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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q/A

(Amendment No. 1)



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(Mark One)

|x | Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ---------------------------------------------------------------------------------------



For the quarterly period ended April 30, 2004



OR



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



For the transition period from to



Commission File Number 000-31257



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McDATA CORPORATION

(Exact name of registrant as specified in its charter)



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



380 Interlocken
Crescent, Broomfield, Colorado 80021

(Address of principal executive offices)(zip code)



(720) 558-8000

(Registrants telephone number, including area code)





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



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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No ̈



Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange
Act).    Yes  x    No ̈



At June 1, 2004, 81,000,000 shares of the registrants Class A Common Stock were
outstanding and 37,739,663 shares of the registrants Class B Common Stock were outstanding.



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EXPLANATORY NOTE



This Amendment No. 1 to the
Registrants Form 10-Q filed with the Securities and Exchange Commission (SEC) on June 7, 2004 reflects revised and additional disclosures in response to comments received from the SEC on June 23, 2004. This Amendment No. 1 provides
revised and additional disclosures under the following captions:



Part I, Item 1. Parenthetical disclosure to the Condensed Consolidated Income Statements



Part I, Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations  Overview,
Revenues and Gross Profit



Part I,
Item 4. Controls and Procedures.



Part II, Item 6. Exhibits
and Reports on Form 8-K  changes to the certifications.



The revised and
additional disclosures do not affect the reported financial results.



McDATA CORPORATION



FORM 10-Q/A

QUARTER ENDED APRIL 30, 2004

TABLE OF CONTENTS



|     |  |                                                                                       |  |     
|---- |  | ------------------------------------------------------------------------------------- |  | ----
|Item |  |                                                                                       |  | Page
|     |  |                                                                                      
|     |  | PART 1  FINANCIAL INFORMATION                                                        |  |     
|     |  |                                                                                      
|1.   |  | Financial Statements                                                                  |  |     
|     |  |                                                                                      
|     |  | Condensed Consolidated Balance Sheets                                                 |  | 1   
|     |  |                                                                                      
|     |  | Condensed Consolidated Income Statements                                              |  | 2   
|     |  |                                                                                      
|     |  | Condensed Consolidated Statements of Cash Flows                                       |  | 3   
|     |  |                                                                                      
|     |  | Notes to Condensed Consolidated Financial Statements                                  |  | 4   
|     |  |                                                                                      
|2.   |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 10  
|     |  |                                                                                      
|4.   |  | Controls and Procedures                                                               |  | 23  
|     |  |                                                                                      
|     |  | PART II  OTHER INFORMATION                                                           |  |     
|     |  |                                                                                      
|6.   |  | Exhibits and Reports on Form 8-K                                                      |  |     



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Special Note Regarding Forward-Looking Statements



Some of the information presented in this Quarterly Report on Form 10-Q contains forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995 (the Reform Act). Although McDATA Corporation (McDATA or the Company, which may also be referred to as we, us or
our) believes that its expectations are based on reasonable assumptions within the bounds of its knowledge of its businesses and operations; there can be no assurance that actual results will not differ materially from our expectations.
Factors that could cause actual results to differ materially from expectations include:



| |  | changes in our relationship with EMC Corporation, or EMC, International Business Machines Corporation, or IBM, and Hitachi Data Systems, or HDS, and the level of their orders;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our ability to successfully increase sales of McDATAs multi-protocol network switches and management software, including SANavigator®;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------



| |  | competition in the multi-protocol (Fibre Channel and IP) network market, including competitive pricing pressures and product give-aways, by our competitors such as Brocade
Communication Systems, Inc., or Brocade, QLogic Corp., or QLogic, Computer Network Technology Corporation, or CNT, Cisco Systems, Inc., or Cisco, and other IP and multi-protocol switch and software suppliers;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | additional manufacturing and component costs and production delays that we may experience as we continue the transition to new products;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------



| |  | a loss of any of our key customers (and our OEMs key customers), distributors, resellers, suppliers or our manufacturers;
| | - | --------------------------------------------------------------------------------------------------------------------------



| |  | our ability to expand our product offerings and any transition to new products (including higher port density, multi-protocol and intelligent network products);
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | any change in business conditions, our business and sales strategy or product development plans, and our ability to attract and retain highly skilled individuals;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | any industry or technology changes that cause obsolescence of our products or components of those products;
| | - | -----------------------------------------------------------------------------------------------------------



| |  | one-time events and other important risks and factors disclosed previously and from time to time in our filings with the U.S. Securities and Exchange Commission, or SEC, including
the risk factors discussed in this Quarterly Report; and
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the impact of any acquisitions by us of businesses, products, or technologies, including difficulties in integrating any acquisitions.
| | - | --------------------------------------------------------------------------------------------------------------------------------------



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



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##### Table of Contents

PART I  FINANCIAL INFORMATION



McDATA CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)



|                                                                                                                                                                                    |  |               |         |   |                 |   |         |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------- | - | --------------- | - | ------- | -
|                                                                                                                                                                                    |  | April 30,2004 |         |   | January 31,2004 |  
|                                                                                                                                                                                    |  | (unaudited)   |         |   |                 |  
|Assets                                                                                                                                                                              |  |               |         |   |                 |   |         |  
|Current assets:                                                                                                                                                                     |  |               |         |   |                 |   |         |  
|Cash and cash equivalents                                                                                                                                                           |  | $             | 50,604  |   |                 | $ | 50,301  |  
|Securities lending collateral                                                                                                                                                       |  |               | 117,931 |   |                 |   | 126,681 |  
|Short-term investments                                                                                                                                                              |  |               | 160,581 |   |                 |   | 157,740 |  
|Accounts receivable, net of allowance for bad debts of $839 and $926, respectively                                                                                                  |  |               | 58,224  |   |                 |   | 62,670  |  
|Inventories, net                                                                                                                                                                    |  |               | 14,085  |   |                 |   | 11,364  |  
|Prepaid expenses and other current assets                                                                                                                                           |  |               | 6,272   |   |                 |   | 6,055   |  
|                                                                                                                                                                                    |  |               |         |   |                 |   |         |  
|Total current assets                                                                                                                                                                |  |               | 407,697 |   |                 |   | 414,811 |  
|                                                                                                                                                                                    |  |              
|Property and equipment, net                                                                                                                                                         |  |               | 97,229  |   |                 |   | 99,225  |  
|Long-term investments                                                                                                                                                               |  |               | 101,872 |   |                 |   | 103,483 |  
|Restricted cash                                                                                                                                                                     |  |               | 5,168   |   |                 |   | 5,130   |  
|Intangible assets, net                                                                                                                                                              |  |               | 105,603 |   |                 |   | 111,313 |  
|Goodwill                                                                                                                                                                            |  |               | 78,693  |   |                 |   | 78,787  |  
|Other assets, net                                                                                                                                                                   |  |               | 18,520  |   |                 |   | 18,219  |  
|                                                                                                                                                                                    |  |               |         |   |                 |   |         |  
|Total assets                                                                                                                                                                        |  | $             | 814,782 |   |                 | $ | 830,968 |  
|                                                                                                                                                                                    |  |               |         |   |                 |   |         |  
|Liabilities and Stockholders Equity                                                                                                                                                |  |               |         |   |                 |   |         |  
|Current liabilities:                                                                                                                                                                |  |               |         |   |                 |   |         |  
|Accounts payable                                                                                                                                                                    |  | $             | 17,214  |   |                 | $ | 16,532  |  
|Accrued liabilities                                                                                                                                                                 |  |               | 49,860  |   |                 |   | 53,330  |  
|Securities lending collateral payable                                                                                                                                               |  |               | 117,931 |   |                 |   | 126,681 |  
|Current portion of deferred revenue                                                                                                                                                 |  |               | 20,469  |   |                 |   | 19,775  |  
|Current portion of obligations under notes payable and capital leases                                                                                                               |  |               | 2,349   |   |                 |   | 2,785   |  
|                                                                                                                                                                                    |  |               |         |   |                 |   |         |  
|Total current liabilities                                                                                                                                                           |  |               | 207,823 |   |                 |   | 219,103 |  
|                                                                                                                                                                                    |  |              
|Obligations under notes payable and capital leases, less current portion                                                                                                            |  |               | 691     |   |                 |   | 1,091   |  
|Deferred revenue, less current portion                                                                                                                                              |  |               | 21,630  |   |                 |   | 20,632  |  
|Interest rate swap                                                                                                                                                                  |  |               | 3,889   |   |                 |   | 349     |  
|Convertible subordinated debt                                                                                                                                                       |  |               | 168,611 |   |                 |   | 172,151 |  
|                                                                                                                                                                                    |  |               |         |   |                 |   |         |  
|Total liabilities                                                                                                                                                                   |  |               | 402,644 |   |                 |   | 413,326 |  
|                                                                                                                                                                                    |  |               |         |   |                 |   |         |  
|Commitments and contingencies(Note 12)                                                                                                                                              |  |               |         |   |                 |   |         |  
|                                                                                                                                                                                    |  |              
|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     |  
|Common stock, Class B, $0.01 par value, 200,000,000 shares authorized, 36,593,226 and 36,051,473 shares issued and outstanding at April 30,
2004 and January 31, 2004, respectively |  |               | 366     |   |                 |   | 361     |  
|Additional paid-in-capital                                                                                                                                                          |  |               | 479,038 |   |                 |   | 476,993 |  
|Treasury stock, at cost, 975,730 shares at April 30, 2004 and January 31, 2004                                                                                                      |  |               | (8,752  | ) |                 |   | (8,752  | )
|Deferred compensation                                                                                                                                                               |  |               | (7,441  | ) |                 |   | (10,375 | )
|Accumulated other comprehensive income (loss)                                                                                                                                       |  |               | (241    | ) |                 |   | 403     |  
|Accumulated deficit                                                                                                                                                                 |  |               | (51,642 | ) |                 |   | (41,798 | )
|                                                                                                                                                                                    |  |               |         |   |                 |   |         |  
|Total stockholders equity                                                                                                                                                          |  |               | 412,138 |   |                 |   | 417,642 |  
|                                                                                                                                                                                    |  |               |         |   |                 |   |         |  
|Total liabilities and stockholders equity                                                                                                                                          |  | $             | 814,782 |   |                 | $ | 830,968 |  
|                                                                                                                                                                                    |  |               |         |   |                 |   |         |  



The accompanying notes
are an integral part of these condensed consolidated financial statements.



1



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##### Table of Contents

McDATA CORPORATION

CONDENSED CONSOLIDATED INCOME STATEMENTS

(in thousands, except per share data)

(unaudited)



|                                                                                                                                                             |  |                              |         |   |      |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ---------------------------- | ------- | - | ---- | - | ------- | -
|                                                                                                                                                             |  | Three Months Ended April 30, |        
|                                                                                                                                                             |  | 2004                         |         |   | 2003 |  
|Revenue                                                                                                                                                      |  | $                            | 97,229  |   |      | $ | 103,179 |  
|Cost of revenue                                                                                                                                              |  |                              | 42,487  |   |      |   | 44,588  |  
|                                                                                                                                                             |  |                              |         |   |      |   |         |  
|Gross profit                                                                                                                                                 |  |                              | 54,742  |   |      |   | 58,591  |  
|                                                                                                                                                             |  |                             
|Operating expenses:                                                                                                                                          |  |                              |         |   |      |   |         |  
|Research and development (excludes amortization of deferred compensation included in Amortization of deferred compensation of $1,490 and $368,
respectively) |  |                              | 25,097  |   |      |   | 18,819  |  
|Selling and marketing (excludes amortization of deferred compensation included in Amortization of deferred compensation of $308 and $212,
respectively)      |  |                              | 23,485  |   |      |   | 23,427  |  
|General and administrative (excludes amortization of deferred compensation included in Amortization of deferred compensation of $460 and $831,
respectively) |  |                              | 6,607   |   |      |   | 6,959   |  
|Amortization of purchased intangible assets                                                                                                                  |  |                              | 5,812   |   |      |   | 525     |  
|Amortization of deferred compensation (excludes amortization of deferred compensation included in cost of revenue of $84 and $137,
respectively)             |  |                              | 2,258   |   |      |   | 1,411   |  
|Restructuring charges                                                                                                                                        |  |                              | 1,345   |   |      |   |        |  
|                                                                                                                                                             |  |                              |         |   |      |   |         |  
|Operating expenses                                                                                                                                           |  |                              | 64,604  |   |      |   | 51,141  |  
|                                                                                                                                                             |  |                              |         |   |      |   |         |  
|Income (loss) from operations                                                                                                                                |  |                              | (9,862  | ) |      |   | 7,450   |  
|                                                                                                                                                             |  |                             
|Interest and other income                                                                                                                                    |  |                              | 1,383   |   |      |   | 2,055   |  
|Interest expense                                                                                                                                             |  |                              | (247    | ) |      |   | (1,084  | )
|                                                                                                                                                             |  |                              |         |   |      |   |         |  
|Income (loss) before income taxes and equity in net loss of affiliated company                                                                               |  |                              | (8,726  | ) |      |   | 8,421   |  
|Income tax expense                                                                                                                                           |  |                              | 541     |   |      |   | 3,109   |  
|                                                                                                                                                             |  |                              |         |   |      |   |         |  
|Income (loss) before equity in net loss of affiliated company                                                                                                |  |                              | (9,267  | ) |      |   | 5,312   |  
|Equity in net loss of affiliated company                                                                                                                     |  |                              | (577    | ) |      |   |        |  
|                                                                                                                                                             |  |                              |         |   |      |   |         |  
|Net income (loss)                                                                                                                                            |  | $                            | (9,844  | ) |      | $ | 5,312   |  
|                                                                                                                                                             |  |                              |         |   |      |   |         |  
|Basic net income (loss) per share                                                                                                                            |  | $                            | (0.09   | ) |      | $ | 0.05    |  
|                                                                                                                                                             |  |                              |         |   |      |   |         |  
|Shares used in computing basic net income (loss) per share                                                                                                   |  |                              | 114,955 |   |      |   | 114,319 |  
|                                                                                                                                                             |  |                              |         |   |      |   |         |  
|Diluted net income (loss) per share                                                                                                                          |  | $                            | (0.09   | ) |      | $ | 0.05    |  
|                                                                                                                                                             |  |                              |         |   |      |   |         |  
|Shares used in computing diluted net income (loss) per share                                                                                                 |  |                              | 114,955 |   |      |   | 117,692 |  
|                                                                                                                                                             |  |                              |         |   |      |   |         |  



