the NS6300 firewall appliance, is a third-generation application layer firewall, VPN and Web-cache solution that provides advanced protection against a wide range of new and emerging security threats, fast and secure Web access, and is very easy to use. The NS6300 can provide security as a perimeter firewall at the Internet edge, can be used to protect Microsoft applications such as Microsoft Exchange and other servers on the internal network, as well as be configured as a Web-caching server to ensure fast, secure Web access.

        The NS6300 became generally available for sale in October 2004 and is targeted for small and medium businesses with up to 1,000 users. The product is sold with an annual support and maintenance program, which includes standard product warranties and a software subscription service. Our NEWS™ technology and software subscription services allow for fast, reliable and secure software updates on a when and if available basis.

Customers and Partners

        Each of our business segments in which we generated revenue in fiscal 2004, OEM Appliance and Distribution operations, target a distinct customer base. Our OEM Appliance business targets network equipment vendors and ISVs that wish to sell server appliance solutions to their customers. During the past fiscal quarter, our OEM Appliance business sold server appliances to 14 customers, including: Borderware, Inc., Computer Associates Inc., EMC Corporation, Network Intelligence Corporation, Nortel Networks, Sonexis, Inc., and Surf Control Inc. EMC was our only customer that represented more than 10% of our revenues for the years ended September 30, 2004 and 2003, during which our sales to EMC were $67.4 million, or 49% of total net revenues and $38.3 million, or 47% of total net revenues, respectively.

        In fiscal 2004, the targeted customers for our Distribution business were VARs and systems integrators in North America. We purchased products from our third-party storage networking vendor partners, including: Brocade, Emulex, McData and QLogic. However in October 2004 we decided to discontinue sales of these third-party data storage networking products. During fiscal 2004, our Distribution business derived substantially all of its revenue from the distribution of HBAs and other third-party data storage networking products.

        For the sale of our NS Series firewall appliances, our targeted customers will primarily be Microsoft-certified resellers and system integrators. The first NS Series firewall appliance, the NS6300, became generally available in October of 2004, therefore we expect that it will take several quarters before revenues from these appliances would become significant.

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Sales and Marketing

Sales

        Our OEM Appliance sales team is focused on developing partnerships with network equipment providers seeking to integrate a server appliance into their offerings and with ISVs seeking to offer their application software as an appliance solution. Once we have identified and qualified a prospective partner and a project is identified, a regional sales manager meets with the customer and begins to work on an appropriate strategy. We then involve other employees from sales, engineering, and product management to analyze the prospective customer's requirements and begin to develop a solution.

        Previously, our Distribution sales team was focused on two separate activities: first, identifying new ISV partners interested in utilizing our appliance development, manufacturing and distribution services and, second, selling our server appliance solutions and third-party data storage networking equipment to our channel of VARs and systems integrators.

        Going forward, our Distribution sales team will focus on partnering with Microsoft certified resellers and system integrators to sell Network Engines NS Series firewall appliances powered by Microsoft ISA Server 2004. We expect that a significant number of these new relationships with Microsoft certified resellers and system integrators will be cultivated through initial contacts derived from working closely with Microsoft sales and marketing personnel. As a result, this requires our sales team to further develop and strengthen our relationship with Microsoft in order to be considered a preferred provider of Microsoft ISA Server 2004 in the form of a server appliance.

Marketing

        Our marketing organization is aligned by two key functions: product management and marketing programs. Our product management team is responsible for managing the technical relationship with our hardware platform, operating systems and components suppliers. The product management team researches the market to anticipate trends and understand and evaluate new technologies that we can leverage in the development and integration of server appliance solutions. They work closely with our engineering team and our network equipment provider and ISV partners to define product requirements. Our marketing program team is responsible for building market awareness and acceptance of Network Engines and our products and services and generating qualified customer leads.

Warranty and post sales support services

        We offer a warranty on certain of the products we sell. The warranty generally provides for us to repair or replace a defective product within certain timeframes and generally lasts for a period of up to 36 months after initial product shipment, depending on the product and our contractual relationships with certain customers.

        For our OEM Appliance customers, we offer a range of post sales support services, including advanced replacement of defective units as well as repair and return service for appliance platforms covered by our contractual warranty.

