8-K

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 8-K

CURRENT REPORT

Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934

Date of Report (Date of earliest event reported): May 18, 2007

BROCADE COMMUNICATIONS SYSTEMS, INC.

(Exact name of Registrant as specified in its charter)

Delaware	000-25601	77-0409517
(State or other jurisdiction of	(Commission File Number)	(I.R.S. Employer
incorporation or organization)		Identification Number)

1745 Technology Drive
San Jose, CA 95110

(Address, including zip code, of principal executive offices)

(408) 333-8000

(Registrant’s telephone number, including area code)

Check the appropriate box below if the Form 8-K filing is intended to simultaneously satisfy the filing obligation of the registrant under any of the following provisions (see General Instruction A.2. below):

o Written communications pursuant to Rule 425 under the Securities Act (17 CFR 230.425)

o Soliciting material pursuant to Rule 14a-12 under the Exchange Act (17 CFR 240.14a-12)

o Pre-commencement communications pursuant to Rule 14d-2(b) under the Exchange Act (17 CFR 240.14d-2(b))

o Pre-commencement communications pursuant to Rule 13e-4(c) under the Exchange Act (17 CFR 240.13e-4(c))

TABLE OF CONTENTS

EXHIBIT 23.1

EXHIBIT 23.2

EXHIBIT 23.3

EXHIBIT 99.1

EXHIBIT 99.2

EXHIBIT 99.3

Item 8.01. Other Events.

This Current Report on Form 8-K (including the documents included as exhibits 99.1, 99.2 and 99.3) is filed to be, and is hereby, incorporated by reference into our Registration Statement on Form S-3 which is being filed simultaneously herewith.

Item 9.01. Financial Statements and Exhibits.

(c) Exhibits.

Exhibit	Description
23.1	Consent of Deloitte & Touche LLP
23.2	Consent of PricewaterhouseCoopers LLP
23.3	Consent of KPMG LLP
99.1	Audited Consolidated Financial Statements of McDATA Corporation for the fiscal years ended January 31, 2006, 2005 and 2004
99.2	Audited Consolidated Financial Statements of Computer Network Technology Corporation (“CNT”) for the fiscal years ended January 31, 2005 and 2004
99.3	Unaudited Financial Statements of CNT for the quarter ended April 30, 2005

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

	BROCADE COMMUNICATIONS SYSTEMS, INC.
Dated: May 18, 2007	By:	/s/ Richard Deranleau
		Richard Deranleau
		Chief Financial Officer and Vice President, Finance

EXHIBIT INDEX

Exhibit	Description
23.1	Consent of Deloitte & Touche LLP
23.2	Consent of PricewaterhouseCoopers LLP
23.3	Consent of KPMG LLP
99.1	Audited Consolidated Financial Statements of McDATA Corporation for the fiscal years ended January 31, 2006, 2005 and 2004
99.2	Audited Consolidated Financial Statements of Computer Network Technology Corporation (“CNT”) for the fiscal years ended January 31, 2005 and 2004
99.3	Unaudited Financial Statements of CNT for the quarter ended April 30, 2005

EX-23.1

Exhibit 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We consent to the incorporation by reference in Registration Statements of Brocade Communications Systems, Inc. on Form S-8 (Nos. 333-129909, 333-129908, 333-117897, 333-103571, 333-100797, 333-72480, 333-64260, 333-53734, 333-39126, 333-95653, 333-85187, 333-140334 and 333-143053) of our report dated April 24, 2006, relating to the consolidated financial statements and consolidated financial statement schedule of McDATA Corporation as of and for the years ended January 31, 2006 and 2005, appearing in this Current Report on Form 8-K of Brocade Communications Systems, Inc. dated May 18, 2007.

/s/ DELOITTE & TOUCHE LLP
Denver, Colorado
May 18, 2007

EX-23.2

Exhibit 23.2

Consent of Independent Registered Public Accounting Firm

We consent to the incorporation by reference in the registration statements on Form S-8 (Nos. 333-129909, 333-129908, 333-117897, 333-103571, 333-100797, 333-72480, 333-64260, 333-53734, 333-39126, 333-95653, 333-85187, 333-140344 and 333-143053) of Brocade Communications Systems, Inc. of our report dated April 14, 2004 (except for Notes 16 and 19 which are as of April 24, 2006), with respect to the consolidated statements of operations, changes in stockholders’ equity and cash flows of McDATA Corporation and its subsidiaries for the year ended January 31, 2004, and the related financial statement schedule, which report appears in Exhibit 99.1 of Brocade Communications Systems, Inc.’s Form 8-K filed herewith.

/s/ PricewaterhouseCoopers LLP
Denver, Colorado
May 18, 2007

EX-23.3

Exhibit 23.3

Consent of Independent Registered Public Accounting Firm

We consent to the incorporation by reference in the registration statements on Form S-8 (Nos. 333-129909, 333-129908, 333-117897, 333-103571, 333-100797, 333-72480, 333-64260, 333-53734, 333-39126, 333-95653, 333-85187, 333-140344 and 333-143053) of Brocade Communications Systems, Inc. of our reports dated April 11, 2005, with respect to the consolidated balance sheets of Computer Network Technology Corporation and its subsidiaries as of January 31, 2005 and 2004, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the years in the three-year period ended January 31, 2005, and the related financial statement schedule, management’s assessment of the effectiveness of internal control over financial reporting as of January 31, 2005, and the effectiveness of internal control over financial reporting as of January 31, 2005,which report appears in Exhibit 99.2 of Brocade Communications Systems, Inc.’s Form 8-K filed herewith.

Our report dated April 11, 2005, on management’s assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting as of January 31, 2005, expresses our opinion that Computer Network Technology Corporation did not maintain effective internal control over financial reporting as of January 31, 2005 because of the effects of material weaknesses on the achievement of the objectives of the control criteria and contains an explanatory paragraph that states that the following material weaknesses were identified as of January 31, 2005:

• Procedures reconciling the Company’s offsite finished goods inventory to the general ledger were not adequate to ensure that the general ledger amounts represented actual offsite finished goods inventory. Specifically, the Company’s personnel were not adequately trained in the Company’s policies and procedures for physical tracking and recording changes to offsite finished goods inventory. This deficiency in internal control resulted in material misstatements of finished goods inventory and cost of products sold and operating expenses as of January 31, 2005.

• The Company’s information technology access controls were not designed to prevent Company personnel from accessing inventory accounting information and initiating erroneous accounting entries affecting amounts recorded as finished goods inventory. Specifically, this deficiency contributed to the aforementioned material misstatements in the Company’s interim and annual financial information.

/s/ KPMG LLP
Minneapolis, Minnesota
May 18, 2007

EX-99.1

Exhibit 99.1

McDATA CORPORATION

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

	Page
Reports of Independent Registered Public Accounting Firms		2
Audited Consolidated Financial Statements:
Consolidated Balance Sheets		4
Consolidated Statements of Operations		5
Consolidated Statements of Changes in Stockholders’ Equity		6
Consolidated Statements of Cash Flows		7
Notes to Consolidated Financial Statements		8
Consolidated Financial Statement Schedule:
Schedule II—Valuation and Qualifying Accounts		54

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

1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of McDATA Corporation

Broomfield, Colorado

We have audited the accompanying consolidated balance sheets of McDATA Corporation and subsidiaries (the “Company”) as of January 31, 2006 and 2005, and the related consolidated statements of operations, changes in stockholders’ equity, and cash flows for the years then ended. Our audits also included the consolidated financial statement schedule included as Schedule II for the years ended January 31, 2006 and 2005. These consolidated financial statements and consolidated financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and consolidated financial statement schedule based on our audits. The consolidated financial statements and consolidated financial statement schedule of the Company for the year ended January 31, 2004 were audited by other auditors whose report, dated April 14, 2004, expressed an unqualified opinion on those statements and schedule.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such 2006 and 2005 consolidated financial statements present fairly, in all material respects, the financial position of the Company as of January 31, 2006 and 2005, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such consolidated financial statement schedule for the years ended January 31, 2006 and 2005, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

/s/ DELOITTE & TOUCHE LLP

Denver, Colorado
April 24, 2006

2

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of McDATA Corporation:

In our opinion, the accompanying consolidated statements of operations, of changes in stockholders’ equity and of cash flows of McDATA Corporation and its subsidiaries for the year ended January 31, 2004, present fairly, in all material respects, the results of operations and cash flows of McDATA Corporation and its subsidiaries for the year ended January 31, 2004, 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 for the year ended January 31, 2004 when read in conjunction with the related consolidated financial statements. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards 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 audit provides a reasonable basis for our opinion.

PricewaterhouseCoopers LLP
Denver, Colorado
April 14, 2004 except for Notes 16 and 19 which are as of April 24, 2006

3

McDATA CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)

	January 31,			January 31,
	2006			2005
Assets
Current assets:
Cash and cash equivalents	$	139,083		$	64,507
Securities lending collateral		62,555			130,804
Short-term investments		171,110			145,259
Accounts receivable, net of allowances for bad debts of $7,880 and $306 as of January 31, 2006 and 2005, respectively		126,106			63,810
Inventories, net		33,100			13,720
Prepaid expenses and other current assets		13,423			7,280
Total current assets		545,377			425,380
Property and equipment, net		109,118			94,929
Long-term investments		31,884			95,589
Restricted cash		10,697			5,047
Intangible assets, net of accumulated amortization of $72,214 and $34,709 as of January 31, 2006 and 2005, respectively		123,694			87,592
Goodwill		266,141			78,693
Other assets, net		59,798			31,005
Total assets	$	1,146,709		$	818,235
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	43,238		$	20,345
Accrued liabilities		94,276			44,549
Securities lending collateral payable		62,555			130,804
Current portion of deferred revenue		61,242			22,736
Current portion of obligations under capital leases		2,977			912
Total current liabilities		264,288			219,346
Obligations under capital leases, less current portion		3,532			256
Deferred revenue, less current portion		31,380			27,001
Other long-term liabilities		1,844			1,908
Interest rate swaps		7,553			2,005
Convertible subordinated debt		285,889			170,495
Total liabilities		594,486			421,011
Commitments and contingencies (Note 17)
Stockholders’ Equity:
Common stock, Class A, $0.01 par value, 250,000,000 shares authorized, 119,599,002 and 81,000,000 shares issued and outstanding as of January 31, 2006 and 2005, respectively		1,197			810
Common stock, Class B, $0.01 par value, 200,000,000 shares authorized, 38,315,628 and 37,960,526 shares issued and outstanding as of January 31, 2006 and 2005, respectively		385			379
Additional paid-in-capital		671,142			481,735
Treasury stock, at cost, 1,439,560 and 678,574 Class A shares as of January 31, 2006 and 2005, respectively and 3,085,256 and 2,343,785 Class B shares as of January 31, 2006 and 2005, respectively		(23,591	)		(19,039	)
Deferred compensation		(2,832	)		(2,738	)
Accumulated other comprehensive loss		(807	)		(1,253	)
Accumulated deficit		(93,271	)		(62,670	)
Total stockholders’ equity		552,223			397,224
Total liabilities and stockholders’ equity	$	1,146,709		$	818,235

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

4

McDATA CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)

	Years Ended January 31,
	2006			2005			2004
Revenue
Product	$	523,440		$	379,344		$	407,137
Service		90,993			20,316			11,723
Total revenue		614,433		$	399,660		$	418,860
Cost of revenue
Product		248,025			158,656			162,151
Service		59,874			17,505			15,178
Restructuring charges		1,192			—			—
Total cost of revenue		309,091			176,161			177,329
Gross profit		305,342			223,499			241,531
Operating expenses:
Research and development (excludes amortization of deferred compensation included in Amortization of deferred compensation of $1,320, $4,027 and $6,142, respectively)		111,715			91,488			88,826
Selling and marketing (excludes amortization of deferred compensation included in Amortization of deferred compensation of $838, $476 and $1,948, respectively)		133,909			101,305			95,820
General and administrative (excludes amortization of deferred compensation included in Amortization of deferred compensation of $3,750, $1,019 and $3,879, respectively)		35,116			25,584			30,234
Amortization of acquired intangible assets		37,510			22,773			9,222
Acquired in-process research and development and other acquisition-related costs		—			—			11,410
Amortization of deferred compensation (excludes amortization of deferred compensation included in Cost of revenue of $250, $180 and $739, respectively)		5,908			5,522			11,969
Restructuring charges		11,685			1,263			2,258
Total operating expenses		335,843			247,935			249,739
Loss from operations		(30,501	)		(24,436	)		(8,208	)
Interest and other income		11,418			6,639			7,231
Interest expense		(11,087	)		(1,333	)		(2,760	)
Loss before income taxes		(30,170	)		(19,130	)		(3,737	)
Income tax expense		431			362			38,412
Loss before equity in net loss of affiliated company		(30,601	)		(19,492	)		(42,149	)
Equity in net loss of affiliated company		—			(1,380	)		(984	)
Net loss	$	(30,601	)	$	(20,872	)	$	(43,133	)
Basic and diluted net loss per share	$	(.22	)	$	(0.18	)	$	(0.38	)
Shares used in computing basic and diluted net loss per share		140,331			115,355			114,682

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

5

McDATA CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
(in thousands)

																			Accumulated
	Common Stock												Additional						Other						Retained			Total
	Class A						Class B						Paid-In			Deferred			Comprehensive			Treasury			Earnings			Stockholders’
	Shares			Amount			Shares			Amount			Capital			Compensation			Income (Loss)			Stock			(Deficit)			Equity
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 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
Shares issued		—			—			2,086			20			5,613			—			—			—			—			5,633
Forfeitures of deferred compensation		—			—			(177	)		(2	)		(1,933	)		1,935			—			—			—			—
Issuance of warrants		—			—			—			—			1,062			—			—			—			—			1,062
Compensation expense		—			—			—			—			—			5,702			—			—			—			5,702
Acquisition of treasury stock		—			—			—			—			—			—			—			(10,287	)		—			(10,287	)
Comprehensive loss:
Net loss		—			—			—			—			—			—			—			—			(20,872	)		(20,872	)
Unrealized loss on investments, net of tax of $0		—			—			—			—			—			—			(1,656	)		—			—			(1,656	)
Total comprehensive loss		—			—			—			—			—			—			—			—			—			(22,528	)
Balances at January 31, 2005		81,000			810			37,960			379			481,735			(2,738	)		(1,253	)		(19,039	)		(62,670	)		397,224
Shares issued in Merger		38,754			388			—			—			185,654			(3,606	)		—			—			—			182,436
Shares issued		136			1			382			4			5,258			(4,151	)		—			—			—			1,112
Forfeitures of deferred compensation		(77	)		—			(105	)		—			(1,505	)		1,505			—			—			—			—
Compensation expense		—			—			—			—			—			6,158			—			—			—			6,158
Acquisition of treasury stock		—			—			—			—			—			—			—			(4,552	)		—			(4,552	)
Other		(214	)		(2	)		78			2			—			—			—			—			—			—
Comprehensive loss:
Net loss		—			—			—			—			—			—			—			—			(30,601	)		(30,601	)
Unrealized loss on investments, net of tax of $0		—			—			—			—			—			—			964			—			—			964
Foreign currency translation adjustment, net of tax of $0					—			—			—			—			—			(518	)		—			—			(518	)
Total comprehensive loss		—			—			—			—			—			—			—			—			—			(30,155	)
Balances at January 31, 2006		119,599		$	1,197			38,315		$	385		$	671,142		$	(2,832	)	$	(807	)	$	(23,591	)	$	(93,271	)	$	552,223

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

6

McDATA CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

	Year Ended January 31,
	2006			2005			2004
Cash flows from operating activities:
Net loss	$	(30,601	)	$	(20,872	)	$	(43,133	)
Adjustments to reconcile net loss to cash flows from operating activities:
Depreciation and amortization		92,653			56,337			44,589
Bad debt provision		1,520			(467	)		(474	)
Equity in net loss of affiliate		—			1,380			984
Net realized loss on investments		247			643			48
Net loss on retirement of assets		17			1,094			400
Acquired in-process research and development		—			—			11,410
Inventory provisions		6,735			4,498			2,608
Impairment loss		—			50			—
Non-cash compensation expense		6,158			5,703			12,708
Deferred taxes		475			—			38,815
Tax benefit (expense) from stock options exercised		—			—			(420	)
Unrealized (gains) losses on derivative transactions		(56	)		(40	)		—
Changes in net assets and liabilities, net of effects of merger with CNT:
Accounts receivable		(8,040	)		(364	)		(26,105	)
Inventories		(9,495	)		(12,013	)		(6,150	)
Prepaid expenses and other current assets		968			(1,225	)		29
Other assets, net		(27,690	)		(18,727	)		(7,682	)
Accounts payable		7,147			3,630			7,091
Accrued liabilities		(31,914	)		(8,573	)		9,621
Deferred revenue and other long-term liabilities		5,417			10,580			17,782
Accrued income taxes		3,022			(210	)		(1,061	)
Goodwill		(2,074	)		—			—
Net cash provided by operating activities		14,489			21,424			61,060
Cash flows from investing activities:
Acquisitions, net of cash acquired		40,395			—			(171,421	)
Purchase of equity investment in Aarohi		—			—			(6,000	)
Purchases of property and equipment		(13,177	)		(16,923	)		(17,999	)
Proceeds from sale of equipment		1,727			—			—
Decrease (increase) in restricted cash related to interest rate swap		(1,825	)		83			(5,130	)
Cash received on cash surrender value of life insurance policy		1,339			—			—
Purchases of investments		(376,952	)		(459,825	)		(654,238	)
Maturities of investments		415,093			278,921			509,444
Sales of investments		—			197,806			101,085
Net cash provided by (used in) investing activities		66,600			62			(244,259	)
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		(4,552	)		(10,287	)		(8,752	)
Payment of notes payable		(222	)		(1,479	)		(15,469	)
Payment of obligations under capital leases		(2,513	)		(1,088	)		(2,697	)
Proceeds from the issuance of common stock		1,082			5,574			5,827
Net cash provided by (used in) financing activities		(6,205	)		(7,280	)		125,332
Effect of Exchange Rates on Cash and Cash Equivalents		(308	)
Net increase (decrease) in cash and cash equivalents		74,576			14,206			(57,867	)
Cash and cash equivalents, beginning of period		64,507			50,301			108,168
Cash and cash equivalents, end of period	$	139,083		$	64,507		$	50,301
Supplemental Disclosure of Non-cash Investing and Financing Activities
Interest paid	$	1,333		$	4,003		$	2,325
Income taxes paid		—			647			1,095
Capital lease obligations incurred, net of trade-ins		—			223			1,783
Transfer of inventory to fixed assets		6,306			4,842			1,859
Fixed assets exchanged for capital leases		—			—			(1,364	)
Restricted stock grant		—			—			17,357
Deferred compensation forfeitures		1,503			—			—

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

7

McDATA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share data)

NOTE 1 OVERVIEW AND BASIS OF PRESENTATION

Our Business

     McDATA Corporation and its subsidiaries provide data infrastructure solutions that simplify and optimize access to and movement of ever increasing volumes of data held within enterprises across the globe. This access is provided across storage area networks (SANs), metropolitan area networks (MANs) and wide area networks (WANs) through a combination of products and services. On June 1 2005, McDATA closed the acquisition of Computer Network Technology Corporation (CNT) and created a combined company with the products, talents and services of two respected names in storage networking. CNT adds significant capabilities in the areas of extending storage networks over distance (MAN and WAN), professional services and maintenance services to McDATA’s strength in SAN directors, switches, routing, security and management. The merger of CNT and McDATA is expected to accelerate McDATA’s Global Enterprise Data Infrastructure (GEDI) initiative, whereby customers can evolve to a globally connected, secure, highly-available, performance-optimized, centrally-managed data access environment.

     McDATA’s product offerings include Intrepid directors, Sphereon switches, embedded blade server switches, Eclipse SAN routers, UltraNet extension products, EFCM management software, storage networking services (SNS) software and related third party products. Many of these products are an integral part of data services infrastructure solutions 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), and Sun Microsystems Inc. (Sun). In addition to these partners, the products are also sold through selected value added distributors (VADs) and value added resellers (VARs) in major geographic locations across the world. In addition to the products, McDATA also offers services including professional services, education, break/fix maintenance support, network monitoring services, as well as upgraded warranty and extended maintenance contracts on our hardware products.

     McDATA combines products and services to deliver solutions in the areas of data access, storage area networking, FICON, backup and recovery and disaster recovery / business continuity and data migration. While the primary fulfillment method is through our channel partners, McDATA’s field organization works directly with customers to drive preference for McDATA solutions, and McDATA has and may continue to directly sell channel extension, third party products, maintenance and support and professional services to end-user customers.

     Certain prior year amounts have been reclassified to conform to the fiscal 2006 presentation.

NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

     The consolidated financial statements include the financial position, 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 affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. Actual results could differ from these estimates. Significant estimates used in the financial statements include estimates related to revenue reserves, inventory reserves, allowances for doubtful accounts, deferred revenue, warranty provisions, income taxes, the valuation of long-lived assets including goodwill and purchased intangible assets and the capitalization of software development costs.

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.

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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 maturities of one year or less are classified as short-term investments. Securities with remaining maturities longer than one year are classified as long-term investments, with the exception of auction rate securities.

     These investments are highly liquid, variable-rate debt securities. While the underlying security typically has a stated maturity of 20 to 30 years, the interest rate is reset through Dutch auctions that are held every 7, 28 or 35 days, creating a highly liquid, short-term instrument. The securities trade at par and are callable at par on any interest payment due date at the option of the issuer and as such are classified as short term investments.

     Based on evaluation of available evidence, including recent changes in market interest rates and credit rating information, management believes the declines in fair value for the Company’s securities are temporary. Should the impairment of any of these securities become other-than-temporary, the adjusted cost basis of the investment will be reduced and the resulting loss recognized in the statement of operations in the period the other-than-temporary impairment is identified.

     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, which is determined using quoted market prices.

Interest Rate Swaps

     The Company has entered into two interest rate swaps to address interest rate market risk exposure. The interest rate swaps are designated and qualify as a fair value hedge under 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 swaps qualify as perfectly effective fair value hedges. As such, there is no ineffective portion to the hedge recognized in earnings. Adjustments to the fair value of the interest rate swap agreements 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.

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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 on a straight-line method over the estimated useful lives of the assets 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 for property and equipment and capital leases was approximately $33.9 million, $26.9 million and $26.9 million in fiscal 2005, 2004 and 2003, respectively. Equipment and furniture at January 31, 2006 and January 31, 2005 includes assets under capitalized leases of $7.1 million and $4.9 million, respectively, with related accumulated amortization of approximately $2.9 million and $3.5 million, 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.

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

     The Company evaluates the carrying value of long-lived assets, excluding goodwill, at least annually for impairment or when events and circumstances indicate the carrying amount of an asset may not be recoverable. For the year ended January 31, 2006, no such events or circumstances were identified. 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 years ended 2005 and 2003, the Company made no material adjustments to its long-lived assets. During fiscal 2004, the Company identified the impairment of a customer relationship asset and retired a $2.2 million intangible asset related to the initial purchase of the Toronto operations in 1997.

     Goodwill and other indefinite lived intangible assets are not subject to amortization, but are subject to an impairment test at least annually or more frequently if events or circumstances indicate that impairment might exist. The Company completed its annual impairment analysis of goodwill in the first quarter of 2005 and found no impairment. SFAS No. 142, “Goodwill and Other Intangible Assets”, 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 finite lives over periods ranging from one to seven years.

Revenue Recognition

     The Company recognize revenue when four basic criteria are met: (a) persuasive evidence of an arrangement exists, (b) products are delivered or services rendered, (c) the sales price is fixed and determinable and (d) collectibility is probable.

Product Revenue

     We recognize revenue when four basic criteria are met: (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 probable.

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Product Revenue

     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 of shipment. 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.

     With respect to revenue from configured products, the Company generally recognize revenue on shipment when we ship directly to an end user. When there are shipments to an OEM or distributor, the Company 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 SEC Staff Accounting Bulletin (SAB) No. 104, “Revenue Recognition” (SAB No. 104) have been met, the Company recognizes revenue for such configured products. These configured products represent high value, customized solutions of directors, cabinets and various combinations of port cards ordered by our OEM and distributor partners as required by the end-user.

     Non-configured products and components, such as our switch products, UltraNet extension products, additional port cards, and FlexPort upgrades, are recognized as revenue when the criteria for SAB No. 104 (as discussed above) have been met, generally at time of shipment.

     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 estimated warranty costs at the time of revenue recognition based on its experience.

Service Revenue

     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 professional services is recognized when such services are performed.

Software Revenue

     Revenue from software is comprised of software licensing and post-contract customer maintenance and support. Software revenue is allocated to the license and support elements using vendor specific objective evidence of fair value (VSOE). Revenue from software licenses is recognized when the four basic criteria above have been met. Revenue from post-contract support and maintenance is recognized ratably over the term of the support contract, assuming the four basic criteria are met. The Company has software embedded in some of its products that is considered more than incidental to the product and represents a separate unit of accounting as defined by the American Institute of Certified Public Accountants Statement of Position 97-2 “Software Revenue Recognition” (SOP 97-2).

Multiple Elements

     The Company enter into certain arrangements where we are obligated to deliver multiple products and/or services. In transactions that include multiple products, services and/or software, in most cases the Company allocates the revenue to each element based upon their VSOE of the fair value of the element, with any remaining elements allocated using the residual method. VSOE of the fair value for an element is based upon the price charged when the element is sold separately. Revenue allocated to each element is then recognized when the basic revenue recognition criteria is met for each element.

Deferred Revenue

     Total deferred revenue consists primarily of unearned revenue from our customer support or maintenance contracts on our software and hardware products. These contracts are billed and collected either upfront or annually at the beginning of each service period. The Company recognizes revenue from these contracts ratably over the contractual period, generally one to three years.

     The remaining portion of the deferred revenue represents deferred revenue related to billings and collections for which one or more of the four basic criteria under SAB No. 104 and the American Institute of Certified Public Accountants’ Statement of Position 97-2, as amended, have not been met. These balances are all classified as short-term on the balance sheet as all four criteria have historically been met in less than twelve months.

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     The accounting periods over which we will recognize this revenue is as follows:

For Fiscal Years:	Amount
2006	$	61,242
2007		21,064
2008		7,646
2009		1,964
2010 and thereafter		706
Total	$	92,622

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, 2006, were approximately $53.9 million and $23.1 million, respectively. Capitalized software costs and accumulated amortization included in other assets at January 31, 2005, were approximately $33.6 million and $11.0 million, respectively. Amortization expense of capitalized software for fiscal 2005, 2004, and 2003 was approximately $12.1 million, $3.7 million and $5.5 million, respectively.

Advertising

     The Company expenses advertising costs as incurred. Advertising expenses for fiscal 2005, 2004, and 2003 were approximately $6.1 million, $5.4 million and $3.2 million, respectively. Approximately $5.7 million of fiscal 2005 advertising expense is recorded in selling and marketing and approximately $400,000 is recorded in general and administrative. For fiscal 2004, approximately $5.2 million and $231,000 were recorded in selling and marketing, and general and administrative operating expenses, respectively. For fiscal 2003, approximately $3.0 million and $206,000 were recorded in selling and marketing, and general and administrative operating expenses, respectively.

Restructuring Charges

     The Company accounts for costs, including termination benefits and facility closure costs, associated with restructuring activities in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” which requires that the liability for costs associated with exit or disposal of activities be recognized when the liability is incurred. See Note 5 for discussion of restructuring activities.

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Earnings Per Share

     Basic net loss per share excludes dilution and is computed by dividing loss available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted net loss per share is based on the weighted-average number of shares outstanding during each period and the assumed exercise of dilutive common stock equivalents 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 is included for shares sold in relation to McDATA’s September 2004 agreement with International Business Machines Corporation (IBM) in which the Company granted IBM five-year warrants for the purchase of up to 350,000 shares of McDATA’s Class B common stock because of their anti-dilutive impact. No dilutive effect has been included for the convertible subordinated debt or the share options sold in relation to the convertible subordinated debt because of their anti-dilutive impact.

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

	Years Ended January 31,
	2006			2005			2004
Net loss	$	(30,601	)	$	(20,872	)	$	(43,133	)
Weighted average shares of common stock outstanding used in computing basic net loss per share		140,331			115,355			114,682
Effect of dilutive stock options and warrants		—			—			—
Weighted average shares of common stock used in computing diluted net loss per share		140,331			115,355			114,682
Basic and diluted net loss per share	$	(.22	)	$	(0.18	)	$	(0.38	)
Options and warrants not included in diluted share base because of the exercise prices		19,891			10,765			8,459
Options, warrants and restricted stock not included in diluted share base because of the net loss		3,166			7,080			6,422

Stock-Based Compensation

     The Company has stock-based employee compensation and employee purchase plans, which are described more fully in Note 13. The Company accounts for these plans according to Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations and has adopted the disclosure-only alternative of SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure, an amendment of FASB Statement No. 123”. Any deferred stock compensation calculated pursuant to APB 25 is amortized ratably over the vesting period of the individual options, generally two to four years. The following table illustrates the effect on net loss and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123.

