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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

COMMISSION FILE NUMBER: 0-13994

COMPUTER NETWORK TECHNOLOGY CORPORATION

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

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

As of September 1, 2003, the registrant had 27,159,852 shares of $.01 par value common stock issued and outstanding.

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COMPUTER NETWORK TECHNOLOGY CORPORATION

INDEX

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PART I

Item 1.

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

See accompanying notes to Consolidated Financial Statements

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

See accompanying notes to Consolidated Financial Statements

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

See accompanying notes to Consolidated Financial Statements

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

(1) BASIS OF PRESENTATION

     The accompanying consolidated financial statements have been prepared in accordance with instructions to Form 10-Q and do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. These consolidated financial statements should be read in conjunction with the consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 31, 2003 as filed with the Securities and Exchange Commission. References to fiscal 2003 and 2002, represent the twelve months ended January 31, 2004 and 2003, respectively.

     On May 5, 2003, the Company completed the acquisition of Inrange Technologies (Inrange) for $190 million in cash. The acquisition was accounted for as a purchase, and the Company’s financial statements include the results of since May 5, 2003. See footnote 4 “Acquisitions” for further information regarding the effect of the Inrange acquisition on the Company’s balance sheet and results of operations.

(2) MARKETABLE SECURITIES

     During the first quarter of fiscal 2003, the Company sold marketable securities totaling $122 million, resulting in a net pre-tax gain of approximately $747. No significant gains or losses from the sale of marketable securities were recorded during the second quarter of fiscal 2003 or the first half of fiscal 2002.

     The Company’s investments in marketable securities primarily consist of U.S. government and agency securities, corporate debt securities and bank certificates of deposit.

(3) INVENTORIES

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

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(4) ACQUISITIONS

Inrange

     On April 6, 2003, the Company entered into an agreement whereby a wholly owned subsidiary of the Company would acquire all of the shares of Inrange Technologies Corporation that were owned by SPX Corporation. The shares acquired constituted approximately 91% of the issued and outstanding shares of Inrange for a purchase price of approximately $2.31 per share and $173 million in the aggregate. On May 5, 2003 the Company completed the acquisition of Inrange and pursuant to the agreement the subsidiary merged into Inrange, and the remaining capital stock owned by the other Inrange shareholders was converted into the right to receive approximately $2.31 per share in cash, resulting in a total payment of $190 million for both the stock purchase and merger. The acquisition was accounted for as a purchase and the consolidated financial statements of the Company include the results of Inrange since May 5, 2003. The purchase price was allocated to the fair value of the assets and liabilities acquired as follows:

     The following table presents the unaudited pro forma consolidated results of operations of the Company for the three and six months ended July 31, 2003 and 2002 as if the acquisition of Inrange took place on February 1, 2003 and 2002, respectively:

     The pro forma results include amortization of the customer list, developed technology and trademarks presented above. The unaudited pro forma results do not include the $19.7 million charge for in-process research and development related to the Inrange acquisition. The unaudited pro forma results are for comparative purposes only and do not necessarily reflect the results that would have been recorded had the acquisition occurred at the beginning of the period presented or the results which might occur in the future. The Inrange purchase price allocation is preliminary and subject to change pending completion of the purchase price allocation analysis.

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BI-Tech

     On June 24, 2002, the Company acquired all the outstanding stock of Business Impact Technology Solutions Limited (BI-Tech), a leading provider of storage management solutions and services, for $12 million in cash plus the assumption of approximately $3.6 million of liabilities and the acquisition of approximately $8.7 million of tangible assets. The Company allocated $6.5 million, $1.1 million and $250 of the purchase price to goodwill, customer list and non-compete agreements, respectively. The customer list and non-compete agreements are amortized over periods of ten and two years, respectively. The accompanying financial statements include the results of BI-Tech since June 24, 2002.

     The original purchase agreement required payments of additional consideration to the former stockholders and the BI-Tech employees based on achievement of certain earnings for each of the two years beginning July 1, 2002. A modification to the purchase agreement was made during the second quarter of fiscal 2003, whereby the first earn out period ended April 30, 2003. It also guarantees the former stockholders a minimum payment for the second earn out period, which ends June 30, 2004, of at least $3.9 million. The portion payable to the former stockholders is recorded as goodwill. The portion payable to the BI-Tech employees is recorded as compensation expense. During the second quarter and first six months of 2003, $3.5 million and $7.7 million, respectively, was added to goodwill and $0 and $1.1 million, respectively, was recorded as compensation expense under the earn out arrangement.

