UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

R QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended January 29, 2005

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: 000-25601

BROCADE COMMUNICATIONS SYSTEMS, INC.

1745 Technology Drive
San Jose, CA 95110
(408) 333-8000
(Address, including zip code, of Registrant’s
principal executive offices and telephone
number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes R No £

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

Yes R No £

The number of shares outstanding of the Registrant’s Common Stock on February 26, 2005 was 268,513,849 shares.

BROCADE COMMUNICATIONS SYSTEMS, INC.

FORM 10-Q

QUARTER ENDED JANUARY 29, 2005

INDEX

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

BROCADE COMMUNICATIONS SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

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

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BROCADE COMMUNICATIONS SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value)
(Unaudited)

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

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BROCADE COMMUNICATIONS SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

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

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BROCADE COMMUNICATIONS SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. Organization and Operations of Brocade

     Brocade Communications Systems, Inc. (Brocade or the Company) designs, develops, markets, sells, and supports data storage networking products and services, offering a line of storage networking products that enables companies to implement highly available, scalable, manageable, and secure environments for data storage applications. The Brocade SilkWorm® family of storage area networking (SAN) products is designed to help companies reduce the cost and complexity of managing business information within a data storage environment. Brocade products and services are marketed, sold, and supported worldwide to end-user customers through distribution partners, including original equipment manufacturers (OEMs), value-added distributors, systems integrators, and value-added resellers.

     Brocade was incorporated on May 14, 1999 as a Delaware corporation, succeeding operations that began on August 24, 1995. The Company’s headquarters are located in San Jose, California.

     Brocade, SilkWorm, and the Brocade logo are trademarks or registered trademarks of Brocade Communications Systems, Inc. in the United States and/or in other countries. All other brands, products, or service names are or may be trademarks or service marks of, and are used to identify, products or services of their respective owners.

2. Summary of Significant Accounting Policies

Fiscal Year

     The Company’s fiscal year is the 52 or 53 weeks ending on the last Saturday in October. As is customary for companies that use 52/53-week convention, every fifth year contains a 53-week year. Fiscal year 2005 is a 52-week fiscal year and fiscal year 2004 was a 53-week fiscal year. The second quarter of fiscal year 2004 consisted of 14 weeks, which is one week more than a typical quarter.

Basis of Presentation

     The accompanying financial data as of January 29, 2005, and for the three months ended January 29, 2005 and January 24, 2004, has been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. The October 30, 2004 Condensed Consolidated Balance Sheet was derived from audited consolidated financial statements, but does not include all disclosures required by generally accepted accounting principles in the United States of America. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended October 30, 2004.

     In the opinion of management, all adjustments (which include only normal recurring adjustments, except as otherwise indicated) necessary to present a fair statement of financial position as of January 29, 2005, results of operations for the three months ended January 29, 2005 and January 24, 2004, and cash flows for the three months ended January 29, 2005 and January 24, 2004, have been made. The results of operations for the three months ended January 29, 2005 are not necessarily indicative of the operating results for the full fiscal year or any future periods.

Cash and Cash Equivalents

     The Company considers all highly liquid investments with an original or remaining maturity of three months or less at the date of purchase to be cash equivalents.

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Investments and Equity Securities

     Investment securities with original or remaining maturities of more than three months but less than one year are considered short-term investments. Investment securities with original or remaining maturities of one year or more are considered long-term investments. Short-term and long-term investments consist of auction rate securities, debt securities issued by United States government agencies, municipal government obligations, and corporate bonds and notes. In the first quarter of fiscal year 2005, the Company concluded that it was appropriate to classify its auction rate securities as short-term investments. These investments were previously classified as cash and cash equivalents. Accordingly, we have revised our October 30, 2004 balance sheet to report these securities as short-term investments on the accompanying Condensed Consolidated Balance Sheets.

     Short-term and long-term investments are maintained at three major financial institutions, are classified as available-for-sale, and are recorded on the accompanying Condensed Consolidated Balance Sheets at fair value. Fair value is determined using quoted market prices for those securities. Unrealized holding gains and losses are included as a separate component of accumulated other comprehensive income on the accompanying Condensed Consolidated Balance Sheets, net of any related tax effect. Realized gains and losses are calculated based on the specific identification method and are included in interest and other income, net, on the Condensed Consolidated Statements of Operations.

     Marketable equity securities consist of equity holdings in public companies and are classified as available-for-sale when there are no restrictions on the Company’s ability to immediately liquidate such securities. Marketable equity securities are recorded on the accompanying Condensed Consolidated Balance Sheets at fair value. Fair value is determined using quoted market prices for those securities. Unrealized holding gains and losses are included as a separate component of accumulated other comprehensive income on the accompanying Condensed Consolidated Balance Sheets, net of any related tax effect. Realized gains and losses are calculated based on the specific identification method and are included in interest and other income, net on the Condensed Consolidated Statements of Operations.

     The Company recognizes an impairment charge when the declines in the fair values of its investments below the cost basis are judged to be other-than-temporary. The Company considers various factors in determining whether to recognize an impairment charge, including the length of time and extent to which the fair value has been less than the Company’s cost basis, the financial condition and near-term prospects of the investee, and the Company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value.

     From time to time the Company makes equity investments in non-publicly traded companies. These investments are included in other assets on the accompanying Condensed Consolidated Balance Sheets, and are generally accounted for under the cost method as the Company does not have the ability to exercise significant influence over the respective company’s operating and financial policies. The Company monitors its investments for impairment on a quarterly basis and makes appropriate reductions in carrying values when such impairments are determined to be other-than-temporary. Impairment charges are included in interest and other income, net on the Condensed Consolidated Statements of Operations. Factors used in determining an impairment include, but are not limited to, the current business environment including competition and uncertainty of financial condition; going concern considerations such as the rate at which the investee company utilizes cash, and the investee company’s ability to obtain additional private financing to fulfill its stated business plan; the need for changes to the investee company’s existing business model due to changing business environments and its ability to successfully implement necessary changes; and comparable valuations. If an investment is determined to be impaired, a determination is made as to whether such impairment is other-than-temporary. As of January 29, 2005 and October 30, 2004, the carrying values of the Company’s equity investments in non-publicly traded companies were $1.0 million and $0.5 million, respectively.

Concentrations

     Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash, cash equivalents, short-term and long-term investments, and accounts receivable. Cash, cash equivalents, and short-term and long-term investments are primarily maintained at five major financial institutions in the United States. Deposits held with banks may be redeemed upon demand and may exceed the amount of insurance provided on such deposits. The Company principally invests in United States government agency debt securities, municipal government obligations, and corporate bonds and notes, and limits the amount of credit exposure to any one entity.

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     A majority of the Company’s trade receivable balance is derived from sales to OEM partners in the computer storage and server industry. As of January 29, 2005 and October 30, 2004, 95 percent and 85 percent, respectively, of accounts receivable were concentrated with five customers. The Company performs ongoing 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.

     For the three months ended January 29, 2005 and January 24, 2004, four customers and three customers, respectively, each represented ten percent or more of the Company’s total revenues for combined totals of 82 percent and 69 percent of total revenues, respectively. The level of sales to any one of these customers may vary, and the loss of, or a decrease in the level of sales to, any one of these customers, could seriously harm the Company’s financial condition and results of operations.

     The Company currently relies on single and limited supply sources for several key components used in the manufacture of its products. Additionally, the Company relies on two contract manufacturers for the production of its products. The inability of any single and limited source suppliers or the inability of either contract manufacturer to fulfill supply and production requirements, respectively, could have a material adverse effect on the Company’s future operating results.

     The Company’s business is concentrated in the SAN industry, which from time to time has been impacted by unfavorable economic conditions and reduced information technology (IT) spending rates. Accordingly, the Company’s future success, in part, depends upon the buying patterns of customers in the SAN 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 future success, in part, 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.

Revenue Recognition

     Product revenue. Product revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is probable. However, for newly introduced products, many of the Company’s large OEM customers require a product qualification period during which the Company’s products are tested and approved by the OEM customer for sale to their customers. Revenue recognition, and related cost, is deferred for shipments to new OEM customers and for shipments of newly introduced products to existing OEM customers until satisfactory evidence of completion of the product qualification has been received from the OEM customer. Revenue from sales to the Company’s master reseller customers is recognized in the same period in which the actual sell-through occurs.

     The Company reduces revenue for estimated sales returns, sales programs, and other allowances at the time of shipment. Sales returns, sales programs, and other allowances are estimated based upon historical experience, current trends, and the Company’s expectations regarding future experience. In addition, the Company maintains allowances for doubtful accounts, which are also accounted for as a reduction in revenue. The allowance for doubtful accounts is estimated based upon analysis of accounts receivable, historical collection patterns, customer concentrations, customer creditworthiness, current economic trends, and changes in customer payment terms and practices.

     Service revenue. Service revenue consists of training, warranty, and maintenance arrangements, including post-contract customer support (PCS) services. PCS services are offered under renewable, annual fee-based contracts or as part of multiple element arrangements and typically include upgrades and enhancements to the Company’s software operating system, and telephone support. Service revenue, including revenue allocated to PCS elements, is deferred and recognized ratably over the contractual period. Service contracts are typically one to three years in length. Training revenue is recognized upon completion of the training. Service revenue was not material in any of the periods presented.

     Multiple-element arrangements. The Company’s multiple-element product offerings include computer hardware and software products, and support services. The Company also sells certain software products and support services separately. The Company’s software products are essential to the functionality of its hardware products and are, therefore, accounted for in accordance with Statement of Position 97-2, “Software Revenue Recognition” (SOP 97-2), as amended. The Company allocates revenue to each element based upon vendor-specific objective evidence (VSOE) of the fair value of the element or, if VSOE is not available, by application of the residual method. VSOE of the fair value for an element is based upon the price charged when the element is sold separately. Revenue allocated to each element is then recognized when the basic revenue recognition criteria are met for each element.

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Warranty Expense. The Company provides warranties on its products ranging from one to three years. Estimated future warranty costs are accrued at the time of shipment and charged to cost of revenues based upon historical experience.

Stock-Based Compensation.

     The Company has several stock-based compensation plans that are described in the Company’s Annual Report on Form 10-K for the fiscal year ended October 30, 2004. The Company accounts for stock-based awards using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), whereby the difference between the exercise price and the fair market value on the date of grant is recognized as compensation expense. Under the intrinsic value method of accounting, no compensation expense is recognized in the Company’s Condensed Consolidated Statements of Operations when the exercise price of the Company’s employee stock option grants equals the market price of the underlying common stock on the date of grant, and the measurement date of the option grant is certain. The measurement date is certain when the date of grant is fixed and determinable. When the measurement date is not certain, then the Company records stock compensation expense using variable accounting under APB 25. When variable accounting is applied to stock option grants, the Company remeasures the intrinsic value of the options at the end of each reporting period until the options are exercised, cancelled or expire unexercised. Compensation expense in any given period is calculated as the difference between total earned compensation at the end of the period, less total earned compensation at the beginning of the period. Compensation earned is calculated under an accelerated vesting method in accordance with FASB Interpretation 28.

     Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (SFAS 123), established a fair value based method of accounting for stock-based plans. Companies that elect to account for stock-based compensation plans in accordance with APB 25 are required to disclose the pro forma net income (loss) that would have resulted from the use of the fair value based method under SFAS 123.

     Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation - - Transition and Disclosure an Amendment of FASB Statement No. 123” (SFAS 148), amended the disclosure requirements of SFAS 123 to require more prominent disclosures in both annual and interim financial statements regarding the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The pro forma information resulting from the use of the fair value based method under SFAS 123 is as follows (in thousands except per share amounts):

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     The assumptions used for the three months ended January 29, 2005 and January 24, 2004 are as follows:

Computation of Net Income (Loss) per Share

     Basic net income (loss) per share is computed using the weighted-average number of common shares outstanding during the period, less shares subject to repurchase. Diluted net income (loss) per share is computed using the weighted-average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares result from the assumed exercise of outstanding stock options, by application of the treasury stock method, that have a dilutive effect on earnings per share, and from the assumed conversion of outstanding convertible debt if it has a dilutive effect on earnings per share.