	Years Ended January 31,
	2006			2005			2004
Net loss, as reported	$	(30,601	)	$	(20,872	)	$	(43,133	)
Add: Total stock-based employee compensation expense included in net loss as determined under the intrinsic value method, net of related tax effects		6,158			5,702			12,708
Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects		(22,370	)		(19,781	)		(34,050	)
Pro forma net loss	$	(46,813	)	$	(34,951	)	$	(64,475	)
Loss per share:
Basic and diluted —as reported	$	(0.22	)	$	(0.18	)	$	(0.38	)
Basic—pro forma	$	(0.33	)	$	(0.30	)	$	(0.56	)

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     The fair value of each option granted during fiscal 2005, 2004 and 2003 is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions:

	Years Ended January 31,
	2006			2005			2004
Dividend yield		—	%		—	%		—	%
Expected volatility		60%-77	%		77%-95	%		90	%
Risk-free interest rate		3.69%-4.55	%		2.7%-4.0	%		2.1%-3.5	%
Expected life, in years		4.0			2.0-4.0			2.0-4.0

Comprehensive Income (Loss)

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

Income Taxes

     The Company estimates a provision for income taxes in each of the jurisdictions in which we operate. The estimated current tax exposure includes the risks associated with tax audits and the temporary differences resulting from the different treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities which the Company includes in the balance sheet. The Company evaluates the likelihood that our deferred tax assets will be recovered from future taxable income and to the that recovery is not more likely than expiration of the deferred benefit, the Company establish a valuation allowance

Recent Accounting Pronouncements

     In December 2003, the Financial Accounting Standards Board (FASB) issued an exposure draft of its proposed amendment to Statement of Financial Standards (SFAS) No. 128, “Earnings Per Share” (SFAS No. 128), which specifies the calculation of earnings per share (EPS). This Statement eliminates the provision of SFAS No. 128 that allows issuing entities to overcome the presumption that certain contracts that may be settled in cash or shares will be settled in shares. Lastly, this Statement requires that shares to be issued upon conversion of a mandatorily convertible security be included in the computation of basic EPS from the date that conversion becomes mandatory. The Company has not yet determined the potential future impact of the proposed amendment on its consolidated financial statements.

     In November 2004, the FASB issued SFAS No. 151, “Inventory Cost—An Amendment of ARB 43, Chapter 4” (SFAS No. 151), to clarify that abnormal amounts of certain costs should be recognized as period costs. This Statement is effective for fiscal years beginning after June 15, 2005. The Company does not believe that the adoption of SFAS No. 151 will have a material impact on its financial position, results of operations, or cash flows.

     In December 2004, the FASB issued Staff Position No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004. The Act creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85 percent dividends received deduction for qualifying dividends from controlled foreign corporations, subject to certain limitations. This Staff Position allows companies additional time beyond the financial reporting period of enactment to evaluate the effect of the Act. The Company has evaluated the potential benefits of this provision and has determined that it will not be paying any dividends pursuant to the specific rules of the Act. This decision does not prevent us from paying dividends from controlled foreign corporations in the future. However, such dividends would not be eligible for the special dividends received deduction provided for by the Act.

     In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (SFAS No. 154), which requires the direct effects of voluntary accounting principle changes to be retrospectively applied to prior periods’ financial statements. The Statement does not change the transition provisions of any existing accounting pronouncements, but would apply in the unusual instance that a pronouncement does not include specific transition provisions. SFAS No. 154 maintains existing guidance with respect to accounting estimate changes and corrections of errors. The Statement is effective for the Company beginning in fiscal year 2006. Adoption is not expected to have a material impact on the Company’s financial position, results of operation or cash flows.

     On September 15, 2005, the FASB issued EITF 05-8, “Income Tax Consequences of Issuing Convertible Debt with a Beneficial Conversion Feature(“EITF 05-8”). EITF 05-8 addresses the accounting for convertible debt issued with a nondetachable conversion feature that is “in-the-money,” and requires that this conversion feature (beneficial conversion feature) be accounted for separately. The beneficial conversion feature is recognized and measured separately by allocating to additional paid-in-capital a portion of the proceeds equal to the intrinsic value of the conversion feature. The EITF addresses the following: 1) whether the issuance of convertible debt with a beneficial conversion feature results in a basis difference for purposes of applying SFAS No. 109 “Accounting for Income Taxes” (SFAS No. 109) 2) If there is a basis difference, whether

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it is a temporary difference under SFAS No. 109 and 3) If there is a temporary difference, whether recognition of the deferred tax liability for the temporary difference of the convertible debt should be recorded as an adjustment to additional paid-in capital or through the recording of a deferred charge. EITF is effective for the first quarter of fiscal year 2006. The Company has assessed the impact of EITF 05-08 and does not anticipate that it will have a material impact on our financial position, results of operation, and cash flows in fiscal year 2006.

     In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140” (“SFAS No. 155”). SFAS No. 155 amends FASB Statements No. 133 (SFAS No. 133), “Accounting for Derivative Instruments and Hedging Activities”, and No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” for the following purposes: permit fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; clarify which interest-only strips and principal-only strips are not subject to the requirements of Statement 133; establish a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarify that concentrations of credit risk in the form of subordination are not embedded derivatives; and eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The Company does not expect the adoption of SFAS No. 155 will have a material impact on its results of operations, financial position, or liquidity.

     In March of 2006, FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets an amendment of FASB Statement No. 140 (SFAS No. 156). SFAS No. 156 requires that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable. SFAS No. 156 permits, but does not require, the subsequent measurement of servicing assets and servicing liabilities at fair value. An entity that uses derivative instruments to mitigate the risks inherent in servicing assets and servicing liabilities is required to account for those derivative instruments at fair value. Under SFAS No. 156 an entity can elect subsequent fair value measurement of its servicing assets and servicing liabilities by class, thus simplifying its accounting and providing for income statement recognition of the potential offsetting changes in fair value of the servicing assets, servicing liabilities, and related derivative instruments. An entity that elects to subsequently measure servicing assets and servicing liabilities at fair value is expected to recognize declines in fair value of the servicing assets and servicing liabilities more consistently than by reporting other-than-temporary impairments. SFAS No. 156 is effective for fiscal years beginning September 15, 2006. The Company does not expect the adoption of SFAS No. 156 will have a material impact on its results of operations, financial position, or cash flows.

Recently Adopted Accounting Pronouncements

     In June 2004, the FASB issued EITF Issue No. 03-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF Issue No. 03-1 establishes a common approach to evaluating other-than-temporary impairment to investments in an effort to reduce the ambiguity in impairment methodology found in APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” and SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities”, which has resulted in inconsistent application. In September 2004, the FASB issued FASB Staff Position EITF Issue No. 03-1-1, which deferred the effective date for the measurement and recognition guidance clarified in EITF Issue No. 03-1 indefinitely; however, the disclosure requirements remain effective for fiscal years ending after June 15, 2004. While the effective date for certain elements of EITF Issue No. 03-1 have been deferred, the adoption of EITF Issue No. 03-1 when finalized in its current form is not expected to have a material impact on our financial position, results of operations or cash flows. In November 2005, the FASB issued FSP FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP 115-1 and 124-1”), which clarifies when an investment is considered impaired, whether the impairment is other than temporary, and the measurement of an impairment loss. It also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP 115-1 and 124-1 are effective for all reporting periods beginning after December 15, 2005.

     The Company adopted FSP 115-1 in the fourth quarter of fiscal 2005 and determined that certain securities sold in the first quarter of fiscal year 2006 at a realized loss of $150,000 were other than temporarily impaired in the fourth quarter of fiscal year 2005, the effect of which has been reported in our financial position, results of operations and cash flows.

     In June, 2004, the FASB issued EITF 04-8, “The Effect of Contingently Convertible Instruments on Diluted Earnings per Share.”(“EITF 04-8). EITF 04-8 addresses when contingently convertible instruments should be included in earnings per

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share. Contingently convertible instruments are defined as instruments that have embedded conversion features that are contingently convertible or exercisable based on 1) a market price trigger or 2) multiple contingencies if one of the contingencies is a market price trigger and the instrument can be converted or share settled based on the specified market condition. The effective date for EITF 04-8 was for reporting periods ending after December 15, 2004. The Company adopted EITF 04-8 in the first quarter of fiscal year 2005 and determined that for the year ended January 31, 2006, there was no effect on our calculation of dilutive earnings per share as the impact was antidilutive.

     In December 2004, the FASB issued a revision of SFAS No. 123, “Accounting for Stock-Based Compensation”, (SFAS No. 123R). SFAS No. 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance. SFAS No. 123R establishes standards for the accounting for transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. SFAS No. 123R does not change the accounting guidance for share-based payment transactions with parties other than employees provided in SFAS No. 123 as originally issued and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” Originally, SFAS No. 123R was effective for interim reporting periods that begin after June 15, 2005. In April 2005, the SEC announced the deferral of the required effective date. The SEC rule provides that SFAS 123R is now effective for registrants as of the beginning of the first fiscal year beginning after June 15, 2005. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to the adoption of SFAS 123R.

     The Company adopted SFAS No. 123R in the first quarter of fiscal 2006 and will continue to evaluate the impact of SFAS No. 123R on our operating results and financial condition. The pro forma information in Note 2 of our Consolidated Financial Statements presents the estimated compensation charges under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” for the fiscal years 2005,2004,and 2003. As a result of the provisions of SFAS 123R and SAB 107, we expect the compensation charges under SFAS 123R to reduce net income by approximately $10 to $11 million for fiscal 2006. However, our assessment of the estimated compensation charges is affected by our stock price as well as assumptions regarding a number of complex and subjective variables and the related tax impact. These variables include, but are not limited to, the volatility of our stock price and employee stock option exercise behaviors. We will recognize compensation cost for stock-based awards issued after January 31, 2006, on a straight-line basis over the requisite service period for the entire award.

     In June 2005, the FASB finalized FASB Staff Positions (FSP) No. 143-1, “Accounting for Electronic Equipment Waste Obligations”. FSP No. 143-1 addresses accounting by commercial users and producers of electrical and electronic equipment, in connection with Directive 2002/96/EC on Waste Electrical and Electronic Equipment issued by the European Union on February 13, 2003 (Directive). This Directive requires EU-member countries to adopt legislation to regulate the collection, treatment, recovery, and environmentally sound disposal of electrical and electronic waste equipment, and sets forth certain obligations relating to covering the cost of disposal of such equipment by commercial users. Producers will also be required to cover the cost of disposal of such equipment by private household users. The FSP sets forth accounting for such obligations by commercial users and producers, with respect to SFAS No. 143, “Asset Retirement Obligations” and the related FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations”, since this type of obligation is an asset retirement obligation. The guidance of this FSP shall be applied in the first reporting period after the date of the adoption of the law by the applicable EU-member country.

     The Company adopted FSP No. 143-1 in the fourth quarter of fiscal 2005 and concluded that although no liability has been incurred as of January 31, 2006, the Company is continuing to analyze the impact of the directive, FSP No. 143-1, on its financial position and results of operations as additional EU member countries adopt the directive.

     In June 2005, the FASB finalized FSP No. 150-5, “Issuer’s Accounting under Statement 150 for Freestanding Warrants and Other Similar Instruments on Shares That Are Redeemable”. FSP No. 150-5 addresses whether freestanding warrants and other similar instruments on shares that are redeemable (either puttable or mandatorily redeemable) would be subject to the requirements of SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” regardless of the timing of the redemption feature or the redemption price. The Company has adopted the FSP and has determined it does not impact its financial position, results of operations or cash flows in fiscal 2005.

     In June 2005, the FASB ratified the EITF’s consensus on Issue No. 05-6, “Determining the Amortization Period for Leasehold Improvements” (EITF 05-6). The guidance requires that leasehold improvements acquired in a business combination or purchased subsequent to the inception of a lease be amortized, based on facts available as of the date of the

16

business combination or purchase, over the shorter of the useful life of the assets or a term that includes renewals that are reasonably assured. The Company adopted EITF 05-6 in the third quarter of fiscal 2005 and concluded that there was no material impact on our financial position, results of operation, and cash flows as of January 31, 2006.

Note 3—FOREIGN CURRENCY

     The financial statements of the Company’s international subsidiaries have been translated into U.S. dollars. Assets and liabilities are translated into U.S. dollars at period-end exchange rates, while fixed assets and equity accounts are translated at historical rates. Income and expenses are translated at the average exchange rates during the period. The resulting translation adjustments are included in stockholders’ equity as a component of accumulated other comprehensive loss.

     The Company is exposed to market risks related to fluctuations in foreign exchange rates because some sales transactions, and the assets and liabilities of its foreign subsidiaries, are denominated in foreign currencies. The Company had no outstanding forward exchange contracts as of January 31, 2006 and 2005. Gains and losses from transactions denominated in foreign currencies and forward exchange contracts are included in the Company’s net loss as part of interest and other income in the accompanying Consolidated Statements of Operations. The Company recognized foreign currency transaction gains (losses) of $(272,000), $41,000 and $62,000 for fiscal 2005, 2004 and 2003, respectively in the accompanying statement of operations.

Note 4—MERGER WITH CNT

Merger Transaction

     On June 1, 2005, the Company consummated the merger transaction between Condor Acquisition, Inc. (Merger Sub), a wholly-owned subsidiary of McDATA Corporation, and CNT (the Merger) pursuant to the terms and conditions of the previously filed Agreement and Plan of Merger, as amended (the Merger Agreement). The transactions contemplated by the Merger Agreement were adopted and approved at a special meeting of the stockholders of the Company on May 24, 2005, and at a special meeting of the shareholders of CNT on May 24, 2005. Pursuant to the terms of the Merger Agreement, Merger Sub was merged with and into CNT with CNT being the surviving corporation as a wholly-owned subsidiary of the Company. In connection with the filing of the Articles of Merger, CNT’s name was changed to “McDATA Services Corporation.”

     Upon completion of the merger, CNT shareholders received 1.3 shares of McDATA Class A common stock for each share of CNT common stock held by them, together with cash in lieu of fractional shares, and the Company assumed the CNT employee equity plans and the awards granted under these plans, as follows:

• Each outstanding CNT stock option was assumed by McDATA and became exercisable for shares of McDATA Class A common stock at the ratio of 1.3 shares of McDATA Class A stock for every share of CNT common stock subject to the option. The exercise price per share of each assumed CNT stock option is equal to the exercise price of the assumed CNT option divided by 1.3. All other terms and conditions of the assumed CNT stock options remained unchanged.

• The outstanding CNT restricted stock units and CNT deferred stock units were assumed by the Company and were converted into, and are deemed to constitute, a right to be issued shares of McDATA Class A common stock. The number of shares of McDATA Class A common stock subject to the assumed CNT restricted stock units and CNT deferred stock units will each be adjusted to reflect the merger exchange ratio. All other terms and conditions of the assumed CNT restricted stock units and CNT deferred stock units remained unchanged. Notwithstanding the foregoing, all outstanding CNT restricted stock units vested in full upon completion of the merger, and the holders thereof received 1.3 shares of McDATA Class A common stock for each CNT restricted stock unit owned at the effective time of the merger, together with cash in lieu of any fractional shares. All deferred stock units were fully vested prior to the acquisition.

• With the exception of retention grants made to certain CNT employees and certain shares of restricted stock issued to one other CNT employee, all outstanding shares of CNT restricted stock became fully vested as of the completion of the merger, and the holders thereof received 1.3 shares of McDATA Class A common stock for each restricted share of CNT common stock owned at the effective time of the merger, together with cash in lieu of any fractional shares. All other terms and conditions of the assumed shares of restricted stock remained unchanged.

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     On June 1, 2005, simultaneously with the effectiveness of the Merger, the Company entered into a supplemental indenture to the indenture between CNT and U.S. Bank National Association, (the Trustee), pursuant to which McDATA fully and unconditionally guarantees the payment of principal and interest on CNT’s outstanding $124,350,000 3.00% Convertible Subordinated Notes due 2007 (the 3.00% Notes), and that upon conversion, a holder of the 3.00% Notes will receive that number of shares of the Company’s Class A common stock that would have been issued if the 3.00% Notes had been converted into CNT common stock immediately prior to the merger.

Reason for the Merger

     The Merger was intended to create a combined company that will establish a leading position in data access, enterprise storage networking, encompassing world-class products, services and software. The merger will combine the products, talent and expertise of two respected names in storage networking and is expected to accelerate McDATA’s “Global Enterprise Data Infrastructure” or GEDI to deploy a broadened tiered network infrastructure.

Preliminary Purchase Accounting

     McDATA was considered the accounting acquirer in the merger, requiring the purchase consideration of $193.0 million to be allocated to the fair value of CNT’s net assets, with the residual to goodwill. The consolidated financial statements include the operating results of CNT from the June 1, 2005, date of acquisition. The purchase consideration consisted of 38.8 million shares of McDATA Class A common stock valued at $170.2 million and issued in exchange for 100% of the outstanding CNT common and restricted shares; the exchange of 19.9 million stock options valued at $15.9 million using the Black Scholes option pricing model; and $6.9 million in direct transaction costs. The value of the stock issued was based upon an average market price per share of $4.39, which was the average McDATA Class A common stock price for the period beginning two days before and ending two days after the announcement of the merger on January 18, 2005. Under the purchase method of accounting, the total purchase price is allocated to CNT’s net tangible and intangible assets and liabilities based on their estimated fair value as of the completion date of the merger.

     We recorded approximately $185.4 million of goodwill, $73.6 million of identified intangible assets, $188.3 million of tangible assets and $154.3 million of liabilities at the time of the acquisition of CNT. The initial purchase price allocation for CNT is subject to revision as more detailed analysis is completed and additional information on the fair values of CNT’s assets and liabilities becomes available. Subsequent to the initial purchase price allocation, we increased our estimated liabilities assumed in the merger by $2.2 million, primarily due to an increase in estimated tax and employee severance liabilities, partially offset by a decrease to our estimate of contract termination liabilities. The primary areas of the purchase price allocation that are not yet finalized relate to collectibility of receivables, severance and relocation benefits, office closure costs, contract termination costs, certain legal matters, income and non-income based taxes, and residual goodwill. With the finalization of the purchase price allocation, additional adjustments to deferred taxes may be made. After the purchase price allocation period (generally within one year of the acquisition date), estimated increases to tax liabilities will be expensed while reductions will result in a decrease in the amount of the purchase price allocated to goodwill.

     Any change in the estimated fair value of the net assets of CNT during the purchase price allocation period will change the amount of the purchase price allocated to goodwill. The actual allocation of purchase cost and its effect on results of operations may differ significantly from the proforma operating results included herein.

Pro Forma Results

     The following unaudited pro forma information presents a summary of the results of operations of the Company assuming the acquisition of CNT occurred at the beginning of each period presented. The pro forma financial information is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the Merger had taken place at the beginning of each of the periods presented, nor is it indicative of future operating results.

	Twelve Months
	Ended
	January 31,
	2006			2005
Total revenue	$	704,743		$	757,074
Net loss	$	(76,145	)	$	(172,288	)
Basic net loss per share	$	(0.50	)	$	(1.14	)
Diluted net loss per share	$	(0.50	)	$	(1.14	)

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Note 5—RESTRUCTURING COSTS

     In connection with the Company’s merger with CNT discussed in Note 4, management approved and initiated a plan of integration which outlined the actions necessary to combine its existing business and resources with those of CNT. An important part of this plan is the integration of the companies’ products and customer bases, elimination of duplicative activities, and the reduction of the Company’s overall cost structure. Restructuring charges of $11.1 million incurred in the year ended January 31, 2006 are based on this integration plan. The Company has completed significant milestones of its integration process, including selling the Lumberton manufacturing operations and eliminating more than 500 redundant jobs. The Company has substantially completed CNT integration activities as of January 31, 2006.

Restructuring Costs Expensed in 2005

     After the acquisition of CNT, the Company notified redundant employees that their employment would be terminated and provided them with a detailed explanation of their benefits, which included separation pay as well as retention pay for transitional employees. Total termination benefits charged to restructuring costs in results of operations as a result of the integration plan was $3.7 million through January 31, 2006. Retention pay offered to all transitional employees was contingent upon the employee rendering future service through a transition period and has no relationship to the employees’ past service; therefore, these benefits were recognized as a restructuring cost ratably over the transition period. A total of $0.6 million has been recognized as a restructuring cost through January 31, 2006. No further termination or retention benefits are expected to be incurred as a result of the CNT integration plan.

     Prior to the acquisition, McDATA and CNT each sold a competing Director class product—McDATA’s is branded the Intrepid 10000 and CNT’s is the UltraNet Multi-Service Director (UMD). In order to eliminate this redundancy and integrate the two company’s product offerings, the Company has decided to withdraw the UMD from the market, and continue to sell the Intrepid 10000 product in the future. As a result, McDATA has offered, and certain existing UMD customers have accepted, an exchange program which allowed customers to trade in their UMD for a comparable Intrepid 10000 at no cost to them. The Company has also offered customers up to 20 hours of professional consulting service to assist with the migration to the new product. The net cost of this program of $6.8 million was recorded as a restructuring cost , which represents the difference between the estimated costs of the Intrepid 10000’s to be installed over the estimated salvage values of the UMD’s to be returned. Changes to our estimated salvage values and costs and quantities of the Intrepid 10000’s to be provided will result in a restructuring charge or benefit in future periods. Consulting costs to be incurred in connection with this program were not accrued because they could not be reasonably estimated. They will be recorded as restructuring costs in future periods as they are incurred.

     Changes to the estimates of executing the currently approved plans of restructuring the pre-merger McDATA organization will be reflected in our future results of operations.

     The following table summarizes the Company’s utilization of restructuring accruals during fiscal 2005:

	Employee			UMD /Intrepid
	Severance			10000
	Benefits			Swap			Totals
Initial estimate at inception of plan	$	3,610		$	6,834		$	10,444
Net cost of product exchanged		—			(6,027	)		(6,027	)
Cash payments		(3,941	)		—			(3,941	)
Additional restructuring charges		655			—			655
Accrual balance at January 31, 2006	$	324		$	807		$	1,131

The restructuring liabilities shown above are included in accrued liabilities in the accompanying balance sheet as of January 31, 2006.

     During the quarter ended January 31, 2006, we announced a reduction in workforce unrelated to the original CNT integration plan, incurring approximately $1.8 million in severance and benefit charges. All activities under this plan had been completed and the related liabilities were paid as of January 31, 2006.

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Restructuring Costs Accounted for in CNT Purchase Allocation

     In connection with the restructuring of the pre-merger CNT organization, $36.3 million in restructuring liabilities, consisting primarily of severance, relocation, facility consolidation costs, and contract termination costs, were recorded as liabilities assumed in the initial purchase price allocation of CNT at June 1, 2005, in accordance with EITF Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination”. Subsequent to the initial purchase price allocation, we decreased our estimated restructuring costs by a net $5.4 million due to the settlement of certain purchase commitments, partially offset by increases to estimated termination benefits and facilities closure costs.

     As of the acquisition date, management had formulated an integration plan which included the elimination of duplicative headcount, elimination of redundant products, the outsourcing of manufacturing, and the closing of duplicative facilities in overlapping geographies. As a result, over 200 pre-merger CNT employees have been terminated and approximately $10.8 million in termination and relocation benefits for former CNT employees has been recognized. We also recognized $8.2 million related to the planned closure of certain pre-merger CNT offices. For sites where the Company expected to negotiate an early termination of the lease, the expected termination costs were accrued. The amounts accrued for the remaining sites were based upon the fair value of the liability at the cease-use date based on the remaining lease rentals reduced by estimated sublease rentals. An additional amount of approximately $9.9 million has been recognized for estimated settlements of various unfulfilled contractual commitments.

     In execution of its plan to continue to outsource its manufacturing operations, on June 24, 2005, the Company sold its manufacturing operations and transferred assets related to the former CNT Lumberton, New Jersey manufacturing operations to Solectron Corporation, Inc (“Solectron”). The terms of the sales agreement include (a) the transfer of equipment related to the manufacturing operations for $1.5 million, (b) the assumption by Solectron of a certain lease obligation related to the facility in Lumberton, New Jersey and a sublease back to the Company for certain space at the facility, (c) the transfer of 123 Company employees to Solectron, and (d) the payment of $3 million in installments over the next year by the Company to Solectron in partial consideration for anticipated restructuring costs to be incurred by Solectron related to this facility. The net payment of $1.5 million required by the Company to transfer these assets and liabilities has been reflected as a liability assumed in the purchase allocation. As discussed more fully in Note 17, in connection with this sale, the Company has agreed to indemnify the buyer and hold them harmless from any loss, as defined in the agreement, which relates to specific issues outlined in the agreement. In accordance with FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, the Company has recognized a liability of approximately $0.4 million for the underlying fair value of these obligations, which has also been included in liabilities assumed in the purchase of CNT.

     Further changes to estimated restructuring costs as a result of executing the currently approved plans associated with the pre-merger activities of CNT will be recorded as an adjustment to goodwill during the purchase price allocation period, and as operating expenses thereafter.

     The following table summarizes the Company’s utilization of restructuring accruals pertaining to pre-merger operations of CNT during fiscal 2005:

	Employee
	Severance and			Facility			Contract
	Relocation			Closure and			Termination
	Benefits			Exit Costs			Costs			Totals
Initial restructuring accruals	$	9,571		$	10,026		$	16,686		$	36,283
Cash payments		(8,715	)		(4,390	)		(5,807	)		(18,912	)
Change to estimated costs		1,250			114			(6,802	)		(5,438	)
Cash receipt from sale of Lumberton		—			1,484			—			1,484
Accrual balance at January 31, 2006	$	2,106		$	7,234		$	4,077		$	13,417

     Of the restructuring liabilities described above, $13.0 million is included in accrued liabilities and the remaining $0.4 million is included in other long-term liabilities in the accompanying balance sheet as of January 31, 2006.

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NOTE 6 COMPONENTS OF SELECTED BALANCE SHEET ACCOUNTS

	January 31,			January 31,
	2006			2005
Inventories:
Raw materials	$	29,362		$	5,375
Work-in-progress		1,836			623
Finished goods		13,426			12,626
Total inventories at cost		44,624			18,624
Less reserves		(11,524	)		(4,904	)
Total inventories, net	$	33,100		$	13,720
Property and equipment:
Land	$	17,799		$	16,091
Building		32,573			32,573
Equipment and furniture		122,680			94,389
Computer software for internal use		30,787			29,146
Leasehold improvements		8,449			6,029
Construction in progress		838			492
		213,126			178,720
Less accumulated depreciation and amortization		(104,008	)		(83,791	)
	$	109,118		$	94,929
Accrued liabilities:
Wages and employee benefits	$	27,916		$	19,483
Purchase commitments and other supply obligations		10,480			5,867
Warranty reserves(1)		6,806			5,592
Accrued income taxes		10,215			1,573
Taxes, other than income tax		5,903			2,662
Interest payable		4,416			1,774
Customer obligations		8,227			4,784
Restructuring accrual		14,188			—
Other accrued liabilities		6,125			2,814
	$	94,276		$	44,549

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

	Years Ended January 31,
	2006			2005
Balance at beginning of period	$	5,592		$	4,522
Warranty expense, net		5,458			791
Non-expensed warranty obligations		17			1,483
Warranty claims		(6,005	)		(1,204	)
Acquired warranty liability		1,744			—
Balance at end of period	$	6,806		$	5,592

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NOTE 7 EQUITY INVESTMENT

     On August 22, 2003, the Company purchased 13.6 million shares of preferred stock of Aarohi Communications, Inc. (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 minimal product revenue and a core ASIC technology that is in the final stages of development. 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, expensed this amount during fiscal year 2003. In March 2005, the Company’s ownership percentage fell to approximately 9.8% due to the increase in ownership of other Aarohi investors.

     In addition to the equity investment, the Company had 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 $1.4 million and $984,000 for fiscal 2004 and 2003, respectively. Because the remaining net equity investment of Aarohi was reduced to zero during fiscal 2004, the Company will no longer recognize its share of Aarohi’s net losses and will not provide for additional losses unless the Company commits to additional financial support for Aarohi, which the Company is not required to provide. If Aarohi subsequently reports net income, then the Company will resume recognizing its share of Aarohi’s net income only after its share of net income equals the share of net losses not recognized.

