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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q/A

Amendment No. 1



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(Mark One)



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



For the quarterly period ended October 31, 2003



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)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|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)



(303) 460-9200

(Registrants telephone number, including area code)



None

(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 December 8, 2003, 81,000,000 shares of the registrants Class A Common Stock were outstanding and 35,961,923 shares of the registrants Class B Common Stock were outstanding.



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EXPLANATORY NOTE



This Amendment No. 1 to our Quarterly Report on Form 10-Q for the quarterly period ended October 31, 2003 initially filed with the
Securities and Exchange Commission (SEC) on December 12, 2003 (the Originally Filed 10-Q) is being filed to reflect a restatement of the condensed consolidated balance sheet at October 31, 2003. On February 26, 2004, we
announced that we would restate our condensed consolidated balance sheet for the quarter ended October 31, 2003 in connection with our securities lending activities entered into during this quarter. Specifically, the condensed consolidated balance
sheet has been amended to reflect the reclassification of certain securities lending collateral obligations previously netted with the related cash collateral received in accordance with Statement of Financial Accounting Standards No. 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (SFAS 140) Note 6 of the Notes to Condensed Consolidated Financial Statements has been updated to describe the securities lending
program activities of the Company.



This Amendment No. 1 amends and restates
Items 1 and 4 of Part I of the Originally Filed 10-Q and, except for such items; no other information in the Originally Filed 10-Q is amended hereby.





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McDATA CORPORATION



FORM 10-Q

QUARTER ENDED OCTOBER 31, 2003

TABLE OF CONTENTS



|     |  |                                                                                                                                        |  |   
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------- |  | --
|Item |  |                                                                                                                                        |  |   
|     |  |                                                                                                                                       
|     |  | PART 1  FINANCIAL INFORMATION                                                                                                         |  |   
|     |  |                                                                                                                                       
|1.   |  | Financial Statements                                                                                                                   |  |   
|     |  |                                                                                                                                       
|     |  | Condensed Consolidated Balance Sheets  October 31, 2003 (unaudited and restated) and December 31, 2002                                |  | 1 
|     |  |                                                                                                                                       
|     |  | Condensed Consolidated Income Statements  Three and Nine months ended October 31, 2003 (unaudited) and September 30, 2002 (unaudited) |  | 2 
|     |  |                                                                                                                                       
|     |  | Condensed Consolidated Statements of Cash Flows  Nine months ended October 31, 2003 (unaudited) and September 30, 2002 (unaudited)    |  | 3 
|     |  |                                                                                                                                       
|     |  | Notes to Condensed Consolidated Financial Statements (unaudited)                                                                       |  | 4 
|     |  |                                                                                                                                       
|2.   |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                                  |  | 16
|     |  |                                                                                                                                       
|3.   |  | Quantitative and Qualitative Disclosures About Market Risks                                                                            |  | 34
|     |  |                                                                                                                                       
|4.   |  | Controls and Procedures                                                                                                                |  | 35
|     |  |                                                                                                                                       
|     |  | PART II  OTHER INFORMATION                                                                                                            |  |   
|     |  |                                                                                                                                       
|1.   |  | Legal Proceedings                                                                                                                      |  | 36
|     |  |                                                                                                                                       
|2.   |  | Changes in Securities and Use of Proceeds                                                                                              |  | 36
|     |  |                                                                                                                                       
|3.   |  | Defaults Upon Senior Securities                                                                                                        |  | 36
|     |  |                                                                                                                                       
|4.   |  | Submission of Matters to A Vote of Security Holders                                                                                    |  | 36
|     |  |                                                                                                                                       
|5.   |  | Other Information                                                                                                                      |  | 36
|     |  |                                                                                                                                       
|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 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, and International Business Machines Corporation, or IBM, 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®;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------



| |  | the impact of a highly competitive market that is expected to lead to longer sales cycles and continued pricing pressures;
| | - | --------------------------------------------------------------------------------------------------------------------------



| |  | 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 or our manufacturers;
| | - | ---------------------------------------------------------------------------------------------------------------



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



| |  | competition in the Multi-protocol (Fibre Channel and IP) network market (including competitive pricing pressures and product give-aways) by our competitors, including but not
limited to, 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 suppliers;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | delays and changes in the development of new products and new technology and component quality and availability;
| | - | ----------------------------------------------------------------------------------------------------------------



| |  | 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.
| | - | ------------------------------------------------------------------------------



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)



|                                                                                                                               |  |                        |         |   |                   |   |         |  
|------------------------------------------------------------------------------------------------------------------------------ |  | ---------------------- | ------- | - | ----------------- | - | ------- | -
|                                                                                                                               |  | October 31, 2003       |         |   | December 31, 2002 |  
|                                                                                                                               |  | (unaudited) (restated) |         |   |                   |  
|Assets                                                                                                                         |  |                        |         |   |                   |   |         |  
|Current assets:                                                                                                                |  |                        |         |   |                   |   |         |  
|Cash and cash equivalents                                                                                                      |  | $                      | 39,520  |   |                   | $ | 72,411  |  
|Short-term investments                                                                                                         |  |                        | 155,980 |   |                   |   | 157,260 |  
|Securities lending collateral                                                                                                  |  |                        | 109,470 |   |                   |   |        |  
|Accounts receivable, net of allowance for bad debts of $1,484 and $1,265, respectively                                         |  |                        | 59,537  |   |                   |   | 73,867  |  
|Inventories, net                                                                                                               |  |                        | 11,000  |   |                   |   | 8,097   |  
|Current portion of deferred tax asset                                                                                          |  |                        |        |   |                   |   | 33,325  |  
|Prepaid expenses and other current assets                                                                                      |  |                        | 7,256   |   |                   |   | 4,699   |  
|                                                                                                                               |  |                        |         |   |                   |   |         |  
|Total current assets                                                                                                           |  |                        | 382,763 |   |                   |   | 349,659 |  
|Property and equipment, net                                                                                                    |  |                        | 101,094 |   |                   |   | 99,927  |  
|Long-term investments                                                                                                          |  |                        | 116,425 |   |                   |   | 73,099  |  
|Restricted cash                                                                                                                |  |                        | 5,130   |   |                   |   |        |  
|Goodwill                                                                                                                       |  |                        | 79,143  |   |                   |   | 11,780  |  
|Intangible assets, net                                                                                                         |  |                        | 126,835 |   |                   |   | 7,887   |  
|Other assets, net                                                                                                              |  |                        | 20,653  |   |                   |   | 12,839  |  
|                                                                                                                               |  |                        |         |   |                   |   |         |  
|Total assets                                                                                                                   |  | $                      | 832,043 |   |                   | $ | 555,191 |  
|                                                                                                                               |  |                        |         |   |                   |   |         |  
|Liabilities and Stockholders Equity                                                                                           |  |                        |         |   |                   |   |         |  
|Current liabilities:                                                                                                           |  |                        |         |   |                   |   |         |  
|Accounts payable                                                                                                               |  | $                      | 18,392  |   |                   | $ | 16,530  |  
|Accrued liabilities                                                                                                            |  |                        | 50,963  |   |                   |   | 40,561  |  
|Securities lending collateral payable                                                                                          |  |                        | 109,470 |   |                   |   |        |  
|Current portion of deferred revenue                                                                                            |  |                        | 17,112  |   |                   |   | 7,337   |  
|Current portion of notes payable                                                                                               |  |                        | 1,964   |   |                   |   |        |  
|Current portion of obligations under capital leases                                                                            |  |                        | 1,333   |   |                   |   | 1,604   |  
|                                                                                                                               |  |                        |         |   |                   |   |         |  
|Total current liabilities                                                                                                      |  |                        | 199,234 |   |                   |   | 66,032  |  
|Deferred tax liability                                                                                                         |  |                        | 10,530  |   |                   |   |        |  
|Notes payable, less current portion                                                                                            |  |                        | 632     |   |                   |   |        |  
|Obligations under capital leases, less current portion                                                                         |  |                        | 1,239   |   |                   |   | 1,540   |  
|Deferred revenue, less current portion                                                                                         |  |                        | 17,301  |   |                   |   | 13,114  |  
|Interest rate swap                                                                                                             |  |                        | 1,133   |   |                   |   |        |  
|Convertible subordinated debt                                                                                                  |  |                        | 171,367 |   |                   |   |        |  
|                                                                                                                               |  |                        |         |   |                   |   |         |  
|Total liabilities                                                                                                              |  |                        | 401,436 |   |                   |   | 80,686  |  
|                                                                                                                               |  |                        |         |   |                   |   |         |  
|Commitments and Contingencies (Note 13)                                                                                        |  |                        |         |   |                   |   |         |  
|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, 35,999,993 and 32,962,212 shares issued and outstanding |  |                        | 360     |   |                   |   | 330     |  
|Additional paid-in-capital                                                                                                     |  |                        | 477,995 |   |                   |   | 474,609 |  
|Deferred compensation                                                                                                          |  |                        | (14,696 | ) |                   |   | (6,812  | )
|Accumulated other comprehensive income                                                                                         |  |                        | 407     |   |                   |   | 773     |  
|Retained earnings (deficit)                                                                                                    |  |                        | (34,269 | ) |                   |   | 4,795   |  
|                                                                                                                               |  |                        |         |   |                   |   |         |  
|Total stockholders equity                                                                                                     |  |                        | 430,607 |   |                   |   | 474,505 |  
|                                                                                                                               |  |                        |         |   |                   |   |         |  
|Total liabilities and stockholders equity                                                                                     |  | $                      | 832,043 |   |                   | $ | 555,191 |  
|                                                                                                                               |  |                        |         |   |                   |   |         |  



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



1



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McDATA CORPORATION



CONDENSED CONSOLIDATED INCOME STATEMENTS

(in thousands, except per share data)

(unaudited)



|                                                                                                                                                              |  |                    |         |   |                   |   |         |                 |  |   |                   |   |  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ------- | - | ----------------- | - | ------- | --------------- |  | - | ----------------- | - |  | - | ------- | -
|                                                                                                                                                              |  | Three Months Ended |         |   | Nine months ended |  
|                                                                                                                                                              |  | October 31,2003    |         |   | September 30,2002 |   |         | October 31,2003 |  |   | September 30,2002 |  
|Revenue                                                                                                                                                       |  | $                  | 94,659  |   |                   | $ | 80,941  |                 |  | $ | 304,852           |   |  | $ | 222,738 |  
|Cost of revenue                                                                                                                                               |  |                    | 40,012  |   |                   |   | 38,361  |                 |  |   | 128,307           |   |  |   | 131,176 |  
|                                                                                                                                                              |  |                    |         |   |                   |   |         |                 |  |   |                   |   |  |   |         |  
|Gross profit                                                                                                                                                  |  |                    | 54,647  |   |                   |   | 42,580  |                 |  |   | 176,545           |   |  |   | 91,562  |  
|Operating expenses:                                                                                                                                           |  |                    |         |   |                   |   |         |                 |  |   |                   |   |  |   |         |  
|Research and development                                                                                                                                      |  |                    | 23,571  |   |                   |   | 15,631  |                 |  |   | 60,546            |   |  |   | 43,475  |  
|Selling and marketing                                                                                                                                         |  |                    | 23,531  |   |                   |   | 17,798  |                 |  |   | 70,452            |   |  |   | 54,466  |  
|General and administrative                                                                                                                                    |  |                    | 10,660  |   |                   |   | 6,960   |                 |  |   | 25,330            |   |  |   | 22,260  |  
|Acquired in-process research & development                                                                                                                    |  |                    | 11,410  |   |                   |   |        |                 |  |   | 11,410            |   |  |   |        |  
|Amortization of deferred compensation (excludes amortization of deferred compensation included in cost of revenue of $285, $137, $555 and
$455, respectively) |  |                    | 5,719   |   |                   |   | 2,217   |                 |  |   | 8,620             |   |  |   | 6,501   |  
|                                                                                                                                                              |  |                    |         |   |                   |   |         |                 |  |   |                   |   |  |   |         |  
|Operating expenses                                                                                                                                            |  |                    | 74,891  |   |                   |   | 42,606  |                 |  |   | 176,358           |   |  |   | 126,702 |  
|                                                                                                                                                              |  |                    |         |   |                   |   |         |                 |  |   |                   |   |  |   |         |  
|Income (loss) from operations                                                                                                                                 |  |                    | (20,244 | ) |                   |   | (26     | )               |  |   | 187               |   |  |   | (35,140 | )
|Interest and other income                                                                                                                                     |  |                    | 1,860   |   |                   |   | 1,851   |                 |  |   | 5,508             |   |  |   | 5,859   |  
|Interest expense                                                                                                                                              |  |                    | (221    | ) |                   |   | (89     | )               |  |   | (2,497            | ) |  |   | (220    | )
|                                                                                                                                                              |  |                    |         |   |                   |   |         |                 |  |   |                   |   |  |   |         |  
|Income (loss) before income taxes                                                                                                                             |  |                    | (18,605 | ) |                   |   | 1,736   |                 |  |   | 3,198             |   |  |   | (29,501 | )
|Income tax expense (benefit)                                                                                                                                  |  |                    | 30,852  |   |                   |   | (607    | )               |  |   | 38,210            |   |  |   | (10,915 | )
|                                                                                                                                                              |  |                    |         |   |                   |   |         |                 |  |   |                   |   |  |   |         |  
|Income (loss) before equity in net loss of affiliated company                                                                                                 |  |                    | (49,457 | ) |                   |   | 2,343   |                 |  |   | (35,012           | ) |  |   | (18,586 | )
|Equity in net loss of affiliated company                                                                                                                      |  |                    | (591    | ) |                   |   |        |                 |  |   | (591              | ) |  |   |        |  
|                                                                                                                                                              |  |                    |         |   |                   |   |         |                 |  |   |                   |   |  |   |         |  
|Net income (loss)                                                                                                                                             |  | $                  | (50,048 | ) |                   | $ | 2,343   |                 |  | $ | (35,603           | ) |  | $ | (18,586 | )
|                                                                                                                                                              |  |                    |         |   |                   |   |         |                 |  |   |                   |   |  |   |         |  
|Basic net income (loss) per share                                                                                                                             |  | $                  | (0.44   | ) |                   | $ | 0.02    |                 |  | $ | (0.31             | ) |  | $ | (0.16   | )
|                                                                                                                                                              |  |                    |         |   |                   |   |         |                 |  |   |                   |   |  |   |         |  
|Shares used in computing basic net income (loss) per share                                                                                                    |  |                    | 114,955 |   |                   |   | 113,280 |                 |  |   | 114,627           |   |  |   | 113,026 |  
|                                                                                                                                                              |  |                    |         |   |                   |   |         |                 |  |   |                   |   |  |   |         |  
|Diluted net income (loss) per share                                                                                                                           |  | $                  | (0.44   | ) |                   | $ | 0.02    |                 |  | $ | (0.31             | ) |  | $ | (0.16   | )
|                                                                                                                                                              |  |                    |         |   |                   |   |         |                 |  |   |                   |   |  |   |         |  
|Shares used in computing diluted net income (loss) per share                                                                                                  |  |                    | 114,955 |   |                   |   | 116,295 |                 |  |   | 114,627           |   |  |   | 113,026 |  
|                                                                                                                                                              |  |                    |         |   |                   |   |         |                 |  |   |                   |   |  |   |         |  



