CROSSROADS SYSTEMS INC - 10-Q Quarterly Report

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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 JULY 31, 2003

OR

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

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER: 000-30362

CROSSROADS SYSTEMS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 74-2846643
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)

8300 NORTH MOPAC EXPRESSWAY
AUSTIN, TEXAS 78759
(Address of Registrant's principal
executive offices, including zip code.)

(512) 349-0300
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Sections 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. [X] Yes [ ] No

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

As of September 12, 2003 Registrant had outstanding 24,335,968 shares of
common stock, par value $0.001 per share.

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

FORM 10-Q
QUARTER ENDED JULY 31, 2003

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE DATA)

See accompanying notes to unaudited condensed consolidated financial statements.

2

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

See accompanying notes to unaudited condensed consolidated financial statements.

3

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)

See accompanying notes to unaudited condensed consolidated financial statements.

4

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES

In the opinion of management, the accompanying Condensed Consolidated
Financial Statements for Crossroads Systems, Inc. (collectively with its
wholly-owned subsidiaries, Crossroads or the Company) include all adjustments,
consisting only of normal recurring items, necessary to present fairly its
financial position as of October 31, 2002 and July 31, 2003, its results of
operations for the three and nine month periods ended July 31, 2002 and 2003,
and its cash flows for the nine month periods ended July 31, 2002 and 2003.
Certain reclassifications have been made to prior year amounts in order to
conform to the current year presentation. The results of operations for the
three and nine months ended July 31, 2003 are not necessarily indicative of
results that may be expected for any other interim period or for the full year.

The accompanying financial data as of July 31, 2003, and for the three and
nine month periods ended July 31, 2002 and 2003, have been prepared by the
Company, without audit, pursuant to the rules and regulations of the Securities
and Exchange Commission (the SEC). Certain information and footnote disclosures
normally included in financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted pursuant to the
SEC's rules and regulations. These unaudited financial statements should be read
in conjunction with the audited financial statements and related notes for the
year ended October 31, 2002, included in our Annual Report on Form 10-K.

The preparation of financial statements in accordance with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.

As defined by Statement of Financial Accounting Standards (SFAS) No. 131,
"Disclosures about Segments of an Enterprise and Related Information," the
Company operates in one disclosable segment, using one measurement of
profitability for its business.

Revenue Recognition

Product revenue is generally recognized when persuasive evidence of an
arrangement exists, delivery has occurred, the price is fixed or determinable,
collectibility is probable and the risk of loss has passed to the customer.
Revenue from product sales to customers that do not have rights of return,
including product sales to Original Equipment Manufacturers (OEMs) and certain
distributors, Value Added Resellers (VARs) and system integrators, are
recognized upon shipment. Sales and cost of sales related to customers that have
rights of return are deferred and subsequently recognized upon sell-through to
end-users.

Royalty and other revenue includes licensing of intellectual property (IP),
royalty payments, sales of service contracts and consulting fees. IP licensing
arrangements usually consist of upfront nonrefundable fees including payments
relating to past sales of licensee products or payments related to a paid-up
license in which the licensee makes a single payment for a lifetime patent
license. Once a license agreement is signed, delivery of the license has
occurred and there are no remaining obligations outstanding, the Company records
revenue from upfront nonrefundable IP license fees. Service revenue is
recognized over the service period.

Warranty Costs

The Company provides for the estimated cost to repair or replace products
under warranty and technical support costs when the related product revenue is
recognized. The Company warrants products for a period from 12 to 39 months
following the sale of its products. A reserve for warranty costs is recorded
based upon the historical level of warranty claims and management's estimate of
future costs.

Recent Accounting Pronouncements

In May 2003, the Financial Accounting Standards Board (FASB) issued SFAS
No. 150, "Accounting for Certain Financial Instruments with Characteristics of
both Liabilities and Equity." SFAS No. 150 states that companies that issue
financial instruments that have characteristics of both liabilities and equity
will have to determine if the

5

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

instrument should be classified as a liability or equity for financial
instruments entered into or modified after May 31, 2003. The adoption of FASB
No. 150 did not have a material effect on the Company's operating results or
financial condition.

SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities" was issued in April 2003. SFAS No. 149 amends and clarifies
accounting for derivative instruments, including certain derivative instruments
embedded in other contracts and for hedging activities under SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities." SFAS No. 149 is
generally effective for derivative instruments, including derivative instruments
embedded in certain contracts, entered into or modified after June 30, 2003 and
for hedging relationships designated after June 30, 2003. The adoption of SFAS
No. 149 did not have a material impact on the Company's operating results or
financial condition.

In January 2003, the FASB issued FASB Interpretation No.46 (FIN 46),
"Consolidation of Variable Interest Entities, an Interpretation of ARB No.51."
FIN 46 requires certain variable interest entities to be consolidated by the
primary beneficiary of the entity if the equity investors in the entity do not
have the characteristics of a controlling financial interest or do not have
sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. FIN 46 is
effective for all new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or acquired prior to
February 1, 2003, the provisions of FIN 46 must be applied for the first interim
or annual period beginning after June 15, 2003. The adoption of FIN 46 did not
have a material effect on the Company's operating results or financial
condition.

In November 2002, the Emerging Issues Task Force (EITF) reached a consensus
on Issue No.00-21, "Revenue Arrangements with Multiple Deliverables." EITF Issue
No.00-21 provides guidance on how to account for arrangements that involve the
delivery or performance of multiple products, services and/or rights to use
assets, The provisions of EITF Issue No.00-21 will apply to revenue arrangements
entered into in fiscal periods beginning after June 15, 2003. The adoption of
EITF 00-21 did not have a material effect on the Company's operating results or
financial condition.

As of July 31, 2003, the Company has one stock-based employee compensation
plan, which is described more fully in Note 8 of our Annual Report on Form 10-K.
The Company accounts for this plan under the recognition and measurement
principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees,"
and related Interpretations. The following table illustrates the effect on net
loss and loss per share if the Company had applied the fair value recognition
provisions of FASB Statement No. 123, "Accounting for Stock-Based Compensation,"
as amended by SFAS No. 148, "Accounting for Stock-Based Compensation -
Transition and Disclosure," to stock-based employee compensation (in thousands,
except share data):

6

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

2. INVENTORIES

Inventories, net consist of the following (in thousands):

3. CONCENTRATIONS

Financial instruments that potentially expose the Company to concentrations
of credit risk consist primarily of cash and cash equivalents, short-term
investments and accounts receivable. The Company invests only in high credit
quality short-term instruments.

The Company's sales are primarily concentrated in the United States and are
primarily derived from sales to OEMs in the computer storage and server
industry. Revenue is concentrated with several major customers. The loss of a
major customer, a change of suppliers or a significant technological change in
the industry could affect operating results adversely. The Company performs
credit evaluations of its customers and generally does not require collateral on
accounts receivable balances. The Company has established reserves for credit
losses and sales returns and other allowances. The Company has not experienced
material credit losses in any of the periods presented.

The Company's business is concentrated in the storage area networking
industry, which has been impacted by unfavorable economic conditions and reduced
information technology, or IT, spending rates. Accordingly, the Company's future
success depends upon the buying patterns of customers in the storage area
networking industry, their response to current and future IT investment trends,
and the continued demand by such customers for the Company's products. The
Company's continued success will depend upon its ability to enhance its existing
products and to develop and introduce, on a timely basis, new cost-effective
products and features that keep pace with technological developments and
emerging industry standards. The Company's supplier arrangement for the
production of certain vital components of its storage routers is concentrated
with a small number of key suppliers.

Additionally, the Company relies on a limited number of contract
manufacturers to provide manufacturing services for its products. The inability
of any contract manufacturer or supplier to fulfill supply requirements could
materially impact future operating results.

7

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

The percentage of sales to significant customers was as follows:

* In May 2002, HP completed its acquisition of Compaq. These percentages
reflect sales to HP and Compaq prior to the merger and sales to the combined
company after the merger.

The level of sales to any customer may vary from quarter to quarter.
However, the Company expects that significant customer concentration,
particularly to our two major customers, will continue for the foreseeable
future. The loss or a decrease in the level of sales to either of these
customers could have a material adverse impact on the Company's financial
condition or results of operations.

4. BUSINESS RESTRUCTURING EXPENSES AND ASSET IMPAIRMENT

In May 2002, the Company completed a restructuring plan that reduced its
workforce by approximately 25%, or 40 people (primarily in the sales, marketing
and general and administrative areas), to scale down its infrastructure and to
consolidate operations.

Components of business restructuring expenses and the remaining
restructuring accruals as of July 31, 2003 are as follows (in thousands):

The entire accrual amount relates to remaining payments to be made for lease
abandonment losses. In March 2003, the Company signed an agreement to sublease a
portion of its abandoned facilities. The anticipated rent payments from this
sublease are approximately $0.5 million through January 2006. A second agreement
to sublease

8

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

a portion of its abandoned properties was signed in May 2003. The anticipated
rent payments from the second sublease are approximately $0.1 million through
January 2006.

The Company reduced the restructuring accrual by approximately $140,000 at
March 31, 2003 and by another $49,000 at July 31, 2003 for rent payments to be
received during the initial twelve months of each sublease term, respectively.
The Company will assess recoverability of these sublease payments on a quarterly
basis.

As of July 31, 2003, remaining cash expenditures resulting from the
restructuring are estimated to be approximately $1.1 million and relate to
facility lease abandonment losses only. During the third fiscal quarter, the
Company adjusted this accrual to reflect $0.1 million in construction cost
savings and $0.1 million in leasing fee savings. The Company has substantially
completed their restructuring efforts initiated in conjunction with the
restructuring announcement made during fiscal 2002; however, there can be no
assurance future restructuring efforts will not be necessary.

5. LINE OF CREDIT

The Company carries a line of credit with its bank. The committed revolving
line provides for an advance of up to $3.0 million with a borrowing base of 80%
of eligible accounts receivable. The line of credit will mature on June 14,
2004. As of July 31, 2003, there were no borrowings outstanding under this
revolving line of credit.

6. COMMITMENTS AND CONTINGENCIES

OPERATING LEASES

The Company leases its facility and certain equipment under various
operating lease agreements expiring on various dates through April 2006. In
conjunction with entering into a lease agreement for its headquarters, the
Company signed an unconditional, irrevocable letter of credit with a bank for
$250,000, which is secured by the $3.0 million line of credit. Future minimum
lease payments under all non-cancelable operating leases as of July 31, 2003
were approximately $5.3 million. In addition to base rent on its facilities
lease, many of the operating lease agreements require that the Company pay a
proportional share of the respective facilities' operating expenses.

As of July 31, 2003, the Company had a facility lease losses reserve,
related to future facility lease commitments of approximately $1.1 million of
space abandoned as part of the Company's restructuring plan.

GUARANTEES AND PRODUCT WARRANTIES

FIN 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others," requires that upon
issuance of a guarantee, the guarantor must disclose and recognize a liability
for the fair value of the obligation it assumes under that guarantee. The
initial recognition and measurement requirement of FIN 45 is effective for
guarantees issued or modified after December 31, 2002. As of July 31, 2003, the
Company's guarantees that were issued or modified after December 31, 2002, were
not material.

