UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended April 30, 2006

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

For the transition period from to

Commission File Number 000-31257

McDATA CORPORATION

(Exact name of registrant as specified in its charter)


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

11802 Ridge Parkway, Broomfield, Colorado 80021

(Address of principal executive offices)(zip code)

(720) 558-8000

(Registrant’s telephone number, including area code)

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of ‘accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

At May 31, 2006, 120,062,956 shares of the registrant’s Class A Common Stock were outstanding and 38,966,562 shares of the registrant’s Class B Common Stock were outstanding.

McDATA CORPORATION

FORM 10-Q

QUARTER ENDED APRIL 30, 2006

TABLE OF CONTENTS


	PART I – FINANCIAL INFORMATION

1.	Financial Statements

	Condensed Consolidated Balance Sheets	4

	Condensed Consolidated Statements of Operations	5

	Condensed Consolidated Statement of Changes in Stockholders’ Equity	6

	Condensed Consolidated Statements of Cash Flows	7

	Notes to Condensed Consolidated Financial Statements	8

2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	34

3.	Quantitative and Qualitative Disclosures About Market Risks	46

4.	Controls and Procedures	47

	PART II – OTHER INFORMATION

1.	Legal Proceedings	48

1a.	Risk Factors	48

6.	Exhibits	58

Special Note Regarding Forward-Looking Statements

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

•

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

•

changes in our relationship with our large end-user customers and the level of their orders;

•

our ability to successfully increase sales of McDATA’s directors, switches, channel extension products, embedded software, management software solutions, third party products, maintenance and support contracts, and professional services;

•

competition in the storage networking and channel extension market, including competitive pricing pressures and product give-aways, by our competitors such as Brocade Communication Systems, Inc., or Brocade, QLogic Corp., or QLogic, Cisco Systems, Inc., or Cisco, Emulex Corporation and other IP and multi-protocol switch and software suppliers;

•

our ability to expand our product offerings including our ability to successfully qualify and ramp sales of new products (including higher port density, multi-protocol and intelligent network products);

•

our ability to continue selling legacy Computer Network Technology (“CNT”) products and services to end-user customers;

•

our ability to partner with other companies and jointly sell products, including but not limited to management software with Network Appliance, Riverbed, FalconStor and software for blade servers with QLogic;

•

unexpected engineering costs or delays, additional manufacturing and component costs or production delays that we may experience in connection with new product development or an inability to source products from third party product providers;

•

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

•

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

•

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

•

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

•

the impact of any acquisitions by us of businesses, products, or technologies, including difficulties in integrating any acquisitions, including the merger with CNT that closed June 1, 2005.

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

PART I—FINANCIAL INFORMATION

McDATA CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)


	April 30, 2006			January 31, 2006
Assets
Current assets:
Cash and cash equivalents	$	124,603		$	139,083
Securities lending collateral		73,137			62,555
Short-term investments		205,457			171,110
Accounts receivable, net of allowance for bad debts of $7,429 and $7,880, respectively		113,074			126,106
Inventories, net		34,658			33,100
Prepaid expenses and other current assets		12,839			13,423
Restricted cash		3,840			—

Total current assets		567,608			545,377
Property and equipment, net		109,973			109,118
Long-term investments		19,703			31,884
Restricted cash		9,922			10,697
Intangible assets, net		112,644			123,694
Goodwill		266,929			266,141
Other assets, net		65,734			59,798

Total assets	$	1,152,513		$	1,146,709

Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	47,738		$	43,238
Accrued liabilities		83,632			94,276
Securities lending collateral payable		73,137			62,555
Current portion of deferred revenue		61,866			61,242
Current portion of obligations under capital leases		2,583			2,977
Interest rate swaps		922			—
Current portion of subordinated debt		120,841			—

Total current liabilities		390,719			264,288
Obligations under capital leases, less current portion		3,164			3,532
Deferred revenue, less current portion		30,960			31,380
Other long-term liabilities		8,609			1,844
Interest rate swaps		8,146			7,553
Convertible subordinated debt		164,353			285,889

Total liabilities		605,951			594,486

Commitments and contingencies (Note 15)
Stockholders’ Equity:
Common stock, Class A, $0.01 par value, 250,000,000 shares authorized, 120,062,956 and 119,599,002 shares issued and outstanding at April 30, 2006 and January 31, 2006, respectively		1,202			1,197
Common stock, Class B, $0.01 par value, 200,000,000 shares authorized, 38,930,446 and 38,315,628 shares issued and outstanding at April 30, 2006 and January 31, 2006, respectively		391			385
Additional paid-in-capital		672,389			671,142
Treasury stock, at cost, 1,439,560 and 1,439,560 Class A shares as of April 30, 2006 and January 31, 2006, respectively and 3,085,256 and 3,085,256 Class B shares as of April 30, 2006 and January 31, 2006, respectively		(23,591	)		(23,591	)
Deferred compensation		—			(2,832	)
Accumulated other comprehensive loss		(1,015	)		(807	)
Accumulated deficit		(102,814	)		(93,271	)

Total stockholders’ equity		546,562			552,223

Total liabilities and stockholders’ equity	$	1,152,513		$	1,146,709

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

McDATA CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)


	Three Months Ended April 30,
	2006			2005
Revenue:
Product	$	135,309		$	92,270
Service		33,003			6,598

Total revenue		168,312			98,868
Cost of revenue: (1)
Product		71,208			40,528
Service		19,907			4,912
Total cost of revenue		91,115			45,440

Gross profit		77,197			53,428

Operating expenses:
Research and development (1)		26,559			21,385
Selling and marketing (1)		37,312			24,117
General and administrative (1)		10,195			5,764
Amortization of acquired intangible assets		11,060			5,570
Restructuring charges		576			—

Total operating expenses		85,702			56,836
Loss from operations		(8,505	)		(3,408	)
Interest and other income		4,239			1,770
Interest expense		(3,614	)		(803	)

Loss before income taxes		(7,880	)		(2,441	)
Income tax expense		1,663			416

Net loss	$	(9,543	)	$	(2,857	)

Basic and diluted net loss per share	$	(0.06	)	$	(0.02	)

Shares used in computing basic and diluted net loss per share		153,702			115,474

(1)

Amounts for the three months ended April 30, 2006 include stock-based compensation expense recognized under SFAS 123R for stock options (see Note 12 “Stock Based Compensation,” of the Notes to Condensed Consolidated Financial Statements). Stock-based compensation amounts for the three months ended April 30, 2005 have been reclassified to confirm to the 2006 presentation.

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

McDATA CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

For the Three Months Ended April 30, 2006

(in thousands)

(unaudited)


	Common Stock						Additional Paid-In Capital		Deferred Compensation (1)			Accumulated Other Comprehensive Loss			Treasury Stock			Accumulated Deficit			Total Stockholders’ Equity
	Class A			Class B
	Shares	Amt		Shares	Amt
Balances at January 31, 2006	119,599	$	1,197	38,315	$	385	$	671,142	$	(2,832	)	$	(807	)	$	(23,591	)	$	(93,271	)	$	552,223
Shares issued	463		5	615		6		820		—			—			—			—			831
Stock based compensation expense, net	—		—	—		—		427		2,832			—			—			—			3,259
Comprehensive loss:
Net loss	—		—	—		—		—		—			—			—			(9,543	)		(9,543	)
Unrealized loss on investments, net of tax of $0	—		—	—		—		—		—			(123	)		—			—			(123	)
Foreign currency translation adjustment, net of tax of $0	—		—	—		—		—		—			(85	)		—			—			(85	)

Total comprehensive loss	—		—	—		—		—		—			(208	)		—			(9,543	)		(9,751	)

Balances at April 30, 2006	120,062	$	1,202	38,930	$	391	$	672,389	$	0		$	(1,015	)	$	(23,591	)	$	(102,814	)	$	546,562

(1)	Adjustment of deferred compensation due to adoption of SFAS 123R. See note 12, Stock Based Compensation

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

McDATA CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)


	Three Months Ended April 30,
	2006			2005
Cash flows from operating activities:
Net loss	$	(9,543	)	$	(2,857	)
Adjustments to reconcile net loss to cash flows from operating activities:
Depreciation and amortization		26,500			15,302
Loss (gain) on trade-in/retirement of assets		18			(170	)
Net realized loss (gain) on investments		(651	)		304
Inventory provisions		1,931			1,465
Bad debt provision		203			68
Non-cash compensation cost		3,259			718
Unrealized gains on investments		270			14
Changes in net assets and liabilities, net of effects of merger with CNT		(7,632	)		(6,739	)

Net cash provided by operating activities		14,355			8,105
Cash flows from investing activities:
Purchases of property and equipment		(3,919	)		(2,301	)
Purchases of investments		(115,036	)		(83,176	)
Proceeds from maturities and sales of investments		93,268			86,664
Decrease (increase) in restricted cash related to interest rate swap		(3,065	)		43

Net cash provided by (used in) investing activities		(28,752	)		1,230
Cash flows from financing activities:
Payments on long-term notes payable and capital leases		(762	)		(277	)
Proceeds from the issuance of common stock		831			64

Net cash provided by (used in) financing activities		69			(213	)
Effect of exchange rate changes on cash		(152	)		—

Net increase (decrease) in cash and cash equivalents		(14,480	)		9,122
Cash and cash equivalents, beginning of period		139,083			64,507

Cash and cash equivalents, end of period	$	124,603		$	73,629

Supplemental Disclosure of Non-Cash Investing and Financing Activities
Deferred compensation forfeitures	$	—		$	207

Capital lease obligations incurred	$	—		$	29

Transfer of inventory to fixed assets	$	19		$	1,522

Tenant improvements funded by the landlord and included in liabilities	$	6,725		$	—

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

McDATA CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(tabular amounts in thousands, except per share data)

(unaudited)

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.

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 mandatory 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 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.

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

On February 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options and employee stock purchases related to the Employee Stock Purchase Plan (“employee stock purchases”) based on estimated fair values. SFAS 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods beginning in fiscal 2006. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).

Note 2—Revenue Recognition Policy

The Company recognizes 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

Revenue from product sales to resellers and end-user customers is recognized when title and risk of loss transfer to the customer, at the time of shipment. Revenue from product sales to 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 recognizes revenue on shipment when shipped directly to an end user. When there are shipments to an OEM or distributor, the Company requests evidence of sell-through from the OEM and distributor partners prior to recognizing revenue. In situations where the 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 the OEM and distributor partners as required by the end-user.

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

(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 enters 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

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.

The accounting periods over which we will recognize this revenue is as follows (in thousands):


For Fiscal Years:	Amount
2006(1)	$	55,080
2007		23,952
2008		10,358
2009		2,757
2010 and thereafter		679

Total	$	92,826

(1)	Reflects the remaining nine months of fiscal 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 stockholder’s 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 April 30, 2006 and January 31, 2006. 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 and (losses) of $134,562 and ($76,715), for the three months ended April 30, 2006 and 2005, 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.

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 combined 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.

