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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)

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



For the quarterly period ended July 31, 2004



OR



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



For the transition period from  to



Commission File Number 000-31257



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McDATA CORPORATION

(Exact name of registrant as specified in its charter)



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



380 Interlocken
Crescent, Broomfield, Colorado 80021

(Address of principal executive offices)(zip code)



(720) 558-8000

(Registrants telephone number, including area code)





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



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



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



At September 3, 2004, 81,000,000 shares of the registrants Class A Common Stock were
outstanding and 37,092,058 shares of the registrants Class B Common Stock were outstanding.



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##### Table of Contents

McDATA CORPORATION



FORM 10-Q

QUARTER ENDED JULY 31, 2004

TABLE OF
CONTENTS



|     |  |                                                                                       |  |   
|---- |  | ------------------------------------------------------------------------------------- |  | --
|     |  |                                                                                      
|Item |  |                                                                                       |  |   
|     |  |                                                                                      
|     |  | PART 1  FINANCIAL INFORMATION                                                        |  | 4 
|     |  |                                                                                      
|1.   |  | Financial Statements                                                                  |  |   
|     |  |                                                                                      
|     |  | Condensed Consolidated Balance Sheets                                                 |  | 4 
|     |  |                                                                                      
|     |  | Condensed Consolidated Income Statements                                              |  | 5 
|     |  |                                                                                      
|     |  | Condensed Consolidated Statements of Cash Flows                                       |  | 6 
|     |  |                                                                                      
|     |  | Notes to Condensed Consolidated Financial Statements                                  |  | 7 
|     |  |                                                                                      
|2.   |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 15
|     |  |                                                                                      
|3.   |  | Quantitative and Qualitative Disclosures About Market Risks                           |  | 35
|     |  |                                                                                      
|4.   |  | Controls and Procedures                                                               |  | 36
|     |  |                                                                                      
|     |  | PART II  OTHER INFORMATION                                                           |  | 37
|     |  |                                                                                      
|1.   |  | Legal Proceedings                                                                     |  | 37
|     |  |                                                                                      
|5.   |  | Other Information                                                                     |  | 37
|     |  |                                                                                      
|6.   |  | Exhibits and Reports on Form 8-K                                                      |  | 37



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Special Note Regarding Forward-Looking Statements



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



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



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



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



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



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



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



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



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



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



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



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



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PART I  FINANCIAL INFORMATION



McDATA CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)



|                                                                                                                                                                                   |  |              |         |   |                 |   |         |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | --------------- | - | ------- | -
|                                                                                                                                                                                   |  | July 31,2004 |         |   | January 31,2004 |  
|                                                                                                                                                                                   |  | (unaudited)  |         |   |                 |  
|Assets                                                                                                                                                                             |  |              |         |   |                 |   |         |  
|Current assets:                                                                                                                                                                    |  |              |         |   |                 |   |         |  
|Cash and cash equivalents                                                                                                                                                          |  | $            | 39,451  |   |                 | $ | 50,301  |  
|Securities lending collateral                                                                                                                                                      |  |              | 123,916 |   |                 |   | 126,681 |  
|Short-term investments                                                                                                                                                             |  |              | 177,332 |   |                 |   | 157,740 |  
|Accounts receivable, net of allowance for bad debts of $758 and $926, respectively                                                                                                 |  |              | 53,541  |   |                 |   | 62,670  |  
|Inventories, net                                                                                                                                                                   |  |              | 12,648  |   |                 |   | 11,364  |  
|Prepaid expenses and other current assets                                                                                                                                          |  |              | 5,236   |   |                 |   | 6,055   |  
|                                                                                                                                                                                   |  |              |         |   |                 |   |         |  
|Total current assets                                                                                                                                                               |  |              | 412,124 |   |                 |   | 414,811 |  
|                                                                                                                                                                                   |  |             
|Property and equipment, net                                                                                                                                                        |  |              | 98,002  |   |                 |   | 99,225  |  
|Long-term investments                                                                                                                                                              |  |              | 99,245  |   |                 |   | 103,483 |  
|Restricted cash                                                                                                                                                                    |  |              | 5,008   |   |                 |   | 5,130   |  
|Intangible assets, net                                                                                                                                                             |  |              | 98,793  |   |                 |   | 111,313 |  
|Goodwill                                                                                                                                                                           |  |              | 78,693  |   |                 |   | 78,787  |  
|Other assets, net                                                                                                                                                                  |  |              | 21,897  |   |                 |   | 18,219  |  
|                                                                                                                                                                                   |  |              |         |   |                 |   |         |  
|Total assets                                                                                                                                                                       |  | $            | 813,762 |   |                 | $ | 830,968 |  
|                                                                                                                                                                                   |  |              |         |   |                 |   |         |  
|Liabilities and Stockholders Equity                                                                                                                                               |  |              |         |   |                 |   |         |  
|Current liabilities:                                                                                                                                                               |  |              |         |   |                 |   |         |  
|Accounts payable                                                                                                                                                                   |  | $            | 19,217  |   |                 | $ | 16,532  |  
|Accrued liabilities                                                                                                                                                                |  |              | 45,991  |   |                 |   | 53,330  |  
|Securities lending collateral payable                                                                                                                                              |  |              | 123,916 |   |                 |   | 126,681 |  
|Current portion of deferred revenue                                                                                                                                                |  |              | 19,135  |   |                 |   | 19,775  |  
|Current portion of obligations under notes payable and capital leases                                                                                                              |  |              | 1,504   |   |                 |   | 2,785   |  
|                                                                                                                                                                                   |  |              |         |   |                 |   |         |  
|Total current liabilities                                                                                                                                                          |  |              | 209,763 |   |                 |   | 219,103 |  
|                                                                                                                                                                                   |  |             
|Obligations under notes payable and capital leases, less current portion                                                                                                           |  |              | 445     |   |                 |   | 1,091   |  
|Deferred revenue, less current portion                                                                                                                                             |  |              | 23,029  |   |                 |   | 20,632  |  
|Interest rate swap                                                                                                                                                                 |  |              | 3,848   |   |                 |   | 349     |  
|Convertible subordinated debt                                                                                                                                                      |  |              | 168,652 |   |                 |   | 172,151 |  
|                                                                                                                                                                                   |  |              |         |   |                 |   |         |  
|Total liabilities                                                                                                                                                                  |  |              | 405,737 |   |                 |   | 413,326 |  
|                                                                                                                                                                                   |  |              |         |   |                 |   |         |  
|Commitments and contingencies (Note 14)                                                                                                                                            |  |              |         |   |                 |   |         |  
|                                                                                                                                                                                   |  |             
|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, 36,710,082 and 36,051,473 shares issued and outstanding at July 31,
2004 and January 31, 2004, respectively |  |              | 367     |   |                 |   | 361     |  
|Additional paid-in-capital                                                                                                                                                         |  |              | 478,678 |   |                 |   | 476,993 |  
|Treasury stock, at cost, 975,730 shares                                                                                                                                            |  |              | (8,752  | ) |                 |   | (8,752  | )
|Deferred compensation                                                                                                                                                              |  |              | (5,250  | ) |                 |   | (10,375 | )
|Accumulated other comprehensive income (loss)                                                                                                                                      |  |              | (761    | ) |                 |   | 403     |  
|Accumulated deficit                                                                                                                                                                |  |              | (57,067 | ) |                 |   | (41,798 | )
|                                                                                                                                                                                   |  |              |         |   |                 |   |         |  
|Total stockholders equity                                                                                                                                                         |  |              | 408,025 |   |                 |   | 417,642 |  
|                                                                                                                                                                                   |  |              |         |   |                 |   |         |  
|Total liabilities and stockholders equity                                                                                                                                         |  | $            | 813,762 |   |                 | $ | 830,968 |  
|                                                                                                                                                                                   |  |              |         |   |                 |   |         |  



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



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McDATA CORPORATION

CONDENSED CONSOLIDATED INCOME STATEMENTS

(in thousands, except per share data)

(unaudited)



|                                                                                                                                                                           |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------- | ------- | - | ------------------------- | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                                                                                           |  | Three Months EndedJuly 31, |         |   | Six Months Ended July, 31 |  
|                                                                                                                                                                           |  | 2004                       |         |   | 2003                      |   |         | 2004 |  |   | 2003    |  
|Revenue                                                                                                                                                                    |  | $                          | 98,221  |   |                           | $ | 107,014 |      |  | $ | 195,450 |   |  | $ | 210,193 |  
|Cost of revenue                                                                                                                                                            |  |                            | 43,377  |   |                           |   | 43,707  |      |  |   | 85,864  |   |  |   | 88,295  |  
|                                                                                                                                                                           |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Gross profit                                                                                                                                                               |  |                            | 54,844  |   |                           |   | 63,307  |      |  |   | 109,586 |   |  |   | 121,898 |  
|Operating expenses (recoveries):                                                                                                                                           |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Research and development (excludes amortization of deferred compensation included in Amortization of deferred compensation of $996, $501,
$2,486 and $868, respectively)   |  |                            | 22,107  |   |                           |   | 18,156  |      |  |   | 47,204  |   |  |   | 36,975  |  
|Selling and marketing (excludes amortization of deferred compensation included in Amortization of deferred compensation of $142, $178, $450
and $390, respectively)        |  |                            | 24,237  |   |                           |   | 23,495  |      |  |   | 47,722  |   |  |   | 46,921  |  
|General and administrative (excludes amortization of deferred compensation included in Amortization of deferred compensation of $351, $811,
$811 and $1,643, respectively) |  |                            | 7,104   |   |                           |   | 6,660   |      |  |   | 13,711  |   |  |   | 13,620  |  
|Amortization of purchased intangible assets                                                                                                                                |  |                            | 5,761   |   |                           |   | 525     |      |  |   | 11,573  |   |  |   | 1,050   |  
|Amortization of deferred compensation (excludes amortization of deferred compensation included in cost of revenue of $52, $133, $136 and $270,
respectively)               |  |                            | 1,489   |   |                           |   | 1,490   |      |  |   | 3,747   |   |  |   | 2,901   |  
|Restructuring charges (recoveries)                                                                                                                                         |  |                            | (27     | ) |                           |   |        |      |  |   | 1,318   |   |  |   |        |  
|                                                                                                                                                                           |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Total operating expenses (recoveries)                                                                                                                                      |  |                            | 60,671  |   |                           |   | 50,326  |      |  |   | 125,275 |   |  |   | 101,467 |  
|                                                                                                                                                                           |  |                            |         |  
|Income (loss) from operations                                                                                                                                              |  |                            | (5,827  | ) |                           |   | 12,981  |      |  |   | (15,689 | ) |  |   | 20,431  |  
|                                                                                                                                                                           |  |                            |         |  
|Interest and other income                                                                                                                                                  |  |                            | 1,280   |   |                           |   | 1,592   |      |  |   | 2,663   |   |  |   | 3,648   |  
|Interest expense                                                                                                                                                           |  |                            | (220    | ) |                           |   | (1,191  | )    |  |   | (467    | ) |  |   | (2,276  | )
|                                                                                                                                                                           |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Income (loss) before income taxes and equity in net loss of affiliated company                                                                                             |  |                            | (4,767  | ) |                           |   | 13,382  |      |  |   | (13,493 | ) |  |   | 21,803  |  
|Income tax expense                                                                                                                                                         |  |                            | 117     |   |                           |   | 4,249   |      |  |   | 658     |   |  |   | 7,358   |  
|                                                                                                                                                                           |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Income (loss) before equity in net loss of affiliated company                                                                                                              |  |                            | (4,884  | ) |                           |   | 9,133   |      |  |   | (14,151 | ) |  |   | 14,445  |  
|Equity in net loss of affiliated company                                                                                                                                   |  |                            | (541    | ) |                           |   |        |      |  |   | (1,118  | ) |  |   |        |  
|                                                                                                                                                                           |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Net income (loss)                                                                                                                                                          |  | $                          | (5,425  | ) |                           | $ | 9,133   |      |  | $ | (15,269 | ) |  | $ | 14,445  |  
|                                                                                                                                                                           |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Basic net income (loss) per share                                                                                                                                          |  | $                          | (0.05   | ) |                           | $ | 0.08    |      |  | $ | (0.13   | ) |  | $ | 0.13    |  
|                                                                                                                                                                           |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Shares used in computing basic net income (loss) per share                                                                                                                 |  |                            | 115,551 |   |                           |   | 114,606 |      |  |   | 115,253 |   |  |   | 114,462 |  
|                                                                                                                                                                           |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Diluted net income (loss) per share                                                                                                                                        |  | $                          | (0.05   | ) |                           | $ | 0.08    |      |  | $ | (0.13   | ) |  | $ | 0.12    |  
|                                                                                                                                                                           |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  
|Shares used in computing diluted net income (loss) per share                                                                                                               |  |                            | 115,551 |   |                           |   | 118,500 |      |  |   | 115,253 |   |  |   | 118,096 |  
|                                                                                                                                                                           |  |                            |         |   |                           |   |         |      |  |   |         |   |  |   |         |  