The disclosure requirements of FIN 45 are effective for interim and annual
periods ending after December 15, 2002, and are applicable to the Company's
product warranty liability and certain guarantees issued before December 31,
2002. The Company's guarantees issued before December 31, 2002, which would have
been disclosed in accordance with the disclosure requirements of FIN 45, were
not material.

It is the Company's policy to repair or replace products that have been
authorized for repair or replacement by the Company's customers. The Company
maintains a reserve for the estimated costs of such repairs or replacements and
adjusts the reserve based on historical sales volumes as well as actual costs
incurred.

9

Activity in the reserve for product returns during the nine months ended
July 31, 2003 was as follows (in thousands):

LEGAL PROCEEDINGS

Intellectual Property Litigation

On March 31, 2000, the Company filed a lawsuit against Chaparral Network
Storage, Inc. ("Chaparral") alleging that Chaparral had infringed one of its
patents (5,941,972, hereinafter the 972 patent) with some of their products.
In September 2001, the jury found that the '972 patent was valid and that all of
Chaparral's RAID and router products that contained LUN Zoning had infringed all
claims of the Crossroads '972 patent. The federal judge in this matter issued a
permanent injunction against Chaparral from manufacturing any RAID or router
product that contained LUN Zoning or access controls and assessed punitive
damages. As a result, the Company was awarded damages with a royalty amount of
5% for Chaparral's router product line and 3% for their RAID product line.
Chaparral appealed the judgment against it, contending that the '972 patent is
invalid and not infringed. In February 2003, the Federal Circuit Court of
Appeals affirmed the lower court ruling that Crossroads' patent was valid and
willfully infringed by Chaparral, which must stop shipping all products that
contain the Crossroads technology and pay Crossroads a royalty for prior
shipments.

On May 19, 2003, the Company received a payment from Chaparral of
approximately $0.2 million to substantially satisfy the damages judgment.

Securities Class Action Litigation

The Company and several of its officers and directors were named as
defendants in several class action lawsuits filed in the United States District
Court for the Western District of Texas. The plaintiffs in the actions purport
to represent purchasers of our common stock during various periods ranging from
January 25, 2000 through August 24, 2000. On November 22, 2002, the court
granted the Company's motion for summary judgment. On February 26, 2003, the
plaintiffs filed a notice of appeal. The plaintiffs are seeking unspecified
amounts of compensatory damages, interest and costs, including legal fees. The
Company denies the allegations in the complaint and intends to defend itself
vigorously. It is not possible at this time to predict whether the Company will
incur any liability or to estimate the damages, or the range of damages, if any,
that the Company might incur in connection with this lawsuit.

Derivative State Action

On November 21, 2001, a derivative state action was filed in the 261st
District Court of Travis County, Texas on behalf of Crossroads by James Robke
and named several of its officers and directors as defendants. The derivative
state action is based upon the same general set of facts and circumstances
outlined above in connection with the purported securities class action
litigation. The derivative state action alleges that certain of the individual
defendants sold shares while in possession of material inside information in
purported breach of their fiduciary duties to Crossroads. The derivative state
action also alleges waste of corporate assets. On January 28, 2002, the Company
filed an answer and general denial to the derivative state action. In April
2003, the parties reached a tentative agreement to settle the derivative
litigation. The settlement has not yet been approved by the district court.
Consequently, it is not possible to predict whether the Company will incur any
liability or to estimate the damages, or the range of damages, if any, that the
Company might incur in connection with this action.

10

Other

From time to time, the Company may be involved in litigation relating to
claims arising out of its ordinary course of business. Management believes that,
other than the matters described above, there are no claims or actions pending
or threatened against the Company, the ultimate disposition of which would have
a material impact on the Company's financial position, results of operations or
cash flows. If the Company reduces or cancels production orders with its third
party contract manufacturer, the Company may be required to reimburse its
contract manufacturer for materials purchased on its behalf in the normal course
of business.

7. STOCKHOLDERS' EQUITY

TREASURY STOCK

During the fiscal second quarter of 2003, the Company elected to retire all
outstanding shares of treasury stock. Therefore, as of July 31, 2003, there was
no treasury stock outstanding.

DEFERRED STOCK-BASED COMPENSATION

Deferred compensation represents, for accounting purposes, the difference
between the deemed fair value of the common stock underlying these options and
their exercise price on the date of grant. The difference has been recorded as
deferred stock-based compensation and is being amortized over the vesting period
of the applicable options, typically four years.

Stock-based compensation for the periods indicated was allocated as follows
(in thousands):

STOCK OPTION EXCHANGE PROGRAM

On February 10, 2003, the Company completed a stock option exchange program
offered to all eligible option holders. Under the exchange offer, eligible
employees and non-employee members of the board of directors had the opportunity
to tender for cancellation certain eligible stock options in exchange for new
options to be granted at least six months and one day after the cancellation of
the tendered options. The number of shares subject to each new option was based
on the exercise price of the exchanged option. If the exercise price per share
of a returned option was $3.99 or less, the number of shares that will be
subject to the new option will be determined by dividing the number of shares
subject to the returned option by 3. If the exercise price per share of a
returned option was at least $4.00 but not more than $49.99, the number of
shares that will be subject to the new option will be determined by dividing the
number of shares subject to the returned option by 4. If the exercise price per
share of a returned option was $50.00 or more, the number of shares that will be
subject to the new option will be determined by dividing the number of shares
subject to the returned option by 5.

The Company accepted approximately 498,806 options for cancellation and
exchange which equals approximately 10.7% of the total number of options
eligible for exchange. While the executive officers and members of the board of
directors were eligible to participate in the exchange program, none of them
elected to participate in the program. The Company granted 97,601 new options on
August 12, 2003 after taking into consideration employee

11

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

terminations since the cancellation date. The exercise price per share of the
new options is $1.85, which is equal to the closing price of the Company's
common stock on the NASDAQ National Market on August 12, 2003. Crossroads did
not record any compensation expense as a result of the exchange program.

8. NET LOSS PER SHARE

In accordance with SFAS No. 128, "Earnings Per Share," basic and diluted
net loss per share is computed by dividing the loss to common stockholders by
the weighted average number of common shares outstanding for the period, less
shares subject to repurchase. Diluted loss per share is equivalent to basic loss
per share because all common stock equivalents are antidilutive for all periods
presented.

Common stock equivalents consist of outstanding stock options. The total
number of outstanding stock options excluded from the calculations of diluted
net loss per common share were 5,698,397 and 5,243,492 as of July 31, 2002 and
2003, respectively.

9. RELATED PARTY TRANSACTIONS

In July 2000, the Company loaned an employee of the Company $50,000 for
personal reasons, not equity related, in exchange for a full recourse promissory
note due in full, with accrued interest, in 2 years or upon the date in which
the employee ceases to remain in service. The note accrues interest at 10.5% per
year, compounded semi-annually. The principal and accrued interest was due in
one lump sum on July 1, 2002. The terms on this note have been extended to July
1, 2004 and the balance is approximately $68,000 as of July 31, 2003.

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

This report contains forward-looking statements, within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934, that involve risks and uncertainties, such as statements
concerning: growth and future operating results; developments in our markets and
strategic focus; new products and product enhancements; potential acquisitions
and the integration of acquired businesses, products and technologies; strategic
relationships; and future economic, business and regulatory conditions. Such
forward-looking statements are generally accompanied by words such as "plan,"
"estimate," "expect," "believe," "should," "would," "could," "anticipate," "may"
or other words that convey uncertainty of future events or outcomes. These
forward-looking statements and other statements made elsewhere in this report
are made in reliance on the Private Securities Litigation Reform Act of 1995.

OVERVIEW

We are a leading provider of enterprise data routing solutions for open
system storage area networks, or SANs. By using our storage routers to serve as
the interconnect between SANs and the other devices in a computer network,
organizations are able to more effectively and efficiently store, manage and
ensure the integrity and availability of their data. Specifically, when used in
SANs our storage routers:

o decrease congestion in the transfer of data within a network;

o reduce the time required to back up and restore data;

o improve utilization of storage resources; and

o preserve and enhance existing server and storage system investments.

Our mission is to be the company customers trust to link business with
information, regardless of technology or location. Our objective is to maintain
our position as a leading provider of storage routing solutions as storage,
server, and network technologies and markets continue to grow and evolve. The
key elements of our strategy are to:

o solve customer storage issues;

o grow our current market position and expand into adjacent markets; and

o increase our market leadership by continual investment in intellectual
property.

To date, we have sold our products primarily to original equipment
manufacturers, or OEMs, of servers and storage systems. These OEMs sell our
storage routers to end-user organizations for use in their SANs. For the nine
months ended July 31, 2002 and 2003, sales to our OEM customers accounted for
82% and 90% of our total revenue, respectively. We also sell our storage routers
through companies that distribute, resell or integrate our storage routers as
part of a complete SAN solution.

In November 2002, we amended our existing licensing agreement with HP.
Pursuant to this amendment we have outsourced the manufacturing of our embedded
routers to HP. As a result, we do not incur the inventory and overhead costs of
the hardware, and we receive a royalty from HP for licensing our technology,
which has resulted in less aggregate revenue on a per unit basis. We are
currently working under the new agreement and completed our transition to the
royalty model during our fiscal second quarter of 2003. We experienced our first
full quarter under this model during our fiscal third quarter of 2003.

In July 2003, we received a patent licensing fee, which was included in our
royalty and other revenue. Gross margin relating to this patent licensing fee
was 90%. We anticipate that our potential to generate patent licensing fees in
the future will be largely dependent upon our ability to identify and pursue
potential licensees. Licensees currently incorporating our technology into their
products are not contractually obligated to continue doing so. Given the

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concentration of patent licensing revenue, fluctuations in patent licensing fees
may occur and could significantly impact royalty and other revenue from period
to period.

A significant portion of our revenue is concentrated among a small number
of OEM customers, and the merger of HP and Compaq in May 2002 has resulted in
additional concentration. For the nine months ended July 31, 2002 and 2003,
StorageTek and HP represented 74% and 84% of our total revenue, respectively.
The level of sales to any single customer may vary and the loss or decrease in
the level of sales to either of our significant customers would seriously harm
our financial condition and results of operations. Fluctuations in revenue have
resulted from, among other things, product and customer transitions, OEM
qualification and testing, reduced IT spending rates by our customers and
potential customers and our transition to the royalty model with HP which is
described more herein. We expect that a significant portion of our future
revenue will continue to come from sales of products to a relatively small
number of customers.

On a product basis, sales have shifted to our fifth generation of products,
the 6000 and 10000, and to our ServerAttach family of products. Sales of the
4100, 4200 and 4x50 product lines, accounted for approximately 46% and 22% of
our product revenue during the nine months ended July 31, 2002 and 2003,
respectively. This decrease was partially offset by increased sales of fifth
generation products, which accounted for approximately 18% and 41% of our
product revenue during the nine months ended July 31, 2002 and 2003,
respectively. We anticipate that sales of our older products as a percentage of
our total revenue will continue to decrease as we successfully transition our
customers to our newer product platforms.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Management's discussion and analysis of our financial condition and results
of operations are based upon our condensed consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these financial statements
requires management to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenue and expenses, and related disclosure of
contingent assets and liabilities. On an ongoing basis, we evaluate our
estimates, including those related to revenue recognition, deferred taxes,
warranty obligations, inventories, bad debts, facility lease abandonment losses
associated with our restructuring and litigation. We base our estimates on
historical experience and on various other assumptions that are believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.