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



2



---

McDATA CORPORATION



CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



|                                                                                    |  |                   |          |   |                    |   |          |  
|----------------------------------------------------------------------------------- |  | ----------------- | -------- | - | ------------------ | - | -------- | -
|                                                                                    |  | Nine months ended |         
|                                                                                    |  | October 31, 2003  |          |   | September 30, 2002 |  
|Cash flows from operating activities:                                               |  |                   |          |   |                    |   |          |  
|Net loss                                                                            |  | $                 | (35,603  | ) |                    | $ | (18,586  | )
|Adjustments to reconcile net income (loss) to cash flows from operating activities: |  |                   |          |   |                    |   |          |  
|Depreciation and amortization                                                       |  |                   | 28,310   |   |                    |   | 17,828   |  
|Loss from write-off of collateralized lease costs                                   |  |                   |         |   |                    |   | 1,256    |  
|Loss on trade-in, sales and retirements of fixed assets                             |  |                   | 482      |   |                    |   | 599      |  
|Net realized loss (gain) on investments                                             |  |                   | (191     | ) |                    |   | 720      |  
|Inventory and inventory commitment provisions                                       |  |                   | 2,077    |   |                    |   | 14,722   |  
|Acquired in-process research and development                                        |  |                   | 11,410   |   |                    |   |         |  
|Equity in net loss of affiliated company                                            |  |                   | 591      |   |                    |   |         |  
|Bad debt provision                                                                  |  |                   | 81       |   |                    |   | 525      |  
|Deferred income taxes                                                               |  |                   | 38,811   |   |                    |   | (15,129  | )
|Non-cash compensation expense                                                       |  |                   | 9,175    |   |                    |   | 6,956    |  
|Tax benefit from stock options exercised                                            |  |                   |         |   |                    |   | 2,116    |  
|Changes in net assets and liabilities excluding amounts acquired:                   |  |                   |          |   |                    |   |          |  
|Accounts receivable                                                                 |  |                   | (23,527  | ) |                    |   | (2,572   | )
|Inventories                                                                         |  |                   | (5,518   | ) |                    |   | 1,092    |  
|Prepaid expenses and other current assets                                           |  |                   | (1,172   | ) |                    |   | 3,855    |  
|Other assets, net                                                                   |  |                   | (7,450   | ) |                    |   | (7,567   | )
|Accounts payable                                                                    |  |                   | 8,800    |   |                    |   | 5,201    |  
|Accrued liabilities                                                                 |  |                   | 8,876    |   |                    |   | 975      |  
|Accrued income taxes                                                                |  |                   | (1,707   | ) |                    |   |         |  
|Deferred revenue                                                                    |  |                   | 11,684   |   |                    |   | 7,624    |  
|                                                                                    |  |                   |          |   |                    |   |          |  
|Net cash provided by operating activities                                           |  |                   | 45,129   |   |                    |   | 19,615   |  
|Cash flows from investing activities:                                               |  |                   |          |   |                    |   |          |  
|Purchases of property and equipment                                                 |  |                   | (12,515  | ) |                    |   | (68,640  | )
|Acquisitions                                                                        |  |                   | (171,174 | ) |                    |   |         |  
|Equity investment                                                                   |  |                   | (6,000   | ) |                    |   |         |  
|Proceeds from disposition of fixed assets                                           |  |                   | 5        |   |                    |   |         |  
|Payment of collateralized lease costs                                               |  |                   |         |   |                    |   | (1,256   | )
|Purchases of investments                                                            |  |                   | (591,554 | ) |                    |   | (389,422 | )
|Sales and maturities of investments                                                 |  |                   | 537,291  |   |                    |   | 439,927  |  
|                                                                                    |  |                   |          |   |                    |   |          |  
|Net cash used by investing activities                                               |  |                   | (243,947 | ) |                    |   | (19,391  | )
|Cash flows from financing activities:                                               |  |                   |          |   |                    |   |          |  
|Net proceeds for issuance of convertible subordinated debt                          |  |                   | 166,933  |   |                    |   |         |  
|Net purchase of share option transactions                                           |  |                   | (20,510  | ) |                    |   |         |  
|Restricted cash related to interest rate swap                                       |  |                   | (5,130   | ) |                    |   |         |  
|Payment on notes payable                                                            |  |                   | (14,528  | ) |                    |   |          |  
|Payment of obligations under capital leases                                         |  |                   | (2,219   | ) |                    |   | (2,126   | )
|Proceeds from the issuance of stock                                                 |  |                   | 5,624    |   |                    |   | 1,876    |  
|                                                                                    |  |                   |          |   |                    |   |          |  
|Net cash provided (used) by financing activities                                    |  |                   | 130,170  |   |                    |   | (250     | )
|                                                                                    |  |                   |          |   |                    |   |          |  
|Net decrease in cash and cash equivalents                                           |  |                   | (68,648  | ) |                    |   | (26      | )
|Cash and cash equivalents, beginning of period                                      |  |                   | 108,168  |   |                    |   | 69,285   |  
|                                                                                    |  |                   |          |   |                    |   |          |  
|Cash and cash equivalents, end of period                                            |  | $                 | 39,520   |   |                    | $ | 69,259   |  
|                                                                                    |  |                   |          |   |                    |   |          |  
|Supplemental Disclosure of Non-Cash Investing and Financing Activities              |  |                   |          |   |                    |   |          |  
|Capital lease obligations incurred, net of trade-ins                                |  | $                 | 1,658    |   |                    | $ | 4,634    |  
|                                                                                    |  |                   |          |   |                    |   |          |  
|Fixed assets exchanged for capital leases                                           |  | $                 | (1,364   | ) |                    | $ | (1,501   | )
|                                                                                    |  |                   |          |   |                    |   |          |  
|Transfer of inventory to fixed assets                                               |  | $                 | 1,478    |   |                    | $ | 5,205    |  
|                                                                                    |  |                   |          |   |                    |   |          |  



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



3



---

McDATA CORPORATION



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(tabular amounts in thousands, except per share data)

(unaudited)



Note 1  Background and Basis of Presentation



McDATA Corporation (McDATA or the Company) provides Multi-CapableStorage Networking Solutions- integrating multiple platforms, networks, protocols and locations- that enables its partners and
customers around the world to reduce their total cost of storage management today, and be ready to adapt to the real-time information demands of tomorrow. McDATA solutions are an integral part of data services infrastructures sold by most major
storage and system vendors, including Dell, EMC, Hewlett-Packard, Hitachi Data Systems, IBM, StorageTek and Sun Microsystems.



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 consolidated balance sheet as of December 31,
2002 has been derived from the audited financial statements as of that date, but does not include all disclosures required by generally accepted accounting principles. For further information, please refer to and read these interim consolidated
financial statements in conjunction with the Companys audited financial statements for the year ended December 31, 2002.



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 November 2002, the Financial Accounting Standards
Board (FASB) issued Interpretation No. 45 (FIN 45), Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN 45 requires that a liability be recorded in the
guarantors balance sheet upon issuance of a guarantee. FIN 45 also requires additional disclosures about the guarantees an entity has issued, including an entitys product warranty liabilities. The initial recognition and measurement
provisions of FIN 45 are applicable to guarantees issued or modified after December 31, 2002. The adoption of FIN 45 has not had a material impact on the Companys financial condition or results of operations. The disclosures for 2003 are
included in Notes 5 and 13, below.



In November 2002, the
Emerging Issues Task Force (EITF) issued EITF Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. EITF Issue No. 00-21 addresses how to determine whether a revenue arrangement involving multiple deliverables
contains more than one unit of accounting for the purposes of revenue recognition and how the revenue arrangement consideration should be measured and allocated to the separate units of accounting. EITF Issue No. 00-21 applies to all revenue
arrangements that the Company enters into in fiscal periods beginning after June 15, 2003. The adoption of this statement is not currently anticipated to have a material impact on the Companys financial condition or results of operations.



In December 2002, the FASB issued SFAS No. 148,
Accounting for Stock-Based Compensation-Transition and Disclosure- an amendment to FAS 123. This statement amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a
voluntary change to the fair value based method of accounting for stock-based compensation. The statement also amends the disclosure provisions of that statement and requires disclosure of the pro forma effect in interim financial statements. The
Company adopted SFAS No. 148 for the fiscal year ended December 31, 2002, and the adoption did not have a material impact on the Companys financial condition or results of operations. The Company plans to continue to account for its
stock-based compensation under the recognition and measurement principles of APB Opinion No. 25. Accordingly, the alternative methods of transition provided under SFAS No. 148 are not expected to impact the Company. The quarterly disclosure
provision of SFAS No. 148 for 2003 is included in Note 9, below.



In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46 provides guidance on how to identify a variable interest entity (VIE) and determine when the assets,
liabilities, and results of operations of a VIE need to be included in a companys consolidated financial statements. FIN 46 also requires additional disclosures by primary beneficiaries and other significant variable interest holders in a VIE.
The consolidated requirements of FIN 46 are effective immediately for all VIEs created after January 31, 2003. The consolidation requirements will apply to entities established on or prior to January 31, 2003 in the first fiscal year or interim
period beginning after December 15, 2003. For VIEs created before February 1, 2003, the provisions of FIN 46 must be adopted at the beginning of the first interim or annual reporting period beginning after June 15, 2003. The disclosure requirements
will apply in all financial statements issued after December 15, 2003. The adoption of this statement did not have a material impact on the Companys financial condition or results of operations.



4



---

In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments
and Hedging Activities. SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133,
Accounting for Derivative Instruments and Hedging Activities. SFAS No. 149 is generally effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. The adoption of
SFAS No. 149 did not have a significant impact on the Companys financial position or results of operations.



In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.
This statement establishes standards for how an issuer classifies and measures, in its balance sheet, certain financial instruments with characteristics of both liabilities and equity. In accordance with the standard, certain financial instruments
that embody obligations for the issuer are required to be classified as liabilities. This Statement shall be effective for financial instruments entered into or modified after May 31, 2003, and otherwise shall be effective at the beginning of the
first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have a significant impact on the Companys financial position or results of operations.



Note 2  Change in Fiscal Year



On January 15, 2003, the Company changed its fiscal year to end on January
31, rather than December 31. References in this Form 10-Q to the third quarter and first nine months of 2003 represent the three and nine months ended October 31, 2003, respectively. References in this Form 10-Q to the third quarter and first nine
months of 2002 represent the three and nine months ended September 30, 2002, respectively. The Company has not submitted financial information for the three and nine months ended October 31, 2002 in this Form 10-Q because the information is not
practical or cost beneficial to prepare. The Company believes that the three and nine months ended September 30, 2002 provide a meaningful comparison to the third quarter and first nine months of 2003. There are no significant factors, seasonal or
otherwise, that would impact the comparability of information or trends, if results for the three and nine months ended October 31, 2002 were presented in lieu of results for the three and nine months ended September 30, 2002.



Note 3  Acquisitions



Nishan Systems, Inc.



On September 19, 2003, the Company completed its acquisition of the stock of Nishan Systems, Inc. (Nishan), a provider of
next generation native IP storage solutions that builds open storage networking products based on IP and Ethernet, the international networking standards. The Nishan transaction accelerates McDATAs delivery of inter-networking capabilities
that scale data center storage networks and extend storage network benefits across the enterprise. Nishans comprehensive family of IP storage switching products allows customers to leverage their fibre channel storage network infrastructure
and their IP networks to consolidate storage infrastructures across the campus, the enterprise and geographies. These solutions allow for integrated disaster recovery architectures, and cost effective integration of low-end servers and applications
into the storage network. These factors contributed to a purchase price in excess of fair value of the Nishans net tangible and intangible assets acquired. As a result, the Company has recorded goodwill in connection with this transaction. The
condensed consolidated financial statements include the operating results of Nishan from the date of the acquisition.



The total purchase price of approximately $69.4 million consisted of $65.0 million in cash consideration and direct transaction costs paid of
approximately $4.4 million. See also Note 13.



Based on
estimates and assumptions of management, the preliminary allocation of the purchase price to the assets acquired and liabilities assumed was as follows:



|                                    |  |   |         |  
|----------------------------------- |  | - | ------- | -
|Cash acquired                       |  | $ | 668     |  
|Other tangible assets acquired      |  |   | 4,906   |  
|Amortizable intangible assets       |  |   |         |  
|Customer relationships              |  |   | 1,622   |  
|Developed technology                |  |   | 8,337   |  
|Customer backlog                    |  |   | 454     |  
|Goodwill                            |  |   | 67,363  |  
|Liabilities assumed                 |  |   | (5,935  | )
|Debt assumed                        |  |   | (15,816 | )
|In-process research and development |  |   | 7,774   |  
|                                    |  |   |         |  
|Total                               |  | $ | 69,373  |  
|                                    |  |   |         |  



5



---

Amortizable Intangible Assets -



Amortizable intangible assets consist of customer-related intangible assets and developed technology with useful lives not
exceeding six years.



Customer relationships represent existing
contracts that relate primarily to customers such as Hitachi Data Systems, IBM, EMC, Tokyo Electron, Sun Microsystems, and Bell Microproducts. The Company is amortizing the fair value of these assets on a straight-line basis over an estimated useful
life of approximately 3 years.



Developed technology, which
consists of products that have reached technological feasibility, includes products which support iSCSI, iFCP and E_Port for trunking to both IP backbones and legacy Fibre Channel fabrics. The technology has a non-blocking architecture that supports
Ethernet Layer 2 switching, IP Layer 3 switching, and Fibre Channel switching over extended distances at full gigabit wire speed. These products also support standard IP routing protocols such as OSPF and DVMRP and can be fully integrated into
existing IP networks. The Company is amortizing the developed technology and related patents on a straight-line basis over an estimated useful life of approximately 5 years.



Goodwill-



A preliminary estimate of $67.4 million has been allocated to goodwill. Goodwill represents the excess of the purchase price over the fair value of the
net tangible and intangible assets acquired, and will not be deductible for tax purposes. Goodwill will not be amortized and will be tested for impairment at least annually. The preliminary purchase price allocation for Nishan is subject to revision
after a more detailed analysis is completed and additional information on the fair value of assets and liabilities becomes available. Any change in the fair value of the net assets of Nishan will change the amount of the purchase price allocable to
goodwill.



In-process research & development (IPR&D) -



Of the total purchase price, $7.8 million was allocated
to IPR&D and was expensed in the third quarter of fiscal 2003. Projects that qualify as IPR&D represent those that have not yet reached technological feasibility and for which no future alternative uses existed at the date of acquisition.
Technological feasibility is defined as being equivalent to a final working prototype or detailed program design in which there is no remaining risk relating to the development. Three IPR&D projects were identified relating to Nishans
multiple-protocol switches.



The value assigned to IPR&D
was determined by evaluating the importance of each project to the overall development plan, estimating costs to develop the purchased IPR&D into commercially viable products, estimating the resulting future revenues and net cash flows from the
projects when completed and discounting the net cash flows to their present value. The revenue estimates used to value the purchased IPR&D were based on estimates of the relevant market sizes and growth factors, expected trends in technology and
the nature and expected timing of new product introductions by the Company and its competitors.



Overall, the IPR&D projects were estimated to be approximately 70% complete with estimated completion in the first half of 2004, at which time the
Company is expected to begin generating economic benefits from the completed projects. In total, costs to complete the IPR&D are expected to be approximately $5.2 million. The rates utilized to discount the net cash flows to their present values
were based on an industry weighted average cost of capital. The weighted average cost of capital was adjusted to reflect the difficulties and uncertainties in completing each project and thereby achieving technological feasibility, the
percentage-of-completion of each project, anticipated market acceptance and penetration, market growth rates and risks related to the impact of potential changes in future target markets. Based on these factors, discount rates that range from 21% -
23% were deemed appropriate for valuing the IPR&D. The estimates used in valuing IPR&D were based upon assumptions believed to be reasonable but which are inherently uncertain and unpredictable. As a result, actual results may differ from
such estimates.



The nature of the efforts to develop the
acquired technologies into commercially viable products consists principally of designing and testing activities, including qualification. Failure to bring these products to market in a timely manner could result in a loss of market share or a lost
opportunity to capitalize on emerging markets and could have a material adverse impact on our business and operating results.



Sanera Systems, Inc.



On September 30, 2003, the Company completed its acquisition of the stock of Sanera Systems, Inc. (Sanera), a producer of next generation intelligent
switching platform technologies. The company was formed in order to bring to market Multi-protocol, high performance, highly scaleable switches delivering storage services over the network infrastructure. The acquisition of Sanera, when combined
with McDATA technologies, extends its multi-capable storage-networking platform and accelerates its vision of delivering a real-time storage services infrastructure. The technology acquired from Sanera will help McDATA extend its reach at the core,
and integrated with McDATAs products and technology, will create a product that allows enterprises to securely consolidate SAN islands



6



---

and integrate intelligent storage utility services on one platform, significantly lowering storage networking costs and simplifying SAN management. These
factors contributed to a purchase price in excess of the fair value of the Sanera net tangible and intangible assets acquired. The condensed consolidated financial statements include the operating results of Sanera from the date of the acquisition.



