**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

----

 

**FORM 10-Q**

 

----

 
|                                                                                                    | **(Mark  One)** |
|---------------------------------------------------------------------------------------------------------|-----------------|
| **ý****Quarterly Report Pursuant to  Section 13 or 15(d) of the  Securities Exchange Act of 1934** |

 

**For the quarterly period ended April30, 2003**

 

**OR**

 
| **o****Transition Report Pursuant to  Section 13 or 15(d) of the  Securities Exchange Act of 1934** |
|-----------------------------------------------------------------------------------------------------|

 

**For the transition periodfrom             to             **

 

**Commission File Number 000-31257**

 

**McDATACORPORATION**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                                     |   | **84-1421844**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation of organization) |   | (I.R.S. Employer  Identification No.) |

 

**380 Interlocken Crescent, Broomfield,Colorado 80021**

(Address ofprincipal executive offices)(zip code)

 

**(303) 460-9200**

(Registrant’stelephone number, including area code)

 

**December 31**

(Former name,former address and former fiscal year,if changed since last report)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes ý  No o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).  Yes ý  No o

 

At June 4, 2003, 81,000,000 shares of the registrant’s Class A CommonStock were outstanding and 33,449,935 shares of the registrant’s Class B CommonStock were outstanding.

 

 

----

 

**McDATA CORPORATION**

 

FORM 10-Q

QUARTER ENDEDAPRIL 30, 2003

TABLE OF CONTENTS

 
| **Item** |                                                                                                                                                                                          |   |
|----------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|     | PART 1 – FINANCIAL  INFORMATION                                                                                                                                                          |   |
|     |                                                                                                                                                                                          |   |
| 1.       | Financial Statements                                                                                                                                                                          |   |
|     |                                                                                                                                                                                          |   |
|     | Condensed Consolidated  Balance Sheets –   April 30, 2003 (unaudited), December 31, 2002 and January 31, 2003 (unaudited)                                                           |   |
|     |                                                                                                                                                                                          |   |
|     | Condensed  Consolidated Income Statements –  Three Months ended April 30, 2003 (unaudited) and March 31, 2002 (unaudited),  and one month ended January 31, 2003 (unaudited)        |   |
|     |                                                                                                                                                                                          |   |
|     | Condensed  Consolidated Statements of Cash Flows –  Three Months ended April 30, 2003 (unaudited) and March 31, 2002 (unaudited),  and one month ended January 31, 2003 (unaudited) |   |
|     |                                                                                                                                                                                          |   |
|     | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                                                                                             |   |
|     |                                                                                                                                                                                          |   |
| 2.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                                                                   |   |
|     |                                                                                                                                                                                          |   |
| 3.       | Quantitative  and Qualitative Disclosures About Market Risks                                                                                                                                  |   |
|     |                                                                                                                                                                                          |   |
| 4.       | Controls and Procedures                                                                                                                                                                       |   |
|     |                                                                                                                                                                                          |   |
|     | PART II – OTHER INFORMATION                                                                                                                                                              |   |
|     |                                                                                                                                                                                          |   |
| 1.       | Legal  Proceedings                                                                                                                                                                            |   |
|     |                                                                                                                                                                                          |   |
| 2.       | Changes  in Securities and Use of Proceeds                                                                                                                                                    |   |
|     |                                                                                                                                                                                          |   |
| 3.       | Defaults Upon  Senior Securities                                                                                                                                                              |   |
|     |                                                                                                                                                                                          |   |
| 4.       | Submission  of Matters to A Vote of Security Holders                                                                                                                                          |   |
|     |                                                                                                                                                                                          |   |
| 5.       | Other Information                                                                                                                                                                             |   |
|     |                                                                                                                                                                                          |   |
| 6.       | Exhibits and  Reports on Form 8-K                                                                                                                                                             |   |

 

----

 

**Special Note Regarding Forward-Looking Statements**

 

Some of the information presented in this QuarterlyReport contains “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995 (the “Reform Act”).  Although McDATA Corporation (“McDATA”or  the “Company”, which may also bereferred to as “we,” “us” or “our”) believes that its expectations are based onreasonable assumptions within the bounds of its knowledge of its businesses andoperations, there can be no assurance that actual results will not differmaterially from our expectations. Factors that could cause actual results to differ materially fromexpectations include:

 

•                  changes in our relationship withEMC Corporation, or EMC, and International Business Machines Corporation, orIBM, and the level of their orders;

 

•                  our ability to successfullyincrease sales of McDATA’s management software, including SANavigatorâ;

 

•                  the impact of the continued generaleconomic slowdown on purchasing decisions by customers and the impact of SevereAcute Respiratory Syndrome (SARS) on sales in Asia Pacific;

 

•                  our ability to complete thesuccessful implementation of an “outsourcing-focused” manufacturing model;

 

•                  additional manufacturing andcomponent costs and production delays that we may experience as we continue thetransition to new products;

 

•                  a loss of any of our key customers(and our OEMs’ key customers), distributors, resellers or our manufacturers;

 

•                  our ability to expand our productofferings and any transition to new products (including higher port densityproducts and multi-protocol products);

 

•                  any change in business conditions,our sales strategy or product development plans, and our ability to attract andretain highly skilled individuals;

 

•                  competition in the storage areanetwork, or SAN, and director, software and switch markets (includingcompetitive pricing pressures and product give-aways by current competitorssuch as Brocade Communication Systems, Inc., or Brocade, Computer NetworkTechnology Corporation, or CNT, and new entrants from the IP and multi-protocolswitch industry such as Cisco Systems, Inc., or Cisco);

 

•                  delays and changes in thedevelopment of new products and new technology and component quality andavailability;

 

•                  any industry or technology changesthat cause obsolescence of our products or components of those products;

 

•                  one-time events and other importantrisks and factors disclosed previously and from time to time in our filingswith the U.S. Securities and Exchange Commission, or SEC, including the riskfactors discussed in this Quarterly Report; and

 

•                  the impact of any acquisitions byus of businesses, products, or technologies.

 

You should not construe these cautionarystatements as an exhaustive list or as any admission by us regarding theadequacy of the disclosures made by us. We cannot always predict or determine after the fact what factors wouldcause actual results to differ materially from those indicated by ourforward-looking statements or other statements.  In addition, you are urged to consider statements that includethe terms “believes,” “belief,” “expects,” “plans,” “objectives,”“anticipates,” “intends,” or the like to be uncertain and forward-looking.  All cautionary statements should be read asbeing applicable to all forward-looking statements wherever they appear.   We do not undertake any obligation topublicly update or revise any forward-looking statements.

 

----

 

**PARTI – FINANCIAL INFORMATION**

 

**McDATACORPORATION**

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

** **
|                                                                                                                                                                                                                                               |   | **April 30,  2003** |    | **December 31,  2002** |   | **January 31,  2003** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|---------|------------------------|--------|-----------------------|--------|
|                                                                                                                                                                                                                                               |   | **(unaudited)**     |    |                   |   | **(unaudited)**       |   |
| **Assets**                                                                                                                                                                                                                                         |   |                |    |                   |   |                  |   |
| Current assets:                                                                                                                                                                                                                                    |   |                |    |                   |   |                  |   |
| Cash and cash equivalents                                                                                                                                                                                                                          |   | $                   | 150,023 |                   | $      | 72,411                |   | $ | 108,168 |   |
| Short-term investments                                                                                                                                                                                                                             |   | 245,268             |    | 157,260                |   | 152,669               |   |
| Accounts receivable, net of allowance for bad debts  of $1,336 and $1,265 and $1,290, respectively                                                                                                                                                 |   | 38,095              |    | 73,867                 |   | 35,102                |   |
| Inventories, net                                                                                                                                                                                                                                   |   | 7,631               |    | 8,097                  |   | 6,749                 |   |
| Current portion of deferred tax asset                                                                                                                                                                                                              |   | 26,897              |    | 33,325                 |   | 30,486                |   |
| Prepaid expenses and other current assets                                                                                                                                                                                                          |   | 5,347               |    | 4,699                  |   | 5,187                 |   |
| Total current assets                                                                                                                                                                                                                               |   | 473,261             |    | 349,659                |   | 338,361               |   |
|                                                                                                                                                                                                                                               |   |                |    |                   |   |                  |   |
| Property and equipment, net                                                                                                                                                                                                                        |   | 96,483              |    | 99,927                 |   | 99,082                |   |
| Long-term investments                                                                                                                                                                                                                              |   | 103,255             |    | 73,099                 |   | 67,084                |   |
| Other assets, net                                                                                                                                                                                                                                  |   | 44,921              |    | 32,506                 |   | 37,906                |   |
| Total assets                                                                                                                                                                                                                                       |   | $                   | 717,920 |                   | $      | 555,191               |   | $ | 542,433 |   |
|                                                                                                                                                                                                                                               |   |                |    |                   |   |                  |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                                                     |   |                |    |                   |   |                  |   |
| Current liabilities:                                                                                                                                                                                                                               |   |                |    |                   |   |                  |   |
| Accounts payable                                                                                                                                                                                                                                   |   | $                   | 12,498  |                   | $      | 16,530                |   | $ | 6,982 |   |
| Accrued liabilities                                                                                                                                                                                                                                |   | 46,302              |    | 40,561                 |   | 39,545                |   |
| Current portion of deferred revenue                                                                                                                                                                                                                |   | 9,600               |    | 7,337                  |   | 7,767                 |   |
| Current portion of obligations under capital leases                                                                                                                                                                                                |   | 1,414               |    | 1,604                  |   | 1,589                 |   |
| Total current liabilities                                                                                                                                                                                                                          |   | 69,814              |    | 66,032                 |   | 55,883                |   |
|                                                                                                                                                                                                                                               |   |                |    |                   |   |                  |   |
| Obligations under capital leases, less current  portion                                                                                                                                                                                            |   | 1,321               |    | 1,540                  |   | 1,544                 |   |
| Deferred revenue, less current portion                                                                                                                                                                                                             |   | 13,871              |    | 13,114                 |   | 12,776                |   |
| Convertible subordinated debt                                                                                                                                                                                                                      |   | 172,500             |    | —                 |   | —                |   |
| Total liabilities                                                                                                                                                                                                                                  |   | 257,506             |    | 80,686                 |   | 70,203                |   |
|                                                                                                                                                                                                                                               |   |                |    |                   |   |                  |   |
| Commitments and Contingencies (*Note 9*)                                                                                                                                                                                                           |   |                |    |                   |   |                  |   |
|                                                                                                                                                                                                                                               |   |                |    |                   |   |                  |   |
| Stockholders’ Equity:                                                                                                                                                                                                                         |   |                |    |                   |   |                  |   |
| Preferred stock, $0.01 par value, 25,000,000 shares  authorized, no shares issued or outstanding                                                                                                                                                   |   | —              |    | —                 |   | —                |   |
| Common stock, Class A, $0.01 par value, 250,000,000  shares authorized, 81,000,000 shares issued and outstanding                                                                                                                                   |   | 810                 |    | 810                    |   | 810                   |   |
| Common stock, Class B, $0.01 par value, 200,000,000  shares authorized, 33,670,132, 32,962,212 and 33,283,684 shares issued and  outstanding at April 30, 2003 (unaudited), December 31, 2002 and January  31, 2003 (unaudited), respectively |   | 337                 |    | 330                    |   | 333                   |   |
| Additional paid-in-capital                                                                                                                                                                                                                         |   | 457,102             |    | 474,609                |   | 475,975               |   |
| Deferred compensation                                                                                                                                                                                                                              |   | (5,205              | )       | (6,812                 | )      | (6,934                | )      |
| Accumulated other comprehensive income                                                                                                                                                                                                             |   | 723                 |    | 773                    |   | 711                   |   |
| Retained earnings                                                                                                                                                                                                                                  |   | 6,647               |    | 4,795                  |   | 1,335                 |   |
| Total stockholders’ equity                                                                                                                                                                                                                    |   | 460,414             |    | 474,505                |   | 472,230               |   |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                    |   | $                   | 717,920 |                   | $      | 555,191               |   | $ | 542,433 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

 

1

----

 

**McDATACORPORATION**

 

CONDENSED CONSOLIDATED INCOME STATEMENTS

(in thousands, except per share data)

(unaudited)

 
|                                                                                                                                                     |   | **Three Months Ended,** |    | **One Month  Ended,** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|---------|-----------------------|--------|
|                                                                                                                                                     |   | **April 30,  2003**     |    | **March 31,  2002**   |   | **January 31,  2003** |   |
|                                                                                                                                                     |   |                    |    |                  |   |   |   |
| Revenue                                                                                                                                                  |   | $                       | 103,179 |                  | $      | 64,543 |   | $ | 17,045 |   |
| Cost of revenue                                                                                                                                          |   | 44,588                  |    | 50,652                |   | 8,475 |   |
| Gross profit                                                                                                                                             |   | 58,591                  |    | 13,891                |   | 8,570 |   |
|                                                                                                                                                     |   |                    |    |                  |   |   |   |
| Operating expenses:                                                                                                                                      |   |                    |    |                  |   |   |   |
| Research and development                                                                                                                                 |   | 18,819                  |    | 13,216                |   | 5,068 |   |
| Selling and marketing                                                                                                                                    |   | 23,427                  |    | 17,993                |   | 5,837 |   |
| General and administrative                                                                                                                               |   | 7,484                   |    | 8,008                 |   | 2,424 |   |
| Amortization of deferred compensation (excludes  amortization of deferred compensation included in cost of revenue of $137,  $172 and $50, respectively) |   | 1,411                   |    | 2,141                 |   | 575 |   |
| Operating expenses                                                                                                                                       |   | 51,141                  |    | 41,358                |   | 13,904 |   |
| Income (loss) from operations                                                                                                                            |   | 7,450                   |    | (27,467               | )      | (5,334 | ) |
|                                                                                                                                                     |   |                    |    |                  |   |   |   |
| Interest and other income                                                                                                                                |   | 2,055                   |    | 2,078                 |   | 28 |   |
| Interest expense                                                                                                                                         |   | (1,084                  | )       | (90                   | )      | (17 | ) |
| Income (loss) before income taxes                                                                                                                        |   | 8,421                   |    | (25,479               | )      | (5,323 | ) |
| Income tax expense (benefit)                                                                                                                             |   | 3,109                   |    | (8,408                | )      | (1,863 | ) |
| Net income (loss)                                                                                                                                        |   | $                       | 5,312   |                  | $      | (17,071 | ) | $ | (3,460 | ) |
|                                                                                                                                                     |   |                    |    |                  |   |   |   |
| Basic net income (loss) per share                                                                                                                        |   | $                       | 0.05    |                  | $      | (0.15 | ) | $ | (0.03 | ) |
| Shares used in computing basic net income (loss) per  share                                                                                              |   | 114,319                 |    | 112,732               |   | 114,000 |   |
|                                                                                                                                                     |   |                    |    |                  |   |   |   |
| Diluted net income (loss) per share                                                                                                                      |   | $                       | 0.05    |                  | $      | (0.15 | ) | $ | (0.03 | ) |
| Shares used in computing diluted net income (loss)  per share                                                                                            |   | 117,692                 |    | 112,732               |   | 114,000 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financial statements**.**

 

2

----

 

**McDATA CORPORATION**

 

CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 
|                                                                                 |   | **Three Months Ended** |    | **One Month  Ended** |   |
|--------------------------------------------------------------------------------------|--------|------------------------|---------|----------------------|--------|
|                                                                                 |   | **April 30,  2003**    |    | **March 31,  2002**  |   | **January 31,  2003** |   |
| **Cash  flows from operating activities:**                                           |   |                   |    |                 |   |   |   |
| Net income (loss)                                                                    |   | $                      | 5,312   |                 | $      | (17,071 | ) | $ | (3,460 | ) |
| Adjustments to reconcile net income (loss) to cash  flows from operating activities; |   |                   |    |                 |   |   |   |
| Depreciation                                                                         |   | 6,094                  |    | 4,041                |   | 1,976 |   |
| Amortization                                                                         |   | 2,101                  |    | 1,100                |   | 552 |   |
| Loss from write-off of capitalized collateralized  lease costs                       |   | —                 |    | 1,250                |   | — |   |
| (Gain) loss on trade-in/retirement of assets                                         |   | (5                     | )       | 464                  |   | 77 |   |
| Net realized gain on investments                                                     |   | (137                   | )       | 340                  |   | 17 |   |
| Inventory and inventory commitment provisions                                        |   | 1,688                  |    | 18,074               |   | 384 |   |
| Bad debt provision                                                                   |   | 50                     |    | 75                   |   | 25 |   |
| Deferred income taxes                                                                |   | 2,129                  |    | (3,094               | )      | (1,902 | ) |
| Non-cash compensation expense                                                        |   | 1,548                  |    | 2,313                |   | 625 |   |
| Tax benefit from stock options exercised                                             |   | —                 |    | 1,200                |   | 39 |   |
| Changes in net assets and liabilities:                                               |   |                   |    |                 |   |   |   |
| Accounts receivable                                                                  |   | (3,043                 | )       | 4,716                |   | 38,740 |   |
| Inventories                                                                          |   | (2,250                 | )       | (3,225               | )      | 418 |   |
| Prepaid expenses and other current assets                                            |   | (160                   | )       | (4,968               | )      | (488 | ) |
| Other assets, net                                                                    |   | (1,978                 | )       | (2,107               | )      | (1,092 | ) |
| Accounts payable                                                                     |   | 5,516                  |    | 3,151                |   | (9,548 | ) |
| Accrued liabilities                                                                  |   | 6,175                  |    | (796                 | )      | (1,083 | ) |
| Deferred revenue                                                                     |   | 2,928                  |    | 2,326                |   | 92 |   |
| Net cash provided by operating activities                                            |   | 25,968                 |    | 7,789                |   | 25,372 |   |
|                                                                                 |   |                   |    |                 |   |   |   |
| **Cash  flows from investing activities:**                                           |   |                   |    |                 |   |   |   |
| Purchases of property and equipment                                                  |   | (2,940                 | )       | (7,509               | )      | (432 | ) |
| Proceeds from the disposition of fixed assets                                        |   | 5                      |    | —               |   | 61 |   |
| Purchases of investments                                                             |   | (314,323               | )       | (85,896              | )      | (11,600 | ) |
| Maturities of investments                                                            |   | 185,393                |    | 55,353               |   | 21,970 |   |
| Net cash provided (used) by investing activities                                     |   | (131,865               | )       | (38,052              | )      | 9,999 |   |
|                                                                                 |   |                   |    |                 |   |   |   |
| **Cash  flows from financing activities:**                                           |   |                   |    |                 |   |   |   |
| Net proceeds for issuance of convertible  subordinated debt                          |   | 166,967                |    | —               |   | — |   |
| Net purchase of share option transactions                                            |   | (20,510                | )       | —               |   | — |   |
| Payment of obligations under capital leases                                          |   | (531                   | )       | (727                 | )      | (196 | ) |
| Proceeds from the issuance of common stock                                           |   | 1,826                  |    | 1,241                |   | 582 |   |
| Net cash provided by financing activities                                            |   | 147,752                |    | 514                  |   | 386 |   |
|                                                                                 |   |                   |    |                 |   |   |   |
| Net increase (decrease) in cash and cash equivalents                                 |   | 41,855                 |    | (29,749              | )      | 35,757 |   |
| Cash and cash equivalents, beginning of period                                       |   | 108,168                |    | 69,285               |   | 72,411 |   |
| Cash and cash equivalents, end of period                                             |   | $                      | 150,023 |                 | $      | 39,536 |   | $ | 108,168 |   |
|                                                                                 |   |                   |    |                 |   |   |   |
| **Supplemental  Disclosure of Non-Cash Investing and Financing Activities**          |   |                   |    |                 |   |   |   |
| Capital lease obligations incurred                                                   |   | $                      | 132     |                 | $      | 4,156 |   | $ | 186 |   |
| Equipment traded in                                                                  |   | $                      | —  |                 | $      | (2,473 | ) | $ | — |   |
| Transfer of inventory to fixed assets                                                |   | $                      | 260     |                 | $      | 1,404 |   | $ | 614 |   |
| Acquisition of collateralized lease assets                                           |   | $                      | —  |                 | $      | 36,884 |   | $ | — |   |
| Collateralized lease liability                                                       |   | $                      | —  |                 | $      | 2,026 |   | $ | — |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

 

3

----

 

**McDATA CORPORATION**

 

NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS

(tabular amountsin thousands, except per share data)

(unaudited)

 

**Note 1 –Backgroundand Basis of Presentation**

 

McDATA Corporation(“McDATA” or “the Company”) provides Multi-Capable Storage Networking SolutionsTM—hardware,software and services—that enables its partners and customers around the worldto reduce their total cost of storage management today, and be ready to adaptto the real-time information demands of tomorrow. McDATA solutions are anintegral part of data services infrastructures sold by most major storagevendors, including Dell, EMC, Hewlett-Packard, Hitachi Data Systems, IBM,StorageTek and Sun Microsystems.

 

The accompanyingcondensed consolidated financial statements of McDATA and its subsidiaries havebeen prepared pursuant to the rules and regulations of the Securities andExchange Commission.  Certaininformation and footnote disclosures normally included in the Company’s annualconsolidated financial statements have been condensed or omitted.  The consolidated balance sheet as ofDecember 31, 2002 has been derived from the audited financial statements as ofthat date, but does not include all disclosures required by generally acceptedaccounting principles. For further information, please refer to and read theseinterim consolidated financial statements in conjunction with the Company’saudited financial statements for the year ended December 31, 2002.

 

The interim condensedconsolidated financial statements, in the opinion of management, reflect alladjustments (consisting only of normal recurring adjustments) necessary for afair presentation of the financial position, results of operations and cashflows of the Company for the periods presented.  The results of operations for the interim periods are not necessarilyindicative of the results of operations to be expected for the entire fiscalyear or future periods.

 

*Recent Accounting*Pronouncements

 

In November 2002, theFASB issued Interpretation No. 45 (FIN 45), “Guarantor’s Accounting andDisclosure Requirements for Guarantees, *Including* Indirect Guarantees ofIndebtedness of Others.” FIN 45 requires that a liability be recorded in theguarantor’s balance sheet upon issuance of a guarantee. FIN 45 also requiresadditional disclosures about the guarantees an entity has issued, including anentity’s product warranty liabilities. The initial recognition and measurementprovisions of FIN 45 are applicable to guarantees issued or modified afterDecember 31, 2002. The adoption of FIN 45 has not had a material impact on theCompany’s financial condition or results of operations. The Company adopted thedisclosure requirements of FIN 45 in the fourth quarter of 2002, and thedisclosures for the first quarter of 2003 are included in Notes 3 and 9, below.

 

In November 2002, theEmerging Issues Task Force (EITF) issued EITF Issue No. 00-21, “Accounting forRevenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21addresses how to determine whether a revenue arrangement involving multipledeliverables contains more than one unit of accounting for the purposes ofrevenue recognition and how the revenue arrangement consideration should bemeasured and allocated to the separate units of accounting. EITF Issue No.00-21 applies to all revenue arrangements that the Company enters into afterJuly 31, 2003. The adoption of this statement is not currently anticipated tohave a material impact on the Company’s financial condition or results ofoperations.

 

4

----

 

In December 2002, theFASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transitionand Disclosure.” This statement amends SFAS No. 123, “Accounting forStock-Based Compensation,” to provide alternative methods of transition for avoluntary change to the fair value based method of accounting for stock-basedcompensation. The statement also amends the disclosure provisions of thatstatement and requires disclosure of the pro forma effect in interim financialstatements. The Company adopted SFAS No. 148 for the fiscal year ended December31, 2002, and the adoption did not have a material impact on the Company’sfinancial condition or results of operations. The Company plans to continue toaccount for its stock-based compensation under the recognition and measurementprinciples of APB Opinion No. 25. Accordingly, the alternative methods oftransition provided under SFAS No. 148 are not expected to impact the Company.The quarterly disclosure provision of SFAS No. 148 for the first quarter of2003 is included in Note 4, below.

 

In January 2003, the FASBissued Interpretation No. 46 (FIN 46), “Consolidation of Variable InterestEntities.” FIN 46 provides guidance on how to identify a variable interestentity (VIE) and determine when the assets, liabilities, and results ofoperations of a VIE need to be included in a company’s consolidated financialstatements. FIN 46 also requires additional disclosures by primarybeneficiaries and other significant variable interest holders in a VIE. Theprovisions of FIN 46 are effective immediately for all VIEs created afterJanuary 31, 2003. For VIEs created before February 1, 2003, the provisions ofFIN 46 must be adopted at the beginning of the first interim or annualreporting period beginning after June 15, 2003. While the Company is currentlyevaluating the potential impact of the adoption of FIN 46, the Company believesthat the adoption of this statement will not have a material impact on theCompany’s financial condition or results of operations.

 

InMay 2003, the FASB issued Statement of Financial Accounting Standards No. 150(FAS 150), “Accounting for Certain Financial Instruments with Characteristicsof both Liabilities and Equity.”  This statement establishes standards forhow an issuer classifies and measures in its statement of financial positioncertain financial instruments with characteristics of both liabilities andequity.  In accordance with the standard, certain****financial instruments that embodyobligations for the issuer are required to be classified as liabilities. ThisStatement shall be effective for financial instruments entered into or modifiedafter May 31, 2003, and otherwise shall be effective at the beginning of thefirst interim period beginning after June 15, 2003.   The Company does notexpect the provision of this statement to have a significant impact on thestatement of financial position.

 

**Note 2 –Change in Fiscal Year**

 

On January 15, 2003, theCompany changed its fiscal year to end on January 31 rather than December31.  The Company has includedinformation for the transition period from January 1 to January 31, 2003 inthis Form 10-Q pursuant to Rule 13a-10 of the Securities Exchange Act of 1934,as amended.  The Company typicallyincurs significant losses in the first month following the completion of acalendar quarter because revenue for that month is significantly less than theaverage monthly revenue generated in any quarterly or annual period.

 

Reference in this Form10Q to the first quarter of 2003 represent the three months ending April 30,2003.  References in this Form 10-Q tothe first quarter of 2002 represent the three months ending March 31,2002.  The Company has not submittedfinancial information for the three months ending April 30, 2002 in this Form10-Q because the information is not practical or cost beneficial toprepare.  Management believes that thefirst quarter of 2002 provides a meaningful comparison to the first quarter of2003.  There are no factors, seasonal orotherwise, that would impact the comparability of information or trends, ifresults for the three months ended April 30, 2002 were presented in lieu ofresults for the first quarter of 2002.

 

**Note 3 – Balance Sheet Details**

 

|                      |   | **April 30,  2003** |       | **December  31,  2002** |       | **January  31,  2003** |       |
|---------------------------|--------|---------------------|------------|-------------------------|------------|------------------------|------------|
| **Inventories:**          |   |                | ** ** |                    | ** ** |                   | ** ** |
| Raw materials             |   | $                   | 5,886      |                    | $          | 8,070                  |       | $ | 6,621 |   |
| Work-in-progress          |   | 1,653               |       | 1,123                   |       | 1,385                  |       |
| Finished goods            |   | 5,936               |       | 6,316                   |       | 5,858                  |       |
| Total inventories at cost |   | 13,475              |       | 15,509                  |       | 13,864                 |       |
| Less reserves             |   | (5,844              | )          | (7,412                  | )          | (7,115                 | )          |
| Total inventories, net    |   | $                   | 7,631      |                    | $          | 8,097                  |       | $ | 6,749 |   |

 

During the quarter endedMarch 31, 2002, the Company recorded inventory-related charges of $14.0 millionprimarily for the excess 1 gigabit (Gb) components used in the Company’sDirector-class products.  This resultedprimarily from the unanticipated reduction in Director-class product orderslate in March 2002.

 

5

----

 

|                         |   | **April 30,  2003** |       | **December  31,  2002** |       | **January  31,  2003** |       |
|------------------------------|--------|---------------------|------------|-------------------------|------------|------------------------|------------|
| **Accrued  Liabilities:**    |   |                | ** ** |                    | ** ** |                   | ** ** |
| Wages and employee benefits  |   | $                   | 17,189     |                    | $          | 16,643                 |       | $ | 17,672 |   |
| Purchase commitments         |   | 9,794               |       | 12,022                  |       | 9,576                  |       |
| Warranty reserves(1)         |   | 3,457               |       | 3,461                   |       | 3,485                  |       |
| Income tax payable           |   | 3,237               |       | 2,782                   |       | 2,844                  |       |
| Taxes, other than income tax |   | 1,177               |       | 1,050                   |       | 1,712                  |       |
| Interest payable             |   | 889                 |       | —                  |       | —                 |       |
| Other accrued liabilities    |   | 10,559              |       | 4,603                   |       | 4,256                  |       |
|                         |   | $                   | 46,302     |                    | $          | 40,561                 |       | $ | 39,545 |   |

 

----

(1)          The Company establishes a warranty liabilityfor the estimated cost of warranty-related claims at the time revenue isrecognized. Activity in the warrantyreserves are as follows for the three months ended April 30, 2003 andMarch 31, 2002 and the one month ended January 31, 2003:

 

|                         |   | **Three  Months Ended** |   | **One Month  Ended** |   |
|------------------------------|--------|-------------------------|--------|----------------------|--------|
|                         |   | **April 30,  2003**     |   | **March 31,  2002**  |   | **January  31,  2003** |   |
|                         |   |                    |   |                 |   |   |   |
| Balance at beginning of year |   | $                       | 3,485  |                 | $      | 2,174 |   | $ | 3,461 |   |
| Warranty expense             |   | 100                     |   | 513                  |   | 24 |   |
| Warranty claims              |   | (128                    | )      | (56                  | )      | — |   |
| Balance at end of year       |   | $                       | 3,457  |                 | $      | 2,631 |   | $ | 3,485 |   |

 

**Note 4 – Net Income (Loss) per Share**

 

Basicearnings per share (EPS) excludes dilution and is computed by dividing incomeavailable to common stockholders by the weighted-average number of commonshares outstanding for the period. Diluted EPS is based on the weighted-average number of sharesoutstanding during each period and the assumed exercise of dilutive stockoptions less the number of treasury shares assumed to be purchased from theproceeds using the average market price of the Company’s common stock for eachof the periods presented.  No dilutiveeffect has been included for the convertible subordinated debt issued February7, 2003 (see Note 7) because the Company currently has the ability and intentto settle the conversion price in cash. Additionally, no dilutive effect has been included for the share optionssold in relation to the convertible subordinate debt because the exercise pricewas higher than the average stock price for the period.

 

Calculation of net income(loss) per share:

 

|                                                                                                     |   | **Three  Months Ended** |   | **One Month  Ended** |   |
|----------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|----------------------|--------|
|                                                                                                     |   | **April 30,  2003**     |   | **March 31,  2002**  |   | **January  31,  2003** |   |
|                                                                                                     |   |                    |   |                 |   |   |   |
| Net income (loss)                                                                                        |   | $                       | 5,312  |                 | $      | (17,071 | ) | $ | (3,460 | ) |
|                                                                                                     |   |                    |   |                 |   |   |   |
| Weighted average shares of common stock outstanding  used in computing basic net income (loss) per share |   | 114,319                 |   | 112,732              |   | 114,000 |   |
| Effect of dilutive stock options                                                                         |   | 3,373                   |   | —               |   | — |   |
| Weighted average shares of common stock used in  computing diluted net income (loss) per share           |   | 117,692                 |   | 112,732              |   | 114,000 |   |
|                                                                                                     |   |                    |   |                 |   |   |   |
| Basic net income (loss) per share                                                                        |   | $                       | 0.05   |                 | $      | (0.15 | ) | $ | (0.03 | ) |
|                                                                                                     |   |                    |   |                 |   |   |   |
| Diluted net income (loss) per share                                                                      |   | $                       | 0.05   |                 | $      | (0.15 | ) | $ | (0.03 | ) |
|                                                                                                     |   |                    |   |                 |   |   |   |
| Options not included in diluted share base because  of the exercise prices                               |   | 7,135                   |   | 2,302                |   | 6,092 |   |
|                                                                                                     |   |                    |   |                 |   |   |   |
| Options and restricted stock not included in diluted  share base because of the net loss                 |   | —                  |   | 8,582                |   | 6,401 |   |

 

6

----

 

**Note 5 – Stock-Based Compensation**

 

TheCompany maintains a stock option and restricted stock plan (the Plan) whichprovide for the grant of stock options, restricted stock and other stock basedawards to officers, other employees, and consultants as determined by thecompensation committee of the Board of Directors. A maximum of 24,000,000shares of common stock were issuable under the terms of the Plan as of April30, 2003, of which no more than 2,400,000 shares may be issued as restrictedstock or other stock based awards. As of April 30, 2003, there wereapproximately 1.8 million shares of common stock available for future grantsunder the Plan.