The accompanying notes
are an integral part of these condensed consolidated financial statements.



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McDATA CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



|                                                                                    |  |                              |         |   |      |   |          |  
|----------------------------------------------------------------------------------- |  | ---------------------------- | ------- | - | ---- | - | -------- | -
|                                                                                    |  | Three Months Ended April 30, |        
|                                                                                    |  | 2004                         |         |   | 2003 |  
|Cash flows from operating activities:                                               |  |                              |         |   |      |   |          |  
|Net income (loss)                                                                   |  | $                            | (9,844  | ) |      | $ | 5,312    |  
|Adjustments to reconcile net income (loss) to cash flows from operating activities; |  |                              |         |   |      |   |          |  
|Depreciation                                                                        |  |                              | 7,553   |   |      |   | 6,094    |  
|Amortization                                                                        |  |                              | 7,098   |   |      |   | 2,101    |  
|Equity in net loss of affiliate                                                     |  |                              | 577     |   |      |   |         |  
|(Gain) loss on trade-in/retirement of assets                                        |  |                              | 38      |   |      |   | (5       | )
|Net realized loss (gain) on investments                                             |  |                              | 159     |   |      |   | (137     | )
|Inventory and inventory commitment provisions                                       |  |                              | 1,262   |   |      |   | 1,688    |  
|Bad debt provision                                                                  |  |                              | 25      |   |      |   | 50       |  
|Deferred income taxes                                                               |  |                              |        |   |      |   | 2,129    |  
|Non-cash compensation expense                                                       |  |                              | 2,342   |   |      |   | 1,548    |  
|Unrealized gains on derivative transactions                                         |  |                              | 45      |   |      |   |         |  
|Changes in net assets and liabilities                                               |  |                              | (3,745  | ) |      |   | 7,188    |  
|                                                                                    |  |                              |         |   |      |   |          |  
|Net cash provided by operating activities                                           |  |                              | 5,510   |   |      |   | 25,968   |  
|                                                                                    |  |                             
|Cash flows from investing activities:                                               |  |                              |         |   |      |   |          |  
|Purchases of property and equipment                                                 |  |                              | (4,462  | ) |      |   | (2,940   | )
|Proceeds from the disposition of fixed assets                                       |  |                              | 40      |   |      |   | 5        |  
|Purchases of investments                                                            |  |                              | (97,504 | ) |      |   | (314,323 | )
|Proceeds from maturities and sales of investments                                   |  |                              | 95,032  |   |      |   | 185,393  |  
|                                                                                    |  |                              |         |   |      |   |          |  
|Net cash used by investing activities                                               |  |                              | (6,894  | ) |      |   | (131,865 | )
|                                                                                    |  |                             
|Cash flows from financing activities:                                               |  |                              |         |   |      |   |          |  
|Net proceeds for issuance of convertible subordinated debt                          |  |                              |        |   |      |   | 166,967  |  
|Net purchase of share option transactions                                           |  |                              |        |   |      |   | (20,510  | )
|Payments on long-term notes payable and capital leases                              |  |                              | (936    | ) |      |   | (531     | )
|Proceeds from the issuance of common stock                                          |  |                              | 2,623   |   |      |   | 1,826    |  
|                                                                                    |  |                              |         |   |      |   |          |  
|Net cash provided by financing activities                                           |  |                              | 1,687   |   |      |   | 147,752  |  
|                                                                                    |  |                              |         |   |      |   |          |  
|Net increase in cash and cash equivalents                                           |  |                              | 303     |   |      |   | 41,855   |  
|Cash and cash equivalents, beginning of period                                      |  |                              | 50,301  |   |      |   | 108,168  |  
|                                                                                    |  |                              |         |   |      |   |          |  
|Cash and cash equivalents, end of period                                            |  | $                            | 50,604  |   |      | $ | 150,023  |  
|                                                                                    |  |                              |         |   |      |   |          |  
|Supplemental Disclosure of Non-cash Investing and Financing Activities              |  |                              |         |   |      |   |          |  
|Deferred compensation forfeitures                                                   |  | $                            | 590     |   |      | $ | 162      |  
|                                                                                    |  |                              |         |   |      |   |          |  
|Capital lease obligations incurred                                                  |  | $                            |        |   |      | $ | 132      |  
|                                                                                    |  |                              |         |   |      |   |          |  
|Transfer of inventory to fixed assets                                               |  | $                            | 957     |   |      | $ | 260      |  
|                                                                                    |  |                              |         |   |      |   |          |  



The accompanying notes
are an integral part of these condensed consolidated financial statements.



3



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##### Table of Contents

McDATA CORPORATION



NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(tabular amounts in thousands, except per share data)

(unaudited)



Note 1  Overview and Basis of Presentation



McDATA Corporation (McDATA or the Company) provides Multi-Capable Storage Network Solutions(integrating multiple platforms, networks, protocols and locations) that enables end-customers around the world to better utilize their storage infrastructure, easily manage the storage network and
implement best-in-class business continuance solutions allowing them to be more efficient and effective. McDATA solutions are an integral part of data services infrastructures sold by most major storage and system vendors, including Dell Products
L.P (Dell), EMC Corporation (EMC), Hewlett-Packard (HP), Hitachi Data Systems (HDS), International Business Machines Corporation (IBM), StorageTechnology Corporation (STK) and Sun Microsystems, Inc. (Sun).



The accompanying condensed consolidated financial statements of McDATA and
its subsidiaries have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in the Companys annual consolidated financial statements have
been condensed or omitted. The condensed consolidated balance sheet as of January 31, 2004 has been derived from the audited financial statements as of that date, but does not include all disclosures required by generally accepted accounting
principles. For further information, please refer to and read these interim condensed consolidated financial statements in conjunction with the Companys audited financial statements for the year ended January 31, 2004.



The interim condensed consolidated financial statements, in the opinion of
management, reflect all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows of the Company for the periods presented. The results of operations for the interim periods are not necessarily
indicative of the results of operations to be expected for the entire fiscal year or future periods.



Note 2  Restructuring Charges



During the quarter ended January 31, 2004, the Company announced that it was taking certain cost improvement actions, which included a workforce reduction and facility consolidation. Total restructuring costs of $3.6
million as of April 30, 2004 consist of severance and benefit charges, facility closure expenses, and other charges. Severance and benefit charges of $2.4 million consist of severance and related employee termination costs, including outplacement
services, associated with the reduction of the Companys workforce by approximately 92 employees, or 9% of the Companys workforce. Facility closure charges of $1.1 million relate to estimated losses for a leased engineering facility in
Toronto, Canada, net of expected sublease income. These charges represented the fair value of the lease liability based on assumptions regarding the vacancy period, sublease terms, other anticipated subleasing expenses and the probability of
subleasing this space. The assumptions that the Company used were based on market data, including the then current vacancy rates and lease activities for similar facilities within the area. Should there be changes in real estate market conditions or
should it take longer than expected to find a suitable tenant to sublease the remaining vacant facilities, adjustments to the facilities lease losses reserve may be necessary in future periods based upon then current actual events and circumstances.



Remaining accrued liabilities related to the Companys
fiscal 2003 restructuring program are included in accrued liabilities on the accompanying Condensed Consolidated Balance Sheets. During the three months ended April 30, 2004, the Company recorded additional expenses of $0.2 million to restructuring
costs, primarily due to higher than expected payments related to employee severance and related benefit costs. No other material changes in estimates were made to the fiscal 2003 fourth quarter restructuring accrual. The Company expects to pay or
otherwise substantially settle the remaining accrued liabilities during fiscal year 2004. The following table summarizes the Companys utilization of restructuring accruals for the three months ended April 30, 2004:



|                                      |  |                             |        |   |                 |   |            |  |   |        |   |  |   |        |  
|------------------------------------- |  | --------------------------- | ------ | - | --------------- | - | ---------- |  | - | ------ | - |  | - | ------ | -
|                                      |  | Employee Severance Benefits |        |   | FacilityClosure |   | OtherCosts |  |   | Totals |  
|Remaining accrual at February 1, 2004 |  | $                           | 2,238  |   |                 | $ |           |  | $ |       |   |  | $ | 2,238  |  
|Expense provision                     |  |                             |       |   |                 |   | 1,117      |  |   |       |   |  |   | 1,117  |  
|Cash payments                         |  |                             | (2,307 | ) |                 |   |           |  |   | (46    | ) |  |   | (2,353 | )
|Changes in estimates                  |  |                             | 182    |   |                 |   |           |  |   | 46     |   |  |   | 228    |  
|                                      |  |                             |        |   |                 |   |            |  |   |        |   |  |   |        |  
|Accrual at April 30, 2004             |  | $                           | 113    |   |                 | $ | 1,117      |  | $ |       |   |  | $ | 1,230  |  
|                                      |  |                             |        |   |                 |   |            |  |   |        |   |  |   |        |  



4



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##### Table of Contents

Note 3  Components of Selected Balance Sheet Accounts



|                                                  |  |                |        |   |                  |   |        |  
|------------------------------------------------- |  | -------------- | ------ | - | ---------------- | - | ------ | -
|                                                  |  | April 30, 2004 |        |   | January 31, 2004 |  
|Inventories:                                      |  |                |        |   |                  |   |        |  
|Raw materials                                     |  | $              | 9,068  |   |                  | $ | 7,037  |  
|Work-in-progress                                  |  |                | 1,319  |   |                  |   | 920    |  
|Finished goods                                    |  |                | 8,258  |   |                  |   | 7,883  |  
|                                                  |  |                |        |   |                  |   |        |  
|Total inventories at cost                         |  |                | 18,645 |   |                  |   | 15,840 |  
|Less reserves                                     |  |                | (4,560 | ) |                  |   | (4,476 | )
|                                                  |  |                |        |   |                  |   |        |  
|Total inventories, net                            |  | $              | 14,085 |   |                  | $ | 11,364 |  
|                                                  |  |                |        |   |                  |   |        |  
|Accrued liabilities:                              |  |                |        |   |                  |   |        |  
|Wages and employee benefits                       |  | $              | 15,108 |   |                  | $ | 17,489 |  
|Purchase commitments and other supply obligations |  |                | 7,508  |   |                  |   | 7,829  |  
|Warranty reserves (1)                             |  |                | 4,380  |   |                  |   | 4,522  |  
|Income taxes payable                              |  |                | 1,954  |   |                  |   | 1,783  |  
|Taxes, other than income tax                      |  |                | 1,912  |   |                  |   | 2,534  |  
|Interest payable                                  |  |                | 803    |   |                  |   | 1,773  |  
|Customer obligations                              |  |                | 4,385  |   |                  |   | 4,729  |  
|ESCON agency funds                                |  |                | 10,571 |   |                  |   | 8,373  |  
|Other accrued liabilities                         |  |                | 3,239  |   |                  |   | 4,298  |  
|                                                  |  |                |        |   |                  |   |        |  
|                                                  |  | $              | 49,860 |   |                  | $ | 53,330 |  
|                                                  |  |                |        |   |                  |   |        |  

---

|(1) | Activity in the warranty reserves is as follows:
|--- | ------------------------------------------------



|                               |  |                              |       |   |      |   |       |  
|------------------------------ |  | ---------------------------- | ----- | - | ---- | - | ----- | -
|                               |  | Three Months Ended April 30, |      
|                               |  | 2004                         |       |   | 2003 |  
|Balance at beginning of period |  | $                            | 4,522 |   |      | $ | 3,485 |  
|Warranty expense, net          |  |                              | 77    |   |      |   | 100   |  
|Warranty claims                |  |                              | (219  | ) |      |   | (128  | )
|                               |  |                              |       |   |      |   |       |  
|Balance at end of period       |  | $                            | 4,380 |   |      | $ | 3,457 |  
|                               |  |                              |       |   |      |   |       |  



Note 4  Equity Investment



On August 22, 2003, the Company purchased 13.6 million
shares of preferred stock, or approximately 17.3% of the total outstanding shares of Aarohi Communications (Aarohi) for $6 million cash. Aarohi is a privately owned provider of next-generation intelligent storage networking technology. In addition
to the equity investment, the Company has entered into a non-exclusive supply arrangement with Aarohi to purchase their ASIC chip for inclusion in the Companys new product launches when, and if, Aarohis product becomes generally
available. The Company has recorded its share of Aarohis net loss of approximately $577,000 for the three months ended April 30, 2004. The remaining net equity investment of approximately $803,000 is recorded as an other asset as of April 30,
2004.



