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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K/A

(Amendment No. 2)



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|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF SECURITIES EXCHANGE ACT OF 1934
|- | --------------------------------------------------------------------------------



For the fiscal year ended January 31, 2004



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from              to



Commission File No. 000-31257



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McDATA Corporation

(Exact name of registrant as specified in its charter)



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



380 Interlocken
Crescent, Broomfield, Colorado 80021

Telephone Number (720) 558-8000



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Securities registered pursuant to Section 12(b) of the Act:



|                                                         |  |                                          
|-------------------------------------------------------- |  | -----------------------------------------
|Title of each class                                      |  | Name of Each Exchange on Which Registered
|McDATA Class B Common Stock ($0.01 per share, par value) |  | Nasdaq National Market                   



Securities
registered pursuant to Section 12(g) of the Act:



McDATA
Class A Common Stock

($0.01 per share, par value)

Nasdaq National Market



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At April 2, 2004, approximately 81,000,000 shares of the registrants
Class A Common Stock were outstanding and approximately 36,468,048 shares of the registrants Class B Common Stock were outstanding. At July 31, 2003, the aggregate market value of the registrants Class A Common Stock held by
non-affiliates was approximately $871 million and the aggregate market value of the registrants Class B Common Stock held by non-affiliates was approximately $285 million.



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 if disclosure
of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K ̈



Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange
Act of 1934).    Yes  x    No ̈



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EXPLANATORY NOTE



This Amendment No. 2 to the Registrants Form 10-K filed with the Securities and Exchange Commission (SEC) on April 15,
2004 and subsequently amended on April 30, 2004 reflects revised and additional disclosures in response to comments received from the SEC on June 23, 2004. This Amendment No. 2 provides revised and additional disclosures under the following
captions:



| |  | Part II, Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations  Overview, Revenues, Gross
Profit and Operating Expenses,
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Part II, Item 8. Consolidated Financial Statements and Supplementary Data,
| | - | --------------------------------------------------------------------------



| |  | Part II, Item 9A. Controls and Procedures
| | - | -----------------------------------------



| |  | Part IV, Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K  parenthetical disclosure to the Consolidated Income Statements and changes to the
certifications
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



McDATA Corporation

Form 10-K/A



TABLE OF CONTENTS



|     |  |                                                                                       |  |     
|---- |  | ------------------------------------------------------------------------------------- |  | ----
|Item |  | Description                                                                           |  | Page
|     |  | PART II                                                                               |  |     
|     |  |                                                                                      
|7.   |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 1   
|     |  |                                                                                      
|8.   |  | Consolidated Financial Statements and Supplementary Data                              |  | 11  
|     |  |                                                                                      
|9A.  |  | Controls and Procedures                                                               |  | 11  
|     |  |                                                                                      
|     |  | PART IV                                                                               |  |     
|     |  |                                                                                      
|15.  |  | Exhibits, Financial Statement Schedules, and Reports on Form 8-K                      |  | 13  



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PART II



ITEM 7.
Managements Discussion and Analysis of Financial Condition and Results of Operations



This section of the Annual Report on Form 10-K discusses the comparative year over year results of our operations, our liquidity and financial
condition, our risk management practices and our critical accounting policies. You should read the following discussion and analysis in conjunction with the consolidated financial statements and related notes that are included in sections F-3
through F-34 of this document.



Overview



Change of Fiscal Year



On January 15, 2003, we changed our fiscal year end to January 31, from
December 31. We believe that the twelve months ended December 31, 2002 and 2001 provide a meaningful comparison to the twelve months ended January 31, 2004. There are no factors, of which we are aware, seasonal or otherwise, that would impact the
comparability of information or trends, if results for the twelve months ended January 31, 2003 and 2002 were presented in lieu of results for the twelve months ended December 31, 2002 and 2001. References in this discussion to fiscal 2003 represent
the twelve months ended January 31, 2004. References to fiscal 2002 and 2001 represent the twelve months ended December 31, 2002 and 2001.



Revenue Growth and Competitive Industry



Our revenue for the fiscal year ended January 31, 2004 represented a 28% increase over fiscal year 2002 and a 22% increase from fiscal year 2001. This
year over year revenue growth was driven by strong demand for our new Intrepid, Sphereon and
Eclipse® director and switch products, as well as
increased sales of our software and services products. In addition, we broadened our channel mix with the addition of HDS as a greater than 10% customer and initial sales to two new OEMs, Sun and STK. This revenue growth has occurred while the
market for our SAN products and solutions has grown more competitive with (a) the entrance of new competitors into our market, (b) pricing pressures resulting from an increase in competitive products and solutions, (c) challenges to our
direct-assist sales model, 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. These market conditions present unique risks and uncertainties in a number of respects. Management believes the trend of revenue growth and the related competitive environment define the overall performance of the
Company and provide a specific context to further analyze the revenues, operating expenses and liquidity. In particular, we anticipate continued lengthened sales cycles and downward pricing pressures that could negatively impact our revenue growth
rate. Moreover, revenue growth in 2004 is dependent on the introduction of our new products. We are currently proceeding 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. As with any product introduction, we face risks in the design, testing, qualification and market acceptance our new
products. Some of the products we are developing may be more complex and feature-rich than our current products, and some of the development on those products was undertaken externally prior to the Nishan and Sanera acquisitions. If we fail to
timely introduce new products, or if there is no demand for these or our current products, we may experience a decline in revenue.



In addition to the recent increased competition in the industry, we have experienced a migration in the buying patterns of our customers from configured
director products to non-configured product sales including our switch products, port cards, and our FlexPort upgrades. Our OEM and reseller partners may purchase certain of these component products ahead of end-user demand, which could reduce
subsequent purchases by those partners. Variations in the buying patterns of our customers would limit our ability to assemble, test and ship orders received in the last weeks and days of each quarter and could cause fluctuations in our 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.



Acquisitions



On September 19, 2003, we completed our acquisition of all of the outstanding stock of Nishan, a provider of multi-protocol
native IP storage switching solutions that builds open storage networking products based on IP and Ethernet, both international networking standards. On September 30, 2003, we completed our acquisition of all of the outstanding stock of Sanera, a
developer of intelligent director class switching platform technologies. The results of operations discussed below



1



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reflect the operating results of Nishan and Sanera from the dates of acquisition. The purpose behind our acquisition of
these two leading technology companies was to accelerate our time to market of leading-edge technology products including IP storage. We will integrate the operations of these entities into our existing engineering and sales divisions to take
advantage of identified cost efficiencies, including consolidation of engineering facilities and support resources and elimination of any redundancies. Although historically these two companies incurred significant operating expenses during their
development phases, we dont believe the historical financial results of the two companies are indicative of future operating expenses for the Company. In the near term, we anticipate these acquisitions will increase overall operating expenses
by approximately 13% to 16% on an annualized basis. We also believe that in the longer term these operating expenses will be offset by increased revenues as the technologies and products are integrated into our existing and next-generation products.



On August 22, 2003, the Company purchased 13.6 million shares
of preferred stock of Aarohi Communications (Aarohi). At January 31, 2004, this represented approximately 17.3% of the total outstanding shares of Aarohi. The shares were acquired at a total cost of $6 million. Approximately $3.6 million of this
purchase price was determined to represent in-process research and development and, as such, management of the Company has expensed this amount during fiscal year 2003. In addition to the equity investment, we have 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. We have recorded our share of Aarohis net loss of
approximately $984,000 from the date of purchase through January 31, 2004. The remaining net equity investment at January 31, 2004 was approximately $1.4 million. We anticipate this remaining balance will be fully expensed in fiscal 2004 based upon
Aarohis forecasted operating results. We have no future obligation to fund Aarohi beyond this initial investment.



Restructuring Activities



In January 2004, we announced that we were taking certain cost improvement actions, which included a workforce reduction and facility consolidation. As a
result, in the fiscal fourth quarter of 2003, the Company recorded an approximate $2.3 million restructuring charge related to the reduction in workforce. In addition, we expect to incur an approximate $1.3 million restructuring charge, (previously
reported as $2.2 million), in our fiscal first quarter of 2004, primarily related to a facilities closure, as well as additional severance costs. We believe these actions, including the consolidation of our engineering facilities and personnel, will
optimize our recent acquisitions to focus on future technology, increase operating efficiencies and better align our business model. In addition, we anticipate the reduction in personnel and facility expenses related to these actions will allow
management to react to potential unexpected declines in our revenue as discussed above by controlling the amount of operating expenses.



Results of Operations



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



|                                                                               |  |                            |      |  |                         |      |  |       |   
|------------------------------------------------------------------------------ |  | -------------------------- | ---- |  | ----------------------- | ---- |  | ----- | --
|                                                                               |  | Year EndedJanuary 31, 2004 |      |  | Years EndedDecember 31, |     
|                                                                               |  |                            | 2002 |  |                         | 2001 | 
|Revenue                                                                        |  | 100.0                      | %    |  | 100.0                   | %    |  | 100.0 | % 
|Cost of revenue                                                                |  | 42.3                       |      |  | 54.2                    |      |  | 62.6  |   
|                                                                               |  |                            |      |  |                         |      |  |       |   
|Gross profit                                                                   |  | 57.7                       |      |  | 45.8                    |      |  | 37.4  |   
|Operating Expenses:                                                            |  |                            |      |  |                         |      |  |       |   
|Research and development                                                       |  | 21.2                       |      |  | 18.1                    |      |  | 14.3  |   
|Selling and marketing                                                          |  | 22.9                       |      |  | 22.9                    |      |  | 20.5  |   
|General and administrative                                                     |  | 9.3                        |      |  | 9.0                     |      |  | 5.9   |   
|Acquired in-process research & development and other acquisition related costs |  | 2.7                        |      |  |                        |      |  | 2.7   |   
|Amortization of deferred compensation                                          |  | 2.9                        |      |  | 2.5                     |      |  | 2.1   |   
|Restructuring charges                                                          |  | 0.6                        |      |  |                        |      |  |      |   
|                                                                               |  |                            |      |  |                         |      |  |       |   
|Operating expenses                                                             |  | 59.6                       |      |  | 52.5                    |      |  | 45.5  |   
|Loss from operations                                                           |  | (1.9                       | )    |  | (6.7                    | )    |  | (8.1  | ) 
|Interest and other income, net                                                 |  | 1.0                        |      |  | 2.0                     |      |  | 4.1   |   
|                                                                               |  |                            |      |  |                         |      |  |       |   
|Loss before income taxes                                                       |  | (0.9                       | )    |  | (4.7                    | )    |  | (4.0  | ) 
|Income tax expense (benefit)                                                   |  | 9.2                        |      |  | (1.7                    | )    |  | (1.5  | ) 
|                                                                               |  |                            |      |  |                         |      |  |       |   
|Loss before equity in net loss of affiliated company                           |  | (10.1                      | )    |  | (3.0                    | )    |  | (2.5  | ) 
|Equity in net loss of affiliated company                                       |  | (0.2                       | )    |  |                        |      |  |      |   
|                                                                               |  |                            |      |  |                         |      |  |       |   
|Net loss                                                                       |  | (10.3                      | )%   |  | (3.0                    | )%   |  | (2.5  | )%
|                                                                               |  |                            |      |  |                         |      |  |       |   



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Revenues



|                             |  |                       |       |                         |   |       |  |   |      
|---------------------------- |  | --------------------- | ----- | ----------------------- | - | ----- |  | - | -----
|                             |  | Year EndedJanuary 31, |       | Years EndedDecember 31,
|                             |  | 2004                  |       | 2002                    |   | 2001 
|                             |  | (in millions)        
|Product revenue              |  | $                     | 360.1 |                         | $ | 284.1 |  | $ | 300.3
|Software and service revenue |  |                       | 41.7  |                         |   | 29.8  |  |   | 27.5 
|Other                        |  |                       | 17.1  |                         |   | 14.4  |  |   | 16.6 
|                             |  |                       |       |                         |   |       |  |   |      
|                             |  | $                     | 418.9 |                         | $ | 328.3 |  | $ | 344.4
|                             |  |                       |       |                         |   |       |  |   |      



Our revenue for the
year ended January 31, 2004 was $418.9 million, which represented a 28% increase over fiscal year 2002 and a 22% increase from fiscal year 2001. This increase in revenue reflects strong demand for our switching and software products. 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.



Product revenue of $360.1 million for fiscal year 2003 was a 27% increase over fiscal year 2002 and a 20% increase from fiscal year 2001. This revenue
increase was generated from the increased demand in our storage products as reflected in the 67% growth in estimated ports sold during the year over fiscal year 2002. In particular, the growth was realized through the strong sales of our 140-port
Intrepid 6000 Series Director and FlexPort
Sphereon 4500 Fabric Switch that were introduced
in the last half of 2002. The increase in ports sold translated into an estimated decline in average sales prices of 24% as this growth was largely driven by our new low cost switch products as well as the entrance of new competition which drove
down prices. We anticipate overall estimated average sales price declines based upon the historical trend of decreasing sales prices for our older generation products. However, as discussed above, competition or unforeseen changes in technology
could negatively impact our revenue growth rate. Our fiscal year 2002 revenue was negatively impacted by the unfavorable economic conditions and suppressed IT storage and infrastructure spending, in particular in the high-end director market and our
transition from 1 Gb to 2 Gb products in the first half of 2002. This environment had a particularly negative effect on our product revenue, which declined, from fiscal year 2001 levels. Our new product introductions in the last half of 2002,
however, were widely received with higher than expected demand and revenue



Software and service revenue of $41.7 million for fiscal year 2003 was a 40% increase over fiscal year 2002 and a 52% increase from fiscal year 2001. This revenue growth is due to continued revenue growth from all of
our software products, in particular our SANavigator® and SANtegrity®
software. A significant portion of our software revenue is generated from sales of our Enterprise Fabric Connectivity Manager, or EFCM, software product.



Other revenues for the 2003 year, including service fees earned under an ESCON Service agreement with EMC, were $17.1 million in fiscal year 2003. This
represents a 19% increase from fiscal year 2002 and a 3% increase from fiscal year 2001. This increase reflects the growth in maintenance fees, which outpaced the decline in service fees related to the ESCON products. We continue to realize
increased attached rates of our extended maintenance contracts to sales of our switching and software solutions. We anticipate that service revenue from EMC under the ESCON service agreement will continue to decrease in future years.



A significant portion of our revenue is concentrated with the largest storage
OEMs. For the year ended January 31, 2004, approximately 56% of our total revenue came from EMC, compared to 54% and 69% for fiscal years 2002 and 2001 respectively. IBM contributed approximately 21% of our revenue for fiscal year 2003 compared to
25% and 17% for fiscal years 2002 and 2001, respectively. In addition, in 2003 HDS became our third largest OEM customer and contributed approximately 10% of total revenue for the year ended January 31, 2004. McDATA solutions are offered by other
major storage and system vendors, including Dell, HP, STK and Sun. In addition to our storage and system vendors, we have relationships with many resellers, distributors and systems integrators. Expanding our reseller, distributor and system



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integrator channels into Small Medium Enterprise (SME) and vertical markets will be a strategic focus for us as we
continue to expand our business, however, the level of sales to any single customer may vary and the loss of any one significant customer, or a decrease in the level of sales to any significant or group of significant customers, could harm our
financial condition and results of operations. Given the dependencies on our limited number of OEM resellers combined with an increasingly competitive environment, we may experience continued adverse price pressures at critical times near the end of
the fiscal quarters.



Domestic and international revenue was
approximately 67% and 33% of our total revenue, respectively, for the fiscal year ended January 31, 2004. For the year ended December 31, 2002, domestic and international revenue was approximately 63% and 37% of our total revenue, respectively. For
the year ended December 31, 2001, domestic and international revenue was approximately 76% and 24% of our total revenue, respectively. Revenues are attributed to geographic areas based on the location of the customers to which our products are
shipped. International revenues primarily consist of sales to customers in Western Europe and the greater Asia Pacific region. Included in domestic revenues are sales to certain OEM customers who take possession of our products domestically and then
distribute these products to their international customers. In addition, included in revenues from Western Europe are sales to certain OEM customers who take possession of our products in distribution centers designated for international-bound
product and then distribute these products among various international regions. Our mix of international and domestic revenue can, therefore, vary depending on the relative mix of sales to certain OEM customers. The increase in international
revenues as a percentage of revenue for fiscal year 2002 was the result of a large domestic order reduction by EMC during the first quarter of that year associated with the technology transition to 2 Gb products.



Gross Profit



Gross profit margin for the fiscal year 2003 was 58% compared to 46% and 37% in fiscal years 2002 and 2001, respectively. The significant
increase in our gross margin was the result of strong revenue growth from our higher margin switching and software products as well as an improved mix of sales to our channel partners. Additionally, during fiscal year 2002 and 2001, we incurred
significant inventory-related charges of $9.4 million and $21 million respectively. These charges were generated primarily from our transition to multiple product lines and quality problems on component parts. We have significantly reduced inventory
costs during fiscal year 2003 with the implementation of our outsource-focused-manufacturing model, which was completed during fiscal year 2003. This model allowed us to move a number of manufacturing tasks to our contract manufacturers and will
continue to keep our inventory costs below the 2002 and 2001 fiscal years levels. We anticipate gross profit margins will remain in the mid-50 percent range during fiscal year 2004.



Operating Expenses



Research and Development Expenses. Research and development expenses increased to $88.8 million for fiscal year 2003, compared with $59.3 million
for fiscal year 2002 and $49.2 million for fiscal year 2001. The approximate $29.5 million, or 50%, increase from fiscal 2002 was primarily attributable to incremental spending associated with our acquisitions, which included research and
development costs and depreciation expense, and to a lesser extent, retention bonuses.Capitalized software costs were approximately $5.1 million, $8.7 million and $481,000 for the 2003, 2002 and 2001 fiscal years, respectively. Capitalized
software development costs have decreased in conjunction with the varying stages of development of our application software, 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 $95.8 million for fiscal year 2003 compared with $75.2 million and $70.5 million for fiscal years 2002 and 2001, respectively. Increases in sales and marketing expenses were primarily due to increased salaries, commissions and travel
costs associated with increased 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 as we grow our sales force to assist our channel partners and increase our contact with end-user customers to create product pull through our channels.



General and Administrative Expenses. General and administrative
expenses increased to $39.1 million for fiscal year 2003, compared to $29.5 million and $20.3 million for fiscal year 2002 and 2001, respectively. Amortization expense for purchased intangible assets increased approximately $7.1 million as a result
of our acquisitions of Sanera and Nishan. In addition, we experienced increased personnel costs, equipment and facilities costs while realizing overall reductions in bad debt and legal expenses. Expenses for fiscal year 2002 included significant
legal expenses related to the costs of litigating Brocade patent infringement lawsuit (see Item 3, Legal Proceedings) and $1.75 million in charges related to the termination of a collateralized lease and the disposal of fixed assets. Amortization
expense will continue to increase in fiscal year 2004 as a full year of Nishan and Sanera intangible asset amortization will be reflected.



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Acquired In-Process Research and Development (IPR&D) and Other Acquisition-related Costs. In
connection with our 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 fiscal year 2003 totaled $11.4 million. In connection with our acquisition of SANavigator in fiscal 2001, we incurred non-recurring acquisition
costs and integration-related charges. Additionally, a portion of the SANavigator purchase price 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 totaled $7.2 million for the year ended December 31, 2001. The other acquisition-related charges recorded during the year ended December 31, 2001, related primarily to one-time consideration paid for the
completion of ongoing employment arrangements with SANavigator employees. See Note 5 to the Notes to the Consolidated Financial Statements.



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 plans. In connection with our acquisitions during fiscal 2003, 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. 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 $12.7 million for fiscal year 2003, $8.9 million for fiscal year 2002 and $8.7 million for fiscal year 2001 (of which approximately $739,000,
$601,000 and $1,437,000 was included in cost of revenue, respectively). Deferred compensation expense levels fluctuate with the Class B 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.



