**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-Q**

 

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

 

**Forthe quarterly period ended April 30, 2004**

 

**OR**

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

 

**Forthe transition periodfrom             to             **

 

**CommissionFile Number 000-31257**

 

**McDATACORPORATION**

(Exact name of registrant as specified in itscharter)

 

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

 

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

(Address of principal executive offices)(zipcode)

 

**(720)558-8000**

(Registrant’s telephone number, includingarea code)

 

 

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

 

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

 

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

 

At June 1, 2004, 81,000,000 shares of the registrant’s Class ACommon Stock were outstanding and 37,739,663 shares of the registrant’s Class BCommon Stock were outstanding.

 

 

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**McDATACORPORATION**

 

FORM 10-Q

QUARTER ENDED APRIL 30, 2004

TABLE OF CONTENTS

 
| **Item**                            |                                                                                        |   |   |
|-------------------------------------|---------------------------------------------------------------------------------------------|--------|--------|
|                                |
| PART 1 – FINANCIAL INFORMATION |                                                                                        |
|                                |                                                                                        |   |
| 1.                                  | Financial Statements                                                                        |   |
|                                |                                                                                        |   |
|                                | Condensed Consolidated Balance Sheets                                                       |   |
|                                |                                                                                        |   |
|                                | Condensed Consolidated Income Statements                                                    |   |
|                                |                                                                                        |   |
|                                | Condensed Consolidated Statements of Cash  Flows                                            |   |
|                                |                                                                                        |   |
|                                | Notes to Condensed Consolidated Financial  Statements                                       |   |
|                                |                                                                                        |   |
| 2.                                  | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |   |
|                                |                                                                                        |   |
| 3.                                  | Quantitative and Qualitative Disclosures  About Market Risks                                |   |
|                                |                                                                                        |   |
| 4.                                  | Controls and Procedures                                                                     |   |
|                                |                                                                                        |   |
| PART II – OTHER INFORMATION    |                                                                                        |
|                                |                                                                                        |   |
| 1.                                  | Legal Proceedings                                                                           |   |
|                                |                                                                                        |   |
| 5.                                  | Other Information                                                                           |   |
|                                |                                                                                        |   |
| 6.                                  | Exhibits and Reports on Form 8-K                                                            |   |

 

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**Special NoteRegarding Forward-Looking Statements**

 

Someof the information presented in this Quarterly Report on Form 10-Q contains“forward-looking statements” within the meaning of the Private SecuritiesLitigation 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 assumptionswithin the bounds of its knowledge of its businesses and operations; there canbe no assurance that actual results will not differ materially from ourexpectations. Factors that could cause actual results to differ materially fromexpectations include:

 

•                  changes in ourrelationship with EMC Corporation, or EMC, International Business MachinesCorporation, or IBM, and Hitachi Data Systems, or HDS, and the level of theirorders;

 

•                  our ability tosuccessfully increase sales of McDATA’s multi-protocol network switches andmanagement software, including SANavigator®;

 

•                  competition inthe multi-protocol (Fibre Channel and IP) network market, including competitivepricing pressures and product give-aways, by our competitors such as BrocadeCommunication Systems, Inc., or Brocade, QLogic Corp., or QLogic, ComputerNetwork Technology Corporation, or CNT, Cisco Systems, Inc., or Cisco, andother IP and multi-protocol switch and software suppliers;

 

•                  additionalmanufacturing and component costs and production delays that we may experienceas we continue the transition to new products;

 

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

 

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

 

•                  any change inbusiness conditions, our business and sales strategy or product developmentplans, and our ability to attract and retain highly skilled individuals;

 

•                  any industry ortechnology changes that cause obsolescence of our products or components ofthose products;

 

•                  one-time eventsand other important risks and factors disclosed previously and from time totime 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 ofany acquisitions by us of businesses, products, or technologies, includingdifficulties in integrating any acquisitions.

 

Youshould not construe these cautionary statements as an exhaustive list or as anyadmission by us regarding the adequacy of the disclosures made by us. We cannotalways predict or determine after the fact what factors would cause actualresults to differ materially from those indicated by our forward-lookingstatements or other statements. In addition, you are urged to considerstatements that include the terms “believes,” “belief,” “expects,” “plans,”“objectives,” “anticipates,” “intends,” or the like to be uncertain andforward-looking. All cautionary statements should be read as being applicableto all forward-looking statements wherever they appear. We do not undertake anyobligation to publicly update or revise any forward-looking statements.

 

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**PART I – FINANCIAL INFORMATION**

 

**McDATACORPORATION**

CONDENSEDCONSOLIDATED 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 partof these condensed consolidated financial statements.

 

1

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**McDATACORPORATION**

CONDENSEDCONSOLIDATED 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                                                                                                                           |   | 25,097                                 |   | 18,819 |   |
| Selling and marketing                                                                                                                              |   | 23,485                                 |   | 23,427 |   |
| General and administrative                                                                                                                         |   | 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 partof these condensed consolidated financial statements**.**

 

2

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**McDATACORPORATION**

CONDENSEDCONSOLIDATED 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 partof these condensed consolidated financial statements.

 

3

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**McDATACORPORATION**

 

NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(tabular amounts in thousands, except pershare data)

(unaudited)

 

**Note 1 – Overview and Basis of Presentation**

 

McDATA Corporation (McDATA or the Company) provides Multi-CapableStorage Network SolutionsTM (integrating multiple platforms, networks, protocols andlocations) that enables end-customers around the world to better utilize theirstorage infrastructure, easily manage the storage network and implementbest-in-class business continuance solutions allowing them to be more efficientand effective. McDATA solutions are an integral part of data servicesinfrastructures sold by most major storage and system vendors, including DellProducts L.P (Dell), EMC Corporation (EMC), Hewlett-Packard (HP), Hitachi DataSystems (HDS), International Business Machines Corporation (IBM),StorageTechnology Corporation (STK) and Sun Microsystems, Inc. (Sun).

 

Theaccompanying condensed consolidated financial statements of McDATA and itssubsidiaries have been prepared pursuant to the rules and regulations of theSecurities and Exchange Commission. Certain information and footnotedisclosures normally included in the Company’s annual consolidated financialstatements have been condensed or omitted. The condensed consolidated balancesheet as of January 31, 2004 has been derived from the audited financialstatements as of that date, but does not include all disclosures required bygenerally accepted accounting principles. For further information, please referto and read these interim condensed consolidated financial statements inconjunction with the Company’s audited financial statements for the year endedJanuary 31, 2004.

 

The interim condensed consolidated financial statements, in the opinionof management, reflect all adjustments necessary for a fair presentation of thefinancial position, results of operations and cash flows of the Company for theperiods presented. The results of operations for the interim periods are notnecessarily indicative of the results of operations to be expected for theentire fiscal year or future periods.

 

**Note 2 – Restructuring Charges**

 

Duringthe quarter ended January 31, 2004, the Company announced that it wastaking certain cost improvement actions, which included a workforce reductionand facility consolidation.  Totalrestructuring costs of $3.6 million as of April 30, 2004 consist ofseverance and benefit charges, facility closure expenses, and other charges.Severance and benefit charges of $2.4 million consist of severance andrelated employee termination costs, including outplacement services, associatedwith the reduction of the Company’s workforce by approximately 92 employees, or9% of the Company’s workforce. Facility closure charges of $1.1 million relateto estimated losses for a leased engineering facility in Toronto, Canada, netof expected sublease income. These charges represented the fair value of thelease liability based on assumptions regarding the vacancy period, subleaseterms, other anticipated subleasing expenses and the probability of subleasingthis space. The assumptions that the Company used were based on market data,including the then current vacancy rates and lease activities for similarfacilities within the area. Should there be changes in real estate market conditionsor should it take longer than expected to find a suitable tenant to subleasethe remaining vacant facilities, adjustments to the facilities lease lossesreserve may be necessary in future periods based upon then current actualevents and circumstances.