We believe the following critical accounting policies, among others, affect
our more significant judgments and estimates used in the preparation of our
Condensed Consolidated Financial Statements:

o Revenue recognition;

o Deferred taxes;

o Warranty obligations;

o Excess and obsolete inventories;

o Allowance for doubtful accounts;

o Facility lease abandonment losses; and

o Litigation.

Revenue recognition. With respect to sales of our products to the OEMs, we
recognize product revenue when persuasive evidence of an arrangement exists,
delivery has occurred, price is fixed or determinable, collectibility is
probable and risk of loss has passed to the OEM. Product sales to distributors,
VARs and system integrators who do not have return rights are recognized upon
shipment. To the extent that we sell products to distributors, VARs and system
integrators that have rights of return, we defer revenue and the related cost of
revenue associated with such sales and recognize these amounts when that
customer sells our products to its customers. Deferred revenue as of

14

July 31, 2003 was approximately $0.5 million. As described above, management
judgments and estimates must be made and used in connection with the revenue
recognized in any accounting period. Material differences may result in the
amount and timing of our revenue for any period if our management made different
judgments or utilized different estimates.

Royalty and other revenue includes licensing of intellectual property (IP),
royalty payments, sales of service contracts and consulting fees. IP licensing
arrangements usually consist of upfront nonrefundable fees including payments
related to past sales of licensee products or payments related to a paid-up
license in which the licensee makes a single payment for a lifetime patent
license. Once a license agreement is signed, delivery of the license has
occurred and there are no remaining obligations outstanding, the Company records
revenue from upfront nonrefundable IP license fees. Service revenue is
recognized over the applicable service period.

Deferred taxes. In preparing our financial statements, we are required to
estimate our income tax obligations. This process involves estimating our actual
tax exposure together with assessing temporary differences resulting from
differing treatment of items for tax and accounting purposes. These differences
result in deferred tax assets and liabilities, which are included within our
balance sheet. We must then assess the likelihood that our deferred tax assets
will be recovered from future taxable income and, to the extent we believe that
recovery is not likely, we must establish a valuation allowance. If we change
this valuation allowance in a period, we must include an expense within the tax
provision in our statement of operations.

Judgment is required in determining our deferred tax assets and liabilities
and our valuation allowance recorded against our net deferred tax assets. In
assessing the potential realization of deferred tax assets, we consider whether
it is more likely than not that some portion or all of the deferred tax assets
will be realized. The ultimate realization of deferred tax assets is dependent
upon us attaining future taxable income during the period in which our deferred
tax assets are recoverable. Due to uncertainty surrounding our ability to
generate taxable income in the near future, we have determined that it is more
likely than not that we will not be able to utilize any of the benefits of our
deferred tax assets, including net operating loss carry forwards, before they
expire. Therefore, we have provided a 100% valuation allowance on our deferred
tax assets, and our net deferred tax assets as of July 31, 2003 is zero.

Warranty obligations. We provide for the estimated cost of product
warranties at the time revenue is recognized. These estimates are developed
based on historical information. While we engage in extensive product quality
programs and processes, including actively monitoring and evaluating the quality
of our component suppliers, our warranty obligation is affected by product
failure rates, material usage and service delivery costs incurred in correcting
a product failure. Should actual product failure rates, material usage or
service delivery costs differ from our estimates, revisions to the estimated
warranty liability would be required.

Excess and obsolete inventory. We write down our inventory for estimated
obsolescence or unmarketable inventory based on the difference between the cost
of inventory and the estimated market value based upon assumptions about future
demand and market conditions. If actual demand and/or market conditions are less
favorable than those projected by management, additional inventory write-downs
may be required.

Allowance for doubtful accounts. We continuously assess the collectibility
of outstanding customer invoices and in doing such, we maintain an allowance for
estimated losses resulting from the non-collection of customer receivables. In
estimating this allowance, we consider factors such as:

o historical collection experience;

o a customer's current credit-worthiness;

o customer concentrations;

o age of the receivable balance, both individually and in the aggregate;
and

o general economic conditions that may affect a customer's ability to
pay.

15

Actual customer collections could differ from our estimates. For example,
if the financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances may be
required.

Facility lease abandonment losses. We vacated excess leased facilities as a
result of the restructuring plan we completed during fiscal 2002. We recorded an
accrual of $2.1 million for the remaining lease liabilities of the vacated
space, leasehold improvements required to sublease the vacated space, and
brokerage commissions. We estimated costs of vacating these leased facilities,
including estimated costs to sublease, based on market information and trend
analysis. Any sublease payments received by us are recorded as a reduction to
this accrual based on the specified sublease terms. Actual results may differ
from these estimates in the near term, and such differences could be material to
our financial statements. We signed two agreements to sublease portions of the
abandoned facilities. The anticipated rent payments from these two subleases are
approximately $0.6 million through January 2006. In total, we decreased the
restructuring accrual by approximately $0.2 million as of July 31, 2003 for rent
payments to be received during the initial twelve months of both sublease terms.
We will assess recoverability of these sublease payments on a quarterly basis.
Of the initial $2.1 million charge recorded during fiscal 2002, approximately
$1.8 million relates to the base rent and fixed operating expenses of the
vacated space through the lease term, which ends April 15, 2006.

Litigation. We evaluate contingent liabilities, including threatened or
pending litigation in accordance with SFAS No. 5, "Accounting for Contingencies"
and record accruals when the outcome of these matters is deemed probable and the
liability is reasonably estimable. We make these assessments based upon the
facts and circumstances, and in some instances based in part upon the advice of
outside legal counsel. As of July 31, 2003, we have not accrued any material
costs associated with any pending or threatened litigation as no amounts have
been deemed probable or reasonably estimable. However, any changes in the
threatened or pending litigation could result in revisions to our estimates of
the potential liability and could materially impact our results of operations
and financial position.

16

RESULTS OF OPERATIONS

The following table sets forth our consolidated financial data for the
periods indicated in thousands and expressed as a percentage of our total
revenue. (Dollars in thousands):

PRODUCT REVENUE

Product revenue includes sales of our fifth generation box products, our
older fourth generation products and our ServerAttach line of products. Product
revenue decreased 49.0% from $7.3 million for the three months ended July 31,
2002 to $3.7 million for the three months ended July 31, 2003. The decrease in
product revenue primarily resulted from the shift to a royalty-based model for
embedded products with HP, which led to an expected decline in product revenue
and an increase in royalty revenue as described herein. During the three months
ended July 31, 2002 and 2003, product sales to HP were $4.8 million and $2.3
million, respectively. We have also seen revenue from channel and other OEM
product sales decrease from $1.8 million to $0.6 million for the three months
ended July 31, 2002 and 2003, respectively.

Product revenue decreased 15.4% from $25.3 million for the nine months
ended July 31, 2002 to $21.4 million for the nine months ended July 31, 2003.
The decrease in product revenue was primarily due to a decrease in revenue from
StorageTek as well as a decrease in channel and other OEM product sales. The
decrease in StorageTek's product revenue was driven by third quarter seasonality
as well as weaker product sales from StorageTek during the nine months ended
July 31, 2003 as compared with the nine months ended July 31, 2002. During the
nine months ended July 31, 2002 and 2003, product sales to StorageTek were $6.8
million and $5.4 million, respectively. Product revenue to HP remained
relatively flat during the nine months ended July 31, 2002 and 2003 as volumes
to Compaq were low during the first part of 2002. In addition, we discontinued
our reseller business relationship with Luminex Software in February 2003
because pursuant to our agreement Luminex met specified minimum purchase
thresholds and exercised the option to purchase

17

the assets of our Oregon subsidiary. During the nine months ended July 31, 2002
and 2003, product sales to Luminex were $1.6 million and $0.3 million,
respectively.

We also experienced a decrease in channel and other OEM product sales.
During the nine months ended July 31, 2002 and 2003, sales to channel and other
OEM customers were $5.2 million and $3.0 million, respectively. The decrease in
the sales to channel and other OEM customers is mainly due to weakening
macroeconomic conditions.

We anticipate that channel and other OEM product sales may increase due to
our ongoing efforts to broaden awareness of the benefits of our existing and
recently introduced products, as well as the growth of our sales and marketing
organization. Our sales organization is now focusing on increasing sales demand
through our channel by educating the direct end user of the features and cost
savings our products have to offer.

ROYALTY AND OTHER REVENUE

Royalty and other revenue includes licensing of intellectual property (IP),
royalty payments from HP, sales of service contracts and consulting fees. IP
licensing arrangements usually consist of upfront nonrefundable fees. These fees
are collected as consideration for either past sales of licensee products or a
lifetime patent license. Once a license agreement is signed, delivery of the
license has occurred and there are no remaining obligations outstanding, the
Company records revenue from upfront nonrefundable IP license fees. Service
revenue is recognized over the service period.

In November 2002, we amended our existing licensing agreement with HP.
Pursuant to this amendment we have outsourced the manufacturing of our embedded
routers to HP. As a result, we do not incur the inventory and overhead costs of
the hardware, and we receive a royalty from HP for licensing our technology,
which results in less aggregate revenue on a per unit basis. We are currently
working under the new agreement and completed our transition to the royalty
model during our second fiscal quarter of 2003. The third fiscal quarter was our
first full quarter under this model.

We received a patent licensing fee in July 2003, which represented 26.7%
and 20.6% of the royalty and other revenue for the three and nine months ended
July 31, 2003, respectively. We anticipate that our potential to generate patent
licensing fees in the future will be largely dependent upon our ability to
identify and pursue potential licensees. We have identified and entered into
discussions with potential licensees for the use of our intellectual property.
Fluctuations in patent licensing fees may occur and could significantly impact
royalty and other revenue from period to period.

Royalty and other revenue increased from $0.2 million for the three months
ended July 31, 2002 to $1.9 million for the three months ended July 31, 2003. In
addition, royalty and other revenue increased from $0.4 million for the nine
months ended July 31, 2002 to $2.4 million for the nine months ended July 31,
2003. The increase in royalty and other revenue, for the three and nine months
ended July 31, 2003, was primarily related to royalties earned during the three
months ended July 31, 2003 under our amended licensing agreement with HP as well
as the licensing of our IP. Royalty and other revenue may continue to fluctuate
due to our recent transition to a royalty-based model with HP and IP licensing
arrangements.

COST OF REVENUE

Product

Cost of revenue consists primarily of contract manufacturing costs,
material costs, manufacturing overhead, warranty costs and stock-based
compensation. Cost of revenue decreased 48.2% from $5.1 million for the three
months ended July 31, 2002 to $2.6 million for the three months ended July 31,
2003. Cost of revenue decreased 15.9% from $17.0 million for the nine months
ended July 31, 2002 to $14.3 million for the nine months ended July 31, 2003.
The decrease in cost of revenue was due to decreases in volume and manufacturing
cost savings due to the transition to the royalty model with HP.