Restructuring Charges.In January 2004, we announced that we were taking certain cost improvement actions, which included a workforce reduction and
facility consolidation. As a result, in the fiscal fourth quarter of 2003, the Company recorded an approximate $2.3 million restructuring charge related to the reduction in workforce. In addition, we expect to incur an approximate $2.2 million
restructuring charge in the fiscal first quarter 2004, primarily related to a facilities closure, as well as additional severance costs.



Interest and Other Income. Interest and other income consisted primarily of interest earnings on our cash, cash equivalents and various investment
holdings. Interest income was $6.8 million, $6.9 million, and $14.5 million for fiscal years 2003, 2002 and 2001, respectively. The decrease in income from 2001 levels reflects the decline in interest rates during 2002 and 2003 fiscal years. These
declines offset the effects of higher cash and investment balances resulting from cash generated from operations and the net proceeds from convertible subordinated notes that were issued in February 2003 (see Note 8  Convertible
Subordinated Debt in the Notes to Consolidated Financial Statements). The average rate of return on investments for the year ended January 31, 2004 was 1.8% compared to 2.2% for fiscal year 2002, and 3.9% for fiscal year 2001.



Interest Expense.Interest expense was $2.8 million for the year ended
January 31, 2004 compared with $293,000 and $349,000 for fiscal years 2002 and 2001, respectively. The increase in interest expense 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 six-month LIBOR setting for the swap was 1.1283% during the 2003 fiscal year,
creating a rate of approximately minus 0.39%, which is effective until February 15, 2004. This rate significantly reduced our overall interest expense during this period. On February 15, 2004, the six-month LIBOR setting was reset to 1.175%,
resulting in a rate of approximately minus 0.345%, which is effective until August 15, 2004. Significant increases in interest rates in future periods could significantly increase interest expense.



Provision for Income Taxes. During the 2003 fiscal year we recorded a
non-cash charge of $38.8 million to create a valuation allowance against the deferred tax asset as of the beginning of the fiscal year. Generally, 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. During 2003, the tax rate is favorably impacted primarily by the settlement of tax items related to previous years, the deductibility of costs
associated with our convertible subordinated debt, and the research tax credit. The tax rate is unfavorably impacted by deferred compensation and the write-off of the IPR&D



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related to Aarohi, as well as by the non-cash charge for the valuation allowance. During 2002, the tax rate was favorably
impacted primarily by tax-exempt interest and the research tax credit. The tax rate was unfavorably impacted by deferred compensation. During 2001, the tax rate was favorably impacted primarily by tax-exempt interest and the benefit attributable to
export sales. The tax rate was unfavorably impacted by deferred compensation.



A full valuation allowance was also created in fiscal 2003 against acquired deferred tax assets for $35.1 million and against deferred tax assets relating to tax benefits recorded directly to shareholders equity
for $1.0 million. Neither of these items resulted in a current charge to income tax expense. The valuation allowance related to acquired deferred tax assets resulted in an increase in goodwill. If this portion of the valuation allowance is released
in subsequent periods, goodwill will decrease by a like amount and we will record a charge to tax expense when the related deferred tax asset is realized. If the valuation allowance charged to shareholders equity is released in subsequent
periods, shareholders equity will increase by a like amount and we will record a charge to tax expense when the related deferred tax asset is realized.



Liquidity and Capital Resources



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



|                                                    |  |                            |          |   |                          |      |         |   |  |   |          |  
|--------------------------------------------------- |  | -------------------------- | -------- | - | ------------------------ | ---- | ------- | - |  | - | -------- | -
|                                                    |  | Year EndedJanuary 31, 2004 |          |   | Years Ended December 31, |     
|                                                    |  |                            | 2002     |   |                          | 2001 |        
|Net cash provided by operating activities           |  | $                          | 61,060   |   |                          | $    | 30,456  |   |  | $ | 8,336    |  
|Net cash used in investing activities               |  |                            | (244,259 | ) |                          |      | (27,039 | ) |  |   | (115,688 | )
|Net cash provided by (used in) financing activities |  |                            | 125,332  |   |                          |      | (291    | ) |  |   | 2,007    |  



We invest excess cash
predominantly in debt instruments that are highly liquid, of high-quality investment grade, and predominantly have maturities of less than three years with the intent to make such funds readily available for operating purposes, including expansion
of operations and potential acquisitions or other transactions. As of January 31, 2004, we had cash and cash equivalents and available-for-sale investments, including restricted cash, of $317 million compared to approximately $303 million as of
December 31, 2002.



Cash provided by operating activities of
$61 million for 2003 primarily consists of our net loss adjusted for non-cash charges (including depreciation, amortization, in-process R&D charges related to our acquisitions, deferred compensation, deferred taxes and inventory-related charges)
offset by approximately $6.5 million of changes in working capital and other activities. Working capital changes included an increase in accounts receivable balances of approximately $26 million, reflecting increases related to our revenue growth
particularly, in the last month of the fiscal fourth quarter. Days sales outstanding (DSO) has decreased in 2003 to 51 days compared to 64 days in 2002. This reflects the impact of the change in fiscal year and increased level of accounts receivable
collection. We believe that DSO may increase in 2004 as compared to 2003 as we see the linearity of our sales shift towards the third month of our fiscal quarters and as our channel mix continues to diversify. Our cash flows from operations were
impacted by the growth in deferred revenue balances of approximately $17.8 million in 2003 representing primarily increased sales of extended maintenance contracts attached to sales of our hardware and software products. In addition, the growth in
deferred revenue reflects deferred service fee revenue related to our ESCON agreement with EMC. From fiscal year 2002 to 2003, the increase in cash provided by operating activities was primarily the result of higher revenues and a lower net loss
before income taxes. Cash provided by operating activities in 2002 of $30.5 million consisted primarily of the net loss adjusted for non-cash charges of approximately $44.9 million offset by approximately $4.4 million used by working capital and
other activities. From fiscal year 2001 to 2002, the increase in cash from operations was primarily a result of large inventory purchases in 2001 and larger income tax payments from our profitable 2000 fiscal year. Cash provided by operating
activities in 2001 of approximately $8.3 million consisted primarily of a net loss of approximately $8.7 million adjusted for non-cash items of approximately $55.5 million and approximately $38.5 million used by working capital and other activities.



Cash used in investing activities in 2003 of approximately
$244 million was primarily attributable to cash used in acquisitions and purchases of equity investments of $177.4 million, cash used to purchase (net of sales and maturities) investments in marketable securities during the year, cash used to secure
restricted investments related to our interest rate swap transaction of approximately $5.1 million, and capital expenditures totaling approximately $18.0 million. Cash used in investing activities increased from 2002 to 2003 primarily as a result of
the acquisitions of Sanera and Nishan, as well as increased net purchases of marketable securities related to higher cash balances available for investing from our issuance of convertible subordinated notes in February 2003. Reduced spending for
capital expenditures in 2003 from 2002 offset these increases. Cash used in investing activities in 2002 of approximately $27 million was primarily attributable to capital



6



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expenditures of $72 million, contributed to by our completion and occupation of our office and engineering building. The
cash purchases were offset by proceeds from sales and maturities (net of purchases) of marketable securities for approximately $46 million. Cash used for investing activities decreased in 2002 from 2001 primarily as a result of cash used for
acquisitions in 2001, as well as net purchases of investments in 2001, compared to net proceeds from investments in 2002. Cash used in investing activities in 2001 of approximately $115.7 million was primarily attributable to cash used in
acquisitions of $29.8 million, capital expenditures totaling approximately $21.5 million and net purchases (net of sales and maturities) of investments of $64.5 million.



Cash provided by financings in 2003 of $125 million was primarily due to proceeds from issuance of convertible subordinated
notes of $172.5 million in principal amount, with proceeds of $167 million and proceeds from the issuance of stock related to our stock option and employee purchase plans of $5.8 million. The 2.25% convertible subordinated notes mature in February
2010, unless converted into McDATA common stock at a conversion price of $10.71 per share, subject to certain conversion price adjustments. Upon conversion, McDATA has the right to deliver cash, stock or a combination of both. See Note 8 in the
Notes to the Consolidated Financial Statements for further information related to the issuance of convertible subordinated notes. Offsetting these net proceeds were the use of $20.5 million of those proceeds to enter into share option transactions,
cash used for payments made on notes payable and capital lease obligations of approximately $18 million, and $8.8 million of cash used to repurchase common stock under our stock buy-back program. See Note 9 in the Notes to the Consolidated Financial
Statements for further information related to the Companys repurchase of common stock. Cash used in financing activities in 2002 of $291,000 was primarily due to principal payments on capital leases of $2.7 million offset by proceeds of
approximately $2.4 million from the issuance of common stock. Cash provided by financing activities in 2001 of $2.0 million was primarily due to proceeds from the issuance of common stock of $4.9 million offset by payments on our capital lease
obligations of $2.9 million.



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 us to submit
purchasing forecasts and place orders sixty calendar days in advance of delivery. At January 31, 2004, our commitment with the contract manufacturers for purchases over the next sixty days totaled $48.1 million. Additionally, the Contract
Manufacturers have outstanding purchase commitments related to materials that have been ordered on our behalf. 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 January 31, 2004, we had recorded obligations of approximately $8 million primarily related to materials purchased by our Contract Manufacturers 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 8, 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, subject to certain conversion adjustments. Upon a conversion, the Company may choose to deliver shares of our Class A common stock, or, in lieu of
shares of our Class A common stock, cash or a combination of cash and shares of Class A common stock. We are required to pay interest on February 15 and August 15 of each year, beginning August 15, 2003. Debt issuance costs of $5.6 million are being
amortized over the term of the notes. The amortization of debt issuance costs will accelerate upon early redemption or conversion of the notes. The net proceeds remain available for general corporate purposes, including working capital requirements
and capital expenditures.



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



7



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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 January 31, 2004 was 1.1283%, creating a rate of approximately minus
0.39%, which was effective until February 15, 2004. On February 15, 2004, the six-month LIBOR setting was reset to 1.175%, resulting in a rate of approximately minus 0.345%, which is effective until August 15, 2004. 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 January 31, 2004, the fair value of the interest rate swap had decreased from inception to $349,000 and is included in other long-term liabilities.
Corresponding to this change, the carrying value of the Notes has decreased by $349,000. 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 January 31, 2004.



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



|                                   |  |       |         |                 |   |           |  |                  |        |  |   |        
|---------------------------------- |  | ----- | ------- | --------------- | - | --------- |  | ---------------- | ------ |  | - | -------
|                                   |  | Total |         | Less Than1 Year |   | 1-3 Years |  | More than5 years
|Convertible subordinated debt      |  | $     | 172,500 |                 | $ |          |  | $                |       |  | $ | 172,500
|Non-cancelable operating leases    |  |       | 20,295  |                 |   | 8,097     |  |                  | 9,568  |  |   | 2,630  
|Non-cancelable purchase agreements |  |       | 48,063  |                 |   | 48,063    |  |                  |       |  |   |       
|Capital leases, including interest |  |       | 2,376   |                 |   | 1,453     |  |                  | 923    |  |   |       
|                                   |  |       |         |                 |   |           |  |                  |        |  |   |        
|Total contractual obligations      |  | $     | 243,234 |                 | $ | 57,613    |  | $                | 10,491 |  | $ | 175,130
|                                   |  |       |         |                 |   |           |  |                  |        |  |   |        



Long-Term Cash Availability



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



Inflation



We believe that our revenue and results of operations have not been significantly impacted by inflation during the last three fiscal years.



Recent Accounting Pronouncements



For information regarding recent accounting pronouncements, see Note 1 of
Notes to Consolidated Financial Statements included in the F-pages of this Form 10-K.



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.



8



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Revenue Recognition



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



With respect to revenue from our configured products, we request evidence of sell-through from our OEM and distributor
partners prior to recognizing revenue. In situations where our OEM and distributor partners refuse to provide sell-through information when requested, but all the criteria under SAB 104 (as discussed above) have been met, we recognize revenue for
such configured products. These configured products represent high value, customized solutions of directors, cabinets and various combinations of port cards ordered by our 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 104 (as discussed above) have been met, generally at time of shipment. Revenue for both configured and non-configured
products and components is reduced for estimated customer returns, price protection, rebates, and other offerings that occur under sales programs established with the Companys OEMs, distributors and resellers.



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,



9



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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.



Income Taxes



Significant management judgment is required in determining the provision for
income taxes, deferred tax assets and liabilities and any valuation allowance recorded against deferred tax assets. We are required to estimate our income taxes in each jurisdiction where we operate. This process involves estimating our actual
current income tax expense together with assessing temporary differences resulting from the different treatment of items for income tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in
our consolidated balance sheet. At January 31, 2004, our net deferred tax assets equaled $77.4 million before any valuation allowance. This balance 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 evaluating the need for a valuation allowance, we assessed the likelihood
that our net deferred tax assets will be recovered from future taxable income. We have considered past operating losses, cumulative losses for financial accounting in recent years, estimated future taxable income and our ongoing prudent and feasible
tax planning strategies in assessing the need for a valuation allowance. After considering all available evidence, both positive and negative, management concluded, after applying the provisions of SFAS 109, that it is more likely than not that we
will not be able to realize our deferred tax assets in the future. Therefore, a full valuation allowance has been provided against those deferred tax assets. The portion relating to the acquisitions is applied as an increase to the basis of other
assets from the acquired companies.



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



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 carrying value
of our net assets including goodwill balances to the fair value of our net assets using the quoted market price of our common stock. We performed the 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 January 31, 2004, goodwill recorded in the consolidated balance sheet totaled $78.8
million.



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



10



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Sales Commission Estimates



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



Restructuring Charges



We monitor and regularly evaluate our organization structure and associated operating expenses. Depending on events and circumstances, we may decide to
restructure our operations to reduce future operating costs. In determining the restructuring charges, we analyze our future operating requirements, including the required headcount by functions and facility space requirements. Our restructuring
costs, and any resulting accruals, involve significant estimates made by management using the best information available at the time the estimates are made, some of which may be provided by third parties. In recording facilities lease loss reserves,
we make various assumptions, including the time period over which the facilities will be vacant, expected sublease terms, expected sublease rates, anticipated future operating expenses, and expected future use of the facilities. Our estimates
involve a number of risks and uncertainties, some of which are beyond our control, including future real estate market conditions and our ability to successfully enter into subleases or lease termination agreements with terms as favorable as those
assumed when arriving at our estimates. We regularly evaluate a number of factors to determine the appropriateness and reasonableness of our restructuring and lease loss accruals including the various assumptions noted above. If actual results
differ significantly from our estimates, we may be required to adjust our restructuring accruals in the future.



ITEM 8.
Consolidated Financial Statements and Supplementary Data



For a discussion of the information required by this item, you should refer to F- pages in Item 15(a) of this Annual Report on Form 10-K.



ITEM 9A.
Controls and Procedures



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 that amended Form 10-Q for the quarter ended October 31, 2003, 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. See Note 7 to the Notes to the Consolidated Financial Statements for further discussion of this program and the balances as of January 31, 2004.



11



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As part of the Companys year-end review and financial statement reporting process, in February
2004, the Companys internal accountants identified, and immediately notified the Chief Financial Officer of, the applicability of SFAS 140 to a material transaction in the third quarter of 2003 involving the Companys securities lending
program, which led to the reclassification discussed above. In its review, the Company investigated the cause of the reclassification and concluded that while the transaction was communicated prior to the filing, the Company did not appropriately
apply SFAS 140 to the securities lending program in preparing its financial statements for the quarter ending October 31, 2003. In response to the reclassification in late February 2004, the Companys independent auditor indicated to the
Company that it believed that a material weakness under AU 325, Communication of Internal Control Related Matters Noted In An Audit, existed with regard to the evaluation of the appropriate accounting treatment for the securities lending program.
This material weakness existed as of the end of the period covered by this Form 10-K, on January 31, 2004. As a result, the Company immediately began implementing enhanced policies and procedures, including additional cross-functional meetings
involving various vice presidents and the finance department, improvements in existing formal investment policies and the establishment of an issues log. These changes to the Companys internal controls were completed in early March 2004. In
April 2004 the Company added an additional CPA with SEC experience dedicated to transaction analysis. The Company believes that it has implemented these changes within its internal controls to improve the timely accounting evaluation and treatment
of such transactions, and that the implementation of these changes has remediated the material weakness.



Disclosure controls and procedures



Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness as of the end of the period covered by this Form 10-K of our disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the Exchange Act)). We maintain disclosure controls and procedures to ensure that information required to be disclosed by us in reports that we file
or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and accumulated and communicated to our management, including our Chief
Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures as a
whole were not effective as of the end of such period. This conclusion was based solely on our determination that our disclosure controls did not result in a timely evaluation of the appropriate accounting treatment for our securities lending
program, as is discussed under the heading Third Quarter Balance Sheet Reclassification/Restatement above. Also as described under that heading, in March and April 2004 we implemented enhanced policies and procedures to improve the timely accounting
evaluation of transactions. We believe these changes resulted in improvements in the ability of our finance and accounting personnel to process and analyze such transactions, thereby enhancing the ability of our Chief Executive Officer and Chief
Financial Officer to make timely disclosure decisions. Our Chief Executive Officer and Chief Financial Officer noted no other conditions that would have caused them to conclude our disclosure controls and procedures were not effective as of the end
of the period covered by this Form 10-K.



Our disclosure
controls and procedures, are designed to provide reasonable assurance of achieving their objectives, although they did not operate effectively at a reasonable assurance level as of the end of the period covered by this Form 10-K. There can be no
assurance that disclosure controls and procedures will operate effectively under all circumstances.



Changes in internal control over financial reporting



As discussed above under the heading Third Quarter Balance Sheet Reclassification/Restatement, during the first quarter of fiscal 2004, we implemented
certain changes in our internal controls over financial reporting. Based on these changes, which were implemented after our fiscal year end but prior to the filing of our Form 10-K, we believe a material weakness in our internal controls over
financial reporting no longer existed at the end of the first quarter of fiscal 2004. There were no changes in our internal controls over financial reporting that occurred during our fourth fiscal quarter that have materially affected, or are
reasonably likely to materially affect, our internal control over financial reporting.



12



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PART IV



ITEM 15.
Exhibits, Financial Statement Schedules, and Reports on Form 8-K



|(a) | Documents filed as part of this report
|--- | --------------------------------------



|   |   |  |                                                            |  |    
|-- | - |  | ---------------------------------------------------------- |  | ---
|(i | ) |  | Index to Consolidated Financial Statements                 |  | F-1
|   |   |  | Report of Independent Auditors                             |  | F-2
|   |   |  | Consolidated Financial Statements:                         |  |    
|   |   |  | Consolidated Balance Sheets                                |  | F-3
|   |   |  | Consolidated Income Statements                             |  | F-4
|   |   |  | Consolidated Statements of Changes in Stockholders Equity |  | F-5
|   |   |  | Consolidated Statements of Cash Flows                      |  | F-6
|   |   |  | Notes to Consolidated Financial Statements                 |  | F-7



13



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SIGNATURES



Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Amendment No. 2 to this
Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Broomfield, State of Colorado, on August 23, 2004.