The total estimated purchase price of approximately $113.3
million consisted of $110.2 million in cash consideration and direct transaction costs paid of approximately $3.1 million.



As of the acquisition date, Sanera was a development stage company with no recognized revenue and no established customer base. Sanera had substantially
completed all the planning, designing, coding and testing activities necessary to establish that the technology underlying the developed products could be utilized to meet the design specifications intended. The Company currently believes that
revenues related to this product will commence during fiscal year 2004. Based upon these factors, the Company concluded that, for accounting purposes, it was not purchasing a business with an existing revenue stream, but rather a group of assets
related to a developed technology that the Company believes will ultimately be developed into a scalable product.



The purchase price was allocated to the assets acquired and liabilities assumed based on their respective fair values. The excess of purchase price over
the fair value of net assets received was allocated to the acquired non-monetary assets on a pro-rata basis.



The following table summarizes the allocation of purchase price for the acquisition of Sanera:



|                               |  |                                      |         |   |                                     |         |   |                                             |   |         |  
|------------------------------ |  | ------------------------------------ | ------- | - | ----------------------------------- | ------- | - | ------------------------------------------- | - | ------- | -
|                               |  | Fair Value of Assets and Liabilities |         |   | Allocation of Excess Purchase Price |         |   | Allocated FairValue ofAssets andLiabilities |  
|Cash                           |  | $                                    | 10,547  |   |                                     |        |   |                                             | $ | 10,547  |  
|Other tangible assets          |  |                                      | 4,492   |   |                                     |        |   |                                             |   | 4,492   |  
|Amortizable intangible assets: |  |                                      |         |   |                                     |         |   |                                             |   |         |  
|Developed technology           |  |                                      | 43,785  |   |                                     | 54,035  |   |                                             |   | 97,820  |  
|Custom ASICs                   |  |                                      | 4,313   |   |                                     | 5,323   |   |                                             |   | 9,636   |  
|Customer Relationships         |  |                                      | 1,399   |   |                                     |        |   |                                             |   | 1,399   |  
|Patents pending                |  |                                      | 434     |   |                                     | 535     |   |                                             |   | 969     |  
|Assembled workforce            |  |                                      | 1,104   |   |                                     | 1,362   |   |                                             |   | 2,466   |  
|Liabilities assumed            |  |                                      | (3,498  | ) |                                     |        |   |                                             |   | (3,498  | )
|Deferred tax liabilities       |  |                                      | (10,530 | ) |                                     |        |   |                                             |   | (10,530 | )
|Excess purchase price          |  |                                      | 61,255  |   |                                     | (61,255 | ) |                                             |   |        |  
|                               |  |                                      |         |   |                                     |         |   |                                             |   |         |  
|Total purchase price           |  | $                                    | 113,301 |   |                                     |        |   |                                             | $ | 113,301 |  
|                               |  |                                      |         |   |                                     |         |   |                                             |   |         |  



Pro Forma Results



The following unaudited pro forma information presents a summary of the
results of operations of the Company assuming the acquisitions of Nishan and Sanera occurred at the beginning of each period presented as required by SFAS 141, Business Combinations:



|                           |  |                    |         |   |                   |   |         |                 |  |   |                   |   |  |   |         |  
|-------------------------- |  | ------------------ | ------- | - | ----------------- | - | ------- | --------------- |  | - | ----------------- | - |  | - | ------- | -
|                           |  | Three Months Ended |         |   | Nine Months Ended |  
|                           |  | October 31,2003    |         |   | September 30,2002 |   |         | October 31,2003 |  |   | September 30,2002 |  
|Revenues                   |  | $                  | 96,561  |   |                   | $ | 82,350  |                 |  | $ | 312,951           |   |  | $ | 226,496 |  
|Net loss                   |  | $                  | (66,102 | ) |                   | $ | (37,216 | )               |  | $ | (91,243           | ) |  | $ | (94,119 | )
|Basic net loss per share   |  | $                  | (0.57   | ) |                   | $ | (0.33   | )               |  | $ | (0.79             | ) |  | $ | (0.83   | )
|Diluted net loss per share |  | $                  | (0.57   | ) |                   | $ | (0.33   | )               |  | $ | (0.79             | ) |  | $ | (0.83   | )



Deferred Compensation



In connection with the acquisitions of Nishan and Sanera,
the Company entered into retention bonus agreements upon employment of certain former Nishan and Sanera employees, whereby cash and restricted awards with fair values totaling $23.8 million were committed. These cash and stock awards are contingent
upon continued employment and vest over a 12 to 24 month period. In addition, the vesting schedules of certain awards are contingent upon the achievement of engineering milestones for the continued development of new technologies. The stock awards
have been recorded as deferred compensation and will be recognized ratably through the expiration date of the vesting periods. The cash bonuses are accrued over the vesting periods and are recorded as operating expenses according to the functional
grouping of employees.



7



---

Note 4  Equity Investment



On August 22, 2003, the Company purchased a 22% equity ownership in Aarohi Communications (Aarohi), a privately owned
provider of next-generation intelligent storage networking technology. In exchange for an equity interest in Aarohis Series B-1 preferred stock and one seat on the board of directors, the Company paid $6 million in cash.



As of the investment date, the purchase price paid by McDATA is in excess of
the Companys underlying proportionate equity in Aarohis net assets. Aarohi is a development stage company with no recognized product revenue and a core ASIC technology that has not yet reached technical feasibility. Management of Aarohi
currently believes that revenues related to this technology will commence during fiscal year 2004. The Company has concluded that the approximately $3.6 million difference between the purchase price of the investment and the underlying share of
equity in the net assets of Aarohi represents in-process research and development and, as such, has expensed this excess purchase price in the quarter ended October 31, 2003.



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 loss of approximately $591,000 from the date of purchase through October 31, 2003. The remaining net
equity investment of approximately $1.8 million is recorded as an other asset at October 31, 2003.



Note 5  Balance Sheet Details



|                          |  |                 |        |   |                   |   |        |  
|------------------------- |  | --------------- | ------ | - | ----------------- | - | ------ | -
|                          |  | October 31,2003 |        |   | December 31, 2002 |  
|Inventories:              |  |                 |        |   |                   |   |        |  
|Raw materials             |  | $               | 6,373  |   |                   | $ | 8,070  |  
|Work-in-progress          |  |                 | 810    |   |                   |   | 1,123  |  
|Finished goods            |  |                 | 9,459  |   |                   |   | 6,316  |  
|                          |  |                 |        |   |                   |   |        |  
|Total inventories at cost |  |                 | 16,642 |   |                   |   | 15,509 |  
|Less reserves             |  |                 | (5,642 | ) |                   |   | (7,412 | )
|                          |  |                 |        |   |                   |   |        |  
|Total inventories, net    |  | $               | 11,000 |   |                   | $ | 8,097  |  
|                          |  |                 |        |   |                   |   |        |  



As a result of an
outsourcing initiative completed in 2003, the Company has moved all of the inventory manufacture and configuration to certain contract manufacturers, thereby, reducing the level of raw material and work-in-process inventory on its balance sheet (See
Note 13). Finished goods inventory has grown, however, reflecting an increase in Company-owned distribution center and OEM hub inventory levels. In addition, net inventory increased $1.3 million with the acquisition of Nishan.



|                                                     |  |                 |        |                  |   |       
|---------------------------------------------------- |  | --------------- | ------ | ---------------- | - | ------
|                                                     |  | October 31,2003 |        | December 31,2002
|Accrued Liabilities:                                 |  |                 |        |                  |   |       
|Wages and employee benefits                          |  | $               | 17,931 |                  | $ | 16,643
|Purchase commitments and other supply obligations(2) |  |                 | 7,812  |                  |   | 12,022
|Warranty reserves(1)                                 |  |                 | 4,194  |                  |   | 3,461 
|Income tax payable                                   |  |                 | 1,137  |                  |   | 2,782 
|Taxes, other than income tax                         |  |                 | 2,379  |                  |   | 1,050 
|Interest payable                                     |  |                 | 803    |                  |   |      
|Customer obligations                                 |  |                 | 6,617  |                  |   | 349   
|ESCON agency funds                                   |  |                 | 8,365  |                  |   | 2,366 
|Other accrued liabilities                            |  |                 | 1,725  |                  |   | 1,888 
|                                                     |  |                 |        |                  |   |       
|                                                     |  | $               | 50,963 |                  | $ | 40,561
|                                                     |  |                 |        |                  |   |       

---

|(1) | The Company establishes a warranty liability for the estimated cost of warranty-related
claims at the time revenue is recognized. Activity in the warranty reserves was as follows for the three and nine months ended October 31, 2003 and September 30, 2002:
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                               |  |                    |       |   |                   |   |       |                 |  |   |                   |   |  |   |       |  
|------------------------------ |  | ------------------ | ----- | - | ----------------- | - | ----- | --------------- |  | - | ----------------- | - |  | - | ----- | -
|                               |  | Three Months Ended |       |   | Nine Months Ended |  
|                               |  | October 31,2003    |       |   | September 30,2002 |   |       | October 31,2003 |  |   | September 30,2002 |  
|Balance at beginning of period |  | $                  | 3,897 |   |                   | $ | 2,390 |                 |  | $ | 3,485             |   |  | $ | 2,174 |  
|Warranty expense               |  |                    | 181   |   |                   |   | 558   |                 |  |   | 844               |   |  |   | 1,119 |  
|Warranty claims                |  |                    | (111  | ) |                   |   | (77   | )               |  |   | (362              | ) |  |   | (422  | )
|Acquired warranty liability    |  |                    | 227   |   |                   |   |      |                 |  |   | 227               |   |  |   |      |  
|                               |  |                    |       |   |                   |   |       |                 |  |   |                   |   |  |   |       |  
|Balance at end of period       |  | $                  | 4,194 |   |                   | $ | 2,871 |                 |  | $ | 4,194             |   |  | $ | 2,871 |  
|                               |  |                    |       |   |                   |   |       |                 |  |   |                   |   |  |   |       |  

---

|(2) | During the nine months ended October 31, 2003, the Company released recorded obligations of
approximately $1.3 million relating to the expiration of certain customer sales obligations.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



8



---

Note 6  Investments



The following tables summarize the Companys investments in short and long-term securities:



|                                       |  |      |         |                          |   |                           |  |             |     |  |   |        
|-------------------------------------- |  | ---- | ------- | ------------------------ | - | ------------------------- |  | ----------- | --- |  | - | -------
|                                       |  | Cost |         | Unrealized Holding Gains |   | Unrealized Holding Losses |  | Fair Values
|October 31, 2003                       |  |      |         |                          |   |                           |  |             |     |  |   |        
|U.S. Government obligations            |  | $    | 155,281 |                          | $ | 564                       |  | $           | 222 |  | $ | 155,623
|State and local government obligations |  |      | 36,867  |                          |   | 33                        |  |             |    |  |   | 36,900 
|Corporate obligations                  |  |      | 42,029  |                          |   | 140                       |  |             | 33  |  |   | 42,136 
|U.S. Treasury put options              |  |      | 170     |                          |   | 14                        |  |             |    |  |   | 184    
|Marketable equity securities           |  |      | 27,534  |                          |   | 14                        |  |             | 63  |  |   | 27,485 
|Fixed income mutual fund               |  |      | 10,152  |                          |   |                          |  |             | 75  |  |   | 10,077 
|                                       |  |      |         |                          |   |                           |  |             |     |  |   |        
|                                       |  | $    | 272,033 |                          | $ | 765                       |  | $           | 393 |  | $ | 272,405
|                                       |  |      |         |                          |   |                           |  |             |     |  |   |        
|Reported as:                           |  |      |         |                          |   |                           |  |             |     |  |   |        
|Short-term investments                 |  |      |         |                          |   |                           |  |             |     |  | $ | 155,980
|Long-term investments                  |  |      |         |                          |   |                           |  |             |     |  |   | 116,425
|                                       |  |      |         |                          |   |                           |  |             |     |  |   |        
|                                       |  |      |         |                          |   |                           |  |             |     |  | $ | 272,405
|                                       |  |      |         |                          |   |                           |  |             |     |  |   |        
|December 31, 2002                      |  |      |         |                          |   |                           |  |             |     |  |   |        
|U.S. Government obligations            |  | $    | 87,570  |                          | $ | 1,026                     |  | $           |    |  | $ | 88,596 
|State and local government obligations |  |      | 89,614  |                          |   | 118                       |  |             |    |  |   | 89,732 
|Corporate obligations                  |  |      | 18,954  |                          |   | 127                       |  |             |    |  |   | 19,081 
|Marketable equity securities           |  |      | 32,956  |                          |   |                          |  |             | 6   |  |   | 32,950 
|                                       |  |      |         |                          |   |                           |  |             |     |  |   |        
|                                       |  | $    | 229,094 |                          | $ | 1,271                     |  | $           | 6   |  | $ | 230,359
|                                       |  |      |         |                          |   |                           |  |             |     |  |   |        
|Reported as:                           |  |      |         |                          |   |                           |  |             |     |  |   |        
|Short-term investments                 |  |      |         |                          |   |                           |  |             |     |  | $ | 157,260
|Long-term investments                  |  |      |         |                          |   |                           |  |             |     |  |   | 73,099 
|                                       |  |      |         |                          |   |                           |  |             |     |  |   |        
|                                       |  |      |         |                          |   |                           |  |             |     |  | $ | 230,359
|                                       |  |      |         |                          |   |                           |  |             |     |  |   |        



As of October 31, 2003
and December 31, 2002, net unrealized holding gains of $407,000 and $1.3 million, respectively, were included in accumulated other comprehensive income in the accompanying condensed consolidated balance sheets. As of October 31, 2003, approximately
$14,000 and $35,000 of unrealized gains and losses, respectively, related to hedged securities were included in investment income for the three and nine months ended respectively. These unrealized gains represent the net ineffectiveness of a
fair-value hedge comprised of certain marketable equity securities and put options on U.S. Treasury futures. At October 31, 2003, the Company held approximately $184,000 of purchase put options for U.S. Treasury futures. These investments were
purchased to effectively hedge the interest rate risk related to a portfolio of preferred equity securities, included in marketable equity securities above, with a market value of approximately $10.0 million at October 31, 2003.



The following table summarizes the maturities of the Companys
investments in debt securities as of October 31, 2003. Certain instruments, although possessing a contractual maturity greater than a year, are classified as short-term investments based on methods of trade and availability for current operations.



|                                          |  |      |         |            |   |        
|----------------------------------------- |  | ---- | ------- | ---------- | - | -------
|                                          |  | Cost |         | Fair Value
|Less than one year                        |  | $    | 71,948  |            | $ | 72,558 
|Greater than one year through five years  |  |      | 106,129 |            |   | 106,000
|Greater than five years through ten years |  |      | 1,950   |            |   | 1,950  
|Greater than ten years                    |  |      | 54,150  |            |   | 54,151 
|                                          |  |      |         |            |   |        
|                                          |  | $    | 234,177 |            | $ | 234,659
|                                          |  |      |         |            |   |        



In the quarter ended
October 31, 2003, the Company began a securities lending program whereby certain Company securities from the portfolio are loaned to other institutions for short periods of time. The market value of the loaned securities is monitored on a daily
basis, with additional collateral obtained or refunded as the market value of the loaned securities changes. The Companys policy is to require initial cash collateral equal to 102 percent of the fair value of the loaned securities. Securities
lending collateral is recorded separately as a current asset and corresponding current liability. The Company maintains full ownership rights to the



9



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securities loaned, and continues to earn interest on them. The Company shares a portion of the interest earned on the collateral with Wells Fargo Bank
Minnesota, N.A. (the Lending Agent). In addition, the Company has the ability to sell the securities while they are on loan. The Company has an indemnification agreement with the lending agents in the event a borrower becomes insolvent or fails to
return securities. At October 31, 2003, the amount of securities on loan equaled $107.2 million.