        For our NS Series firewall appliances, we offer two different post sales support service programs, each of which includes call center support, software subscription service, web registration and support, and twenty-four hour domestic advanced replacement of appliances. However, only one of our programs offers twenty-four hour call center support. Our software subscription service enables our NS Series firewall appliance customers to easily apply software updates for the operating system, application and appliance management software. Software updates may include patches, service packs and feature enhancements, when and if available. Web registration and support allows the customer to register its NS Series firewall appliance through our website, which also provides customers with

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additional product information including technical advice, aforementioned software updates and an online support request form.

Manufacturing

        We provide manufacturing, test and fulfillment services for server appliances through our 22,500 square foot manufacturing facility located at our headquarters in Canton, Massachusetts. In October 2003, we received our initial ISO 9001:2000 certification. We operate separate server appliance manufacturing lines for high volume and low volume manufacturing. We maintain two separate lines in order to provide our partners with the appropriate type of manufacturing resources and skill sets to best meet the volume, cost and quality requirements of a particular product. In addition, our low volume line allows us to provide customers with rapid manufacturing turn-around time, which provides a significant time to market advantage for new products.

        We also supplement our manufacturing capacity for certain high-volume products by utilizing a third-party contract manufacturer who has multiple manufacturing locations in the United States and abroad. We use this partner to handle a portion of our ongoing volume requirements to ensure that they are prepared to handle surge and/or excess volume requirements and also as a disaster-recovery site in the event that our Canton facility is shut down for any reason.

Logistic Services

        In order to deliver products in a timely and reliable manner to our North American and in some cases European customers, we leverage the global logistics capabilities of FedEx™. Substantially all Distribution inventory is consigned to a FedEx depot. Electronic links between FedEx and Network Engines allow us to electronically send shipping instructions to FedEx, allowing same-day shipment of products from the FedEx facility Monday through Friday, subject to product availability.

Engineering

        We believe that much of our future success depends on our ability to customize server appliances developed utilizing commercially available 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, contractors and suppliers with significant industry experience in high-density packaging, server appliance design, system software, quality assurance, testing and technical documentation.

        We are making a considerable investment in Network Engines Web Server, or NEWS™ technology, which is our proprietary software used in our NS Series firewall appliances. NEWS™ is a secure, web-based appliance management sub-system that enables deployment and maintenance tasks such as provisioning and remote system updates.

Employees

        As of September 30, 2004, we had 132 employees, of whom 31 were engaged in manufacturing, 43 were engaged in sales and marketing, 32 were engaged in research and development and 26 were engaged in general and administrative. We also employ contract labor, predominately in our manufacturing operations. As of September 30, 2004, we also utilized 43 contract employees.

Backlog

        Our backlog includes orders confirmed with a purchase order for products scheduled to be shipped within 180 days to customers with approved credit status. Certain of our OEM Appliance customers place large orders with us to be delivered over time. In addition, we have an inventory consignment

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agreement with our largest customer whereby shipments for certain products to this customer are held at this customer's location until this customer requires the products for their production process. We do not recognize revenues from consignment shipments until the consigned product is utilized. Also, certain of our OEM Appliance customers, including our largest customer, have certain rights under our agreements with them to change the delivery timing of future shipments to them. In addition, our agreement with our largest customer includes provisions that allow this customer to cancel orders within certain contractual time periods. As a result of these factors, we do not consider our backlog to be firm nor do we believe that our backlog, as of any particular date, is necessarily indicative of actual net revenues for any future period.

Competition

        Our markets are highly competitive, and we expect this competition to persist and intensify in the future.

        The principal competitors of our OEM Appliance business are general-purpose server manufacturers that provide solutions for network equipment providers and ISVs and build servers for the OEM marketplace. These competitors include Dell, Hewlett-Packard, IBM and Sun Microsystems. We also compete with major distributor integrators such as Arrow Electronics, Inc. and Avnet, Inc. that offer distribution as well as 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.

        We believe that our NS Series firewall appliances, will compete with other technology companies that license Microsoft ISA Server 2004 software, and develop their own firewall appliances, such as Hewlett-Packard Company, Celestix Networks, Inc., and Pyramid Computer GmbH. In addition, we expect to compete with technology companies in the firewall security industry that sell appliances using technology other than Microsoft ISA Server 2004, including Cisco Systems, Inc., Nokia Corporation, Juniper Networks, Inc, Watchguard Technologies, Inc. and SonicWALL, Inc.