 

The Company accounts forthese plans according to Accounting Principles Board Opinion No. 25, Accountingfor Stock Issues to Employees (APB 25), and related interpretations and hasadopted the disclosure-only alternative of SFAS No. 123, “Accounting forStock-Based Compensation” (SFAS No. 123) as amended by SFAS No. 148. Anydeferred stock compensation calculated pursuant to APB 25 is amortized ratablyover the vesting period of the individual options, generally four years.  The following table illustrates the effecton net income and earnings per share if the Company had applied the fair valuerecognition provisions of SFAS No. 123.

 

|                                                                                                                                                           |   | **Three Months Ended,** |   | **One Month  Ended** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|----------------------|--------|
|                                                                                                                                                           |   | **April 30,  2003**     |   | **March 31,  2002**  |   | **January 31,****2003** |   |
|                                                                                                                                                           |   |                    |   |                 |   |   |   |
| Net income (loss), as  reported                                                                                                                                |   | $                       | 5,312  |                 | $      | (17,071 | ) | $ | (3,460 | ) |
| Add:  Total stock-based employee compensation  expense included in net income as determined under the intrinsic value  method, net of related tax effects |   | 974                     |   | 1,550                |   | 406 |   |
| Deduct:  Total stock-based employee compensation  expense determined under the fair value based method for all awards, net of  related tax effects        |   | (3,863                  | )      | (5,297               | )      | (1,481 | ) |
| Pro forma net income (loss)                                                                                                                                    |   | $                       | 2,423  |                 | $      | (20,818 | ) | $ | (4,535 | ) |
|                                                                                                                                                           |   |                    |   |                 |   |   |   |
| Earnings (loss) per share:                                                                                                                                     |   |                    |   |                 |   |   |   |
| Basic-as reported                                                                                                                                              |   | $                       | 0.05   |                 | $      | (0.15 | ) | $ | (0.03 | ) |
| Basic-pro forma                                                                                                                                                |   | $                       | 0.02   |                 | $      | (0.18 | ) | $ | (0.04 | ) |
|                                                                                                                                                           |   |                    |   |                 |   |   |   |
| Diluted-as reported                                                                                                                                            |   | $                       | 0.05   |                 | $      | (0.15 | ) | $ | (0.03 | ) |
| Diluted-pro forma                                                                                                                                              |   | $                       | 0.02   |                 | $      | (0.18 | ) | $ | (0.04 | ) |

 

7

----

 

**Note 6 – Comprehensive Income (Loss)**

 

Comprehensive income (loss)consisted of the following:

 

|                                                                    |   | **Three  Months Ended** |   | **One Month  Ended** |   |
|-------------------------------------------------------------------------|--------|-------------------------|--------|----------------------|--------|
|                                                                    |   | **April 30,  2003**     |   | **March 31,  2002**  |   | **January  31,  2003** |   |
|                                                                    |   |                    |   |                 |   |   |   |
| Net income (loss)                                                       |   | $                       | 5,312  |                 | $      | (17,071 | ) | $ | (3,460 | ) |
| Net change in net unrealized gains (losses) on  investments, net of tax |   | 12                      |   | 484                  |   | (62 | ) |
| Comprehensive income (loss)                                             |   | $                       | 5,324  |                 | $      | (16,587 | ) | $ | (3,522 | ) |

 

**Note 7 – Convertible Subordinated Debt**

 

OnFebruary 7, 2003, the Company sold $172.5 million of 2.25%convertible subordinated notes (the “Notes”) due February 15, 2010,raising net proceeds of approximately $167 million. The Notes areconvertible into Class A common stock at conversion rate of 93.3986 sharesper $1,000 principal amount of notes (aggregate of approximately16.1 million shares) at any time prior to February 15, 2010. In addition,holders of the Notes may require the Company to purchase all or a portion ofthe Notes upon a change in control of the Company.  Upon a conversion, the Company may choose to deliver, in lieu ofshares of Class A common stock, cash or a combination of cash andClass A common stock. The Notes do not contain any restrictivecovenants.   The Company hasfiled a registration statement with respect to the Notes and the commonstock issuable upon conversion of the Notes.

 

Concurrentwith the issuance of the Notes, the Company entered into share optiontransactions using approximately $20.5 million of net proceeds. As part ofthese share option transactions, the Company purchased options that coverapproximately 16.1 million shares of Class A common stock, at a strike price of$10.71.  The Company also sold optionsthat cover approximately 16.9 million shares of Class A common stock, at astrike price of $15.08. The net cost of the share option transactions wasrecorded against additional paid in capital. These share option transactions are intended to give the Company theoption to significantly mitigate dilution as a result of the Notes beingconverted to common shares up to the $15.08 price per common share and mitigatedilution if the share price exceeds $15.08 at that time.  Should there be an early unwind of either ofthe share option transactions, the amount of cash or net shares potentiallyreceived or paid by the Company will be dependent on then existing overallmarket conditions, the stock price, the volatility of the stock, and the amountof time remaining until expiration of the options.

 

**Note 8 – Employee Stock Purchase Plan**

#  

The Company’s EmployeeStock Purchase Plan (ESPP), which was implemented in 2002, allows eligible employeesto purchase shares of the Company’s Class B common stock, through accumulatedpayroll deductions, at 85% of the lesser of the fair market value of the ClassB common stock at the beginning or end of the six-month purchase period.  During the three months ended April 30,2003, employees purchased a total of approximately 232,000 shares of commonstock for approximately $1,600,000.

 

8

----

 

# **Note 9 – Commitments and Contingencies**

#  

From time to time, theCompany is subject to claims arising in the ordinary course of business. In theopinion of management and except as set forth below, no such matter,individually or in the aggregate, exists which is expected to have a materialeffect on the Company’s consolidated results of operations, financial positionor cash flows.

 

*Manufacturing and Purchase Commitments*

 

TheCompany has contracted with Sanmina SCI Systems, Inc. (“SSCI”) andSolectron Corporation (“Solectron”) (collectively, “Contract Manufacturers”)for the manufacture of printed circuit boards and box build assembly andconfiguration for specific Fibre Channel directors and switches. The agreementsrequire the Company to submit purchasing forecasts and place orders sixtycalendar days in advance of delivery. At April 30, 2003, the Company’scommitment with the Contract Manufacturers for purchases over the nextsixty days totaled $44 million.  The Company may be liable for materials that the Contract Manufacturerspurchase on McDATA’s behalf if the Company’s actual requirements do not meet orexceed its forecasts and those materials cannot be redirected to other uses. AtApril 30, 2003, the Company had recorded obligations of approximately$7 million primarily related to materials purchased by SSCI for certainend-of-life and obsolete material. Management does not expect the remainingcommitments under these agreements to have a material adverse effect on theCompany’s business, results of operations, financial position or cash flows.

 

TheCompany has various other commitments for sales and purchases in the ordinarycourse of business. In the aggregate, such commitments do not differsignificantly from current market prices or anticipated usage requirements.

 

*Indemnifications and Guarantees*

 

Duringits normal course of business, the Company has made certain indemnities,commitments and guarantees under which it may be required to make payments inrelation to certain transactions. These indemnities include intellectualproperty indemnities to the Company’s customers in connection with the sales ofits products, indemnities for liabilities associated with the infringement ofother parties’ technology based upon the Company’s software products,indemnities to various lessors in connection with facility leases for certainclaims arising from such facility or lease, and indemnities to directors andofficers of the Company to the maximum extent permitted under the laws of theState of Delaware. The Company has also indemnified its former parent, EMC forany income taxes arising out of the February 7, 2001 distribution of our ClassA common stock in the event it does not qualify for tax-free treatment. Theduration of these indemnities, commitments and guarantees varies, and incertain cases, is indefinite. In addition, the majority of these indemnities,commitments and guarantees do not provide for any limitation of the maximumpotential future payments the Company could be obligated to make. As such, theCompany is unable to estimate with any reasonableness its potential exposureunder these items. The Company has not recorded any liability for theseindemnities, commitments and guarantees in the accompanying consolidatedbalance sheets. The Company does, however, accrue for losses for any knowncontingent liability, including those that may arise from indemnificationprovisions, when future payment is both reasonably determinable and probable.Finally, the Company carries specific and general liability insurance policies,which the Company believes would provide, in most circumstances, some, if nottotal recourse to any claims arising from these indemnifications.

 

9

----

 

*Litigation*

 

*Raytheon Lawsuit*

 

On May 5, 2003, the Company was added as the ninthdefendant to a January 2003 patent infringement lawsuit that was filed byRaytheon Company in the United States District Court for the Eastern Districtof Texas - Marshall Division (Civil Action No. 2:03CV13).  The complaint alleges that the Company’sproducts infringe and/or the Company is actively inducing the infringementof  Raytheon’s United States Patent No.5,412,791, entitled “Mass Data Storage Library.” Notice of the complaint wasreceived only recently, and consequently, is at an early stage in theinvestigation of this matter and management cannot assess the merit orpotential materiality of the complaint at this time. However, the Company  intends to defend the action vigorously.

* *

*Class Action Laddering Lawsuits*

 

TheCompany, two current officers and one former officer have been named asdefendants in purported securities class-action lawsuits filed in the UnitedStates District Court, Southern District of New York. The first of theselawsuits, filed on July 20, 2001, is captioned Gutner v. McDATACorporation, Credit Suisse First Boston (CSFB), Merrill Lynch, PierceFenner & Smith Incorporated, Bear, Stearns & Co., Inc.,FleetBoston Robertson Stephens et al., No. 01 CIV. 6627. Three othersimilar suits have been filed against the Company. The complaints aresubstantially identical to numerous other complaints filed against othercompanies that went public over the last several years. These lawsuitsgenerally allege, among other things, that the registration statements andprospectus filed with the SEC by such companies were materially false andmisleading because they failed to disclose (a) that certain underwritershad allegedly solicited and received excessive and undisclosed commissions fromcertain investors in exchange for which the underwriters allocated to those investorsmaterial portions of shares in connection with the initial public offerings, orIPOs, and (b) that certain of the underwriters had allegedly entered intoagreements with customers whereby the underwriters agreed to allocate IPOshares in exchange for which the customers agreed to purchase additionalcompany shares in the aftermarket at pre-determined prices. The complaintsrelating to the Company allege claims against the Company, two of the Company’scurrent officers, one former officer of the Company, and CSFB, the leadunderwriter of the Company’s August 9, 2000 initial public offering, underSections 11 and 15 of the Securities Act. The complaints also allegeclaims solely against CSFB and the other underwriter defendants underSection 12(a)(2) of the Securities Act, and claims against the individualdefendants under Section 10(b) of the Securities Exchange Act. Althoughmanagement believes that all of the lawsuits are without legal merit and intendto defend them vigorously, there is not assurance that the Company willprevail.

 

InSeptember 2002, plaintiffs’ counsel in the above-mentioned lawsuitsoffered to individual defendants of many of the public companies being sued theopportunity to enter into a Reservation of Rights and Tolling Agreement that woulddismiss without prejudice and without costs all claims against such persons ifthe company itself had entity coverage insurance. This agreement was signed byMr. John F. McDonnell, Chairman, Mrs. Dee J. Perry, former chieffinancial officer, and Mr. Thomas O. McGimpsey, Vice President and GeneralCounsel and the plaintiffs’ executive committee. Under the Reservation ofRights and Tolling Agreement the plaintiffs are required to dismiss the claimsagainst such individuals.

 

OnFebruary 19, 2003, the court in the above-mentioned lawsuits entered aruling on the pending motions to dismiss, which dismissed some, but not all, ofthe plaintiffs’ claims against the Company.

 

*Patent Infringement Lawsuit*

 

OnFebruary 14, 2002, the Company filed a patent infringement lawsuit againstBrocade in the United States District Court for the District of Coloradoalleging that Brocade’s Frame Filtering feature in their productsinfringed  U.S. PatentNo. 6,233,236 “Method and apparatus for measuring traffic within a switch.”On March 5, 2002, the Company filed for a preliminary injunction againstBrocade to immediately stop infringing the patent after Brocade announcedanother product containing its Advanced Performance Monitoring feature.

 

OnApril 8, 2002, Brocade filed an answer to the motion for preliminaryinjunction generally alleging that Brocade has not infringed and is notinfringing the patent. Brocade alleged various counterclaims in its answerincluding a claim that the patent is invalid and unenforceable, and that wemisappropriated trade secret information from Brocade under prior agreementsand that a 1999 OEM agreement contained a covenant not to sue. The UnitedStates District Court for the District of Colorado on December 6, 2002denied the Company’s motion for a preliminary injunction. The Company

 

10

----

 

filed documents on December 23, 2002 with the American ArbitrationAssociation to initiate an arbitration proceeding to resolve contract andpatent issues relating to the 1999 OEM agreement with Brocade. OnJanuary 24, 2003, Brocade, in response to the initiation of thearbitration proceeding, filed an answer and counterclaim with the AmericanArbitration Association that objected to the inclusion of the patent infringementclaims in the arbitration, claims the patent is invalid and unenforceable andclaims the Company misappropriated trade secret information from Brocade.Although management strongly believes that Brocade’s counterclaims arefactually incorrect and without any merit and intends to vigorously pursue ourpatent infringement claims against Brocade, there is no assurance that theCompany will prevail.

 

**ITEM 2.  Management’s****Discussion and Analysis of Financial Condition and Results ofOperations**

 

*You shouldread the following discussion and analysis in conjunction with the consolidatedfinancial statements and notes thereto included in Item 1 of this QuarterlyReport and with Management’s Discussion and Analysis of Financial Condition andResults of Operations contained in our Annual Report filed on Form 10-K withthe Securities and Exchange Commission on March 27, 2003.*

 

**Overview**

 

On January 15, 2003, wechanged our fiscal year to end on January 31, rather than December 31.  We have included information for thetransition period from January 1-January 31, 2003 in this Form 10-Q pursuant toRule 13a-10 of the Securities Exchange Act of 1934, as amended.  We typically incur significant losses in thefirst month following the completion of a quarter because our revenue for thatmonth is significantly less than the average monthly revenue we generate in anyquarterly or annual period.  Results forany given monthly period are not indicative of potential results for any futureperiod.

 

References in this Form 10-Qto the first quarter of 2003 represent the three months ending April 30,2003.  References in this Form 10-Q tothe first quarter of 2002 represent the three months ending March 31, 2002. Wehave not submitted financial information for the three months ending April 30,2002 in this Form 10-Q because the information is not practical or costbeneficial to prepare.  We believe thatthe first quarter of 2002 provides a meaningful comparison to the first quarterof 2003.  There are no factors, seasonalor otherwise, that would impact the comparability of information or trends, ifresults for the three months ended April 30, 2002 were presented in lieu ofresults for the first quarter of 2002.

 

**CriticalAccounting Policies**

 

***General***

 

Management’sDiscussion and Analysis of Financial Condition and Results of Operations isbased upon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United States.The preparation of these financial statements requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities, revenue and expenses, and the related disclosure of contingentassets and liabilities as of the date of the financial statements. Managementbases its estimates on historical experience and on various other assumptionsthat are believed to be reasonable under the circumstances, the results ofwhich form the basis for making judgments about the carrying values of assetsand liabilities that are not readily apparent from other sources. Seniormanagement has discussed the development, selection and disclosure of theseestimates with the Audit Committee of McDATA’s Board of Directors. Actualresults may differ materially from these estimates under different assumptionsor conditions. Management believes the following critical accounting policiesreflect its more significant estimates and assumptions used in the preparationof its consolidated financial statements.