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



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McDATA CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



|                                                                                    |  |                           |          |   |      |   |          |  
|----------------------------------------------------------------------------------- |  | ------------------------- | -------- | - | ---- | - | -------- | -
|                                                                                    |  | Six Months Ended July 31, |         
|                                                                                    |  | 2004                      |          |   | 2003 |  
|Cash flows from operating activities:                                               |  |                           |          |   |      |   |          |  
|Net income (loss)                                                                   |  | $                         | (15,269  | ) |      | $ | 14,445   |  
|Adjustments to reconcile net income (loss) to cash flows from operating activities; |  |                           |          |   |      |   |          |  
|Depreciation                                                                        |  |                           | 14,204   |   |      |   | 12,483   |  
|Amortization                                                                        |  |                           | 14,098   |   |      |   | 4,405    |  
|Equity in net loss of affiliate                                                     |  |                           | 1,118    |   |      |   |         |  
|Loss on trade-in/retirement of assets                                               |  |                           | 112      |   |      |   | 414      |  
|Net realized loss (gain) on investments                                             |  |                           | 483      |   |      |   | (160     | )
|Inventory and inventory commitment provisions                                       |  |                           | 4,075    |   |      |   | 2,080    |  
|Impairment loss                                                                     |  |                           | 50       |   |      |   |         |  
|Bad debt provision                                                                  |  |                           | 25       |   |      |   | 81       |  
|Deferred income taxes                                                               |  |                           |         |   |      |   | 6,507    |  
|Non-cash compensation expense                                                       |  |                           | 3,883    |   |      |   | 3,171    |  
|Tax benefit from stock options exercised                                            |  |                           |         |   |      |   | 588      |  
|Unrealized gains on derivative transactions                                         |  |                           | 38       |   |      |   |         |  
|Changes in net assets and liabilities                                               |  |                           | (7,187   | ) |      |   | (3,339   | )
|                                                                                    |  |                           |          |   |      |   |          |  
|Net cash provided by operating activities                                           |  |                           | 15,630   |   |      |   | 40,675   |  
|                                                                                    |  |                          
|Cash flows from investing activities:                                               |  |                           |          |   |      |   |          |  
|Purchases of property and equipment                                                 |  |                           | (9,815   | ) |      |   | (6,811   | )
|Purchases of investments                                                            |  |                           | (274,732 | ) |      |   | (492,591 | )
|Proceeds from maturities and sales of investments                                   |  |                           | 256,989  |   |      |   | 336,403  |  
|                                                                                    |  |                           |          |   |      |   |          |  
|Net cash used by investing activities                                               |  |                           | (27,558  | ) |      |   | (162,999 | )
|                                                                                    |  |                          
|Cash flows from financing activities:                                               |  |                           |          |   |      |   |          |  
|Net proceeds for issuance of convertible subordinated debt                          |  |                           |         |   |      |   | 166,947  |  
|Net purchase of share option transactions                                           |  |                           |         |   |      |   | (20,510  | )
|Restricted cash related to interest rate swap                                       |  |                           |         |   |      |   | (5,000   | )
|Payments on long-term notes payable and capital leases                              |  |                           | (1,796   | ) |      |   | (1,812   | )
|Proceeds from the issuance of common stock                                          |  |                           | 2,874    |   |      |   | 3,285    |  
|                                                                                    |  |                           |          |   |      |   |          |  
|Net cash provided by financing activities                                           |  |                           | 1,078    |   |      |   | 142,910  |  
|                                                                                    |  |                           |          |   |      |   |          |  
|Net increase (decrease) in cash and cash equivalents                                |  |                           | (10,850  | ) |      |   | 20,586   |  
|Cash and cash equivalents, beginning of period                                      |  |                           | 50,301   |   |      |   | 108,168  |  
|                                                                                    |  |                           |          |   |      |   |          |  
|Cash and cash equivalents, end of period                                            |  | $                         | 39,451   |   |      | $ | 128,754  |  
|                                                                                    |  |                           |          |   |      |   |          |  
|                                                                                    |  |                          
|Supplemental Disclosure of Non-Cash Investing and Financing Activities              |  |                           |          |   |      |   |          |  
|Deferred compensation forfeitures                                                   |  | $                         | 1,240    |   |      | $ |         |  
|                                                                                    |  |                           |          |   |      |   |          |  
|Capital lease obligations incurred                                                  |  | $                         |         |   |      | $ | 1,658    |  
|                                                                                    |  |                           |          |   |      |   |          |  
|Fixed assets exchanged for capital leases                                           |  | $                         |         |   |      |   | (1,364   | )
|                                                                                    |  |                           |          |   |      |   |          |  
|Transfer of inventory to fixed assets                                               |  | $                         |         |   |      | $ | 835      |  
|                                                                                    |  |                           |          |   |      |   |          |  



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



6



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##### Table of Contents

McDATA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(tabular amounts in thousands, except per share data)

(unaudited)



Note 1  Overview and Basis of Presentation



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



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



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



Recent Accounting
Pronouncements



In January 2004, the Financial Accounting
Standards Board issued Emerging Issues Task Force (EITF) Issue No. 03-1, The Meaning of Other-Than Temporary Impairment and Its Application to Certain Investments (EITF 03-1). EITF 03-1 provides guidance on the disclosure requirements
for other-than-temporary impairments of debt and marketable equity investments that are accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS 115). The adoption of EITF 03-1 would require the
Company to include certain quantitative and qualitative disclosures for debt and marketable equity securities classified as available-for-sale or held-to-maturity under SFAS 115 that are impaired at the balance sheet date but for which an
other-than-temporary impairment has not been recognized. This guidance is effective for financial periods beginning after June 15, 2004. The Company does not anticipate that the adoption of this issue would have a material impact on the
Companys financial position or results of operations.



Note 2 
ESCON Agreement Amendment



In 1997, the Company entered
into a services agreement with McDATA Holdings Corporation, a wholly-owned subsidiary of EMC, to provide manufacturing and distribution management services for proprietary mainframe protocol, or ESCONTM, switching solutions manufactured for and sold to IBM. Under the terms of this agreement, McDATA agreed to manage the ESCON product manufacture, design, order
and product shipment in exchange for a service fee calculated as a fixed percentage of EMCs ESCON revenues. In the second quarter ended July 31, 2004, the Company amended the service agreement to effectively assume the ESCON business
operations. This comprises the acceptance of the rights, risks and costs of inventory ownership and distribution; accounts receivable billing and collections; and sales and marketing activities.



Effective July 1, 2004, the Company began to fully consolidate the operations
of the ESCON product line. Under this new arrangement, McDATA recorded $1.6 million of ESCON product revenue related to sales made in July 2004. In addition, the Company recorded the initial ESCON product inventory of $340,000 on the balance sheet
and has included outstanding purchase commitments in the overall contract manufacturer commitments at July 31, 2004.



7



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##### Table of Contents

In addition to the assumption of the ESCON business, the Company renegotiated the prior service agreement
with EMC to include an increased service fee percentage through June 30, 2004. As a result, McDATA has recognized $1.6 million of previously deferred revenue related to past service fees which were in dispute. Additionally, the Company remitted to
EMC approximately $11 million of ESCON-related collections, which were retained by the Company during the negotiations and classified in accrued liabilities in prior periods.



Note 3  Restructuring Charges



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



Remaining accrued liabilities related to the Companys fiscal 2003 restructuring program are included in accrued liabilities on the accompanying condensed consolidated balance sheets. No material changes in estimates were made to the
restructuring accrual during the second quarter ended July 31, 2004. The Company expects to pay or otherwise substantially settle the remaining accrued liabilities during fiscal year 2004. The following table summarizes the Companys
utilization of restructuring accruals for the six months ended July 31, 2004:



|                                         |  |                           |        |   |                 |   |       |            |  |   |        |   |  |   |        |  
|---------------------------------------- |  | ------------------------- | ------ | - | --------------- | - | ----- | ---------- |  | - | ------ | - |  | - | ------ | -
|Six Months Ended July 31, 2004           |  | EmployeeSeveranceBenefits |        |   | FacilityClosure |   |       | OtherCosts |  |   | Totals |  
|Remaining accrual at beginning of period |  | $                         | 2,238  |   |                 | $ |      |            |  | $ |       |   |  | $ | 2,238  |  
|Expense provision                        |  |                           |       |   |                 |   | 1,117 |            |  |   |       |   |  |   | 1,117  |  
|Cash payments and other                  |  |                           | (2,299 | ) |                 |   | (134  | )          |  |   | (123   | ) |  |   | (2,556 | )
|Changes in estimates                     |  |                           | 116    |   |                 |   | (38   | )          |  |   | 123    |   |  |   | 201    |  
|                                         |  |                           |        |   |                 |   |       |            |  |   |        |   |  |   |        |  
|Accrual at end of period                 |  | $                         | 55     |   |                 | $ | 945   |            |  | $ |       |   |  | $ | 1,000  |  
|                                         |  |                           |        |   |                 |   |       |            |  |   |        |   |  |   |        |  



Note 4  Components of
Selected Balance Sheet Accounts



|                                                  |  |              |        |   |                 |   |        |  
|------------------------------------------------- |  | ------------ | ------ | - | --------------- | - | ------ | -
|                                                  |  | July 31,2004 |        |   | January 31,2004 |  
|Inventories:                                      |  |              |        |   |                 |   |        |  
|Raw materials                                     |  | $            | 9,775  |   |                 | $ | 7,037  |  
|Work-in-progress                                  |  |              | 591    |   |                 |   | 920    |  
|Finished goods                                    |  |              | 7,680  |   |                 |   | 7,883  |  
|                                                  |  |              |        |   |                 |   |        |  
|Total inventories at cost                         |  |              | 18,046 |   |                 |   | 15,840 |  
|Less reserves                                     |  |              | (5,398 | ) |                 |   | (4,476 | )
|                                                  |  |              |        |   |                 |   |        |  
|Total inventories, net                            |  | $            | 12,648 |   |                 | $ | 11,364 |  
|                                                  |  |              |        |   |                 |   |        |  
|Accrued liabilities:                              |  |              |        |   |                 |   |        |  
|Wages and employee benefits                       |  | $            | 20,411 |   |                 | $ | 17,489 |  
|Purchase commitments and other supply obligations |  |              | 6,794  |   |                 |   | 7,829  |  
|Warranty reserves (1)                             |  |              | 4,396  |   |                 |   | 4,522  |  
|Income taxes payable                              |  |              | 1,888  |   |                 |   | 1,783  |  
|Taxes, other than income tax                      |  |              | 2,140  |   |                 |   | 2,534  |  
|Interest payable                                  |  |              | 1,773  |   |                 |   | 1,773  |  
|Customer obligations                              |  |              | 5,331  |   |                 |   | 4,729  |  
|ESCON agency funds                                |  |              |       |   |                 |   | 8,373  |  
|Other accrued liabilities                         |  |              | 3,258  |   |                 |   | 4,298  |  
|                                                  |  |              |        |   |                 |   |        |  
|                                                  |  | $            | 45,991 |   |                 | $ | 53,330 |  
|                                                  |  |              |        |   |                 |   |        |  

---

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



|                               |  |                             |        |   |                           |   |       |      |  |   |       |   |  |   |       |  
|------------------------------ |  | --------------------------- | ------ | - | ------------------------- | - | ----- | ---- |  | - | ----- | - |  | - | ----- | -
|                               |  | Three Months Ended July 31, |        |   | Six Months Ended July 31, |  
|                               |  | 2004                        |        |   | 2003                      |   |       | 2004 |  |   | 2003  |  
|Balance at beginning of period |  | $                           | 4,380  |   |                           | $ | 3,457 |      |  | $ | 4,522 |   |  | $ | 3,485 |  
|Warranty expense , net         |  |                             | 417    |   |                           |   | 563   |      |  |   | 494   |   |  |   | 663   |  
|Warranty claims                |  |                             | (401   | ) |                           |   | (123  | )    |  |   | (620  | ) |  |   | (251  | )
|                               |  |                             |        |   |                           |   |       |      |  |   |       |   |  |   |       |  
|Balance at end of period       |  |                             | $4,396 |   |                           | $ | 3,897 |      |  | $ | 4,396 |   |  | $ | 3,897 |  
|                               |  |                             |        |   |                           |   |       |      |  |   |       |   |  |   |       |  



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##### Table of Contents

Note 5  Equity Investment



On August 22, 2003, the Company purchased 13.6 million shares of preferred stock, or approximately 17.3% of the total
outstanding shares of Aarohi Communications (Aarohi) for $6 million cash. Aarohi is a privately owned provider of next-generation intelligent storage networking technology. In addition to the equity investment, the Company has entered into a
non-exclusive supply arrangement with Aarohi to purchase their ASIC chip for inclusion in the Companys new product launches when, and if, Aarohis product becomes generally available. The Company has recorded its share of Aarohis
net loss of approximately $541,000 and $1.1 million for the three months and six months ended July 31, 2004, respectively. The remaining net equity investment of approximately $262,000 is recorded as an other asset as of July 31, 2004. During the
six months ended July 31, 2004, the Company received software development services from Aarohi at a cost of $52,000. These expenses have been classified as research and development expenditures.