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NOTE 8 INVESTMENTS

     Short- and long-term investments consisted of the following available-for-sale securities at January 31, 2006 and January 31, 2005:

			Unrealized		Unrealized
	Amortized		Holding		Holding		Fair
	Cost		Gains		Losses		Values
Fiscal 2005
U.S. Government obligations	$	79,108	$	—	$	338	$	78,770
State and local government obligations		5,400		—		—		5,400
Corporate obligations		68,373		14		140		68,247
Marketable equity securities		29,199		180		53		29,326
Fixed income mutual funds		21,203		91		43		21,251
	$	203,283	$	285	$	574	$	202,994
Reported as:
Short-term investments							$	171,110
Long-term investments								31,884
							$	202,994
Fiscal 2004
U.S. Government obligations	$	136,933	$	1	$	989	$	135,945
State and local government obligations		13,900		—		—		13,900
Corporate obligations		49,804		13		128		49,689
U.S. Treasury options		92		—		57		35
Marketable equity securities		31,201		23		204		31,020
Fixed income mutual funds		10,225		34		—		10,259
	$	242,155	$	71	$	1,378	$	240,848
Reported as:
Short-term investments							$	145,259
Long-term investments								95,589
							$	240,848

     Amortized cost is determined based on specific identification. As of January 31, 2006 and January 31, 2005, net unrealized holding losses of approximately $289,000 and $1.3 million, respectively, were included in accumulated other comprehensive income in the accompanying consolidated balance sheets. At January 31, 2006 and January 31, 2005, the Company held approximately $210,000 and $35,000 of purchased put options for U.S. Treasury futures, respectively. These investments were purchased as an economic hedge to mitigate interest rate risk related to a portfolio of preferred equity securities, included in marketable equity securities above, with a market value of approximately $29 million and $20.9 million at January 31, 2006 and January 31, 2005, respectively. Because these are not effective hedges, holding gains and losses resulting from valuing the securities to market are recognized in the statement of operations. As of January 31, 2006 and January 31, 2005, an unrealized gain of approximately $71,000 and an unrealized loss of approximately $56,000, respectively, associated with the purchased put options for U.S. Treasury futures was recorded in the statement of operations.

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     The following table presents the gross unrealized losses and fair value of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at January 31, 2006 and January 31, 2005.

					More Than 12
	Less Than 12 Months				Months						Total
			Unrealized				Unrealized				Unrealized
			Holding		Fair		Holding		Total Fair		Holding
	Fair Value		Losses		Value		Losses		Value		Losses
Fiscal 2005
U.S. Government obligations	$	51,758	$	145	$	21,801	$	193	$	73,559	$	338
Corporate obligations		26,657		75		4,603		65		31,260		140
Fixed income mutual funds		10,478		43		—		—		10,478		43
Marketable equity securities		5,852		36		1,712		17		7,564		53
Total	$	94,745	$	299	$	28,116	$	275	$	122,861	$	574
Fiscal 2004
U.S. Government obligations	$	132,246	$	989	$	—	$	—	$	132,246	$	989
Corporate obligations		29,039		109		2,049		19		31,088		128
U.S. Treasury options		35		57		—		—		35		57
Marketable equity securities		13,587		204		—		—		13,587		204
Total	$	174,907	$	1,359	$	2,049	$	19	$	176,956	$	1,378

     As of January 31, 2006 and 2005, the Company’s unrealized losses related to the following:

     U.S. Government obligations—The unrealized losses on the Company’s investments in U.S. Government obligations result from an increase in interest rates and are not related to credit quality. The unrealized losses are deemed to be temporary because the Company has the ability and intent to hold these investments until a recovery of fair value occurs which may be upon maturity. The Company held 43 and 55 U.S. government obligations in an unrealized loss position as of January 31, 2006 and 2005, respectively.

     Corporate obligations—The majority of the Company’s investments in corporate obligations are in corporate obligations of industrial, financial and consumer type entities. The unrealized losses on corporate obligations result from changes in interest rates and are not related to credit quality. The unrealized losses are deemed to be temporary because the Company has the ability and intent to hold the investments until a recovery of fair value occurs which may be upon maturity. The Company held 65 and 66 corporate obligations in an unrealized loss position as of January 31, 2006 and 2005, respectively.

     Marketable equity securities—The majority of the Company’s investments in marketable equity securities are in preferred stock of utility entities. The unrealized losses on these marketable equity securities result from changes in interest rates and are not related to credit quality. The unrealized losses are deemed to be temporary because the Company has the ability and intent to hold the investments until a recovery of fair value occurs. The Company held 10 and 25 marketable equity securities in an unrealized loss position as of January 31, 2006 and 2005, respectively.

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

	Years Ended January 31,
	2006			2005			2004
Realized gains	$	1,739		$	741		$	863
Realized losses		(2,099	)		(1,350	)		(834	)
Net realized gains (losses)	$	(360	)	$	(609	)	$	29

     The amortized cost and estimated fair value of debt securities held at January 31, 2006, 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.

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	Amortized		Fair
	Cost		Values
Less than one year	$	158,105	$	158,002
Greater than one year through five years		25,407		25,236
Greater than five years through ten years		—		—
Greater than ten years		19,771		19,756
	$	203,283	$	202,994

     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, 2006 and 2005, the amount of securities on loan equaled $61.3 million and $128.2 million, respectively.

     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 9 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 built open storage networking products based on IP and Ethernet, the international networking standards. 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.

     An estimated $67 million was allocated to goodwill. Goodwill represents the excess of the purchase price over the fair value of the net tangible and intangible assets acquired, and was not deductible for tax purposes. In addition, as this was the purchase of stock, the tax basis of Nishan’s assets and liabilities resulted 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.

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 consolidated financial statements include the operating results of Sanera from the date of the acquisition.

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Goodwill and Other Intangible Assets

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

	January 31, 2006						January 31, 2005
	Gross				Net		Gross				Net
	Carrying		Accumulated		Carrying		Carrying		Accumulated		Carrying
	Amount		Amortization		Amount		Amount		Amortization		Amount
Developed technology	$	143,490	$	55,025	$	88,465	$	116,866	$	31,595	$	85,271
Customer relationships		30,234		4,005		26,229		1,622		739		883
Backlog		17,606		9,801		7,805		—		—		—
Other		4,578		3,383		1,195		3,813		2,375		1,438
Total intangible assets	$	195,908	$	72,214	$	123,694	$	122,301	$	34,709	$	87,592

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

Fiscal Years:
2006	$	35,949
2007		26,857
2008		26,522
2009		20,391
2010		8,297
Thereafter		5,678
Total expected annual amortization expense	$	123,694

     Amortization expense related to acquired intangible assets was $37.5 million, $22.8 million and $9.4 for fiscal 2005, 2004, and 2003, respectively.

Changes in the carrying amount of goodwill for the twelve months ended January 31, 2006 are as follows:

	Product			Services
	Segment			Segment		Total
Balance as of January 31, 2005	$	78,693		$	—	$	78,693
Goodwill Acquired		51,905			133,469		185,374
Goodwill Impaired		—			—		—
Other(1)		(1,626	)		3,700		2,074
Balance as of January 31, 2006	$	128,972		$	137,169	$	266,141

(1) Represents a net increase to goodwill in the year ended January 31, 2006, as a result of adjusting the estimated fair market value of certain purchased assets and liabilities of CNT.

     As a result of the merger with CNT, and upon the integration of CNT’s service business in the third quarter of fiscal 2005, the Company operates in two distinct reporting segments, each constituting a separate reporting unit for purposes of allocating goodwill. Goodwill acquired in the merger with CNT has been allocated to these two reporting segments based on the work of a third party valuation expert. Goodwill was allocated between the two segments based upon each segment’s relative projected operating profits. As discussed in Note 4, the amount of goodwill and its allocations to the reporting segments are subject to change. As part of the Company’s process to finalize purchase accounting we will re-evaluate the goodwill allocation between the segments. The product and service segment goodwill balances will each be tested for impairment annually or more frequently, if events or circumstances indicate that impairment might exist. There were no impairments of goodwill recognized for the year ended January 31, 2006.

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NOTE 10 CONVERTIBLE SUBORDINATED DEBT

     Convertible subordinated debt includes the Company’s 2.25% convertible subordinated notes (the 2.25% Notes) due February 15, 2010, as well the $124.4 million 3.00% Convertible Subordinated Notes due February 15, 2007, previously issued by CNT (the 3.00% Notes), which were assumed in the Merger.

     On February 7, 2003, the Company sold $172.5 million of 2.25% convertible subordinated notes due February 15, 2010, raising net proceeds of approximately $167 million. The 2.25% 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 2.25% Notes may require the Company to purchase all or a portion of the Notes upon a change in control of the Company under certain conditions. 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 2.25% Notes do not contain any restrictive covenants and are not listed on any securities exchange or included in any automated quotation system; however, the notes are eligible for trading on the Portal^sm Market. On January 31, 2006, the approximate bid and ask prices per $100 of our 2.25% Notes was $84.73 and $85.23, respectively, resulting in an aggregate fair value of between $146.2 million and $147.0 million. Our Class A common stock is quoted on the NASDAQ National Market under the symbol, “MCDTA.”

     Concurrent with the issuance of the 2.25% 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 2.25% Notes being converted to common shares up to the $15.08 price per common share and mitigate dilution if the share price exceeds $15.08 at that time. Should there be an early unwind of either of the share option transactions, the amount of cash or net shares potentially received or paid by the Company will be dependent on then existing overall market conditions, the stock price, the volatility of the stock, and the amount of time remaining until expiration of the options.

     In July 2003, the Company entered into an interest rate swap agreement with a notional amount of $155.3 million that has the economic effect of modifying that dollar portion of the fixed interest obligations associated with the 2.25% 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, 2006, the six-month LIBOR setting for the swap was 4.03%, creating a rate of approximately 2.51%, which was effective until February 15, 2006. On February 15, 2006, the six-month LIBOR setting was reset to 4.93%, resulting in a rate of approximately 3.41%, which is effective until August 15, 2006. 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 2.25% Notes attributable to the hedged risk, were recognized in earnings. At January 31, 2006, the fair value of the interest rate swap had decreased from inception to a negative $6.6 million and is included in long-term liabilities. Corresponding to this change, the carrying value of the Notes has decreased by $6.6 million. As part of the agreement, the Company is also required to post collateral based on changes in the fair value of the interest rate swap. This collateral, in the form of restricted cash, approximated $6.9 million at January 31, 2006.

     On June 1, 2005, effective upon the consummation of the Merger, the Company fully and unconditionally guaranteed the 3.00% Notes and became a co-obligor on the 3.00% Notes with CNT and the 3.00% Notes became convertible into the Company’s Class A stock at a price of approximately $14.75 per share (aggregate of approximately 8.4 million shares) at any time prior to maturity on February 15, 2007, all pursuant to the terms of the Supplemental Indenture. All other terms of the 3.00% Notes remained unchanged.

     The 3.00% Notes were issued by CNT in 2002 and had an aggregate par value of $124.4 million. In accordance with purchase accounting rules, the Notes were adjusted to their aggregate fair value of $118.8 million based on the quoted market closing price as of the acquisition date. The $5.6 million reduction in the Notes’ carrying value will be accreted to interest expense on a straight-line basis over the remaining term of the Notes.

     The 3.00% Notes may be redeemed upon payment of the outstanding principal balance, accrued interest and a make whole payment if the closing price of the Class A stock exceeds 175% of the conversion price for at least twenty (20) consecutive trading days within a period of thirty (30) consecutive trading days ending on the trading day prior to the date of the mailing of the redemption notice. The make whole payment represents additional interest payments that would be made if the 3.00% Notes were not redeemed prior to their due date. Interest is payable on February 15 and August 15 of each year while the 3.00% Notes are outstanding. Payment of the notes will also accelerate upon certain events of default. On January 31, 2006, the approximate bid and ask prices per $100 of our 3.00% Notes was $96.75 and $97.50, respectively, resulting in an aggregate fair value of between $120.3 million and $121.2 million.

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     Prior to the Merger, CNT entered into an interest-rate swap agreement with a notional amount of $75 million that has the economic effect of modifying that dollar portion of the fixed interest obligations associated with $75 million of the 3.00% Notes such that the interest payable effectively becomes variable based on the three month LIBOR plus 69.5 basis points. The payment and reset dates of the swap are January 31st, April 30th, July 31st and October 31st of each year, until maturity on February 15, 2007. At January 31, 2006, the three-month LIBOR setting for the swap was 4.668%, resulting in a combined effective rate of approximately 5.363% which is effective until April 2006. 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, are recognized in earnings. Fair value hedge accounting is provided only if the hedging instrument is expected to be, and actually is, effective at offsetting changes in the value of the hedged item. During the fourth quarter, the fair value of the interest rate swap increased $0.8 million, resulting in a swap liability of $1.0 million as of January 31, 2006, which has been included in other long-term liabilities. This amount excluded accrued interest of $1.1 million, payable to the Company on February 15, 2006. Corresponding to this increase, the carrying value of the notes covered by the swap agreement has also been increased by $0.8 million. As part of the agreement, the Company is also required to post collateral based on changes in the fair value of the interest rate swap. This collateral, in the form of restricted cash, was $3.8 million at January 31, 2006, and has been included in restricted cash in the accompanying consolidated balance sheets.

Note 11—INTEREST AND OTHER INCOME, NET

     Interest and other income, net, consists of:

	Twelve Months Ended
	January 31,
	2006			2005			2004
Interest income	$	11,707		$	7,304		$	7,301
Net realized gains/(losses) on available-for-sale investments		(360	)		(609	)		29
Unrealized gain/(loss) on economic hedging investments		71			(56	)		(99	)
Interest and other income, net	$	11,418		$	6,639		$	7,231

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NOTE 12 INCOME TAX

     Income (loss) before income taxes from domestic and foreign operations consisted of the following:

	Years Ended
	January 31,
	2006			2005			2004
Domestic	$	(33,778	)	$	(21,675	)	$	(5,526	)
Foreign		3,608			2,545			1,789
	$	(30,170	)	$	(19,130	)	$	(3,737	)

Income tax expense (benefit) consisted of the following:

	Years Ended
	January 31,
	2006			2005			2004
Current:
Federal	$	—		$	(701	)	$	(974	)
State		(1,038	)		118			(39	)
Foreign		994			945			610
		(44	)		362			(403	)
Deferred:
Federal		—			—			34,943
State		—			—			3,872
Foreign		475
		475			—			38,815
Total expense	$	431		$	362		$	38,412

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

	Years Ended
	January 31,
	2006			2005			2004
Federal income tax benefit at statutory rate	$	(10,560	)	$	(6,695	)	$	(1,308	)
Research and development credit		(4,073	)		(7,483	)		(1,400	)
State taxes, net of federal benefit		(2,304	)		(427	)		(131	)
Foreign taxes in excess of statutory rate		367			123			126
Convertible debt discount		(2,423	)		(2,238	)		(2,028	)
Stock-based compensation		1,038			1,596			1,083
Write-off of acquired in-process R&D		—			—			1,273
Benefit from export sales		(439	)		(2,110	)		(158	)
Exempt investment income		(85	)		(287	)		(140	)
Increase in valuation allowance		18,983			17,717			41,332
Transfer pricing		(423	)		—			—
Foreign taxable income difference		224			—			—
Meals and entertainment		368			—			—
Other		(242	)		166			(237	)
Income tax expense	$	431		$	362		$	38,412

     Deferred income taxes reflect the net tax effect of temporary differences between the carrying amount of assets (other than goodwill) and liabilities for financial reporting purposes and the amounts used for 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:

	Years Ended
	January 31,
	2006			2005
Current deferred tax assets:
Inventory reserves and costs	$	16,706		$	6,708
Revenue recognition		22,995			7,584
Warranty reserves		2,599			2,135
Reserves related to employee benefits		4,614			2,077
Stock-based compensation		338			1,103
Restructuring reserves		6,032			—
Other		2,943			279
		56,227			19,886
Non-current deferred tax assets (liabilities):
Capitalized research expenditures		30,268			35,211
Capitalized acquired intangible assets		(14,808	)		(32,126	)
Tax credit carry forward		39,953			28,089
Revenue recognition		7,497			6,299

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	Years Ended
	January 31,
	2006			2005
Stock compensation		1,285			1,344
Difference between book and tax depreciation		2,730			3,955
Capitalized software, net of amortization		(11,737	)		(8,624	)
Foreign earnings		(3,302	)		(2,346	)
Net operating loss carry forward		77,692			43,048
Other		3,329			668
		132,907			75,518
		189,134			95,404
Valuation allowance		(188,126	)		(95,404	)
Total deferred tax asset, net	$	1,008		$	—

     As of January 31, 2006, the Company has U.S. federal net operating loss and general business credit carry-forwards of approximately $186.1 million and $21.6 million respectively. If not used, these carry-forwards will expire between the years 2018 and 2026. The utilization of a portion of the Company’s federal net operating loss and credit carry-forwards is subject to an annual limitation under Internal Revenue Code Section 382. The carry-forwards subject to this limitation were accumulated in the tax returns of CNT and Subsidiaries, Nishan Systems and Sanera Systems for tax periods prior to the date those companies were acquired by McDATA. The Company also has state net operating loss and credit carry-forwards of approximately $205.7 million and $14.9 million respectively. If not used, the state net operating loss carry-forwards will expire between the years 2009 and 2026. A portion of the state tax credit carry-forwards will expire between the years 2014 and 2018. The balance of the state credit carryforwards do not expire.

     In the third quarter of our 2003 fiscal year, we established a valuation allowance against the entire balance of our net deferred tax assets. We continue to maintain a valuation allowance against the amount of deferred tax assets for which we believe it is more likely than not that we will not realize the benefit of those assets.

     As a result of the acquisition of CNT Corporation and Subsidiaries during fiscal 2005, we recorded $75.2 million of deferred tax assets relating to the acquired companies as of the date of acquisition. A valuation allowance was also recorded against $73.7 million of these deferred tax assets. If any portion of the acquired deferred tax assets is utilized, the valuation allowance related to the acquired deferred tax assets that were utilized will be released, resulting in a decrease in goodwill by a like amount and we will record a charge to tax expense for the utilization of the deferred tax assets.

     For the year ended January 31, 2006, we recorded an increase in the valuation allowance of $19.0 million with respect to the net increase in deferred tax assets during the year, other than the acquired CNT deferred tax assets described above. As of the end of the fiscal year, the gross deferred tax assets less the valuation allowance results in a net deferred tax asset of $1.0 million, which reflects deferred tax assets in foreign jurisdictions where we expect to realize the deferred tax assets.

     The need for a valuation allowance is determined in accordance with the provisions of SFAS No. 109, which requires an assessment of both negative and positive evidence, including past operating results, the existence of cumulative losses in the most recent fiscal years and forecasts of future taxable income. Significant management judgment is required in determining the need to establish or maintain a valuation allowance. SFAS No. 109 requires that greater weight be given to previous cumulative losses than the outlook for future profitability when determining whether it is more likely than not that a deferred tax asset can be used. To the extent future utilization of a deferred tax asset is unlikely, a valuation allowance is recorded.

     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. At January 31, 2006 and 2005, current liabilities included reserves of $9.9 million and $3.9 million, respectively, associated with a variety of tax matters in various domestic and foreign jurisdictions. 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. During the fiscal year ended January 31, 2006 the Company released reserves of approximately $1.4 million due to the expiration of state statutes of limitations and $1.6 million based on the Company’s recently updated analysis of intercompany pricing.

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     In February 2005, the Internal Revenue Service concluded an audit of our 2000, 2001 and 2002 income tax returns. The audit was mandated by Joint Committee Review procedures because the Company had filed a refund claim for the carry back of net operating losses from 2001 and 2002 to 2000. The IRS completed its audit of the three returns in the fall of 2004 and submitted its conclusions to the Joint Committee on Taxation for review. On February 25, 2005 the Company received a letter from the Joint Committee Reviewer stating that the IRS’ conclusions had been accepted. The net result of the audit was a nominal increase to the Company’s net operating loss carryforward.

     Prior to the initial public offering on August 9, 2000, the Company was included in a consolidated Federal income tax return with EMC. As a result of the IPO, 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 subsequent tax periods. The Company is, however, subject to a tax sharing agreement with EMC. Pursuant to the terms of this agreement, if a taxing authority effects a change to the EMC consolidated return, the Company is required to reimburse EMC for the tax on any Company-related unfavorable adjustment. Conversely, the Company is entitled to any refund of tax for any Company-related favorable adjustment.

     Inrange Technologies Corporation (Inrange) is subject to a tax sharing agreement with SPX Corporation (SPX) relating to previous tax years when Inrange was part of the SPX consolidated tax group (the SPX Agreement). Inrange was acquired by CNT from SPX in May 2003. When CNT merged with McDATA, Inrange became a subsidiary of McDATA. Pursuant to the SPX Agreement, if a taxing authority makes an adjustment to Inrange losses utilized in previous tax years by the SPX consolidated group, Inrange must compensate SPX for the lost tax benefits. The Internal Revenue Service is currently examining tax returns filed by SPX for certain years that Inrange was included in the SPX consolidated return. At this time, we are not aware of any audit adjustments that would require Inrange to compensate SPX for lost tax benefits.

     The earnings of the foreign subsidiaries acquired through the Merger with CNT are considered permanently reinvested. We have made no provision for U.S. federal or state income tax or foreign withholding tax with respect to these earnings. If these earnings were distributed, we would be subject to U.S. income taxes (subject to a reduction for foreign tax credits) and may also be subject to foreign withholding taxes on the distributions by the relevant foreign jurisdictions.

     The American Jobs Creation Act of 2004 (“the Act”) introduced a special one-time 85% dividends received deduction for certain repatriated foreign earnings, available only in 2004 or 2005. After careful evaluation of this provision and thorough analysis of earnings accumulated by the foreign subsidiaries of McDATA and CNT, the Company has chosen not to have the foreign subsidiaries pay any cash dividends that would be eligible for the one-time benefit.

     The Act also provided for the repeal of the extraterritorial income (“ETI”) exclusion. The ETI tax rules are being phased out through reduced benefits in 2005 and 2006, with full repeal effective in 2007. A new tax deduction for qualified domestic production activities is being phased in between 2005 and 2009, becoming fully effective in 2010. The new deduction for domestic production activities is not expected to have a significant impact on our effective tax rate or US tax liabilities in the immediate future because of our loss position in the US and the resulting recording and maintaining of valuation allowances against our deferred tax assets, which includes net operating loss carry-forwards.

NOTE 13 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 fiscal 2005, 2004 or 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, 2006, there is no outstanding preferred stock.

Stock Repurchase Plan

     The Company’s Board of Directors has authorized a plan for the Company to repurchase its common stock (Class A, Class B or a combination thereof). In October 2005, the Company’s Board of Directors amended its stock repurchase plan to authorize the repurchase of up to $25 million of its common stock (Class A, Class B or a combination thereof). This

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repurchase plan will expire on October 31, 2006 and allows the Company to repurchase shares on the open market, in negotiated transactions off the market, or pursuant to a Rule 10b5-1 plan adopted by the Company. The Company adopted a Rule 10b5-1 plan in September 2004, which allows the Company to repurchase its shares during a period in which the Company is in possession of material non- public information, provided the Company communicates share repurchase instructions to the broker at a time when the Company was not in possession of such material non-public information. Since inception of the original repurchase plan in fiscal 2003, approximately 4.5 million shares (approximately 1.3 million shares of Class A and approximately 3.2 million shares of Class B) have been repurchased with a total cost of approximately $23.6 million. During the first, third and fourth quarters of fiscal 2005, there were no share repurchases. During the second quarter of fiscal 2005, the Company repurchased 760,986 and 741,471 shares of Class A and Class B shares, respectively.

Warrants to Purchase Stock

     In September 2004, the Company entered into an OEM agreement with IBM. In connection with this agreement, the Company granted IBM five-year warrants for the purchase of up to 350,000 shares of McDATA’s Class B common stock. The warrants are structured into three substantially equal tranches at exercise prices of $4.700, $5.052 and $5.405 per share. The warrants contain customary terms and conditions, including piggyback SEC registration rights and anti-dilution protections in favor of IBM, and are fully exercisable. The warrants have been valued at approximately $1.0 million using the Black-Scholes option pricing model with the following assumptions: risk-free interest rate of 3.29%, volatility of 80%, dividend rate of 0% and an expected life of five years. The warrants are recorded as an other asset related to the OEM contract and are amortized ratably over the 60-month term of the OEM contract as a reduction to revenue.

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 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 33,000,000 shares of common stock were issuable under the terms of the 2001 Plan as of January 31, 2006, 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). On May 24, 2005, the Company’s stockholders approved the addition of 3,000,000 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

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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 3.0 million shares of common stock are issuable under the terms of the 2003 Plan. Approximately 1.3 million restricted stock shares were issued under this 2003 Plan in connection with the acquisitions discussed in Note 9.

     In May 2004, the Board of Directors approved the Company’s 2004 Inducement Equity Grant Plan (the 2004 Plan). The 2004 Plan provides for the issuance of non-qualified options, stock bonus awards, stock purchase awards, stock appreciation rights, stock unit awards and other stock awards for newly hired employees of the Company. A maximum of 3.0 million shares are issuable under the 2004 Plan. As of January 31, 2006, there were approximately 6.2 million shares of common stock available for future grants under the 2001 Plan, 2003 Plan and the 2004 Plan.

     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. These grants were fully amortized in fiscal 2004. During 2004 and 2003, the Company recorded amortization expense related to these grants of approximately $336,000 and $4.3 million, respectively (of which $34,000 and $377,000 is included in the cost of revenue for 2004 and 2003, respectively).

     Upon completion of the Merger in fiscal 2005, McDATA assumed the CNT stock plans in accordance with the terms of each such plan (the CNT Plans), which provide for the grant of stock options, restricted stock, stock units and other stock-based awards to officers, directors, employees, and consultants. In July 2005, the Company filed an SEC Registration Statement on Form S-8 to register McDATA Class A common stock that may be issued pursuant to the exercise or settlement of outstanding awards under the CNT Plans and shares of McDATA Class A common stock that are still available for issuance under the CNT Plans. As of January 31, 2006, approximately 9.6 million shares of McDATA Class A common stock may be issued pursuant to outstanding awards and approximately 9.4 million shares of McDATA Class A common stock are still available for issuance under the CNT Plans.

     Upon completion of the Merger, each outstanding option to purchase shares of CNT common stock under any CNT Plan, whether or not exercisable or vested, was converted into an option to acquire, that number of shares of McDATA Class A common stock equal to the number of shares of CNT common stock subject to such option immediately prior to the effective time of the merger multiplied by the exchange ratio of 1.3, rounded down to the nearest whole share. The per share exercise price for shares of McDATA Class A common stock assumable upon exercise of each assumed option was adjusted to equal to the exercise price per share of CNT common stock at which such option was exercisable immediately prior to the effective time of the merger divided by the exchange ratio of 1.3, rounded up to the nearest whole cent. In addition, outstanding CNT restricted stock units and deferred stock units, whether or not vested, were converted into a right to be issued that number of shares of McDATA Class A common stock equal to the number of shares of CNT common stock covered by the CNT restricted stock unit or deferred stock unit immediately prior to the effective time of the merger multiplied by the exchange ratio of 1.3.

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     The following summarizes stock option transactions for the period from January 1, 2004 to January 31, 2006 (shares in thousands):

	Class A
	Year ended
	January 31, 2006
				Weighted
				Average
				Exercise
Options	Shares			Price
Outstanding at beginning of period (1)		—			—
CNT options converted in the Merger		12,733		$	10.46
Granted		629			3.71
Exercised		(218	)		3.86
Forfeited or expired		(3,931	)		9.98
Outstanding end of period		9,213		$	10.36
Exercisable at end of period		7,441		$	11.61
Weighted-average fair value of options granted with an exercise price equal to fair market value				$	3.71

(1) There were no Class A options outstanding as of January 31, 2005 and 2004.

	Class B
	Years Ended January 31,
	2006					2005					2004
				Weighted					Weighted					Weighted
				Average					Average					Average
				Exercise					Exercise					Exercise
Options	Shares			Price		Shares			Price		Shares			Price
Outstanding at beginning of period		16,895		$	9.11		13,648		$	11.38		12,324		$	11.43
Granted		5,693			3.64		8,078			5.22		3,683			10.47
Exercised		(241	)		2.16		(1,409	)		1.33		(805	)		2.75
Forfeited or expired		(3,206	)		9.04		(3,422	)		12.17		(1,554	)		14.17
Outstanding end of period		19,141		$	7.58		16,895		$	9.11		13,648		$	11.38
Exercisable at end of period		9,509		$	10.29		6,457		$	12.58		6,602		$	10.76
Weighted-average fair value of options granted with an exercise price equal to fair market value				$	3.46				$	5.51				$	6.84

The status of total stock options outstanding and exercisable at January 31, 2006 was as follows (shares in thousands):

	Class A
	Options Outstanding						Options Exercisable
			Weighted
			Average		Weighted				Weighted
	Number		Remaining		Average		Number		Average
	of		Contractual		Exercise		of		Exercise
Exercise Prices	Shares		Life (Years)		Price		Shares		Price
$0.00  —  $5.10		3,072		4.9	$	3.99		2,124	$	4.10
$5.11 — $10.20		3,656		4.9		7.09		2,843		7.23
$10.21—$15.30		667		3.5		12.40		656		12.39
$15.31—$20.40		718		2.6		16.87		718		16.87
$20.41—$25.50		29		4.7		21.89		29		21.89
$25.51—$30.60		573		4.4		30.45		573		30.45
$30.61—$35.70		10		3.8		33.28		10		33.28
$35.71—$40.80		471		3.5		37.52		471		37.52
$40.81—$45.90		6		5.2		43.36		6		43.36
$45.91—$51.00		11		2.8		50.63		11		50.63
		9,213		4.5	$	10.36		7,441	$	11.61

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	Class B
	Options Outstanding						Options Exercisable
			Weighted
			Average		Weighted				Weighted
			Remaining		Average				Average
	Number of		Contractual		Exercise		Number of		Exercise
Exercise Prices	Shares		Life (Years)		Price		Shares		Price
$0.00  —  $9.33		14,240		7.5	$	4.58		5,439	$	4.96
$9.34  —$18.67		3,983		5.6		11.99		3,156		12.34
$18.68—$28.00		676		4.3		25.79		672		25.81
$28.01—$37.34		57		4.0		35.09		57		35.09
$37.35—$46.67		12		3.0		43.00		12		43.00
$46.68—$56.01		21		4.7		47.83		21		47.83
$56.02—$65.35		39		3.9		63.77		39		63.77
$65.36—$74.68		37		4.6		71.80		37		71.80
$74.69—$84.02		70		4.2		77.29		70		77.29
$84.03—$93.36		6		4.6		93.36		6		93.36
		19,141		6.9	$	7.58		9,509	$	10.29

Restricted Stock

     Restricted stock issued under the plans is recorded at fair market value on the date of the grant and generally vests 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.