 

11

----

 

***Revenue Recognition***

 

Wegenerally recognize revenue, in accordance with SAB 101, when persuasiveevidence of an arrangement exists, products are delivered or services rendered,the sales price is fixed or determinable and collectibility is assured. Withrespect to revenue from product sales to our resellers, we recognize revenuewhen title and risk of loss transfer to the reseller generally at the time theproduct is delivered to the customer. Revenue from product sales to our OEMs anddistributors is recognized when title and risk of loss transfer to the customerin accordance with the master agreement, generally upon sell-through to theend-user as communicated to us by our OEMs and distributors. Revenue is reducedfor estimated customer returns, price protection, rebates, and other offeringsthat occur under sales programs established with the Company’s OEMs,distributors and resellers.

 

Servicerevenues, which to date have not been material, include training, consultingand customer support. Revenue from training and consulting are recognized whenthe service has been performed and the customer has accepted the work. Werecognize revenue from support or maintenance contracts, includingpost-contract customer support, or PCS, services, ratably over the contractualperiod.

 

Werecognize revenue from software products in accordance with the AmericanInstitute of Certified Public Accountants’ Statement of Position 97-2 (SOP97-2), as amended. Software revenue is allocated to the software license andPCS service elements using vendor specific objective evidence of fair value, orVSOE, and recognized appropriately as discussed above. VSOE of the fair valuefor an element is based upon the price charged when the element is sold separately.

 

Intransactions that include multiple products, services and/or software, weallocate the revenue to each element based on their relative fair values (or inthe absence of fair value, the residual method) and recognize the revenue whenthe above recognition criteria have been met for each element.

 

***Inventory Reserves***

 

Wevalue our inventory at the lower of cost or net realizable values. We regularlyreview inventory on hand and record a provision for excess and obsoleteinventory based upon assumptions about current and future demand for ourproducts, the current market conditions, new product introductions, newtechnologies and the current life cycle of our products. Adverse changes inthese factors and our assumptions could result in an increase in the amount ofexcess and obsolete inventory on hand and increase our cost of revenue.

 

Additionally,we have certain purchase commitments with our contract manufacturers that arenon-cancelable. We may be liable for materials that our third-partymanufacturers purchase on our behalf if our actual requirements do not meet orexceed our forecasts and those materials cannot be redirected to other uses bythe contract manufacturers. We evaluate these open purchase orders in light ofour current inventory on hand, expected demand, market conditions and newproduct introductions. Based on this information, we record purchaseobligations for inventory we believe is excess or obsolete and cannot beredirected to other uses by our contract manufacturers. Adverse changes in ourand our contract manufacturers’ calculations and assumptions concerning thesepurchase commitments may result in an increase to our vendor obligations andincrease our cost of revenue.

 

***Valuation of Accounts Receivable***

 

Wereview accounts receivable to determine which are doubtful of collection. Inaddition, we also make estimates of potential future product returns. In makingthe determination of the appropriate allowance for doubtful accounts andproduct returns, we consider specific accounts, analysis of our accountsreceivable aging, changes in customer payment terms, historical write-offs andreturns, changes in customer demand and relationships, concentrations of creditrisk and customer credit worthiness. Historically, we have experienced a lowlevel of write-offs and returns given our customer relationships, contractprovisions and credit assessments. Changes in the credit worthiness ofcustomers, general economic conditions and other factors may impact the levelof future write-offs and product returns and increase our general andadministrative expenses.

 

***Warranty Provision***

 

Wealso provide for estimated expenses for warranty obligations as revenue isrecognized. Our warranty accruals utilize management’s estimates of potentialfuture product warranty claims including the estimated numbers of failures byproduct and estimated costs to repair or replace failed product. We have notexperienced material warranty claims,

 

12

----

 

however material warranty claims, including the catastrophic orepidemic failure of any one of our products, would require revisions to theestimated warranty liability and could significantly increase our productcosts, reduce revenue and cause significant customer relations problems.

 

***Valuation of Deferred Taxes***

 

Significantmanagement judgment is required in determining the provision for income taxes,deferred tax assets and liabilities and any valuation allowance recordedagainst net deferred tax assets. We are required to estimate our income taxesin each jurisdiction where we operate. This process involves estimating ouractual current tax exposure together with assessing temporary differencesresulting from different treatment of items for tax and accounting purposes.These differences result in deferred tax assets and liabilities, which areincluded in our consolidated balance sheet. At April 30, 2003, our deferred taxassets equaled $36.2 million. We are required to assess the likelihood that ournet deferred tax assets will be recovered from future taxable income. We haveconsidered estimated future taxable income and our ongoing prudent and feasibletax planning strategies in assessing the need for a valuation allowance andconcluded that no such allowance is required at April 30, 2003. In the event wewere to determine that we would not be able to realize deferred tax assets inthe future, we would have to record a valuation allowance that wouldsignificantly reduce net income in the period such a determination were made.

 

***Valuation of Long-Lived Assets IncludingGoodwill and Purchased Intangible Assets***

 

Wereview property, plant and equipment and purchased intangible assets forimpairment whenever events or changes in circumstances indicate the carryingvalue of an asset may not be recoverable. Our asset impairment review assessesthe fair value of the assets based on the future cash flows the assets areexpected to generate. An impairment loss is recognized when estimatedundiscounted future cash flows expected to result from the use of the assetplus net proceeds expected from disposition of the asset (if any) are less thanthe carrying value of the asset. This approach uses our estimates of futuremarket growth, forecasted revenue and costs, expected periods the assets willbe utilized and appropriate discount rates.

 

Wehave performed and will perform an annual impairment test for goodwill inaccordance with Statement of Financial Accounting Standards No. 142(SFAS 142). This review is based on a comparison of the fair value of ournet assets including goodwill balances using the quoted market price of ourcommon stock. The assumptions used to estimate fair value include our bestestimate of future growth rates, capital expenditures, discount rates andmarket conditions over an estimate of the remaining operating period. Weperformed the 2003 impairment test and determined that no impairment lossshould be recognized. Due to changing business conditions, future tests mayresult in a need to record a loss due to write down of the value of goodwill.At April 30, 2003, goodwill recorded in the consolidated balance sheet totaled$11.8 million.

 

Wecurrently operate our business as a single solutions business and do notmaintain separate cash flows or operating margins. Future operating losses,deterioration of our business or segmentation of our operations in the futurecould also lead to impairment adjustments as such issues are identified.

 

***SalesCommission Estimates***

 

Our sales approach is focused on an indirect modelexecuted primarily through OEMs and resellers. Our field sales and service personnel support these distributionchannels using a direct-assist model and are commissioned based on salesresults achieved during the reporting period. In the first quarter ended April 30, 2003, we implemented a revisedsales commission plan.  Because specificsales data used to calculate these commissions is not always available at thetime our financial results are released, we routinely make certain estimatesbased on known revenue achievement, historical experience and assumptionsregarding individual sales contributions. Changes to these assumptions and estimates could cause revisions to oursales commission liabilities and result in variations between estimatedliabilities and actual payments.

 

13

----

 

**Results of Operations**

 

Thefollowing table sets forth certain financial data for the periods indicated asa percentage of total revenues.

 

|                                   |   | **Three Months Ended** |   |
|----------------------------------------|--------|------------------------|--------|
|                                   |   | **April 30, 2003**     |   | **March 31, 2002** |   |
|                                   |   |                   |   |   |   |
| Revenue                                |   | 100.0                  | %      | 100.0 | % |
| Cost of revenue                        |   | 43.2                   |   | 78.5 |   |
| Gross profit                           |   | 56.8                   |   | 21.5 |   |
|                                   |   |                   |   |   |   |
| Operating expenses:                    |   |                   |   |   |   |
| Research and development               |   | 18.2                   |   | 20.5 |   |
| Selling and marketing                  |   | 22.7                   |   | 27.9 |   |
| General and administrative             |   | 7.3                    |   | 12.4 |   |
| Amortization of deferred  compensation |   | 1.4                    |   | 3.3 |   |
| Total operating expenses               |   | 49.6                   |   | 64.1 |   |
|                                   |   |                   |   |   |   |
| Income (loss) from operations          |   | 7.2                    |   | (42.6 | ) |
| Interest and other  income, net   |   | 1.0                    |   | 3.1 |   |
| Income (loss) before income  taxes     |   | 8.2                    |   | (39.5 | ) |
| Income tax expense (benefit)           |   | 3.0                    |   | (13.0 | ) |
| Net income (loss)                      |   | 5.2                    | %      | (26.5 | )% |

 

*Revenues*

 

Total revenue increasedby approximately 60% to $103.2 million for the three months ended April 30,2003 from $64.5 million for the three months ended March 31, 2002.  Ourrevenue for the three months ended March 31, 2002 was negatively impacted bythe unfavorable economic conditions and suppressed IT storage andinfrastructure spending, in particular in the high-end director market and ourtransition from 1 Gb to 2 Gb products. Highlighting the impact of theslow-down of IT spending, we experienced a late first-quarter order reductionfrom EMC, which materially reduced anticipated earnings in the first quarter of2002.  Thisenvironment had a particularly negative effect on our product revenue. In thelast half of 2002, however, our new product introductions, including our 2 Gbdirectors and switches and our SphereonTM 4500 switch, with Flexport capability,were well received with higher than expected demand and revenue. We cannotpredict when the IT spending environment will improve, as there continues to bea level of uncertainty as to how the macro economic environment may influenceIT spending in 2003. We are pleased, however, with the demand for our newproducts and expect the demand to continue through our fiscal 2003 year.

 

Productrevenue of $91.4 million for the three months ended April 30, 2003 was a66% increase over product revenue of $55.0 million for the three months endedMarch 31, 2002. This revenue increase was generated from the increased demandin our storage products including our newly introduced 140-port IntrepidTM6000 Series Director and 24-port SphereonTM 4500 Fabric Switch.

 

Softwareand service revenue increased 41%**to**$8.4 million for the three months endedApril 30, 2003 from $5.9 million for the three months ended March 31, 2002. Wecontinue to experience revenue growth from the sale of all our softwareproducts, in particular our SANavigator® software product that was acquired aspart of the business acquisition completed in late September 2001.  A significant portion of our softwarerevenue is from our Enterprise Fabric Connectivity Manager, or EFCM, softwareproduct.

 

Otherrevenues for the three months ended April 30, 2003 remained consistent to prioryear with $3.4 million and $3.6 million for the three months endedApril 30, 2003 and March 31, 2002, respectively. This revenuereflects the growth in maintenance fees, which were outpaced by the decline inservice fees related to the ESCON service agreement with EMC. We anticipatethat service revenue from EMC under the ESCON service agreement will continueto decrease significantly in future periods.

 

Asignificant portion of our revenue is concentrated with two of our OEMcustomers. For the three months ended April 30, 2003, approximately 61% ofour total revenue, excluding the ESCON service fee, came from

 

14

----

EMC, compared to 53% forthe three months ended March 31, 2002. Additionally, IBM contributed approximately 17% of our revenue for thethree months ended April 30, 2003 compared to 24% for the three months endedMarch 31, 2002. Revenues for the three months ended April 30, 2003 increased82% and 14%, respectively for EMC and IBM from the quarter ended March 31,2002.  The decline in the IBM-relatedrevenue percentage, however, reflects the large late first-quarter orderreduction from EMC, which materially reduced anticipated earnings in the firstquarter of 2002.  The significant declinein revenue from our largest customer increased IBM’s contribution as apercentage of revenue for the three months ended March 31, 2002.  We expect a majority of our revenues in theforeseeable future to be derived from these two customers. The level of salesto any single customer may vary and the loss of any one significant customer,or a decrease in the level of sales to any significant or group of significantcustomers, could harm our financial condition and results of operations.

 

Domestic andinternational revenues were approximately 72% and 28% of total revenues,respectively, for the three months ended April 30, 2003.  Domestic and international revenues were 64%and 36%, respectively for the three months ended March 31, 2002.  Revenues are attributed to geographic areasbased on the location of the customers to which our products are shipped.  International revenues primarily consist ofsales to customers in Western Europe and the greater Asia Pacific region.  Included in domestic revenues are sales tocertain OEM customers who take possession of our products domestically and thendistribute these products to their international customers.  In addition, included in revenues fromWestern Europe are sales to certain OEM customers who take possession of ourproducts in distribution centers designated for international-bound product andthen distribute these products among various international regions.  Our mix of international and domesticrevenue can, therefore, vary depending on the relative mix of sales to certainOEM customers.  International revenuesfor the three months ended March 31, 2002 represented a higher percentage ofrevenue as a result of the large domestic order reduction by EMC.  During the three months ended April 30,2003, we experienced an increase in total international revenues, however,sales to customers in the Asia Pacific region decreased from the first quarterended March 31, 2002, possibly due to the SARS virus.

 

*Gross Profit*

 

Gross profit for thethree months ended April 30, 2003 was 57% compared to 22% for the three monthsended March 31, 2002.  During the threemonths ended March 31, 2002, we incurred a $14.0 million inventory-relatedcharge primarily for the excess 1 Gb components used in our discontinued 1 Gbproducts.  Excluding this write-down,the gross profit percentage for the three months ended March 31, 2002 wouldhave been 43%.  The significant increasein our gross profit between the three months ended April 30, 2003 and March 31,2002 was the result of an improved mix of higher-margin software and newproduct sales.  In addition, we realizedbetter fixed cost absorption due to higher total revenue and reduced fixedcosts resulting from the implementation of our outsource-focused manufacturingmodel.

 

*Operating Expenses*

 

*Researchand Development Expenses.* Research and development expenses increased to $18.8 million forthe three months ended April 30, 2003, compared with $13.2 million forthe three months ended March 31, 2002. The approximate $5.6 millionor 42% increase was primarily attributable to reductions in capitalizedsoftware costs, increases in staffing levels, non-recurring engineeringcharges, and depreciation related to engineering and test equipment and the newengineering building occupied in the second half of 2002.  Capitalized software costs wereapproximately $648,000 and $1,946,000 for the three months ended April 30,2003 and March 31, 2002, respectively. Capitalized software development costshave decreased in conjunction with the varying stages of development of our newdirector and switch products and the related firmware software.

 

*Sellingand Marketing Expenses.* Selling and marketing expenses increased to $23.4 million for thethree months ended April 30, 2003, compared with $18.0 million forthe three months ended March 31, 2002. Increases in sales and marketingexpenses were primarily due to increased salaries and commissions associatedwith increased revenues and expanded commitments to our equipment sale andmarketing programs with our partners. In addition, customer acquisition costs associated with the completionof two new OEM contracts in the quarter ended April 30, 2003 increased ouroverall sales and marketing expenses.

 

15

----

 

*General and Administrative Expenses*.  General and administrative expensesdecreased by approximately 7% to $7.5 million for the three months ended April30, 2003 from $8.0 million for the three months ended March 31, 2002. Duringthe three months ended April 30, 2003, we experienced increased personnel costsrelated primarily to an executive and employee incentive bonus plansimplemented in the third and fourth quarter of 2002 and increased legal feesdue to the patent infringement lawsuit (see Part II, Item 1, LegalProceedings).  Offsetting these increasesin the current quarter were decreases associated with $1.75 million in chargesduring the three months ended March 31, 2002 related to the termination of acollateralized lease and the disposal of fixed assets.

 

*Amortization of Deferred Compensation*.  We have recorded deferred compensation inconnection with certain Class B stock options granted prior to our August 9,2000 initial public offering and certain restricted Class B stock grants.  We are amortizing all deferred compensationon a straight-line basis over the vesting period of the applicable options andstock awards, resulting in amortization expense of $1.5 million for the threemonths ended April 30, 2003 and $2.3 million for the three months ended March31, 2002 (of which approximately $0.1 million and $0.2 million was included incost of revenue for the three months ended April 30, 2003 and March 31, 2002,respectively).

 

*Interest and Other Income*.  Interest and other income consistedprimarily of interest earnings on our cash, cash equivalents and variousinvestment holdings. Interest and other income for both the three months endedApril 30, 2003 and March 31, 2002 was approximately $2.1 million.  For the three months ended April 30, 2003,cash and investment balances increased significantly related to cash generatedfrom operations and the net proceeds from convertible subordinated notes thatwere issued in February 2003 (see Note 7 – “Convertible Subordinated Debt” inthe Notes to Condensed Consolidated Financial Statements).  The increased interest earnings on thehigher cash and investment balances were offset by lower interest rates.  If interest rates continue to decrease,interest income may decrease in future periods.