Summarized unaudited financial information for Aarohi is as follows:



|                                       |  |   |         |  
|-------------------------------------- |  | - | ------- | -
|Six Months Ended June 30, 2004         |  |   |        
|Net sales                              |  | $ | 61      |  
|Gross profit                           |  | $ | 61      |  
|Operating loss                         |  | $ | (6,388  | )
|Net loss                               |  | $ | (6,409  | )
|                                       | 
|As of June 30, 2004                    |  |   |        
|Current assets                         |  | $ | 8,129   |  
|Noncurrent assets                      |  | $ | 1,453   |  
|Current liabilities                    |  | $ | 823     |  
|Noncurrent liabilities                 |  | $ | 2,307   |  
|Redeemable convertible preferred stock |  | $ | 34,471  |  
|Retained deficit                       |  | $ | (28,028 | )



Note 6  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 July 31, 2004    |  | $ | 78,693 |  
|                                |  |   |        |  



The Company completed
its acquisitions of Nishan Systems, Inc. and Sanera Systems, Inc. in the third quarter of 2003. No further material purchase adjustments are anticipated except for potential goodwill adjustments as a result of the potential future release of
valuation allowance on the deferred tax assets of the acquired companies that was recorded at the time of the acquisitions.



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##### Table of Contents

The Company is currently amortizing its acquired intangible assets with finite lives over periods ranging
from 1 to 6 years. During the quarter ended July 31, 2004, the Company identified the impairment of a customer relationship asset (the termination of Saneras prior Original Equipment Manufacturers Agreement with Computer Network
Technology Corporation) with a net carrying value of $1.0 million. This impairment was mostly offset by the indemnification by former owners of Sanera. A net impairment charge of $50,000 has been recorded in general and administrative expenses. The
following table summarizes the components of gross and net intangible asset balances:



|                        |  |                     |         |                         |   |                    |  |                     |        |                         |   |                    |  |   |        |  |   |        
|----------------------- |  | ------------------- | ------- | ----------------------- | - | ------------------ |  | ------------------- | ------ | ----------------------- | - | ------------------ |  | - | ------ |  | - | -------
|                        |  | July 31, 2004       |         | January 31, 2004       
|                        |  | GrossCarryingAmount |         | AccumulatedAmortization |   | Net CarryingAmount |  | GrossCarryingAmount |        | AccumulatedAmortization |   | Net CarryingAmount
|Developed technology    |  | $                   | 116,868 |                         | $ | 21,363             |  | $                   | 95,505 |                         | $ | 116,769            |  | $ | 11,133 |  | $ | 105,636
|Customer relationships  |  |                     | 1,622   |                         |   | 469                |  |                     | 1,153  |                         |   | 3,021              |  |   | 340    |  |   | 2,681  
|Other                   |  |                     | 3,813   |                         |   | 1,678              |  |                     | 2,135  |                         |   | 5,993              |  |   | 2,997  |  |   | 2,996  
|                        |  |                     |         |                         |   |                    |  |                     |        |                         |   |                    |  |   |        |  |   |        
|Total intangible assets |  | $                   | 122,303 |                         | $ | 23,510             |  | $                   | 98,793 |                         | $ | 125,783            |  | $ | 14,470 |  | $ | 111,313
|                        |  |                     |         |                         |   |                    |  |                     |        |                         |   |                    |  |   |        |  |   |        



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



|                                    |  |   |       
|----------------------------------- |  | - | ------
|Fiscal Years:                       |  |   |       
|2004(1)                             |  | $ | 11,200
|2005                                |  |   | 21,639
|2006                                |  |   | 19,494
|2007                                |  |   | 17,754
|2008                                |  |   | 17,418
|Thereafter                          |  |   | 11,288
|                                    |  |   |       
|Total expected amortization expense |  | $ | 98,793
|                                    |  |   |       

---

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



Amortization expense related to acquired intangible assets was $5.8 million and $0.5 million for the quarters ended July 31, 2004 and 2003, respectively.
For the six months ended July 31, 2004 and 2003, amortization of purchased intangibles was $11.6 million and $1.1 million, respectively.



Note 7  Interest and Other Income, Net



Interest and other income consists of:



|                                                              |  |                             |       |                           |      |   |       |  |   |       |   |  |   |      
|------------------------------------------------------------- |  | --------------------------- | ----- | ------------------------- | ---- | - | ----- |  | - | ----- | - |  | - | -----
|                                                              |  | Three Months Ended July 31, |       | Six Months Ended July 31,
|                                                              |  | 2004                        |       |                           | 2003 |   | 2004  |  |   | 2003 
|Interest income                                               |  | $                           | 1,597 |                           |      | $ | 1,561 |  | $ | 3,184 |   |  | $ | 3,506
|Net realized gains/(losses) on available-for-sale investments |  |                             | (324  | )                         |      |   | 11    |  |   | (483  | ) |  |   | 121  
|Unrealized loss on hedged investments                         |  |                             | 7     |                           |      |   | 21    |  |   | (38   | ) |  |   | 21   
|                                                              |  |                             |       |                           |      |   |       |  |   |       |   |  |   |      
|Interest and other income, net                                |  | $                           | 1,280 |                           |      | $ | 1,592 |  | $ | 2,663 |   |  | $ | 3,648
|                                                              |  |                             |       |                           |      |   |       |  |   |       |   |  |   |      



Note 8  Income Tax



For the three months ended July 31, 2004 and July 31,
2003 we recorded an income tax provision of $117,000 and $4.2 million, respectively. Income tax provisions of $658,000 and $7.4 million were recorded for the six months ended July 31, 2004 and 2003, respectively. The tax provision for fiscal 2004
reflects foreign tax that McDATA will owe on the profit of its foreign subsidiary activities as well as state taxes where there are insufficient tax operating losses to offset allocable taxable income. No federal tax benefit is recorded because the
Company has established a valuation allowance against its entire net deferred tax asset. The tax provision for the three and six months ended July 31, 2003 reflects federal, state and foreign tax expense prior to the establishment of a valuation
allowance.



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##### Table of Contents

Note 9  Net Income (Loss) Per Share



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



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



|                                                                                                        |  |                             |         |                           |      |   |         |  |   |         |   |  |   |        
|------------------------------------------------------------------------------------------------------- |  | --------------------------- | ------- | ------------------------- | ---- | - | ------- |  | - | ------- | - |  | - | -------
|                                                                                                        |  | Three Months Ended July 31, |         | Six Months Ended July 31,
|                                                                                                        |  | 2004                        |         |                           | 2003 |   | 2004    |  |   | 2003   
|Net income (loss)                                                                                       |  | $                           | (5,425  | )                         |      | $ | 9,133   |  | $ | (15,269 | ) |  | $ | 14,445 
|                                                                                                        |  |                             |         |                          
|Weighted average shares of common stock outstanding used in computing basic net income (loss) per share |  |                             | 115,551 |                           |      |   | 114,606 |  |   | 115,253 |   |  |   | 114,462
|Effect of dilutive stock options                                                                        |  |                             |        |                           |      |   | 3,894   |  |   |        |   |  |   | 3,634  
|                                                                                                        |  |                             |         |                           |      |   |         |  |   |         |   |  |   |        
|Weighted average shares of common stock used in computing diluted net income (loss) per share           |  |                             | 115,551 |                           |      |   | 118,500 |  |   | 115,253 |   |  |   | 118,096
|                                                                                                        |  |                             |         |                           |      |   |         |  |   |         |   |  |   |        
|Basic net income (loss) per share                                                                       |  | $                           | (0.05   | )                         |      | $ | 0.08    |  | $ | (0.13   | ) |  | $ | 0.13   
|                                                                                                        |  |                             |         |                           |      |   |         |  |   |         |   |  |   |        
|Diluted net income (loss) per share                                                                     |  | $                           | (0.05   | )                         |      | $ | 0.08    |  | $ | (0.13   | ) |  | $ | 0.12   
|                                                                                                        |  |                             |         |                           |      |   |         |  |   |         |   |  |   |        
|Options not included in diluted share base because of the exercise prices                               |  |                             | 12,493  |                           |      |   | 3,577   |  |   | 10,907  |   |  |   | 5,395  
|                                                                                                        |  |                             |         |                           |      |   |         |  |   |         |   |  |   |        
|Options and restricted stock not included in diluted share base because of the net loss                 |  |                             | 7,549   |                           |      |   |        |  |   | 9,135   |   |  |   |       
|                                                                                                        |  |                             |         |                           |      |   |         |  |   |         |   |  |   |        



Note 10  Stock-Based
Compensation



The Company has stock-based employee
compensation and employee purchase plans, which are described more fully in the Companys Annual Report on Form 10-K for the year ended January 31, 2004. In addition, the Board of Directors approved the Companys 2004 Inducement Equity
Grant Plan (the 2004 Plan) in May 2004. The 2004 Plan provides for the issuance of non-qualified options, stock bonus awards, stock purchase awards, stock appreciation rights, stock unit awards and other stock awards for newly hired employees of the
Company. A maximum of 3 million shares are issuable under the 2004 Plan. As of July 31, 2004, there were approximately 5.6 million shares of common stock available for future grants under these plans.



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



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|                                                                                                                                                              |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------- | ------ | - | ------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                                                                                                                              |  | Three Months Ended July 31, |        |   | Six Months Ended July 31, |  
|                                                                                                                                                              |  | 2004                        |        |   | 2003                      |   |        | 2004 |  |   | 2003    |  
|Net income (loss), as reported                                                                                                                                |  | $                           | (5,425 | ) |                           | $ | 9,133  |      |  | $ | (15,269 | ) |  | $ | 14,445 |  
|Add: Total stock-based employee compensation expense included in net income (loss) as determined under the intrinsic value method, net of
related tax effects |  |                             | 1,541  |   |                           |   | 1,107  |      |  |   | 3,883   |   |  |   | 2,102  |  
|Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax
effects               |  |                             | (5,290 | ) |                           |   | (5,450 | )    |  |   | (9,961  | ) |  |   | (9,208 | )
|                                                                                                                                                              |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Pro forma net income (loss)                                                                                                                                   |  | $                           | (9,174 | ) |                           | $ | 4,790  |      |  | $ | (21,347 | ) |  | $ | 7,339  |  
|                                                                                                                                                              |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Earnings (loss) per share:                                                                                                                                    |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Basic-as reported                                                                                                                                             |  | $                           | (0.05  | ) |                           | $ | 0.08   |      |  | $ | (0.13   | ) |  | $ | 0.13   |  
|                                                                                                                                                              |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Basic-pro forma                                                                                                                                               |  | $                           | (0.08  | ) |                           | $ | 0.04   |      |  | $ | (0.19   | ) |  | $ | 0.06   |  
|                                                                                                                                                              |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Diluted-as reported                                                                                                                                           |  | $                           | (0.05  | ) |                           | $ | 0.08   |      |  | $ | (0.13   | ) |  | $ | 0.12   |  
|                                                                                                                                                              |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  
|Diluted-pro forma                                                                                                                                             |  | $                           | (0.08  | ) |                           | $ | 0.04   |      |  | $ | (0.19   | ) |  | $ | 0.06   |  
|                                                                                                                                                              |  |                             |        |   |                           |   |        |      |  |   |         |   |  |   |        |  



Note 11  Comprehensive Income
(Loss)



Comprehensive income (loss) consisted of the following:



|                                           |  |                             |        |   |                           |   |       |      |  |   |         |   |  |   |        |  
|------------------------------------------ |  | --------------------------- | ------ | - | ------------------------- | - | ----- | ---- |  | - | ------- | - |  | - | ------ | -
|                                           |  | Three Months Ended July 31, |        |   | Six Months Ended July 31, |  
|                                           |  | 2004                        |        |   | 2003                      |   |       | 2004 |  |   | 2003    |  
|Net income (loss)                          |  | $                           | (5,425 | ) |                           | $ | 9,133 |      |  | $ | (15,269 | ) |  | $ | 14,445 |  
|Unrealized loss on investments, net of tax |  |                             | (520   | ) |                           |   | (454  | )    |  |   | (1,164  | ) |  |   | (442   | )
|                                           |  |                             |        |   |                           |   |       |      |  |   |         |   |  |   |        |  
|Comprehensive income (loss)                |  | $                           | (5,945 | ) |                           | $ | 8,679 |      |  | $ | (16,433 | ) |  | $ | 14,003 |  
|                                           |  |                             |        |   |                           |   |       |      |  |   |         |   |  |   |        |  



Note 12  Segment Information



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



A significant portion of revenue is concentrated with the largest storage
OEMs. For the three months ended July 31, 2004, approximately 47% of our total revenue came from EMC as compared to 62% for the three months ended July 31, 2003; IBM contributed approximately 26% of our revenue compared to 18% for the three months
ended July 31, 2003; and HDS contributed approximately 10% for the three months ended July 31 2004, and contributed less than 10% for the three months ended July 31, 2003. For the six months ended July 31, 2004, approximately 46% of our total
revenue came from EMC as compared to 61% for the six months ended July 31, 2003; IBM contributed approximately 25% of total revenue compared to 17% for the six months ended July 31, 2003; and HDS contributed approximately 11% of total revenue for
the six months ended July 31, 2004 as compared to 10% for the six months ended July 31, 2003. Other major storage and system vendors, including Dell, HP, STK and Sun, offer McDATA solutions. In addition to our storage and system vendors, we have
relationships with many resellers, distributors and systems integrators. Sales to these other channels represented 17% and 12%, respectively for the three months ended July 31, 2004 and 2003 and 18% and 12%, respectively for the six months ended
July 31, 2004 and 2003.