McDATA CorporationBy:

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




Pursuant to the
requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.



|                                                                                                    |  |                
|--------------------------------------------------------------------------------------------------- |  | ---------------
|PRINCIPAL EXECUTIVE OFFICER                                                                         |  |                
|                                                                                                    | 
|/s/ JOHN A. KELLEY, JR.John A. Kelley, Jr. President and Chief Executive Officer                    |  | August 23, 2004
|                                                                                                    | 
|Principal Financial Officer                                                                         |  |                
|                                                                                                    | 
|/s/ ERNEST J. SAMPIASErnest J. Sampias Senior Vice President of Finance and Chief Financial Officer |  | August 23, 2004
|                                                                                                    | 
|Principal Accounting Officer                                                                        |  |                
|                                                                                                    | 
|/s/ ERNEST J. SAMPIASErnest J. Sampias Senior Vice President of Finance and Chief Financial Officer |  | August 23, 2004



14



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|                                                              |  |                
|------------------------------------------------------------- |  | ---------------
|Directors:                                                    |  |                
|                                                              | 
|/s/ JOHN A. KELLEY, JR. *John A. Kelley, Jr. Chairman and CEO |  | August 23, 2004
|                                                              | 
|/s/ JOHN W. GERDELMAN *John W. Gerdelman                      |  | August 23, 2004
|                                                              | 
|/s/ CHARLES C. JOHNSTON *Charles C. Johnston                  |  | August 23, 2004
|                                                              | 
|/s/ D. VAN SKILLING *D. Van Skilling                          |  | August 23, 2004
|                                                              | 
|/s/ THOMAS M. UHLMAN *Thomas M. Uhlman                        |  | August 23, 2004
|                                                              | 
|/s/ LAURENCE G. WALKER *Laurence G. Walker                    |  | August 23, 2004
|                                                              | 
|/s/ BETSY S. ATKINS *Betsy S. Atkins                          |  | August 23, 2004
|                                                              | 
|/s/ MICHAEL J. SOPHIE *Michael J. Sophie                      |  | August 23, 2004
|                                                              | 
|/s/ M. ALEX MENDEZ *M. Alex Mendez                            |  | August 23, 2004

---

|* | By Ernest J. Sampias as attorney in fact.
|- | -----------------------------------------



15



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McDATA CORPORATION



INDEX TO CONSOLIDATED
FINANCIAL STATEMENTS



|                                                           |  |     
|---------------------------------------------------------- |  | ----
|                                                           |  | Page
|Report of Independent Auditors                             |  | F-2 
|                                                           | 
|Audited Financial Statements                               |  |     
|                                                           | 
|Consolidated Balance Sheets                                |  | F-3 
|Consolidated Income Statements                             |  | F-4 
|Consolidated Statements of Changes in Stockholders Equity |  | F-5 
|Consolidated Statements of Cash Flows                      |  | F-6 
|Notes to Consolidated Financial Statements                 |  | F-7 



Note: All other
financial statement schedules are omitted because they are not applicable or the required information is included in the consolidated financial statements or notes thereto.



F-1



---

REPORT OF INDEPENDENT AUDITORS



To the Board of Directors and Stockholders of McDATA Corporation:



In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of McDATA Corporation and its subsidiaries at January 31, 2004
and December 31, 2002, and the results of their operations and their cash flows for the year ended January 31, 2004, month ended January 31, 2003 and the years ended December 31, 2002 and 2001, in conformity with accounting principles generally
accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the
related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Companys management; our responsibility is to express an opinion on these financial statements and financial
statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used
and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.



PricewaterhouseCoopers LLP



Denver, Colorado

April 14, 2004



F-2



---

McDATA CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)



|                                                                                                                             |  |                  |         |   |                   |   |         |  
|---------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | ------- | - | ----------------- | - | ------- | -
|                                                                                                                             |  | January 31, 2004 |         |   | December 31, 2002 |  
|Assets                                                                                                                       |  |                  |         |   |                   |   |         |  
|Current assets:                                                                                                              |  |                  |         |   |                   |   |         |  
|Cash and cash equivalents                                                                                                    |  | $                | 50,301  |   |                   | $ | 72,411  |  
|Securities lending collateral                                                                                                |  |                  | 126,681 |   |                   |   |        |  
|Short-term investments                                                                                                       |  |                  | 157,740 |   |                   |   | 157,260 |  
|Accounts receivable, net of allowances for doubtful accounts of $926 and $1,265, respectively                                |  |                  | 62,670  |   |                   |   | 73,867  |  
|Inventories, net                                                                                                             |  |                  | 11,364  |   |                   |   | 8,097   |  
|Deferred tax asset                                                                                                           |  |                  |        |   |                   |   | 33,325  |  
|Prepaid expenses and other current assets                                                                                    |  |                  | 6,055   |   |                   |   | 4,699   |  
|                                                                                                                             |  |                  |         |   |                   |   |         |  
|Total current assets                                                                                                         |  |                  | 414,811 |   |                   |   | 349,659 |  
|Property and equipment, net                                                                                                  |  |                  | 99,225  |   |                   |   | 99,927  |  
|Long-term investments                                                                                                        |  |                  | 103,483 |   |                   |   | 73,099  |  
|Restricted cash                                                                                                              |  |                  | 5,130   |   |                   |   |        |  
|Intangible assets, net of accumulated amortization of $14,470 and $5,037, respectively                                       |  |                  | 111,313 |   |                   |   | 7,887   |  
|Goodwill                                                                                                                     |  |                  | 78,787  |   |                   |   | 11,780  |  
|Other assets, net                                                                                                            |  |                  | 18,219  |   |                   |   | 12,839  |  
|                                                                                                                             |  |                  |         |   |                   |   |         |  
|Total assets                                                                                                                 |  | $                | 830,968 |   |                   | $ | 555,191 |  
|                                                                                                                             |  |                  |         |   |                   |   |         |  
|Liabilities and Stockholders Equity                                                                                         |  |                  |         |   |                   |   |         |  
|Current liabilities:                                                                                                         |  |                  |         |   |                   |   |         |  
|Accounts payable                                                                                                             |  | $                | 16,532  |   |                   | $ | 16,530  |  
|Accrued liabilities                                                                                                          |  |                  | 51,547  |   |                   |   | 37,779  |  
|Securities lending collateral payable                                                                                        |  |                  | 126,681 |   |                   |   |        |  
|Current portion of deferred revenue                                                                                          |  |                  | 19,775  |   |                   |   | 7,337   |  
|Income taxes payable                                                                                                         |  |                  | 1,783   |   |                   |   | 2,782   |  
|Current portion of obligations under notes payable                                                                           |  |                  | 1,408   |   |                   |   |        |  
|Current portion of obligations under capital leases                                                                          |  |                  | 1,377   |   |                   |   | 1,604   |  
|                                                                                                                             |  |                  |         |   |                   |   |         |  
|Total current liabilities                                                                                                    |  |                  | 219,103 |   |                   |   | 66,032  |  
|Obligations under notes payable, less current portion                                                                        |  |                  | 201     |   |                   |   |        |  
|Obligations under capital leases, less current portion                                                                       |  |                  | 890     |   |                   |   | 1,540   |  
|Deferred revenue, less current portion                                                                                       |  |                  | 20,632  |   |                   |   | 13,114  |  
|Interest rate swap                                                                                                           |  |                  | 349     |   |                   |   |        |  
|Convertible subordinated debt                                                                                                |  |                  | 172,151 |   |                   |   |        |  
|                                                                                                                             |  |                  |         |   |                   |   |         |  
|Total liabilities                                                                                                            |  |                  | 413,326 |   |                   |   | 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                              |  |                  | 810     |   |                   |   | 810     |  
|Common stock, Class B, $0.01 par value, 200,000,000 shares authorized, 36,051,473 and 32,962,212 shares issued, respectively |  |                  | 361     |   |                   |   | 330     |  
|Additional paid-in-capital                                                                                                   |  |                  | 476,993 |   |                   |   | 474,609 |  
|Treasury stock, at cost, 975,730 shares at January 31, 2004                                                                  |  |                  | (8,752  | ) |                   |   |        |  
|Deferred compensation                                                                                                        |  |                  | (10,375 | ) |                   |   | (6,812  | )
|Accumulated other comprehensive income                                                                                       |  |                  | 403     |   |                   |   | 773     |  
|Retained earnings (deficit)                                                                                                  |  |                  | (41,798 | ) |                   |   | 4,795   |  
|                                                                                                                             |  |                  |         |   |                   |   |         |  
|Total stockholders equity                                                                                                   |  |                  | 417,642 |   |                   |   | 474,505 |  
|                                                                                                                             |  |                  |         |   |                   |   |         |  
|Total liabilities and stockholders equity                                                                                   |  | $                | 830,968 |   |                   | $ | 555,191 |  
|                                                                                                                             |  |                  |         |   |                   |   |         |  



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



F-3



---

McDATA CORPORATION

CONSOLIDATED INCOME STATEMENTS

(in thousands, except per share data)



|                                                                                                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | --------------------------- | ------- | - | ------------------------ | ---- | ------- | ---------------------------- |  | - | ------- | - |  | - | ------- | -
|                                                                                                                                                                               |  | Year Ended January 31, 2004 |         |   | Years Ended December 31, |      |         | Month Ended January 31, 2003 | 
|                                                                                                                                                                               |  |                             | 2002    |   |                          | 2001 |         |                             
|Revenue                                                                                                                                                                        |  | $                           | 418,860 |   |                          | $    | 328,279 |                              |  | $ | 344,406 |   |  | $ | 17,045  |  
|Cost of revenue                                                                                                                                                                |  |                             | 177,329 |   |                          |      | 178,114 |                              |  |   | 215,751 |   |  |   | 8,475   |  
|                                                                                                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Gross profit                                                                                                                                                                   |  |                             | 241,531 |   |                          |      | 150,165 |                              |  |   | 128,655 |   |  |   | 8,570   |  
|Operating expenses:                                                                                                                                                            |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Research and development (excludes amortization of deferred compensation included in Amortization of deferred compensation of $6,142, $3,459,
$2,826 and $191, respectively)   |  |                             | 88,826  |   |                          |      | 59,324  |                              |  |   | 49,166  |   |  |   | 5,068   |  
|Selling and marketing (excludes amortization of deferred compensation included in Amortization of deferred compensation of $1,948, $931, $751
and $73, respectively)           |  |                             | 95,820  |   |                          |      | 75,213  |                              |  |   | 70,489  |   |  |   | 5,837   |  
|General and administrative (excludes amortization of deferred compensation included in Amortization of deferred compensation of $3,879,
$3,890, $3,682 and $311, respectively) |  |                             | 39,057  |   |                          |      | 29,495  |                              |  |   | 20,337  |   |  |   | 2,424   |  
|Acquired in-process research and development and other acquisition-related costs                                                                                               |  |                             | 11,410  |   |                          |      |        |                              |  |   | 9,327   |   |  |   |        |  
|Amortization of deferred compensation (excludes amortization of deferred compensation included in cost of revenue of $739, $601, $1,437 and
$50, respectively)                 |  |                             | 11,969  |   |                          |      | 8,280   |                              |  |   | 7,259   |   |  |   | 575     |  
|Restructuring charges                                                                                                                                                          |  |                             | 2,258   |   |                          |      |        |                              |  |   |        |   |  |   |        |  
|                                                                                                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Operating expenses                                                                                                                                                             |  |                             | 249,340 |   |                          |      | 172,312 |                              |  |   | 156,578 |   |  |   | 13,904  |  
|                                                                                                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Loss from operations                                                                                                                                                           |  |                             | (7,809  | ) |                          |      | (22,147 | )                            |  |   | (27,923 | ) |  |   | (5,334  | )
|Interest and other income                                                                                                                                                      |  |                             | 6,832   |   |                          |      | 6,924   |                              |  |   | 14,532  |   |  |   | 28      |  
|Interest expense                                                                                                                                                               |  |                             | (2,760  | ) |                          |      | (293    | )                            |  |   | (349    | ) |  |   | (17     | )
|                                                                                                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Loss before income taxes                                                                                                                                                       |  |                             | (3,737  | ) |                          |      | (15,516 | )                            |  |   | (13,740 | ) |  |   | (5,323  | )
|Income tax expense (benefit)                                                                                                                                                   |  |                             | 38,412  |   |                          |      | (5,529  | )                            |  |   | (5,084  | ) |  |   | (1,863  | )
|                                                                                                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Loss before equity in net loss of affiliated company                                                                                                                           |  |                             | (42,149 | ) |                          |      | (9,987  | )                            |  |   | (8,656  | ) |  |   | (3,460  | )
|Equity in net loss of affiliated company                                                                                                                                       |  |                             | (984    | ) |                          |      |        |                              |  |   |        |   |  |   |        |  
|                                                                                                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Net loss                                                                                                                                                                       |  | $                           | (43,133 | ) |                          | $    | (9,987  | )                            |  | $ | (8,656  | ) |  | $ | (3,460  | )
|                                                                                                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Basic net loss per share                                                                                                                                                       |  | $                           | (0.38   | ) |                          | $    | (0.09   | )                            |  | $ | (0.08   | ) |  | $ | (0.03   | )
|                                                                                                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Shares used in computing basic net loss per share                                                                                                                              |  |                             | 114,682 |   |                          |      | 113,185 |                              |  |   | 111,475 |   |  |   | 114,000 |  
|                                                                                                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Diluted net loss per share                                                                                                                                                     |  | $                           | (0.38   | ) |                          | $    | (0.09   | )                            |  | $ | (0.08   | ) |  | $ | (0.03   | )
|                                                                                                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Shares used in computing diluted net loss per share                                                                                                                            |  |                             | 114,682 |   |                          |      | 113,185 |                              |  |   | 111,475 |   |  |   | 114,000 |  
|                                                                                                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  



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



F-4



---

McDATA CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY

(in thousands)



|                                                   |  |              |  |         |                            |        |        |                      |        |   |                                        |   |  |               |         |   |                             |   |         |                            |  |   |      |   |  |   |        |   |  |   |         |   |  |   |         |  
|-------------------------------------------------- |  | ------------ |  | ------- | -------------------------- | ------ | ------ | -------------------- | ------ | - | -------------------------------------- | - |  | ------------- | ------- | - | --------------------------- | - | ------- | -------------------------- |  | - | ---- | - |  | - | ------ | - |  | - | ------- | - |  | - | ------- | -
|                                                   |  | Common Stock |  |         | Additional Paid-In Capital |        |        | DeferredCompensation |        |   | Accumulated Other Comprehensive Income |   |  | TreasuryStock |         |   | Retained Earnings (Deficit) |   |         | Total Stockholders Equity | 
|                                                   |  | Class A      |  | Class B |                            |        |        |                      |        |   |                                       
|                                                   |  | Shares       |  | Amount  |                            | Shares |        |                      | Amount |   |                                        |   |  |               |         |  
|Balances at December 31, 2000                      |  | 81,000       |  | $       | 810                        |        | 28,908 |                      |        | $ | 289                                    |   |  | $             | 454,009 |   |                             | $ | (24,850 | )                          |  | $ | 117  |   |  | $ |       |   |  | $ | 23,438  |   |  | $ | 453,813 |  
|Shares issued                                      |  |             |  |         |                           |        | 2,654  |                      |        |   | 27                                     |   |  |               | 6,797   |   |                             |   | (1,896  | )                          |  |   |     |   |  |   |       |   |  |   |        |   |  |   | 4,928   |  
|Forfeitures of deferred compensation               |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               | (3,280  | ) |                             |   | 3,280   |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   |        |  
|Compensation expense                               |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   | 8,696   |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   | 8,696   |  
|Tax benefit of stock options                       |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               | 10,607  |   |                             |   |        |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   | 10,607  |  
|Comprehensive income (loss):                       |  |              |  |         |                            |        |        |                      |        |   |                                        |   |  |               |         |   |                             |   |         |                            |  |   |      |   |  |   |        |   |  |   |         |   |  |   |         |  
|Net loss                                           |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   |        |                            |  |   |     |   |  |   |       |   |  |   | (8,656  | ) |  |   | (8,656  | )
|Unrealized gain on investments, net of tax of $234 |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   |        |                            |  |   | 403  |   |  |   |       |   |  |   |        |   |  |   | 403     |  
|                                                   |  |              |  |         |                            |        |        |                      |        |   |                                        |   |  |               |         |   |                             |   |         |                            |  |   |      |   |  |   |        |   |  |   |         |   |  |   |         |  
|Total comprehensive loss                           |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   |        |                            |  |   |     |   |  |   |       |   |  |   |         |   |  |   | (8,253  | )
|                                                   |  |              |  |         |                            |        |        |                      |        |   |                                        |   |  |               |         |   |                             |   |         |                            |  |   |      |   |  |   |        |   |  |   |         |   |  |   |         |  
|Balances at December 31, 2001                      |  | 81,000       |  |         | 810                        |        | 31,562 |                      |        |   | 316                                    |   |  |               | 468,133 |   |                             |   | (14,770 | )                          |  |   | 520  |   |  |   |       |   |  |   | 14,782  |   |  |   | 469,791 |  
|Shares issued                                      |  |             |  |         |                           |        | 1,407  |                      |        |   | 14                                     |   |  |               | 4,274   |   |                             |   | (1,867  | )                          |  |   |     |   |  |   |       |   |  |   |        |   |  |   | 2,421   |  
|Forfeitures of deferred compensation               |  |             |  |         |                           |        | (7     | )                    |        |   |                                       |   |  |               | (944    | ) |                             |   | 944     |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   |        |  
|Compensation expense                               |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   | 8,881   |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   | 8,881   |  
|Tax benefit of stock options                       |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               | 3,146   |   |                             |   |        |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   | 3,146   |  
|Comprehensive income (loss):                       |  |             |  |         |                            |        |        |                      |        |   |                                        |   |  |               |         |   |                             |   |         |                            |  |   |      |   |  |   |        |   |  |   |         |   |  |   |         |  
|Net loss                                           |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   |        |                            |  |   |     |   |  |   |       |   |  |   | (9,987  | ) |  |   | (9,987  | )
|Unrealized gain on investments, net of tax of $188 |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   |        |                            |  |   | 253  |   |  |   |       |   |  |   |        |   |  |   | 253     |  
|                                                   |  |              |  |         |                            |        |        |                      |        |   |                                        |   |  |               |         |   |                             |   |         |                            |  |   |      |   |  |   |        |   |  |   |         |   |  |   |         |  
|Total comprehensive loss                           |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   |        |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   | (9,734  | )
|                                                   |  |              |  |         |                            |        |        |                      |        |   |                                        |   |  |               |         |   |                             |   |         |                            |  |   |      |   |  |   |        |   |  |   |         |   |  |   |         |  
|Balances at December 31, 2002                      |  | 81,000       |  |         | 810                        |        | 32,962 |                      |        |   | 330                                    |   |  |               | 474,609 |   |                             |   | (6,812  | )                          |  |   | 773  |   |  |   |       |   |  |   | 4,795   |   |  |   | 474,505 |  
|Shares issued                                      |  |             |  |         |                           |        | 321    |                      |        |   | 3                                      |   |  |               | 1,327   |   |                             |   | (747    | )                          |  |   |     |   |  |   |       |   |  |   |        |   |  |   | 583     |  
|Compensation expense                               |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   | 625     |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   | 625     |  
|Tax benefit of stock options                       |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               | 39      |   |                             |   |        |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   | 39      |  
|Comprehensive income (loss):                       |  |              |  |         |                            |        |        |                      |        |   |                                        |   |  |               |         |   |                             |   |         |                            |  |   |      |   |  |   |        |   |  |   |         |   |  |   |         |  
|Net loss                                           |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   |        |                            |  |   |     |   |  |   |       |   |  |   | (3,460  | ) |  |   | (3,460  | )
|Unrealized loss on investments, net of tax of $40  |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   |        |                            |  |   | (62  | ) |  |   |       |   |  |   |        |   |  |   | (62     | )
|                                                   |  |              |  |         |                            |        |        |                      |        |   |                                        |   |  |               |         |   |                             |   |         |                            |  |   |      |   |  |   |        |   |  |   |         |   |  |   |         |  
|Total comprehensive loss                           |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   |        |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   | (3,522  | )
|                                                   |  |              |  |         |                            |        |        |                      |        |   |                                        |   |  |               |         |   |                             |   |         |                            |  |   |      |   |  |   |        |   |  |   |         |   |  |   |         |  
|Balances at January 31, 2003                       |  | 81,000       |  |         | 810                        |        | 33,283 |                      |        |   | 333                                    |   |  |               | 475,975 |   |                             |   | (6,934  | )                          |  |   | 711  |   |  |   |       |   |  |   | 1,335   |   |  |   | 472,230 |  
|Shares issued                                      |  |             |  |         |                           |        | 2,880  |                      |        |   | 29                                     |   |  |               | 23,155  |   |                             |   | (17,357 | )                          |  |   |     |   |  |   |       |   |  |   |        |   |  |   | 5,827   |  
|Forfeitures of deferred compensation               |  |             |  |         |                           |        | (112   | )                    |        |   | (1                                     | ) |  |               | (1,207  | ) |                             |   | 1,208   |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   |        |  
|Purchase of call options, net                      |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               | (20,510 | ) |                             |   |        |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   | (20,510 | )
|Compensation expense                               |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   | 12,708  |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   | 12,708  |  
|Tax benefit (expense) of stock options             |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               | (420    | ) |                             |   |        |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   | (420    | )
|Acquisition of treasury stock                      |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   |        |                            |  |   |     |   |  |   | (8,752 | ) |  |   |        |   |  |   | (8,752  | )
|Comprehensive income (loss)                        |  |              |  |         |                            |        |        |                      |        |   |                                        |   |  |               |         |   |                             |   |         |                            |  |   |      |   |  |   |        |   |  |   |         |   |  |   |         |  
|Net loss                                           |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   |        |                            |  |   |     |   |  |   |       |   |  |   | (43,133 | ) |  |   | (43,133 | )
|Unrealized loss on investments, net of tax of $453 |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   |        |                            |  |   | (308 | ) |  |   |       |   |  |   |        |   |  |   | (308    | )
|                                                   |  |              |  |         |                            |        |        |                      |        |   |                                        |   |  |               |         |   |                             |   |         |                            |  |   |      |   |  |   |        |   |  |   |         |   |  |   |         |  
|Total comprehensive loss                           |  |             |  |         |                           |        |       |                      |        |   |                                       |   |  |               |        |   |                             |   |        |                            |  |   |     |   |  |   |       |   |  |   |        |   |  |   | (43,441 | )
|                                                   |  |              |  |         |                            |        |        |                      |        |   |                                        |   |  |               |         |   |                             |   |         |                            |  |   |      |   |  |   |        |   |  |   |         |   |  |   |         |  
|Balances at January 31, 2004                       |  | 81,000       |  | $       | 810                        |        | 36,051 |                      |        | $ | 361                                    |   |  | $             | 476,993 |   |                             | $ | (10,375 | )                          |  | $ | 403  |   |  | $ | (8,752 | ) |  | $ | (41,798 | ) |  | $ | 417,642 |  
|                                                   |  |              |  |         |                            |        |        |                      |        |   |                                        |   |  |               |         |   |                             |   |         |                            |  |   |      |   |  |   |        |   |  |   |         |   |  |   |         |  