Note 7  Convertible Subordinated Debt



On February 7, 2003, the Company sold $172.5 million of 2.25% convertible subordinated notes (the Notes) due February 15, 2010, raising net proceeds of approximately $167 million. The Notes are convertible
into 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) at any time prior to February 15, 2010. In addition, holders of the Notes may require the Company to
purchase all or a portion of the Notes upon a change in control of the Company. Upon a conversion, the Company may choose to deliver, in lieu of shares of Class A common stock, cash or a combination of cash and Class A common stock. The Notes do not
contain any restrictive covenants.



Concurrent with the
issuance of the Notes, the Company entered into share option transactions using approximately $20.5 million of net 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 ability to significantly 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, the Company entered into an interest-rate swap agreement with a notional amount of $155.3 million that has the economic effect of modifying
that dollar portion of the fixed interest obligations associated with the Notes so that the interest payable 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. The initial six-month LIBOR setting for the swap is 1.1283%, creating a rate of approximately minus 0.39%, which is effective until February 15, 2004. The swap was
designated as a fair value hedge, and as such, the gain or loss on the swap, as well as the fully offsetting gain or loss on the Notes attributable to the hedged risk, were recognized in earnings. At October 31, 2003, the fair value of the interest
rate swap had decreased from inception by $1.1 million at October 31, 2003 and is included in other long-term liabilities. Corresponding to this change, the carrying value of the Notes has decreased by $1.1 million. As part of the agreement, the
Company is 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 $5.1 million at October 31, 2003.



Note 8  Net Income (Loss) per Share



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



Calculation of net income (loss) per share:



|                                                                                                        |  |                    |         |                   |                    |   |                  |  |   |                    |   |  |   |         |  
|------------------------------------------------------------------------------------------------------- |  | ------------------ | ------- | ----------------- | ------------------ | - | ---------------- |  | - | ------------------ | - |  | - | ------- | -
|                                                                                                        |  | Three Months Ended |         | Nine Months Ended |                   
|                                                                                                        |  | October 31, 2003   |         |                   | September 30, 2002 |   | October 31, 2003 |  |   | September 30, 2002 |  
|Net income (loss)                                                                                       |  | $                  | (50,048 | )                 |                    | $ | 2,343            |  | $ | (35,603            | ) |  | $ | (18,586 | )
|Weighted average shares of common stock outstanding used in computing basic net income (loss) per share |  |                    | 114,955 |                   |                    |   | 113,280          |  |   | 114,627            |   |  |   | 113,026 |  
|Effect of dilutive stock options                                                                        |  |                    |        |                   |                    |   | 3,015            |  |   |                   |   |  |   |        |  
|                                                                                                        |  |                    |         |                   |                    |   |                  |  |   |                    |   |  |   |         |  
|Weighted average shares of common stock used in computing diluted net income (loss) per share           |  |                    | 114,955 |                   |                    |   | 116,295          |  |   | 114,627            |   |  |   | 113,026 |  
|                                                                                                        |  |                    |         |                   |                    |   |                  |  |   |                    |   |  |   |         |  
|Basic net income (loss) per share                                                                       |  | $                  | (0.44   | )                 |                    | $ | 0.02             |  | $ | (0.31              | ) |  | $ | (0.16   | )
|                                                                                                        |  |                    |         |                   |                    |   |                  |  |   |                    |   |  |   |         |  
|Diluted net income (loss) per share                                                                     |  | $                  | (0.44   | )                 |                    | $ | 0.02             |  | $ | (0.31              | ) |  | $ | (0.16   | )
|                                                                                                        |  |                    |         |                   |                    |   |                  |  |   |                    |   |  |   |         |  
|Options not included in diluted share base because of the exercise prices                               |  |                    | 5,379   |                   |                    |   | 6,107            |  |   | 6,324              |   |  |   | 3,837   |  
|                                                                                                        |  |                    |         |                   |                    |   |                  |  |   |                    |   |  |   |         |  
|Options and restricted stock not included in diluted share base because of the net loss                 |  |                    | 10,233  |                   |                    |   |                 |  |   | 9,288              |   |  |   | 7,538   |  
|                                                                                                        |  |                    |         |                   |                    |   |                  |  |   |                    |   |  |   |         |  



10



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Note 9  Stock-Based Compensation



The Company maintains a stock option and restricted stock plan known as the 2001 McDATA Equity Incentive Plan (the Plan)
which provides for the grant of Class B stock options, restricted stock and other stock based awards to directors, officers, other employees, and consultants as determined by the compensation committee of the Board of Directors. A maximum of
30,000,000 shares of common stock were issuable under the terms of the Plan as of October 31, 2003, of which no more than 2,400,000 shares may be issued as restricted stock or other stock based awards. On August 27, 2003, the Companys
stockholders approved the addition of 6,000,000 shares to the Plan (included in the maximum amount noted above).



In August 2003 and in connection with our acquisitions of Nishan and Sanera, the Company adopted the 2003 McDATA Acquisition Equity Incentive Plan (the
Acquisition Plan). This plan is a limited purpose plan to allow for the issuance of inducement grants of restricted and unrestricted Class B common stock to new employees in connection with a merger or acquisition of a company or business by McDATA.
Stock awards may only be granted to new employees resulting from a merger or acquisition by the Company. A maximum of 3,000,000 shares of common stock are issuable under the terms of this Acquisition Plan. Approximately 1,300,000 restricted stock
shares were issued under this Acquisition Plan in connection with the acquisitions discussed in Note 3.



As of October 31, 2003, there were approximately 7.8 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 SFAS No. 123 as amended by SFAS No. 148. Any deferred stock compensation calculated pursuant to APB 25
is amortized ratably over the vesting period of the individual award, generally one to four years. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of
SFAS No. 123.



|                                                                                                                                                       |  |                     |         |   |                    |   |        |                  |  |   |                    |   |  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------- | ------- | - | ------------------ | - | ------ | ---------------- |  | - | ------------------ | - |  | - | ------- | -
|                                                                                                                                                       |  | Three Months Ended, |         |   | Nine months ended, |  
|                                                                                                                                                       |  | October 31, 2003    |         |   | September 30, 2002 |   |        | October 31, 2003 |  |   | September 30, 2002 |  
|Net income (loss), as reported                                                                                                                         |  | $                   | (50,048 | ) |                    | $ | 2,343  |                  |  | $ | (35,603            | ) |  | $ | (18,586 | )
|Add: Total stock-based employee compensation expense included in net income as determined under the intrinsic value method, net of related tax
effects |  |                     | 6,004   |   |                    |   | 1,530  |                  |  |   | 9,175              |   |  |   | 4,382   |  
|Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax
effects        |  |                     | (11,562 | ) |                    |   | (5,916 | )                |  |   | (25,785            | ) |  |   | (15,294 | )
|                                                                                                                                                       |  |                     |         |   |                    |   |        |                  |  |   |                    |   |  |   |         |  
|Pro forma net loss                                                                                                                                     |  | $                   | (55,606 | ) |                    | $ | (2,043 | )                |  | $ | (52,213            | ) |  | $ | (29,498 | )
|                                                                                                                                                       |  |                     |         |   |                    |   |        |                  |  |   |                    |   |  |   |         |  
|Loss per share:                                                                                                                                        |  |                     |         |   |                    |   |        |                  |  |   |                    |   |  |   |         |  
|Basic-as reported                                                                                                                                      |  | $                   | (0.44   | ) |                    | $ | 0.02   |                  |  | $ | (0.31              | ) |  | $ | (0.16   | )
|                                                                                                                                                       |  |                     |         |   |                    |   |        |                  |  |   |                    |   |  |   |         |  
|Basic-pro forma                                                                                                                                        |  | $                   | (0.48   | ) |                    | $ | (0.02  | )                |  | $ | (0.46              | ) |  | $ | (0.26   | )
|                                                                                                                                                       |  |                     |         |   |                    |   |        |                  |  |   |                    |   |  |   |         |  
|Diluted-as reported                                                                                                                                    |  | $                   | (0.44   | ) |                    | $ | 0.02   |                  |  | $ | (0.31              | ) |  | $ | (0.16   | )
|                                                                                                                                                       |  |                     |         |   |                    |   |        |                  |  |   |                    |   |  |   |         |  
|Diluted-pro forma                                                                                                                                      |  | $                   | (0.48   | ) |                    | $ | (0.02  | )                |  | $ | (0.46              | ) |  | $ | (0.26   | )
|                                                                                                                                                       |  |                     |         |   |                    |   |        |                  |  |   |                    |   |  |   |         |  



Note 10  Comprehensive Income
(Loss)



Comprehensive income (loss) consisted of the
following:



|                                                  |  |                    |         |                   |                    |   |                  |  |   |                    |   |  |   |         |  
|------------------------------------------------- |  | ------------------ | ------- | ----------------- | ------------------ | - | ---------------- |  | - | ------------------ | - |  | - | ------- | -
|                                                  |  | Three Months Ended |         | Nine months ended |                   
|                                                  |  | October 31, 2003   |         |                   | September 30, 2002 |   | October 31, 2003 |  |   | September 30, 2002 |  
|Net income (loss)                                 |  | $                  | (50,048 | )                 |                    | $ | 2,343            |  | $ | (35,603            | ) |  | $ | (18,586 | )
|Unrealized gain (loss) on investments, net of tax |  |                    | 139     |                   |                    |   | 81               |  |   | (304               | ) |  |   | 141     |  
|                                                  |  |                    |         |                   |                    |   |                  |  |   |                    |   |  |   |         |  
|Comprehensive income (loss)                       |  | $                  | (49,909 | )                 |                    | $ | 2,424            |  | $ | (35,907            | ) |  | $ | (18,445 | )
|                                                  |  |                    |         |                   |                    |   |                  |  |   |                    |   |  |   |         |  



Note 11  Stockholders
Equity



The Companys Employee Stock Purchase Plan
(ESPP), which was adopted in 2002, allows eligible employees to purchase shares of the Companys Class B common stock, through accumulated payroll deductions, at 85% of the lesser of the fair market value



11



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of the Class B common stock at the beginning or end of the six-month purchase period. During the nine months ended October 31, 2003, employees purchased a
total of approximately 521,000 shares of common stock for approximately $3.7 million.



In May 2003, the Companys Board of Directors authorized a plan for the Company to repurchase up to $50 million of its common stock (Class A, Class B or a combination thereof). This repurchase plan does not
obligate the Company to acquire any specific number of shares or acquire shares over any specified period of time. At October 31, 2003, no shares have been repurchased under the plan.



Note 12  Income Taxes



In the third quarter ended October 31, 2003, the Company recorded an income tax provision of $30.9 million which included a non-cash charge of $38.7
million related to recording of a valuation allowance against the deferred tax assets. In evaluating the ability to realize the benefits of the recorded deferred tax assets, management considers all available positive and negative evidence including
past operating results, the existence of cumulative losses in the most recent fiscal years and forecasts of future taxable income. In determining future taxable income, management is responsible for assumptions utilized including the amount of
state, federal and international pre-tax operating income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future
taxable income and are consistent with the plans and estimates used to manage the underlying businesses.



In performing the analysis of the realizability of the recorded deferred tax assets, the specific evidence considered by management included cumulative
accounting losses over the past three years, tax net operating losses previously reported, net operating losses acquired, estimated future taxable income, ongoing prudent and feasible tax planning strategies, progress against the forecast of
operating results, continuing market uncertainties and the impact of the loss in the third quarter ended October 31, 2003. Through this analysis, management assessed the likelihood that the net deferred tax assets will be recovered against future
taxable income. After considering all of the evidence and applying the provisions of SFAS No. 109, Accounting for Income Taxes (SFAS 109), management concluded that a valuation allowance for the entire deferred tax asset was required.



A deferred tax liability of $10.5 million has been accrued for
the different treatment between income tax and financial accounting for intangibles acquired in the Nishan and Sanera transactions. The reversal of this liability would not be offset by the items comprising the deferred tax asset.



Note 13  Commitments and Contingencies



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



Manufacturing and Purchase Commitments



The Company has contracted with Sanmina SCI Systems, Inc.
(SSCI) and Solectron Corporation (Solectron) (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 October 31, 2003, the Companys commitment with the Contract Manufacturers for purchases over the next sixty days totaled $44.5 million. The
Company may be liable for materials that the Contract Manufacturers purchase on McDATAs behalf if the Companys actual requirements do not meet or exceed its forecasts and those materials cannot be redirected to other uses. At October 31,
2003, the Company had recorded obligations of approximately $8 million (See Note 5) 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.



Indemnifications and Guarantees



During its
normal course of business, the Company has made certain indemnities, commitments and guarantees under which it may be required to make payments in relation to certain transactions. These indemnities include intellectual property indemnities to the
Companys customers in connection with the sales of its products, indemnities for liabilities associated with the infringement of other parties technology based upon the Companys hardware and software products, indemnities to
various lessors in connection with facility leases for certain claims arising from such facility or lease, and indemnities to directors and officers of the Company to



12



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the maximum extent permitted under the laws of the State of Delaware. The Company has also indemnified its former parent, EMC for any income taxes arising
out of the February 7, 2001 distribution of our Class A common stock in the event it does not qualify for tax-free treatment. The duration of these indemnities, commitments and guarantees varies, and in certain cases, is indefinite. 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. As such, the Company is unable to estimate with any reasonableness whether
any potential exposures exist under these items and, if so, what the range of losses involved could be. As such, the Company has not recorded any liability for these indemnities, commitments and guarantees in the accompanying condensed consolidated
balance sheets. The Company does, however, accrue for losses for any known contingent liability, including those that may arise from indemnification provisions, when future payment is both reasonably determinable and probable. Finally, the Company
carries specific and general liability insurance policies, which the Company believes would provide, in most circumstances, some, if not total recourse to any claims arising from these indemnifications.



Litigation



Raytheon Lawsuit



On May 5, 2003, the Company was added as the ninth defendant to a January 2003 patent infringement lawsuit that was filed by Raytheon Company in the
United States District Court for the Eastern District of TexasMarshall Division (Civil Action No. 2:03CV13). The complaint alleges that the Companys products infringe and/or the Company is actively inducing the infringement of
Raytheons United States Patent No. 5,412,791, entitled Mass Data Storage Library. After a review of the complaint and the Raytheon patent, we believe that we neither infringe Raytheons patent nor induce infringement of that
patent. We intend to defend against this lawsuit vigorously. A claim construction hearing is anticipated to occur in January 2004. Defending against this lawsuit is costly and time consuming, and is subject to inherent risks and uncertainties.



Class Action Laddering Lawsuits



The Company, the Chairman of the board of directors, one current officer and
one former officer have been 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 have been filed against
the Company. The complaints are substantially identical to numerous other complaints filed against other companies that went public over the last several years. 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 relating to the Company allege claims against the
Company, the Chairman of the board of directors, one of the Companys current officers, one former officer of the Company, and CSFB, the lead underwriter of the Companys August 9, 2000 initial public offering, under Sections 11 and 15 of
the Securities Act. The complaints also allege claims solely against CSFB and the other underwriter defendants under Section 12(a)(2) of the Securities Act, and claims against the individual defendants under Section 10(b) of the Securities Exchange
Act. Although management believes that all of the lawsuits are without legal merit and intend to defend them vigorously, there is not 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 McDATA, the opportunity to enter into a Reservation of Rights and Tolling Agreement that would dismiss without prejudice and without costs all claims against such persons if the company itself had entity
coverage insurance. This agreement was signed by Mr. John F. McDonnell, Chairman, Mrs. Dee J. Perry, former chief financial officer, and Mr. Thomas O. McGimpsey, Vice President and General Counsel and the plaintiffs executive committee. Under
the Reservation of Rights and Tolling Agreement the plaintiffs dismissed the claims against such individuals.