Summarized unaudited financial information for Aarohi is as follows:



|                                       |  |   |         |  
|-------------------------------------- |  | - | ------- | -
|Three Months Ended March 31, 2004      |  |   |        
|Net sales                              |  | $ | 60      |  
|Gross profit                           |  | $ | 60      |  
|Operating loss                         |  | $ | (3,349  | )
|Net loss                               |  | $ | (3,357  | )
|                                       | 
|As of March 31, 2004                   |  |   |        
|Current assets                         |  | $ | 11,245  |  
|Noncurrent assets                      |  | $ | 1,546   |  
|Current liabilities                    |  | $ | 1,043   |  
|Noncurrent liabilities                 |  | $ | 2,253   |  
|Redeemable convertible preferred stock |  | $ | 34,457  |  
|Stockholders deficit                  |  | $ | (24,986 | )



5



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##### Table of Contents

Note 5  Goodwill and Intangible assets



Changes in the carrying amounts of goodwill are as follows:



|                                |  |   |        |  
|------------------------------- |  | - | ------ | -
|Goodwill as of January 31, 2004 |  | $ | 78,787 |  
|Purchase price adjustment       |  |   | (94    | )
|                                |  |   |        |  
|Goodwill as of April 30, 2004   |  | $ | 78,693 |  
|                                |  |   |        |  



The Company completed
its acquisitions of Nishan Systems, Inc. and Sanera Systems, Inc. in the third quarter of 2003. Purchase price adjustments during the quarter ended April 30, 2004 included an adjustment to the acquired balances for notes payable and net accounts
receivables. No further material purchase adjustments are anticipated except for potential goodwill adjustments related to the deferred tax asset and related valuation allowances which may result in future goodwill adjustments that were recorded at
the time of acquisitions.



The Company is currently amortizing
its acquired intangible assets with finite lives over periods ranging from 1 to 6 years. The following table summarizes the components of gross and net intangible asset balances:



|                        |  |                      |         |                         |   |                    |  |                      |         |                         |   |                    |  |   |        |  |   |        
|----------------------- |  | -------------------- | ------- | ----------------------- | - | ------------------ |  | -------------------- | ------- | ----------------------- | - | ------------------ |  | - | ------ |  | - | -------
|                        |  | April 30, 2004       |         | January 31, 2004       
|                        |  | Gross CarryingAmount |         | AccumulatedAmortization |   | Net CarryingAmount |  | Gross CarryingAmount |         | AccumulatedAmortization |   | Net CarryingAmount
|Developed technology    |  | $                    | 116,869 |                         | $ | 16,248             |  | $                    | 100,621 |                         | $ | 116,769            |  | $ | 11,133 |  | $ | 105,636
|Customer relationships  |  |                      | 3,021   |                         |   | 605                |  |                      | 2,416   |                         |   | 3,021              |  |   | 340    |  |   | 2,681  
|Other                   |  |                      | 5,996   |                         |   | 3,430              |  |                      | 2,566   |                         |   | 5,993              |  |   | 2,997  |  |   | 2,996  
|                        |  |                      |         |                         |   |                    |  |                      |         |                         |   |                    |  |   |        |  |   |        
|Total intangible assets |  | $                    | 125,886 |                         | $ | 20,283             |  | $                    | 105,603 |                         | $ | 125,783            |  | $ | 14,470 |  | $ | 111,313
|                        |  |                      |         |                         |   |                    |  |                      |         |                         |   |                    |  |   |        |  |   |        



Expected annual amortization expense
related to acquired intangible assets is as follows:



|                                           |  |   |        
|------------------------------------------ |  | - | -------
|Fiscal Years:                              |  |   |        
|2004(1)                                    |  | $ | 17,233 
|2005                                       |  |   | 22,106 
|2006                                       |  |   | 19,805 
|2007                                       |  |   | 17,754 
|2008                                       |  |   | 17,418 
|Thereafter                                 |  |   | 11,287 
|                                           |  |   |        
|Total expected annual amortization expense |  | $ | 105,603
|                                           |  |   |        

---

|(1) | Reflects the remaining nine months of fiscal 2004.
|--- | --------------------------------------------------



Amortization expense related to acquired intangible assets was $5.8 million and $0.5 million for the quarters ending April 30, 2004 and 2003,
respectively.



Note 6  Interest and Other Income, Net



Interest and other income consists of:



|                                                              |  |                              |       |   |      |   |      
|------------------------------------------------------------- |  | ---------------------------- | ----- | - | ---- | - | -----
|                                                              |  | Three Months Ended April 30,
|                                                              |  | 2004                         |       |   | 2003
|Interest income                                               |  | $                            | 1,587 |   |      | $ | 1,945
|Net realized gains/(losses) on available-for-sale investments |  |                              | (159  | ) |      |   | 110  
|Unrealized loss on hedged investments                         |  |                              | (45   | ) |      |   |     
|                                                              |  |                              |       |   |      |   |      
|Interest and other income, net                                |  | $                            | 1,383 |   |      | $ | 2,055
|                                                              |  |                              |       |   |      |   |      



Note 7  Income Tax



For the three months ended April 30, 2004 and April 30,
2003, we recorded an income tax provision of $541,000 and $3.1 million, respectively. The tax provision for the three months ended April 30, 2004 reflects foreign tax which McDATA will owe on the profit of its foreign subsidiary activities which
will not be eliminated by a net operating loss for applicable jurisdictions. No federal or state tax benefit is recorded because the Company has established a valuation allowance against its net deferred tax asset. The tax provision ended April 30,
2003 reflects federal, state and foreign tax expense prior to the establishment of a valuation allowance.



6



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##### Table of Contents

Note 8  Net Income (Loss) Per Share



Basic net income (loss) per share excludes dilution and is computed by dividing income available to common stockholders by
the weighted-average number of common shares outstanding for the period. Diluted net income (loss) per share is based on the weighted-average number of shares outstanding during each period and the assumed exercise of dilutive stock options less the
number of treasury shares assumed to be purchased from the proceeds using the average market price of the Companys common stock for each of the periods presented. No dilutive effect has been included for the convertible subordinated debt
issued February 7, 2003 because the Company currently has the ability and intent to settle the conversion in cash. Additionally, no dilutive effect has been included for the share options sold in relation to the convertible subordinated debt because
the exercise price was higher than the average stock price for the period.



Following is a reconciliation between basic and diluted earnings (loss) per share:



|                                                                                                        |  |                               |         |   |      |   |        
|------------------------------------------------------------------------------------------------------- |  | ----------------------------- | ------- | - | ---- | - | -------
|                                                                                                        |  | Three Months Ended April 30 ,
|                                                                                                        |  | 2004                          |         |   | 2003
|Net income (loss)                                                                                       |  | $                             | (9,844  | ) |      | $ | 5,312  
|Weighted average shares of common stock outstanding used in computing basic net income (loss) per share |  |                               | 114,955 |   |      |   | 114,319
|Net effect of dilutive stock options                                                                    |  |                               |        |   |      |   | 3,373  
|                                                                                                        |  |                               |         |   |      |   |        
|Weighted average shares of common stock used in computing diluted net income (loss) per share           |  |                               | 114,955 |   |      |   | 117,692
|                                                                                                        |  |                               |         |   |      |   |        
|Basic net income (loss) per share                                                                       |  | $                             | (0.09   | ) |      | $ | 0.05   
|                                                                                                        |  |                               |         |   |      |   |        
|Diluted net income (loss) per share                                                                     |  | $                             | (0.09   | ) |      | $ | 0.05   
|                                                                                                        |  |                               |         |   |      |   |        
|Options not included in diluted share base because of the exercise prices                               |  |                               | 10,205  |   |      |   | 7,135  
|                                                                                                        |  |                               |         |   |      |   |        
|Options and restricted stock not included in diluted share because of net loss                          |  |                               | 5,259   |   |      |   |       
|                                                                                                        |  |                               |         |   |      |   |        



Note 9  Stock-Based
Compensation



At April 30, 2004, the Company has
stock-based employee compensation and employee purchase plans, which are described more fully in the Companys Annual Report on Form 10-K for the year ended January 31, 2004. As of April 30, 2004, there were approximately 7.4 million shares of
common stock available for future grants under these plans.



The Company accounts for these plans according to Accounting Principles Board Opinion No. 25, Accounting for Stock Issues to Employees (APB 25), and related interpretations and has adopted the disclosure-only alternative of
Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation(SFAS No. 123), as amended by SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure an amendment of FASB
Statement No. 123. Any deferred stock compensation calculated pursuant to APB 25 is amortized ratably over the vesting period of the individual options, generally two to four years. The following table illustrates the effect on net loss and
earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123.



|                                                                                                                                                              |  |                              |         |   |      |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------- | ------- | - | ---- | - | ------ | -
|                                                                                                                                                              |  | Three Months Ended April 30, |        
|                                                                                                                                                              |  | 2004                         |         |   | 2003 |  
|Net income (loss), as reported                                                                                                                                |  | $                            | (9,844  | ) |      | $ | 5,312  |  
|Add: Total stock-based employee compensation expense included in net income (loss) as determined under the intrinsic value method, net of
related tax effects |  |                              | 2,342   |   |      |   | 974    |  
|Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax
effects               |  |                              | (4,670  | ) |      |   | (3,863 | )
|                                                                                                                                                              |  |                              |         |   |      |   |        |  
|Pro forma net income (loss)                                                                                                                                   |  | $                            | (12,172 | ) |      | $ | 2,423  |  
|                                                                                                                                                              |  |                              |         |   |      |   |        |  
|Earnings (loss) per share:                                                                                                                                    |  |                              |         |   |      |   |        |  
|Basic-as reported                                                                                                                                             |  | $                            | (0.09   | ) |      | $ | 0.05   |  
|                                                                                                                                                              |  |                              |         |   |      |   |        |  
|Basic-pro forma                                                                                                                                               |  | $                            | (0.11   | ) |      | $ | 0.02   |  
|                                                                                                                                                              |  |                              |         |   |      |   |        |  
|Diluted-as reported                                                                                                                                           |  | $                            | (0.09   | ) |      | $ | 0.05   |  
|                                                                                                                                                              |  |                              |         |   |      |   |        |  
|Diluted-pro forma                                                                                                                                             |  | $                            | (0.11   | ) |      | $ | 0.02   |  
|                                                                                                                                                              |  |                              |         |   |      |   |        |  



7



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Note 10  Comprehensive Income (Loss)



Comprehensive income (loss) consisted of the following:



|                                                  |  |                              |         |   |      |   |      
|------------------------------------------------- |  | ---------------------------- | ------- | - | ---- | - | -----
|                                                  |  | Three Months Ended April 30,
|                                                  |  | 2004                         |         |   | 2003
|Net income (loss)                                 |  | $                            | (9,844  | ) |      | $ | 5,312
|Unrealized gain (loss) on investments, net of tax |  |                              | (644    | ) |      |   | 12   
|                                                  |  |                              |         |   |      |   |      
|Comprehensive income (loss)                       |  | $                            | (10,488 | ) |      | $ | 5,324
|                                                  |  |                              |         |   |      |   |      



Note 11  Segment Information



The Company has one reporting segment relating to the
design, development, manufacture and sales of open storage networking solutions that provide highly available, scalable and centrally managed storage area networks (SANs). The Companys Chief Operating Decision Makers, as defined by SFAS No.
131, Disclosures about Segments of an Enterprise and Related Information, allocate resources and assess the performance of the Company based on revenue and overall profitability.