 

Remainingaccrued liabilities related to the Company’s fiscal 2003 restructuring programare included in accrued liabilities on the accompanying Condensed ConsolidatedBalance Sheets. During the three months ended April 30, 2004, the Companyrecorded additional expenses of $0.2 million to restructuring costs,primarily due to higher than expected payments related to employee severanceand related benefit costs. No other material changes in estimates were made tothe fiscal 2003 fourth quarter restructuring accrual. The Company expects topay or otherwise substantially settle the remaining accrued liabilities duringfiscal year 2004.   The following tablesummarizes the Company’s utilization of restructuring accruals for the threemonths ended April 30, 2004:

 
|                                       |   | **Employee  Severance  Benefits** |   | **Facility  Closure** |   | **Other  Costs** |   | **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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**Note 3 – Components of Selected Balance SheetAccounts**

 
|                                               |   | **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 |   |

 

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(1)          Activity in the warranty reserves is asfollows:

 
|                           |   | **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 ofpreferred stock, or approximately 17.3% of the total outstanding shares ofAarohi Communications (Aarohi) for $6 million cash.  Aarohi is a privately owned provider of next-generationintelligent storage networking technology. In addition to the equity investment, the Company has entered into anon-exclusive supply arrangement with Aarohi to purchase their ASIC chip forinclusion in the Company’s new product launches when, and if, Aarohi’s productbecomes generally available.  TheCompany has recorded its share of Aarohi’s net loss of approximately $577,000for the three months ended April 30, 2004. The remaining net equityinvestment of approximately $803,000 is recorded as an other asset as ofApril 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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**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. andSanera Systems, Inc. in the third quarter of 2003.  Purchase price adjustments during the quarter endedApril 30, 2004 included an adjustment to the acquired balances for notespayable and net accounts receivables.  No further material purchase adjustments are anticipated except forpotential goodwill adjustments related to the deferred tax asset and relatedvaluation allowances which may result in future goodwill adjustments that wererecorded at the time of acquisitions.

 

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

 
|                    |   | **April 30,  2004**    |    | **January 31,  2004**    |   |
|-------------------------|--------|-----------------------------|---------|-------------------------------|--------|
|                    |   | **Gross  Carrying  Amount** |    | **Accumulated  Amortization** |   | **Net  Carrying  Amount** |   | **Gross  Carrying  Amount** |   | **Accumulated  Amortization** |   | **Net  Carrying  Amount** |   |
|                    |   |                        |    |                          |   |   |   |   |   |   |   |   |   |
| 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 intangibleassets 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 fiscal2004.

 

Amortization expense related to acquired intangible assets was $5.8million 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 thethree months ended April 30, 2004 reflects foreign tax which McDATA willowe on the profit of its foreign subsidiary activities which will not beeliminated by a net operating loss for applicable jurisdictions.  No federal or state tax benefit is recordedbecause the Company has established a valuation allowance against its netdeferred tax asset.  The tax provisionended April 30, 2003 reflects federal, state and foreign tax expense priorto the establishment of a valuation allowance.

 

6

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**Note 8 – Net Income (Loss) Per Share**

 

Basicnet income (loss) per share excludes dilution and is computed by dividingincome available to common stockholders by the weighted-average number ofcommon shares outstanding for the period. Diluted net income (loss) per shareis based on the weighted-average number of shares outstanding during eachperiod and the assumed exercise of dilutive stock options less the number oftreasury shares assumed to be purchased from the proceeds using the averagemarket price of the Company’s common stock for each of the periods presented.No dilutive effect has been included for the convertible subordinated debtissued February 7, 2003 because the Company currently has the ability andintent to settle the conversion in cash. Additionally, no dilutive effect hasbeen included for the share options sold in relation to the convertiblesubordinated debt because the exercise price was higher than the average stockprice 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 employeecompensation and employee purchase plans, which are described more fully in theCompany’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 forfuture grants under these plans.

 

The Company accounts for these plans according to Accounting PrinciplesBoard Opinion No. 25, “Accounting for Stock Issues to Employees (APB 25)”,and related interpretations and has adopted the disclosure-only alternativeof  Statement of Financial AccountingStandards (SFAS) No. 123, “Accounting for Stock-Based Compensation”(SFASNo. 123), as amended by SFAS No. 148, “Accounting for Stock-BasedCompensation - Transition and Disclosure an amendment of FASB Statement No.123”. Any deferred stock compensation calculated pursuant to APB 25 isamortized ratably over the vesting period of the individual options, generallytwo to four years. The following table illustrates the effect on net lossand earnings per share if the Company had applied the fair value recognitionprovisions 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 hasone reporting segment relating to the design, development, manufacture andsales of open storage networking solutions that provide highly available,scalable and centrally managed storage area networks (SANs).  The Company’s Chief Operating DecisionMakers, as defined by SFAS No. 131, “Disclosures about Segments of anEnterprise and Related Information,” allocate resources and assess theperformance of the Company based on revenue and overall profitability.

 

A significantportion of revenue is concentrated with the largest storage OEMs. For the threemonths ended April 30, 2004, approximately 47% of total revenue came fromEMC, compared to 61% for the three months ended April 30, 2003.  IBM contributed approximately 25% of revenuefor the first quarter of 2004 compared to 17% for the first quarter of2003.   In addition, HDS contributedapproximately 12% and 11% of total revenue for the three months endedApril 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 systemvendors, the Company has relationships with many resellers, distributors andsystems integrators. Sales to these other channels represented 16% and 11% ofrevenue, respectively for the three months ended April 30, 2004 and 2003.

 

Revenuesare attributed to geographic areas based on the location of the customers towhich products are shipped. International revenues primarily consist of salesto customers in Western Europe and the greater Asia Pacific region. Included indomestic revenues are sales to certain OEM customers who take possession ofproducts domestically and then distribute these products to their internationalcustomers. In addition, included in revenues from Western Europe are sales tocertain OEM customers who take possession of products in distribution centersdesignated for international-bound product and then distribute these productsamong various international regions. The mix of international and domesticrevenue can, therefore, vary depending on the relative mix of sales to certainOEM customers.  Domestic andinternational 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 totalrevenue, respectively.

 

**Note 12 – Commitment and Contingencies**

 

Fromtime to time, the Company is subject to claims arising in the ordinary courseof business. In the opinion of management and except as set forth below, nosuch matter, individually or in the aggregate, exists which is expected to havea material effect on the Company’s consolidated results of operations,financial position or cash flows.

 

*Manufacturing and Purchase Commitments*

 

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

 

The Company has various other commitments for sales and purchases inthe ordinary course of business. In the aggregate, such commitments do notdiffer significantly from current market prices or anticipated usagerequirements.

 

8

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*Litigation*

 

Class Action Laddering Lawsuits

 

TheCompany, 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 currentofficer were named as defendants in purported securities class-action lawsuitsfiled in the United States District Court, Southern District of New York. Thefirst of these lawsuits, filed on July 20, 2001, is captioned Gutner v.McDATA Corporation, Credit Suisse First Boston (CSFB), Merrill Lynch, PierceFenner & Smith Incorporated, Bear, Stearns & Co., Inc., FleetBostonRobertson Stephens et al., No. 01 CIV. 6627. Three other similar suits werefiled against the Company and the individuals. The complaints are substantiallyidentical to numerous other complaints filed against other companies that wentpublic in 1999 and 2000. These lawsuits generally allege, among other things,that the registration statements and prospectus filed with the SEC by suchcompanies were materially false and misleading because they failed to disclose(a) that certain underwriters had allegedly solicited and received excessiveand undisclosed commissions from certain investors in exchange for which theunderwriters allocated to those investors material portions of shares inconnection with the initial public offerings, or IPOs, and (b) that certain ofthe underwriters had allegedly entered into agreements with customers wherebythe underwriters agreed to allocate IPO shares in exchange for which thecustomers agreed to purchase additional company shares in the aftermarket atpre-determined prices. The complaints allege claims against the Company, thenamed individuals, and CSFB, the lead underwriter of the Company’sAugust 9, 2000 initial public offering, under Sections 11 and 15 of theSecurities Act. The complaints also allege claims solely against CSFB and theother underwriter defendants under Section 12(a)(2) of the Securities Act,and claims against the individual defendants under Section 10(b) of theSecurities Exchange Act. Although management believes that all of the lawsuitsare without legal merit and they intend to defend against them vigorously,there is no assurance that the Company will prevail.

 

InSeptember 2002, plaintiffs’ counsel in the above-mentioned lawsuitsoffered to individual defendants of many of the public companies being sued,including the Company, the opportunity to enter into a Reservation of Rightsand Tolling Agreement that would dismiss without prejudice and without costsall claims against such persons if the company itself had entity coverageinsurance. This agreement was signed by Mr. John F. McDonnell, the formerCompany Chairman, Mrs. Dee J. Perry, the former chief financial officer, andMr. Thomas O. McGimpsey, the current Vice President and General Counsel and theplaintiffs’ executive committee. Under the Reservation of Rights and TollingAgreement, the plaintiffs dismissed the claims against such individuals.