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



13



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Patent Infringement Lawsuit



On February 14, 2002, the Company filed a patent infringement lawsuit against Brocade in the United States District Court
for the District of Colorado alleging that Brocades Frame Filtering feature in their products infringed the Companys U.S. Patent No. 6,233,236 Method and apparatus for measuring traffic within a switch. On March 5, 2002, the
Company filed for a preliminary injunction against Brocade to immediately stop infringing the patent after Brocade announced another product containing its Advanced Performance Monitoring feature. On April 8, 2002, Brocade filed an answer to the
motion for preliminary injunction generally alleging that Brocade has not infringed and is not infringing the patent. Brocade alleged various counterclaims in its answer including a claim that the patent is invalid and unenforceable, and that the
Company misappropriated trade secret information from Brocade under prior agreements and that a 1999 OEM agreement contained a covenant not to sue. The United States District Court for the District of Colorado on December 6, 2002 denied the
Companys motion for a preliminary injunction. The Company filed documents on December 23, 2002 with the American Arbitration Association to initiate an arbitration proceeding to resolve contract and patent issues relating to the 1999 OEM
agreement with Brocade. On January 24, 2003, Brocade, in response to the initiation of the arbitration proceeding, filed an answer and counterclaim with the American Arbitration Association that objected to the inclusion of the patent infringement
claims in the arbitration, claims the patent is invalid and unenforceable and claims the Company misappropriated trade secret information from Brocade. The arbitration proceeding may occur during the first half of 2004. Although management strongly
believes that Brocades counterclaims are factually incorrect and without any merit and intends to vigorously pursue our patent infringement claims against Brocade, there is no assurance that the Company will prevail.



Nishan Acquisition Related Lawsuit



In connection with the Companys acquisition of Nishan, the Company was
named along with Nishan, various investors of Nishan, Credit Suisse First Boston (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) 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 a declaration by the
Court to allocate the merger proceeds in a fair and non-discriminatory fashion and seeks compensatory damages. 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. The defendants are unified in their defense of this action and the Company and former Nishan affiliated defendants have agreed that these lawsuit expenses are covered by
indemnification under the merger agreement from the selling shareholders of Nishan. The defendants have jointly filed a demurer to dismiss this action, which is expected to be heard by the Court in early 2004.



Note 14  Third Quarter Balance Sheet Reclassification/Restatement



On February 26, 2004, the Company announced that it would amend its Form
10-Q for the quarter ending October 31, 2003 to restate its previously filed balance sheet to effect a reclassification relating to a securities lending program with Wells Fargo Bank, N.A. (Wells Fargo), in effect during the quarter, in
order to properly account for the program in accordance with SFAS 140. Under the program, McDATAs investment securities may be loaned against a pledge of cash collateral, which is held by Wells Fargo as McDATAs agent.



The reclassification involved a gross-up of the Companys balance sheet
to reflect a line item entitled Securities lending collateral as a current asset and the addition of a line item entitled Securities lending collateral payable as a current liability, both for the approximate
amount of $109.5 million. These two balance sheet adjustments net to zero, and neither the income statement nor the statement of cash flows is affected. The financial statement accounts affected by the reclassification are as follows:



|                                           |  |                           |   |  |                             |  
|------------------------------------------ |  | ------------------------- | - |  | --------------------------- | -
|                                           |  | As Filed October 31, 2003 |   |  | As Amended October 31, 2003 |  
|                                           | 
|Securities lending collateral              |  |                          |   |  | 109,470                     |  
|Total current assets                       |  | 273,293                   |   |  | 382,763                     |  
|Total assets                               |  | 722,573                   |   |  | 832,043                     |  
|Securities lending collateral payable      |  |                          |   |  | (109,470                    | )
|Total current liabilities                  |  | (89,764                   | ) |  | (199,234                    | )
|Total liabilities                          |  | (291,966                  | ) |  | (401,436                    | )
|Total liabilities and stockholders equity |  | (722,573                  | ) |  | (832,043                    | )



14



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15



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|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 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
March 27, 2003.



Overview



On January 15, 2003, we changed our fiscal year to end on January 31, rather
than December 31. References in this Form 10-Q to the third quarter and first nine months of 2003 represent the three and nine months ended October 31, 2003. References in this Form 10-Q to the third quarter and first nine months of 2002 represent
the three and nine months ended September 30, 2002. We have not submitted financial information for the three and nine months ended October 31, 2002 in this Form 10-Q because the information is not practical or cost beneficial to prepare. We believe
that the three and nine months ended September 30, 2002 provides a meaningful comparison to the third quarter and first nine months of 2003. There are no significant factors, seasonal or otherwise, that would impact the comparability of information
or trends, if results for the three and nine months ended October 31, 2002 were presented in lieu of results for the three and nine months ended September 30, 2002.



Recent Events



On September 19, 2003 and September 30, 2003, we acquired all the outstanding shares of Nishan Systems, Inc. and Sanera Systems, Inc., respectively, for
approximately $171 million, net of cash. Operating results of Nishan and Sanera are included in our results of operations as of these dates. We also provided approximately 1.3 million shares of Class B common stock and approximately $8.3 million in
cash to fund retention programs over the next two years for employees added as a result of these acquisitions. Separately, we entered into an equity investment agreement with Aarohi Communications to acquire approximately 22% stock ownership for $6
million and obtained a seat on the board of directors. In addition to the equity investment, we signed a non-exclusive supply agreement with Aarohi to purchase intelligent switch technology for the Companys products, if and when available.



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.



Revenue Recognition



We recognize revenue, in accordance with SEC Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements(SAB 101) 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 are not met, we will defer recognition of revenue until all the criteria have been met.



With respect to revenue from our configured director 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 101 (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 sales 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 101 (as discussed above) have been met, 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 offerings that occur under sales programs established with the Companys OEMs, distributors and resellers.



16



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Service revenues, which to date have not been material, include training, consulting and customer
support. Revenue from training and consulting are recognized when the service has been performed and the customer has accepted the work. We recognize revenue from support or maintenance contracts, including post-contract customer support (PCS)
services, ratably over the contractual period.



We recognize
revenue from software products in accordance with the SOP 97-2. Software revenue is allocated to the software license and PCS service elements using vendor specific objective evidence of fair value, or VSOE, and recognized appropriately as discussed
above. VSOE of the fair value for an element is based upon the price charged when the element is sold separately.



In transactions that include multiple products, services and/or software, we allocate the revenue to each element based on their relative fair values (or
in the absence of fair value, the residual method) and recognize the revenue when the above recognition criteria have been met for each element.



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. 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.



Valuation of Accounts Receivable



We review accounts receivable to determine which are doubtful of collection.
In addition, we also make estimates of potential future product returns. In making the determination of the appropriate allowance for doubtful accounts and product returns, we consider specific accounts, analysis of our accounts receivable aging,
changes in customer payment terms, historical write-offs and returns, changes in customer demand and relationships, concentrations of credit risk and customer credit worthiness. Historically, we have experienced a low level of write-offs and returns
given our customer relationships, contract provisions and credit assessments. Changes in the credit worthiness of customers, general economic conditions and other factors may impact the level of future write-offs and product returns and increase our
general and administrative expenses or decrease product revenues.



Warranty Provision



We also provide for
estimated expenses for warranty obligations as revenue is recognized. Our warranty accruals utilize managements estimates of potential future product warranty claims including the estimated numbers of failures by product and estimated costs to
repair or replace failed product. We have not experienced material warranty claims, however material warranty claims, including the catastrophic or epidemic failure of any one of our products, would require revisions to the estimated warranty
liability and could significantly increase our product costs, reduce revenue and cause significant customer relations problems.



Valuation of Deferred 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. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheet. At October 31, 2003, our net deferred tax assets
equaled $91.4 million. Of this amount, $52.7 million related to the acquisition of Nishan and Sanera. The balance of $38.7 million relates to various items in McDATAs results of operations that have different timing or treatment for income tax
and financial accounting purposes, such as the timing of revenue recognition and accrued expenses, depreciation methods, and reserve accounts, as well as research and development credits. In addition, a deferred tax liability of $10.5 million was
accrued with respect to intangible assets of the acquired companies that are not amortizable for income tax purposes. The reversal of this liability would not be offset by



17



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the items comprising the deferred tax asset. 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.



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



We review property, plant and equipment and purchased
intangible assets for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. Our asset impairment review assesses the fair value of the assets based on the future cash flows the assets
are expected to generate. An impairment loss is recognized when estimated undiscounted future cash flows expected to result from the use of the asset plus net proceeds expected from disposition of the asset (if any) are less than the carrying value
of the asset. This approach uses our estimates of future market growth, forecasted revenue and costs, expected periods the assets will be utilized and appropriate discount rates.



We have performed and will perform an annual impairment test for goodwill in accordance with Statement of Financial
Accounting Standards No. 142 (SFAS 142). This review is based on a comparison of the fair value of our net assets including goodwill balances using the quoted market price of our common stock. The assumptions used to estimate fair value include our
best estimate of future growth rates, capital expenditures, discount rates and market conditions over an estimate of the remaining operating period. We performed the 2003 impairment test during our first fiscal quarter and determined that no
impairment loss should be recognized. In the event that business conditions change, future tests may result in a need to record a loss due to write down of the value of goodwill. At October 31, 2003, goodwill recorded in the consolidated balance
sheet totaled $79.1 million.



We currently operate our business
as a single solutions business and do not maintain separate cash flows or operating margins for any business segments. 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.



Results of Operations



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



|                                                  |  |                    |    |  |                    |   |  |                  |       |    |                    |       |   
|------------------------------------------------- |  | ------------------ | -- |  | ------------------ | - |  | ---------------- | ----- | -- | ------------------ | ----- | --
|                                                  |  | Three Months Ended |    |  | Nine months ended  |  
|                                                  |  | October 31, 2003   |    |  | September 30, 2002 |   |  | October 31, 2003 |       |    | September 30, 2002 |      
|Revenue                                           |  | 100.0              | %  |  | 100.0              | % |  | $                | 100.0 | %  |                    | 100.0 | % 
|Cost of revenue                                   |  | 42.3               |    |  | 47.4               |   |  |                  | 42.1  |    |                    | 58.9  |   
|                                                  |  |                    |    |  |                    |   |  |                  |       |    |                    |       |   
|Gross profit                                      |  | 57.7               |    |  | 52.6               |   |  |                  | 57.9  |    |                    | 41.1  |   
|Operating expenses:                               |  |                    |    |  |                    |   |  |                  |       |    |                    |       |   
|Research and development                          |  | 24.9               |    |  | 19.3               |   |  |                  | 19.9  |    |                    | 19.5  |   
|Selling and marketing                             |  | 24.8               |    |  | 22.0               |   |  |                  | 23.1  |    |                    | 24.5  |   
|General and administrative                        |  | 11.3               |    |  | 8.6                |   |  |                  | 8.3   |    |                    | 10.0  |   
|Acquired in-process research & development        |  | 12.1               |    |  |                   |   |  |                  | 3.7   |    |                    |      |   
|Amortization of deferred compensation             |  | 6.0                |    |  | 2.7                |   |  |                  | 2.8   |    |                    | 2.9   |   
|                                                  |  |                    |    |  |                    |   |  |                  |       |    |                    |       |   
|Total operating expenses                          |  | 79.1               |    |  | 52.6               |   |  |                  | 57.8  |    |                    | 56.9  |   
|Income (loss) from operations                     |  | (21.4              | )  |  |                   |   |  |                  | 0.1   |    |                    | (15.8 | ) 
|Interest income, net                              |  | 1.7                |    |  | 2.2                |   |  |                  | 0.9   |    |                    | 2.5   |   
|                                                  |  |                    |    |  |                    |   |  |                  |       |    |                    |       |   
|Income (loss) before income taxes                 |  | (19.7              | )  |  | 2.2                |   |  |                  | 1.0   |    |                    | (13.3 | ) 
|Income tax expense (benefit)                      |  | 32.6               |    |  | (0.7               | ) |  |                  | 12.5  |    |                    | (4.9  | ) 
|                                                  |  |                    |    |  |                    |   |  |                  |       |    |                    |       |   
|Income (loss) before equity in affiliated company |  | (52.3              | )  |  | 2.9                |   |  |                  | (11.5 | )  |                    | (8.4  | ) 
|Loss in equity in affiliated company              |  | (0.6               | )  |  |                   |   |  |                  | (0.2  | )  |                    |      |   
|                                                  |  |                    |    |  |                    |   |  |                  |       |    |                    |       |   
|Net income (loss)                                 |  | (52.9              | )% |  | 2.9                | % |  |                  | (11.7 | )% |                    | (8.4  | )%
|                                                  |  |                    |    |  |                    |   |  |                  |       |    |                    |       |   



18



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Three Months Ended October 31, 2003 and September 30, 2002



Revenues



Total revenue increased by 17% to $94.7 million for the quarter ended
October 31, 2003 from $80.9 million for the quarter ended September 30, 2002. This increase was driven, primarily, by significant increases in sales of our Sphereon4500 switch that was introduced in the last half of 2002. Our revenues for the quarter ended October 31, 2003, however, were
significantly impacted by a decline in sales to our largest customer, EMC. This revenue decline was driven by an inability to reach an agreement in a timely manner, which reduced the shipment of products during the quarter. Although, we continue to
see solid end-user demand and increased year-over-year revenue for our products and solutions, the on-going competitive marketplace is expected to create a challenging sales environment for the foreseeable future. Given the entrance of new
competitors and products in our industry, we anticipate longer sales cycles and price declines that could negatively impact our revenue growth rate. We are currently on track with the development of new products, which incorporate the new
technologies from our acquisitions of Nishan and Sanera. In addition, we are taking action to continue sales of existing products acquired in connection with our acquisition of Nishan.



Product revenue of $80.1 million for the quarter ended October 31, 2003 was a 15% increase over product revenue of $69.9
million for the quarter ended September 30, 2002. This revenue increase was generated from the strong demand for our flex port Sphereon4500 Fabric Switch and initial sales of our new products acquired in connection with the Nishan acquisition. Director and related-component sales declined slightly as director sales to our largest
customer decreased as discussed above.



Software and service
revenue increased 25% to $10.0 million for the quarter ended October 31, 2003 from $8.0 million for the quarter ended September 30, 2002. We continue to experience revenue growth from the sale of all our software products, in particular our
SANavigator®and SANtegritysoftware. A significant portion of our software revenue is generated from sales of our Enterprise Fabric Connectivity Manager, or
EFCM, software product.



Other revenues for the quarter ended
October 31, 2003 were $4.6 million and $3.1 million for the quarter ended October 31, 2003 and September 30, 2002, respectively. This revenue reflects the growth in maintenance fees, which was offset by a small decline in service fees related to the
ESCON service agreement with EMC. We anticipate that service revenue from EMC under the ESCON service agreement will continue to decrease in future periods.



A significant portion of our revenue is concentrated with the largest storage OEMs. For the quarter ended October 31, 2003, approximately 54% of our total
revenue, excluding the ESCON service fee, came from EMC, compared to 56% for the quarter ended September 30, 2002. Additionally, IBM contributed approximately 21% of our revenue for the quarter ended October 31, 2003 compared to 20% for the quarter
ended September 30, 2002. Although we saw increased revenues from both customers over prior year levels, sales to EMC were significantly lower than anticipated due to the late quarter signing of an agreement that delayed shipments of product during
the quarter. We expect a majority of our revenues in the foreseeable future to continue to be derived from these customers. In addition, we have seen the level of revenues for the majority of our other OEM customers increase in the quarter. 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 customer or group of significant customers, could harm our financial condition and results of
operations.



Domestic and international revenues were
approximately 66% and 34% of total revenues, respectively, for the quarter ended October 31, 2003. Domestic and international revenues were approximately 69% and 31% of total revenues, respectively for the quarter ended September 30, 2002. 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 Europe, the Middle-East and Africa (EMEA) 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.