     In March 2005, the Company issued 80,000 shares of Class B restricted stock to its Board of Directors with an aggregate fair value of approximately $302,400. These shares vest over a two-year period. Compensation expense will be recognized over the vesting period, and was $201,000 for the year ended January 31, 2006.

     In May 2005, the Company granted 640,000 Class B restricted stock units (RSU’s) to eligible participants of the Executive Performance Incentive Bonus (EPIB) Plan with an aggregate fair value at date of grant of $1.9 million. The Company subsequently granted an additional 380,000 Class B RSU’s as a part of the EPIB plan from June 2005 to January 2006 and 210,000 RSU’s were forfeited. 25% of the total grant will vest each year upon the attainment of the annual corporate milestone established by the Company. If the annual milestone is not achieved, 12.5% of the total grant is forfeited, and the remaining 12.5% will cliff vest as of January 31, 2009. The Company met the first milestone in FYE January 31, 2006 and 216,250 RSU’s vested on March 9, 2006. Compensation expense related to these RSU’s will be recognized evenly over their related vesting periods, and was $1.4 million for the twelve month periods ending January 31, 2006. As of January 31, 2006, 643,750 RSU’s for this grant are still outstanding.

     During the year ended January 31, 2004, the Company issued approximately 1,532,000 of restricted shares, having an aggregate fair market value of $17,357,000. Compensation expense recognized for restricted shares in 2004 and 2003 was $5,366,000 and $8,429,000, respectively.

     As part of the CNT integration, one executive member of the Integration Team received 75,000 shares of Class B restricted stock. These shares will become fully vested on September 9, 2006.

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 January 31, 2005 all 1,200,000 shares had been issued under the plan and as of January 31, 2004, 521,000 shares had been issued.

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NOTE 14 OTHER COMPREHENSIVE INCOME

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

	Years Ended January 31,
	2006			2005			2004
Change in net unrealized losses on investments, net of related income tax expense (benefit) of $0, $0 and $(401), respectively	$	1,324		$	(1,903	)	$	(227	)
Reclassification adjustment for net realized (gains) losses included in net income, net of related income tax (expense) benefit of $0, $0 and $(52), respectively		(360	)		247			(81	)
Foreign currency translation adjustment, net of related income tax (expense) benefit of $0, $0 and $0, respectively		(518	)		—			—
	$	446		$	(1,656	)	$	(308	)

NOTE 15 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 $2.7 million, $2.5 million and $2.0 million in 2005, 2004 and 2003, respectively.

Incentive Bonus Plans

     The Company has various employee bonus plans. The Executive Performance Incentive Bonus (EPIB), Performance Incentive Bonus (PIB) and success share plans provide cash funding based upon corporate performance, creating a pool that is allocated based upon individual and corporate performance. The board of directors reviews and approves these plans and measurements annually. Compensation charges related to these plans were approximately $2.5, $6.0 million and $3.0 million for 2005, 2004, and 2003, respectively.

NOTE 16 SEGMENT INFORMATION

     FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information (SFAS No. 131), establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision makers are our Chief Executive Officer and Chief Operating Officer.

     Prior to the Merger with CNT, the Company had one reporting segment relating to the design, development, manufacture and sale of data access and storage networking solutions that provide highly available, scalable and centrally managed storage area networks (SANs). The Company’s Chief Operating Decision Makers, as defined by SFAS No. 131, had allocated resources and assessed the performance of the Company based on consolidated revenue and overall profitability. As a result of the merger with CNT, and the completion of the integration of CNT’s service business, the Company is operating in two distinct reporting segments, one for products and the other for services beginning in August 2005. The products segment consists of hardware and software products and related software maintenance and support revenue. The services segment consists of break/fix maintenance, extended warranty, installation, consulting, network management and telecommunications services.

     Financial decisions and the allocation of resources are based on the information from the Company’s management reporting system. The Company does not allocate selling and marketing or general and administrative expenses to its operating segments. At this point in time, we do not track all of our assets by operating segments. Consequently, it is not practical to present assets by operating segments.

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     Summarized financial information by operating segment for the year ended January 31, 2006, based on the internal management system is as follows:

	Product		Service			Unallocated			Total
Year ended January 31, 2006
Revenue	$	523,440	$	90,993		$	—		$	614,433
Cost of revenue	$	248,025	$	59,874		$	1,192		$	309,091
Gross margin	$	275,415	$	31,119		$	(1,192	)	$	305,342
Research and development	$	111,715	$	—		$	—		$	111,715
Selling and marketing	$	—	$	—		$	133,909		$	133,909
General and administrative	$	—	$	—		$	35,116		$	35,116
Amortization	$	—	$	—		$	43,418		$	43,418
Restructuring charges	$	—	$	—		$	11,685		$	11,685
Income (loss) from operations	$	163,700	$	31,119		$	(225,320	)	$	(30,501	)
Year ended January 31, 2005
Revenue	$	379,344	$	20,316		$	—		$	399,660
Cost of revenue	$	158,656	$	17,505		$	—		$	176,161
Gross margin	$	220,688	$	2,811		$	—		$	223,499
Research and development	$	91,488	$	—		$	—		$	91,488
Selling and marketing	$	—	$	—		$	101,305		$	101,305
General and administrative	$	—	$	—		$	25,584		$	25,584
Amortization	$	—	$	—		$	28,295		$	28,295
Restructuring charges	$	—	$	—		$	1,263		$	1,263
Income (loss) from operations	$	129,200	$	2,811		$	(156,447	)	$	(24,436	)
Year ended January 31, 2004
Revenue	$	407,137	$	11,723		$	—		$	418,860
Cost of revenue	$	162,151	$	15,178		$	—		$	177,329
Gross margin	$	244,986	$	(3,455	)	$	—		$	241,531
Research and development	$	88,826	$	—		$	—		$	88,826
Selling and marketing	$	—	$	—		$	95,820		$	95,820
General and administrative	$	—	$	—		$	30,234		$	30,234
Amortization	$	—	$	—		$	21,191		$	21,191
Restructuring charges	$	—	$	—		$	2,258		$	2,258
Acquired in process research and development	$	—	$	—		$	11,410		$	11,410
Income (loss) from operations	$	156,160	$	(3,455	)	$	(160,913	)	$	(8,208	)

     The following table presents supplemental data for McDATA revenue channels. A significant portion of revenue is concentrated with the largest storage OEMs, EMC, IBM and HDS. Other major storage and system vendors, including Dell, HP, and Sun, offer McDATA solutions to their customers. In addition to storage and system vendors, the Company has relationships with many resellers, distributors and systems integrators.

	Year Ended
	January 31,
	2006			2005			2004
EMC		31	%		47	%		56	%
IBM		26	%		25	%		21	%
HDS		9	%		9	%		10	%
Other channels		34	%		19	%		13	%
Total revenue		100	%		100	%		100	%

     Revenues are attributed to geographic areas based on the location of the customers to which products are shipped. International revenues primarily consist of sales to customers in Western Europe and the greater Asia Pacific region. Included in domestic revenues are sales to certain OEM customers who take possession of products domestically and then distribute these products to their international customers. In addition, included in revenues from Western Europe are sales to certain OEM customers who take possession of products in distribution centers designated for international-bound product and then distribute these products among various international regions. The mix of international and domestic revenue can, therefore, vary depending on the relative mix of sales to certain OEM customers. For the year ended January 31, 2006, domestic and international revenue was 58% and 42% of our total revenue, respectively, as compared to 62%, and 38%, respectively, for the same period in 2005. For the twelve months ended January 31, 2004, domestic and international revenue was 67% and 33%, respectively.

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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.

	Net		Long-Lived
	Sales		Assets
Fiscal 2005
United States	$	356,371	$	162,892
Foreign countries		258,062		6,024
Total	$	614,433	$	168,916
Fiscal 2004
United States	$	249,592	$	124,953
Foreign countries		150,068		981
Total	$	399,660	$	125,934
Fiscal 2003
United States	$	282,503	$	115,450
Foreign countries		136,357		1,994
Total	$	418,860	$	117,444

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NOTE 17 COMMITMENTS AND CONTINGENCIES

Commitments

Operating and Capital Leases

     The Company had various operating and capital leases in effect at January 31, 2006, 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, 2006:

	Capital			Operating
	Leases			Leases
2006	$	3,542		$	11,889
2007		2,081			8,988
2008		1,451			8,158
2009		—			5,894
2010		—			5,599
Thereafter		—			35,606
Total minimum lease payments		7,074		$	76,134
Less portion representing interest		(565	)
Less current portion		(2,977	)
Long term obligations under capital leases	$	3,532

     Rent expense in 2005, 2004 and 2003 totaled approximately $17.0 million, $10.9 million and $10.4 million, respectively.

     On September 9, 2004, the Company entered into a triple net office lease with Ridge Parkway Associates, LLC, a Delaware limited liability company, for the lease of office space at 11802 Ridge Parkway, Building 2, Broomfield, Colorado (the “New Premises”). The Company moved its current world headquarters location at 380 Interlocken Crescent, Broomfield, Colorado 80021 to the New Premises with the lease commencing in February of 2006. The term of the new lease is for 11 years (with two 5 year renewal options). The base annual lease rates per rentable square foot for the New Premises range from $0 in the first year to $14.15 in the last year of the lease, plus normal operating expenses. The Company began recognizing rent expense in July 2005 upon the start of the build-out of the premises. The lease has customary terms and conditions. Since the lease agreement did not limit the total potential expenditures related to this project, the Company was deemed to be the accounting owner of the project, and therefore total project costs incurred to date by all parties had been reflected as Construction in progress—leased assets, and as Non-cash obligations for construction in progress—lease facilities in the long term liability section of the balance sheet in the second and third quarter of fiscal 2005.

     The Company received the certificate of occupancy on January 31, 2006, and because the project is substantially complete, the Company derecognized the amounts in Construction in progress—leased assets, and Non-cash obligations for construction in progress—lease facilities in the long term liability section of the accompanying balance sheet.

Manufacturing and Purchase Commitments

     The Company has contracted with Sanmina SCI Systems, Inc. (SSCI), Solectron Corporation (Solectron) and others (collectively, Contract Manufacturers) for the manufacture of printed circuit boards and box build assembly and configuration for specific multi-protocol directors and switches. The agreements require the Company to submit purchasing forecasts and place orders sixty calendar days in advance of delivery. At January 31, 2006, the Company’s commitment with our Contract Manufacturers for purchases over the next sixty days totaled $75.3 million, and $18.6 million for commitments beyond 60 days. 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. We may also be liable for materials that certain component suppliers or product manufacturers have produced or made available to us if our actual requirements do not meet or exceed minimums that we have committed to purchase. At January 31, 2006, the Company had recorded approximately $6.3 million of purchase obligations that we believe is excess or obsolete and cannot be redirected to other uses. 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.

Indebtedness

     As discussed in Note 10, as part of the acquisition of CNT, McDATA guaranteed the payment of principal and interest on approximately $124.4 million principal amount of CNT’s 3.00% Notes. In addition, McDATA has $172.5 million principal amount of outstanding 2.25% subordinated convertible notes due 2010. Unless the price of our common stock increases significantly so that the holders of the convertible notes find it economically advantageous to exercise the

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conversion feature and receive common stock in lieu of a cash payment of the principal amount and any accrued interest, we may have to repay the debt in cash. At present, we have sufficient resources to satisfy these obligations as they mature. However, in the future, we may lack the resources to satisfy these obligations as they mature, and there can be no assurance that we will possess the resources or be able to secure the resources to satisfy these obligations on commercially reasonable terms, if at all. Any failure by us to satisfy these obligations when due would have a material adverse effect on our business.

Contingencies—Litigation

     From time to time, the Company is subject to claims arising in the ordinary course of business. Litigation is subject to inherent risks and uncertainties and an adverse result in a matter that may arise from time to time may harm our business, financial condition or results of operations. In the opinion of management and, except as set forth below, no such lawsuit, individually or in the aggregate, exists which is expected to have a material adverse effect on the Company’s consolidated results of operations, financial position or cash flows.

     McDATA’s IPO Laddering Class Action Lawsuits

     The Company, Mr. John F. McDonnell, the former Chairman of the board of directors, Mrs. Dee J. Perry, a former officer and Mr. Thomas O. McGimpsey, a current officer were named as defendants in purported securities class-action lawsuits filed in the United States District Court, Southern District of New York. The first of these lawsuits, filed on July 20, 2001, is captioned Gutner v. McDATA Corporation, Credit Suisse First Boston (CSFB), Merrill Lynch, Pierce Fenner & Smith Incorporated, Bear, Stearns & Co., Inc., FleetBoston Robertson Stephens et al., No. 01 CIV. 6627. Three other similar suits were filed against the Company and the individuals. The complaints are substantially identical to numerous other complaints filed against other companies that went public in 1999 and 2000. These lawsuits generally allege, among other things, that the registration statements and prospectus filed with the SEC by such companies were materially false and misleading because they failed to disclose (a) that certain underwriters had allegedly solicited and received excessive and undisclosed commissions from certain investors in exchange for which the underwriters allocated to those investors material portions of shares in connection with the initial public offerings, or IPOs, and (b) that certain of the underwriters had allegedly entered into agreements with customers whereby the underwriters agreed to allocate IPO shares in exchange for which the customers agreed to purchase additional company shares in the aftermarket at pre-determined prices. The complaints allege claims against the Company, the named individuals, and CSFB, the lead underwriter of the Company’s August 9, 2000 initial public offering, under Sections 11 and 15 of the Securities Act. The complaints also allege claims solely against CSFB and the other underwriter defendants under Section 12(a)(2) of the Securities Act, and claims against the individual defendants under Section 10(b) of the Securities Exchange Act. Although management believes that all of the lawsuits are without legal merit and they intend to defend against them vigorously, there is no assurance that the Company will prevail. In September 2002, plaintiffs’ counsel in the above-mentioned lawsuits offered to individual defendants of many of the public companies being sued, including the Company, the opportunity to enter into a Reservation of Rights and Tolling Agreement that would dismiss without prejudice and without costs all claims against such persons if the company itself had entity coverage insurance. This agreement was signed by Mr. John F. McDonnell, the former Company Chairman, Mrs. Dee J. Perry, the former chief financial officer, and Mr. Thomas O. McGimpsey, the current General Counsel and Vice President of Business Development 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. On August 31, 2005, the court preliminarily approved the proposed settlement. A fairness hearing will be held in 2006 before any final settlement is approved, if at all. Until that settlement is fully effective, Management intends to defend against the consolidated proceeding vigorously.

     Eclipsys Indemnification Claim

     Inrange Technologies Corporation, which was a wholly owned subsidiary of CNT, had been named as a defendant in the case SBC Technology Resources, Inc. v. Inrange Technologies Corp., Eclipsys Corp. and Resource Bancshares Mortgage Group, Inc., No. 303-CV-418-N, that was pending in the United States District Court for the Northern District of Texas, Dallas Division (the SBC Patent Litigation). The SBC Patent Litigation was commenced on February 27, 2003. The complaint claimed that Inrange was infringing U.S. Patent No. 5,530,845 (845 patent) by manufacturing and selling storage area networking equipment, in particular the FC/9000, that is used in storage networks. On May 31, 2005, Inrange and SBC Laboratories, Inc. (f/k/a SBC Technology Resources, Inc.) entered into a Settlement Agreement settling the SBC Patent

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Litigation on confidential terms that included a license to the 845 patent, and the case was dismissed with prejudice. Eclipsys Corp. (Eclipsys) had settled earlier with SBC Technology Resources, Inc. for an undisclosed sum without the consent of InRange. Eclipsys has demanded that Inrange indemnify Eclipsys pursuant to alleged documentation under which it purportedly acquired certain allegedly infringing products from Inrange. Hitachi Data Systems Corporation (a non-party to the SBC Patent Litigation) has also informed Inrange that it received a demand from Eclipsys that Hitachi indemnify Eclipsys in connection with the SBC Patent Litigation. Hitachi notified Inrange that it would tender to Inrange any claim by Eclipsys for indemnification of any aspect of the litigation. Based on current information, Inrange believes that the indemnification demands of Eclipsys and Hitachi are without merit. Accordingly, McDATA intends to vigorously defend against any claims, if made, by Eclipsys or Hitachi for indemnification.

     State of Connecticut Tax Audit of InRange

     The audit division of the State of Connecticut Department of Revenue Services (Audit Division) has proposed adjustments to the Connecticut income tax returns for Inrange for the years ended December 31, 1996, through December 31, 1999. The proposed adjustments, in the amount of $433,995 plus interest, relate to (1) gain from a stock sale following the exercise of warrants, and whether Inrange had sufficient nexus with Connecticut to subject the gain to Connecticut taxation, and (2) the availability of claimed credits for certain research and development expenditures, and whether Inrange has provided sufficient documentation to support the claimed credits. Inrange made a written offer to settle the matter, which was rejected by the Audit Division. Inrange has formally appealed the matter and has posted a $750,000 appeal bond to avoid the accrual of additional interest.

     InRange’s IPO Laddering Class Action Lawsuits

     A shareholder class action was filed against Inrange and certain of its officers on November 30, 2001, in the United States District Court for the Southern District of New York, seeking recovery of damages caused by Inrange’s alleged violation of securities laws, including section 11 of the Securities Act of 1933 and section 10(b) of the Exchange Act of 1934. The complaint, which was also filed against the various underwriters that participated in Inrange’s initial public offering (IPO), is identical to hundreds of shareholder class actions pending in this court in connection with other recent IPOs and is generally referred to as In re Initial Public Offering Securities Litigation. The complaint alleges, in essence, (a) that the underwriters combined and conspired to increase their respective compensation in connection with the IPO by (i) receiving excessive, undisclosed commissions in exchange for lucrative allocations of IPO shares, and (ii) trading in Inrange’s stock after creating artificially high prices for the stock post-IPO through “tie-in” or “laddering” arrangements (whereby recipients of allocations of IPO shares agreed to purchase shares in the aftermarket for more than the public offering price for Inrange shares) and dissemination of misleading market analysis on Inrange’s prospects; and (b) that Inrange violated federal securities laws by not disclosing these underwriting arrangements in its prospectus. The defense has been tendered to the carriers of Inrange’s director and officer liability insurance, and a request for indemnification has been made to the various underwriters in the IPO. At this point the insurers have issued a reservation of rights letter and the underwriters have refused indemnification. The court has granted Inrange’s motion to dismiss claims under section 10(b) of the Securities Exchange Act of 1934 because of the absence of a pleading of intent to defraud. The court granted plaintiffs leave to replead these claims, but no further amended complaint has been filed. The court denied Inrange’s motion to dismiss claims under section 11 of the Securities Act of 1933. The court has also dismissed Inrange’s individual officers without prejudice, after they entered into a tolling agreement with the plaintiffs. On July 25, 2003, Inrange’s board of directors conditionally approved a proposed partial settlement with the plaintiffs in this matter. The settlement would provide, among other things, a release of Inrange and of the individual defendants for the conduct alleged in the action to be wrongful in the complaint. Inrange would agree to undertake other responsibilities under the partial settlement, including agreeing to assign away, not assert, or release certain potential claims Inrange may have against its underwriters. Any direct financial impact of the proposed settlement is expected to be borne by Inrange’s insurers. In June 2004, an agreement of settlement was submitted to the court for preliminary approval. On August 31, 2005, the court preliminarily approved the proposed settlement. A fairness hearing will be held in 2006 before any final settlement is approved, if at all. Until the settlement is effective, management intends to defend against this consolidated proceeding vigorously.

     Data Center Systems Litigation

     On March 29, 2006, McDATA Services Corporation was notified that Kevin M. Ehringer Enterprises Inc. d/b/a Data Center Systems (“DCS”) had filed in the State District Court in Dallas Texas, a lawsuit seeking damages and injunctive relief against McDATA Services Corporation (“McDATA Services”) f/k/a Computer Network Technology Corporation alleging that McDATA Services Corporation had breached its duties under a Distributor, Development, Asset Sale Agreement entered into by the parties in November 2003. It is likely that a full lawsuit on the merits will be forthcoming. McDATA Services intends to defend itself vigorously and, based on facts known to its management team, believes the case is wholly without merit.

42

Indemnifications and Guarantees

          Ordinary Course Purchase and Sale Agreements

          During its normal course of business, the Company may enter into agreements with customers, resellers, OEMs, systems integrators, distributors and others. These agreements typically require the Company to indemnify the other party against claims of intellectual property infringement made by third parties arising for the use of our products. In addition, the majority of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. The Company evaluates and estimates losses from such indemnification under SFAS No. 5, “Accounting for Contingencies”, as interpreted by FASB Interpretation No. 45. To date, the Company has not incurred any material costs as a result of such obligations and has not accrued any liabilities related to such indemnification and guarantees in our financial statements

          Sale of Lumberton, New Jersey Manufacturing Operations

          As described in Note 5, on June 24, 2005 the Company entered into a series of agreements with Solectron in connection with the sale of manufacturing operations and transfer of assets related to its Lumberton, New Jersey production facility. As part of the Asset Purchase Agreement between the Company and Solectron, the Company has made a number of representations and has agreed to indemnify the buyer and hold them harmless from certain losses suffered in connection with their purchase of assets and assumption of liabilities of the Lumberton facility. The more significant indemnifications relate to representations made by the Company as to the proper maintenance of the tangible assets purchased, compliance with ERISA as it relates to benefit plans in which the transferred employees have participated prior to the sale, and the absence of undisclosed environmental issues or significant contracts. The term of the representations relating to undisclosed environmental issues is five years, with the term of the remaining representations being two years. Although, there are no maximum potential indemnification amounts stated in the agreement for these representations, based on facts currently available, management estimates the maximum potential amount of payments that could be required under these representations to be $5.3 million. However, it is management’s judgment that the probability of the Company having to make any payments under any one of the representations ranges from 0% to 20%. In calculating the fair value of the Company’s obligation under these representations, the maximum potential loss estimate was multiplied by the probability of each occurring. The resulting potential future cash flows were then discounted using a rate of 8%, resulting in the Company recognizing a liability of approximately $400,000 in accordance with FIN 45. Due to the uncertainty surrounding the risks involved, the liability balance will be maintained and reevaluated as needed, over the full term of the related indemnifications. Any future reversals of previous accrual amounts which were recorded during the purchase accounting period as an increase to goodwill will be recorded as a reduction to goodwill. Otherwise, any portion of the liability that is derecognized in the future will be credited to operating results.

          SPX Tax Sharing Agreement

          Inrange Technologies Corporation (Inrange) is subject to a tax sharing agreement with SPX Corporation (SPX) relating to previous tax years when Inrange was part of the SPX consolidated tax group (the SPX Agreement). Inrange was acquired by CNT from SPX in May 2003. When CNT was acquired by McDATA, Inrange became an indirect subsidiary of McDATA. Pursuant to the SPX Agreement, if the a taxing authority makes an adjustment to Inrange losses utilized in previous tax years by the SPX consolidated group, Inrange must compensate SPX for the lost tax benefits. The Internal Revenue Service is currently examining tax returns filed by SPX for certain years that Inrange was included in the SPX consolidated return. At this time, we are not aware of any audit adjustments that would require Inrange to compensate SPX for lost tax benefits.

43

NOTE 18 RELATED PARTIES

     There has not been nor is there currently proposed any transaction or series of similar transactions to which we were or are a party in which the amount involved exceeds $60,000 and in which any director, executive officer, holder of more than 5% of our common stock or any member of the immediate family of any of the foregoing persons had or will have a direct or indirect material interest other than (a) compensation agreements and other arrangements, which are described in “Item 11—Executive Compensation,” and (b) the transactions described below.

     In June 2005, the Company entered into a one year consulting agreement with Thomas G. Hudson, a director of the Company. Please see the Company’s Form 8-K filed June 1, 2005 for further information. Mr. Hudson’s son-in-law is a sales employee with the Company. Mr. Hudson has also taken the position of Chairman of 20/20 Technologies Corporation (20/20 Technologies). An affiliate of 20/20 Technologies and McDATA Services Corporation (formerly CNT) had previously entered into a business development agreement in February 2003 whereby the affiliate of 20/20 Technologies provides telecommunication management services to us. Payments for these services aggregated $141,000 in 2005. The Company has also entered into indemnification agreements with its directors and officers. For a discussion regarding the indemnification agreements, please see Item 11. Executive Compensation under the caption entitled “Limitation of Liability and Indemnification.”

Note 19—SUPPLEMENTAL GUARANTOR INFORMATION

     On June 1, 2005, as part of the merger with CNT, McDATA Corporation (Parent Guarantor) fully and unconditionally guaranteed CNT’s convertible debt. In February 2002, CNT (Issuer of Notes) sold $125,000,000 of 3% convertible subordinated notes due February 15, 2007. The notes were convertible into CNT common stock at the price of $19.17 per share. Due to the Merger, the notes are now convertible into Class A McDATA stock at a price of approximately $14.75 per share (aggregate of approximately 8.4 million shares) at any time prior to their maturity on February 15, 2007. At January 31, 2006, the amount outstanding on the CNT notes was $124.4 million. After the merger, the corporate name of CNT was changed to McDATA Services Corporation.

     The following condensed consolidating financial statements have been prepared from the Company’s financial information on the same basis of accounting as of the consolidated financial statements. Investments in our subsidiaries are accounted for on the equity method; accordingly, entries necessary to consolidate the Parent Guarantor, Issuer of Notes, and all of its subsidiaries are reflected in the eliminations column.

44

McDATA CORPORATION

CONDENSED CONSOLIDATING BALANCE SHEETS (1)
As of January 31, 2006
(in thousand)

						Subsidiaries
	Parent			Issuer of		Non
	Guarantor			Notes		Guarantors			Eliminations			Consolidated
Assets
Current assets:
Cash and cash equivalents	$	122,595		$	13,306	$	3,182		$	—		$	139,083
Securities lending collateral		62,555			—		—			—			62,555
Short-term investments		171,110			—		—			—			171,110
Accounts receivable, net		110,937			15,090		79			—			126,106
Intercompany accounts receivable, net		(392,087	)		176,752		(32,576	)		247,911			—
Inventories, net		24,431			8,702		—			(33	)		33,100
Prepaid expenses and other current assets		7,154			5,696		573			—			13,423
Total current assets		106,695			219,546		(28,742	)		247,878			545,377
Property and equipment, net		85,045			22,628		1,445			—			109,118
Long-term investments		31,881			3		—			—			31,884
Investment in subsidiaries		410,529			—		2			(410,531	)		—
Restricted cash		6,858			3,839		—			—			10,697
Intangible assets, net		57,751			—		65,952			(9	)		123,694
Goodwill		187,448			—		78,693			—			266,141
Other assets, net		40,440			18,917		432			9			59,798
Total assets	$	926,647		$	264,933	$	117,782		$	(162,653	)	$	1,146,709
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	39,054		$	4,052	$	132		$	—		$	43,238
Accrued liabilities		58,771			41,384		241			(6,120	)		94,276
Securities lending collateral payable		62,555			—		—			—			62,555
Current portion of deferred revenue		25,506			35,503		233			—			61,242
Current portion of notes payable and obligations under capital leases		628			2,340		9			—			2,977
Total current liabilities		186,514			83,279		615			(6,120	)		264,288
Notes payable and obligations under capital leases, less current portion		972			2,560		—			—			3,532
Deferred revenue, less current portion		13,461			17,913		6			—			31,380
Other long-term liabilities		1,523			321		—			—			1,844
Interest rate swap		6,449			1,104		—			—			7,553
Convertible subordinated debt		165,505			120,111		273			—			285,889
Total liabilities		374,424			225,288		894			(6,120	)		594,486
Total stockholders’ equity		552,223			39,645		116,888			(156,533	)		552,223
Total liabilities and stockholders’ equity	$	926,647			264,933	$	117,782			(162,653	)	$	1,146,709

(1) In conjunction with the guarantee of McDATA Services Corporation’s (formerly known as CNT) convertible debt, the accompanying condensed consolidating financial information has been prepared and presented pursuant to SEC Regulation S-X Rule 3-10 “Financial statements of guarantors and affiliates whose securities collateralize an issue registered or being registered.” This information is not intended to present the financial position, results of operations and cash flows of the individual companies or groups of companies in accordance with generally accepted accounting principles and is not representative of the operations of McDATA or the former CNT on either a pre-merger or stand-alone basis.