 

*InterestExpense. *Interestexpense was $1.1 million for the three months ended April 30, 2003 comparedwith $90,000 for the three months ended March 31, 2002.  Interest expense primarily represents theinterest cost associated with our convertible subordinated notes issued duringthe three months ended April 30, 2003.

 

*Provision for Income Taxes.*  The effective tax rates for the three monthsended April 30, 2003 and March 31, 2002, were 37.0% and 33.0%,respectively.  The effective tax rate isdetermined by the relationship between pre-tax book income or loss and certainamounts which are reported differently between the financial statements and thetax return.  For the three months endedApril 30, 2003, we generated pre-tax book income while the three months endedMarch 31, 2002, reflected a pre-tax book loss. For the three months ended April 30, 2003, our effective tax ratebenefits primarily from a reduction in deferred compensation and thedeductibility of costs associated with our convertible subordinated debt.  These tax rate benefits are offset by highertax costs on our investment income due to a reduction in tax-exemptinvestments.

 

**Liquidity and Capital Resources**

 

Cash and cash equivalentsand available-for-sale investments were $499 million at April 30, 2003, anincrease of $171 million from $328 million at January 31, 2003. Wegenerated approximately $26.0 million in net cash from operatingactivities, primarily from net income before non-cash charges includingdepreciation and amortization, deferred compensation, inventory-relatedprovisions and deferred income tax benefits. Also, contributing to the cashfrom operations was an increase in our accounts payable and accruedliabilities, offset by increases in accounts receivable and inventory balancesfrom January 31, 2003. At April 30, 2003, we had deferred tax assets of$36.2 million, which we believe will be realizable through futureprofitable operations.

 

Net cash used ininvesting activities was $132 million related primarily to the investmentof the proceeds received from our issuance of convertible subordinated notes inFebruary 2003 into our short and long-term investment portfolio.  Net cash from financing activities was $148million as net proceeds of $167 million were received from the issuance ofconvertible subordinated notes in February 2003 and $20.5 million of thoseproceeds were used to enter into share option transactions.

 

16

----

 

Our principal sources ofliquidity at April 30, 2003 consisted of our cash and available-for-saleinvestments of $499 million and net accounts receivable of$38.1 million.  We believe ourexisting cash, short-term and long-term investment balances, and cash expectedto be generated from future operations will be sufficient to meet our capitaland operating requirements at least through the next twelve months,although we could be required, or could elect, to seek additional funding priorto that time. Our future capital requirements will depend on many factors,including our rate of revenue growth, the timing and extent of spending tosupport development of new products and expansion of sales and marketing, thetiming of new product introductions and enhancements to existing products, anyacquisitions of businesses, and market acceptance of our products.

 

**Commitments**

 

We have entered intoagreements with the contract manufacturers for the manufacture of printedcircuit boards and box build assembly for specific Fibre Channel directors andswitches. The agreements require us to submit purchasing forecasts and placeorders sixty calendar days in advance of delivery. At April 30, 2003, ourcommitment with the contract manufacturers for purchases over the nextsixty days totaled $44 million. We may be liable for materials thatthe contract manufacturers purchase on our behalf if our actual requirements donot meet or exceed our forecasts and those materials cannot be redirected toother uses. At April 30, 2003, we had recorded obligations of approximately$7 million primarily related to materials purchased by SSCI for certainend-of-life and obsolete material used to manufacture our products. We do notexpect the remaining commitments under these agreements to have a continuedmaterial adverse effect on our business, results of operations, financialposition or cash flows.

 

In February 2003,the Company sold $172.5 million of 2.25% convertible subordinated notesdue February 15, 2010 (see Note 7, “Convertible Subordinated Debt,” of theNotes to Consolidated Financial Statements). The Notes are convertible into ourClass A common stock at conversion rate of 93.3986 shares per $1,000principal amount of notes (aggregate of approximately 16.1 millionshares). Upon a conversion, the Company may choose to deliver shares of ourClass A common stock, or, in lieu of shares of our Class A commonstock, cash or a combination of cash and shares of Class A common stock.

 

Concurrent with theissuance of the Notes, the Company entered into share option transactions usingapproximately $20.5 million of net proceeds. As part of these share optiontransactions, the Company purchased options that cover approximately 16.1million shares of Class A common stock, at a strike price of $10.71.  The Company also sold options that coverapproximately 16.9 million shares of Class A common stock, at a strike price of$15.08. The net cost of the share option transactions was recorded againstadditional paid in capital.  These shareoption transactions are intended to give the Company the option to mitigatedilution as a result of the Notes being converted to common shares up to the$15.08 price per common share and mitigate dilution if the share price exceeds$15.08 at that time.  Should there be anearly unwind of either of the share option transactions, the amount of cash ornet shares potentially received or paid by the Company will be dependent onthen existing overall market conditions, the stock price, the volatility of thestock, and the amount of time remaining until expiration of the options.

 

We are required to payinterest on February 15 and August 15 of each year, beginning August 1,2003.  Debt issuance costs of $5.5million are being amortized over the term of the notes.  The amortization of debt issuance costs willaccelerate upon early redemption or conversion of the notes.  The net proceeds remain available forgeneral corporate purposes, including working capital and capital expenditures.

 

**Recent Accounting Pronouncements**

 

Forinformation regarding recent accounting pronouncements, see Note 1 of “Notes toCondensed Consolidated Financial Statements,” included in Item 1 of this Form10-Q.

 

17

----

 

**Risk Factors**

 

***Risks Relating to Our Business***

 

**Weincurred a substantial loss for the years ended December 31, 2002 and 2001and may not maintain profitability in the future.**

 

Although recently we havehad profitable quarters, we may not be profitable in the future. Our futureoperating results will depend on many factors, including the growth of theFibre Channel market, market acceptance of new products we introduce, demandfor our products, levels of product and price competition and our reaching andmaintaining targeted costs for our products. In addition, we expect to incurcontinued significant product development, sales and marketing, and general andadministrative expenses. We also anticipate expenses related to theimplementation of an “outsourcing focused” manufacturing model during 2003. Wecannot provide assurance that we will generate sufficient revenue to achieve orsustain profitability.

 

**Ourbusiness is subject to risks from global operations.**

 

We conduct significantsales and customer support operations in countries outside of the United Statesand also depend on non-U.S. operations of our contract manufacturers and ourdistribution partners. We derived approximately 37% of our 2002 revenue fromcustomers located outside of the United States. We believe that our continuedgrowth and profitability will require us to continue to expand marketing andselling efforts internationally. We have limited experience in marketing,distributing and supporting our products internationally and may not be able tomaintain or increase international market demand for our products. In addition,our international operations are generally subject to inherent risks and challengesthat could harm our operating results, including:

 

•                  expenses associated with developingand customizing our products for foreign countries;

 

•                  difficulties in staffing andmanaging international operations, including reliance on third parties to managecertain aspects of our foreign operations, including hub inventory locations;

 

•                  multiple, conflicting and changinggovernmental laws and regulations;

 

•                  tariffs, quotas and other import orexport restrictions, trade protection measures and other regulatoryrequirements on computer peripheral equipment;

 

•                  longer sales cycles for ourproducts;

 

•                  reduced or limited protections ofintellectual property rights;

 

•                  adverse tax consequences, includingimposition of withholding or other taxes on payments by subsidiaries andcustomers;

 

•                  compliance with internationalstandards that differ from domestic standards,

 

•                  risks surrounding any productoutsourcing activities in foreign countries; and

 

•                  political, social and economicinstability in a specific country or region.

 

Any negative effects onour international business could harm our business, operating results andfinancial condition as a whole. To date, substantially all of our internationalrevenue or costs have been denominated in U.S. dollars. As a result, anincrease in the value of the U.S. dollar relative to foreign currencies couldmake our products more expensive and thus less competitive in foreign markets.A portion of our international revenue may be denominated in foreign currenciesin the future, which will subject us to risks associated with fluctuations inthose foreign currencies.

 

**Increasedinternational political instability may decrease customer purchases, increaseour costs and disrupt our business.**

 

Increased internationalpolitical instability, as demonstrated by the September 11, 2001 terroristattacks, disruption in air transportation and enhanced security measures as aresult of the terrorist attacks and increasing tension in the Middle East, mayhinder our ability to do business and may increase our costs. Additionally,this increased instability may, for example, negatively impact the capitalmarkets and the reliability and cost of transportation and adversely affect ourability to obtain adequate insurance at reasonable rates or require us to incurcosts for extra security precautions for our operations. In addition, to theextent that air transportation is delayed or disrupted, the operations of ourcontract

 

18

----

 

manufacturers and suppliersmay be disrupted, particularly if shipments of components and raw materials aredelayed. If this international political instability continues or increases,our business and results of operations could be harmed and we may not be ableto obtain financing in the capital markets.

 

**Theprices and gross margins of our products may decline, which would reduce ourrevenues, gross margins and profitability.**

 

In response to changes inproduct mix, competitive pricing pressures, increased sales discounts, introductionsof new products and product enhancements by our competitors, increase inmanufacturing or labor costs or other factors, we may experience declines inboth the prices and gross margins in some or all of our products. To maintainour gross margins we must maintain or increase current shipment volumes,develop and introduce new products and product enhancements and reduce themanufacturing cost of our products. Moreover, most of our expenses are fixed inthe short-term or incurred in advance of receipt of corresponding revenue. As aresult, we may not be able to decrease our spending to offset any unexpectedshortfall in revenues. If this occurs, we could incur losses, and our revenue,operating results and gross margins may be below our expectations and those ofinvestors and stock market analysts.

 

**We mayincur an expense relating to the impairment of our deferred tax assets.**

 

As of April 30, 2003, wehave deferred tax assets of $36.2 million, which we believe will berealized more likely than not through future profitable operations. However, itis possible that if additional operating losses are incurred, or if weotherwise conclude that our deferred tax asset will not be realized throughfuture operations, we may need to provide a valuation allowance to recognizethe impairment of our deferred tax assets. To the extent we were to establish avaluation allowance, we would recognize an expense within the tax provision ofour income statement, which could materially impact our financial position and resultsof operations.

 

**Wedepend on two key distribution relationships for most of our revenue and theloss of either of them could significantly reduce our revenues.**

 

We depend on EMC and IBMfor a significant portion of our total revenue. Sales and services to EMC,which is an original equipment manufacturer customer, represented approximately61% of our revenue for the three months ended April 30, 2003. In 2001, EMCagreed to resell products offered by our competitors, and nothing restricts EMCfrom expanding those relationships in a manner that could be adverse to us.Sales to IBM represented approximately 17% of our revenue for the three monthsended April 30, 2003. We anticipate that our future operating results willcontinue to depend heavily on sales to EMC and IBM. Therefore, the loss ofeither EMC or IBM as a customer, or a significant reduction in sales to eitherEMC or IBM could significantly reduce our revenue.

 

**Themarket for Fibre Channel switches and other products for SANs is highlycompetitive, new competitors have recently entered this market and we may notbe able to successfully compete against existing or potential competitors.**

 

The market for our FibreChannel switching hardware and software products is highly competitive, andwill become even more so with the entrance of new competitors from the InternetProtocol (IP) based switch market.  Ourcompetitors are planning to provide switching hardware and software that ismulti-protocol capable (such as Fibre Channel over IP (FCIP), SCSI overInternet (iSCSI), Internet Fibre Channel and InfiniBand). Our competitors inthe Fibre Channel switching hardware and software market include Brocade, CNT(which recently acquired InRange), Cisco, Qlogic Corp., Vixel Corporation,Broadcom Corporation (which recently acquired the assets of Gadzoox Networks),Veritas Software Corporation, Fujitsu Softech and others, and even storageproviders.  Given the recent entrance byCisco, other IP based switching companies will likely enter the market formulti-protocol products. Some of our competitors and potential competitors havelonger operating histories, greater name recognition, access to larger customerbases, more established distribution channels and substantially greaterfinancial and managerial resources than we have.

 

19

----

 

In August 2002, Cisco announced that it would beentering the storage switch market with the introduction of a family ofswitches and directors. In January 2003, Cisco announced that it hadentered into a non-exclusive agreement with IBM which would allow IBM to sellstorage switches provided by Cisco in addition to the product lines provided byBrocade and us. IBM is our second largest customer, and the agreement betweenCisco and IBM may significantly reduce our sales to IBM. Also inJanuary 2003, Hewlett-Packard Co., or HPQ, announced that it would resellCisco’s new line of Fibre Channel switches. HPQ has substantial sales withinthe SAN infrastructure market, and the agreement between HPQ and Cisco couldsignificantly reduce our future sales to HPQ. In late April 2003, EMC announced that it had entered into a letter ofintent whereby EMC would resell and support Cisco’s family of switches anddirectors.  EMC is our largest customer,and the agreement between EMC and Cisco may significantly reduce our sales toEMC.  The introduction of Cisco’scompeting product line may delay purchase decisions by our customers.Furthermore, Cisco has greater access to enterprise customers and greaterdirect sales experience and capacity than we do. To be competitive with Ciscoand others, we may have to substantially increase our direct sales, which wemay not be able to do successfully and which, in any case, will increaseexpenses.

 

In August 2000, EMCagreed not to develop or manufacture products that compete with ourthen-existing products for two years. Since August 2002, EMC has notbeen contractually restricted from competing with us in the development ormanufacture of these products. In addition, EMC has agreed to resell productsoffered by our competitors. Moreover, under a cross license agreement betweenus and EMC, we have granted EMC a license under our patents to make, use andsell any products that EMC was selling or distributing up to August 9,2000, including products that compete with ours.

 

Continued or increasedcompetition could result in pricing pressures, reduced sales, reduced margins,reduced profits, reduced market share or the failure of our products to achieveor maintain market acceptance.

 

**Wecurrently have limited product offerings and must successfully introduce newproducts and product enhancements that respond to rapid technological changesand evolving industry standards.**

 

For the three monthsended April 30, 2003, we derived approximately 66% of our revenue from sales ofour Director-class products. We expect that revenue from our Director-classproducts will continue to account for a substantial portion of our revenue forthe foreseeable future. Therefore, continued market acceptance of theseproducts and their successor products is critical to our future success.Factors such as performance, market positioning, the availability and price ofcompeting products, the introduction of new technologies and the success of ourOEMs, reseller and systems integrator customers will affect the marketacceptance of our products.

 

In addition, our futuresuccess depends upon our ability to address the changing needs of customers andto transition to new technologies and industry standards. The introduction ofcompeting products embodying new technologies or the emergence of new industrystandards could render our products non-competitive, obsolete or unmarketableand seriously harm our market share, revenue and gross margin. For instance,there are competing protocols for storage area network switches and relateddevices, such as SCSI over Internet (iSCSI), Fibre Channel over IP (FCIP),Internet Fibre Channel and InfiniBand, which may be more readily adopted oraccepted by our customers. Risks inherent in transitions to new technology,industry standards and new protocols include the inability to expand productioncapacity to meet demand for new products, write-downs of our existing inventorydue to obsolescence, the impact of customer demand for new products or productsbeing replaced, and delays in the introduction or initial shipment of newproducts. There can be no assurance that we will successfully manage thesetransitions.

 

We are currentlydeveloping next generation products that contain untested devices andsubassemblies. As with any development, there are inherent risks should suchdevices or subassemblies require redesign or rework. In particular, inconjunction with our transition of our products from 1 to 2 Gb transmission speedtechnology and higher port density, we have begun introducing products with newfeatures and functionality. We face risks relating to this product transition,including risks relating to forecasting of demand for 2 Gb and higher portdensity products and related transition issues, as discussed in the previousparagraph, as well as possible product and software defects and a potentiallydifferent sales and support environment due to the complexity of these newsystems. Finally, if we fail to timely introduce new products that aremulti-protocol products to compete against new entrants in the SAN market, orif there is no demand for these or our current products, our business could beseriously harmed.

 

20

----

 

**Ourproducts must continue to support and be interoperable with other SAN products.**

 

SAN products arecontinuing to emerge and evolve. All components of the SAN must utilize thesame standards in order to operate together. To remain competitive, we must continueto introduce new products and product enhancements that are compatible andinteroperable with other SAN products, industry standards and new technology.If our products are not interoperable with SAN products we may have difficultyin selling our products and we may lose market share.

 

**If weare unable to integrate the new members of our senior executive team, if welose key personnel or if we are unable to hire additional qualified personnel,we may not be successful.**

 

Our success depends to asignificant degree upon the continued contributions of our key management,technical, sales and marketing, finance and operations personnel, many of whomwould be difficult to replace. In particular, we believe that our futuresuccess is highly dependent on our senior executive team. In the past we haveexperienced high turnover in our senior executive team. The majority of thecurrent senior executive team was hired during the last eighteen months.Although our executive team consists of experienced members, many of them arenew to our company and have only worked with each other for a short period oftime. As a result they may not operate efficiently as part of an integratedmanagement team.

 

In addition, ourengineering and product development teams are critical in developing ourproducts and have developed important relationships with customers and theirtechnical staffs. The loss of any of these key personnel could harm ouroperations and customer relationships. We do not have key person life insuranceon any of our key personnel.

 

We believe our futuresuccess will also depend in large part upon our ability to attract and retainhighly skilled managerial, engineering, sales and marketing, and finance andoperations personnel. As we increase our production and sales levels, we willneed to attract and retain additional qualified skilled workers for ouroperations. In recent years there has been great demand for such personnelby companies, some of which are larger and have greater resources to attractand retain highly qualified personnel. We cannot assure you that we willcontinue to be able to attract and retain qualified personnel, or that delaysin hiring required personnel, particularly engineers, will not delay thedevelopment or introduction of products or negatively impact our ability tosell our products.

 

**If weare unable to adequately protect our intellectual property, we may not be ableto compete effectively.**

 

We rely on a combinationof patent, copyright, trademark and trade secret laws and restrictions ondisclosure to protect our intellectual property rights. We also enter intoconfidentiality and/or license agreements with our employees, consultants andcorporate partners. Despite our efforts to protect our proprietary rights,unauthorized parties may copy or otherwise obtain and use our products ortechnology. Monitoring unauthorized use of our products is difficult and we maynot be aware that someone is using our rights without our authorization. Inaddition, the steps we have taken, and those we may take in the future, may notprevent unauthorized use of our technology, particularly in foreign countrieswhere the laws may not protect our proprietary rights as fully as in the UnitedStates.

 

We may be a party tointellectual property litigation in the future, either to protect ourintellectual property or as a result of alleged infringements of others’intellectual property. In particular we filed on February 14, 2002, apatent infringement lawsuit against Brocade in the United States District Courtfor the District of Colorado (Case No. 02-K-0303) alleging that Brocade’sAdvanced Performance Monitoring feature in its switch products infringed ourU.S. Patent No. 6,233,236 “Method and apparatus for measuring trafficwithin a switch.” On March 5, 2002, we filed for a preliminary injunctionagainst Brocade to immediately stop infringing the patent after Brocadeannounced another product containing its Advanced Performance Monitoringfeature.

 

On April 8, 2002,Brocade filed an answer to the motion for preliminary injunction generallyalleging that Brocade has not infringed and is not infringing the patent.Brocade alleged various counterclaims in its answer including a claim that thepatent is invalid and unenforceable, and that we misappropriated trade secretinformation from Brocade under prior agreements and that a 1999 OEM agreementcontained a covenant not to sue. The United States District Court for theDistrict of Colorado on December 6, 2002 denied our motion for apreliminary injunction. We filed documents on December 23, 2002 with theAmerican Arbitration Association to initiate an arbitration proceeding toresolve contract and patent issues relating to the 1999 OEM agreement withBrocade. On January 24, 2003, Brocade, in response to our

 

21

----

 

initiating thearbitration proceeding, filed an answer and counterclaim with the AmericanArbitration Association that objected to the inclusion of our patentinfringement claims in the arbitration, claims the patent is invalid andunenforceable and claims we misappropriated trade secret information fromBrocade. Although we strongly believe that Brocade’s counterclaims arefactually incorrect and without any merit and we intend to vigorously pursueour patent infringement claims against Brocade, we cannot assure you we willprevail.

 

On May 5, 2003, we wereadded as the ninth defendant to a January 2003 patent infringement lawsuit thatwas filed by Raytheon Company in the United States District Court for the EasternDistrict of Texas – Marshall Division (Civil Action No. 2:03CV13).  The complaint alleges that our productsinfringe and/or we are actively inducing the infringement of Raytheon’s UnitedStates Patent No. 5,412,791, entitled “Mass Data Storage Library.” Wereceived notice of the complaint only recently, and consequently we are at anearly stage in our investigation of this matter and we cannot assess the meritor potential materiality of the complaint at this time. However, we intend todefend the action vigorously.

 

These or other claims andany resulting litigation or arbitration could subject us to significant costs,liability for damages or could cause our proprietary rights to be invalidatedor deemed unenforceable, which could allow third parties to use our rightswithout reservation. Litigation or arbitration, regardless of the merits of theclaim or outcome, would likely be time consuming and expensive to resolve andwould divert management time and attention.

 

Any potentialintellectual property litigation filed against us could also force us to do oneor more of the following:

 

•                  stop using the challengedintellectual property or selling our products or services that incorporate it;

 

•                  obtain a license to use thechallenged intellectual property or to sell products or services thatincorporate it, which license may not be available on reasonable terms, or atall; and

 

•                  redesign those products or servicesthat are based on or incorporate the challenged intellectual property.

 

If we are forced to takeany of these actions, we may be unable to manufacture and sell our products,our customer relationships would be harmed and our revenue would be reduced.

 

In March 1999, we,as an EMC subsidiary, granted IBM a license to all of our patents under a crosslicense agreement between IBM and EMC. Under the terms of that agreement,effective upon EMC’s February 7, 2001 distribution of our Class Acommon stock to its stockholders, the sublicense we previously held to thoseIBM patents terminated. We believe that the termination of the sublicense doesnot materially affect our business. We are not aware of any issued or pendingIBM patents that are infringed by our products, but if IBM were to allege anysuch infringement, and we were unable to negotiate a settlement with IBM, ourability to produce the alleged infringing product could be affected, whichcould materially and adversely affect our business.

 

**We haveexperienced increased inventory costs and delays and have incurredinventory-related write-downs.**

 

During fiscal year 2002,we incurred a net $9.5 million inventory related charge related primarilyto our 1 Gb product inventory. There can be no assurance that we will not incuradditional inventory write-downs in the future or that any such write-downs wouldnot have a material adverse affect on our future operating results.

 

22

----

 

**Thestorage area network market in which we compete is still developing, and ifthis market does not continue to develop and expand as we anticipate, ourbusiness will suffer.**

 

The market for storagearea network and related products has only recently begun to develop andcontinues to evolve. Because this market is relatively new, it is difficult topredict its potential size or future growth rate. Potential end-user customerswho have invested substantial resources in their existing data storage andmanagement systems may be reluctant or slow to adopt a new approach, like SANs.Our success in generating net revenue in this developing market will thereforedepend on, among other things, our ability to:

 

•                  educatepotential OEMs, reseller and systems integrator customers and end users aboutthe benefits of SANs and the use of our products in the SAN environment, and

 

•                  predict, developand base our products on standards that ultimately become industry standards.

 

Accordingly, becausesubstantially all of our revenues are derived from our SAN solutions, theadoption of SANs as an integral part of data-intensive enterprise computingenvironments is critical to our future success and delays or failure to adoptour SAN and related products will have an adverse effect on revenue andoperations.

 

**If wefail to optimize our distribution channels and manage our distributionrelationships, our revenue or operating results could be significantly reduced.**

 

Our success will dependon our continuing ability to develop and manage relationships with significantOEMs, resellers and systems integrators, as well as on the sales efforts andsuccess of these customers. We cannot provide assurance that we will be able toexpand our distribution channels or manage our distribution relationshipssuccessfully or that our customers will market our products effectively. Ourfailure to expand our distribution channels or manage successfully ourdistribution relationships or the failure of our OEM and reseller customers tosell our products could reduce our revenue and operating results.

 

**We aredependent on a single or limited number of suppliers for certain key componentsof our products, and the failure of any of those suppliers to meet ourproduction needs could seriously harm our ability to manufacture our products,result in delays in the delivery of our products and harm our revenue.**

 

We currently purchaseseveral key components from single or limited sources. We purchase applicationspecific integrated circuits (ASICs) and power supplies from single sources,and gigabit interface converters and optic transceivers from limited sources.Additional sole or limited sourced components may be incorporated into ourproducts in the future. Delays in the delivery of components for our productscould result in decreased revenue. We do not have any long-term supplycontracts to ensure sources of supply of components. In addition, our suppliersmay enter into exclusive arrangements with our competitors, stop selling theirproducts or components to us at commercially reasonable prices or refuse tosell their products or components to us at any price, which could harm our operatingresults. If our suppliers are unable to provide, or we are unable otherwise toobtain these components for our products on the schedule and in the quantitieswe require, we will be unable to manufacture our products. We have experiencedand may continue to experience production delays and quality control problemswith certain of our suppliers, which, if not effectively managed, could preventus from satisfying our production requirements. If we fail to effectivelymanage our relationships with these key suppliers, or if our suppliersexperience delays, disruptions, capacity constraints or quality controlproblems in their manufacturing operations, our ability to manufacture and shipproducts to our customers could be delayed, and our competitive position,reputation, business, financial condition and results of operations could beseriously harmed.

 

**The lossof our contract manufacturers, or the failure to forecast demand accurately forour products or to manage our relationship with our contract manufacturerssuccessfully, would negatively impact our ability to manufacture and sell ourproducts.**

 

We are in the process ofimplementing a multi-phased “outsourcing-focused” manufacturing model that weanticipate with be completed at the end of fiscal 2003. We rely on SanminaSCI, Inc., or SSCI, and Solectron Corporation, together our contractmanufacturers, to manufacture substantially all of our circuit boards and toperform extensive testing and assembly of our products. Our supply contractwith SSCI is cancelable by either party without

 

23

----

 

cause on advance notice.In May 2002, we outsourced to SSCI the integration of our Directors intocabinets. In mid-2002, we contracted with Solectron to be our contract manufacturerfor our SphereonTM 4500 24-port switch product. Our contract manufacturers arenot obligated to supply products to us for any specific period, or in anyspecific quantity, except as may be provided in a particular purchase order. Inaddition, our contract manufacturers do not guarantee that adequate capacitywill be available to us within the time required to meet additional demand forour products. We generally place forecasts for circuit boards with our contractmanufacturers approximately four to five months prior to the anticipateddelivery date, with order volumes based on forecasts of demand for ourproducts. We generally place purchase orders sixty calendar days inadvance of delivery. If we fail to forecast demand for our products accurately,we may be unable to obtain adequate manufacturing capacity from our contractmanufacturers to meet our customers’ delivery requirements or unexpectedincreases in customer purchase orders. As a result, we may not be able tobenefit from this incremental demand and could lose customers. If weover-estimate demand for our product, we may accumulate excess inventories andobligations to our contract manufacturers under binding purchase orders inexcess of our needs. At April 30, 2003, our commitment with our contract manufacturersfor purchases and anticipated transformation costs over the nextsixty days totaled approximately $44 million, net of purchase commitmentreserves of $7 million.

 

In addition, wecoordinate our efforts with those of our component suppliers and contractmanufacturers in order to rapidly achieve volume production. We haveexperienced and may continue to experience production delays and qualitycontrol problems with certain of our suppliers and with our contractmanufacturers, which, if not effectively managed, could prevent us fromsatisfying our production requirements on a timely basis and could harm ourcustomer relationships. If we should fail to manage effectively ourrelationships with our component suppliers or contract manufacturers, or if anyof our suppliers or our manufacturers experience delays, disruptions, capacityconstraints or quality control problems in their manufacturing operations, ourability to ship products to our customers could be delayed, and our competitiveposition and reputation could be harmed. Qualifying a new contract manufacturerand commencing volume production can be expensive and time consuming. If we arerequired to change or choose to change contract manufacturers, we may loserevenue and damage our customer relationships.

 

**Thecontinued general economic slowdown may significantly reduce expenditures oninformation technology infrastructure.**

 

Continuing unfavorablegeneral economic conditions have had a pronounced negative impact oninformation technology, or IT, spending. Demand for SAN products in theenterprise-class sector may continue to be adversely impacted as a result ofthe weakened economy and because larger businesses have begun to focus on moreefficiently using their existing IT infrastructure rather than making newequipment purchases. This in turn may decrease the demand for our SAN products.If there are further reductions in either domestic or international ITexpenditure, or if IT expenditure does not increase from current levels, ourrevenues, operating results and financial condition may be adversely affected.

 

**Failureto manage expansion effectively could seriously harm our business, financialcondition and prospects.**

 

Our ability tosuccessfully implement our business plan, develop and offer products, andmanage expansion in a rapidly evolving market requires a comprehensive andeffective planning and management process. We continue to increase the scope ofour operations domestically and internationally. Our growth in business andrelationships with customers and other third parties has placed, and willcontinue to place, a significant strain on management systems, resources,intercompany communication and coordination. As we grow, our failure tomaintain and to continue to improve upon our operational, managerial andfinancial controls, reporting systems and procedures, and /or our failure tocontinue to expand, train, and manage our work force worldwide, could seriouslyharm our business and financial results.

 

**If wefail to successfully develop the McDATA brand, our revenue may not grow.**

 

We have operated as aseparate company from EMC only since February 2001. EMC, which currentlyaccounts for a significant portion of our revenue, markets our products underits own brand name. As a result, our name is not widely recognized as a brandin the marketplace. We believe that establishing and maintaining the McDATAbrand is a critical component in maintaining and developing strategic originalequipment manufacturer, reseller and systems integrator relationships, and theimportance of brand recognition will increase as the number of vendors ofcompetitive products increases. Our failure to successfully develop our brandmay prevent us from expanding our business and growing our

 

24

----

 

revenue. Similarly, if weincur excessive expenses in an attempt to promote and maintain the McDATAbrand, our business, financial condition and results of operations could beseriously harmed.

 

**Undetectedsoftware or hardware defects in our products could result in loss of or delayin market acceptance of our products and could increase our costs or reduce ourrevenue.**

 

Our products may containundetected software or hardware errors when first introduced or when newversions are released. Our products are complex, and we have from time to timedetected errors in existing products. In addition, our products are combinedwith products from other vendors. As a result, should problems occur, it mightbe difficult to identify the source of the problem. These errors could resultin a loss of or delay in market acceptance of our products, cause delays indelivering our products or meeting customer demands and would increase ourcosts, reduce our revenue and cause significant customer relations problems.

 

**We aredefendants in several class action lawsuits and we may be subject to furtherlitigation in the future which could seriously harm our business.**

 

Several purportedsecurities class action lawsuits have been filed against us. In particular,McDATA, two current officers and one former officer were named as defendants inpurported securities class-action lawsuits filed in the United States DistrictCourt, Southern District of New York. The first of these lawsuits, filed onJuly 20, 2001, is captioned Gutner v. McDATA Corporation, Credit SuisseFirst Boston, Merrill Lynch, Pierce Fenner & Smith Incorporated, Bear,Stearns & Co., Inc., FleetBoston Robertson Stephens et al.,No. 01 CIV. 6627. Three other similar suits have been filed against us.The complaints are substantially identical to over 300 other complaints filedagainst other companies that went public over the last several years.These lawsuits generally allege, among other things, that the registrationstatements and prospectus filed with the SEC by such companies were materiallyfalse and misleading because they failed to disclose (a) that certainunderwriters had solicited and received excessive and undisclosed commissionsfrom certain investors in exchange for which the underwriters allocated tothose investors material portions of shares in connection with the initialpublic offerings and (b) that certain of the underwriters had entered intoagreements with customers whereby the underwriters agreed to allocate initialpublic offering shares in exchange for which the customers agreed to purchaseadditional company shares in the aftermarket at pre-determined prices. Thecomplaints relating to us allege claims against us, two of our currentofficers, one of our former officers and Credit Suisse First Boston, or CSFB,the lead underwriter for our August 9, 2000 initial public offering, underSections 11 and 15 of the Securities Act of 1933, as amended, or theSecurities Act. Although we believe that all of the lawsuits are without legalmerit and intend to defend them vigorously, we cannot assure you we willprevail.

 

In September 2002,plaintiffs’ counsel in the above-mentioned lawsuits offered to individualdefendants of many of the public companies being sued the opportunity to enterinto a Reservation of Rights and Tolling Agreement that would dismiss withoutprejudice and without costs all claims against such persons if the companyitself had entity coverage insurance. This agreement was signed byMr. John F. McDonnell, our Chairman, Mrs. Dee J. Perry, our formerchief financial officer, and Mr. Thomas O. McGimpsey, our Vice Presidentand General Counsel, and the plaintiffs’ executive committee. Under theReservation of Rights and Tolling Agreement the plaintiffs are required todismiss the claims against such individuals.

 

On February 19,2003, the court in the above-mentioned lawsuits entered a ruling on the pendingmotions to dismiss that dismissed some, but not all, of the plaintiff’s claimsagainst us.

 

We may become subject toadditional class action litigation following a period of volatility in themarket price of our common stock. Securities class action litigation couldresult in substantial costs and divert the attention of management and ourresources and seriously harm our business, financial condition and results ofoperation.

 

**Ourchange of fiscal year may not result in more predictable quarterly earnings.**

 

Historically, ourquarterly operating results have depended on our performance in the later partof each calendar quarter, when a large percentage of our product shipmentstypically occur. This fluctuation has made consistent quarter-to-quarterperformance and revenue forecasting difficult. We have adopted a number ofmeasures to address this issue, including changing our fiscal year end toJanuary 31, rather than December 31. We cannot be certain thatchanging our fiscal year or adopting other measures will result in productshipments occurring more evenly during each quarter, resulting in consistentquarter-to-quarter performance or improving revenue forecasts.

 

25

----

 

Additional factors thataffect us and which could cause our revenue and operating results to vary infuture periods include:

 

•                  thesize, timing, terms and fluctuations of customer orders, particularly largeorders from our significant OEM (e.g. EMC) or reseller customers (e.g. IBM);

 

•                  ourability to attain and maintain market acceptance of our products;

 

•                  seasonalfluctuations in customer buying patterns;

 

•                  thetiming of the introduction or enhancement of products by us, our significantOEM or reseller customers or our competitors (e.g., transition to higher speedand higher port density products);

 

•                  ourability to obtain sufficient supplies of single- or limited-source componentsof our products; and

 

•                  increasedoperating expenses, particularly in connection with our strategies to increasebrand awareness or to invest in research and development.

 

Our uneven sales patternmakes it difficult for our management to predict near-term demand and adjustmanufacturing capacity accordingly. If orders for our products varysubstantially from the predicted demand, our ability to assemble, test and shiporders received in the last weeks and days of each quarter may be limited,which could seriously harm quarterly revenue or earnings. Moreover, anunexpected decline in revenue without a corresponding and timely reduction inexpenses could intensify the impact of these factors on our business, financialcondition and results of operations.

 

**Thesales cycle for our products is long, and we may incur substantialnon-recoverable expenses and devote significant resources to prospects that donot produce revenues in the foreseeable future or at all.**

 

Our OEMs, reseller andsystems integrator customers typically conduct significant evaluation, testing,implementation and acceptance procedures before they begin to market and sellnew solutions that include our products. This evaluation process is lengthy andmay extend up to one year or more. This process is complex and may requiresignificant sales, marketing and management efforts on our part. This processbecomes more complex as we simultaneously qualify our products with multiplecustomers. As a result, we may expend significant resources to develop customerrelationships before we recognize revenue, if any, from these relationships.

 

**We mayengage in future acquisitions that dilute our stockholders and cause us to usecash, incur debt or assume contingent liabilities.**

 

As part of our strategy,from time to time we expect to review opportunities to buy other businesses ortechnologies that would complement our current products, expand the breadth ofour markets or enhance our technical capabilities, or that may otherwise offergrowth opportunities. We may buy businesses, products or technologies in thefuture. In the event of any future purchases, we could:

 

•                  issue stock thatwould dilute our current stockholders’ percentage ownership;

 

•                  use cash, whichmay result in a reduction of our liquidity;

 

•                  incur debt; or

 

26

----

 

•                  assumeliabilities.

 

These purchases alsoinvolve numerous risks, including:

 

•                  problemscombining and integrating the purchased operations, technologies, personnel orproducts;

 

•                  unanticipatedcosts;

 

•                  diversion ofmanagement’s attention from our core business;

 

•                  adverse effectson existing business relationships with suppliers and customers;

 

•                  risks associatedwith entering markets in which we have no or limited prior experience; and

 

•                  potential lossof key employees of acquired organizations.

 

We may not be able tosuccessfully integrate any businesses, products, technologies or personnel thatwe might acquire in the future.

 

**If webecome subject to unfair hiring claims, we could incur substantial costs indefending ourselves.**

 

Companies in our industrywhose employees accept positions with competitors frequently claim that theircompetitors have engaged in unfair hiring practices or that employees havemisappropriated confidential information or trade secrets. Because we oftenseek to hire individuals with relevant experience in our industry, we may besubject to claims of this kind or other claims relating to our employees in thefuture. We could incur substantial costs in defending ourselves or ouremployees against such claims, regardless of their merits. In addition,defending ourselves or our employees from such claims could divert theattention of our management away from our operations.

 

**Ourproducts must comply with governmental regulation.**

 

In addition, in theUnited States, our products comply with various regulations and standardsdefined by the Federal Communications Commission and Underwriters Laboratories.Internationally, products that we develop will be required to comply withstandards established by authorities in various countries. Failure to complywith existing or evolving industry standards or to obtain timely domestic orforeign regulatory approvals or certificates could materially harm our business.

 

**Provisionsin our charter documents, our rights agreement and Delaware law could preventor delay a change in control of McDATA and may reduce the market price of ourcommon stock.**

 

Provisions of ourcertificate of incorporation, by-laws and rights agreement may discourage,delay or prevent a merger, acquisition or other business combination that astockholder may consider favorable. These provisions include:

 

•                  authorizing theissuance of preferred stock without stockholder approval;

 

•                  providing for aclassified board of directors with staggered three year terms;

 

•                  limiting thepersons who may call special meetings of stockholders;

 

•                  requiringsuper-majority voting for stockholder action by written consent;

 

•                  establishingadvance notice requirements for nominations for election to the board ofdirectors and for proposing other matters that can be acted on by stockholdersat stockholder meetings;

 

•                  prohibitingcumulative voting for the election of directors;

 

•                  requiringsuper-majority voting to effect certain amendments to our certificate ofincorporation and by-laws; and

 

•                  requiringparties to request board approval prior to acquiring 15% or more of the votingpower of our common stock to avoid economic and voting dilution of their stockholdings.

 

We are incorporated inDelaware and certain provisions of Delaware law may also discourage, delay orprevent someone from acquiring or merging with us, which may cause the marketprice of our common stock to decline.

 

27

----

 

**Ourstock price is volatile.**

 

Since the distribution ofour Class A common stock by EMC in February 2001, the market price of our ClassA common stock has been volatile. Because we are a technology company, the market price of our Class Acommon stock is usually subject to the same volatility and fluctuations thathave recently characterized the stock prices of other technology companies.This volatility is often unrelated or disproportionate to the operatingperformance of these companies and, as a result, the price of our Class Acommon stock could fall regardless of our performance.

 

***Risks Related to Our Relationship With EMC***

 

**We haveentered into agreements with EMC that, due to our prior parent-subsidiaryrelationship, may contain terms less beneficial to us than if they had beennegotiated with unaffiliated third parties.**

 

In October 1997, inconnection with the reorganization of our business, we entered into certainagreements with EMC relating to our business relationship with EMC. Inaddition, we have entered into agreements with EMC relating to our relationshipwith EMC after the completion of our initial public offering inAugust 2000 and the distribution by EMC of our Class A common stockin February 2001. We have also entered into an OEM Purchase and LicenseAgreement with EMC that governs EMC’s purchases of our products and grants EMCrights to use, support and distribute software for use in connection with theseproducts. The agreement does not provide for the purchase of a guaranteedminimum amount of product. These agreements were negotiated and made in thecontext of our prior parent-subsidiary relationship. As a result, some of theseagreements may have terms and conditions, in the case of the OEM agreement,including the terms of pricing, that are less beneficial to us than agreementsnegotiated with unaffiliated third parties. Sales and services revenue pursuantto these agreements represented approximately 61% of our revenue for the threemonths ended April 30, 2003. In addition, in some instances, our ability toterminate these agreements is limited, which may prevent us from being able tonegotiate more favorable terms with EMC or from entering into similaragreements with third parties.

 

**Provisionsof our agreements with EMC relating to our relationship with EMC after thedistribution by EMC of our Class A common stock to EMC’s stockholders mayaffect the operation of our business, limit our ability to finance ouroperations or prevent a change in control of our company.**

 

Under the terms of theTax Sharing Agreement between EMC and us, until May 2003, we may not,without the consent of EMC or the receipt by EMC of a private letter rulingfrom the Internal Revenue Service that the tax treatment of the distributionwill not be adversely affected:

 

•                  enterinto any transaction that would result in any one or more persons acquiring a50% or greater interest in us;

 

•                  takeor fail to take any other action, if the result of such act or failure to act,would cause the distribution to be taxable to EMC stockholders;

 

•                  issuestock or other equity interests in us, or redeem or repurchase any of ourcapital stock which would involve the acquisition by one or more persons ofmore than 35% of our stock; or

 

•                  undertakeany transaction which would be treated as a liquidation or reorganization fortax purposes.

 

These restrictions mayprevent us from being acquired, either in a negotiated transaction orotherwise, from using shares of our common stock as payment in the acquisitionby us of other companies or from financing our operations through sales ofsecurities.

 

Under the terms of theMaster Confidential Disclosure and License Agreement between EMC and us, EMChas granted us a license under then existing EMC patents. If we are acquired,our acquirer will retain this license as long as our acquirer grants to EMC alicense under all of the acquirer’s patents for all products licensed under theagreement under the same terms as the license we have granted to EMC under theagreement. The potential loss of the license from EMC under this agreementcould decrease our attractiveness as an acquisition target.

 

28

----

 

**We maybe obligated to indemnify EMC if the distribution of our Series A common stockto EMC’s stockholders was not tax free.**

 

The Tax Sharing Agreementthat we have entered into with EMC obligates us to indemnify EMC for taxesrelating to the failure of EMC’s distribution to EMC’s stockholders of ourClass A common stock that it indirectly held to be tax free if thatfailure results from, among other things:

 

•                  anyact or omission by us that would cause the distribution to fail to qualify as atax-free distribution under the Internal Revenue Code;

 

•                  anyact or omission by us that is inconsistent with any representation made to theInternal Revenue Service in connection with the request for a private letterruling regarding the tax-free nature of the distribution by EMC of ourClass A common stock indirectly held by it to its stockholders;

 

•                  anyacquisition by a third party of our stock or assets; or

 

•                  anyissuance by us of stock or any change in ownership of our stock.

 

As a result, we may beliable to EMC under the Tax Sharing Agreement upon the occurrence of eventsthat are beyond our control. If the distribution of our Class A commonstock fails to qualify as a tax-free distribution, EMC would incur taxliability as if our Class A common stock that was distributed by EMC hadbeen sold by EMC for its fair market value in a taxable transaction, and wewould be required to indemnify EMC under the Tax Sharing Agreement. In theevent that we are required to indemnify EMC because the distribution of ourClass A common stock fails to qualify as a tax-free distribution, ourliability could exceed 35% of the value of the Class A common stockdistributed by EMC as determined on the date of the distribution. If triggered,this indemnity obligation would have a significant adverse effect on ourfinancial position and results of operations, and we might not have sufficientresources to fulfill it.

 

**ITEM 3.  Quantitative and Qualitative Disclosures about Market Risks**

 

We are exposed to marketrisk, primarily from changes in interest rates, foreign currency exchange ratesand credit risks.

 

*Interest Rate Risk*

 

We earn interest incomeon both our cash and cash equivalents and our investment portfolio. Ourinvestment portfolio consists of readily marketable investment-grade debtsecurities of various issuers and maturities ranging from overnight to twoyears. All investments are denominated in U.S. dollars and are classified as“available for sale.” These instruments are not leveraged, and are not held fortrading purposes. As interest rates change, the amount of realized andunrealized gain or loss on these securities will change.  The quantitative and qualitative disclosuresabout market risk are discussed in Item 7 – Quantitative and QualitativeDisclosure About Market Risk, contained in our Form 10-K.

 

Our convertiblesubordinated debt is subject to a fixed interest rate and the Notes are basedon a fixed conversion ratio into Class A common stock.  Therefore, we are not exposed to changes ininterest rates related to our long-term debt instruments.  The Notes are not listed on any securitiesexchange or included in any automated quotation system; however, the notes areeligible for trading on the PortalSM Market. On May 29, 2003, the approximate bid price of our Notes was $138 and theapproximate ask price of our Notes was $138.50, resulting in an aggregate fairvalue of between $238 million and $238.9 million.  Our Class A common stock is quoted on the Nasdaq National Marketunder the symbol, “MCDTA.”  On June 4,2003, the last reported sale price of our Class A common stock on the NasdaqNational Market was $13.61 per share.

 

*Foreign Currency Exchange Risk*

 

We operate sales andsupport offices in several countries. All of our sales contracts have beendenominated in U.S. dollars, therefore our transactions in foreign currenciesare limited to operating expense transactions. Due to the limited nature andamount of these transactions, we do not believe we have had or will havematerial exposure to foreign currency exchange risk.

 

29

----

 

*Credit Risk*

 

Financial instruments,which potentially subject us to concentrations of credit risk, consistprincipally of temporary cash investments, investments and trade receivables.We place our temporary cash investments and investment securities in primarilyinvestment grade instruments and limit the amount of investment with any onefinancial institution. We evaluate the credit risk associated with each of ourcustomers but generally do not require collateral.  We depend on two customers for most of our total revenue who comprisea significant portion of our trade receivables and, therefore, expose us to aconcentration of credit risk.

 

In conjunction with theissuance of our convertible subordinated notes, we also entered into shareoption transactions on our Class A common stock with Bank of America, N.A.and /or certain of its affiliates. Subject to the movement in our Class Acommon stock price, we could be exposed to credit risk arising out of netsettlement of these options in our favor. Based on our review of the possiblenet settlements and the credit strength of Bank of America, N.A. and itsaffiliates, we have concluded that we do not have a material exposure to creditrisk as a result of these share option transactions.

 

**ITEM 4.****Controlsand Procedures**

 

Within 90 days priorto the date of this report, we carried out an evaluation, under the supervisionand with the participation of our principal executive officer and principalfinancial officer, of the effectiveness of the design and operation of ourdisclosure controls and procedures. Based on this evaluation, our principalexecutive officer and principal financial officer concluded that our disclosurecontrols and procedures are effective in timely alerting them to materialinformation required to be included in our periodic SEC reports. It should benoted that the design of any system of controls is based in part upon certainassumptions, and there can be no assurance that any design will succeed inachieving its stated goals.

 

In addition, we reviewedour internal controls, and there have been no significant changes in ourinternal controls or in other factors that could significantly affect thosecontrols subsequent to the date of their last evaluation.

 

**PARTII – OTHER INFORMATION**

 

**ITEM1. Legal Proceedings**

 

From time to time, webecome involved in various lawsuits and legal proceedings that arise in thenormal course of business. Litigation is subject to inherent uncertainties andan adverse result in a matter that may arise from time to time may harm ourbusiness, financial condition or results of operations. In the opinion ofmanagement and except as set forth below, the ultimate disposition of any ofthe claims described below will not have a material adverse effect on ourconsolidated results of operations, financial position or cash flow.  Please see Note 9 of the CondensedConsolidated Financial Statements for a description of litigation matters.

 

30

----

 

**ITEM2.   Changes in Securities and Use ofProceeds**

 

In February 2003, weissued $172.5 million of 2.25% Convertible Subordinated Notes due 2010 (theNotes).  The Notes were issued to Bankof America Securities LLC and Solomon Smith Barney Inc., in transactions exemptfrom the Securities Act of 1933, as amended (the Securities Act) andsubsequently resold to Qualified Institutional Buyers in reliance on Rule 144Aand Regulation S of the Securities Act of 1933, as amended.  We capitalized the initial transaction feesassociated with the Notes, which totaled approximately $5.5 million, and thenet proceeds to the Company were approximately $167 million.  The net proceeds shall be used for generalcorporate purposes.