Revenues are attributed to geographic
areas based on the location of the customers to which our products are shipped. International revenues primarily consist of sales to customers in Western Europe and the greater Asia



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Pacific region. Included in domestic revenues are sales to certain OEM customers who take possession of our products
domestically and then distribute these products to their international customers. In addition, included in revenues from Western Europe are sales to certain OEM customers who take possession of our products in distribution centers designated for
international-bound product and then distribute these products among various international regions. Our mix of international and domestic revenue can, therefore, vary depending on the relative mix of sales to certain OEM customers. The increase in
international revenues as a percentage of revenue is the result of increased sales in both Western Europe and the Asia Pacific region. Domestic and international revenue was approximately 64% and 36% of total revenue, respectively, for the three
months ended July 31, 2004. For the three months ended July 31, 2003, domestic and international revenue was approximately 72% and 28% of total revenue, respectively. For the six months ended July 31, 2004, domestic and international revenue was 63%
and 37% of total revenue as compared to 71% and 29%, respectively for the six months ended July 31, 2003.



Note 13  Related Party Transaction



On June 10, 2004, the Company entered into a Software OEM Agreement (OEM Agreement) with Crosswalk, Inc. (Crosswalk). John F. McDonnell, a Class B shareholder of the Company and its former Chairman is the founder and
sole director of Crosswalk. Pursuant to the OEM Agreement, the Company granted Crosswalk a license to develop and integrate the Companys SANavigator® software into Crosswalks software platform, create certain enhancements for use with such integrated software product, and re-brand such
integrated software product with Crosswalks trademarks. The Company also granted Crosswalk a limited license to distribute the integrated software product furnished by the Company. The Company has deferred a $250,000 license fee and is
recognizing license fee revenue over the license period of twelve months. For the quarter ended July 31, 2004, approximately $42,000 of revenue had been recorded. Upon release and distribution of the Crosswalk proprietary software, software
royalties will be recognized in accordance with the terms of the OEM Agreement and the Companys revenue recognition policies.



Note 14  Commitment and Contingencies



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



Manufacturing and Purchase Commitments



The Company has contracted with Sanmina SCI Systems, Inc. (SSCI), Solectron
Corporation (Solectron) and others (collectively, Contract Manufacturers) for the manufacture of printed circuit boards and box build assembly and configuration for specific multi-protocol directors and switches. The agreements require the Company
to submit purchasing forecasts and place orders sixty calendar days in advance of delivery. At July 31, 2004, the Companys commitment with the Contract Manufacturers for purchases over the next sixty days totaled $48.2 million. The Company may
be liable for materials that the Contract Manufacturers purchase on McDATAs behalf if the Companys actual requirements do not meet or exceed its forecasts and those materials cannot be redirected to other uses. At July 31, 2004, the
Company had recorded obligations of approximately $6.8 million (See Note 4) primarily related to materials purchased by the Contract Manufacturers for certain end-of-life and obsolete material. Management does not expect the remaining commitments
under these agreements to have a material adverse effect on the Companys business, results of operations, financial position or cash flows.



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



Litigation



Class Action Laddering Lawsuits



The Company, John F. McDonnell, the former Chairman of
the board of directors, Dee J. Perry, a former officer and Thomas O. McGimpsey a current officer were named as defendants in purported securities class-action lawsuits filed in the United States District Court, Southern District of New York. The
first of these lawsuits, filed on July 20, 2001, is captioned Gutner v. McDATA Corporation, Credit Suisse First Boston (CSFB), Merrill Lynch, Pierce Fenner & Smith Incorporated, Bear, Stearns & Co., Inc., FleetBoston Robertson Stephens et
al., No. 01 CIV. 6627. Three other similar suits were filed against the Company and the individuals. The complaints are



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substantially identical to numerous other complaints filed against other companies that went public in 1999 and 2000.
These lawsuits generally allege, among other things, that the registration statements and prospectus filed with the SEC by such companies were materially false and misleading because they failed to disclose (a) that certain underwriters had
allegedly solicited and received excessive and undisclosed commissions from certain investors in exchange for which the underwriters allocated to those investors material portions of shares in connection with the initial public offerings, or IPOs,
and (b) that certain of the underwriters had allegedly entered into agreements with customers whereby the underwriters agreed to allocate IPO shares in exchange for which the customers agreed to purchase additional company shares in the aftermarket
at pre-determined prices. The complaints allege claims against the Company, the named individuals, and CSFB, the lead underwriter of the Companys August 9, 2000 initial public offering, under Sections 11 and 15 of the Securities Act of 1933.
The complaints also allege claims solely against CSFB and the other underwriter defendants under Section 12(a)(2) of the Securities Act of 1933, and claims against the individual defendants under Section 10(b) of the Securities Exchange Act of 1934.
Although management believes that all of the lawsuits are without legal merit and they intend to defend against them vigorously, there is no assurance that the Company will prevail.



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



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



Nishan Acquisition Related Lawsuit



In connection with the Companys acquisition of Nishan, the Company was named along with Nishan, various investors of Nishan, CSFB and former board
members and officers of Nishan in a lawsuit brought by Aamer Latif, a former board member and ex-CEO of Nishan, in the Superior Court of California, County of Santa Clara on September 11, 2003 (as amended on October 10, 2003 and March 24, 2004)
entitled Aamer Latif v. Nishan Systems, Inc. et al (103 CV 004 939). The Complaint makes various allegations against the other defendants such as fraud, directors breach of the duty of care, shareholders breach of fiduciary duty,
unjust enrichment, and conspiracy to commit unjust enrichment. The allegations made against the Company are vote buying, unjust enrichment, and conspiracy to commit unjust enrichment. The allegation made against Nishan is breach of Section 1602 of
the California Corporations Code (a provision dealing with books and records inspection). The complaint primarily seeks compensatory damages of approximately $11.5 million and other relief. The defendants have agreed that lawsuit expenses are
covered by indemnification under the merger agreement from the selling shareholders of Nishan. The defendants filed a demurer to dismiss this action, which was denied by the Court in January 2004. In May 2004, the defendants filed another demurer to
dismiss this action. On August 6, 2004, the defendants received a favorable ruling from the Judge. The Judge ruled against Mr. Latif and dismissed his claims since they were barred by Californias appraisal rights statute (Corporations Code
Section 1312(a)). The Judge also gave Mr. Latif 20 days leave to attempt to amend his complaint since it failed to state facts sufficient to constitute a legal cause of action. After significant review of the allegations made by the plaintiff, the
Company strongly believes that the lawsuit is wholly without legal merit and the Company intends to vigorously defend against this action.



Indemnifications and Guarantees



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



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



Note 15  Subsequent Events



In August 2004, the Company entered into agreements to sublease to an
unrelated third-party a leased facility in Toronto, Canada through the Companys remaining original lease term. In connection with these agreements, the Company made a one-time payment of approximately $1 million to satisfy all of its
outstanding lease commitments for this facility. These payments will be applied against the restructuring reserve accrual discussed in Note 3 and approximate the original estimates made by the Company. In addition to this facility closure and
release, management is currently evaluating potential leasing options for the Companys headquarters in Broomfield, Colorado, for which its lease expires in mid-2006.



As previously disclosed, the Company has a stock repurchase program for up to $42 million of its common stock. As part of
this repurchase program, in late August 2004, the Board authorized an SEC Rule 10b5-1 repurchase plan with a broker that allows the Company to make repurchases of our common stock including during traditional blackout periods. Under the program, the
Company may repurchase common stock under SEC Rule 10b-18, SEC Rule 10b5-1, open market purchases, private purchases or under other allowable programs.



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



You should read the following discussion and analysis in conjunction with the condensed consolidated financial statements and notes thereto included in
Item 1 of this Quarterly Report and with Managements Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report filed on Form 10-K, with the Securities and Exchange Commission on April 15, 2004, and
as amended on April 30, 2004 and August 23, 2004.



Overview



Competitive and Industry Environment



The market for our multi-protocol SAN switching hardware and software
products is highly competitive. Our competitors are providing or plan to provide SAN switching and routing hardware and software that is multi-protocol capable such as Fibre Channel over IP (FCIP), SCSI over Internet (iSCSI), Internet Fibre Channel
(iFCP) and InfiniBand(IB). A number of our current and potential competitors have longer operating histories, greater name recognition, access to larger customer bases, more established distribution channels and substantially greater financial and
managerial resources. To remain competitive, we will need to build on the new products and technologies developed and acquired through our 2003 acquisitions of Nishan and Sanera as well as our investment in Aarohi Communications. In addition, we
continue to expand our distribution channels for our product lines, including our Eclipse switch product line, which is based upon the technology acquired from Nishan. The financial results discussed below reflect our efforts to expand our channels
and to develop our new hardware and software products for release in the last half of fiscal 2004. Our recent port sales of hardware products, although down from the first half of 2003, reflect increases from the quarter ended April 30, 2004 and our
Eclipse SAN routing switch saw a strong increase in sales since its release in the fourth quarter of fiscal 2003. In addition, our software revenue has steadily increased from prior years to represent almost 15% of total revenue; up from 8% in the
second quarter of 2003. Our operating expense results reflect our continued product development efforts and, in the last half of 2004, will reflect development and launch-related expenditures as we introduce new products. We also continue to make
investments in our future technology.



We believe that we are
well positioned in the industry with a full complement of hardware and software products that customers require for the next phase of their infrastructure development. Management believes the trend of revenue growth and the related competitive
environment define the overall performance of the Company and provide a specific context to further analyze the financial results of the company.



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Revenue Reclassification



Beginning during the three months ended July 31, 2004, we have presented a reformatted classification of revenue to provide
further visibility into our product lines and to emphasize our software growth strategy. All prior periods have been reclassified to reflect the new classification. Our revenue comprises the following product categories:



| |  | Product Revenue  revenue from the sales of our director and switch products (including Eclipse SAN routers)
| | - | ------------------------------------------------------------------------------------------------------------



| |  | Software and Related Maintenance Revenue  revenue from the sales of our software licenses and related maintenance agreements. Our software maintenance agreements consist of
our standard post-contract services (PCS) that are sold in conjunction with the initial sales of the software licenses. These services include customer support that provides bug fixes, upgrades and telephone support.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Other Service Revenue  revenue from our professional service offerings as well as services provided under extended maintenance and upgraded warranty contracts for our hardware
products.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | ESCON Revenue  historical revenue earned from the ESCON service agreement and, beginning July 1, 2004, ongoing revenue from our ESCON product sales.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------



ESCON Agreement Amendment



In 1997, we entered into a services agreement with McDATA Holdings
Corporation, a wholly-owned subsidiary of EMC, to provide manufacturing and distribution management services for proprietary mainframe protocol, or ESCONTM, switching solutions manufactured for and sold to IBM. Under the terms of this agreement, we agreed to manage the ESCON product manufacture, design, order and product shipment in exchange for a
service fee calculated as a fixed percentage of EMCs ESCON revenues. In the second quarter ended July 31, 2004, we amended the service agreement to effectively assume the ESCON business operations. This comprises the acceptance of the rights,
risks and costs of inventory ownership and distribution; accounts receivable billing and collections; and sales and marketing activities. We elected to amend the service agreement and effectively assume the ESCON business operations for two primary
reasons. First, we believe that the gross margin dollars that we will earn by managing the business in its entirety will exceed the service fees we would have earned under the prior arrangement. Second, as a result of our amendment of the service
agreement, we obtained a retroactive increase in the prior service fee.



Therefore, effective July 1, 2004, we began to fully consolidate the operations of the ESCON product line. Under this new arrangement, we recorded $1.6 million of ESCON product revenue related to sales made in July 2004. In addition, we
recorded the initial ESCON product inventory of $340,000 on our balance sheet and have included outstanding purchase commitments in our overall contract manufacturer commitments at July 31, 2004. The ESCON technology is a mature technology, and
therefore, we anticipate revenues from this product line will decline over time. We will classify the ESCON revenue results as ESCON revenue in an effort to segregate this business from our current product sales, including our
next-generation products, which will be introduced in the second half of fiscal 2004.



In addition to the assumption of the ESCON business, the Company renegotiated the prior service agreement with EMC to include an increased service fee percentage through June 30, 2004. As a result, we have recognized
$1.6 million of previously deferred revenue related to past service fees which were in dispute. Additionally, we remitted to EMC approximately $11 million of ESCON-related collections, which were retained by us during the negotiations and classified
in accrued liabilities in prior periods.



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Results of Operations



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



|                                                                           |  |                             |    |  |                           |   |  |       |    |  |       |  
|-------------------------------------------------------------------------- |  | --------------------------- | -- |  | ------------------------- | - |  | ----- | -- |  | ----- | -
|                                                                           |  | Three Months Ended July 31, |    |  | Six Months Ended July 31, |  
|                                                                           |  | 2004                        |    |  | 2003                      |   |  | 2004  |    |  | 2003  |  
|Revenue                                                                    |  | 100.0                       | %  |  | 100.0                     | % |  | 100.0 | %  |  | 100.0 | %
|Cost of revenue                                                            |  | 44.2                        |    |  | 40.8                      |   |  | 43.9  |    |  | 42.0  |  
|                                                                           |  |                             |    |  |                           |   |  |       |    |  |       |  
|Gross profit                                                               |  | 55.8                        |    |  | 59.2                      |   |  | 56.1  |    |  | 58.0  |  
|Operating expenses:                                                        |  |                             |    |  |                           |   |  |       |    |  |       |  
|Research and development                                                   |  | 22.5                        |    |  | 17.0                      |   |  | 24.2  |    |  | 17.6  |  
|Selling and marketing                                                      |  | 24.7                        |    |  | 22.0                      |   |  | 24.4  |    |  | 22.3  |  
|General and administrative                                                 |  | 7.2                         |    |  | 6.2                       |   |  | 7.0   |    |  | 6.5   |  
|Amortization of purchased intangible assets                                |  | 5.9                         |    |  | 0.5                       |   |  | 5.9   |    |  | 0.5   |  
|Amortization of deferred compensation                                      |  | 1.5                         |    |  | 1.4                       |   |  | 1.9   |    |  | 1.4   |  
|Restructuring charges                                                      |  |                            |    |  |                          |   |  | 0.7   |    |  |      |  
|                                                                           |  |                             |    |  |                           |   |  |       |    |  |       |  
|Total operating expenses                                                   |  | 61.8                        |    |  | 47.1                      |   |  | 64.1  |    |  | 48.3  |  
|                                                                           |  |                             |    | 
|Income (loss) from operations                                              |  | (6.0                        | )  |  | 12.1                      |   |  | (8.0  | )  |  | 9.7   |  
|Interest and other income, net                                             |  | 1.1                         |    |  | 0.4                       |   |  | 1.2   |    |  | 0.7   |  
|                                                                           |  |                             |    |  |                           |   |  |       |    |  |       |  
|Income (loss) before income taxes and equity in loss of affiliated company |  | (4.9                        | )  |  | 12.5                      |   |  | (6.8  | )  |  | 10.4  |  
|Income tax expense                                                         |  | 0.1                         |    |  | 4.0                       |   |  | 0.3   |    |  | 3.5   |  
|                                                                           |  |                             |    |  |                           |   |  |       |    |  |       |  
|Income (loss) before equity in net loss of affiliated company              |  | (5.0                        | )  |  | 8.5                       |   |  | (7.1  | )  |  | 6.9   |  
|Equity in net loss of affiliated company                                   |  | (0.6                        | )  |  |                          |   |  | (0.6  | )  |  |      |  
|                                                                           |  |                             |    |  |                           |   |  |       |    |  |       |  
|Net income (loss)                                                          |  | (5.6                        | )% |  | 8.5                       | % |  | (7.7  | )% |  | 6.9   | %
|                                                                           |  |                             |    |  |                           |   |  |       |    |  |       |  



Revenues



|                                         |  |                            |        |                           |   |         |  |      |         |  |   |        
|---------------------------------------- |  | -------------------------- | ------ | ------------------------- | - | ------- |  | ---- | ------- |  | - | -------
|                                         |  | Three Months EndedJuly 31, |        | Six Months Ended July 31,
|                                         |  | 2004                       |        | 2003                      |   | 2004    |  | 2003
|Product revenue                          |  | $                          | 74,873 |                           | $ | 93,870  |  | $    | 154,157 |  | $ | 185,245
|Software and related maintenance revenue |  |                            | 14,804 |                           |   | 10,170  |  |      | 27,865  |  |   | 18,870 
|Other service revenue                    |  |                            | 4,580  |                           |   | 2,427   |  |      | 8,873   |  |   | 5,058  
|ESCON revenue                            |  |                            | 3,964  |                           |   | 547     |  |      | 4,555   |  |   | 1,020  
|                                         |  |                            |        |                           |   |         |  |      |         |  |   |        
|Total Revenue                            |  | $                          | 98,221 |                           | $ | 107,014 |  | $    | 195,450 |  | $ | 210,193
|                                         |  |                            |        |                           |   |         |  |      |         |  |   |        



Product revenue of
$74.9 million for the three months ended July 31, 2004 decreased 20% from $93.9 million for the three months ended July 31, 2003. This decline in product revenue reflects a 12% decrease in estimated director and switch ports sold and a 9% decrease
in estimated average sales prices. Product revenue of $154.2 million for the six months ended July 31, 2004 decreased 17% from $185.2 million for the six months ended July 31, 2003. This decline in product revenue reflects a 5% decrease in estimated
ports sold and a 15% decrease in estimated average sales prices from the second quarter ended July 31, 2003. The declines in sales of hardware ports reflects a subdued IT spending environment, as well as increased competition from the first half of
fiscal 2003 when we experienced record product revenue. This economic and competitive environment has lengthened the decision making process of our end-users and lengthened our sales cycles. We expect the number of ports shipped to fluctuate
depending on the demand for our existing and newly introduced products including the timing of product introductions by our OEM customers. We believe the decrease in average sales prices reflects historical pricing declines typical with our
technology products, the ongoing competitive environment and marketing and sales programs. In addition, average sales price declines during the second quarter were deeper than previous quarters as we lowered pricing on our switch and director
products in anticipation of the transition to lower cost switches and director blade components. Ongoing competition and macroeconomic factors could continue to provide downward pricing pressures that could impact our revenue growth and related
margins.



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For the three months ended July 31, 2004, software revenue of $14.8 million was a 46% increase from $10.2
million for the three months ended July 31, 2003. Software revenue of $27.9 million for the six months ended July 31, 2004 increased 48% from $18.9 million for the six months ended July 31, 2003. This revenue growth is due to continued revenue
growth from our software products, including our SANavigator®, SANtegrity® and SAN
routing software.



Other service revenue includes professional
service revenue and revenue earned from our upgraded warranty and extended maintenance contracts on our hardware products. For the three months ended July 31, 2004, other service revenue increased 89% to $4.6 million as compared to $2.4 million for
the three months ended July 31, 2003. For the six months ended July 31, 2004, other service revenue increased 75% to $8.9 million as compared to $5.1 million for the six months ended July 31, 2003. These increases are due primarily to higher sales
of extended maintenance and upgraded warranty contracts sold in conjunction with our hardware products.



ESCON revenues of $4.0 million for the three months ended July 31, 2004, include both service fee revenue and product revenue (as of July 1, 2004) earned
under the ESCON service agreement with EMC, which was amended in June 2004. The significant increase from $0.5 million for the three months ended July 31, 2003, reflects, in part, the $1.6 million of previously deferred service fees discussed above.
These fees were deferred in prior periods in accordance with revenue recognition policies and the on-going contract negotiations. In addition, $1.6 million of gross ESCON product revenues earned subsequent to the amendment and our assumption of the
ESCON business are also included in other revenues for the three months ended July 31, 2004.



A significant portion of our revenue is concentrated with the largest storage OEMs. For the three months ended July 31, 2004, approximately 47% of our total revenue came from EMC as compared to 62% for the three
months ended July 31, 2003; IBM contributed approximately 26% of our revenue compared to 18% for the three months ended July 31, 2003; and HDS contributed approximately 10% for the three months ended July 31 2004, and contributed less than 10% of
total revenue for the three months ended July 31, 2003. For the six months ended July 31, 2004, approximately 46% of our total revenue came from EMC as compared to 61% for the six months ended July 31, 2003; IBM contributed approximately 25% of
total revenue compared to 17% for the six months ended July 31, 2003; and HDS contributed approximately 11% of total revenue for the six months ended July 31, 2004 as compared to 10% for the six months ended July 31, 2003. Other major storage and
system vendors, including Dell, HP, STK and Sun, offer McDATA solutions. In addition to our storage and system vendors, we have relationships with many resellers, distributors and systems integrators. Sales to these other channels represented 17%
and 12%, respectively for the three months ended July 31, 2004 and 2003 and 18% and 12%, respectively for the six months ended July 31, 2004 and 2003. The decline in the revenue from EMC as a percentage of our sales is the result of the entrance of
new competitors into the storage market and the lengthened sales cycle in the high-end director market; as well as the overall growth in revenue dollars from our other OEMs and non-OEM channels. Expanding our reseller, distributor and system
integrator channels into Small Medium Enterprise (SME) and vertical markets will be a strategic focus for us as we continue to grow our business. However, the level of sales to any single customer may vary and the loss of any one significant
customer, or a decrease in the level of sales to any significant or group of significant customers, could harm our financial condition and results of operations. Given the dependencies on our limited number of OEM resellers combined with an
increasingly competitive environment, we may experience continued adverse price pressures at critical times near the end of the fiscal quarters.



Domestic and international revenue was approximately 64% and 36% of our total revenue, respectively, for the three months ended July 31, 2004. For the
three months ended July 31, 2003, domestic and international revenue was approximately 72% and 28% of our total revenue, respectively. For the six months ended July 31, 2004, domestic and international revenue was 63% and 37% of total revenue as
compared to 71% and 29%, respectively for the six months ended July 31, 2003. Revenues are attributed to geographic areas based on the location of the customers to which our products are shipped. International revenues primarily consist of sales to
customers in Western Europe and the greater Asia Pacific region. Included in domestic revenues are sales to certain OEM customers who take possession of our products domestically and then distribute these products to their international customers.
In addition, included in revenues from Western Europe are sales to certain OEM customers who take possession of our products in distribution centers designated for international-bound product and then distribute these products among various
international regions. Our mix of international and domestic revenue can, therefore, vary depending on the relative mix of sales to certain OEM customers. The increase in international revenues as a percentage of revenue is the result of increased
sales in both Western Europe and the Asia Pacific region.



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Gross Profit



Gross profit margin of 56% for the three months ended July 31, 2004 reflects a 330 basis point decline from the gross profit
margin of 59% for the three months ended July 31, 2003. Costs of goods sold consists of product costs, which are generally variable, and manufacturing operating cost, which include both variable and fixed expenses. Product costs as a percentage of
revenue increased 0.7% due to increases in lower revenue and average sales prices which were offset by higher margin software revenues, lower component costs and the one time increase in revenue due to retroactive ESCON service fees. Manufacturing
operating costs as a percentage of revenue increased 2.6% due primarily from a $2.2 million release of inventory reserves and obligations during the second quarter of fiscal 2003.



For the six months ended July 31, 2004 and 2003, gross profit margin was 56% and 58%, respectively, reflecting a decrease of
190 basis points. Product costs as a percentage of revenue increased 0.5% due to lower revenues which were offset by increases in higher margin software sales, lower component costs and the one-time increase in revenue due to retroactive ESCON
service fees. Manufacturing operating costs as a percentage of revenue increased 1.4% due lower revenues. In addition, during the six months ended July 31, 2003, we released inventory-related reserves and obligations of approximately $2.7 million or
1.3% of the six-month 2003 gross margins reported above.