A significant portion of revenue is concentrated with the largest storage
OEMs. For the three months ended April 30, 2004, approximately 47% of total revenue came from EMC, compared to 61% for the three months ended April 30, 2003. IBM contributed approximately 25% of revenue for the first quarter of 2004 compared to 17%
for the first quarter of 2003. In addition, HDS contributed approximately 12% and 11% of total revenue for the three months ended April 30, 2004 and 2003, respectively. Other major storage and system vendors, including Dell, HP, STK and Sun, offer
McDATA solutions. In addition to the Companys storage and system vendors, the Company has relationships with many resellers, distributors and systems integrators. Sales to these other channels represented 16% and 11% of revenue, respectively
for the three months ended April 30, 2004 and 2003.



Revenues
are attributed to geographic areas based on the location of the customers to which products are shipped. International revenues primarily consist of sales to customers in Western Europe and the greater Asia Pacific region. Included in domestic
revenues are sales to certain OEM customers who take possession of products domestically and then distribute these products to their international customers. In addition, included in revenues from Western Europe are sales to certain OEM customers
who take possession of products in distribution centers designated for international-bound product and then distribute these products among various international regions. The mix of international and domestic revenue can, therefore, vary depending
on the relative mix of sales to certain OEM customers. Domestic and international revenue was approximately 62% and 38% of total revenue, respectively, for the three months ended April 30, 2004. For the three months ended April 30, 2003, domestic
and international revenue was approximately 72% and 28% of total revenue, respectively.



Note 12  Commitment and Contingencies



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



Manufacturing and Purchase Commitments



The Company has contracted with Sanmina SCI Systems, Inc. (SSCI), Solectron Corporation (Solectron) and others (collectively, Contract Manufacturers) for the manufacture of printed circuit boards and box build
assembly and configuration for specific multi-protocol directors and switches. The agreements require the Company to submit purchasing forecasts and place orders sixty calendar days in advance of delivery. At April 30, 2004, the Companys
commitment with the Contract Manufacturers for purchases over the next sixty days totaled $45.5 million. The Company may be liable for materials that the Contract Manufacturers purchase on McDATAs behalf if the Companys actual
requirements do not meet or exceed its forecasts and those materials cannot be redirected to other uses. At April 30, 2004, the Company had recorded obligations of approximately $7.5 million (See Note 3) primarily related to materials purchased by
the Contract Manufacturers for certain end-of-life and obsolete material. Management does not expect the remaining commitments under these agreements to have a material adverse effect on the Companys business, results of operations, financial
position or cash flows.



The Company has various other
commitments for sales and purchases in the ordinary course of business. In the aggregate, such commitments do not differ significantly from current market prices or anticipated usage requirements.



8



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##### Table of Contents

Litigation



Class Action Laddering Lawsuits



The Company, Mr. John F. McDonnell, the former Chairman of the board of directors, Mrs. Dee J. Perry, a former officer and Mr. Thomas O. McGimpsey a
current officer were named as defendants in purported securities class-action lawsuits filed in the United States District Court, Southern District of New York. The first of these lawsuits, filed on July 20, 2001, is captioned Gutner v. McDATA
Corporation, Credit Suisse First Boston (CSFB), Merrill Lynch, Pierce Fenner & Smith Incorporated, Bear, Stearns & Co., Inc., FleetBoston Robertson Stephens et al., No. 01 CIV. 6627. Three other similar suits were filed against the Company
and the individuals. The complaints are substantially identical to numerous other complaints filed against other companies that went public in 1999 and 2000. These lawsuits generally allege, among other things, that the registration statements and
prospectus filed with the SEC by such companies were materially false and misleading because they failed to disclose (a) that certain underwriters had allegedly solicited and received excessive and undisclosed commissions from certain investors in
exchange for which the underwriters allocated to those investors material portions of shares in connection with the initial public offerings, or IPOs, and (b) that certain of the underwriters had allegedly entered into agreements with customers
whereby the underwriters agreed to allocate IPO shares in exchange for which the customers agreed to purchase additional company shares in the aftermarket at pre-determined prices. The complaints allege claims against the Company, the named
individuals, and CSFB, the lead underwriter of the Companys August 9, 2000 initial public offering, under Sections 11 and 15 of the Securities Act. The complaints also allege claims solely against CSFB and the other underwriter defendants
under Section 12(a)(2) of the Securities Act, and claims against the individual defendants under Section 10(b) of the Securities Exchange Act. Although management believes that all of the lawsuits are without legal merit and they intend to defend
against them vigorously, there is no assurance that the Company will prevail.



In September 2002, plaintiffs counsel in the above-mentioned lawsuits offered to individual defendants of many of the public companies being sued, including the Company, the opportunity to enter into a
Reservation of Rights and Tolling Agreement that would dismiss without prejudice and without costs all claims against such persons if the company itself had entity coverage insurance. This agreement was signed by Mr. John F. McDonnell, the former
Company Chairman, Mrs. Dee J. Perry, the former chief financial officer, and Mr. Thomas O. McGimpsey, the current Vice President and General Counsel and the plaintiffs executive committee. Under the Reservation of Rights and Tolling Agreement,
the plaintiffs dismissed the claims against such individuals.



On February 19, 2003, the court in the above-mentioned lawsuits entered a ruling on the pending motions to dismiss, which dismissed some, but not all, of the plaintiffs claims against the Company. These lawsuits have been consolidated
as part of In Re Initial Public Offering Securities Litigation (SDNY). The Company has considered and agreed to enter into a proposed settlement offer with representatives of the plaintiffs in the consolidated proceeding, and we believe that any
liability on behalf of the Company that may accrue under that settlement offer would be covered by our insurance policies. Until that settlement is fully effective, Management intends to defend against the consolidated proceeding vigorously.



Nishan Acquisition Related Lawsuit



In connection with the Companys acquisition of Nishan,
the Company was named along with Nishan, various investors of Nishan, CSFB and former board members and officers of Nishan in a lawsuit brought by Aamer Latif, a former board member and ex-CEO of Nishan, in the Superior Court of California, County
of Santa Clara on September 11, 2003 (as amended on October 10, 2003 and March 24, 2004) entitled Aamer Latif v. Nishan Systems, Inc. et al (103 CV 004 939). The Complaint makes various allegations against the other defendants such as fraud,
directors breach of the duty of care, shareholders breach of fiduciary duty, unjust enrichment, and conspiracy to commit unjust enrichment. The allegations made against the Company are vote buying, unjust enrichment, and conspiracy to
commit unjust enrichment. The allegation made against Nishan is breach of Section 1602 of the California Corporations Code (a provision dealing with books and records inspection). The complaint primarily seeks compensatory damages of approximately
$11.5 million and other relief. The defendants have agreed that lawsuit expenses are covered by indemnification under the merger agreement from the selling shareholders of Nishan. The defendants filed a demurer to dismiss this action, which was
denied by the Court in January 2004. In May 2004, the defendants filed another demurer to dismiss this action, which is currently before the Court. After significant review of the allegations made by the plaintiff, the Company strongly believes that
the lawsuit is wholly without legal merit and the Company intends to vigorously defend against this action.



Indemnifications and Guarantees



During its normal course of business, the Company may enter into agreements with, among others, customers, resellers, OEMs, systems integrators and distributors. These agreements typically require the Company to indemnify the other party
against third party claims or product infringements on patents or copyrights. The Company provides indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising for
the use of our products.



9



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##### Table of Contents

In addition, the majority of these indemnities, commitments and guarantees do not provide for any limitation of the
maximum potential future payments the Company could be obligated to make. The Company evaluates and estimates losses from such indemnification under SFAS No. 5, Accounting for Contingencies, as interpreted by FASB Interpretation No. 45.
To date, the Company has not incurred any material costs as a result of such obligations and has not accrued any liabilities related to such indemnification and guarantees in our financial statements.



ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations



You should read the following discussion and analysis in conjunction with the condensed consolidated financial statements and notes thereto included in
Item 1 of this Quarterly Report and with Managements Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report filed on Form 10-K with the Securities and Exchange Commission on April 15, 2004.



|Overview | 
|-------- | 



McDATA provides storage area networking (SAN) solutions, including hardware and software, for connecting servers and storage devices from the core to the edge of an enterprises data infrastructure, and
heterogenous SANs via our SAN Routing capabilities. Our solutions include hardware and software products, professional services and education that enable businesses to scale their operations globally through a comprehensive, manageable, flexible
data infrastructure that is optimized for rapid deployment and responsiveness to customer needs. We combine experience in designing, developing and manufacturing high performance SAN solutions with knowledge of business critical applications,
service and support to solve data infrastructure challenges facing enterprises of varying sizes.



The market for our multi-protocol SAN switching hardware and software products is highly competitive, especially with the entrance of competitors from the
IP based switch market. Our competitors are providing or plan to provide SAN switching hardware and software that is multi-protocol capable such as Fibre Channel over IP (FCIP), SCSI over Internet (iSCSI), Internet Fibre Channel (iFCP) and
InfiniBand(IB). A number of our current and potential competitors have longer operating histories, greater name recognition, access to larger customer bases, more established distribution channels and substantially greater financial and managerial
resources. Given the highly competitive market, we anticipate continued lengthened sales cycles and continued downward pricing pressures during fiscal year 2004. Management believes the trend of revenue growth and the related competitive environment
define the overall performance of the Company and provide a specific context to further analyze the revenues, operating expenses and liquidity.



To remain competitive, we will need to build on the new products and technologies developed and acquired through our 2003 acquisitions of Nishan and
Sanera as well as our investment in Aarohi Communications. In addition, we continue to expand our distribution channels for our new Eclipse switch product lines, which is a technology based upon the technology acquired from Nishan. We also continue
to execute on a broader base of sales channels, with non-EMC channels growing in the first quarter of 2004.



|Results of Operations | 
|--------------------- | 



The following table sets forth certain financial data for the periods indicated as a percentage of total revenues.



|                                                                               |  |                              |    |  |       |  
|------------------------------------------------------------------------------ |  | ---------------------------- | -- |  | ----- | -
|                                                                               |  | Three Months Ended April 30, |   
|                                                                               |  | 2004                         |    |  | 2003  |  
|Revenue                                                                        |  | 100.0                        | %  |  | 100.0 | %
|Cost of revenue                                                                |  | 43.7                         |    |  | 43.2  |  
|                                                                               |  |                              |    |  |       |  
|Gross profit                                                                   |  | 56.3                         |    |  | 56.8  |  
|                                                                               |  |                             
|Operating expenses:                                                            |  |                              |    |  |       |  
|Research and development                                                       |  | 25.8                         |    |  | 18.2  |  
|Selling and marketing                                                          |  | 24.2                         |    |  | 22.7  |  
|General and administrative                                                     |  | 12.8                         |    |  | 7.3   |  
|Amortization of deferred compensation                                          |  | 2.3                          |    |  | 1.4   |  
|Restructuring charges                                                          |  | 1.4                          |    |  |      |  
|                                                                               |  |                              |    |  |       |  
|Total operating expenses                                                       |  | 66.5                         |    |  | 49.6  |  
|                                                                               |  |                             
|Income (loss) from operations                                                  |  | (10.2                        | )  |  | 7.2   |  
|Interest and other income, net                                                 |  | 1.2                          |    |  | 1.0   |  
|                                                                               |  |                              |    |  |       |  
|Income (loss) before income taxes and equity in net loss of affiliated company |  | (9.0                         | )  |  | 8.2   |  
|Income tax expense                                                             |  | 0.6                          |    |  | 3.0   |  
|                                                                               |  |                              |    |  |       |  
|Income (loss) before equity in net loss of affiliated company                  |  | (9.6                         | )  |  | 5.2   |  
|Equity in net loss of affiliated company                                       |  | (0.6                         | )  |  |      |  
|                                                                               |  |                              |    |  |       |  
|Net income (loss)                                                              |  | (10.2                        | )% |  | 5.2   | %
|                                                                               |  |                              |    |  |       |  



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Revenues



|                             |  |                              |        |      |   |        
|---------------------------- |  | ---------------------------- | ------ | ---- | - | -------
|                             |  | Three Months Ended April 30,
|                             |  | 2004                         |        | 2003
|                             |  | (in thousands)              
|Product revenue              |  | $                            | 79,284 |      | $ | 91,374 
|Software and service revenue |  |                              | 12,104 |      |   | 8,393  
|Other                        |  |                              | 5,841  |      |   | 3,412  
|                             |  |                              |        |      |   |        
|Revenue                      |  | $                            | 97,229 |      | $ | 103,179
|                             |  |                              |        |      |   |        



Our revenue for the
three months ended April 30, 2004 was $97.2 million, which represented a 6% decrease over the three months ended April 30, 2003. The decrease in revenue during the first quarter of 2004 was created by several factors including the delay of our new
product distribution agreements, the slower-than-expected ramp-up for high-volume channels, and a continued lengthened sales cycle due, in part, by the competitive market and longer decision-making processes by end-users. We have subsequently
executed one new product distribution agreement for the new Eclipse-line of products. However, the competitive marketplace will continue to cause the sales cycle for products to lengthen, especially in the high-end director market. This limits our
visibility into product demand and timing of revenues. Overall pricing remained stable during the first quarter having realized only the typical pricing declines associated with our products. We expect these price declines, which are typical for
technology products, to continue. In addition, we could experience further pricing declines if the competitive marketplace creates additional downward pricing pressures.