45

McDATA CORPORATION

CONDENSED CONSOLIDATING BALANCE SHEETS (1)
As of January 31, 2005
(in thousands)

						Subsidiaries
	Parent			Issuer of		Non
	Guarantor			Notes		Guarantors			Eliminations			Consolidated
Assets
Current assets:
Cash and cash equivalents	$	62,473		$	—	$	2,034		$	—		$	64,507
Securities lending collateral		130,804			—		—			—			130,804
Short-term investments		145,259			—		—			—			145,259
Accounts receivable, net		63,787			—		23			—			63,810
Intercompany accounts receivable, net		(41,595	)		—		(30,404	)		71,999			—
Inventories, net		13,720			—		—			—			13,720
Prepaid expenses and other current assets		6,272			—		1,008			—			7,280
Total current assets		380,720			—		(27,339	)		71,999			425,380
Property and equipment, net		91,718			—		3,211			—			94,929
Long-term investments		95,589			—		—			—			95,589
Investment in subsidiaries		216,900			—		2			(216,902	)		—
Restricted cash		5,047			—		—			—			5,047
Intangible assets, net		—			—		87,592			—			87,592
Goodwill		—			—		78,693			—			78,693
Other assets, net		30,453			—		552			—			31,005
Total assets	$	820,427		$	—	$	142,711		$	(144,903	)	$	818,235
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	20,150		$	—	$	195		$	—		$	20,345
Accrued liabilities		47,576			—		3,310			(6,335	)		44,549
Securities lending collateral payable		130,804			—		—			—			130,804
Current portion of deferred revenue		22,102			—		634			—			22,736
Current portion of notes payable and obligations under capital leases		912			—		0			—			912
Total current liabilities		221,770			—		4,134			(6,335	)		219,346
Notes payable and obligations under capital leases, less current portion		252			—		4			—			256
Deferred revenue, less current portion		27,001			—		—			—			27,001
Other long-term liabilities		1,908			—		0			—			1,908
Interest rate swap		2,005			—		—			—			2,005
Convertible subordinated debt		170,495			—		—			—			170,495
Total liabilities		423,203			—		4,143			(6,335	)		421,011
Total stockholders’ equity		397,224			—		138,568			(138,568	)		397,224
Total liabilities and stockholders’ equity	$	820,427			—	$	142,711			(144,903	)	$	818,235

(1) In conjunction with the guarantee of McDATA Services Corporation’s (formerly known as CNT) convertible debt, the accompanying condensed consolidating financial information has been prepared and presented pursuant to SEC Regulation S-X Rule 3-10 “Financial statements of guarantors and affiliates whose securities collateralize an issue registered or being registered.” This information is not intended to present the financial position, results of operations and cash flows of the individual companies or groups of companies in accordance with generally accepted accounting principles and is not representative of the operations of McDATA or the former CNT on either a pre-merger or stand-alone basis.

46

McDATA CORPORATION

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS (1)
For the Year Ended January 31, 2006
(in thousands, except per share data)

							Subsidiaries
	Parent			Issuer of			Non
	Guarantor			Notes			Guarantors			Eliminations			Consolidated
Total revenue	$	474,371		$	144,945		$	664		$	(5,547	)	$	614,433
Total cost of revenue		221,908			89,702			2,560			(5,079	)		309,091
Gross profit		252,463			55,243			(1,896	)		(468	)		305,342
Operating expenses:
Research and development		105,607			4,758			1,350			—			111,715
Selling and marketing		87,289			17,895			28,678			47			133,909
General and administrative		29,251			3,600			2,265			—			35,116
Amortization of purchased intangible assets		15,870			—			21,640			—			37,510
Amortization of deferred compensation		5,908			—			—			—			5,908
Restructuring charges		11,720			(35	)		—			—			11,685
Total operating expenses		255,645			26,218			53,933			47			335,843
Income (loss) from operations		(3,182	)		29,025			(55,829	)		(515	)		(30,501	)
Interest and other income, net of interest expense		(29,453	)		(3,939	)		33,574			149			331
Income (loss) before income taxes		(32,635	)		25,086			(22,255	)		(366	)		(30,170	)
Income tax expense (benefit)		(705	)		1,709			(573	)		—			431
Equity loss from subsidiaries of nonguarantors		(21,682	)		—			—			21,682			—
Net income (loss)	$	(53,612	)	$	23,377		$	(21,682	)	$	21,316		$	(30,601	)

(1) In conjunction with the guarantee of McDATA Services Corporation’s (formerly known as CNT) convertible debt, the accompanying condensed consolidating financial information has been prepared and presented pursuant to SEC Regulation S-X Rule 3-10 “Financial statements of guarantors and affiliates whose securities collateralize an issue registered or being registered.” This information is not intended to present the financial position, results of operations and cash flows of the individual companies or groups of companies in accordance with generally accepted accounting principles and is not representative of the operations of McDATA or the former CNT on either a pre-merger or stand-alone basis.

47

McDATA CORPORATION

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS (1)
For the Year Ended January 31, 2005
(in thousands, except per share data)

						Subsidiaries
	Parent			Issuer of		Non
	Guarantor			Notes		Guarantors			Eliminations		Consolidated
Total revenue	$	397,928		$	—	$	1,732		$	—	$	399,660
Total cost of revenue		173,518			—		2,643			—		176,161
Gross profit		224,410			—		(911	)		—		223,499
Operating expenses:
Research and development		88,092			—		3,396			—		91,488
Selling and marketing		75,943			—		25,362			—		101,305
General and administrative		21,993			—		3,591			—		25,584
Amortization of purchased intangible assets		—			—		22,773			—		22,773
Amortization of deferred compensation		5,522			—		—			—		5,522
Restructuring charges		8			—		1,255			—		1,263
Total operating expenses		191,558			—		56,377			—		247,935
Income (loss) from operations		32,852			—		(57,288	)		—		(24,436	)
Interest and other income, net of interest expense		(22,046	)		—		27,352			—		5,306
Income (loss) before income taxes		10,806			—		(29,936	)		—		(19,130	)
Income tax expense (benefit)		(457	)		—		819			—		362
Income (loss) before equity in net loss of affiliated company		11,263			—		(30,755	)		—		(19,492	)
Equity in net loss of affiliated company		(1,380	)		—		—			—		(1,380	)
Equity loss from subsidiaries of nonguarantors		(30,755	)		—		—			30,755		—
Net income (loss)	$	(20,872	)	$	—	$	(30,755	)	$	30,755	$	(20,872	)

(1) In conjunction with the guarantee of McDATA Services Corporation’s (formerly known as CNT) convertible debt, the accompanying condensed consolidating financial information has been prepared and presented pursuant to SEC Regulation S-X Rule 3-10 “Financial statements of guarantors and affiliates whose securities collateralize an issue registered or being registered.” This information is not intended to present the financial position, results of operations and cash flows of the individual companies or groups of companies in accordance with generally accepted accounting principles and is not representative of the operations of McDATA or the former CNT on either a pre-merger or stand-alone basis.

48

McDATA CORPORATION

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS (1)
For the Year Ended January 31, 2004
(in thousands, except per share data)

				Issuer		Subsidiaries
	Parent			of		Non
	Guarantor			Notes		Guarantors			Eliminations			Consolidated
Total revenue	$	412,284		$	—	$	9,832		$	(3,256	)	$	418,860
Total cost of revenue		174,929			—		5,656			(3,256	)		177,329
Gross profit		237,355			—		4,176			—			241,531
Operating expenses:
Research and development		79,452			—		9,374			—			88,826
Selling and marketing		73,206			—		22,614			—			95,820
General and administrative		25,896			—		4,338			—			30,234
Amortization of purchased intangible assets		—			—		9,222			—			9,222
Acquired in-process research and development and other acquisition-related costs		3,636			—		7,774			—			11,410
Amortization of deferred compensation		11,969			—		—			—			11,969
Restructuring charges		2,258			—		—			—			2,258
Total operating expenses		196,417			—		53,322			—			249,739
Income (loss) from operations		40,938			—		(49,146	)		—			(8,208	)
Interest and other income, net of interest expense		(15,219	)		—		19,690			—			4,471
Income (loss) before income taxes		25,719			—		(29,456	)		—			(3,737	)
Income tax expense (benefit)		35,522			—		2,890			—			38,412
Income (loss) before equity in net loss of affiliated company		(9,803	)		—		(32,346	)		—			(42,149	)
Equity in net loss of affiliated company		(984	)		—		—			—			(984	)
Equity loss from subsidiaries of nonguarantors		(32,346	)		—		—			32,346			—
Net income (loss)	$	(43,133	)	$	—	$	(32,346	)	$	32,346		$	(43,133	)

(1) In conjunction with the guarantee of McDATA Services Corporation’s (formerly known as CNT) convertible debt, the accompanying condensed consolidating financial information has been prepared and presented pursuant to SEC Regulation S-X Rule 3-10 “Financial statements of guarantors and affiliates whose securities collateralize an issue registered or being registered.” This information is not representative of the operations of McDATA or the former CNT on either a pre-merger or stand-alone basis.

49

McDATA CORPORATION

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS (1)

For the Year Ended January 31, 2006
(in thousands)

							Subsidiaries
	Parent			Issuer of			Non
	Guarantor			Notes			Guarantors			Eliminations		Consolidated
Net cash provided by (used in) operating activities	$	45,630		$	(32,675	)	$	1,534		$	—	$	14,489
Cash flows from investing activities: (2)
Purchases of property and equipment		(11,074	)		(1,937	)		(166	)		—		(13,177	)
Proceeds from sale of equipment		193			1,532			2			—		1,727
Purchases of investments		(376,952	)		—			—			—		(376,952	)
Proceeds from maturities and sales of investments		415,093			—			—			—		415,093
Cash used for acquisition costs		(6,912	)		47,307			—			—		40,395
Restricted cash related to interest rate swap		(1,811	)		(14	)		—			—		(1,825	)
Cash received on cash surrender value of life insurance policy		—			1,339			—			—		1,339
Net cash provided by (used in) investing activities		18,537			48,227			(164	)		—		66,600
Cash flows from financing activities:
Payments on long-term notes payable and capital leases		(575	)		(1,938	)		(222	)		—		(2,735	)
Purchase of treasury stock		(4,552	)		—			—			—		(4,552	)
Proceeds from the issuance of common stock		1,082			—			—			—		1,082
Net cash used in financing activities		(4,045	)		(1,938	)		(222	)		—		(6,205	)
Effect of exchange rate changes on cash		—			(308	)		—			—		(308	)
Net increase (decrease) in cash and cash equivalents		60,122			13,306			1,148			—		74,576
Cash and cash equivalents, beginning of period		62,473			—			2,034			—		64,507
Cash and cash equivalents, end of period	$	122,595		$	13,306		$	3,182		$	—	$	139,083

(1)

In conjunction with the guarantee of McDATA Services Corporation’s (formerly known as CNT) convertible debt, the accompanying condensed consolidating financial information has been prepared and presented pursuant to SEC Regulation S-X Rule 3-10 “Financial statements of guarantors and affiliates whose securities collateralize an issue registered or being registered.” This information is not intended to present the financial position, results of operations and cash flows of the individual companies or groups of companies in accordance with generally accepted accounting principles and is not representative of the operations of McDATA or the former CNT on either a pre-merger or stand-alone basis.

(2)

Cash acquired in the merger with CNT, net of transaction costs, is recognized as investing inflow of cash in the consolidated cash flows statement for the twelve-month period ended January 31, 2006.

50

McDATA CORPORATION

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS (1)

For the Year Ended January 31, 2005
(in thousands)

						Subsidiaries
	Parent			Issuer of		Non
	Guarantor			Notes		Guarantors			Eliminations		Consolidated
Net cash provided by (used in) operating activities	$	20,095		$	—	$	1,329		$	—	$	21,424
Cash flows from investing activities: (2)
Purchases of property and equipment		(17,657	)		—		638			—		(17,019	)
Proceeds from sale of equipment		96			—		—			—		96
Purchases of investments		(459,825	)		—		—			—		(459,825	)
Proceeds from maturities and sales of investments		476,727			—		—			—		476,727
Restricted cash related to interest rate swap		83			—		—			—		83
Net cash provided by (used in) investing activities		(576	)		—		638			—		62
Cash flows from financing activities:
Payments on long-term notes payable and capital leases		(1,088	)		—		(1,479	)		—		(2,567	)
Purchase of treasury stock		(10,287	)		—		—			—		(10,287	)
Proceeds from the exercise of stock options		5,574			—		—			—		5,574
Net cash used in financing activities		(5,801	)		—		(1,479	)		—		(7,280	)
Net increase (decrease) in cash and cash equivalents		13,718			—		488			—		14,206
Cash and cash equivalents, beginning of period		48,755			—		1,546			—		50,301
Cash and cash equivalents, end of period	$	62,473		$	—	$	2,034		$	—	$	64,507

(1)

In conjunction with the guarantee of McDATA Services Corporation’s (formerly known as CNT) convertible debt, the accompanying condensed consolidating financial information has been prepared and presented pursuant to SEC Regulation S-X Rule 3-10 “Financial statements of guarantors and affiliates whose securities collateralize an issue registered or being registered.” This information is not intended to present the financial position, results of operations and cash flows of the individual companies or groups of companies in accordance with generally accepted accounting principles and is not representative of the operations of McDATA or the former CNT on either a pre-merger or stand-alone basis.

(2)

Cash acquired in the merger with CNT, net of transaction costs, is recognized as investing inflow of cash in the consolidated cash flows statement for the twelve-month period ended January 31, 2006.

51

McDATA CORPORATION

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS (1)

For the Year Ended January 31, 2004
(in thousands)

				Issuer		Subsidiaries
	Parent			of		Non
	Guarantor			Notes		Guarantors			Eliminations		Consolidated
Net cash provided by (used in) operating activities	$	(127,778	)	$	—	$	188,838		$	—	$	61,060
Cash flows from investing activities: (2)
Purchases of property and equipment		(17,762	)		—		(242	)		—		(18,004	)
Proceeds from sale of equipment		5			—		—			—		5
Acquisitions, net of cash acquired		—			—		(171,421	)		—		(171,421	)
Purchase of equity investment in Aarohi		(6,000	)		—		—			—		(6,000	)
Purchases of investments		(654,238	)		—		—			—		(654,238	)
Proceeds from maturities and sales of investments		610,529			—		—			—		610,529
Restricted cash related to interest rate swap		(5,130	)		—		—			—		(5,130	)
Net cash provided by (used in) investing activities		(72,596	)		—		(171,663	)		—		(244,259	)
Cash flows from financing activities:
Proceeds from issuance of subordinate debt		172,500			—		—			—		172,500
Cost of debt issuance		(5,567	)		—		—			—		(5,567	)
Purchase of call options		(53,455	)		—		—			—		(53,455	)
Sale of call options		32,945			—		—			—		32,945
Payments on long-term notes payable and capital leases		(2,116	)		—		(16,050	)		—		(18,166	)
Purchase of treasury stock		(8,752	)		—		—			—		(8,752	)
Proceeds from the exercise of stock options		5,827			—		—			—		5,827
Net cash used in financing activities		141,382			—		(16,050	)		—		125,332
Net increase (decrease) in cash and cash equivalents		(58,992	)		—		1,125			—		(57,867	)
Cash and cash equivalents, beginning of period		107,739			—		429			—		108,168
Cash and cash equivalents, end of period	$	48,747		$	—	$	1,554		$	—	$	50,301

(1)

In conjunction with the guarantee of McDATA Services Corporation’s (formerly known as CNT) convertible debt, the accompanying condensed consolidating financial information has been prepared and presented pursuant to SEC Regulation S-X Rule 3-10 “Financial statements of guarantors and affiliates whose securities collateralize an issue registered or being registered.” This information is not representative of the operations of McDATA or the former CNT on either a pre-merger or stand-alone basis.

(2)

Cash acquired in the merger with CNT, net of transaction costs, is recognized as investing inflow of cash in the consolidated cash flows statement for the twelve-month period ended January 31, 2006.

52

NOTE 20 SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

          The following summarizes selected financial information for each of the two years in the period ended January 31, 2006:

	Q1			Q2			Q3			Q4			Total
2005
Total revenue	$	98,868		$	165,309		$	168,505		$	181,751		$	614,433
Gross profit		53,428			81,624			79,435			90,855			305,432
Net income (loss)		(2,857	)		(25,518	)		(7,484	)		5,258			(30,601	)
Basic net income (loss) per share (1)	$	(0.02	)	$	(0.18	)	$	(0.05	)	$	0.03		$	(0.22	)
Diluted net income (loss) per share (1)	$	(0.02	)	$	(0.18	)	$	(0.05	)	$	0.03		$	(0.22	)
2004
Total revenue	$	97,229		$	98,221		$	98,525		$	105,685		$	399,660
Gross profit		54,742			54,844			54,821			59,092			223,499
Net income loss		(9,844	)		(5,425	)		(5,523	)		(80	)		(20,872	)
Basic net loss per share (1)	$	(0.09	)	$	(0.05	)	$	(0.05	)	$	(0.00	)	$	(0.18	)
Diluted net income per share (1)	$	(0.09	)	$	(0.05	)	$	(0.05	)	$	(0.00	)	$	(0.18	)

(1) The sum of the basic and diluted net income (loss) per share for the fiscal quarters may not add to the fiscal year per share due to rounding.

53

MCDATA CORPORATION

SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)

	Balance at		Charged to									Balance at
	Beginning		Costs and									End of
	of Period		Expenses			Deductions			Other			Period
Year ended January 31, 2004
Allowance for doubtful accounts	$	1,290	$	(474	)	$	(64	)(a)	$	174	(c)	$	926
Inventory reserves		7,115		1,923			(5,870	)(b)		1,308	(c)		4,476
Year ended January 31, 2005
Allowance for doubtful accounts	$	926	$	(468	)	$	(152	)(a)	$	—		$	306
Inventory reserves		4,476		4,576			(4,148	)(b)		—			4,904
Year ended January 31, 2006
Allowance for doubtful accounts	$	306	$	1,520		$	(1,987	)(a)	$	8,041	(d)	$	7,880
Inventory reserves		4,904		6,735			(4,122	)		4,007	(e)		11,524

(a)	Reflects uncollectible amounts written-off, net of recoveries.
(b)	Reflects disposals of obsolete inventory and reductions to lower-of-cost or market reserves.
(c)	Reflects the acquisition of Nishan in fiscal year 2003.
(d)	Reflects the acquisition of CNT in fiscal year 2005.
(e)	Reflects the increase to reserves as a result of the UMD Swap program as discussed in Note 5 to the Consolidated Financial Statements.

54

EX-99.2

Exhibit 99.2

COMPUTER NETWORK TECHNOLOGY CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

			January 31,
			2005			2004
Assets
Current assets:
	Cash and cash equivalents		$	32,481		$	75,267
	Marketable securities			21,728			2,069
	Receivables, net			96,327			101,748
	Inventories			29,871			29,976
	Other current assets			5,348			4,400
		Total current assets		185,755			213,460
Property and equipment, net				40,056			40,313
Field support spares, net				10,022			11,951
Deferred tax asset				185			872
Interest rate swap				—			179
Goodwill				31,769			105,203
Other intangibles, net				15,722			33,225
Other assets				12,079			9,290
			$	295,588		$	414,493
Liabilities and shareholders’ equity
Current liabilities:
	Accounts payable		$	36,459		$	47,696
	Accrued liabilities			33,714			43,733
	Deferred revenue			53,219			48,991
	Current installments of obligations under capital lease			3,092			1,619
		Total current liabilities		126,484			142,039
Convertible subordinated debt				123,563			125,179
Interest rate swap				787			—
Obligations under capital lease, less current installments				4,952			4,468
		Total liabilities		255,786			271,686
Shareholders’ equity:
	Undesignated preferred stock, authorized 965 shares; none issued and outstanding			—			—
	Series A junior participating preferred stock, authorized 40 shares; none issued and outstanding			—			—
	Common stock, $.01 par value; authorized 100,000 shares; issued and outstanding 29,487 at January 31, 2005, and 27,501 at January 31, 2004			295			275
	Additional paid-in capital			199,380			187,652
	Unearned compensation			(5,461	)		(319	)
	Accumulated deficit			(157,603	)		(46,999	)
	Accumulated other comprehensive income			3,191			2,198
		Total shareholders’ equity		39,802			142,807
			$	295,588		$	414,493

See accompanying notes to consolidated financial statements

1

COMPUTER NETWORK TECHNOLOGY CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

				Years Ended January 31,
				2005			2004			2003
Revenue:
	Product sales			$	237,410		$	239,839		$	145,355
	Service fees				128,892			114,878			66,160
			Total revenue		366,302			354,717			211,515
Cost of revenue:
	Cost of product sales				142,979			143,992			89,110
	Cost of service fees				76,421			65,650			38,210
	Impairment-developed technology				11,198			—			—
			Total cost of revenue		230,598			209,642			127,320
Gross profit					135,704			145,075			84,195
Operating expenses:
	Sales and marketing				97,570			87,664			57,849
	Engineering and development				51,664			42,719			26,872
	General and administrative				17,088			16,073			10,694
	In-process research and development				—			19,706			—
	Impairment-trademark				911			—			—
	Impairment-goodwill				73,317			204			—
	Restructuring charge				—			—			1,666
			Total operating expenses		240,550			166,366			97,081
Loss from operations					(104,846	)		(21,291	)		(12,886	)
Other income (expense):
	Write-down of investment				—			—			(1,000	)
	Net gain on sale of marketable securities				—			747			—
	Interest income				1,246			1,609			6,183
	Interest expense				(4,384	)		(4,435	)		(4,326	)
	Other, net				305			411			12
		Other income (expense), net			(2,833	)		(1,668	)		869
Loss from continuing operations before income taxes					(107,679	)		(22,959	)		(12,017	)
	Provision for income taxes				2,237			625			16,527
Loss from continuing operations					(109,916	)		(23,584	)		(28,544	)
Income (loss) from discontinued operations, net of tax					(688	)		(469	)		207
Net loss before cumulative effect of change in accounting principle					(110,604	)		(24,053	)		(28,337	)
Cumulative effect of change in accounting principle					—			—			(10,068	)
Net loss				$	(110,604	)	$	(24,053	)	$	(38,405	)
Basic and diluted loss per share:
	Continuing operations			$	(3.93	)	$	(0.87	)	$	(1.02	)
	Discontinued operations			$	(0.02	)	$	(0.02	)	$	0.01
	Cumulative effect of change in accounting principle			$	—		$	—		$	(0.36	)
	Net loss			$	(3.95	)	$	(0.89	)	$	(1.37	)
	Shares				27,981			27,116			28,111

See accompanying notes to consolidated financial statements

2

COMPUTER NETWORK TECHNOLOGY CORPORATION

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(in thousands)

														Retained			Accumulated
		Common Stock						Additional						Earnings			Other
								Paid-In			Unearned			(Accumulated			Comprehensive
		Shares			Amount			Capital			Compensation			Deficit)			Income (Loss)			Total
Balance, January 31, 2002			30,383		$	304		$	202,996		$	(1,232	)	$	15,459		$	(884	)	$	216,643
Shares issued pursuant to the employee stock purchase plan, restricted stock and exercise of stock options			583			5			3,124			(165	)		—			—			2,964
Repurchase of common stock			(4,045	)		(40	)		(32,165	)		—			—			—			(32,205	)
Compensation expense			—			—			—			722			—			—			722
Comprehensive loss:
	Net loss		—			—			—			—			(38,405	)		—			(38,405	)
	Unrealized gain on marketable securities, net of tax effect of $266		—			—			—			—			—			393			393
	Translation adjustment, net of tax effect of $0		—			—			—			—			—			1,519			1,519
Total comprehensive loss			—			—			—			—			—			—			(36,493	)
Balance, January 31, 2003			26,921		$	269		$	173,955		$	(675	)	$	(22,946	)	$	1,028		$	151,631
Shares issued pursuant to the employee stock purchase plan, restricted stock and exercise of stock options			580			6			3,411			(147	)		—			—			3,270
Conversion of Inrange options			—			—			10,286			—			—			—			10,286
Compensation expense			—			—			—			503			—			—			503
Comprehensive loss:
	Net loss		—			—			—			—			(24,053	)		—			(24,053	)
	Unrealized loss on marketable securities, net of tax effect of $277		—			—			—			—			—			(444	)		(444	)
	Realized gain on marketable securities, net of tax effect of $288		—			—			—			—			—			(459	)		(459	)
	Translation adjustment, net of tax effect of $0		—			—			—			—			—			2,073			2,073
Total comprehensive loss			—			—			—			—			—			—			(22,883	)
Balance, January 31, 2004			27,501		$	275		$	187,652		$	(319	)	$	(46,999	)	$	2,198		$	142,807
Shares issued pursuant to the employee stock purchase plan, restricted stock and exercise of stock options			1,286			13			8,767			(6,107	)		—			—			2,673
Shares issued for BI-Tech earn out			700			7			2,961			—			—			—			2,968
Compensation expense			—			—			—			965			—			—			965
Comprehensive loss:
	Net loss		—			—			—			—			(110,604	)		—			(110,604	)
	Unrealized loss on marketable securities, net of tax effect of $0		—			—			—			—			—			(281	)		(281	)
	Translation adjustment, net of tax effect of $0		—			—			—			—			—			1,274			1,274
Total comprehensive loss			—			—			—			—			—			—			(109,611	)
Balance, January 31, 2005			29,487		$	295		$	199,380		$	(5,461	)	$	(157,603	)	$	3,191		$	39,802

See accompanying notes to consolidated financial statements

3

COMPUTER NETWORK TECHNOLOGY CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

				Years Ended January 31,
				2005			2004			2003
Operating Activities:
	Net loss			$	(110,604	)	$	(24,053	)	$	(38,405	)
	Adjustments to reconcile net (loss) to net cash provided by (used in) operating activities:
	Cumulative effect of change in accounting principle				—			—			10,068
	Discontinued operations				688			469			(207	)
	Depreciation and amortization				29,735			25,132			15,868
	Compensation expense				1,292			503			722
	In-process research and development charge				—			19,706			—
	Marketable securities impairment				181			—			—
	Impairment of goodwill and other intangibles				85,426			204			—
	Net gain on repurchase of convertible subordinated debt				(141	)		—			—
	Net gain on sale of marketable securities				—			(747	)		—
	Write-down of investment				—			—			1,000
	Change in deferred taxes				687			(773	)		16,077
	Changes in operating assets and liabilities, net of acquisitions:
		Receivables			5,625			(9,342	)		1,714
		Inventories			590			6,151			7,370
		Other current assets			(715	)		3,322			2,020
		Accounts payable			(11,237	)		20,019			(2,110	)
		Accrued liabilities			(5,219	)		(13,557	)		(2,670	)
		Deferred revenue			4,228			6,774			5,875
		Net cash provided by continuing operations			536			33,808			17,322
		Net cash provided by (used in) discontinued operations			(688	)		(469	)		207
			Cash provided by (used in) operating activities		(152	)		33,339			17,529
Investing Activities:
	Additions to property and equipment				(14,303	)		(7,599	)		(6,878	)
	Additions to field support spares				(5,917	)		(2,719	)		(5,486	)
	Acquisition of BI-Tech, net of cash acquired				(840	)		(3,868	)		(7,723	)
	Acquisition of Inrange, net of cash acquired				—			(152,785	)		—
	Purchase of marketable securities				(187,017	)		(106,584	)		(163,860	)
	Proceeds from redemption of marketable securities				167,358			214,787			136,988
	Other assets				(3,472	)		(1,714	)		695
			Cash used in investing activities		(44,191	)		(60,482	)		(46,264	)
Financing Activities:
	Net proceeds from issuance of convertible subordinated debt				—			—			121,559
	Repurchase of convertible subordinated debt				(509	)		—			—
	Payments for repurchases of common stock				—			—			(32,205	)
	Proceeds from issuance of common stock				2,346			3,270			2,964
	Repayments of obligations under capital leases				(888	)		(1,333	)		(1,523	)
			Cash provided by financing activities		949			1,937			90,795
Effects of exchange rate changes					608			2,132			1,879
Net increase (decrease) in cash and cash equivalents					(42,786	)		(23,074	)		63,939
Cash and cash equivalents — beginning of year					75,267			98,341			34,402
Cash and cash equivalents — end of year				$	32,481		$	75,267		$	98,341

See accompanying notes to consolidated financial statements

4

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

January 31, 2005, 2004 and 2003

(tabular amounts in thousands except per share data)

(1)  Summary of Significant Accounting Policies

Description of Business

      Computer Network Technology Corporation (the Company) is a leading provider of end-to-end storage solutions, related consulting and integration services, and managed services in the high-performance storage networking market.