The Company initially recorded approximately $185.4 million of goodwill, $73.6 million of identified intangible assets, and $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 which is expected to be completed during the quarter ended July 31, 2006. Subsequent to the initial purchase price allocation, the Company 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 pro forma 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 (in thousands) 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.


	April 30, 2005
Total revenue	$	180,410
Net loss	$	(20,700	)
Basic and diluted net loss per share	$	(.14	)

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. 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 April 30, 2006.

Restructuring Costs Expensed in 2006

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. 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. No termination or retention benefits were incurred for the quarter ended April 30, 2006 or are expected to be incurred in the future 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 decided to withdraw the UMD from the market, and continue to sell the Intrepid 10000 product. As a result, McDATA offered, and certain existing UMD customers accepted, an exchange program that allowed customers to trade their UMD for a comparable Intrepid 10000 at no cost. The Company 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 in our estimated salvage values and costs and quantities of the Intrepid 10000’s 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 as they are incurred. This program is substantially complete as of April 30, 2006.

Changes to the estimates of executing the currently approved plans of restructuring the pre-merger McDATA organization will be reflected in our results of operations. Restructuring charges of $0.6 million for the three months ended April 30, 2006 consists of additional expenses incurred associated with the acquisition of CNT.

The following table summarizes the Company’s utilization of restructuring accruals during the three months ended April 30, 2006 (in thousands):


	Employee Severance Benefits			UMD /Intrepid 10000 Swap			Totals
Accrual balance at January 31, 2006	$	324		$	807		$	1,131
Net cost of product exchanged		—			(807	)		(807	)
Cash payments		(190	)		—			(190	)
Additional restructuring charges		576			—			576

Accrual balance at April 30, 2006	$	710		$	—		$	710

The restructuring liabilities shown above are included in accrued liabilities in the accompanying balance sheet as of April 30, 2006.

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 of the 10K for the year ended January 31, 2006. 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 from June 1, 2005 through the quarter ended April 30, 2006 (in thousands):


	Employee Severance and Relocation Benefits			Facility Closure and Exit Costs			Contract Termination Costs			Totals
Accrual balance at January 31, 2006	$	2,106		$	7,234		$	4,077		$	13,417
Cash payments		(900	)		(1,183	)		(210	)		(2,293	)
Change to estimated costs		(415	)		(689	)		—			(1,104	)

Accrual balance at April 30, 2006	$	791		$	5,362		$	3,867		$	10,020

Of the restructuring liabilities described above, $9.6 million is included in accrued liabilities and the remaining $.4 million is included in other long term liabilities in the accompanying balance sheet as of April 30, 2006.

Note 6—Components of Selected Balance Sheet Accounts

(in thousands)


	April 30, 2006		January 31, 2006
Inventories:
Raw materials	$	19,360	$	22,868
Work-in-progress		1,021		1,253
Finished goods		14,277		8,979

Total inventories	$	34,658	$	33,100


	April 30, 2006			January 31, 2006
Property and Equipment:
Land	$	17,799		$	17,799
Building		32,577			32,573
Equipment and Furniture		124,924			122,680
Computer software for internal use		30,099			30,787
Leasehold Improvements		15,149			8,449
Construction in progress		1,200			838

		221,748			213,126
Less accumulated depreciation and amortization		(111,775	)		(104,008	)

Total property and equipment, net	$	109,973		$	109,118


	April 30, 2006			January 31, 2006
Accrued liabilities:
Wages and employee benefits	$	25,287		$	27,916
Purchase commitments and other supply obligations		9,730			10,480
Warranty reserves (1)		6,318			6,806
Income taxes payable		10,454			10,215
Taxes, other than income tax		7,761			5,903
Interest payable		1,581			4,416
Customer obligations		9,308			8,227
Restructuring accruals		9,615			14,188
Other accrued liabilities		3,578			6,125

	$	83,632		$	94,276

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


	Three Months Ended April 30,
	2006			2005
Balance at beginning of period	$	6,806		$	5,592
Warranty expense		1,475			42
Non-expensed warranty obligations		—			17
Warranty claims		(1,963	)		(213	)

Balance at end of period	$	6,318		$	5,438

From time to time the Company is indemnified by its suppliers for warranty claims related to components that are contained within its products. In these circumstances, the Company records a non-expensed warranty obligation against which future warranty claims for those components will be provided by the Company to its customers.

Note 7—Goodwill and Intangible assets

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


	April 30, 2006						January 31, 2006
	Gross Carrying Amount		Accumulated Amortization		Net Carrying Amount		Gross Carrying Amount		Accumulated Amortization		Net Carrying Amount
Developed technology	$	143,490	$	61,170	$	82,320	$	143,490	$	55,025	$	88,465
Customer relationships		30,234		5,162		25,072		30,234		4,005		26,229
Backlog		17,606		13,931		3,675		17,606		10,255		7,351
Other		4,578		3,001		1,577		4,578		2,929		1,649

Total intangible assets	$	195,908	$	83,264	$	112,644	$	195,908	$	72,214	$	123,694

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


Fiscal Years:
2006(1)	$	24,905
2007		26,857
2008		26,522
2009		20,390
2010 and thereafter		13,970

Total expected amortization expense	$	112,644

(1)	Reflects the remaining nine months of fiscal year 2006.

Amortization expense related to acquired intangible assets was $11.1 million and $5.6 million for the three months ended April 30, 2006 and 2005, respectively.

Changes in the carrying amount of goodwill for the three months ended April 30, 2006 are as follows (in thousands):


	Product Segment			Services Segment		Total
Balance as of January 31, 2006	$	128,972		$	137,169	$	266,141
Goodwill Acquired		—			—		—
Goodwill Impaired		—			—		—
Other(1)		(432	)		1,220		788

Balance as of April 30, 2006	$	128,540		$	138,389	$	266,929

(1)	Represents a net increase to goodwill in the three months ended April 30, 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 completing 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 process to finalize purchase accounting, the Company 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 three months ended April 30, 2006.

Note 8—Convertible Subordinated Debt

Convertible subordinated debt includes the Company’s 2.25% convertible subordinated notes (the 2.25% Notes) due February 15, 2010, and $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. As of April 30, 2006, the approximate bid and ask prices per $100 of our 2.25% Notes was $88.77 and $89.27, respectively, resulting in an aggregate fair value of between $153.1 million and $154.0 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 April 30, 2006, the six-month LIBOR setting for the swap was 4.93%, creating a rate of approximately 3.41%, which is effective until August 15, 2006. The swap was designated as a fair value hedge and, 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 April 30, 2006, the fair value of the interest rate swap had decreased from inception to a negative $8.5 million and is included in long-term liabilities. Corresponding to this change, the carrying value of the Notes has decreased by $8.5 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 $9.9 million at April 30, 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 April 30, 2006, the approximate bid and ask prices per $100 of our 3.00% Notes was $97.635 and $98.00, respectively, resulting in an aggregate fair value of between $121.4 million and $121.9 million.

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 April 30, 2006, the three-month LIBOR setting for the swap was 5.13%, resulting in a combined effective rate of approximately 5.82% which is effective until July 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 first quarter, the fair value of the interest rate swap decreased $0.4 million, resulting in a swap liability of $.9 million as of April 30, 2006, which has been included in short-term liabilities. This amount excluded accrued interest of $.5 million, payable to the Company on August 15, 2006. Corresponding to this increase, the carrying value of the notes covered by the swap agreement has also been increased by $0.4 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 April 30, 2006, and has been included in restricted cash in the accompanying consolidated balance sheets.

Note 9—Interest and Other Income, Net

Interest and other income, net consist of:


	Three Months Ended April 30,
	2006			2005
Interest income	$	3,849		$	2,085
Net realized gains/(losses) on available-for-sale investments		660			(301	)
Unrealized gains/(losses) on economic hedge investments		(270	)		(14	)

Interest and other income, net	$	4,239		$	1,770

Note 10—Income Tax

For the three-month periods ended April 30, 2006 and April 30, 2005 the Company recorded an income tax expense of $1.7 million and $416,000, respectively.

The calculation of income tax expense or benefit is based in part on estimates of future results and projections of taxable income for the full fiscal year in each jurisdiction in which the Company operates. These projections could be affected, positively or negatively, by such factors as future changes in tax law or implementation of possible tax planning strategies. The tax provision for each of the periods reported in the Consolidated Statement of Operations includes foreign taxes accrued on the projected net profits of foreign branch and subsidiary operations.

The Company has established a valuation allowance against its entire domestic net deferred tax asset and a substantial portion of the net deferred tax asset in various foreign jurisdictions. Therefore, no tax benefit is recognized currently if there is an increase to the net deferred tax asset in any of these jurisdictions. The need for a valuation allowance is determined in accordance with the provisions of SFAS No. 109, which requires an assessment of all available 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 the benefits of a recorded deferred tax asset will be realized. To the extent future realization of the benefits of a deferred tax asset is unlikely, a valuation allowance is recorded. The Company has re-evaluated the need for a valuation allowance based on its most recent results and concluded that a valuation allowance is still required with respect to the domestic net deferred tax asset and the net deferred tax asset in many of the foreign jurisdictions in which the Company is subject to income tax.

The Company adopted SFAS 123R on February 1, 2006. Statement 109 requires that differences between the deductible temporary difference between the compensation expense calculated under FAS 123R and the tax deduction that would result based on the current fair value of the entity’s shares shall not be considered in measuring the gross deferred tax asset or determining the need for a valuation allowance for a deferred tax asset recognized. Because the Company has established a valuation allowance, the tax benefit of approximately $500,000 is not recorded, but will be tracked by the Company and will be used when the existing deferred tax asset is realized.

Note 11—Net Loss 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 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 reconciliation between basic and diluted loss per share (in thousands, except per share data):


	Three Months Ended April 30,
	2006			2005
Net loss	$	(9,543	)	$	(2,857	)
Weighted average shares of common stock outstanding used in computing basic net loss per share		153,702			115,474
Effect of dilutive stock options and warrants		—			—

Weighted average shares of common stock used in computing diluted net loss per share		153,702			115,474

Basic and diluted net loss per share	$	(0.06	)	$	(0.02	)

Note 12—Stock-Based Compensation

Effective February 1, 2006 the Company began recording compensation expense associated with stock-based awards and other forms of equity compensation in accordance with Statement of Financial Accounting Standards No. 123-R, Share-Based Payment, (“SFAS 123R”) as interpreted by SEC Staff Accounting Bulletin No. 107. The Company adopted the modified prospective transition method provided for under SFAS 123R, and consequently has not retroactively adjusted results from prior periods. Under this transition method, compensation cost associated with stock-based awards recognized in the first quarter of fiscal year 2006 now includes amortization related to the remaining unvested portion of stock-based awards granted prior to February 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, (“SFAS 123”); and amortization related to stock-based awards granted on or subsequent to February 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. The compensation expense for stock-based awards includes an estimate for forfeitures and is recognized over the expected term of the award.