Product revenue of $79.3 million for the three months ended April 30, 2004 was a 13% decrease over the three months ended
April 30, 2003. Decreases in revenue for both our director and switch products resulted from an estimated 16% decline in average sales prices. We anticipate continued overall declines of average sales price based upon the historical trend of
decreasing sales prices for our older generation products. However, competition or unforeseen changes in technology could have further negative impacts to our revenue growth rate.



Software and service revenue of $12.1 million for the three months ended April 30, 2004 was a 44% increase over the three
months ended April 30, 2003. This revenue growth is due to continued revenue growth from all of our software products, in particular our SANavigator®and SANtegrity® software. A significant portion of our software revenue is generated from sales of our Enterprise Fabric Connectivity Manager, or EFCM, software
product.



Other revenues for the three months ended April 30,
2004, including service fees earned under an ESCON Service agreement with EMC, were $5.8 million. This represents a 71% increase from the three months ended April 30, 2003. This increase reflects significant growth in maintenance and service fees.
These increased revenues are the result of higher sales of extended maintenance contracts that are sold in conjunction with sales of hardware and software products. Service fees recorded under the ESCON service agreement are expected to decline as
the ESCON products near their end of life. However, in the near term we anticipate an increase in service revenues as certain deferred revenues related to this service contract with EMC are recognized in accordance with revenue recognition rules and
on-going contract negotiations.



A significant portion of our
revenue is concentrated with the largest storage OEMs. For the three months ended April 30, 2004, approximately 47% of our total revenue came from EMC, compared to 61% for the three months ended April 30, 2003. IBM contributed approximately 25% of
our revenue for the first quarter of 2004 compared to 17% for the first quarter of 2003. In addition, HDS contributed approximately 12% and 11% of total revenue for the three months ended April 30, 2004 and 2003, respectively. Other major storage
and system vendors, including Dell, HP, STK and Sun, offer McDATA solutions. In addition to our storage and system vendors, we have relationships with many resellers, distributors and systems integrators. Sales to these other channels represented
16% and 11%, respectively for the three months ended April 30, 2004 and 2003. The decline in the revenue from EMC as a percentage of our sales is the result of the entrance of new competitors into the storage market and the lengthened sales cycle in
the high-end director market; as well as the overall growth in revenue dollars from our other OEMs as well and other channels. Expanding our reseller, distributor and system integrator channels into Small Medium Enterprise (SME) and vertical markets
will be a strategic focus for us as we continue to grow our business. However, the level of sales to 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
significant customers, could harm our



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financial condition and results of operations. Given the dependencies on our limited number of OEM resellers combined
with an increasingly competitive environment, we may experience continued adverse price pressures at critical times near the end of the fiscal quarters.



Domestic and international revenue was approximately 62% and 38% of our total revenue, respectively, for the three months ended April 30, 2004. For the
three months ended April 30, 2003, domestic and international revenue was approximately 72% and 28% of our total revenue, respectively. Revenues are attributed to geographic areas based on the location of the customers to which our products are
shipped. International revenues primarily consist of sales to customers in Western Europe and the greater Asia Pacific region. Included in domestic revenues are sales to certain OEM customers who take possession of our products domestically and then
distribute these products to their international customers. In addition, included in revenues from Western Europe are sales to certain OEM customers who take possession of our products in distribution centers designated for international-bound
product and then distribute these products among various international regions. Our mix of international and domestic revenue can, therefore, vary depending on the relative mix of sales to certain OEM customers. The increase in international
revenues as a percentage of revenue for the first quarter of fiscal year 2004 was the result of increased sales in both Western Europe and the Asia Pacific region. For the three months ended April 30, 2003, we experienced a decrease in sales to
customers in the Asia Pacific region, possibly due indirectly to the market effects of the SARS virus.



Gross Profit



Gross profit margin was 56% and 57% for the three months ended April 30, 2004 and 2003, respectively. In anticipation of the natural decline in selling
prices, we continue to drive cost advantages through our engineering and manufacturing processes. In April 2004, we announced the availability of the lower cost versions of our second generation switch-on-a-chip and began shipping the lower cost
versions of our director components. Through these actions, we anticipate gross profit margins will remain in the mid-50 percent range.



Operating Expenses



Research and Development Expenses. Research and development expenses increased to $25.1 million for the three months ended April 30, 2004, compared
with $18.8 million for the three months ended April 30, 2003. Research and development expenses consist primarily of salaries and related expenses for personnel engaged in engineering and R&D activities; fees paid to consultants and outside
service providers; nonrecurring engineering charges; prototyping expenses related to the design, development, testing and enhancement of our products; depreciation related to engineering and other test equipment; and IT and facilities expenses. The
approximate $6.3 million or 33% increase was primarily attributable to increased staffing levels related to our 2003 acquisitions and increased spending related to new product development. Capitalized software costs were approximately $2.3 million
and $648,000 for the three months ended April 30, 2004 and April 30, 2003, respectively. Capitalized software development costs vary in conjunction with stages of development of our application software, our new director and switch products and
related firmware software.



Selling and Marketing
Expenses. Selling and marketing of $23.5 million for the three months ended April 30, 2004, were comparable to $23.4 million for the three months ended April 30, 2003. Sales and marketing expenses consist primarily of salaries, commissions and
related expenses for personnel engaged in marketing and sales; costs associated with promotional and travel expenses; and IT and facilities expenses. Modest increases in salaries and travel costs were offset by the decrease in customer acquisition
costs from the first quarter of 2003 that were attributable to two new OEM contracts signed during that period.



General and Administrative Expenses. General and administrative expenses increased by approximately 66% to $12.4 million for the three months ended
April 30, 2004 from $7.5 million for the three months ended April 30, 2003. General and administrative expenses consist primarily of salaries and related expenses for corporate executives, finance, human resources and investor relations, as well as
accounting and professional fees, corporate legal expenses, other corporate expenses, and IT and facilities expenses. Amortization expense for purchased intangible assets increased approximately $5.3 million as a result of our 2003 acquisitions.



Amortization of Deferred Compensation. We have recorded
deferred compensation in connection with Class B common stock options granted prior to our August 9, 2000 initial public offering (IPO) and restricted Class B stock grants granted through our equity incentive plans. In addition, we issued
approximately 1.0 million shares of Class B restricted common stock with vesting periods ranging from 12 to 24 months in connection with our acquisitions during fiscal 2003. We are amortizing all deferred compensation on a straight-line basis over
the vesting period of the applicable options and stock awards, resulting in amortization expense of $2.3 million for the three months ended April 30, 2004 and $1.5 million for the three months ended April 30, 2003 (of which approximately $84,000 and
$137,000 was included in cost of revenue, respectively). Additional grants of stock-based awards under existing equity plans, future plans or through acquisitions could increase the level of deferred compensation expense.



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Restructuring Charges.In January 2004, we announced that we were taking certain cost improvement
actions, which included a workforce reduction and facility consolidation. For the three months ended April 30, 2004, we completed our planned closure of our Toronto engineering facility. As a result, the Company recorded an approximate $1.1 million
restructuring charge related to the leased facility closure. In addition, we incurred an additional $182,000 restructuring charge in the first fiscal quarter for additional severance-related costs as we finalized the reduction in workforce that was
initiated in the fourth quarter of 2003.



Interest and Other
Income. Interest and other income consisted primarily of interest earnings on our cash, cash equivalents and various investment holdings. Interest and other income decreased to $1.4 million for the quarter ended April 30, 2004 compared with
approximately $2.1 million for the quarter ended April 30, 2003. This decrease in income reflects the decline of our investment balances from the first quarter of 2003 as a result of our use of debt proceeds to fund our third quarter 2003
acquisitions. Fluctuations in our investment balances as well as fluctuations in interest rates could cause our investment income to vary between periods.



Interest Expense.Interest expense of $0.2 million for the three months ended April 30, 2004 decreased 77% compared with $1.1 million for the three
months ended April 30, 2003. The decrease is attributable to the interest rate swap which was entered into during the second quarter fiscal 2003. This interest-rate swap agreement has the economic effect of modifying the fixed interest obligations
associated with our convertible debt so that the interest payable on the majority of the debt effectively becomes variable based on the six month LIBOR minus 152 basis points. The reset dates of the swap are February 15 and August 15 of each year
until maturity on February 15, 2010. At April 30, 2004, the six-month LIBOR setting was set at 1.175%, resulting in a rate of minus 0.345%, which is effective until August 15, 2004. Significant increases in interest rates in future periods could
significantly increase interest expense.



Provision for
Income Taxes. Generally, the effective tax rate is determined by the relationship between the estimated tax payable in all jurisdictions in which the Company is subject to income tax and pre-tax book income or loss. In calculating the estimated
tax payable, book income is adjusted for certain amounts that are reported differently between the financial statements and the tax return.



The Company has recorded tax expense for the period even though the pre-tax result on the books is a loss. This is due primarily to taxes payable in
foreign jurisdictions where the net taxable income will be positive. No tax benefit is realized currently for the book loss or available tax credits as the Company has established a valuation allowance against all of its deferred tax assets.



We are subject to audit by federal, state and foreign tax
authorities. These audits may result in additional tax liabilities. We account for such contingent liabilities in accordance with SFAS No. 5, Accounting for Contingencies, and believe that we have appropriately provided for taxes for all years.
Several factors drive the calculation of our tax reserves including (i) the expiration of statutes of limitations, (ii) changes in tax law and regulations, and (iii) settlements with tax authorities. Changes in any of these factors may result in
adjustments to our reserves which could impact our reported financial results.



Liquidity and Capital Resources



Our financial
condition remains solid. At April 30, 2004, cash, short- and long-term investments were $318 million compared to approximately $317 million as of January 31, 2004. These balances both include approximately $5 million of restricted cash that we are
required to maintain in relation to the interest rate swap we have executed in connection with our convertible debt. We invest excess cash predominantly in debt instruments that are highly liquid, of high-quality investment grade, and predominantly
have maturities of less than three years with the intent to make such funds readily available for operating purposes, including expansion of operations and potential acquisitions or other transactions.



We believe our existing cash, short-term and long-term investment balances,
and cash expected to be generated from future operations will be sufficient to meet our capital and operating requirements at least through the next twelve months, although we could be required, or could elect, to seek additional funding prior to
that time. Our future capital requirements will depend on many factors, including our rate of revenue growth, the timing and extent of spending to support development of new products and expansion of sales and marketing, the timing of new product
introductions and enhancements to existing products, and market acceptance of our products.



In summary, our cash flows were (in thousands):



|                                          |  |                              |        |   |      |   |          |  
|----------------------------------------- |  | ---------------------------- | ------ | - | ---- | - | -------- | -
|                                          |  | Three Months Ended April 30, |       
|Source/(use) (in thousands)               |  | 2004                         |        |   | 2003 |  
|Net cash provided by operating activities |  | $                            | 5,510  |   |      | $ | 25,968   |  
|Net cash used by investing activities     |  |                              | (6,894 | ) |      |   | (131,865 | )
|Net cash provided by financing activities |  |                              | 1,687  |   |      |   | 147,752  |  



The decrease in cash
provided by operating activities reflects the net loss for the quarter ended April 30, 2004 adjusted for non-



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cash charges including depreciation, amortization, deferred compensation and changes in working capital items. Working
capital items include accounts receivable, inventories, other current and non-current assets, accounts payable, accrued liabilities and deferred revenue. Accounts receivable was the source of $4.5 million in the first quarter of fiscal year 2004
compared to a use of $3.0 million in the first quarter of 2003. Days sales outstanding (DSO) was 54 days and 33 days for the first quarter ended April 30, 2004 and 2003, respectively. The change between years is the result of the timing and
collections compared to billings. The use of $4.7 million in the first quarter of 2004 compared to the $2.3 million use in the first quarter of 2003 of cash from inventories is the result of a build of inventories surrounding the next generation of
products that are currently in the pre-production phase. The use of cash of $4.1 million from accounts payable and accrued liabilities in the first quarter of 2004 compared to the $11.7 source of cash in the first quarter of fiscal year 2003 results
from the timing of payments of vendor invoices. We anticipate the use of cash for accrued liabilities to increase significantly in the second quarter of fiscal 2004 as funds due under our ESCON service fee arrangement are settled.