Gross Profit



Gross
profit margin for the quarter ended October 31, 2003 was 58% compared to 53% for the quarter ended September 30, 2002. The increase in our gross profit margins between these periods was the result of the change in the channel partner mix as lower
margin sales to our largest customer represented a smaller portion of total revenue. In addition, our margins benefited from an improved mix of higher-margin product sales and software. Lastly, we are realizing better fixed cost absorption due to
higher total revenue and reduced fixed costs resulting from the implementation of our outsource-focused manufacturing model. We anticipate gross margins will be in the mid-50% range in the fourth quarter as the competitive environment, less
favorable channel and product mix and increased amortization of capitalized software lower the levels experienced during this current third quarter.



19



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Operating Expenses



Research and Development Expenses. Research and development expenses increased to $23.6 million for the quarter ended
October 31, 2003, compared with $15.7 million for the quarter ended September 30, 2002. The approximate 51% increase was the result of retention bonuses and incremental spending associated with our acquisitions, and increases in depreciation costs
related to the new engineering building occupied in the second half of 2002. In addition, we saw increased spending for prototype and non-recurring expenses related to the design and testing of our products. Capitalized software costs remained at
comparable levels between quarters at $2.0 million and $2.2 million for the quarters ended October 31, 2003 and September 30, 2002, respectively. We anticipate the level of spending for the design, testing and qualification of our products to
increase over prior years levels as we continue to broaden our product offerings and integrate the personnel and technology of Nishan and Sanera.



Selling and Marketing Expenses. Selling and marketing expenses increased to $23.5 million for the quarter ended October 31, 2003, compared with
$17.8 million for the quarter ended September 30, 2002. Net increases in sales and marketing expenses were primarily due to retention bonuses associated with our acquisitions and increased salaries and sales-related travel costs associated with
increased revenues. These increases were partially offset by reductions in expenses related to our demonstration and evaluation equipment. We believe that selling and marketing expenses will increase in the fourth quarter as we fully integrate the
personnel from Nishan and Sanera.



General and
Administrative Expenses. General and administrative expenses increased by approximately 53% to $10.7 million for the quarter ended October 31, 2003 from $7.0 million for the quarter ended September 30, 2002. During the quarter ended October 31,
2003, we recorded new personnel and facilities costs associated with our acquisitions and increased amortization expense associated with purchased intangibles. In addition, we saw increased spending for accounting fees, health claims, and
directors and officers insurance premiums . Amortization expenses related to purchased intangibles will increase in the fourth quarter as the full impact of our acquisitions made during the quarter ended October 31, 2003 are realized. In
addition, levels of spending for accounting-related expenses, health, and D&O insurance are expected to remain at current levels, given the current economic and business environment.



Amortization of Deferred Compensation. We have recorded deferred compensation in connection with Class B stock
options granted prior to our August 9, 2000 initial public offering and restricted Class B stock grants granted through our equity incentive programs. In addition, in connection with our acquisitions during the quarter, we issued approximately 1.0
million shares of Class B restricted common stock with vesting periods ranging from 12 to 24 months. In addition, 300,000 shares vested immediately upon the retention of employees at Nishan and Sanera and were fully expensed during the quarter ended
October 31, 2003. We are amortizing all deferred compensation on a straight-line basis over the vesting period of the applicable options and stock awards, resulting in amortization expense of $6.0 million for the quarter ended October 31, 2003 and
$2.4 million for the quarter ended September 30, 2002 (of which approximately $285,000 and $137,000 was included in cost of revenue for the quarters ended October 31, 2003 and September 30, 2002, respectively). Deferred compensation expense levels
fluctuate with the option and restricted stock award activity. Additional grants of these awards under existing compensations plans, future plans or through acquisitions could increase the level of deferred compensation expense.



Acquired In-Process Research and Development (IPR&D). In
connection with an equity investment in Aarohi and our acquisition of Nishan in September 2003, a portion of the respective purchase prices was allocated to IPR&D. This IPR&D was expensed at the time of purchase because technological
feasibility had not been established and no future alternative use existed. The IPR&D charge for the three months ended October 31, 2003 totaled $11.4 million.



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 for both the quarters ended October 31, 2003 and September 30, 2002 was approximately $1.9 million.



Interest Expense.Interest expense was approximately $200,000 for the quarter ended October 31, 2003 compared with
$89,000 for the quarter ended September 30, 2002. Interest expense represents the interest cost associated with our 2.25% convertible subordinated notes issued in February 2003 and interest incurred for our various capital lease obligations. In July
2003, we entered into an interest-rate swap agreement 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. The initial LIBOR setting for the swap was 1.1283%, creating a rate of approximately minus 0.39%,
which is effective until February 15, 2004. This rate will significantly reduce our overall interest expense during this six-month period. Significant increases in interest rates in future periods could significantly increase interest expense.



20



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Provision for Income Taxes. For the quarter ended October 31, 2003, we recorded a non-cash charge
of $38.7 million to create a valuation allowance against our deferred tax asset. For the quarter ended September 30, 2002, we identified and recorded a $1.2 million tax benefit generated from our 2001 Research and Development Tax Credit. Excluding
both of the non-cash charge and the tax benefit, the effective tax rates were 42% and 33% for the quarters ended October 31, 2003 and September 30, 2002, respectively. The effective tax rate is determined by the relationship between pre-tax book
income or loss and certain amounts which are reported differently between the financial statements and the tax return. For the quarter ended October 31, 2003, we generated a pre-tax book loss while the quarter ended September 30, 2002, reflected
pre-tax book income. For the quarter ended October 31, 2003, our adjusted effective tax rate benefits primarily from the reduction in deferred compensation and the deductibility of costs associated with our convertible subordinated debt. These tax
rate benefits are offset by higher tax costs on our investment income due to a reduction in tax-exempt investments.



Equity in Net Loss of Affiliated Company.During the quarter ended October 31, 2003, we purchased a 22% equity ownership in Aarohi in exchange for
$6 million in cash. We have recorded a $591,000 charge representing our ownership share of Aarohis net loss for the period of purchase through October 31, 2003.



Nine months ended October 31, 2003 and September 30, 2002



Revenues



Total revenue increased by approximately 37% to $304.9 million for the nine
months ended October 31, 2003 from $222.7 million for the nine months ended September 30, 2002. This significant increase in revenue reflects strong demand from our products, in particular our SphereonTM4500 switch that was introduced in the last half of 2002. Although, we continue to see solid end-user demand and increased year-over-year revenue for our
products and solutions, the on-going competitive marketplace is expected to create a challenging sales environment for the foreseeable future. Given the entrance of new competitors and products in our industry, we anticipate longer sales cycles and
price declines that could negatively impact our revenue growth rate. We are currently on track with the development of new products, which incorporate the new technologies from our acquisitions of Nishan and Sanera. In addition, we are taking action
to continue sales of existing products acquired in connection with our acquisition of Nishan.



Product revenue of $265.3 million for the nine months ended October 31, 2003 was a 38% increase over product revenue of $192.1 million for the nine months ended September 30, 2002. This revenue increase was generated
from the increased demand in our storage products including our 140-port IntrepidTM6000 Series Director and flex
port SphereonTM4500 Fabric Switch.



Software and service revenue increased 35% to $27.6 million for the nine months ended October 31, 2003 from $20.4 million
for the nine months ended September 30, 2002. We continue to experience revenue growth from the sale of all our software products, in particular, our SANavigator®and SANtegritysoftware. A significant portion of our software revenue is generated from sales of our Enterprise Fabric Connectivity Manager, or EFCM, software product.



Other revenues remained consistent with the prior year with $11.9 million and
$10.2 million realized for the nine months ended October 31, 2003 and September 30, 2002, respectively. This revenue reflects the growth in maintenance fees, which were partially offset by the decline in service fees related to the ESCON service
agreement with EMC. We anticipate that service revenue from EMC under the ESCON service agreement will continue to decrease in future periods.



A significant portion of our revenue is concentrated with the largest storage OEMs. For the nine months ended October 31, 2003, approximately 59% of our
total revenue, excluding the ESCON service fee, came from EMC, compared to 53% for the nine months ended September 30, 2002. Additionally, IBM contributed approximately 19% of our revenue for the nine months ended October 31, 2003 compared to 24%
for the nine months ended September 30, 2002. Although we saw increased revenues from both customers during the nine months ended October 31, 2003, IBM as a percentage of revenue decreased from the prior year due to shifting product mix, including
FICON product sales. In addition, we have seen the level of revenues for the majority of our other OEM customers increase during the current year. 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.



Domestic and international revenues were approximately 69% and 31% of total revenues, respectively, for the nine months ended October 31, 2003. Domestic
and international revenues were 66% and 34%, respectively for the nine months ended September 30, 2002. 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 EMEA 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



21



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sales to certain OEM customers. International revenues for the nine months ended September 30, 2002 represented a higher percentage of revenue as a result of
the large domestic order reduction by EMC during the first quarter of the year associated with the technology transition to 2 Gb products. During the nine months ended October 31, 2003, we experienced an increase in total international revenues,
however, sales to customers in the Asia Pacific region decreased in the first quarter ended April 30, 2003, possibly due to the SARS virus.



Gross Profit



Gross profit margin for the nine months ended October 31, 2003 was 58% compared to 41% for the nine months ended September 30, 2002. During the nine
months ended October 31, 2003, we released inventory-related reserves and obligations of approximately $2.7 million primarily relating to the expiration of customer sales obligations, reductions of our estimates of excess and obsolete inventory and
improved warranty experience. These reserve releases resulted in approximately 1.0% of the gross profit margin increase. In addition, during the nine months ended September 30, 2002, we incurred a $12.9 million net inventory-related charge primarily
for the excess 1 Gb components used in our discontinued 1 Gb products. Excluding this write-down, the gross profit margin percentage for the nine months ended September 30, 2002 would have been 47%. The significant increase in gross profit margins,
excluding the items discussed above was the result of newly introduced 2 Gb product pricing, an improved mix of higher-margin software and new product sales. In addition, we are realizing better fixed cost absorption due to higher total revenue and
reduced fixed costs resulting from the implementation of our outsource-focused manufacturing model.



Operating Expenses



Research and Development Expenses. Research and development expenses increased to $60.5 million for the nine months ended October 31, 2003,
compared with $43.5 million for the nine months ended September 30, 2002. The approximate 39% increase was primarily attributable to retention bonuses and incremental spending associated with our acquisitions, reductions in capitalized software
costs, increases in personnel costs, non-recurring engineering charges, and depreciation related to engineering and test equipment and the new engineering building occupied in the second half of 2002. Capitalized software costs were approximately
$4.9 million and $6.8 million for the nine months ended October 31, 2003 and September 30, 2002, respectively. Capitalized software development costs have decreased in conjunction with the varying stages of development of our application software
and our new director and switch products and the related firmware software. We anticipate the level of spending for the design, testing and qualification of our products to increase over prior years levels as we continue to broaden our product
offerings and integrate the personnel and technology of Nishan and Sanera.



Selling and Marketing Expenses. Selling and marketing expenses increased to $70.5 million for the nine months ended October 31, 2003, compared with $54.5 million for the nine months ended September 30, 2002.
Increases in sales and marketing expenses were primarily due to increased salaries, commissions and travel costs associated with increased year to date revenues. In addition, demonstration equipment and marketing costs associated with the completion
of two new OEM contracts as well as market development activities with our partners increased our overall sales and marketing expenses. We believe that selling and marketing expenses will increase in the fourth quarter as we fully integrate the
personnel from Nishan and Sanera.



General and
Administrative Expenses. General and administrative expenses increased by approximately 14% to $25.3 million for the nine months ended October 31, 2003 from $22.3 million for the nine months ended September 30, 2002. Amortization expense for
purchased intangible assets increased significantly as a result of our third quarter acquisitions. These expenses will increase in Q4 2003 to reflect a full period of amortization and then plateau for the foreseeable future. In addition, we
experienced increased personnel costs, equipment and facilities costs while realizing overall reductions in bad debt and legal expenses. Expenses for the nine months ended September 30, 2002 included significant legal expenses related to the ongoing
patent infringement lawsuit (see Part II, Item 1, Legal Proceedings) and $1.75 million in charges related to the termination of a collateralized lease and the disposal of fixed assets.



Amortization of Deferred Compensation. We have recorded deferred compensation in connection with Class B stock
options granted prior to our August 9, 2000 initial public offering (cheap stock) and restricted Class B stock grants granted through our equity incentive programs. In addition, in connection with our acquisitions during the quarter, we issued
approximately 1.0 million shares of Class B restricted common stock with vesting periods ranging from 12 to 24 months. In addition, 300,000 shares vested immediately upon the retention of employees at Nishan and Sanera and were fully expensed during
the quarter ended October 31, 2003. We are amortizing all deferred compensation on a straight-line basis over the vesting period of the applicable options and stock awards, resulting in amortization expense of $9.2 million for the nine months ended
October 31, 2003 and $7.0 million for the nine months ended September 30, 2002 (of which approximately $555,000 and $455,000 was included in cost of revenue for the nine months ended October 31, 2003 and September 30, 2002, respectively). Deferred
compensation expense levels fluctuate with the option and restricted stock award activity. Additional grants of these awards under existing compensations plans, future plans or through acquisitions could increase the level of deferred compensation
expense.



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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 for the nine months ended October 31, 2003 was approximately $5.5 million. Interest and other income for the nine months ended September 30, 2002 was approximately
$5.9 million. For the nine months ended October 31, 2003, average cash and investment balances were higher related to cash generated from operations and the net proceeds from convertible subordinated notes that were issued in February 2003 (see Note
5  Convertible Subordinated Debt in the Notes to Condensed Consolidated Financial Statements). The increased interest earnings on the higher cash and investment balances were offset by lower interest rates. If interest rates
decrease, interest income may decrease in future periods.



Interest Expense.Interest expense was $2.5 million for the nine months ended October 31, 2003 compared with $220,000 for the nine months ended September 30, 2002. Interest expense primarily represents the interest cost associated
with our 2.25% convertible subordinated notes issued in February 2003. In July 2003, we entered into an interest-rate swap agreement 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. The initial
six-month LIBOR setting for the swap was 1.1283%, creating a rate of approximately minus 0.39%, which is effective until February 15, 2004. This rate will significantly reduce our overall interest expense during this period. Significant increases in
interest rates in future periods could significantly increase interest expense.



Provision for Income Taxes. During the nine months ended October 31, 2003, we recorded a non-cash charge of $38.7 million to create a valuation allowance against our deferred tax asset. Excluding the non-cash
charge, the effective tax rates were (15)% and 33% for the nine months ended October 31, 2003 and September 30, 2002, respectively. The effective tax rate is determined by the relationship between pre-tax book income or loss and certain amounts
which are reported differently between the financial statements and the tax return. For the nine months ended October 31, 2003, we generated pre-tax book income while the nine months ended September 30, 2002, reflected a pre-tax book loss. For the
nine months ended October 31, 2003, our adjusted effective tax rate benefits primarily from the favorable settlement of tax items related to previous years, the reduction in deferred compensation and the deductibility of costs associated with our
convertible subordinated debt. These tax rate benefits are offset by higher tax costs on our investment income due to a reduction in tax-exempt investments.



Liquidity and Capital Resources



Cash and cash equivalents and available-for-sale investments were $312 million at October 31, 2003, excluding restricted cash. This was a slight decrease
from $328 million at January 31, 2003. We generated approximately $45.1 million in net cash from operating activities, primarily from net income before non-cash charges of depreciation and amortization, deferred compensation, inventory-related
provisions, IPR&D and deferred income tax benefits. Also, contributing to the cash from operations was an increase in our accounts payable and accrued liabilities, offset by increases in accounts receivable and inventory balances from January
31, 2003.



Net cash used in investing activities was $244
million related primarily to the third quarter acquisitions of Nishan and Sanera and our equity investment in Aarohi. In addition, the use of cash also reflects our investment of the proceeds received from our issuance of convertible subordinated
notes in February 2003 into our short and long-term investment portfolio. Net cash from financing activities was $130 million reflecting the net proceeds of $167 million, which were received from the issuance of convertible subordinated notes in
February 2003 and the use of $20.5 million of those proceeds to enter into share option transactions.