Because the Company had not followed the recognition provisions of SFAS 123 for its Incentive Stock Options (ISO’s) and Nonqualified Stock Options (NQSO’s) awards, the Company will not record an adjustment for the cumulative effect of a change in accounting principle when estimating forfeitures. With respect to the Non-Vested Restricted Stock Units (RSU’s) which were recognized under the provisions of APB 25, the Company will not record an adjustment for the cumulative effect of a change in accounting principle for estimating forfeitures as the Company has estimated that there will be no forfeitures associated with these awards.

Stock Options

The Company provides ISO’s and NQSO’s to certain employees. When the measurement date is certain, the fair value of each option grant is estimated on the date of grant using the Black-Scholes valuation model and the assumptions noted in the following table. The expected volatility is based on an equal weighted average of implied volatilities from traded options of the Company’s stock and historical volatility of the Company’s stock. The risk free interest rate is based on the implied yield on a U.S. Treasury zero-coupon issue with a remaining term equal to the expected term of the option. The dividend yield reflects that the Company has not paid any cash dividends since inception and does not anticipate paying cash dividends in the foreseeable future. The Company has computed the fair values of an option granted during the three months ended April 30, 2006 and 2005, using the Black Scholes option pricing model and the following assumptions:


	Three Months Ended April 30,
	2006		2005
Stock Options
Expected dividend yield	0.0	%	0.0	%
Risk free interest rate	4.57% - 4.9	%	3.77% - 4.	27%
Expected volatility	50	%	52.8	%
Expected term (in years)	2-4		2-4

Non-Vested Restricted Stock and Restricted Stock Units

The Company provided certain directors and executives with restricted stock awards have service and performance components prior to the adoption of SFAS 123R. The Company accounted for the compensation cost service component in accordance with APB 25, using the grant date fair value and amortizing the cost over the service period. At interim periods the performance component was measured in accordance with FASB Interpretation 28 based on an estimate of the number of shares that would vest and the market price of the stock at interim dates. Upon adoption of SFAS 123R, the Company ceased applying variable accounting for APB 25 awards. The company will record compensation cost for the unvested portion using the grant date value and amortizing the unvested awards over the service period.

In addition, the Company adjusted the remaining deferred compensation balance that was established when the restricted stock awards were granted to additional paid in capital.

Effective February 1, 2006, the Company changed its expense recognition policy from using the graded vesting attribution model to the straight line attribution model as permitted with the adoption of SFAS 123R.

Compensation Costs

For the quarter ended April 30, 2006, the Company recorded $2.6 million of compensation expense in its statement of operations. Of this amount, $354,000 was included in cost of sales, $326,000 in research and development, $639,000 in sales and marketing, $1.3 million in general and administrative expenses. In addition, the Company capitalized $632,000 of these costs as part of their software development assets in the consolidated balance sheet. Total stock-based compensation expense for the three months ended April 30, 2005 was $718,000. Of this amount, of $15,000 was included in cost of sales, $453,000 in research and development, $69,000 in sales and marketing, and $181,000 in general and administrative expenses. Total stock-based compensation benefit as of April 30, 2005 excludes certain stock-based awards which were previously reported as proforma compensation expense under FAS 123. A summary of stock option and restricted stock activity under the plans for the three months ended April 30, 2006 is presented as follows:


	Shares (in thousands)		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (Years)	Aggregate Intrinsic Value ($000)
Class A Common Stock Options
Outstanding, January 31, 2006	9,565		$	9.97
Granted	—			—
Exercised	(463	)		.66
Forfeited or Expired	(550	)		—

Outstanding, April 30, 2006	8,552		$	10.28	4.30	$	2,458

Ending Vested and Expected to Vest, April 30, 2006	7,349		$	11.21	3.62	$	1,601

Exercisable and Vested, April 30, 2006	7,349		$	11.21	3.62	$	1,601


	Shares (in thousands)		Weighted Average Grant Date Fair Value
Nonvested Shares—Class A Common Stock Options
Nonvested at January 31, 2006	2,152		$	3.61
Granted	—			—
Vested	(776	)
Forfeited or Expired	(173	)		3.33

Outstanding, April 30, 2006	1,203		$	3.07

As of April 30, 2006, there was $1.7 million of total unrecognized compensation costs related to stock options. These costs are expected to be recognized over a weighted average period of 2.47 years.


	Shares (in thousands)		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (Years)	Aggregate Intrinsic Value ($000)
Class B Common Stock Options
Outstanding, January 31, 2006	20,348		$	7.13
Granted	1,400			.96
Exercised	(615	)		.71
Forfeited or Expired	(1,373	)		7.30

Outstanding, April 30, 2006	19,760		$	6.87	7.34	$	19,749

Ending Vested and Expected to Vest, April 30, 2006	9,360		$	10.30	5.54	$	3,794

Exercisable and Vested, April 30, 2006	9,360		$	10.30	5.54	$	3,794


	Shares (in thousands)		Weighted Average Grant Date Fair Value
Nonvested Shares—Class B Common Stock Options
Nonvested at January 31, 2006	10,824		$	2.93
Granted	1,400			.66
Vested	(1,052	)
Forfeited or Expired	(771	)		2.83

Outstanding, April 30, 2006	10,401		$	2.48

As of April 30, 2006, there was $17.3 million of total unrecognized compensation costs related to stock options. These costs are expected to be recognized over a weighted average period of 2.9 years.

Note 13—Stockholders’ Equity

Stock Repurchase Plan

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 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 three months ended April 30, 2006, there were no share repurchases.

Note 14—Segment Information

FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information, 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, “Disclosures about Segments of an Enterprise and Related Information,” 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. 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 show assets by operating segments.

Summarized financial information by operating segment for the three months ended April 30, 2006 and 2005, based on the internal management system is as follows (in thousands):


	Three Months Ended April 30, 2006
	Product		Service		Unallocated		Total
Revenue	$	135,309	$	33,003	$	—	$	168,312
Cost of revenue	$	71,208	$	19,907	$	—	$	91,115
Research and development	$	26,559	$	—	$	—	$	26,559
Selling and marketing	$	—	$	—	$	37,312	$	37,312
General and administrative	$	—	$	—	$	10,195	$	10,195

	Three Months Ended April 30, 2005
	Product		Service		Unallocated		Total
Revenue	$	92,270	$	6,598	$	—	$	98,868
Cost of revenue	$	40,528	$	4,912	$	—	$	45,440
Research and development	$	21,385	$	—	$	—	$	21,385
Selling and marketing	$	—	$	—	$	24,117	$	24,117
General and administrative	$	—	$	—	$	5,764	$	5,764

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.


	Three Months Ended April 30,
	2006		2005
EMC	29	%	49	%
IBM	27	%	25	%
HDS	7	%	10	%
Other channels	37	%	16	%

Total revenue	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 quarter ended April 30, 2006, domestic and international revenue was 59% and 41% of our total revenue, respectively, as compared to 61%, and 39%, respectively, for the same period in 2005.

Note 15—Commitments and Contingencies

Commitments

Operating and Capital Leases

The Company had various operating and capital leases in effect at April 30, 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 April 30, 2006 (in thousands):


	Capital Leases			Operating Leases
2006(1)	$	2,358		$	8,111
2007		2,323			9,296
2008		952			9,750
2009		425			6,154
2010		—			5,599
Thereafter		—			35,606

Total minimum lease payments		6,058		$	74,516

Less portion representing interest		(311	)
Less current portion		(2,583	)

Long term obligations under capital leases	$	3,164

(1)	Reflects the remaining nine months of fiscal 2006.

Rent expense for the three months ended April 30, 2006 and 2005 was $4.2 million and $2.4 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 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.

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.

Under the terms of the lease, the Company was provided with approximately $6.7 million of tenant improvements .The Company has recorded these improvements as an addition to property and equipment, and as an addition to long term liabilities on its consolidated balance sheet. The improvements are being depreciated over the lesser of the life of the related assets or the term of the lease. The related long liability is being amortized over the life of the lease effectively adjusting the Company’s rent expense.

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 April 30, 2006, the Company’s commitment with our Contract Manufacturers for purchases over the next sixty days totaled $59.0 million, and $32.3 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 April 30, 2006, the Company had recorded approximately $9.7 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.

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 no liability has been incurred as of January 31, 2006. The Company continued to analyze the impact of the directive, in the first quarter of fiscal 2006 and recognized reserve of $1.9M related to the elimination of non-RoHS compliant components at our contract manufacturers.

Indebtedness

As discussed in Note 8, 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 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 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. In May 2006, the Company removed the case to federal district court. McDATA Services intends to defend itself vigorously and, based on facts known to its management team, believes the case is wholly without merit.

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.

Note 16 – Subsequent Events

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. In March 2005, the Company’s ownership percentage fell to approximately 9.8% due to the increase in ownership of other Aarohi investors. The Company had recorded its share of Aarohi’s net loss of approximately $1.4 million and $984,000 for fiscal 2004 and 2003, respectively. The remaining net equity investment of Aarohi was reduced to zero during fiscal 2004.

In April of 2006, Emulex Corporation announced their intent to purchase Aarohi, and in May of 2006, Emulex announced the completion of that purchase. Under the terms of the cross indemnification agreement, the pro rata share of merger consideration received by the Company in May of 2006 will be approximately $3.1 million. Approximately $2.7 million of the merger consideration was received in May of 2006, and the remainder has been deposited in an escrow account and will be distributed in whole or in part over the next 18 months. The Company will record its pro rata share as other income in its fiscal second quarter statement of operations.

Note 17—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 million 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 April 30, 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 condensed 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.

McDATA CORPORATION

CONDENSED CONSOLIDATING BALANCE SHEETS (1)

As of April 30, 2006

(in thousands, unaudited)


	Parent Guarantor			Issuer of Notes			Subsidiaries Non Guarantors			Eliminations			Consolidated
Assets
Current assets:
Cash and cash equivalents	$	103,701		$	17,517		$	3,385		$	—		$	124,603
Securities lending collateral		73,137			—			—			—			73,137
Short-term investments		205,457			—			—			—			205,457
Accounts receivable, net		102,568			10,095			46			365			113,074
Intercompany accounts receivable, net		(328,980	)		192,702			(37,709	)		173,987			—
Inventories, net		27,981			8,020			—			(1,343	)		34,658
Prepaid expenses and other current assets		6,082			6,452			434			(129	)		12,839
Restricted Cash		—			3,840			—			—			3,840

Total current assets		189,946			238,626			(33,844	)		172,880			567,608
Property and equipment, net		88,918			18,908			1,428			719			109,973
Long-term investments		19,691			12			—			—			19,703
Investment in subsidiaries		410,529			235,655			2			(646,186	)		—
Restricted cash		9,922			—			—			—			9,922
Intangible assets, net		51,800			(836	)		60,844			836			112,644
Goodwill		187,977			259			78,693			—			266,929
Other assets, net		38,326			26,156			389			863			65,734

Total assets	$	997,109		$	518,780		$	107,512		$	(470,888	)	$	1,152,513

Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	39,408		$	7,441		$	190		$	699		$	47,738
Accrued liabilities		49,779			38,257			(4,404	)		—			83,632
Securities lending collateral payable		73,137			—			—			—			73,137
Current portion of deferred revenue		18,528			43,190			148			—			61,866
Current portion of notes payable and obligations under capital leases		587			1,996			—			—			2,583
Interest rate swap		—			922			—			—			922
Convertible subordinated debt		—			120,841			—			—			120,841

Total current liabilities		181,439			212,647			(4,066	)		699			390,719
Notes payable and obligations under capital leases, less current portion		790			2,374			—			—			3,164
Deferred revenue, less current portion		10,219			20,736			5			—			30,960
Other long-term liabilities		8,285			17			—			307			8,609
Interest rate swap		8,146			—			—			—			8,146
Convertible subordinated debt		164,353			—			—			—			164,353

Total liabilities		373,232			235,774			(4,061	)		1,006			605,951
Total stockholders’ equity		623,877			283,006			111,573			(471,894	)		546,562

Total liabilities and stockholders’ equity	$	997,109			518,780		$	107,512			(470,888	)	$	1,152,513

(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.