Discontinued Operations

      In connection with the acquisition of Inrange, the Company acquired a non-complimentary business focused on enterprise resource planning (ERP) consulting services. In April 2004, the company sold substantially all of the business and its assets.

Fiscal Year End

      References in these footnotes to fiscal 2004, 2003 and 2002 represent the twelve months ended January 31, 2005, 2004 and 2003, respectively.

Principles of Consolidation

      The accompanying consolidated financial statements include the accounts of Computer Network Technology Corporation and its subsidiaries (together, the Company). All significant intercompany balances and transactions are eliminated in consolidation.

Revenue Recognition

      Most of the Company’s sales arrangements include multiple deliverables, and are subject to the provisions of Emerging Issues Task Force consensus opinion No. 00-21 Revenue Arrangements with Multiple Deliverables (EITF 00-21). All of the elements included in the Company’s sales arrangements, including proprietary products, third party products, professional services, standard maintenance and network monitoring services qualify as separate deliverables because each element is sufficiently separable, and the Company has sufficient evidence of the relative fair value of each deliverable. Each of the elements in the Company’s sales arrangements has stand-alone value. With respect to product sales, fair value is based on the prices charged to other customers for similar products, or standard market prices in the case of third party products. The fair value for professional consulting services is based on the hours required to perform the services at actual hourly billing rates. These rates are based on rates charged for similar consulting services in stand-alone contracts. Valuation for standard maintenance and network monitoring services is based on the fair value for these services as evidenced by the separately priced contract value for these services when sold on a stand alone basis. In transactions that include multiple products and/or services, the sales value is allocated among each of the deliverables based on their relative fair values.

      Once the Company’s sales arrangement have been divided into separate units of accounting, the relative fair value of each element has been determined, and any revenue contingencies have been fulfilled, the Company recognizes revenue for each element as follows:

      Revenue is recognized upon shipment for product sales with standard configurations and product sales with other than standard configurations, which have demonstrated performance in accordance with customer specifications prior to shipment provided that (a) evidence of an arrangement exists, (b) delivery has occurred, (c) the price to the customer is fixed and determinable, and (d) collectibility is assured. All

5

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

other product sales are recognized as revenue when customer acceptance is received or upon passage of the customer acceptance period.

      Warranty costs and sales returns are accrued at the time of shipment based on experience.

      Service fees are recognized as revenue when earned, which is generally on a straight-line basis over the contracted service period or as the services are rendered. Deferred revenue primarily consists of the unearned portion of service agreements billed in advance to customers, including amounts both collected and uncollected.

Valuation of Accounts Receivable

      Accounts receivable are reviewed to determine which are doubtful of collection. Estimates are also made of potential future product returns. In making the determination of the appropriate allowance for doubtful accounts and product returns, the Company considers specific accounts, changes in customer payment terms, historical write-offs and returns, changes in customer demand and relationships, concentrations of credit risk and customer credit worthiness. The provision for doubtful accounts and product returns was $2,830,000, $1,700,000 and $1,388,000 in fiscal 2004, 2003 and 2002, respectively.

Valuation of Inventory

      Inventories are stated at the lower of cost (determined on a first in, first out basis) or market. The Company reviews obsolescence to determine that inventory items deemed obsolete are appropriately reserved. In making the determination, consideration is given to the history of inventory write-offs, future sales of related products, and quantity of inventory at the balance sheet date, assessed against past usage rates and future expected usage rates.

Valuation of Deferred Taxes

      Significant management judgment is required in determining the provision for incomes taxes, deferred tax assets and liabilities and any valuation allowance recorded against net deferred tax assets. The Company is required to estimate income taxes in each jurisdiction where it operates. This process involves estimating actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as the depreciable life of fixed assets for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in the consolidated balance sheet. The Company assesses the likelihood that its deferred tax assets will be recovered from future taxable income and to the extent recovery is believed unlikely, establishes a valuation allowance. The Company has increased tax expense within its statements of operations when a valuation allowance is established or increased in a given period.

      In the fourth quarter of fiscal 2002, the Company recorded a non-cash charge of $23,568,000 to provide a full valuation allowance for its United States deferred tax assets. The Company’s cumulative valuation allowance recorded against its deferred tax assets at January 31, 2005 was $91,821,000. The net deferred tax asset that still exists is attributable to foreign operations. The establishment of the valuation allowance does not impair the Company’s ability to use the deferred tax asset upon achieving profitability. As the Company generates taxable income in future periods, it does not expect to record significant income tax expense in the United States until it is able to determine that it is more likely than not that the Company will be able to utilize the deferred tax assets, and reduce its valuation allowance. The establishment of the valuation allowance does not impair the Company’s ability to use the deferred tax assets upon achieving profitability. The Company’s federal net operating loss carryforwards and research tax credits do not expire for the next 15 to 20 years.

6

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Goodwill and Other Intangible Assets

      Goodwill represents the excess of the purchase price over the fair value of net assets. Upon adoption of Statement of Financial Accounting Standard (SFAS) No. 142, Goodwill and Other Intangible Assets, in the first quarter of fiscal 2002, the Company no longer amortized goodwill. Other intangible assets related to the acquisitions of Articulent, BI-Tech and Inrange are amortized on a straight-line basis over periods ranging from one to ten years.

Impairment of Long-lived Assets

      The Company accounts for long-lived assets in accordance with the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. This Statement requires that long-lived and intangible assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

Impairment of Intangible Assets and Goodwill

      The Company reviews intangible assets and goodwill for impairment annually in its third fiscal quarter ending October 31, or more frequently if changes in circumstances or the occurrence of events suggest the remaining value may not be recoverable. An asset is deemed impaired and written down to its fair value if estimated related net undiscounted future cash flows are less than its carrying value in accordance with the provisions of SFAS No. 142. In connection with SFAS No. 142’s transitional goodwill impairment evaluation, the Statement requires the Company to perform an assessment of whether there is an indication that goodwill is impaired as of the date of adoption. Impairment adjustments recognized after adoption, if any, generally are required to be recognized as operating expenses, captioned in general and administrative expenses. The Company incurred impairment charges in fiscal 2004 for developed technology of $11,198,000, trademark of $911,000 and goodwill of $73,317,000, see Note 6-Goodwill and Intangible Assets.

Cash Equivalents

      The Company considers investments in highly liquid debt securities having an initial maturity of three months or less to be cash equivalents. Cash equivalents consist primarily of money market instruments, bank certificates of deposits, U.S. treasury bills, U.S. agency discount notes and corporate debt instruments.

Marketable Securities

      Unrealized gains and losses on available-for-sale securities are excluded from earnings and are reflected as a separate component of shareholders’ equity. Unrealized gains and losses on trading securities are included in earnings.

Property and Equipment

      Property and equipment owned by the Company is carried at cost and depreciated using the straight-line method over three to eight years. Leasehold improvements and capital lease equipment are amortized

7

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

using the straight-line method over the shorter of the life of the asset or the terms of the respective leases. Expenditures for repairs and maintenance are charged to expense as incurred.

      The carrying value of long-lived assets is reviewed whenever events or changes in circumstances such as market value, asset utilization, physical change, legal factors or other matters indicate that the carrying value may not be recoverable. When the review indicates that the carrying value of the asset or group of assets representing the lowest level of identifiable cash flows exceeds the sum of the expected future cash flows (undiscounted and without interest charges), an impairment loss is recognized. The amount of the impairment loss is the amount by which the carrying value exceeds the fair value of the impaired asset or group of assets.

Field Support Spares

      Field support spares are carried at cost and depreciated using the straight-line method over three years.

Engineering and Development

      The Company has expensed all engineering and development costs to date.

Foreign Currency

      The financial statements of the Company’s international subsidiaries have been translated into U.S. dollars. Assets and liabilities are translated into U.S. dollars at year-end exchange rates, while equity accounts are translated at historical rates. Income and expenses are translated at the average exchange rates during the year. The resulting translation adjustments are recorded as a separate component of shareholders’ equity.

      The Company is exposed to market risks related to fluctuations in foreign exchange rates because some sales transactions, and the assets and liabilities of its foreign subsidiaries, are denominated in foreign currencies. The Company had no outstanding forward exchange contracts as of January 31, 2005. Gains and losses from transactions denominated in foreign currencies and forward exchange contracts are included in the Company’s net loss. The Company recognized foreign currency transaction gains in fiscal 2004, 2003 and 2002 of $277,000, $599,000 and $63,000, respectively.

Stock Compensation Plans

      The Company accounts for its stock based compensation awards in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and provides the footnote disclosures required by SFAS No. 123 Accounting for Stock Based Compensation.

      The Company has elected to continue to account for its plans in accordance with APB No. 25. Accordingly, no compensation cost associated with the fair value of stock option grants or shares sold to employees under the Employee Stock Purchase Plan has been recognized in the Company’s financial statements. The Company has recognized compensation cost for the fair value associated with the issuance of restricted and deferred stock awards and units. Had compensation cost for the Company’s stock-based compensation plans been recognized consistent with the fair value method of SFAS No. 123, the

8

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Company’s net loss and net loss per basic and diluted share would have been reduced to the pro forma amounts indicated below:

			Years Ended January 31,
			2005			2004			2003
Net loss, as reported			$	(110,604	)	$	(24,053	)	$	(38,405	)
Add: Total stock-based employee compensation expenses included in net loss, as reported				1,292			503			722
Deduct: Total stock-based employee compensation expense under fair value based method of all awards, net of tax effects				(7,743	)		(13,829	)		(13,023	)
Pro forma net loss			$	(117,055	)	$	(37,379	)	$	(50,706	)
	As reported
		Basic	$	(3.95	)	$	(0.89	)	$	(1.37	)
		Diluted	$	(3.95	)	$	(0.89	)	$	(1.37	)
	Pro forma
		Basic	$	(4.18	)	$	(1.38	)	$	(1.80	)
		Diluted	$	(4.18	)	$	(1.38	)	$	(1.80	)

      Weighted average fair value of stock-based awards granted at fair market value during:

Fiscal 2005	$	5.73
Fiscal 2004	$	4.83
Fiscal 2003	$	6.25

      In determining the compensation cost of stock option grants and shares sold to employees under the employee stock purchase plan, as specified by SFAS No. 123, the fair value of each award has been estimated on the date of grant using the Black-Scholes option pricing model. The weighted average assumptions used in these calculations are summarized below:

	Years Ended January 31,
	2005			2004			2003
Risk free interest rate		3.90	%		2.97	%		3.71	%
Expected life		5.75			5.73			5.68
Expected volatility		93.16	%		94.59	%		87.29	%

      In December 2004, the FASB issued SFAS No. 123(R) “Share-Based Payment”. SFAS 123(R) requires the recognition of compensation cost relating to share-based payment transactions in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued as of the grant date, based on the estimated number of awards that are expected to vest. SFAS 123(R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. Statement 123(R) replaces FASB Statement No. 123, “Accounting for Stock-Based compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”. Statement 123(R) is effective for the company beginning August 1, 2005. The company is in the process of evaluating the impact of SFAS 123(R) on the company’s overall results of operations, financial position and cash flows.

9

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Reclassifications

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

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 affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

      Estimates that could significantly affect the results of operations or financial condition of the Company include the determination of the valuation of the deferred tax asset, recoverability of goodwill, valuation of accounts receivable and valuation of inventory. Further discussion on these estimates can be found in related disclosures elsewhere in these notes to the consolidated financial statements.

Net Income (Loss) Per Share

      Basic net income (loss) per share is computed based on the weighted average number of common shares outstanding, while diluted net income per share is computed based on the weighted average number of common shares outstanding plus potential dilutive shares of common stock. Potential dilutive shares of common stock include stock options which have been granted to employees and directors, awards under the employee stock purchase plan and common shares issuable upon conversion of the Company’s outstanding convertible subordinated debt. Net loss per basic and diluted share is based on the weighted average number of common shares outstanding. Potential dilutive shares of common stock have been excluded from the computation of net loss per share due to their anti-dilutive effect.

Comprehensive Income (loss)

      Comprehensive income (loss) consists of the Company’s net income (loss), foreign currency translation adjustment and unrealized gains and losses from available-for-sale securities and is presented in the consolidated statement of shareholders’ equity.

(2) Acquisitions

Inrange

      On April 6, 2003, the Company entered into an agreement whereby a wholly owned subsidiary of the Company would acquire all of the shares of Inrange Corporation that were owned by SPX Corporation. The shares to be acquired constituted approximately 91% of the issued and outstanding shares of Inrange for a purchase price of approximately $2.31 per share and approximately $173,000,000 in the aggregate. On May 5, 2003 the Company completed the acquisition of Inrange and pursuant to the agreement the subsidiary merged into Inrange, and the remaining capital stock owned by the other Inrange shareholders was converted into the right to receive approximately $2.31 per share in cash, resulting in a total payment of approximately $190,000,000 for both the stock purchase and merger.

      The Company acquired Inrange to significantly broaden its portfolio of storage networking products and solutions, particularly in the area of Fibre Channel and FICON switching, increase its global size and scope, and expand its customer base.

10

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The acquisition was accounted for as a purchase and the consolidated financial statements of the Company include the results of Inrange since May 5, 2003. The purchase price was allocated to the fair value of the assets and liabilities acquired as follows:

Purchase Price:
	Cash paid	$	190,526
	Value of stock option grants		10,286
	Transaction costs		3,347
Total purchase consideration paid		$	204,159
Fair Value of Assets Acquired and Liabilities Assumed:
	Cash	$	41,088
	Accounts receivable		34,542
	Inventory		12,461
	Property and equipment		22,538
	Field support spares		7,757
	Developed technology		20,248
	Customer list		15,294
	Trademarks		1,234
	In-process research and development		19,706
	Goodwill		86,899
	Deferred taxes		75
	Other assets		6,677
	Accounts payable		(10,788	)
	Accrued expenses		(32,628	)
	Deferred revenue		(20,944	)
Total purchase consideration paid		$	204,159

      The Company incurred impairment charges in fiscal 2004 for developed technology of $11,198,000, trademark of $911,000 and goodwill of $73,317,000, see Note 6-Goodwill and Intangible Assets.

      As part of the Inrange acquisition, the Company assumed the 2000 Inrange stock compensation plan which provides for the issuance of up to 3,782,993 shares of the Company’s common stock. The plan provided for the conversion of pre-existing Inrange stock options into company stock options. The options granted under the 2000 Inrange stock compensation plan were valued at $10,286,000 using the Black-Scholes option-pricing model. The amount was deemed to be part of the Inrange purchase price and was recorded as additional paid-in capital.

      The intangible assets acquired included developed technology, customer list and trademarks valued at $20,248,000, $15,294,000 and $1,234,000, respectively. The developed technology, customer list and trademarks were initially being amortized on a straight-line basis over periods of approximately five years, seven years and five years, respectively. The estimated useful life for the developed technology and trademarks were subsequently revised to three and one years, respectively (see note 6). Goodwill resulting from the acquisition of $86,899,000 is deductible for income tax purposes.

      The Company allocated $19,706,000 of the Inrange purchase price to acquired in-process research and development to reflect the value of new Fibre Channel switching technology that was approximately 50% complete at the time of acquisition. At the date of acquisition, the technological feasibility of the new

11

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Fibre Channel switching technology had not been attained and the technology had no alternative future use. The new Fibre Channel switching technology was projected to have significantly greater functionality and port density when compared to other Fibre Channel technology currently available in the marketplace. The allocation to in-process research and development was based on an independent third party appraisal that utilized the excess earnings approach. Significant assumptions used in the third party appraisal include the cost to complete the project, and the projected revenue and expense generated over the estimated life cycle of the new Fibre Channel switching technology. The new Fibre Channel switching technology subsequently evolved into the Company’s new UMD product that was launched in the second half of fiscal 2004.

      The following table presents the unaudited pro forma consolidated results of operations of the Company for the fiscal years ended January 31, 2004 and 2003 as if the acquisition of Inrange took place on February 1, 2003 and 2002, respectively:

	Pro Forma Year Ended
	January 31,
	2004			2003
Total revenue	$	394,879		$	421,269
Net loss before cumulative effect of change in accounting principle	$	(11,815	)	$	(43,876	)
Net loss	$	(11,815	)	$	(53,944	)
Net loss per share	$	(0.44	)	$	(1.92	)

      The pro forma results include amortization of the customer list, developed technology and trademarks presented above. The unaudited pro forma results do not include the $19,706,000 charge for in-process research and development related to the Inrange acquisition. The unaudited pro forma results are for comparative purposes only and do not necessarily reflect the results that would have been recorded had the acquisition occurred at the beginning of the period presented or the results which might occur in the future.

BI-Tech

      On June 24, 2002, the Company acquired all the outstanding stock of BI-Tech, a leading provider of storage management solutions and services, for $12,000,000 in cash plus the assumption of approximately $3,600,000 of liabilities and the acquisition of approximately $8,700,000 of tangible assets. The Company had allocated $6,544,000, $1,125,000 and $250,000 of the purchase price to goodwill, customer list and non-compete agreements, respectively. The customer list and non-compete agreements are currently being amortized over periods of ten and two years, respectively. The accompanying financial statements include the results of BI-Tech since June 24, 2002.

      The original purchase agreement required payments of additional consideration to the former stockholders and the BI-Tech employees based on achievement of certain earnings for each of the two years beginning July 1, 2002. The portion payable to the former stockholders is recorded as goodwill. The portion payable to BI-Tech employees is recorded as compensation expense. During fiscal year 2003, an additional $4,100,000 was added to goodwill and $312,000 was recorded as compensation expense. Goodwill and compensation expense recorded under this earn out agreement between July 1, 2002 and January 31, 2004 totaled $7,735,000 and $1,056,000, respectively. There was no earn-out in fiscal 2004.

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COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(3) Marketable Securities

      The Company’s investments in marketable securities are summarized as follows:

		January 31,
		2005		2004
Available-for-Sale:
	Bank certificates of deposit	$	870	$	750
	U.S. government and agency securities		10,032		—
	Corporate debt securities		10,767		—
	Corporate equity securities		42		383
			21,711		1,133
Trading:
	Mutual funds		17		936
		$	21,728	$	2,069

      There were no gross unrealized gains with respect to investments in available-for-sale securities at January 31, 2005 and 2004. The amount of gross unrealized losses with respect to investments in available-for-sale securities at January 31, 2005 was $281,000. The amount of gross unrealized losses with respect to investments in available-for-sale securities at January 31, 2004 was not significant. The Company recognized a permanent impairment loss for an available-for-sale security during fiscal 2004 of $181,000. The amount of gross realized gains and losses from sales of available-for-sale securities in fiscal 2004 was not significant.

      The Company had gross realized gains and losses from sales of available-for-sale securities in fiscal 2003 of $1,041,000 and $294,000, respectively. The Company realized no significant gains or losses from sales of available-for-sale securities in fiscal 2002.

      Proceeds from the sale of available-for-sale securities in fiscal 2004, 2003 and 2002 were $6,495,458, $182,457,000, and $34,373,000, respectively. At January 31, 2005, investments in available-for-sale securities with contractual maturities of less than twelve months totaled $17,630,000. The Company’s remaining investments in debt securities classified as available-for-sale at January 31, 2005 had contractual maturities ranging from one year to three years.

      The Company’s trading securities consist of various mutual fund investments. The Company intends to use any gain or loss from these investments to fund the investment gains or losses allocated to participants under the Company’s executive deferred compensation plan. The amount of unrealized holding gains and (losses) with respect to trading securities included in net income loss for fiscal 2004 were not significant. The amount of unrealized holding gains and (losses) with respect to trading securities included in net loss for fiscal 2003 and 2002 were $78,000, and ($132,000), respectively.

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COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(4) Components of Selected Balance Sheet Accounts

		January 31,
		2005		2004
Accounts receivable:
	Accounts receivable	$	100,009	$	106,404
	Less allowance for doubtful accounts and sales returns		3,682		4,656
		$	96,327	$	101,748
Inventories:
	Components and subassemblies	$	16,538	$	14,311
	Work in process		1,576		4,015
	Finished goods		11,757		11,650
		$	29,871	$	29,976
Property and equipment:
	Land	$	1,226	$	1,226
	Machinery and equipment		79,599		66,516
	Office and data processing equipment		37,814		31,271
	Furniture and fixtures		5,599		5,284
	Leasehold improvements		4,700		4,564
			128,938		108,861
	Less accumulated depreciation and amortization		88,882		68,548
		$	40,056	$	40,313
Field support spares:
	Field support spares	$	27,684	$	21,767
	Less accumulated depreciation		17,662		9,816
		$	10,022	$	11,951
Accrued liabilities:
	Compensation	$	15,941	$	18,199
	Income taxes		5,024		4,482
	Interest		1,313		1,676
	Product warranty		2,029		2,348
	Earn-out		—		3,866
	Facilities		4,605		5,574
	Other		4,802		7,588
		$	33,714	$	43,733

(5) Cumulative Effect of Change in Accounting Principle

      In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires use of the purchase method of accounting for all business

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COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

combinations initiated after June 30, 2001. SFAS No. 141 also provides new criteria in the determination of intangible assets, including goodwill acquired in a business combination, and expands financial disclosure concerning business combinations consummated after June 30, 2001. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized but instead be tested for impairment at least annually using a two-step impairment test. The application of SFAS No. 141 did not affect previously reported amounts included in goodwill and other intangible assets.

      Effective February 1, 2002, the Company adopted SFAS No. 142, which provides a six-month transitional period from the effective date of adoption for the Company to perform an assessment of whether there is an indication of goodwill impairment. The Company tested its reporting units for impairment by comparing fair value to carrying value. Fair value was determined using a discounted cash flow and cost methodology. The Company engaged a third-party appraisal firm to determine the fair value of a reporting unit within its former Storage Solutions segment. This valuation indicated that the goodwill associated with the acquisition of Articulent in April of 2001 was impaired. The performance of this business had not met management’s original expectations, primarily due to the unexpected global slow down in capital spending for information technology equipment. Accordingly, a non-cash impairment charge of $10,068,000 from the adoption of SFAS No. 142 was recognized as a cumulative effect of change in accounting principle in the first quarter ended April 30, 2002.

(6) Goodwill and Intangible Assets

      In August 2004, the Company’s market capitalization fell substantially below recorded net book value, indicating that goodwill and other long-lived assets may be impaired, including developed technology, trademarks, and customer lists. As part of management’s evaluation and analysis, the Company engaged an independent third party to appraise these assets. The Company’s evaluation and analysis indicated that impairment charges for developed technology, trademarks and goodwill of $11,198,000, $911,000 and $73,317,000 respectively, should be reflected in results of operations for fiscal year 2004. Developed technology and trademarks intangibles resulted entirely from the Company’s Inrange acquisition, while most of the Company’s goodwill resulted from the Inrange acquisition. See footnote 2 to the consolidated financial statements for a summary of the Inrange purchase price allocation. Developed technology was analyzed using the excess earnings method, and was impaired due to more rapid market acceptance of the Company’s new generation UMD product following its introduction this year. Trademarks were analyzed using the relief from royalty approach and were impaired due to use of the UltraNet name for the new generation UMD product, and the subsequent rapid market acceptance of this product. The more rapid market acceptance of the Company’s new UMD product resulted in lower estimated revenue and excess earnings, primarily for developed technology, compared to the Company’s original estimate when Inrange was acquired. The Company determined that its customer lists intangible was not impaired. The Company’s fair value was based on a combination of the income and market value approaches. The analysis indicated that the Company’s net book value exceeded its implied fair value, resulting in the $73,317,000 charge for goodwill impairment. The goodwill impairment charge resulted from the Company’s later than planned launch of the UMD coupled with slower than planned development of the direct sales channel for these products, and more rapid acceptance of the Company’s wide area extension products by the Inrange customer set. The remaining useful lives for developed technology and trademarks were revised to three and one years, respectively. The impairment charges will not result in future cash expenditures.

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COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The change in the net carrying amount of goodwill for the years ended January 31, 2005 and 2004 was as follows:

		Years Ended January 31,
		2005			2004
Beginning of year		$	105,203		$	14,113
	Acquisition of Inrange		(117	)		87,016
	Additional purchase price consideration for BI-Tech		—			4,100
	Goodwill impairment		(73,317	)		(204	)
	Translation adjustment		—			178
End of year		$	31,769		$	105,203

      The components of other amortizable intangible assets as of January 31, 2005 and 2004 were as follows:

		January 31, 2005					January 31, 2004
		Gross Carrying		Accumulated			Gross Carrying		Accumulated			Weighted Average
		Amount		Amortization			Amount		Amortization			Life (in years)
Customer lists		$	16,924	$	(4,259	)	$	16,924	$	(1,883	)		7.3
Trademarks			4		(2	)		1,234		(185	)		1.0
Developed technology			3,606		(551	)		20,248		(3,165	)		3.0
Non-compete agreements			250		(250	)		250		(198	)		2.0
	Total	$	20,784	$	(5,062	)	$	38,656	$	(5,431	)		5.9
	Total other intangible assets, net	$	15,722				$	33,225

      Amortization expense for intangible assets for the year ended January 31, 2005 was $5,394,000. Amortization expense is estimated to be $3,552,000 in fiscal 2005, $3,550,000 in fiscal 2006, $2,999,000 in fiscal 2007, $2,348,000, in fiscal 2008 and fiscal 2009.

      During the fourth quarter of fiscal 2003, the Company recorded a charge of $204,000 for goodwill impairment related to the closing of a small sales subsidiary in Europe. The subsidiary was operated as a stand-alone business, and the impairment charge represents the amount of goodwill resulting from the acquisition of the business in fiscal 2002.

(7) Discontinued Operations

      In connection with the acquisition of Inrange, the Company acquired a non-complementary business focused on enterprise resource planning (ERP) consulting services. In April 2004, substantially all of the business and its net assets totaling approximately $1,712,000 were sold for cash proceeds of $934,000 and installments payments having a discounted value of approximately $1,228,000. The business was divested to allow the Company to focus on its core storage networking solutions business. Revenue for the ERP business in fiscal 2004 and 2003 totaled $2,198,000 and $6,160,000, respectively. Expense for the ERP business in fiscal 2004 and 2003 totaled $2,886,000 and $7,344,000, respectively. The business has been accounted for as a discontinued operation in the accompanying financial statements, meaning that its revenues and expenses are not included in results from continuing operations, and the net income/(loss) of

16

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

the ERP business was included under the discontinued operations caption in the statement of operations.

      Propelis Software, Inc. formerly known as the Enterprise Integration Solutions Division, including IntelliFrame, developed and sold EAI software that automates the integration of computer software applications and business workflow processes. In August 2000, the Company determined to divest Propelis Software, Inc. and focus on its core storage networking business. The business was subsequently sold in fiscal 2001 in a series of transactions. As a result, Propelis Software, Inc. has been accounted for as a discontinued operation in the accompanying financial statements.

      In fiscal 2002, the Company received $207,000 of royalty income, net of tax, related to the discontinued operations of Propelis Software, Inc that were sold in fiscal 2001.

      In fiscal 2003, the Company recognized $715,000 of income from discontinued operations related to the reversal of an accrual for an abandoned facility which was subleased in fiscal 2003. This facility was previously used by Propelis Software which the Company accounted for as a discontinued operation.

(8) Leases

      The Company leases all office and manufacturing space and certain equipment under noncancelable capital and operating leases. At January 31, 2005 and 2004, leased capital assets included in property and equipment were as follows:

	January 31,
	2005		2004
Property and equipment:
Office and data processing equipment	$	5,845	$	2,498
Less accumulated amortization		1,839		247
	$	4,006	$	2,251

17

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      Future minimum lease payments, excluding executory costs such as real estate taxes, insurance and maintenance expense, by year and in the aggregate are as follows:

	Minimum Lease
	Commitments
	Capital		Operating
Year Ending January 31,2006	$	3,295	$	10,233
2007		3,122		7,740
2008		1,980		6,368
2009		424		5,428
2010		—		4,735
Thereafter		—		2,809
Total minimum lease payments		8,821	$	37,313
Less amounts representing interest at rates ranging from 4.74% to 13.54%		777
Present value of minimum capital lease payments		8,044
Less current installments		3,092
Obligations under capital lease, less current installments	$	4,952

      Rent expense under non-cancelable operating leases, exclusive of executory costs, for fiscal 2004, 2003 and 2002 was $10,054,000, $8,405,000, and $6,244,000, respectively.

(9) Convertible Subordinated Debt Offering

      In February 2002, the Company sold $125,000,000 of 3% convertible subordinated notes due February 15, 2007, raising net proceeds of $121,639,000. The notes are convertible into the Company’s common stock at a price of $19.17 per share. The Company may redeem the notes upon payment of the outstanding principal balance, accrued interest and a make whole payment if the closing price of its common stock exceeds 175% of the conversion price for at least 20 consecutive trading days within a period of 30 consecutive trading days ending on the trading day prior to the date the redemption notice is mailed. The make whole payment represents additional interest payments that would be made if the notes were not redeemed prior to the due date.

      Original debt issuance costs of $3,441,000 are being amortized to interest expense on a straight-line basis, which approximates the effective interest method. At January 31, 2005, the remaining debt issuance costs, net of accumulated amortization, were $1,411,000.