Our principal sources of liquidity at October 31, 2003 consisted of our cash and available-for-sale investments of $312 million and net accounts
receivable of $59.5 million. 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, our authorized share
repurchase program, payment of retention bonuses related to our business acquisitions and other cash outlays in the foreseeable future. With changes in operating and industry expectations, however, we could 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.



Commitments



We have entered into agreements with the contract manufacturers for the manufacture of printed circuit boards and box build assembly for specific
Multi-protocol directors and switches. The agreements require us to submit purchasing forecasts and place orders sixty calendar days in advance of delivery. At October 31, 2003, our commitment with the contract manufacturers for purchases over the
next sixty days totaled $44.5 million. We may be liable for materials that the contract 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. At
October 31, 2003, we had recorded obligations of approximately $8 million primarily related to materials purchased by our contract manufacturers



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for certain end-of-life and obsolete material used to manufacture our products. We do not expect the remaining commitments under these agreements to have a
continued material adverse effect on our 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 (see Note 7, Convertible
Subordinated Debt, of the Notes to Consolidated Financial Statements). 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. 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 $5.5 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 and capital expenditures.



Concurrent with the issuance of the Notes, the Company entered into share option transactions using approximately $20.5 million of net 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 $155.25 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. The reset dates of the swap are February 15 and August 15 of each year until maturity on February 15, 2010. The six-month LIBOR setting for the swap at October 31, 2003 was 1.1283%,
creating a rate of approximately minus 0.39%, which is effective until February 15, 2004. 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. At October 31, 2003, the fair
value of the interest rate swap had decreased from inception by $1.1 million at October 31, 2003 and is included in other long-term liabilities. Corresponding to this change, the carrying value of the Notes has decreased by $1.1 million. 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 $5.1 million at October 31, 2003.



Recent Accounting Pronouncements



For information regarding recent accounting pronouncements, see Note 1 of Notes to Condensed Consolidated Financial Statements, included in
Item 1 of this Form 10-Q.



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 more competitive with (a) the entrance of new competitors from the Internet Protocol (IP) based switching market into our market, (b) pricing pressures resulting from an increase in competitive SAN networking products and
solutions, (c) challenges to our indirect sales assist distribution model 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 a lengthening of product sales cycles and price erosion in an environment where storage OEM certification of our products may still be required
for end-user customer acceptance in the marketplace. Further, given our indirect sales assist distribution model through our channel partners, we are highly dependent upon their 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 negatively affect our revenues.



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These market conditions present unique risks and uncertainties in a number of respects. Given our
concentration of sales with EMC, the revenue shortfall with EMC experienced in the fiscal quarter ending October 31, 2003 and EMCs public statements that they will further reduce their suppliers prices, we may experience unanticipated
decreases in sales revenue and gross margins that may lead us to be unprofitable. The above-mentioned factors may also strain business relationships with our storage OEM partners and may adversely affect the qualification and certification of our
products. Moreover, the introduction of such new products and any pending qualification and certification by our partners may stall sales of our existing products with end user customers.



We incurred a substantial loss for the nine months ended October 31, 2003 and for the years ended December 31, 2002 and 2001 and may not
maintain profitability in the future.



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



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



In response to changes in product mix, competitive pricing pressures, increased sales discounts, introductions of new products and product enhancements by
our competitors, increases in manufacturing or labor costs or other operating expenses, we may experience declines in both the 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 manufacturing cost of 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 and services to EMC, which is an original equipment manufacturer customer,
represented approximately 54% of our revenue for the three months ended October 31, 2003. We experienced a revenue decline during this quarter, which was driven by an inability to reach an agreement in a timely manner, thereby reducing the shipment
of products during the quarter. Sales to IBM represented approximately 21% of our revenue for the nine months ended October 31, 2003. 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 or 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 partners do not
provide for the purchase of a guaranteed minimum a mount of product.



Risks
related to recent acquisitions.



On August 25, 2003, we
announced that we had entered into agreements to acquire Nishan Systems, Inc. and Sanera Systems, Inc., While management believes that such acquisitions are an integral part of its 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 finalizing the development of such products (if needed), retaining critical employees from the acquired companies, qualifying such products with our OEM and
reseller partners and ramping sales of those products with such partners.



Our business is subject to risks from global operations.



We conduct significant sales and customer support operations in countries outside of the United States and also depend on non-U.S. operations of our contract manufacturers and our distribution partners. We derived
approximately 32% of our revenue for the quarter ended October 31, 2003, 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;
| | - | ---------------------------------------------------------------------------------------



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



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



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



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 harmed and we may not be able to obtain financing in the
capital markets.



The market for Multi-protocol network directors, switches
and other products for SANs is highly competitive, 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 network switching hardware and software products is highly competitive, especially with
the entrance of competitors from the Internet Protocol (IP) based switch market. Our competitors are providing 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 (which recently acquired Vixel Corporation), Broadcom Corporation (which recently acquired the assets of Gadzoox Networks),
Veritas Software Corporation, Fujitsu Softech and others, and even storage providers. Given the market share gain by Cisco, other IP based switching companies such as Juniper, Extreme, Foundry and others will likely enter the market for
Multi-protocol 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 we have. Given the highly competitive market, we anticipate longer sales cycles and continued pricing pressures.



To be competitive, we may have to substantially increase our direct sales, which we may not be able to do successfully and which, in any case, will
increase expenses.



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



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



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 October 31, 2003, we derived a significant
portion of our revenue from sales of our Director-class products. We expect that revenue from our Director-class products will continue to account for a substantial portion of our revenue for the foreseeable future. Therefore, continued market
acceptance of these products and their successor products is critical to our future success. Factors such as performance, market positioning, the availability and price of competing products, the introduction of new technologies and the success of
our OEMs, reseller and systems integrator customers will affect the market acceptance of our products.



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. For instance, there are competing protocols for storage area network switches and related devices, such as SCSI over Internet (iSCSI), Fibre Channel over IP (FCIP), Internet Fibre Channel (iFCP) and InfiniBand, which may be more readily
adopted or accepted by our customers. 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 2 to 4 Gb and to 10 Gb transmission
speed technology, higher port density, and advanced management capabilities over Multi-protocols, we will be introducing products with new features and functionality. We face risks relating to this product transition, including risks relating to
getting storage and system OEMs to qualify such products, 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 timely introduce new products, 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.



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



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



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



Our success depends to a significant degree upon the continued contributions
of our key management, technical, sales and marketing, finance and operations personnel, many of whom would be difficult to replace. In particular, we believe that our future success is highly dependent on our senior executive team. In the past we
have experienced high turnover in our senior executive team. A significant portion of the current senior executive team was hired during the last year. Although our senior executive team consists of experienced members, many of them are new to our
company and have only worked with each other for a short period of time. As a result they may not operate efficiently as part of an integrated management team.



In addition, our engineering and product development teams are critical in developing our products and have developed important relationships with
customers and their technical staffs. The loss of any of these key personnel could harm our operations and customer relationships. 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. We do not have key person life insurance on any of our key personnel.



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. As 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



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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 negatively impact our ability to sell our products.



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. For a discussion of our IP litigation, please see Note 13, of the Condensed Consolidated Financial Statements.



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 harmed and our revenue would be reduced.



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



We have experienced increased inventory costs and delays and have incurred inventory-related write-downs.



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



The storage area network market in which we compete is still developing, and if this market does not continue to develop and expand as we
anticipate, our business will suffer.



The market for
storage area network and related products is in its early states of development and continues to evolve. Because this market is relatively new, it is difficult to predict its potential size or future growth rate. Potential end-user customers who
have invested substantial resources in their existing data storage and management systems may be reluctant or slow to adopt a new approach, like SANs. Our success in generating net revenue in this developing market will therefore depend on, among
other things, our ability to:



| |  | educate potential OEMs, reseller and systems integrator customers and end users about the benefits of SANs and the use of our products in the SAN environment, and
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | predict, develop and base our products on standards that ultimately become industry standards.
| | - | ----------------------------------------------------------------------------------------------





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Accordingly, because substantially all of our revenues are derived from our SAN solutions, the adoption
of SANs as an integral part of data-intensive enterprise computing environments is critical to our future success and delays or failure to adopt our SAN and related products will have an adverse effect on revenue and operations.



In addition, the market for products that connect geographically disbursed
SANs through gateways to the internet has only recently begun to develop and continues to evolve.



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 provide first and second level customer support. If this occurs, we may need to substantially invest in a direct sales force and 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) 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 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. If our
suppliers are unable to provide, or we are unable otherwise to obtain these components for our products on the schedule and in the quantities we require, we will be unable to manufacture our products. We have experienced and may continue to
experience production delays and quality control problems with certain of our suppliers, which, if not effectively managed, could prevent us from satisfying our production requirements. If we fail to effectively manage our relationships with these
key suppliers, or if our suppliers experience delays, disruptions, capacity constraints or quality control problems in their manufacturing operations, our ability to manufacture and ship products to our customers could be delayed, and our
competitive position, reputation, business, financial condition and results of operations could be seriously harmed.



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., or SSCI, and Solectron Corporation, together our contract manufacturers, to manufacture substantially all of our circuit boards and to perform extensive testing and assembly of our
products. Our supply contract with SSCI is cancelable by either party without cause on advance notice. In May 2002, we outsourced to SSCI the integration of our Directors into cabinets. In mid-2002, we contracted with Solectron to be our contract
manufacturer for our Sphereon4500 24-port switch product. Solectron is also the
contract manufacturer for our recently announced SphereonTM4300 12-port switch. 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 circuit boards 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 this incremental demand and could lose customers. If we over-estimate
demand for our product, we may accumulate excess inventories and obligations to our contract manufacturers under binding purchase orders in excess of our needs. At October 31, 2003, our commitment with our contract manufacturers for purchases and
anticipated transformation costs over the next sixty days totaled approximately $44.5 million.



29



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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 revenue and damage our
customer relationships.



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



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



We have operated as a separate company from EMC only since February 2001. EMC, which currently accounts for a significant portion of our revenue, markets our products under its own brand name. As a result, our name is
not widely recognized as a brand in the marketplace. We believe that establishing and maintaining the McDATA brand is a critical component in maintaining and developing strategic original equipment manufacturer, 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.



We are defendants in several class action lawsuits and we may be subject to further litigation in the future which could seriously harm our business.



As more fully set forth in Note 13 to our Condensed Consolidated
Financial Statements, we are a defendant in a consolidated securities class action 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 divert the attention of management and our resources and seriously harm our business, financial condition and results of operation.



30



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



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



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



| |  | the size, timing, terms and fluctuations of customer orders, particularly large orders from our significant OEM (e.g. EMC) or reseller customers (e.g. IBM);
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



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



| |  | the timing of the introduction or enhancement of 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 brand awareness or to invest in research and development.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------



Our uneven sales pattern makes it difficult for our management to predict
near-term demand and adjust manufacturing capacity 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.



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.



We may engage in future acquisitions that dilute our stockholders 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.
| | - | -------------------



31



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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.



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 addition, 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
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 materially 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;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



32



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| |  | 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, in connection with the reorganization of our business, we entered into certain agreements with EMC relating to our business relationship
with EMC. In addition, we have entered into agreements with EMC relating to our relationship with EMC after the completion of our initial public offering in August 2000 and the distribution by EMC of our Class A common stock in February 2001. We
have also entered into an OEM Purchase and License Agreement with EMC that governs EMCs purchases of our products and grants EMC rights to use, support and distribute software for use in connection with these products. The agreement does not
provide for the purchase of a guaranteed minimum amount of product. These agreements were negotiated and made in the context of our prior parent-subsidiary relationship. As a result, some of these agreements may have terms and conditions, in the
case of the OEM agreement, 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 represented approximately 54% of our
revenue for the three months ended October 31, 2003. 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 by EMC of our Class A common stock to EMCs stockholders may prevent a change in control of our company.



Under the terms of the Master Confidential Disclosure and License Agreement between EMC and us, EMC has granted us a license
under then existing EMC patents. If we are acquired, our acquirer will retain this license as long as our acquirer grants to EMC 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 Series A common stock to EMCs stockholders was not tax free.



The 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 that it indirectly held 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.
| | - | --------------------------------------------------------------------



33



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As a result, we may be liable to EMC under the Tax Sharing Agreement upon the occurrence of events that
are beyond our control. If the distribution of our Class A common stock fails to qualify as a tax-free distribution, EMC would incur tax liability as if our Class A common stock that was distributed by EMC had been sold by EMC for its fair market
value in a taxable transaction, and we would be required to indemnify EMC under the Tax Sharing Agreement. In the event that we are required to indemnify EMC because the distribution of our Class A common stock fails to qualify as a tax-free
distribution, our liability could exceed 35% of the value of the Class A common stock distributed by EMC as determined on the date of the distribution. If triggered, this indemnity obligation would have a significant adverse effect on our financial
position and results of operations, and we might not have sufficient resources to fulfill it.



|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 from overnight to two 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 7  Quantitative and Qualitative Disclosure About Market Risk, contained in our Form 10-K.



Our convertible subordinated notes are subject to a fixed interest rate and such 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 by 100 basis points, our annual
interest expense would increase or decrease by approximately $1.6 million. This increased 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 PortalSMMarket. On December 5, 2003, the approximate bid price of our notes was $116.25 and the approximate ask price of our notes was $116.75, resulting in an aggregate fair value of between $200.5 million and $201.4million. Our
Class A common stock is quoted on the Nasdaq National Market under the symbol, MCDTA. On December 5, 2003, the last reported sale price of our Class A common stock on the Nasdaq National Market was $8.88 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. However, increases 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.



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) as more fully described in Item 2.  Managements Discussion and Analysis of Financial Condition and Results of
OperationsCommitments. Subject to the



34



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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
|------- | -----------------------



Disclosure Controls and Procedures



The Companys CEO and CFO have evaluated the effectiveness of the Companys disclosure controls and procedures (as such term is defined in Rules
13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based on such evaluation, the Companys Chief Executive Officer and Chief Financial Officer have concluded that,
as of the end of such period, except as disclosed in this report, the Companys disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the
Company in the reports that it files or submits under the Securities Exchange Act of 1934, as amended.



Internal Controls over Financial Reporting



Except as disclosed below, there have not been any changes in the Companys internal controls over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act
of 1934, as amended) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.



Third Quarter Balance Sheet Reclassification/Restatement



On February 26, 2004, the Company announced that it would amend its Form
10-Q for the quarter ending October 31, 2003 to reflect a balance sheet reclassification. The reclassification did not affect either the income statement or the statement of cash flows for the quarter. The reclassification results from a securities
lending program with Wells Fargo Bank, N.A. (Wells Fargo), which the company began during that quarter. Under the program the Companys investment securities may be loaned against a pledge of cash collateral, which is held by Wells
Fargo as the Companys agent.



In accordance with
generally accepted accounting principles, the balance sheet in this amended Form 10-Q shows the addition of a line item entitled Securities lending collateral as a current asset and the addition of a line item entitled
Securities lending collateral payable as a current liability, both for the approximate amount of $109.5 million. These two balance sheet adjustments net to zero, and neither the income statement nor the statement of cash flows is
affected.



As part of its year-end review, the Company
subsequently identified the applicability of FAS 140 to the previous quarters securities lending program. In its review, the Company investigated the cause of the reclassification and has concluded that while the transaction was communicated
prior to the filing, the Company did not appropriately apply SFAS 140 to the securities lending program in preparing its financial statements for the quarter ending October 31, 2003. In response to the reclassification, the Companys
independent auditors have indicated in a letter to the Company that it believes that a material weakness under AU 325, Communication of Internal Control Related Matters Noted In An Audit, existed with regard to the evaluation of the
appropriate accounting treatment for the securities lending program. As a result, the Company has implemented enhanced policies and procedures including additional cross-functional meetings with the Finance organization, establishment of an issues
log, adding additional support personnel dedicated to this area and improvements in existing formal investment policies. The Company believes that it has implemented the recommended changes within its internal controls to improve the timely
accounting evaluation and treatment of such transactions.