In
anticipation of the competitive-driven and natural decline in selling prices, we continue to drive cost advantages through our engineering and manufacturing processes. In April 2004, we announced the availability of the lower cost versions of our
second-generation switch technology and began shipping the lower cost versions of our director components. Through these actions, we anticipate gross profit margin will remain in the mid-50 percent range through the third quarter of fiscal 2004.



Operating Expenses



Research and Development Expenses. Research and development expenses
consist primarily of salaries and related expenses for personnel engaged in engineering and R&D activities; fees paid to consultants and outside service providers; nonrecurring engineering charges; prototyping expenses related to the design,
development, testing and enhancement of our products; depreciation related to engineering and other test equipment; and IT and facilities expenses.



For the three months ended July 31, 2004, research and development expenses increased by $4.0 million to $22.1 million as compared with $18.2 million for
the three months ended July 31, 2003. This increase was primarily due to a $3.8 million increase in personnel related expenses attributable to our third quarter 2003 acquisitions and a $3.0 million increase in spending related to product development
and testing. This increased spending was partially offset by increases in the capitalization of software development costs, i.e. less expense, from the second quarter of fiscal 2003. Capitalized software costs increased $2.7 million to $4.7 million
for the three months ended July 31, 2004 compared to $2.0 million for the three months ended July 31, 2003. These costs vary in conjunction with stages of development of our application software, our new director and switch products and related
firmware software.



For the six months ended July 31, 2004,
research and development increased by $10.2 million to $47.2 million as compared with $37.0 million for the six months ended July 31, 2004. This increase was primarily due to a $7.4 million increase in personnel related expenses attributable to
fiscal 2003 acquisitions and a $7.2 million increase in spending related to new product development and testing. This increased spending was partially offset by increases in the capitalization of software development costs from fiscal 2003.
Capitalized software costs for the six months ended July 31, 2004, increased $4.3 million to $7 million as compared to $2.7 million for the six months ended July 31, 2003. These costs vary in conjunction with stages of development of our application
software, our new director and switch products and related firmware software.



We currently expect that research and development expenses for the three months ending October 31, 2004 will increase on an absolute dollar basis as we will incur additional development costs related to the completion
of our new product offerings and we will experience declines in expenses eligible for capitalization.



Selling and Marketing Expenses. Sales and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged
in marketing and sales; costs associated with promotional and travel expenses; and IT and facilities expenses.



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For the three months ended July 31, 2004, selling and marketing expenses increased by $0.8 million to
$24.2 million as compared to $23.5 million for the three months ended July 31, 2003. This increase was primarily due to a $1.0 million increase for increased tradeshow and marketing activities offset by $0.6 million decline for reduced personnel
expenses driven by the lowered revenue.



For the six months
ended July 31, 2004, selling and marketing expenses increased by $1.0 million to $47.7 million as compared to $46.9 million for the six months ended July 31, 2003. Increases in travel, personnel and equipment costs of $1.5 million in fiscal 2004
were offset by a $1.0 million decrease in customer acquisition costs from the six months ended July 31, 2003 attributable to two new OEM contracts signed during that period.



We currently expect that sales and marketing expenses for the three months ending October 31, 2004 will increase on an
absolute dollar basis as we will incur additional launch costs related to the introduction of our new product offerings.



General and Administrative Expenses. General and administrative expenses consist primarily of salaries and related expenses for corporate
executives, finance, human resources and investor relations, as well as accounting and professional fees, corporate legal expenses, other corporate expenses, and IT and facilities expenses.



For the three months ended July 31, 2004 and 2003, respective, general and
administrative expenses were $7.1 million and $6.7 million. For the six months ended July 31, 2004 and 2003, respectively, general and administrative expenses were $13.7 million and $13.6 million.



Amortization Of Purchased Intangible Assets. Amortization of purchased
intangible assets was $5.8 million and $0.5 million for the three months ended July 31, 2004 and 2003, respectively, and $11.6 million and $1.0 million for the six months ended July 31, 2003, respectively. The increases were the result of our fiscal
2003 acquisitions through which we recorded approximately $113 million of amortizable intangible assets. These assets are being amortized on a straight-line basis over a period of one to six years.



Amortization of Deferred Compensation. Amortization of deferred
compensation was $1.5 million for the three months ended July 31, 2004, and $1.6 million for the three months ended July 31, 2003 (of which approximately $52,000 and $133,000 was included in cost of revenue, respectively). Deferred amortization
expense of $3.9 million was recorded for the six months ended July 31, 2004 and $3.2 million for the same period July 31, 2003 (of which approximately $136,000 and $270,000 was included in cost of revenue, respectively). We have recorded deferred
compensation in connection with Class B common stock options granted prior to our August 9, 2000 initial public offering (IPO) and restricted Class B stock grants granted through our equity incentive plans. In addition, we issued approximately 1.0
million shares of Class B restricted common stock with vesting periods ranging from 12 to 24 months in connection with our acquisitions during fiscal 2003. We are amortizing all deferred compensation on a straight-line basis over the vesting period
of the applicable options and stock awards. Deferred compensation expense related to these awards will decrease as the awards become fully vested over the following two to five years



Restructuring Charges. In the fourth quarter of fiscal 2003, we announced that we were taking certain cost
improvement actions, which included a workforce reduction and facility consolidation. During the six months ended July 31, 2004, we completed our planned closure of our Toronto engineering facility and recorded an approximate $1.1 million
restructuring charge related to this closure. In addition, we incurred an additional $239,000 restructuring charge in fiscal 2004 for additional severance-related and other costs as we finalized the reduction in workforce that was initiated in the
fourth quarter of 2003.



Interest and Other Income.
Interest and other income consisted primarily of interest earnings on our cash, cash equivalents and various investment holdings. Interest and other income decreased to $1.3 million for the three months ended July 31, 2004 as compared with $1.6
million for the three months ended July 31, 2003. Interest and other income decreased to $2.7 million for the six months ended July 31, 2004 as compared with $3.6 million for the six months ended July 31, 2003. This decrease in income reflects the
use of a portion of our investment portfolio to fund our third quarter 2003 acquisitions. Fluctuations in our investment balances as well as fluctuations in interest rates could cause our investment income to vary between periods.



Interest Expense. For the three months ended July 31, 2004, interest
expense decreased $1.0 million to $0.2 million compared with $1.2 million for the three months ended July 31, 2003. For the six months ended July 31, 2004, interest expense decreased $1.8 million to $0.5 million compared to $2.3 million for the six
months ended July 31, 2003. These decreases were attributable to the interest rate swap which was established during the second



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quarter fiscal 2003. This interest-rate swap agreement has the economic effect of modifying the fixed interest
obligations associated with our convertible debt so that the interest payable on the majority of the debt effectively becomes variable based on the six-month London Interbank Offered Rate (LIBOR) minus 152 basis points. The reset dates of the swap
are February 15 and August 15 of each year until maturity on February 15, 2010. At July 31, 2004, the six-month LIBOR setting was set at 1.175%, resulting in a rate of minus 0.345%, which was effective until August 15, 2004. On August 16, 2004, the
six-month LIBOR setting was reset to 1.92%, resulting in a rate of approximately 0.4%, which is effective until February 15, 2005. Significant increases in interest rates in future periods could significantly increase interest expense.



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



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



The Internal Revenue Service is currently conducting an audit
of the Companys US income tax returns for 2000, 2001 and 2002. An audit of these years is mandated by the procedures for Joint Committee cases due to the carry back of tax losses from the 2001 and 2002 tax years to 2000. In addition, the state
of Colorado has notified the Company of its intent to review income tax returns filed with the state for 2001 and 2002.



Liquidity and Capital Resources



Our financial condition remains solid. At July 31, 2004, cash, short- and long-term investments were $321 million compared to approximately $317 million
as of January 31, 2004. These balances both include approximately $5 million of restricted cash that we are required to maintain in relation to the interest rate swap we have executed in connection with our convertible debt. We invest excess cash
predominantly in debt and equity instruments that are highly liquid, of high-quality investment grade, and predominantly have maturities of less than three years with the intent to make such funds readily available for operating purposes, including
expansion of operations and potential acquisitions or other transactions.



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



In summary, our cash flows were:



|                                          |  |                           |         |   |      |   |          |  
|----------------------------------------- |  | ------------------------- | ------- | - | ---- | - | -------- | -
|                                          |  | Six Months Ended July 31, |        
|Source/(use) (in thousands)               |  | 2004                      |         |   | 2003 |  
|Net cash provided by operating activities |  | $                         | 15,630  |   |      | $ | 40,675   |  
|Net cash used by investing activities     |  |                           | (27,558 | ) |      |   | (162,999 | )
|Net cash provided by financing activities |  |                           | 1,078   |   |      |   | 142,910  |  



The decrease in cash
provided by operating activities reflects the net loss for the six months ended July 31, 2004 adjusted for non-cash charges including depreciation, amortization, deferred compensation and changes in working capital items. Working capital items
include accounts receivable, inventories, other current and non-current assets, accounts payable, accrued liabilities and deferred revenue. Accounts receivable was the source of $9.1 million in the first six months of fiscal year 2004 compared to a
use of $16.9 million in the first six months of 2003. Days sales outstanding (DSO) was 50 days and 45 days for the six months ended July 31, 2004 and 2003, respectively. The change between years is the result of the timing and collections compared
to the linearity of billings within the quarter. The use of cash of $8.1 million in the first half of fiscal 2004 for the net purchase of inventories compares to the $2.9 million use of cash in the first half of fiscal 2003. The increased purchasing



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reflects the build of inventories surrounding the next generation of products that are currently in the pre-production
phase. The use of cash of $4.9 million from accounts payable and accrued liabilities for the six months ended July 31, 2004 compares to the $15.2 million source of cash for the six months ended July 31, 2003. This change reflects the timing of
payments of vendor invoices as well as an $11 million payment made during the second quarter of fiscal 2004 to EMC in connection with the ESCON service agreement amendment.



The decrease in net cash used by investing activities reflects the use of cash proceeds from the issuance of convertible
subordinated notes to purchase investments in the six months ended July 31, 2003, offset in part by an increase in property, plant and equipment purchases and capitalization of software development costs.



Net cash provided by financing activities during the six months ended July
31, 2004 reflects proceeds from the issuance of common stock from stock option exercises and purchases under the Companys employee stock purchase plan. In the February 2003, we issued convertible subordinated notes of $172.5 million in
principal amount, with proceeds of $167 million. The 2.25% convertible subordinated notes mature in February 2010, unless converted into McDATA common stock at a conversion price of $10.71 per share, subject to certain conversion price adjustments.
Offsetting these net proceeds were the use of $20.5 million of those proceeds to enter into share option transactions and $5 million of cash being classified as restricted related to our interest rate swap agreement.



Off-Balance Sheet Arrangements



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



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



Commitments



The Company has contracted with Sanmina SCI Systems, Inc. (SSCI), Solectron Corporation (Solectron) and others (collectively, Contract Manufacturers) for
the manufacture of printed circuit boards and box build assembly and configuration for specific multi-protocol directors and switches. The agreements require the Company to submit purchasing forecasts and place orders sixty calendar days in advance
of delivery. At July 31, 2004, the Companys commitment with the Contract Manufacturers for purchases over the next sixty days totaled $48.2 million. The Company may be liable for materials that the Contract Manufacturers purchase on
McDATAs behalf if the Companys actual requirements do not meet or exceed its forecasts and those materials cannot be redirected to other uses. At July 31, 2004, the Company had recorded obligations of approximately $6.8 million (See Note
4) primarily related to materials purchased by the Contract Manufacturers for certain end-of-life and obsolete material. Management does not expect the remaining commitments under these agreements to have a material adverse effect on the
Companys business, results of operations, financial position or cash flows.



In February 2003, the Company sold $172.5 million of 2.25% convertible subordinated notes due February 15, 2010 (the Notes). The Notes are convertible into our Class A common stock at conversion rate of 93.3986 shares
per $1,000 principal amount of notes (aggregate of approximately 16.1 million shares) or $10.71 per share, subject to certain conversion adjustments. Upon a conversion, the Company may choose to deliver shares of our Class A common stock, or, in
lieu of shares of our Class A common stock, cash or a combination of cash and shares of Class A common stock. We are required to pay interest on February 15 and August 15 of each year, beginning August 15, 2003. Debt issuance costs of $5.6 million
are being amortized over the term of the Notes. The amortization of debt issuance costs will accelerate upon early redemption or conversion of the Notes. The net proceeds remain available for general corporate purposes, including working capital
requirements and capital expenditures.