      In January 2004, the Company entered into an interest-rate swap agreement with a notional amount of $75,000,000 that has the economic effect of modifying that dollar portion of the fixed interest obligations associated with $75,000,000 of its 3% convertible subordinated notes due February 2007 such that the interest payable effectively becomes variable based on the three month LIBOR plus 69.5 basis points. The payment dates of the swap are January 31st, April 30th, July 31st and October 31st of each year, commencing April 30, 2004, until maturity on February 15, 2007. At January 31, 2005, LIBOR setting for the swap was 2.13%, creating a combined effective rate of approximately 2.825%. On February 1, 2005, the LIBOR setting was reset to 2.73% creating a combined effective rate of 3.425% which is effective until April 30, 2005. 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. Fair value hedge accounting is provided only if the hedging instrument is expected to be, and actually is, effective at offsetting changes in the value of the hedged item. At January 31, 2005, the fair value of the interest rate swap had decreased from inception to $787,000 and is

18

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

included in other long-term liabilities. Corresponding to this decline, the carrying value of the notes has decreased by $787,000. 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 $3,225,000 at January 31, 2005, and has been classified as other long-term assets in the accompanying consolidated balance sheets. The Company could incur charges to terminate the swap in the future if interest rates rise, or upon certain events such as a change in control or certain redemptions of convertible subordinated notes.

(10) Shareholders’ Equity

Common Stock and Convertible Subordinated Debt Repurchase

      In April 2001, the Company’s board of directors authorized the repurchase of up to $50,000,000 of its common stock. Subsequent to April 2001, the Company’s board of directors modified the authorization so that the remaining balance of the initial $50,000,000 authorization can be used for the repurchase of either debt or stock. There is no expiration date for this program. As of January 31, 2004, the Company had purchased 4.1 million shares of its common stock for $33.0 million under this authorization. No common stock was repurchased during fiscal 2004. In August of 2004, the Company repurchased $650,000 in principal amount of its convertible debt. The Company recognized a gain of $141,000 from its repurchase. The gain is included in other income in the consolidated statement of operations.

Rights Plan

      On July 24, 1998 the Company’s board of directors adopted a shareholders rights plan pursuant to which rights were distributed as a dividend at the rate of one preferred share purchase right for each outstanding share of common stock of the Company. The rights will expire on July 23, 2008 unless extended, earlier redeemed or exchanged by the Company.

Stock Options and Stock Awards

      The Company maintains stock option and restricted stock plans (the Plans) which provide for the grant of stock options, restricted stock and stock based awards to officers, other employees, consultants, and independent contractors as determined by the compensation committee of the board of directors. A maximum of 19,812,993 shares of common stock were issuable under the terms of the Plans as of January 31, 2005, of which no more than 7,980,000 shares may be issued as restricted stock or other stock based awards. As of January 31, 2005, there were 4,536,214 shares of common stock available for future grants under these plans.

      Restricted and deferred stock awards and units issued under the Plans are recorded at fair market value on the date of grant and generally vest over a two 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. Compensation cost for fixed awards with pro-rata vesting is recognized using the straight-line method. During fiscal 2004, 2003 and 2002, the Company issued 891,410, 25,000, and 5,000 restricted shares, respectively, having an aggregate weighted fair market value per share of $5.86, $7.33, and $14.15, respectively. During fiscal 2004, the Company issued restricted and deferred stock units for 201,053 shares with an aggregate weighted fair market value per share of $6.71. Compensation expense recognized for restricted and deferred stock awards and units in fiscal 2004, 2003 and 2002 was $1,292,000, $503,000, and $722,000, respectively.

      All stock options granted under the Plans have an exercise price equal to fair market value on the date of grant, vest and become exercisable over individually defined periods, generally four years, and expire ten years from the date of grant.

19

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      A summary of the status of the Company’s outstanding stock options and related changes for fiscal 2004, 2003 and 2002 is presented below:

	Years Ended January 31,
	2005					2004					2003
				Weighted					Weighted					Weighted
				Average					Average					Average
				Exercise					Exercise					Exercise
Options	Shares			Price		Shares			Price		Shares			Price
Outstanding at beginning of year		10,762		$	14.49		7,517		$	10.87		5,753		$	11.99
Converted Inrange options		—			—		2,235			35.72		—			—
Granted		1,230			7.46		2,279			6.58		2,970			8.52
Exercised		(58	)		5.30		(247	)		5.89		(231	)		5.26
Canceled		(2,163	)		14.18		(1,022	)		16.55		(975	)		11.59
Outstanding at end of year		9,771		$	13.61		10,762		$	14.49		7,517		$	10.87
Exercisable at end of year		6,559		$	16.52		6,072		$	19.25		3,028		$	11.80

      The following table summarizes information about stock options outstanding at January 31, 2005:

	Options Outstanding						Options Exercisable
			Weighted-
			Average
			Remaining		Weighted-				Weighted-
			Contractual		Average				Average
	Number		Life		Exercise		Number		Exercise
Range of Exercise Prices	Outstanding		(in years)		Price		Exercisable		Price
$ 2.88 — $ 4.99		1,294		6.2	$	4.53		720	$	4.47
$ 5.00 — $ 7.99		2,959		7.1	$	6.76		1,297	$	6.44
$ 8.00 — $ 9.99		1,729		5.7	$	9.04		1,288	$	9.02
$10.00 — $11.99		1,097		6.6	$	11.09		629	$	10.98
$12.00 — $20.99		897		4.7	$	15.96		834	$	16.04
$21.00 — $37.99		712		4.5	$	22.56		708	$	22.56
$38.00 — $66.29		1,083		5.3	$	45.20		1,083	$	45.20
		9,771						6,559

Employee Stock Purchase Plan

      The 1992 Employee Stock Purchase Plan (the Purchase Plan) allows eligible employees an opportunity to purchase an aggregate of 2,800,000 shares of the Company’s 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 5,000 shares of the Company’s common stock or more than $7,500 in aggregate fair market value of common stock (as defined) during any six-month purchase period. Common shares sold to employees under the Purchase Plan in fiscal 2004, 2003 and 2002 were 391,344, 283,497, and 346,982, respectively.

      The weighted-average fair value of each purchase right granted in fiscal 2004, 2003 and 2002 was $3.03, $2.72, and $4.41, respectively.

20

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(11)  Net Loss Per Share

      The components of net loss per basic and diluted share are as follows:

					Weighted
					Average Shares		Per Share
		Net loss			Outstanding		Amount
Years Ended January 31,
2005:
	Basic	$	(110,604	)		27,981	$	(3.95	)
	Dilutive effect of employee stock purchase awards and options and shares issuable upon the conversion of convertible subordinated debt		—			—		—
	Diluted	$	(110,604	)		27,981	$	(3.95	)
2004:
	Basic	$	(24,053	)		27,116	$	(0.89	)
	Dilutive effect of employee stock purchase awards and options and shares issuable upon the conversion of convertible subordinated debt		—			—		—
	Diluted	$	(24,053	)		27,116	$	(0.89	)
2003:
	Basic	$	(38,405	)		28,111	$	(1.37	)
	Dilutive effect of employee stock purchase awards and options and shares issuable upon the conversion of convertible subordinated debt		—			—		—
	Diluted	$	(38,405	)		28,111	$	(1.37	)

      The total weighted average number of common stock equivalents excluded from the calculation of net loss per share due to their anti-dilutive effect for fiscal 2004, 2003 and 2002 was 735,103, 1,420,456 and 567,761, respectively. The Company also excluded shares of common stock issuable upon conversion of the Company’s convertible subordinated debt from the calculation of net loss per share in fiscal 2004, 2003 and 2002 due to the anti-dilutive effect of the assumed conversion. The shares so excluded were 6,487,993 for fiscal 2004, and 6,521,900 for fiscal 2003 and 2002, respectively.

21

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(12) Income Taxes

      The components of income from continuing operations before income taxes and income tax expense (benefit) for each of the years in the three-year period ended January 31, 2005 consists of the following:

				Years Ended January 31,
				2005			2004			2003
Loss from continuing operations before income taxes:
	U.S.			$	(110,189	)	$	(20,555	)	$	(12,657	)
	Foreign				2,510			(2,404	)		640
			Total	$	(107,679	)	$	(22,959	)	$	(12,017	)
Income tax provision:
	Current:
		U.S.		$	165		$	—		$	—
		Foreign			1,385			1,473			533
		State			—			—			—
			Total current		1,550			1,473			533
	Deferred:
		U.S.			—			565			15,361
		Foreign			687			(1,413	)		—
		State			—			—			633
			Total deferred		687			(848	)		15,994
Total income tax expense				$	2,237		$	625		$	16,527

      The reconciliation of the statutory federal tax rate and the effective tax rate for each of the years in the three-year period ended January 31, 2005 is as follows:

		Years Ended January 31,
		2005			2004			2003
Statutory tax rate			(34.0	)%		(34.0	)%		(34.0	)%
Increase (decrease) in taxes resulting from:
	State taxes, net of federal tax benefit		(3.6	)		(3.2	)		(3.5	)
	Extraterritorial income and foreign sales corporation		—			(0.6	)		(0.8	)
	Meals and entertainment		0.1			0.6			0.6
	Valuation allowance		39.3			39.5			177.5
	Other		0.3			0.4			(2.3	)
Total			2.1	%		2.7	%		137.5	%

22

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The tax effects of temporary differences that give rise to significant portions of the Company’s deferred tax assets and (liabilities) as of January 31, 2005 and 2004 were as follows:

			Years Ended
			January 31,
			2005			2004
Deferred tax assets:
	Inventory		$	12,237		$	12,473
	Accrued compensation			1,129			1,726
	Allowance for doubtful accounts and sales returns			958			1,644
	Intangibles			41,726			7,409
	Tax credits			7,625			6,545
	Net operating loss carryforwards			29,983			14,643
	Property and equipment			—			1,617
	Other			1,202			240
	Total gross deferred tax assets			94,860			46,297
	Valuation allowance			(91,821	)		(44,591	)
		Net deferred tax assets		3,039			1,706
Deferred tax liabilities:
	Property and equipment			(1,976	)		—
	Other			(878	)		(834	)
	Total gross deferred tax liabilities			(2,854	)		(834	)
		Net deferred tax assets	$	185		$	872

      The valuation allowance for deferred tax assets as of January 31, 2005 and 2004 was $91,821,000, and $44,591,000, respectively. The net change in the total valuation allowance for the years ended January 31, 2005 and 2004 was an increase of $47,230,000, and $19,783,000, respectively. The increase in the valuation allowance during fiscal 2003 includes $10,198,000 related to the acquisition of Inrange.

      Significant management judgment is required in determining the valuation allowance recorded against gross deferred tax assets. The Company assesses the likelihood that its deferred tax assets will be recovered from future taxable income and, to the extent recovery is believed unlikely, establishes a valuation allowance. The Company must increase tax expense within its statements of operations when a valuation allowance is established or increased, without a corresponding increase in gross deferred tax assets in a given period.

      In fiscal 2002, the Company recorded a non-cash charge of $23,568,000 to provide a full valuation allowance for its United States deferred tax assets. The net deferred tax asset that still exists is attributable to foreign operations. The establishment of the valuation allowance does not impair the Company’s ability to use the deferred tax assets upon achieving profitability. As the Company generates taxable income in future periods, it does not expect to record significant income tax expense in the United States until it has utilized its net operating loss and credit carryforwards.

      As of January 31, 2005, the Company has U.S. net operating loss and credit carryforwards available to reduce taxable income in future years of approximately $72,159,000 and $7,625,000 respectively. If not used, the U.S. net operating loss carryforwards will expire between the years 2019 and 2024. The utilization of a portion of the Company’s U.S. net operating loss and credit carryforwards is subject to

23

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

annual limitations under Internal Revenue Code Section 382. Subsequent equity changes could further limit the utilization of these federal net operating loss and credit carryforwards. Foreign loss carryforwards of $10,000,000 at January 31, 2005 include loss carryforwards of $5,450,000 in Switzerland, $3,140,000 in the United Kingdom, $1,000,000 in France and $410,000 in Belgium.

      At January 31, 2005, there were approximately $1,300,000 of accumulated undistributed earnings of subsidiaries outside the United States that are considered to be reinvested indefinitely as of such date. Accordingly, no deferred tax liability has been provided on such earnings. If they were remitted to the Company, applicable U.S. federal and state income taxes would be substantially offset by available net operating loss carryforwards.

      The American Jobs Creation Act of 2004 (the “Act”), enacted in October 2004, created a one-time 85% dividends received deduction for qualifying repatriations of foreign earnings. No U.S. net operating loss carryforwards can be utilized against the remaining 15% qualifying dividend amount. Management has not yet begun a formal evaluation of the opportunity created by the Act. It anticipates that a formal evaluation of the repatriation provisions will be completed during the Company’s second quarter ended July 31, 2005. Accordingly, as of January 31, 2005, no decision to remit qualifying earnings to the U.S. had been made.

      The range of potential repatriation amounts is zero to $1,300,000 and the related income tax effect is zero to $70,000.

      In future years, the recognized tax benefits relating to the reversal of the valuation allowance for deferred tax assets as of January 31, 2005 will be recorded as follows:

	Total
Income tax benefit from continuing operations	$	81,366
Goodwill		10,198
Additional paid in capital		257
Total	$	91,821

(13)  401(k) and Deferred Compensation Plans

      The Company has a 401(k) salary savings plan which covers substantially all of its employees. The Company matches 100% of a participant’s annual plan contributions up to an annual maximum per participant of $2,500 which vests over a four-year period from the participant’s date of hire.

      The Company has also established an executive deferred compensation plan for selected key employees which allow participants to defer a substantial portion of their compensation each year. The Company matches 20% of a participant’s annual plan contributions up to an annual maximum per participant of $10,000. Matching contributions vest over a four-year period from the later of July 1, 1997 or the participant’s date of hire. In addition, the Company provides participants with an annual earnings credit based on the investment indexes selected by the participant prior to the start of each plan year.

      The Company’s expense under the 401(k) and deferred compensation plans for fiscal 2004, 2003 and 2002 was 1,921,000, $1,804,000, and $1,674,000, respectively.

(14)  Segment and Enterprise-Wide Information

      The Company operates as a single segment. The Company’s management reviews and makes decisions based on financial information for the consolidated business.

24

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      Summarized information regarding foreign operations follows:

			Years Ended January 31,
			Revenue						Loss from Operations
			2005		2004		2003		2005			2004			2003
	United States		$	243,866	$	232,784	$	153,235	$	(81,705	)	$	(21,059	)	$	(12,333	)
	United Kingdom			33,943		38,091		26,412		(16,919	)		(1,766	)		180
	France			8,464		10,392		6,072		(3,903	)		43			(48	)
	Germany			23,293		21,102		1,254		961			764			(190	)
	Other			56,736		52,348		24,542		(3,280	)		727			(495	)
		Total	$	366,302	$	354,717	$	211,515	$	(104,846	)	$	(21,291	)	$	(12,886	)
Long-lived assets (end of period):
	United States		$	92,256	$	170,872	$	30,554
	United Kingdom			3,344		17,246		13,709
	Other			1,969		2,574		94
		Total	$	97,569	$	190,692	$	44,357

      Revenue has been attributed to the country where the end-user customer is located.

      Summarized information regarding enterprise-wide revenue and gross margins from external customers are as follows:

			Years Ended January 31,
			2005		2004		2003
Revenue:
	Proprietary products		$	166,089	$	167,743	$	94,561
	Third party products			71,321		72,096		50,794
	Professional services			42,790		39,471		22,831
	Maintenance			86,102		75,407		43,329
		Total	$	366,302	$	354,717	$	211,515
Gross margins:
	Proprietary products		$	72,635	$	83,593	$	46,111
	Third party products			10,598		12,254		10,134
	Professional services			11,844		12,566		7,563
	Maintenance			40,627		36,662		20,387
		Total	$	135,704	$	145,075	$	84,195

      Gross margins represent the lowest available measure of enterprise-wide profitability by product line. Assets are not allocated to product lines.

      One customer accounted for 20%, 22% and 10% of the Company’s revenue in fiscal 2004, 2003 and 2002, respectively. One customer accounted for 14% of the Company’s revenue in fiscal 2004.

25

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(15)  Product Warranty

      The Company records a liability for warranty claims at the time of sale. The amount of the liability is based on contract terms and historical warranty loss expenses, which is periodically adjusted for recent actual experience. Warranty terms on the Company’s equipment range from 90 days to 13 months. The following is a roll forward of the Company’s product warranty accrual for each of the years in the three-year period ended January 31, 2005:

	Balance at				Charged to
Years Ended	Beginning		Acquisition		Cost of		Cost of			Balance at
January 31,	of Year		of Inrange		Product		Warranty			End of Year
2005	$	2,348		—		3,485		(3,804	)	$	2,029
2004	$	1,521		1,709		2,713		(3,595	)	$	2,348
2003	$	1,935		—		2,429		(2,843	)	$	1,521

(16)  Integration and Cost Reduction Accruals

      A significant part of the Company’s integration strategy related to the Inrange acquisition, included the termination of duplicative employees across most functional areas, and the closing of duplicative facilities to obtain cost synergies. Integration planning was initiated prior to the closing of the acquisition. Severance costs for terminated Inrange employees were treated as an acquired liability, effectively increasing the purchase price. Severance costs for terminated CNT employees of $1,440,000 were recorded as an expense in the statement of operations. The integration plan resulted in the termination of 165 employees, including employees of both CNT and Inrange. The duplicative facilities that were closed were part of the pre-acquisition Inrange business, and the accrual for future rents was treated as an acquired liability, effectively increasing the purchase price. The integration of product strategies for the new combined entity resulted in a $1,607,000 charge in fiscal 2003 to cost of products sold for the write-down of inventory that CNT had purchased prior to the acquisition. There have been no significant subsequent sales of this inventory.

      During 2004, the Company experienced a continued slow-down in the IT spending environment, competitive pressures and customers’ desire for more flexibility in financing terms, particularly for large investments, such as remote storage networking solutions. The Company also experienced a decline in traditional large-scale ESCON projects, while FICON extension, the new mainframe channel technology, has not grown as fast as anticipated. In fiscal 2004, the Company took actions to adjust its expense levels to reflect the current outlook for its markets, including reductions of approximately 220 employees and consultants, along with reductions in other discretionary expenses. The Company’s results for fiscal 2004 include charges of approximately $4,680,000 for severance, and $225,000 for facility closure costs.

      A summary of severance and facility accrual activity follows:

						Obligation							Obligation
	Accrual		Use			January 31, 2004		Accrual		Use			January 31, 2005
Inrange Integration Related:
Inrange severance	$	4,583	$	(4,300	)	$	283	$	—	$	(283	)	$	—
CNT severance	$	1,440	$	(1,206	)	$	234	$	—	$	(234	)	$	—
Duplicative facilities	$	7,441	$	(1,867	)	$	5,574	$	—	$	(2,033	)	$	3,541
2004 Cost Actions:
Severance	$	—	$	—		$	—	$	4,680	$	(3,989	)	$	691
Facility closure	$	—	$	—		$	—	$	225	$	(130	)	$	95

26

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The Inrange integration related obligation for duplicative facilities will be paid in various installments through 2013. The severance and facility closure obligations related to the 2004 cost actions will be paid in full by July 31, 2005.

      The charges for severance and product write-down in fiscal 2003 related to the Inrange integration and in fiscal 2004 for severance and facility closures related to cost reduction actions are reflected in the accompanying consolidated statement of operations for fiscal 2004 and 2003 as follows:

		Fiscal 2004		Fiscal 2003
Cost of product sales		$	—	$	2,152
Cost of service fees			1,519		199
Sales and marketing			2,217		608
Engineering and development			619		52
General and administrative			550		36
	Total	$	4,905	$	3,047

      In fiscal 2002, the Company recorded a $1,666,000 restructuring charge for severance from a reduction in workforce of 80 employees resulting from the integration of the Company’s former networking and storage solutions segments and professional fees related to canceled acquisition activity. Of this amount, approximately $1,300,000 was paid prior to January 31, 2003, with the balance being paid prior to April 30, 2003.

(17)  Noncash Financing and Investing Activities and Supplemental Cash Flow Information

      Cash payments for interest expense in fiscal 2004, 2003, 2002 were $4,057,000, $3,802,000 and $1,946,000, respectively.

      Cash payments for income taxes, net of refunds received, in fiscal 2004, 2003 and 2002 were $1,366,000, $2,051,000 and $3,535,000, respectively.

      During fiscal 2004 and 2003, the Company entered into capital lease obligations for equipment valued at $2,845,000 and $2,988,000, respectively. Also during fiscal year 2004 and 2003, the Company entered into capital leases to finance product sales totaling $3,104,000 and $3,724,000, respectively. The Company did not enter into any capital leases during fiscal 2002.

      During fiscal 2004, the Company issued 700,000 shares of its common stock valued at $2,968,000 to retire an earn-out obligation related to the BI-Tech acquisition.

(18) Disclosures about Fair Value of Financial Instruments

      The carrying amount for cash and cash equivalents, accounts receivable and capital lease obligations approximates fair value because of the short maturity of those instruments. Marketable securities are recorded at market value at January 31, 2005.

      At January 31, 2005, the Company’s 3% convertible subordinated notes due February 15, 2007 in the amount of $124,350,000 had a fair value of $107,414,000, based on a reported trading price of $86.38 per $100 in face amount of principal indebtedness.

(19) Related Party Transactions

      The Company’s CEO, Thomas G. Hudson has a son-in-law who is employed by the Company as an Account Executive. In fiscal 2004, he was paid $525,710 in compensation, commissions and bonuses.

27

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(20) Legal Proceedings

      Inrange Technologies Corporation, which is now a wholly owned subsidiary of the Company, has been named as a defendant in the case SBC Technology Resources, Inc. v. Inrange Technologies Corp., Eclipsys Corp. and Resource Bancshares Mortgage Group, Inc., No. 303-CV-418-N, pending in the United States District Court for the Northern District of Texas, Dallas Division (“the Litigation”). The Litigation was commenced on February 27, 2003. The Complaint claims that Inrange is infringing U.S. Patent No. 5,530,845 (“845 patent”) by manufacturing and selling storage area networking equipment, in particular the FC/9000, that is used in storage networks. The Complaint asks for judgment that the ‘845 patent is infringed by the defendants in the case, an accounting for actual damages, attorney’s fees, costs of suit and other relief. Inrange has answered the Complaint, denying SBC’s allegations. The case is in the discovery phase, and a claim construction of the asserted patent is pending. However, on or about February 1, 2005, SBC requested leave of court (i) to amend its Complaint to assert that the UltraNet Multi-service Director (“UMD”) infringes the ‘845 patent, and (ii) for a continuance of the trial to permit discovery and related proceedings concerning the UMD. The court has denied this motion. Management is evaluating the litigation. At this point, it is too early to form a definitive opinion concerning the ultimate outcome of this matter. Eclipsys Corp. (“Eclipsys”) settled with SBC for an undisclosed sum. Eclipsys has demanded that Inrange indemnify and defend Eclipsys pursuant to documentation under which it acquired certain allegedly infringing products from Inrange. Hitachi Data Systems Corporation (a non-party to the Litigation) has also informed Inrange that it received a demand from Eclipsys that Hitachi indemnify and defend Eclipsys in connection with the Litigation. Hitachi has put Inrange on notice that it will tender to Inrange any claim by Eclipsys for indemnification and defense of any aspect the Litigation. Inrange is evaluating the indemnification demands asserted by Eclipsys and Hitachi.

Shareholder Litigation

      Following the announcement of the proposed merger with McDATA, an action was commenced purporting to challenge the merger. The case, styled Jack Gaither v. Thomas G. Hudson et al. (File No. MC 05-003129) was filed in the District Court of Hennepin County, State of Minnesota. The complaint asserts claims on behalf of a purported class of CNT stockholders, and it names CNT and certain of its directors on claims of breach of fiduciary duty in connection with the merger on the grounds that the defendants allegedly failed to take appropriate steps to maximize the value of a merger transaction for CNT stockholders. Additionally, the plaintiff claims that the defendants have made insufficient disclosures in connection with the merger. The lawsuit is in its preliminary stages. At this point, it is too early to form a definitive opinion concerning the ultimate outcome of this matter. CNT and the directors intend to defend themselves vigorously in respect of the claims asserted.

IPO Litigation

      A shareholder class action was filed against Inrange and certain of its officers on November 30, 2001, in the United States District Court for the Southern District of New York, seeking recovery of damages caused by Inrange’s alleged violation of securities laws, including section 11 of the Securities Act of 1933 and section 10(b) of the Exchange Act of 1934. The complaint, which was also filed against the various underwriters that participated in Inrange’s initial public offering (IPO), is identical to hundreds of shareholder class actions pending in this court in connection with other recent IPOs and is generally referred to as In re Initial Public Offering Securities Litigation. The complaint alleges, in essence, (a) that the underwriters combined and conspired to increase their respective compensation in connection with the IPO by (i) receiving excessive, undisclosed commissions in exchange for lucrative allocations of IPO shares, and (ii) trading in Inrange’s stock after creating artificially high prices for the stock post-IPO through “tie-in” or “laddering” arrangements (whereby recipients of allocations of IPO shares agreed to

28

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

purchase shares in the aftermarket for more than the public offering price for Inrange shares) and dissemination of misleading market analysis on Inrange’s prospects; and (b) that Inrange violated federal securities laws by not disclosing these underwriting arrangements in its prospectus. The defense has been tendered to the carriers of Inrange’s director and officer liability insurance, and a request for indemnification has been made to the various underwriters in the IPO. At this point the insurers have issued a reservation of rights letter and the underwriters have refused indemnification. The court has granted Inrange’s motion to dismiss claims under section 10(b) of the Securities Exchange Act of 1934 because of the absence of a pleading of intent to defraud. The court granted plaintiffs leave to replead these claims, but no further amended complaint has been filed. The court denied Inrange’s motion to dismiss claims under section 11 of the Securities Act of 1933. The court has also dismissed Inrange’s individual officers without prejudice, after they entered into a tolling agreement with the plaintiffs. On July 25, 2003, the Company’s board of directors conditionally approved a proposed partial settlement with the plaintiffs in this matter. The settlement would provide, among other things, a release of Inrange and of the individual defendants for the conduct alleged in the action to be wrongful in the complaint. Inrange would agree to undertake other responsibilities under the partial settlement, including agreeing to assign away, not assert, or release certain potential claims Inrange may have against its underwriters. Any direct financial impact of the proposed settlement is expected to be borne by Inrange’s insurers. In June 2004, an agreement of settlement was submitted to the court for preliminary approval. The underwriters objected to the proposed settlement and the plaintiffs and issuer defendants separately filed replies to the underwriter defendants’ objections. The court granted the preliminary approval motion on February 15, 2005, subject to certain modifications. If the parties are able to agree upon the required modifications, and such modifications are acceptable to the court, notice will be given to all class members of the settlement, a “fairness” hearing will be held and if the court determines that the settlement is fair to the class members, the settlement will be approved. There can be no assurance that this proposed settlement would be approved and implemented in its current form, or at all.

(21) Proposed Merger with McData

      On January 17, 2005, Computer Network Technology Corporation, entered into a definitive agreement to be merged with a wholly-owned subsidiary of McDATA Corporation (“McDATA”). The Company believes the proposed merger will create a combined company that will establish a leading position in enterprise storage networking, encompassing world-class products, services and software. Under the terms of the agreement, the Company will be merged into a wholly-owned subsidiary of McDATA, and the Company will survive the merger as a wholly owned subsidiary of McDATA. Each issued and outstanding share of common stock of the Company will be converted into the right to receive 1.3 shares of McDATA Class A common stock, together with cash in lieu of fractional shares. Consummation of the merger is subject to satisfaction of significant conditions, and there can be no assurance the merger will be consummated. The joint proxy statement/ prospectus is filed as part of a registration statement on Form S-4 (Registration No. 333-122758) filed with the SEC and available at the SEC’s internet site www.sec.gov. In several circumstances involving a change in the Company’s board’s recommendation in favor of the merger agreement, breaches of certain provisions of the merger agreement or a third party acquisition proposal, the Company may become obligated to pay McDATA up to $11 million in termination fees. In other circumstances, the Company must reimburse McDATA for expenses incurred in connection with the merger. On February 14, 2005, early termination of the waiting period under Hart-Scott-Rodino Antitrust Improvement Act was granted for the proposed merger transaction.

(22)     Restatement of Fiscal 2004 Quarterly Earnings — (unaudited)

      On March 7, 2005, the Company’s management, after consultation with the Audit Committee of the Company’s Board of Directors, determined that the Company’s consolidated financial statements for the

29

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

first fiscal quarter ended April 30, 2004, second fiscal quarter ended July 31, 2004 and third fiscal quarter ended October 31, 2004 should no longer be relied upon, including the consolidated financial statements and other financial information in the Form 10-Qs filed for those quarters. The determination was made as a result of errors discovered when reconciling offsite finished goods inventory between the general ledger and the Company’s materials requirement planning, or MRP, system. The Company believes the errors began to occur in February 2004 when the Company transitioned manufacturing of certain products from its Plymouth, Minnesota headquarters to its facility in Lumberton, New Jersey. As a result of the transition, there were procedural changes for the tracking and recording of certain offsite finished goods inventory that resulted in inventory items for certain transactions being double counted. The effect of the errors was to overstate inventory and understate cost of goods sold and operating expenses in the first, second and third quarters of fiscal 2004 by $499,000, $408,000 and $538,000, respectively.