McDATA CORPORATION

CONDENSED CONSOLIDATING BALANCE SHEETS (1)

As of January 31, 2006

(in thousands, unaudited)


	Parent Guarantor			Issuer of Notes		Subsidiaries Non 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

McDATA CORPORATION

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS (1)

For the Three Months Ended April 30, 2006

(in thousands, except per share data)

(unaudited)


	Parent Guarantor			Issuer of Notes			Subsidiaries Non Guarantors			Eliminations			Consolidated
Total revenue	$	130,150		$	39,149		$	81		$	(1,068	)	$	168,312
Total cost of revenue		67,527			23,931			449			(792	)		91,115

Gross profit		62,623			15,218			(368	)		(276	)		77,197
Operating expenses:
Research and development		25,505			933			121			—			26,559
Selling and marketing		24,008			5,682			7,622			—			37,312
General and administrative		8,810			856			529			—			10,195
Amortization of purchased intangible assets		5,951			—			5,109			—			11,060
Restructuring charges		576			—			—			—			576

Total operating expenses		64,850			7,471			13,381			—			85,702
Income (loss) from operations		(2,227	)		7,747			(13,749	)		(276	)		(8,505	)
Interest and other income, net of interest expense		(8,235	)		(1,355	)		10,215			—			625

Income (loss) before income taxes		(10,462	)		6,392			(3,534	)		(276	)		(7,880	)
Income tax expense (benefit)		50			1,399			214			—			1,663
Equity loss from subsidiaries of non-guarantors		(3,748	)		—			—			3,748			—

Net income (loss)	$	(14,260	)	$	4,993		$	(3,748	)	$	3,472		$	(9,543	)

(1)

McDATA CORPORATION

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS (1)

For the Three Months Ended April 30, 2005

(in thousands, except per share data)

(unaudited)


	Parent Guarantor			Issuer of Notes		Subsidiaries Non Guarantors			Eliminations		Consolidated
Total revenue	$	98,669		$	—	$	199		$	—	$	98,868
Total cost of revenue		44,321			—		1,119			—		45,440

Gross profit		54,348			—		(920	)		—		53,428
Operating expenses:
Research and development		20,984			—		401			—		21,385
Selling and marketing		17,268			—		6,849			—		24,117
General and administrative		5,109			—		655			—		5,764
Amortization of purchased intangible assets		—			—		5,570			—		5,570

Total operating expenses		43,361			—		13,475			—		56,836
Income (loss) from operations		10,987			—		(14,395	)		—		(3,408	)
Interest and other income, net of interest expense		(7,095	)		—		8,062			—		967

Income (loss) before income taxes		3,892			—		(6,333	)		—		(2,441	)
Income tax expense (benefit)		64			—		352			—		416

Equity loss from subsidiaries of non-guarantors		(6,685	)		—		—			6,658		—

Net income (loss)	$	(2,857	)	$	—	$	(6,685	)	$	6,685	$	(2,857	)

(1)

McDATA CORPORATION

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS (1)

For the Three Months Ended April 30, 2006

(in thousands)

(unaudited)


	Parent Guarantor			Issuer of Notes			Subsidiaries Non Guarantors			Eliminations		Consolidated
Net cash provided by operating activities	$	8,709		$	5,156		$	490		$	—	$	14,355
Cash flows from investing activities: (2)
Purchases of property and equipment		(3,394	)		(247	)		(278	)		—		(3,919	)
Purchases of investments		(115,040	)		4			—			—		(115,036	)
Proceeds from maturities and sales of investments		93,268			—			—			—		93,268
Restricted cash related to interest rate swap		(3,064	)		(1	)		—			—		(3,065	)

Net cash used in investing activities		(28,230	)		(244	)		(278	)				(28,752	)
Cash flows from financing activities:
Payments on long-term notes payable and capital leases		(222	) )		(531	)		(9	)		—		(762	)
Proceeds from the issuance of common stock		831			—			—			—		831

Net cash provided by (used in) financing activities		609			(531	)		(9	)				69
Effect of exchange rate changes on cash		16			(168	)		—			—		(152	)

Net increase (decrease) in cash and cash equivalents		(18,896	)		4,213			203			—		(14,480	)
Cash and cash equivalents, beginning of period		122,594			13,306			3,183			—		139,083

Cash and cash equivalents, end of period	$	103,698		$	17,519		$	3,386		$	—	$	124,603

(1)

(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 three month period ended April 30, 2006.

McDATA CORPORATION

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS (1)

For the Three Months Ended April 30, 2005

(in thousands)

(unaudited)


	Parent Guarantor			Issuer of Notes		Subsidiaries Non Guarantors			Eliminations		Consolidated
Net cash provided by operating activities	$	7,361		$	—	$	744		$	—	$	8,105
Cash flows from investing activities:
Purchases of property and equipment		(2,188	)		—		(113	)		—		(2,301	)
Purchases of investments		(83,176	)		—		—			—		(83,176	)
Proceeds from maturities and sales of investments		86,664			—		—			—		86,664
Restricted cash related to interest rate swap		43			—		—			—		43
Cash received on cash surrender value of life insurance policy		—			—		—			—		—

Net cash provided by (used in) investing activities		1,343					(113	)				1,230
Cash flows from financing activities:
Payments on long-term notes payable and capital leases		(243	)		—		(34	)		—		(277	)
Proceeds from the issuance of common stock		64			—		—			—		64

Net cash used in financing activities		(179	)				(34	)				(213	)
Effect of exchange rate changes on cash		—			—		—			—		—

Net increase in cash and cash equivalents		8,525			—		597			—		9,122
Cash and cash equivalents, beginning of period		62,473			—		2,034			—		64,507

Cash and cash equivalents, end of period	$	70,998		$	—	$	2,631		$	—	$	73,629

(1)

ITEM 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion and analysis in conjunction with the condensed consolidated financial statements and notes thereto included in Item 1 of this Quarterly Report and with Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report filed on Form 10-K with the Securities and Exchange Commission on April 24, 2006.

Overview

McDATA acquired CNT on June 1, 2005, and their results are included in the three months ended April 30, 2006. Therefore, the acquisition of CNT has significantly affected the year over year comparisons in the results of operations.

Revenue Growth and Competitive Industry

Our revenue for the three months ended April 30, 2006 increased approximately 70.2% over the three months ended April 30, 2005. This year over year revenue increase is the result of the CNT acquisition resulting in higher sales of hardware and service products. The increase in hardware revenue was driven by higher sales of directors, SAN routers and extention hardware, and third party products. In addition, our software revenue was increased 21%. The market for our SAN and WAN products and solutions remains competitive with (a) the entrance of competitors into our market, (b) pricing pressures resulting from an increase in competitive products and solutions, and (c) anticipated competition from our own storage OEM partners through their partnerships with competitors to jointly sell complementary products. These market conditions present unique risks and uncertainties in a number of respects. We believe the competitive market environment defines the overall performance and provides a specific context to further analyze revenues, operating expenses and liquidity. In particular, we anticipate continued elongated sales cycles and downward pricing pressures that could negatively impact our revenue growth rate. Moreover, revenue growth in fiscal 2006 is dependent on the success of our products, including the Intrepid 10000 Director, higher performance switch products and our Remote Office Consolidation (ROC) products.

Our OEM and reseller partners may purchase certain of these component products ahead of end-user demand, which could reduce subsequent purchases by those partners. Variations in the buying patterns of our customers would limit our ability to assemble, test and ship orders received in the last weeks and days of each quarter and could cause fluctuations in our quarterly revenue or earnings. Moreover, an unexpected decline in revenue without a corresponding and timely reduction in expenses could intensify the impact of these factors on our business, financial condition and results of operations.

We believe the trend of revenue, controlling of operating expense and the related competitive environment define the overall performance and provides a specific context to further analyzing our financial results.

Results of Operations

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


	Three Months Ended April 30,
	2006		2005
Total revenue	100.0	%	100.0	%
Total cost of revenue	54.1		46.0

Gross profit	45.9		54.0
Operating expenses:
Research and development	15.8		21.6
Selling and marketing	22.1		24.4
General and administrative	6.1		5.6
Amortization of purchased intangible assets	6.6		5.8
Restructuring charges	0.3		—

Total operating expenses	50.9		57.4
Loss from operations	(5.0	)	(3.4	)
Interest and other income, net	.4		1.0

Loss before income taxes	(4.6	)	(2.4	)
Income tax expense (benefit)	1.0		0.4

Net loss	(5.6	)%	(2.8	)%

Revenues


	Three Months Ended April 30,
	2006		2005
Product revenue	$	115,954	$	75,332
Software and related maintenance revenue		19,000		15,670
Service revenue		33,003		6,598
Other revenue		355		1,268

Total revenue	$	168,312	$	98,868

Our total revenue for the three months ended April 30, 2006 was $168.3 million, which represented an approximate 70.2% increase over the three months ended April 30, 2005. Although we continue to see solid end-user interest for our products and solutions, the on-going competitive marketplace is expected to create a challenging sales environment for the foreseeable future. Given the nature of competitors and products in our industry, we anticipate longer sales cycles and price declines that could negatively impact our revenue growth rate.

Product

Revenues from hardware, software, and other sources are included in our product revenue category in our statement of operations. Hardware revenue of $116.0 million for the three months ended April 30, 2006 was a 54% increase over the three months ended April 30, 2005. This year over year revenue increase in hardware revenue reflects three months of results with CNT in 2006 and a 16% increase in estimated ports sold offset by a 2% decrease in estimated average sales prices. The increase in sales of hardware ports reflects the market strength of our high-end Director products despite the economic and competitive environment. We expect the number of ports shipped to fluctuate depending on the demand for our existing and newly introduced products including the timing of product introductions by our OEM customers. Ongoing competition and macroeconomic factors could continue to provide downward pricing pressures that could impact our revenue growth and related margins.

