UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

     (Mark One)

COMMISSION FILE NUMBER: 0-13994

COMPUTER NETWORK TECHNOLOGY CORPORATION

6000 Nathan Lane North, Minneapolis, Minnesota 55442

Telephone Number: (763) 268-6000

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 April 30, 2004, the registrant had 27,729,549 shares of $.01 par value common stock issued and outstanding.

COMPUTER NETWORK TECHNOLOGY CORPORATION

INDEX

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PART I. FINANCIAL INFORMATION

Item 1.

COMPUTER NETWORK TECHNOLOGY CORPORATION

See accompanying notes to Consolidated Financial Statements

3

COMPUTER NETWORK TECHNOLOGY CORPORATION

See accompanying notes to Consolidated Financial Statements

4

COMPUTER NETWORK TECHNOLOGY CORPORATION

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, 2004 as filed with the Securities and Exchange Commission. References to fiscal 2004 and 2003, represent the twelve months ended January 31, 2005 and 2004, 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 Inrange 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 other periods presented.

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

(3) INVENTORIES

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

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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 (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 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 Company acquired Inrange to significantly broaden its portfolio of storage networking products and solutions, particularly in the area of Fibre Channel and FICON switching, increase its global size and scope, and expand its customer base. Management believes the acquisition provides the Company with significant revenue growth and cost reduction synergies. Management believes the integration of the two companies completed in fiscal 2003, will result in over $20,000 in annualized cost savings.

     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 months ended April 30, 2004 and 2003 as if the acquisition of Inrange took place on February 1, 2003:

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     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.

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

     The intangible assets acquired included developed technology, customer list and trademarks valued at $20.2 million, $15.3 million and $1.2 million, respectively. The developed technology, customer list and trademarks are being amortized on a straight-line basis over periods of approximately five years, seven years and five years, respectively. Goodwill resulting from the acquisition of $86.9 million is deductible for income tax purposes.

     The Company has allocated $19.7 million of the Inrange purchase price to acquired in-process research and development to reflect the value of new Fibre Channel switching technology that was approximately 50% complete at the time of acquisition. At the date of acquisition, the technological feasibility of the new Fibre Channel switching technology had not been attained and the technology had no alternative future use. The new Fibre Channel switching technology is projected to have significantly greater functionality and port density when compared to other Fibre Channel technology currently available in the marketplace. The allocation to in-process research and development was based on an independent third party appraisal that utilized the excess earnings approach. Significant assumptions used in the third party appraisal include the cost to complete the project, and the projected revenue and expense generated over the estimated life cycle of the new Fibre Channel switching technology.

     A significant part of our integration strategy related to the Inrange acquisition, included the termination of duplicative employees across most functional areas, and the closing of duplicative facilities to obtain cost synergies. Integration planning was initiated prior to the closing of the acquisition. Severance costs for terminated Inrange employees were treated as an acquired liability, effectively increasing the purchase price. Severance costs for terminated CNT employees were recorded as an expense in the statement of operations. The integration plan resulted in the termination of 165 employees, including employees of both CNT and Inrange. The duplicative facilities that were closed were part of the pre-acquisition Inrange business, and the accrual for future rents associated with these facilities was treated as an acquired liability, effectively increasing the purchase price. The integration of product strategies for the new combined entity resulted in a $1.6 million charge in fiscal 2003 for the write-down of inventory that CNT had purchased prior to the acquisition. There have been no subsequent sales of this inventory.

     A summary of severance and facility accrual activity follows:

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BI-Tech

     On June 24, 2002, the Company acquired all the outstanding stock of BI-Tech, a leading provider of storage management solutions and services, for $12 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 has 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 currently being amortized over periods of ten and two years, respectively. The accompanying financial statements include the results of BI-Tech since June 24, 2002.

     The original purchase agreement required payments of additional consideration to the former stockholders and the BI-Tech employees based on achievement of certain earnings for each of the two years beginning July 1, 2002. 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 BI-Tech employees is recorded as compensation expense. No additional goodwill and compensation expense has been recorded under this earn out agreement since February 1, 2004.

(5) GOODWILL AND INTANGIBLE ASSETS

     The change in the net carrying amount of goodwill for the first three months of 2004 was as follows:

     The components of other amortizable intangible assets were as follows:

     Amortization expense for intangible assets during the first quarter of 2004 was $1.7 million. Amortization expense for the remainder of 2004 is estimated to be $5.2 million. Amortization expense is estimated to be $6.8 million in 2005 and 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 15, 2007, raising net proceeds of $121.6 million. The notes are convertible into the Company’s common stock at a price of $19.17 per share. The Company may redeem the notes upon payment of the outstanding principal balance, accrued interest and a make whole payment if the closing price of its common stock exceeds 175% of the conversion price for at least 20 consecutive trading days within a period of 30 consecutive trading days ending on the trading day prior to the date the redemption notice is mailed. The make whole payment represents additional interest payments that would be made if the notes were not redeemed prior to the due date.

     In January 2004, the Company entered into an interest-rate swap agreement with a notional amount of $75 million that has the economic effect of modifying that dollar portion of the fixed interest obligations associated with $75 million of its 3% convertible subordinated notes due February 2007 such that the interest payable effectively becomes variable based on the three month LIBOR plus 69.5 basis points. The payment dates of the swap are January 31st, April 30th, July 31st and October 31st of each year, commencing April 30, 2004, until maturity on February 15, 2007. The initial LIBOR setting for the swap was 1.15%, creating a combined effective rate of approximately 1.845%, which was effective until April 30, 2004. The combined effective rate for the period from May 1, 2004 through July 31, 2004 is approximately 1.865%. The swap was designated as a fair value hedge, and as such, the gain or loss on the swap, as well as the fully offsetting gain or loss on the notes attributable to the hedged risk, were recognized in earnings. As part of the agreement, the Company is also required to post collateral based on changes in the fair value of the interest rate swap. This collateral, in the form of restricted cash, was $2.5 million at April 30, 2004. The Company could incur charges to terminate the swap in the future prior to February 15, 2007 if interest rates rise, or upon certain events such as a change in control or certain redemptions of convertible subordinated notes.

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(8) STOCK-BASED COMPENSATION

     The estimated per share weighted average fair value of all stock options granted during the three months ended April 30, 2004 and 2003 was $5.92 and $5.01, 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 for its stock options based on the estimated fair value on the date of grant, as defined by SFAS 123, the Company’s pro forma net loss would have been as follows:

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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 costs, which is periodically adjusted for recent actual experience. Warranty terms on the Company’s equipment range from 90 days to 13 months. The changes in warranty reserve balances for the three months ended April 30, 2004 and 2003 were as follows:

(10) NEW ACCOUNTING PRONOUNCEMENTS

     On December 24, 2003, the Financial Accounting Standards Board (the “FASB”) issued Interpretation (“FIN”) No. 46R “Consolidation of Variable Interest Entities”. FIN No. 46R replaces Interpretation No. 46, “Consolidation of Variable Interest Entities” FIN 46, which was issued on January 17, 2003. FIN No. 46R provides guidance on identification of entities for which control is achieved through means other than through voting rights called “variable interest entities or “VIEs” and how to determine when and which business enterprise should consolidate the VIE (the “primary beneficiary”). This new model for consolidation applies to an entity in which either (1) the equity investors (if any) do not have a controlling financial interest or (2) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties. In addition, FIN 46R requires that both the primary beneficiary and all other enterprises with a significant variable interest in a VIE to make additional disclosures. The adoption of FIN No. 46R did not have material effect on our financial statements.

(11) DISCONTINUED OPERATIONS

     In connection with the acquisition of Inrange, the Company acquired a non-complementary business focused on enterprise resource planning (ERP) consulting services. In April 2004, the business and its net assets totaling approximately $2.0 million were sold for estimated cash proceeds of $1.3 million, subject to adjustment based on the final agreed upon net assets of the business, and installments payments having a discounted value of approximately $1.2 million. The business was divested to allow the Company to focus on its core storage networking solutions business. Revenue and expense for the ERP business in the first quarter of 2004 totaled approximately $2.5 million and $2.8 million, respectively. The business has been accounted for as a discontinued operation in the accompanying financial statements, meaning that its revenues and expenses are not included in results from continuing operations, and the net loss of the ERP business for the first quarter of 2004 totaling $344 was included under the discontinued operations caption in the statement of operations.

     The pre-tax gain from the sale of $450 has been recorded as reduction in goodwill from the Inrange Technologies acquisition during the first quarter of 2004.

(12) ENTERPRISE-WIDE INFORMATION

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

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(13) 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 claims that Inrange is infringing one SBC patent by manufacturing and selling storage area networking equipment, including Fibre Channel directors and switches, for use in storage networks that allegedly 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. Inrange has answered, denying SBC’s allegations. The case is in its preliminary stages and management is evaluating the litigation. At this point, it is too early to form a definitive opinion concerning the ultimate outcome of this matter.

     A shareholder class action was filed against Inrange and certain of its officers on November 30, 2001, in the United States District Court for the Southern District of New York, seeking recovery of damages caused by Inrange’s alleged violation of securities laws, including section 11 of the Securities Act of 1933 and section 10(b) of the Exchange Act of 1934. The complaint, which was also filed against the various underwriters that participated in Inrange’s initial public offering (IPO), is identical to hundreds of shareholder class actions pending in this court in connection with other recent IPOs and is generally referred to as In re Initial Public Offering Securities Litigation. The complaint alleges, in essence, (a) that the underwriters combined and conspired to increase their respective compensation in connection with the IPO by (i) receiving excessive, undisclosed commissions in exchange for lucrative allocations of IPO shares, and (ii) trading in Inrange’s stock after creating artificially high prices for the stock post-IPO through “tie-in” or “laddering” arrangements (whereby recipients of allocations of IPO shares agreed to purchase shares in the aftermarket for more than the public offering price for Inrange shares) and dissemination of misleading market analysis on Inrange’s prospects; and (b) that Inrange violated federal securities laws by not disclosing these underwriting arrangements in its prospectus. The defense has been tendered to the carriers of Inrange’s director and officer liability insurance, and a request for indemnification has been made to the various underwriters in the IPO. At this point the insurers have issued a reservation of rights letter and the underwriters have refused indemnification. The court has granted Inrange’s motion to dismiss claims under section 10(b) of the Securities Exchange Act of 1934 because of the absence of a pleading of intent to defraud. The court granted plaintiffs leave to replead these claims, but no further amended complaint has been filed. The court 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 of this matter.

     From time-to-time we are a party to various other legal actions and receive threats of litigation. At this time, management does not believe any such litigation or threats will have a material impact on our consolidated financial position or results of operations.

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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 14, 2004.

Overview

     We are a leading provider of today’s most cost-effective and reliable storage networking solutions. For over 20 years, businesses around the world have depended on us to improve business efficiency, increase data availability and manage their business-critical information. We apply our technology, products and expertise in open storage networking architecture and business continuity to help companies build end-to-end storage solutions, including hardware and software products, analysis, planning and design, multi-vendor integration, implementation and ongoing remote management. We focus primarily on helping our customers design, develop, deploy and manage storage and data 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. We design, manufacture, market and support a wide range of solutions that 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, including applications such as remote data replication, or the real-time backup of data to remotely located disks, and remote tape vaulting, or the backup of data to remotely archived tapes. We market our 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, telecommunications and fibre switching companies, including Brocade, EMC, Hewlett-Packard, Hitachi Data Systems, IBM, StorageTek, and Dell Computer Corporation.

     On May 5, 2003, we completed the acquisition of Inrange for $190 million in cash plus transaction costs. Inrange designs, manufactures, markets and supports switching and networking products for storage and data networks. Inrange’s flagship product, the FC/9000®, is the most scalable storage networking director-class 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 enterprises can build storage networks that can be used in systems where reliability and continuous availability are critical. The acquisition of Inrange makes us one of the world’s largest providers of complete storage networking products, solutions and services, with combined 2003 pro forma annual revenues of approximately $400 million. We believe we have global leadership positions in our combined markets. The acquisition significantly broadens and strengthens our portfolio of storage networking products and solutions, increases our global size and scope, expands our customer base, and provided us with significant opportunities for both revenue growth and cost reduction synergies. Our integration of the two companies has resulted in over $20 million in projected annualized cost savings.

     The markets in which we operate are characterized by rapidly changing technology and evolving industry standards, resulting in rapid product obsolescence and frequent product and feature introductions and improvements. We compete with several companies that have greater engineering and development resources, marketing resources, financial resources, manufacturing capability, customer support resources and name recognition. As a result, our competitors may have greater credibility with 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 we can to new or emerging technologies and changes in customer requirements.

     Our competitors for our storage networking products, primarily our UltraNet® family of products, include storage system vendors and others including Akara, which is owned by Ciena, and Nishan Systems, which is owned by McData. In addition, Cisco has acquired technology (Andiamo and NuSpeed) with functionality similar to our product offerings. EMC has a WAN capability for storage networking that competes with our products. Our UltraNet® product revenue may be impacted as customers switch to channels such as FICON with improved distance and price performance capabilities or to less expensive IP based solutions. There are numerous competitors for our third party product and solution sales.

     While the Fibre Channel and FICON switching markets have yet to develop fully, we believe that the market for our FC/9000® Fibre Channel and FICON director switching products, and our next generation products, will be highly competitive, continually evolving and subject to rapid technology change. Our competitors in Fibre Channel and FICON switching include Brocade Communications Systems, McData Corporation, Cisco Systems, Inc., and Qlogic Corporation, as well as storage system vendors who may re-sell the Fibre Channel and FICON switching products manufactured by our competitors.

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     We anticipate that the proprietary products acquired in the Inrange acquisition, including the Inrange Fibre Channel and FICON director products, will account for a significant and growing portion of our proprietary product revenue in future periods. IDC estimates that the revenue for Fibre Channel hubs, switches and directors will grow from $938 million in 2003 to $2.2 billion in 2007, reflecting a compound annual growth rate of 23%. We anticipate that we will be able to capture a larger share of this growing market by expanding our established relationships with leaders in the storage networking market, including the major storage vendors, such as EMC, Hitachi Data Systems and IBM. We believe our current and future strategic relationships will facilitate the integration of our products, thereby increasing our market share and reducing the length of our sales cycle. We will also expand sales of our proprietary products, including our Fibre Channel and FICON director products, through our direct sales force. We believe that our ability to provide the customer with complete professional consulting services, product maintenance and advanced networking monitoring services gives us an advantage over our competitors, that will enable us to expand sales and grow market share.

     Our revenue can be significantly impacted by general economic trends in the global economy and capital spending plans for information technology equipment. Our revenue can also be impacted by the introduction or phase out of products and services, either by us, or competitors. The introductions of new technologies by other companies, including the large storage vendors with whom we do business, can also impact our quarterly revenue. We expect continued quarter-to-quarter fluctuations in revenue in both domestic and international markets. The timing of sizable orders, because of their relative impact on total quarterly sales, may contribute to such fluctuations. The level of product sales reported by us in any given period will continue to be affected by the receipt and fulfillment of sizable new orders in both domestic and international markets.

     In fiscal 2003, we achieved cost synergies in most functional areas of our business due to the Inrange acquisition. We consolidated our manufacturing operations, including the in-house capability to add parts and components to printed circuit boards. We anticipate that these cost synergies will continue in fiscal 2004. The mix of products sold by us, (i.e. our proprietary products or third party products), and the level of services we provide to customers has a significant impact on our level of profitability in any given quarterly period.

     We acquired new Fibre Channel switching technology in connection with the Inrange acquisition that is in development and is projected to have greater functionality when compared to other Fibre Channel technology currently existing in the marketplace. We expect to expend significant research and development resources in fiscal 2004 to bring this new technology to market. Significant costs for us include wages, fringe benefits, facilities and depreciation and amortization. These costs tend to be relatively fixed in the short term, or may be incurred in advance of anticipated revenue. As a result, the timing of the receipt of sizable of new orders, and the related recognition of revenue, has a significant impact on our level of profitability in any given quarterly period.

Acquisition of Inrange

     On April 6, 2003, we entered into an agreement whereby a 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. During fiscal 2003 we incurred integration charges related to the acquisition of $5.4 million, primarily for wages and severance for terminated employees, and extra travel costs for integration activities. We also recorded a $1.6 million charge for the write-down of inventory resulting from the integration of the product strategies for the new combined entity, and a $19.7 million charge for in-process research and development related to the acquisition of Inrange. The integration of Inrange is now complete and no further integration charges are anticipated in fiscal 2004. Our consolidated financial statements include the results of Inrange from May 5, 2003. See footnote 4 per the accompanying financial statements for a summary of the purchase price allocation and pro forma results of operations as if the acquisition of Inrange took place on February 1, 2003.

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Acquisition of BI-Tech Solutions, Inc.

     In June 2002, we acquired all of 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 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 BI-Tech employees is recorded as compensation expense. No additional goodwill and compensation expense have been recorded under this earn out agreement since February 1, 2004.

Discontinued Operations

     In connection with the acquisition of Inrange Technologies in May 2003, we acquired a non-complementary business focused on enterprise resource planning (ERP) consulting services. In April 2004, the business and its net assets totaling approximately $2.0 million were sold for estimated cash proceeds of $1.3 million, subject to adjustment based on the final agreed upon net assets of the business, and installments payments having a discounted value of approximately $1.2 million. The business was divested to allow us to focus on our core storage networking solutions business. Revenue and expense for the ERP business in the first quarter of 2004 totaled approximately $2.5 million and $2.8 million, respectively. The business has been accounted for as a discontinued operation in the accompanying financial statements, meaning that its revenues and expenses are not included in results from continuing operations, and the net loss of the ERP business for the first quarter of 2004 totaling $344,000 was included under the discontinued operations caption in the statement of operations.

     The pre-tax gain from the sale of $450,000 during the first quarter of 2004 has been recorded as reduction in goodwill related to the Inrange acquisition.

Convertible Debt Offering

     In February 2002, we sold $125 million of 3% convertible subordinated notes due February 2007, raising net proceeds of $121.6 million. The notes are convertible into our common stock at a price of $19.17 per share. We may redeem the notes upon payment of the outstanding principal balance, accrued interest and a make whole premium if the closing price of our 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 we mail the redemption notice. On August 15, 2002 a registration statement for the resale of the notes and the 6.5 million shares of common stock issuable upon conversion of the notes became effective.

Valuation Allowance for Deferred Tax Assets

     In the fourth quarter of fiscal 2002, we recorded a non-cash charge of $23.6 million to provide a full valuation allowance for our United States deferred tax assets. As we generate taxable income in future periods, we do not expect to record significant income tax expense in the United States until it becomes more likely than not that we will be able to utilize the deferred tax assets, and we reduce the valuation allowance. The establishment of the valuation allowance does not impair our ability to use the deferred tax assets upon achieving profitability. Our federal net operating loss carry-forwards and credits do not expire until 15 to 20 years from now.

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Results of Operations

     The following table sets forth financial data for our operations for the periods indicated as a percentage of total revenue except for gross profit, which is expressed as a percentage of the related revenue.

     Cost of product for the first three months of 2004 includes $1.1 million of amortization of developed technology related to the Inrange acquisition. Sales and marketing expense includes $608,000 of amortization for trademarks and customer lists which are also related to the Inrange acquisition.

Revenue

Product revenue

     Sales of our proprietary products generated revenues of $38.5 million in the first quarter of 2004, up $20.2 million or 111% from the first quarter of 2003. The vast majority of the increase in proprietary product sales relates to the acquisition of Inrange. Throughout fiscal 2003, we worked to fully integrate the Inrange products into our existing proprietary product offerings, and now offer our customers one complete and fully integrated line of proprietary storage networking products.

     Sales of our third party storage solutions products generated revenues of $25.2 million in the first quarter of 2004, up $9.1 million or 56% from the first quarter of 2003. During the first three months of 2004, we received a large customer order which accounted for the majority of this increase. Our sales representatives that we employed prior to our acquisition of Inrange also have become more proficient at selling third party storage solutions. We also anticipate that third party storage solutions products revenue will increase in the future periods once the sales representatives we acquired with the Inrange acquisition become more experienced and proficient at selling third party products.

Service revenue

     Maintenance revenues from our proprietary products for the first quarter of 2004 totaled $21.0 million, up $10.1 or 93% from the first quarter of 2003. The increase is primarily attributable to our acquisition of Inrange, as maintenance related to the proprietary products acquired from Inrange provide us with a recurring annual revenue stream of approximately $40 million.

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     Our consulting fee revenues increased 64% in the first quarter of 2004 to $11.6 million from $7.1 million in the first quarter of 2003. We have started to offer professional consulting services with sales of the proprietary products we acquired from Inrange, and have trained the Inrange sales force to sell these services, along with our proprietary and third party products. Our sales force has also become more experienced and proficient at selling our consulting services. A significant component of our strategy includes having a direct sales force and professional consulting organization capable of providing customers with complete end-to-end storage networking solutions, thereby capturing more of the customers IT spending and increasing our overall consulting fee and product revenue.

General

     Revenue generated from the sale of products and services outside the United States for the first quarter of 2004 totaled $31.4 million, up 104% from $15.3 million in the first quarter of 2003. We derived 33% and 29% of our revenue outside the United States for the first quarter of fiscal 2004 and 2003, respectively. The increase in revenue generated outside the United States and the increase in revenue generated outside the United States as a percentage of our total revenue is primarily attributable to the acquisition of Inrange in May 2003. The acquisition of Inrange expanded our presence outside the United States, primarily in Europe. During calendar year 2002, international sales accounted for approximately 40% of Inrange’s total revenue. We expect to continue to expand our presence outside the United States, thereby increasing both our sales outside the United States, and our overall percentage of revenue coming from international markets.

     Two customers accounted for 17% and 20%, respectively, of our revenue during the first quarter of 2004. No customer accounted for more than 10% of our revenue during the first quarter of 2003. Price discounting had a small impact on our product revenue during these periods.

Gross Profit Margins

Product margins

     Gross margins from the sale of our proprietary products for the first quarter of 2004 were 55%, compared to 55% in the first quarter of 2003. Excluding the $1.1 million of amortization expense for developed technology related to the Inrange acquisition, gross margins for the first quarter of 2004 would have been 58%. The improvement in gross margin percentage, excluding the amortization of developed technology, was due to the cost synergies resulting from the Inrange acquisition. We obtained significant cost synergies by consolidating our manufacturing operations following the acquisition of Inrange, resulting in lower labor and overhead costs. A significant part of our product cost includes the addition of parts and components to printed circuit boards. Following the acquisition of Inrange, we were able to reduce our material costs by bringing this activity in-house. We previously outsourced this activity to various third party suppliers.

     Gross margins from the sale of third party storage solutions products for the first quarter of 2004 were 16% compared to 17% in the first quarter of 2003. The slight decrease in gross margin percentage was primarily due to product mix. We anticipate that product margins for third party products will remain in the high teens in future periods.

Service margins

     Gross service margins from maintenance of our proprietary products in the first quarter of 2004 were 45%, compared to 50% in the first quarter of 2003. The decrease in gross margin percentage was primarily due to the cost associated with our continued efforts to enhance the level of service provided to the Inrange customer install base.

     Gross profit margins from our consulting fees in the first quarter of 2004 were 20%, compared to 34% in the first quarter of 2003. The decrease in gross margin percentage was due to our acquisition of Inrange, and a planned expansion of our consulting workforce. The consulting business we acquired with our May 2003 acquisition of Inrange generated lower gross margin percentages than our pre-acquisition consulting business due to lower utilization of employee consultants. We also expanded our workforce of consulting employees in the first quarter of 2004 in anticipation of additional future revenue. We anticipate that our gross profit margin percentages from consulting fees will increase in future periods as revenue and utilization of the Inrange consulting force and our newly hired consulting employees increase.

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Operating Expenses

Sales and marketing

     Sales and marketing expense for the first quarter of 2004 totaled $23.7 million, up 67% from $14.2 million in the first quarter of 2003. Excluding amortization for customer list and trademarks related to our acquisition of Inrange for the first quarter 2004 of $608,000, our sales and marketing expense would have been $23.1 million. Substantially all of the increase was due to our acquisition of Inrange in May 2003.

Engineering

     Engineering and development expense for the first quarter of 2004 totaled $13.2 million, up 122% from $5.9 million in the first quarter of 2003. The increase was primarily due to our acquisition of Inrange in May of 2003. We are committed to the future development of our Fibre Channel director products, and our UltraNet® family of products. In future periods, we expect to continue to invest a significant portion of our resources in the engineering and development of new products, and new features for existing products.

General and administrative

     General and administrative expenses for the first quarter of 2004 totaled $3.5 million, up 37% from $2.6 million in the first quarter of 2003. The increase in expense was primarily due to our acquisition of Inrange in May 2003.

Other

     Other expense for the first quarter of 2004 totaled $822,000, compared to other income of $700,000 for the first quarter of 2003. In February 2002, we sold $125 million of 3% convertible subordinated notes due February 2007, raising net proceeds of $121.6 million. Coupon interest on the notes, plus amortization of debt issuance costs, and interest expense from our capital lease obligations resulted in interest expense for the first quarter of 2004 of $1.0 million, compared to interest expense of $1.1 million in the first quarter of 2003. In January 2004, we entered into an interest-rate swap agreement with a notional amount of $75 million that has the economic effect of modifying that dollar portion of the fixed interest obligations associated with $75 million of our 3% convertible subordinated notes due February 2007 such that the interest payable effectively becomes variable based on the three month LIBOR plus 69.5 basis points. The initial LIBOR setting for the swap was 1.15%, creating a combined effective rate of approximately 1.845%, which was effective until April 30, 2004. The combined effective rate for the period from May 1, 2004 through July 31, 2004 is approximately 1.865%. Interest and other income totaled $210,000 in the first quarter of 2004, compared to $1.1 million in the first quarter of 2003. During the first quarter of 2003, we sold substantially all of our investments in marketable securities to finance our acquisition of Inrange on May 5, 2003 for $190 million in cash. The sale resulted in a net realized gain totaling $747,000, and was the primary reason for the reduction in interest income when comparing the first quarter of 2004 and 2003.

Liquidity and Capital Resources

     We have historically financed our operations through the public and private sale of debt and equity securities, bank borrowings under lines of credit, capital and operating leases and cash generated by operations.

     Cash, cash equivalents and marketable securities at April 30, 2004 totaled $80.4 million, an increase of $2.9 million since January 31, 2004. The increase is primarily due to a reduction in our accounts receivable during the first three months of 2004 of $25.5 million which was offset by a reduction in accounts payable and accrued expenses of $13.9 million. Other uses of cash during the first three months of 2004 included capital equipment and field support spares totaling $6.9 million. Expenditures for capital equipment and field support spares have been, and will likely continue to be, a significant capital requirement.

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     At April 30, 2004, our available cash and marketable securities totaled $80.4 million. We believe that our available balances of cash, cash equivalents and marketable securities, when combined with anticipated cash flows from operations, will be adequate to fund our operating plans and meet our current anticipated aggregate capital requirements, at least for the next twelve months. This belief is based upon a number of assumptions and estimates, including obtaining certain revenue levels from Inrange products and services and payments of expenses in line with estimates by management. If these estimates and assumptions do not turn out to be correct, or if we encounter unanticipated difficulties or economic conditions, our liquidity could be impaired.

     We believe that inflation has not had a material impact on our operations or liquidity to date.

     Our future minimum contractual cash obligations at April 30, 2004, including open purchase orders incurred in the ordinary course of business, are as follows (in millions):

     Our acquisition of BI-Tech originally required us to pay the former stockholders and BI-Tech employees additional consideration 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.

ITEM 3. MARKET RISK

     Our exposure to market risk due to changes in the general level of U.S. interest rates relates primarily to our cash, cash equivalents, and marketable securities. The primary objective of our investment activities is the preservation of principal while maximizing investment income and minimizing risk. We mainly invest our cash, cash equivalents and marketable securities in investment grade, highly liquid investments, consisting of U.S. government and agency securities, corporate debt securities and bank certificates of deposits.

     At April 30, 2004, our marketable securities include $1.4 million of various mutual funds. These investments were purchased to directly offset any investment gains or losses owed to participants under our executive deferred compensation plan, which has been established for selected key employees.

     We are exposed to market risks related to fluctuations in foreign exchange rates because some sales transactions, and the assets and liabilities of our foreign subsidiaries, are denominated in foreign currencies, primarily the euro and British pounds sterling. As of April 30, 2004, we had no open forward exchange contracts.

     In January 2004, we entered into an interest-rate swap agreement with a notional amount of $75 million that has the economic effect of modifying that dollar portion of the fixed interest obligations associated with $75 million of our 3% convertible subordinated notes due February 2007, such that the interest payable effectively becomes variable based on the three month LIBOR plus 69.5 basis points. The payment dates of the swap are January 31st, April 30th, July 31st and October 31st of each year, commencing April 30, 2004, until maturity on February 15, 2007. The initial LIBOR setting for the swap was 1.15%, creating a combined effective rate of approximately 1.845%, which was effective until April 30, 2004. The combined effective rate for the period from May 1, 2004 through July 31, 2004 is approximately 1.865%. The swap was designated as a fair value hedge, and as such, the gain or loss on the swap, as well as the fully offsetting gain or loss on the notes attributable to the hedged risk, were recognized in earnings. As part of the agreement, we are also required to post collateral based on changes in the fair value of the interest rate swap. This collateral, in the form of restricted cash, was $2.5 million at April 30, 2004. We could incur charges to terminate the swap in the future prior to February 15, 2007 if interest rates rise, or upon certain events such as a change in control or certain redemptions of convertible subordinated notes. A 25 basis point increase in the LIBOR rate would increase our annual interest expense by $187,500.

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     On April 30, 2004, the reported trading price of our convertible subordinated notes due 2007 was $86 per $100 in face amount of principal indebtedness, resulting in an aggregate fair value of approximately $107.7 million. Our common stock is quoted on the Nasdaq National Market under the symbol “CMNT”. On April 30, 2004, the last reported sale price of our common stock on the Nasdaq Market was $6.55 per share.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

     The Company reviewed and evaluated the effectiveness of our disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13a-14(c) and 15d-14(c)) as of the end of the period covered by this report (the Evaluation Date). This review and evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer (CEO) and Chief Financial Officer (“CFO”). Based on their review and evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, our disclosure controls and procedures were adequate and effective to ensure that information required to be disclosed by us in reports we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. It should be noted that the design of any system of controls is based upon certain assumptions about the likelihood of future events, and there can be assurance that design will succeed in achieving its stated objective under all potential future conditions, regardless of how remote. However, the CEO and CFO believe the Company’s disclosure controls and procedures provide reasonable assurance that the disclosure controls and procedures are effective at the reasonable assurance level.

(b) Change in Internal Controls

     There have been no changes in our internal controls over financial reporting that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

Forward Looking Statements

     This Form 10-Q and other documents we have filed with the Securities and Exchange Commission contain forward-looking statements, which may include statements about our:

•		anticipated receipt of orders and their impact on quarterly sales;
•		business strategy;
•		expectations regarding future liquidity revenue levels, gross margins, expenses, operating margins and earnings per share;
•		timing of and plans for the introduction or phase-out of products or services;
•		enhancements of existing products or services;
•		plans for hiring or reducing personnel;
•		entering into strategic partnerships;
•		other plans, objectives, expectations and intentions contained in this Form 10-Q that are not historical facts.

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When used in this Form 10-Q, the words “may,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential” or “continue” and similar expressions are generally intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. These forward-looking statements involve risks and uncertainties. Actual results could differ materially from those expressed or implied by these forward-looking statements as a result of certain risk factors, including but not limited to (i) competitive factors, including pricing pressures, (ii) variability in quarterly and annual sales, (iii) economic trends in various geographic markets, including changes in IT spending levels; (iv) relationships with our strategic partners; (v) unanticipated risks associated with introducing new products and features; (vi) technological change affecting our products; (vii) adverse judgments in present and future litigation; (viii) our ability to obtain market acceptance of our new products; (ix) our ability to anticipate end user needs; (x) dependence on sole source and limited source suppliers; (xi) our ability to retain and attract key personnel; (xii) the existence of undetected errors in our products; (xiii) our ability to protect our intellectual property and defend against infringement claims; (xiv) variability in gross profit caused by sales mix and other factors; (xv) receipt of anticipated orders; and (xvi) other events and other important factors disclosed previously and from time to time in our filings with the U.S. Securities and Exchange Commission, including our Form 10-K. We assume no obligation to update any forward-looking statements. These statements are only predictions. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The information set forth in Note 13 (Litigation) to the consolidated financial statements included in Part I of this form 10-Q is hereby incorporated by reference.

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

     (a) Not applicable.

     (b) Not applicable.

     (c) Not applicable.

     (d) Not applicable.

     (e) Repurchases of securities in current quarter.

In April 2001, our board of directors authorized the repurchase of up to $50.0 million of our common stock. Subsequent to April 2001, our board changed the authorization so that the remaining balance of the initial $50 million authorization can be used for the repurchase of either debt or stock. As of January 31, 2004, we had repurchased 4.1 million shares of our common stock for $33.0 million under this authorization. No common stock or debt was repurchased during the three months ended April 31, 2004.

Items 3-5. None

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Item 6. Exhibits and Reports on Form 8-K

     (a) Exhibits filed herewith.

     (b) Reports on Form 8-K

          A current report on Form 8-K was dated and furnished March 1, 2004, pursuant to Item 12 (Results of Operations and Financial Condition) to report the press release announcing the Company’s financial results for the fourth quarter of 2003 and certain other information.

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SIGNATURES

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

COMPUTER NETWORK TECHNOLOGY CORPORATION
(Registrant)

Date: May 28, 2004

	By:	/s/ Gregory T. Barnum
		Gregory T. Barnum
		Chief Financial Officer (Principal financial officer)

	By:	/s/ Jeffrey A. Bertelsen
		Jeffrey A. Bertelsen
		Corporate Controller and Treasurer (Principal accounting officer)

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EXHIBIT INDEX

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