Comprehensive Income (Loss)

     The components of comprehensive income (loss), net of tax, are as follows (in thousands):

Recent Accounting Pronouncements

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

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Reclassifications

     Certain reclassifications have been made to prior year balances in order to conform to the current year presentation.

3. Restatement of Consolidated Financial Statements

     On January 24, 2005, the Company announced that its Audit Committee completed an internal review regarding the Company’s stock option granting process. In connection with this internal review, the Company recorded internal review costs of $3.7 million during the three months ended January 29, 2005. As a result of certain findings of the review, the Company determined that certain of its historical financial statements required restatement.

     Specifically, the Company determined that the restatement was required because it incorrectly accounted for: (A) grants that were made to new hires on their offer acceptance date, rather than the date of their commencement of employment, during the period May 1999 to July 2000; (B) grants that were made to persons engaged on a part-time basis prior to their new hire full-time employment during the period August 2000 to October 2002; and (C) there was insufficient basis to rely on the Company’s process and related documentation to support recorded measurement dates used to account for certain stock options granted prior to August 2003. Therefore, the Company recorded additional stock-based compensation charges relating to many of its stock option grants made during the period 1999 through the third quarter of fiscal year 2003. In addition, the Company recorded a valuation allowance associated with deferred tax assets related to previously recorded stock option tax benefits.

     These charges affected the previously filed financial statements for fiscal years ended October 25, 2003, and October 26, 2002, including the corresponding interim periods for fiscal years 2003 and 2002, and the interim periods ended January 24, 2004, May 1, 2004 and July 31, 2004. The Company also recorded stock-based compensation and associated income tax adjustments to previously announced financial results for the fourth quarter and year ended October 30, 2004. These adjustments relate solely to matters pertaining to stock options granted prior to August 2003.

     As a result of the stock compensation adjustments, the Company’s deferred tax assets previously recognized have now been fully reserved. The Company expects to realize a tax benefit in future reporting periods when it is able to utilize net operating loss carryforwards to offset future taxable income.

Impact of the Financial Statement Adjustments on the Condensed Consolidated Statements of Operations

     The following table presents the impact of the financial statement adjustments on the Company’s previously reported condensed consolidated statements of operations for the three months ended January 24, 2004.

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4. Restructuring Costs

Fiscal 2004 Second Quarter Restructuring

     During the three months ended May 1, 2004, the Company implemented a restructuring plan designed to optimize the Company’s business model to drive improved profitability through reduction of headcount as well as certain structural changes in the business. The plan announced on May 19, 2004 encompassed organizational changes, which included a reduction in force of 110 people, or nine percent of the Company’s then workforce. As a result, the Company recorded $10.5 million in restructuring costs consisting of severance and benefit charges, equipment impairment charges, and contract termination and other charges. Severance and benefits charges of $7.5 million consisted of severance and related employee termination costs, including outplacement services, associated with the reduction of the Company’s workforce. Equipment impairment charges of $1.2 million primarily consisted of excess equipment that is no longer being used as a result of the restructuring program. Contract termination and other charges of $1.7 million were primarily related to the cancellation of certain contracts in connection with the restructuring of certain business functions.

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     Remaining accrued liabilities related to the Company’s fiscal 2004 second quarter restructuring program are included in other accrued liabilities on the accompanying Condensed Consolidated Balance Sheets. During the three months ended October 30, 2004, the Company recorded a reduction of $1.0 million to restructuring costs, primarily because actual payments were lower than the estimated amount. No other material changes in estimates were made to the fiscal 2004 second quarter restructuring accrual. The Company expects to pay or otherwise substantially settle the remaining accrued liabilities during the fiscal year 2005.

     The following table summarizes the total restructuring costs incurred and charged to restructuring expense during the second quarter of fiscal year 2004, costs paid or otherwise settled, and the remaining unpaid or otherwise unsettled accrued liabilities (in thousands) as of January 29, 2005:

5. Balance Sheet Details

     The following tables provide details of selected balance sheet items (in thousands):

     Leasehold improvements as of January 29, 2005 and October 30, 2004, are shown net of estimated asset impairments related to facilities lease losses (see Note 7).

6. Investments and Equity Securities

     The following tables summarize the Company’s investments and equity securities (in thousands):

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     For the three months ended January 29, 2005 and January 24, 2004, total gains realized on the sale of investments or marketable equity securities were zero and $0.2 million, respectively. As of January 29, 2005 and October 30, 2004, net unrealized holding gains (losses) of $(3.7) million and $0.1 million, respectively, were included in accumulated other comprehensive income in the accompanying Condensed Consolidated Balance Sheets.

     The following table summarizes the maturities of the Company’s investments in debt securities issued by United States government agencies, municipal government obligations, and corporate bonds and notes as of January 29, 2005 (in thousands):

7. Liabilities Associated with Facilities Lease Losses

Lease Termination Charge and Other, Net

     On November 18, 2003, the Company purchased a building located near its San Jose headquarters. This 194,000 square foot facility was previously leased, and certain unused portions of the facility were previously reserved and included in the facilities lease losses liability noted below. The total consideration for the building purchase was $106.8 million plus transaction costs, consisting of the purchase of land and building valued at $30.0 million and a lease termination fee of $76.8 million. The fair value of the land and building as of the purchase date was determined based on the estimated fair value of the land and building. As a result of the building purchase, during the first quarter of fiscal 2004, the Company recorded adjustments of $23.7 million to the previously recorded facilities lease loss reserve, deferred rent, and leasehold improvement impairments related to the purchased facility.

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     During the first quarter of fiscal 2004, the Company consolidated the engineering organization and development, test and interoperability laboratories into the purchased facilities and vacated other existing leased facilities. As a result, the Company recorded a charge of $20.9 million related to estimated facilities lease losses, net of expected sublease income, on the vacated facilities. These charges represented the fair value of the lease liability based on assumptions regarding the vacancy period, sublease terms, and the probability of subleasing this space. The assumptions that the Company used were based on market data, including the then current vacancy rates and lease activities for similar facilities within the area. Should there be changes in real estate market conditions or should it take longer than expected to find a suitable tenant to sublease the remaining vacant facilities, adjustments to the facilities lease losses reserve may be necessary in future periods based upon then current actual events and circumstances.

     The following table summarizes the activity related to the lease termination charge and other, net incurred in the first three months ended January 24, 2004 (in thousands):

Facilities Lease Losses Liability

     During the three months ended October 27, 2001, the Company recorded a charge of $39.8 million related to estimated facilities lease losses, net of expected sublease income, and a charge of $5.7 million in connection with the estimated impairment of certain related leasehold improvements. These charges represented the low-end of the then estimated range of $39.8 million to $63.0 million and may be adjusted upon the occurrence of future triggering events.

     During the three months ended July 27, 2002, the Company completed a transaction to sublease a portion of these vacant facilities. Accordingly, based on then current market data, the Company revised certain estimates and assumptions, including those related to estimated sublease rates, estimated time to sublease the facilities, expected future operating costs, and expected future use of the facilities. The Company reevaluates its estimates and assumptions on a quarterly basis and makes adjustments to the reserve balance if necessary.

     As previously described, in November 2003 the Company purchased a previously leased building. In addition, the Company consolidated the engineering organization and development, test and interoperability laboratories into the purchased facilities and vacated other existing leased facilities. As a result, the Company recorded adjustments to the previously recorded facilities lease loss reserve, deferred rent and leasehold improvement impairments, and recorded additional reserves in connection with the facilities consolidation.

     The following table summarizes the activity related to the facilities lease losses reserve, net of expected sublease income (in thousands), as of January 29, 2005:

     Cash payments for facilities leases related to the above noted facilities lease losses will be paid over the respective lease terms through fiscal year 2010.

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8. Convertible Subordinated Debt

     On December 21, 2001, and January 10, 2002, the Company sold, in private placements pursuant to Section 4(2) of the Securities Act of 1933, as amended, an aggregate of $550 million in principal amount, two percent convertible subordinated notes due January 2007 (the notes or convertible subordinated debt). The initial purchasers purchased the notes from the Company at a discount of 2.25 percent of the aggregate principal amount. Holders of the notes may, in whole or in part, convert the notes into shares of the Company’s common stock at a conversion rate of 22.8571 shares per $1,000 principal amount of notes (approximately 8.0 million shares may be issued upon conversion based on outstanding debt of $348.1 million as of January 29, 2005) at any time prior to maturity on January 1, 2007. At any time on or after January 5, 2005, the Company may redeem the notes in whole or in part at the following prices expressed as a percentage of the principal amount:

     The Company is required to pay interest on January 1 and July 1 of each year, beginning July 1, 2002. Debt issuance costs of $12.4 million are being amortized over the term of the notes. The amortization of debt issuance costs will accelerate upon early redemption or conversion of the notes. The net proceeds remain available for general corporate purposes, including working capital and capital expenditures. As of January 29, 2005, the remaining balance of unamortized debt issuance costs was $3.0 million.

     During the first quarter of fiscal years 2005 and 2004, the Company repurchased $4.2 million and $9.2 million in face value of its convertible subordinated debt, respectively, on the open market. For the three months ended January 29, 2005, the Company paid an average of $0.955 on each dollar of face value for an aggregate purchase price of $4.0 million, which resulted in a pre-tax gain of $0.15 million. For the three months ended January 24, 2004, the Company paid an average of $0.93 on each dollar of face value for an aggregate purchase price of $8.6 million, which resulted in a pre-tax gain of $0.5 million. To date, the Company has repurchased a total of $201.9 million in face value of its convertible subordinated notes. As of January 29, 2005, the remaining balance outstanding of the convertible subordinated debt was $348.1 million.

     The notes are not listed on any securities exchange or included in any automated quotation system; however, the notes are eligible for trading on the Portal^SM Market. On January 28, 2005, the average bid and ask price on the Portal Market of the notes was 95.25, resulting in an aggregate fair value of approximately $331.6 million.

9. Commitments and Contingencies

Leases

     The Company leases its facilities and certain equipment under various operating lease agreements expiring through August 2010. In connection with its facilities lease agreements, the Company has signed unconditional, irrevocable letters of credit totaling $8.3 million as security for the leases. Future minimum lease payments under all non-cancelable operating leases as of January 29, 2005 were $78.3 million. In addition to base rent, many of the facilities lease agreements require that the Company pay a proportional share of the respective facilities’ operating expenses.

     As of January 29, 2005, the Company had recorded $21.0 million in facilities lease loss reserves related to future lease commitments, net of expected sublease income (see Note 7).

Product Warranties

     The Company provides warranties on its products ranging from one to three years. Estimated future warranty costs are accrued at the time of shipment and charged to cost of revenues based upon historical experience. The Company’s accrued liability for estimated future warranty costs is included in other accrued liabilities on the accompanying Condensed Consolidated Balance Sheets. For the three months ended January 29, 2005, the Company recorded a warranty benefit of approximately $1.9 million as a result of a change in warranty terms with a customer. The following table summarizes the

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activity related to the Company’s accrued liability for estimated future warranty costs during the three months ended January 29, 2005 (in thousands):

     In addition, the Company has standard indemnification clauses contained within its various customer contracts. As such, the Company indemnifies the parties to whom it sells its products with respect to the Company’s product infringing upon any patents, trademarks, copyrights, or trade secrets, as well as against bodily injury or damage to real or tangible personal property caused by a defective Company product. As of January 29, 2005, there have been no known events or circumstances that have resulted in an indemnification related liability to the Company.