Software and related maintenance revenue of $19.0 million for the quarter ended April 30, 2006 increased approximately 21% over the quarter ended April 30, 2005. This revenue growth is due to higher sales of our embedded software products including our SANtegrity security solution and higher maintenance revenue that attaches to the sale of software licenses.

Other revenue of $0.4 million for the quarter ended April 30, 2006 decreased $0.9 million from the $1.3 million for the quarter ended April 30, 2005. Other revenue represents the ESCON business which is expected to continue to decline. IBM announced end of life on several ESCON products in 2004; therefore, we expect revenue from this category to be less than $1 million per quarter through the remainder of fiscal 2006.

Service

Service revenue includes professional service revenue, break/fix maintenance support, network monitoring services, and revenue earned from our upgraded warranty and extended maintenance contracts on our hardware products. Service revenue for the three months ended April 30, 2006 was $33.0 million. This represents a $26.4 million increase from the same period in fiscal 2005. These increases are due primarily to the addition of CNT’s business.

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.


	Three Months Ended April 30,
	2006		2005
EMC	29	%	49	%
IBM	27	%	25	%
HDS	7	%	10	%
Other channels	37	%	16	%

Total revenue	100	%	100	%

Expanding our reseller, distributor and system integrator channels into commercial and vertical markets will be a strategic focus for us as we continue to grow our business. However, the level of sales to any single customer may vary and the loss of any one significant customer, or a decrease in the level of sales to any significant or group of significant customers, could harm our financial condition and results of operations. Given the dependencies on our limited number of OEM resellers combined with an increasingly competitive environment, we may experience continued adverse pricing pressures at critical times near the end of the fiscal quarters. In addition, the fiscal quarters for many of our largest OEM and reseller partners begin during the last month of our OEM’s quarter. While we do not have complete insight into the purchasing processes of our OEM and reseller partners, we believe that such partners may purchase some amount of our non-configured product in anticipation of end-user customer demand that will be realized in the later portion of their fiscal quarter. Large end-of-quarter purchases by our partners could result in lower future revenues or earnings if market demand as forecasted by our partners is not met.

Domestic and international revenue was approximately 59% and 41% of our total revenue, respectively, for the three months ended April 30, 2006. For the three months ended April 30, 2005, domestic and international revenue was approximately 61% and 39% of our total revenue, respectively. Revenues are attributed to geographic areas based on the location of the customers to which our products are shipped. International revenues primarily consist of sales to customers in Western Europe and the greater Asia Pacific region. Included in domestic revenues are sales to certain OEM customers who take possession of our products domestically and then distribute these products to their international customers. In addition, included in revenues from Western Europe are sales to certain OEM customers who take possession of our products in distribution centers designated for international-bound product and then distribute these products among various international regions. Our mix of international and domestic revenue can, therefore, vary depending on the relative mix of sales to certain OEM customers.

For a description of our revenue recognition policies, see the Revenue Recognition section of the Critical Accounting Policies.

Gross Margin

Product

Product gross margin percentages were 47% and 56% for the three months ended April 30, 2006 and 2005, respectively. Costs of goods sold consists of product costs, which are generally variable, and manufacturing operating cost, and includes both variable and fixed expenses. The decline in product margins for the three month ending April 30, 2006 compared to the same periods ending April 30, 2005 was due to discounting that we offered during the market introduction

phase for our director products. In addition, we were negatively impact by the change in our product offerings which includes now third party products as a result of acquisition of CNT. Gross margins were also adversely affected by a $1.9 million inventory reserve for non RoHS compliant inventory components, and $354,000 of stock based compensation due to our adoption of SFAS 123R in the quarter ended April 30, 2006.

In anticipation of the competitive-driven and natural decline in selling prices, we continue to drive cost advantages through our engineering and manufacturing processes. The terms of our agreement with Solectron will allow for a reduction of manufacturing costs once Solectron moves manufacturing processes to their other facilities.

We believe that average selling prices and the related gross profit margins will decline for our mature products as volume price discounts in distributor contracts and direct sales relationships take effect due to competition. In addition, new product introductions could harm our gross profit margins due to lower absorption of fixed manufacturing overhead costs per unit until production volumes increase.

Service

Service gross margin percentages were 40% and 26% for the three months ended April 30, 2006 and 2005, respectively. Gross margins increased in 2006 due to the acquisition of CNT’s service business. Management expects future service gross margins to be comparable to the results achieved in the first quarter 2006.

Operating Expenses

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

For the three months ended April 30, 2006, research and development expenses increased $5.2 million to $26.6 million compared with $21.4 million for the three months ended April 30, 2005. These increases in research and development expense reflect a 12% increase in personnel, increased depreciation expense for equipment, spending related to outsourced services and product development and testing. These increases are due primarily to the Merger. Research and development expenses also reflect the net impact of capitalized software development costs which reduce research and development expenses when recorded on the balance sheet and amortized against cost of goods sold upon introduction of the software product. For the quarter ended April 30, 2006, capitalized software costs were $7.4 million compared to $7.2 million for the three months ended April 30, 2005. These costs vary in conjunction with stages of development of our application software, our new director and switch products and related firmware software. In addition, we recognized $326,000 of stock based compensation expense due to our adoption of FAS 123R

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

For the three months ended April 30, 2006, selling and marketing expenses increased $13.2 million to $37.3 million as compared to $24.1 million for the three months ended April 30, 2005. These increases were primarily due to a 41% increase in personnel and $639,000 due to our adoption of FAS 123R.

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

For the three months ended April 30, 2006 and 2005, respectively, general and administrative expenses were $10.2 million and $5.8 million. These increases over prior year were attributable to increased personnel costs related to the increase in personnel and severance costs and increased facility costs associated with the Merger In addition, we recognized $1.3 million of stock based compensation expense due to our adoption of FAS 123R.

Amortization of Purchased Intangible Assets. Amortization of purchased intangible assets was $11.1 million and $5.6 million for the three months ended April 30, 2006 and 2005, respectively. These increases are due to the increase of purchased intangibles acquired through the merger with CNT. These assets are being amortized on a straight-line basis over a period of one to seven years.

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 $.6 million for the quarter ended April 30, 2006. Retention pay offered to all transitional employees is 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. For the quarter ended April 30, 2006, $.6 million has been recognized as a restructuring cost. No further 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 was the UltraNet Multi-Service Director (UMD). In order to eliminate this redundancy and integrate the two company’s product offerings, the Company decided to withdraw the UMD from the market, and continue to sell the Intrepid 10000 product. As a result, McDATA offered, and certain existing UMD customers accepted, an exchange program which allowed customers to trade in their UMD for a comparable Intrepid 10000 at no cost. The Company 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 during the quarter ended April 30, 2006, which represents the difference between the costs of the Intrepid 10000 to be installed over the salvage value of the UMD’s to be returned. 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. This program is substantially complete as of April 30, 2006.

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.

Interest and Other Income. Interest and other income consisted primarily of interest earnings on our cash, cash equivalents and various investment holdings. Interest and other income increased to $4.2 million for the three months ended April 30, 2006 as compared with $1.8 million for the three months ended April 30, 2005. The increase in income from the prior year level reflects an increase in interest rates and increased our cash balances. Fluctuations in our investment balances as well as fluctuations in interest rates could cause our investment income to vary between periods.

Interest Expense. Interest expense consists primarily of the amortization of issuance costs related to the convertible subordinated debt, the convertible debt interest expense not offset by the interest rate swap interest income (discussed below), the amortization of the discount on the CNT debt, and interest expense related to capital leases and notes payable.

For the three months ended April 30, 2006, interest expense increased to $3.6 million compared with $0.8 million for the three months ended April 30, 2005, due primarily to the effect of increased interest rates and the addition of the CNT Notes. In order to manage interest expense on our convertible debt, the Company has two interest-rate swap agreements in effect, which have the economic effect of modifying the fixed interest obligations associated with our convertible debt so that the interest payable on the majority of the debt effectively becomes variable. The rate on the interest rate swap agreement covering $155.3 million of the 2.25% Convertible Notes is based on the six-month London Interbank Offered Rate (LIBOR) minus 152 basis points, is reset semiannually on February 15 and August 15 of each year until maturity on February 15, 2010, and was 3.41% as of April 30, 2006. The rate on the interest rate swap agreement covering $75 million of the 3.00% Convertible Notes is based on the three-month LIBOR plus 69.5 basis points, is reset quarterly on January 31, April 30, July 31, and October 31 of each year, and was 5.82% as of April 30, 2006. Significant increases in interest rates in future periods could significantly increase interest expense.

Provision for Income Taxes. The Company has recorded tax expense for the three months ended April 30, 2006 even though the pre-tax result reported in these financial statements is a loss. This is due primarily to taxes payable in foreign jurisdictions where the net taxable income of our branch and subsidiary operations is projected to be positive. No federal tax benefit is recorded currently for the year-to-date loss. We are booking tax expense of $1.7 million for the three months ended April 30, 2006 but projecting full year expense of $3.2 million plus expense generated from the utilization, if any, of Nishan and CNT acquired tax attributes.

The calculation of income tax expense or benefit for the current period is based in part on estimates of future results and projections of taxable income for the full fiscal year in each jurisdiction in which the Company operates. These projections could be affected, positively or negatively, by such factors as future changes in tax law or implementation of possible tax planning strategies.

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

Stock compensation expense. Effective February 1, 2006 we began recording compensation expense associated with stock-based awards and other forms of equity compensation in accordance with SFAS 123R. Under the fair value recognition provisions of SFAS 123R, stock-based compensation expense is measured at the grant date based on the fair value of the award and is recognized as expense over the vesting period. Determining the fair value of stock-based awards and other forms of equity compensation at the grant date requires judgment, including estimating our stock price volatility and employee stock option exercise behaviors. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially impacted.

Total stock-based compensation expense for the three months ended April 30, 2006 was $2.6 million. Of this amount, $354,000 was included in cost of sales, $326,000 in research and development, $639,000 in sales and marketing, $1.3 million in general and administrative expenses. In addition, $632,000 of these costs were capitalized into our software assets. Total stock-based compensation expense for the three months ended April 30, 2005 was $718,000. Of this amount, of $15,000 was included in cost of sales, $453,000 in research and development, $69,000 in sales and marketing, and $181,000 in general and administrative expenses. Total stock-based compensation benefit as of April 30, 2005 excludes certain stock-based awards which were previously reported as proforma compensation expense under APB 25 (see Note 2, “Summary of Significant Accounting Policies,” of the 10K for the year ended January 31, 2006).

Restructuring Charges. Restructuring charges of $0.6 million for the three months ended April 30, 2006 consists of additional expenses incurred associated with the CNT acquisition.

Liquidity and Capital Resources

At April 30, 2006, cash and cash equivalents, short and long-term investments and restricted cash were approximately $364 million compared to approximately $353 million as of January 31, 2006. The April 30, 2006 balance includes approximately $3.8 and $9.9 million of restricted cash classified as short term and long term, respectively, that we are required to maintain in relation to the interest rate swap we have executed in connection with our convertible debt. We invest excess cash predominantly in debt and equity instruments that are highly liquid, of high-quality investment grade, and predominantly have maturities of less than three years with the intent to make such funds readily available for operating purposes, including expansion of operations and potential acquisitions or other transactions.