The decrease in net cash used by investing activities reflects the use of
cash proceeds for the issuance of convertible subordinated notes to purchase investments in the first quarter of 2003.



Net cash used by financing proceeds during the three months ended April 30, 2004 reflects proceeds from the issuance of common stock from stock option
exercises and purchases under the Companys employee stock purchase plan. In the first quarter of 2003, we issued convertible subordinated notes of $172.5 million in principal amount, with proceeds of $167 million. The 2.25% convertible
subordinated notes mature in February 2010, unless converted into McDATA common stock at a conversion price of $10.71 per share, subject to certain conversion price adjustments. Offsetting these net proceeds were the use of $20.5 million of those
proceeds to enter into share option transactions.



Off-Balance Sheet
Arrangements



Other than facility and equipment leasing
arrangements, the Company does not engage in off-balance sheet financing activities.



During its normal course of business, we may enter into agreements with, among others, customers, resellers, OEMs, systems integrators and distributors. These agreements typically require us to indemnify the other
party against third party claims or product infringements on patents or copyrights. We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising for the
use of our products. We have also indemnified our former parent, EMC, for any income taxes arising out of the distribution of our Class A common stock in February 2001. In addition, the majority of these indemnities, commitments and guarantees do
not provide for any limitation of the maximum potential future payments we could be obligated to make. We evaluate and estimate losses from such indemnification under SFAS No. 5, Accounting for Contingencies, as interpreted by FASB Interpretation
No. 45. To date, we have not incurred any material costs as a result of such obligations and have not accrued any liabilities related to such indemnification and guarantees in our financial statements.



Commitments



There have been no material changes in our contractual obligations and commercial commitments from those reported at January
31, 2004 in the Companys Annual Report on Form 10-K.



Critical
Accounting Policies



The Companys critical
accounting policies have not changed from those reported in Managements Discussion and Analysis of Financial Condition and Results of Operations in the Companys 2003 Annual Report on Form 10-K.



Risk Factors



Risks Relating to Our Business



Changing Market Conditions and Increased Competitive Risks.



The market for our multi-protocol storage area networking (SAN) products and solutions has grown and will continue to become more competitive with (a) the
entrance of new competitors from the IP based switching market into our market, (b) pricing pressures resulting from this increase in competitive SAN networking products and solutions, (c) challenges to our direct-assist sales model with
distribution through channels when our competitors engage end-user customers directly or otherwise have the ability to drive end-user customer preference for SAN equipment through their traditional IP networking presence and relationships, and (d)
anticipated competition from our own storage OEM partners through their recent acquisitions of, or alliances with, competitive software management products and/or application providers that would utilize the intelligence in the network. As a result
of these market changes, we anticipate continued lengthened sales cycles and price erosion in an environment where storage OEM certification of our products may still be required for end-user customer acceptance. Given our direct-assist sales model
with distribution through our channel partners, we are highly dependent upon our channel partners relationships with end-user customers to promote the value of



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our products. If our channel partners do not promote the value of our products or competitors begin to control end-user
customer preference, we may lose sales in key enterprise accounts that would materially adversely affect our revenues.



We are highly dependent on our OEM re-sellers, especially EMC, and efforts by them to reduce the prices of their suppliers may decrease our revenue and gross margins.



We are highly dependent on our OEM partners, especially
EMC, and efforts by them to reduce the prices of their suppliers may decrease our revenue and gross margins. For example, given our concentration of sales with EMC, the revenue shortfall with EMC experienced this fiscal quarter and EMCs public
statements that they will further reduce their suppliers prices, we may experience unanticipated decreases in sales revenue and gross margins that may lead us to be unprofitable. The above-mentioned factors may also strain business
relationships with our storage OEM partners and may adversely affect the qualification and certification of our products. Moreover, the introduction of such new products and any pending qualification and certification by our partners may stall sales
of our existing products with end user customers. Given the dependencies on our limited number of OEM resellers combined with an increasingly competitive environment, we may experience continued adverse price pressures at critical times near the end
of the fiscal quarters.



New competitors have entered this market and we may
not be able to successfully compete against existing or potential competitors.



The market for our multi-protocol SAN switching hardware and software products is highly competitive, especially with the entrance of competitors from the IP based switch market. Our competitors are providing or plan
to provide SAN switching hardware and software that is multi-protocol capable (such as Fibre Channel over IP (FCIP), SCSI over Internet (iSCSI), Internet Fibre Channel (iFCP) and InfiniBand). Our competitors in the this market include Brocade, CNT,
Cisco, QLogic Corp., Emulex Corporation (which acquired Vixel Corporation), Broadcom Corporation (which acquired the assets of Gadzoox Networks), Veritas Software Corporation, Fujitsu Softech and others, including storage hardware device providers.
Given the market share gain by Cisco, other IP based switching companies such as Juniper, Extreme, Foundry and others may enter the market for multi-protocol SAN products. Many of our competitors and potential competitors have longer operating
histories, greater name recognition, access to larger customer bases, more established distribution channels and substantially greater financial and managerial resources than McDATA. Given the highly competitive market, we anticipate continued
lengthened sales cycles and continued downward pricing pressures. To be competitive, we may have to substantially increase headcount in our direct-assist sales model and migrate to a direct end-user customers touch and possibly to direct sales,
which we may not be able to do successfully and which, in any case, will increase expenses. Continued or increased competition could result in pricing pressures, reduced sales, reduced margins, reduced profits, reduced market share, further
elongating of sales cycles, or the failure of our products to achieve or maintain market acceptance.



We incurred a substantial loss for the three months ended April 30, 2004 and for the fiscal years ended January 31, 2004, and December 31, 2002 and may not be profitable in the future.



Our future operating results will depend on many factors, including the
growth of the multi-protocol (Fibre Channel and IP) market, market acceptance of new products we introduce, demand for our products, levels of product and price competition and our reaching and maintaining targeted costs for our products. In
addition, we expect to incur continued significant product development, sales and marketing, and general and administrative expenses. We cannot provide assurance that we will generate sufficient revenue to achieve or sustain profitability.



The prices and gross margins of our products may decline, which would
reduce our revenues and profitability.



In response to
changes in product mix, competitive pricing pressures, increased sales discounts, introductions of new competitive products, product enhancements by our competitors, increases in manufacturing or labor costs or other operating expenses, we may
experience declines in prices, gross margins and profitability. To maintain our gross margins we must maintain or increase current shipment volumes, develop and introduce new products and product enhancements and reduce the costs to produce our
products. Moreover, most of our expenses are fixed in the short-term or incurred in advance of receipt of corresponding revenue. As a result, we may not be able to decrease our spending to offset any unexpected shortfall in revenues. If this occurs,
we could incur losses, and our revenue, gross margins and operating results may be below our expectations and those of investors and stock market analysts.



We depend on two key distribution relationships for most of our revenue and the loss of either of them could significantly reduce our revenues.



We depend on EMC and IBM, for a significant portion of our total revenue.
Sales to EMC and IBM represented approximately 47% and 25%, respectively, of our revenue for the three months ended April 30, 2004. We anticipate that our future operating results



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will continue to depend heavily on sales to EMC and IBM. EMC and IBM resell products offered by our competitors, and
nothing restricts EMC and IBM from expanding those relationships in a manner that could be adverse to us. Therefore, the loss of either EMC or IBM as a customer, or a significant reduction in sales to either EMC or IBM could significantly reduce our
revenue. While we are aware that Dell sources some of our switch product through EMC, it is unclear whether this mitigates our dependency on EMC. Our product sales agreements with sales partners do not provide for the purchase of a guaranteed
minimum amount of product.



Our change of fiscal year may not result in more
predictable quarterly earnings.



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



Additional factors that affect us and which could cause our revenue and operating results to vary in future periods include:



| |  | the size, timing, terms and fluctuations of customer orders, particularly large orders from EMC, IBM or HDS;
| | - | ------------------------------------------------------------------------------------------------------------



| |  | pricing discussions late in a quarter and a limited capability to ramp shipments near the end of that quarter;
| | - | --------------------------------------------------------------------------------------------------------------



| |  | our ability to attain and maintain market acceptance of our products;
| | - | ---------------------------------------------------------------------



| |  | seasonal fluctuations in customer buying patterns;
| | - | --------------------------------------------------



| |  | the timing of the introduction of or enhancement to, products by us, our significant OEM or reseller customers or our competitors (e.g., transition to higher speed, higher port
density and multi-protocol products);
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our ability to obtain sufficient supplies of single- or limited-source components of our products; and
| | - | ------------------------------------------------------------------------------------------------------



| |  | increased operating expenses, particularly in connection with our strategies to increase customer touch and purchase preference for our products or to invest in research and
development.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Our uneven sales pattern makes it
difficult for our management to predict near-term demand and adjust manufacturing capacity. Further, our OEM and reseller partners may purchase certain of our products ahead of end-user customer demand, which could reduce subsequent purchases by
those partners. Accordingly, if orders for our products vary substantially from the predicted demand, our ability to assemble, test and ship orders received in the last weeks and days of each quarter may be limited, which could seriously harm
quarterly revenue or earnings. Moreover, an unexpected decline in revenue without a corresponding and timely reduction in expenses could intensify the impact of these factors on our business, financial condition and results of operations.



We currently have limited product offerings and must successfully introduce
new products and product enhancements that respond to rapid technological changes and evolving industry standards.



For the three months ended April 30, 2004, we derived a significant portion of our revenue from sales of our director-class IntrepidTMswitch products. We expect that revenue from our director-class IntrepidTMswitch products will continue to account for a substantial portion of our revenue for the foreseeable
future. Factors such as performance, market positioning, the availability and price of competing products, the introduction of new technologies and the success of our OEM, reseller and systems integrator customers will affect the market acceptance
of our products. Therefore, continued market acceptance of these products and their successor products, along with our SphereonTMand Eclipse® switches, are critical to our future success.



In addition, our future success depends upon our ability to address the changing needs of customers and to transition to new technologies and industry standards. The introduction of competing products embodying new
technologies or the emergence of new industry standards could render our products non-competitive, obsolete or unmarketable and seriously harm our market share, revenue and gross margin. Risks inherent in transitions to new technology, industry
standards and new protocols include the inability to expand production capacity to meet demand for new products, write-downs of our existing inventory due to obsolescence, the impact of customer demand for new products or products being replaced,
and delays in the introduction or initial shipment of new products. There can be no assurance that we will successfully manage these transitions.



We are currently developing products that contain untested devices and subassemblies. As with any development, there are inherent risks should such
devices or subassemblies require redesign or rework. In particular, in conjunction with the transition of our products from fibre channel to multi-protocol, 2 Gb to 4Gb to 10 Gb transmission speed technology, higher port densities, and advanced
management capabilities, we will be introducing products with new features and functionality, such as our next generation director-class switch product, the Intrepid 10000 Director. We face risks relating to this product transition, including risks relating to the qualification of
such products by our storage and system OEMs, forecasting of demand, as well as possible product and software defects and a potentially different sales and support environment due to the complexity of these new systems. Finally, if we



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fail to introduce new products timely, or to add new features and functions to existing products to compete against new
entrants in the market, or if there is no demand for these or our current products, our business could be seriously harmed.



Risks related to recent acquisitions.



In September 2003, we closed our acquisitions of Nishan Systems, Inc. (Nishan) and Sanera Systems, Inc. (Sanera). While management believes that such
acquisitions are an integral part of their long-term strategy, there are risks and uncertainties related to acquiring companies that have limited or no product sales to date. Our success depends upon integrating Nishan and Sanera with McDATA,
finalizing the development of such products, retaining critical employees from the acquired companies, qualifying such products with our OEM and reseller partners and ramping sales of those products with such partners.



Our business is subject to risks from global operations.