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



F-5



---

McDATA CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                          |  |                            |          |   |                          |      |          |                              |  |   |          |   |  |   |         |  
|------------------------------------------------------------------------- |  | -------------------------- | -------- | - | ------------------------ | ---- | -------- | ---------------------------- |  | - | -------- | - |  | - | ------- | -
|                                                                          |  | Year Ended January 31 2004 |          |   | Years Ended December 31, |      |          | Month Ended January 31, 2003 | 
|                                                                          |  |                            | 2002     |   |                          | 2001 |          |                             
|Cash flows from operating activities:                                     |  |                            |          |   |                          |      |          |                              |  |   |          |   |  |   |         |  
|Net loss                                                                  |  | $                          | (43,133  | ) |                          | $    | (9,987   | )                            |  | $ | (8,656   | ) |  | $ | (3,460  | )
|Adjustments to reconcile net loss to cash flows from operating activities |  |                            |          |   |                          |      |          |                              |  |   |          |   |  |   |         |  
|Depreciation and amortization                                             |  |                            | 44,589   |   |                          |      | 25,524   |                              |  |   | 16,383   |   |  |   | 2,527   |  
|Bad debt provision                                                        |  |                            | (474     | ) |                          |      | 525      |                              |  |   | 707      |   |  |   | 25      |  
|Loss from write-off of collateralized lease costs                         |  |                            |         |   |                          |      | 1,256    |                              |  |   |         |   |  |   |        |  
|Equity in net loss of affiliate                                           |  |                            | 984      |   |                          |      |         |                              |  |   |         |   |  |   |        |  
|Net realized and unrealized (gain)/loss on investments                    |  |                            | 48       |   |                          |      | 723      |                              |  |   | (262     | ) |  |   | 17      |  
|Net loss on retirement of assets                                          |  |                            | 400      |   |                          |      | 1,196    |                              |  |   | 102      |   |  |   | 77      |  
|Acquired in-process research and development                              |  |                            | 11,410   |   |                          |      |         |                              |  |   | 7,200    |   |  |   |        |  
|Inventory and inventory commitment provisions                             |  |                            | 2,608    |   |                          |      | 15,199   |                              |  |   | 26,788   |   |  |   | 384     |  
|Non-cash compensation expense                                             |  |                            | 12,708   |   |                          |      | 8,881    |                              |  |   | 8,696    |   |  |   | 625     |  
|Deferred tax asset                                                        |  |                            | 38,815   |   |                          |      | (11,560  | )                            |  |   | (14,715  | ) |  |   | (1,902  | )
|Tax benefit (expense) from stock options exercised                        |  |                            | (420     | ) |                          |      | 3,146    |                              |  |   | 10,607   |   |  |   | 39      |  
|Changes in net assets and liabilities, net of acquired amounts:           |  |                            |          |   |                          |      |          |                              |  |   |          |   |  |   |         |  
|Accounts receivable                                                       |  |                            | (26,105  | ) |                          |      | (30,587  | )                            |  |   | 14,452   |   |  |   | 38,740  |  
|Inventories                                                               |  |                            | (6,150   | ) |                          |      | 2,870    |                              |  |   | (33,244  | ) |  |   | 418     |  
|Prepaid expenses and other current assets                                 |  |                            | 29       |   |                          |      | 400      |                              |  |   | (1,632   | ) |  |   | (488    | )
|Other assets, net                                                         |  |                            | (7,682   | ) |                          |      | (10,929  | )                            |  |   | (970     | ) |  |   | (1,092  | )
|Accounts payable                                                          |  |                            | 7,091    |   |                          |      | 4,986    |                              |  |   | (8,714   | ) |  |   | (9,548  | )
|Accrued liabilities                                                       |  |                            | 9,621    |   |                          |      | 8,338    |                              |  |   | 6,717    |   |  |   | (1,083  | )
|Deferred revenue                                                          |  |                            | 17,782   |   |                          |      | 12,997   |                              |  |   | (324     | ) |  |   | 92      |  
|Accrued income taxes                                                      |  |                            | (1,061   | ) |                          |      | 7,478    |                              |  |   | (14,799  | ) |  |   |        |  
|                                                                          |  |                            |          |   |                          |      |          |                              |  |   |          |   |  |   |         |  
|Net cash provided by operating activities                                 |  |                            | 61,060   |   |                          |      | 30,456   |                              |  |   | 8,336    |   |  |   | 25,371  |  
|Cash flows from investing activities:                                     |  |                            |          |   |                          |      |          |                              |  |   |          |   |  |   |         |  
|Acquisitions, net of cash acquired                                        |  |                            | (171,421 | ) |                          |      |         |                              |  |   | (29,750  | ) |  |   |        |  
|Purchase of equity investment in Aarohi                                   |  |                            | (6,000   | ) |                          |      |         |                              |  |   |         |   |  |   |        |  
|Purchases of property and equipment                                       |  |                            | (17,999  | ) |                          |      | (71,937  | )                            |  |   | (21,473  | ) |  |   | (371    | )
|Payment of collateralized lease costs                                     |  |                            |         |   |                          |      | (1,256   | )                            |  |   |         |   |  |   |        |  
|Restricted cash related to interest rate swap                             |  |                            | (5,130   | ) |                          |      |         |                              |  |   |         |   |  |   |        |  
|Purchases of investments                                                  |  |                            | (654,238 | ) |                          |      | (481,078 | )                            |  |   | (614,064 | ) |  |   | (11,600 | )
|Maturities of investments                                                 |  |                            | 509,444  |   |                          |      | 403,123  |                              |  |   | 446,929  |   |  |   | 21,970  |  
|Sales of investments                                                      |  |                            | 101,085  |   |                          |      | 124,109  |                              |  |   | 102,670  |   |  |   |        |  
|                                                                          |  |                            |          |   |                          |      |          |                              |  |   |          |   |  |   |         |  
|Net cash provided (used) in investing activities                          |  |                            | (244,259 | ) |                          |      | (27,039  | )                            |  |   | (115,688 | ) |  |   | 9,999   |  
|Cash flows from financing activities:                                     |  |                            |          |   |                          |      |          |                              |  |   |          |   |  |   |         |  
|Proceeds from issuance of convertible subordinated debt                   |  |                            | 172,500  |   |                          |      |         |                              |  |   |         |   |  |   |        |  
|Costs of debt issuance                                                    |  |                            | (5,567   | ) |                          |      |         |                              |  |   |         |   |  |   |        |  
|Purchase of call options                                                  |  |                            | (53,455  | ) |                          |      |         |                              |  |   |         |   |  |   |        |  
|Sale of call options                                                      |  |                            | 32,945   |   |                          |      |         |                              |  |   |         |   |  |   |        |  
|Purchase of treasury stock                                                |  |                            | (8,752   | ) |                          |      |         |                              |  |   |         |   |  |   |        |  
|Payment of notes payable                                                  |  |                            | (15,469  | ) |                          |      |         |                              |  |   |         |   |  |   |        |  
|Payment of obligations under capital leases                               |  |                            | (2,697   | ) |                          |      | (2,712   | )                            |  |   | (2,921   | ) |  |   | (196    | )
|Proceeds from the issuance of stock                                       |  |                            | 5,827    |   |                          |      | 2,421    |                              |  |   | 4,928    |   |  |   | 583     |  
|                                                                          |  |                            |          |   |                          |      |          |                              |  |   |          |   |  |   |         |  
|Net cash provided by (used in) financing activities                       |  |                            | 125,332  |   |                          |      | (291     | )                            |  |   | 2,007    |   |  |   | 387     |  
|                                                                          |  |                            |          |  
|Net increase (decrease) in cash and cash equivalents                      |  |                            | (57,867  | ) |                          |      | 3,126    |                              |  |   | (105,345 | ) |  |   | 35,757  |  
|Cash and cash equivalents, beginning of period                            |  |                            | 108,168  |   |                          |      | 69,285   |                              |  |   | 174,630  |   |  |   | 72,411  |  
|                                                                          |  |                            |          |   |                          |      |          |                              |  |   |          |   |  |   |         |  
|Cash and cash equivalents, end of period                                  |  | $                          | 50,301   |   |                          | $    | 72,411   |                              |  | $ | 69,285   |   |  | $ | 108,168 |  
|                                                                          |  |                            |          |   |                          |      |          |                              |  |   |          |   |  |   |         |  
|Supplemental Disclosure of Non-cash Investing and Financing Activities    |  |                            |          |   |                          |      |          |                              |  |   |          |   |  |   |         |  
|Interest paid                                                             |  | $                          | 2,325    |   |                          | $    | 293      |                              |  | $ | 350      |   |  | $ |        |  
|Income taxes paid (received)                                              |  |                            | 1,095    |   |                          |      | (3,285   | )                            |  |   | 13,505   |   |  |   | (59     | )
|Capital lease obligations incurred, net of trade-ins                      |  |                            | 1,783    |   |                          |      | 4,634    |                              |  |   | 1,574    |   |  |   | 186     |  
|Transfer of inventory to fixed assets                                     |  |                            | 1,859    |   |                          |      | 5,679    |                              |  |   | 4,549    |   |  |   | 614     |  
|Fixed assets exchanged for capital leases                                 |  |                            | (1,364   | ) |                          |      | (1,501   | )                            |  |   |         |   |  |   |        |  
|Restricted stock grant                                                    |  |                            | 17,357   |   |                          |      | 1,867    |                              |  |   | 1,896    |   |  |   | 747     |  
|Unrealized gain (loss) on investments                                     |  |                            | (761     | ) |                          |      | 441      |                              |  |   | 637      |   |  |   | (102    | )



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



F-6



---

McDATA CORPORATION



NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS



(tabular amounts in
thousands, except per share data)



NOTE 1 OVERVIEW AND BASIS OF
PRESENTATION



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



Prior to February 7, 2001, McDATA was a majority-owned subsidiary of EMC. On February 7, 2001, EMC distributed all of the
shares it held of McDATA Class A common stock to EMCs shareholders of record as of January 24, 2001 (the Distribution). EMC has received a ruling from the Internal Revenue Service that the Distribution to EMC stockholders was tax free for U.S.
federal income tax purposes. The Company continues to believe that the distribution of its Class A common stock by EMC was tax-free. As a result of the Distribution, EMC no longer has any ownership in or voting power over McDATA and, therefore, is
no longer considered a related party.



On January 15, 2003, the
Company changed its fiscal year end to January 31, from December 31. The Company believes that the twelve months ended December 31, 2002 and 2001 provide a meaningful comparison to the twelve months ended January 31, 2004. There are no factors, of
which the Company is aware, seasonal or otherwise, that would impact the comparability of information or trends, if results for the twelve months ended January 31, 2003 and 2002 were presented in lieu of results for the twelve months ended December
31, 2002 and 2001. References in these footnotes to 2003 represent the twelve months ended January 31, 2004. References to 2002 and 2001 represent the twelve months ended December 31, 2002 and 2001.



NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Principles of Consolidation



The consolidated financial statements include the assets, liabilities,
results of operations, cash flows and changes in stockholders equity of the Company and its wholly-owned subsidiaries. The equity method of accounting is used for investments in affiliates in which we have significant influence. All material
intercompany transactions and balances have been eliminated.



Use of
Estimates



The preparation of financial statements in
conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that effect the reported amounts of assets, liabilities, revenues and expenses and disclosure of
contingent assets and liabilities. Actual results could differ from these estimates.



Cash and Cash Equivalents



Cash equivalents
are short-term, highly liquid investments that are readily convertible to cash and have remaining maturities of ninety days or less at date of purchase.



F-7



---

Valuation of Accounts Receivable



Accounts receivable are reviewed to determine which are doubtful of collection. Estimates are also made for potential future
product returns. In making the determination of the appropriate allowance for doubtful accounts and product returns, the Company considers specific accounts, analysis of accounts receivable agings, changes in customer payment terms, historical
write-offs and returns, changes in customer demand and relationships, concentrations of credit risk and customer credit worthiness.



Inventories



Inventories, which include material, labor, factory overhead and purchased finished goods, are stated using standard costs which approximate the lower of
cost (first-in, first-out method) or market. The Company evaluates the need for reserves associated with obsolete, slow-moving and non-salable inventory by reviewing net realizable values on a quarterly basis. The Companys inventories do not
include materials purchased and held by the Companys component subcontractors, as the Company does not own this inventory.



Investments



The Companys short- and long-term investments consist primarily of marketable debt and equity securities, all of which are classified as
available-for-sale and recorded at fair value. Fair values are determined using quoted market prices. Unrealized holding gains and losses are recorded, net of any tax effect, as a separate component of accumulated other comprehensive income.
Securities with stated maturities of one year or less at time of purchase are classified as short-term investments. Securities with remaining maturities longer than one year are classified as long-term investments.



Included in investment balances are certain derivatives used as fair-value
hedges against positions held in certain marketable equity securities. Any ineffectiveness in these hedged instruments or the loss of hedge-accounting treatment could result in significant fluctuations to earnings.



Fair Value of Financial Instruments



The carrying value of financial instruments, including cash equivalents,
accounts receivable, accounts payable and accrued liabilities, approximate fair value due to their short maturities. Based upon borrowing rates currently available to the Company, with similar terms, the carrying values of the capital lease
obligations approximate their fair values. The fair values of the Companys investments and convertible debt are determined using quoted market prices for those securities. The Company recognizes all derivatives as either assets or liabilities
in the statement of financial position and measures those instruments at fair value.



Interest Rate Swaps



The Company has entered
into an interest rate swap to address interest rate market risk exposure. The interest rate swap is designated and qualifies as a fair value hedge under Statement of Financial Standards (SFAS) No. 133, Accounting for Derivative Instruments and
Hedging Activities. For derivative instruments that are designated and qualify as a fair value hedge, the gains and losses on the derivative instrument, as well as the offsetting gain or loss on the hedged item attributable to the hedged risk,
are recognized in current earnings during the period of change in fair values. If the change in the value of the hedging instrument offsets the change in the value of the hedged item, the hedge is considered perfectly effective. The accounting for
hedge effectiveness is measured at least quarterly based on the relative change in fair value between the derivative contract and the hedged item over time. Any change in fair value resulting from ineffectiveness, the amount by which the change in
the value of the hedge does not exactly offset the change in the value of the hedged item, is recognized immediately in earnings. The Companys interest rate swap qualifies as a perfectly effective fair value hedge. As such, there is no
ineffective portion to the hedge recognized in earnings. Adjustments to the fair value of the interest rate swap agreement are recorded as either an other asset or long-term liability. The differential to be paid or received under these agreements
is accrued consistently with the terms of the agreements and is recognized in interest expense over the term of the related debt. The related amounts payable to or receivable from counterparties are included in accounts receivable or accrued
liabilities.



F-8



---

Property and Equipment



Property and equipment is stated at cost less accumulated depreciation. Expenditures that substantially extend the useful life of an asset are
capitalized. Ordinary repair and maintenance expenditures are expensed as incurred. For financial reporting purposes, depreciation is recorded principally on a straight-line method over the estimated useful lives of the asset as follows:



|                        |  |                                                          
|----------------------- |  | ---------------------------------------------------------
|Building                |  | 39 years                                                 
|Building equipment      |  | 5-39 years                                               
|Equipment and furniture |  | 3-5 years                                                
|Computer software       |  | 2-5 years                                                
|Capital lease equipment |  | The shorter of the useful life of 3-5 years or lease term
|Leasehold improvements  |  | The shorter of the useful life of 3-5 years or lease term



Depreciation expense
was approximately $26,933,000, $18,648,000, $14,297,000 and $1,979,000 in 2003, 2002, 2001 and for the month ended January 31, 2003, respectively. Equipment and furniture at January 31, 2004 and December 31, 2002 includes assets under capitalized
leases of $8,361,000 and $10,679,000, respectively, with related accumulated amortization of approximately $4,627,000 and $6,436,000, respectively.



In accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 98-1, Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use, certain costs incurred in connection with the application development state of internal-use software projects are capitalized and amortized over the estimated useful life of the asset.
Amortization expense related to these costs are included in depreciation expense.



Long-Lived Assets, Including Goodwill and Other Acquired Intangible Assets



The Company periodically evaluates the carrying value of long-lived assets, excluding goodwill, for impairment when events and circumstances indicate the carrying amount of an asset may not be recoverable. The
carrying value of a long-lived asset is considered impaired when the anticipated undiscounted cash flows from such asset (or asset group) are separately identifiable and less than the assets (or asset groups) carrying value. In that
event, a loss is recognized to the extent that the carrying value exceeds the fair value of the long-lived asset. Fair value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risk involved. For the
three years ended 2003, 2002, 2001 and the month ended January 31, 2003, the Company has made no material adjustments to its long-lived assets.



The Company has adopted SFAS No. 142, Goodwill and Other Intangible Assets for the year ended December 31, 2002. As the Companys
goodwill at that time resulted from acquisitions subsequent to July 1, 2001, no significant amortization was incurred in 2001. See Note 5  Acquisitions and Intangible Assets. Under SFAS No. 142, goodwill and other indefinite lived intangible
assets are not subject to amortization, but are subject to an impairment test upon adoption and at least annually thereafter. The Company completed its annual impairment analysis of goodwill in the first quarter of 2003 and found no impairment. SFAS
No. 142 also requires that intangible assets with definite lives be amortized over their estimated useful lives and reviewed for impairment in accordance with SFAS No. 144, Accounting for the Impairment of Long-Lived Assets to Be Disposed
Of. The Company is currently amortizing its acquired intangible assets with definite lives over periods ranging from one to six years.



Revenue Recognition



The Company recognizes revenue when (a) persuasive evidence of an arrangement exists (b) products are delivered or services rendered (c) the sales price
is fixed or determinable and (d) collectibility is assured. Revenue from product sales to our resellers and end-user customers is recognized when title and risk of loss transfer to the customer, generally at the time the product is delivered.
Revenue from product sales to our OEMs and distributors is recognized when title and risk of loss transfer to the customer in accordance with the master agreement, generally upon sell-through



F-9



---

to the end-user. Revenue 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. The Company accrues for warranty costs and sales returns at the time of shipment based on its experience. Revenue from support or maintenance contracts
is recognized ratably over the contractual period. Amounts invoiced to customers in excess of revenue recognized on these contracts are recorded as deferred revenue until all revenue recognition criteria are met. Revenue from software is comprised
of software licensing and post-contract customer support. Software revenue is allocated to the license and support elements using vendor specific objective evidence of fair value (VSOE). Revenue allocated to software licenses is recognized when the
four basic criteria above have been met. Revenue allocated to post-contract support is recognized ratably over the term of the support contract, assuming the four basic criteria are met.



In transactions that include multiple products, services and/or software, the Company allocates the revenue to each element
based on their relative fair value (or in the absence of fair value, the residual method) and recognizes the associated revenue when all revenue recognition criteria have been met for each element.



Research and Development



Research and development (R&D) costs are expensed as incurred. R&D
costs consist primarily of salaries and related expenses of personnel engaged in engineering and R&D activities; fees paid to consultants and outside service providers; nonrecurring engineering charges; prototyping expenses related to the
design, development, testing and enhancement of our products; depreciation related to engineering and test equipment; and IT and facilities expenses.



Software Development Costs



The Company capitalizes eligible computer software development costs upon the establishment of technological feasibility, which it has defined as
completion of designing, coding and testing activities or the completion of a working model as defined by our software and hardware engineering development processes. Costs incurred prior to the establishment of technological feasibility are
expensed to research and development. The establishment of technological feasibility and the ongoing assessment of recoverability of capitalized software development costs require considerable judgment by management with respect to certain external
factors, including, but not limited to, anticipated future revenues, estimated economic life and changes in software and hardware technologies. Upon the general release of the software product to customers, capitalization ceases and such costs are
amortized (using the straight-line method) on a product-by-product basis over the estimated life, which is generally one to three years. Capitalized software costs and accumulated amortization included in other assets at January 31, 2004, were
approximately $15,079,000 and $7,312,000, respectively. Capitalized software costs and accumulated amortization included in other assets at December 31, 2002, were approximately $9,220,000 and $1,546,000, respectively. Capitalized software
amortization expense for 2003, 2002 and 2001 were approximately $5,506,000, $1,520,000 and $27,000, respectively. Capitalized software amortization expense for the month ended January 31, 2003 was approximately $260,000.



Advertising



The Company expenses advertising costs as incurred. Advertising expenses for 2003, 2002, and 2001 were approximately
$3,225,000, $6,222,000, and $6,941,000, respectively. Advertising expenses for the month ended January 31, 2003 were approximately $556,000.



Restructuring Charges



In July 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal
Activities. SFAS No. 146 supercedes Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring) and requires that costs related to exiting an activity or to a restructuring not be recognized until the liability is incurred as opposed to when management commits to an exit plan. This statement was effective for exit or
disposal activities initiated after December 31, 2002. The provisions of SFAS No. 146 were required to be applied prospectively after the adoption date to newly initiated exit activities. See Note 4 for discussion of 2003 restructuring activities.



F-10



---

Earnings 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 8) because the Company currently has the ability and intent to settle the conversion in cash. Additionally, no dilutive effect has been included for the share options sold in relation to the convertible subordinated debt because the exercise
price was higher than the average stock price for the period.



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



|                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|---------------------------------------------------------------------------------------------- |  | --------------------------- | ------- | - | ------------------------ | ---- | ------- | ---------------------------- |  | - | ------- | - |  | - | ------- | -
|                                                                                               |  | Year Ended January 31, 2004 |         |   | Years Ended December 31, |      |         | Month Ended January 31, 2003 | 
|                                                                                               |  |                             | 2002    |   |                          | 2001 |         |                             
|Net loss                                                                                       |  | $                           | (43,133 | ) |                          | $    | (9,987  | )                            |  | $ | (8,656  | ) |  | $ | (3,460  | )
|Weighted average shares of common stock outstanding used in computing basic net loss per share |  |                             | 114,682 |   |                          |      | 113,185 |                              |  |   | 111,475 |   |  |   | 114,000 |  
|Net effect of dilutive stock options                                                           |  |                             |        |   |                          |      |        |                              |  |   |        |   |  |   |        |  
|                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Weighted average shares of common stock used in computing diluted net loss per share           |  |                             | 114,682 |   |                          |      | 113,185 |                              |  |   | 111,475 |   |  |   | 114,000 |  
|                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Basic net loss per share                                                                       |  | $                           | (0.38   | ) |                          | $    | (0.09   | )                            |  | $ | (0.08   | ) |  | $ | (0.03   | )
|                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Diluted net loss per share                                                                     |  | $                           | (0.38   | ) |                          | $    | (0.09   | )                            |  | $ | (0.08   | ) |  | $ | (0.03   | )
|                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Options not included in diluted share base because of the exercise prices                      |  |                             | 8,459   |   |                          |      | 4,840   |                              |  |   | 1,344   |   |  |   | 6,092   |  
|                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  
|Options and restricted stock not included in diluted share because of net loss                 |  |                             | 6,422   |   |                          |      | 6,984   |                              |  |   | 9,520   |   |  |   | 6,401   |  
|                                                                                               |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |         |  



Stock-Based Compensation



At January 31, 2004, the Company has stock-based employee
compensation and employee purchase plans, which are described more fully in Note 9. 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, Accounting for Stock-Based Compensation(SFAS No. 123), as amended by SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure
an amendment of FASB Statement No. 123 (SFAS No. 148). Any deferred stock compensation calculated pursuant to APB 25 is amortized ratably over the vesting period of the individual options, generally two to four years. The following table
illustrates the effect on net loss and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123.



F-11



---

|                                                                                                                                                       |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------------------------ |  | --------------------------- | ------- | - | ------------------------ | ---- | ------- | ---------------------------- |  | - | ------- | - |  | - | ------ | -
|                                                                                                                                                       |  | Year Ended January 31, 2004 |         |   | Years Ended December 31, |      |         | Month Ended January 31, 2003 | 
|                                                                                                                                                       |  |                             | 2002    |   |                          | 2001 |         |                             
|Net loss, as reported                                                                                                                                  |  | $                           | (43,133 | ) |                          | $    | (9,987  | )                            |  | $ | (8,656  | ) |  | $ | (3,460 | )
|Add: Total stock-based employee compensation expense included in net income as determined under the intrinsic value method, net of related tax
effects |  |                             | 12,708  |   |                          |      | 5,542   |                              |  |   | 5,426   |   |  |   | 406    |  
|Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax
effects        |  |                             | (34,050 | ) |                          |      | (16,879 | )                            |  |   | (15,894 | ) |  |   | (1,481 | )
|                                                                                                                                                       |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |        |  
|Pro forma net loss                                                                                                                                     |  | $                           | (64,475 | ) |                          | $    | (21,324 | )                            |  | $ | (19,124 | ) |  | $ | (4,535 | )
|                                                                                                                                                       |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |        |  
|Loss per share:                                                                                                                                        |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |        |  
|Basic-as reported                                                                                                                                      |  | $                           | (0.38   | ) |                          | $    | (0.09   | )                            |  | $ | (0.08   | ) |  | $ | (0.03  | )
|                                                                                                                                                       |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |        |  
|Basic-pro forma                                                                                                                                        |  | $                           | (0.56   | ) |                          | $    | (0.19   | )                            |  | $ | (0.17   | ) |  | $ | (0.04  | )
|                                                                                                                                                       |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |        |  
|Diluted-as reported                                                                                                                                    |  | $                           | (0.38   | ) |                          | $    | (0.09   | )                            |  | $ | (0.08   | ) |  | $ | (0.03  | )
|                                                                                                                                                       |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |        |  
|Diluted-pro forma                                                                                                                                      |  | $                           | (0.56   | ) |                          | $    | (0.19   | )                            |  | $ | (0.17   | ) |  | $ | (0.04  | )
|                                                                                                                                                       |  |                             |         |   |                          |      |         |                              |  |   |         |   |  |   |        |  



The fair value of each
option granted during 2003, 2002, 2001, and the month ended January 31, 2003 is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:



|                        |  |                             |      |  |                          |      |  |                              |   |  |           |  
|----------------------- |  | --------------------------- | ---- |  | ------------------------ | ---- |  | ---------------------------- | - |  | --------- | -
|                        |  | Year Ended January 31, 2004 |      |  | Years Ended December 31, |      |  | Month Ended January 31, 2003 |  
|                        |  |                             | 2002 |  |                          | 2001 |  |                             
|Dividend yield          |  |                            | %    |  |                         | %    |  |                             | % |  |          | %
|Expected volatility     |  | 90                          | %    |  | 90                       | %    |  | 125                          | % |  | 90        | %
|Risk-free interest rate |  | 2.1%-3.5                    | %    |  | 2.5%-4.9                 | %    |  | 3.7%-5.0                     | % |  | 3.0%-3.1  | %
|Expected life, in years |  | 2.0  4.0                   |      |  | 2.0 - 4.0                |      |  | 4.0                          |   |  | 2.0 - 4.0 |  



Comprehensive Income (Loss)



Comprehensive income (loss) includes net earnings as well
as additional other comprehensive income. McDATAs other comprehensive income consists of unrealized gains and losses on available-for-sale securities, recorded net of any related tax, that are recorded as changes in equity and not an element
of the Companys income statement.



Reclassifications



Certain prior year amounts have been reclassified to conform to the 2003
presentation.



Recent Accounting Pronouncements



The FASB issued Interpretation No. 46 (FIN 46), Consolidation of
Variable Interest Entities in January 2003, and a revised interpretation of FIN 46 (FIN 46-R) in December 2003. 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. FIN46-R applies
at different dates to different types of enterprises and entities, and special provisions apply to enterprises that have fully or partially applied FIN 46 prior to issuance of FIN 46-R. Generally, application of FIN 46-R is required in financial
statements of public entities that have interest in variable interest entities or potential variable interest entities commonly referred to as special-purpose entities for periods ending after December 15, 2003. Application by public entities for
all other types of entities is required in financial statements for periods ending after March 15, 2004. The adoption of FIN 46 and FIN 46-R did not have a material impact on the Companys results of operations or financial condition.



F-12



---

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 October 2003, the Emerging Issues Task Force (EITF) reached a consensus on its tentative conclusions for EITF 03-05, Applicability of SOP 97-2 to
Non-Software Deliverables in an Arrangement Containing More-Than Incidental Software (EITF 03-05). EITF 03-05 discusses that software deliverables are within the scope of SOP 97-2 as are non-software deliverables. The Company is required to
adopt this consensus for fiscal periods beginning after August 2003. The Company believes the adoption of EITF 03-05 will not have an impact on the Companys consolidated financial statements.



In December 2003, the Staff of the Securities and Exchange Commission (SEC)
issued Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition, which supercedes SAB No. 101, Revenue Recognition in Financial Statements. SAB No. 104s primary purpose is to rescind accounting guidance contained in
SAB No. 101 related to multiple-element revenue arrangements and to rescind the SECs Revenue Recognition in Financial Statements Frequently Asked Questions and Answers (FAQ) issued with SAB No. 101. Selected portions of the FAQ
have been incorporated into SAB No. 104. The adoption of SAB No. 104 did not have a material impact on the Companys revenue recognition policies.



NOTE 3 COMPONENTS OF SELECTED BALANCE SHEET ACCOUNTS



|                                                         |  |                             |         |   |                              |   |         |  
|-------------------------------------------------------- |  | --------------------------- | ------- | - | ---------------------------- | - | ------- | -
|                                                         |  | Year Ended January 31, 2004 |         |   | Year Ended December 31, 2002 |  
|                                                         |  |                            
|Inventories:                                             |  |                             |         |   |                              |   |         |  
|Raw materials                                            |  | $                           | 7,037   |   |                              | $ | 8,070   |  
|Work-in-progress                                         |  |                             | 920     |   |                              |   | 1,123   |  
|Finished goods                                           |  |                             | 7,883   |   |                              |   | 6,316   |  
|                                                         |  |                             |         |   |                              |   |         |  
|Total inventories at cost                                |  |                             | 15,840  |   |                              |   | 15,509  |  
|Less reserves (1)                                        |  |                             | (4,476  | ) |                              |   | (7,412  | )
|                                                         |  |                             |         |   |                              |   |         |  
|Total inventories, net                                   |  | $                           | 11,364  |   |                              | $ | 8,097   |  
|                                                         |  |                             |         |   |                              |   |         |  
|Property and equipment:                                  |  |                             |         |   |                              |   |         |  
|Land                                                     |  | $                           | 16,091  |   |                              | $ | 16,091  |  
|Building                                                 |  |                             | 32,410  |   |                              |   | 29,712  |  
|Equipment and furniture                                  |  |                             | 85,680  |   |                              |   | 74,608  |  
|Computer software for internal use                       |  |                             | 25,492  |   |                              |   | 18,877  |  
|Leasehold improvements                                   |  |                             | 3,271   |   |                              |   | 4,805   |  
|Construction in progress                                 |  |                             | 958     |   |                              |   | 2,361   |  
|                                                         |  |                             |         |   |                              |   |         |  
|                                                         |  |                             | 163,902 |   |                              |   | 146,454 |  
|Less accumulated depreciation and amortization           |  |                             | (64,677 | ) |                              |   | (46,527 | )
|                                                         |  |                             |         |   |                              |   |         |  
|                                                         |  | $                           | 99,225  |   |                              | $ | 99,927  |  
|                                                         |  |                             |         |   |                              |   |         |  
|Accrued liabilities:                                     |  |                             |         |   |                              |   |         |  
|Wages and employee benefits                              |  | $                           | 17,489  |   |                              | $ | 16,643  |  
|Purchase commitments and other supply obligations (1)(2) |  |                             | 7,829   |   |                              |   | 12,022  |  
|Warranty reserves (3)                                    |  |                             | 4,522   |   |                              |   | 3,461   |  
|Taxes, other than income tax                             |  |                             | 2,534   |   |                              |   | 1,050   |  
|Interest payable                                         |  |                             | 1,773   |   |                              |   |        |  
|Customer obligations                                     |  |                             | 4,729   |   |                              |   | 349     |  
|ESCON agency funds                                       |  |                             | 8,373   |   |                              |   | 2,366   |  
|Other accrued liabilities                                |  |                             | 4,298   |   |                              |   | 1,888   |  
|                                                         |  |                             |         |   |                              |   |         |  
|                                                         |  | $                           | 51,547  |   |                              | $ | 37,779  |  
|                                                         |  |                             |         |   |                              |   |         |  

---

|(1) | During the year ended December 31, 2002, the Company recorded net inventory-related charges of $9.5 million, primarily for excess 1 gigabit (Gb) components used in the
Companys director-class products. The excess inventory resulted primarily from the Companys introduction of 2 Gb products in the second quarter of 2002 and the unanticipated reduction in demand for the 1 Gb product orders prior to the
new product release. These charges were in excess of the routine excess and obsolete reserves recorded by the Company during the year.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



F-13



---

|(2) | During the fiscal 2003 year, the Company released recorded obligations of approximately $1.3 million relating to the expiration of certain customer sales obligations which were
provided for in fiscal 2001.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Activity in the warranty reserves is as follows:
|--- | ------------------------------------------------



|                                  |  |                  |        |   |                                  |   |       |   |  |   |      
|--------------------------------- |  | ---------------- | ------ | - | -------------------------------- | - | ----- | - |  | - | -----
|                                  |  | Year Ended       |        |   | One Month Ended January 31, 2003
|                                  |  | January 31, 2004 |        |   | December 31, 2002                |   |      
|                                  |  |                  |       
|Balance at beginning of period    |  | $                | 3,485  |   |                                  | $ | 2,174 |   |  | $ | 3,461
|Warranty expense                  |  |                  | 2,104  |   |                                  |   | 1,853 |   |  |   | 24   
|Warranty claims                   |  |                  | (1,294 | ) |                                  |   | (566  | ) |  |   |     
|Acquisition of warranty liability |  |                  | 227    |   |                                  |   |      |   |  |   |     
|                                  |  |                  |        |   |                                  |   |       |   |  |   |      
|Balance at end of period          |  | $                | 4,522  |   |                                  | $ | 3,461 |   |  | $ | 3,485
|                                  |  |                  |        |   |                                  |   |       |   |  |   |      



NOTE 4 RESTRUCTURING CHARGES



In January 2004, the Company announced that it was taking
certain cost improvement actions, which included a workforce reduction and facility consolidation. As a result, in the fiscal fourth quarter of 2003, the Company recorded to accrued liabilities an approximate $2.3 million restructuring charge
related to the reduction in workforce. The reduction in workforce represented approximately nine percent primarily in the engineering, sales and marketing organizations. In addition, the Company announced the anticipated first quarter 2004 closure
of its Canadian leased engineering facility. All of these charges are to be paid in fiscal year 2004. In addition, the Company expects to incur an approximate $2.2 million restructuring charge in its fiscal first quarter 2004, primarily related to
the facilities closure, as well as additional severance costs.



NOTE
5 ACQUISITIONS AND INTANGIBLE ASSETS



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



F-14



---

Ethernet, the international networking standards. The Nishan transaction is intended to accelerate 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 Nishans net tangible and intangible assets acquired. As a result, the Company has recorded goodwill in
connection with this transaction. The consolidated financial statements include the operating results of Nishan from the date of the acquisition.



The total purchase price of approximately $69.3 million consisted of $65.0 million in cash consideration and direct transaction costs paid of
approximately $4.3 million. 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                                |  | $ | 668     |  
|Other tangible assets               |  |   | 4,905   |  
|Amortizable intangible assets:      |  |   |         |  
|Customer relationships              |  |   | 1,622   |  
|Developed technology                |  |   | 8,337   |  
|Customer backlog                    |  |   | 454     |  
|Goodwill                            |  |   | 67,007  |  
|Liabilities                         |  |   | (5,680  | )
|Debt                                |  |   | (15,816 | )
|In-process research and development |  |   | 7,774   |  
|                                    |  |   |         |  
|Total                               |  | $ | 69,271  |  
|                                    |  |   |         |  



Amortizable intangible
assets consist of customer-related intangible assets and developed technology. 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 various protocols (iSCSI, iFCP and E_Port for trunking) to connect IP backbones to 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.



A preliminary estimate of $67 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 addition, as this was the purchase of stock, the tax basis of Nishans assets and liabilities carry over resulting in temporary differences and a net deferred tax asset of $35.1 million. In light of the Companys tax position
(see Note 12) a full valuation allowance of $35.1 million was recorded against the net acquired deferred tax asset. Pursuant to the provisions of SFAS No. 109, Accounting for Income Taxes, if this valuation allowance is released in
subsequent periods, goodwill will be decreased by the amount released up to a maximum of $35.1 million.



Of the total purchase price, $7.8 million was allocated to IPR&D and expensed in 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



F-15



---

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, and then 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 determined to be approximately 70% complete with estimated full completion in the first half of 2004, at which time the Company is expected to begin generating economic benefits. 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 adjusted to reflect the difficulties and
uncertainties in completing each project 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 used to value 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 consist 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 the Companys Multi-Capable Storage Network Solutionsplatform and believe it will accelerate its vision of delivering a real-time storage services infrastructure. The technology
acquired from Sanera will help McDATA extend its reach at the core of the data center, and integrated with McDATAs products and technology, will create a product that allows enterprises to securely consolidate their separate SAN networks 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 purchase price of approximately $113.2 million consisted of $110.2 million in cash consideration and direct transaction costs paid of
approximately $3.0 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.



F-16



---

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. The preliminary purchase price allocation for Sanera 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 Sanera will change the amount of the purchase price allocable to intangible assets. 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 Fair Value of Assets and Liabilities | 
|Cash                           |  | $                                    | 10,547  |   |                                     | $ |        |                                                |  | $ | 10,547  |  
|Other tangible assets          |  |                                      | 4,492   |   |                                     |   |        |                                                |  |   | 4,492   |  
|Amortizable intangible assets: |  |                                      |         |   |                                     |   |         |                                                |  |   |         |  
|Developed technology           |  |                                      | 48,098  |   |                                     |   | 49,833  |                                                |  |   | 97,931  |  
|Customer Relationships         |  |                                      | 1,399   |   |                                     |   |        |                                                |  |   | 1,399   |  
|Patents pending                |  |                                      | 434     |   |                                     |   | 450     |                                                |  |   | 884     |  
|Assembled workforce            |  |                                      | 1,104   |   |                                     |   | 1,144   |                                                |  |   | 2,248   |  
|Liabilities assumed            |  |                                      | (4,272  | ) |                                     |   |        |                                                |  |   | (4,272  | )
|Excess purchase price          |  |                                      | 51,427  |   |                                     |   | (51,427 | )                                              |  |   |        |  
|                               |  |                                      |         |   |                                     |   |         |                                                |  |   |         |  
|Total purchase price           |  | $                                    | 113,229 |   |                                     | $ |        |                                                |  | $ | 113,229 |  
|                               |  |                                      |         |   |                                     |   |         |                                                |  |   |         |  



Amortizable intangible
assets consist of customer relationships, patents pending, an assembled workforce and developed technology. Customer relationships represent an existing contract that relates primarily to an outstanding purchase order for future product, when and if
available. The Company is amortizing the fair value of this asset on a straight-line basis over an estimated useful life of approximately three years. Developed technology represents next-generation intelligent switching platform technologies and
consists of products that have reached technological feasibility. The Company is amortizing the developed technology on a straight-line basis over an estimated useful life of approximately six years. Patents pending and the assembled workforce
intangible assets are being amortized over lives of six and two years, respectively.



Consolidation of Facilities



In conjunction
with the acquisitions of Nishan and Sanera, management completed a facilities consolidation plan during the fourth quarter of 2003. In accordance with the provisions of EITF95-3 Recognition of Liabilities in Connection With a Purchase Business
Combination, a liability of $1.2 million has been recorded as part of purchase accounting to reflect the estimated obligation related to uncancellable leases for both Nishan and Sanera through the expected cease-use date. The Company estimates
that the consolidation will be completed by the third quarter of 2004.



Purchase of SANavigator, Inc.



On September
21, 2001, the Company acquired the assets of SANavigator, Inc. (SANavigator) for a cash purchase price of $29.75 million. In addition, one-time costs associated with the acquisition were approximately $2.1 million. The results of SANavigators
operations have been included in the consolidated financial statements since that date. SANavigator is a software company that designs and develops a scalable and stable SAN management tool that manages entry-level through complex SAN environments
utilizing vendor- and platform-independent software. As a result of the acquisition, the Company is expected to be in a leading position in offering storage network management software that provides visibility and discovery in a multi-vendor fabric
environment.



The estimated excess of the purchase price over
the fair value of the tangible net assets acquired was valued at $29.2 million. Of this excess, $10.5 million was allocated to developed technology (5 year average useful life), $7.2 million was allocated to in-process research and development
(IPR&D), and the remaining $11.5 million was allocated to goodwill. Of the total goodwill amount, $11.5 million is deductible for tax purposes. In conjunction with the acquisition, the Company issued approximately 192,000 shares of Class B
common stock, with a fair value of $1.9 million, for the completion of ongoing employment arrangements with certain SANavigator employees. The stock awards were contingent upon the continued employment of these employees. As such, these awards were
recorded as deferred compensation and recognized ratably through the expiration date of the employee agreements. At January 31, 2004, all awards were fully vested.



The 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 arose from SANavigators on-going development of the next-generation of



F-17



---

SANavigator software. This software was intended to significantly enhance the features of the current version of
SANavigator software. The status of the development at the acquisition date was dependent on several factors including the complexity of working with diverse servers and storage devices and integrating with other applications. Overall,
SANavigators IPR&D project was estimated to be approximately 40% complete at the time of acquisition and it was expected that the remaining 60% would be completed during the Companys 2002 fiscal year at a cost of approximately $2.1
million. The remaining efforts, which were completed during 2002, included completion of coding, finalizing user interface design and development, and testing. The amount allocated to in-process research and development was determined using the
discounted cash flow method. This model employed cash flow projections for revenue based on the projected incremental increase in revenue that the Company expected to receive from the completed IPR&D. Estimated operating expenses, capital
charges and applicable income taxes were deducted to arrive at an estimated after-tax cash flow. The Company discounted the after-tax cash flow projections using a risk-adjusted rate of return of 75%.



Pro Forma Information



The unaudited pro forma information presented below assumes that the acquisitions were completed at the beginning of the
year acquired and the immediate preceding year and includes the effect of amortization of identified intangibles and costs from those dates. The impact of charges for IPR&D has been excluded. This is presented for informational purposes only and
is not necessarily indicative of the results of future operations or results that would have been achieved had the acquisition taken place at the beginning of the periods presented.



|                                    |  |                             |          |   |                          |      |         |   |  |   |         |  
|----------------------------------- |  | --------------------------- | -------- | - | ------------------------ | ---- | ------- | - |  | - | ------- | -
|                                    |  | Year Ended January 31, 2004 |          |   | Years Ended December 31, |     
|                                    |  |                             | 2002     |   |                          | 2001 |        
|Revenue                             |  | $                           | 426,959  |   |                          | $    | 344,106 |   |  | $ | 344,636 |  
|Net income (loss)                   |  | $                           | (110,500 | ) |                          | $    | (93,183 | ) |  | $ | (9,248  | )
|Basic net income (loss) per share   |  | $                           | (0.96    | ) |                          | $    | (0.82   | ) |  | $ | (0.08   | )
|Diluted net income (loss) per share |  | $                           | (0.96    | ) |                          | $    | (0.82   | ) |  | $ | (0.08   | )



Goodwill and Other Intangible
Assets



Changes in the carrying amounts of goodwill are as
follows:



|                                                                    |  |   |       
|------------------------------------------------------------------- |  | - | ------
|Goodwill as of December 31, 2001 and 2001 and January 31, 2003, net |  | $ | 11,780
|Acquisitions (Note 5)                                               |  |   | 67,007
|                                                                    |  |   |       
|Goodwill as of January 31, 2004, net                                |  | $ | 78,787
|                                                                    |  |   |       



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



|                        |  |                     |         |                         |   |                   |  |                     |         |                         |   |                   |  |   |       |  |   |      
|----------------------- |  | ------------------- | ------- | ----------------------- | - | ----------------- |  | ------------------- | ------- | ----------------------- | - | ----------------- |  | - | ----- |  | - | -----
|                        |  | January 31, 2004    |         | December 31, 2002      
|                        |  | GrossCarryingAmount |         | AccumulatedAmortization |   | NetCarryingAmount |  | GrossCarryingAmount |         | AccumulatedAmortization |   | NetCarryingAmount
|Developed technology    |  | $                   | 116,769 |                         | $ | 11,133            |  | $                   | 105,636 |                         | $ | 10,501            |  | $ | 2,666 |  | $ | 7,835
|Customer relationships  |  |                     | 3,021   |                         |   | 340               |  |                     | 2,681   |                         |   |                  |  |   |      |  |   |     
|Workforce               |  |                     | 2,248   |                         |   | 375               |  |                     | 1,873   |                         |   |                  |  |   |      |  |   |     
|Other                   |  |                     | 3,745   |                         |   | 2,622             |  |                     | 1,123   |                         |   | 2,423             |  |   | 2,371 |  |   | 52   
|                        |  |                     |         |                         |   |                   |  |                     |         |                         |   |                   |  |   |       |  |   |      
|Total intangible assets |  | $                   | 125,783 |                         | $ | 14,470            |  | $                   | 111,313 |                         | $ | 12,924            |  | $ | 5,037 |  | $ | 7,887
|                        |  |                     |         |                         |   |                   |  |                     |         |                         |   |                   |  |   |       |  |   |      



F-18



---

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



|                                           |  |   |        
|------------------------------------------ |  | - | -------
|Fiscal Years:                              |  |   |        
|2004                                       |  | $ | 22,995 
|2005                                       |  |   | 22,068 
|2006                                       |  |   | 19,781 
|2007                                       |  |   | 17,757 
|2008                                       |  |   | 17,421 
|Thereafter                                 |  |   | 11,291 
|                                           |  |   |        
|Total expected annual amortization expense |  | $ | 111,313
|                                           |  |   |        



Amortization expense
related to acquired intangible assets was $9.4 million, $2.1 million, $565,000 and $175,000 for 2003, 2002, 2001 and the month ended January 31, 2003, respectively.



NOTE 6 EQUITY INVESTMENT



On August 22, 2003, the Company purchased 13.6 million shares of preferred stock of Aarohi Communications (Aarohi) for $6 million cash. At January 31,
2004, this represented approximately 17.3% of the total outstanding shares of Aarohi. Aarohi is a privately owned provider of next-generation intelligent storage networking technology. As of the investment date, the purchase price paid by McDATA
exceeded the Companys underlying proportionate equity in Aarohis net assets by $3.6 million. 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 $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 amount during fiscal year 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 net loss of approximately $984,000 from the date of purchase through January 31, 2004. The remaining
net equity investment of approximately $1.4 million is recorded as an Other Asset at January 31, 2004.



Summarized financial information for Aarohi is as follows:



|                                       |  |   |         |  
|-------------------------------------- |  | - | ------- | -
|Year Ended December 31, 2003           |  |   |         |  
|Net sales                              |  | $ | 126     |  
|Gross profit                           |  | $ | 48      |  
|Operating loss                         |  | $ | (10,231 | )
|Net loss                               |  | $ | (9,908  | )
|                                       | 
|As of December 31, 2003                |  |   |         |  
|Current assets                         |  | $ | 14,524  |  
|Noncurrent assets                      |  | $ | 1,581   |  
|Current liabilities                    |  | $ | 1,253   |  
|Noncurrent liabilities                 |  | $ | 2,020   |  
|Redeemable convertible preferred stock |  | $ | 34,249  |  
|Stockholders deficit                  |  | $ | (21,417 | )



F-19



---

NOTE 7 INVESTMENTS



Short and long-term investments consisted of the following available-for-sale securities at January 31, 2004 and December 31, 2003 (in thousands):



|                                       |  |               |         |                        |   |                         |  |            |     |  |   |        
|-------------------------------------- |  | ------------- | ------- | ---------------------- | - | ----------------------- |  | ---------- | --- |  | - | -------
|                                       |  | AmortizedCost |         | UnrealizedHoldingGains |   | UnrealizedHoldingLosses |  | FairValues
|2003                                   |  |               |         |                        |   |                         |  |            |     |  |   |        
|U.S. Government obligations            |  | $             | 126,250 |                        | $ | 418                     |  | $          | 67  |  | $ | 126,601
|State and local government obligations |  |               | 48,459  |                        |   | 18                      |  |            |    |  |   | 48,477 
|Corporate obligations                  |  |               | 44,788  |                        |   | 145                     |  |            | 4   |  |   | 44,929 
|U.S. Treasury options                  |  |               | 66      |                        |   |                        |  |            | 34  |  |   | 32     
|Marketable equity securities           |  |               | 31,109  |                        |   |                        |  |            | 64  |  |   | 31,045 
|Fixed income mutual funds              |  |               | 10,246  |                        |   |                        |  |            | 107 |  |   | 10,139 
|                                       |  |               |         |                        |   |                         |  |            |     |  |   |        
|                                       |  | $             | 260,918 |                        | $ | 581                     |  | $          | 276 |  | $ | 261,223
|                                       |  |               |         |                        |   |                         |  |            |     |  |   |        
|Reported as:                           |  |               |         |                        |   |                         |  |            |     |  |   |        
|Short-term investments                 |  |               |         |                        |   |                         |  |            |     |  | $ | 157,740
|Long-term investments                  |  |               |         |                        |   |                         |  |            |     |  |   | 103,483
|                                       |  |               |         |                        |   |                         |  |            |     |  |   |        
|                                       |  |               |         |                        |   |                         |  |            |     |  | $ | 261,223
|                                       |  |               |         |                        |   |                         |  |            |     |  |   |        
|2002                                   |  |               |         |                        |   |                         |  |            |     |  |   |        
|U.S. Government obligations            |  | $             | 87,570  |                        | $ | 1,026                   |  | $          |    |  | $ | 88,596 
|State and local government obligations |  |               | 89,614  |                        |   | 118                     |  |            |    |  |   | 89,732 
|Mutual funds                           |  |               | 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
|                                       |  |               |         |                        |   |                         |  |            |     |  |   |        



Amortized cost is
determined based on specific identification. As of January 31, 2004 and December 31, 2002, net unrealized holding gains of $403,000 and $1,265,000 million, respectively, were included in accumulated other comprehensive income in the accompanying
condensed consolidated balance sheets. For the fiscal year ended January 31, 2004, approximately $98,000 of unrealized losses related to hedged securities were included in investment income. These unrealized losses represent the net ineffectiveness
of a fair-value hedge comprised of certain marketable equity securities and put options on U.S. Treasury futures. At January 31, 2004, the Company held approximately $32,000 of purchase put options for U.S. Treasury futures. These investments were
purchased to 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 $8.2 million at January 31, 2004.



Realized gains and losses on sales of securities were recorded as other
income as follows:



|                            |  |                             |      |   |                         |      |      |                              |  |   |      |   |  |   |    |  
|--------------------------- |  | --------------------------- | ---- | - | ----------------------- | ---- | ---- | ---------------------------- |  | - | ---- | - |  | - | -- | -
|                            |  | Year Ended January 31, 2004 |      |   | Years EndedDecember 31, |      |      | Month Ended January 31, 2003 | 
|                            |  |                             | 2002 |   |                         | 2001 |      |                             
|Realized gains              |  | $                           | 863  |   |                         | $    | 3    |                              |  | $ | 396  |   |  | $ |   |  
|Realized losses             |  |                             | (834 | ) |                         |      | (343 | )                            |  |   | (134 | ) |  |   | (6 | )
|                            |  |                             |      |   |                         |      |      |                              |  |   |      |   |  |   |    |  
|Net realized gains (losses) |  | $                           | 29   |   |                         | $    | (340 | )                            |  | $ | 262  |   |  | $ | (6 | )
|                            |  |                             |      |   |                         |      |      |                              |  |   |      |   |  |   |    |  



The amortized cost and
estimated fair value of debt securities held at January 31, 2004, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because the issuers of securities may have the right to repay obligations without
prepayment penalties. 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.



F-20



---

|                                          |  |               |         |            |   |        
|----------------------------------------- |  | ------------- | ------- | ---------- | - | -------
|                                          |  | AmortizedCost |         | FairValues
|Less than one year                        |  | $             | 65,037  |            | $ | 65,412 
|Greater than one year through five years  |  |               | 96,211  |            |   | 96,345 
|Greater than five years through ten years |  |               | 1,950   |            |   | 1,950  
|Greater than ten years                    |  |               | 56,299  |            |   | 56,300 
|                                          |  |               |         |            |   |        
|                                          |  | $             | 219,497 |            | $ | 220,007
|                                          |  |               |         |            |   |        



In fiscal year 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 ownership of the securities loaned, and continues to earn income 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 January 31, 2004, the amount of securities on loan equaled $124.5 million.



Financial instruments that potentially subject the Company to concentrations of credit risk are cash equivalents, short and long-term investments and
accounts receivable. The Company maintains cash and cash equivalents and short- and long-term investments with various financial institutions. These financial institutions are geographically dispersed and company policy restricts investments and
limits the amount invested with any single financial institution. The Company has not sustained material credit losses from instruments held at financial institutions.



NOTE 8 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 a 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, subject to adjustments. 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. 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 January 31, 2004, the approximate bid price of our notes was
$116.0 and the approximate ask price of our notes was $116.5, resulting in an aggregate fair value of between $200.1 million and $201.0 million. Our Class A common stock is quoted on the NASDAQ National Market under the symbol, MCDTA.



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.



F-21



---

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. At January 31, 2004, the six-month LIBOR setting for the swap was 1.1283%, creating a rate of approximately minus
0.39%, which was effective until February 15, 2004. On February 15, 2004, the six-month LIBOR setting was reset to 1.175%, resulting in a rate of approximately minus 0.345%, which is effective until August 15, 2004. 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 January 31, 2004, the fair value of the interest rate swap had
decreased from inception to $349,000 and is included in other long-term liabilities. Corresponding to this change, the carrying value of the Notes has decreased by $349,000. 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 January 31, 2004.



NOTE 9 STOCKHOLDERS EQUITY



The Company has both Class A and Class B common stock. Holders of Class A and Class B common stock have voting rights equal to one vote and one-tenth
vote, respectively, for each share held. Holders of Class A and Class B common stock share equal rights as to dividends. No dividends attributable to common stock were declared or paid during 2003, 2002, 2001 or the month ended January 31, 2003.



The Board of Directors is authorized to issue preferred stock
with voting, conversion and other rights and preferences that may differ from the Class A and Class B common stock. At January 31, 2004, there is no outstanding preferred stock.



Stock Repurchase Plan



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 January 31, 2004, approximately 976,000 shares have been repurchased under
the plan with a total cost at $8.8 million.



Stockholders Rights Plan



Effective June 5, 2001, the Companys Board of
Directors approved a Stockholder Rights Plan in which preferred stock purchase rights were distributed as a dividend. Each Right, expiring June 5, 2011, represents a right to buy from the Company one ten-thousandth (1/10,000) of a share of Series A
Junior Participating Preferred Stock, $0.01 par value, at a price of $200 per Right. This dividend distribution of the Rights was not taxable to the Company or its stockholders.



Separate certificates for Rights will not be distributed, nor will the Rights be exercisable, unless a person or group
acquires 15 percent or more, or announces an offer that could result in acquiring 15 percent or more, of the aggregate number of votes entitled to be cast by all then outstanding shares of Common Stock (a Stock Acquisition). Following a Stock
Acquisition, each Right holder, except the 15 percent or more stockholder, has the right to receive, upon exercise, common shares valued at twice the then applicable exercise price of the Right (or, under certain circumstances, cash, property or
other Company securities), unless the 15 percent or more stockholder has offered to acquire all of the outstanding shares of the Company under terms that a majority of the independent directors of the Company have determined to be fair and in the
best interest of the Company and its stockholders. Similarly, unless certain conditions are met, if the Company engages in a merger or other business combination following a Stock Acquisition where it does not survive or survives with a change or
exchange of its common shares or if 50 percent or more of its assets, earning power, or cash flow is sold or transferred, the Rights will become exercisable for shares of the acquirers stock having a value of twice the exercise price (or under
certain circumstances, cash or property). The Rights are not exercisable, however, until the Companys right of redemption described below has expired. Generally, Rights



F-22



---

may be redeemed for $0.01 each (in cash, common shares or other consideration the Company deems appropriate) until the
earlier of (i) the tenth day following public announcement that a 15 percent or greater position has been acquired in the Companys stock or (ii) the final expiration of the Rights. Until exercise, a Right holder, as such, has no rights as a
stockholder of the Company.



Stock Options



The Company maintains a stock option and restricted stock plan known as the
2001 McDATA Equity Incentive Plan (the 2001 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 2001 Plan as of January 31, 2004, of which no more than 3,000,000 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 2001 Plan (included in the maximum amount noted above).



In August 2003 and in connection with the acquisitions of Nishan and Sanera, the Company adopted the 2003 McDATA Acquisition
Equity Incentive Plan (the 2003 Plan). The 2003 Plan is a limited purpose plan that allows 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 the 2003 Plan. Approximately
1,300,000 restricted stock shares were issued under this 2003 Plan in connection with the acquisitions discussed in Note 5. As of January 31, 2004, there were approximately 8.3 million shares of common stock available for future grants under these
plans.



All stock option grants under the plans since August
2000 have been granted at an exercise price equal to the fair market value of the Companys stock. Prior to 2001, in connection with the grant of certain stock options to employees, the Company recorded deferred stock-based compensation, net of
forfeitures, of $36,110,000, representing the difference between the exercise price and the deemed fair market value of the Companys common stock on the dates these stock options were granted. Deferred compensation related to these grants is
included as a reduction of stockholders equity and is being amortized on a straight-line basis over the vesting periods of the related options, which is generally four years. During 2003, 2002, 2001, and the month ended January 31, 2003, the
Company recorded amortization expense related to these grants of approximately $4,279,000, $7,218,000, $8,195,000, and $572,000, respectively (of which $377,000, $584,000, $1,437,000, and $44,000 is included in the cost of revenue for 2003, 2002,
2001, and the month ended January 31, 2003, respectively).



The
following summarizes stock option transactions for the period from January 1, 2001 to January 31, 2004:



|                                                                                                 |  |                       |   |                          |                              |                         |        |        |   |                              |   |        |  |        |                              |  |        |       |  |                              |   |  |   |      
|------------------------------------------------------------------------------------------------ |  | --------------------- | - | ------------------------ | ---------------------------- | ----------------------- | ------ | ------ | - | ---------------------------- | - | ------ |  | ------ | ---------------------------- |  | ------ | ----- |  | ---------------------------- | - |  | - | -----
|                                                                                                 |  | Year EndedJanuary 31, |   | Years Ended December 31, |                              | Month Ended January 31,
|                                                                                                 |  | 2004                  |   | 2002                     |                              | 2001                    |        | 2003  
|Options                                                                                          |  | Shares                |   |                          | WeightedAverageExercisePrice |                         | Shares |        |   | WeightedAverageExercisePrice |   | Shares |  |        | WeightedAverageExercisePrice |  | Shares |       |  | WeightedAverageExercisePrice
|Outstanding at beginning of period                                                               |  | 12,324                |   |                          | $                            | 11.43                   |        | 10,672 |   |                              | $ | 11.32  |  | 11,891 |                              |  | $      | 7.41  |  | 11,654                       |   |  | $ | 11.56
|Granted                                                                                          |  | 3,683                 |   |                          |                              | 10.47                   |        | 3,296  |   |                              |   | 11.44  |  | 2,526  |                              |  |        | 19.29 |  | 1,073                        |   |  |   | 8.24 
|Exercised                                                                                        |  | (805                  | ) |                          |                              | 2.75                    |        | (1,234 | ) |                              |   | 1.97   |  | (2,462 | )                            |  |        | 2.00  |  | (238                         | ) |  |   | 2.45 
|Forfeited or expired                                                                             |  | (1,554                | ) |                          |                              | 14.17                   |        | (1,080 | ) |                              |   | 19.89  |  | (1,283 | )                            |  |        | 8.64  |  | (165                         | ) |  |   | 12.41
|                                                                                                 |  |                       |   |                          |                              |                         |        |        |   |                              |   |        |  |        |                              |  |        |       |  |                              |   |  |   |      
|Outstanding end of period                                                                        |  | 13,648                |   |                          | $                            | 11.38                   |        | 11,654 |   |                              | $ | 11.56  |  | 10,672 |                              |  | $      | 11.32 |  | 12,324                       |   |  | $ | 11.43
|                                                                                                 |  |                       |   |                          |                              |                         |        |        |   |                              |   |        |  |        |                              |  |        |       |  |                              |   |  |   |      
|                                                                                                 |  |                       |   |                          |                              |                         |        | 5,194  |   |                              | $ | 8.17   |  | 4,377  |                              |  | $      | 4.70  |  | 5,061                        |   |  | $ | 8.95 
|Exercisable at end of period                                                                     |  | 6,602                 |   |                          | $                            | 10.76                   |        |        |   |                              |   |        |  |        |                              |  |        |       |  |                              |   |  |   |      
|Weighted-average fair value of options granted with an exercise price equal to fair market value |  |                       |   |                          | $                            | 6.84                    |        |        |   |                              | $ | 7.52   |  |        |                              |  | $      | 15.55 |  |                              |   |  | $ | 5.39 



---

The status of total stock options outstanding and exercisable at January 31, 2004 was as follows:



|                |  |                     |  |                                                 |  |                              |       |                |       |                              |   |      
|--------------- |  | ------------------- |  | ----------------------------------------------- |  | ---------------------------- | ----- | -------------- | ----- | ---------------------------- | - | -----
|                |  | Options Outstanding |  | Options Exercisable                            
|Exercise Prices |  | NumberofShares      |  | WeightedAverageRemainingContractualLife (Years) |  | WeightedAverageExercisePrice |       | NumberofShares |       | WeightedAverageExercisePrice
|$1.00$9.99     |  | 6,831               |  | 6.9                                             |  | $                            | 5.35  |                | 3,697 |                              | $ | 2.74 
|$10.00$19.99   |  | 5,281               |  | 8.0                                             |  |                              | 12.44 |                | 1,906 |                              |   | 13.15
|$20.00$29.99   |  | 1,177               |  | 7.1                                             |  |                              | 26.41 |                | 748   |                              |   | 26.71
|$30.00$39.99   |  | 79                  |  | 7.3                                             |  |                              | 34.99 |                | 41    |                              |   | 34.98
|$40.00$49.99   |  | 47                  |  | 6.9                                             |  |                              | 45.60 |                | 35    |                              |   | 45.60
|$50.00$59.99   |  | 13                  |  | 7.0                                             |  |                              | 54.43 |                | 7     |                              |   | 54.21
|$60.00$69.99   |  | 44                  |  | 6.9                                             |  |                              | 63.51 |                | 33    |                              |   | 63.51
|$70.00$79.99   |  | 168                 |  | 6.8                                             |  |                              | 76.01 |                | 129   |                              |   | 76.04
|$80.00$93.36   |  | 8                   |  | 6.6                                             |  |                              | 93.36 |                | 6     |                              |   | 93.36
|                |  |                     |  |                                                 |  |                              |       |                |       |                              |   |      
|                |  | 13,648              |  | 7.4                                             |  | $                            | 11.38 |                | 6,602 |                              | $ | 10.76
|                |  |                     |  |                                                 |  |                              |       |                |       |                              |   |      



Restricted Stock



Restricted stock issued under the plans are recorded at fair market value on
the date of the grant and generally vest over a one to four year period. Vesting for some grants may be accelerated if certain performance criteria are achieved. Compensation expense is recognized over the applicable vesting period. During the years
ended January 31, 2004, and December 31, 2002, and 2001, and the month ended January 31, 2003 the Company issued approximately 1,532,000, 182,000, 192,000 and 107,000 of restricted shares, respectively, having an aggregate fair market value of
$17,357,000, $1,867,000, $1,896,000 and $747,000, respectively. Compensation expense recognized for restricted shares in 2003, 2002 and 2001 and the month ended January 31, 2003 was $8,429,000, $1,663,000, $501,000, and $53,000, respectively.



Employee Stock Purchase Plan



On August 1, 2002, the Board of Directors approved the 2002 Employee Stock
Purchase Plan (the Purchase Plan). The Purchase Plan allows eligible employees an opportunity to purchase an aggregate of 1,200,000 shares of the Companys Class B common stock at a price per share equal to 85% of the lesser of the fair market
value of the Companys common stock at the beginning or the end of each six-month purchase period. Under the terms of the Purchase Plan, no participant may acquire more than more than $25,000 in aggregate fair market value of common stock
during any one-year calendar period. As of December 31, 2002 and January 31, 2004, 0 and 521,000 shares had been issued under the plan.



NOTE 10 OTHER COMPREHENSIVE INCOME



Other comprehensive income consisted solely of unrealized gains (losses) on investments. The changes in the components of other comprehensive income, net
of taxes were as follows:



F-24



---

|                                                                                                                                                                            |  |                        |      |   |                         |   |      |                         |  |   |      |   |  |   |     |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------- | ---- | - | ----------------------- | - | ---- | ----------------------- |  | - | ---- | - |  | - | --- | -
|                                                                                                                                                                            |  | Year Ended January 31, |      |   | Years EndedDecember 31, |   |      | Month Ended January 31, | 
|                                                                                                                                                                            |  | 2004                   |      |   | 2002                    |   |      | 2001                    |  |   | 2003 |  
|Change in net unrealized gains (losses) on investments, net of related income tax expense (benefit) of $(401), $(94), $331,and $(42),
respectively                          |  | $                      | (227 | ) |                         | $ | (189 | )                       |  | $ | 570  |   |  | $ | (66 | )
|Reclassification adjustment for net realized (gains) losses included in net income, net of related income tax (expense) benefit of $(52),
$282, $(97), and $2, respectively |  |                        | (81  | ) |                         |   | 442  |                         |  |   | (167 | ) |  |   | 4   |  
|                                                                                                                                                                            |  |                        |      |   |                         |   |      |                         |  |   |      |   |  |   |     |  
|                                                                                                                                                                            |  | $                      | (308 | ) |                         | $ | 253  |                         |  | $ | 403  |   |  | $ | (62 | )
|                                                                                                                                                                            |  |                        |      |   |                         |   |      |                         |  |   |      |   |  |   |     |  



NOTE 11 EMPLOYEE BENEFIT PLANS



Defined Contribution Plan



The Company has a defined contribution plan (the McDATA Retirement Savings
Plan) that covers eligible employees. The Company matches 50% of an employees contribution up to 6% of annual eligible compensation, subject to restrictions of such plans. Such Company contributions are made in cash, and amounted to
approximately $2,049,000, $1,803,000, and $1,359,000 in 2003, 2002 and 2001, respectively. Contributions for the month ended January 31, 2003 totaled $313,000.



Profit Sharing and Bonus Plans



The Company has various employee bonus plans. A profit sharing plan provides for the contribution of a portion of each years profits to a profit
sharing pool that is distributed to all employees not eligible for other performance-based incentive plans. The profit sharing amount is determined annually by the Board of Directors and is paid in cash. Other bonus plans award quarterly bonuses to
the Companys executives and other members of management based on the achievement of pre-defined performance measures and other specific performance criteria. Compensation charges related to these plans were approximately $3,046,000,
$2,991,000, and $981,000 for 2003, 2002, and 2001, respectively. Compensation charges for the month ended January 31, 2003 were immaterial.



NOTE 12 INCOME TAXES



Income (loss) before income taxes consisted of the following:



|         |  |                        |        |   |                         |   |         |                         |  |   |         |   |  |   |        |  
|-------- |  | ---------------------- | ------ | - | ----------------------- | - | ------- | ----------------------- |  | - | ------- | - |  | - | ------ | -
|         |  | Year Ended January 31, |        |   | Years EndedDecember 31, |   |         | Month Ended January 31, | 
|         |  | 2004                   |        |   | 2002                    |   |         | 2001                    |  |   | 2003    |  
|Domestic |  | $                      | (5,526 | ) |                         | $ | (16,620 | )                       |  | $ | (14,270 | ) |  | $ | (5,445 | )
|Foreign  |  |                        | 1,789  |   |                         |   | 1,104   |                         |  |   | 530     |   |  |   | 122    |  
|         |  |                        |        |   |                         |   |         |                         |  |   |         |   |  |   |        |  
|         |  | $                      | (3,737 | ) |                         | $ | (15,516 | )                       |  | $ | (13,740 | ) |  | $ | (5,323 | )
|         |  |                        |        |   |                         |   |         |                         |  |   |         |   |  |   |        |  



Income tax expense
(benefit) consisted of the following:



|                        |  |                        |        |   |                        |   |        |                         |  |   |         |   |  |   |        |  
|----------------------- |  | ---------------------- | ------ | - | ---------------------- | - | ------ | ----------------------- |  | - | ------- | - |  | - | ------ | -
|                        |  | Year Ended January 31, |        |   | Year EndedDecember 31, |   |        | Month Ended January 31, | 
|                        |  | 2004                   |        |   | 2002                   |   |        | 2001                    |  |   | 2003    |  
|Current:                |  |                        |        |   |                        |   |        |                         |  |   |         |   |  |   |        |  
|Federal                 |  | $                      | (974   | ) |                        | $ | 3,190  |                         |  | $ | 8,894   |   |  | $ |       |  
|State                   |  |                        | (39    | ) |                        |   | 442    |                         |  |   | 508     |   |  |   |       |  
|Foreign                 |  |                        | 610    |   |                        |   | 185    |                         |  |   |        |   |  |   |       |  
|                        |  |                        |        |   |                        |   |        |                         |  |   |         |   |  |   |        |  
|                        |  |                        | (403   | ) |                        |   | 3,817  |                         |  |   | 9,402   |   |  |   |       |  
|Deferred:               |  |                        |        |   |                        |   |        |                         |  |   |         |   |  |   |        |  
|Federal                 |  |                        | 34,943 |   |                        |   | (8,328 | )                       |  |   | (13,423 | ) |  |   | (1,716 | )
|State                   |  |                        | 3,872  |   |                        |   | (1,018 | )                       |  |   | (1,063  | ) |  |   | (147   | )
|                        |  |                        |        |   |                        |   |        |                         |  |   |         |   |  |   |        |  
|                        |  |                        | 38,815 |   |                        |   | (9,346 | )                       |  |   | (14,486 | ) |  |   | (1,863 | )
|                        |  |                        |        |   |                        |   |        |                         |  |   |         |   |  |   |        |  
|Total expense (benefit) |  | $                      | 38,412 |   |                        | $ | (5,529 | )                       |  | $ | (5,084  | ) |  | $ | (1,863 | )
|                        |  |                        |        |   |                        |   |        |                         |  |   |         |   |  |   |        |  



F-25



---

The total income tax expense (benefit) differs from the amount computed using the federal income tax rate
of 35% for the following reasons:



|                                                       |  |                        |        |   |                         |   |        |                         |  |   |        |   |  |   |        |  
|------------------------------------------------------ |  | ---------------------- | ------ | - | ----------------------- | - | ------ | ----------------------- |  | - | ------ | - |  | - | ------ | -
|                                                       |  | Year Ended January 31, |        |   | Years EndedDecember 31, |   |        | Month Ended January 31, | 
|                                                       |  | 2004                   |        |   | 2002                    |   |        | 2001                    |  |   | 2003   |  
|Federal income tax expense (benefit) at statutory rate |  | $                      | (1,308 | ) |                         | $ | (5,430 | )                       |  | $ | (4,809 | ) |  | $ | (1,863 | )
|Research and development credit                        |  |                        | (1,400 | ) |                         |   | (1,970 | )                       |  |   |       |   |  |   | (100   | )
|State taxes, net of federal benefit                    |  |                        | (131   | ) |                         |   | (373   | )                       |  |   | (346   | ) |  |   | (147   | )
|Foreign taxes                                          |  |                        | 126    |   |                         |   | 185    |                         |  |   |       |   |  |   | 33     |  
|Convertible debt discount                              |  |                        | (2,028 | ) |                         |   |       |                         |  |   |       |   |  |   |       |  
|Stock-based compensation                               |  |                        | 1,083  |   |                         |   | 2,958  |                         |  |   | 1,803  |   |  |   | 267    |  
|Write-off of acquired in-process R&D                   |  |                        | 1,273  |   |                         |   |       |                         |  |   |       |   |  |   |       |  
|Benefit from export sales                              |  |                        | (158   | ) |                         |   | (247   | )                       |  |   | (305   | ) |  |   | (13    | )
|Municipal interest income                              |  |                        | (140   | ) |                         |   | (872   | )                       |  |   | (1,625 | ) |  |   | (53    | )
|Increase in valuation allowance                        |  |                        | 41,332 |   |                         |   |       |                         |  |   |       |   |  |   |       |  
|Other                                                  |  |                        | (237   | ) |                         |   | 220    |                         |  |   | 198    |   |  |   | 13     |  
|                                                       |  |                        |        |   |                         |   |        |                         |  |   |        |   |  |   |        |  
|Income tax expense (benefit)                           |  | $                      | 38,412 |   |                         | $ | (5,529 | )                       |  | $ | (5,084 | ) |  | $ | (1,863 | )
|                                                       |  |                        |        |   |                         |   |        |                         |  |   |        |   |  |   |        |  



Deferred income taxes
reflect the tax effect of temporary differences between the amount of assets and liabilities for financial reporting purposes and income tax purposes. The tax effects of each type of temporary difference that give rise to significant portions of the
net deferred tax assets are as follows:



|                                               |  |                            |         |   |                              |   |        |  
|---------------------------------------------- |  | -------------------------- | ------- | - | ---------------------------- | - | ------ | -
|                                               |  | Year Ended January 31 2004 |         |   | Year Ended December 31, 2002 |  
|Current deferred tax assets (liabilities):     |  |                            |         |   |                              |   |        |  
|Inventory reserves and costs                   |  | $                          | 6,931   |   |                              | $ | 10,726 |  
|Revenue recognition                            |  |                            | 8,743   |   |                              |   | 10,368 |  
|Net operating loss carry forward               |  |                            | 12,323  |   |                              |   | 7,373  |  
|Warranty reserves                              |  |                            | 1,727   |   |                              |   | 1,321  |  
|Reserves related to employee benefits          |  |                            | 2,140   |   |                              |   | 1,993  |  
|Stock-based compensation                       |  |                            | 1,253   |   |                              |   | 1,544  |  
|Restructuring reserves                         |  |                            | 855     |   |                              |   |       |  
|Other                                          |  |                            | (149    | ) |                              |   |       |  
|                                               |  |                            |         |   |                              |   |        |  
|                                               |  |                            | 33,823  |   |                              |   | 33,325 |  
|Non-current deferred tax assets (liabilities): |  |                            |         |   |                              |   |        |  
|Capitalized research expenditures              |  |                            | 40,999  |   |                              |   |       |  
|Capitalized acquired intangible assets         |  |                            | (40,381 | ) |                              |   |       |  
|Tax credit carry forward                       |  |                            | 16,796  |   |                              |   | 3,537  |  
|Revenue recognition                            |  |                            | 8,005   |   |                              |   |       |  
|Stock compensation                             |  |                            | 1,476   |   |                              |   |       |  
|Difference between book and tax depreciation   |  |                            | 4,994   |   |                              |   | 2,485  |  
|Capitalized software, net of amortization      |  |                            | (2,966  | ) |                              |   | (2,930 | )
|Foreign earnings                               |  |                            | (1,374  | ) |                              |   |       |  
|Net operating loss carry forward               |  |                            | 15,769  |   |                              |   |       |  
|Other                                          |  |                            | 229     |   |                              |   |       |  
|                                               |  |                            |         |   |                              |   |        |  
|                                               |  |                            | 43,547  |   |                              |   | 3,092  |  
|                                               |  |                            |         |   |                              |   |        |  
|                                               |  |                            | 77,370  |   |                              |   | 36,417 |  
|Valuation allowance                            |  |                            | (77,370 | ) |                              |   |       |  
|                                               |  |                            |         |   |                              |   |        |  
|Total deferred tax asset, net                  |  | $                          |        |   |                              | $ | 36,417 |  
|                                               |  |                            |         |   |                              |   |        |  



F-26



---

The $77.4 million valuation allowance was recorded against deferred tax assets as follows:



|                                                                                                |  |   |       
|----------------------------------------------------------------------------------------------- |  | - | ------
|Opening balance of deferred tax asset at February 1, 2003                                       |  | $ | 38,815
|Additional deferred tax asset arising during 2003                                               |  |   | 2,517 
|Acquired deferred tax assets                                                                    |  |   | 35,070
|Deferred tax asset for stock-based compensation in 2003 (net of alternative minimum tax effect) |  |   | 968   
|                                                                                                |  |   |       
|                                                                                                |  | $ | 77,370
|                                                                                                |  |   |       



Gross operating loss
carry forwards and tax credit carry forwards will expire as follows:



|                   |  |                                       |        |                                              |   |       
|------------------ |  | ------------------------------------- | ------ | -------------------------------------------- | - | ------
|Year of Expiration |  | FederalNet OperatingLoss CarryForward |        | Research &DevelopmentTax CreditCarry Forward
|2019               |  | $                                     | 99     |                                              | $ | 104   
|2020               |  |                                       |       |                                              |   | 1,074 
|2021               |  |                                       | 11,718 |                                              |   | 4,579 
|2022               |  |                                       | 22,686 |                                              |   | 3,540 
|2023               |  |                                       | 41,501 |                                              |   | 4,358 
|2024               |  |                                       |       |                                              |   | 1,400 
|                   |  |                                       |        |                                              |   |       
|                   |  | $                                     | 76,004 |                                              | $ | 15,055
|                   |  |                                       |        |                                              |   |       



Approximately $51
million of the net operating loss carryforward and $10 million of the research and development tax credit carry forward are subject to annual limitations on the amount that can be utilized in the Companys tax returns, pursuant to Internal
Revenue Code Section 382, as these amounts were accumulated in the tax returns of Nishan Systems and Sanera Systems for tax periods prior to the date those companies were acquired by McDATA.