(5) GOODWILL AND INTANGIBLE ASSETS

     The change in the carrying amount of goodwill for the first six months of 2003 was as follows:

     The components of other amortizable intangible assets were as follows:

     Amortization expense for intangible assets during the second quarter and first six months of 2003 was $1.7 million and $1.8 million, respectively. Amortization expense for the remainder of 2003 is estimated to be $3.5 million. Amortization expense is estimated to be $6.8 million in 2004 through 2006, $6.2 million in 2007 and $3.2 million in 2008.

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(6) COMPREHENSIVE LOSS

     Comprehensive loss consists of the following:

(7) CONVERTIBLE SUBORDINATED DEBT

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

(8) STOCK-BASED COMPENSATION

     The estimated per share weighted average fair value of all stock options granted during the six months ended July 31, 2003 and 2002 was $5.02 and $7.13 respectively. The fair value of each option grant was estimated using the Black-Scholes option pricing model with the following weighted average assumptions:

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

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(9) WARRANTY

     The Company records a liability for warranty claims at the time of sale. The amount of the liability is based on contract terms and historical warranty loss expenses, which is periodically adjusted for recent actual experience. Warranty terms on the Company’s equipment range from 90 days to 13 months. The changes in warranty reserve balances for the six months ended July 31, 2003 and 2002 were as follows:

(10) NEW ACCOUNTING PRONOUNCEMENTS

     In December 2002, the EITF reached a consensus on EITF 00-21, “Revenue Arrangements with Multiple Deliverables”. This Issue addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. In some arrangements, the different revenue-generating activities (deliverables) are sufficiently separable and there exists sufficient evidence of their fair values to separately account for some or all of the deliverables (that is, there are separate units of accounting). In other arrangements, some or all of the deliverables are not independently functional, or there is not sufficient evidence of their fair values to account for them separately. This Issue addresses when and, if so, how an arrangement involving multiple deliverables should be divided into separate units of accounting. This Issue does not change otherwise applicable revenue recognition criteria. The guidance in this Issue is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. We do not expect the adoption of EITF 00-21 will have a material effect on our financial statements.

     In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging, which amends and clarifies financial accounting and reporting for derivative instruments. The adoption of SFAS 149 in June of 2003 did not have an effect on our consolidated financial statements.

     On May 15, 2003, the Financial Accounting Standards Board issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. The Statement requires issuers to classify as liabilities (or assets in some circumstance) three classes of freestanding financial instruments that embody obligations for the issuer. Generally, the Statement is effective for financial instruments entered into or modified after May 31, 2003 and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003. We will adopt the provisions of the Statement on August 1, 2003. We did not enter into any financial instruments within the scope of the Statement during June or July of 2003. We do not expect that the adoption of SFAS 150 will have an effect on our consolidated financial statements.

(11) LITIGATION

     Inrange Technologies Corporation, which is now a wholly owned subsidiary of the Company, has been named as a defendant in the case SBC Technology Resources, Inc. v. Inrange Technologies Corp., Eclipsys Corp. and Resource Bancshares Mortgage Group, Inc., No. 303-CV-418-N, pending in the United States District Court for the Northern District of Texas, Dallas Division. The action was commenced on February 27, 2003. The complaint alleges Inrange is infringing the SBC patent by manufacturing and selling storage area networking equipment, including Fibre Channel directors and switches, for use in storage networks that embody certain inventions claimed in a patent owned by SBC. The complaint asks for judgment that SBC’s patent is infringed by the defendants in the case, an accounting for actual damages, attorneys fees, costs of suit and other relief. Additionally, Eclipsys has demanded that Inrange indemnify and defend Eclipsys pursuant to documentation under which it acquired the product from Inrange. Hitachi Data Systems Corporation has informed Inrange that it has also received a demand from Eclipsys that Hitachi indemnify and defend Eclipsys for this action. Hitachi has put Inrange on notice that it will tender any claim by Eclipsys for indemnification and defense of this action to Inrange. The case is in its preliminary stages and management is evaluating the litigation.