        We believe we can compete favorably on factors that are important to our target market, including our expertise in integrating software applications into server appliances, the strength of Microsoft ISA Server 2004, our sales and marketing relationship with Microsoft and the Microsoft reseller customer base, our proprietary NEWS™ technology, our knowledge of sales and marketing to a channel, our logistics and support infrastructure, our manufacturing proficiency and our commitment to quality.

Intellectual Property

        We have trademarks for the use of the Network Engines name and the Network Engines logos. 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. We also have five patents that primarily pertain to our historical business and will remain in effect until 2020 or later. In addition, we have five patent applications pending for manufacturing techniques.

        We have patents applied for and in process for our NEWS™ based appliance framework technology, including our automated update management system, and we are continuing to work on additional technology that we expect to be patented in the future.

        Despite our efforts to protect our proprietary rights, our competitors might independently develop similar technology and unauthorized parties may attempt to copy or otherwise obtain and use our technology. Monitoring unauthorized use of our proprietary technology is difficult, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology, particularly in

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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.

Financial Information About Geographic Areas

        See Note 16 to our Consolidated Financial Statements, entitled "Segment and Geographic Data", for financial information about geographic areas. The Notes to the Company's Consolidated Financial Statements are contained herein in Item 8.

Website Access to Securities and Exchange Commission Reports

        We maintain an internet website at www.networkengines.com. We are not including the information contained on our website as part of, or incorporating it by reference, in this Annual Report on Form 10-K. Our periodic Securities and Exchange Commission reports (including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K) are accessible through our website, free of charge, as soon as reasonably practicable after these reports are filed electronically with, or furnished to, the Securities and Exchange Commission. We have posted on our website a copy of our code of business conduct and ethics. In addition, we intend to disclose on our website any amendments to, or waivers from, our code of business conduct and ethics that are required to be publicly disclosed pursuant to the rules of the Securities and Exchange Commission or NASDAQ National Market.

ITEM 2. PROPERTIES

        Our principal business operations are conducted in our corporate headquarters in Canton, Massachusetts where we lease approximately 52,000 square feet of manufacturing and office space. We believe that our Canton facility will be adequate to meet our requirements for the foreseeable future.

ITEM 3.    LEGAL PROCEEDINGS

Announcement Timing Lawsuit

        On March 17, 2004, the United States District Court for the District of Massachusetts consolidated a number of purported class action lawsuits filed against Network Engines, Inc. and certain individual Network Engines defendants, collectively the defendants. These suits generally concern the timing of the announcement of an amendment to Network Engines' agreement with EMC Corporation regarding the resale of EMC-approved Fibre Channel HBAs. In its March 17, 2004 order, the court selected Wing Kam Yu, Blake Kunkel, and Thomas Cunningham as lead plaintiffs and appointed Milberg Weiss Bershad Hynes & Lerach LLP (now Milberg Weiss Bershad & Schulman LLP) as plaintiffs' lead counsel. The lead plaintiffs filed an amended consolidated complaint on June 4, 2004. The defendants on August 13, 2004 filed a motion to dismiss the amended consolidated complaint. The plaintiffs on October 12, 2004 filed an opposition to the defendants' motion to dismiss. The defendants filed a reply to the plaintiff's opposition on November 12, 2004. The court on November 22, 2004 denied our motion to dismiss the amended consolidated complaint.

        Network Engines believes that the plaintiffs' allegations are without merit, and it intends to pursue a vigorous defense. We are unable to predict the outcome of this suit and its ultimate effect, if any, on the Company's financial condition; however, our defense against this suit may result in the expenditure of significant financial and managerial resources. No amounts have been accrued for this matter.

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TidalWire Acquisition Lawsuit

        A purported class action and derivative lawsuit was filed on January 7, 2003 in the Court of Chancery in the State of Delaware against Network Engines, Inc., Robert M. Wadsworth, Frank M. Polestra, John H. Curtis, Lawrence A. Genovesi, John A. Blaeser and Fontaine K. Richardson relating to the acquisition of TidalWire Inc. The plaintiffs in the complaint alleged that Network Engines and the named directors of its Board of Directors breached their fiduciary duties by, among other things, paying an excessive amount in the acquisition of TidalWire and purportedly failing to disclose material facts in our Joint Proxy Statement/Information Statement distributed to stockholders for approval of the issuance of shares of our common stock in the merger. The plaintiffs sought damages, rescission of the merger and other relief. On October 30, 2003, the court approved a settlement of the action negotiated by the parties, and that settlement became final on December 1, 2003. Under the settlement, all claims against us and our individual board members were dismissed with prejudice, and (a) the defendants in the lawsuit paid $600,000 to us, (b) plaintiff's attorney fees of $185,000 were paid out of that $600,000 amount and (c) in the disclosure for our next annual meeting, we were required to detail certain information concerning relationships among its board members, which we have complied with. Payments to us under this settlement, net of payments of plaintiff's attorney fees, were recorded as an increase of $415,000 to additional paid-in capital in the three months ended December 31, 2003.