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



In July 2003, we
entered into an interest-rate swap agreement with a notional amount of $155.3 million that has the economic effect of modifying the fixed interest obligations associated with the Notes so that the interest payable on the majority of the Notes
effectively becomes variable based on the six-month LIBOR minus 152 basis points. The reset dates of the swap are February 15 and August 15 of each year until maturity on February 15, 2010. On February 15, 2004, the six-month LIBOR setting was reset
to 1.175%, resulting in a rate of approximately minus 0.345%, which is effective until August 15, 2004. At July 31, 2004, the six-month LIBOR setting was set at 1.175%, resulting in a rate of minus 0.345%, which was effective until August 15, 2004.
On August 16, 2004, the six-month LIBOR setting was reset to 1.92%, resulting in a rate of approximately 0.4%, which is effective until February 15, 2005. Significant increases in interest rates could significantly increase the interest expense we
are obligated to pay to holders of the Notes in future periods. The swap was designated as a fair value hedge and, as such, the gain or loss on the derivative instrument, as well as the fully offsetting gain or loss on the Notes attributable to the
swap, were recognized in earnings. We are also required to post collateral based on changes in the fair value of the interest rate swap. This collateral, in the form of restricted cash, was $5.0 million at July 31, 2004.



The following table summarizes our contractual obligations (including
interest expense) and commitments as of July 31, 2004 (in thousands):



|                                   |  |       |         |                  |   |           |  |                  |        |  |   |        
|---------------------------------- |  | ----- | ------- | ---------------- | - | --------- |  | ---------------- | ------ |  | - | -------
|                                   |  | Total |         | Less Than 1 Year |   | 1-3 Years |  | More than5 years
|Convertible subordinated debt      |  | $     | 172,500 |                  | $ |          |  | $                |       |  | $ | 172,500
|Non-cancelable operating leases    |  |       | 54,921  |                  |   | 9,659     |  |                  | 12,342 |  |   | 32,920 
|Non-cancelable purchase agreements |  |       | 48,213  |                  |   | 48,213    |  |                  |       |  |   |       
|Capital leases, including interest |  |       | 1,385   |                  |   | 941       |  |                  | 444    |  |   |       
|                                   |  |       |         |                  |   |           |  |                  |        |  |   |        
|Total contractual obligations      |  | $     | 277,019 |                  | $ | 58,813    |  | $                | 12,786 |  | $ | 205,420
|                                   |  |       |         |                  |   |           |  |                  |        |  |   |        



Critical Accounting Policies



General



Managements Discussion and Analysis of Financial Condition and Results
of Operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make
estimates and assumptions that affect the reported amounts of assets and liabilities, revenue and expenses, and the related disclosure of contingent assets and liabilities as of the date of the financial statements. Management bases its estimates on
historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily
apparent from other sources. Senior management has discussed the development, selection and disclosure of these estimates with the Audit Committee of McDATAs Board of Directors. Actual results may differ materially from these estimates under
different assumptions or conditions. Management believes the following critical accounting policies reflect its more significant estimates and assumptions used in the preparation of its consolidated financial statements.



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Revenue Recognition



We recognize revenue, in accordance with SEC Staff Accounting Bulletin No. 104, Revenue Recognition (SAB 104) and the American Institute of Certified
Public Accountants Statement of Position 97-2 (SOP 97-2), as amended, when persuasive evidence of an arrangement exists, products are delivered or services rendered, the sales price is fixed or determinable and collectibility is assured. In
instances when any one of these four criteria is not met, we will defer recognition of revenue until all the criteria have been met.



With respect to revenue from our configured products, we request evidence of sell-through from our OEM and distributor partners prior to recognizing
revenue. In situations where our OEM and distributor partners refuse to provide sell-through information when requested, but all the criteria under SAB 104 (as discussed above) have been met, we recognize revenue for such configured products. These
configured products represent high value, customized solutions of directors, cabinets and various combinations of port cards ordered by our OEM and distributor partners as required by the end user. Non-configured products and components, such as our
switch products, port cards, and FlexPort upgrades, are recognized as revenue when the criteria for SAB 104 (as discussed above) have been met, generally at time of shipment. Revenue for both configured and non-configured products and components is
reduced for estimated customer returns, price protection rebates, and other contract terms that are provided to the Companys OEMs, distributors and resellers. These estimates are calculated in accordance with SFAS No. 48, Revenue
Recognition When Rights of Return Exist (SFAS 48) and rely on historical experience. We have not experienced credits in excess of 1% of annual revenues. If actual credit experience varies from our historical experience due to changes in
product technology, the pricing environment or other unforeseen factors, our revenue could be adversely affected. Additionally, to date our distributor revenue has represented a small portion of our overall revenues and our historical experience
regarding returns or credits under price protection or inventory rotation rights has not been sufficient to recognize revenue for non-configured products at time of shipment. Accordingly, these revenues are currently recorded when evidence of
sell-through is obtained. As our business and experience with distributors continues to increase and relevant historical information is obtained and monitored, we plan to estimate the potential for returns in accordance with SFAS 48 and record
revenues upon shipment if all SAB 104 revenue recognition criteria have been met. We believe we have obtained sufficient historical experience as of the end of the second quarter of fiscal 2004, and therefore, we will recognize distributor revenue
at time of shipment beginning in Q3 2004. At July 31, 2004, the amount of unearned distributor revenue was $1.3 million. If actual credits received by our partners for returns or price protection and inventory rotation actions were to deviate
significantly from our estimates, which are based on historical experience, our revenue could be adversely affected.



Inventory Reserves



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



Additionally, we have certain purchase commitments with our Contract Manufacturers that are non-cancelable. We may be liable for materials that our
third-party manufacturers purchase on our behalf if our actual requirements do not meet or exceed our forecasts and those materials cannot be redirected to other uses by the Contract Manufacturers. We evaluate these open purchase orders in light of
our current inventory on hand, expected demand, market conditions and new product introductions. Based on this information, we record purchase obligations for inventory we believe is excess or obsolete and cannot be redirected to other uses by our
contract manufacturers. At July 31, 2004, the Companys commitment with our Contract Manufacturers for purchases over the next sixty days totaled $48.2 million, of which we had recorded reserves of $6.8 million. Adverse changes in our and our
contract manufacturers calculations and assumptions concerning these purchase commitments may result in an increase to our vendor obligations and increase our cost of revenue.



Warranty Provision



We also provide for estimated expenses for warranty obligations as revenue is recognized. These estimates are based
primarily on our historical experience with product failures, cost to repair and known identified product quality issues. Our historical warranty claims has been immaterial with actual warranty claims representing less than 1% of our annual cost of
sales. Future material changes in our product and component quality or significant increases in our warranty repair and replacement cost could require revisions to the estimated warranty liability and could significantly increase our product costs,
cause significant customer relations problems and reduce revenue.



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Income Taxes



Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities and any valuation allowance
recorded against deferred tax assets. We are required to estimate our income taxes in each jurisdiction where we operate. This process involves estimating our actual current income tax expense together with assessing temporary differences resulting
from the different treatment of items for income tax and accounting purposes such as the timing of revenue recognition and accrued expenses, depreciation methods, and reserve accounts, as well as research and development costs. These differences
result in deferred tax assets and liabilities, which are included in our consolidated balance sheet.



These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheet net of any valuation allowance. In
evaluating the need for a valuation allowance, we assessed the likelihood that our net deferred tax assets will be recovered from future taxable income. We have considered past operating losses, cumulative losses for financial accounting in recent
years, estimated future taxable income and our ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. After considering all available evidence, both positive and negative, management concluded, after
applying the provisions of SFAS 109, that it is more likely than not that we will not be able to realize our deferred tax assets in the future. Therefore, a full valuation allowance has been provided against those deferred tax assets. The portion
relating to the acquisitions is applied as an increase to the basis of other assets from the acquired companies.



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



Valuation of Long-Lived Assets Including Goodwill and Purchased Intangible
Assets



We have performed and will perform an annual
impairment test for goodwill in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, (SFAS 142). This review is based on a comparison of the carrying value of our net assets including
goodwill balances to the fair value of our net assets using the quoted market price of our common stock. We performed the 2004 impairment test during our first fiscal quarter and determined that no impairment loss should be recognized. In the event
that business conditions change and our market value were to drop significantly below year-end levels, future tests may result in a need to record a loss due to write down of the value of goodwill. At July 31, 2004, goodwill recorded in the
consolidated balance sheet totaled $78.7 million.



We currently
operate our business as a single solutions business and do not maintain separate cash flows or operating margins on a segmented level. Future operating losses, deterioration of our business or segmentation of our operations in the future could also
lead to impairment adjustments as such issues are identified.



Sales
Commission Estimates



Our sales approach is focused on an
indirect model executed primarily through OEMs and resellers. Our field sales and service personnel support these distribution channels using a direct-assist model and are commissioned based on sales results achieved during the reporting period.
Because specific sales data used to calculate these commissions is not always available at the time our financial results are released, we routinely make certain estimates based on known revenue achievement, historical experience and assumptions
regarding individual sales contributions. Changes to these assumptions and estimates could cause revisions to our sales commission liabilities and result in variations between estimated liabilities and actual payments.



Restructuring Charges



We monitor and regularly evaluate our organization structure and associated operating expenses. Depending on events and
circumstances, we may decide to restructure our operations to reduce future operating costs. In determining the restructuring charges, we analyze our future operating requirements, including the required headcount by functions and facility space
requirements. Our restructuring costs, and any resulting accruals, involve significant estimates made by management using the best information available at the time the estimates are made, some of which may be provided by third parties. In recording
facilities lease loss reserves, we make



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various assumptions, including the time period over which the facilities will be vacant, expected sublease terms,
expected sublease rates, anticipated future operating expenses, and expected future use of the facilities. Our estimates involve a number of risks and uncertainties, some of which are beyond our control, including future real estate market
conditions and our ability to successfully enter into subleases or lease termination agreements with terms as favorable as those assumed when arriving at our estimates. We regularly evaluate a number of factors to determine the appropriateness and
reasonableness of our restructuring and lease commitment accruals including the various assumptions noted above. If actual results differ significantly from our estimates, we may be required to adjust our restructuring accruals in the future.



Risk Factors



Risks Relating to Our Business



Changing Market Conditions and Increased Competitive Risks.



The market for our multi-protocol storage area networking (SAN) products and
solutions has grown and will continue to become more competitive with (a) the entrance of new competitors from the IP based switching market into our market, (b) pricing pressures resulting from this increase in competitive SAN networking products
and solutions, (c) challenges to our direct-assist sales model with distribution through channels when our competitors engage end-user customers directly or otherwise have the ability to drive end-user customer preference for SAN equipment through
their traditional IP networking presence and relationships, and (d) anticipated competition from our own storage OEM partners through their recent acquisitions of, or alliances with, competitive software management products and/or application
providers that would utilize the intelligence in the network. As a result of these market changes, we anticipate continued lengthened sales cycles and price erosion in an environment where storage OEM certification of our products may still be
required for end-user customer acceptance. Given our direct-assist sales model with distribution through our channel partners, we are highly dependent upon our channel partners relationships with end-user customers to promote the value of our
products. If our channel partners do not promote the value of our products or competitors begin to control end-user customer preference, we may lose sales in key enterprise accounts that would materially adversely affect our revenues.



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



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



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



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



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



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



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



We depend on EMC and IBM, for a significant portion of our total revenue.
Sales to EMC and IBM represented approximately 47% and 26%, respectively, of our revenue for the three months ended July 31, 2004 and 46% and 25% respectively, for the six months ended July 31, 2004. We anticipate that our future operating results
will continue to depend heavily on sales to EMC and IBM. EMC and IBM resell products offered by our competitors, and nothing restricts EMC and IBM from expanding those relationships in a manner that could be adverse to us. Therefore, the loss of
either EMC or IBM as a customer, or a significant reduction in sales to either EMC or IBM could significantly reduce our revenue. While we are aware that Dell sources some of our switch product through EMC, it is unclear whether this mitigates our
dependency on EMC. Our product sales agreements with sales partners do not provide for the purchase of a guaranteed minimum amount of product.



Our business may be subject to seasonal fluctuations and uneven sales patterns in the future.



Many of our OEM partners experience seasonality and uneven sales patterns in their businesses. For example, some of our
partners close a disproportionate percentage of their sales transactions in the last month, weeks and days of each quarter; and other partners experience increased sales during the fourth calendar quarter of each year.



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



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



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



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



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



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



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



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



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



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



For the three months ended July 31, 2004, we derived a significant portion of our revenue from sales of our director-class IntrepidTMswitch products. We expect that revenue from our director-class IntrepidTMswitch products will continue to account for a substantial portion of our revenue for the foreseeable future. Factors such as performance, market positioning, the availability and price of competing products, the introduction of new
technologies and the success of our OEM, reseller and systems integrator customers will affect the market acceptance of our products. Therefore, continued market acceptance of these products and their successor products, along with our
SphereonTMswitches and Eclipse® routers, are critical to our future success.