 

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

 

Nishan Acquisition RelatedLawsuit

 

Inconnection with the Company’s acquisition of Nishan, the Company was namedalong with Nishan, various investors of Nishan, CSFB and former board membersand officers of Nishan in a lawsuit brought by Aamer Latif, a former boardmember and ex-CEO of Nishan, in the Superior Court of California, County ofSanta Clara on September 11, 2003 (as amended on October 10, 2003 andMarch 24, 2004) entitled *Aamer Latif v.Nishan Systems, Inc. et al (103 CV 004 939)*. The Complaint makesvarious allegations against the other defendants such as fraud, directors’breach of the duty of care, shareholders’ breach of fiduciary duty, unjustenrichment, and conspiracy to commit unjust enrichment. The allegations madeagainst the Company are vote buying, unjust enrichment, and conspiracy tocommit unjust enrichment. The allegation made against Nishan is breach ofSection 1602 of the California Corporations Code (a provision dealing withbooks and records inspection). The complaint primarily seeks compensatorydamages of approximately $11.5 million and other relief. The defendants haveagreed that lawsuit expenses are covered by indemnification under the mergeragreement from the selling shareholders of Nishan. The defendants filed ademurer to dismiss this action, which was denied by the Court inJanuary 2004.  In May 2004, thedefendants filed another demurer to dismiss this action, which is currentlybefore the Court.  After significantreview of the allegations made by the plaintiff, the Company strongly believesthat the lawsuit is wholly without legal merit and the Company intends tovigorously defend against this action.

 

*Indemnifications and Guarantees*

 

During its normal course of business, the Company may enter intoagreements with, among others, customers, resellers, OEMs, systems integratorsand distributors.  These agreementstypically require the Company to indemnify the other party against third partyclaims or product infringements on patents or copyrights.  The Company provides indemnifications ofvarying scope and size to certain customers against claims of intellectualproperty infringement made by third parties arising for the use of ourproducts.

 

In addition, the majority of these indemnities, commitments andguarantees do not provide for any limitation of the maximum potential futurepayments the Company could be obligated to make.  The Company evaluates and estimates losses from suchindemnification under SFAS No. 5, “Accounting for Contingencies”, asinterpreted by FASB Interpretation No. 45. To date, the Company has not incurred any material costs as a result ofsuch obligations and has not accrued any liabilities related to such 

 

9

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indemnification and guarantees in our financial statements.

 

 

10

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**ITEM2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

*You should read the following discussion and analysis in conjunctionwith the condensed consolidated financial statements and notes thereto includedin Item 1 of this Quarterly Report and with Management’s Discussion andAnalysis of Financial Condition and Results of Operations contained in ourAnnual Report filed on Form 10-K with the Securities and Exchange Commission onApril 15, 2004.*

 

**Overview**

 

McDATA provides storage area networking (SAN)solutions, including hardware and software, for connecting servers and storagedevices from the core to the edge of an enterprise’s data infrastructure, andheterogenous SANs via our SAN Routing capabilities.  Our solutions include hardware and software products,professional services and education that enable businesses to scale theiroperations globally through a comprehensive, manageable, flexible datainfrastructure that is optimized for rapid deployment and responsiveness tocustomer needs. We combine experience in designing, developing andmanufacturing high performance SAN solutions with knowledge of businesscritical applications, service and support to solve data infrastructurechallenges facing enterprises of varying sizes.

 

Themarket for our multi-protocol SAN switching hardware and software products ishighly competitive, especially with the entrance of competitors from the IPbased switch market. Our competitors are providing or plan to provide SANswitching hardware and software that is multi-protocol capable such as FibreChannel over IP (FCIP), SCSI over Internet (iSCSI), Internet Fibre Channel(iFCP) and InfiniBand(IB). A number of our current and potential competitorshave longer operating histories, greater name recognition, access to largercustomer bases, more established distribution channels and substantially greaterfinancial and managerial resources. Given the highly competitive market, weanticipate continued lengthened sales cycles and continued downward pricingpressures during fiscal year 2004.

 

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

 

**Resultsof Operations**

 

The following table sets forth certain financial data for the periodsindicated 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 | % |

 

11

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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 $97.2million, which represented a 6% decrease over the three months endedApril 30, 2003.  Thedecrease in revenue during the first quarter of 2004 was created by severalfactors including the delay of our new product distribution agreements, theslower-than-expected ramp-up for high-volume channels, and a continuedlengthened sales cycle due, in part, by the competitive market and longerdecision-making processes by end-users. We have subsequently executed one new product distribution agreement forthe new Eclipse-line of products. However, the competitive marketplace will continue to cause the salescycle for products to lengthen, especially in the high-end director market.This limits our visibility into product demand and timing of revenues. Overallpricing remained stable during the first quarter having realized only thetypical pricing declines associated with our products.  We expect these price declines, which aretypical for technology products, to continue. In addition, we could experience further pricing declines if thecompetitive marketplace creates additional downward pricing pressures.

 

Product revenue of $79.3 million for the three months endedApril 30, 2004 was a 13% decrease over the three months endedApril 30, 2003.  Decreases in salesof both our director and switch products contributed to the decline in revenue.

 

Software and service revenue of $12.1 million for the three monthsended April 30, 2004 was a 44% increase over the three months endedApril 30, 2003.  This revenuegrowth is due to continued revenue growth from all of our softwareproducts, in particular our SANavigator® and SANtegrity® software. A significant portion of our softwarerevenue 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 increasereflects significant growth in maintenance and service fees.  These increased revenues are the result ofhigher sales of extended maintenance contracts that are sold in conjunctionwith sales of hardware and software products. Service fees recorded under the ESCON service agreement are expected todecline as the ESCON products near their end of life.  However, in the near term we anticipate an increase in servicerevenues as certain deferred revenues related to this service contract with EMCare recognized in accordance with revenue recognition rules and on-goingcontract negotiations.

 

A significantportion of our revenue is concentrated with the largest storage OEMs. For thethree months ended April 30, 2004, approximately 47% of our total revenuecame 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 firstquarter of 2003.   In addition, HDScontributed approximately 12% and 11% of total revenue for the three monthsended April 30, 2004 and 2003, respectively.  Other major storage and system vendors, including Dell, HP, STKand 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 thethree months ended April 30, 2004 and 2003.  The decline in the revenue from EMC as a percentage of our salesis the result of the entrance of new competitors into the storage market andthe lengthened sales cycle in the high-end director market; as well as theoverall growth in revenue dollars from our other OEMs as well and otherchannels.  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 growour business. However, the level of sales to any single customer may vary andthe loss of any one significant customer, or a decrease in the level of sales toany significant or group of significant customers, could harm our financialcondition and results of operations. Given the dependencies on our limitednumber of OEM resellers combined with an increasingly competitive environment,we may experience continued adverse price pressures at critical times near theend of the fiscal quarters.

 

Domestic and international revenue was approximately 62% and 38% of ourtotal 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 ourtotal revenue, respectively.  Revenuesare attributed to geographic areas based on the location of the customers towhich our products are shipped. International revenues primarily consist ofsales to customers in Western Europe and the greater Asia Pacific region.Included in domestic revenues are sales to certain OEM customers who takepossession of our products domestically and then distribute these products totheir international customers. In addition, included in revenues from WesternEurope are sales to certain OEM customers who take possession of our productsin distribution centers designated for international-bound product and thendistribute these products among various international regions. Our mix ofinternational and domestic revenue can, therefore, vary depending on therelative mix of sales to certain OEM customers. The increase in internationalrevenues as a percentage of revenue for the first quarter of fiscal year 2004was the result of increased sales in both Western Europe and the Asia Pacificregion.  For the three months endedApril 30, 2003, we experienced a decrease in sales to customers in theAsia Pacific region, possibly due indirectly to the market effects of the SARSvirus.

 

12

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*Gross Profit*

 

Gross profit was 56% and 57% for the three months ended April 30,2004 and 2003, respectively.   Inanticipation of the natural decline in selling prices, we continue to drivecost advantages through our engineering and manufacturing processes.  In April 2004, we announced theavailability of the lower cost versions of our second generationswitch-on-a-chip and began shipping the lower cost versions of our directorcomponents.  Through these actions, weanticipate gross profit will remain in the mid-50 percent range.

 

*Operating Expenses*

 

*Research and Development Expenses.*  Research and development expenses increasedto $25.1 million for the three months ended April 30, 2004, comparedwith $18.8 million for the three months ended April 30, 2003.Research and development expenses consist primarily of salaries and relatedexpenses for personnel engaged in engineering and R&D activities; fees paidto consultants and outside service providers; nonrecurring engineering charges;prototyping expenses related to the design, development, testing andenhancement of our products; depreciation related to engineering and other testequipment; and IT and facilities expenses. The approximate $6.3 million or 33% increase was primarily attributableto increased staffing levels related to our 2003 acquisitions and increasedspending related to new product development.  Capitalized software costs were approximately $2.3 million and $648,000for the three months ended April 30, 2004 and April 30, 2003,respectively. Capitalized software development costs vary in conjunction withstages of development of our application software, our new director and switchproducts and related firmware software.

 

*Selling and Marketing Expenses.*  Selling and marketing of $23.5 millionfor the three months ended April 30, 2004, were comparable to$23.4 million for the three months ended April 30, 2003. Salesand marketing expenses consist primarily of salaries, commissions and relatedexpenses for personnel engaged in marketing and sales; costs associated withpromotional and travel expenses; and IT and facilities expenses. Modestincreases in salaries and travel costs were offset by the decrease in customeracquisition costs from the first quarter of 2003 that were attributable to twonew OEM contracts signed during that period.