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 Chairman and former Chief Executive Officer), Douglas G. Bryant (the Company's Chief Financial Officer and Vice President of Finance and 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 our initial public offering in July 2000, or 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 our common stock in the offering, in exchange for which the customers agreed to purchase additional shares of our common stock 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 our 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 our 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. On February 19, 2003, the court issued an opinion and order denying the motion as to Network Engines. In addition, in October 2002, Lawrence A. Genovesi and Douglas G. Bryant were dismissed from this case without prejudice.

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        On July 9, 2003, a Special Committee of our Board of Directors authorized Network Engines to negotiate a settlement of the pending claims substantially consistent with a memorandum of understanding negotiated among class plaintiffs, all issuer defendants and their insurers. We have negotiated the settlement, which provides, among other things, for a release of Network Engines and the individual defendants for the conduct alleged in the amended complaint to be wrongful. We would agree to undertake other responsibilities under the settlement, including agreeing to assign, or not assert, certain potential claims that we may have against the underwriters. Any direct financial impact of the proposed settlement is expected to be borne by our insurers. The settlement is subject to various contingencies, including approval by the Court overseeing the litigation.

        We are unable to predict the outcome of this suit and its ultimate effect, if any, on our financial condition; however, our defense against this suit has and may continue to result in the expenditure of significant financial and managerial resources. No amounts have been accrued for this matter.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

        No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended September 30, 2004.

EXECUTIVE OFFICERS OF THE COMPANY

John H. Curtis

        John H. Curtis joined the Company in March 2001 as President and Chief Executive Officer. Mr. Curtis has served as a director of the Company since March 2001. Prior to joining the Company, he was Vice President of Worldwide Sales at Artel Video Systems, Inc., from August 1996 to March 2001. Prior to Artel Video Systems, Mr. Curtis served as Senior Vice President of Worldwide Operations at Banyan Systems, Inc. from July 1995 to May 1996 and was Vice President of Worldwide Sales at Intellution Inc. from September 1992 to May 1995. 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.

John Amaral

        John Amaral joined Network Engines in June 2004 as Chief Technology Officer. Prior to joining Network Engines, he served as Chief Technology officer for Artel Video Systems, a provider of advanced networking and media processing equipment, from September 1999 to February 2004,. Prior to Artel, Mr. Amaral was Chief Technology Officer for ITS Corp. from June 1991 to August 1999.

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Jeffrey A. Brandes

        Jeffrey A. Brandes has served as Vice President and General Manager of Distribution Operations from our acquisition of TidalWire Inc. in December 2002 to April 2004 when he assumed the role of Vice President of Corporate Development. Mr. Brandes joined TidalWire as its President and Chief Executive Officer in May 2000. In 1997, Mr. Brandes co-founded and served as Director of Business Development at WebSpective, a content distribution and tracking software company. WebSpective was acquired by Inktomi Corporation in 1999. From November 1999 to May 2000, Mr. Brandes held a variety of sales and management positions at Inktomi. Prior to WebSpective, Mr. Brandes held a number of enterprise software senior sales and business development positions.

Douglas G. Bryant

        Douglas G. Bryant has served as Secretary and Vice President of Finance and Administration since March 2000, Treasurer since January 1998 and Chief Financial Officer since September 1997. Prior to joining the Company, 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.

Richard P. Graber

        Richard P. Graber joined the Company in October 2003 as Vice President of Engineering and Operations. Prior to joining the Company, Mr. Graber was the Vice President of Engineering and Operations at Jedai Broadband Networks, Inc., a developer of access technology for broadband providers. Prior to Jedai Broadband Networks, Mr. Graber was Vice President of Engineering for ViaGate Technologies, Inc. from November 2000 to August 2001. Prior to joining ViaGate Technologies, Mr. Graber held senior engineering positions at Dialogic, an Intel company, from June 1988 to October 2000.