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

In summary, our cash flows were:


Source (use) (in thousands)	Three Months Ended April 30,
Source (use) (in thousands)	2006			2005
Net cash provided by operating activities	$	14,355		$	8,105
Net cash provided by (used in) investing activities		(28,752	)		1,230
Net cash provided by (used in) financing activities		69			(213	)

Cash provided by operating activities of $14.4 million for the three months ended April 30, 2006 consists of our net loss adjusted for non-cash charges (including depreciation, amortization, deferred compensation and inventory-related charges) and changes in working capital and other activities. Working capital items include accounts receivable, inventories, other current and non-current assets, accounts payable, accrued liabilities and deferred revenue.

Cash used in investing activities of ($28.8) million for the three months ended April 30, 2006 consists of $115 million in purchases of investments, partially offset by $93 million of proceeds from maturities and sales of investments and $4 million of capital expenditures.

Cash provided by financing activities of $69,000 for the three months ended April 30, 2006 was primarily due to $0.8 million of proceeds from the issuance of common stock partially offset by $0.7 million of payments on long term notes payable and capital leases.

Off-Balance Sheet Arrangements

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

Ordinary Course Purchase and Sale Agreements

During its normal course of business, the Company may enter into agreements with, among others, customers, resellers, OEMs, systems integrators and distributors. These agreements typically require the Company to indemnify the other party against third party claims or product infringements on patents or copyrights. The Company provides indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising for the use of our products. We have also indemnified our former parent, EMC, for any income taxes arising out of the distribution of our Class A common stock in February 2001.

In addition, the majority of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential future payments 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 (FIN 45). To date, the Company has not incurred any material costs as a result of such obligations and has not accrued any liabilities related to such indemnification and guarantees in our financial statements.

Sale of Lumberton, New Jersey Manufacturing Operations

As described in Note 15, 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. 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. Based on the probability of having to make payments under any one of the representations, management has calculated potential discounted future cash flows of approximately $400,000, which has been recorded in the accompanying financial statements as a liability assumed in the acquisition of CNT, in accordance with FIN 45.

SPX Tax Sharing Agreement

Pursuant to the SPX Agreement, if the Internal Revenue Service (IRS) 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 IRS 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 issues raised during the audit that would require Inrange to compensate SPX for lost tax benefits.

Commitments

Purchase Commitments

Convertible Notes

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

Concurrent with the issuance of the 2.25% Notes, the Company entered into share option transactions using approximately $20.5 million of proceeds. As part of these share option transactions, the Company purchased options that cover approximately 16.1 million shares of Class A common stock, at a strike price of $10.71. The Company also sold options that cover approximately 16.9 million shares of Class A common stock, at a strike price of $15.08. The net cost of the share option transactions was recorded against additional paid in capital. These share option transactions are intended to give the Company the option to mitigate dilution as a result of the 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.

On June 1, 2005, effective upon the consummation of the Merger, the Company fully and unconditionally guaranteed the $124.4 million 3.00% convertible subordinated notes due February 15, 2007 previously issued by CNT (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 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.

In order to manage interest expense on our convertible debt, the Company has two interest-rate swap agreements in effect, which have the economic effect of modifying the fixed interest obligations associated with our convertible debt so that

the interest payable on the majority of the debt effectively becomes variable. In July 2003, we entered into an interest rate swap agreement covering $155.3 million of the 2.25% Notes which is based on the six-month London Interbank Offered Rate (LIBOR) minus 152 basis points. The rate on this swap agreement is reset semiannually on February 15 and August 15 of each year until maturity on February 15, 2010, and was 3.41% as of April 30, 2006. Prior to the Merger, CNT entered into an interest rate swap agreement covering $75 million of the 3.00% Notes which is based on the three-month LIBOR plus 69.5 basis points. This rate is reset quarterly on January 31, April 30, July 31, and October 31 of each year until maturity on February 15, 2007, and was 5.82% as of April 30, 2006. Increases in interest rates could significantly increase the interest expense we are obligated to pay under the interest-rate swap agreements in future periods. The swaps were designated as a fair value hedge and, as such, the gain or loss on the derivative instrument, as well as the fully offsetting gain or loss on the Notes attributable to the swaps, were recognized in earnings. We are also required to post collateral based on changes in the fair value of the interest rate swaps. This collateral, in the form of restricted cash, was $13.7 million as of April 30, 2006 and $10.7 million as of January 31, 2006.

Headquarters Lease Commitment

The Company received the certificate of occupancy on January 31, 2006, and because the project was 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.

Contractual Obligations

The following table summarizes our contractual obligations (including interest expense) and commitments as of April 30, 2006 (in thousands):


	Total	Less Than 1 Year	1-3 Years	4-5 Years	More Than 5 Years
Convertible subordinated debt	296,850	124,350	—	172,500	—
Interest on convertible subordinated debt	17,593	5,868	7,763	3,962	—
Non-cancelable operating leases	74,516	8,111	19,046	11,753	35,606
Non-cancelable purchase agreements	91,309	79,809	7,667	3,833	—
Capital leases, including interest	6,058	2,358	3,275	425	—

Total contractual obligations	486,326	220,496	37,751	192,473	35,606

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 mandatory convertible security be included in the computation of basic EPS from the date that conversion becomes mandatory. The FASB made further modifications to this exposure draft and plans to reissue it in the third quarter of 2005, with the final statement expected to be issued in the first quarter of 2006. The Company has not yet determined the potential future impact of the proposed amendment on its consolidated financial statements.

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

Critical Accounting Policies

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. We evaluate the need for reserves associated with obsolete, slow-moving and non-salable inventory by reviewing net realizable values on a quarterly basis. Our inventories does not include materials purchased and held by the Company’s component subcontractors, as the Company does not own this inventory.

Investments

Our 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.

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 economic hedges against positions held in certain marketable equity securities. Because these are ineffective hedges, unrealized gains and losses are charged in the period they occur.

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 us, with similar terms, the carrying values of the capital lease obligations approximate their fair values. The fair values of our investments and convertible debt are determined using quoted market prices for those securities. We recognize 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

We have 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. Our 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.

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

We evaluate 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 three months ended April 30, 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 three months ended April 30, 2006 and 2005, we made no material adjustments to its long-lived assets.

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. We completed our annual impairment analysis of goodwill in the first quarter of 2006 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.” We are currently amortizing its acquired intangible assets with finite lives over periods ranging from one to seven years.

Revenue Recognition

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.

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, 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 our configured products, we recognize revenue on shipment when we ship directly to an end user. When we ship to an OEM or distributor we request evidence of sell-through from our OEM and distributor partners prior to recognizing revenue. In situations where our OEM and distributor partners refuse to provide sell-through information when requested, but all the criteria under SEC Staff Accounting Bulletin (SAB) No. 104, “Revenue Recognition” (SAB No. 104) have been met, we recognize revenue for such configured products. These configured products represent high value, customized solutions of directors, cabinets and various combinations of port cards ordered by our OEM and distributor partners as required by the end-user.

Non-configured products and components, such as our switch products, 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. We accrue for estimated warranty costs at the time of revenue recognition based on its experience.

Service Revenue

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

We 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. We recognize revenue from these contracts ratably over the contractual period, generally one to three years. Although certain contracts are cancellable at the customer’s discretion, we reclassified certain deferred revenue amounts acquired in the purchase of CNT from short to long term based on our analysis of the future periods over which this revenue will be recognized.

Software Development Costs

We capitalize 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 April 30, 2006, were approximately $61.2 million and $26.8 million, respectively. Capitalized software costs and accumulated amortization included in other assets at January 31, 2006, were approximately $53.9 million and $23.1million, respectively. Amortization expense of capitalized software for the three months ended April 30, 2006 was approximately $3.7 million, respectively.

Restructuring Charges

We account 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.

Income Taxes

We estimate a provision for income taxes in each of the jurisdictions in which we operate. We estimate our actual current tax exposure including 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 we include within our balance sheet. We evaluate the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not more likely than expiration of the deferred benefit, we establish a valuation allowance

ITEM 3.

Quantitative and Qualitative Disclosures about Market Risks

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

Interest Rate Risk

We earn interest income on both our cash and cash equivalents and our investment portfolio. Our investment portfolio generally consists of readily marketable investment-grade debt securities of various issuers and maturities ranging primarily from overnight to three years. All investments are denominated in U.S. dollars and are classified as “available for sale.” These instruments are not leveraged, and are not held for trading purposes. As interest rates change, the amount of realized and unrealized gain or loss on these securities will change. The quantitative and qualitative disclosures about market risk are discussed in Item 7A—Qualitative and Quantitative Disclosure About Market Risk, contained in our Form 10-K for fiscal year 2005.

Given our cash and cash equivalents and short- and long-term investments of approximately $363 million at April 30, 2006 a theoretical 1% change in interest rates and security prices would impact our net income positively or negatively by approximately $3.6 million.

Our convertible subordinated debt is subject to a fixed interest rate and the notes are based on a fixed conversion ratio into Class A common stock. The Company has two interest-rate swap agreements covering its convertible debt. The first was entered into by the Company in July 2003 covering $155.3 million of its 2.25% convertible subordinated notes (2.25% Notes) and is set at six-month LIBOR minus 152 basis points, and the second was assumed in the acquisition of CNT which covers $75.0 million of the 3.00% convertible subordinated notes (3.00% Notes) previously issued by CNT and is set at three-month LIBOR plus 69.5 basis points. Both agreements have the economic effect of modifying the fixed interest obligations associated with the notes so that the interest payable on the majority of the notes effectively becomes variable. If interest rates on this variable rate debt were to increase or decrease, our annual interest expense would increase or decrease accordingly. This increased or decreased interest expense would be partially offset by the effects of these interest rate changes on our cash and investment portfolio. The 2.25% Notes are not listed on any securities exchange or included in any automated quotation system; however, the notes are eligible for trading on the PortalSM Market. On April 30, 2006, the approximate bid and ask prices per $100 of our 2.25% Notes was $88.77 and $89.27, respectively, resulting in an aggregate fair value of between $153.1 million and $154.0 million. On April 30, 2006, the approximate bid and ask prices per $100 of our 3.00% Notes was $97.63 and $98.00, respectively, resulting in an aggregate fair value of between $121.4 million and $121.9 million. Our Class A common stock is quoted on the Nasdaq National Market under the symbol, “MCDTA.” On May 31, 2006, the last reported sale price of our Class A common stock on the NASDAQ National Market was $3.78 per share.

Foreign Currency Exchange Risk

We operate sales and support offices in several countries. We are exposed to market risks related to fluctuations in foreign exchange rates because some sales transactions, and the assets and liabilities of our foreign subsidiaries, are denominated in foreign currencies, primarily the Euro and British pounds sterling. As of April 30, 2006, we had no open forward exchange contracts.

Credit Risk

Financial instruments, which potentially subject us to concentrations of credit risk, consist principally of temporary cash investments, investments and trade receivables. We place our temporary cash investments and investment securities in primarily investment grade instruments and limit the amount of investment with any one financial institution. We evaluate the credit risk associated with each of our customers, including our largest customers, EMC and IBM, but generally do not require collateral. We depend on these two customers for most of our total revenue. They also comprise a significant portion of our trade receivables and, therefore, expose us to a concentration of credit risk.

A small portion of our cash is invested in higher yielding investments, and within those investments there may be small amounts invested in derivative financial instruments. These investments are diminimus relative to our overall cash portfolio, and are not subject to any risk beyond our principal investment. We mainly invest our cash, cash equivalents and marketable securities in investment grade, highly liquid investments, consisting of money market instruments, bank certificates of deposits, government obligations and corporate debt instruments.

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

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

In January 2004, CNT entered into an interest-rate swap agreement with Credit Suisse First Boston (CSFB). Subject to the movement in interest rates, we could be exposed to credit risk arising out of net interest payments due to us from CSFB. Based on our review of the possible movement interest rates and the credit strength of CSFB, we have concluded that we do not have a material exposure to credit risk as a result of this interest-rate swap

ITEM 4.

Controls and Procedures

Evaluation of Disclosure Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports under Securities Exchange Act of 1934, as amended (the Exchange Act), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the management of McDATA Corporation (Management), including the Company’s Chief Executive Officer (CEO) and Chief Financial Officer (CFO), as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, Management recognizes that any controls and procedures, no matter how well designed and operated, can only provide reasonable assurance of achieving the desired control objectives. As a result, the Company’s CEO and CFO have concluded that, based upon the evaluation of disclosure controls and procedures (as defined in Rule 13a-15(e) or 15d-15(e) under the Exchange Act), the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report.

Changes in Internal Control Over Financial Reporting

The Company’s Management, with the participation of the CEO and CFO, have evaluated whether any change in the Company’s internal control over financial reporting occurred during the first quarter of fiscal 2006. Based on that evaluation, Management concluded that there has been no change in the Company’s internal control over financial reporting during the first quarter of fiscal 2006 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II—OTHER INFORMATION

ITEM 1.

Legal Proceedings

From time to time, we become involved in various lawsuits and legal proceedings that arise in the normal course of business. Litigation is subject to inherent 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. While it is the current opinion of management that the ultimate disposition of any of the lawsuits described in this Quarterly Report should not have a material adverse effect on our business, financial condition or results of operations, we are incurring significant legal costs and expenses, and such litigation is subject to inherent risks and uncertainties. Please see Note 15 of the Notes to the Consolidated Financial Statements for a description of significant litigation matters.

ITEM 1A.

Risk Factors

Cautionary Statements—Risk Factors

Our Quarterly Revenues and Operating Results Have Historically Fluctuated for a Number of Reasons, Which Has Also Caused Our Stock Price to Fluctuate

Quarterly revenues and operating results from continuing operations have varied significantly in the past due to a number of factors, which has caused our stock price to fluctuate. The primary factors that have historically affected our quarterly financial performance include the following:

•

fluctuations in demand for our products and services;

•

increasing competition from competitors which have products similar to ours and the availability of alternative products that can address storage networking needs of customers;

•

potentially negative financial impact related to our acquisition of CNT;

•

the timing of customer orders, which are often grouped toward the end of a quarter, particularly large orders from our significant customers and whether any orders are cancelled;

•

sales mix among our storage networking products and services;

•

our traditionally long sales cycle, which can range from 90 days to 12 months or more;

•

the fact that our products and services are usually only part of an overall solution that our customers may have problems implementing or obtaining the required components or services from other vendors;

•

our ability to successfully qualify our products with storage OEM’s and our ability to source third party products that we resell;

•

announcements and new product introductions by our competitors and deferrals of customer orders in anticipation of new products, services or product enhancements introduced by us or our competitors;

•

decreases over time in the prices at which we can sell our products;

•

our ability to obtain sufficient supplies of components, including limited sourced components, and products we supply at reasonable prices, or at all;

•

communication costs and the availability of communication lines;

•

increases in the prices of the components and supplied products we purchase;

•

under utilization of consultants;

•

our ability to attain and maintain production volumes and quality levels for our products;

•

increased expenses, particularly in connection with our strategy to continue to expand our relationships with the parties with whom we have entered into strategic relationships; and

•

general economic and political conditions and related customer budget constraints.

Accordingly, you should not rely on the results of any past periods as an indication of our future performance. Because most of our expenses are fixed in the short-term or incurred in advance of anticipated revenue, we may not be able to decrease our expenses in a timely manner to offset any unexpected shortfall in revenue.

Changing Market Conditions and Increased Competitive Risks.

The competition in the data access and SAN, MAN, and WAN market for our products, software and solutions has grown and will continue to become more competitive with (a) the recent introduction of competitive products (b) alternative competitive technologies offered by other network companies that can effectively network storage data, and (c) pricing pressures resulting from this increased competition. As a result of these market changes, we anticipate continued lengthened sales cycles and price erosion in an environment where storage OEM certification of our products may still be required for end-user customer acceptance. Given that a majority of our revenues are derived from our direct-assist sales model with distribution through our channel partners, we are still highly dependent upon our channel partners’ relationships with end-user customers to promote the value of our products. If our channel partners do not promote the value of our products or competitors begin to control end-user customer preference, we may lose sales in key enterprise accounts that would materially adversely affect our revenues. While our recent acquisition of CNT allows us to offer SAN extension products, third party products and services directly to end-user customers, and such offerings are generally not in conflict with our channel partners, we are nonetheless cautious in our sales model to properly manage and leverage the existing channel relationships we have.

We may not be able to successfully compete against existing or potential SAN competitors.

The market for our SAN switching products, software and solutions is highly competitive, especially with the entrance of Cisco into the market in 2002. Our competitors are providing SAN switching hardware, server blade solutions and software that is multi-protocol capable (such as Fibre Channel over IP (FCIP), SCSI over Internet (iSCSI), Internet Fibre Channel (iFCP) and InfiniBand). Our competitors in this market include Brocade, Cisco, QLogic Corp., Emulex Corporation (which acquired Vixel Corporation), Broadcom Corporation (which acquired the assets of Gadzoox Networks), Fujitsu Softech and others, including storage hardware device providers. Given the market share gain by Cisco, other IP based switching companies such as Juniper, Extreme, Foundry and others may enter the market for SAN products. Many of our competitors and potential competitors have longer operating histories, greater name recognition, access to larger customer bases, more established distribution channels and substantially greater financial and managerial resources than McDATA. Given the highly competitive market, we anticipate continued lengthened sales cycles and continued downward pricing pressures. To be competitive, we recently acquired CNT to expand our Global Enterprise Data Infrastructure (GEDI) strategy, which is to enable customers to consolidate their data assets in storage networks and to extend the boundary of those networks through network connectivity and distance products (i.e., SAN extension products previously offered by CNT). These products and services are sold directly and through channels partners. Continued or increased competition could result in pricing pressures, reduced sales, reduced margins, reduced profits, reduced market share, further elongating of sales cycles, or the failure of our products to achieve or maintain market acceptance.

We incurred a substantial loss for the three months ended April 30, 2006 and for the fiscal year ended January 31, 2006 and may not be profitable in the future.

We incurred losses of $9.5 million and $30.6 million, respectively, for the three months ended April 30, 2006 and for the fiscal year ended January 31, 2006. Our future operating results will depend on many factors, including the growth of the SAN market, market acceptance of new products we introduce, demand for our products, levels of product and price competition and our reaching and maintaining targeted costs for our products. In addition, we expect to incur continued significant product development, sales and marketing, and general and administrative expenses. We cannot provide assurance that we will generate sufficient revenue to achieve or sustain profitability.

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

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

We depend on large distribution and end-user customer relationships.

We depend on EMC, IBM and HDS, for a significant portion of our total revenue. Sales to EMC, IBM and HDS represented approximately 29%, 27% and 7%, respectively, of our revenue for the three months ended April 30, 2006. We anticipate that our future operating results will continue to depend heavily on sales to EMC, IBM and HDS. EMC, IBM and HDS resell products offered by our competitors, and nothing restricts EMC, IBM and HDS from expanding those relationships in a manner that could be adverse to us. Therefore, the loss of either EMC, IBM or HDS as a channel customer, or a significant reduction in sales to either EMC, IBM and HDS could significantly reduce our revenue. While we are aware that Dell sources some of our switch product through EMC, it is unclear whether this mitigates our dependency on EMC. Our product sales agreements with sales partners do not provide for the purchase of a guaranteed minimum amount of product.

With our acquisition of CNT, a significant portion of our total revenue is also dependent on large sale transactions with Fortune 500 customers in the financial services, telecommunications, information outsourcing and retail market segments. Failure to close a large SAN extension or solutions sale with a single end-user customer may adversely affect our revenue in any particular fiscal quarter.

We currently have limited product offerings and must successfully introduce new products (such as the Remote Office Consolidation Solution (ROC)) and product enhancements that respond to rapid technological changes and evolving industry standards.

We derive a substantial portion of our revenue from a limited number of products. As a result, we could have a significant decrease in revenue if one of our products lines becomes obsolete, does not obtain and maintain market acceptance or if there is a decrease in demand for our products for any other reason.

For the three months ended April 30, 2006, we derived a significant portion of our revenue from sales of our director-class Intrepid switch products. We expect that revenue from our director-class Intrepid products will continue to account for a substantial portion of our revenue for the foreseeable future. Factors such as performance, market positioning, the availability and price of competing products, the introduction of new technologies and the success of our OEM, reseller and systems integrator customers will affect the market acceptance of our products. Therefore, continued market acceptance of these products and their successor products are critical to our future success.

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

We are currently developing products that contain untested devices and subassemblies. During the quarter ended April 30, 2006, we introduced the “McDATA ROC” —a total solution for Remote Office Consolidation enabling consolidation, optimization and protection of remote corporate data without slowing the pace of real-time global business. The ROC offering allows corporations to centralize their data and solve the latency issue by using special appliances and software to speed application response. The ROC offering allows remote users instant access to applications and data housed at the central data center while enabling faster block data transfer over the wide area network.

As with any development, there are inherent risks should such devices or subassemblies require redesign or rework. In particular, in conjunction with the transition of our products from fibre channel to multi-protocol, 2 Gb to 4 Gb to 8 Gb to 10 Gb transmission speed technology, higher port densities, and advanced management capabilities, we will be introducing products with new features and functionality, such as our next generation director-class switch product, the Intrepid 10000 Director and our next generation switch, such as the Sphereon 4400 and Sphereon 4700. We face risks relating to this product transition, including risks relating to getting storage and system OEMs to qualify such products, forecasting of demand, as well as possible product and software defects and a potentially different sales and support environment due to the complexity of these new systems. Finally, if we fail to timely introduce new products, or to add new features and functions to existing products to compete against new entrants in the market, or if there is no demand for these or our current products, our business could be seriously harmed.