 

*General and Administrative Expenses*.  General and administrative expensesincreased by approximately 66% to $12.4 million for the three months endedApril 30, 2004 from $7.5 million for the three months ended April 30,2003. General and administrative expenses consist primarily of salaries andrelated expenses for corporate executives, finance, human resources and investorrelations, as well as accounting and professional fees, corporate legalexpenses, 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 ofDeferred Compensation*.  We have recorded deferredcompensation in connection with Class B common stock options granted prior toour August 9, 2000 initial public offering (IPO) and restricted Class Bstock grants granted through our equity incentive plans. In addition, we issuedapproximately 1.0 million shares of Class B restricted common stock withvesting periods ranging from 12 to 24 months in connection with ouracquisitions during fiscal 2003. We are amortizing all deferred compensation ona straight-line basis over the vesting period of the applicable options andstock awards, resulting in amortization expense of $2.3 million for the threemonths ended April 30, 2004 and $1.5 million for the three months endedApril 30, 2003 (of which approximately $84,000 and $137,000 was includedin cost of revenue, respectively).  Additional grants of stock-based awards under existing equity plans,future plans or through acquisitions could increase the level of deferredcompensation expense.

 

*Restructuring Charges.*InJanuary 2004, we announced that we were taking certain cost improvementactions, which included a workforce reduction and facility consolidation. Forthe three months ended April 30, 2004, we completed our planned closure ofour Toronto engineering facility.  As aresult, the Company recorded an approximate $1.1 million restructuring chargerelated to the leased facility closure. In addition, we incurred an additional$182,000 restructuring charge in the first fiscal quarter for additionalseverance-related costs as we finalized the reduction in workforce that wasinitiated in the fourth quarter of 2003.

 

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

 

*Interest Expense. *Interest expense of $0.2 million for thethree months ended April 30, 2004 decreased 77% compared with $1.1 millionfor the three months ended April 30, 2003.  The decrease is attributable to the interest rate swap which wasentered into during the second quarter fiscal 2003.  This interest-rate swap agreement has the economic effect ofmodifying the fixed interest obligations associated with our convertible debtso that the interest payable on the majority of the debt effectively becomesvariable based on the six month LIBOR minus 152 basis points. The reset datesof the swap are February 15 and August 15 of each year until maturityon February 15, 2010. At April 30, 2004, the six-month LIBOR settingwas set at 1.175%, resulting in a rate of minus 0.345%, which is effectiveuntil August 15, 2004.  Significantincreases in interest rates in future periods could significantly increaseinterest expense.

 

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*Provision for IncomeTaxes.* Generally, the effective tax rate is determined by the relationshipbetween the estimated tax payable in all jurisdictions in which the Company issubject to income tax and pre-tax book income or loss.  In calculating the estimated tax payable, bookincome is adjusted for certain amounts that are reported differently betweenthe financial statements and the tax return.

 

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

 

We are subject to audit by federal, state and foreign taxauthorities.  These audits may result inadditional tax liabilities.  We accountfor such contingent liabilities in accordance with SFAS No. 5, Accounting forContingencies, and believe that we have appropriately provided for taxes forall years.  Several factors drive thecalculation of our tax reserves including (i) the expiration of statutes oflimitations, (ii) changes in tax law and regulations, and (iii) settlementswith tax authorities.  Changes in any ofthese factors may result in adjustments to our reserves which could impact ourreported financial results.

 

**Liquidity and CapitalResources**

 

Our financialcondition remains solid.  AtApril 30, 2004, cash, short- and long-term investments were $318 millioncompared to approximately $317 million as of January 31, 2004.  These balances both include approximately $5million of restricted cash that we are required to maintain in relation to theinterest rate swap we have executed in connection with our convertibledebt.  We invest excess cashpredominantly in debt instruments that are highly liquid, of high-qualityinvestment grade, and predominantly have maturities of less than three yearswith the intent to make such funds readily available for operating purposes,including expansion of operations and potential acquisitions or othertransactions.

 

We believe our existing cash, short-term and long-terminvestment balances, and cash expected to be generated from future operationswill be sufficient to meet our capital and operating requirements at leastthrough 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, includingour rate of revenue growth, the timing and extent of spending to supportdevelopment of new products and expansion of sales and marketing, the timing ofnew product introductions and enhancements to existing products, and marketacceptance 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 operatingactivities reflects the net loss for the quarter ended April 30, 2004adjusted for non-cash charges including depreciation, amortization, deferredcompensation and changes in working capital items.  Working capital items include accounts receivable, inventories,other current and non-current assets, accounts payable, accrued liabilities anddeferred revenue.  Accounts receivablewas the source of $4.5 million in the first quarter of fiscal year 2004compared to a use of $3.0 million in the first quarter of 2003.  Days sales outstanding (DSO) was 54 days and33 days for the first quarter ended April 30, 2004 and 2003,respectively.  The change between yearsis the result of the timing and collections compared to billings.  The use of $4.7 million in the first quarterof 2004 compared to the $2.3 million use in the first quarter of 2003 of cashfrom inventories is the result of a build of inventories surrounding the nextgeneration of products that are currently in the pre-production phase.  The use of cash of $4.1 million fromaccounts payable and accrued liabilities in the first quarter of 2004 comparedto the $11.7 source of cash in the first quarter of fiscal year 2003 resultsfrom the timing of payments of vendor invoices.  We anticipate the use of cash for accrued liabilities to increasesignificantly in the second quarter of fiscal 2004 as funds due under our ESCONservice fee arrangement are settled.

 

The decrease in net cash used by investingactivities reflects the use of cash proceeds for the issuance of convertiblesubordinated notes to purchase investments in the first quarter of 2003.

 

Netcash used by financing proceeds during the three months ended April 30,2004 reflects proceeds from the issuance of common stock from stock optionexercises and purchases under the Company’s employee stock purchase plan.  In the first quarter of 2003, weissued convertible subordinated notes of $172.5 million in principal amount,with proceeds of $167 million.  The 2.25% convertible subordinatednotes mature in February 2010, unless converted into McDATA common stockat a conversion price of $10.71 per share, subject to certain conversion priceadjustments.  Offsetting these netproceeds were the use of $20.5 millionof those proceeds to enter into share option transactions.

 

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*Off-BalanceSheet Arrangements*

 

Other than facility andequipment leasing arrangements, the Company does not engage in off-balancesheet financing activities.

 

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

 

*Commitments*

 

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

 

**Critical AccountingPolicies**

 

The Company’scritical accounting policies have not changed from those reported inManagement’s Discussion and Analysis of Financial Condition and Results ofOperations in the Company’s 2003 Annual Report on Form 10-K.

 

**Risk Factors**

 

***Risks Relating toOur Business***

 

**ChangingMarket Conditions and Increased Competitive Risks.**

 

The market for ourmulti-protocol storage area networking (SAN) products and solutions has grownand will continue to become more competitive with (a) the entrance of newcompetitors from the IP based switching market into our market, (b) pricingpressures resulting from this increase in competitive SAN networking productsand solutions, (c) challenges to our direct-assist sales model withdistribution through channels when our competitors engage end-user customersdirectly or otherwise have the ability to drive end-user customer preferencefor SAN equipment through their traditional IP networking presence andrelationships, and (d) anticipated competition from our own storage OEMpartners through their recent acquisitions of, or alliances with, competitivesoftware management products and/or application providers that would utilizethe intelligence in the network. As a result of these market changes, weanticipate continued lengthened sales cycles and price erosion in anenvironment where storage OEM certification of our products may still berequired for end-user customer acceptance. Given our direct-assist sales modelwith distribution through our channel partners, we are highly dependent uponour channel partners’ relationships with end-user customers to promote thevalue of our products. If our channel partners do not promote the value of ourproducts or competitors begin to control end-user customer preference, we maylose sales in key enterprise accounts that would materially adversely affect ourrevenues.

 

**We are highly dependent on our OEMre-sellers, especially EMC, and efforts by them to reduce the prices of theirsuppliers may decrease our revenue and gross margins.**

 

We are highly dependent onour OEM partners, especially EMC, and efforts by them to reduce the prices oftheir suppliers may decrease our revenue and gross margins.  For example, given our concentration ofsales with EMC, the revenue shortfall with EMC experienced this fiscal quarterand EMC’s public statements that they will further reduce their suppliers’prices, we may experience unanticipated decreases in sales revenue and grossmargins that may lead us to be unprofitable. The above-mentioned factors mayalso strain business relationships with our storage OEM partners and mayadversely affect the qualification and certification of our products. Moreover,the introduction of such new products and any pending qualification andcertification by our partners may stall sales of our existing products with enduser customers.  Given the dependencieson our limited number of OEM resellers combined with an increasinglycompetitive environment, we may experience continued adverse price pressures atcritical times near the end of the fiscal quarters.