J. Donald Oldham

        J. Donald Oldham joined the Company in October 2002 as Vice President of OEM Appliance Sales. Prior to joining the Company, Mr. Oldham was Vice President of Sales and Program Management at Manufacturers Services, Inc., a full-service global electronic manufacturing services and supply-chain company, from February 2001 to March 2002. 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 also held a variety of sales management positions at International Business Machines Corporation, from 1969 to 1985.

Michael D. Riley

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

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PART II

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

(a) Market Information

        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:

(b) Holders of record

        As of December 6, 2004, there were approximately 242 holders of record of our common stock. Because many of such shares are held by brokers and other institutions on behalf of stockholders, the Company is unable to estimate the total number of stockholders represented by these record holders.

(c) Dividends

        We have never paid or declared any cash dividends on our common stock. We currently intend to retain any earnings for future growth and, therefore, do not expect to pay cash dividends in the foreseeable future.

(d) Recent Sales of Unregistered Securities

        During the fourth quarter of fiscal 2004, we did not issue any unregistered shares of our common stock.

(e) Use of Proceeds

        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 (Registration No. 333-34286), which was declared effective by the Securities and Exchange Commission on July 12, 2000. The aggregate proceeds to us 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. During the period from the offering through September 30, 2004, we used the proceeds from its initial public offering as follows: approximately $57.8 million to fund our operations, approximately $7.2 million for the purchase of property and equipment, approximately $4.6 million to repurchase our common stock under a stock repurchase plan and approximately $13.2 million for our acquisition of TidalWire Inc.

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ITEM 6. SELECTED FINANCIAL DATA

        The following selected 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, 2002, 2003 and 2004 and the consolidated balance sheet data as of September 30, 2003 and 2004 have been derived from our 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, 2000 and 2001 and the consolidated balance sheet data as of September 30, 2000, 2001, and 2002 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 December 27, 2002, we completed our acquisition of TidalWire. As a result, the quarter ended March 31, 2003 was the first quarter that included the TidalWire operations in our consolidated results for an entire quarter. Our financial results for the year ended September 30, 2003 only include TidalWire financial results for the period from December 28, 2002 through September 30, 2003. As such, the presentation of historical financial information and any discussion regarding the comparison of historical financial information to financial information for the year ended September 30, 2003, does not include any financial information for TidalWire prior to December 28, 2002, unless otherwise indicated.

Selected Financial Data
(in thousands, except per share data)

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

Overview

        We develop, manufacture and in some cases distribute server appliance solutions that enable network equipment providers and independent software vendors, or ISVs, to deliver data storage and security networking applications on server appliances. Server appliances are pre-configured network infrastructure devices designed to deliver specific application functionality. The server appliance is sold and supported by the network equipment or ISV partner in our OEM Appliance segment, or by us through our Distribution operation.

        During fiscal years 2003 and 2004, we also distributed third-party data storage networking products, primarily Fibre Channel host bus adapters, or HBAs, and network security products to our customer base of value-added resellers, or VARs, and systems integrators. However, in October 2004 we decided to cease selling these third-party data storage networking products. This decision was based on a review of this portion of the business and its prospects. As a result of the commoditization of the Fibre Channel HBA technology and increasing competition in the market, we have experienced declining gross profits from sales of these products. Furthermore, future net revenues and gross profits in this portion of the business were expected to deteriorate. We believe this decision will enable us to focus our remaining distribution sales, marketing, and support infrastructure on the sale of our NS Series firewall appliances powered by Microsoft Internet Security and Acceleration (ISA) Server 2004. Our new NS Series firewall appliances were not available for sale until the first quarter of fiscal year 2005.

        We are currently organized into two reportable segments: OEM Appliance and Distribution.

OEM Appliance operations

        Our OEM Appliance operation leverages our server appliance development, manufacturing and supply chain services. We design, produce, and fulfill devices branded for our network equipment and ISV partners, and we derive our revenues from the sale of value-added hardware platforms and certain services to these partners. These partners subsequently market, sell and support the server appliance under their own brands to their customer base. During the years ended September 30, 2004 and 2003, sales to EMC represented 84% and 88%, respectively, of our OEM Appliance segment revenues.