18

Royalty and Other

Cost of revenue relating to royalty and other revenue consists primarily of
costs relating to obtaining intellectual property license revenue, as well as
amounts paid to our service provider. Cost of revenue relating to royalty and
other revenue increased 102.2% from $45,000 for the three months ended July 31,
2002 to $0.1 million for the three months ended July 31, 2003. Cost of revenue
increased 85.2% from $0.1 million for the nine months ended July 31, 2002 to
$0.2 million for the nine months ended July 31, 2003. The increase in cost of
revenue relating to royalty and other revenue was mainly due to costs associated
with intellectual property license revenue.

GROSS PROFIT

Gross profit increased 23.9% from $2.4 million for the three months ended
July 31, 2002 to $3.0 million for the three months ended July 31, 2003. Gross
profit margin increased from 32.1% for the three months ended July 31, 2002 to
53.0% for the three months ended July 31, 2003. This increase in gross margin is
primarily attributable to our transition to a royalty-based sales model with HP,
as well increased sales from our higher margin fifth generation products and
patent licensing revenue. Our fifth generation products represented 31.4% and
65.3% of our total product mix for the three months ended July 31, 2002 and July
31, 2003, respectively.

Gross profit increased 9.2% from $8.8 million for the nine months ended
July 31, 2002 to $9.6 million for the nine months ended July 31, 2003. Gross
profit margin increased from 34.2% for the nine months ended July 31, 2002 to
40.3% for the nine months ended July 31, 2003. This increase in gross margin is
also due to our transition to a royalty-based sales model with HP as well as a
higher margin product mix from our fifth generation products and patent
licensing revenue. Our fifth generation products represented 17.6% and 40.9% of
our total product mix for the nine months ended July 31, 2002 and July 31, 2003,
respectively.

Under the terms of the amended agreement with HP for our embedded products,
we will continue to manufacture our stand-alone box versions of our fifth
generation products for HP, as well as for our other OEMs for whom we will also
continue to manufacture our Crossroads branded solutions. We have seen a higher
proportion of revenues being comprised of sales of the fifth generation products
as we transition from our older product lines. The fifth generation products
also provide a higher margin as compared to our older product lines due to their
enhanced features and functionalities.

We have identified and entered into discussions with potential licensees
for the use of our intellectual property. Fluctuations in patent licensing fees
may occur and could significantly impact gross profit from period to period. We
believe that gross margin may continue to fluctuate depending on when volumes
change, when IP licensing revenues are earned and when changes in the type of
products sold occur.

SALES AND MARKETING EXPENSES

Sales and marketing expenses consist primarily of salaries, commissions and
other personnel-related costs, travel, advertising programs, other promotional
activities and stock-based compensation expenses.

Sales and marketing expenses decreased 6.6% from $1.1 million for the three
months ended July 31, 2002 to $1.0 million for the three months ended July 31,
2003. The primary reason for this decrease in sales and marketing expenses was
due to a decrease in stock-based compensation. Stock-based compensation expense
was $0.1 million and $5,000 for the three months ended July 31, 2002 and 2003,
respectively. As a percentage of total revenue, sales and marketing expenses
increased from 14.5% for the three months ended July 31, 2002 to 18.1% for the
three months ended July 31, 2003.

Sales and marketing expenses decreased 40.2% from $5.1 million for the nine
months ended July 31, 2002 to $3.0 million for the nine months ended July 31,
2003. Stock-based compensation expense was $0.4 million and $0.1 million for the
nine months ended July 31, 2002 and 2003, respectively. As a percentage of total
revenue, sales and marketing expenses decreased from 19.7% for the nine months
ended July 31, 2002 to 12.7% for the nine months ended July 31, 2003. This
decrease in sales and marketing expenses was primarily due to our restructuring
efforts

19

during May 2002, which resulted in $1.0 million of decreased compensation
expenses and $0.5 million of decreased advertising, depreciation and tradeshow
expenses.

Sales and marketing personnel totaled 12 at July 31, 2002 and 17 at July
31, 2003. We anticipate that sales and marketing expenses may increase as a
percentage of total revenue, due to our ongoing sales and marketing efforts that
are intended to broaden awareness of the benefits of our existing and recently
introduced products, as well as the growth of our sales and marketing
organization.

RESEARCH AND DEVELOPMENT EXPENSES

Research and development expenses consist primarily of salaries and other
personnel-related costs, product development costs and stock-based compensation
expenses.

Research and development expenses decreased 19.4% from $3.6 million for the
three months ended July 31, 2002 to $2.9 million for the three months ended July
31, 2003. Stock-based compensation expense was $100,000 and $65,000 for the
three months ended July 31, 2002 and 2003, respectively. As a percentage of
total revenue, research and development expenses increased from 48.4% for the
three months ended July 31, 2002 to 52.1% for the three months ended July 31,
2003. This decrease in research and development expenses was primarily due to
our restructuring efforts during fiscal 2002, which resulted in $0.6 million of
decreased overhead allocations.

Research and development expenses decreased 32.3% from $13.4 million for
the nine months ended July 31, 2002 to $9.1 million for the nine months ended
July 31, 2003. Stock-based compensation expense was $0.3 million and $0.2
million for the nine months ended July 31, 2002 and 2003, respectively. As a
percentage of total revenue, research and development expenses decreased from
52.0% for the nine months ended July 31, 2002 to 38.0% for the nine months ended
July 31, 2003. This decrease in research and development expenses was primarily
due to our restructuring efforts during May 2002, which resulted in $1.4 million
of decreased corporate overhead allocations, decreased compensation expenses of
$1.1 million and decreased prototype costs of $1.0 million.

Research and development personnel totaled 66 at July 31, 2002 and 67 at
July 31, 2003. We anticipate that research and development expenses may increase
due to continued development of our technologies and the expansion of our
product offerings.

GENERAL AND ADMINISTRATIVE EXPENSES

General and administrative expenses consist primarily of salaries and other
personnel-related costs, costs of our administrative, executive and information
technology departments, as well as legal and accounting, insurance and
stock-based compensation expenses.

General and administrative expenses decreased 5.5% from $1.2 million for
the three months ended July 31, 2002 to $1.1 million for the three months ended
July 31, 2003. Stock-based compensation expense was $87,000 and $124,000 for the
three months ended July 31, 2002 and 2003, respectively. As a percentage of
total revenue, general and administrative expenses increased from 16.0% for the
three months ended July 31, 2002 to 20.2% for the three months ended July 31,
2003. The decrease in general and administrative expenses is primarily due to
decreased corporate overhead allocations.

General and administrative expenses decreased 30.3% from $6.1 million for
the nine months ended July 31, 2002 to $4.3 million for the nine months ended
July 31, 2003. Stock-based compensation expense was $1.8 million and $0.6
million for the nine months ended July 31, 2002 and 2003, respectively. As a
percentage of total revenue, general and administrative expenses decreased from
23.9% for the nine months ended July 31, 2002 to 17.9% for the nine months ended
July 31, 2003. This decrease in general and administrative expenses was
primarily due to our restructuring efforts during fiscal 2002, which resulted in
$1.1 million of decreased compensation expense, $1.0 million of decreased
depreciation expense and $0.6 million of decreased professional services.

20

General and administrative personnel totaled 17 at both July 31, 2002 and
2003. We anticipate that general and administrative expenses may increase due to
additional costs associated with the Sarbanes-Oxley Act of 2002 and related
legislative and regulatory changes.

BUSINESS RESTRUCTURING EXPENSES AND ASSET IMPAIRMENT

In May 2002, we completed a restructuring plan that reduced our workforce
by approximately 25%, or 40 people (primarily in the sales, marketing and
general and administrative areas), to scale down our infrastructure and to
consolidate operations.

Components of business restructuring expenses, asset impairments and the
remaining restructuring accruals as of July 31, 2003 are as follows (in
thousands):

In March 2003, we signed an agreement to sublease a portion of our
abandoned facilities. The anticipated rent payments from this sublease are
approximately $0.5 million through January 2006. We decreased our restructuring
accrual by approximately $0.1 million at July 31, 2003 for rent payments to be
received during the initial twelve months of the sublease term.

In addition, we signed another agreement to sublease a portion of our
abandoned facilities during the third quarter of 2003. The anticipated rent
payments from this sublease are approximately $0.1 million through January 31,
2006. We decreased our restructuring accrual by approximately $49,000 at July
31, 2003 for rent payments to be received during the initial twelve months of
the sublease term. We will assess recoverability of these two sublease payments
on a quarterly basis.

As of July 31, 2003, remaining cash expenditures resulting from the
restructuring are estimated to be approximately $1.1 million and relate to
facility lease abandonment losses only. During the third fiscal quarter, we
adjusted this accrual to reflect approximately $0.1 million in construction cost
savings and $0.1 million in leasing fee savings. We have substantially completed
our restructuring efforts initiated in conjunction with the restructuring
announcement made during fiscal 2002; however, there can be no assurance future
restructuring efforts will not be necessary.

21

LIQUIDITY AND CAPITAL RESOURCES

The following table presents selected financial statistics and information
related to our liquidity and capital resources (dollars in thousands):

Our principal sources of liquidity at July 31, 2003 consisted of $13.7
million in cash and cash equivalents and $16.3 million in short-term
investments.

We renegotiated our line of credit with Silicon Valley Bank. The committed
revolving line is an advance of up to $3.0 million with a borrowing base of 80%
of eligible accounts receivable. The line of credit contains provisions that
prohibit the payment of cash dividends and require the maintenance of specified
levels of tangible net worth and certain financial performance covenants
measured on a monthly basis. The line of credit matures on June 14, 2004. As of
July 31, 2003, there were no borrowings outstanding under the revolving line of
credit and no term loans outstanding.

As of July 31, 2003, we did not have any relationships with unconsolidated
entities or financial partnerships, such as entities often referred to as
structured finance or special purpose entities, which would have been
established for the purpose of facilitating off-balance sheet arrangements or
other contractually narrow or limited purposes. As such, we are not exposed to
any financing, liquidity, market or credit risk that could arise if we had
engaged in such relationships.

Cash utilized by operating activities was approximately $14.8 million for
the nine months ended July 31, 2002 as compared to approximately $2.2 million
for the nine months ended July 31, 2003. This decrease in net cash utilized was
primarily due to a significant reduction in net loss for the nine months ended
July 31, 2003 as compared to the nine months ended July 31, 2002. In addition,
cash utilized by operating activities fluctuated due to several factors
including a decrease in accounts receivable, an increase in cash provided due to
a reduction of inventory levels and a decrease of cash utilized for accounts
payable as a result of less inventory purchases. These factors were largely a
result of our transition to the royalty-based model with HP.

Cash utilized by investing activities was approximately $23.8 million for
the nine months ended July 31, 2002 as compared to approximately $2.8 million
provided by investing activities for the nine months ended July 31, 2003. The
increase in net cash provided by investing activities is primarily due to the
timing of investment transactions and reflects the maturity of, held-to-maturity
investments net of purchases, of approximately $3.2 million during the nine
months ended July 31, 2003, compared to the purchase of held-to-maturity
investments of approximately $22.3 million during the nine months ended July 31,
2002. Capital expenditures were $1.7 million and $0.6 million for the nine
months ended July 31, 2002 and 2003, respectively. These capital expenditures
reflect our investments in computer equipment and software, test equipment,
software development tools and leasehold improvements, all of which were
required to support our ongoing research and development in our technologies and
expanding our product offerings. We anticipate moderate additional capital
expenditures through fiscal 2003, primarily to support our ongoing product
development efforts.