 

**Newcompetitors have entered this market and we may not be able to successfullycompete against existing or potential competitors.**

 

The market forour multi-protocol SAN switching hardware and software products is highlycompetitive, especially with the entrance of competitors from the IP basedswitch market. Our competitors are providing or plan to provide SAN switchinghardware 

 

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and software that is multi-protocol capable(such as Fibre Channel over IP (FCIP), SCSI over Internet (iSCSI), InternetFibre Channel (iFCP) and InfiniBand). Our competitors in the this marketinclude Brocade, CNT, Cisco, QLogic Corp., Emulex Corporation (which acquiredVixel Corporation), Broadcom Corporation (which acquired the assets of GadzooxNetworks), Veritas Software Corporation, Fujitsu Softech and others, includingstorage hardware device providers. Given the market share gain by Cisco, otherIP based switching companies such as Juniper, Extreme, Foundry and others mayenter the market for multi-protocol SAN products. Many of our competitors andpotential competitors have longer operating histories, greater namerecognition, access to larger customer bases, more established distributionchannels and substantially greater financial and managerial resources thanMcDATA. Given the highly competitive market, we anticipate continued lengthenedsales cycles and continued downward pricing pressures.  To be competitive, we may have tosubstantially increase headcount in our direct-assist sales model and migrateto a direct end-user customers touch and possibly to direct sales, which we maynot be able to do successfully and which, in any case, will increase expenses. Continuedor increased competition could result in pricing pressures, reduced sales,reduced margins, reduced profits, reduced market share, further elongating ofsales cycles, or the failure of our products to achieve or maintain marketacceptance.

 

**We incurreda substantial loss for the three months ended April 30, 2004 and for thefiscal years ended January 31, 2004, and December 31, 2002 and maynot be profitable in the future.**

 

Our future operating resultswill depend on many factors, including the growth of the multi-protocol (FibreChannel and IP) market, market acceptance of new products we introduce, demandfor our products, levels of product and price competition and our reaching andmaintaining targeted costs for our products. In addition, we expect to incurcontinued significant product development, sales and marketing, and general andadministrative expenses. We cannot provide assurance that we will generatesufficient revenue to achieve or sustain profitability.

 

**The pricesand gross margins of our products may decline, which would reduce our revenuesand profitability.**

 

In response to changes inproduct mix, competitive pricing pressures, increased sales discounts,introductions of new competitive products, product enhancements by ourcompetitors, increases in manufacturing or labor costs or other operatingexpenses, we may experience declines in prices, gross margins andprofitability. To maintain our gross margins we must maintain or increasecurrent shipment volumes, develop and introduce new products and productenhancements and reduce the costs to produce our products. Moreover, most of ourexpenses are fixed in the short-term or incurred in advance of receipt ofcorresponding revenue. As a result, we may not be able to decrease our spendingto offset any unexpected shortfall in revenues. If this occurs, we could incurlosses, and our revenue, gross margins and operating results may be below ourexpectations and those of investors and stock market analysts.

 

**We dependon two key distribution relationships for most of our revenue and the loss ofeither 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 IBMrepresented approximately 47% and 25%, respectively, of our revenue for thethree months ended April 30, 2004. We anticipate that our future operatingresults will continue to depend heavily on sales to EMC and IBM. EMC and IBMresell products offered by our competitors, and nothing restricts EMC and IBMfrom 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 significantreduction 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, itis unclear whether this mitigates our dependency on EMC. Our product salesagreements with sales partners do not provide for the purchase of a guaranteedminimum amount of product.

 

**Our changeof fiscal year may not result in more predictable quarterly earnings.**

 

Historically, our quarterlyoperating results have depended on our performance in the later part of eachcalendar quarter, when a large percentage of our product shipments typicallyoccur. This fluctuation has made consistent quarter-to-quarter performance andrevenue forecasting difficult. We have adopted a number of measures to addressthis issue, including changing our fiscal year end to January 31, ratherthan December 31. We cannot be certain that changing our fiscal year oradopting other measures will result in product shipments occurring more evenlyduring each quarter, resulting in consistent quarter-to-quarter performance orimproving revenue forecasts.

 

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

 

•                  the size,timing, terms and fluctuations of customer orders, particularly large ordersfrom EMC,  IBM or HDS;

•                  pricingdiscussions late in a quarter and a limited capability to ramp shipments nearthe end of that quarter;

•                  our ability toattain and maintain market acceptance of our products;

•                  seasonalfluctuations in customer buying patterns;

•                  the timing ofthe introduction of or enhancement to, products by us, our significant OEM orreseller customers or our competitors (e.g., transition to higher speed, higherport density and multi-protocol products);

 

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•                  our ability toobtain sufficient supplies of single- or limited-source components of ourproducts; and

•                  increasedoperating expenses, particularly in connection with our strategies to increasecustomer touch and purchase preference for our products or to invest inresearch and development.

 

Our uneven sales patternmakes it difficult for our management to predict near-term demand and adjustmanufacturing capacity. Further, our OEM and reseller partners may purchasecertain of our products ahead of end-user customer demand, which could reducesubsequent purchases by those partners. Accordingly, if orders for our productsvary substantially from the predicted demand, our ability to assemble, test andship orders received in the last weeks and days of each quarter may be limited,which could seriously harm quarterly revenue or earnings. Moreover, anunexpected decline in revenue without a corresponding and timely reduction inexpenses could intensify the impact of these factors on our business, financialcondition and results of operations.

 

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

 

For the three months endedApril 30, 2004, we derived a significant portion of our revenue from salesof our director-class IntrepidTM switch products. We expect thatrevenue from our director-class IntrepidTM switch products willcontinue to account for a substantial portion of our revenue for theforeseeable future. Factors such as performance, market positioning, theavailability and price of competing products, the introduction of new technologiesand the success of our OEM, reseller and systems integrator customers willaffect the market acceptance of our products. Therefore, continued market acceptance of these products and theirsuccessor products, along with our SphereonTM and Eclipse® switches,are critical to our future success.

 

In addition, our futuresuccess depends upon our ability to address the changing needs of customers andto transition to new technologies and industry standards. The introduction ofcompeting products embodying new technologies or the emergence of new industrystandards could render our products non-competitive, obsolete or unmarketableand seriously harm our market share, revenue and gross margin. Risks inherentin transitions to new technology, industry standards and new protocols includethe inability to expand production capacity to meet demand for new products,write-downs of our existing inventory due to obsolescence, the impact ofcustomer demand for new products or products being replaced, and delays in theintroduction or initial shipment of new products. There can be no assurancethat we will successfully manage these transitions.

 

We are currently developingproducts that contain untested devices and subassemblies. As with anydevelopment, there are inherent risks should such devices or subassembliesrequire redesign or rework. In particular, in conjunction with the transitionof our products from fibre channel to multi-protocol, 2 Gb to 4Gb to 10 Gbtransmission speed technology, higher port densities, and advanced managementcapabilities, we will be introducing products with new features andfunctionality, such as our next generation director-class switch product, the IntrepidTM10000 Director. We face risksrelating to this product transition, including risks relating to thequalification of such products by our storage and system OEMs, forecasting ofdemand, as well as possible product and software defects and a potentially differentsales and support environment due to the complexity of these new systems.Finally, if we fail to introduce new products timely, or to add new featuresand functions to existing products to compete against new entrants in themarket, or if there is no demand for these or our current products, ourbusiness could be seriously harmed.

 

**Risksrelated to recent acquisitions.**

 

In September 2003, weclosed our acquisitions of Nishan Systems, Inc. (Nishan) and Sanera Systems,Inc. (Sanera). While management believes that such acquisitions are an integralpart of their long-term strategy, there are risks and uncertainties related toacquiring companies that have limited or no product sales to date. Our successdepends upon integrating Nishan and Sanera with McDATA, finalizing thedevelopment of such products, retaining critical employees from the acquiredcompanies, qualifying such products with our OEM and reseller partners andramping sales of those products with such partners.