        On July 1, 2004, we were notified by EMC that we were selected to develop a server appliance hardware platform for a future version of EMC's Centera product. This selection continues our relationship with the EMC Centera program, which began in July of 2001. Based on this selection, we have and will continue to incur increased research and development expenses related to this project.

Distribution operations

        Revenues from our Distribution operations have been derived from two activities: first is the revenue derived from the distribution of third-party products and components, primarily related to data storage area networking; second is the distribution of server appliances that we develop, manufacture, sell and support based on our ISV partners' software applications.

        Third-party data storage product revenues.    To date, substantially all of our Distribution operations' revenue has been derived from the sale of third-party data storage networking components and products, predominantly EMC-approved Fibre Channel HBAs. We have been one of two authorized distributors in North America for Fibre Channel HBAs that have been approved by EMC, although other companies have been permitted by EMC to sell such HBAs and EMC sells such HBAs itself. We were also a distributor of standard Fibre Channel HBAs, network switches and other storage area

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networking products. During the years ended September 30, 2004 and 2003, sales of these third-party data storage networking products represented 99% of our Distribution segment revenues.

        In December 2003, we amended our distribution agreement with EMC regarding our sales of EMC-approved Fibre Channel HBAs. This amendment was effective January 1, 2004 and required that we pay a royalty to EMC for each EMC-approved Fibre Channel HBA that we sell. As a result of this amendment, there has been a decline in our gross profits related to sales of EMC-approved Fibre Channel HBAs, which in turn has had a negative impact on our Distribution segment gross profits as well as our consolidated gross profits and operating results. In addition, as a result of the higher costs per EMC-approved Fibre Channel HBA that this amendment imposed upon us, our Distribution segment's ability to compete in large sales transactions involving EMC-approved Fibre Channel HBAs has been negatively affected. For the years ended September 30, 2004 and 2003, sales of EMC-approved Fibre Channel HBAs represented 64% and 70%, respectively, of our Distribution segment revenues.

        Based on our October 2004 decision to discontinue sales of third-party data storage networking connectivity products, we expect that Distribution net revenues in fiscal 2005 will decline significantly. After we discontinue sales of third-party data storage networking products in the quarter ending December 31, 2004, our Distribution segment revenues will consist primarily of sales of our NS Series firewall appliances.

        Server Appliance revenues.    During fiscal year 2004 we began to recognize revenue derived from the sale and support of server appliances we have developed in conjunction with certain of our ISV partners. In this case, we are acting as a value-added distributor for the ISV, distributing the ISV's software in the form of a server appliance, and acting as the point of sale and support for the device. We have also developed our NS6300 firewall appliance by licensing Microsoft's Internet Security and Acceleration ("ISA") Server 2004 software application, however sales of these servers did not commence until fiscal year 2005. We expect that the sale of our NS Series firewall appliances will be the primary source of our future Distribution revenues after we discontinue the sale of our third-party data storage networking products.

Critical Accounting Policies and Estimates

        Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates and judgments, including those related to: revenue recognition; allowances for doubtful accounts and sales returns; inventory valuation; product warranty obligations; acquisition accounting; goodwill, intangible assets and long-lived assets; restructuring and other charges; stock compensation expense; and income tax asset valuation. We base our estimates and judgments on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

        We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements.

Revenue recognition

        Revenues from products are generally recognized upon delivery to customers if persuasive evidence of the arrangement has been received, the sales price is fixed or determinable, collectibility of the

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related receivable is reasonably assured and title and risk of loss have passed to the customer. We have an inventory consignment agreement with our largest customer related to certain server appliances sold through our OEM Appliance segment. This customer notifies us when it utilizes inventory and we recognize revenues from sales to this customer based upon these notifications.

        Contracts and customer purchase orders are generally used to determine the existence of an arrangement. Shipping documents and consignment usage notifications are used to verify shipment or transfer of ownership, as applicable. We assess whether the sales price is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We assess collectibility based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer's payment history.

        For revenue arrangements that contain multiple elements, such as the sale of both the product and post-sales support, in which software is not incidental to the product, such as our sales of server appliances through our Distribution segment, we determine fair value based upon vendor specific objective evidence, which is typically established through contractual post-sales support renewal rates whereby the residual fair value is allocated to the server appliance. For revenue arrangements that contain multiple elements, in which software is not included or is incidental to the product, such as our sales of server appliances through our OEM Appliance segment, we determine fair value based on objective and reliable evidence of fair value, which is typically determined through stand-alone sales of post sales support and competitive market analyses whereby the residual fair value is allocated to the server appliance. We recognize revenue when the revenue recognition criteria for each element of the sale is met. If we are not able to derive the fair value of each element of the sale, all revenues from the arrangement are deferred and recognized ratably over the period of the support arrangement, which is typically one to three years. For post-sales support services, revenue is recognized ratably over the period in which the services are performed.