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.



35



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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. While it is the current opinion of management that the ultimate disposition of any of the
lawsuits described herein should not have a material adverse effect on our consolidated results of operations, financial position or cash flow, we are incurring significant legal costs and expenses, and such litigation is subject to inherent risks
and uncertainties. Please see Note 13 of the Condensed Consolidated Financial Statements for a description of significant litigation matters.



|ITEM 2. | Changes in Securities and Use of Proceeds
|------- | -----------------------------------------



In February 2003, we issued $172.5 million of 2.25% Convertible Subordinated Notes due 2010 (the Notes). The Notes were issued to the Bank of
America Securities LLC and Solomon Smith Barney Inc., in transactions exempt from the Securities Act of 1933, as amended (the Securities Act) and subsequently resold to Qualified Institutional Buyers in reliance on Rule 144A and Regulation S of the
Securities Act of 1933, as amended. We capitalized the initial transaction fees associated with the Notes, which totaled approximately $5.5 million, and the net proceeds to the Company were approximately $167 million. The net proceeds shall be used
for general corporate purposes.



The Notes are subordinate in
right of payment to all existing and future senior indebtedness. The holders of the Notes may convert all or some of their Notes to Class A common stock at any time at a conversion price of $10.71 per share. The initial conversion rate is 93.3986
common shares per $1,000 principal amount of the Notes and is subject to adjustment under certain circumstances. Upon a conversion, the Company may choose to deliver, in lieu of shares of its Class A common stock, cash or a combination of cash and
shares of Class A common stock. Holders of the Notes have the right to require the Company to repurchase their Notes at par upon the occurrence of certain fundamental changes. The Company has filed a registration statement with respect to the Notes
and the Class A common stock issuable upon conversion of the Notes.



|ITEM 3. | Defaults Upon Senior Securities
|------- | -------------------------------



None



|ITEM 4. | Submission of Matters to A Vote of Security Holders
|------- | ---------------------------------------------------



The annual meeting of the Companys stockholders was held on August 27, 2003. At that meeting, three proposals were submitted to a vote of the
Companys stockholders. Proposal 1 was a proposal to elect three directors, Charles C. Johnston, John F. McDonnell and Laurence G. Walker, to serve until the 2006 Annual Meeting of Stockholders. Proposal 2 was a proposal to ratify the
appointment of PricewaterhouseCoopers LLP as the Companys independent public accountants for the fiscal year ending January 31, 2004. Proposal 3 was a proposal to amend the 2001 McDATA Equity Incentive Plan to (a) increase the authorized
number of Class B common stock shares issuable under the plan by 6 million (from 24 million to 30 million), (b) extend the termination date of the 2001 Plan from September 30, 2007 to September 30, 2010 and (c) increase the maximum option term for
nonstatutory stock options to 10 years and 1 month to avoid adverse tax issues in foreign countries. For further information regarding the annual meeting, please see the Companys Proxy Statement on Schedule 14A filed on July 3, 2003.



|                                                                     |  |                 |  |            |  |                 
|-------------------------------------------------------------------- |  | --------------- |  | ---------- |  | ----------------
|                                                                     |  | Number of Votes
|Proposal                                                             |  | For             |  | Against    |  | Abstain/Withhold
|Proposal 1 - Election of director: Charles C. Johnston               |  | 71,521,250      |  |           |  | 1,999,129       
|Proposal 1 - Election of director: John F. McDonnell                 |  | 71,825,097      |  |           |  | 1,695,283       
|Proposal 1 - Election of director: Laurence G. Walker                |  | 69,905,172      |  |           |  | 3,615,208       
|Proposal 2 - Ratification of PricewaterhouseCoopers LLP appointment  |  | 70,938,999      |  | 2,536,850  |  | 44,530          
|Proposal 3 - Approval to amend the McDATA 2001 Equity Incentive Plan |  | 41,320,446      |  | 15,280,812 |  | 706,276         



Consequently, all
proposals were passed by stockholders.



|ITEM 5. | Other Information
|------- | -----------------



In December 2003, the Company entered into a one year single trigger severance agreement for John Kelley, the Companys Chief Executive Officer and
President, should he be terminated without cause or voluntarily leaves for good reason. The Company would receive in consideration for the severance agreement (a) an extension of Mr. Kelleys current 12 month restriction, to not compete against
the company and to not solicit Company employees after such termination, to 24 months and (b) a release of all claims, if any, against the Company before payment of any benefits thereunder. The benefits under the severance agreement would include
one year of salary and target bonus, medical benefits under COBRA for up to one year, an extension of option exerciseablity from ninety days to one year and continued vesting of restricted stock for one year after termination. Mr. Kelleys
existing Change of



36



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Control Severance Agreement, as more fully described in the Companys Proxy Statement, would continue to be in full force and effect, however benefits
under the new single trigger severance agreement would not be payable if the Change of Control Severance Agreement is triggered.



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



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



|         |  |                                                                                                                                                                                                           
|-------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|         | 
|(3.1)    |  | Amended and Restated Certificate of Incorporation of the Company.                                                                                                                                         
|         | 
|(3.2)    |  | Amended and Restated By-laws of the Company.                                                                                                                                                              
|         | 
|(4.1)    |  | Form of Companys Class B Common Stock Certificates.                                                                                                                                                      
|         | 
|(4.1.1)  |  | Form of Companys Class A Common Stock Certificates.                                                                                                                                                      
|         | 
|(4.2)    |  | Investors Rights Agreement dated as of October 1, 1997 by and among the Company, EMC Corporation, McDATA Holdings Corporation and Certain Investors.                                                     
|         | 
|(4.3)    |  | Amendment No. 1 to the Investors Rights Agreement dated May 23, 2000 by and among the Company, McDATA Holdings Corporation and certain Investors.                                                        
|         | 
|(4.4)    |  | Rights Agreement dated as of May 18, 2001, by and between the Company and the Bank of New York, as rights agent (Filed on Form 8-K dated May 21, 2001).                                                   
|         | 
|(4.5)    |  | Form of Indenture dated as of February 7, 2003 by and between the Company and Wells Fargo Bank Minnesota, National Association (Filed on Form 8-K dated February 14, 2003).                               
|         | 
|(4.6)    |  | Form of Registration Rights Agreement dated as of February 7, 2003 by and among the Company and the parties thereto (Filed on Form 8-K dated February 14, 2003).                                          
|         | 
|(10.1)   |  | Asset Transfer Agreement dated as of October 1, 1997 by and among the Company, EMC Corporation, and McDATA Holdings Corporation.                                                                          
|         | 
|(10.2)   |  | Investors Rights Agreement dated as of October 1, 1997 by and among the Company, EMC Corporation, McDATA Holdings Corporation and certain Investors (see Exhibit 4.2).                                   
|         | 
|(10.3)   |  | Amendment No. 1 to the Investors Rights Agreement dated May 23, 2000 by and among the Company, McDATA Holdings Corporation and certain Investors (see Exhibit 4.3).                                      
|         | 
|(10.3.1) |  | Termination of Investors Rights Agreement, dated as of January 24, 2001, by and among the Company, McDATA Holdings Corporation and Certain Investors (Filed on Form 10-K for the fiscal
year ended 2000).
|         | 
|(10.4)   |  | Services Agreement dated as of October 1, 1997 by and among EMC Corporation, McDATA Holdings Corporation and the Company.                                                                                 
|         | 
|(10.5)   |  | Letter Agreement dated April 19, 1999 by and between the Company and McDATA Holdings Corporation.                                                                                                         
|         | 
|(10.6)   |  | Technology Rights Agreement dated as of October 1, 1997 by and among the Company, EMC Corporation and McDATA Holdings Corporation.                                                                        
|         | 
|(10.7)   |  | Amended and Restated Tax Sharing Agreement dated as of May 31, 2000 by and among EMC Corporation, McDATA Holdings Corporation and the Company.                                                            
|         | 
|(10.8)   |  | Form of Master Transaction Agreement entered into by and among the Company and EMC Corporation dated May 31, 2000.                                                                                        
|         | 
|(10.9)   |  | Form of Indemnification and Insurance Matters Agreement entered into by and among the Company and EMC Corporation dated May 31, 2000.                                                                     
|         | 
|(10.10)  |  | Master Confidential Disclosure and License Agreement dated as of May 31, 2000 by and among the Company and EMC Corporation.                                                                               
|         | 
|(10.11)+ |  | Reseller Agreement dated as of February 22, 2000 by and between International Business Machines Corporation and the Company.                                                                              
|         | 
|(10.12)  |  | Amendment Number One to the Resale Agreement dated September 30, 2000 by and between International Business Machines Corporation and the Company.                                                         
|         | 
|(10.13)+ |  | OEM Purchase and License Agreement dated as of May 19, 2000 by and between EMC Corporation and the Company.                                                                                               



37



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|           |  |                                                                                                                                                                                                             
|---------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|           | 
|(10.13.1)+ |  | Amendment to OEM Purchase and License Agreement dated as of September 21, 2001, by and between EMC Corporation and the Company.                                                                             
|           | 
|(10.14)+   |  | Development Agreement dated as of May 19, 2000 by and between EMC Corporation and the Company.                                                                                                              
|           | 
|(10.15)+   |  | Manufacturing Agreement dated as of September 17, 1992 by and between SCI Systems, Inc. and the Company.                                                                                                    
|           | 
|(10.15.1)+ |  | Manufacturing and Purchasing Agreement dated as of December 14, 2001 by and between SCI Systems, Inc. and the Company (Filed on Form 8-K dated February 25, 2002).                                          
|           | 
|(10.15.2)+ |  | Manufacturing and Purchase Agreement effective as of March 1, 2003 by and between Sanmina-SCI Corporation and the Company (Filed on Form 10-K for the year ended December 31,
2002).                        
|           | 
|(10.16)+   |  | OEM and License Agreement dated as of April 27, 1999 by and between Brocade Communication Systems, Inc. and the Company.                                                                                    
|           | 
|(10.17)    |  | Lease dated September 12, 1997 by and between the Company and WHLNF Real Estate Limited Partnership.                                                                                                        
|           | 
|(10.18)    |  | Lease dated November 2, 1999 by and between the Company and the Mills Family LLC.                                                                                                                           
|           | 
|(10.19)    |  | Lease dated May 28, 1997 by and between the Company and 1211486 Ontario Limited.                                                                                                                            
|           | 
|(10.19.1)  |  | Lease dated October 6, 2000, by and between the Company and Amber Drive I, LLC (Filed on Form 10-Q for the fiscal quarter ended September 30, 2000).                                                        
|           | 
|(10.19.2)  |  | Lease dated February 9, 2001 by and between the Company and Deutsche Bank (Filed on Form 10-K for the fiscal year ended 2000).                                                                              
|           | 
|(10.19.3)  |  | Participation Agreement dated February 9, 2001 by and between the Company and Deutsche Bank (Filed on Form 10-K for the fiscal year ended 2000).                                                            
|           | 
|(10.19.4)  |  | Second Amendment to Participation Agreement dated November 9, 2001 by and between the Company and Deutsche Bank (Filed on Form 10-Q for the fiscal quarter ended September 30,
2001).                       
|           | 
|(10.19.5)  |  | Third Amendment to Participation Agreement dated January 24, 2002 by and between the Company and Deutsche Bank (Filed on Form 8-K dated February 25, 2002).                                                 
|           | 
|(10.20)*   |  | Form of Change of Control Severance Agreement.                                                                                                                                                              
|           | 
|10.20.1*   |  | CEO Severance Agreement dated December 2003.                                                                                                                                                                
|           | 
|(10.21)*   |  | 1997 Stock Option Plan.                                                                                                                                                                                     
|           | 
|(10.21.1)* |  | 2001 McDATA Equity Incentive Plan (Filed on Schedule 14A dated July 3, 2003).                                                                                                                               
|           | 
|(10.21.2)* |  | Employee Stock Purchase Plan (Filed on Schedule 14A Proxy Statement filed June 10, 2002).                                                                                                                   
|           | 
|(10.21.3)* |  | 2003 McDATA Acquisition Equity Incentive Plan (Filed on Form S-8 dated September 22, 2003).                                                                                                                 
|           | 
|(10.22)*   |  | Form of Stock Option Agreement for 1997 Stock Option Plan.                                                                                                                                                  
|           | 
|(10.23)*   |  | Description of the Companys Management Bonus Program.                                                                                                                                                      
|           | 
|(10.24)    |  | Asset Purchase Agreement dated August 3, 2001 by and among the Company, SANavigator, Inc., Western Digital Corporation and Connex Inc. (Filed on Form 10-Q for the fiscal quarter ended
September 30, 2001).
|           | 
|(10.25)*   |  | Performance Incentive Bonus Plan (Filed on Form 10-K for the year ended December 31, 2002).                                                                                                                 
|           | 
|(10.25.1)  |  | Agreement and Plan of Merger dated August 25, 2003 by and among the Company, Nice Acquisition, Inc. and Nishan Systems, Inc. (filed on Form 8-K dated August 25, 2003 as Exhibit
99.4).                     
|           | 
|(10.25.2)  |  | Agreement and Plan of Merger dated August 25, 2003 by and among the Company, Whitney Acquisition, Inc. and Sanera Systems, Inc. (filed on Form 8-K dated August 25, 2003 as Exhibit
99.5).                  
|           | 
|(10.26)*   |  | Executive Performance Incentive Bonus Plan (Filed on Form 10-K for the year ended December 31, 2002).                                                                                                       
|           | 
|(10.27)*   |  | Chairman of the Board of Directors Performance Incentive Bonus Plan (Filed on Form 10-K for the year ended December 31, 2002).                                                                              



38



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

---

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



|+ | Portions of these Exhibits have been omitted and filed separately with the Securities and Exchange Commission pursuant to an order for confidential treatment.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------



|* | Executive compensation plans and arrangements.
|- | ----------------------------------------------



|(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                                                                                                                                                                                                                                                                                                                                                  
|August 25, 2003    |  | Item 5, 7 and 9. We filed press releases announcing second quarter 2003 results, the Nishan Systems, Inc. and Sanera Systems, Inc. acquisitions and an investment in Aarohi
Communications.                                                                                                                                                                       
|                   | 
|September 19, 2003 |  | Items 5 and 7. We filed a press release announcing our close of the Nishan Systems, Inc. acquisition.                                                                                                                                                                                                                                                             
|                   | 
|October 1, 2003    |  | Items 5 and 7. We filed a press release announcing that we had closed our acquisition of Sanera Systems, Inc. after close of business on September 30, 2003. In addition, we discussed the
ongoing Rule 10b5-1 Stock Selling Plans for John McDonnell, the Chairman of the Company, and his spouse, and Mike Gustafson, the Vice President of Worldwide Marketing.
|                   | 
|November 6, 2003   |  | Items 7 and 12. We filed a press release announcing preliminary third quarter results.                                                                                                                                                                                                                                                                            
|                   | 
|November 13, 2003  |  | Items 5 and 7. We filed an amendment to our September 19, 2003 8-K filing the required audited, unaudited and pro forma financial statements for Nishan Systems, Inc.                                                                                                                                                                                             
|                   | 
|November 25, 2003  |  | Item 5. We disclosed the announcement that Alain Andreoli, the Companys Executive Vice President of Worldwide Sales and Service, resigned effective December 1, 2003 to pursue another
business opportunity.                                                                                                                                                     
|                   | 
|November 26, 2003  |  | Item 7. We filed an amendment to our October 1, 2003 8-K filing the required audited, unaudited and pro forma financial statements for Sanera Systems, Inc.                                                                                                                                                                                                       
|                   | 
|December 2, 2003   |  | Items 7, 9, and 12. We filed a press release announcing third quarter 2003 results.                                                                                                                                                                                                                                                                               
|                   | 
|December 4, 2003   |  | Item 5. The Board of Directors of McDATA Corporation (the Company) elected M. Alex Mendez as a Class III Board Member and a member of the Boards Technology
Committee.                                                                                                                                                                                         



39



---

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




March 5, 2004



40