      Statements of operations previously reported in the first, second and third quarters of fiscal 2004 in Form 10-Q are restated as follows:

		Year Ended January 31, 2005
		First			First			Second			Second			Third			Third
		Quarter			Quarter			Quarter			Quarter			Quarter			Quarter
		($ in thousands, except per share data)
2004		(Reported)			(Restated)			(Reported)			(Restated)			(Reported)			(Restated)
Revenue		$	96,237		$	96,237		$	77,164		$	77,164		$	88,952		$	88,952
Gross profit			37,300			36,749			31,956			31,496			25,587			24,997
Loss from operations			(3,085	)		(3,584	)		(10,108	)		(10,516	)		(89,655	)		(90,193	)
Income (loss) from discontinued operations, net of tax			(343	)		(343	)		(370	)		(370	)		25			25
Net loss			(4,526	)		(5,025	)		(12,139	)		(12,547	)		(90,326	)		(90,864	)
Net loss per share:
	Basic and Diluted		(0.16	)		(0.18	)		(0.44	)		(0.45	)		(3.19	)		(3.21	)

(23)     Quarterly Financial Data (unaudited)

		Year Ended January 31, 2005
		First			Second			Third			Fourth
		Quarter			Quarter			Quarter			Quarter
		($ in thousands, except per share data)
2004(1)		(Restated)			(Restated)			(Restated)
Revenue		$	96,237		$	77,164		$	88,952		$	103,949
Gross profit			36,749			31,496			24,997			42,462
Loss from operations			(3,584	)		(10,516	)		(90,193	)		(553	)
Income (loss) from discontinued operations, net of tax			(343	)		(370	)		25			—
Net loss			(5,025	)		(12,547	)		(90,864	)		(2,168	)
Net loss per share:
	Basic and Diluted		(0.18	)		(0.45	)		(3.21	)		(0.08	)

30

COMPUTER NETWORK TECHNOLOGY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

		Year Ended January 31, 2004
		First			Second			Third			Fourth
		Quarter			Quarter			Quarter			Quarter
2003		($ in thousands, except per share data)
Revenue		$	52,330		$	94,879		$	97,333		$	110,175
Gross profit			20,610			37,250			41,897			45,318
Income (loss) from operations			(2,072	)		(24,378	)		1,372			3,787
Income (loss) from discontinued operations, net of tax			—			(437	)		(388	)		356
Net income (loss)			(2,082	)		(25,822	)		237			3,614
Net income (loss) per share:
	Basic		(0.08	)		(0.96	)		0.01			0.13
	Diluted		(0.08	)		(0.96	)		0.01			0.12

31

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders

Computer Network Technology Corporation:

      We have audited the accompanying consolidated balance sheets of Computer Network Technology Corporation and subsidiaries as of January 31, 2005 and 2004, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended January 31, 2005. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule for each of the years in the three-year period ended January 31, 2005, listed in Item 15 (a) (2) of this Form 10-K. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

      We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

      In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Computer Network Technology Corporation and subsidiaries as of January 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended January 31, 2005, in conformity with U.S. generally accepted accounting principles. In addition, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

      We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Computer Network Technology Corporation’s internal control over financial reporting as of January 31, 2005, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated April 11, 2005 expressed an unqualified opinion on management’s assessment of, and an adverse opinion on the effective operation of, internal control over financial reporting.

/s/ KPMG LLP

Minneapolis, Minnesota

April 11, 2005

32

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders

Computer Network Technology Corporation:

      We have audited management’s assessment, included in the accompanying “Management’s Report on Internal Control over Financial Reporting as of January 31, 2005” (Item 9A.a), that Computer Network Technology Corporation did not maintain effective internal control over financial reporting as of January 31, 2005, because of the effects of inadequate procedures to reconcile the Company’s offsite finished goods inventory to the general ledger and inadequate information technology access controls, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Computer Network Technology Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

      We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

      A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

      Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

      A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment as of January 31, 2005:

•  Procedures reconciling the Company’s offsite finished goods inventory to the general ledger were not adequate to ensure that the general ledger amounts represented actual offsite finished goods inventory. Specifically, the Company’s personnel were not adequately trained in the Company’s policies and procedures for physical tracking and recording changes to offsite finished goods inventory. This deficiency in internal control resulted in material misstatements of finished goods inventory and cost of products sold and operating expenses as of January 31, 2005. As a result, the Company recorded an adjustment to the accompanying consolidated financial statements. In addition, the Company restated its interim financial information as of and for the fiscal quarters

33

	ended April 30, July 31 and October 31, 2004 to correct material misstatements in those periods resulting from this material weakness in internal control over financial reporting.
•	The Company’s information technology access controls were not designed to prevent Company personnel from accessing inventory accounting information and initiating erroneous accounting entries affecting amounts recorded as finished goods inventory. Specifically, this deficiency contributed to the aforementioned material misstatements in the Company’s interim and annual financial information.

      We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Computer Network Technology Corporation and subsidiaries as of January 31, 2005 and 2004 and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended January 31, 2005, and the related financial statement schedule. The aforementioned material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the January 31, 2005 consolidated financial statements, and this report does not affect our report dated April 11, 2005 which expressed an unqualified opinion on those consolidated financial statements and the related financial statement schedule.

      In our opinion, management’s assessment that Computer Network Technology Corporation did not maintain effective internal control over financial reporting as of January 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, Computer Network Technology Corporation has not maintained effective internal control over financial reporting as of January 31, 2005, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

/s/ KPMG LLP

Minneapolis, Minnesota

April 11, 2005

34 EX-99.3 7 f30417exv99w3.htm EXHIBIT 99.3

Exhibit 99.3

COMPUTER NETWORK TECHNOLOGY CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)

	Three months ended
	April 30,
	2005			2004
				(Restated –
				Note 14)
Revenue:
Product sales	$	52,504		$	63,675
Service fees		31,534			32,562
Total revenue		84,038			96,237
Cost of revenue:
Cost of product sales		34,959			38,726
Cost of service fees		18,059			20,762
Total cost of revenue		53,018			59,488
Gross profit		31,020			36,749
Operating expenses:
Sales and marketing		21,265			23,708
Engineering and development		11,604			13,123
General and administrative		4,835			3,502
Total operating expenses		37,704			40,333
Loss from operations		(6,684	)		(3,584	)
Other income (expense):
Interest expense		(1,393	)		(1,032	)
Interest and other income, net		171			210
Other (expense), net		(1,222	)		(822	)
Loss before income taxes		(7,906	)		(4,406	)
Provision for income taxes		488			275
Loss from continuing operations		(8,394	)		(4,681	)
Discontinued operations, net of tax		—			(344	)
Net loss	$	(8,394	)	$	(5,025	)
Basic and diluted income (loss) per share:
Continuing operations	$	(.29	)	$	(.17	)
Discontinued operations	$	—		$	(.01	)
Net loss	$	(.29	)	$	(.18	)
Shares		28,615			27,598

See accompanying notes to Condensed Consolidated Financial Statements

1

COMPUTER NETWORK TECHNOLOGY CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
(unaudited)

	April 30,			January 31,
	2005			2005
				(Restated –
				Note 14)
Assets
Current assets:
Cash and cash equivalents	$	45,416		$	32,481
Marketable securities		16,280			21,728
Receivables, net		83,632			96,327
Inventories		31,993			29,871
Other current assets		4,848			5,348
Total current assets		182,169			185,755
Property and equipment, net		37,463			40,056
Field support spares, net		9,873			10,022
Goodwill		31,769			31,769
Other intangibles, net		14,833			15,722
Deferred tax asset		187			185
Other assets		12,253			12,079
	$	288,547		$	295,588
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	36,891		$	36,459
Accrued liabilities		32,229			33,714
Deferred revenue		55,966			53,219
Current installments of obligations under capital lease		2,999			3,092
Total current liabilities		128,085			126,484
Obligations under capital lease, less current installments		4,421			4,952
Interest rate swap		1,561			787
Convertible subordinated debt		122,789			123,563
Total liabilities		256,856			255,786
Shareholders’ equity:
Common stock, $.01 par value; authorized 100,000 shares, issued and outstanding 29,520 at April 30, 2005 and 29,487 at January 31, 2005		295			295
Additional paid-in capital		199,241			199,380
Unearned compensation		(4,785	)		(5,461	)
Accumulated deficit		(165,997	)		(157,603	)
Accumulated other comprehensive income		2,937			3,191
Total shareholders’ equity		31,691			39,802
	$	288,547		$	295,588

See accompanying notes to Condensed Consolidated Financial Statements

2

COMPUTER NETWORK TECHNOLOGY CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

	Three months ended
	April 30,
	2005			2004
				(Restated –
				Note 14)
Operating Activities:
Net loss	$	(8,394	)	$	(5,025	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		6,470			7,251
Non-cash compensation expense		529			149
Changes in deferred taxes		(2	)		—
Changes in operating assets and liabilities:
Receivables		12,665			25,484
Inventories		(2,122	)		211
Other current assets		500			(1,132	)
Accounts payable		432			(10,353	)
Accrued liabilities		(1,485	)		(3,561	)
Deferred revenue		2,747			359
Cash provided by operating activities		11,340			13,383
Investing Activities:
Additions to property and equipment		(1,679	)		(4,811	)
Additions to field support spares		(1,160	)		(2,094	)
Net redemption (purchase) of marketable securities		5,448			(4,692	)
Other assets		(174	)		(2,347	)
Cash provided by (used in) investing activities		2,435			(13,944	)
Financing Activities:
Proceeds from issuance of common stock		8			228
Repayments of obligations under capital leases		(624	)		(777	)
Cash used in financing activities		(616	)		(549	)
Effects of exchange rate changes		(224	)		(666	)
Net increase (decrease) in cash and cash equivalents		12,935			(1,776	)
Cash and cash equivalents— beginning of period		32,481			75,267
Cash and cash equivalents— end of period	$	45,416		$	73,491

See accompanying notes to Condensed Consolidated Financial Statements

3

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS EXCEPT SHARE AND PER SHARE AMOUNTS)

(1) BASIS OF PRESENTATION

     The accompanying condensed consolidated financial statements have been prepared in accordance with instructions to Form 10-Q and do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. These consolidated financial statements should be read in conjunction with the condensed consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 31, 2005 as filed with the Securities and Exchange Commission. References to fiscal 2005 and 2004 represent the twelve months ended January 31, 2005 and 2004, respectively.

Recent Accounting Pronouncements

     In December 2004, the Financial Accounting Standards Board (FASB) issued a revision of Statement of Financial Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” (SFAS No. 123R). SFAS No. 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance. SFAS No. 123R establishes standards for the accounting for transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. SFAS No. 123R does not change the accounting guidance for share-based payment transactions with parties other than employees provided in SFAS No. 123 as originally issued and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” Originally, SFAS No. 123R was effective for interim reporting period that begins after June 15, 2005. In April, 2005, SEC announced the deferral of the required effective date. The SEC rule provides that SFAS 123R is now effective for registrants as of the beginning of the first fiscal year beginning after June 15, 2005. The Company is in the process of determining the effect that adopting SFAS No. 123R will have on its financial position, results of operations, or cash flows.

On March 7, 2005, FASB released Proposed FASB Staff Positions (FSP) No. 143-a, “Accounting for Electronic Equipment Waste Obligations.” The proposed FSP addresses accounting by commercial users and producers of electrical and electronic equipment, in connection with Directive 2002/96/EC on Waste Electrical and Electronic Equipment issued by the European Union on February 13, 2003 (Directive). This Directive requires EU-member countries to adopt legislation to regulate the collection, treatment, recovery, and environmentally sound disposal of electrical and electronic waste equipment, and sets forth certain obligations relating to covering the cost of disposal of such equipment by commercial users. Producers will also be required to cover the cost of disposal of such equipment by private household users. The proposed FSP sets forth accounting for such obligations by commercial users and producers, with respect to SFAS No. 143, “Asset Retirement Obligations.” The Company has not yet determined the effect, if any, of the proposed FSP on its financial position, results of operations, or cash flows.

(2) MARKETABLE SECURITIES

     The Company’s investments in marketable securities primarily consist of U.S. government and agency securities, corporate debt securities and bank certificates of deposit. The Company also holds trading securities consisting of various mutual funds. The Company intends to use any gain or loss from these investments to fund the investments gains and losses allocated to participants under the Company’s executive deferred compensation plan.

(3) INVENTORIES

     Inventories, stated at the lower of cost (first-in, first-out method) or market, consist of:

	April 30,		January 31,
	2005		2005
Inventories:
Components and subassemblies	$	17,574	$	16,538
Work in process		648		1,576
Finished goods		13,771		11,757
	$	31,993	$	29,871

4

(4) INTANGIBLE ASSETS

     The components of other amortizable intangible assets are as follows:

	April 30, 2005					January 31, 2005
	Gross Carrying		Accumulated			Gross Carrying		Accumulated
	Amount		Amortization			Amount		Amortization
Customer relationships	$	16,924	$	(4,847	)	$	16,924	$	(4,259	)
Trademarks		4		(3	)		4		(2	)
Developed technology		3,606		(851	)		3,606		(551	)
Non-compete agreements		250		(250	)		250		(250	)
Total	$	20,784	$	(5,951	)	$	20,784	$	(5,062	)
Total other intangible assets, net	$	14,833				$	15,722

     Amortization expense for intangible assets during the first quarter of 2005 was $.9 million. Amortization expense for the remainder of 2005 is estimated to be $2.7 million. Amortization expense is estimated to be $3.5 million in 2006, $3.0 million in 2007 and $2.3 million in 2008 and 2009.

(5) COMPREHENSIVE LOSS

     Comprehensive loss consists of the following:

	Three months
	ended
	April 30,
	2005			2004
Net loss	$	(8,394	)	$	(5,025	)
Unrealized loss on marketable securities, net of tax effect of $0		(102	)		—
Foreign currency translation adjustment, net of tax effect of $0		(152	)		(845	)
Total comprehensive loss	$	(8,648	)	$	(5,870	)

(6) CONVERTIBLE SUBORDINATED DEBT

     In February 2002, the Company sold $125 million of 3% convertible subordinated notes due February 15, 2007, raising net proceeds of $121.6 million. The notes are convertible into the Company’s common stock at a price of $19.17 per share. The Company may redeem the notes upon payment of the outstanding principal balance, accrued interest and a make whole payment if the closing price of its common stock exceeds 175% of the conversion price for at least 20 consecutive trading days within a period of 30 consecutive trading days ending on the trading day prior to the date the redemption notice is mailed. The make whole payment represents additional interest payments that would be made if the notes were not redeemed prior to the due date.

Original debt issuance costs of $3,441,000 are being amortized to interest expense on a straight-line basis, which approximates the effective interest method. At April 30, 2005, the remaining debt issuance costs, net of accumulated amortization, were $1,241,000.

     In January 2004, the Company entered into an interest-rate swap agreement with a notional amount of $75 million that has the economic effect of modifying that dollar portion of the fixed interest obligations associated with $75 million of its 3% convertible subordinated notes due February 2007, such that the interest payable effectively becomes variable based on the three month LIBOR plus 69.5 basis points. The payment dates of the swap are January 31^st, April 30^th, July 31^st and October 31^st of each year, commencing April 30, 2004, until maturity on February 15, 2007. On February 1, 2005, the LIBOR setting was 2.73% creating a combined effective rate of 3.425% which was effective until April 30, 2005. On May 1, 2005, the LIBOR setting was reset to 3.19%, creating a combined effective rate of 3.885% which is effective until July 31, 2005. 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. Fair value hedge accounting is provided only if the hedging instrument is expected to be, and actually is, effective at offsetting changes in the value of the hedged item. At April 30, 2005, the fair value of the interest rate swap had decreased from inception to $1,561,000 and is included in other long-term liabilities. Corresponding to this decline, the carrying value of the notes has decreased by $1,561,000.

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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 $3,825,000 at April 30, 2005, and has been classified as other long-term assets in the accompanying condensed consolidated balance sheets. The Company could incur charges to terminate the swap in the future if interest rates rise, or upon certain events such as a change in control or certain redemptions of convertible subordinated notes.

     In April 2001, our board of directors authorized the repurchase of up to $50.0 million of our common stock. Subsequent to April 2001, our board changed the authorization so that the remaining balance of the initial $50 million authorization can be used for the repurchase of either debt or stock. As of January 31, 2005, we had repurchased 4.1 million shares of our common stock and $650,000 in principal amount of our convertible subordinated indebtedness for $33.5 million under this authorization. No common stock or convertible subordinated debt was repurchased during the three months ended April 30, 2005.

(7) STOCK-BASED COMPENSATION

     No stock options were granted during the three months ended April 30, 2005. The estimated per share weighted average fair value of all stock options granted during the three months ended April 30, 2004 was $5.92. The fair value of each option grant was estimated using the Black-Scholes option pricing model with the following weighted average assumptions:

	Three months ended
	April 30,
	2005			2004
Risk free interest rate		4.15	%		3.08	%
Expected life		5.50			5.73
Expected volatility		91.77	%		94.59	%

     Had the Company recorded compensation cost for its stock options based on the estimated fair value on the date of grant, as defined by SFAS 123, the Company’s pro forma net loss would have been as follows:

	Three months
	ended
	April 30,
	2005			2004
Net loss, as reported	$	(8,394	)	$	(5,025	)
Deduct: Total stock-based employee compensation expense under fair value based method of all awards, net of tax of $0		(1,055	)		(2,810	)
Pro forma net loss	$	(9,449	)	$	(7,835	)
Basic & diluted net loss per share:
As reported	$	(.29	)	$	(.18	)
Pro forma	$	(.33	)	$	(.28	)

(8) WARRANTY

     The Company records a liability for warranty claims at the time of sale. The amount of the liability is based on contract terms and historical warranty costs, which is periodically adjusted for recent actual experience. Warranty terms on the Company’s equipment range from 90 days to 13 months. The changes in warranty reserve balances for the three months ended April 30, 2005 and 2004 were as follows:

	April 30,
	2005			2004
Beginning balance	$	2,029		$	2,348
Charged to cost of product		609			1,010
Cost of warranty		(793	)		(892	)
Ending balance	$	1,845		$	2,466

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(9) DISCONTINUED OPERATIONS

     In connection with the acquisition of Inrange, the Company acquired a non-complementary business focused on enterprise resource planning (ERP) consulting services. In April 2004, substantially all of the business and its net assets totaling approximately $1.7 million were sold for installment payments having a discounted value of approximately $1.2 million. The business was divested to allow the Company to focus on its core storage networking solutions business. Revenue and expense for the ERP business in the first three months of 2004 totaled approximately $2.5 million and $2.8 million, respectively. The business has been accounted for as a discontinued operation in the accompanying condensed consolidated financial statements, meaning that its revenues and expenses are not included in results from continuing operations, and the net income/(loss) of the ERP business was included under the discontinued operations caption in the statement of operations.

(10) ENTERPRISE-WIDE INFORMATION

     Summarized information regarding enterprise-wide revenue and gross margins from external customers are as follows:

	Three months
	ended
	April 30,
	2005		2004
Revenue:
Proprietary products	$	30,317	$	38,511
Third party products		22,186		25,164
Professional services		10,771		11,604
Maintenance		20,764		20,958
Total	$	84,038	$	96,237
Gross margins:
Proprietary products	$	14,470	$	20,821
Third party products		3,074		4,128
Professional services		4,486		2,335
Maintenance		8,990		9,465
Total	$	31,020	$	36,749

(11) INTEGRATION AND COST REDUCTION ACCRUALS

     During 2004, the Company experienced a continued slow-down in the IT spending environment, competitive pressures and customers’ desire for more flexibility in financing terms, particularly for large investments, such as remote storage networking solutions. The Company also experienced a decline in traditional large-scale ESCON projects, while FICON extension, the new mainframe channel technology, has not grown as fast as anticipated. In the third quarter of fiscal 2004, the Company took actions to adjust its expense levels to reflect the current outlook for its markets, including reductions of approximately 220 employees and consultants, along with reductions in other discretionary expenses. The duplicative facilities that were closed were part of the pre-acquisition Inrange business, and the accrual for future rents was treated as an acquired liability, effectively increasing the purchase price.

     A summary of severance and facility accrual activity follows:

	Obligation						Obligation
	As of						As of
	January 31,		New				April 30,
	2005		Accrual		Utilization		2005
2004 Cost Reduction Actions:
Severance	$	691		—		12	$	679
Facility closure	$	95		—		70	$	25
Facility closures related to Inrange acquisition	$	3,541		—		384	$	3,157

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(12) LITIGATION

Eclipsys Indemnification Claim

Inrange Technologies Corporation, which was a wholly owned subsidiary of CNT, had been named as a defendant in the case SBC Technology Resources, Inc. v. Inrange Technologies Corp., Eclipsys Corp. and Resource Bancshares Mortgage Group, Inc., No. 303-CV-418-N, that was pending in the United States District Court for the Northern District of Texas, Dallas Division (the SBC Patent Litigation). The SBC Patent Litigation was commenced on February 27, 2003. The complaint claimed that Inrange was infringing U.S. Patent No. 5,530,845 (845 patent) by manufacturing and selling storage area networking equipment, in particular the FC/9000, that is used in storage networks. On May 31, 2005, Inrange and SBC Laboratories, Inc. (f/k/a SBC Technology Resources, Inc.) entered into a Settlement Agreement settling the SBC Patent Litigation on confidential terms that included a license to the 845 patent, and the case was dismissed with prejudice. Eclipsys Corp. (Eclipsys) had settled earlier with SBC Technology Resources, Inc. for an undisclosed sum without the consent of Inrange. Eclipsys has demanded that Inrange indemnify Eclipsys pursuant to alleged documentation under which it purportedly acquired certain allegedly infringing products from Inrange. Hitachi Data Systems Corporation (a non-party to the SBC Patent Litigation) has also informed Inrange that it received a demand from Eclipsys that Hitachi indemnify Eclipsys in connection with the SBC Patent Litigation. Hitachi notified Inrange that it would tender to Inrange any claim by Eclipsys for indemnification of any aspect of the litigation. Based on current information, Inrange believes that the indemnification demands of Eclipsys and Hitachi are without merit. Accordingly, McDATA intends to vigorously defend against any claims, if made, by Eclipsys or Hitachi for indemnification.

Shareholder Litigation

      Following the announcement of the proposed merger with McDATA, an action was commenced purporting to challenge the merger. The case, styled Jack Gaither v. Thomas G. Hudson et al. (File No. MC 05-003129) was filed in the District Court of Hennepin County, State of Minnesota. The complaint asserts claims on behalf of a purported class of CNT stockholders, and it names CNT and certain of its directors on claims of breach of fiduciary duty in connection with the merger on the grounds that the defendants allegedly failed to take appropriate steps to maximize the value of a merger transaction for CNT stockholders. Additionally, the plaintiff claims that the defendants made insufficient disclosures in connection with the merger. Defendants have denied the claims and have asserted numerous defenses. To avoid the costs and inherent risks of litigation, the Company and the plaintiff have entered into a memorandum of understanding with respect to a proposed settlement of the matter. Any settlement is subject to a number of conditions, including execution of definitive documentation and court approval. The Company does not believe the settlement, if it becomes final, will have a material effect on its financial position. However, there can be no assurance that this proposed settlement will be approved and implemented in its current form, or at all.

Inrange’s IPO Laddering Class Action Lawsuits

A shareholder class action was filed against Inrange and certain of its officers on November 30, 2001, in the United States District Court for the Southern District of New York, seeking recovery of damages caused by Inrange’s alleged violation of securities laws, including section 11 of the Securities Act of 1933 and section 10(b) of the Exchange Act of 1934. The complaint, which was also filed against the various underwriters that participated in Inrange’s initial public offering (IPO), is identical to hundreds of shareholder class actions pending in this court in connection with other recent IPOs and is generally referred to as In re Initial Public Offering Securities Litigation. The complaint alleges, in essence, (a) that the underwriters combined and conspired to increase their respective compensation in connection with the IPO by (i) receiving excessive, undisclosed commissions in exchange for lucrative allocations of IPO shares, and (ii) trading in Inrange’s stock after creating artificially high prices for the stock post-IPO through “tie-in” or “laddering” arrangements (whereby recipients of allocations of IPO shares agreed to purchase shares in the aftermarket for more than the public offering price for Inrange shares) and dissemination of misleading market analysis on Inrange’s prospects; and (b) that Inrange violated federal securities laws by not disclosing these underwriting arrangements in its prospectus. The defense has been tendered to the carriers of Inrange’s director and officer liability insurance, and a request for indemnification has been made to the various underwriters in the IPO. At this point, the insurers have issued a reservation of rights letter and the underwriters have refused indemnification. The court has granted Inrange’s motion to dismiss claims under section 10(b) of the Securities Exchange Act of 1934 because of the absence of a pleading of intent to defraud. The court granted plaintiffs leave to replead these claims, but no further amended complaint has been filed. The court denied Inrange’s motion to dismiss claims under section 11 of the Securities Act of 1933. The court has also dismissed Inrange’s individual officers without prejudice, after they entered into a tolling agreement with the plaintiffs. On July 25, 2003, Inrange’s board of directors conditionally approved a proposed partial settlement with the plaintiffs in this matter. The settlement would provide, among other things, a release of Inrange and of the individual defendants for the conduct alleged in the action to be wrongful in the complaint. Inrange would agree to undertake other responsibilities under the partial settlement, including agreeing to assign away, not assert, or release certain potential claims Inrange may have against its underwriters. Any direct financial impact of the proposed settlement is expected to be borne by Inrange’s insurers. In June 2004, an agreement of settlement was submitted to the court for preliminary approval. On August 31, 2005, the court preliminarily approved the proposed

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settlement. A fairness hearing will be held in 2006 before any final settlement is approved, if at all. Until the settlement is effective, management intends to defend against this consolidated proceeding vigorously.

State of Connecticut Tax Audit of Inrange

The audit division of the State of Connecticut Department of Revenue Services (Audit Division) has proposed adjustments to the Connecticut income tax returns for Inrange for the years ended December 31, 1996, through December 31, 1999. The proposed adjustments, in the amount of $433,995 plus interest, relate to (1) gain from a stock sale following the exercise of warrants, and whether Inrange had sufficient nexus with Connecticut to subject the gain to Connecticut taxation, and (2) the availability of claimed credits for certain research and development expenditures, and whether Inrange has provided sufficient documentation to support the claimed credits. Inrange made a written offer to settle the matter, which was rejected by the Audit Division. Inrange has formally appealed the matter and has posted a $750,000 appeal bond to avoid the accrual of additional interest.

(13) MERGER WITH MCDATA

     On January 17, 2005, Computer Network Technology Corporation, entered into a definitive agreement to be merged with a wholly-owned subsidiary of McDATA Corporation (“McDATA”). On June 1, 2005, under the terms of the agreement, the Company was merged into a wholly-owned subsidiary of McDATA. Each issued and outstanding share of common stock of the Company was converted into the right to receive 1.3 shares of McDATA Class A common stock, together with cash in lieu of fractional shares.

(14) RESTATEMENT OF FISCAL 2004 QUARTERLY EARNINGS

     On March 7, 2005, the Company’s management, after consultation with the Audit Committee of the Company’s Board of Directors, determined that the Company’s consolidated financial statements for the first fiscal quarter ended April 30, 2004, second fiscal quarter ended July 31, 2004 and third fiscal quarter ended October 31, 2004 should no longer relied upon, including the consolidated financial statements and other financial information in the Form 10-Qs filed for those quarters. The determination was made as a result of errors discovered when reconciling offsite finished goods inventory between the general ledger and the Company’s materials requirement planning, or MRP, system. The Company believes the errors began to occur in February 2004 when the Company transitioned manufacturing of certain products from its Plymouth, Minnesota headquarters to its facility in Lumberton, New Jersey. As a result of the transition, there were procedural changes for the tracking and recording of certain offsite finished goods inventory that resulted in inventory items for certain transactions being doubled counted. The effect of the errors was to overstate inventory and understate cost of goods sold and operating expenses in the first, second and third quarters of fiscal 2004 by $499,000, $408,000 and $538,000, respectively.

     The statement of operations previously reported in the first quarter of fiscal 2004 in Form 10-Q has been restated as follows:

	Quarter Ended April 30, 2004
	(As reported)			(Restated)
Revenue	$	96,237		$	96,237
Gross profit		37,300			36,749
Loss from operations		(3,085	)		(3,584	)
Loss from discontinued operations, net of tax		(343	)		(344	)
Net loss		(4,526	)		(5,025	)
Net loss per share: Basic and Diluted		(0.16	)		(0.18	)

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EX-99.3

exv99w3