 

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

 

We conduct significant salesand customer support operations in countries outside of the United States andalso depend on non-U.S. operations of our contract manufacturers, and ourdistribution partners. Further, we utilize an India based firm to providecertain software engineering services, and our virtualization chip supplier,Aarohi Communications, is also reliant on offshore engineering. We derivedapproximately 38% of our revenue for the three months ended April 30,2004, from customers located outside of the United States. We believe that ourcontinued growth and profitability will require us to continue to expandmarketing and selling efforts internationally. We have limited experience inmarketing, distributing and supporting our products internationally and may notbe able to maintain or increase international market demand for our products.In addition, our international operations are generally subject to inherentrisks and challenges that could harm our operating results, including:

 

•                  expensesassociated with developing and customizing our products for foreign countries;

 

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•                  difficulties instaffing and managing international operations, including reliance on third partiesto manage certain aspects of our foreign operations, including hub inventorylocations;

•                  multiple,conflicting and changing governmental laws and regulations;

•                  tariffs, quotasand other import or export restrictions, trade protection measures and otherregulatory requirements on computer peripheral equipment;

•                  longer salescycles for our products;

•                  reduced orlimited protections of intellectual property rights;

•                  adverse taxconsequences, including imposition of withholding or other taxes on payments bysubsidiaries and customers;

•                  compliance withinternational standards that differ from domestic standards;

•                  riskssurrounding any product and software outsourcing activities in foreigncountries; and

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

 

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

 

**Unforeseenenvironmental costs could impact our future net earnings***.*

 

Some of our operations use substances regulated undervarious 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 cleanupof contaminated sites. Certain of our products are subject to various federal,state and international laws governing chemical substances in electronicproducts. We could incur costs, fines and civil or criminal sanctions,third-party property damage or personal injury claims if we were to violate or becomeliable under environmental laws. The ultimate costs under environmental lawsand the timing of these costs are difficult to predict.

 

The European Union has finalized the Waste Electricaland Electronic Equipment Directive, which makes producers of electrical goodsfinancially responsible for specified collection, recycling, treatment anddisposal of past and future covered products. This directive must now beenacted and implemented by individual European Union governments byAugust 13, 2004 (such legislation together with the directive, the “WEEELegislation”), and certain producers are to be financially responsible underthe WEEE Legislation beginning in August 2005. In addition, the EuropeanParliament has enacted a requirement for the recovery of hazardous substance(RoHS).  This legislation governs therecovery of such substances as mercury, lead, cadmium, and hexavalent cadmium.We are currently reviewing the applicability of WEEE and RoHS Legislation to ourelectronic products.  Accordingly, wecannot currently estimate the extent of increased costs resulting from the WEEEand RoHS Legislation. Similar legislation may be enacted in other geographies,including federal and state legislation in the United States, the cumulativeimpact of which could be significant costs.

 

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

 

Increased internationalpolitical instability as demonstrated by the September 11, 2001 terroristattacks, disruption in air transportation and enhanced security measures as aresult of the terrorist attacks and increasing tension in the Middle East, mayhinder our ability to do business and may increase our costs. Additionally,this increased instability may, for example, negatively impact the capitalmarkets and the reliability and cost of transportation and adversely affect ourability to obtain adequate insurance at reasonable rates or require us to incurcosts for extra security precautions for our operations. In addition, to theextent that air transportation is delayed or disrupted, the operations of ourcontract manufacturers and suppliers may be disrupted, particularly ifshipments of components and raw materials are delayed. If this international politicalinstability continues or increases, our business and results of operationscould be seriously harmed and we may not be able to obtain financing in thecapital markets.

 

**If we losekey personnel or if we are unable to hire additional qualified personnel, wemay not be successful.**

 

Our success depends to asignificant degree upon the continued contributions of our key management,technical, sales and marketing, finance and operations personnel, many of whomwould be difficult to replace. In particular, we believe that our futuresuccess is highly dependent on our senior executive team. In the past we haveexperienced high turnover in our senior executive team. A significant portionof the current senior executive team was hired during the last year and a half.Although our senior executive team consists of experienced members, many ofthem are new to our company and industry and have only worked with each otherfor a relatively short period of time. As a result they may not operateefficiently as part of an integrated management team.

 

In addition, our engineeringand product development teams are critical in developing our products and havedeveloped important relationships with customers and their technical staffs.The loss of any of these key personnel, including our senior sales staff, could

 

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harm our operations and customer relationships. We do not have keyperson life insurance on any of our key personnel. Given our recentacquisitions of Nishan and Sanera, a large percentage of our engineeringdevelopment team is now located in California, is new to the Company and maynot operate as efficiently during the transition period. In January 2004,we announced a 9% reduction in-force (RIF) of our employee base and we areclosing down our Canadian engineering operations.

 

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

 

**Risksrelated to internal controls.**

 

Publiccompanies in the United States are required to review their internal controlsunder the Sarbanes-Oxley Act of 2002. It should be noted that any system of controls, however well designedand operated, can provide only reasonable, and not absolute, assurance that theobjectives of the system are met. In addition, the design of any control systemis based in part upon certain assumptions about the likelihood of futureevents. Because of these and other inherent limitations of control systems,there can be no assurance that any design will succeed in achieving its statedgoals under all potential future conditions, regardless of how remote. If theinternal controls put in place by us are not adequate or in conformity with therequirements of the Sarbanes-Oxley Act of 2002, and the rules and regulationspromulgated by the Securities and Exchange Commission, we may be forced torestate our financial statements and take other actions which will takesignificant financial and managerial resources, as well as be subject to finesand other government enforcement actions.

 

**If we areunable to adequately protect our intellectual property, we may not be able tocompete effectively.**

 

Werely on a combination of patent, copyright, trademark and trade secret laws andrestrictions on disclosure to protect our intellectual property rights. We alsoenter into confidentiality and/or license agreements with our employees,consultants and corporate partners. Despite our efforts to protect ourproprietary rights, unauthorized parties may copy or otherwise obtain and useour products or technology. Monitoring unauthorized use of our products isdifficult and we may not be aware that someone is using our rights without ourauthorization. In addition, the steps we have taken, and those we may take inthe future, may not prevent unauthorized use of our technology, particularly inforeign countries where the laws may not protect our proprietary rights asfully as in the United States.  We maybe a party to intellectual property litigation in the future, either to protectour intellectual property or as a result of alleged infringements of others’intellectual property.

 

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

 

•                  stop using thechallenged intellectual property or selling our products or services thatincorporate it;

•                  obtain a licenseto use the challenged intellectual property or to sell products or servicesthat incorporate it, which license may not be available on reasonable terms, orat all; and

•                  redesign thoseproducts or services that are based on or incorporate the challengedintellectual property.

 

If we are forced to take anyof these actions, we may be unable to manufacture and sell our products, ourcustomer relationships would be seriously harmed and our revenue would bereduced.

 

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

 

**If we failto optimize our distribution channels and manage our distributionrelationships, our revenue or operating results could be significantlyreduced.  Our competitors may sell theirproducts directly to end-user customers.**

 

Our success will depend onour continuing ability to develop and manage relationships with significantOEMs, resellers and 

 

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systems integrators, as well as on the sales efforts and success ofthese customers. We cannot provide assurance that we will be able to expand ourdistribution channels or manage our distribution relationships successfully orthat our customers will market our products effectively. Our failure to expandour distribution channels or manage successfully our distribution relationshipsor the failure of our OEM and reseller customers to sell our products couldreduce our revenue and operating results. Moreover, to the extent ourcompetitors sell directly to end-user customers, we may not be able to competegiven the lack of a direct sales force and the current inability to directly providefirst and second level customer support. If this occurs, we may need tosubstantially invest in a direct sales force and direct customer support whichwould increase our expenses.

 

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

 

We currently purchaseseveral key components from single or limited sources. We purchase applicationspecific integrated circuits (ASICs), special purpose processors and powersupplies from single sources, and gigabit interface converters and optictransceivers from limited sources. Additional sole or limited sourcedcomponents may be incorporated into our products in the future. Delays in thedelivery of components for our products could result in delays or the inabilityto meet our customers’ demands and result in decreased revenue. We do not haveany long-term supply contracts to ensure sources of supply of components. Inaddition, our suppliers may enter into exclusive arrangements with ourcompetitors, stop selling their products or components to us at commercially reasonableprices or refuse to sell their products or components to us at any price, whichcould harm our operating results. Further, we have purchased components fromour suppliers from time to time that have been subsequently found not to meetthe supplier’s published specifications. If our suppliers are unable to provide(or we are unable otherwise to obtain) components for our products on theschedule and in the quantities and quality we require, we will be unableto manufacture our products. We have experienced and may continue to experienceproduction delays and quality control problems with certain of our suppliers,which, if not effectively managed, could prevent us from satisfying ourproduction requirements. If we fail to effectively manage our relationshipswith these key suppliers, or if our suppliers experience delays, disruptions,capacity constraints or quality control problems in their manufacturingoperations, our ability to manufacture and ship products to our customers couldbe delayed, and our competitive position, reputation, business, financialcondition and results of operations could be seriously harmed.