Manufacturing and Purchase Commitments

     The Company has manufacturing agreements with Solectron Corporation (Solectron) and Hon Hai Precision Industry Co. (Foxconn) under which the Company provides twelve-month product forecasts and places purchase orders in advance of the scheduled delivery of products to the Company’s customers. The required lead-time for placing orders with both Solectron and Foxconn depends on the specific product. As of January 29, 2005, the Company’s aggregate commitment to Solectron and Foxconn for inventory components used in the manufacture of Brocade products was $56.7 million, net of purchase commitment reserves of $7.2 million, which the Company expects to utilize during future normal ongoing operations. The Company’s purchase orders placed with Solectron and Foxconn are cancelable, however if cancelled, the agreements with Solectron and Foxconn require the Company to purchase from Solectron and Foxconn all inventory components not returnable, usable by, or sold to, other customers of Solectron or Foxconn. Our purchase commitments reserve reflects our estimate of purchase commitments we do not expect to consume in normal operations.

Legal Proceedings

     From time to time, claims are made against the Company in the ordinary course of its business, which could result in litigation. Claims and associated litigation are subject to inherent uncertainties and unfavorable outcomes could occur, such as monetary damages, fines, penalties or injunctions prohibiting the Company from selling one or more products or engaging in other activities. The occurrence of an unfavorable outcome in any specific period could have a material adverse affect on the Company’s results of operations for that period or future periods.

     On July 20, 2001, the first of a number of putative class actions for violations of the federal securities laws was filed in the United States District Court for the Southern District of New York against the Company, certain of its officers and directors, and certain of the underwriters for the Company’s initial public offering of securities. A consolidated amended class action captioned In Re Brocade Communications Systems, Inc. Initial Public Offering Securities Litigation was filed on April 19, 2002. The complaint generally alleges that various underwriters engaged in improper and undisclosed activities related to the allocation of shares in the Company’s initial public offering and seeks unspecified damages on behalf of a purported class of purchasers of common stock from May 24, 1999 to December 6, 2000. The lawsuit against the Company is being coordinated for pretrial proceedings with a number of other pending litigations challenging underwriter practices in over 300 cases as In Re Initial Public Offering Securities Litigation, 21 MC 92(SAS). In October 2002, the individual defendants were dismissed without prejudice from the action, pursuant to a tolling agreement. On February 19, 2003, the Court issued an Opinion and Order dismissing all of the plaintiffs’ claims against the Company. In July 2004, a stipulation of settlement for the claims against the issuer defendants, including the Company, was submitted to the Court for approval. The settlement is subject to a number of conditions, including approval by the Court.

10. Segment Information

     The Company is organized and operates as one operating segment: the design, development, marketing and selling of infrastructure for SANs. The CEO is the Company’s Chief Operating Decision Maker (CODM), as defined by SFAS 131,

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“Disclosures about Segments of an Enterprise and Related Information.” The CODM allocates resources and assesses the performance of the Company based on revenues and overall profitability.

     Revenues are attributed to geographic areas based on the location of the customer to which products are shipped. Domestic revenues include sales to certain OEM customers who take possession of Brocade products domestically and then distribute these products to their international customers. Domestic and international revenues were approximately 66 percent and 34 percent of total revenues, respectively, for the three months ended January 29, 2005. Domestic and international revenues were approximately 63 percent and 37 percent of total revenues, respectively, for the three months ended January 24, 2004. To date, service revenue has not exceeded 10 percent of total revenues. Identifiable assets located in foreign countries were not material as of January 29, 2005 and October 30, 2004. For the three months ended January 29, 2005, four customers accounted for 82 percent of total revenues. For the three months ended January 24, 2004, three customers accounted for 69 percent of total revenues.

11. Net Income (Loss) per Share

     The following table presents the calculation of basic and diluted net income (loss) per common share (in thousands, except per share amounts):

     For the three months ended January 29, 2005, potential common shares in the form of stock options to purchase 2.4 million weighted-average shares of common stock were antidilutive and, therefore, not included in the computation of diluted earnings per share. For the three months ended January 24, 2004, stock options outstanding of 47.5 million shares were antidilutive as the Company had net loss for the period, and therefore, not included in the computation of diluted earnings per share. In addition, for the three months ended January 29, 2005 and January 24, 2004, potential common shares resulting from the potential conversion, on a weighted average basis, of the Company’s convertible subordinated debt of 8.0 million and 9.9 million common shares, respectively, were antidilutive and therefore not included in the computation of diluted earnings per share.

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

     This Quarterly Report on Form 10-Q (Quarterly Report) contains forward-looking statements. These forward-looking statements include predictions regarding our future:

	•	revenues and profits, including average selling price per port and number of ports shipped;
	•	gross margin;
	•	new products and market opportunity;
	•	customer concentration;
	•	research and development expenses;
	•	sales and marketing expenses;
	•	general and administrative expenses;

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	•	pricing and cost reduction activities;
	•	income tax provision and effective tax rate;
	•	cash flows from employee participation in employee stock programs;
	•	liquidity and sufficiency of existing cash, cash equivalents, and short-term investments for near-term requirements;
	•	purchase commitments;
	•	product development and transitions;
	•	competition and competing technology;
	•	stock price;
	•	internal controls;
	•	outcomes of litigation; and
	•	financial condition and results of operations as a result of recent accounting pronouncements.

     You can identify these and other forward-looking statements by the use of words such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “intends,” “potential,” “continue,” or the negative of such terms, or other comparable terminology. Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements.

     Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth below under the heading “Risk Factors.” All forward-looking statements included in this document are based on information available to us on the date hereof. We assume no obligation to update any forward-looking statements.

     The following information should be read in conjunction with the Condensed Consolidated Financial Statements and notes thereto included in Item 1 of this Quarterly Report, and with the Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and notes thereto contained in our Annual Report on Form 10-K for the fiscal year ended October 30, 2004.

Restatement of Consolidated Financial Statements

     On January 24, 2005, Brocade announced that its Audit Committee completed its previously announced internal review. As a result of certain findings of the review, Brocade determined that certain of its historical financial statements required restatement.

     Specifically, Brocade determined that the restatement was required because it incorrectly accounted for: (A) grants that were made to new hires on their offer acceptance date, rather than the date of their commencement of employment, during the period May 1999 to July 2000; (B) grants that were made to persons engaged on a part-time basis prior to their new hire full-time employment during the period August 2000 to October 2002; and (C) grants where there was insufficient basis to rely on Brocade’s process and related documentation to support recorded measurement dates used to account for certain stock options granted prior to August 2003. Therefore, Brocade recorded additional stock-based compensation charges relating to many of its stock option grants made during the period 1999 through the third quarter of fiscal year 2003. In addition, Brocade recorded a valuation allowance associated with deferred tax assets related to previously recorded stock option tax benefits. In addition, it was concluded that there were improprieties in connection with the documentation of stock option grants and related employment records of a small number of employees prior to mid 2002, which resulted in immaterial adjustments included in this restatement.

     These charges affected the previously filed financial statements for fiscal years ended October 25, 2003 and October 26, 2002, including the corresponding interim periods for fiscal years 2003 and 2002, and the interim periods ended January 24, 2004, May 1, 2004 and July 31, 2004. Brocade also recorded stock-based compensation and associated income tax adjustments to previously announced financial results for the fourth quarter and year ended October 30, 2004. These adjustments relate solely to matters pertaining to stock options granted prior to August 2003.

     This Management’s Discussion and Analysis of Financial Condition and Results of Operations gives effect to the restatement of our financial statements described above. The results set forth below for the three months ended January 24, 2004 differ from those previously reported in our Form 10-Q for the three months ended January 24, 2004.

Results of Operations

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

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     Revenues. Our revenues are derived primarily from sales of our SilkWorm family of products. Our SilkWorm products, which range in size from 8 ports to 128 ports, connect servers and storage devices creating a storage area network (SAN). Net revenues for the three months ended January 29, 2005 were $161.6 million, an increase of 11 percent compared with net revenues of $145.0 million for the three months ended January 24, 2004. The increase in net revenues reflected a 32 percent increase in the number of ports shipped, partially offset by a 21 percent decline in average selling price per port. We believe the increase in the number of ports shipped reflects higher demand for our products as end-users continue to consolidate storage and servers infrastructures using SANs, expand SANs to support more applications, and deploy SANs in new environments. We also believe some of the increase in ports shipped reflects the stocking of new products by our OEM customers.

     Historically, domestic revenues have been between 60 percent and 75 percent of total revenues. Domestic and international revenues were approximately 66 percent and 34 percent of total revenues, respectively, for the three months ended January 29, 2005, compared to 63 percent and 37 percent of total revenues, respectively, for the three months ended January 24, 2004. International revenues primarily consist of sales to customers in Western Europe and the greater Asia Pacific region. However, certain OEM customers take possession of our products domestically and then distribute these products to their international customers. Because we account for all of those OEM revenues as domestic revenues, we cannot be certain of the extent to which our domestic and international revenue mix is impacted by the practices of our OEM customers.

     A significant portion of our revenues is concentrated among a relatively small number of customers. For the three months ended January 29, 2005, four customers each represented ten percent or more of our total revenues for combined totals of 82 percent of total revenues. For the three months ended January 24, 2004, three customers each represented ten percent or more of our total revenues for combined totals of 69 percent of total revenues. We expect that a significant portion of our future revenues will continue to come from sales of products to a relatively small number of customers. Therefore, the loss of, or a decrease in the level of sales to, any one of these customers could seriously harm our financial condition and results of operations.

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     Gross margin. Gross margin for the three months ended January 29, 2005 was 60.1 percent, compared with 53.4 percent for the three months ended January 24, 2004. Cost of goods sold consists of product costs, which are variable, and manufacturing operations costs, which are generally fixed. For the three months ended January 29, 2005, product costs relative to net revenues decreased by 2.5 percent, primarily due to a $1.9 million warranty benefit related to a change in warranty terms with a customer recorded in the three months ended January 29, 2005, and decreases in component and manufacturing costs. Manufacturing operations costs relative to net revenues decreased by 3.9% principally due to increases in net revenues and savings from the restructuring programs we implemented during the second quarter of fiscal year 2004 (see Note 4, “Restructuring Costs,” of the Notes to Condensed Consolidated Financial Statements). In addition, gross margin increased by 0.3% due to lower variable stock-based compensation expense in the three months ended January 29, 2005 primarily as a result of changes in the market value of our common stock.

     Gross margin is primarily affected by average selling price per port, number of ports shipped, and cost of goods sold. We expect that average selling price per port for our products will continue to decline at rates consistent with the rates we experienced in the three months ended January 29, 2005, unless they are further affected by accelerated pricing pressures, new product introductions by us or our competitors, or other factors that may be beyond our control. We believe that we have the ability to partially mitigate the effect of declines in average selling price per port on gross margins through our product and manufacturing operations cost reductions.

     During fiscal year 2003, the average unit selling prices of our products began to decline at a faster pace than we had previously experienced. If this dynamic reoccurs, we may not be able to reduce our costs fast enough to prevent a decline in our gross margins. In addition, we must also maintain or increase current volume of ports shipped to maintain our current gross margins. If we are unable to offset future reductions of average selling price per port with reductions in product and manufacturing operations costs, or if as a result of future reductions in average selling price per port our revenues do not grow, our gross margins would be negatively affected.

     We recently introduced several new products and expect to introduce additional new products in the future. As new or enhanced products are introduced, we must successfully manage the transition from older products in order to minimize disruption in customers’ ordering patterns, avoid excessive levels of older product inventories, and provide sufficient supplies of new products to meet customer demands. Our gross margins may be adversely affected if we fail to successfully manage the introductions of these new products.

     Research and development expenses. Research and development (R&D) expenses consist primarily of salaries and related expenses for personnel engaged in engineering and R&D activities; fees paid to consultants and outside service providers; nonrecurring engineering charges; prototyping expenses related to the design, development, testing and enhancement of our products; depreciation related to engineering and other test equipment; and IT and facilities expenses.

     For the three months ended January 29, 2005, R&D expenses decreased by $5.3 million, or 14 percent, to $31.7 million, compared with $37.0 million for the three months ended January 24, 2004. This decrease is primarily due to a $5.4 million decrease in salaries and related expenses related to the restructuring programs we implemented in the second quarter of fiscal year 2004, and a $1.5 million decrease in variable stock-based compensation expense as a result of changes in the market value of our common stock. The decreases in R&D expenses were partially offset by a $2.4 million increase in expenses related to new product development spending.

     Excluding the effect of variable stock-based compensation related charges, which will vary depending on the changes in the market value of our common stock, we currently anticipate that R&D expenses for the three months ending April 30, 2005 will increase in absolute dollars primarily resulting from additional spending related to new product development.

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

     For the three months ended January 29, 2005, Sales and marketing expenses decreased by $1.8 million, or seven percent, to $24.8 million, compared with $26.6 million for the three months ended January 24, 2004. This decrease is primarily due to a $1.1 million decrease in travel and marketing program expenses resulting from various cost-cutting actions, and a $0.5 million decrease in variable stock-based compensation expense as a result of changes in the market value of our common stock.

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     Excluding the effect of variable stock-based compensation related charges, which will vary depending on the changes in the market value of our common stock, we currently anticipate that sales and marketing expenses for the three months ending April 30, 2005 will increase in absolute dollars, primarily resulting from additional salaries and related expenses.

     General and administrative expenses. General and administrative (G&A) expenses consist primarily of salaries and related expenses for corporate executives, finance, human resources and investor relations, as well as recruiting expenses, accounting and professional fees, corporate legal expenses, other corporate expenses, and IT and facilities expenses.

     G&A expenses increased by $0.7 million, or 12 percent, to $6.7 million for the three months ended January 29, 2005, compared with $5.9 million for the three months ended January 24, 2004. This increase in G&A expenses is primarily due to a $0.8 million increase in professional service fees primarily related to non-recurring litigation fees, offset by a $0.4 million decrease in variable stock-based compensation expense as a result of changes in the market value of our common stock.

     Excluding the effect of variable stock-based compensation related charges, which will vary depending on the changes in the market value of our common stock, we currently anticipate that G&A expenses for the three months ending April 30, 2005 will remained consistent or decrease in absolute dollars resulting from a decrease in professional service fees.

     Amortization of deferred stock compensation. Amortization of deferred stock compensation was $0.1 million and $0.2 million for the three months ended January 29, 2005 and January 24, 2004, respectively. In the second quarter of fiscal 2003, we recorded $1.7 million of deferred stock compensation in connection with our acquisition of Rhapsody. The $1.7 million of deferred stock compensation represented the intrinsic value of unvested restricted common stock and assumed stock options, and is being amortized over the respective remaining service periods on a straight-line basis. As of January 29, 2005, the remaining unamortized balance of this deferred stock compensation was $0.1 million.

     In addition to the deferred stock compensation connected with our acquisition of Rhapsody, we have recorded deferred stock compensation arising from stock option grants subject to variable accounting and restricted stock award grants to certain employees. Compensation expense resulting from these non-acquisition related grants are included in cost of sales, R&D, sales and marketing, or G&A, based on the department of the employee receiving the award. Accordingly, amortization of deferred stock compensation does not include the compensation expense arising from these awards.

     Total stock-based compensation expense (benefit) recognized for the quarters ended January 29, 2005, and January 24, 2004 was $(0.9) million and $1.6 million, respectively. Stock-based compensation expense related to stock options subject to variable accounting will vary significantly as a result of future changes in the market value of our common stock. The decrease in stock-based compensation during the three months ended January 29, 2005 as compared to the three months ended January 24, 2004 is due to a decrease in the market value of our common stock during the first quarter of fiscal year 2005.

     Internal review costs. On January 24, 2005, we announced that our Audit Committee completed an internal review regarding stock option granting practices. As a result of certain findings of the review, we determined that certain of our historical financial statements required restatement. In connection with this internal review, we recorded internal review costs of $3.7 million, primarily related to professional service fees, during the three months ended January 29, 2005. We did not incur any internal review costs during the three months ended January 24, 2004.

     Restructuring costs. During the three months ended January 24, 2004, we recorded a reduction of $0.4 million to restructuring costs related to our other previously recorded restructuring liability, primarily due to a lower than expected outcome related to outplacement costs (see Note 4, “Restructuring Costs,” of the Notes to Condensed Consolidated Financial Statements). We did not incur any restructuring costs during the three months ended January 29, 2005.

     Lease termination charge and other, net. During the three months ended January 24, 2004, we purchased a previously leased building located near our San Jose headquarters for $106.8 million in cash plus transaction costs, consisting of the purchase of land and building valued at $30.0 million and a lease termination fee of $76.8 million. The 194,000 square foot facility, which houses our engineering organization and development, test and interoperability laboratories, was previously leased. As a result of the building purchase, during the first quarter of fiscal year 2004, we recorded adjustments to the previously recorded facilities lease loss reserve and recorded a charge of $75.6 million primarily related to lease termination, facilities consolidation and other associated costs (see Note 7, “Liabilities Associated with Facilities Lease Losses,” of the

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Notes to Condensed Consolidated Financial Statements). We did not incur any lease termination charge during the three months ended January 29, 2005.

     Interest and other income, net. Interest and other income, net increased to $5.2 million for the three months ended January 29, 2005, compared with $4.5 million for the three months ended January 24, 2004. The increase is primarily the result of higher average rates of return due to investment mix, increase in interest rates, and higher average cash, cash equivalent and investment balances.

     Interest expense. Interest expense was $2.2 million for the three months ended January 29, 2005, compared with $2.7 million for the three months ended January 24, 2004. Interest expense primarily represents the interest cost associated with our two percent convertible subordinated notes due 2007. The decrease was primarily the result of the repurchases of our convertible subordinated debt, resulting in a lower aggregate amount of debt outstanding as of January 29, 2005. The balance outstanding of our convertible subordinated debt as of January 29, 2005 and January 24, 2004 was $348.1 million and $433.7 million, respectively.

     Gain on repurchases of convertible subordinated debt. During the three months ended January 29, 2005 and January 24, 2004, we repurchased $4.2 million and $9.2 million in face value of our two percent convertible subordinated notes due 2007 (the notes or convertible subordinated debt), respectively, on the open market. For the three months ended January 29, 2005, we paid an average of $0.955 on each dollar of face value for an aggregate purchase price of $4.0 million, which resulted in a pre-tax gain of $0.15 million. For the three months ended January 24, 2004, we paid an average of $0.93 on each dollar of face value for an aggregate purchase price of $8.6 million, which resulted in a pre-tax gain of $0.5 million.

     Provision for income taxes. For the three months ended January 29, 2005, we recorded an income tax provision of $5.3 million, compared to a provision of $3.7 million for the three months ended January 24, 2004. Our income tax provision is composed of US alternative minimum tax and foreign income taxes. Brocade has a full valuation allowance against its deferred tax assets. Any US tax liability over the level of alternative minimum tax is reduced through the utilization of existing deferred tax assets, and the corresponding valuation allowance is reduced as those assets are utilized. We expect to continue to record an income tax provision for US alternative minimum tax and foreign income taxes. To the extent that our estimates of book to tax differences differ from the actual year-end amounts, or international revenues and earnings differ from those historically achieved, a factor largely influenced by the buying behavior of our OEM partners, or unfavorable changes in tax laws and regulations occur, our income tax provision could change.

Liquidity and Capital Resources

     Cash, cash equivalents, short-term investments and long-term investments were $778.0 million as of January 29, 2005. For the three months ended January 29, 2005, we generated $35.2 million in cash from operating activities, primarily related to net income and non-cash expense items, including depreciation and amortization, offset by an increase in accounts receivable. Days sales outstanding in accounts receivable for the three months ended January 29, 2005 was 58 days, compared with 49 days for the three months ended January 24, 2004.

     Net cash provided by investing activities for the three months ended January 29, 2005 totaled $110.2 million and was the result of $116.0 million in net proceeds of short, long-term, and other non-marketable equity investments, offset by $5.8 million cash invested in capital equipment.

     Net cash provided by financing activities for the three months ended January 29, 2005 was $17.4 million, and was the result of $21.4 million in net proceeds from the issuance of common stock related to employee participation in employee stock programs and exercises of stock options, partially offset by $4.0 million cash used for repurchases of our convertible subordinated debt.

     Net proceeds from the issuance of common stock related to employee participation in employee stock programs have historically been a significant component of our liquidity. The extent to which our employees participate in these programs generally increases or decreases based upon changes in the market price of our common stock. As a result, our cash flows resulting from the issuance of common stock related to employee participation in employee stock programs will vary and cannot be predicted. As a result of our voluntary stock option exchange program, which was completed in July 2003, we do not expect to generate significant cash flow from the issuance of common stock related to the employee participation in employee stock programs during fiscal year 2005 unless our future common stock price exceeds $6.54 per share.

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     We have manufacturing agreements with Solectron and Foxconn under which we provide twelve-month product forecasts and place purchase orders in advance of the scheduled delivery of products to our customers. The required lead-time for placing orders with both Solectron and Foxconn depends on the specific product. As of January 29, 2005, our aggregate commitment to Solectron and Foxconn for inventory components used in the manufacture of Brocade products was $56.7 million, net of purchase commitment reserves of $7.2 million, which we expect to utilize during future normal ongoing operations. Although the purchase orders we place with Solectron and Foxconn are cancelable, the terms of the agreements require us to purchase from Solectron and Foxconn all inventory components not returnable or usable by, or sold to, other customers of Solectron or Foxconn. Our purchase commitments reserve reflects our estimate of purchase commitments we do not expect to consume in normal operations.

     On December 21, 2001, and January 10, 2002, we sold $550 million in aggregate principal amount of our convertible subordinated debt (see note 8, “Convertible Subordinated Debt,” of the Notes to Condensed Consolidated Financial Statements). Holders of the notes may, in whole or in part, convert the notes into shares of our common stock at a conversion rate of 22.8571 shares per $1,000 principal amount of notes (aggregate of approximately 8.0 million shares based on outstanding debt of $348.1 million as of January 29, 2005) at any time prior to maturity on January 1, 2007. At any time on or after January 5, 2005, we may redeem the notes in whole or in part at the following prices expressed as a percentage of the principal amount:

     We are required to pay interest on January 1 and July 1 of each year, beginning July 1, 2002. Debt issuance costs of $12.4 million are being amortized over the term of the notes. The amortization of debt issuance costs will accelerate upon early redemption or conversion of the notes. The net proceeds remain available for general corporate purposes, including working capital and capital expenditures. As of January 29, 2005, the remaining balance of unamortized debt issuance costs was $3.0 million.

     During the first quarter of fiscal years 2005 and 2004, we repurchased $4.2 million and $9.2 million in face value of our convertible subordinated notes, respectively, on the open market. As of January 29, 2005, we have repurchased a total of $201.9 million in face value of our convertible subordinated notes. As of January 29, 2005, the remaining balance outstanding of the convertible subordinated debt was $348.1 million.

     In November 2003, we purchased a previously leased building located near our San Jose headquarters, and issued a $1.0 million guarantee as part of the purchase agreements.

     The following table summarizes our contractual obligations (including interest expense) and commitments as of January 29, 2005 (in thousands):

     We believe that our existing cash, cash equivalents, short-term and long-term investments, and cash expected to be generated from future operations will be sufficient to meet our capital requirements at least through the next 12 months. 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 and the expansion of sales and marketing; the timing of introductions of new products and enhancements to existing products; and the market acceptance of our products.

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Critical Accounting Policies and Estimates

     Our discussion and analysis of financial condition and results of operations is based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these Condensed Consolidated Financial Statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate, on an on-going basis, our estimates and judgments, including those related to sales returns, bad debts, excess inventory and purchase commitments, investments, warranty obligations, lease losses, income taxes, and contingencies and litigation. We base our estimates on historical experience and assumptions that we believe 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.

     The methods, estimates, and judgments we use in applying our most critical accounting policies have a significant impact on the results that we report in our Consolidated Financial Statements. The SEC considers an entity’s most critical accounting policies to be those policies that are both most important to the portrayal of a company’s financial condition and results of operations, and those that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about matters that are inherently uncertain at the time of estimation. We believe the following critical accounting policies, among others, require significant judgments and estimates used in the preparation of our Consolidated Financial Statements:

	•	Revenue recognition, and allowances for sales returns, sales programs, and doubtful accounts;
	•	Stock-based compensation;
	•	Warranty reserves;
	•	Inventory and purchase commitment reserves;
	•	Restructuring charges and lease loss reserves;
	•	Litigation costs; and
	•	Accounting for income taxes.

     Revenue recognition, and allowances for sales returns, sales programs, and doubtful accounts. Product revenue is generally recognized when persuasive evidence of an arrangement exists, delivery has occurred, fee is fixed or determinable, and collection is probable. However, for newly introduced products, many of our large OEM customers require a product qualification period during which our products are tested and approved by the OEM customer for sale to their customers. Revenue recognition, and related cost, is deferred for shipments to new OEM customers and for shipments of newly introduced products to existing OEM customers until satisfactory evidence of completion of the product qualification has been received from the OEM customer. In addition, revenue from sales to our master reseller customers is recognized in the same period in which the product is sold by the master reseller (sell through).

     We reduce revenue for estimated sales returns, sales programs, and other allowances at the time of shipment. Sales returns, sales programs, and other allowances are estimated based on historical experience, current trends, and our expectations regarding future experience. Reductions to revenue associated with sales returns, sales programs, and other allowances include consideration of historical sales levels, the timing and magnitude of historical sales returns, claims under sales programs, and other allowances, and a projection of this experience into the future. In addition, we maintain allowances for doubtful accounts, which are also accounted for as a reduction in revenue, for estimated losses resulting from the inability of our customers to make required payments. We analyze accounts receivable, historical collection patterns, customer concentrations, customer creditworthiness, current economic trends, changes in customer payment terms and practices, and customer communication when evaluating the adequacy of the allowance for doubtful accounts. If actual sales returns, sales programs, and other allowances exceed our estimate, or if the financial condition of our customers was to deteriorate, resulting in an impairment of their ability to make payments, additional allowances and charges may be required.

     Service revenue consists of training, warranty, and maintenance arrangements, including post-contract customer support (PCS) services. PCS services are offered under renewable, annual fee-based contracts or as part of multiple element arrangements and typically include upgrades and enhancements to our software operating system software, and telephone support. Service revenue, including revenue allocated to PCS elements, is deferred and recognized ratably over the contractual period. Service contracts are typically one to three years in length. Training revenue is recognized upon completion of the training.

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     Our multiple-element product offerings include computer hardware and software products, and support services. We also sell certain software products and support services separately. Our software products are essential to the functionality of our hardware products and are, therefore, accounted for in accordance with Statement of Position 97-2, “Software Revenue Recognition” (SOP 97-2), as amended. We allocate revenue to each element based upon vendor-specific objective evidence (VSOE) of the fair value of the element or, if VSOE is not available, by application of the residual method. VSOE of the fair value for an element is based upon the price charged when the element is sold separately. Revenue allocated to each element is then recognized when the basic revenue recognition criteria are met for each element. Changes in the allocation of revenue to each element in a multiple element arrangement may affect the timing of revenue recognition.

     Stock-Based Compensation. The Company accounts for its stock option plans and its Employee Stock Purchase Plan in accordance with the provisions of Accounting Principles Board Opinion 25, “Accounting for Stock Issued To Employees,” (APB 25), whereby the difference between the exercise price and the fair market value on the date of grant is recognized as compensation expense. Under the intrinsic value method of accounting, no compensation expense is recognized in the Company’s Consolidated Statements of Operations when the exercise price of the Company’s employee stock option grants equals the market price of the underlying common stock on the date of grant, and the measurement date of the option grant is certain. The measurement date is certain when the date of grant is fixed and determinable. When the measurement date is not certain, then the Company records stock compensation expense using variable accounting under APB 25. When variable accounting is applied to stock option grants, the Company remeasures the intrinsic value of the options at the end of each reporting period or until the options are exercised, cancelled or expire unexercised. Compensation expense in any given period is calculated as the difference between total earned compensation at the end of the period, less total earned compensation at the beginning of the period. Compensation earned is calculated under an accelerated vesting method in accordance with FASB Interpretation 28. As a result, changes in stock prices will change the intrinsic value of the options and compensation expense or benefit recognized in any given period.

     Warranty reserves. We provide warranties on our products ranging from one to three years. Estimated future warranty costs are accrued at the time of shipment and charged to cost of revenues based upon historical experience, current trends and our expectations regarding future experience. If actual warranty costs exceed our estimate, additional charges may be required.

     Inventory and purchase commitment reserves. We write down inventory and record purchase commitment reserves for estimated excess and obsolete inventory equal to the difference between the cost of inventory and the estimated fair value based upon assumptions about future demand, product transition cycles, and market conditions. Although we strive to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and commitments, and our reported results. If actual market conditions are less favorable than those projected, additional inventory write-downs, purchase commitment reserves, and charges against earnings might be required.

     Restructuring charges and lease loss reserves. We monitor and regularly evaluate our organizational structure and associated operating expenses. Depending on events and circumstances, we may decide to restructure our operations to reduce future operating costs as our business requirements evolve. In determining the restructuring charges, we analyze our future operating requirements, including the required headcount by business functions and facility space requirements. Our restructuring costs, and any resulting accruals, involve significant estimates made by management using the best information available at the time the estimates are made, some of which may be provided by third parties. In recording facilities lease loss reserves, we make various assumptions, including the time period over which the facilities will be vacant, expected sublease terms, expected sublease rates, anticipated future operating expenses, and expected future use of the facilities. Our estimates involve a number of risks and uncertainties, some of which are beyond our control, including future real estate market conditions and our ability to successfully enter into subleases or lease termination agreements with terms as favorable as those assumed when arriving at our estimates. We regularly evaluate a number of factors to determine the appropriateness and reasonableness of our restructuring and lease loss accruals including the various assumptions noted above. If actual results differ significantly from our estimates, we may be required to adjust our restructuring and lease loss accruals in the future.

     Litigation costs. We are subject to the possibility of legal actions arising in the ordinary course of business. We regularly monitor the status of pending legal actions to evaluate both the magnitude and likelihood of any potential loss. We accrue for these potential losses when it is probable that a liability has been incurred and the amount of loss, or possible range of loss, can be reasonably estimated. If actual results differ significantly from our estimates, we may be required to adjust our accruals in the future.

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     Accounting for income taxes. The determination of our tax provision is subject to judgments and estimates due to operations in multiple tax jurisdictions outside the United States. Sales to our international customers are principally taxed at rates that are lower than the United States statutory rates. The ability to maintain our current effective tax rate is contingent upon existing tax laws in both the United States and in the respective countries in which our international subsidiaries are located. Future changes in domestic or international tax laws could affect the continued realization of the tax benefits we are currently receiving and expect to receive from international sales. In addition, an increase in the percentage of our total revenue from international customers or in the mix of international revenue among particular tax jurisdictions could change our overall effective tax rate. Also, our current effective tax rate assumes that United States income taxes are not provided for undistributed earnings of certain non-United States subsidiaries. These earnings could become subject to United States federal and state income taxes and foreign withholding taxes, as applicable, should they be either deemed or actually remitted from our international subsidiaries to the United States.

     The carrying value of our net deferred tax assets is subject to a full valuation allowance. At some point in the future, the Company may have sufficient United States taxable income to release the valuation allowance and accrue United States tax. We evaluate the expected realization of our deferred tax assets and assess the need for valuation allowances quarterly.

Recent Accounting Pronouncements

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

Risk Factors

As we introduce new products, we must manage the transition between our new products and our older products and achieve market acceptance of these new products.

     The market for SANs is characterized by rapidly changing technology and accelerating product introduction cycles. As new or enhanced products are introduced, we must successfully manage the transition from older products in order to minimize disruption in customers’ ordering patterns, avoid excessive levels of older product inventories and provide sufficient supplies of new products to meet customer demands. We must also achieve widespread market acceptance of the new or enhanced products in order to realize the benefits of our investments in these products. When we introduce new or enhanced products, we face numerous risks relating to product transitions, including the inability to accurately forecast demand, excess inventories of older products, hardware and software defects, and different sales and support requirements due to the complexity of the new products. In addition, we face the risk that the new or enhanced products may not achieve widespread market acceptance. Factors that may affect market acceptance include:

	•	product performance, price and total cost of ownership;
	•	product features and functionality;
	•	availability and price of competing products and technologies; and
	•	the ability of our OEM partners to successfully distribute, support and provide training for our products.

     For example, during the second half of fiscal year 2004, we introduced six new SilkWorm products, which are the SilkWorm 24000 Director, the SilkWorm 3250 and SilkWorm 3850 entry level fabric switches, the SilkWorm Multiprotocol Router, a switch module for bladed server solutions, and the SilkWorm 4100 4 Gigabit per second fabric switch. Because we currently derive the majority of our revenues from sales of our SilkWorm product family and we expect that revenue from this product family will continue to account for a substantial portion of our revenues for the foreseeable future, sustained and widespread market acceptance of these products is critical to our future success. If we fail to successfully manage the transition to these new products or if the products do not achieve market acceptance, our business and financial results will be

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adversely affected. For instance, during the fourth quarter of fiscal year 2001, we recorded charges to cost of revenues of $7.7 million primarily associated with the accrual of purchase commitments for excess inventory components related to a transition of product offerings from 1 to 2 Gigabit per second technology.

     The success of our new products also depends on several factors, including our ability to properly define the new products, timely complete and introduce the new products, differentiate of our new products from the products of our competitors and address the complexities of interoperability of our products with our OEM partners’ server and storage products. If we are not able to successfully develop new products or enter into new market segments, or if we are unable to obtain or maintain requisite third-party interoperability licenses, our business and results of operations will be harmed.

We cannot be certain that we will benefit fully from the substantial investments we have made and continue to make in our recently introduced Silkworm Fabric Application Platform product family.

     We recently introduced, and intend to continue to make substantial investments in, our Silkworm Fabric Application Platform product family. The first product in the Silkworm Fabric Application Platform product family that we announced for general availability is the Silkworm Multiprotocol Router. Our success with the Silkworm Multiprotocol Router and the subsequent products in the Silkworm Fabric Application Platform product family will depend on:

	•	the market acceptance of these products by both end-users and our OEM partners;
	•	the availability of complementary applications developed by our OEM partners and other application developers for these products; and
	•	our ability to timely develop and manufacture these products in volumes and with the performance levels and feature sets required by customers

     We cannot be certain that these new products will be successfully developed or achieve market acceptance, or that we will benefit fully from the substantial investments we have made and continue to make in the Silkworm Fabric Application Platform product family. In addition, we cannot be certain that our OEM partners or other application developers will develop applications for these products in a timely manner, if at all, or if applications that are developed will meet end-user requirements. If we are unable to successfully manage any of these aspects of our Silkworm Fabric Application Platform product family introductions, our business and financial results will be adversely affected.

Increased market competition may lead to reduced sales, margins, profits and market share.

     The SAN market is becoming more competitive and subject to rapid technological change. Increased competition has in the past resulted in greater pricing pressures, and reduced sales, margins, profits and market share. Currently, we believe that we principally face competition from providers of Fibre Channel switching products for interconnecting servers and storage. These competitors include Cisco Systems, Computer Network Technology Corporation (CNT), Qlogic Corporation, and McDATA Corporation, which recently announced its intention to acquire CNT.

     The SAN market is likely to become even more competitive as new products and technologies are introduced by existing competitors and as new competitors enter the market. These new competitive products could be based on existing technologies or new technologies that may or may not be compatible with our SAN technology. Competitive products might include, but are not limited to, non-Fibre Channel based emerging products utilizing Gigabit Ethernet, 10 Gigabit Ethernet, InfiniBand or iSCSI. In addition, our OEM partners, who also have relationships with some of our current competitors, could become new competitors by developing and introducing products competitive with our product offerings, choose to sell our competitors’ products instead of our products, or offer preferred pricing or promotions on our competitors’ products.

     Some of our competitors have longer operating histories and significantly greater human, financial and capital resources than us. These competitors may have the ability to devote a larger number of sales personnel to focus on the SAN industry, compete with us and potentially change the current distribution model. Our competitors could also adopt more aggressive pricing policies and devote greater resources to the development, promotion, and sale of their products than we can. As a result, they may be able to respond more quickly to changes in customer or market requirements. We may not have the financial resources, technical expertise or marketing, manufacturing, distribution and support capabilities to compete successfully against current or future competitors. This could materially harm our business and financial results.

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We depend on OEM partners for a majority of our revenues, and the loss of any of these OEM partners or a decrease in the levels of their purchases could significantly reduce our revenues and negatively affect our financial results.

     We depend on recurring purchases from a limited number of large OEM partners for the majority of our revenue. As a result, these large OEM partners have a significant influence on our quarterly and annual financial results. Our agreements with our OEM partners are typically cancelable, non-exclusive, have no minimum purchase requirements and have no specific timing requirements for purchases. For the three months ended January 29, 2005, four customers each represented ten percent or more of our total revenues for a combined total of 82 percent. We anticipate that our revenues and operating results will continue to depend on sales to a relatively small number of customers. The loss of any one significant customer, or a decrease in the level of sales to any one significant customer, or unsuccessful quarterly negotiation on key terms, conditions or timing of purchase orders placed during a quarter, could seriously harm our business and financial results.

     In addition, some of our OEM partners purchase our products for their inventories in anticipation of customer demand. These OEM partners make decisions to purchase inventory based on a variety of factors, including their product qualification cycles and their expectations of end customer demand, which may be affected by seasonality and their internal supply management objectives. Others require that we maintain inventories of our products in hubs adjacent to their manufacturing facilities and purchase our products only as necessary to fulfill immediate customer demand. If more of our OEM partners transition into a hub model, form partnerships, alliances or agreements with other companies that diverts business away from us, or otherwise change their business practices, their ordering patterns may become less predictable. Consequently, changes in ordering pattern may affect both the timing and volatility of our reported revenues. The timing of sales to our OEM partners, and consequently the timing and volatility of our reported revenues, may be further affected by the product introduction schedules of our OEM partners. Our OEM partners may delay or postpone their product orders in order to coordinate receipt of our products with their product introduction schedules. We also may be exposed to higher risks of obsolete or excess inventories.

     Our OEM partners evaluate and qualify our products for a limited time period before they begin to market and sell them. Assisting these distribution partners through the evaluation process requires significant sales, marketing and engineering management efforts on our part, particularly if our products are being qualified with multiple distribution partners at the same time. In addition, once our products have been qualified, our customer agreements have no minimum purchase commitments. We may not be able to effectively maintain or expand our distribution channels, manage distribution relationships successfully, or market our products through distribution partners. We must continually assess, anticipate and respond to the needs of our distribution partners and their customers, and ensure that our products integrate with their solutions. Our failure to manage successfully our distribution relationships or the failure of our distribution partners to sell our products could reduce our revenues significantly. In addition, our ability to respond to the needs of our distribution partners in the future may depend on third parties producing complementary products and applications for our products. If we fail to respond to the needs of these groups, our business and financial results could be harmed.

The prices of our products have declined in the past, and we expect the price of our products to continue to decline, which would reduce our revenues, gross margins and profitability.

     The average selling price per port for our products has declined in the past, and we expect it to continue to decline in the future as a result of changes in product mix, competitive pricing pressures, increased sales discounts, marketing programs, new product introductions by us or our competitors, the entrance of new competitors or other factors. For example, during the second half of fiscal year 2004, we introduced and began shipping several new products that expand and extend the breadth of our product offerings. Several of these new products have different revenues, gross margin, and profitability characteristics than our traditional products. It will take some time for us to be able to determine the impact that these new products will have on our total revenues, gross margins and overall profitability. If we are unable to offset any negative impact that changes in product mix, competitive pricing pressures, increased sales discounts, enhanced marketing programs, new product introductions by us or our competitors, or other factors may have on us by increasing the number of ports shipped or reducing product manufacturing cost, our total revenues and gross margins will decline.

     In addition, to maintain our gross margins we must maintain or increase the number of ports shipped, develop and introduce new products and product enhancements, and continue to reduce the manufacturing cost of our products. While we have successfully reduced the cost of manufacturing our products, we may not be able to continue to reduce cost of production at historical rates. If we fail to effectively respond to declines in average selling price per port, our gross margins will further decline. Moreover, most of our expenses are fixed in the short-term or incurred in advance of receipt of

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corresponding revenue. As a result, we may not be able to decrease our spending to offset any unexpected shortfall in revenues. If this occurs, we could incur losses, our operating results and gross margins would be below our expectations and the expectations of investors and stock market analysts, and our stock price would be negatively affected.

Our future revenue growth depends on our ability to rapidly develop new and enhanced products that achieve widespread market acceptance.

     Our future success depends upon our ability to address the rapidly changing needs of our customers by developing and manufacturing high-quality, cost-effective products and product enhancements on a timely basis, and by keeping pace with technological developments and emerging industry standards. This risk could become more pronounced as the SAN market becomes more competitive and subject to increased demand for new and improved technologies. In the past, we experienced delays in product development, and such delays could occur in the future. If we are required to develop new technologies and introduce new products more rapidly than in the past, or if we have to manage shorter product cycles and transitions, our business and financial results may be harmed.

     We expect to launch new products and product enhancements during the next year that will further expand the market opportunity for our products. We also expect our future revenue growth to be dependent on the success of our current line of products and our ability to rapidly develop and introduce new products and new product enhancements. If we are unable to timely introduce our new products, our business and financial results will be adversely affected.

     We have invested significant resources developing products that are dependent on the adoption rate of new technologies. For example, in the fourth quarter of fiscal year 2004, we announced the future availability of 4 Gigabit switch technology. The success of these products will depend upon the rate that our OEM partners and end users adopt this new technology. If these products are not adopted or are adopted more slowly by our customers than we planned, our business could be harmed. In addition, our ability to sell 4 Gigabit products is partially dependent upon the availability of components, such as HBAs and SFPs. If sufficient supply of the required components is not available, our business could be harmed.

The loss of our third-party contract manufacturers, the failure to accurately forecast demand for our products or the failure to successfully manage the production of our products could negatively affect our ability to manufacture and sell our products.

     We currently depend on two third-party contract manufacturers, Solectron and Foxconn, to manufacture our products. Each of our products is produced by one of the two contract manufacturers. If production is disrupted at one of these manufacturers’ facilities, our ability to produce a particular product could be terminated for an indefinite period of time. Qualifying a new contract manufacturer and commencing volume production is a lengthy and expensive process. If we are required or choose to change contract manufacturers and we encounter production, administrative or logistical obstacles during the transition, we may lose revenue and injure our customer relationships. In addition, if we fail to effectively manage the production of our products through Solectron and Foxconn, or if Solectron or Foxconn experience delays, disruptions, capacity constraints, component parts shortages or quality control problems in their manufacturing operations, shipment of our products to our customers could be delayed and our competitive position and reputation could be harmed.

     We provide product forecasts to our contract manufacturers and place purchase orders with them in advance of the scheduled delivery of products to our customers. In preparing sales and demand forecasts, we rely largely on input from our distribution partners. Therefore, if our distribution partners are unable to accurately forecast demand, or if 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. If these forecasts are inaccurate we may be unable to obtain from our contract manufacturers adequate manufacturing capacity to meet customers’ delivery requirements, or we may accumulate excess inventories. Furthermore, we may not be able to identify forecast discrepancies until late in our fiscal quarter. Consequently, we may not be able to make adjustments to our business model. If we are unable to obtain adequate manufacturing capacity from our contract manufacturers, if we accumulate excess inventories, or if we are unable to make necessary adjustments to our business model, our business and financial results may be negatively affected. In addition, although the purchase orders placed with our contract manufacturers are cancelable, in certain circumstances we could be required to purchase certain unused material not returnable, usable by, or sold to other customers if we cancel any of our orders. This purchase commitment exposure is particularly high in periods of product transition, for example, the ones we experienced in the third quarter of fiscal year 2004 with the introduction of our 3250 and 3850 switch products. If we are required to purchase unused material from our contract manufacturers, we would incur unanticipated expenses and our business and financial results could be negatively affected.

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     As part of our business strategy, we may seek to transition a greater portion of our product manufacturing to third parties that are located overseas. This kind of transition would expose us to certain inherent risks, including unexpected changes in regulatory requirements and tariffs, delays related to the acquisition of product components and distribution of our products, and potentially adverse tax consequences, all of which could harm our business. If we are not successful in our strategy to further transition our manufacturing to overseas markets, or if we are not successful in the implementation of this overseas manufacturing, our ability to manufacture and sell our products could be substantially impaired.

We are subject to an informal investigation by the SEC and may be subject to litigation arising from our recent audit committee internal review and related restatement.

     In January 2005, on management’s recommendation, our Board of Directors, in consultation with KPMG LLP, our Independent Registered Public Accounting Firm, and our advisors, concluded that our financial statements for the fiscal years ended 2002, 2003 and the nine months ended July 31, 2004, and the interim periods contained therein, should no longer be relied upon because of an error in such financial statements as addressed in Accounting Principles Board Opinion No. 20. We restated those financial statements, which appear elsewhere in our Annual Report on Form 10-K for the year ended October 30, 2004. We have been informed by the SEC that it has begun an informal investigation and we are responding to inquiries from the SEC. In addition, we may become the subject of government or private litigation. Both the SEC investigation and any litigation could require significant human and financial resources which could otherwise be devoted to the operation of our business. If we are subject to an adverse finding resulting from the SEC investigation or litigation, we could be required to pay damages or penalties or have other remedies imposed upon us. In addition, we could become the target of costly securities litigation related to other matters in the future. The SEC investigation or any litigation could adversely affect our business, results of operations, financial position and cash flows.

If we lose key personnel or are unable to hire additional qualified personnel, our business may be harmed.

     Our success depends to a significant degree upon the continued contributions of key management, engineering, sales and other personnel, many of whom would be difficult to replace. Our compensation packages include equity-based incentives. Therefore, our compensation packages could be adversely affected if our stock price does not increase.

     We believe our future success will also depend, in large part, upon our ability to attract and retain highly skilled managerial, engineering, sales and other personnel, and on the ability of management to operate effectively, both individually and as a group. We have experienced difficulty in hiring qualified ASIC, software, system and test, sales, marketing, key management and customer support personnel. In addition, our recent reductions in force could potentially make attracting and retaining qualified employees more difficult in the future. The loss of the services of any of our key employees, the inability to attract or retain qualified personnel in the future, or delays in hiring required personnel, particularly engineers and sales personnel, could delay the development and introduction of, and negatively affect our ability to sell, our products.

     In addition, companies in the computer storage and server industry whose employees accept positions with competitors frequently claim that their competitors have engaged in unfair hiring practices or that there will be inappropriate disclosure of confidential or proprietary information. We may receive such claims in the future as we seek to hire additional qualified personnel. Such claims could result in material litigation. As a result, we could incur substantial costs in defending against these claims, regardless of their merits.

Our quarterly and annual revenues and operating results may fluctuate in future periods due to a number of factors, which could adversely affect the trading price of our stock.

     Our quarterly and annual revenues and operating results may vary significantly in the future due to a number of factors, any of which may cause our stock price to fluctuate. Factors that may affect the predictability of our annual and quarterly results include, but are not limited to, the following:

	•	changes, disruptions or downturns in general economic conditions, particularly in the information technology industry;
	•	the timing of customer orders, product qualifications, and product introductions of our OEM partners;
	•	announcements, introductions, and transitions of new products by us and our competitors or our OEM partners;
	•	declines in average selling price per port for our products as a result of competitive pricing pressures or new product introductions by us or our competitors;

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	•	the emergence of new competitors in the SAN market;
	•	deferrals of customer orders in anticipation of new products, services, or product enhancements introduced by us or our competitors;
	•	our ability to obtain sufficient supplies of sole- or limited-sourced components, including ASICs, microprocessors, certain connectors, certain logic chips, and programmable logic devices;
	•	increases in prices of components used in the manufacture of our products;
	•	our ability to attain and maintain production volumes and quality levels;
	•	variations in the mix of our products sold and the mix of distribution channels through which they are sold;
	•	pending or threatened litigation; and
	•	new legislation and regulatory developments.

     Accordingly, the results of any prior periods should not be relied upon as an indication of future performance. It is possible that in some future quarter our revenues or operating results will not meet our projections or the expectations of stock market analysts or investors, and our stock price will decline.

Our revenues may be affected by changes in IT spending levels.

     In the past, unfavorable or uncertain economic conditions and reduced global IT spending rates have adversely affected our operating results and have led to a decline in our growth rates. We are unable to predict changes in general economic conditions and when IT spending rates will be affected. Furthermore, even if IT spending rates are positively affected, we cannot be certain that the market for SAN solutions will be positively impacted. If there are future reductions in either domestic or international IT spending rates, or if IT spending rates do not improve, our revenues, operating results and financial condition may be adversely affected.

     Our storage networking products are sold as part of storage systems and subsystems. As a result, the demand for our storage networking products has historically been affected by changes in storage requirements associated with growth related to new applications and an increase in transaction levels. Although in the past we have experienced historical growth in our business as enterprise-class customers have adopted SAN technology, demand for SAN products in the enterprise-class sector continues to be adversely affected by weak or uncertain economic conditions, and because larger businesses are focusing on more efficiently using their existing IT infrastructure rather than making new equipment purchases. If weakened IT spending levels persist, and new products improve our customers’ ability to utilize their existing storage infrastructure, the demand for SAN products may decline. If this occurs, our business and financial results will be harmed.

Our business may be subject to seasonal fluctuations and uneven sales patterns in the future.

     Many of our OEM partners experience seasonality and uneven sales patterns in their businesses. For example, some of our partners close a disproportionate percentage of their sales transactions in the last month, weeks and days of each fiscal quarter; and other partners experience spikes in sales during the fourth calendar quarter of each year. Because the majority of our sales are derived from a small number of OEM partners, when they experience seasonality, we experience similar seasonality. In addition, we have experienced quarters where uneven sales patterns of our OEM partners have resulted in a significant portion of our revenue occurring in the last month of our fiscal quarter. This exposes us to additional inventory risk as we have to order products in anticipation of expected future orders. We are not able to predict the degree to which the seasonality and uneven sales patterns of our OEM partners or other customers will affect our business in the future because the historical growth of our business may have lessened the effect of this seasonality and uneven sales patterns on our business in the past.

We are dependent on sole source and limited source suppliers for certain key components.

     We purchase certain key components used in the manufacture of our products from single or limited sources. We purchase application specific integrated circuits (ASICs) from a single source, and we purchase microprocessors, certain connectors, logic chips, power supplies and programmable logic devices from limited sources. We also license certain third-party software that is incorporated into our operating system software and other software products. If we are unable to timely purchase or license these components or experience significant component defects, we may not be able to deliver our products to our customers in a timely manner. As a result, our business and financial results could be harmed.

     We use rolling forecasts based on anticipated product orders to determine component requirements. If we overestimate component requirements, we may have excess inventory, which would increase our costs. If we underestimate component

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requirements, we may have inadequate inventory, which could interrupt the manufacturing process and result in lost or deferred revenue. In addition, lead times for components vary significantly and depend on factors such as the specific supplier, contract terms, and demand for a component at a given time. We also may experience shortages of certain components from time to time, which also could delay the manufacturing and sales processes. If we overestimate or underestimate our component requirements, or if we experience shortages, our business and financial results could be harmed.

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

     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 domestically and internationally, including managing our headcount appropriately. During fiscal year 2003 and the second quarter of fiscal year 2004, we completed programs to restructure certain business operations that included workforce reductions and structural cost reductions. If we do not properly manage these cost and headcount reductions, our ability to generate revenue and to produce and sell products could be harmed.

     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 management systems and resources. Our failure to continue to improve upon our operational, managerial, and financial controls, enterprise-wide management information and reporting systems, and procedures, and our failure to continue to train and manage our workforce worldwide, could seriously harm our business and financial results.

     In the past we have vacated certain unused facilities and made various assumptions in recording facilities lease loss reserves, including the time period over which the facilities are expected to be vacant, expected sublease terms, expected sublease rates, anticipated future operating expenses, and expected future use of the facilities. Our estimates involve a number of risks and uncertainties, some of which are beyond our control, including future vacancy rates and lease activities for similar facilities within the area and our ability to successfully enter into subleases or lease termination agreements with terms as favorable as those assumed when arriving at our estimates. If actual results differ significantly from our estimates, or if there are changes in real estate market conditions or if it takes longer than expected to find a suitable tenant to sublease the remaining vacant facilities, we may be required to take additional charge and the financial impact could be material.

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

     We completed our acquisition of Rhapsody on January 27, 2003. As part of our business strategy, we expect to continue to review opportunities to buy other businesses or technologies that would complement our current products, expand the breadth of our markets or enhance our technical capabilities, or that may otherwise offer growth opportunities. If we buy other businesses, products or technologies in the future, we could:

	•	incur significant unplanned expenses and personnel costs;
	•	issue stock, or assume stock option plans that would dilute our current stockholders’ percentage ownership;
	•	use cash, which may result in a reduction of our liquidity;
	•	incur debt; or
	•	assume liabilities.

     These purchases also involve numerous risks, including:

	•	problems integrating the purchased operations, technologies, personnel or products;
	•	unanticipated costs, litigation and other contingent liabilities;
	•	diversion of management’s attention from our core business;
	•	adverse effects on existing business relationships with suppliers and customers;
	•	risks associated with entering into markets in which we have no, or limited, prior experience;
	•	unconsummated transactions; and
	•	potential loss of our key employees or the key employees of an acquired organization.

     We may not be able to successfully integrate any businesses, products, technologies or personnel that we might acquire, or to realize expected benefits of acquisitions that we may undertake in the future. If this occurs, our business and financial results may be adversely affected.

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If our assumptions regarding our revenues and margins do not materialize, our future profitability could be adversely affected.

     We did not attain profitability for the full fiscal years 2004 or 2003, and we may not be able to attain profitability in the future. We make our investment decisions and plan our operating expenses based in part on future revenue projections. However, our ability to accurately forecast quarterly and annual revenues is limited, as discussed above in “Our quarterly and annual revenues and operating results may fluctuate in future periods due to a number of factors, which could adversely affect the trading price of our stock.” If our projected revenues and margins do not materialize, our future profitability could be adversely affected. Moreover, we expect to incur significant costs and expenses for product development, sales, marketing and customer support, most of which are fixed in the short-term or incurred in advance of receipt of corresponding revenue. As a result, we may not be able to decrease our spending to offset any unexpected shortfall in revenues.

     We also make operating and investment decisions based on our anticipated future expansion, which may have an adverse effect on our earnings in the short term. For example, in fiscal year 2004, we purchased a 194,000 square foot building located near our San Jose headquarters. Our building purchase has adversely affected our earnings per share for our fiscal year 2004 as we recorded a $75.6 million charge related to lease termination, facilities consolidation and other associated costs (see Note 7, “Liabilities Associated with Facilities Lease Losses,” of the Notes to Condensed Consolidated Financial Statements).

     During fiscal year 2003 and the second quarter of fiscal year 2004, we completed programs to restructure certain business operations that included workforce reductions and the impairment of certain assets no longer being used as a result of the restructuring programs. These actions involve numerous risks, including unanticipated costs, diversion of management’s attention from our core business and adverse effects on existing business relationships with suppliers, customers, and employees. We may not be able to achieve our planned reduction in spending related to these restructuring programs if we incur unforeseen expenses in future quarters or if we are unable to reduce expenses without jeopardizing further development, marketing and sales of our products. Additionally, it is possible that these reductions in spending may not be sufficient to achieve their intended goals. If we are unable to achieve our planned reduction in spending or if our current reductions in spending are insufficient, we may be required to undertake additional restructuring activities that may involve our personnel, real estate, fixed assets, marketing programs and research and development programs.

Changes in financial accounting standards or practices may cause adverse unexpected fluctuations and affect our reported business and financial results.

     FASB’s recent change to mandate the expensing of stock options, will require us to record charges to earnings for employee stock option grants and will adversely affect our financial results. In addition, the FASB requires certain valuation models to estimate the fair value of employee stock options. These models, including the Black-Scholes option-pricing model, use varying methods, inputs and assumptions across companies. If another party asserts that the fair value of our employee stock options are misstated, securities class action litigation could be brought against us or the market price of our common stock could decline or both could occur. As a result of these changes, we could incur losses and our operating results and gross margins may be below our expectations and those of investors and stock market analysts.

Our future operating expenses may be adversely affected by changes in our stock prices.

     A portion of our outstanding stock options are subject to variable accounting under Accounting Principles Board Opinion No. 25. Under variable accounting we are required to remeasure the value of the options, and the corresponding compensation expense, at the end of each reporting period until the option is exercised, cancelled, or expires unexercised. As a result, the stock-based compensation recognized in any given period can vary substantially due to changes in the market value of our common stock. In order to illustrate the volatility associated with stock price movements we offer the following example. If the market value of our common stock at the end of the second quarter of fiscal year 2005 is $7, we will record additional compensation expense in that quarter of approximately $1.9 million. If, however the market value of our common stock at the end of the second quarter of fiscal year 2005 is $9, the compensation expense recorded will increase to $5.6 million. We are unable to predict the future market value of our common stock and therefore are unable to predict the compensation expense that we will record in future periods.

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International political instability and concerns about other international crises may increase our cost of doing business and disrupt our business.

     International political instability, evidenced by the occurrence and threat of terrorist attacks, enhanced national security measures and military action and armed conflicts, may halt or hinder our ability to do business and may increase our costs. In addition, concerns about other international crises, such as the spread of the SARS and West Nile viruses, may have an adverse effect upon the world economy and could adversely affect our business operations or the operations of our OEM partners, contract manufacturers and suppliers. This political instability and concerns about other international crises may, for example:

	•	negatively affect the reliability and cost of transportation;
	•	negatively affect the desire and ability of our employees and customers to travel;
	•	disrupt the production capabilities of our OEM partners, contract manufacturers and suppliers;
	•	adversely affect our ability to obtain adequate insurance at reasonable rates; and
	•	require us to take extra security precautions for our operations.

     Furthermore, to the extent that air transportation is delayed or disrupted, the operations of our contract manufacturers and suppliers may be disrupted, particularly if shipments of components and raw materials are delayed.

We plan to continue to increase our international sales activities, which will subject us to additional business risks.

     We plan to continue to expand our international operations and sales activities. Expansion of international operations will involve inherent risks that we may not be able to control, including:

	•	supporting multiple languages;
	•	recruiting sales and technical support personnel with the skills to design, manufacture, sell, and support our products;
	•	increased complexity and costs of managing international operations;
	•	increased exposure to foreign currency exchange rate fluctuations;
	•	commercial laws and business practices that favor local competition;
	•	multiple, potentially conflicting, and changing governmental laws and regulations, including differing labor and employment laws;
	•	longer sales cycles and manufacturing lead times;
	•	difficulties in collecting accounts receivable;
	•	reduced or limited protections of intellectual property rights;
	•	more complicated logistics and distribution arrangements; and
	•	political and economic instability.

     To date, no material amount of our international revenues and costs of revenues have been denominated in foreign currencies. As a result, an increase in the value of the United States dollar relative to foreign currencies could make our products more expensive and, thus, not competitively priced in foreign markets. Additionally, a decrease in the value of the United States dollar relative to foreign currencies could increase our operating costs in foreign locations. In the future, a larger portion of our international revenues may be denominated in foreign currencies, including the Euro, which will subject us to risks associated with fluctuations in those foreign currencies.

Undetected software or hardware errors could increase our costs and reduce our revenues.

     Networking products frequently contain undetected software or hardware errors, or “bugs,” when first introduced or as new versions are released. Our products are becoming increasingly complex, and errors may be found from time to time in our new or enhanced products. In addition, our products are combined with products from other vendors. As a result, when problems occur, it may be difficult to identify the source of the problem. These problems may cause us to incur significant warranty and repair costs, divert the attention of engineering personnel from product development efforts and cause significant customer relations problems. Moreover, the occurrence of hardware and software errors, whether caused by another vendor’s SAN products, or ours, could delay or prevent the development of the SAN market.

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We may be unable to protect our intellectual property, which would negatively affect our ability to compete.

     We rely on a combination of patent, copyright, trademark, and trade secret laws, confidentiality agreements, and other contractual restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality or license agreements with our employees, consultants, and corporate partners, and control access to and distribution of our technology, software, documentation, and other confidential information. These measures may not preclude the disclosure of our confidential or propriety information, or prevent competitors from independently developing products with functionality or features similar to our products. Despite efforts to protect our proprietary rights, 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 take to prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect proprietary rights as fully as in the United States, will be effective.

Others may bring infringement claims, which could be time-consuming and expensive to defend, against us.

     In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights and we have been a party to such litigation. Moreover, we are currently a party to an intellectual property-related lawsuit, and may be a party to litigation in the future, to protect our intellectual property or as a result of an alleged infringement of the intellectual property of others. These claims and any resulting lawsuit, including the current lawsuit, could subject us to significant liability for damages and invalidation of proprietary rights. These lawsuits, regardless of their success, would likely be time-consuming and expensive to resolve and would divert management’s time and attention. Any potential intellectual property litigation also could force us to do one or more of the following:

	•	stop selling, incorporating or using products or services that use the challenged intellectual property;
	•	obtain from the owner of the infringed intellectual property a license to the relevant intellectual property, which may require us to license our intellectual property to such owner, or may not be available on reasonable terms or at all; and
	•	redesign those products or services that use technology that is the subject of an infringement claim.

     If we are forced to take any of the foregoing actions, we may be unable to manufacture, use, sell, import and export our products, which would reduce our revenues.

We believe that we currently have adequate internal controls but we are still exposed to potential risks resulting from new requirements that we evaluate disclosure controls under Section 404 of the Sarbanes-Oxley Act of 2002.

     We are evaluating our internal controls in order to allow management to report on, and our independent auditors to attest to, our internal controls, as required by Section 404 of the Sarbanes-Oxley Act of 2002. We may encounter unexpected delays in implementing the requirements relating to internal controls, therefore, we cannot be certain about the timing of completion of our evaluation, testing and remediation actions or the impact that these activities will have on our operations since there is no precedent available by which to measure the adequacy of our compliance. We also expect to incur additional expenses and diversion of management’s time as a result of performing the system and process evaluation, testing and remediation required in order to comply with the management certification and auditor attestation requirements. If we are not able to timely comply with the requirements set forth in Section 404, we might be subject to sanctions or investigation by regulatory authorities. Any such action could adversely affect our business and financial results. The requirement to comply with Section 404 of the Sarbanes-Oxley Act of 2002 will become effective for our fiscal year ending October 29, 2005.

     In addition, in our system of internal controls we may rely on the internal controls of third parties including, but not limited to, payroll service providers, financial institutions, contract manufacturers, master resellers and certain OEM customers. In our evaluation of our internal controls, we will consider the implication of our reliance on the internal controls of third parties. Until we have completed our evaluation, we are unable to determine the extent of our reliance on those controls, the extent and nature of the testing of those controls, and remediation actions necessary where that reliance cannot be adequately evaluated and tested.

Our products must comply with evolving industry standards and government regulations.

     Industry standards for SAN products are continuing to emerge, evolve, and achieve acceptance. To remain competitive, we must continue to introduce new products and product enhancements that meet these industry standards. All components of the SAN must interoperate together. Industry standards are in place to specify guidelines for interoperability and

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communication based on standard specifications. Our products encompass only a part of the entire SAN solution utilized by the end-user, and we depend on the companies that provide other components of the SAN solution, many of whom are significantly larger than we are, to support the industry standards as they evolve. The failure of these providers to support these industry standards could adversely affect the market acceptance of our products.

     In addition, in the United States, our products comply with various regulations and standards defined by the Federal Communications Commission and Underwriters Laboratories. Internationally, products that we develop will be required to comply with standards established by authorities in various countries. Failure to comply with existing or evolving industry standards or to obtain timely domestic or foreign regulatory approvals or certificates could materially harm our business.

Provisions in our charter documents, customer agreements, Delaware law, our convertible subordinated debt, and our stockholder rights plan could prevent or delay a change in control of Brocade, which could hinder stockholders’ ability to receive a premium for our stock.

     Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include:

	•	authorizing the issuance of preferred stock without stockholder approval;
	•	providing for a classified board of directors with staggered, three-year terms;
	•	prohibiting cumulative voting in the election of directors;
	•	limiting the persons who may call special meetings of stockholders;
	•	prohibiting stockholder actions by written consent; and
	•	requiring super-majority voting to effect amendments to the foregoing provisions of our certificate of incorporation and bylaws.

     Certain provisions of Delaware law also may discourage, delay, or prevent someone from acquiring or merging with us, and our agreements with certain of our customers require that we give prior notice of a change of control and grant certain manufacturing rights following a change of control. In addition, we currently have in place a stockholder rights plan. Furthermore, any of these things could prevent or delay a change in control of Brocade, which could hinder stockholders’ ability to receive a premium for our stock.

     Also, if we incur a “fundamental change” as defined in our convertible subordinated debt, we could be required to repurchase all of our outstanding notes. A “fundamental change” is generally defined as any transfer or event in which all or substantially all of our common stock is exchanged for, converted into or acquired for, or constitutes solely the right to receive consideration which is not all or substantially all common stock that is listed on a United States national securities exchange or the Nasdaq National Market or similar automated quotation system.

We expect to experience volatility in our stock price, which could negatively affect stockholders’ investments.

     The market price of our common stock has experienced significant volatility in the past and will likely continue to fluctuate significantly in response to the following factors, some of which are beyond our control:

	•	macroeconomic conditions;
	•	actual or anticipated fluctuations in our operating results;
	•	changes in financial estimates and ratings by securities analysts;
	•	changes in market valuations of other technology companies;
	•	announcements of financial results by us or other technology companies;
	•	announcements by us, our competitors, customers, or similar businesses of significant technical innovations, contracts, acquisitions, strategic partnerships, joint ventures or capital commitments;
	•	losses of major OEM partners;
	•	additions or departures of key personnel;
	•	sales by us of common stock or convertible securities;
	•	incurring additional debt; and
	•	other risk factors detailed in this section.

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     In addition, 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 how the business performs.

Business interruptions could adversely affect our business.

     Our operations are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure and other events beyond our control. A substantial portion of our facilities, including our corporate headquarters, is located near major earthquake faults. In the event of a major earthquake, we could experience business interruptions, destruction of facilities and loss of life. We do not carry earthquake insurance and have not set aside funds or reserves to cover such potential earthquake-related losses.

     Our operations are also subject to business interruptions that may occur as a result of a change or upgrade in our information technology systems, consolidation of our business operations, or a transition to new facilities in the United States of America or abroad. We do not carry sufficient insurance to mitigate the effect of potential material business interruptions. Consequently, should a material business interruption occur, our business and financial results could be seriously harmed.

Item 3. Quantitative and Qualitative Disclosures About Market Risks

     We are exposed to market risk related to changes in interest rates and equity security prices.

Interest Rate Risk

     Our exposure to market risk due to changes in the general level of United States interest rates relates primarily to our cash equivalents and short-term and long-term investment portfolios. Our cash, cash equivalents, and short-term and long-term investments are primarily maintained at five major financial institutions in the United States. As of January 29, 2005, we did not hold any derivative instruments. The primary objective of our investment activities is the preservation of principal while maximizing investment income and minimizing risk.

     The following table presents the hypothetical changes in fair values of our investments as of January 29, 2005 that are sensitive to changes in interest rates (in thousands):

     These instruments are not leveraged and are classified as available-for-sale. The modeling technique used measures the change in fair values arising from selected potential changes in interest rates. Market changes reflect immediate hypothetical parallel shifts in the yield curve of plus or minus 50 basis points (BPS), 100 BPS, and 150 BPS, which are representative of the historical movements in the Federal Funds Rate.

     The following table (in thousands) presents our cash equivalents and short-term and long-term investments subject to interest rate risk and their related weighted average interest rates as of January 29, 2005. Carrying value approximates fair value.

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     Our convertible subordinated debt is subject to a fixed interest rate and the notes are based on a fixed conversion ratio into common stock. Therefore, we are not exposed to changes in interest rates related to our long-term debt instruments. The notes are not listed on any securities exchange or included in any automated quotation system; however, the notes are eligible for trading on the Portal^SM Market. On January 28, 2005, the average bid and ask price on the Portal Market of our convertible subordinated notes due 2007 was 95.25, resulting in an aggregate fair value of approximately $331.6 million. Our common stock is quoted on the Nasdaq National Market under the symbol “BRCD.” On January 28, 2005, the last reported sale price of our common stock on the Nasdaq National Market was $5.99 per share.

Equity Security Price Risk

     Our exposure to market risk due to equity security price fluctuations primarily relates to investments in marketable equity securities. These investments are principally in companies in the volatile high-technology sector. We do not attempt to reduce or eliminate the market exposure on these securities. Adverse changes in equity prices of 25 percent, 50 percent, and 75 percent would result in decreases of approximately $0.2 million, $0.4 million and $0.6 million in the fair value of marketable equity securities as of January 29, 2005, respectively. Any changes in fair value are accounted for as unrealized holding gains and losses, and are included as a separate component of accumulated other comprehensive income on the accompanying Condensed Consolidated Balance Sheets, net of any related tax effect.

Item 4. Controls and Procedures

	(a)	Evaluation of disclosure controls and procedures: Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this Quarterly Report on Form 10-Q (the Evaluation Date). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the information relating to the Company, required to be disclosed in our Securities and Exchange Commission (SEC) reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to the Company’s management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
	(b)	Changes in internal control over financial reporting: There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

     From time to time, claims are made against us in the ordinary course of our business, which could result in litigation. Claims and associated litigation are subject to inherent uncertainties and unfavorable outcomes could occur, such as monetary damages, fines, penalties or injunctions prohibiting us from selling one or more products or engaging in other activities. The occurrence of an unfavorable outcome in any specific period could have a material adverse affect on our results of operations for that period or future periods.

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     On July 20, 2001, the first of a number of putative class actions for violations of the federal securities laws was filed in the United States District Court for the Southern District of New York against Brocade, certain of its officers and directors, and certain of the underwriters for Brocade’s initial public offering of securities. A consolidated amended class action captioned In Re Brocade Communications Systems, Inc. Initial Public Offering Securities Litigation was filed on April 19, 2002. The complaint generally alleges that various underwriters engaged in improper and undisclosed activities related to the allocation of shares in Brocade’s initial public offering and seeks unspecified damages on behalf of a purported class of purchasers of common stock from May 24, 1999 to December 6, 2000. The lawsuit against Brocade is being coordinated for pretrial proceedings with a number of other pending litigations challenging underwriter practices in over 300 cases as In Re Initial Public Offering Securities Litigation, 21 MC 92(SAS). In October 2002, the individual defendants were dismissed without prejudice from the action, pursuant to a tolling agreement. On February 19, 2003, the Court issued an Opinion and Order dismissing all of the plaintiffs’ claims against Brocade. In July 2004, a stipulation of settlement for the claims against the issuer defendants, including Brocade, was submitted to the Court for approval. The settlement is subject to a number of conditions, including approval by the Court.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

The following table summarizes employee stock repurchase activity for the three months ended January 29, 2005 (shares in thousands):

Item 6. Exhibits

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