Cash utilized by financing activities was approximately $1.2 million for
the nine months ended July 31, 2002 as compared to approximately $1.6 million
for the nine months ended July 31, 2003. The increased utilization of net cash
from financing activities reflects the purchase of Crossroads' shares through
our open market stock purchase program of approximately $2.0 million during the
nine months ended July 31, 2003, compared to approximately $1.6 million during
the nine months ended July 31, 2002.

22

We have funded our operations to date primarily through sales of preferred
stock and our initial public offering, resulting in aggregate gross proceeds to
us of $98.2 million, product sales and, to a lesser extent, bank debt (equipment
loan).

We believe our existing cash balances and our credit facilities will be
sufficient to meet our capital requirements beyond the next 12 months. However,
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 the
rate of revenue growth, the timing and extent of spending to support product
development efforts, the timing of introductions of new products and
enhancements to existing products, the amount of cash used to fund our stock
repurchase program, and market acceptance of our products. Additionally, we may
enter into acquisitions or strategic arrangements in the future that also could
require us to seek additional equity or debt financing. We cannot assure you
that additional equity or debt financing, if required, will be available to us
on acceptable terms, or at all.

STOCK REPURCHASE PROGRAM

In September 2001, our board of directors authorized a stock repurchase
program pursuant to which we were authorized to repurchase up to $5.0 million of
our common stock in the open market. From September 2001 to April 2002, we
repurchased 661,300 shares of our common stock at an aggregate purchase price of
$2.1 million. In May 2002, our board of directors authorized the extension of
our stock repurchase program and authorized the repurchase up to an additional
$5.0 million worth of our common stock, for an aggregate amount of up to $7.1
million. From May 2002 through October 31, 2002, we repurchased 1,714,465 shares
of our common stock at an aggregate purchase price of $1.7 million. In October
2002, our board of directors authorized the further extension of our stock
repurchase program through the end of 2003. From November 2002 to July 31, 2003,
we repurchased 1,772,300 shares of our common stock at an aggregate purchase
price of $1.9 million. As of July 31, 2003, we had repurchased an aggregate of
4,148,065 shares of our common stock for an aggregate purchase price of $5.7
million under our stock repurchase program representing a total of approximately
15% of the Company.

Under the repurchase program, the stock will be purchased in the open
market or privately negotiated transactions from time to time in compliance with
the SEC's Rule 10b-18, subject to market conditions, applicable legal
requirements and other factors. The timing and amounts of any purchases will be
as determined by our management from time to time or may be suspended at any
time without prior notice, depending on market conditions and other factors they
deem relevant. The timing and size of any future stock repurchases are subject
to market conditions, stock prices, cash position and other cash requirements.

CONTRACTUAL CASH OBLIGATIONS AND COMMITMENTS

We lease office space and equipment under long-term operating lease
agreements that expire on various dates through April 15, 2006. In April 2000,
we relocated our headquarters in accordance with an agreement to lease
approximately 63,548 square feet of administrative office space in Austin,
Texas. The term of the lease agreement is approximately six years, from April 1,
2000 through April 15, 2006, and represents a lease commitment of approximately
$1.8 million per year through the lease term. In conjunction with entering into
the lease agreement, we signed an unconditional, irrevocable letter of credit
with a bank for $250,000, which is secured by a $3.0 million line of credit.

The following summarizes our contractual cash obligations as of July 31,
2003 (in thousands):

23

RECENT ACCOUNTING PRONOUNCEMENTS

In May 2003, the Financial Accounting Standards Board (FASB) issued SFAS
No. 150, "Accounting for Certain Financial Instruments with Characteristics of
both Liabilities and Equity." SFAS No. 150 states that companies that issue
financial instruments that have characteristics of both liabilities and equity
will have to determine if the instrument should be classified as a liability or
equity for financial instruments entered into or modified after May 31, 2003.
The adoption of FASB No. 150 did not have a material effect on our operating
results or financial condition.

SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities" was issued in April 2003. SFAS No. 149 amends and clarifies
accounting for derivative instruments, including certain derivative instruments
embedded in other contracts and for hedging activities under SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities." SFAS No. 149 is
generally effective for derivative instruments, including derivative instruments
embedded in certain contracts, entered into or modified after June 30, 2003 and
for hedging relationships designated after June 30, 2003. The adoption of SFAS
No. 149 did not have a material impact on our operating results or financial
condition.

In January 2003, the FASB issued FASB Interpretation No.46 (FIN 46),
"Consolidation of Variable Interest Entities, an Interpretation of ARB No.51."
FIN 46 requires certain variable interest entities to be consolidated by the
primary beneficiary of the entity if the equity investors in the entity do not
have the characteristics of a controlling financial interest or do not have
sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. FIN 46 is
effective for all new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or acquired prior to
February 1, 2003, the provisions of FIN 46 must be applied for the first interim
or annual period beginning after June 15, 2003. The adoption of FIN 46 did not
have a material effect on our operating results or financial condition.

In November 2002, the Emerging Issues Task Force (EITF) reached a consensus
on Issue No.00-21, "Revenue Arrangements with Multiple Deliverables." EITF Issue
No.00-21 provides guidance on how to account for arrangements that involve the
delivery or performance of multiple products, services and/or rights to use
assets. The provisions of EITF Issue No.00-21 will apply to revenue arrangements
entered into in fiscal periods beginning after June 15, 2003. The adoption of
EITF 00-21 did not have a material effect on our operating results or financial
condition.

24

ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS

In addition to the other information in this Form 10-Q, the following
factors should be considered in evaluating Crossroads and our business. These
factors include, but are not limited to the potential for significant losses to
continue; our inability to accurately predict revenue and budget for expenses
for future periods; fluctuations in revenue and operating results; class action
securities litigation; overall market performance; limited product lines;
limited number of OEM customers; lengthy OEM product qualification process;
competition; delays in research and development; inventory risks; the loss of
our primary contract manufacturers; risks of delay or poor execution from a
variety of sources; limited resources; pricing; dependence upon key personnel;
product liability claims; the inability to protect our intellectual property
rights; concentration of ownership; volatility of stock price; and the impact on
our results or operations due to changes in accounting standards. The discussion
below addresses some of these factors. Additional risks and uncertainties that
we are unaware of or that we currently deem immaterial also may become important
factors that affect us.

WE HAVE INCURRED SIGNIFICANT LOSSES AND NEGATIVE CASH
FLOW, WE MAY EXPERIENCE FUTURE LOSSES AND NEGATIVE CASH FLOW, AND WE MAY NEVER
BECOME PROFITABLE OR CASH FLOW POSITIVE.

We have incurred significant losses in every fiscal quarter since fiscal
1996 and may continue to incur losses in the future. As of July 31, 2003, we had
an accumulated deficit of $147.2 million. We cannot be certain that we will be
able to generate sufficient revenue to achieve profitability or become cash flow
positive. Although we engaged in a restructuring plan in 2002 pursuant to which
we significantly reduced our expense structure, we still may incur significant
sales and marketing, research and development and general and administrative
expenses and, as a result, we may continue to incur losses. Moreover, even if we
do achieve profitability, we may not be able to sustain or increase
profitability or cash flow.

WE HAVE EXPERIENCED AND MAY CONTINUE TO EXPERIENCE SIGNIFICANT
PERIOD-TO-PERIOD FLUCTUATIONS IN OUR REVENUE AND OPERATING RESULTS, WHICH MAY
RESULT IN VOLATILITY IN OUR STOCK PRICE.

We have experienced and may continue to experience significant
period-to-period fluctuations in our revenue and operating results due to a
number of factors, and any such variations and factors may cause our stock price
to fluctuate. Accordingly, you should not rely on the results of any past
quarterly or annual periods as an indication of our future performance.

It is likely that in some future period our operating results will be below
the expectations of public market analysts or investors. If this occurs, our
stock price may drop, perhaps significantly.

A number of factors may particularly contribute to fluctuations in our
revenue and operating results, including:

o changes in general economic conditions and specific economic
conditions in the computer, storage, and networking industries. In
particular, continuing economic uncertainty has resulted in a general
reduction in IT spending. This reduction in IT spending has lead to a
decline in our growth rates compared to historical trends;

o timing and amount of intellectual property licenses;

o the timing of orders from, and product integration by, our customers,
particularly our OEMs, and the tendency of these customers to change
their order requirements frequently with little or no advance notice
to us;

o the rate of adoption of SANs as an alternative to existing data
storage and management systems;

o the ongoing need for storage routing products in storage area network
architectures;

25

o the deferrals of customer orders in anticipation of new products,
services or product enhancements from us or our competitors or from
other providers of storage area network products;

o the rate at which new markets emerge for products we are currently
developing;

o the deferrals of customer orders based on budgetary restrictions;

o the successful launch and customer acceptance of our new products;

o disruptions or downturns in general economic activity resulting from
terrorist activity and armed conflict;

o increases in prices of components used in the manufacture of our
products; and

o variations in the mix of our products sold and the mix of distribution
channels through which they are sold.

In addition, potential and existing OEM customers often place initial
orders for our products for purposes of qualification and testing. As a result,
we may report an increase in sales or a commencement of sales of a product in a
quarter that will not be followed by similar sales in subsequent quarters as
OEMs conduct qualification and testing. This order pattern has in the past and
could in the future lead to fluctuations in quarterly revenue and gross profits.

GLOBAL ECONOMIC CONDITIONS MAY CONTINUE TO NEGATIVELY IMPACT US AND THE PRICE OF
OUR COMMON STOCK.

The macroeconomic environment and capital spending on information
technology have continued to erode, resulting in continued uncertainty in our
revenue expectations. The operating results of our business depend on the
overall demand for storage area network products. Because our sales are
primarily to major corporate customers whose businesses fluctuate with general
economic and business conditions, continued soft demand for storage area network
products caused by a weakening economy and budgetary constraints have resulted
in decreased revenue. We may be especially prone to this as a result of the
relatively high percentage of revenue we have historically derived from the
high-tech industry, which has been more adversely impacted by the current weak
economic environment. Customers may continue to defer or reconsider purchasing
products if they continue to experience a lack of growth in their business or if
the general economy fails to significantly improve, resulting in a continued
decrease in our product revenue.

THE STORAGE TECHNOLOGY MARKET IS CHARACTERIZED BY RAPID TECHNOLOGICAL EVOLUTION,
AND OUR SUCCESS DEPENDS ON OUR ABILITY TO DEVELOP NEW PRODUCTS.