 

The Notes are subordinatein right of payment to all existing and future senior indebtedness.  The holders of the Notes may convert all orsome of their Notes to Class A common stock at any time at a conversion price of $10.71 per share.  The initial conversion rate is 93.3986common shares per $1,000 principal amount of the Notes and is subject to adjustmentunder certain circumstances.  Upon aconversion, the Company may choose to deliver, in lieu of shares of its Class Acommon stock, cash or a combination of cash and shares of Class A common stock.  Holders of the Notes have the right torequire the Company to repurchase their Notes at par upon the occurrence ofcertain fundamental changes.

 

The Company has filed aregistration statement with respect to the Notes and the Class A common stockissuable upon conversion of the Notes.

 

**ITEM3.   Defaults Upon Senior Securities**

 

None

 

**ITEM 4.   Submission of Matters to A Vote of Security Holders**

 

None

 

**ITEM5.  Other Information**

 

In May 2003, we enteredinto a replacement office sub-lease agreement for our software developmentfacility located in San Jose, California. We plan to vacate our current location at 2030 Fortune Drive, San Jose,California by mid-Summer and relocate to a 23,542 square foot office and labspace at 4555 Great American Parkway, Santa Clara, California.  The term of the lease is 7 years and thebase monthly lease rate per square foot ranges from $0.80 to $1.70 over theterm. We are also required to pay for the costs of operating the space inaccordance with a fixed schedule of operating expense cost reimbursements.

 

**ITEM6. Exhibits and Reports on Form 8-K**

 

*(a)**            Exhibitsfiled for the Company through the filing of this Form 10-Q.*

* *
| (3.1)   |   | Amended and Restated  Certificate of Incorporation of the Company                                                                                                        |
|---------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |   |                                                                                                                                                                     |
| (3.2)   |   | Amended and Restated  By-laws of the Company                                                                                                                             |
|    |   |                                                                                                                                                                     |
| (4.1)   |   | Form of Company’s  Class B Common Stock Certificates                                                                                                      |
|    |   |                                                                                                                                                                     |
| (4.1.1) |   | Form of Company’s  Class A Common Stock Certificates                                                                                                      |
|    |   |                                                                                                                                                                     |
| (4.2)   |   | Investors’ Rights  Agreement dated as of October 1, 1997 by and among the Company, EMC  Corporation, McDATA Holdings Corporation and Certain Investors         |
|    |   |                                                                                                                                                                     |
| (4.3)   |   | Amendment No. 1 to  the Investors’ Rights Agreement dated May 23, 2000 by and among the  Company, McDATA Holdings Corporation and certain Investors       |
|    |   |                                                                                                                                                                     |
| (4.4)   |   | Rights Agreement dated  as of May 18, 2001, by and between the Company and the Bank of New York,  as rights agent (Filed on Form 8-K dated May 21, 2001). |

 

31

----

 
| (4.5)      |   | Form of Indenture  dated as of February 7, 2003 by and between the Company and Wells Fargo  Bank Minnesota, National Association (Filed on Form 8-K dated  February 14, 2003)                           |
|------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                        |
| (4.6)      |   | Form of  Registration Rights Agreement dated as of February 7, 2003 by and among  the Company and the parties thereto (Filed on Form 8-K dated February  14, 2003)                                           |
|       |   |                                                                                                                                                                                                                        |
| (10.1)     |   | Asset Transfer  Agreement dated as of October 1, 1997 by and among the Company, EMC  Corporation, and McDATA Holdings Corporation                                                                                      |
|       |   |                                                                                                                                                                                                                        |
| (10.2)     |   | Investors’ Rights  Agreement dated as of October 1, 1997 by and among the Company, EMC  Corporation, McDATA Holdings Corporation and certain Investors (see  Exhibit 4.2)                                    |
|       |   |                                                                                                                                                                                                                        |
| (10.3)     |   | Amendment No. 1 to  the Investors’ Rights Agreement dated May 23, 2000 by and among the  Company, McDATA Holdings Corporation and certain Investors (see  Exhibit 4.3)                                  |
|       |   |                                                                                                                                                                                                                        |
| (10.3.1)   |   | Termination of  Investors’ Rights Agreement, dated as of January 24, 2001, by and among  the Company, McDATA Holdings Corporation and Certain Investors (Filed on  Form 10-K for the fiscal year ended 2000) |
|       |   |                                                                                                                                                                                                                        |
| (10.4)     |   | Services Agreement  dated as of October 1, 1997 by and among EMC Corporation, McDATA  Holdings Corporation and the Company                                                                                             |
|       |   |                                                                                                                                                                                                                        |
| (10.5)     |   | Letter Agreement dated  April 19, 1999 by and between the Company and McDATA Holdings  Corporation                                                                                                                     |
|       |   |                                                                                                                                                                                                                        |
| (10.6)     |   | Technology Rights  Agreement dated as of October 1, 1997 by and among the Company, EMC  Corporation and McDATA Holdings Corporation                                                                                    |
|       |   |                                                                                                                                                                                                                        |
| (10.7)     |   | Amended and Restated  Tax Sharing Agreement dated as of May 31, 2000 by and among EMC  Corporation, McDATA Holdings Corporation and the Company                                                                        |
|       |   |                                                                                                                                                                                                                        |
| (10.8)     |   | Form of Master  Transaction Agreement entered into by and among the Company and EMC  Corporation dated May 31, 2000                                                                                               |
|       |   |                                                                                                                                                                                                                        |
| (10.9)     |   | Form of  Indemnification and Insurance Matters Agreement entered into by and among the  Company and EMC Corporation dated May 31, 2000                                                                            |
|       |   |                                                                                                                                                                                                                        |
| (10.10)    |   | Master Confidential  Disclosure and License Agreement dated as of May 31, 2000 by and among  the Company and EMC Corporation                                                                                           |
|       |   |                                                                                                                                                                                                                        |
| (10.11)+   |   | Reseller Agreement  dated as of February 22, 2000 by and between International Business  Machines Corporation and the Company                                                                                          |
|       |   |                                                                                                                                                                                                                        |
| (10.12)    |   | Amendment Number One to  the Resale Agreement dated September 30, 2000 by and between  International Business Machines Corporation and the Company                                                                     |
|       |   |                                                                                                                                                                                                                        |
| (10.13)+   |   | OEM Purchase and  License Agreement dated as of May 19, 2000 by and between EMC  Corporation and the Company                                                                                                           |
|       |   |                                                                                                                                                                                                                        |
| 10.13.1+   |   | Amendment to OEM  Purchase and License Agreement dated as of September 21, 2001, by and  between EMC Corporation and the Company                                                                                       |
|       |   |                                                                                                                                                                                                                        |
| (10.14)+   |   | Development Agreement  dated as of May 19, 2000 by and between EMC Corporation and the Company                                                                                                                         |
|       |   |                                                                                                                                                                                                                        |
| (10.15)+   |   | Manufacturing Agreement  dated as of September 17, 1992 by and between SCI Systems, Inc. and  the Company                                                                                                         |
|       |   |                                                                                                                                                                                                                        |
| (10.15.1)+ |   | Manufacturing and  Purchasing Agreement dated as of December 14, 2001 by and between SCI  Systems, Inc. and the Company (Filed on Form 8-K dated  February 25, 2002)                                    |
|       |   |                                                                                                                                                                                                                        |
| (10.15.2)+ |   | Manufacturing and  Purchase Agreement effective as of March 1, 2003 by and between  Sanmina-SCI Corporation and the Company (Filed on Form 10-K for the year  ended December 31, 2002)                                 |
|       |   |                                                                                                                                                                                                                        |
| (10.16)+   |   | OEM and License  Agreement dated as of April 27, 1999 by and between Brocade  Communication                                                                                                                            |

 

32

----

 
|       |   | Systems, Inc. and  the Company                                                                                                                                                                                           |
|------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                          |
| (10.17)    |   | Lease dated  September 12, 1997 by and between the Company and WHLNF Real Estate  Limited Partnership                                                                                                                    |
|       |   |                                                                                                                                                                                                                          |
| (10.18)    |   | Lease dated  November 2, 1999 by and between the Company and the Mills Family LLC                                                                                                                                        |
|       |   |                                                                                                                                                                                                                          |
| (10.19)    |   | Lease dated  May 28, 1997 by and between the Company and 1211486 Ontario Limited                                                                                                                                         |
|       |   |                                                                                                                                                                                                                          |
| (10.19.1)  |   | Lease dated  October 6, 2000, by and between the Company and Amber Drive I, LLC  (Filed on Form 10-Q for the fiscal quarter ended September 30,  2000)                                                         |
|       |   |                                                                                                                                                                                                                          |
| (10.19.2)  |   | Lease dated  February 9, 2001 by and between the Company and Deutsche Bank (Filed on  Form 10-K for the fiscal year ended 2000)                                                                                     |
|       |   |                                                                                                                                                                                                                          |
| (10.19.3)  |   | Participation Agreement  dated February 9, 2001 by and between the Company and Deutsche Bank  (Filed on Form 10-K for the fiscal year ended 2000)                                                                   |
|       |   |                                                                                                                                                                                                                          |
| (10.19.4)  |   | Second Amendment to  Participation Agreement dated November 9, 2001 by and between the  Company and Deutsche Bank (Filed on Form 10-Q for the fiscal quarter  ended September 30, 2001)                        |
|       |   |                                                                                                                                                                                                                          |
| (10.19.5)  |   | Third Amendment to  Participation Agreement dated January 24, 2002 by and between the  Company and Deutsche Bank (Filed on Form 8-K dated February 25, 2002)                                                        |
|       |   |                                                                                                                                                                                                                          |
| (10.20)*   |   | Form of Severance  Agreement                                                                                                                                                                                             |
|       |   |                                                                                                                                                                                                                          |
| (10.21)*   |   | 1997 Stock Option Plan                                                                                                                                                                                                        |
|       |   |                                                                                                                                                                                                                          |
| (10.21.1)* |   | 2001 McDATA Equity  Incentive Plan (Filed on Form 10-Q for the fiscal quarter ended  September 30, 2001)                                                                                                            |
|       |   |                                                                                                                                                                                                                          |
| (10.21.2)* |   | Employee Stock Purchase  Plan (Filed on Schedule 14A Proxy Statement filed June 10, 2002)                                                                                                                                |
|       |   |                                                                                                                                                                                                                          |
| (10.22)*   |   | Form of Stock  Option Agreement for 1997 Stock Option Plan                                                                                                                                                               |
|       |   |                                                                                                                                                                                                                          |
| (10.23)*   |   | Description of the  Company’s Management Bonus Program                                                                                                                                                                   |
|       |   |                                                                                                                                                                                                                          |
| (10.24)    |   | Asset Purchase Agreement  dated August 3, 2001 by and among the Company, SANavigator, Inc.,  Western Digital Corporation and Connex Inc. (Filed on Form 10-Q for the  fiscal quarter ended September 30, 2001) |
|       |   |                                                                                                                                                                                                                          |
| (10.25)*   |   | Performance Incentive  Bonus Plan (Filed on Form 10-K for the year ended December 31, 2002)                                                                                                                                   |
|       |   |                                                                                                                                                                                                                          |
| (10.26)*   |   | Executive Performance  Incentive Bonus Plan (Filed on Form 10-K for the year ended December 31,  2002)                                                                                                                        |
|       |   |                                                                                                                                                                                                                          |
| (10.27)*   |   | Chairman of the Board  of Directors Performance Incentive Bonus Plan (Filed on Form 10-K for the  year ended December 31, 2002)                                                                                               |
|       |   |                                                                                                                                                                                                                          |
| 99.1       |   | Certification of the  Chief Executive Officer of McDATA Corporation pursuant to Section 906 of The  Sarbanes-Oxley Act Of 2002.                                                                                               |
|       |   |                                                                                                                                                                                                                          |
| 99.2       |   | Certification of the  Chief Financial Officer of McDATA Corporation pursuant to Section 906 of The  Sarbanes-Oxley Act Of 2002.                                                                                               |

 

----

( ) Exhibits previouslyfiled in the Company’s Registration Statement on Form S-1, SEC File No.333-38106, declared effective on August 8, 2000 or filed in the Company’speriodic filings as specifically noted.

+  Portions of these Exhibits have been omittedand filed separately with the Securities and Exchange Commission pursuant to anorder for confidential treatment.

*  Executive compensation plans andarrangements.

 

*(b)**            Reportson Form 8-K*

 

The Company filed thefollowing reports on Form 8-K through the filing of this Form 10-Q.Information regarding the items reported on is as follows:

 

33

----

 
| **Date**          |   | **Item Reported On**                                                                                                                                                      |
|-------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|              |   |                                                                                                                                                                      |
| February 3, 2003  |   | Item 5.  We filed a press  release announcing the private offering of convertible subordinated notes.                                                                |
|              |   |                                                                                                                                                                      |
| February 7, 2003  |   | Items 5 and 7.  We filed a  press release to announce the sale $172,500,000 of 2.25% Convertible  Subordinated Notes due 2010.                                       |
|              |   |                                                                                                                                                                      |
| February 27, 2003 |   | Items 5 and 7.  We announced  Michael J. Sophie as a director of the Company effective March 1, 2003.                                                                |
|              |   |                                                                                                                                                                      |
| March 3, 2003     |   | Item 5.  We disclosed the  filings of 10b5-1 Stock Selling Plans for John F. McDonnell, McDATA’s  Chairman and Patricia McDonnell, Mr. McDonnell’s spouse. |
|              |   |                                                                                                                                                                      |
| March 4, 2003     |   | Item 5.  We announced a  Product Purchase Agreement signed between the Company and Sun Microsystems,  Inc..                                                          |
|              |   |                                                                                                                                                                      |
| March 27, 2003    |   | Items 7 and 9.  The Company announced that it had  submitted to the SEC the Statements under Oath of Principal Executive Officer  and Principal Financial Officer.   |

 

SIGNATURE

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|         | McDATA CORPORATION                                            |
|--------------|---------------------------------------------------------------|
|         |                                                          |
|         |                                                          |
|         | By:                                                           | /s/ ERNEST J. SAMPIAS |   |
|         | Ernest J. Sampias                                             |
|         | Senior Vice President  of Finance and Chief Financial Officer |
| June 9, 2003 |                                                          |

 

34

----

 

**CERTIFICATIONS**

 

I, John A. Kelley, Jr.,certify that:

 

1.                                       Ihave reviewed this quarterly report on From 10-Q of McDATA Corporation;

 

2.                                       Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.                                       Theregistrant’s other certifying officer and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

a.                                       designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including it consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

b.                                      evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report(the “Evaluation Date”); and

 

c.                                       presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.                                       Theregistrant’s other certifying officer and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a.                                       allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal audit controls; and

 

b.                                      anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officer and I have indicated in this quarterlyreport whether there were any significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 
| Dated: June 9, 2003 | /s/ JOHN A. KELLEY, JR.                |   |
|---------------------|----------------------------------------|--------|
|                | John A. Kelley, Jr.                    |
|                | President and Chief  Executive Officer |

 

A signed original of thiswritten statement required by Section 906 has been provided to McDATACorporation and will be retained by McDATA Corporation and furnished to theSecurities and Exchange Commission or its staff upon request.

 

35

----

 

I, Ernest J. Sampias,certify that:

 

1.                                       Ihave reviewed this quarterly report on From 10-Q of McDATA Corporation;

 

2.                                       Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.                                       Theregistrant’s other certifying officer and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

a.                                       designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including it consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

b.                                      evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report(the “Evaluation Date”); and

 

c.                                       presentedin this quarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.                                       Theregistrant’s other certifying officer and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a.                                       allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal audit controls; and

 

b.                                      anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officer and I have indicated in this quarterlyreport whether there were any significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 
| Dated: June 9,  2003 | /s/ ERNEST J. SAMPIAS                                         |   |
|---------------------------|---------------------------------------------------------------|--------|
|                      | Ernest J. Sampias                                             |
|                      | Senior Vice President  of Finance and Chief Financial Officer |

 

A signed original of thiswritten statement required by Section 906 has been provided to McDATACorporation and will be retained by McDATA Corporation and furnished to theSecurities and Exchange Commission or its staff upon request.

 

36

----