We conduct significant sales and customer support operations in countries
outside of the United States and also depend on non-U.S. operations of our contract manufacturers, and our distribution partners. Further, we utilize an India based firm to provide certain software engineering services, and our virtualization chip
supplier, Aarohi Communications, is also reliant on offshore engineering. We derived approximately 38% of our revenue for the three months ended April 30, 2004, from customers located outside of the United States. We believe that our continued
growth and profitability will require us to continue to expand marketing and selling efforts internationally. We have limited experience in marketing, distributing and supporting our products internationally and may not be able to maintain or
increase international market demand for our products. In addition, our international operations are generally subject to inherent risks and challenges that could harm our operating results, including:



| |  | expenses associated with developing and customizing our products for foreign countries;
| | - | ---------------------------------------------------------------------------------------



| |  | difficulties in staffing and managing international operations, including reliance on third parties to manage certain aspects of our foreign operations, including hub inventory
locations;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | multiple, conflicting and changing governmental laws and regulations;
| | - | ---------------------------------------------------------------------



| |  | tariffs, quotas and other import or export restrictions, trade protection measures and other regulatory requirements on computer peripheral equipment;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | longer sales cycles for our products;
| | - | -------------------------------------



| |  | reduced or limited protections of intellectual property rights;
| | - | ---------------------------------------------------------------



| |  | adverse tax consequences, including imposition of withholding or other taxes on payments by subsidiaries and customers;
| | - | -----------------------------------------------------------------------------------------------------------------------



| |  | compliance with international standards that differ from domestic standards;
| | - | ----------------------------------------------------------------------------



| |  | risks surrounding any product and software outsourcing activities in foreign countries; and
| | - | -------------------------------------------------------------------------------------------



| |  | political, social and economic instability in a specific country or region.
| | - | ---------------------------------------------------------------------------



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



Unforeseen environmental costs could impact our future net earnings.



Some of our operations use substances regulated under various federal, state
and international laws governing the environment, including those governing the discharge of pollutants into the air and water, the management and disposal of hazardous substances and wastes and the cleanup of contaminated sites. Certain of our
products are subject to various federal, state and international laws governing chemical substances in electronic products. We could incur costs, fines and civil or criminal sanctions, third-party property damage or personal injury claims if we were
to violate or become liable under environmental laws. The ultimate costs under environmental laws and the timing of these costs are difficult to predict.



The European Union has finalized the Waste Electrical and Electronic Equipment Directive, which makes producers of electrical goods financially
responsible for specified collection, recycling, treatment and disposal of past and future covered products. This directive must now be enacted and implemented by individual European Union governments by August 13, 2004 (such legislation together
with the directive, the WEEE Legislation), and certain producers are to be financially responsible under the WEEE Legislation beginning in August 2005. In addition, the European Parliament has enacted a requirement for the recovery of
hazardous



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substance (RoHS). This legislation governs the recovery of such substances as mercury, lead, cadmium, and hexavalent
cadmium. We are currently reviewing the applicability of WEEE and RoHS Legislation to our electronic products. Accordingly, we cannot currently estimate the extent of increased costs resulting from the WEEE and RoHS Legislation. Similar legislation
may be enacted in other geographies, including federal and state legislation in the United States, the cumulative impact of which could be significant costs.



Increased international political instability may decrease customer purchases, increase our costs and disrupt our business.



Increased international political instability as demonstrated by the
September 11, 2001 terrorist attacks, disruption in air transportation and enhanced security measures as a result of the terrorist attacks and increasing tension in the Middle East, may hinder our ability to do business and may increase our costs.
Additionally, this increased instability may, for example, negatively impact the capital markets and the reliability and cost of transportation and adversely affect our ability to obtain adequate insurance at reasonable rates or require us to incur
costs for extra security precautions for our operations. In addition, to the extent that air transportation is delayed or disrupted, the operations of our contract manufacturers and suppliers may be disrupted, particularly if shipments of components
and raw materials are delayed. If this international political instability continues or increases, our business and results of operations could be seriously harmed and we may not be able to obtain financing in the capital markets.



If we lose key personnel or if we are unable to hire additional qualified personnel, we
may not be successful.



Our success depends to a
significant degree upon the continued contributions of our key management, technical, sales and marketing, finance and operations personnel, many of whom would be difficult to replace. In particular, we believe that our future success is highly
dependent on our senior executive team. In the past we have experienced high turnover in our senior executive team. A significant portion of the current senior executive team was hired during the last year and a half. Although our senior executive
team consists of experienced members, many of them are new to our company and industry and have only worked with each other for a relatively short period of time. As a result they may not operate efficiently as part of an integrated management team.
In addition, our engineering and product development teams are critical in developing our products and have developed important relationships with customers and their technical staffs. The loss of any of these key personnel, including our senior
sales staff, could harm our operations and customer relationships. We do not have key person life insurance on any of our key personnel. Given our recent acquisitions of Nishan and Sanera, a large percentage of our engineering development team is
now located in California, is new to the Company and may not operate as efficiently during the transition period. In January 2004, we announced a 9% reduction in-force (RIF) of our employee base and we are closing down our Canadian engineering
operations.



We believe our future success will also depend in
large part upon our ability to attract and retain highly skilled managerial, engineering, sales and marketing, and finance and operations personnel. If we increase our production and sales levels, we will need to attract and retain additional
qualified skilled workers for our operations. In the last year, there has been an increasing demand for such personnel by companies, some of which are larger and have greater resources to attract and retain highly qualified personnel. We cannot
assure you that we will continue to be able to attract and retain qualified personnel, or that delays in hiring required personnel, particularly engineers, will not delay the development or introduction of products or materially adversely impact our
ability to sell our products.



Risks related to internal controls.



Public companies in the United States are required to
review their internal controls under the Sarbanes-Oxley Act of 2002. It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are
met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there can be no assurance that any design will
succeed in achieving its stated goals under all potential future conditions, regardless of how remote. If the internal controls put in place by us are not adequate or in conformity with the requirements of the Sarbanes-Oxley Act of 2002, and the
rules and regulations promulgated by the Securities and Exchange Commission, we may be forced to restate our financial statements and take other actions which will take significant financial and managerial resources, as well as be subject to fines
and other government enforcement actions.



If we are unable to adequately
protect our intellectual property, we may not be able to compete effectively.



We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality and/or license agreements
with our employees, consultants and corporate partners. Despite our efforts to protect our proprietary rights, unauthorized parties may copy or otherwise obtain and use our products or technology. Monitoring unauthorized use of our products is
difficult and we may not be aware that someone is using our rights without our authorization. In addition, the steps we have taken, and those we may take in the future, may not prevent unauthorized use



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of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in
the United States. We may be a party to intellectual property litigation in the future, either to protect our intellectual property or as a result of alleged infringements of others intellectual property.



These or other claims and any resulting litigation or arbitration could
subject us to significant costs, liability for damages or could cause our proprietary rights to be invalidated or deemed unenforceable, which could allow third parties to use our rights without reservation. Litigation or arbitration, regardless of
the merits of the claim or outcome, would likely be time consuming and expensive to resolve and would divert management time and attention. Any potential intellectual property litigation filed against us could also force us to do one or more of the
following:



| |  | stop using the challenged intellectual property or selling our products or services that incorporate it;
| | - | --------------------------------------------------------------------------------------------------------



| |  | obtain a license to use the challenged intellectual property or to sell products or services that incorporate it, which license may not be available on reasonable terms, or at all;
and
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | redesign those products or services that are based on or incorporate the challenged intellectual property.
| | - | ----------------------------------------------------------------------------------------------------------



If we are forced to take any of these actions, we may be unable to
manufacture and sell our products, our customer relationships would be seriously 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 cross license agreement between IBM and EMC. Under the terms
of that agreement, effective upon EMCs February 7, 2001 distribution of our Class A common stock to its stockholders, the sublicense we previously held to those IBM patents terminated. We believe that the termination of the sublicense does not
materially affect our business. We are not aware of any issued or pending IBM patents that are infringed by our products, but if IBM were to allege any such infringement, and we were unable to negotiate a settlement with IBM, our ability to produce
the alleged infringing product could be affected, which could materially and adversely affect our business.



If we fail to optimize our distribution channels and manage our distribution relationships, our revenue or operating results could be significantly reduced. Our competitors may sell their products directly to
end-user customers.



Our success will depend on our
continuing ability to develop and manage relationships with significant OEMs, resellers and systems integrators, as well as on the sales efforts and success of these customers. We cannot provide assurance that we will be able to expand our
distribution channels or manage our distribution relationships successfully or that our customers will market our products effectively. Our failure to expand our distribution channels or manage successfully our distribution relationships or the
failure of our OEM and reseller customers to sell our products could reduce our revenue and operating results. Moreover, to the extent our competitors sell directly to end-user customers, we may not be able to compete given the lack of a direct
sales force and the current inability to directly provide first and second level customer support. If this occurs, we may need to substantially invest in a direct sales force and direct customer support which would increase our expenses.



We are dependent on a single or limited number of suppliers for certain key components
of our products, and the failure of any of those suppliers to meet our production 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 purchase several key components from single or limited sources.
We purchase application specific integrated circuits (ASICs), special purpose processors 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 our products in the future. Delays in the delivery of components for our products could result in delays or the inability to meet our customers demands and result in decreased revenue. We do not have any
long-term supply contracts to ensure sources of supply of components. In addition, our suppliers may enter into exclusive arrangements with our competitors, stop selling their products or components to us at commercially reasonable prices or refuse
to sell their products or components to us at any price, which could harm our operating results. Further, we have purchased components from our suppliers from time to time that have been subsequently found not to meet the suppliers published
specifications. If our suppliers are unable to provide (or we are unable otherwise to obtain) components for our products on the schedule and in the quantities and quality we require, we will be unable to manufacture our products. We have
experienced and may continue to experience production delays and quality control problems with certain of our suppliers, which, if not effectively managed, could prevent us from satisfying our production requirements. If we fail to effectively
manage our relationships with these key suppliers, or if our suppliers experience delays, disruptions, capacity constraints or quality control problems in their manufacturing operations, our ability to manufacture and ship products to our customers
could be delayed, and our competitive position, reputation, business, financial condition and results of operations could be seriously harmed.



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The loss of our contract manufacturers, or the failure to forecast demand accurately for our products or to manage our
relationship with our contract manufacturers successfully, would negatively impact our ability to manufacture and sell our products.



We rely on Sanmina SCI, Inc. (SSCI), Solectron Corporation, Pycon Incorporated, IBM and LSI Logic, together our contract manufacturers, to manufacture our
products. Our contract manufacturers are not obligated to supply products to us for any specific period, or in any specific quantity, except as may be provided in a particular purchase order. In addition, our contract manufacturers do not guarantee
that adequate capacity will be available to us within the time required to meet additional demand for our products. We generally place forecasts for products with our contract manufacturers approximately four to five months prior to the anticipated
delivery date, with order volumes based on forecasts of demand for our products. We generally place purchase orders sixty calendar days in advance of delivery. If we fail to forecast demand for our products accurately, we may be unable to obtain
adequate manufacturing capacity from our contract manufacturers to meet our customers delivery requirements or unexpected increases in customer purchase orders. As a result, we may not be able to benefit from any incremental demand and could
lose customers. If we over-estimate demand for our product, we may accumulate excess inventories and obligations to our contract manufacturers under binding purchase orders in excess of our needs. At April 30, 2004, our commitment with our contract
manufacturers for purchases and anticipated transformation costs over the next sixty days totaled approximately $45.5 million.



In addition, we coordinate our efforts with those of our component suppliers and contract manufacturers in order to rapidly achieve volume production. We
have experienced and may continue to experience production delays and quality control problems with certain of our suppliers and with our contract manufacturers, which, if not effectively managed, could prevent us from satisfying our production
requirements on a timely basis and could harm our customer relationships. If we should fail to manage effectively our relationships with our component suppliers or contract manufacturers, or if any of our suppliers or our manufacturers experience
delays, disruptions, capacity constraints or quality control problems in their manufacturing operations, our ability to ship products to our customers could be delayed, and our competitive position and reputation could be harmed. Qualifying a new
contract manufacturer and commencing volume production can be expensive and time consuming. If we are required to change or choose to change contract manufacturers, we may lose significant revenue and seriously damage our customer relationships.



The continued general economic slowdown may significantly reduce
expenditures on information technology infrastructure.



Unfavorable general economic conditions over the last 3 plus years have had a pronounced negative impact on information technology, or IT, spending. Demand for SAN products in the enterprise-class sector may continue to be adversely
impacted as a result of a weakened economy and because larger businesses have begun to focus on more efficiently using their existing IT infrastructure rather than making new equipment purchases. If there are further reductions in either domestic or
international IT expenditure, or if IT expenditure does not increase as anticipated from current levels, our revenues, operating results and financial condition may be materially adversely affected.



Failure to manage expansion effectively could seriously harm our business, financial
condition and prospects.



Our ability to successfully
implement our business plan, develop and offer products, and manage expansion in a rapidly evolving market requires a comprehensive and effective planning and management process. We continue to increase the scope of our operations domestically and
internationally. In addition, in September 2003, we acquired Sanera and Nishan which significantly increased the size of our operations. Our growth in business and relationships with customers and other third parties has placed, and will continue to
place, a significant strain on management systems, resources, intercompany communication and coordination. As we grow, our failure to maintain and to continue to improve upon our operational, managerial and financial controls, reporting systems,
processes and procedures, and /or our failure to continue to expand, train, and manage our work force worldwide, could seriously harm our business and financial results.



If we fail to successfully develop the McDATA brand, our revenue may not grow.



Our name is not widely recognized as a brand in the marketplace given our
indirect sales model. We believe that establishing and maintaining the McDATA brand is a critical component in maintaining and developing strategic OEM, reseller and systems integrator relationships, and the importance of brand recognition will
increase as the number of vendors of competitive products increases. Our failure to successfully develop our brand may prevent us from expanding our business and growing our revenue. Similarly, if we incur excessive expenses in an attempt to promote
and maintain the McDATA brand, our business, financial condition and results of operations could be seriously harmed.



Undetected software or hardware defects in our products could result in loss of or delay in market acceptance of our products and could increase our costs or reduce
our revenue.



Our products may contain undetected software
or hardware errors when first introduced or when new versions are released. Our products are complex, and we have from time to time detected errors in existing products. In addition, our products are combined



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with products from other vendors. As a result, should problems occur, it might be difficult to identify the source of the
problem. These errors could result in a loss of or delay in market acceptance of our products, cause delays in delivering our products or meeting customer demands and would increase our costs, reduce our revenue and cause significant customer
relations problems. Errors could also result in the need for us to upgrade existing products at customer locations which would increase our costs or cause significant customer relations problems.



We are a defendant in a class action lawsuit and we may be subject to further litigation
in the future which could seriously harm our business.



As
more fully set forth in Note 12 to our Condensed Consolidated Financial Statements, we are a defendant in a consolidated securities class action know as In Re Initial Public Offering Securities Litigation (SDNY).We may become subject to
additional class action litigation following a period of volatility in the market price of our common stock. Securities class action litigation results in substantial costs and diverts the attention of management and our resources and seriously
harms our business, financial condition and results of operations.



The
sales cycle for our products is long, and we may incur substantial non-recoverable expenses and devote significant resources to prospects that do not produce revenues in the foreseeable future or at all.



Our OEMs, reseller and systems integrator customers typically conduct
significant evaluation, testing, implementation and acceptance procedures before they begin to market and sell new solutions that include our products. This evaluation process is lengthy and may extend up to one year or more. This process is complex
and may require significant sales, marketing and management efforts on our part. This process becomes more complex as we simultaneously qualify our products with multiple customers. As a result, we may expend significant resources to develop
customer relationships before we recognize revenue, if any, from these relationships. Products that are not qualified by storage and system OEMs and resellers, may not gain market acceptance. Our OEM and reseller customers have multiple sources for
products similar to ours, and as such, may not qualify our products for any number of reasons.



We may engage in future acquisitions that dilute our stockholders ownership and cause us to use cash, incur debt or assume contingent liabilities.



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



| |  | issue stock that would dilute our current stockholders percentage ownership;
| | - | -----------------------------------------------------------------------------



| |  | use cash, which may result in a reduction of our liquidity;
| | - | -----------------------------------------------------------



| |  | incur debt; or
| | - | --------------



| |  | assume liabilities.
| | - | -------------------



These purchases also involve numerous risks, including:



| |  | problems combining and integrating the purchased operations, technologies, personnel or products;
| | - | -------------------------------------------------------------------------------------------------



| |  | unanticipated costs;
| | - | --------------------



| |  | diversion of managements attention from our core business;
| | - | -----------------------------------------------------------



| |  | adverse effects on existing business relationships with suppliers and customers;
| | - | --------------------------------------------------------------------------------



| |  | risks associated with entering markets in which we have no or limited prior experience; and
| | - | -------------------------------------------------------------------------------------------



| |  | potential loss of key employees of acquired organizations.
| | - | ----------------------------------------------------------



We may not be able to successfully integrate any businesses, products, technologies or personnel that we might acquire in the future. In addition,
technology acquisitions of start-up companies could result in one-time charges related to acquisition costs, severance costs, employee retention costs and in-process research and development.



We may require, or could elect, to seek additional funding.



Our future capital requirements will depend on many factors, including our
rate of revenue growth, the timing and extent of spending to support development of new products and expansion of sales and marketing, the timing of new product introductions and enhancements to existing products, any acquisitions of businesses, and
market acceptance of our products. With changes in operating and industry expectations, we could require, or could elect, to seek additional funding including accessing the equity and debt markets.



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If we become subject to unfair hiring claims, we could incur substantial costs in defending ourselves.



Companies in our industry whose employees accept positions with
competitors frequently claim that their competitors have engaged in unfair hiring practices or that employees have misappropriated confidential information or trade secrets. Because we often seek to hire individuals with relevant experience in our
industry, we may be subject to claims of this kind or other claims relating to our employees in the future. We could incur substantial costs in defending ourselves or our employees against such claims, regardless of their merits. In addition,
defending ourselves or our employees from such claims could divert the attention of our management away from our operations.



Our products must comply with governmental regulation.



In the United States, our products comply with various regulations and standards defined by the Federal Communications Commission and Underwriters
Laboratories. Internationally, products that we develop will be required to comply with standards established by authorities in various countries. In the last several years, the European Union (EU) has adopted a number of initiatives (WEEE, RoHS,
etc.) related to equipment emissions, electronic waste, privacy of information and expanded consumer warranties. Failure to comply with existing or evolving industry standards or to obtain timely domestic or foreign regulatory approvals or
certificates could seriously harm our business.



Provisions in our charter
documents, our rights agreement and Delaware law could prevent or delay a change in control of McDATA and may reduce the market price of our common stock.



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



| |  | authorizing the issuance of preferred stock without stockholder approval;
| | - | -------------------------------------------------------------------------



| |  | providing for a classified board of directors with staggered three year terms;
| | - | ------------------------------------------------------------------------------



| |  | limiting the persons who may call special meetings of stockholders;
| | - | -------------------------------------------------------------------



| |  | requiring super-majority voting for stockholder action by written consent;
| | - | --------------------------------------------------------------------------



| |  | establishing advance notice requirements for nominations for election to the board of directors and for proposing other matters that can be acted on by stockholders at stockholder
meetings;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | prohibiting cumulative voting for the election of directors;
| | - | ------------------------------------------------------------



| |  | requiring super-majority voting to effect certain amendments to our certificate of incorporation and by-laws; and
| | - | -----------------------------------------------------------------------------------------------------------------



| |  | requiring parties to request board approval prior to acquiring 15% or more of the voting power of our common stock to avoid economic and voting dilution of their stock holdings.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



Our stock price is volatile.



The market price of our common stock has been volatile. Because we are a technology company, the market price of our common stock is usually subject to
similar volatility and fluctuations that occur in our sector and to our competitors. This volatility is often unrelated or disproportionate to the operating performance of our company and, as a result, the price of our common stock could fall
regardless of our performance.



Risks Related to Our Relationship With
EMC



We have entered into agreements with EMC that, due to our
prior parent-subsidiary relationship, may contain terms less beneficial to us than if they had been negotiated with unaffiliated third parties.



In October 1997, and in connection with the reorganization of our business, we entered into certain agreements with EMC relating to our business
relationship with EMC. In addition, we have entered into agreements with EMC relating to our relationship with EMC after the completion of our initial public offering in August 2000 and the distribution by EMC of our Class A common stock in February
2001. We have also entered into an OEM Purchase and License Agreement with EMC that governs EMCs purchases of our products and grants EMC rights to use, support and distribute software for use in connection with these products. The agreement
does not provide for the purchase of a guaranteed minimum amount of product. These agreements were negotiated and made in the context of our prior parent-subsidiary relationship. As a result, some of these agreements may have terms and conditions,
including the terms of pricing, that are less beneficial to us than agreements negotiated with unaffiliated third parties. Sales and services revenue pursuant



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to these agreements with EMC represented approximately 47% of our revenue for the three months ended April 30, 2004. In
addition, in some instances, our ability to terminate these agreements is limited, which may prevent us from being able to negotiate more favorable terms with EMC or from entering into similar agreements with third parties.



Provisions of our agreements with EMC relating to our relationship with EMC after the
distribution of our Class A common stock to EMCs stockholders may prevent a change in control of our company.



Under the terms of the May 2000 Master Confidential Disclosure and License Agreement between EMC and us, EMC has granted us a license to then existing EMC
patents and we granted to EMC a license to then existing McDATA patents. If we are acquired, our acquirer will retain this license as long as our acquirer grants to EMC a license under all of the acquirers patents for all products licensed
under the agreement under the same terms as the license we have granted to EMC under the agreement. The potential loss of the license from EMC under this agreement could decrease our attractiveness as an acquisition target.



We may be obligated to indemnify EMC if the distribution of our Class A common stock to
EMCs stockholders was not tax free.



The May 2000
Tax Sharing Agreement that we have entered into with EMC obligates us to indemnify EMC for taxes relating to the failure of EMCs distribution to EMCs stockholders of our Class A common stock to be tax free if that failure results from,
among other things:



| |  | any act or omission by us that would cause the distribution to fail to qualify as a tax-free distribution under the Internal Revenue Code;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------



| |  | any act or omission by us that is inconsistent with any representation made to the Internal Revenue Service in connection with the request for a private letter ruling regarding the
tax-free nature of the distribution by EMC of our Class A common stock indirectly held by it to its stockholders;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | any acquisition by a third party of our stock or assets; or
| | - | -----------------------------------------------------------



| |  | any issuance by us of stock or any change in ownership of our stock.
| | - | --------------------------------------------------------------------



While the risk associated with the Companys obligations under the Tax Sharing Agreement should diminish over time, the Companys tax years
covered by the agreement, as it relates to the Distribution, will remain open to examination by the IRS for at least three years from the date the returns for those years were filed.



ITEM 4. Controls and Procedures



Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures
pursuant to Exchange Act Rule 13a-14(c) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective.



As previously disclosed in the Companys annual report on
Form 10-K for the fiscal year ended January 31, 2004, in connection with the Companys year-end review and financial statement reporting process, in February 2004, the Companys internal accountants identified the applicability of SFAS 140
to a material transaction in the third quarter of fiscal 2003 involving the Companys securities lending program. As a result, on February 26, 2004, the Company announced that it would amend its Form 10-Q for the quarter ending October 31, 2003
to reflect a balance sheet reclassification related to the securities lending program. In its review, the Company investigated the cause of the reclassification and concluded that while the transaction was communicated prior to the filing, the
Company did not appropriately apply SFAS 140 to the securities lending program in preparing its financial statements for the quarter ending October 31, 2003. In response to the reclassification, the Companys independent auditors indicated in
late February to the Company that it believed that a material weakness under AU 325, Communication of Internal Control Related Matters Noted In An Audit, existed with regard to the evaluation of the appropriate accounting treatment for the
securities lending program. As a result, the Company immediately began implementing enhanced policies and procedures, including additional cross-functional meetings involving various vice presidents and the finance department, made improvements in
existing formal investment policies and established an issues log. These changes to the Companys internal controls were completed in early March 2004. In April 2004 the Company added an additional CPA with SEC experience dedicated to
transaction analysis. The Company believes that it has implemented these changes within its internal controls to improve the timely accounting evaluation and treatment of such transactions, and that the implementation of these changes during the
Companys first fiscal quarter has remediated the material weakness identified by its auditors. There were no other changes in the Companys internal control over financial reporting during the quarter ended April 30, 2004 that have
materially affected, or are reasonably likely to materially affect, the Companys internal controls over financial reporting.



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PART II  OTHER INFORMATION



|ITEM 6. | Exhibits and Reports on Form 8-K
|------- | --------------------------------



|(a) | Exhibits filed for the Company through the filing of this Form 10-Q/A.
|--- | ----------------------------------------------------------------------



|     |  |                                                                                                                                                                              
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|31.1 |  | CEO Certification required by Rule 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934.                                                                            
|     | 
|31.2 |  | CFO Certification required by Rule 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934.                                                                            
|     | 
|32   |  | Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, by Chief Executive Officer and Chief Financial Officer



SIGNATURE



Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



McDATA CORPORATIONBy:

/s/ ERNEST J. SAMPIASErnest J. SampiasSenior Vice President of Finance and Chief Financial Officer


August 23, 2004



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