The market for our products is characterized by rapidly changing technology
and evolving industry standards and is highly competitive with respect to timely
innovation. At this time, the storage technology market is particularly subject
to change with the emergence of fibre channel and iSCSI protocols and other new
storage technologies and solutions. The introduction of new products embodying
new or alternative technology or the emergence of new industry standards could
render our existing products obsolete or unmarketable. Our future success will
depend in part on our ability to anticipate changes in technology, to gain
access to such technology for incorporation into our products and to develop new
and enhanced products on a timely and cost-effective basis. Risks inherent in
the development and introduction of new products include:

o delay in our initial shipment of new products;

o the difficulty in forecasting customer demand accurately;

o our inability to expand production capacity fast enough to meet
customer demand;

26

o the possibility that new products may erode our current products;

o competitors' responses to our introduction of new products; and

o the desire by customers to evaluate new products for longer periods of
time before making a purchase decision.

In addition, we must be able to maintain the compatibility of our products
with future device technologies, and we must rely on producers of new device
technologies to achieve and sustain market acceptance of those technologies.
Development schedules for high-technology products are subject to uncertainty,
and we may not meet our product development schedules. If we are unable, for
technological or other reasons, to develop products in a timely manner or if the
products or product enhancements that we develop do not achieve market
acceptance, our business will be harmed.

FAILURE TO MANAGE OUR BUSINESS EFFECTIVELY COULD SERIOUSLY HARM OUR BUSINESS,
FINANCIAL CONDITION, AND PROSPECTS.

Our ability to successfully implement our business plan, develop and offer
products, and manage our business in a rapidly evolving market requires a
comprehensive and effective planning and management process. We continue to
change the scope of our operations, including managing our headcount
appropriately. Changes in our business, headcount, organizational structure and
relationships with customers and other third parties has placed, and will
continue to place, a significant strain on our management systems and resources.
Our failure to continue to improve upon our operational, managerial and
financial controls, reporting systems, and internal control procedures, and our
failure to continue to train and manage our work force, could seriously harm our
business and financial results.

AN ADVERSE DECISION IN THE VARIOUS SECURITIES CLASS ACTION AND DERIVATIVE
LAWSUITS FILED AGAINST US MAY HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS AND
FINANCIAL PERFORMANCE.

We and several of our officers and directors were named as defendants in
several class action lawsuits filed in the United States District Court for the
Western District of Texas. The plaintiffs in the actions purport to represent
purchasers of our common stock during various periods ranging from January 25,
2000 through August 24, 2000. On November 22, 2002, the court granted our motion
for summary judgment, concluding that the plaintiffs failed to demonstrate an
essential element to their claim of securities fraud. On February 26, 2003, the
plaintiffs filed a notice of appeal to the Fifth Circuit Court of Appeals. The
plaintiffs are seeking unspecified amounts of compensatory damages, interest and
costs, including legal fees. It is not possible at this time to predict whether
we will incur any liability or to estimate the damages, or the range of damages,
that we might incur in connection with such actions. An adverse judgment may
have a material adverse effect on our business and financial performance.

On November 21, 2001, a derivative state action was filed in the 261st
District Court of Travis County, Texas on behalf of Crossroads by James Robke
and named several of its officers and directors as defendants. The derivative
state action is based upon the same general set of facts and circumstances
outlined above in connection with the purported securities class action
litigation. The derivative state action alleges that certain of the individual
defendants sold shares while in possession of material inside information in
purported breach of their fiduciary duties to Crossroads. The derivative state
action also alleges waste of corporate assets. On January 28, 2002, the Company
filed an answer and general denial to the derivative state action. In April
2003, the parties reached a tentative agreement to settle the derivative
litigation. The settlement has not yet been approved by the district court.
Consequently, it is not possible to predict whether the Company will incur any
liability or to estimate the damages, or the range of damages, if any, that the
Company might incur in connection with this action. Our inability to prevail in
this action could have a material adverse effect on our future business,
financial condition and results of operations.

OUR BUSINESS IS DEPENDENT ON THE STORAGE AREA NETWORK MARKET WHICH IS
UNPREDICTABLE, AND IF THIS MARKET DOES NOT DEVELOP AND EXPAND AS WE ANTICIPATE,
OUR BUSINESS WILL SUFFER.

Fibre channel-based SANs, were first deployed in 1997. However, the market
for SANs and related storage router products is slowly evolving. Because this
market is growing at a relatively slow pace, it is difficult to predict its
potential size or future growth rate. Substantially all of our products are used
exclusively in SANs and, therefore, our

27

business is dependent on the SAN market. Accordingly, the widespread adoption of
SANs for use in organizations' computing systems is critical to our future
success. Most of the organizations that would be likely to purchase our products
have invested substantial resources in their existing computing and data storage
systems and, as a result, may be reluctant or slow to adopt a new approach like
SANs, particularly in the current economic environment. SANs are often
implemented in connection with the deployment of new storage systems and
servers. Therefore, our future success is also substantially dependent on the
market for new storage systems and servers. Furthermore, the ability of the
different components used in a SAN to function effectively, or interoperate,
with each other when placed in a computing system has not yet been achieved on a
widespread basis. Until greater interoperability is achieved, customers may be
reluctant to deploy SANs. Our success in generating revenue in the emerging SAN
market will depend on, among other things, our ability to:

o educate potential OEM customers, distributors, VARs, system integrators,
storage service providers and end-user organizations about the benefits
of SANs and storage router technology, including, in particular, the
ability to use storage routers with SANs to improve system backup and
recovery processes;

o maintain and enhance our relationships with OEM customers, distributors,
VARs, system integrators, storage system providers and end-user
organizations;

o predict and base our products on standards which ultimately become
industry standards; and

o achieve interoperability between our products and other SAN components
from diverse vendors.

WE HAVE LIMITED PRODUCT OFFERINGS AND OUR SUCCESS DEPENDS ON OUR ABILITY TO
DEVELOP IN A TIMELY MANNER NEW AND ENHANCED PRODUCTS THAT ACHIEVE MARKET
ACCEPTANCE.

We currently have a limited number of products that we sell in commercial
quantities. Our future growth and competitiveness will depend greatly on the
market acceptance of our newly introduced product lines, including the 6000 and
10000 storage routers as well as the ServerAttach(TM) line of products which
were released in 2002. While we have recently begun to receive revenue from the
sale of our 6000, 10000 and ServerAttach line of products, their market
acceptance remains uncertain. If any of these products do not achieve sufficient
market acceptance, our future growth prospects could be seriously harmed.
Moreover, even if we are able to develop and commercially introduce new products
and enhancements, these new products or enhancements may not achieve market
acceptance.

Factors that may affect the market acceptance of our products, some of which
are beyond our control, include the following:

o growth of the SAN market;

o changing requirements of customers within the SAN market;

o performance, quality, price and total cost of ownership of our products;

o availability, performance, quality and price of competing products and
technologies;

o our customer service and support capabilities and responsiveness; and

o successful development of our relationships with existing and potential
OEM, distributor, system integrator and storage system provider
customers.

28

WE DEPEND ON A LIMITED NUMBER OF CUSTOMERS FOR THE VAST MAJORITY OF OUR REVENUE.
THE LOSS OF OR SIGNIFICANT REDUCTION IN ORDERS FROM ANY KEY CUSTOMERS WOULD
SIGNIFICANTLY REDUCE OUR REVENUE AND WOULD SUBSTANTIALLY HARM OUR FUTURE RESULTS
OF OPERATIONS.

In fiscal 2000, 2001, 2002, and the nine months ended July 31, 2003, 77%,
70%, 78% and 90% of our total revenue, respectively, was derived from our top
OEM customers. In fiscal 2002, HP and StorageTek represented 51% and 24% of our
total revenue, respectively. For the nine months ended July 31, 2003, HP and
StorageTek represented 61% and 23% of our total revenue, respectively. In May
2002, the merger between HP and Compaq was consummated which significantly
increased our customer concentration. If we experience any adverse effect of the
acquisition of Compaq by HP, including the risks due to the increase in customer
concentration or any change in product focus or strategy, which adversely
affects anticipated revenue or margins or our overall relationship with the
newly combined company, our results of operations and future prospects will
suffer. Our operating results in the foreseeable future will continue to depend
on sales to a relatively small number of OEM customers. Therefore, the loss of
any of our key OEM customers, or a significant reduction in sales to any one of
them, would significantly reduce our revenue.

OUR OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIVE
QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.

Prior to offering our products for sale, our OEM customers require that each
of our products undergo an extensive qualification process, which involves
interoperability testing of our product in the OEM's system as well as rigorous
reliability testing. This qualification process may continue for a year or
longer. However, qualification of a product by an OEM does not assure any sales
of the product to the OEM. Despite this uncertainty, we devote substantial
resources, including sales, marketing and management efforts, toward qualifying
our products with OEMs in anticipation of sales to them. If we are unsuccessful
or delayed in qualifying any products with an OEM, such failure or delay would
preclude or delay sales of that product to the OEM, which may impede our ability
to grow our business.

DEMAND FOR OUR PRODUCTS DEPENDS SIGNIFICANTLY UPON THE NEED TO INTERCONNECT
SCSI-BASED TAPE STORAGE SYSTEMS WITH FIBRE CHANNEL SANS, AND WE MAY FACE
COMPETITION FROM MANUFACTURERS OF TAPE STORAGE SYSTEMS THAT INCORPORATE FIBRE
CHANNEL INTERFACES INTO THEIR PRODUCTS.

In traditional computer networks, system backup is accomplished by
transferring data from applications and databases through the servers used in
the network to tape drives or other media where the data is safely stored. Tape
storage devices generally rely on a SCSI connection to interface with the server
in receiving and transmitting data. Our routers enable these SCSI-based storage
devices to interface with the fibre channel-based devices of the SAN. Because
our routers allow communication between SCSI storage devices and a fibre channel
SAN, organizations are able to affect their backup processes over the SAN rather
than through the computer network, enabling the servers of the network to remain
available for other computing purposes. We currently derive the majority of our
revenue from sales of storage routers that are used to connect SCSI-based tape
storage systems with SANs. The introduction of tape storage systems that
incorporate fibre channel interfaces would enable tape storage devices to
communicate directly with SANs, without using storage routers. We are aware that
a number of manufacturers of storage systems, including several of our current
customers, are developing tape storage systems with embedded fibre channel
interfaces, with products in the market today. If these or other manufacturers
are successful in fibre channel-based storage systems, demand for our storage
router products would be materially reduced and our revenue would decline.

OUR RESEARCH AND DEVELOPMENT EFFORTS ARE FOCUSED ON UTILIZING EMERGING
TECHNOLOGIES AND STANDARDS AND ANY DELAY OR ABANDONMENT OF EFFORTS TO DEVELOP
THESE TECHNOLOGIES OR STANDARDS BY INDUSTRY PARTICIPANTS, OR FAILURE OF THESE
TECHNOLOGIES OR STANDARDS TO ACHIEVE MARKET ACCEPTANCE, COULD COMPROMISE OUR
COMPETITIVE POSITION.

Our products are intended to complement other SAN products to improve the
performance of computer networks by addressing the I/O bottlenecks that have
emerged between the storage systems and the servers within a computing system.
We have devoted and expect to continue to devote significant resources to
developing products based on emerging technologies and standards that reduce I/O
bottlenecks, such as iSCSI. A number of large companies in the computer hardware
and software industries are actively involved in the development of new
technologies and standards that we expect to incorporate in our new products.
Should any of these companies delay or abandon their efforts to develop
commercially available products based on these new technologies and standards,
our research and development efforts with respect to such technologies and
standards likely would have no appreciable value. In addition, if we do not
correctly anticipate new technologies and standards, or if our products based on
these new technologies and standards fail to achieve market acceptance, our
competitors may be better able to address market demand than would we.
Furthermore, if markets for these new technologies and standards develop later
than we

29

anticipate, or do not develop at all, demand for our products that are currently
in development would suffer, resulting in less revenue for these products than
we currently anticipate.