 

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

 

We rely on Sanmina SCI, Inc.(SSCI), Solectron Corporation, Pycon Incorporated, IBM and LSI Logic, togetherour contract manufacturers, to manufacture our products. Our contractmanufacturers are not obligated to supply products to us for any specificperiod, or in any specific quantity, except as may be provided in a particularpurchase order. In addition, our contract manufacturers do not guarantee thatadequate capacity will be available to us within the time required to meetadditional demand for our products. We generally place forecasts for productswith our contract manufacturers approximately four to five months prior to theanticipated delivery date, with order volumes based on forecasts of demand forour products. We generally place purchase orders sixty calendar days in advanceof delivery. If we fail to forecast demand for our products accurately, we maybe unable to obtain adequate manufacturing capacity from our contractmanufacturers to meet our customers’ delivery requirements or unexpectedincreases in customer purchase orders. As a result, we may not be able tobenefit from any incremental demand and could lose customers. If weover-estimate demand for our product, we may accumulate excess inventories andobligations to our contract manufacturers under binding purchase orders inexcess of our needs. At April 30, 2004, our commitment with our contractmanufacturers for purchases and anticipated transformation costs over the nextsixty days totaled approximately $45.5 million.

 

In addition, we coordinateour efforts with those of our component suppliers and contract manufacturers inorder to rapidly achieve volume production. We have experienced and maycontinue to experience production delays and quality control problems withcertain of our suppliers and with our contract manufacturers, which, if noteffectively managed, could prevent us from satisfying our production requirementson a timely basis and could harm our customer relationships. If we should failto manage effectively our relationships with our component suppliers orcontract manufacturers, or if any of our suppliers or our manufacturersexperience delays, disruptions, capacity constraints or quality controlproblems in their manufacturing operations, our ability to ship products to ourcustomers could be delayed, and our competitive position and reputation couldbe harmed. Qualifying a new contract manufacturer and commencing volumeproduction can be expensive and time consuming. If we are required to change orchoose to change contract manufacturers, we may lose significant revenue andseriously damage our customer relationships.

 

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

 

Unfavorable general economicconditions over the last 3 plus years have had a pronounced negative impact oninformation technology, or IT, spending. Demand for SAN products in theenterprise-class sector may continue to be adversely impacted as a result of aweakened economy and because larger businesses have begun to focus on moreefficiently using their existing IT infrastructure rather than making newequipment purchases. If there are further reductions in either domestic orinternational IT expenditure, or if IT 

 

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expenditure does not increase as anticipated from current levels, ourrevenues, operating results and financial condition may be materially adverselyaffected.

 

**Failure tomanage expansion effectively could seriously harm our business, financialcondition and prospects.**

 

Our ability to successfullyimplement our business plan, develop and offer products, and manage expansionin a rapidly evolving market requires a comprehensive and effective planningand management process. We continue to increase the scope of our operationsdomestically and internationally. In addition, in September 2003, weacquired Sanera and Nishan which significantly increased the size of ouroperations.  Our growth in business andrelationships with customers and other third parties has placed, and willcontinue to place, a significant strain on management systems, resources,intercompany communication and coordination. As we grow, our failure tomaintain and to continue to improve upon our operational, managerial andfinancial controls, reporting systems, processes and procedures, and /or ourfailure to continue to expand, train, and manage our work force worldwide,could seriously harm our business and financial results.

 

**If we failto successfully develop the McDATA brand, our revenue may not grow.**

 

Our name is not widelyrecognized as a brand in the marketplace given our indirect sales model. Webelieve that establishing and maintaining the McDATA brand is a criticalcomponent in maintaining and developing strategic OEM, reseller and systemsintegrator relationships, and the importance of brand recognition will increaseas the number of vendors of competitive products increases. Our failure tosuccessfully develop our brand may prevent us from expanding our business andgrowing our revenue. Similarly, if we incur excessive expenses in an attempt topromote and maintain the McDATA brand, our business, financial condition andresults of operations could be seriously harmed.

 

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

 

Our products may containundetected software or hardware errors when first introduced or when newversions are released. Our products are complex, and we have from time to timedetected errors in existing  products.In addition, our products are combined with products from other vendors. As aresult, should problems occur, it might be difficult to identify the source ofthe problem. These errors could result in a loss of or delay in marketacceptance of our products, cause delays in delivering our products or meetingcustomer demands and would increase our costs, reduce our revenue and causesignificant customer relations problems. Errors could also result in the needfor us to upgrade existing products at customer locations which would increaseour costs or cause significant customer relations problems.

 

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

 

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

 

**The salescycle for our products is long, and we may incur substantial non-recoverableexpenses and devote significant resources to prospects that do not producerevenues in the foreseeable future or at all.**

 

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

 

**We mayengage in future acquisitions that dilute our stockholders ownership and causeus to use cash, incur debt or assume contingent liabilities.**

 

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

 

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

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

•                  incur debt; or

•                  assumeliabilities.

 

Thesepurchases also involve numerous risks, including:

 

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

•                  unanticipatedcosts;

•                  diversion ofmanagement’s attention from our core business;

•                  adverse effectson existing business relationships with suppliers and customers;

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

•                  potential lossof key employees of acquired organizations.

 

We may not be able tosuccessfully integrate any businesses, products, technologies or personnel thatwe might acquire in the future. In addition, technology acquisitions ofstart-up companies could result in one-time charges related to acquisitioncosts, severance costs, employee retention costs and in-process research anddevelopment.

 

**We mayrequire, or could elect, to seek additional funding.**

 

Our future capitalrequirements will depend on many factors, including our rate of revenue growth,the timing and extent of spending to support development of new products andexpansion of sales and marketing, the timing of new product introductions andenhancements to existing products, any acquisitions of businesses, and marketacceptance of our products. With changes in operating and industryexpectations, we could require, or could elect, to seek additional fundingincluding accessing the equity and debt markets.

 

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

 

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

 

**Ourproducts must comply with governmental regulation.**

 

In the United States, ourproducts comply with various regulations and standards defined by the FederalCommunications Commission and Underwriters Laboratories. Internationally,products that we develop will be required to comply with standards establishedby authorities in various countries. In the last several years, the EuropeanUnion (EU) has adopted a number of initiatives (WEEE, RoHS, etc.) related toequipment emissions, electronic waste, privacy of information and expandedconsumer warranties. Failure to comply with existing or evolving industrystandards or to obtain timely domestic or foreign regulatory approvals orcertificates could seriously harm our business.

 

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

 

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

 

•                  authorizing theissuance of preferred stock without stockholder approval;

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

•                  limiting thepersons who may call special meetings of stockholders;

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

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

•                  prohibitingcumulative voting for the election of directors;

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

 

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

 

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

 

**Our stockprice is volatile.**

 

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

 

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

 

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

 

In October 1997, and inconnection with the reorganization of our business, we entered into certainagreements with EMC relating to our business relationship with EMC. Inaddition, we have entered into agreements with EMC relating to our relationshipwith EMC after the completion of our initial public offering inAugust 2000 and the distribution by EMC of our Class A common stock inFebruary 2001. We have also entered into an OEM Purchase and LicenseAgreement with EMC that governs EMC’s purchases of our products and grants EMCrights to use, support and distribute software for use in connection with theseproducts. The agreement does not provide for the purchase of a guaranteedminimum amount of product. These agreements were negotiated and made in thecontext of our prior parent-subsidiary relationship. As a result, some of theseagreements may have terms and conditions, including the terms of pricing, thatare less beneficial to us than agreements negotiated with unaffiliated thirdparties. Sales and services revenue pursuant to these agreements with EMCrepresented approximately 47% of our revenue for the three months endedApril 30, 2004. In addition, in some instances, our ability to terminatethese agreements is limited, which may prevent us from being able to negotiatemore favorable terms with EMC or from entering into similar agreements withthird parties.

 

**Provisionsof our agreements with EMC relating to our relationship with EMC after thedistribution of our Class A common stock to EMC’s stockholders may prevent achange in control of our company.**

 

Under the terms of the May2000 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 EMCa license to then existing McDATA patents. If we are acquired, our acquirerwill retain this license as long as our acquirer grants to EMC a license underall of the acquirer’s patents for all products licensed under the agreementunder 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 decreaseour attractiveness as an acquisition target.

 

**We may beobligated to indemnify EMC if the distribution of our Class A common stock toEMC’s stockholders was not tax free.**

 

The May 2000 Tax SharingAgreement that we have entered into with EMC obligates us to indemnify EMC fortaxes relating to the failure of EMC’s distribution to EMC’s stockholders ofour Class A common stock to be tax free if that failure results from, amongother things:

 

•                  any act oromission by us that would cause the distribution to fail to qualify as atax-free distribution under the Internal Revenue Code;

•                  any act oromission by us that is inconsistent with any representation made to theInternal Revenue Service in connection with the request for a private letterruling regarding the tax-free nature of the distribution by EMC of our Class Acommon stock indirectly held by it to its stockholders;

•                  any acquisitionby a third party of our stock or assets; or

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

 

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

 

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**ITEM3.  Quantitative and QualitativeDisclosures about Market Risks**

 

We are exposed to market risk, primarily from changes in interestrates, foreign currency exchange rates and credit risks.