In fiscal 2003, the Company recorded an income tax provision of $38.4
million, which included a non-cash charge of $38.8 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, and continuing market uncertainties. 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 it was not more likely than not that the deferred tax assets would be realized and that a valuation allowance for the entire deferred tax
asset was required.



F-27



---

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



Prior to the initial public offering on August 9, 2000, the Company was included in a consolidated Federal income tax return with EMC. As of the Distribution, the Company is no longer eligible to be included in EMCs consolidated tax
returns and has consequently filed separate income tax returns for the tax periods, which began immediately following the Distribution. Under the terms of a tax sharing agreement between the Company and EMC, the Company is obligated to indemnify EMC
for any taxes arising out of the failure of the Distribution to be tax free if that failure results from, among other things, (i) any act or omission by the Company that would cause such Distribution to fail to qualify as a tax free distribution
under the Internal Revenue Code of 1986, as amended; (ii) any act or omission by the Company 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; (iii) any acquisition by a third party of the Companys stock or assets; or (iv) any issuance by the Company of stock or any change in ownership of the Companys stock. If the distribution of the
Companys Class A common stock fails to qualify as a tax-free distribution, EMC would incur tax liability as if the Companys Class A common stock that was distributed by EMC had been sold by EMC for its fair market value in a taxable
transaction. In the event that the Company is required to indemnify EMC because the distribution of the Companys Class A common stock fails to qualify as a tax-free distribution, the Companys liability could exceed 35% of the value of
the Companys Class A common stock distributed by EMC as determined on the date of the distribution.



Although the Company is no longer a member of EMCs consolidated tax group, the tax sharing agreement between the Company and EMC continues to affect
the Company. If a taxing authority effects a change to the EMC consolidated return, the Company is required to reimburse EMC for the tax of any Company-related unfavorable adjustment. Conversely, the Company is entitled to any refund for any
Company-related favorable adjustment. Second, the Company is required to remit to EMC any tax savings generated by the tax deductions, if any, related to the issuance or sale of EMC stock upon the exercise of options held by Company employees.
Included in the Companys 2001 federal tax return was a stock-based compensation deduction of $25 million related to the issuance or sale of EMC stock. Subsequent to the receipt of its IRS refund of its 2001 net operating loss carry back into
2000, the Company remitted to EMC $9.5 million pursuant to the tax sharing agreement.



NOTE 13 COMMITMENTS AND CONTINGENCIES



Operating and
Capital Leases



The Company had various operating and
capital leases in effect at January 31, 2004 for certain buildings, office space and machinery and equipment. Future minimum lease payments under non- cancelable capital and operating leases with terms of one year or more are as follows at January
31, 2004:



|                                   |  |               |       |                 |   |       
|---------------------------------- |  | ------------- | ----- | --------------- | - | ------
|                                   |  | CapitalLeases |       | OperatingLeases
|2004                               |  | $             | 1,453 |                 | $ | 8,097 
|2005                               |  |               | 739   |                 |   | 5,655 
|2006                               |  |               | 184   |                 |   | 2,554 
|2007                               |  |               |      |                 |   | 1,359 
|2008                               |  |               |      |                 |   | 1,250 
|Thereafter                         |  |               |      |                 |   | 1,380 
|                                   |  |               |       |                 |   |       
|Total minimum lease payments       |  |               | 2,376 |                 | $ | 20,295
|                                   |  |               |       |                 |   |       
|Less portion representing interest |  |               | 109   |                 |   |       
|                                   |  |               |       |                 |   |       
|                                   |  |               | 2,267 |                 |   |       
|Less: current portion              |  |               | 1,377 |                 |   |       
|                                   |  |               |       |                 |   |       
|                                   |  | $             | 890   |                 |   |       
|                                   |  |               |       |                 |   |       



F-28



---

Operating rent expense in 2003, 2002, 2001 and the month ended January 31, 2003 totaled approximately
$10,414,000, $8,946,000, $7,671,000, and $771,000, respectively.



As part of the Companys move to the new office and engineering building in 2002, the Company performed a review of its real estate facility requirements and identified excess leased facility space, which was offered for sublease.
Based upon the results of this analysis, the Company recorded a charge of $83,000 and $941,000 included in selling and marketing expense related to facility lease losses for the years ended December 31, 2002 and 2001, respectively. In determining
the anticipated lease losses, various assumptions were made, including, the time period over which the excess space will be under contract; expected sublease terms; and expected sublease rates and anticipated recoveries from sublease income. The new
office and engineering building was completed in July 2002. Lease charges of $589,000, $341,000 and $57,000 were recorded against the loss accrual during the years ended January 31, 2004 and December 31, 2002 and the month ended January 31, 2003,
respectively. As of January 31, 2004, the balance of this accrual was $0.



Collateralized Lease



On February 9, 2001, the
Company entered into an operating lease and associated agreements with Deutsche Bank AG, New York Branch (Deutsche Bank) for the lease of an approximately 167,000 square foot multi-story office and engineering building to be constructed
on a 106 acre parcel of land located in Broomfield, Colorado. Construction of the building commenced in the first half of 2001 and was completed in July 2002, at which time lease payments were scheduled to commence. As part of the transaction, the
Company guaranteed a residual value of the facility to Deutsche Bank of approximately 89% during the construction period and 85% thereafter of the $60 million total original cost and agreed to restrict up to $63 million of its investment securities
as collateral for specified obligations under the lease. During the first quarter of 2002, the Company elected to terminate the lease under the provisions of the agreements. On May 9, 2002, the Company entered into a Termination Agreement with
Deutsche Bank and recorded approximately $39 million in construction costs as property and equipment. $41 million in restricted assets were used to pay off the lease obligation and construction costs. In addition, a loss of $1.25 million was
recorded during the first quarter of 2002 to reflect the write-off of certain lease costs that could not be capitalized.



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 January 31, 2004, the Companys commitment with the Contract Manufacturers for purchases over the next sixty days totaled $48.1 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 January 31, 2004, the Company had recorded obligations of approximately $8 million (See
Note 3) primarily related to materials purchased by the Contract Manufacturers for certain end-of-life and obsolete material. Management does not expect the remaining commitments under these agreements to have a material adverse effect on the
Companys business, results of operations, financial position or cash flows.



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



Litigation



Class Action Laddering Lawsuits



The Company, Mr. John F. McDonnell, the former Chairman of the board of
directors, Mrs. Dee J. Perry, a former officer and Mr. Thomas O. McGimpsey a current officer were named as defendants in purported securities class-action lawsuits filed in the United States District Court, Southern District of New York. The first
of these lawsuits, filed on July 20, 2001, is captioned Gutner v. McDATA Corporation, Credit Suisse First Boston (CSFB), Merrill Lynch,



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Pierce Fenner & Smith Incorporated, Bear, Stearns & Co., Inc., FleetBoston Robertson Stephens et al., No. 01 CIV.
6627. Three other similar suits were filed against the Company and the individuals. The complaints are substantially identical to numerous other complaints filed against other companies that went public in 1999 and 2000. These lawsuits generally
allege, among other things, that the registration statements and prospectus filed with the SEC by such companies were materially false and misleading because they failed to disclose (a) that certain underwriters had allegedly solicited and received
excessive and undisclosed commissions from certain investors in exchange for which the underwriters allocated to those investors material portions of shares in connection with the initial public offerings, or IPOs, and (b) that certain of the
underwriters had allegedly entered into agreements with customers whereby the underwriters agreed to allocate IPO shares in exchange for which the customers agreed to purchase additional company shares in the aftermarket at pre-determined prices.
The complaints allege claims against the Company, the named individuals, and CSFB, the lead underwriter of the Companys August 9, 2000 initial public offering, under Sections 11 and 15 of the Securities Act. The complaints also allege claims
solely against CSFB and the other underwriter defendants under Section 12(a)(2) of the Securities Act, and claims against the individual defendants under Section 10(b) of the Securities Exchange Act. Although management believes that all of the
lawsuits are without legal merit and they intend to defend against them vigorously, there is no assurance that the Company will prevail.



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



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



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.



On March 5, 2004, the Company and Brocade entered into a confidential settlement agreement whereby both parties agreed to dismiss without prejudice their
respective claims against each other in the pending infringement case in the United States District Court for the District of Colorado entitled McDATA Corp. v. Brocade Communications Systems, Inc., Civil Action No. 02-K-303 and the related
arbitration proceedings before the



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American Arbitration Association entitled McDATA Corp. v. Brocade Communications Systems, Inc., Case No. 74 133
00025 03 SAT. Under the confidential settlement agreement both parties preserved their respective rights, no licenses were granted and they agreed to a three-year standstill during which neither party may initiate litigation against the other party
with respect to their respective patents



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 (Raytheon) in the United States District Court for the Eastern District of TexasMarshall Division (Civil Action No. 2:03CV13). The
complaint alleged that the our products infringed and/or we actively induced the infringement of Raytheons United States Patent No. 5,412,791, entitled Mass Data Storage Library. On January 8, 2004, we settled this lawsuit with
Raytheon and the parties agreed to dismiss with prejudice their respective claims and counterclaims against each other.



Nishan Acquisition Related Lawsuit



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



Indemnifications and Guarantees



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



The Company has also indemnified its former parent, EMC, for any income taxes arising out of the Distribution as discussed in Note 12.



In addition, the majority of these indemnities, commitments and guarantees do
not provide for any limitation of the maximum potential future payments the Company could be obligated to make. The Company evaluates and estimates losses from such indemnification under SFAS 5, Accounting for Contingencies, as interpreted by FIN
45. To date, the Company has not incurred any material costs as a result of such obligations and has not accrued any liabilities related to such indemnification and guarantees in our financial statements.



NOTE 14 RELATED PARTY TRANSACTIONS



In January 2004, the Company entered into a three-year litigation support
and consulting agreement with John F. McDonnell, the Companys former Chairman, pursuant to which Mr. McDonnell will render litigation support and consulting services to McDATA. Under the agreement, the Company is assured on-demand access to
Mr. McDonnell at a



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rate of $250 per hour and the reimbursement of out-of-pocket expenses. The agreement was reviewed and approved by a
committee of independent directors of the Board of Directors. As of January 31, 2004, there was no liability or related expense recorded from this agreement.



In February 2004, the Company entered into a six-month standard lab services agreement with JRBM Incorporated (JRBM), a company partially owned by John F.
McDonnell, the Companys former Chairman. Under this arrangement, the Company leases approximately 155 square feet of unused lab space and equipment to JRBM at an arms-length market rate, and JRBM may purchase McDATA products under our standard
OpenReadyequipment discount program. The arrangement was reviewed and approved by a
committee of independent directors of the Board of Directors. JRBM also made a business proposal to McDATA to review the SANavigator®software, over a nine month period, for the purpose of potentially reselling, licensing or utilizing certain features or modules of SANavigator®and potentially developing application program interfaces. The agreement evidencing such an arrangement was signed on February 25,
2004 (with a February 27, 2004 effective date) by both parties after review and approval by a committee of independent directors of the Board of Directors.



NOTE 15 SEGMENT INFORMATION



The Company has one reporting segment relating to the design, development, manufacture and sales of open storage networking solutions that provide highly
available, scalable and centrally managed storage area networks (SANs). The Companys Chief Operating Decision Makers, as defined by SFAS 131, Disclosures about Segments of an Enterprise and Related Information, allocate resources
and assess the performance of the Company based on revenue and overall profitability.



For the year ended January 31, 2004, the Company had three customers who each contributed greater than 10% of the Companys total revenues. For the fiscal years ended December 31, 2002 and 2001, and the one-month
ended January 31, 2003, the Company had two customers each who contributed greater than 10% of the Companys total revenues as follows:



|    |  |                        |   |  |                         |   |  |                         |   |  |      |  
|--- |  | ---------------------- | - |  | ----------------------- | - |  | ----------------------- | - |  | ---- | -
|    |  | Year Ended January 31, |   |  | Years EndedDecember 31, |   |  | Month Ended January 31, |  
|    |  | 2004                   |   |  | 2002                    |   |  | 2001                    |   |  | 2003 |  
|EMC |  | 56                     | % |  | 54                      | % |  | 69                      | % |  | 54   | %
|IBM |  | 21                     | % |  | 25                      | % |  | 17                      | % |  | 21   | %
|HDS |  | 10                     | % |  | <10                     | % |  | <10                     | % |  | <10  | %



At January 31, 2004
and December 31, 2002, 73% and 80% of accounts receivable were concentrated with our two largest customers, EMC and IBM. The Company performs ongoing evaluations of its customers financial condition and, generally, requires no collateral from
its customers. The level of sales to any single customer may vary and the loss of any one of these customers, or a decrease in the level of sales to any one of these customers, could have a material impact on the Companys financial condition
or results of operations



The Companys operations are
conducted in the United States with sales offices throughout the European Community and Asia Pacific, none of which are individually significant to the Companys overall operations. The Company has not incurred any foreign currency translation
adjustments as all of its sales are settled in U.S. dollars.



Certain information related to the Companys operations by geographic area is presented below. The Companys revenues are attributed to the geographic areas according to the location of the customers. Long-lived assets include
property and equipment and other non-current assets.



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|                             |  |           |         |                   |   |        
|---------------------------- |  | --------- | ------- | ----------------- | - | -------
|                             |  | Net Sales |         | Long-Lived Assets
|2003                         |  |           |         |                   |   |        
|United States                |  | $         | 282,503 |                   | $ | 115,450
|Foreign countries            |  |           | 136,357 |                   |   | 1,994  
|                             |  |           |         |                   |   |        
|Total                        |  | $         | 418,860 |                   | $ | 117,444
|                             |  |           |         |                   |   |        
|2002                         |  |           |         |                   |   |        
|United States                |  | $         | 207,015 |                   | $ | 111,479
|Foreign countries            |  |           | 121,264 |                   |   | 1,287  
|                             |  |           |         |                   |   |        
|Total                        |  | $         | 328,279 |                   | $ | 112,766
|                             |  |           |         |                   |   |        
|2001                         |  |           |         |                   |   |        
|United States                |  | $         | 263,416 |                   |   |        
|Foreign countries            |  |           | 80,990  |                   |   |        
|                             |  |           |         |                   |   |        
|Total                        |  | $         | 344,406 |                   |   |        
|                             |  |           |         |                   |   |        
|Month Ended January 31, 2003 |  |           |         |                   |   |        
|United States                |  | $         | 12,582  |                   |   |       
|Foreign countries            |  |           | 4,463   |                   |   |        
|                             |  |           |         |                   |   |        
|Total                        |  | $         | 17,045  |                   |   |        
|                             |  |           |         |                   |   |        



NOTE 16 SELECTED QUARTERLY
FINANCIAL DATA (UNAUDITED)



The following summarizes
selected financial information for each of the two years in the period ended January 31, 2004:



|                                    |  |    |         |   |    |   |         |       |  |   |         |   |  |       |         |   |  |   |         |  
|----------------------------------- |  | -- | ------- | - | -- | - | ------- | ----- |  | - | ------- | - |  | ----- | ------- | - |  | - | ------- | -
|                                    |  | Q1 |         |   | Q2 |   |         | Q3(6) |  |   | Q4(6)   |   |  | Total |        
|2003(1)                             |  |    |         |   |    |   |         |       |  |   |         |   |  |       |         |   |  |   |         |  
|Total revenue(2)                    |  | $  | 103,179 |   |    | $ | 107,014 |       |  | $ | 94,659  |   |  | $     | 114,008 |   |  | $ | 418,860 |  
|Gross profit                        |  |    | 58,591  |   |    |   | 63,307  |       |  |   | 54,647  |   |  |       | 64,986  |   |  |   | 241,531 |  
|Net income (loss)(3)                |  |    | 5,312   |   |    |   | 9,133   |       |  |   | (50,048 | ) |  |       | (7,530  | ) |  |   | (43,133 | )
|Basic net income (loss) per share   |  | $  | 0.05    |   |    | $ | 0.08    |       |  | $ | (0.44   | ) |  | $     | (0.07   | ) |  | $ | (0.38   | )
|Diluted net income (loss) per share |  | $  | 0.05    |   |    | $ | 0.08    |       |  | $ | (0.44   | ) |  | $     | (0.07   | ) |  | $ | (0.38   | )
|2002                                |  |    |         |   |    |   |         |       |  |   |         |   |  |       |         |   |  |   |         |  
|Total revenue                       |  | $  | 64,543  |   |    | $ | 77,254  |       |  | $ | 80,941  |   |  | $     | 105,541 |   |  | $ | 328,279 |  
|Gross profit(4)                     |  |    | 13,890  |   |    |   | 35,091  |       |  |   | 42,580  |   |  |       | 58,604  |   |  |   | 150,165 |  
|Net income (loss)(4)(5)             |  |    | (17,071 | ) |    |   | (3,858  | )     |  |   | 2,343   |   |  |       | 8,599   |   |  |   | (9,987  | )
|Basic net income (loss) per share   |  | $  | (0.15   | ) |    | $ | (0.03   | )     |  | $ | 0.02    |   |  | $     | 0.08    |   |  | $ | (0.09   | )
|Diluted net income (loss) per share |  | $  | (0.15   | ) |    | $ | (0.03   | )     |  | $ | 0.02    |   |  | $     | 0.07    |   |  | $ | (0.09   | )

---

|(1) | On January 15, 2003, we changed our fiscal year end to January 31, rather than December 31.
|--- | -------------------------------------------------------------------------------------------

|(2) | Revenues for the quarter ended October 31, 2003, 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.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Net income for the quarter ended October 31, 2003 includes the impacts of a $38.8 million valuation allowance recorded against the deferred tax asset and a $11.4 million charge for
IPR&D related to the equity acquisitions of Nishan and Aarohi.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Gross profit and net loss for the quarter ended March 31, 2002 includes the impact of a $14.0 million charge to cost of revenues primarily as a result of identified excesses 1 Gb
components user in the Director-class products. During the quarters ended June 30, 2002, September 30, 2002 and December 31, 2002, approximately $1.1 million, $2.5 million and $0.9 million, respectively, of these reserves were reversed as the
Company experienced higher-than-expected sales of discontinued 1 Gb products and, therefore, realized 100% margins for these product sales.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Net loss for the quarter ended March 31, 2002 includes the impact of a $1.25 million charge to general and administrated expenses associated with the termination of the
collateralized lease with Deutsche Bank.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Total revenue, gross profit and net income for the third and fourth quarters of 2003 reflect our acquisitions of Nishan and Sanera on September 19, 2003 and September 30, 2003,
respectively.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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