UNCERTAINTIES INVOLVING SALES AND DEMAND FORECASTS FOR OUR PRODUCTS COULD
NEGATIVELY AFFECT OUR BUSINESS.

We have limited ability to forecast the demand for our products. In
preparing sales and demand forecasts, we rely largely on input from our
distribution partners. If our distribution partners are unable to accurately
forecast demand, or we fail to effectively communicate with our distribution
partners about end-user demand or other time sensitive information, sales and
demand forecasts may not reflect the most accurate, up-to-date information.
Because we make business decisions based on our sales and demand forecasts, if
these forecasts are inaccurate, our business and financial results could be
negatively impacted. Furthermore, we may not be able to identify these forecast
differences until late in our fiscal quarter. Consequently, we may not be able
to make adjustments to our business model without negatively impacting our
business and results of operations.

WE ARE SUBJECT TO INCREASED INVENTORY RISKS AND COSTS BECAUSE WE MANUFACTURE
PRODUCTS IN ADVANCE OF BINDING COMMITMENTS FROM OUR CUSTOMERS TO PURCHASE OUR
PRODUCTS.

In order to assure availability of our products for some of our largest OEM
customers, we manufacture products in advance of purchase orders from these
customers based on forecasts provided by them. However, these forecasts do not
represent binding purchase commitments and we do not recognize revenue for such
products until the product is shipped and risk of loss has passed to the OEM. As
a result, we incur inventory and manufacturing costs in advance of anticipated
revenue. Because demand for our products may not materialize, this product
delivery method subjects us to increased risks of high inventory carrying costs
and increased obsolescence and may increase our operating costs.

THE LOSS OF OUR PRIMARY CONTRACT MANUFACTURER, OR THE FAILURE TO FORECAST DEMAND
ACCURATELY FOR OUR PRODUCTS OR TO MANAGE OUR RELATIONSHIP WITH OUR PRIMARY
CONTRACT MANUFACTURER SUCCESSFULLY, WOULD NEGATIVELY IMPACT OUR ABILITY TO
MANUFACTURE AND SELL OUR PRODUCTS.

We rely on a limited number of contract manufacturers, primarily Solectron,
to assemble the printed circuit board for our current shipping programs,
including our 6000 and 10000. We generally place orders for products with
Solectron approximately four months prior to the anticipated delivery date, with
order volumes based on forecasts of demand from our customers. Accordingly, if
we inaccurately forecast demand for our products, we may be unable to obtain
adequate manufacturing capacity from Solectron to meet our customers' delivery
requirements, or we may accumulate excess inventories. We have on occasion in
the past been unable to adequately respond to unexpected increases in customer
purchase orders, and therefore were unable to benefit from this incremental
demand. Solectron has not provided assurance to us that adequate capacity will
be available to us within the time required to meet additional demand for our
products.

OUR PLANS TO INTRODUCE NEW PRODUCTS AND PRODUCT ENHANCEMENTS TO MARKET REQUIRE
COORDINATION ACROSS OUR SUPPLIERS AND MANUFACTURERS, WHICH EXPOSE US TO RISKS OF
DELAY OR POOR EXECUTION FROM A VARIETY OF SOURCES.

We have recently introduced new products and product enhancements, which
requires that we coordinate our efforts with those of our component suppliers
and our contract manufacturers to rapidly achieve volume production. In
addition, we are in the process of transitioning the manufacture of our embedded
router products to HP. If we should fail to effectively manage our relationships
with our component suppliers, our contract manufacturers and other manufacturers
of our products 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 component supplier or contract manufacturer and commencing volume
production can be expensive and time consuming. If we are required to change or
choose to change suppliers, we may lose revenue and damage our customer
relationships.

30

WE DEPEND ON SOLE SOURCE AND LIMITED SOURCE SUPPLIERS FOR CERTAIN KEY
COMPONENTS, AND IF WE ARE UNABLE TO BUY THESE COMPONENTS ON A TIMELY BASIS, OUR
DELAYED ABILITY TO DELIVER OUR PRODUCTS TO OUR CUSTOMERS MAY RESULT IN REDUCED
REVENUE AND LOST SALES.

We currently purchase fibre channel application specific integrated circuits
and other key components for our products from sole or limited sources. To date,
most of our component purchases have been made in relatively small volumes. As a
result, if our suppliers receive excess demand for their products, we likely
will receive a low priority for order fulfillment, as large volume customers
will use our suppliers' available capacity. If we are delayed in acquiring
components for our products, the manufacture and shipment of our products will
also be delayed, which will reduce our revenue and may result in lost sales. We
generally use a rolling nine-month forecast of our future product sales to
determine our component requirements. Lead times for ordering materials and
components vary significantly and depend on factors such as specific supplier
requirements, contract terms and current market demand for such components. If
we overestimate our component requirements, we may have excess inventory which
would increase our costs. If we underestimate our component requirements, we may
have inadequate inventory that would delay our manufacturing and render us
unable to deliver products to customers on a scheduled delivery date. We also
may experience shortages of certain components from time to time, which also
could delay our manufacturing. Manufacturing delays could negatively impact our
ability to sell our products and damage our customer relationships.

COMPETITION WITHIN OUR MARKETS MAY REDUCE SALES OF OUR PRODUCTS AND REDUCE OUR
MARKET SHARE.

The market for SAN products generally, and storage routers in particular, is
increasingly competitive. We anticipate that the market for our products will
continually evolve and will be subject to rapid technological change. We
currently face competition from ADIC through their acquisition of Pathlight in
2001, ATTO and Chaparral Network Storage. In addition, other OEM customers could
develop products or technologies internally, or by entering into strategic
relationships with or acquiring other existing SAN product providers that would
replace their need for our products and would become a source of competition. We
may face competition in the future from OEMs, including our customers and
potential customers, LAN router manufacturers, storage system industry
suppliers, including manufacturers and vendors of other SAN products or entire
SAN systems, and innovative start-up companies. For example, manufacturers of
fibre channel switches or directors could seek to include router functionality
within their SAN products that would obviate the need for our storage routers.
As the market for SAN products grows, we also may face competition from
traditional networking companies and other manufacturers of networking products.
These networking companies may enter the storage router market by introducing
their own products or by entering into strategic relationships with or acquiring
other existing SAN product providers. This could introduce additional
competition in our markets, especially, if one of our OEMs begins to manufacture
our higher end storage routers. While we do not currently face significant
direct competition for our ServerAttach products, we anticipate we will see
increased competition as this market develops.

WE ARE A RELATIVELY SMALL COMPANY WITH LIMITED RESOURCES COMPARED TO SOME OF OUR
CURRENT AND POTENTIAL COMPETITORS.

Some of our current and potential competitors have longer operating
histories, significantly greater resources, broader name recognition and a
larger installed base of customers than Crossroads. As a result, these
competitors may have greater credibility with our existing and potential
customers. They also may be able to adopt more aggressive pricing policies and
devote greater resources to the development, promotion and sale of their
products than we can to ours, which would allow them to respond more quickly
than us to new or emerging technologies or changes in customer requirements. In
addition, some of our current and potential competitors have already established
supplier or joint development relationships with decision makers at our current
or potential customers. These competitors may be able to leverage their existing
relationships to discourage these customers from purchasing products from us or
to persuade them to replace our products with their products. Increased
competition could decrease our prices, reduce our sales, lower our margins, or
decrease our market share. These and other competitive pressures may prevent us
from competing successfully against current or future competitors, and may
materially harm our business.

31

WE HAVE LICENSED OUR STORAGE ROUTER TECHNOLOGY TO A KEY CUSTOMER, WHICH MAY
ENABLE THIS CUSTOMER TO COMPETE WITH US.

In November 2002, we amended our existing licensing agreement with HP.
Pursuant to this amendment we have outsourced the manufacturing of our embedded
routers to HP. As a result, we do not incur the inventory and overhead costs of
the hardware, and we will receive a royalty from HP for licensing our
technology, which will result in less aggregate revenue for us. However, even
though total revenue from the sale of our embedded routers will be less in the
future, our arrangement will have a positive impact on per unit gross margin. We
believe this agreement will allow us to leverage the strengths of both companies
including HP's economies of scale in manufacturing and systems integration
expertise and our software, value-added applications and intellectual property.
We have been working under this new agreement since the fiscal second quarter of
2003. HP has vastly greater resources and distribution capabilities than we do,
and therefore, it could establish market acceptance in a relatively short time
frame for any competitive products that it may introduce using our licensed
technologies, which, in turn, would reduce demand for our products from HP and
could reduce demand for our products from other customers.

UNIT PRICES OF SOME OF OUR PRODUCTS MAY DECREASE OVER TIME, AND IF WE CANNOT
INCREASE OUR SALES VOLUMES, OUR REVENUE WILL DECLINE.

As storage networking continues to mature as an industry, we have seen a
trend towards simplification of devices. The impact of this trend on our
business has been the push for, and subsequent ramp of embedded routers being
shipped with tape libraries. These embedded routers are lower cost than the
stand-alone box routers and this lower cost is passed on to our OEM customers.
As our mix shifts from box routers to embedded routers, we will see a reduction
in average price per unit and revenue will decline if volume does not increase.
To date, some of our agreements with OEM customers, including our largest
customer, provide for quarterly reductions in pricing on a product-by-product
basis, with the actual discount determined according to the volume potential
expected from the customer, the OEM's customer base, the credibility the OEM may
bring to our solution, additional technology the OEM may help us incorporate
with our product, and other Crossroads products the OEM supports.
Notwithstanding, the decreases in our average selling prices of our older
products generally have been partially offset by higher average selling prices
for our newer products, as well as sales to distributors and system integrators
where price decreases are not generally required. Nonetheless, we could
experience declines in our average unit selling prices for our products in the
future, especially if our newer products do not receive broad market acceptance.
In addition, declines in our average selling prices may be more pronounced
should we encounter significant pricing pressures from increased competition
within the storage router market.

OUR PRODUCTS ARE COMPLEX AND MAY CONTAIN UNDETECTED SOFTWARE OR HARDWARE ERRORS
THAT COULD LEAD TO AN INCREASE IN OUR COSTS OR A REDUCTION IN OUR REVENUE.

Networking products such as ours may contain undetected software or hardware
errors when first introduced or as new versions are released. Our products are
complex and errors have been found in the past and may be found from time to
time in the future. In addition, our products include components from a number
of third-party vendors. We rely on the quality testing of these vendors to
ensure the adequate operation of their products. Because our products are
manufactured with a number of components supplied by various third-party
sources, should problems occur in the operation or performance of our products,
it may be difficult to identify the source. In addition, our products are
deployed within SANs from a variety of vendors. Therefore, the occurrence of
hardware and software errors, whether caused by our or another vendor's SAN
products, could adversely affect sales of our products. Furthermore, defects may
not be discovered until our products are already deployed in the SAN. These
errors also could cause us to incur significant warranty, diagnostic and repair
costs, divert the attention of our engineering personnel from our product
development efforts and cause significant customer relations and business
reputation problems.