Allowances for Doubtful Accounts and Sales Returns

        Our allowance for doubtful accounts as of September 30, 2004 was $190,000, compared with $389,000 as of September 30, 2003. This 51% decrease in our allowance is primarily a result of write offs of approximately $230,000. The allowance is based on our assessment of the collectibility of customer accounts. We regularly review the allowance by considering factors such as historical experience, credit quality, age of the accounts receivable balances, and current economic conditions that may affect a customer's ability to pay. If a major customer's creditworthiness deteriorates, or if actual defaults are higher than our historical experience, or if other circumstances arise, our estimates of the recoverability of amounts due to us could be overstated, and additional allowances could be required, which could have an adverse impact on our results of operations. As of September 30, 2004 and September 30, 2003, receivables from EMC represented 38% and 42%, respectively, of our accounts receivable.

        Our Distribution segment customers have been offered a thirty-day right of return on "un-opened" third-party data storage networking products. A reserve for sales returns is established based on historical trends in product return rates. The reserve for sales returns as of September 30, 2004 and 2003 was $252,000 and $245,000, respectively, for estimated future returns that were recorded as a reduction of our revenues and accounts receivable. If the actual future returns were to deviate from the historical data on which the reserve had been established, our revenues could be adversely affected.

Inventories

        We value our inventory at the lower of cost (first-in, first-out method) or market. We regularly review inventory quantities on hand and record a write-down for excess and obsolete inventory based primarily on our estimated forecast of product demand and anticipated production requirements in the

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near future. Our inventory write-downs balance as of September 30, 2004 was $2.1 million, compared with $1.6 million as of September 30, 2003. Any rapid technological changes or significant changes in our future server appliance product development strategy could result in an increase in the amount of obsolete inventory quantities on hand. Agreements with certain suppliers of our third-party data storage networking products include stock rotation provisions for certain products and agreements with certain of our OEM Appliance customers include inventory protection provisions, however, these provisions may not provide us with complete protection from loss due to excess or obsolete inventory. We do not have inventory stock rotation rights on EMC-approved Fibre Channel HBAs. As a result, we considered the implications of this in connection with our decision to discontinue sales of third-party data storage networking products in order to estimate the required write-down for excess inventory on hand. At September 30, 2004 we had approximately $4 million of inventory related to these third-party data storage networking products, after write-downs for excess and obsolescence.

        In the past, we have had substantial write-downs due to excess and obsolete inventory, which was primarily related to internally developed products. Our current products include more standards-based technologies, which may help to mitigate our inventory obsolescence risk. However, if there were to be a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to increase our inventory write-downs and our gross profit could be adversely effected. Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels to ensure competitive lead times versus the risk of inventory obsolescence because of rapidly changing technology and customer requirements.

Product Warranty Obligations

        We offer a warranty on certain of our products that generally provide for us to repair or replace any defective products for a period of up to 36 months after shipment. We reserve for the estimated costs to fulfill customer warranty obligations upon the recognition of the related revenue and record warranty expense as a component of cost of sales.

        OEM server appliance products—As of September 30, 2004, our server appliance product warranty obligations were $390,000 versus $524,000 as of September 30, 2003. Costs included in our server appliance product warranty obligation include shipping, materials, internal and external labor, external testing costs and travel. Significant judgment and estimates are involved in estimating our warranty reserve on our server appliance products. Although our current server appliance products use more standards-based technologies than in the past, certain of our server appliance products incorporate proprietary technologies, which may increase our risks related to product warranty obligations. In the past we have experienced unexpected component failures in certain of our server appliance products, which have required us to increase our product warranty accruals. At the time any unexpected component failure arises, we assess the costs to repair any defects and record what we believe to be an appropriate warranty obligation based on the available information at the time. To the extent we may experience increased warranty claim activity, increased costs associated with servicing those claims, or use estimates that prove to be materially different from actual claims, our product warranty obligations may need to be increased, resulting in decreased gross profits.

        HBA