We may not successfully integrate or realize the benefits of the acquisition of Computer Network Technology Corporation.

On June 1, 2005, we acquired CNT. While management believes that such acquisitions are an integral part of our long-term strategy, there are risks and uncertainties related to acquiring companies. The integration of CNT is a complex, time-consuming and expensive process that, without proper planning and implementation, could significantly disrupt our business, controls and procedures. We may not successfully integrate CNT and the failure to meet the challenges involved in integrating the operations of McDATA and CNT successfully or otherwise to realize any of the anticipated benefits of the

merger could seriously harm our business. The challenges involved in this integration include, but are not limited to, the following:

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successfully combining product and service offerings;

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integrating and coordinating sales and marketing activities;

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realizing the financial, operational and headcount synergies to improve the overall business model of the company;

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integrating and coordinating research and development activities to enhance existing or introduce new products and services;

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preserving customer, distribution, reseller, OEM, manufacturing, supplier and other important relationships of both McDATA and CNT and resolving potential conflicts that may arise;

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minimizing the diversion of management attention from other strategic opportunities and operational matters;

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integrating the diverse financial systems of both McDATA and CNT;

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addressing differences in the business cultures of McDATA and CNT, maintaining employee morale and retaining key employees; and

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coordinating and combining overseas operations, relationships and facilities, which may be subject to additional constraints imposed by geographic distance, local laws and regulations.

The anticipated benefits of the merger are based on projections and assumptions, including successful integration, not actual experience. In addition to the integration risks discussed above, our ability to realize these benefits could be adversely affected by practical or legal constraints on our ability to combine operations. Finally, if our stock price decreases significantly, this may result in a reassessment of our goodwill (which includes significant goodwill related to the acquisition of CNT) to determine if an impairment is necessary.

Our business is subject to risks from global operations.

We conduct significant sales and customer support operations in countries outside of the United States and also depend on non-U.S. operations of our contract manufacturers, and our distribution partners. Further, we utilize an India based firm, HCL Technologies, to provide certain software engineering services, and our virtualization chip supplier, Aarohi Communications, is also reliant on offshore engineering. We derived approximately 41% of our revenue for the three months ended April 30, 2006, from customers located outside of the United States. We believe that our continued growth and profitability will require us to continue to expand marketing and selling efforts internationally. We have limited experience in marketing, distributing and supporting our products internationally and may not be able to maintain or increase international market demand for our products. In addition, our international operations are generally subject to inherent risks and challenges that could harm our operating results, including:

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expenses associated with developing and customizing our products for foreign countries and different languages;

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difficulties in staffing and managing international operations, including recruiting qualified personnel in foreign markets and reliance on third parties to manage certain aspects of our foreign operations, including hub inventory locations;

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unusually high expenses and timeliness with the hiring and termination of employees in foreign countries;

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multiple, conflicting and changing governmental laws and regulations, including difficulty in enforcing our legal rights in foreign jurisdictions;

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

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longer sales cycles for our products;

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reduced or limited protections of intellectual property rights;

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

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compliance with international standards that differ from domestic standards;

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

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

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

Unforeseen environmental costs could impact our future net earnings.

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

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

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

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

Risks related to internal controls.

Public companies in the United States are required to review their internal controls under the Sarbanes-Oxley Act of 2002. It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. The acquisition of CNT in June, 2005 added significantly to the size, complexity and geographic reach of our operations and increased the risk that our control systems will not be adequate to prevent or detect errors in our financial statements. If the internal controls put in place by us are not adequate or in conformity with the requirements of the Sarbanes-Oxley Act of 2002, and the rules and regulations promulgated by the Securities and Exchange Commission, we may be forced to restate our financial statements and take other actions which will take significant financial and managerial resources, as well as be subject to fines and other government enforcement actions.

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

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

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

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

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

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

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

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

Our success will depend on our continuing ability to develop and manage relationships with significant OEMs, resellers and systems integrators, as well as on the sales efforts and success of these customers. We cannot provide assurance that we will be able to expand our distribution channels or manage our distribution relationships successfully or that our customers will market our products effectively. Our failure to expand our distribution channels or manage successfully our distribution relationships or the failure of our OEM and reseller customers to sell our products could reduce our revenue and operating results.

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

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

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

We rely on Sanmina SCI, Inc. (SSCI) and Solectron Corporation, together our contract manufacturers, to manufacture our products. Our contract manufacturers are not obligated to supply products to us for any specific period, or in any specific quantity, except as may be provided in a particular purchase order. In addition, our contract manufacturers do not guarantee that adequate capacity will be available to us within the time required to meet additional demand for our products. We generally place forecasts for products with our contract manufacturers approximately four to five months prior to the anticipated delivery date, with order volumes based on forecasts of demand for our products. We generally place purchase orders sixty calendar days in advance of delivery. If we fail to forecast demand for our products accurately, we may be unable to obtain adequate manufacturing capacity from our contract manufacturers to meet our customers’ delivery requirements or unexpected increases in customer purchase orders. As a result, we may not be able to benefit from any incremental demand and could lose customers. If we over-estimate demand for our product, we may accumulate excess inventories and obligations to our contract manufacturers under binding purchase orders in excess of our needs. At April 30, 2006, the Company’s commitment with our Contract Manufacturers for purchases over the next 60 days totaled $59.0 million, and $32.3 million for commitments beyond 60 days.

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

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

Our ability to successfully implement our business plan, develop and offer products, and manage expansion in a rapidly evolving market requires a comprehensive and effective planning and management process. We continue to increase the scope of our operations domestically and internationally. In addition, in September 2003, we acquired Sanera and Nishan and in June 2005, we acquired CNT, which significantly increased the size of our operations. Our growth in business and relationships with customers and other third parties has placed, and will continue to place, a significant strain on management systems, resources, intercompany communication and coordination. As we grow, our failure to maintain and to continue to improve upon our operational, managerial and financial controls, reporting systems, processes and procedures, and/or our failure to continue to expand, train, and manage our work force worldwide, could seriously harm our business and financial results.

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

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

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

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

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

As more fully set forth our Consolidated Financial Statements, we are a defendant in several class action lawsuits. We may become subject to additional class action litigation following a period of volatility in the market price of our common stock. Securities class action litigation results in substantial costs and diverts the attention of management and our resources and seriously harms our business, financial condition and results of operations. In addition, and as a result of the CNT acquisition, CNT and its subsidiaries are involved in various lawsuits that we are now defending against. Defense costs, an adverse judgment or even a significant settlement of these lawsuits may adversely affect our financial results in any given fiscal quarter.

We have an uneven sales pattern.

Our quarterly operating results may vary due to the following factors:

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the size, timing, terms and fluctuations of customer orders, which are often grouped toward the end of a calendar quarter, particularly large orders from EMC, IBM or HDS;

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

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sales mix among our storage network products and services;

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fluctuations in our direct sales to customers;

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our ability to attain and maintain market acceptance of our existing product and new products;

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seasonal fluctuations in customer buying patterns;

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

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our ability to obtain sufficient supplies of third party products or single- or limited-source components for our own products; and

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

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

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

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

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

As part of our strategy, from time to time we expect to review opportunities to buy other businesses or technologies that would complement our current products, expand the breadth of our markets or enhance our technical capabilities, or that

may otherwise offer growth opportunities. We may buy businesses, products or technologies in the future. In the event of any future purchases, we could:

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issue stock that would dilute our current stockholders’ percentage ownership;

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

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incur debt; or

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assume liabilities.

These purchases also involve numerous risks, including:

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

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unanticipated costs;

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diversion of management’s attention from our core business;

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adverse effects on existing business relationships with suppliers and customers;

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

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potential loss of key employees of acquired organizations.

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

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

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

McDATA has guaranteed the payment of principal and interest on approximately $124.4 million principal amount of CNT’s 3.00 % convertible subordinated notes due 2007. 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 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.

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

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

Our products must comply with governmental regulation.

In the United States, our products comply with various regulations and standards defined by the Federal Communications Commission and Underwriters Laboratories. Internationally, products that we develop will be required to comply with standards established by authorities in various countries. In the last several years, the European Union (EU) has adopted a number of initiatives (WEEE, RoHS, etc.) related to equipment emissions, electronic waste, privacy of information

and expanded consumer warranties. Failure to comply with existing or evolving industry standards or to obtain timely domestic or foreign regulatory approvals or certificates could seriously harm our business.

Providing telecommunications services to our customer’s subjects us to new risks.

Our provision of telecommunications and bandwidth to our customers subjects us to various risks. First, telecommunications networks and circuits can fail which would make it difficult for us to attract and retain clients. In addition, we may experience difficulty in obtaining or developing circuits to provide to our clients. The telecommunications industry is heavily regulated by state and federal governments, and changes in these regulations could make it difficult for us to compete. In addition, the regulatory framework under which we operate and new regulatory requirements or new interpretations of existing regulatory requirements could require substantial time and resources for compliance, which could make it difficult for us to operate our business. Such regulation could also impede our ability to enter into change-of-control transactions.

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

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

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authorizing the issuance of preferred stock without stockholder approval;

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

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limiting the persons who may call special meetings of stockholders;

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

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

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prohibiting cumulative voting for the election of directors;

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

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

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

Our stock price is volatile.

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

Risks Related to Our Relationship With EMC

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

In October 1997, and in connection with the reorganization of our business, we entered into certain agreements with EMC relating to our business relationship with EMC. In addition, we have entered into agreements with EMC relating to our relationship with EMC after the completion of our initial public offering in August 2000 and the distribution by EMC of our Class A common stock in February 2001. We have also entered into an OEM Purchase and License Agreement with EMC that governs EMC’s purchases of our products and grants EMC rights to use, support and distribute software for use in connection with these products. The agreement does not provide for the purchase of a guaranteed minimum amount of product. These agreements were negotiated and made in the context of our prior parent-subsidiary relationship. As a result, some of these agreements may have terms and conditions, including the terms of pricing, that are less beneficial to us than agreements negotiated with unaffiliated third parties. Sales and services revenue pursuant to these agreements with EMC represented approximately 29% of our revenue for the three months ended April 30, 2006. In addition, in some instances, our

ability to terminate these agreements is limited, which may prevent us from being able to negotiate more favorable terms with EMC or from entering into similar agreements with third parties.

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

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

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

ITEM 6.

Exhibits

(a)

Exhibits filed for the Company through the filing of this Form 10-Q.



31.1		Certification of Chief Executive Officer

31.2		Certification of Chief Financial Officer

32		Certification of Chief Executive Officer and Chief Financial Officer

SIGNATURE

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


McDATA CORPORATION

By:		/s/ SCOTT BERMAN
		Scott Berman Executive Vice President of Finance and Chief Financial Officer

By:		/s/ MICHAEL MORENO
		Michael Moreno Controller Chief Accounting Officer

June 9, 2006

MCDATA CORP 10-Q