WE DEPEND ON OUR KEY PERSONNEL TO MANAGE OUR BUSINESS EFFECTIVELY IN A RAPIDLY
CHANGING MARKET, AND IF WE ARE UNABLE TO RETAIN OUR CURRENT PERSONNEL AND HIRE
ADDITIONAL PERSONNEL, OUR ABILITY TO SELL OUR PRODUCTS COULD BE HARMED.

We believe our future success will depend in large part upon our ability to
attract and retain highly skilled managerial, engineering and sales and
marketing personnel. The loss of the services of any of our key employees or key
management, particularly after we eliminated several management positions and
reallocated those responsibilities

32

among the remaining management, would harm our business. Additionally, our
inability to attract or retain qualified personnel in the future or any delays
in hiring required personnel, particularly engineers and sales personnel, could
delay the development and introduction of, and negatively impact our ability to
sell, our products.

WE MAY BE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, WHICH WOULD NEGATIVELY
AFFECT OUR ABILITY TO COMPETE.

Our products rely on our proprietary technology, and we expect that future
technological advancements made by us will be critical to sustain market
acceptance of our products. Therefore, we believe that the protection of our
intellectual property rights is and will continue to be important to the success
of our business. 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 or license agreements with
our employees, consultants and business partners, and control access to and
distribution of our software, documentation and other proprietary information.
Despite these efforts, unauthorized parties may attempt to copy or otherwise
obtain and use our products or technology. Monitoring unauthorized use of our
products is difficult, and we cannot be certain that the steps we have taken
will prevent unauthorized use of our technology, particularly in foreign
countries where applicable laws may not protect our proprietary rights as fully
as in the United States.

OUR EFFORTS TO PROTECT OUR INTELLECTUAL PROPERTY MAY CAUSE US TO BECOME INVOLVED
IN COSTLY AND LENGTHY LITIGATION WHICH COULD SERIOUSLY HARM OUR BUSINESS.

In recent years, there has been significant litigation in the United States
involving patents, trademarks and other intellectual property rights. Legal
proceedings could subject us to significant liability for damages or invalidate
our intellectual property rights. Any litigation, regardless of its outcome,
would likely be time consuming and expensive to resolve and would divert
management's time and attention. Any potential intellectual property litigation
against us could force us to take specific actions, including:

o cease selling our products that use the challenged intellectual
property;

o obtain from the owner of the infringed intellectual property right a
license to sell or use the relevant technology or trademark, which
license may not be available on reasonable terms, or at all; or

o redesign those products that use infringing intellectual property or
cease to use an infringing trademark.

As we have discussed elsewhere in this report, we have engaged in lengthy
and costly litigation regarding our '972 patent. While we have prevailed to date
in these cases, we cannot assure you that we would prevail in any future effort
to enforce our rights in the '972 patent.

ANY ACQUISITIONS WE MAKE COULD DISRUPT OUR BUSINESS AND HARM OUR FINANCIAL
CONDITION.

As part of our growth strategy, we intend to review opportunities to acquire
other businesses or technologies that would complement our current products,
expand the breadth of our markets or enhance our technical capabilities. This
would entail a number of risks that could materially and adversely affect our
business and operating results, including:

o problems integrating the acquired operations, technologies or products
with our existing business and products;

o diversion of management's time and attention from our core business;

o difficulties in retaining business relationships with suppliers and
customers of the acquired company;

o risks associated with entering markets in which we lack prior
experience; and

o potential loss of key employees of the acquired company.

33

OUR PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED BY
CUSTOMERS IN OUR MARKET.

Our products comprise only a part of a SAN. All components of a SAN must
uniformly comply with the same industry standards in order to operate
efficiently together. We depend on companies that provide other components of
the SAN to support prevailing industry standards. Many of these companies are
significantly larger and more influential in effecting industry standards than
we are. Some industry standards may not be widely adopted or implemented
uniformly, and competing standards may emerge that may be preferred by OEM
customers or end users. If larger companies do not support the same industry
standards that we do, or if competing standards emerge, our products may not
achieve market acceptance, which would adversely affect our business.

INSIDERS WILL CONTINUE TO HAVE SUBSTANTIAL CONTROL OVER OUR COMPANY AND COULD
DELAY OR PREVENT A CHANGE IN CORPORATE CONTROL.

Our executive officers and directors, and their affiliates, beneficially own
a significant portion of the total voting power of our company. As a result,
these stockholders will be able to exert significant control over all matters
requiring stockholder approval, including the election of directors and approval
of significant corporate transactions. Our ongoing open market stock repurchase
program has also increased the control our affiliates have over us. This
concentration of voting power could delay or prevent an acquisition of us on
terms that other stockholders may desire.

PROVISIONS IN OUR CHARTER DOCUMENTS AND DELAWARE LAW COULD PREVENT, DELAY OR
IMPEDE A CHANGE IN CONTROL OF US AND MAY REDUCE THE MARKET PRICE OF OUR COMMON
STOCK.

Provisions of our certificate of incorporation and bylaws could have the
effect of discouraging, delaying or preventing a merger or acquisition that a
stockholder may consider favorable. We also are subject to the anti-takeover
laws of the State of Delaware that may discourage, delay or prevent someone from
acquiring or merging with us, which may adversely affect the market price of our
common stock. Further, in August 2002, our Board of Directors approved, adopted
and entered into a Stockholder Rights Plan which also may have the effect of
discouraging, delaying or preventing an acquisition which stockholders otherwise
may desire to support.

OUR STOCK PRICE IS VOLATILE.

The market price of our common stock has been volatile in the past and may
be volatile in the future. For example, since May 1, 2002, the market price of
our common stock as quoted on the NASDAQ National Market fluctuated between
$0.38 and $3.30. The market price of our common stock may be significantly
affected by the following factors:

o actual or anticipated fluctuations in our operating results;

o changes in financial estimates by securities analysts or our failure to
perform in line with such estimates;

o changes in market valuations of other technology companies, particularly
those that sell products used in SANs;

o announcements by us or our competitors of significant technical
innovations, acquisitions, strategic partnerships, joint ventures or
capital commitments;

o sale of or distribution by Austin Ventures of our common stock to their
limited partners or substantial sales by other significant stockholders;

o introduction of technologies or product enhancements that reduce the
need for storage routers;

o the loss of one or more key OEM customers; and

34

o departures of key personnel.

The stock market has experienced extreme volatility that often has been
unrelated to the performance of particular companies. These market fluctuations
may cause our stock price to fall regardless of our performance.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

For a description of the Company's market risks, see "Item 7 - Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Market Risk" in the Company's Annual Report on Form 10-K for the fiscal year
ended October 31, 2002.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures.

Our Chief Executive Officer (CEO) and Chief Financial Officer (CFO) have
evaluated the effectiveness of our disclosure controls and procedures (as
defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of
1934, as amended (the "Exchange Act")), as of a date within 90 days of the
filing date of this Quarterly Report on Form 10-Q. Based on that evaluation,
they have concluded that as of such date, our disclosure controls and procedures
are effective and designed to ensure that information required to be disclosed
by us in reports that we file or submit under the Exchange Act is recorded,
processed, summarized and reported within the time periods specified in
applicable SEC rules and forms.

(b) Changes in internal controls.

There have been no significant changes in our internal controls or other
factors that could significantly affect internal controls subsequent to the date
of evaluation by our CEO and CFO.

35

CROSSROADS SYSTEMS, INC. AND SUBSIDIARIES

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Intellectual Property Litigation

On March 31, 2000, the Company filed a lawsuit against Chaparral Network
Storage, Inc. ("Chaparral") alleging that Chaparral had infringed one of its
patents (5,941,972, hereinafter the "972 patent") with some of their products.
In September 2001, the jury found that the '972 patent was valid and that all of
Chaparral's RAID and router products that contained LUN Zoning had infringed all
claims of the Crossroads '972 patent. The federal judge in this matter issued a
permanent injunction against Chaparral from manufacturing any RAID or router
product that contained LUN Zoning or access controls and assessed punitive
damages. As a result, the Company was awarded damages with a royalty amount of
5% for Chaparral's router product line and 3% for their RAID product line.
Chaparral appealed the judgment against it, contending that the '972 patent is
invalid and not infringed. In February 2003, the Federal Circuit Court of
Appeals recently affirmed the lower court ruling that Crossroads' patent was
valid and willfully infringed by Chaparral, which must stop shipping all
products that contain the Crossroads technology and pay Crossroads a royalty for
prior shipments. On May 19, 2003, the Company received a payment from Chaparral
of approximately $0.2 million to substantially satisfy the damages judgment that
was based on past sales of infringing products.

There have been no other changes in our legal proceedings since the
Company's quarterly report on Form 10-Q filed for the first fiscal quarter of
2003.

Derivative State Action

On November 21, 2001, a derivative state action was filed in the 261st
District Court of Travis County, Texas on behalf of Crossroads by James Robke
and named several of its officers and directors as defendants. The derivative
state action is based upon the same general set of facts and circumstances
outlined above in connection with the purported securities class action
litigation. The derivative state action alleges that certain of the individual
defendants sold shares while in possession of material inside information in
purported breach of their fiduciary duties to Crossroads. The derivative state
action also alleges waste of corporate assets. On January 28, 2002, the Company
filed an answer and general denial to the derivative state action. In April
2003, the parties reached a tentative agreement to settle the derivative
litigation. The settlement has not yet been approved by the district court.
Consequently, it is not possible to predict whether the Company will incur any
liability or to estimate the damages, or the range of damages, if any, that the
Company might incur in connection with this action.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

ITEM 5. OTHER INFORMATION

None.

36

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

31.1 Certification of Brian R. Smith, Chairman of the Board,
President and Chief Executive Officer of the Company, as
adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.

31.2 Certification of Andrea Wenholz, Vice President and Chief
Financial Officer of the Company, as adopted pursuant to
Section 302 of Sarbanes-Oxley Act of 2002.

32.1 Certification of Brian R. Smith, Chairman of the Board,
President and Chief Executive Officer of the Company, as
adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

32.2 Certification of Andrea Wenholz, Vice President and Chief
Financial Officer of the Company, as adopted pursuant to
Section 906 of Sarbanes-Oxley Act of 2002.

(b) Reports on Form 8-K

During the fiscal quarter ended July 31, 2003, Crossroads filed the
following current report on Form 8-K:

o We filed a Form 8-K dated May 21, 2003 announcing our earnings
for the second fiscal quarter of 2003

37

SIGNATURES

Pursuant to the requirements of the Section 13 or 15(d) 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.

CROSSROADS SYSTEMS, INC.

September 12, 2003 /s/ Brian R. Smith
------------------ -----------------------------
(Date) Brian R. Smith
Chief Executive Officer
(Principal Executive Officer)

September 12, 2003 /s/ Andrea C. Wenholz
------------------ -----------------------------
(Date) Andrea C. Wenholz
Chief Financial Officer
(Principal Financial and
Accounting Officer)

38

EXHIBIT INDEX