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



We are currently developing products that contain untested devices and
subassemblies. As with any development, there are inherent risks should such devices or subassemblies require redesign or rework. In particular, in conjunction with the transition of our products from fibre channel to multi-protocol, 2 Gb to 4Gb to
10 Gb transmission speed technology, higher port densities, and advanced management capabilities, we will be introducing products with new features and functionality, such as our next generation director-class switch product, the Intrepid 10000 Director. We face risks relating to this product
transition, including risks relating to the qualification of such products by our storage and system OEMs, forecasting of demand, as well as possible product and software defects and a potentially different sales and support environment due to the
complexity of these new systems. Finally, if we fail to introduce new products timely, or to add new features and functions to existing products to compete against new entrants in the market, or if there is no demand for these or our current
products, our business could be seriously harmed.



Risks related to recent
acquisitions.



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



Our business is subject to risks from global operations.



We conduct significant marketing, pre-sales assistance and customer support operations in countries outside of the United States and also depend on non-U.S. operations of our contract manufacturers, and our
distribution partners. Further, we utilize an India-based firm to provide certain software engineering services, and our virtualization chip supplier, Aarohi Communications, is also reliant on offshore engineering. We derived approximately 36% of
our revenue for the three months ended July 31, 2004, from customers located outside of the United States. We believe that our continued growth and profitability will require us to continue to expand marketing and selling efforts internationally. We
have limited experience in marketing, distributing and supporting our products internationally and may not be able to maintain or increase international market demand for our products. In addition, our international operations are generally subject
to inherent risks and challenges that could harm our operating results, including:



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



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



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



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



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



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



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



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



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



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



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



Unforeseen environmental costs could impact our future net earnings.



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



The European Union has finalized the Waste Electrical and Electronic Equipment Directive, which makes producers of
electrical goods financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. This directive must now be enacted and implemented by individual European Union governments (such legislation
together with the directive, the WEEE Legislation), and certain producers are to be financially responsible under the WEEE Legislation beginning in August 2005. In addition, the European Parliament has enacted a requirement for the
recovery of hazardous substance (RoHS). This legislation governs the recovery of such substances as mercury, lead, cadmium, and hexavalent cadmium. We are currently reviewing the applicability of WEEE and RoHS Legislation to our electronic products.
Accordingly, we cannot currently estimate the extent of increased costs resulting from the WEEE and RoHS Legislation. Similar legislation may be enacted in other geographies, including federal and state legislation in the United States, the
cumulative impact of which could be significant costs.



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



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



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



Our success depends to a significant degree upon the continued contributions
of our key management, technical, sales and marketing, finance and operations personnel, many of whom would be difficult to replace. In particular, we believe that our future success is highly dependent on our senior executive team. In the past we
have experienced high turnover in our senior executive team.



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In addition, our engineering and product development teams are critical in developing our products and
have developed important relationships with customers and their technical staffs. The loss of any of these key personnel, including our senior sales staff, could harm our operations and customer relationships. We do not have key person life
insurance on any of our key personnel. Given our recent acquisitions of Nishan and Sanera, a large percentage of our engineering development team is now located in California, is new to the Company and may not operate as efficiently during the
transition period. In January 2004, we announced a 9% reduction in-force (RIF) of our employee base and we have closed down our Canadian engineering operations.



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



Risks related to internal controls.



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



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



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



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



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



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



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



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



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In March 1999, we, as an EMC subsidiary, granted IBM a license to all of our patents under a cross
license agreement between IBM and EMC. Under the terms of that agreement, effective upon EMCs February 7, 2001 distribution of our Class A common stock to its stockholders, the sublicense we previously held to those IBM patents terminated. We
believe that the termination of the sublicense does not materially affect our business. We are not aware of any issued or pending IBM patents that are infringed by our products, but if IBM were to allege any such infringement, and we were unable to
negotiate a settlement with IBM, our ability to produce the alleged infringing product could be affected, which could materially and adversely affect our business.



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



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



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



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



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



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



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inventories and obligations to our contract manufacturers under binding purchase orders in excess of our needs. At July
31, 2004, our commitment with our contract manufacturers for purchases and anticipated transformation costs over the next sixty days totaled approximately $48.2 million.



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



The continued general economic slowdown and
potential international slowdowns may significantly reduce expenditures on information technology infrastructure.



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



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



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



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



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



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



Our products may contain undetected software
or hardware errors when first introduced or when new versions are released. Our products are complex, and we have from time to time detected errors in existing products. In addition, our products are combined with products from other vendors. As a
result, should problems occur, it might be difficult to identify the source of the problem. These errors could result in a loss of or delay in market acceptance of our products, cause delays in delivering our products or meeting customer demands and
would increase our costs, reduce our revenue and cause significant customer relations problems. Errors could also result in the need for us to upgrade existing products at customer locations which would increase our costs or cause significant
customer relations problems.



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



As more fully set forth in
Note 14 to our Condensed Consolidated Financial Statements, we are a defendant in a consolidated securities class action know as In Re Initial Public Offering Securities Litigation (SDNY).We may become subject to additional class action
litigation following a period of volatility in the market price of our common stock. Securities class action litigation results in substantial costs and diverts the attention of management and our resources and seriously harms our business,
financial condition and results of operations.



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



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



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



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



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



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



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



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



These purchases also involve numerous risks, including:



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



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



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



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



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



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



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



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



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



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



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



Our products must comply with governmental regulation.



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



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



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



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



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



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



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



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



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



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



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



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



Our stock price is volatile.



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



Risks Related to Our Relationship With
EMC



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



In October 1997, and in connection with the reorganization of our business, we entered into certain agreements with EMC relating to our business
relationship with EMC. In addition, we have entered into agreements with EMC relating to our relationship with EMC after the completion of our initial public offering in August 2000 and the distribution by EMC of our Class A common stock in February
2001. We have also entered



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into an OEM Purchase and License Agreement with EMC that governs EMCs purchases of our products and grants EMC
rights to use, support and distribute software for use in connection with these products. The agreement does not provide for the purchase of a guaranteed minimum amount of product. These agreements were negotiated and made in the context of our
prior parent-subsidiary relationship. As a result, some of these agreements may have terms and conditions, including the terms of pricing, that are less beneficial to us than agreements negotiated with unaffiliated third parties. Sales and services
revenue pursuant to these agreements with EMC represented approximately 47% of our revenue for the three months ended July 31, 2004. In addition, in some instances, our ability to terminate these agreements is limited, which may prevent us from
being able to negotiate more favorable terms with EMC or from entering into similar agreements with third parties.



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



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



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



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



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



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



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



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



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



ITEM 3. Quantitative and Qualitative Disclosures about Market Risks



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



Interest Rate Risk



We earn interest income on both our cash and cash equivalents and our investment portfolio. Our investment portfolio
consists of readily marketable investment-grade debt securities of various issuers and maturities ranging primarily from overnight to three years. All investments are denominated in U.S. dollars and are classified as available for sale.
These instruments are not leveraged, and are not held for trading purposes. As interest rates change, the amount of realized and unrealized gain or loss on these securities will change. The quantitative and qualitative disclosures about market risk
are discussed in Item 7A Qualitative and Quantitative Disclosure About Market Risk, contained in our Form 10-K for fiscal year 2003.



Our convertible subordinated debt is subject to a fixed interest rate and the notes are based on a fixed conversion ratio into Class A common stock. In
July 2003, the Company entered into an interest-rate swap agreement with a notional amount of $155.3 million that has the economic effect of modifying the fixed interest obligations associated with the notes so that the interest payable on the
majority of the notes effectively becomes variable based on the six-month London Interbank Offered Rate (LIBOR) minus 152 basis points. If interest rates on this variable rate debt were to increase or decrease, our annual interest expense would
increase or decrease



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accordingly. This increase or decreased interest expense would be partially offset by the effects of these interest rate
changes on our cash and investment portfolio. The notes are not listed on any securities exchange or included in any automated quotation system; however, the notes are eligible for trading on the PortalSM Market. On September 3, 2004, the
approximate bid price per $100 of our notes was $91.38 and the approximate ask price of our Notes was $91.88, resulting in an aggregate fair value of between $157.6 million and $158.5 million. Our Class A common stock is quoted on the Nasdaq
National Market under the symbol, MCDTA. On September 3, 2004, the last reported sale price of our Class A common stock on the Nasdaq National Market was $5.18 per share.



Foreign Currency Exchange Risk



We operate sales and support offices in several countries. All of our sales contracts have been denominated in U.S. dollars, therefore our transactions in
foreign currencies are limited to operating expense transactions. Due to the limited nature and amount of these transactions, we do not believe we have had or will have material exposure to foreign currency exchange risk.



Credit Risk



Financial instruments, which potentially subject us to concentrations of credit risk, consist principally of temporary cash
investments, investments and trade receivables. We place our temporary cash investments and investment securities in primarily investment grade instruments and limit the amount of investment with any one financial institution. We evaluate the credit
risk associated with each of our customers but generally do not require collateral. We depend on two customers for most of our total revenue who comprise a significant portion of our trade receivables 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 stock with Bank of America, N.A. and /or certain of its affiliates. Subject to the movement in our Class A common stock price, we could be exposed
to credit risk arising out of net settlement of these options in our favor. Based on our review of the possible net settlements and the credit strength of Bank of America, N.A. and its affiliates, we have concluded that we do not have a material
exposure to credit risk as a result of these share option transactions.



In July 2003, we entered into an interest-rate swap agreement with JPMorgan Chase Bank (JPMorgan). Subject to the movement in interest rates, we could be exposed to credit risk arising out of net interest payments due to us from JPMorgan.
Based on our review of the possible movement in interest rates and the credit strength of JPMorgan, we have concluded that we do not have a material exposure to credit risk as a result of this interest-rate swap.



ITEM 4. Controls and Procedures



Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures
pursuant to Exchange Act Rule 13a-14(c) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective.
There were no changes in our internal control over financial reporting during the quarter ended July 31, 2004 that have materially affected, or are reasonably likely to materially affect, our internal 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 legal proceedings that arise in the normal course of business. Litigation is subject to inherent uncertainties and an adverse result in a matter that may arise from time to time may harm our
business, financial condition or results of operations. In the opinion of management and except as otherwise noted, the ultimate disposition of any of the claims described and not expected to have a material adverse effect on our consolidated
results of operations, financial position or cash flow. Please see Note 14 of the Condensed Consolidated Financial Statements for a description of litigation matters.



ITEMS 2, 3, 4 and 5 are not applicable and have been omitted.



ITEM 6. Exhibits and Reports on Form 8-K



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



|     |  |                                                                                          
|---- |  | -----------------------------------------------------------------------------------------
|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 the filing of this Form 10-Q. Information regarding the items reported on is as follows:



|                |  |                                                                                                                                                                                                                                                                                                                                                                                                                                  |  |  |  |  |  |  |  | 
|--------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  |  | 
|Date            |  | Item Reported On                                                                                                                                                                                                                                                                                                                                                                                                                
|                | 
|May 17, 2004    |  | Item 5. We disclosed the resignation of Mike Gustafson, Senior Vice President of Marketing, effective May 17, 2004.                                                                                                                                                                                                                                                                                                             
|                | 
|May 20, 2004    |  | Items 7 and 9. We filed a press release announcing our First Quarter 2004 results.                                                                                                                                                                                                                                                                                                                                              
|                | 
|June 14, 2004   |  | Item 5. We announced the date of our Annual Meeting of Stockholders as well as our entering into a Software OEM Agreement with Crosswalk, Inc., a related party.                                                                                                                                                                                                                                                                
|                | 
|August 19, 2004 |  | Items 7 and 9. We filed a press release announcing our Second Quarter 2004 results.                                                                                                                                                                                                                                                                                                                                             
|                | 
|August 20, 2004 |  | Item 9. We provided revised revenue components for the first quarter of 2004 using new classification methodology.                                                                                                                                                                                                                                                                                                              
|                | 
|August 27, 2004 |  | Item 8.01. We announced that our Annual Meeting of Stockholders on October 27, 2004, will take place at The Westin Hotel, 10600 Westminster boulevard, Westminster, Colorado 80020
at 12:00 noon (MDT). Additionally, consistent with its previously disclosed stock repurchase plan, the Company will be utilizing an SEC Rule 10b5-1 repurchase plan to allow for purchases of stock even during traditional blackout
periods.



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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 the
undersigned thereunto duly authorized.



McDATA CORPORATIONBy:

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




September 7, 2004



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