 

*Interest Rate Risk*

 

We earn interest income on both our cash and cash equivalents and ourinvestment portfolio. Our investment portfolio consists of readily marketableinvestment-grade debt securities of various issuers and maturities ranging fromovernight to two years. All investments are denominated in U.S. dollars and areclassified as “available for sale.” These instruments are not leveraged, andare not held for trading purposes. As interest rates change, the amount ofrealized and unrealized gain or loss on these securities will change.  The quantitative and qualitative disclosuresabout market risk are discussed in Item 7 – Quantitative and QualitativeDisclosure About Market Risk, contained in our Form 10-K.

 

Our convertible subordinated debt is subject to a fixed interest rateand the notes are based on a fixed conversion ratio into Class A commonstock.  In July 2003, the Companyentered into an interest-rate swap agreement with a notional amount of $155.3million that has the economic effect of modifying the fixed interestobligations associated with the notes so that the interest payable on themajority of the notes effectively becomes variable based on the six monthLondon Interbank Offered Rate (LIBOR) minus 152 basis points.  If interest rates on this variable rate debtwere to increase or decrease, our annual interest expense would increase ordecrease accordingly.  This increase ordecreased interest expense would be partially offset by the effects of theseinterest rate changes on our cash and investment portfolio.  The notes are not listed on any securitiesexchange or included in any automated quotation system; however, the notes areeligible for trading on the PortalSM Market. On May 26, 2004, the approximate bid price per $100 of our notes was$87.00 and the approximate ask price of our Notes was $88.00, resulting in anaggregate fair value of between $150 million and $152 million.  Our Class A common stock is quoted on theNasdaq National Market under the symbol, “MCDTA.”  On June 3, 2004, the last reported sale price of our Class Acommon stock on the Nasdaq National Market was $4.99 per share.

 

*Foreign CurrencyExchange Risk*

 

We operate sales and support offices in several countries. All of oursales contracts have been denominated in U.S. dollars, therefore ourtransactions in foreign currencies are limited to operating expensetransactions. Due to the limited nature and amount of these transactions, we donot believe we have had or will have material exposure to foreign currencyexchange risk.

 

*Credit Risk*

 

Financial instruments, which potentially subject us to concentrationsof credit risk, consist principally of temporary cash investments, investmentsand trade receivables. We place our temporary cash investments and investmentsecurities in primarily investment grade instruments and limit the amount ofinvestment with any one financial institution. We evaluate the credit riskassociated with each of our customers but generally do not requirecollateral.  We depend on two customersfor most of our total revenue who comprise a significant portion of our tradereceivables and, therefore, expose us to a concentration of credit risk.

 

In conjunction with the issuance of our convertible subordinated notes,we also entered into share option transactions on our Class A common stockwith Bank of America, N.A. and /or certain of its affiliates. Subject to themovement in our Class A common stock price, we could be exposed to creditrisk arising out of net settlement of these options in our favor. Based on ourreview of the possible net settlements and the credit strength of Bank ofAmerica, N.A. and its affiliates, we have concluded that we do not have amaterial exposure to credit risk as a result of these share optiontransactions.

 

InJuly 2003, we entered into an interest-rate swap agreement with JPMorganChase Bank (JPMorgan). Subject to the movement in interest rates, we could beexposed to credit risk arising out of net interest payments due to us fromJPMorgan. Based on our review of the possible movement in interest rates andthe credit strength of JPMorgan, we have concluded that we do not have amaterial exposure to credit risk as a result of this interest-rate swap.

 

**ITEM 4. Controls and Procedures**

 

Under thesupervision and with the participation of our management, including the ChiefExecutive Officer and Chief Financial Officer, we have evaluated theeffectiveness of the design and operation of our disclosure controls and procedurespursuant to Exchange Act Rule 13a-14(c) as of the end of the period covered bythis report.  Based on that evaluation,the Chief Executive Officer and Chief Financial Officer have concluded thatthese disclosure controls and procedures are effective.  There were no changes in our internal controlover financial reporting during the quarter ended April 30, 2004 that havematerially affected, or are reasonably likely to materially affect, ourinternal controls over financial reporting.

 

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**PART II – OTHER INFORMATION**

 

**ITEM 1. Legal Proceedings**

 

From time to time, we become involved in various lawsuits and legalproceedings that arise in the normal course of business. Litigation is subjectto inherent uncertainties and an adverse result in a matter that may arise fromtime to time may harm our business, financial condition or results ofoperations. In the opinion of management and except as otherwise noted, theultimate disposition of any of the claims described will not have a materialadverse effect on our consolidated results of operations, financial position orcash flow.  Please see Note 12 of theCondensed Consolidated Financial Statements for a description of litigationmatters.

 

**ITEMS 2, 3, and 4 are not applicable and havebeen omitted.**

 

**ITEM 5. OtherInformation**

 

InNovember 2003 and May 2004, the Company’s Board of Directors authorizedsingle trigger severance agreements for the CEO and the key executive officers,respectively.  John A. Kelley, Jr., theCompany’s Chairman, Chief Executive Officer and President, and the Companyentered into such a single trigger severance agreement inDecember 2003.  The single triggerseverance agreement provides that should Mr. Kelley be terminated without causeor voluntarily leaves for good reason, Mr. Kelley would be eligible for oneyear of salary and target bonus, medical benefits under COBRA for up to oneyear, an extension of option exercisablity from ninety days to one year forsubsequently issued options and continued vesting of restricted stock for oneyear after termination.  In return, theCompany received an extension to 24 months of Mr. Kelley’s current 12 monthnon-compete and non-solicitation restriction and a release of all claims, ifany, against the Company before payment of any benefits there under.  The Company plans to enter into similarsingle trigger severance agreements with its key executive officers selected byMr. Kelley.  The benefits under thoseagreements may range from 6 months, 9 months to 12 months depending upon theyears of service and favorable reviews. Benefits under the single trigger severance agreements would not bepayable if the current change of control severance agreements are triggered.

 

In May 2004, the Board of Directors approved the Company’s 2004Inducement Equity Grant Plan (the “2004 Plan”).  The 2004 Plan providesfor the issuance of non-qualified options, stock bonus awards, stock purchaseawards, stock appreciation rights, stock unit awards and other stock awards fornew hire employees of the Company.  The 2004 Plan is a limited purposeplan in accordance with NASD Marketplace Rule 4350 and does not requireshareholder approval.  The 2004 Plan has a share capacity of no more than3 million shares of Company Class B common stock.

 

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

 

*(a)**            Exhibits filed for theCompany through the filing of this Form 10-Q.*

 
| 10.20.2 |   | Form Executive Single Trigger Severance Agreement                                               |
|---------|--------|-------------------------------------------------------------------------------------------------|
|    |   |                                                                                            |
| 10.21.4 |   | 2004 McDATA Inducement Equity Grant Plan                                                        |
|    |   |                                                                                            |
| 31.1    |   | Section 302 Certification of Principal Executive Officer                                   |
|    |   |                                                                                            |
| 31.2    |   | Section 302 Certification of Principal Financial Officer                                   |
|    |   |                                                                                            |
| 32      |   | Section 906 Certifications of Principal Executive Officer and  Principal Financial Officer |

 

*(b)**       Reports on Form 8-K*

 

The Company filed the following reports on Form 8-K through thefiling of this Form 10-Q. Information regarding the items reported on is asfollows:

 

 
| **Date**            |   | **Item  Reported On**                                                                                                                                                  |
|---------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                                                                                   |
| April 15, 2004 |   | Items 4 and 7.  We filed a press release announcing our  revised financial outlook for the First Quarter 2004.                                                    |
|                |   |                                                                                                                                                                   |
| April 29, 2004 |   | Items 4 and 7.  We disclosed our dismissal of  PricewaterhouseCoopers LLP as our independent accountants.                                                         |
|                |   |                                                                                                                                                                   |
| May 5, 2004         |   | Items 4 and 7.  We filed an amendment to our  April 29, 2004 Form 8-K filing pursuant to comments received from the  SEC on May 3, 2004.                     |
|                |   |                                                                                                                                                                   |
| May 17, 2004        |   | Item 5.  We disclosed the announcement that Mike  Gustafson, Senior Vice President of Marketing, resigned effective May 17,  2004, to pursue other opportunities. |
|                |   |                                                                                                                                                                   |
| May 20, 2004        |   | Items 7 and 9.  We filed a press release announcing our  First Quarter 2004 results.                                                                              |

 

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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 theundersigned thereunto duly authorized.

 

 
|              | McDATA CORPORATION                                           |
|-------------------|--------------------------------------------------------------|
|              |                                                         |
|              |                                                         |
|              | By:                                                          | /s/ ERNEST J. SAMPIAS |   |
|              | Ernest J. Sampias                                            |
|              | Senior Vice President of Finance and Chief Financial Officer |
| June 7, 2004 |                                                         |

 

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