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     Inrange has also been named as a defendant in the case Onex, Inc., Joseph P. Huffine, and Sally Huffine Breen v. Inrange Technologies Corporation, No. CV-0593LJM-WTL, pending in the United States District Court, Southern District of Indiana. The action was commenced on April 23, 2003. The complaint alleges breach of the contract pursuant to which Inrange acquired certain assets of Onex, Inc. The contract includes a provision for additional payments of purchase price based on the performance of the business acquired over a two year period. The contract requires the payments be made at the end of each year in such two year period. Specifically, the complaint alleges, among other things, that Inrange did not conduct the business in a commercially reasonable manner and the pay out for the first year should have been $6 million. The complaint also alleges the plaintiffs were harmed by the failure to provide accurate data with respect to the business acquired and Inrange’s failure to pay certain liabilities harmed the plaintiffs. The case is in its preliminary stages and management is evaluating the litigation.

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

(12) CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE

     In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized but instead be tested for impairment at least annually using a two-step impairment test.

     Effective February 1, 2002, the Company adopted SFAS No. 142. SFAS No. 142 provides a six-month transitional period from the effective date of adoption for the Company to perform an assessment of whether there is an indication of goodwill impairment. The Company tested its reporting units for impairment by comparing fair value to carrying value. Fair value was determined using a discounted cash flow and cost methodology. The valuation of the Company’s former Storage Solutions segment indicated that the goodwill associated with the acquisition of Articulent in April of 2001 was impaired. The performance of this business had not met management’s original expectations, primarily due to the unexpected global slow down in capital spending for information technology equipment. Accordingly, a non-cash impairment charge of $10.1 million from the adoption of SFAS No. 142 was recognized as a cumulative effect of change in accounting principle in the first quarter ended April 30, 2002.

(13) SEVERANCE

     The consolidated statement of operations for the three and six months ended July 31, 2003 includes severance costs related to our integration of Inrange Technologies Corporation as follows:

At July 31, 2003 the Company had a remaining accrual for severance in the amount of $345,000.

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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with our interim consolidated financial statements and notes thereto which appear elsewhere in this Quarterly Report and the MD&A contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 30, 2003.

Overview

     We are a leading provider of end-to-end storage solutions, including hardware and software products, related consulting and integration services, and managed services in the growing storage networking market. We focus primarily on helping our customers design, develop, deploy and manage a wide range of solutions for critical storage networks, including storage area networks, or SANs, a high speed network within a business’ existing computer system that allows the business to manage its data storage needs with greater efficiency and less disruption to its overall network.

     Our storage networking solutions enable businesses to cost-effectively design, implement, monitor and manage their storage requirements, connect geographically dispersed storage networks, provide continuous availability to greater amounts of data and protect increasing amounts of data more efficiently. We market out storage networking products and services directly to customers through our sales force and worldwide distributors. We also have strategic marketing and supply relationships with leading storage and telecommunications companies, including EMC, Hewlett-Packard, Hitachi Data Systems, IBM, StorageTek, Dell Computer Corporation and Veritas.

     Our wholly owned subsidiary, Inrange Technologies Corporation (Inrange), which we acquired on May 5, 2003, also designs, manufactures, markets and services networking and switching products for storage and data networks. These products provide fast and reliable connections among networks of computers and related devices, allowing customers to manage and expand large, complex, storage networks efficiently, without geographic limitations.

     The flagship product of Inrange, the FC/9000, is the most scalable storage networking director-class Fibre Channel switch available for SANs. With an ability for customers to upgrade and scale to 256 ports without disrupting existing systems, the FC/9000 provides a platform from which an enterprise can build storage networks that can be used in systems where reliability and continuous availability are critical. These products are designed to be compatible with various vendors’ products and multiple communication standards and protocols. Inrange distributes and supports these products through a combination of direct sales and service operations and indirect channels.

     We also supply storage systems, telecommunications capacity, storage application software and other products and services manufactured or provided by others.

Acquisition of Inrange

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

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Completion of this acquisition makes us one of the world’s largest providers of complete storage networking products, solutions and services, with combined 2002 pro forma annual revenues of approximately $435 million. We have global leadership positions in our markets. The acquisition significantly broadens and strengthens our portfolio of storage and networking products and solutions, increases our global size and scope, expands our customer base, and provides us with significant scale and cost reduction opportunities.

Impact of Inrange Integration

     During the second quarter of 2003, we incurred integration charges related to the Inrange acquisition of $3.4 million for wages and severance related to terminated employees, and travel costs for integration activities. Employees were terminated in most functional areas to obtain cost synergies. We also incurred a $1.6 million charge to write-down inventory related to the integration of product strategies for the new combined entity. The following table sets forth the impact of the integration charges on our Statements of Operations for the three and six months ended July 31, 2003: