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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
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ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d) OF SECURITIES EXCHANGE ACT
OF 1934
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for the fiscal year ended January 31,
2004
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OR
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TRANSITION REPORT PURSUANT TO SECTION 13 OR
15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
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for the transition period
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to
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Commission File No. 000-31257
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McDATA
Corporation
(Exact name of registrant as specified in its
charter)
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A Delaware Corporation
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84-1421844
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(State or other jurisdiction
of incorporation or organization)
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(I.R.S. Employer
Identification No.)
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380 Interlocken Crescent, Broomfield,
Colorado 80021
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Telephone Number (720) 558-8000
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Securities registered pursuant to
Section 12(b) of the Act:
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Title of each class
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Name of Each Exchange on
Which Registered
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McDATA Class B Common
Stock
($0.01 per share, par value)
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Nasdaq National Market
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Securities registered pursuant to
Section 12(g) of the Act:
McDATA Class A Common Stock
($0.01 per share, par value)
Nasdaq National Market
At April 2, 2004, approximately 81,000,000 shares of the
registrant’s Class A Common Stock were outstanding and approximately
36,468,048 shares of the registrant’s Class B Common Stock were
outstanding. At July 31, 2003, the aggregate market value of the
registrant’s Class A Common Stock held by non-affiliates was approximately
$871 million and the aggregate market value of the registrant’s Class B
Common Stock held by non-affiliates was approximately $285 million.
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 ý No o
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant’s knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K o
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Securities Exchange Act of
1934). Yes ý No o
McDATA Corporation
Form 10-K
TABLE OF CONTENTS
McDATA Corporation
FORM 10-K
Special Note Regarding Forward-Looking
Statements
Some
of the information presented in this Annual Report on Form 10-K contains
“forward-looking statements” within the meaning of the Private Securities
Litigation Reform Act of 1995 (the “Reform Act”). Although McDATA Corporation
(“McDATA” or the “Company,” which may also be referred to as “we,” “us” or
“our”) believes that its expectations are based on reasonable assumptions
within the bounds of its knowledge of its businesses and operations; there can
be no assurance that actual results will not differ materially from our
expectations. Factors that could cause actual results to differ materially from
expectations include:
• changes in our relationship with EMC
Corporation, or EMC, International Business Machines Corporation, or IBM, and
Hitachi Data Systems, or HDS, and the level of their orders;
• our ability to successfully increase sales of
McDATA’s multi-protocol network switches and management software, including
SANavigator®;
• competition in the multi-protocol (Fibre
Channel and IP) network market, including competitive pricing pressures and
product give-aways, by our competitors such as Brocade Communication Systems,
Inc., or Brocade, QLogic Corp, or QLogic, Computer Network Technology
Corporation, or CNT, Cisco Systems, Inc., or Cisco, and other IP and
multi-protocol switch and software suppliers;
• additional manufacturing and component costs
and production delays that we may experience as we continue the transition to
new products;
• a loss of any of our key customers (and our
OEMs’ key customers), distributors, resellers, suppliers or our manufacturers;
• our ability to expand our product offerings
and any transition to new products (including higher port density,
multi-protocol and intelligent network products);
• any change in
business conditions, our business and sales strategy or product development
plans, and our ability to attract and retain highly skilled individuals;
• any industry or technology changes that cause
obsolescence of our products or components of those products;
• one-time events and other important risks and
factors disclosed previously and from time to time in our filings with the U.S.
Securities and Exchange Commission, or SEC, including the risk factors
discussed in this Annual Report; and
• the impact of any acquisitions by us of
businesses, products, or technologies, including difficulties in integrating
any acquisitions.
You
should not construe these cautionary statements as an exhaustive list or as any
admission by us regarding the adequacy of the disclosures made by us. We cannot
always predict or determine after the fact what factors would cause actual
results to differ materially from those indicated by our forward-looking
statements or other statements. In addition, you are urged to consider
statements that include the terms “believes,” “belief,” “expects,” “plans,”
“objectives,” “anticipates,” “intends,” or the like to be uncertain and forward-looking.
All cautionary statements should be read as being applicable to all
forward-looking statements wherever they appear. We do not undertake any
obligation to publicly update or revise any forward-looking statements.
1
Part I
ITEM
1. Business
Who We Are
McDATA
Corporation provides Multi-Capable Storage Network Solutions™ (integrating multiple platforms, networks, protocols and locations)
that enable end-customers around the world to better consolidate and utilize
their storage infrastructure, easily manage the storage network, and implement
best-in-class business continuance solutions. McDATA solutions are an integral
part of data services infrastructures sold by many major storage and system
vendors, including Dell Products L.P. (Dell), EMC Corporation (EMC),
Hewlett-Packard (HP), Hitachi Data Systems (HDS), International Business
Machines Corporation (IBM), StorageTechnology Corporation (STK) and Sun
Microsystems, Inc. (Sun). The Company
was reorganized and incorporated in the state of Delaware in October of
1997.
McDATA provides storage area networking (SAN)
solutions, including hardware and software, for connecting servers and storage
devices from the core to the edge of an enterprise’s data infrastructure, and
heterogenous SANs via our SAN Routing capabilities. Our solutions include hardware and software products, professional
services and education that enable businesses to scale their operations
globally through a comprehensive, manageable, flexible data infrastructure that
is optimized for rapid deployment and responsiveness to customer needs. We
combine experience in designing, developing and manufacturing high performance
SAN solutions with knowledge of business critical applications, service and
support to solve data infrastructure challenges facing enterprises of varying
sizes.
Recent Developments
Acquisitions
On
September 19, 2003, we completed our acquisition of Nishan Systems, Inc.
(Nishan), a provider of native IP storage switching solutions that builds open
storage networking products based on IP and Ethernet, both international
networking standards. The Nishan transaction accelerates our delivery of
multi-protocol inter-networking capabilities that scale data center storage
networks and extend storage network benefits across the campus, the enterprise
and geographies. On September 30, 2003, we completed our acquisition of
Sanera Systems, Inc. (Sanera), a producer of intelligent Director class
switching platform technologies. The
acquisition of Sanera, when combined with McDATA technologies, extends our
multi-capable storage-networking director platform and accelerates our vision
of delivering a real-time storage services infrastructure. On August 25, 2003, we also made an
equity investment in Aarohi Communications, Inc.
Hardware Products
SAN Fibre Channel
Directors
We are a leading provider of high availability SAN
directors with our Intrepid™ 6140 Director (140 ports) and Intrepid™ 6064
Director (64 ports). The Intrepid™ 6140 Director provides high-availability and
high-port density within 12u (“u” equals 1.75 inches in height) of vertical
space, enabling 420 ports to reside in a single McDATA Fabricenter® Cabinet or
any other industry standard rack. The
full line of Intrepid™ Directors are flexible building blocks for storage
networks with hundreds and even thousands of connections.
The distinction between a director-class environment
and a simple combined or clustered switching solution environment is
significant at the core of the data center. Our directors offer full
redundancy, “five-nines” (99.999%) of availability, ultra-high predictive performance
provided by a non-blocking architecture, security and highly integrated
centralized management provided through software management tools. McDATA’s
directors provide customers with high performance, high availability solutions
to network storage. Both the Intrepid™
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6140 Director and Intrepid™ 6064 Director
provide optimal port granularity with 4 ports per card module, with 35
swappable port card modules per chassis for a total of 140 ports, and 16 swappable
port card modules per chassis for a total of 64 ports, respectively. In the
rare event of a single port failure, only one port module in a director would
be affected and can be replaced without network disruption. Therefore, the McDATA Intrepid™ Director
provides very low disruption to the network, with only 4 ports being affected
in the rare event of a port failure, unlike a similar failure with a combined
or clustered switching solution that has sixteen ports per module. In addition,
the extensibility and openness of our architecture provides customers with
investment protection by providing a platform that can be upgraded to new
performance levels and protocols including FICON, or mainframe multi-speeds,
such as 1 Gb and 2 Gb; and has a passive backplane allowing for multi-protocol
transmission in the future. As a result of our acquisition of Sanera, we plan
to introduce the Intrepid™ 10000 Director, which will be fully interoperable
with McDATA’s current products, after qualification testing with our sales
channels is completed.
SAN Fibre Channel Fabric
Switches
For small and mid-sized enterprises that want high
performance features at a cost effective “pay as you grow” upgrade price, we
offer the Sphereon™ Family of Fabric Switches with flexport technology. The Sphereon™ 4500 delivers
“connectivity-on-demand” in 8 port increments (8, 16 and 24 ports) and the
Sphereon™ 4300 Fabric Switch delivers “connectivity-on-demand” in 4 port
increments (4, 8 and 12 ports). When upgrading a switch from 8 ports to 12
ports, for example, the end-customer simply purchases a flexport upgrade, and
implements the upgrade using a simple software feature enablement key which
upgrades the switch non-disruptively. With each Sphereon™ Fabric Switch we
offer web-based management software known as SANPilot™. SANPilot™ provides the
features necessary to easily manage small SAN fabrics. The Sphereon™
4000-Series (4500 and 4300) Fabric Switches also offer non-disruptive software
code load and activation (HotCAT Technology), hot-plug capable transceivers,
fibre channel loop connectivity for storage consolidation (directly attaching
disk or tape and maximizing storage utilization) and other industry leading
features.
For larger departments within a data center,
we offer the Sphereon™ 3232 Fabric Switch.
The Sphereon™ 3232 Fabric Switch is also available for FICON
environments and offers HotCAT Technology (non-disruptive code load and
activation), redundant power and cooling, hot-plug capable transceivers and
other industry leading features. With each Sphereon™ 3232 Fabric Switch we also
include our web-based management software, SANPilot™ at no additional cost.
Multi-Protocol IP Storage Switches and Internetworking
Switches
For
enterprises that want to leverage their fibre channel storage network
infrastructure and their IP networks to consolidate storage infrastructures
across the campus, the enterprise and geographies, we offer the Eclipse®
IPS 4300 multi-protocol IP Storage Switch (16 multi-service ports), the Eclipse® IPS 3300
multi-protocol IP Storage Switch (8 multi-service ports) and the Eclipse® 1620 SAN
Inter-networking Switch. These switch solutions allow for integrated
disaster recovery architectures, and cost effective integration of low-end
servers and applications into the storage network. The Eclipse® IPS 4300 and 3300 switches
also provide SAN routing capabilities, allowing end-customers to consolidate
heterogeneous SANs and share data between heterogeneous storage environments,
while at the same time isolating faults from propagating between SANs with
fault isolation technology. With the Eclipse® line of switch
products we offer our SANvergenceâ
Manager software.
Cabinets
Our Fabricenter® Cabinet supports internal cable management for 512
Fibre Channel cables and provides 36u of vertical space while occupying only
one tile width (24”) of valuable data center floor space. Its sleek, industrial
design provides maximum airflow, security and visibility of equipment. The
Fabricenter® Cabinet can house our Intrepid™ ,
Sphereon™ and Eclipse® line
of products. These cabinets, when
populated with our director, switch and software products, represent our
configured products.
3
Software Products
Through our Extendable Open Network (EON) software architecture, we
offer open, end-to-end SAN management through a layered software approach. Our
SANavigatorâ
software provides complete SAN monitoring, management, visualization and
control of heterogeneous fabric environments. Our Enterprise Fabric
Connectivity Manager (EFCM) software systematically simplifies the setup and
configuration of a SAN with our SAN directors and fibre channel fabric switches, and provides fabric level SAN
management and administration. Both SANavigator® and EFCM software
can be run locally on the server platform or remotely on any network-attached
workstation in the enterprise. We recently integrated certain features of our
SANavigator® software into EFCM, providing end-customers and our
sales channels the flexibility to purchase only those modules that fit their
business strategies.
Our Element Manager (EM) software (formerly known as Product Manager
software) provides device level management and administration of our SAN fibre
channel directors and fabric switches. Our Enterprise Operating System™ (E/OS)
operating system software is embedded in our directors and switches and forms
the foundation for our Enterprise Architecture providing a myriad of advanced
services to upper layers of software applications including HotCAT™ Technology.
Our SAN Internetworking Operating System (SIOS) software is embedded in our Eclipse®
line of switch products and our SANvergence® Manager is a collection
of software tools for managing an IP storage fabric consisting of Eclipse®
switches and gateways. Our FICON
Management Server software is available with our Intrepid™ Directors and the
Sphereon™ 3232 Fibre Channel Fabric Switch to provide mainframe customers with
single-console management of FICON storage networks from the mainframe
console. Our web-based management
software known as SANPilot® is available in our Sphereon™ line of
switch products. Our SANtegrity® Security Suite software applies
layers of security to individual storage network ports, switches and entire
fabrics, limiting exposure to intentional security threats and accidental
changes to the storage network.
Professional Services and Solutions
Our Professional Services group provides our customers with
some of the most experienced and comprehensive storage network consulting
services and solutions in the industry.
Our full line of service offerings and state-of-the-art tools such as
ProSADA™ and SANavigator® allow customers to efficiently plan,
implement, and manage complex storage networks worldwide. We provide customers
with complete solutions that solve critical customer problems such as
consolidation and data protection allowing the customers to focus on their
business mission with the assurance of high availability and functionality. We
also provide technology-centric, vendor-neutral storage network training to IT
professionals through our Learning Services group. Our training emphasizes system-level solutions by providing IT
professionals the skills necessary to be effective in today’s multi-vendor,
heterogeneous storage networking environments.
Technology
We have developed ASIC (Application Specific
Integrated Circuit) technology that serves as the foundation for the
development of our complete family of SAN products. These ASICs combine a
number of Fibre Channel functions in a single chip, reducing the number of
components needed in our fibre channel directors and switches. Our ASICs are used in our current fibre
channel directors and fibre channel fabric switch products and we intend to use
variations of such ASICs in our future products.
The implementation of our Fibre Channel directors and switch
architecture is based on a common hardware and software design. The
architecture enables product designs that span from the high-end data center to
low-end workgroup storage computing environments with gigabit performance and
24x7 operation.
Our technology/architecture allows us to offer
director-class products with a higher number of data transmission ports in less
space than similarly sized competitive products. This architecture allows
end-customers to maximize space in their data centers. Our Intrepid™ 6140 and Intrepid™ 6064
Directors utilize a durable serial crossbar non-blocking architecture, which
allows for the maximization of usable ports because none of our director
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ports needs to be diverted to other network
switches – unlike developed architectures based upon small port-count switches
in a meshed switch environment. Our current architecture enables us to address
large enterprise core-to-edge customer fabrics with thousands of ports. The architecture supports transmission of up
to 2 gigabits per second and is designed to support transmission of up to 10
gigabits per second in the future. The flexibility of our architecture provides
customers with investment protection by allowing the director platform to be
upgraded from 1 gigabite, to 2 gigabits and to 10 gigabits, when generally
available, as well as future technology protocols like IP, iSCSI and Infiniband
(IB).
Our current director products include, and we expect our future
products will include, many of the following characteristics:
• system status
monitoring;
• ability to
replace faulty internal component parts without interruption of data
transmission;
• non-disruptive
serviceability;
• automated
component failure detection and reporting;
• user friendly
operation;
• automated call
home features;
• network
management that supports both in-band and out-of-band systems; and
• network
management via our SANavigator®, EFCM, Element Manager, E/OS, SANPilot®, and SANvergence®
Manager software products.
Customers
Three major customers, EMC, IBM and HDS, are significant providers of
enterprise storage systems. For the fiscal year ending January 31, 2004,
EMC accounted for approximately 56% (54% in 2002), IBM accounted for
approximately 21% (down from 25% in 2002), and HDS accounted for approximately
10% (up from 9% in 2002) of our total revenue. McDATA solutions are
offered and sold by other major storage and system vendors, including Dell, HP,
STK and Sun. In addition to our storage and system vendors, we have
relationships with resellers, distributors and systems integrators
worldwide. Expanding our reseller,
distributor and system integrator channels into Small Medium Enterprise (SME)
and vertical markets will be a strategic focus for us as we continue to expand
our business.
Backlog
We manufacture our products on the basis of our
forecast of near-term demand and maintain inventory in advance of receipt of
firm orders from customers. Some of our products are configured to customer
specifications and are generally shipped by us, via our contract manufacturers,
shortly after receipt of the order. For this reason, our backlog at any
particular time is not meaningful to our business because it is not necessarily
indicative of future sales levels.
Sales and Marketing
Our sales and marketing approach is focused on an indirect sales model
executed through OEMs and large resellers, such as EMC, IBM, HDS, HP, STK,
Sun and Dell, and our distributors and system integrators. We support these
distribution customers in a direct-assist sales model with our field sales and
service personnel. In order to be competitive, we may need to increase our
field sales team and we may need to enhance our direct-assist model and
5
contact with end-user customers to create product pull through our
channels. With regard to our Eclipse® line of
Internetworking Switch products and our SANavigator® software, we
sell primarily through reseller, systems integrator and distributor channels,
and directly to end-user customers as necessary. We also offer our Professional Services directly and indirectly
through a number of our channels and other service providers. Our Professional
Services group is recognized within the industry as technical experts with
proven system design and deployment methodologies and comprehensive
multi-protocol education curricula.
Our OEMs and several of our large reseller
customers incorporate our directors and switches into their end-user customer
products that are installed and field-serviced by the partner’s technical
support organizations. IBM Global
Services provides our first level of field support for all products that are
sold through IBM and IBM Global Services and Anacomp provide first level field
support for products sold through our indirect channel partners (generally,
system integrators, smaller resellers and distributors). The sales cycle used in selling to an OEM
and large reseller customer can vary significantly in terms of its length and
complexity. Often, it involves the use of our testing labs or those of our
strategic partner to qualify the products through substantial testing. It also
often involves the submission of proposal documentation and presentations to
such customers. This sales process generally involves the combined efforts of
our sales and marketing, engineering and management teams and can take from
several weeks to more than one year.
In December of 1999, we entered into a
distribution agreement with HDS that governs HDS’ resale of our products. In May of 2000, we entered into a
five-year agreement for EMC to remarket, or rebrand, and resell our products to
end-user customers or for EMC to purchase our products for internal use. Under
the terms of this agreement, we provide varying degrees of support to EMC for
those products. We also entered into a resale agreement with IBM in
February of 2000 and another resale agreement in August of 2003 that
governs IBM’s purchases of our products and appoints IBM as a non-exclusive
authorized reseller of our products and services to IBM resellers and end-user
customers. In August 2002,
January 2003 and February of 2003, we entered into purchase agreements
with Dell, STK, and Sun, respectively.
None of these agreements provide for the purchase of a guaranteed
minimum amount of product.
As of January 31, 2004, our sales organization
was located in several major cities in the United States, Canada, Germany, the
United Kingdom, Japan, Austria, France, Italy, Norway, Australia, Hong Kong,
Korea, Switzerland, Singapore and China. Our sales and marketing organization
includes field sales personnel, systems engineers, channel sales professionals,
educational services providers and sales operations professionals.
For financial information about geographic areas and
segments, see Note 14 “Segment Information,” of the Notes to Consolidated
Financial Statements
Customer Service, Support and Solutions
We provide technical support to our OEM and reseller
customers and to systems integrators, enabling them to provide technical
support to their end-user customers. We do this by providing training and
documentation together with 24x7 support.
When a customer issue originates from our call center, we typically
remain in contact with the customer until the issue is resolved. Our customer support includes a
comprehensive array of full-service support elements, including: 24x7 call home
monitoring; spare parts depots; direct support through IBM Global Services and
Anacomp; field engineers, manufacturer-based technical support specialists and
regional support specialists available to handle on-site requirements. We have
been certified to ISO9001 standards since 1994 and we are now certified to
ISO9001:2000 standards.
Manufacturing
Our leased manufacturing facility, located in
Louisville, Colorado, is currently 91,000 square feet. In May 2004, upon
renewal of the operating lease, we plan to reduce the size of this leased
facility to approximately half of its current size given the manufacturing
outsourcing efforts we have implemented. We perform customer service repair and
logistics in this facility. We currently anticipate that this facility will be
adequate for our activities for the foreseeable future. Since
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November of 2001, we have been
transitioning to a more outsourced manufacturing model by moving a number of
manufacturing tasks to our contract manufacturers. Please see Note 13
“Commitments” of the Notes to Consolidated Financial Statements for a further
discussion of our outsourcing activities.
We subcontract a majority of our production activities, including the
manufacture, assembly and testing of a substantial portion of our products.
Sanmina–SCI, Inc. (SSCI) is the contract manufacturer for our printed
circuit boards, and they perform assembly, testing, box build and cabinet
integration for our directors. SSCI
also manufactures our Sphereon™ 3232 Fabric Switch. SSCI manufactures these
products in Fountain, Colorado.
Solectron Corporation (Solectron) is the contract manufacturer for our
Sphereon™ 4500 and 4300 Fabric Switches and for our Eclipse® 1620
Switch. Solectron manufactures these products in Austin, Texas and Guadalajara,
Mexico. SSCI and Solectron have
multiple sites in multiple countries that can be used to significantly expand
their manufacturing capacity. Pycon
Incorporated (Pycon) manufactures the Eclipse® 3300
and 4300 Switch products in San Jose, California. We currently depend upon LSI Logic and IBM for the production of
all of our custom ASICs.
We depend on SSCI, Solectron, Pycon, IBM, LSI Logic
and our other subcontractors to deliver high-quality products in a timely
manner, but we cannot be assured that they will be able to do so. We do not have long-term supply contracts
with any of our subcontractors and we are subject to component supply
shortages.
We design test processes for all of our products to
identify the causes and measure the frequency of product failures. We and our
major suppliers use these test processes in connection with the manufacture of
our products. For certain of our high reliability products, our tests include
environmental stress screening, which seeks to ensure product performance and
reduce premature product failures, and other test processes, designed to
identify product defects prior to shipping. In addition to qualifying our
products, we also qualify our component suppliers based on their ability to
manufacture components within defined specifications.
Research and Development
The SAN and other information infrastructure markets
are characterized by rapid technological change, including changes in customer
requirements, frequent new product introductions and enhancements, and evolving
industry standards. We believe that continued research and development efforts
are an important factor in our ability to maintain technological
competitiveness. We employ individuals in engineering and development efforts
that are focused on the development, enhancement and testing of directors and
switches, ASICs and the associated software offerings that address the needs of
the SAN market. We intend to dedicate resources to the continued development of
the Fibre Channel and other protocol standards, and to achieve interoperability
with the storage networking devices of other companies. Finally, our Systems Integration Lab located
in Broomfield, Colorado is the industry’s premiere fibre channel switched
fabric interoperability lab and is staffed by fibre channel and open systems
experts.
Our research and development expenditures were
approximately $89 million in fiscal year 2003, $59 million in fiscal year
2002, and $49 million in fiscal year 2001.
Competition
The
market for our multi-protocol SAN switching hardware and software products is
highly competitive, especially with the entrance of competitors from the IP
based switch market. Our competitors are providing SAN switching hardware and
software that is multi-protocol capable such as Fibre Channel over IP (FCIP),
SCSI over Internet (iSCSI), Internet Fibre Channel (iFCP) and InfiniBand(IB).
Our competitors in the this market include Brocade, CNT, Cisco, QLogic Corp.,
Emulex Corporation (which recently acquired Vixel Corporation), Broadcom
Corporation (which acquired the assets of Gadzoox Networks), Veritas Software
Corporation, Fujitsu Softech and others, including storage hardware device
providers. Given the recent market share gain by Cisco, other IP-based
switching companies such as Juniper, Extreme, and Foundry may enter the market
for multi-protocol SAN products. A number of our current and potential
competitors have longer operating histories, greater name recognition, access
to larger customer bases, more established distribution channels and
substantially greater financial and managerial resources. Given the highly
competitive market, we
7
anticipate continued
elongated sales cycles and continued pricing pressures. To remain competitive, we may have to
substantially increase headcount in our direct-assist sales model to enhance
direct end-user customer touch.
Intellectual Property
Our success depends on our ability to protect our
proprietary technology and to operate without infringing the proprietary rights
of third parties. We rely on a combination of patents, copyrights, trademarks
and trade secrets, as well as confidentiality agreements and other contractual
restrictions with employees and third parties, to establish and protect our
proprietary rights. We cannot be assured that the steps we take to protect our
intellectual property will adequately protect our proprietary rights; that
others will not copy or otherwise obtain and use our products and technology
without authorization, independently develop or otherwise acquire equivalent or
superior technology; or that we can maintain such technology as trade
secrets. In addition, the laws of some
of the countries in which our products are or may be sold may not protect our
proprietary rights as fully as do the laws of the United States.
Currently, we hold 37 U.S. patents and have 50
additional U.S. patents pending (including 13 pending for SANavigator®).
We are seeking additional patent protection for certain additional aspects of
our technology. However, it is possible that patents may not be issued for
these applications. It is possible that litigation may be necessary in the
future to enforce our intellectual property rights, to protect our trade
secrets or to determine the validity and scope of the proprietary rights of
others. Litigation could result in substantial costs and diversion of our
resources and could materially harm our business. From time to time, we have
received, and may receive in the future, notice of claims of infringement of
other parties’ proprietary rights. Infringement or other claims could be
asserted or prosecuted against us in the future, and it is possible that past
or future assertions or prosecutions could harm our business. Any such claims,
with or without merit, could be time-consuming, result in costly litigation and
diversion of technical and management personnel, cause delays in the
development and release of our products, or require us to develop alternative
non-infringing technology or enter into royalty or licensing arrangements. Such
royalty arrangements, if required, may not be available on terms acceptable to
us, or at all. For these reasons, infringement claims could materially harm our
business.
Under the terms of the May 2000 Master Confidential
Disclosure and License Agreement between EMC and us, EMC has granted us a
license to then existing EMC patents and we granted EMC a license under then
existing McDATA patents. If we are
acquired, our acquirer will retain this license as long as our acquirer grants
to EMC a license under all of the acquirer’s patents for those products
licensed under the agreement under the same terms as the license we have
granted to EMC under the agreement. The potential for a loss of the license
from EMC after an acquisition may make an acquisition of us by a third party
unlikely.
EMC and IBM entered into a cross-license agreement
on March 19, 1999, and amended that agreement on May 12, 2000, under
which each party, on behalf of itself and its subsidiaries, granted the other a
license under patents issued or issuing on applications entitled to an
effective filing date through December 31, 2005. Under the terms of this
cross-license agreement, patents held by us were licensed to IBM and patents
held by IBM were sublicensed to us by EMC. Each party released the other and
its subsidiaries from claims of patent infringement committed prior to the date
of the cross-license. Effective as of the February 7, 2001 distribution of
our Class A common stock by EMC, IBM, pursuant to the cross-license
agreement, retained the benefit of a license to our patents with an effective
filing date through the date of such distribution, but the sublicense to us
under IBM patents terminated upon such date in accordance with the terms of the
cross license agreement. We believe that the termination of the sublicense does
not materially affect our business.
Employees
At January 31, 2004, we had 1022 full-time
employees. Of these employees, 412 were engaged in engineering and development,
352 in sales and marketing, 105 in manufacturing and customer support, and 153
in finance and administration. None of our employees are represented by a labor
union. We have not experienced any
8
work stoppages and consider our
relations with our employees to be good. In January 2004, we announced a
9% reduction in force (RIF) of our employee base (See Note 4 to our Notes to
the Consolidated Financial Statements). We currently anticipate that we will
only need to hire additional employees for sales and certain other critical
positions in 2004 to meet the expected growth of our business.
Available Information
Our company web site is located at www.mcdata.com.
Our web site contains a link to a third party SEC filings web site that makes
our filings with the SEC available free of charge as soon as reasonably
practicable after they are electronically filed with the SEC. Our filings with
the SEC are available free of charge by contacting:
McDATA Corporation
Attn: Investor Relations
380 Interlocken Crescent
Broomfield, Colorado 80021
(720) 558-8000
9
Risk Factors
Risks Relating to
Our Business
Changing
Market Conditions and Increased Competitive Risks.
The
market for our multi-protocol storage area networking (SAN) products and
solutions has grown and will continue to become more competitive with (a) the
entrance of new competitors from the IP based switching market into our market,
(b) pricing pressures resulting from this increase in competitive SAN networking
products and solutions, (c) challenges to our direct-assist sales model with
distribution through channels when our competitors engage end-user customers
directly or otherwise have the ability to drive end-user customer preference
for SAN equipment through their traditional IP networking presence and
relationships, and (d) anticipated competition from our own storage OEM
partners through their recent acquisitions of, or alliances with, competitive
software management products and/or application providers that would utilize
the intelligence in the network. As a result of these market changes, we
anticipate continued lengthened sales cycles and price erosion in an
environment where storage OEM certification of our products may still be
required for end-user customer acceptance. Given our direct-assist sales model
with distribution through our channel partners, we are highly dependent upon
our channel partners’ relationships with end-user customers to promote the
value of our products. If our channel partners do not promote the value of our
products or competitors begin to control end-user customer preference, we may
lose sales in key enterprise accounts that would materially adversely affect
our revenues.
We are highly dependent on our OEM sellers,
especially EMC, and efforts by them to reduce the prices of their suppliers may
decrease our revenue and gross margins.
We
are highly dependent on our OEM partners, especially EMC, and efforts by them
to reduce the prices of their suppliers may decrease our revenue and gross
margins. For example, given our
concentration of sales with EMC, the revenue shortfall with EMC experienced in
the fiscal quarter ending October 31, 2003 and EMC’s public statements
that they will further reduce their suppliers’ prices, we may experience
unanticipated decreases in sales revenue and gross margins that may lead us to
be unprofitable. The above-mentioned factors may also strain business
relationships with our storage OEM partners and may adversely affect the
qualification and certification of our products. Moreover, the introduction of
such new products and any pending qualification and certification by our
partners may stall sales of our existing products with end user customers. Given the dependencies on our limited number
of OEM resellers combined with an increasingly competitive environment, we may
experience continued adverse price pressures at critical times near the end of
the fiscal quarters.
New
competitors have entered this market and we may not be able to successfully
compete against existing or potential competitors.
The market for our multi-protocol SAN switching hardware and software
products is highly competitive, especially with the entrance of competitors
from the IP based switch market. Our competitors are providing or plan to
provide SAN switching hardware and software that is multi-protocol capable
(such as Fibre Channel over IP (FCIP), SCSI over Internet (iSCSI), Internet
Fibre Channel (iFCP) and InfiniBand). Our competitors in the this market
include Brocade, CNT, Cisco, QLogic Corp., Emulex Corporation (which recently
acquired Vixel Corporation), Broadcom Corporation (which acquired the assets of
Gadzoox Networks), Veritas Software Corporation, Fujitsu Softech and others,
including storage hardware device providers. Given the market share gain by
Cisco, other IP based switching companies such as Juniper, Extreme, Foundry and
others may enter the market for multi-protocol SAN products. Many of our
competitors and potential competitors have longer operating histories, greater
name recognition, access to larger customer bases, more established
distribution channels and substantially greater financial and managerial
resources than McDATA. Given the highly competitive market, we anticipate
continued lengthened sales cycles and continued downward pricing
pressures. To be competitive, we may
have to substantially increase headcount in our direct-assist sales model and
migrate to a direct end-user customers touch and possibly to direct sales,
which we may not be able to do successfully and
10
which, in any
case, will increase expenses. Continued or increased competition could
result in pricing pressures, reduced sales, reduced margins, reduced profits,
reduced market share, further elongating of sales cycles, or the failure of our
products to achieve or maintain market acceptance.
We incurred
a substantial loss for the fiscal years ended January 31, 2004,
December 31, 2002 and December 31, 2001 and may not be profitable in
the future.
We
incurred losses of $43.1 million, $10.0 million and $8.7 million, respectively,
for the fiscal years ended January 31, 2004, December 31, 2002 and
December 31, 2001. Our future
operating results will depend on many factors, including the growth of the
multi-protocol (Fibre Channel and IP) market, market acceptance of new products
we introduce, demand for our products, levels of product and price competition
and our reaching and maintaining targeted costs for our products. In addition,
we expect to incur continued significant product development, sales and
marketing, and general and administrative expenses. We cannot provide assurance
that we will generate sufficient revenue to achieve or sustain profitability.
The prices
and gross margins of our products may decline, which would reduce our revenues
and profitability.
In
response to changes in product mix, competitive pricing pressures, increased
sales discounts, introductions of new competitive products, product
enhancements by our competitors, increases in manufacturing or labor costs or
other operating expenses, we may experience declines in the prices, gross
margins and profitability. To maintain our gross margins we must maintain or
increase current shipment volumes, develop and introduce new products and
product enhancements and reduce the costs to produce our products. Moreover,
most of our expenses are fixed in the short-term or incurred in advance of
receipt of corresponding revenue. As a result, we may not be able to decrease our
spending to offset any unexpected shortfall in revenues. If this occurs, we
could incur losses, and our revenue, gross margins and operating results may be
below our expectations and those of investors and stock market analysts.
We depend
on two key distribution relationships for most of our revenue and the loss of
either of them could significantly reduce our revenues.
We
depend on EMC and IBM, for a significant portion of our total revenue. Sales to
EMC and IBM represented approximately 56% and 21%, respectively, of our revenue
for the fiscal year ended January 31, 2004. We anticipate that our future
operating results will continue to depend heavily on sales to EMC and IBM. EMC
and IBM resell products offered by our competitors, and nothing restricts EMC
and IBM from expanding those relationships in a manner that could be adverse to
us. Therefore, the loss of either EMC and IBM as a customer, or a significant
reduction in sales to either EMC and IBM could significantly reduce our
revenue. While we are aware that Dell sources some of our switch product
through EMC, it is unclear whether this mitigates our dependency on EMC. Our
product sales agreements with sales partners do not provide for the purchase of
a guaranteed minimum amount of product.
We currently
have limited product offerings and must successfully introduce new products and
product enhancements that respond to rapid technological changes and evolving
industry standards.
For
the fiscal year ended January 31, 2004, we derived a significant portion
of our revenue from sales of our director-class IntrepidTM switch
products. We expect that revenue from our director-class IntrepidTM
switch products will continue to account for a substantial portion of our
revenue for the foreseeable future. Factors such as performance, market
positioning, the availability and price of competing products, the introduction
of new technologies and the success of our OEM, reseller and systems integrator
customers will affect the market acceptance of our products. Therefore, continued market acceptance of
these products and their successor products, along with our SphereonTM
and Eclipse® switches, are critical to our future success.
11
In
addition, our future success depends upon our ability to address the changing
needs of customers and to transition to new technologies and industry
standards. The introduction of competing products embodying new technologies or
the emergence of new industry standards could render our products
non-competitive, obsolete or unmarketable and seriously harm our market share,
revenue and gross margin. Risks inherent in transitions to new technology,
industry standards and new protocols include the inability to expand production
capacity to meet demand for new products, write-downs of our existing inventory
due to obsolescence, the impact of customer demand for new products or products
being replaced, and delays in the introduction or initial shipment of new
products. There can be no assurance that we will successfully manage these
transitions.
We
are currently developing products that contain untested devices and
subassemblies. As with any development, there are inherent risks should such
devices or subassemblies require redesign or rework. In particular, in
conjunction with the transition of our products from fibre channel to
multi-protocol, 2 Gb to 4Gb to 10 Gb transmission speed technology, higher port
densities, and advanced management capabilities, we will be introducing
products with new features and functionality, such as our next generation
director-class switch product, the Intrepid™ 10000 Director. We face risks relating to this product
transition, including risks relating to getting storage and system OEMs to
qualify such products, forecasting of demand, as well as possible product and
software defects and a potentially different sales and support environment due
to the complexity of these new systems. Finally, if we fail to introduce new
products timely, or to add new features and functions to existing products to
compete against new entrants in the market, or if there is no demand for these
or our current products, our business could be seriously harmed.
Risks
related to recent acquisitions.
In
September 2003, we closed our acquisitions of Nishan Systems, Inc.
(Nishan) and Sanera Systems, Inc. (Sanera). While management believes that such
acquisitions are an integral part of their long-term strategy, there are risks
and uncertainties related to acquiring companies that have limited or no
product sales to date. Our success depends upon integrating Nishan and Sanera
with McDATA, finalizing the development of such products, retaining critical
employees from the acquired companies, qualifying such products with our OEM
and reseller partners and ramping sales of those products with such partners.
Our
business is subject to risks from global operations.
We
conduct significant sales and customer support operations in countries outside
of the United States and also depend on non-U.S. operations of our contract
manufacturers, and our distribution partners. Further, we utilize an India
based firm to provide certain software engineering services, and our
virtualization chip supplier, Aarohi Communications, is also reliant on
offshore engineering. We derived approximately 33% of our revenue for the
fiscal year ended January 31, 2004, from customers located outside of the
United States. We believe that our continued growth and profitability will
require us to continue to expand marketing and selling efforts internationally.
We have limited experience in marketing, distributing and supporting our
products internationally and may not be able to maintain or increase
international market demand for our products. In addition, our international
operations are generally subject to inherent risks and challenges that could
harm our operating results, including:
• expenses
associated with developing and customizing our products for foreign countries;
• difficulties in
staffing and managing international operations, including reliance on third
parties to manage certain aspects of our foreign operations, including hub
inventory locations;
• multiple,
conflicting and changing governmental laws and regulations;
• tariffs, quotas
and other import or export restrictions, trade protection measures and other
regulatory requirements on computer peripheral equipment;
• longer sales
cycles for our products;
• reduced or
limited protections of intellectual property rights;
• adverse tax
consequences, including imposition of withholding or other taxes on payments by
subsidiaries and customers;
12
• compliance with
international standards that differ from domestic standards;
• risks
surrounding any product and software outsourcing activities in foreign
countries; and
• political, social and economic instability in
a specific country or region.
Any
negative effects on our international business could harm our business,
operating results and financial condition as a whole. To date, substantially
all of our international revenue or costs have been denominated in U.S.
dollars. As a result, an increase in the value of the U.S. dollar relative to
foreign currencies could make our products more expensive and thus less
competitive in foreign markets. A portion of our international revenue may be
denominated in foreign currencies in the future, which will subject us to risks
associated with fluctuations in those foreign currencies.
Unforeseen
environmental costs could impact our future net earnings.
Some of our operations use substances regulated under
various federal, state and international laws governing the environment,
including those governing the discharge of pollutants into the air and water,
the management and disposal of hazardous substances and wastes and the cleanup
of contaminated sites. Certain of our products are subject to various federal,
state and international laws governing chemical substances in electronic
products. We could incur costs, fines and civil or criminal sanctions,
third-party property damage or personal injury claims if we were to violate or
become liable under environmental laws. The ultimate costs under environmental
laws and the timing of these costs are difficult to predict.
The European Union has finalized the Waste Electrical
and Electronic Equipment Directive, which makes producers of electrical goods
financially responsible for specified collection, recycling, treatment and
disposal of past and future covered products. This directive must now be enacted
and implemented by individual European Union governments by August 13,
2004 (such legislation together with the directive, the “WEEE Legislation”),
and certain producers are to be financially responsible under the WEEE
Legislation beginning in August 2005. In addition, the European Parliament
has enacted a requirement for the recovery of hazardous substance (RoHS). This legislation governs the recovery of
such substances as mercury, lead, cadmium, and hexavalent cadmium. We are
currently reviewing the applicability of WEEE and RoHS Legislation to our
electronic products. Accordingly, we
cannot currently estimate the extent of increased costs resulting from the WEEE
and RoHS Legislation. Similar legislation may be enacted in other geographies,
including federal and state legislation in the United States, the cumulative
impact of which could be significant costs.
Increased
international political instability may decrease customer purchases, increase
our costs and disrupt our business.
Increased
international political instability as demonstrated by the September 11,
2001 terrorist attacks, disruption in air transportation and enhanced security
measures as a result of the terrorist attacks and increasing tension in the
Middle East, may hinder our ability to do business and may increase our costs.
Additionally, this increased instability may, for example, negatively impact
the capital markets and the reliability and cost of transportation and
adversely affect our ability to obtain adequate insurance at reasonable rates
or require us to incur costs for extra security precautions for our operations.
In addition, to the extent that air transportation is delayed or disrupted, the
operations of our contract manufacturers and suppliers may be disrupted, particularly
if shipments of components and raw materials are delayed. If this international
political instability continues or increases, our business and results of
operations could be seriously harmed and we may not be able to obtain financing
in the capital markets.
If we lose
key personnel or if we are unable to hire additional qualified personnel, we
may not be successful.
Our
success depends to a significant degree upon the continued contributions of our
key management, technical, sales and marketing, finance and operations
personnel, many of whom would be difficult to replace. In particular, we
believe that our future success is highly dependent on our senior executive
team. In the past we
13
have experienced high
turnover in our senior executive team. A significant portion of the current
senior executive team was hired during the last year and a half. Although our
senior executive team consists of experienced members, many of them are new to
our company and industry and have only worked with each other for a relatively
short period of time. As a result they may not operate efficiently as part of
an integrated management team.
In
addition, our engineering and product development teams are critical in developing
our products and have developed important relationships with customers and
their technical staffs. The loss of any of these key personnel, including our
senior sales staff, could harm our operations and customer relationships. We do
not have key person life insurance on any of our key personnel. Given our
recent acquisitions of Nishan and Sanera, a large percentage of our engineering
development team is now located in California, is new to the Company and may
not operate as efficiently during the transition period. In January 2004,
we announced a 9% reduction in-force (RIF) of our employee base and we are
closing down our Canadian engineering operations.
We
believe our future success will also depend in large part upon our ability to
attract and retain highly skilled managerial, engineering, sales and marketing,
and finance and operations personnel. If we increase our production and sales
levels, we will need to attract and retain additional qualified skilled workers
for our operations. In the last year, there has been an increasing demand for
such personnel by companies, some of which are larger and have greater
resources to attract and retain highly qualified personnel. We cannot assure
you that we will continue to be able to attract and retain qualified personnel,
or that delays in hiring required personnel, particularly engineers, will not
delay the development or introduction of products or materially adversely
impact our ability to sell our products.
Risks
related to internal controls.
Public companies in the United States are required to review their
internal controls under the Sarbanes-Oxley Act of 2002. It should be noted that any system of
controls, however well designed and operated, can provide only reasonable, and
not absolute, assurance that the objectives of the system are met. In addition,
the design of any control system is based in part upon certain assumptions
about the likelihood of future events. Because of these and other inherent
limitations of control systems, there can be no assurance that any design will
succeed in achieving its stated goals under all potential future conditions,
regardless of how remote. If the internal controls put in place by us are not
adequate or in conformity with the requirements of the Sarbanes-Oxley Act of
2002, and the rules and regulations promulgated by the Securities and Exchange
Commission, we may be forced to restate our financial statements and take other
actions which will take significant financial and managerial resources, as well
as be subject to fines and other government enforcement actions. See Item 9A-Controls and Procedures for
discussion of a third quarter balance sheet reclassification/restatement
pertaining to our securities lending program.
If we are
unable to adequately protect our intellectual property, we may not be able to
compete effectively.
We
rely on a combination of patent, copyright, trademark and trade secret laws and
restrictions on disclosure to protect our intellectual property rights. We also
enter into confidentiality and/or license agreements with our employees,
consultants and corporate partners. Despite our efforts to protect our
proprietary rights, unauthorized parties may copy or otherwise obtain and use
our products or technology. Monitoring unauthorized use of our products is
difficult and we may not be aware that someone is using our rights without our
authorization. In addition, the steps we have taken, and those we may take in
the future, may not prevent unauthorized use of our technology, particularly in
foreign countries where the laws may not protect our proprietary rights as
fully as in the United States.
We
may be a party to intellectual property litigation in the future, either to
protect our intellectual property or as a result of alleged infringements of
others’ intellectual property. For a discussion of our IP litigation, please
see Note 13 of the Consolidated Financial Statements.
14
These
or other claims and any resulting litigation or arbitration could subject us to
significant costs, liability for damages or could cause our proprietary rights
to be invalidated or deemed unenforceable, which could allow third parties to
use our rights without reservation. Litigation or arbitration, regardless of the
merits of the claim or outcome, would likely be time consuming and expensive to
resolve and would divert management time and attention. Any potential intellectual property
litigation filed against us could also force us to do one or more of the
following:
• stop using the
challenged intellectual property or selling our products or services that
incorporate it;
• obtain a license
to use the challenged intellectual property or to sell products or services
that incorporate it, which license may not be available on reasonable terms, or
at all; and
• redesign those products or services that are
based on or incorporate the challenged intellectual property.
If
we are forced to take any of these actions, we may be unable to manufacture and
sell our products, our customer relationships would be seriously harmed and our
revenue would be reduced.
In
March 1999, we, as an EMC subsidiary, granted IBM a license to all of our
patents under a cross license agreement between IBM and EMC. Under the terms of
that agreement, effective upon EMC’s February 7, 2001 distribution of our
Class A common stock to its stockholders, the sublicense we previously held to
those IBM patents terminated. We believe that the termination of the sublicense
does not materially affect our business. We are not aware of any issued or
pending IBM patents that are infringed by our products, but if IBM were to
allege any such infringement, and we were unable to negotiate a settlement with
IBM, our ability to produce the alleged infringing product could be affected,
which could materially and adversely affect our business.
We have
experienced increased inventory costs and delays and have incurred
inventory-related write-downs.
During
fiscal year 2002, we incurred a net $9.5 million inventory related charge
related primarily to our 1 Gb product inventory. There can be no assurance that
we will not incur additional inventory write-downs in the future or that any
such write-downs would not have a material adverse affect on our future
operating results.
The
multi-protocol SAN market in which we compete is still developing, and if this
market does not continue to develop and expand as we anticipate, our business
will suffer.
The
market for multi-protocol SAN and related products is still developing and continues
to evolve. Because this market is relatively new, it is difficult to predict
its potential size or future growth rate. Potential end-user customers who have
invested substantial resources in their existing data storage and management
systems may be reluctant or slow to adopt a new approach, like multi-protocol
SANs. Our success in generating net revenue in this developing market will
therefore depend on, among other things, our ability to:
• educate
potential OEMs, reseller and systems integrator customers and end users about
the benefits and the use of our products in the SAN environment; and
• predict, develop and base our products on
standards that ultimately become industry standards.
Accordingly,
because substantially all of our revenues are derived from our Fibre Channel
SAN solutions, our ability to provide multi-protocol and multi-capable products
and solutions is critical to our future success and delays or a failure to
provide such products and solutions could have a material adverse effect on our
revenue and operations.
If we fail
to optimize our distribution channels and manage our distribution
relationships, our revenue or operating results could be significantly
reduced. Our competitors may sell their
products directly to end-user customers.
15
Our
success will depend on our continuing ability to develop and manage
relationships with significant OEMs, resellers and systems integrators, as well
as on the sales efforts and success of these customers. We cannot provide
assurance that we will be able to expand our distribution channels or manage
our distribution relationships successfully or that our customers will market
our products effectively. Our failure to expand our distribution channels or
manage successfully our distribution relationships or the failure of our OEM
and reseller customers to sell our products could reduce our revenue and
operating results. Moreover, to the extent our competitors sell directly to
end-user customers, we may not be able to compete given the lack of a direct
sales force and the current inability to directly provide first and second
level customer support. If this occurs, we may need to substantially invest in
a direct sales force and direct customer support which would increase our
expenses.
We are
dependent on a single or limited number of suppliers for certain key components
of our products, and the failure of any of those suppliers to meet our
production needs could seriously harm our ability to manufacture our products,
result in delays in the delivery of our products and harm our revenue.
We
currently purchase several key components from single or limited sources. We
purchase application specific integrated circuits (ASICs), special purpose
processors and power supplies from single sources, and gigabit interface
converters and optic transceivers from limited sources. Additional sole or
limited sourced components may be incorporated into our products in the future.
Delays in the delivery of components for our products could result in delays or
the inability to meet our customers’ demands and result in decreased revenue.
We do not have any long-term supply contracts to ensure sources of supply of
components. In addition, our suppliers may enter into exclusive arrangements
with our competitors, stop selling their products or components to us at
commercially reasonable prices or refuse to sell their products or components
to us at any price, which could harm our operating results. Further, we have
purchased components from our suppliers from time to time that have been
subsequently found not to meet the supplier’s published specifications. If our
suppliers are unable to provide (or we are unable otherwise to obtain)
components for our products on the schedule and in the quantities and
quality we require, we will be unable to manufacture our products. We have
experienced and may continue to experience production delays and quality
control problems with certain of our suppliers, which, if not effectively
managed, could prevent us from satisfying our production requirements. If we
fail to effectively manage our relationships with these key suppliers, or if
our suppliers experience delays, disruptions, capacity constraints or quality
control problems in their manufacturing operations, our ability to manufacture
and ship products to our customers could be delayed, and our competitive
position, reputation, business, financial condition and results of operations
could be seriously harmed.
The loss of
our contract manufacturers, or the failure to forecast demand accurately for
our products or to manage our relationship with our contract manufacturers
successfully, would negatively impact our ability to manufacture and sell our
products.
We
rely on Sanmina SCI, Inc. (SSCI), Solectron Corporation, Pycon Incorporated,
IBM and LSI Logic, together our contract manufacturers, to manufacture our
products. Our contract manufacturers are not obligated to supply products to us
for any specific period, or in any specific quantity, except as may be provided
in a particular purchase order. In addition, our contract manufacturers do not
guarantee that adequate capacity will be available to us within the time
required to meet additional demand for our products. We generally place forecasts
for products with our contract manufacturers approximately four to five months
prior to the anticipated delivery date, with order volumes based on forecasts
of demand for our products. We generally place purchase orders sixty calendar
days in advance of delivery. If we fail to forecast demand for our products
accurately, we may be unable to obtain adequate manufacturing capacity from our
contract manufacturers to meet our customers’ delivery requirements or
unexpected increases in customer purchase orders. As a result, we may not be
able to benefit from any incremental demand and could lose customers. If we
over-estimate demand for our product, we may accumulate excess inventories and
obligations to our contract manufacturers under binding purchase orders in
excess of our needs. At January 31, 2004, our commitment with our contract
manufacturers for purchases and anticipated transformation costs over the next
sixty days totaled approximately $48.1 million.
16
In
addition, we coordinate our efforts with those of our component suppliers and
contract manufacturers in order to rapidly achieve volume production. We have
experienced and may continue to experience production delays and quality
control problems with certain of our suppliers and with our contract
manufacturers, which, if not effectively managed, could prevent us from
satisfying our production requirements on a timely basis and could harm our
customer relationships. If we should fail to manage effectively our
relationships with our component suppliers or contract manufacturers, or if any
of our suppliers or our manufacturers experience delays, disruptions, capacity
constraints or quality control problems in their manufacturing operations, our
ability to ship products to our customers could be delayed, and our competitive
position and reputation could be harmed. Qualifying a new contract manufacturer
and commencing volume production can be expensive and time consuming. If we are
required to change or choose to change contract manufacturers, we may lose
significant revenue and seriously damage our customer relationships.
The
continued general economic slowdown may significantly reduce expenditures on
information technology infrastructure.
Unfavorable
general economic conditions over the last 3 plus years have had a pronounced
negative impact on information technology, or IT, spending. Demand for SAN
products in the enterprise-class sector may continue to be adversely impacted
as a result of the weakened economy and because larger businesses have begun to
focus on more efficiently using their existing IT infrastructure rather than
making new equipment purchases. This in turn may decrease the demand for our
SAN products. If there are further reductions in either domestic or
international IT expenditure, or if IT expenditure does not increase from
current levels, our revenues, operating results and financial condition may be
materially adversely affected.
Failure to
manage expansion effectively could seriously harm our business, financial
condition and prospects.
Our
ability to successfully implement our business plan, develop and offer
products, and manage expansion in a rapidly evolving market requires a
comprehensive and effective planning and management process. We continue to
increase the scope of our operations domestically and internationally. In
addition, in September 2003, we acquired Sanera and Nishan which
significantly increased the size of our operations. Our growth in business and relationships with customers and other
third parties has placed, and will continue to place, a significant strain on
management systems, resources, intercompany communication and coordination. As
we grow, our failure to maintain and to continue to improve upon our operational,
managerial and financial controls, reporting systems, processes and procedures,
and /or our failure to continue to expand, train, and manage our work force
worldwide, could seriously harm our business and financial results.
If we fail
to successfully develop the McDATA brand, our revenue may not grow.
Our
name is not widely recognized as a brand in the marketplace given our indirect
sales model. We believe that establishing and maintaining the McDATA brand is a
critical component in maintaining and developing strategic OEM, reseller and
systems integrator relationships, and the importance of brand recognition will
increase as the number of vendors of competitive products increases. Our
failure to successfully develop our brand may prevent us from expanding our
business and growing our revenue. Similarly, if we incur excessive expenses in
an attempt to promote and maintain the McDATA brand, our business, financial
condition and results of operations could be seriously harmed.
Undetected
software or hardware defects in our products could result in loss of or delay
in market acceptance of our products and could increase our costs or reduce our
revenue.
Our
products may contain undetected software or hardware errors when first
introduced or when new versions are released. Our products are complex, and we
have from time to time detected errors in existing
17
products. In addition, our
products are combined with products from other vendors. As a result, should
problems occur, it might be difficult to identify the source of the problem.
These errors could result in a loss of or delay in market acceptance of our
products, cause delays in delivering our products or meeting customer demands
and would increase our costs, reduce our revenue and cause significant customer
relations problems. Errors could also result in the need for us to upgrade
existing products at customer locations which would increase our costs or cause
significant customer relations problems.
We are a
defendant in a class action lawsuit and we may be subject to further litigation
in the future which could seriously harm our business.
As
more fully set forth in Note 13 to our Consolidated Financial Statements, we
are a defendant in a consolidated securities class action know as In Re Initial Public Offering Securities Litigation
(SDNY). We may become subject to additional class action litigation
following a period of volatility in the market price of our common stock. Securities class action litigation results
in substantial costs and diverts the attention of management and our resources
and seriously harms our business, financial condition and results of
operations.
Our change
of fiscal year may not result in more predictable quarterly earnings.
Historically,
our quarterly operating results have depended on our performance in the later
part of each calendar quarter, when a large percentage of our product shipments
typically occur. This fluctuation has made consistent quarter-to-quarter performance
and revenue forecasting difficult. We have adopted a number of measures to
address this issue, including changing our fiscal year end to January 31,
rather than December 31. We cannot be certain that changing our fiscal
year or adopting other measures will result in product shipments occurring more
evenly during each quarter, resulting in consistent quarter-to-quarter
performance or improving revenue forecasts.
Additional
factors that affect us and which could cause our revenue and operating results
to vary in future periods include:
• the size,
timing, terms and fluctuations of customer orders, particularly large orders
from EMC, IBM or HDS;
• pricing
discussions late in a quarter and a limited capability to ramp shipments near
the end of that quarter;
• our ability to
attain and maintain market acceptance of our products;
• seasonal
fluctuations in customer buying patterns;
• the timing of
the introduction of or enhancement to, products by us, our significant OEM or
reseller customers or our competitors (e.g., transition to higher speed, higher
port density and multi-protocol products);
• our ability to obtain sufficient supplies of
single- or limited-source components of our products; and
• increased operating expenses, particularly in
connection with our strategies to increase customer touch and purchase
preference for our products or to invest in research and development.
Our
uneven sales pattern makes it difficult for our management to predict near-term
demand and adjust manufacturing capacity. Further, our OEM and reseller
partners may purchase certain of our products ahead of end-user customer
demand, which could reduce subsequent purchases by those partners. Accordingly,
if orders for our products vary substantially from the predicted demand, our
ability to assemble, test and ship orders received in the last weeks and days
of each quarter may be limited, which could seriously harm quarterly revenue or
earnings. Moreover, an unexpected decline in revenue without a corresponding
and timely reduction in expenses could intensify the impact of these factors on
our business, financial condition and results of operations.
The sales
cycle for our products is long, and we may incur substantial non-recoverable
expenses and devote significant resources to prospects that do not produce
revenues in the foreseeable future or at all.
18
Our
OEMs, reseller and systems integrator customers typically conduct significant
evaluation, testing, implementation and acceptance procedures before they begin
to market and sell new solutions that include our products. This evaluation
process is lengthy and may extend up to one year or more. This process is
complex and may require significant sales, marketing and management efforts on
our part. This process becomes more complex as we simultaneously qualify our
products with multiple customers. As a result, we may expend significant
resources to develop customer relationships before we recognize revenue, if
any, from these relationships. Products that are not qualified by storage and
system OEMs and resellers, may not gain market acceptance. Our OEM and reseller customers have multiple
sources for products similar to ours, and as such, may not qualify our products
for any number of reasons.
We may
engage in future acquisitions that dilute our stockholders ownership and cause
us to use cash, incur debt or assume contingent liabilities.
As
part of our strategy, from time to time we expect to review opportunities to
buy other businesses or technologies that would complement our current
products, expand the breadth of our markets or enhance our technical
capabilities, or that may otherwise offer growth opportunities. We may buy
businesses, products or technologies in the future. In the event of any future
purchases, we could:
• issue stock 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
combining and integrating the purchased operations, technologies, personnel or
products;
• unanticipated
costs;
• diversion of
management’s attention from our core business;
• adverse effects
on existing business relationships with suppliers and customers;
• risks associated
with entering markets in which we have no or limited prior experience; and
• potential loss of key employees of acquired
organizations.
We
may not be able to successfully integrate any businesses, products,
technologies or personnel that we might acquire in the future. In addition,
technology acquisitions of start-up companies could result in one-time charges
related to acquisition costs, severance costs, employee retention costs and
in-process research and development.
We may
require, or could elect, to seek additional funding.
Our
future capital requirements will depend on many factors, including our rate of
revenue growth, the timing and extent of spending to support development of new
products and expansion of sales and marketing, the timing of new product
introductions and enhancements to existing products, any acquisitions of
businesses, and market acceptance of our products. With changes in operating
and industry expectations, we could require, or could elect, to seek additional
funding including accessing the equity and debt markets.
If we
become subject to unfair hiring claims, we could incur substantial costs in
defending ourselves.
Companies
in our industry whose employees accept positions with competitors frequently
claim that their competitors have engaged in unfair hiring practices or that
employees have misappropriated confidential information or trade secrets.
Because we often seek to hire individuals with relevant experience in our
industry, we may be subject to claims of this kind or other claims relating to
our employees in the future. We could incur substantial costs in defending
ourselves or our employees against such claims, regardless of their merits. In
19
addition, defending
ourselves or our employees from such claims could divert the attention of our
management away from our operations.
Our
products must comply with governmental regulation.
In
the United States, our products comply with various regulations and standards
defined by the Federal Communications Commission and Underwriters Laboratories.
Internationally, products that we develop will be required to comply with
standards established by authorities in various countries. In the last several
years, the European Union (EU) has adopted a number of initiatives (WEEE, RoHS,
etc.) related to equipment emissions, electronic waste, privacy of information
and expanded consumer warranties. Failure to comply with existing or evolving
industry standards or to obtain timely domestic or foreign regulatory approvals
or certificates could seriously harm our business.
Provisions
in our charter documents, our rights agreement and Delaware law could prevent
or delay a change in control of McDATA and may reduce the market price of our
common stock.
Provisions
of our certificate of incorporation, by-laws and rights agreement may
discourage, delay or prevent a merger, acquisition or other business
combination that a stockholder may consider favorable. These provisions
include:
• authorizing the
issuance of preferred stock without stockholder approval;
• providing for a
classified board of directors with staggered three year terms;
• limiting the
persons who may call special meetings of stockholders;
• requiring super-majority voting for
stockholder action by written consent;
• establishing
advance notice requirements for nominations for election to the board of
directors and for proposing other matters that can be acted on by stockholders
at stockholder meetings;
• prohibiting
cumulative voting for the election of directors;
• requiring
super-majority voting to effect certain amendments to our certificate of
incorporation and by-laws; and
• requiring parties to request board approval
prior to acquiring 15% or more of the voting power of our common stock to avoid
economic and voting dilution of their stock holdings.
We
are incorporated in Delaware and certain provisions of Delaware law may also
discourage, delay or prevent someone from acquiring or merging with us, which
may cause the market price of our common stock to decline.
Our stock
price is volatile.
The
market price of our common stock has been volatile. Because we are a technology
company, the market price of our common stock is usually subject to similar
volatility and fluctuations that occur in our sector and to our competitors.
This volatility is often unrelated or disproportionate to the operating
performance of our company and, as a result, the price of our common stock could
fall regardless of our performance.
Risks Related to Our Relationship With EMC
We have
entered into agreements with EMC that, due to our prior parent-subsidiary
relationship, may contain terms less beneficial to us than if they had been
negotiated with unaffiliated third parties.
In
October 1997, and in connection with the reorganization of our business,
we entered into certain agreements with EMC relating to our business
relationship with EMC. In addition, we have entered into agreements with EMC
relating to our relationship with EMC after the completion of our initial
public offering in August 2000 and the distribution by EMC of our Class A
common stock in February 2001. We have also entered into an OEM Purchase
and License Agreement with EMC that governs EMC’s purchases of our products and
20
grants EMC rights to use,
support and distribute software for use in connection with these products. The
agreement does not provide for the purchase of a guaranteed minimum amount of
product. These agreements were negotiated and made in the context of our prior
parent-subsidiary relationship. As a result, some of these agreements may have
terms and conditions, including the terms of pricing, that are less beneficial
to us than agreements negotiated with unaffiliated third parties. Sales and
services revenue pursuant to these agreements with EMC represented
approximately 56% of our revenue for the fiscal year ended January 31,
2004. In addition, in some instances, our ability to terminate these agreements
is limited, which may prevent us from being able to negotiate more favorable
terms with EMC or from entering into similar agreements with third parties.
Provisions
of our agreements with EMC relating to our relationship with EMC after the
distribution of our Class A common stock to EMC’s stockholders may prevent a
change in control of our company.
Under
the terms of the May 2000 Master Confidential Disclosure and License Agreement
between EMC and us, EMC has granted us a license to then existing EMC patents
and we granted to EMC a license to then existing McDATA patents. If we are
acquired, our acquirer will retain this license as long as our acquirer grants
to EMC a license under all of the acquirer’s patents for all products licensed
under the agreement under the same terms as the license we have granted to EMC
under the agreement. The potential loss of the license from EMC under this
agreement could decrease our attractiveness as an acquisition target.
We may be
obligated to indemnify EMC if the distribution of our Class A common stock to
EMC’s stockholders was not tax free.
The
May 2000 Tax Sharing Agreement that we have entered into with EMC obligates us
to indemnify EMC for taxes relating to the failure of EMC’s distribution to
EMC’s stockholders of our Class A common stock to be tax free if that failure
results from, among other things:
• any act or
omission by us that would cause the distribution to fail to qualify as a
tax-free distribution under the Internal Revenue Code;
• any act or
omission by us that is inconsistent with any representation made to the
Internal Revenue Service in connection with the request for a private letter
ruling regarding the tax-free nature of the distribution by EMC of our Class A
common stock indirectly held by it to its stockholders;
• any acquisition
by a third party of our stock or assets; or
• any issuance by
us of stock or any change in ownership of our stock.
While the risk associated with the Company’s
obligations under the Tax Sharing Agreement should diminish over time, the
Company’s tax years covered by the agreement, as it relates to the
Distribution, will remain open to examination by the IRS for at least three
years from the date the returns for those years were filed.
21
ITEM 2. Properties
Our principal facilities for administration, sales, marketing, customer
support, manufacturing, engineering and research and development are described
below.
|
Location
|
|
Size
|
|
Lease
Termination
|
|
General Use
|
|
|
|
|
|
|
|
|
|
1. 380 Interlocken Crescent, Broomfield, CO
|
|
100,207 sq.ft
|
|
April 2006
|
|
Admin, Sales, Support
|
|
2. 1722 Boxelder Street, Louisville CO (1)
Intended to commence March 2004:
|
|
91,497 sq. ft 45,552 sq. ft
|
|
March 2004 March 2009
|
|
Manufacturing, Product Test Facility
|
|
3. 4 McDATA parkway, Broomfield, CO
|
|
164,984 sq. ft
|
|
Owned
|
|
Engineering, Labs, Education and Support
|
|
4. 4555 Great America Parkway, Santa Clara,
CA (2)
Newly amended to:
|
|
23,542 sq. ft 103,622 sq. ft
|
|
June 2010 November 2016
|
|
Software Development SW, Engineering, Labs and Support
|
|
5. 3850 N. 1st Street, San Jose, CA (Nishan)
|
|
48,000 sq. ft
|
|
August 2004
|
|
Engineering, Labs, Support, and G&A
|
|
6. 370 San Aleso Ave., Sunnyvale, CA (Sanera)
|
|
32,538 sq. ft
|
|
July 2005
|
|
Engineering & Labs, G&A
|
|
7. 105 Commerce Valley Dr. West, Markham, ON (3)
|
|
19,045 sq. ft
|
|
June 2009
|
|
Engineering & Labs
|
(1) We are in the process of negotiating a new
lease that will reduce the size of our rented space at 1722 Boxelder
Street. We have signed a letter of
intent with the building owner that specifies a reduction of space down to
46,184 sq. ft and a new lease term of 5 years.
We intend for the new lease to terminate in March 2009. The new lease will also provide for an early
termination option in March 2007 in exchange for a 1-time payment if we
choose to exercise this option.
(2) We have recently signed a lease amendment
which increases the size of our rented space and lengthens the term of our
lease at 4555 Great America Parkway. We
intend to consolidate our three major California facilities into the newly
leased space at 4555 Great America Parkway.
It is our current intent to complete this consolidation by
August 2004. The new lease also
provides for early termination options in June 2010 and June 2011 in
exchange for a 1-time payment if we choose to exercise either of those options.
(3) We are in the process of closing this
facility as part of our January 2004 restructuring plan. We are subject to a long-term lease
obligation with regard to this facility.
In addition to the facilities discussed above, we also lease smaller
sales, marketing and administrative office space in various locations
throughout the world.
22
ITEM 3. Legal Proceedings
From
time to time, we become involved in various lawsuits and legal proceedings that
arise in the normal course of business. Litigation is subject to inherent risks
and uncertainties and an adverse result in a matter that may arise from time to
time may harm our business, financial condition or results of operations. While
it is the current opinion of management that the ultimate disposition of any of
the lawsuits described herein should not have a material adverse effect on our
business, financial condition or results of operations, we are incurring
significant legal costs and expenses, and such litigation is subject to
inherent risks and uncertainties. Please see Note 13 of the Notes to the
Consolidated Financial Statements for a description of significant litigation
matters.
ITEM 4. Submission of Matters to a Vote of Security Holders
No shareholder meeting was held in the fourth quarter of 2003. We
intend to hold our annual meeting of shareholders in September of 2004.
Accordingly, shareholder proposals for inclusion in the annual meeting proxy
statement should have been sent to our Secretary at 380 Interlocken Crescent,
Broomfield, Colorado 80021 and must have been received by February 16,
2004.
PART
II
ITEM 5. Market for Registrant’s Common Equity and Related
Stockholder Matters
Our Class B common stock has been quoted on the
Nasdaq National Market under the symbol “MCDT” since our initial public
offering on August 9, 2000. Our Class A common stock has been quoted
on the Nasdaq National Market under the symbol “MCDTA” since EMC’s distribution
of that stock on February 7, 2001. Prior to those respective times there
was no public market for either class of stock.
We currently expect to retain future earnings, if
any, for use in the operation and expansion of our business and we have not
declared or paid any cash dividends on our capital stock since inception, and
do not anticipate paying any cash dividends in the foreseeable future. At
April 2, 2004, there were approximately 10,500 stockholders of record of
our Class A common stock and approximately 348 stockholders of record of
our Class B common stock.
The following table sets forth the range of high and
low bid quotation per share of our Class A and Class B common stock
reported on the Nasdaq National Market during fiscal 2003 and 2002:
|
|
|
Class A
|
|
Class B
|
|
|
|
|
High
|
|
Low
|
|
High
|
|
Low
|
|
|
Year Ended
December 31, 2002
|
|
|
|
|
|
|
|
|
|
|
January - March
|
|
$
|
32.45
|
|
$
|
11.08
|
|
$
|
33.11
|
|
$
|
11.41
|
|
|
April - June
|
|
$
|
12.99
|
|
$
|
5.88
|
|
$
|
13.26
|
|
$
|
6.11
|
|
|
July - September
|
|
$
|
11.02
|
|
$
|
5.43
|
|
$
|
11.30
|
|
$
|
5.49
|
|
|
October - December
|
|
$
|
8.99
|
|
$
|
4.40
|
|
$
|
8.29
|
|
$
|
4.35
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year Ended
January 31, 2004*
|
|
|
|
|
|
|
|
|
|
|
January
|
|
$
|
10.23
|
|
$
|
7.07
|
|
$
|
10.25
|
|
$
|
7.02
|
|
|
February - April
|
|
$
|
10.76
|
|
$
|
7.00
|
|
$
|
10.79
|
|
$
|
7.05
|
|
|
May - July
|
|
$
|
15.88
|
|
$
|
9.21
|
|
$
|
15.79
|
|
$
|
9.19
|
|
|
August - October
|
|
$
|
13.15
|
|
$
|
10.05
|
|
$
|
12.93
|
|
$
|
9.89
|
|
|
November - January
|
|
$
|
10.95
|
|
$
|
8.09
|
|
$
|
10.88
|
|
$
|
8.10
|
|
* McDATA changed its fiscal year end to January 31. The corresponding fiscal quarter ends are
April 30, July 31, October 31 and January 31.
23
In
May 2003, the Company’s Board of Directors authorized a plan for the Company to
repurchase up to $50 million of its common stock (Class A, Class B or a
combination thereof). This repurchase plan does not obligate the Company to
acquire any specific number of shares or acquire shares over any specified
period of time. At January 31, 2004, approximately 976,000 shares have
been repurchased under the plan with a total cost at $8.8 million, as more
fully described below.
|
Period
|
|
Total
number of
shares (or units)
purchased*
|
|
Average price paid
per share (or unit)*
|
|
Total
number of
shares (or units)
purchased as part of
publicly announced
plans or program
|
|
Maximum
number (or
approximate dollar value) of
shares (or units) that may yet
be purchased under the plans or
programs**
|
|
|
December 15-16,
2003
|
|
678,574 Class A
|
|
$8.99
|
|
678,574 Class A
|
|
$41.25 Million
|
|
|
December 15-16,
2003
|
|
297,156 Class B
|
|
$8.93
|
|
297,156 Class B
|
|
$41.25 Million
|
|
(*) Inclusive of commissions.
(**) No more than $41.25 million of Class A common stock, Class B
common stock or a combination thereof may be purchased.
ITEM 6. Selected Financial Data
You should read the following selected consolidated financial data in
conjunction with our consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial
Condition and Results of Operations,” and other financial
information appearing elsewhere in this Annual Report. The consolidated income
statement data set forth below with respect to the fiscal years ended
January 31, 2004, December 31, 2002, and 2001, and the consolidated
balance sheet data as of January 31, 2004 and December 31, 2002, are
derived from our audited financial statements appearing in Item 8. The
consolidated income statement data set forth below with respect to the fiscal
years ended December 31, 2000 and 1999, and the consolidated balance sheet
data as of December 31, 2001, 2000 and 1999 were derived from audited
financial statements not included herein. Historical results are not
necessarily indicative of the results of any future period.
|
|
|
Year Ended
January 31,
|
|
Years Ended December 31,
|
|
|
|
|
2004 (1)
|
|
2002
|
|
2001
|
|
2000
|
|
1999
|
|
|
|
|
(in thousands, except per share date)
|
|
|
Consolidated Income
Statement Data:
|
|
|
|
|
|
|
|
|
|
|
|
|
Total revenue
|
|
$
|
418,860
|
|
$
|
328,279
|
|
$
|
344,406
|
|
$
|
248,686
|
|
$
|
95,263
|
|
|
Total cost of revenue
|
|
177,329
|
|
178,114
|
|
215,751
|
|
119,543
|
|
50,280
|
|
|
Gross profit
|
|
241,531
|
|
150,165
|
|
128,655
|
|
129,143
|
|
44,983
|
|
|
Total operating expenses (2)
|
|
249,340
|
|
172,312
|
|
156,578
|
|
85,724
|
|
45,913
|
|
|
Income (loss) from operations (2)
|
|
(7,809
|
)
|
(22,147
|
)
|
(27,923
|
)
|
43,419
|
|
(930
|
)
|
|
Net income (loss)
|
|
$
|
(43,133
|
)
|
$
|
(9,987
|
)
|
$
|
(8,656
|
)
|
$
|
30,764
|
|
$
|
(1,616
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic net income (loss) per share
|
|
$
|
(0.38
|
)
|
$
|
(0.09
|
)
|
$
|
(0.08
|
)
|
$
|
0.31
|
|
$
|
(0.02
|
)
|
|
Diluted net income (loss) per share
|
|
$
|
(0.38
|
)
|
$
|
(0.09
|
)
|
$
|
(0.08
|
)
|
$
|
0.28
|
|
$
|
(0.02
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Shares used in computing basic net income
(loss) per share
|
|
114,682
|
|
113,185
|
|
111,475
|
|
99,989
|
|
91,638
|
|
|
Shares used in computing diluted net income
(loss) per share
|
|
114,682
|
|
113,185
|
|
111,475
|
|
107,953
|
|
91,638
|
|
24
|
|
|
January 31,
|
|
December 31,
|
|
|
|
|
2004 (1)
|
|
2002
|
|
2001
|
|
2000
|
|
1999
|
|
|
|
|
(in thousands)
|
|
|
Consolidated
Balance Sheets Data:
|
|
|
|
|
|
|
|
|
|
|
|
|
Total assets (3)
|
|
$
|
830,968
|
|
$
|
555,191
|
|
$
|
513,953
|
|
$
|
511,369
|
|
$
|
48,424
|
|
|
Working capital (3)
|
|
195,708
|
|
283,627
|
|
277,471
|
|
404,359
|
|
15,813
|
|
|
Long-term portion of obligations (4)
|
|
173,591
|
|
1,540
|
|
789
|
|
1,624
|
|
3,075
|
|
|
Total stockholders’ equity
|
|
417,642
|
|
474,505
|
|
469,791
|
|
453,813
|
|
29,624
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1) On January 15, 2003, the Company changed
its fiscal year to end on January 31 rather than December 31. We believe that the twelve months ended
December 31, 2002 and 2001 provide a meaningful comparison to the twelve
months ended January 31, 2004.
(2) In fiscal 2003, we incurred restructuring costs
and acquisition-related charges totaling approximately $13.7 million. In 2001, we incurred acquisition-related
charges of $9.3 million.
(3) Reflects approximately $127 million in
current assets and current liabilities related to our securities lending
program entered into during fiscal 2003.
(4) Includes long-term convertible debt issued
during fiscal 2003, notes payable acquired in fiscal 2003 with our acquisition
of Nishan and Sanera, and capital leases, excluding current portion.
ITEM 7. Management’s Discussion and Analysis of Financial
Condition and Results of Operations
This section of the Annual Report on
Form 10-K discusses the comparative year over year results of our operations,
our liquidity and financial condition, our risk management practices and our
critical accounting policies. You
should read the following discussion and analysis in conjunction with the
consolidated financial statements and related notes that are included in
sections F-3 through F-34 of this document.
Overview
Change of Fiscal Year
On January 15, 2003, we changed our fiscal year
end to January 31, from December 31. We believe that the twelve
months ended December 31, 2002 and 2001 provide a meaningful comparison to
the twelve months ended January 31, 2004. There are no factors, of which
we are aware, seasonal or otherwise, that would impact the comparability of
information or trends, if results for the twelve months ended January 31,
2003 and 2002 were presented in lieu of results for the twelve months ended December 31,
2002 and 2001. References in this discussion to fiscal 2003 represent the
twelve months ended January 31, 2004. References to fiscal 2002 and 2001
represent the twelve months ended December 31, 2002 and 2001.
Revenue Growth and Competitive Industry
Our revenue for the fiscal year ended January 31, 2004 represented
a 28% increase over fiscal year 2002 and a 22% increase from fiscal year
2001. This year over year revenue
growth was driven by strong demand for our new IntrepidTM, SphereonTM
and Eclipse® director and switch products, as well as increased sales of our
software and services products. In
addition, we broadened our channel mix with the addition of HDS as a greater
than 10% customer and initial sales to two new OEMs, Sun and STK. This revenue growth has occurred while the
market for our SAN products and solutions has grown more competitive with (a)
the entrance of new competitors into our market, (b) pricing pressures
resulting from an increase in competitive products and solutions, (c) challenges
to our direct-assist sales model, and (d) anticipated competition from our own
storage OEM partners through their recent acquisitions of, or alliances with,
competitive software management products and/or application providers that
would utilize the intelligence in the network. These market conditions present
unique risks and uncertainties in a number of respects. In particular, we anticipate continued
lengthened sales cycles and downward pricing pressures that could negatively
impact our revenue growth rate. Moreover, revenue
25
growth in 2004 is dependent
on the introduction of our new products.
We are currently proceeding with the development of new products, which
incorporate the new technologies from our acquisitions of Nishan and Sanera. In
addition, we are taking action to continue sales of existing products acquired
in connection with our acquisition of Nishan.
As with any product introduction, we face risks in the design, testing,
qualification and market acceptance our new products. Some of the products we are developing may be more complex and
feature-rich than our current products, and some of the development on those
products was undertaken externally prior to the Nishan and Sanera acquisitions. If we fail to timely introduce new products,
or if there is no demand for these or our current products, we may experience a
decline in revenue.
In
addition to the recent increased competition in the industry, we have
experienced a migration in the buying patterns of our customers from configured
director products to non-configured product sales including our switch
products, port cards, and our FlexPort upgrades. Our OEM and reseller partners may purchase certain of these
component products ahead of end-user demand, which could reduce subsequent
purchases by those partners. Variations
in the buying patterns of our customers would limit our ability to assemble,
test and ship orders received in the last weeks and days of each quarter and
could cause fluctuations in our quarterly revenue or earnings. Moreover, an unexpected decline in revenue
without a corresponding and timely reduction in expenses could intensify the
impact of these factors on our business, financial condition and results of operations.
Acquisitions
On September 19, 2003, we completed our
acquisition of all of the outstanding stock of Nishan, a provider of
multi-protocol native IP storage switching solutions that builds open storage
networking products based on IP and Ethernet, both international networking
standards. On September 30, 2003,
we completed our acquisition of all of the outstanding stock of Sanera, a
producer of intelligent director class switching platform technologies. The results of operations discussed below reflect
the operating results of Nishan and Sanera from the dates of acquisition.
On
August 22, 2003, the Company purchased 13.6 million shares of preferred
stock of Aarohi Communications (Aarohi). At January 31, 2004, this
represented approximately 17.3% of the total outstanding shares of Aarohi. The shares were acquired at a total cost of
$6 million. Approximately $3.6 million of this purchase price was determined to
represent in-process research and development and, as such, management of the
Company has expensed this amount during fiscal year 2003. In
addition to the equity investment, we have entered into a non-exclusive supply
arrangement with Aarohi to purchase their ASIC chip for inclusion in the
Company’s new product launches when, and if, Aarohi’s product becomes generally
available. We have recorded our share of Aarohi’s net
loss of approximately $984,000 from the date of purchase through
January 31, 2004.
Restructuring Activities
In January 2004, we announced that we were taking certain cost
improvement actions, which included a workforce reduction and facility
consolidation. As a result, in the fiscal fourth quarter of 2003, the Company
recorded an approximate $2.3 million restructuring charge related to the
reduction in workforce. In addition, we expect to incur an approximate $2.2
million restructuring charge in our fiscal first quarter of 2004, primarily
related to a facilities closure, as well as additional severance costs.
Results of Operations
The following table sets forth certain financial data for the periods
indicated as a percentage of total revenues.
|
|
|
Year Ended
January 31,
|
|
Years Ended December 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
|
|
|
|
|
|
|
|
|
|
Revenue
|
|
100.0
|
%
|
100.0
|
%
|
100.0
|
%
|
|
Cost of revenue
|
|
42.3
|
|
54.2
|
|
62.6
|
|
|
Gross profit
|
|
57.7
|
|
45.8
|
|
37.4
|
|
|
Operating Expenses:
|
|
|
|
|
|
|
|
|
Research and development
|
|
21.2
|
|
18.1
|
|
14.3
|
|
|
Selling and marketing
|
|
22.9
|
|
22.9
|
|
20.5
|
|
|
General and administrative
|
|
9.3
|
|
9.0
|
|
5.9
|
|
|
Acquired in-process research & development and other
acquisition related costs
|
|
2.7
|
|
—
|
|
2.7
|
|
|
Amortization of deferred compensation
|
|
2.9
|
|
2.5
|
|
2.1
|
|
|
Restructuring charges
|
|
0.6
|
|
—
|
|
—
|
|
|
Operating expenses
|
|
59.6
|
|
52.5
|
|
45.5
|
|
|
Loss from operations
|
|
(1.9
|
)
|
(6.7
|
)
|
(8.1
|
)
|
|
Interest and other income, net
|
|
1.0
|
|
2.0
|
|
4.1
|
|
|
Loss before income taxes
|
|
(0.9
|
)
|
(4.7
|
)
|
(4.0
|
)
|
|
Income tax expense (benefit)
|
|
9.2
|
|
(1.7
|
)
|
(1.5
|
)
|
|
Loss before equity in net loss of affiliated company
|
|
(10.1
|
)
|
(3.0
|
)
|
(2.5
|
)
|
|
Equity in net loss of affiliated company
|
|
(0.2
|
)
|
—
|
|
—
|
|
|
Net loss
|
|
(10.3
|
)%
|
(3.0
|
)%
|
(2.5
|
)%
|
26
Revenues
|
|
|
Year Ended
January 31,
|
|
Years Ended December 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
|
|
|
(in millions)
|
|
|
Product revenue
|
|
$
|
360.1
|
|
$
|
284.1
|
|
$
|
300.3
|
|
|
Software and service revenue
|
|
41.7
|
|
29.8
|
|
27.5
|
|
|
Other
|
|
17.1
|
|
14.4
|
|
16.6
|
|
|
|
|
$
|
418.9
|
|
$
|
328.3
|
|
$
|
344.4
|
|
Our revenue for the year ended January 31, 2004 was $418.9
million, which represented a 28% increase over fiscal year 2002 and a 22%
increase from fiscal year 2001. This
increase in revenue reflects strong demand for our switching and software
products. Although we continue to see solid end-user demand and increased
year-over-year revenue for our products and solutions, the on-going competitive
marketplace is expected to create a challenging sales environment for the
foreseeable future. Given the entrance of new competitors and products in our
industry, we anticipate longer sales cycles and price declines that could
negatively impact our revenue growth rate.
Product revenue of $360.1 million for fiscal year 2003 was a 27%
increase over fiscal year 2002 and a 20% increase from fiscal year 2001. This revenue increase was generated from the
increased demand in our storage products, in particular our 140-port IntrepidTM 6000 Series Director and
FlexPort SphereonTM
4500 Fabric Switch that were introduced in the last half of 2002. Our fiscal year 2002 revenue was negatively
impacted by the unfavorable economic conditions and suppressed IT storage and
infrastructure spending, in particular in the high-end director market and our
transition from 1 Gb to 2 Gb products in the first half of 2002. This environment had a particularly negative
effect on our product revenue which declined from fiscal year 2001 levels. Our new product introductions in the last
half of 2002, however, were widely received with higher than expected demand
and revenue.
Software and service revenue of $41.7 million for fiscal year 2003 was
a 40% increase over fiscal year 2002 and a 52% increase from fiscal year 2001. This revenue growth is due to
continued revenue growth from all of our software products, in particular our
SANavigator® and SANtegrity® software. A significant
portion of our software revenue is generated from sales of our Enterprise
Fabric Connectivity Manager, or EFCM, software product.
Other revenues for the 2003 year, including service
fees earned under an ESCON Service agreement with EMC, were $17.1 million in
fiscal year 2003. This represents a 19%
increase from fiscal year 2002 and a 3%
27
increase from fiscal year 2001. This increase
reflects the growth in maintenance fees, which outpaced the decline in service
fees related to the ESCON products. We
continue to realize increased attached rates of our extended maintenance
contracts to sales of our switching and software solutions. We anticipate that service revenue from EMC
under the ESCON service agreement will continue to decrease in future years.
A significant portion of our revenue is concentrated with the largest
storage OEMs. For the year ended January 31, 2004, approximately 56% of
our total revenue came from EMC, compared to 54% and 69% for fiscal years 2002
and 2001 respectively. IBM contributed
approximately 21% of our revenue for fiscal year 2003 compared to 25% and 17%
for fiscal years 2002 and 2001, respectively.
In addition, in 2003 HDS became our third largest OEM customer and
contributed approximately 10% of total revenue for the year ended
January 31, 2004. McDATA solutions
are offered by other major storage and system vendors, including Dell, HP, STK
and Sun. In addition to our storage and system vendors, we have relationships
with many resellers, distributors and systems integrators. Expanding our
reseller, distributor and system integrator channels into Small Medium
Enterprise (SME) and vertical markets will be a strategic focus for us as we
continue to expand our business, however, the level of sales to any single
customer may vary and the loss of any one significant customer, or a decrease
in the level of sales to any significant or group of significant customers,
could harm our financial condition and results of operations. Given the
dependencies on our limited number of OEM resellers combined with an
increasingly competitive environment, we may experience continued adverse price
pressures at critical times near the end of the fiscal quarters.
Domestic and international revenue was approximately 67% and 33% of our
total revenue, respectively, for the fiscal year ended January 31,
2004. For the year ended
December 31, 2002, domestic and international revenue was approximately
63% and 37% of our total revenue, respectively. For the year ended December 31, 2001, domestic and
international revenue was approximately 76% and 24% of our total revenue,
respectively. Revenues are
attributed to geographic areas based on the location of the customers to which
our products are shipped. International revenues primarily consist of sales to
customers in Western Europe and the greater Asia Pacific region. Included in
domestic revenues are sales to certain OEM customers who take possession of our
products domestically and then distribute these products to their international
customers. In addition, included in revenues from Western Europe are sales to
certain OEM customers who take possession of our products in distribution
centers designated for international-bound product and then distribute these
products among various international regions. Our mix of international and
domestic revenue can, therefore, vary depending on the relative mix of sales to
certain OEM customers. The increase in international revenues as a percentage
of revenue for fiscal year 2002 was the result of a large domestic order
reduction by EMC during the first quarter of that year associated with the
technology transition to 2 Gb products.
Gross Profit
Gross profit for the fiscal year 2003 was 58% compared to 46% and 37%
in fiscal years 2002 and 2001, respectively.
The significant increase in our gross margin was the result of strong
revenue growth from our higher margin switching and software products as well
as an improved mix of sales to our channel partners. Additionally, during fiscal year 2002 and 2001, we
incurred significant inventory-related charges of $9.4 million and $21 million
respectively. These charges were
generated primarily from our transition to multiple product lines and quality
problems on component parts. We have
significantly reduced inventory costs with the implementation of our
outsource-focused-manufacturing model, which was completed during fiscal year
2003.
Operating Expenses
Research and Development Expenses. Research and development expenses increased
to $88.8 million for fiscal year 2003, compared with $59.3 million for fiscal
year 2002 and $49.2 million for fiscal year 2001. The approximate $29.5 million, or 50%, increase from fiscal 2002
was primarily attributable to retention
bonuses and incremental spending associated with our acquisitions, reductions
in capitalized software costs, increases in personnel costs, non-recurring
engineering charges, and depreciation related to engineering and test equipment
28
and the new engineering
building occupied in the second half of 2002. Capitalized software costs were
approximately $5.1 million, $8.7 million and $481,000 for the 2003, 2002 and
2001 fiscal years, respectively. Capitalized software development costs have
decreased in conjunction with the varying stages of development of our application
software, our new director and switch products and the related firmware
software. We anticipate the level of spending for the design, testing and
qualification of our products to increase over prior years’ levels as we
continue to broaden our product offerings and integrate the personnel and
technology of Nishan and Sanera.
Selling and Marketing Expenses. Selling and marketing expenses increased to
$95.8 million for fiscal year 2003 compared with $75.2 million and $70.5
million for fiscal years 2002 and 2001, respectively. Increases in sales and
marketing expenses were primarily due to increased salaries, commissions and
travel costs associated with increased revenues. In addition, demonstration
equipment and marketing costs associated with the completion of two new OEM
contracts as well as market development activities with our partners increased
our overall sales and marketing expenses. We believe that selling and marketing
expenses will increase as we grow our sales force to assist our channel
partners and increase our contact with end-user customers to create
product pull through our channels.
General and Administrative Expenses. General and administrative expenses
increased to $39.1 million for fiscal year 2003, compared to $29.5 million and
$20.3 million for fiscal year 2002 and 2001, respectively. Amortization
expense for purchased intangible assets increased approximately $7.1 million as
a result of our acquisitions of Sanera and Nishan. In addition, we experienced
increased personnel costs, equipment and facilities costs while realizing
overall reductions in bad debt and legal expenses. Expenses for fiscal year
2002 included significant legal expenses related to the costs of litigating
Brocade patent infringement lawsuit (see Item 3, Legal Proceedings) and $1.75
million in charges related to the termination of a collateralized lease and the
disposal of fixed assets. Amortization expense will continue to increase in
fiscal year 2004 as a full year of Nishan and Sanera intangible asset amortization
will be reflected.
Acquired In-Process Research and Development
(IPR&D) and Other Acquisition-related Costs. In connection with our equity investment in
Aarohi and our acquisition of Nishan in September 2003, a portion of the
respective purchase prices was allocated to IPR&D. This IPR&D was
expensed at the time of purchase because technological feasibility had not been
established and no future alternative use existed. The IPR&D charge for
fiscal year 2003 totaled $11.4 million.
In connection with our acquisition of SANavigator in fiscal 2001, we
incurred non-recurring acquisition costs and integration-related charges.
Additionally, a portion of the SANavigator purchase price was allocated to
IPR&D. This IPR&D was expensed at the time of purchase because
technological feasibility had not been established and no future alternative
use existed. The IPR&D charge
totaled $7.2 million for the year ended December 31, 2001. The other acquisition-related charges
recorded during the year ended December 31, 2001, related primarily to
one-time consideration paid for the completion of ongoing employment
arrangements with SANavigator employees. See Note 5 to the Notes to the
Consolidated Financial Statements.
Amortization of Deferred Compensation. We have recorded deferred compensation in
connection with Class B stock options granted prior to our August 9, 2000
initial public offering and restricted Class B stock grants granted through our
equity incentive plans. In connection with our acquisitions during fiscal 2003,
we issued approximately 1.0 million shares of Class B restricted common stock
with vesting periods ranging from 12 to 24 months. In addition, 300,000 shares
vested immediately upon the retention of employees at Nishan and Sanera and
were fully expensed. We are amortizing all deferred compensation on a
straight-line basis over the vesting period of the applicable options and stock
awards, resulting in amortization expense of $12.7 million for fiscal year
2003, $8.9 million for fiscal year 2002 and $8.7 million for fiscal year 2001
(of which approximately $739,000, $601,000 and $1,437,000 was included in cost
of revenue, respectively). Deferred compensation expense levels fluctuate with
the Class B option and restricted stock award activity. Additional grants of
these awards under existing compensations plans, future plans or through
acquisitions could increase the level of deferred compensation expense.
29
Restructuring Charges. In
January 2004, we announced that we were taking certain cost improvement
actions, which included a workforce reduction and facility consolidation. As a
result, in the fiscal fourth quarter of 2003, the Company recorded an
approximate $2.3 million restructuring charge related to the reduction in
workforce. In addition, we expect to incur an approximate $2.2 million
restructuring charge in the fiscal first quarter 2004, primarily related to a
facilities closure, as well as additional severance costs.
Interest and Other Income. Interest and other income consisted
primarily of interest earnings on our cash, cash equivalents and various
investment holdings. Interest income
was $6.8 million, $6.9 million, and $14.5 million for fiscal years 2003, 2002
and 2001, respectively. The decrease in
income from 2001 levels reflects the decline in interest rates during 2002 and
2003 fiscal years. These declines
offset the effects of higher cash and investment balances resulting from cash generated from operations and the net
proceeds from convertible subordinated notes that were issued in
February 2003 (see Note 8 – “Convertible Subordinated Debt” in the Notes
to Consolidated Financial Statements). The average rate of return on
investments for the year ended January 31, 2004 was 1.8% compared to 2.2%
for fiscal year 2002, and 3.9% for fiscal year 2001.
Interest Expense. Interest expense was $2.8 million for the year ended January 31,
2004 compared with $293,000 and $349,000 for fiscal years 2002 and 2001,
respectively. The increase in interest
expense represents the interest cost associated with our 2.25% convertible
subordinated notes issued in February 2003. In July 2003, we entered
into an interest-rate swap agreement that has the economic effect of modifying
the fixed interest obligations associated with the Notes so that the interest
payable on the majority of the Notes effectively becomes variable based on the
six month LIBOR minus 152 basis points. The reset dates of the swap are
February 15 and August 15 of each year until maturity on
February 15, 2010. The six-month LIBOR setting for the swap was 1.1283%
during the 2003 fiscal year, creating a rate of approximately minus 0.39%,
which is effective until February 15, 2004. This rate significantly
reduced our overall interest expense during this period. On February 15,
2004, the six-month LIBOR setting was reset to 1.175%, resulting in a rate of
approximately minus 0.345%, which is effective until August 15, 2004. Significant increases in interest rates in
future periods could significantly increase interest expense.
Provision for Income Taxes. During the 2003 fiscal year we recorded a
non-cash charge of $38.8 million to create a valuation allowance against the
deferred tax asset as of the beginning of the fiscal year. Generally, the effective tax rate is
determined by the relationship between pre-tax book income or loss and certain
amounts which are reported differently between the financial statements and the
tax return. During 2003, the tax rate
is favorably impacted primarily by the settlement of tax items related to
previous years, the deductibility of costs associated with our convertible
subordinated debt, and the research tax credit. The tax rate is unfavorably impacted by deferred compensation and
the write-off of the IPR&D related to Aarohi, as well as by the non-cash
charge for the valuation allowance.
During 2002, the tax rate was favorably impacted primarily by tax-exempt
interest and the research tax credit.
The tax rate was unfavorably impacted by deferred compensation. During 2001, the tax rate was favorably
impacted primarily by tax-exempt interest and the benefit attributable to
export sales. The tax rate was
unfavorably impacted by deferred compensation.
A full valuation allowance was also created in fiscal 2003 against
acquired deferred tax assets for $35.1 million and against deferred tax assets
relating to tax benefits recorded directly to shareholders’ equity for $1.0
million. Neither of these items
resulted in a current charge to income tax expense. The valuation allowance related to acquired deferred tax assets
resulted in an increase in goodwill. If
this portion of the valuation allowance is released in subsequent periods,
goodwill will decrease by a like amount and we will record a charge to tax
expense when the related deferred tax asset is realized. If the valuation allowance charged to
shareholders’ equity is released in subsequent periods, shareholders’ equity
will increase by a like amount and we will record a charge to tax expense when
the related deferred tax asset is realized.
Liquidity and Capital Resources
In summary, our cash flows were (in thousands):
30
|
|
|
Year Ended
January 31,
|
|
Years Ended December 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
|
|
|
|
|
|
|
|
|
|
Net cash provided by operating activities
|
|
$
|
61,060
|
|
$
|
30,456
|
|
$
|
8,336
|
|
|
Net cash used in investing activities
|
|
(244,259
|
)
|
(27,039
|
)
|
(115,688
|
)
|
|
Net cash provided by (used in) financing
activities
|
|
125,332
|
|
(291
|
)
|
2,007
|
|
|
|
|
|
|
|
|
|
|
|
|
We invest excess cash predominantly in debt instruments that are highly
liquid, of high-quality investment grade, and predominantly have maturities of
less than three years with the intent to make such funds readily available for
operating purposes, including expansion of operations and potential
acquisitions or other transactions. As
of January 31, 2004, we had cash and cash equivalents and
available-for-sale investments, including restricted cash, of $317 million
compared to approximately $303 million as of December 31, 2002.
Cash provided by operating activities of $61 million
for 2003 primarily consists of our net loss adjusted for non-cash charges
(including depreciation, amortization, in-process R&D charges related to
our acquisitions, deferred compensation, deferred taxes and inventory-related
charges) offset by approximately $6.5 million of changes in working capital and
other activities. Working capital
changes included an increase in accounts receivable balances of approximately
$26 million, reflecting increases related to our revenue growth particularly,
in the last month of the fiscal fourth quarter. Days sales outstanding (DSO) has decreased in 2003 to 51 days
compared to 64 days in 2002. This
reflects the impact of the change in fiscal year and increased level of accounts
receivable collection. We believe that
DSO may increase in 2004 as compared to 2003 as we see the linearity of our
sales shift towards the third month of our fiscal quarters and as our channel
mix continues to diversify. Our cash
flows from operations were impacted by the growth in deferred revenue balances
of approximately $17.8 million in 2003 representing primarily increased sales
of extended maintenance contracts attached to sales of our hardware and
software products. In addition, the growth in deferred revenue reflects
deferred service fee revenue related to our ESCON agreement with EMC. From fiscal year 2002 to 2003, the increase
in cash provided by operating activities was primarily the result of higher
revenues and a lower net loss before income taxes. Cash provided by operating activities in 2002 of $30.5 million
consisted primarily of the net loss adjusted for non-cash charges of
approximately $44.9 million offset by approximately $4.4 million used by
working capital and other activities. From
fiscal year 2001 to 2002, the increase in cash from operations was primarily a
result of large inventory purchases in 2001 and larger income tax payments from
our profitable 2000 fiscal year. Cash
provided by operating activities in 2001 of approximately $8.3 million
consisted primarily of a net loss of approximately $8.7 million adjusted for
non-cash items of approximately $55.5 million and approximately $38.5 million
used by working capital and other activities.
Cash used in investing activities in 2003 of
approximately $244 million was primarily attributable to cash used in
acquisitions and purchases of equity investments of $177.4 million, cash used
to purchase (net of sales and maturities) investments in marketable securities
during the year, cash used to secure restricted investments related to our
interest rate swap transaction of approximately $5.1 million, and capital
expenditures totaling approximately $18.0 million. Cash used in investing activities increased from 2002 to 2003
primarily as a result of the acquisitions of Sanera and Nishan, as well as
increased net purchases of marketable securities related to higher cash
balances available for investing from our issuance of convertible subordinated
notes in February 2003. Reduced
spending for capital expenditures in 2003 from 2002 offset these increases.
Cash used in investing activities in 2002 of approximately $27 million was
primarily attributable to capital expenditures of $72 million, contributed to
by our completion and occupation of our office and engineering building. The cash purchases were offset by proceeds
from sales and maturities (net of purchases) of marketable securities for
approximately $46 million. Cash used
for investing activities decreased in 2002 from 2001 primarily as a result of
cash used for acquisitions in 2001, as well as net purchases of investments in
2001, compared to net proceeds from investments in 2002. Cash used in investing activities in 2001 of
approximately $115.7 million was primarily attributable to cash used in
acquisitions of $29.8 million, capital expenditures totaling approximately
$21.5 million and net purchases (net of sales and maturities) of investments of
$64.5 million.
Cash provided by financings in 2003 of $125 million was primarily due
to proceeds from issuance of convertible subordinated notes of $172.5 million
in principal amount, with proceeds of $167 million and proceeds
from the issuance of stock related to our stock option and employee purchase
plans of $5.8 million. The
31
2.25%
convertible subordinated notes mature in February 2010, unless converted
into McDATA common stock at a conversion price of $10.71 per share, subject to
certain conversion price adjustments.
Upon conversion, McDATA has the right to deliver cash, stock or a
combination of both. See Note 8 in the
Notes to the Consolidated Financial Statements for further information related
to the issuance of convertible subordinated notes. Offsetting these net proceeds were the use of $20.5
million of those proceeds to enter into share option transactions, cash
used for payments made on notes payable and capital lease obligations of
approximately $18 million, and $8.8 million of cash used to repurchase common
stock under our stock buy-back program.
See Note 9 in the Notes to the Consolidated Financial Statements for
further information related to the Company’s repurchase of common stock. Cash used in financing activities in 2002 of
$291,000 was primarily due to principal payments on capital leases of $2.7
million offset by proceeds of approximately $2.4 million from the issuance of
common stock. Cash provided by
financing activities in 2001 of $2.0 million was primarily due to proceeds from
the issuance of common stock of $4.9 million offset by payments on our capital
lease obligations of $2.9 million.
Commitments
The
Company has contracted with Sanmina SCI Systems, Inc. (SSCI) and Solectron
Corporation (Solectron) (collectively, Contract Manufacturers) for the
manufacture of printed circuit boards and box build assembly and configuration
for specific multi-protocol directors and switches. The agreements require us to submit purchasing
forecasts and place orders sixty calendar days in advance of delivery. At January 31, 2004, our commitment
with the contract manufacturers for purchases over the next sixty days totaled
$48.1 million. Additionally, the
Contract Manufacturers have outstanding purchase commitments related to
materials that have been ordered on our behalf. We may be liable for materials that the Contract Manufacturers
purchase on our behalf if our actual requirements do not meet or exceed our
forecasts and those materials cannot be redirected to other uses. At January 31, 2004, we had recorded
obligations of approximately $8 million primarily related to materials
purchased by our Contract Manufacturers for certain end-of-life and obsolete
material used to manufacture our products.
We do not expect the remaining commitments under these agreements to
have a continued material adverse effect on our business, results of
operations, financial position or cash flows.
In
February 2003, the Company sold $172.5 million of 2.25% convertible
subordinated notes due February 15, 2010 (see Note 8, “Convertible
Subordinated Debt,” of the Notes to Consolidated Financial Statements). The
Notes are convertible into our Class A common stock at conversion rate of
93.3986 shares per $1,000 principal amount of notes (aggregate of approximately
16.1 million shares) or $10.71 per share, subject to certain conversion
adjustments. Upon a conversion, the Company may choose to deliver shares of our
Class A common stock, or, in lieu of shares of our Class A common stock, cash
or a combination of cash and shares of Class A common stock. We are required to
pay interest on February 15 and August 15 of each year, beginning
August 15, 2003. Debt issuance costs of $5.6 million are being amortized
over the term of the notes. The amortization of debt issuance costs will
accelerate upon early redemption or conversion of the notes. The net proceeds
remain available for general corporate purposes, including working capital
requirements and capital expenditures.
Concurrent
with the issuance of the Notes, the Company entered into share option
transactions using approximately $20.5 million of proceeds. As part of these
share option transactions, the Company purchased options that cover
approximately 16.1 million shares of Class A common stock, at a strike price of
$10.71. The Company also sold options that cover approximately 16.9 million
shares of Class A common stock, at a strike price of $15.08. The net cost of
the share option transactions was recorded against additional paid in capital.
These share option transactions are intended to give the Company the option to
mitigate dilution as a result of the Notes being converted to common shares up
to the $15.08 price per common share and mitigate dilution if the share price
exceeds $15.08 at that time. Should there be an early unwind of either of the
share option transactions, the amount of cash or net shares potentially
received or paid by the Company will be dependent on then existing overall
market conditions, the stock price, the volatility of the stock, and the amount
of time remaining until expiration of the options.
32
In July 2003, we entered into an interest-rate swap agreement with
a notional amount of $155.25 million that has the economic effect of modifying
the fixed interest obligations associated with the Notes so that the interest
payable on the majority of the Notes effectively becomes variable based on the
six month London Interbank Offered Rate (LIBOR) minus 152 basis points. The
reset dates of the swap are February 15 and August 15 of each year
until maturity on February 15, 2010. The six-month LIBOR setting for the
swap at January 31, 2004 was 1.1283%, creating a rate of approximately
minus 0.39%, which was effective until February 15, 2004. On
February 15, 2004, the six-month LIBOR setting was reset to 1.175%,
resulting in a rate of approximately minus 0.345%, which is effective until
August 15, 2004. Significant
increases in interest rates could significantly increase the interest expense
we are obligated to pay to holders of the Notes in future periods. The swap was
designated as a fair value hedge and, as such, the gain or loss on the
derivative instrument, as well as the fully offsetting gain or loss on the
Notes attributable to the swap, were recognized in earnings. At
January 31, 2004, the fair value of the interest rate swap had decreased
from inception to $349,000 and is included in other long-term liabilities.
Corresponding to this change, the carrying value of the Notes has decreased by
$349,000. We are also required to post collateral based on changes in the fair
value of the interest rate swap. This collateral, in the form of restricted
cash, was $5.1 million at January 31, 2004.
The following table summarizes our contractual obligations (including
interest expense) and commitments as of January 31, 2004 (in thousands):
|
|
|
Total
|
|
Less Than
1Year
|
|
1-3 Years
|
|
More
than
5 years
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Convertible subordinated debt
|
|
$
|
172,500
|
|
$
|
—
|
|
$
|
—
|
|
$
|
172,500
|
|
|
Non-cancelable operating leases
|
|
20,295
|
|
8,097
|
|
9,568
|
|
2,630
|
|
|
Non-cancelable purchase agreements
|
|
48,063
|
|
48,063
|
|
—
|
|
—
|
|
|
Capital leases, including interest
|
|
2,376
|
|
1,453
|
|
923
|
|
—
|
|
|
Total contractual obligations
|
|
$
|
243,234
|
|
$
|
57,613
|
|
$
|
10,491
|
|
$
|
175,130
|
|
Long-Term Cash Availability
We believe our existing cash, short-term and long-term investment
balances, and cash expected to be generated from future operations will be
sufficient to meet our capital and operating requirements at least through the
next twelve months, although we could be required, or could elect, to seek
additional funding prior to that time.
Our future capital requirements will depend on many factors, including
our rate of revenue growth, the timing and extent of spending to support
development of new products and expansion of sales and marketing, the timing of
new product introductions and enhancements to existing products, and market
acceptance of our products.
Inflation
We believe that our revenue and results of operations have not been
significantly impacted by inflation during the last three fiscal years.
Recent Accounting Pronouncements
For
information regarding recent accounting pronouncements, see Note 1 of Notes to
Consolidated Financial Statements included in the F-pages of this Form 10-K.
Critical Accounting Policies
General
Management’s
Discussion and Analysis of Financial Condition and Results of Operations is
based upon our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
The preparation of these financial statements requires management to
33
make
estimates and assumptions that affect the reported amounts of assets and
liabilities, revenue and expenses, and the related disclosure of contingent
assets and liabilities as of the date of the financial statements. Management
bases its estimates on historical experience and on various other assumptions
that are believed to be reasonable under the circumstances, the results of
which form the basis for making judgments about the carrying values of assets
and liabilities that are not readily apparent from other sources. Senior
management has discussed the development, selection and disclosure of these
estimates with the Audit Committee of McDATA’s Board of Directors. Actual
results may differ materially from these estimates under different assumptions
or conditions. Management believes the following critical accounting policies
reflect its more significant estimates and assumptions used in the preparation
of its consolidated financial statements.
Revenue Recognition
We
recognize revenue, in accordance with SEC Staff Accounting Bulletin No. 104, Revenue Recognition (SAB 104) and the
American Institute of Certified Public Accountants’ Statement of Position 97-2
(SOP 97-2), as amended, when persuasive evidence of an arrangement exists,
products are delivered or services rendered, the sales price is fixed or
determinable and collectibility is assured. In instances when any one of these
four criteria is not met, we will defer recognition of revenue until all the
criteria have been met.
With
respect to revenue from our configured products, we request evidence of
sell-through from our OEM and distributor partners prior to recognizing
revenue. In situations where our OEM and distributor partners refuse to provide
sell-through information when requested, but all the criteria under SAB 104 (as
discussed above) have been met, we recognize revenue for such configured
products. These configured products represent high value, customized solutions
of directors, cabinets and various combinations of port cards ordered by our
sales partners as required by the end user. Non-configured products and
components, such as our switch products, port cards, and FlexPort upgrades, are
recognized as revenue when the criteria for SAB 104 (as discussed above) have
been met, generally at time of shipment. Revenue for both configured and
non-configured products and components is reduced for estimated customer
returns, price protection, rebates, and other offerings that occur under sales
programs established with the Company’s OEMs, distributors and resellers.
Service
revenues, which to date have not been material, include training, consulting
and customer support. Revenue from training and consulting are recognized when
the service has been performed and the customer has accepted the work. We
recognize revenue from support or maintenance contracts, including
post-contract customer support (PCS) services, ratably over the contractual
period.
We
recognize revenue from software products in accordance with the SOP 97-2.
Software revenue is allocated to the software license and PCS service elements
using vendor specific objective evidence of fair value, or VSOE, and recognized
appropriately as discussed above. VSOE of the fair value for an element is based
upon the price charged when the element is sold separately.
In
transactions that include multiple products, services and/or software, we
allocate the revenue to each element based on their relative fair values (or in
the absence of fair value, the residual method) and recognize the revenue when
the above recognition criteria have been met for each element.
Inventory Reserves
We
value our inventory at the lower of cost or net realizable values. We regularly
review inventory on hand and record a provision for excess and obsolete
inventory based upon assumptions about current and future demand for our
products, the current market conditions, new product introductions, new
technologies and the current life cycle of our products. Adverse changes in
these factors and our assumptions could result in an increase in the amount of
excess and obsolete inventory on hand and increase our cost of revenue.
Additionally,
we have certain purchase commitments with our Contract Manufacturers that are
non-cancelable. We may be liable for materials that our third-party
manufacturers purchase on our behalf if our actual
34
requirements
do not meet or exceed our forecasts and those materials cannot be redirected to
other uses by the Contract Manufacturers. We evaluate these open purchase
orders in light of our current inventory on hand, expected demand, market
conditions and new product introductions. Based on this information, we record
purchase obligations for inventory we believe is excess or obsolete and cannot
be redirected to other uses by our contract manufacturers. Adverse changes in
our and our contract manufacturers’ calculations and assumptions concerning
these purchase commitments may result in an increase to our vendor obligations
and increase our cost of revenue.
Valuation of Accounts Receivable
We
review accounts receivable to determine which are doubtful of collection. In
addition, we also make estimates of potential future product returns. In making
the determination of the appropriate allowance for doubtful accounts and
product returns, we consider specific accounts, analysis of our accounts
receivable aging, changes in customer payment terms, historical write-offs and
returns, changes in customer demand and relationships, concentrations of credit
risk and customer credit worthiness. Historically, we have experienced a low
level of write-offs and returns given our customer relationships, contract
provisions and credit assessments. Changes in the credit worthiness of
customers, general economic conditions and other factors may impact the level
of future write-offs and product returns and increase our general and
administrative expenses or decrease product revenues.
Warranty Provision
We
also provide for estimated expenses for warranty obligations as revenue is
recognized. Our warranty accruals utilize management’s estimates of potential
future product warranty claims including the estimated numbers of failures by
product and estimated costs to repair or replace failed product. We have not
experienced material warranty claims, however material warranty claims,
including the catastrophic or epidemic failure of any one of our products,
would require revisions to the estimated warranty liability and could significantly
increase our product costs, reduce revenue and cause significant customer
relations problems.
Income Taxes
Significant
management judgment is required in determining the provision for income taxes,
deferred tax assets and liabilities and any valuation allowance recorded
against deferred tax assets. We are required to estimate our income taxes in
each jurisdiction where we operate. This process involves estimating our actual
current income tax expense together with assessing temporary differences resulting
from the different treatment of items for income tax and accounting purposes.
These differences result in deferred tax assets and liabilities, which are
included in our consolidated balance sheet. At January 31, 2004, our net
deferred tax assets equaled $77.4 million before any valuation allowance. This
balance relates to various items in McDATA’s results of operations that have
different timing or treatment for income tax and financial accounting purposes,
such as the timing of revenue recognition and accrued expenses, depreciation
methods, and reserve accounts, as well as research and development credits.
In
evaluating the need for a valuation allowance, we assessed the likelihood that
our net deferred tax assets will be recovered from future taxable income. We
have considered past operating losses, cumulative losses for financial
accounting in recent years, estimated future taxable income and our ongoing
prudent and feasible tax planning strategies in assessing the need for a
valuation allowance. After considering all available evidence, both positive
and negative, management concluded, after applying the provisions of SFAS 109,
that it is more likely than not that we will not be able to realize our
deferred tax assets in the future. Therefore, a full valuation allowance has
been provided against those deferred tax assets. The portion relating to the
acquisitions is applied as an increase to the basis of other assets from the
acquired companies.
We
are subject to audit by federal, state and foreign tax authorities. These audits may result in additional tax
liabilities. We account for such
contingent liabilities in accordance with SFAS No. 5, Accounting for
35
Contingencies,
and believe that we have appropriately provided for taxes for all years. Several factors drive the calculation of our
tax reserves including (i) the expiration of statutes of limitations, (ii)
changes in tax law and regulations, and (iii) settlements with tax
authorities. Changes in any of these
factors may result in adjustments to our reserves which could impact our
reported financial results.
Valuation of Long-Lived Assets Including
Goodwill and Purchased Intangible Assets
We
review property, plant and equipment and purchased intangible assets for
impairment whenever events or changes in circumstances indicate the carrying
value of an asset may not be recoverable. Our asset impairment review assesses
the fair value of the assets based on the future cash flows the assets are expected
to generate. An impairment loss is recognized when estimated undiscounted
future cash flows expected to result from the use of the asset plus net
proceeds expected from disposition of the asset (if any) are less than the
carrying value of the asset. This approach uses our estimates of future market
growth, forecasted revenue and costs, expected periods the assets will be
utilized and appropriate discount rates.
We
have performed and will perform an annual impairment test for goodwill in
accordance with Statement of Financial Accounting Standards No. 142 (SFAS 142).
This review is based on a comparison of the carrying value of our net assets
including goodwill balances to the fair value of our net assets using the
quoted market price of our common stock. We performed the 2003 impairment test
during our first fiscal quarter and determined that no impairment loss should
be recognized. In the event that business conditions change, future tests may
result in a need to record a loss due to write down of the value of goodwill.
At January 31, 2004, goodwill recorded in the consolidated balance sheet
totaled $78.8 million.
We
currently operate our business as a single solutions business and do not
maintain separate cash flows or operating margins for any other business
segments. Future operating losses, deterioration of our business or
segmentation of our operations in the future could also lead to impairment
adjustments as such issues are identified.
Sales Commission Estimates
Our
sales approach is focused on an indirect model executed primarily through OEMs
and resellers. Our field sales and service personnel support these distribution
channels using a direct-assist model and are commissioned based on sales
results achieved during the reporting period. Because specific sales data used
to calculate these commissions is not always available at the time our
financial results are released, we routinely make certain estimates based on
known revenue achievement, historical experience and assumptions regarding
individual sales contributions. Changes to these assumptions and estimates
could cause revisions to our sales commission liabilities and result in
variations between estimated liabilities and actual payments.
Restructuring Charges
We
monitor and regularly evaluate our organization structure and associated
operating expenses. Depending on events
and circumstances, we may decide to restructure our operations to reduce future
operating costs. In determining the
restructuring charges, we analyze our future operating requirements, including
the required headcount by 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
36
loss
accruals including the various assumptions noted above. If actual results differ significantly from
our estimates, we may be required to adjust our restructuring accruals in the
future.
Item 7A. Qualitative
and Quantitative Disclosure about Market Risk
We are exposed to market risk, primarily from changes in interest rates
and credit risks.
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 and cash equivalents
and our investment portfolio. Our investment portfolio is primarily maintained
in four major financial institutions in the United States and consists
primarily of readily marketable investment-grade debt securities of various
issuers and maturities ranging from overnight to greater than ten years.
All investments are denominated in U.S. dollars and are classified as
“available for sale.” These instruments are not leveraged, and are not held for
trading purposes. As interest rates change, the amount of unrealized gain or
loss on these securities will change.
We have performed a sensitivity analysis as of January 31, 2004,
using a modeling technique that measures the change in the fair values arising
from a hypothetical 10% adverse movement in the levels of interest rates with
all other variables held constant. The discount rates used were based on the
market interest rates in effect at January 31, 2004. The sensitivity
analysis indicated that a hypothetical 10% increase in interest rates would
result in a decrease in the fair values of our investment instruments of
approximately $275,000 assuming that such investment holdings remained constant
through the year 2003 and an increase of investment income of approximately
$398,000. A hypothetical 10% decrease in interest rates would result in an
increase of the fair values of our investment instruments of approximately
$276,000 and a decrease in investment income of approximately $416,000.
Our convertible subordinated notes are
subject to a fixed interest rate and such notes are based on a fixed conversion
ratio into Class A common stock. In July 2003, the Company entered into an
interest-rate swap agreement with a notional amount of $155.3 million that has
the economic effect of modifying the fixed interest obligations associated with
the notes so that the interest payable on the majority of the notes effectively
becomes variable based on the six month London Interbank Offered Rate (LIBOR)
minus 152 basis points. If interest rates on this variable rate debt were to
increase or decrease by 100 basis points, our annual interest expense would
increase or decrease by approximately $1.6 million. This increased or decreased
interest expense would be partially offset by the effects of these interest
rate changes on our cash and investment portfolio. The notes are not listed on
any securities exchange or included in any automated quotation system; however,
the notes are eligible for trading on the PortalSM Market. On
January 31, 2004, the approximate bid price of our notes was $116.00 and the
approximate ask price of our notes was $116.50, resulting in an aggregate fair
value of between $200.1 million and $201.0 million. Our Class A common stock is
quoted on the Nasdaq National Market under the symbol, “MCDTA.” On January 31,
2004, the last reported sale price of our Class A common stock on the Nasdaq
National Market was $8.79 per share.
Credit Risk
Financial instruments which potentially subject the Company to concentrations
of credit risk consist principally of temporary cash investments, short and
long term investments, including collateral held under the securities lending
program as discussed in Note 7 of our Notes to the Consolidated Financial
Statements, trade receivables and certain share option transactions. The
Company places its temporary cash investments and short- and long-term
investments in investment grade instruments and limits the amount of investment
with any one financial institution. The Company evaluates the credit risk
associated with each of its customers and has concluded that it does not have a
material exposure to credit risk with its customers.
In February 2003, the Company sold $172.5 million of 2.25%
convertible subordinated notes due February 15, 2010. In conjunction with
the issuance of these convertible notes, we also entered into share option
transactions on our Class A common stock with Bank of America, N.A. and
/or certain of its affiliates. Subject to the movement in our Class A common
stock price, we could be exposed to credit risk arising out of net settlement
of these options in our favor. Based on our review of the possible net
settlements and the credit strength of Bank of America, N.A. and its
affiliates, we have concluded that we do not have a material exposure to credit
risk as a result of these share option transactions.
ITEM 8. Consolidated Financial Statements and
Supplementary Data
For a discussion of the information required by this item, you should
refer to F- pages in Item 15(a) of this Annual Report on Form 10-K.
ITEM 9. Changes
In and Disagreements With Accountants on Accounting and Financial
Disclosure
We have nothing to report under this item.
37
ITEM 9A. Controls
and Procedures
Disclosure controls and procedures
Our
management evaluated, with the participation of our Chief Executive Officer and
Chief Financial Officer, the effectiveness of our disclosure controls and
procedures as of the end of the period covered by this Annual Report on
Form 10-K. Based on this evaluation, our Chief Executive Officer and Chief
Financial Officer have concluded that our disclosure controls and procedures
(as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange
Act of 1934 (the Exchange Act)), as of the end of such period, and except as
disclosed in this Annual Report, are effective to ensure that information
required to be disclosed by us in reports that we file or submit under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in Securities and Exchange Commission rules and forms. It
should be noted that the design of any system of controls is based in part upon
certain assumptions about the likelihood of future events, and there can be no
assurance that any design will succeed in achieving its stated goals under all
potential future conditions, regardless of how remote.
Changes in internal control over financial reporting
Except
as disclosed below, there was no change in our internal control over financial
reporting that occurred during the period covered by this Annual Report on
Form 10-K that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.
Third Quarter
Balance Sheet Reclassification/Restatement
On
February 26, 2004, the Company announced that it would amend its Form 10-Q
for the quarter ending October 31, 2003 to reflect a balance sheet
reclassification. The reclassification did not affect either the income
statement or the statement of cash flows for the quarter. The reclassification
results from a securities lending program with Wells Fargo Bank, N.A. (Wells
Fargo), which the company began during that quarter. Under the program the
Company’s investment securities may be loaned against a pledge of cash
collateral, which is held by Wells Fargo as the Company’s agent.
In
accordance with generally accepted accounting principles, the balance sheet in
that amended Form 10-Q for the quarter ended October 31, 2003, shows the
addition of a line item entitled “Securities
lending collateral” as a current asset and the addition of a line
item entitled “Securities lending collateral
payable” as a current liability, both for the approximate amount of
$109.5 million. These two balance sheet adjustments net to zero, and neither
the income statement nor the statement of cash flows is affected. See Note 7 to
the Notes to the Consolidated Financial Statements for further discussion of
this program and the balances as of January 31, 2004.
As
part of its year-end review, the Company subsequently identified the
applicability of SFAS 140 to the previous quarter’s securities lending program.
In its review, the Company investigated the cause of the reclassification and
has concluded that while the transaction was communicated prior to the filing,
the Company did not appropriately apply SFAS 140 to the securities lending
program in preparing its financial statements for the quarter ending
October 31, 2003. In response to the reclassification, the Company’s
independent auditors have indicated in a letter to the Company that it believes
that a material weakness under AU 325, Communication
of Internal Control Related Matters Noted In An Audit, existed with
regard to the evaluation of the appropriate accounting treatment for the
securities lending program. As a result, the Company has implemented enhanced
policies and procedures including additional cross-functional meetings with the
Finance organization, establishment of an issues log, adding additional support
personnel dedicated to this area and improvements in existing formal investment
policies. The Company believes that it has implemented these changes within its
internal controls to improve the timely accounting evaluation and treatment of
such transactions.
It
should be noted that any system of controls, however well designed and
operated, can provide only reasonable, and not absolute, assurance that the
objectives of the system are met. In addition, the design of any control system
is based in part upon certain assumptions about the likelihood of future
events. Because of these and other inherent limitations of control systems,
there can be no assurance that any design will succeed in
38
achieving
its stated goals under all potential future conditions, regardless of how
remote.
Within 90 days prior to the date of this report, we carried out an
evaluation, under the supervision and with the participation of our principal
executive officer and principal financial officer, of the effectiveness of the
design and operation of our disclosure controls and procedures. Based on this
evaluation, our principal executive officer and principal financial officer
concluded that our disclosure controls and procedures are effective in timely
alerting them to material information required to be included in our periodic
SEC reports. It should be noted that the design of any system of controls is
based in part upon certain assumptions, and there can be no assurance that any
design will succeed in achieving its stated goals.
PART
III
ITEM 10. Directors
and Executive Officers of the Registrant
The following table sets forth certain information regarding our
executive officers and directors as of the date of this Annual Report on Form
10-K:
|
Name
|
|
Age
|
|
Position
|
|
|
|
|
|
|
|
John A. Kelley, Jr.
|
|
54
|
|
Chairman of the Board of Directors, President and Chief Executive
Officer
|
|
Ernest J. Sampias
|
|
53
|
|
Chief Financial Officer and Senior Vice President of Finance
|
|
Thomas O. McGimpsey
|
|
42
|
|
General Counsel, Vice President of Business Development
|
|
Gary M. Gysin
|
|
44
|
|
Senior Vice President of Worldwide Sales and Service
|
|
Jean M. Becker
|
|
44
|
|
Senior Vice President of Engineering
|
|
Robert F. Finley
|
|
54
|
|
Vice President of Manufacturing
|
|
Michael B. Gustafson
|
|
37
|
|
Senior Vice President of Worldwide Marketing
|
|
Karen L. Niparko
|
|
47
|
|
Vice President of Human Resources
|
|
Laurence G. Walker (2)(4)
|
|
55
|
|
Lead Director
|
|
Charles C. Johnston (1)
|
|
69
|
|
Director
|
|
D. Van Skilling (1)(3)
|
|
70
|
|
Director
|
|
Thomas M. Uhlman (2)(4)
|
|
55
|
|
Director
|
|
John W. Gerdelman (3)(4)
|
|
51
|
|
Director
|
|
Betsy S. Atkins (2)(3)
|
|
48
|
|
Director
|
|
Michael J. Sophie (1)
|
|
46
|
|
Director
|
|
Alex Mendez (4)
|
|
46
|
|
Director
|
(1) Member of Audit
Committee
(2) Member of Compensation
Committee
(3) Member
of Governance and Nominating Committee
(4) Member of Technology
Committee
Executive Officers and Directors
John A. Kelley, Jr. has
been Chairman of the Board of Directors since February 2004, President and
Chief Executive Officer since August 2002 and was President and Chief
Operating Officer from August 2001 to August 2002. Prior to joining
McDATA, Mr. Kelley was Executive Vice President for Qwest Communications
International Inc., or Qwest, from July 2000 to January 2001.
Prior to the acquisition of US WEST by Qwest, he was Executive Vice
President for U S WEST from April 1995 to June 2000. Prior to his
employment at US WEST, Mr. Kelley was in key senior leadership
positions at Mead Corporation from 1991 to 1995. Mr. Kelley received his
Bachelor of Science degree in business from the University of Missouri, St.
Louis. He serves on the board of directors of Polycom, Inc. and
Captaris, Inc., and is also Vice Chairman of the National INROADS Board, a
not-for-profit mentoring program and a board member of the Women’s Vision
Foundation and Tie-Rockies.
39
Ernest J. Sampias
has been the Senior Vice President of Finance and Chief Financial Officer since
June 1, 2002. Prior thereto he was Vice President of Finance from
September 2001 to June 2002 and Controller from September 2001
to February 2003. Prior to joining McDATA, Mr. Sampias was Vice
President and Chief Financial Officer of Convergent Communications, Inc.
from November 2000 to May 2001, was Vice President and Chief
Financial Officer of U S WEST Dex, Inc. from 1997 to 2000 and
held various financial management positions with U S WEST from 1985
to 2000. Mr. Sampias is a Certified Public Accountant, received a Masters
degree in Taxation in 1979 from DePaul University in Chicago, Illinois, and
received a Bachelor of Science degree (with distinction) in Business in 1973
from Indiana University. Mr. Sampias also sat on the Board of Directors of
PointServe Corporation from March 2000 to November 2000.
Thomas O. McGimpsey
is General Counsel and Vice President of Business Development. In 2002, Mr. McGimpsey also held the
position of Vice President of Corporate Development. Mr. McGimpsey is
responsible for managing all internal and external legal efforts, corporate
governance matters, business development, mergers and acquisition activities,
hardware and software purchase/licensing contracts, and the
internationalization efforts for the company. Prior to joining McDATA in
June 2000, Mr. McGimpsey was the Senior Corporate and Securities
Attorney at U S WEST, Inc. and U S WEST
Communications, Inc. from 1998 until U S WEST’s merger with Qwest in June 2000. From 1991 to 1998,
Mr. McGimpsey was in private practice at national law firms. From 1984 to
1988, Mr. McGimpsey was a Senior Engineer for Software
Technology, Inc. Mr. McGimpsey received his Juris Doctor degree from
the University of Colorado in 1991 and his Bachelor of Science degree in
Computer Science (with a minor in electrical and microprocessor systems) from
Embry-Riddle Aeronautical University in 1984.
Gary M. Gysin, has
been the Senior Vice President of World Wide Sales and Services since
January 2004. Mr. Gysin joined
McDATA in December 2002 as Vice President and General Manager of Software.
Prior to joining McDATA, Mr. Gysin was Senior Vice President of products at
Volera from February 2000 to November 2002, where he drove
development of strategic direction, and Sales and Marketing activities.
Additionally, Mr. Gysin has shown strong success in previous sales leaderships
roles at growth companies, and has a wide range of sales leadership experience
including previous vice president of sales positions, territory management,
compensation organization, and routes-to-market development. Mr. Gysin received his Bachelor of Arts
degree in Economics in 1992 from the University of California at Santa Cruz.
Jean M. Becker has
been the Senior Vice President of Engineering since December 2002. Just
prior to joining McDATA, Ms. Becker was President of Qwest Solutions from
July 2001 and Senior Vice President of Qwest National xDSL/Broadband
Deployment from July 2000. Prior to Qwest, Ms. Becker held the Chief
Technology Officer and Senior Vice President, Vice President of Network Planning
and other senior management positions with U S WEST since 1988.
Ms. Becker earned a Masters of Business and Administration degree in 1992
from Portland State University and earned a Bachelor of Science degree in
electrical engineering in 1988 from Portland State University. Ms. Becker also serves on the board of
directors of Aarohi Communications,
Inc.
Robert F. Finley has
been the Vice President of Manufacturing since June 2001. Prior to joining
McDATA, he served as Vice President, Business Programs Management—Global
Accounts at SMTC Corp. from December 1996 to May 2001. Prior to
joining McDATA, Mr. Finley held several positions at SMTC including
Director of Materials, MIS, Document Control, Component Engineering and
Supplier Quality Assurance and Director of Manufacturing Operations from
February 1991 to December 1996. In addition, Mr. Finley worked
for McDATA from 1987 to 1990 as a manager of quality assurance, reliability
engineering and mechanical procurement and a manager of turnkey operations.
Mr. Finley holds a Bachelor of Science degree in electronics engineering
technology from Arizona State University.
Michael B. Gustafson
has been the Senior Vice President of Worldwide Marketing since June 2002.
From March 1999 until June 2002, he served as our Vice President of
Worldwide Sales. Mr. Gustafson also had responsibility for McDATA’s
Professional and Learning Services offerings from March 1999 to
December 2000. From May 1998, when he joined McDATA, until
March 1999, Mr. Gustafson served as a regional sales manager of
McDATA. Prior to joining McDATA, Mr. Gustafson spent nine years with
IBM serving in various sales management positions, including most recently as
Business Unit Executive and Director of U.S. Channel Field Sales
40
of IBM from June 1997 until May 1998. Mr. Gustafson
received his Bachelor of Science degree in business administration from
Washington University in St. Louis. Mr.
Gustafson joined the Board of Directors of InPhase Technologies in December 2003.
Karen L. Niparko has
been Vice President of Human Resources since January 2004, Vice President
of Business Operations since October 2002 and prior thereto was Vice
President of Human Resources from September 2001 to October 2002.
Prior to joining McDATA, Mrs. Niparko was Executive Consultant for
Corporate Solutions, Inc. from April 2001 to September 2001,
Corporate Vice President of Human Resources and Officer and former
Vice-President of Human Resources for Worldwide Sales & Service of
Storage Technology Corporation from April 1997 to February 2001, and
Vice President of Operations for Auto-trol Technology Corporation from
January 1993 to April 1997. Mrs. Niparko has a Masters of
Business Administration degree from the University of Colorado, a Bachelor of
Arts degree from the University of Michigan and a Certificate for Leadership
for Sr. Executives Programs from Harvard University. Mrs. Niparko serves
on the Boards of the Colorado Safety Association and
INROADS-Colorado Inc., both non-profit organizations. She served as Chair
for the eLearning committee of Governor Owen’s Strategy Workforce Development
Council. She is an advisor for the Chancellor’s Community Advisory Committee
for the University of Colorado at Boulder and a member of the Women’s Vision
Foundation.
Laurence G. Walker,
an independent investor, has served as a Director of McDATA since May 1998
and Lead Director since February 2004. Previously, Mr. Walker served
as Vice President of Strategy of the Network & Computing Systems Group
of Motorola from February 2002 until May 2002. From August 2001
until February 2002, Mr. Walker served as Vice President and General
Manager of the Network & Computing Systems Group of Motorola.
Mr. Walker co-founded C-Port in November 1997 and was Chief Executive
Officer until August 2001. C-Port was acquired by Motorola in
May 2000. From June 1997 until October 1997, Mr. Walker was
self-employed. From August 1996 until May 1997, Mr. Walker
served as Chief Executive Officer of CertCo, a digital certification supplier.
Prior thereto, he was Vice President and General Manager, Network Product
Business Unit, Digital Equipment Corporation
from January 1994 to July 1996. From 1981 to 1994, he held a variety
of other management positions at Digital Equipment Corporation. He received his
Ph.D. and Master of Science degree in electrical engineering from the
Massachusetts Institute of Technology and his Bachelor of Science degree in
Electrical Engineering from Princeton. He serves as a Director of Silicon
Laboratories, Oasis Semiconductors, and Propagate Networks.
Charles C. Johnston,
has served as a Director of McDATA since May 1998. Mr. Johnston has
been Chairman of AFD Technologies, Inc., J&C Resources, LLC, and
Ultraclenz Corporation since 1992 and Chairman of Ventex
Technologies, Inc. since 1994.
Mr. Johnston was founder, Chairman and CEO of ISI Systems, a
developer of software systems and related services, from 1969 to 1992 (ISI was
sold to Teleglobe Corporation of Montreal, Canada in 1989). He served in
various capacities at IBM from 1959 until 1965 and served as Director of
Grumman Corporation and Teleglobe Corporation from 1989 to 1994. He received
his Bachelor of Science degree in 1957 from Worcester Polytechnic Institute. He
currently serves as a Director of AuthentiDate Holding Corporation, Internet
Commerce Company and Visual Data.
D. Van Skilling, has served as a Director of McDATA since
May 1998. Mr. Skilling has been as President of Skilling Enterprises
since March 1999. He retired as Chairman and Chief Executive Officer of
Experian Information Solutions, Inc., formerly TRW Information
Systems & Services, in April 1999. From September 1996 until
April 1999, Mr. Skilling was Chairman and Chief Executive Officer of
Experian. From March 1970 until September 1996, Mr. Skilling was
the Executive Vice President of TRW Information Systems and Services. He
received his Bachelor of Science degree in chemistry from Colorado College and
his Masters of Business Administration degree in International Business from
Pepperdine University. He currently serves on the Boards of Directors of The
Lamson & Sessions Company, First American Corporation and American
Business Bank and is Chairman of the Board of Trustees of Colorado College.
Thomas M. Uhlman, has served as a Director of McDATA since
May 1998. Mr. Uhlman has been Managing Partner, New Venture Partners,
LLC since January 2001. From 1997 to 2001, Mr. Uhlman was President,
New Ventures Group at Lucent Technologies. From 1996 to 1997, Mr. Uhlman
was Senior Vice President, Corporate Strategy, Business Development and Public
Affairs of Lucent Technologies. From 1995 to
41
1996
Mr. Uhlman was the Vice President, Corporate Development of AT&T Corp.
Prior to joining AT&T, he was with Hewlett-Packard Company in various
advisory and management roles. He received his Ph.D. in Political Science from
the University of North Carolina—Chapel Hill, his Masters degree in management
from Stanford University School of Business and his Bachelor of Arts degree in
political science from the University of Rochester.
John W. Gerdelman,
has served as a director of McDATA since May 1998. Since January 2004, he has been the Executive Chairman of
Intelliden Corporation a company he co-founded which provides software
solutions that enable networks to operate more intelligently by automating
network change management and enforcing business policy in network
operations. In April 2002, Mr.
Gerdelman took on the bankruptcy reorganization of Metromedia Fiber Networks
and successfully emerged from Chapter 11 in September 2003 and completed
his contract in December 2003.
From April 1999 until 2002, Mr. Gerdelman worked with several new
ventures as Managing Member of Mortonsgroup LLC. From 1986 until 1999, Mr. Gerdelman held various positions with
MCI Telecommunications Corporation in Sales, Marketing, Sales Operations,
Network Operations and Information Technology.
For four of these years, he served as President of the Network and
Information Technology Division. He was
also CEO of a startup call center company and returned to MCI upon its
acquisition. Before joining MCI, Mr.
Gerdelman was with Baxter Travenol Corporation in Sales Operations. He served in the U.S. Navy as a Naval
Aviator. He received his Bachelor of
Science degree in chemistry from the College of William and Mary where he now
serves on the Board of Visitors. Mr.
Gerdelman currently serves as a Director of APAC, Sycamore Networks, Inc. and
the Terebeam Corporation.
Betsy S. Atkins, has
served as a Director of McDATA since April 2002. Ms. Atkins has been
the Chief Executive Officer of Baja Accordiant Ventures, an independent venture
capital firm focused on the technology and life sciences industry since 1994.
From 1991 through 1993, Ms. Atkins was CEO of NCI, Inc. a
Nutraceutical company. Ms. Atkins was a co-founder of Ascend
Communications, Inc. in 1989 and served as a member of its Board of
Directors, until its acquisition by Lucent Technologies in 1999. Ms. Atkins
currently serves on the Boards of Directors of Polycom, Inc. and
UTStarcom. She received her Bachelor of Arts degree from the University of
Massachusetts. Ms. Atkins publishes and keynote speaks on board governance
matters and best practices for the National Association of Corporate Directors.
Ms. Atkins is also a member of the President-appointed Pension Benefit
Guaranty Corporation advisory committee and a Governor-appointed member of the
Florida International University Board of Trustees.
Michael J. Sophie, has served as a Director of McDATA since
March 2003. Mr. Sophie has served as Senior Vice President Finance of
UTStarcom Inc., a manufacturer and marketer of telecommunications
equipment for use in worldwide markets, from January 2003 to present and
as Chief Financial Officer from August 1999 to present. He served as Vice
President Finance of UTStarcom from August 1999 to January 2003. From
1993 to 1999, Mr. Sophie was Vice President Finance and Chief Financial
Officer of P-Com, Inc., a manufacturer of microwave radio stations for
worldwide wireless telecommunications markets. Mr. Sophie holds a Bachelor
of Science degree in business administration from California State University
and a Masters of Business Administration degree from the Santa Clara
University.
Alex Mendez, has
served as a Director of McDATA since December 2003. Mr. Mendez has
twenty-five years of experience in the high technology industry at ROLM, IBM,
Stratacom, and Cisco, holding several executive positions in operations,
marketing and business development, most recently as an SVP/GM at Cisco. He was
part of the founding team of Stratacom which Cisco acquired in 1996. He is also
Founding General Partner of Storm Ventures, and ex-CEO and Chairman of Sanera
Systems which McData acquired in 2003. He is on the board of directors of
Airespace, Venturi Wireless, and Inovys. He is also Executive Chairman of Inkra
Networks and Chairman of Bivio Networks.
Mr. Mendez holds a Bachelor of Science degree in electrical engineering
from Stanford University and a Masters of Business Administration degree from
Santa Clara University. He was born in Buenos Aires, Argentina and speaks both
Spanish and German fluently.
Our Board of Directors is divided into three classes, the members of
which serve for a staggered three-year term until they or their successors are
duly elected and qualified. Messrs. Gerdelman and Kelley and
Ms. Atkins
42
serve in class I whose term expires at the annual meeting of
stockholders in 2004, Messrs. Skilling, Uhlman and Sophie serve in class
II whose term expires at the annual meeting of stockholders in 2005 and Messrs.
Johnston, Walker and Mendez serve in class III whose term expires at an annual
meeting of stockholders in 2006. Upon the expiration of the term of a class of
directors, directors in that class will be elected for three-year terms at the
annual meeting of stockholders in the year in which that term expires. Upon the
appointment of John A. Kelley, Jr. as Chairman of the Board in February 2004,
the Board also elected Laurence G. Walker as the Lead Director of the
independent directors of the Board.
Our officers serve at the discretion of the Board of Directors. There
are no family relationships among our directors and officers.
Board Committees and Other Information
Our Board of Directors has a separately designated Audit Committee,
Compensation Committee, Governance and Nominating Committee and Technology
Committee. The Audit Committee, currently comprised of Messrs. Johnston,
Skilling and Sophie, reviews our accounting policies and practices, financial
reporting and internal control structures, recommends to our Board of Directors
the appointment of independent auditors to audit our financial statements each
year and confers with our officers for purposes of reviewing our internal
controls, accounting practices, financial structures and financial reporting.
In addition, the Audit Committee confers with the independent auditors on any
significant matters regarding internal controls over financial reporting that
have come to their attention during the conduct of their audit. Our Audit
Committee has been established in accordance with section 3(a)(58)(A) of
the Securities Exchange Act and is comprised of directors who are independent
within the meaning of the NASDAQ Stock Market, Inc. director independence
standards, as currently in effect. The
Board of Directors has determined that Mr. Sophie is an “audit committee
financial expert” as defined by SEC rules.
The Audit Committee held nine meetings in fiscal year 2003 and three
meetings since our fiscal year ended. The Compensation Committee currently
comprised of Messrs. Uhlman and Walker and Ms. Atkins, reviews
salaries, incentives and other forms of compensation for our executive officers
and administers our incentive compensation plans. The Compensation Committee
has delegated its duties with respect to option grants for employees and
non-executive officers to a compensation subcommittee, which is chaired by
Mr. Kelley, in accordance with the terms of the Company’s 2001 Equity
Incentive Plan (formerly the 1997 Stock Option Plan). The Governance and
Nominating Committee, currently comprised of Messrs. Gerdelman and
Skilling and Ms. Atkins, reviews corporate governance, board compensation
matters, oversees the evaluation and nomination process for new board members,
reviews committee charters and the composition of new Board committees and
considers questions of conflicts of interest of Board members and corporate
officers. The Technology Committee, currently comprised of
Messrs. Gerdelman, Uhlman, Walker and Mendez, reviews the Company’s
long-term strategic technical direction and product roadmap and the Company’s
planned investments in research and development.
Stockholder
Recommendations
It is the policy of the Board of Directors of McDATA to consider
recommendations for candidates to the Board of Directors from stockholders
holding no less than 100,000 shares of our common stock continuously for at
least six (6) months prior to the date of the submission of the
recommendation. Stockholder
recommendations for candidates to the Board of Directors must be directed in
writing to McDATA Corporation, Corporate Secretary, 380 Interlocken Crescent,
Broomfield, CO 80021, and must include the candidate’s name, home and business
contact information, detailed biographical data and qualifications, information
regarding any relationships between the candidate and McDATA within the last
three years and evidence of the nominating person’s ownership of company Stock
Stockholder nominations to the Board of Directors must meet the
requirements set forth in Article 3, Section 2(c) of our Bylaws. Under these requirements, nominations for
election to the Board of Directors may be made at a meeting of stockholders by
any stockholder entitled to vote in the election of directors who provides
timely written notice to the Secretary of the Company. This notice must contain specified
information concerning the nominee and concerning the stockholder proposing the
nomination. In order to be timely, a
stockholder’s notice must be delivered to or mailed and received by the
Secretary of the Company not
43
less than 120 calendar days before the date of our proxy statement
released to stockholders in connection with the previous year’s annual meeting
of stockholders.
The Governing/Nominating Committee’s Criteria and process for
evaluating and identifying the candidates that it selects, or recommends to the
full Board for selection, as director nominees, are as follows:
• The
Governing/Nominating Committee regularly reviews the composition and size of
the Board and determines the criteria for Board membership including issues of
character, judgment, diversity, age, expertise, corporate experience and the
like.
• The
Governing/Nominating Committee considers and recommends candidates to fill new
positions or vacancies on the Board, and reviews any candidates recommended by
stockholders in accordance with the bylaws.
• The Governing/Nominating
Committee conducts an annual evaluation of the Board as a whole and evaluates
the performance of current Board members proposed for reelection, and
recommends the Director nominees each year for approval by the Board and
stockholders.
• In evaluating
the qualifications of candidates, the Governing/Nominating Committee considers
many factors, including issues of character, judgment, diversity, age,
independence, expertise, (especially in the Company’s industry but also the
systems manufacturing industry), corporate/business experience (especially as a
member of senior Management of a high growth company), international
experience, length of service, other commitments and the like. While the Governing/Nominating Committee has
not established specific minimum qualifications for Director candidates, the
Governing/Nominating Committee believes that candidates and nominees must
reflect a Board that is comprised of directors who (i) are predominantly
independent, (ii) are of high integrity, (iii) have qualifications that will
increase overall Board effectiveness and (iv) meet other requirements as may be
required by applicable rules, such as financial literacy or financial expertise
with respect to audit committee members.
• With regard to
candidates who are properly recommended by stockholders, the
Governing/Nominating Committee will review the qualifications of any such
candidate, which review may, in the Governing/Nominating Committee’s direction,
include interviewing references for the candidate, direct interview with the
candidate, or other actions that the Governing/Nominating Committee deems
necessary or proper.
• In evaluating
and identifying candidates, the Governing/Nominating Committee has the
authority to retain and terminate any third party search firm that is used to
identify director candidates, and has the authority to approve the fees and
retention terms of any search firm.
• The
Governing/Nominating Committee will apply these same principles when evaluating
Board candidates who may be elected initially by the full Board to fill
vacancies or add additional directors prior to the annual meeting of
stockholders at which directors are elected.
• After completing
its review and evaluation of director candidates, the Governing/Nominating
Committee selects, or recommends to the full Board of Directors for selection,
the director nominees.
Code of Ethics
We have adopted a code of ethics that applies to our principal
executive officer, members of our
finance department (including the principal financial officer and principal
accounting officer) and employees. This code of ethics, which is entitled “McDATA’s Corporate Code of Conduct,” is
posted on our website. The Internet
44
address for our code is located at the following Website:
http://www.mcdata.com/about/board/gov.
We intend to satisfy the disclosure requirement under Item 10 of Form
8-K regarding an amendment to, or waiver from, a provision of this code of
ethics by posting such information on our website, at the address and location
specified above.
Section 16(a) Beneficial Ownership
Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934, as
amended, requires our executive officers and directors, and persons who own
more than 10% of our common stock, to file with the SEC reports of ownership
and changes in ownership of common stock and other equity securities of our
Company. Executive officers, directors and greater than 10% stockholders are
required by the SEC regulation to furnish to us copies of all
Section 16(a) forms they file.
Based solely on a review of the copies of Section 16(a) forms
furnished to us and written representations that no other filings were
required, we believe that all the SEC filing requirements applicable to our
executive officers, directors and greater than 10% stockholders were complied
with for 2003, other than the late filing of a report on Form 4 for John
A. Kelley, Jr. with regard to his January 2003 grant of 400,000 class B
stock options.
ITEM 11. Executive
Compensation
The following table sets forth information for the fiscal year ended
January 31, 2004 concerning the compensation paid to persons who served as
our Chief Executive Officer, our four other most highly compensated executive
officers at fiscal year end and one executive that resigned prior to fiscal
year end, all of whose total salary and bonus for such fiscal year exceeded
$100,000, collectively referred to below as the Named Executive Officers.
Long-term compensation awards include awards grant during the period January 1,
2003 through January 31, 2004.
Summary Compensation Table
|
|
|
|
|
|
|
|
|
Long-Term
Compensation
|
|
|
|
|
|
|
|
|
Annual
Compensation
|
|
Awards
|
|
|
|
|
Name and Principal Position
|
|
Year
|
|
Salary($)
|
|
Bonus($)
|
|
Restricted
Stock Award(s)
($)(1)
|
|
Securities
Underlying
Options(#)
|
|
All Other
Compensation
($)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
John A. Kelley, Jr.
|
|
2003
|
|
$390,854
|
|
$125,000
|
|
$590,606
|
|
400,000
|
|
$14,533
|
(2)
|
|
Chairman, President and Chief
|
|
2002
|
|
$339,234
|
|
$127,452
|
|
$427,490
|
|
315,000
|
|
$4,068
|
(3)
|
|
Executive Officer
|
|
2001
|
|
$98,082
|
|
$56,829
|
|
—
|
|
250,000
|
|
$2,817
|
(4)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Ernest J. Sampias
|
|
2003
|
|
$312,972
|
|
$54,750
|
|
$248,834
|
|
200,000
|
|
$5,855
|
(5)
|
|
Chief Financial Officer and Senior
|
|
2002
|
|
$217,308
|
|
$150,000
|
|
$180,000
|
|
70,000
|
|
$5,165
|
(6)
|
|
Vice President of Finance
|
|
2001
|
|
$46,769
|
|
$12,469
|
|
—
|
|
15,000
|
|
$238
|
(7)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Michael B. Gustafson
|
|
2003
|
|
$260,273
|
|
$43,125
|
|
$262,350
|
|
50,000
|
|
$11,563
|
(8)
|
|
Senior Vice President of Worldwide
|
|
2002
|
|
$234,615
|
|
$192,871
|
|
—
|
|
90,000
|
|
$5,855
|
(9)
|
|
Marketing
|
|
2001
|
|
$136,669
|
|
$245,794
|
|
—
|
|
—
|
|
$5,720
|
(10)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Jean M. Becker
|
|
2003
|
|
$258,885
|
|
$43,125
|
|
$173,640
|
|
—
|
|
$15,022
|
(11)
|
|
Senior Vice President of Engineering
|
|
2002
|
|
—
|
|
—
|
|
$42,840
|
|
150,000
|
|
—
|
|
|
|
|
2001
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gary M. Gysin
|
|
2003
|
|
$219,254
|
|
$61,250
|
|
$173,640
|
|
—
|
|
$11,018
|
(12)
|
|
Senior Vice President of Worldwide
|
|
2002
|
|
—
|
|
—
|
|
$42,840
|
|
200,000
|
|
—
|
|
|
Sales and Service
|
|
2001
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Alain F. Andreoli (14)
|
|
2003
|
|
$285,769
|
|
$65,938
|
|
—
|
|
—
|
|
$34,284
|
(13)
|
|
Former Senior Vice President of
|
|
2002
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
|
Worldwide Sales and Services
|
|
2001
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
45
(1) The Named Executive Officers were
each granted restricted Class B common stock under the Company’s Executive
Performance Incentive Bonus (EPIB) Plan from February 1, 2003 through
January 31, 2004. Messrs. Kelley,
Gustafson, Sampias, Gysin, Andreoli and Ms. Becker were granted 19,700, 6,875,
8,300, 6,000, 7,775 and 6,000 shares both on August 1, 2003 at a per share
price of $10.61 and on November 1, 2003 at a per share price of
$9.90. These shares are restricted
under the EPIB Plan for 48 months from the date of grant however a portion of
the grant may have the restricted period accelerated to 18 months if certain
quarterly targets are met. The Company
met its quarterly objectives for the first and second quarter of 2003, and accordingly,
the shares relating to those quarters were accelerated to 18 month cliff
vesting. In addition, Messrs. Kelley,
Sampias , Gustafson, Gysin, Andreoli and Ms. Becker were granted 19,700, 8,300,
13,750, 6,000, 7,800 and 6,000 shares on January 29, 2003 at a per share price
of $8.18.
(2) For 2003, this amount includes
$1,645 of term life insurance premium, $2,804 paid to Mr. Kelley’s account in
our 401(k) plan, $4,000 for tax and financial planning and $6,084 for a taxable
fringe sales trip.
(3) For 2002, this amount includes
$1,868 of term life insurance premium and $2,200 paid to Mr. Kelley’s account
in our 401(k) plan.
(4) For 2001, this amount includes
$531 of term life insurance premium and $2,286 paid to Mr. Kelley’s account in
our 401(k) plan.
(5) For 2003, this amount includes
$1,528 of term life insurance premium, $3,396 paid to Mr. Sampias’s account in
our 401(k) plan, and $931 for a taxable fringe sales trip.
(6) For 2002, this amount includes
$1,040 of term life insurance premium and $4,125 paid to Mr. Sampias’s account
in our 401(k) plan.
(7) For 2001, this amount includes
$238 of term life insurance premium.
(8) For 2003, this amount includes
$513 of term life insurance premium, $6,000 paid to Mr. Gustafson’s account in
our 401 (k) plan, and $5,050 for a taxable fringe sales trip.
(9) For 2002, this amount includes
$355 of term life insurance premium and $5,500 paid to Mr. Gustafson’s account
in our 401(k) plan.
(10) For 2001, This amount includes $216 for
term life insurance premium and $5,504 paid to Mr. Gustafson’s account in our
401(k) plan.
(11) For 2003, this amount includes $576 of
term life insurance premium, $6,000 paid to Ms. Becker’s account in our 401(k)
plan, $2,650 for tax and financial planning, and $5,796 for a taxable fringe
sales trip.
(12) For 2003, this amount includes $425 of
term life insurance premium, $6,000 paid to Mr. Gysin’s account in our 401(k)
plan, and $4,593 for a taxable fringe sales trip.
(13) For 2003, this amount includes $831 of
term life insurance premium, $6,370 for a taxable fringe sales trip, and
$27,083 in severance benefits.
(14) Mr. Andreoli resigned from the Company
December 2003 and forfeited all options and restricted stock.
Option Grants in Last Fiscal Year
The following table sets forth certain information for each grant of
stock options during the year ended January 31, 2004 to each of the Named
Executive Officers. All of these options were granted under our 2001 McDATA
Equity Incentive Plan and have a term of 10 years, subject to earlier
termination in the event an optionee’s services to us cease. For more
information, see “Employee Benefit Plans” below for descriptions of the
material terms of these options. During the month ended January 31, 2003 and
the year ended January 31, 2004, we granted options to purchase an aggregate
of 1,071,275 shares and 3,682,640 shares, respectively, of Class B common
stock under the 2001 McDATA Equity Incentive Plan. Options were granted at an
exercise price equal to the fair market value (as determined under the 2001
McDATA Equity Incentive Plan) of our Class B common stock on the day prior
to the grant date. Potential realizable values are net of exercise prices
before taxes, and are based on the assumption that our Class B common
stock appreciates at the annual rate shown, compounded annually, from the date
of grant until the expiration of the ten-year term and that the option is
exercised at the exercise price and sold on the last day of its term at the
appreciated price. These numbers are calculated based on SEC requirements and
do not
46
reflect any projection or estimate of future stock price growth. No
stock appreciation rights were granted during the fiscal year ended
January 31, 2004.
|
|
|
Individual
Grants
|
|
|
|
|
|
|
|
|
Number
Of
Securities
Underlying
Options
|
|
Percent of
Total
Options
Granted to
Employees
|
|
Exercise
Price Per
Share
|
|
Expiration
|
|
Potential
Realizable Value at Assumed
Annual Rate of Stock Price
Appreciation for Option Term
|
|
|
Name
|
|
Granted(#)
|
|
In FY 2003
|
|
($/share)
|
|
Date
|
|
5% ($)
|
|
10% ($)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
John A. Kelley, Jr.
|
|
100,000
|
*
|
|
|
$
|
7.90
|
|
1/24/13
|
|
$
|
501,229.02
|
|
$
|
1,270,212.74
|
|
|
|
|
300,000
|
*
|
8.4
|
%
|
8.18
|
|
1/29/13
|
|
1,543,307.42
|
|
3,911,043.99
|
|
|
Ernest J.Sampias
|
|
200,000
|
*
|
4.2
|
%
|
8.18
|
|
1/29/13
|
|
1,028,871.61
|
|
2,607,362.67
|
|
|
Michael B. Gustafson
|
|
50,000
|
*
|
1.1
|
%
|
8.18
|
|
1/29/13
|
|
257,217.90
|
|
651,840.67
|
|
|
Jean M. Becker
|
|
0
|
|
|
**
|
—
|
|
—
|
|
—
|
|
—
|
|
|
Gary M. Gysin
|
|
0
|
|
|
**
|
—
|
|
—
|
|
—
|
|
—
|
|
|
Alain Andreoli
|
|
0
|
|
|
**
|
—
|
|
—
|
|
—
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
* McDATA changed its fiscal year end to January 31. While these 2003 grants did not occur during
the 2003 fiscal year, we have nonetheless disclosed the gap period between
January 1, 2003 and January 31, 2003.
**Less than 1%
Aggregated Option Exercises in Last Fiscal
Year and Fiscal Year-End Option Values
The following table sets forth information with respect to the Named
Executive Officers concerning exercisable and unexercisable options held as of
January 31, 2004. The dollar value of in-the-money options at
January 31, 2004 is calculated by determining the difference between the
year-end fair market value of $8.71 per share and the option exercise price.
|
|
|
Shares
Acquired on
|
|
Value
|
|
Number of
Securities
Underlying Unexercised
Options at
January 31, 2004
|
|
Value of
Unexercised
In-the-Money Options at
January 31, 2004
|
|
|
Name
|
|
Exercise(#)
|
|
Realized($)
|
|
Exercisable
|
|
Unexercisable
|
|
Exercisable
|
|
Unexercisable
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
John A. Kelley, Jr.
|
|
—
|
|
—
|
|
300,750
|
|
652,085
|
|
$
|
60,000
|
|
$
|
180,000
|
|
|
Ernest J. Sampias
|
|
—
|
|
—
|
|
80,000
|
|
205,000
|
|
33,500
|
|
100,500
|
|
|
Michael B. Gustafson
|
|
40,000
|
|
$
|
333,625
|
|
225,000
|
|
134,761
|
|
856,225
|
|
19,875
|
|
|
Jean M. Becker
|
|
—
|
|
—
|
|
37,500
|
|
112,500
|
|
58,875
|
|
176,625
|
|
|
Gary M. Gysin
|
|
—
|
|
—
|
|
50,000
|
|
150,000
|
|
78,500
|
|
235,500
|
|
|
Alain F. Andreoli
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Management Bonus Program
Beginning
in the third quarter of 2002, a revised Executive Performance Incentive Bonus
(EPIB) plan was implemented in lieu of the prior cash bonus plan. The EPIB plan
uses restricted Class B common stock with accelerated vesting opportunities to
reward participants for the collective achievement of strategic corporate
revenue and EPS goals on a quarterly basis. The EPIB plan is designed to
further drive performance beyond target levels through the availability of
additional cash bonus opportunities when target metrics are substantially
exceeded. Currently the cash bonus component of the EPIB plan is calculated as
a percentage of base compensation and can range from 7.5% to 18.75% of
quarterly base salary if corporate objectives are achieved, and from 30% to 75%
if more progressive objectives are met.
47
John F. McDonnell, the former Chairman of the Board of Directors,
participated in an incentive compensation plan which was based upon the
attainment of annual corporate financial objectives established by the Board of
Directors. Upon attainment of these objectives, the plan provided for a payment
equal to a percentage of annual salary.
Change of Control Arrangements/Employment
Agreements
Named Executive Officers and certain other officers have entered into
change of control severance agreements and employment agreements with us. The
change of control severance agreements provide these officers with (i) a
payment (in a lump sum or according to our normal payroll timetable) equal to
four times the average of their quarterly compensation over the preceding eight
calendar quarters, (ii) payment for all accrued but unused vacation days,
(iii) the provision of health benefits for a period of time and (iv) automatic
acceleration of the vesting of all stock options held if we terminate without
cause their employment upon a change in control; provided that our executive
officers will not engage in any activity that conflicts with their obligations
to us, induce other employees to leave us, or compete with us for a period of
one year after termination of their employment. Under the terms of the
employment agreements to which we are party with certain of our executive
officers, all confidential, proprietary or other trade secret information and
all other discoveries, inventions, processes, methods and improvements made by
the employee are our property. In addition, pursuant to these agreements,
employees may not compete with us for one year after termination of their employment.
In
December 2003, the Company entered into a one year single trigger
severance agreement with John A. Kelley, Jr., the Company’s Chief Executive
Officer and President, should he be terminated without cause or voluntarily
leaves for good reason. The Company received in consideration for the severance
agreement (a) an extension to 24 months of Mr. Kelley’s current 12 month
restriction, to not compete against the Company and to not solicit Company
employees after such termination, and (b) a release of all claims, if any,
against the Company before payment of any benefits there under. The benefits
under the severance agreement would include one year of salary and target
bonus, medical benefits under COBRA for up to one year, an extension of option
exercisablity from ninety days to one year for subsequently issued options and
continued vesting of restricted stock for one year after termination. Mr.
Kelley’s existing change of control severance agreement, as described above,
will continue to be in full force and effect, however benefits under the new
single trigger severance agreement would not be payable if the Change of
Control Severance Agreement is triggered.
Limitation of Liability and Indemnification
Our amended and restated certificate of incorporation and amended and
restated by-laws provide that we shall indemnify our directors and officers to
the fullest extent that Delaware law permits. Delaware law permits a
corporation to indemnify any director, officer, employee or agent made or
threatened to be made a party to any pending or completed proceeding if the
person acted in good faith and in a manner that the person reasonably believed
to be in the best interests of the corporation and, with respect to any
criminal proceeding, had no reasonable cause to believe that his or her conduct
was unlawful.
Our amended and restated certificate of incorporation limits the
liability of our directors to the maximum extent permitted by Delaware law.
Delaware law provides that directors will not be personally liable for monetary
damages for breach of their fiduciary duties as directors, except liability
for:
• any breach of
their duty of loyalty to the corporation or its stockholders;
• acts or
omissions not in good faith or which involve intentional misconduct or a
knowing violation of law;
• unlawful
payments of dividends or unlawful stock repurchases or redemptions; or
48
• any transaction
from which the director derived an improper personal benefit.
This provision has no effect on any non-monetary remedies that may be
available to us or our stockholders, nor does it relieve us or our officers or
directors from compliance with federal or state securities laws.
Given the increasing difficulty in obtaining additional liability
insurance for directors and officers and in recognition of the need to protect
certain directors and officers from unwarranted personal liability, we extend
indemnification agreements to our board members and certain key officers to provide
specific contractual assurance that the indemnification protection promised by
the laws will be available to such officers.
Insofar as indemnification for liabilities arising under the Securities
Act may be permitted to directors, officers, or persons controlling us under
the provisions that we describe above or otherwise, we have been informed that
in the opinion of the SEC, this indemnification is against public policy as
expressed in the Securities Act and is therefore unenforceable.
Our amended and restated by-laws also permit us to purchase and
maintain insurance on behalf of any officer or director for any liability
arising out of his or her actions in that capacity, regardless of whether our
by-laws would otherwise permit indemnification for that liability. We currently
have such liability insurance for our officers and directors.
At the present time, there are several class action lawsuits (see Item
3. Legal Proceedings) involving certain of our current and former officers. We
believe these lawsuits are without legal merit. Accordingly, the Board of
Directors has authorized indemnification for such current and former officers.
Employee Benefit Plans
2001 McDATA Equity
Incentive Plan
Our
Board of Directors and our stockholders originally approved and adopted our
McDATA Stock Option Plan in October 1997.
This plan was subsequently renamed the 2001 McDATA Equity Incentive
Plan, or the 2001 Plan, and was amended to increase (from 24 million to 30 million
shares) the authorized number of Class B common shares issuable under the plan
and expand the type of awards to include restricted stock and stock awards and
other necessary changes. As of January 31, 2004, approximately
6,473,692 million shares of our Class B common stock were reserved
for issuance under the 2001 Plan. Under the terms of the 2001 Plan, our Board
of Directors may grant incentive stock options, non-qualified stock options,
stock bonuses and rights to acquire restricted stock to our employees and
non-qualified stock options to our directors, provided that certain eligibility
requirements are satisfied. Our Board of Directors administers the 2001 Plan,
but has delegated to the Compensation Committee the authority to administer the
plan. A summary of the terms related to options are as follows:
• the duration of the option, which may not
exceed 10 years for incentive stock options and 10 years and 1 month for
nonstatutory stock options;
• whether an option will be an incentive stock
option or a non-qualified stock option;
• the number of shares of Class B common
stock covered by the option; and
• when the option becomes exercisable.
The
exercise price per share of Class B common stock for:
• non-qualified options must be no less than
85% of the fair market value per share of the Class B common stock subject
to the option;
• incentive stock options must be no less than
the fair market value of the Class B common stock
49
subject
to the option; and
• incentive stock options granted to an
employee owning more than 10% of the total combined voting power of all classes
of our capital stock, or of any related company, must not be less than 110% of
the fair market value per share of the Class B common stock.
Initially, each incentive stock option granted is exercisable over a
period determined by the Compensation Committee in its discretion, not to
exceed ten years from the date of the grant as required by the Internal Revenue
Code of 1986. In addition, the exercise period for an incentive stock option
may not exceed five years from the date of the grant if the option is
granted to an individual who, at the time of the grant, owns more than 10% of
the total combined voting power of all classes of our capital stock. The
Compensation Committee generally has the right to accelerate the exercisability
of any options granted under the 2001 Plan that would otherwise be
unexercisable. In the event of certain changes in control, the acquiring or
successor corporation may assume or grant substitute options for options then
outstanding under the 2001 Plan, or such options shall terminate.
The
2001 Plan expires on September 30, 2010, except as to options or awards
outstanding on that date. Subject to the terms of the 2001 Plan, the Board of
Directors or the Compensation Committee may terminate or amend the 2001 Equity
Incentive Plan at any time.
The
Compensation Committee determines the purchase price of other stock awards.
However, the Compensation Committee may award stock bonuses in consideration of
past services without purchase payment. Shares that we sell or award under the
2001 Plan may, but need not be, restricted and subject to a repurchase option
in our favor in accordance with a vesting schedule that the Compensation
Committee determines. The Compensation Committee, however, may accelerate the
vesting of the restricted stock. In accordance with the terms of the 2001 Plan,
the Compensation Committee has delegated its duties with respect to equity
grants for non-executive officers to a Compensation Subcommittee, which is
chaired by Mr. Kelley.
As
of January 31, 2004, outstanding Class B common stock awards consisting of
options and restricted stock totaled 14,000,000. Of this amount 415,000 shares of restricted Class B common stock
have been issued and 2,585,000 are available for issuance. The weighted average exercise price of
restricted stock awards was $11.04. As
of January 31, 2004, the weighted average exercise price of outstanding stock
options was $11.38.
2003 McDATA Acquisition Equity Incentive
Plan
Our Board of Directors approved and adopted our 2003 McDATA Acquisition
Equity Incentive Plan, or the 2003 Plan, in August 2003. The 2003 Plan is a limited purpose plan to
allow for the issuance of inducement grants of restricted and unrestricted
Class B common stock to new employees in connection with a merger with or
acquisition of a company or business by McDATA. The authorized number of Class B common shares issuable under the
plan is 3,000,000 and includes awards such as restricted stock and stock
awards. As of January 31, 2004,
approximately 1,300,000 shares of our Class B common stock had been issued
under the 2003 Plan in connection with the 2003 acquisitions of Nishan and
Sanera and 1,700,000 shares of our Class B common stock are available
for future issuances. The 2003 Plan expires in
September 30, 2013, except as to awards outstanding on that date. Subject
to the terms of the 2003 Plan, the Board of Directors or the Compensation
Committee may terminate or amend the 2003 Plan at any time. The
Compensation Committee may accelerate the vesting of restricted stock.
2002 Employee Stock Purchase Plan
In
2002, our Board of Directors adopted and our stockholders approved the McDATA
Employee Stock Purchase Plan, or the Purchase Plan. The Purchase Plan became
effective as of August 1, 2002. The Purchase Plan is an employee stock
purchase plan under Section 423 of the Internal Revenue Code. The Purchase
Plan is administered by the Compensation Committee, and the Compensation
Committee is authorized to determine any questions arising in the
administration, interpretation and application of the Purchase Plan. The Board
of Directors may at any time amend the Purchase Plan in any respect which shall
not adversely affect the rights of
50
participants
pursuant to shares previously acquired under the Purchase Plan, provided that
approval by our stockholders of the Company is required to (i) increase
the number of shares to be reserved under the Purchase Plan (except for
adjustments by reason of stock dividends, stock splits, corporate separations,
recapitalizations, mergers, consolidations, combinations, exchanges of shares
and similar transactions), (ii) decrease the minimum purchase price, (iii) withdraw
the administration of the Purchase Plan from the Compensation Committee, or
(iv) change the definition of employees eligible to participate in the
Purchase Plan.
Up
to 1,200,000 shares of our Class B common stock are available for
distribution under the Purchase Plan, subject to appropriate adjustments by the
Compensation Committee in the event of certain changes in the outstanding
shares of Class B common stock by reason of stock dividends, stock splits,
corporate separations, recapitalizations, mergers, consolidations,
combinations, exchanges of shares or similar transactions. As of
January 31, 2004 approximately 679,000 shares of our Class B
common stock remain available for issuance under the Purchase Plan.
Any of our employees or, subject to approval by the Board of Directors,
employees of any of our subsidiary corporations (including officers and any
directors who are also employees) will be eligible to participate in the
Purchase Plan for any Purchase Period. “Purchase Period” means a six-month
period ending on the last day of February or August of each year (or
another period determined by the Compensation Committee). No employee may
participate in the Purchase Plan if such employee would be deemed for purposes
of the Internal Revenue Code to own stock possessing 5% or more of the total
combined voting power or value of all classes of our stock. If the employment
of a participant terminates for any reason, including death, disability or
retirement, the amounts previously withheld will be refunded. The rights of a
participant under the Purchase Plan are exercisable only by the participant
during his or her lifetime. No right or interest of any participant in the
Purchase Plan may be sold, pledged, assigned or transferred in any manner other
than by will or the laws of descent and distribution.
An
eligible employee who elects to participate in the Purchase Plan will deliver a
signed election form which authorizes us to make payroll deductions of a
specified whole percentage from 1% to 10% of the employee’s gross cash
compensation as defined in the Purchase Plan. A participant may elect to
withdraw from the Purchase Plan at any time before the end of a Purchase
Period. As of the last day of each Purchase Period, the amounts withheld for a
participant in the Purchase Plan will be used to purchase shares of our
Class B common stock. The purchase price of each share will be equal to
85% of the lesser of the fair market value (as determined under the provisions
of the Purchase Plan) of a share of Class B common stock on either the
first or last day of the Purchase Period. All amounts so withheld will be used
to purchase the number of shares of Class B common stock that can be
purchased with such amounts at such price, unless the participant has properly
notified us that he or she elects to purchase a lesser number of shares or to
receive all or a portion of the entire amount in cash in accordance with the
terms of the Purchase Plan.
No
more than $25,000 in fair market value (determined on the first day of the
respective Purchase Periods) of shares of Class B common stock may be
purchased by any participant for each calendar year under the Purchase Plan and
all other employee stock purchase plans, if any, that we or any of our parent
or subsidiary corporations may establish. If purchases by all participants
would exceed the number of shares of Class B common stock available for
purchase under the Purchase Plan, each participant will be allocated a ratable
portion of such available shares. Any amount not used to purchase shares of
Class B common stock will be refunded to the participant in cash.
Shares
of Class B common stock acquired by each participant will be held in a
general securities brokerage account maintained by the Agent for the benefit of
all participants, with an agent, selected by us, maintaining individual sub
accounts for each participant. Each participant will be entitled to vote all
shares held for the benefit of such participant in the general securities
brokerage account. After meeting certain holding requirements, certificates for
the number of shares of Class B common stock purchased by a participant
will be issued and delivered to him or her only upon the request of such
participant or his or her representative.
51
All
rights of participants in any offering under the Purchase Plan will terminate
at the earlier of (i) the day that participants become entitled to
purchase a number of shares of Class B common stock equal to or greater than
the number of shares remaining available for purchase or (ii) at any time,
at the discretion of the Board of Directors, after 30 days’ notice has
been given to all participants. Upon termination of the Purchase Plan, shares
of Class B common stock will be purchased for participants in accordance
with the terms of the Purchase Plan, and cash, if any, previously withheld and
not used to purchase Class B common stock will be refunded to the
participants, as if the Purchase Plan were terminated at the end of a Purchase
Period.
401(k) Plan
The
Company has adopted a 401(k) Plan. Participants in our 401(k) plan
may contribute up to 15% of their total annual compensation, not to exceed the
specified statutory limit, which was $12,000 in calendar year 2003. The
401(k) plan permits, but does not require, us to make contributions to the
401(k) plan on behalf of our employees. Our current practice is to match
$0.50 on each dollar of an employee’s contributions up to the first 6% of an
employee’s compensation with a total maximum matching contribution of 3% of an
employee’s compensation. All contributions to the 401(k) plan by or on
behalf of employees are subject to the aggregate annual limits prescribed by
the Internal Revenue Service. Under our 401(k) plan, our participants
received full and immediate vesting of their contributions and are vested in
matching contributions over a three-year period.
Profit Sharing
Subject
to approval by the Board of Directors or the Compensation Committee, we have
historically awarded limited profit sharing to eligible employees based on
Company performance. For 2001, the amount approved was 2.5% of annual base
salary. For 2002, the amount approved was 7.5% of an employee’s fourth quarter
base earnings if the employee did not participate in any other incentive
compensation plan of the Company. In 2003, the profit sharing program was
replaced by the success share program described below.
Other Bonus Program
A
Performance Incentive Bonus (PIB) plan was implemented in the third quarter of
2002 for eligible managers that were not eligible under the EPIB plan for
executives or any other sales or incentive compensation plan. The PIB plan is designed to further drive
performance beyond target levels through the availability of additional cash
bonus opportunities when target metrics are substantially exceeded. The target
cash bonus of the PIB plan can range from 8% to 22% of the manager’s quarterly
base salary if certain quarterly corporate and individual objectives are
achieved. The Compensation Committee has significant discretion in determining
whether objectives have been met under the plan.
In
addition, a Success Share plan was implemented in the third quarter of 2002 for
eligible employees that are not managers and are not otherwise eligible under
the EPIB plan for executives, the PIB plan for managers or any other sales or
incentive compensation plan. The
Success Share plan is designed to further drive performance beyond target
levels through the availability of additional cash bonus opportunities when
target metrics are substantially exceeded. The target cash bonus of the Success
Share plan may not exceed more than 5% of the eligible employee’s quarterly
base salary if certain quarterly corporate objectives are achieved. The Compensation
Committee has significant discretion in determining whether the objectives have
been met under the plan.
Director Compensation
Director’s
fees for 2003, paid only to Directors who are not McDATA employees, are as
follows:
|
Lead Director Retainer
|
|
$ 10,000
|
|
|
Annual Director Retainer
|
|
15,000
|
|
|
Board Meeting Fee
|
|
2,000
|
|
|
Audit Committee Chair Fee
|
|
2,000
|
|
|
Other Committee Chair Fee
|
|
1,500
|
|
|
Audit Committee Meeting Fee
|
|
1,500
|
|
|
Other Committee Meeting Fee
|
|
1,000
|
|
52
Any
Director who is an employee of McDATA or one of its subsidiaries receives no
compensation for serving as a Director. Accordingly, John F. McDonnell and John
A. Kelley, Jr., did not receive fees for their services as Board members in
fiscal year 2003. With regard to incentive compensation for our directors, our
practice has been to grant Directors options to purchase 50,000 shares of our
Class B common stock when they become directors and to grant them options
to purchase an additional 30,000 shares of our Class B common stock each
year thereafter, with each grant vesting as to fifty percent each year. The Lead Director is granted an
additional 10,000 shares of our Class B
common stock each year.
In
October 1997, before he became a director, Mr. McDonnell was granted
an option to purchase 1,000,000 shares of our Class B common stock. In
August 2001, Mr. Kelley was hired as President and Chief Operating
Officer and was granted an option to purchase 250,000 shares of our
Class B common stock. In August 2002 and January 2003,
Mr. Kelley, our current Chairman, Chief Executive Officer and President,
was granted an option to purchase 315,000 and 400,000 shares of our
Class B common stock, respectively.
Compensation Committee Interlocks and Insider Participation
The members of the Compensation Committee for the fiscal year ended
January 31, 2004 were Betsy S. Atkins, Thomas M. Uhlman and Laurence G.
Walker. No member of this committee was at any time during the 2003 fiscal year
or at any other time an officer or employee of the Company, and no member had
any relationship with the Company requiring disclosure under Item 404 of
Regulation S-K. No executive officer of the Company has served on the board of
directors or compensation committee of any other entity that has or has had one
or more executive officers who served as a member of the Board of Directors or
the Compensation Committee during the fiscal year ended January 31, 2004.
No
interlocking relationship exists between our Board of Directors or Compensation
Committee and the board of directors or compensation committee of any other
entity, nor has any interlocking relationship existed in the past.
53
REPORT OF THE COMPENSATION COMMITTEE OF THE BOARD OF
DIRECTORS
The
following is the report of the Compensation Committee of the Board of Directors
with respect to the compensation paid to the Company’s executive officers
during fiscal year 2003. Actual compensation earned during fiscal year 2003 by
the Named Executive Officers is shown in the Summary Compensation Table.
Compensation Philosophy
The
Company operates in the extremely competitive and rapidly changing high
technology industry. The Compensation Committee believes that the compensation
programs for the executive officers should be designed to attract, motivate and
retain talented executives responsible for the success of the Company and
should be determined within a competitive framework and based on the
achievement of designated business objectives, individual contribution,
customer satisfaction and financial performance. Within this overall
philosophy, the Compensation Committee’s objectives are to:
• Provide a competitive total compensation
package that takes into consideration the compensation practices of companies
with which the Company competes for executive talent.
• Provide variable compensation opportunities
that are linked to achievement of financial, organization, management and
individual performance goals.
• Align the financial interests of executive
officers with those of stockholders by providing executives with an equity
stake in the Company.
Components of Executive Compensation
The
compensation program for the Company’s executive officers consists of the following
components:
• Base Salary
• Management Bonus Program
• Long-Term Stock Option Incentives
Base Salary
The Compensation Committee reviews salaries for the Chief Executive
Officer and other executive officers early in the fiscal year. Base salaries are
established by the Compensation Committee based upon competitive compensation
data, an executive’s job responsibilities, level of experience, individual
performance and contribution to the business. No specific formula is applied to
determine the weight of each factor. The Compensation Committee bases its
determination of Mr. Kelley’s salary on his individual performance and the
salaries paid to chief executive officers of peer companies. Based upon a
review of competitive compensation data in early 2003, the Compensation
Committee set Mr. Kelley’s base salary to $400,000 for 2003. The salaries for the other Named Executive
Officers are listed in the Summary
Compensation Table.
Management Bonus Program
Beginning
in the third quarter of 2002, a revised Executive Performance Incentive Bonus
(EPIB) plan was implemented in lieu of the earlier cash only based management
bonus program. The EPIB plan uses restricted stock with accelerated vesting
opportunities to reward participants for the collective achievement of
strategic corporate revenue and pro forma EPS goals on a quarterly basis. The
EPIB plan is designed to further drive performance beyond target levels through
the availability of additional cash bonus opportunities when target metrics are
substantially exceeded. Currently the cash bonus component of the EPIB plan is
calculated as a percentage of base compensation and can range from 7.5% to
18.75% of quarterly base salary if corporate objectives are achieved, and from
30% to 75% if more progressive objectives are met. The EPIB plan did pay for corporate performance in the first and
second fiscal quarter of 2003 and the applicable restricted shares for those
54
quarters
were accelerated per the plan. Under the EPIB plan since January 1, 2003, Mr.
Kelley was granted 59,100 shares of restricted Class B common stock with a 48
month cliff restriction period. As a
result of the achievement of goals set under the EPIB plan in the first and
second fiscal quarters of 2003, 29,550 of these shares of restricted Class B
common stock had their restriction period accelerated to 18 months. The grants under the EPIB plan for the other
Named Executive Officers are listed in the Summary
Compensation Table.
Long-Term Stock Option Incentives
The
Compensation Committee provides the Company’s executive officers with long-term
incentive compensation through grants of options to purchase the Company’s
Class B common stock. The goal of the long-term stock option incentive program
is to align the interests of executive officers with those of the Company’s
stockholders and to provide each executive officer with a significant incentive
to manage the Company from the perspective of an owner with an equity stake in
the business. It is the belief of the Compensation Committee that stock options
directly motivate an executive to maximize long-term stockholder value. The
options also utilize vesting periods that encourage key executives to continue
in the employ of the Company. The Compensation Committee considers the grant of
each option subjectively, reviewing factors such as the anticipated future
contribution of the executive toward the attainment of the Company’s long-term
strategic performance goals. Under the 2001 McDATA Equity Incentive Plan, Mr.
Kelley was granted 400,000 options to purchase Class B common stock since
January 1, 2003. The grants under the
2001 McDATA Equity Incentive Plan for the other Named Executive Officers are
listed in the Summary Compensation Table.
Section 162(m)
The
Company has considered the potential future effects of Section 162(m) of
the Internal Revenue Code on the compensation paid to the Company’s executive
officers. Section 162(m) disallows a tax deduction for any publicly held
corporation for individual compensation exceeding $1.0 million in any
taxable year for any of the Named Executive Officers, unless compensation is
performance-based. The Company will seek to qualify the variable compensation
paid to its executive officers for an exemption from the deductibility
limitations of Section 162(m).
|
|
Respectfully
submitted by:
|
|
|
|
|
|
The Compensation Committee
|
|
|
Thomas
M. Uhlman, Chairman
|
|
|
Betsy
S. Atkins
|
|
|
Laurence
G. Walker
|
55
Performance Graph
Set forth below is a line graph comparing the annual percentage change
in the cumulative return to the stockholders of our Class A Common Stock
with the cumulative return of the NASDAQ Market Index and the SIC Code Computer
Peripheral Equipment Index for the period commencing February 5, 2001 and
ending on January 30, 2004. Returns for the indices are weighted based on
market capitalization at the beginning of each measurement point.
COMPARING CUMULATIVE TOTAL RETURN
AMONG MCDATA CORPORATION CLASS A,
NASDAQ MARKET INDEX AND SIC CODE INDEX
ASSUMES $100 INVESTED ON FEB. 5 2001
ASSUMES DIVIDENDS REINVESTED
FISCAL YEAR ENDING JANUARY 31, 2004
|
|
|
2/5/2001
|
|
1/31/2002
|
|
1/31/2003
|
|
1/30/2004
|
|
|
|
|
|
|
|
|
|
|
|
|
|
McDATA Corporation Cl A
|
|
$
|
100.00
|
|
$
|
53.62
|
|
$
|
17.06
|
|
$
|
19.00
|
|
|
SIC Code 3669
|
|
$
|
100.00
|
|
$
|
27.07
|
|
$
|
10.46
|
|
$
|
22.19
|
|
|
NASDAQ Market Index
|
|
$
|
100.00
|
|
$
|
70.45
|
|
$
|
48.63
|
|
$
|
76.33
|
|
(1) The
graph assumes that $100 was invested on February 5, 2001 in the Company’s
Class A common stock, in the NASDAQ Market Index, and the SIC Code, and that
all dividends were reinvested. No
dividends have been declared or paid on the Company’s Class A common
stock. Stockholder returns over the
indicated period should not be considered indicative of future stockholder
returns.
56
Set forth
below is a line graph comparing the annual percentage change in the cumulative
return to the stockholders of our Class B Common Stock with the cumulative
return of the NASDAQ Market Index and the SIC Code Computer Peripheral
Equipment Index for the period commencing August 9, 2000 and ending on
January 30, 2004. Returns for the indices are weighted based on market
capitalization at the beginning of each measurement point.
COMPARING CUMULATIVE TOTAL RETURN
AMONG MCDATA CORPORATION CLASS B,
NASDAQ MARKET INDEX AND SIC CODE INDEX
ASSUMES $100 INVESTED ON AUG. 9, 2000
ASSUMES DIVIDENDS REINVESTED
FISCAL YEAR ENDING JANUARY 30,
2004
|
|
|
8/9/2000
|
|
1/31/2001
|
|
1/31/2002
|
|
1/31/2003
|
|
1/30/2004
|
|
|
McDATA Corporation Cl B
|
|
$
|
100.00
|
|
$
|
64.28
|
|
$
|
30.74
|
|
$
|
9.27
|
|
$
|
10.18
|
|
|
SIC Code 3669
|
|
$
|
100.00
|
|
$
|
74.53
|
|
$
|
20.18
|
|
$
|
7.79
|
|
$
|
16.54
|
|
|
NASDAQ Market Index
|
|
$
|
100.00
|
|
$
|
73.53
|
|
$
|
51.80
|
|
$
|
35.79
|
|
$
|
56.12
|
|
(1) The graph assumes
that $100 was invested on August 9, 2000 in the Company’s Class B common
stock, in the NASDAQ Market Index, and the SIC Code Index, and that all
dividends were reinvested. No dividends
have been declared or paid on the Company’s Class B common stock. Stockholder returns over the indicated
period should not be considered indicative of future stockholder returns. The information contained above under the
captions “Report of the Compensation
Committee of the Board of Directors” and “Performance Graph” shall not be deemed to be “soliciting
material” or to be “filed” with the SEC, nor shall such information be
incorporated by reference into any future filing under the Securities Act or
the Securities Exchange Act, except to the extent that the Company specifically
incorporates it by reference into such filing.
57
ITEM
12. Security Ownership of Certain Beneficial
Owners and Management
The following table sets forth certain information concerning the
beneficial ownership of our common stock as of January 31, 2004. Unless otherwise indicated, the address of
each listed stockholder is c/o McDATA Corporation, 380 Interlocken Crescent,
Broomfield, Colorado 80021.
We have determined beneficial ownership in accordance with the rules of
the SEC. Except as indicated by the footnotes below, we believe, based on the
information furnished to us, that the persons and entities named in the tables
below have sole voting and investment power with respect to all shares of
common stock that they beneficially own, subject to applicable community
property laws. We have based our
calculation of the percentage of beneficial ownership on the number of shares
of Class A common stock outstanding on January 31, 2004, or the number of
shares of Class B common stock outstanding on January 31, 2004, as the
case may be. There were 81,000,000
shares of Class A common stock outstanding on January 31, 2004, and
36,051,473 shares of Class B common stock outstanding on January 31, 2004.
In computing the number of shares of Class B common stock beneficially
owned by a person and the percentage ownership of that person, we deemed
outstanding shares of Class B common stock subject to options held by that person
that are currently exercisable or exercisable within 60 days of
January 31, 2004. Asterisks
represent beneficial ownership of less than one percent.
|
|
|
Number of
Shares of Common Stock
Class Beneficially Owned
|
|
Percent of
Shares of
Common Stock Class
Beneficially Owned
|
|
|
Name and Address of the
Beneficial Owner
|
|
Class A
|
|
Class B
|
|
Class A
|
|
Class B
|
|
|
|
|
|
|
|
|
|
|
|
|
|
5% Stockholders
|
|
|
|
|
|
|
|
|
|
|
Essex Investment Management Co. LLC.
125 High Street, 29th Floor
Boston, MA 02110
|
|
9,172,506
|
(1)
|
—
|
|
11.3
|
%
|
—
|
|
|
Wellington Management Company LLP
75 State Street
Boston, MA 02109
|
|
6,315,300
|
(1)
|
3,105,400
|
(1)
|
7.8
|
%
|
8.6
|
%
|
|
Oak Associates, LTD
3875 Embassy Parkway #250
Akron, OH 44333
|
|
5,938,245
|
(1)
|
—
|
|
7.3
|
%
|
—
|
|
|
Mellon Financial Corporation
One Mellon Center
Pittsburgh, PA 15258
|
|
5,314,522
|
(1)
|
—
|
|
6.6
|
%
|
—
|
|
|
Denver Investment Advisors LLC
1225 17th Street, 26th Floor
Denver, CO 80202
|
|
—
|
|
3,604,470
|
(1)
|
—
|
|
10.0
|
%
|
|
Patricia L.
McDonnell
|
|
37,819
|
(2)
|
2,961,500
|
(1)(3)
|
|
*
|
8.2
|
%
|
|
John F. McDonnell
|
|
28,311
|
(4)
|
5,820,000
|
(1)
|
|
*
|
16.1
|
%
|
|
Executive Officers
and Directors
|
|
|
|
|
|
|
|
|
|
|
John F. McDonnell
|
|
28,311
|
(4)
|
5,820,000
|
(5)
|
|
*
|
16.1
|
%
|
|
John A. Kelley
|
|
—
|
|
417,077
|
(6)
|
—
|
|
1.2
|
%
|
|
Alain Andreoli
|
|
—
|
|
—
|
|
—
|
|
—
|
|
|
Jean M. Becker
|
|
—
|
|
62,672
|
(7)
|
—
|
|
|
*
|
|
Robert F. Finley
|
|
185
|
|
83,770
|
(8)
|
|
*
|
|
*
|
|
Michael B. Gustafson
|
|
53
|
|
362,500
|
(9)
|
|
*
|
1.0
|
%
|
|
Gary M. Gysin
|
|
—
|
|
74,000
|
(10)
|
—
|
|
|
*
|
|
Thomas O. McGimpsey
|
|
—
|
|
60,213
|
(11)
|
—
|
|
|
*
|
|
Karen L. Niparko
|
|
—
|
|
88,713
|
(12)
|
—
|
|
|
*
|
|
Ernest J. Sampias
|
|
—
|
|
127,043
|
(13)
|
—
|
|
|
*
|
|
John W. Gerdelman
|
|
—
|
|
132,250
|
(14)
|
—
|
|
|
*
|
|
Charles C. Johnston
|
|
—
|
|
132, 250
|
(16)
|
—
|
|
|
*
|
|
D. Van Skilling
|
|
300
|
|
132, 250
|
(14)
|
|
*
|
|
*
|
|
Thomas M. Uhlman
|
|
—
|
|
132, 250
|
(14)
|
—
|
|
|
*
|
|
Laurence G. Walker
|
|
1
|
(18)
|
132, 250
|
(14)
|
|
*
|
|
*
|
|
Betsy S. Atkins
|
|
—
|
|
15,000
|
(17)
|
—
|
|
|
*
|
|
Michael J. Sophie
|
|
—
|
|
12,500
|
(15)
|
—
|
|
|
*
|
|
All Executive Officers and Directors as a
Group (17 persons)
|
|
28,850
|
|
7,784,738
|
|
|
*
|
21.6
|
%
|
58
(1) Based
on Schedule 13G filings (as of December 31, 2003).
(2) Includes
28,311 shares held jointly with John F. McDonnell, Ms. McDonnell’s
husband, and 1,491 shares held as a trustee and custodian in a custodial
account for their son.
(3) Includes
51,500 shares held by Ms. McDonnell as trustee and custodian in a custodial
account for their son.
(4) Includes
28,311 shares held jointly with Ms. McDonnell, Mr. McDonnell’s wife.
Mr. McDonnell disclaims beneficial ownership of the shares of Class A
common stock held by Ms. McDonnell personally and as trustee and
custodian.
(5) Excludes
40,000 shares held by the McDonnell Family Partnership, L.L.L.P., a limited
liability limited partnership of which Mr. McDonnell is the general
partner. Includes 940,000 shares which remain outstanding and exercisable while
Mr. McDonnell provides continuous service under his three-year
January 2004 Litigation Support Agreement with the Company. The number of
shares of common stock beneficially owned by John F. McDonnell does not include
2,961,500 shares held by Ms. McDonnell, Mr. McDonnell’s wife, which
includes 51,500 shares held as trustee and custodian by Ms. McDonnell in a
custodial account for their son. Mr. McDonnell disclaims beneficial
ownership of the shares of Class B common stock held by Ms. McDonnell
personally and as trustee and custodian.
(6) Includes
98,500 shares of restricted stock and 303,750 shares subject to stock options
exercisable within 60 days after January 31, 2004.
(7) Includes
24,000 shares of restricted stock and 37,500 shares subject to stock options
exercisable within 60 days after January 31, 2004.
(8) Includes
22,500 shares of restricted stock and 60,000 shares subject to stock options
exercisable within 60 days after January 31, 2004.
(9) Includes
27,500 shares of restricted stocks and 275,000 shares subject to stock options
exercisable within 60 days after January 31, 2004.
(10) Includes
24,000 shares of restricted stock and 50,000 shares subject to stock options
exercisable within 60 days after January 31, 2004.
(11) Includes
23,625 shares of restricted stock and 35,250 shares subject to stock options
exercisable within 60 days after January 31, 2004.
(12) Includes
32,745 shares of restricted stock and 52,500 shares subject to stock options
exercisable within 60 days after January 31, 2004.
(13) Includes
41,500 shares of restricted stock and 80,000 shares exercisable within 60 days
of January 31, 2004.
(14) Includes
132,250 shares subject to stock option exercisable within 60 days of
January 31, 2004.
(15) Includes
12,500 shares subject to stock options exercisable within 60 days after
January 31, 2004.
(16) Includes
67,250 shares subject to stock options exercisable within 60 days after
January 31, 2004 and 65,000 shares held by CCJ Trust.
(17) Includes
15,000 shares subject to stock options exercisable within 60 days of
January 31, 2004.
(18) Includes
1 share of Class A common stock held by Katherine Walker,
Mr. Walker’s wife.
* Less than 1%
59
On February 7, 2001, EMC distributed all the shares of our
Class A common stock held by EMC to EMC stockholders on a pro rata basis
in a transaction that was tax free to EMC. A total of 81,000,000 shares of our
Class A common stock were distributed. EMC stockholders paid no
consideration for the shares of Class A common stock distributed to them.
The following table sets forth certain information concerning all
equity compensation plans previously approved by stockholders and all equity
compensation plans not previously approved by stockholders as of
January 31, 2004. The 2001 McDATA Equity Incentive Plan is our only equity
compensation plan that was approved by stockholders. The 2003 McDATA Acquisition Equity Incentive Plan was adopted in
August 2003 to provide Class B restricted stock grants for newly hired
employees as a result of acquisitions.
The 2003 McDATA Acquisition Equity Incentive Plan was not approved by
stockholders in accordance with an exemption available under NASDAQ rules.
Equity Compensation Plan Information as of
January 31, 2004
|
Plan Category
|
|
Number of
Securities to
be issued upon exercise
of outstanding options,
warrants and rights
|
|
Weighted
average
exercise price of
outstanding option,
warrants and rights
|
|
Number of
securities remaining
available for future issuance under
equity compensation plans (excluding
securities reflected in column (a))
|
|
|
|
|
|
|
|
|
|
|
|
Equity compensation plans approved by
security holders
|
|
14,062,853
|
|
$11.04
|
|
6,473,692
|
|
|
Equity compensation plans not approved by
security holders
|
|
818,945
|
|
$0.00
|
|
1,754,215
|
|
|
Total
|
|
14,881,798
|
|
$11.04
|
|
8,227,907
|
|
Other Matters
In October 2000, new SEC rules went into effect that establish
affirmative defenses to insider trading claims under certain defined
circumstances, irrespective of the possession of material non-public
information, for transactions planned before coming into possession of such
information. Generally, such persons may purchase or sell such securities
pursuant to a binding pre-existing plan, contract or instruction, or
collectively a Pre-Existing Plan, which sets forth either (a) the amount,
price and date of such trade, (b) a formula, algorithm or computer program
for determining amounts, prices and dates; or (c) such Pre-Existing Plan
does not permit the person to exercise any subsequent influence over the trade.
Several of our directors and officers have established Pre-Existing Plans for
the purpose of selling a portion of their shares of Class B common stock
to diversify their holdings. Other officers may enter into Pre-existing Plans
to diversify their holdings.
ITEM 13. Certain
Relationships and Related Transactions
There has not been nor is there currently proposed any transaction or
series of similar transactions to which we were or are a party in which the
amount involved exceeds $60,000 and in which any director, executive officer,
holder of more than 5% of our common stock or any member of the immediate
family of any of the foregoing persons had or will have a direct or indirect
material interest other than (a) compensation agreements and other arrangements,
which are described in “Item 11—Executive Compensation,” and (b) the
transactions described below.
In
January 2004, we entered into a three-year litigation support and
consulting agreement with John F. McDonnell, our former Chairman, pursuant to
which Mr. McDonnell will render litigation support and consulting services to
McDATA. Under the agreement, we are assured on-demand access to Mr. McDonnell
at a rate of $250 per hour and the reimbursement of out-of-pocket expenses. The
agreement was reviewed and approved by a committee of independent directors of
the Board of Directors.
In
February 2004, we entered into a six-month standard lab services agreement
with JRBM Incorporated (JRBM), a company partially owned by John F. McDonnell,
our former Chairman. Under this arrangement, we lease approximately 155 square
feet of unused lab space and equipment to JRBM at an arms-length market rate,
and
60
JRBM may purchase McDATA products under our standard OpenReady™
equipment discount program. The arrangement was reviewed and approved by a
committee of independent directors of the Board of Directors. JRBM has also
made a business proposal to McDATA to review our SANavigator®
software, over a nine month period, for the purpose of potentially reselling,
licensing or utilizing certain features or modules of SANavigator®
and potentially developing application program interfaces. The agreement
evidencing such an arrangement was signed on February 25, 2004 (with a
February 27, 2004 effective date) by both parties after review and
approval by a committee of independent directors of the Board of Directors.
The Company has also entered into indemnification agreements with its
directors and officers. For a
discussion regarding the indemnification agreements, please see Item II.
Executive Compensation under the caption entitled “Limitation of Liability and
Indemnification.”
ITEM 14. Principal
Accountant Fees and Services
Audit and Non-Audit Fees
The following table presents fees for professional services rendered by
PricewaterhouseCoopers LLP for the fiscal years ended December 31,
2002 and January 31, 2004.
|
|
|
2002
|
|
2003
|
|
|
Audit fees:(1)
|
|
$
|
423,328
|
|
$
|
477,500
|
|
|
Audit related fees:(2)
|
|
12,155
|
|
273,459
|
|
|
Tax fees:(3)
|
|
73,086
|
|
88,407
|
|
|
All other fees:(4)
|
|
47,384
|
|
70,000
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
555,953
|
|
$
|
909,366
|
|
(1) Audit fees consisted of audit work performed and billed through the
date of this filing in the preparation of financial statements, as well as work
generally only the independent auditor can reasonably be expected to provide,
such as statutory audits, comfort letters, consents and assistance with and
review of documents filed with the Securities and Exchange Commission.
(2) Audit-related fees consisted principally of the review in 2002 of
certain revenue contracts and our RMA (return materials authorization)
reconciliation project. In 2003, fees related to acquisition work in Nishan,
Sanera and other projects and initial Sarbanes-Oxley Act discussions.
(3) Tax fees consisted principally of assistance with tax planning,
compliance and reporting.
(4) All other fees consisted principally in 2002 of our convertible
debt offering and in 2003 of our completion of the convertible debt offering.
Policy on Audit Committee Pre-Approval of
Audit and Permissible Non-Audit Services of Independent Auditor
Consistent with SEC policies regarding auditor independence, the Audit
Committee has responsibility for appointing, setting compensation and
overseeing the work of the independent auditor. In recognition of this
responsibility, the Audit Committee has established a policy to pre-approve all
audit and permissible non-audit services provided by the independent auditor.
The Audit Committee has approved of all permissible non-audit services
consistent with SEC requirements.
Prior to engagement of the independent auditor for the next year’s
audit, management will submit an aggregate of services expected to be rendered
during that year for each of four categories of services to the Audit
61
Committee for approval.
1. Audit services include audit work
performed in the preparation of financial statements, as well as work that
generally only the independent auditor can reasonably be expected to provide,
including comfort letters, statutory audits, and attest services and
consultation regarding financial accounting and/or reporting standards.
2. Audit-Related services are for assurance
and related services that are traditionally performed by the independent
auditor, including due diligence related to mergers and acquisitions, employee
benefit plan audits, and special procedures required to meet certain regulatory
requirements.
3. Tax services include all services
performed by the independent auditor’s tax personnel except those services
specifically related to the audit of the financial statements, and includes
fees in the areas of tax compliance, tax planning, and tax advice.
4. Other Fees are those associated with
services not captured in the other categories.
Prior to engagement, the Audit Committee pre-approves these services by
category of service. The fees are budgeted and the Audit Committee requires the
independent auditor and management to report actual fees versus the budget
periodically throughout the year by category of service. During the year,
circumstances may arise when it may become necessary to engage the independent
auditor for additional services not contemplated in the original pre-approval.
In those instances, the Audit Committee requires specific pre-approval before
engaging the independent auditor. The Audit Committee may delegate
pre-approval authority to one or more of its members. The member to whom such
authority is delegated must report, for informational purposes only, any
pre-approval decisions to the Audit Committee at its next scheduled meeting.
62
PART IV
ITEM 15. Exhibits,
Financial Statement Schedules, and Reports on Form 8-K
(a) Documents
filed as part of this report
Financial statement schedules other than the one listed above have been
omitted because the required information is contained in the consolidated
financial statements and notes thereto or because such schedules are not
required or applicable.
(b) Reports
on Form 8-K:
We filed the following reports on Form 8-K during the fourth
quarter of 2003 through the date of the filing of this Annual Report on Form
10-K:
(1) Form 8-K filed March 8, 2004 announcing the settlement of the
Brocade lawsuit
(2) Form 8-K filed February 26, 2004 announcing fourth quarter
financial results
(3) Form 8-K filed January 29, 2004 announcing cost improvement
actions
(4) Form 8-K filed January 9, 2004 announcing retirement of
Chairman and settlement of Raytheon lawsuit
(5) Form 8-K filed December 4, 2003 announcing election of board
member
(6) Form 8-K filed December 2, 2004 announcing third quarter
financial results
(7) Form 8-K/A filed November 26, 2003 providing financial
statements for the Sanera acquisition
(8) Form 8-K filed November 25, 2003 announcing the departure of
the company’s Executive Vice President of Worldwide Sales and Services
(9) Form 8-K/A filed November 13, 2003 providing financial
statements for the Nishan acquisition
(10) Form 8-K filed November 6, 2003 announcing preliminary third
quarter financial results
(c) Exhibits:
Exhibits identified in parentheses below are on file with the SEC and
are incorporated herein by reference. All other exhibits are provided as part
of this submission.
Exhibits filed for the Company through the
filing of this Form 10-K.
|
(3.1)
|
|
Amended and Restated Certificate of Incorporation of the Company
|
|
|
|
|
|
(3.2)
|
|
Amended and Restated By-laws of the Company
|
|
|
|
|
|
(4.1)
|
|
Form of Company’s Class B Common Stock Certificates
|
63
|
(4.1.1)
|
|
Form of Company’s Class A Common Stock Certificates
|
|
|
|
|
|
(4.2)
|
|
Investors’ Rights Agreement dated as of October 1, 1997 by and
among the Company, EMC Corporation, McDATA Holdings Corporation and Certain
Investors
|
|
|
|
|
|
(4.3)
|
|
Amendment No. 1 to the Investors’ Rights Agreement dated
May 23, 2000 by and among the Company, McDATA Holdings Corporation and
certain Investors
|
|
|
|
|
|
(4.4)
|
|
Rights Agreement dated as of May 18, 2001, by and between the
Company and the Bank of New York, as rights agent (Filed on Form 8-K
dated May 21, 2001).
|
|
|
|
|
|
(4.5)
|
|
Form of Indenture dated as of February 7, 2003 by and
between the Company and Wells Fargo Bank Minnesota, National Association
(Filed on Form 8-K dated February 14, 2003)
|
|
|
|
|
|
(4.6)
|
|
Form of Registration Rights Agreement dated as of
February 7, 2003 by and among the Company and the parties thereto (Filed
on Form 8-K dated February 14, 2003)
|
|
|
|
|
|
(10.1)
|
|
Asset Transfer Agreement dated as of October 1, 1997 by and
among the Company, EMC Corporation, and McDATA Holdings Corporation
|
|
|
|
|
|
(10.2)
|
|
Investors’ Rights Agreement dated as of October 1, 1997 by and
among the Company, EMC Corporation, McDATA Holdings Corporation and certain
Investors (see Exhibit 4.2)
|
|
|
|
|
|
(10.3)
|
|
Amendment No. 1 to the Investors’ Rights Agreement dated
May 23, 2000 by and among the Company, McDATA Holdings Corporation and
certain Investors (see Exhibit 4.3)
|
|
|
|
|
|
(10.3.1)
|
|
Termination of Investors’ Rights Agreement, dated as of
January 24, 2001, by and among the Company, McDATA Holdings Corporation
and Certain Investors (Filed on Form 10-K for the fiscal year ended
2000)
|
|
|
|
|
|
(10.4)
|
|
Services Agreement dated as of October 1, 1997 by and among EMC
Corporation, McDATA Holdings Corporation and the Company
|
|
|
|
|
|
(10.5)
|
|
Letter Agreement dated April 19, 1999 by and between the Company
and McDATA Holdings Corporation
|
|
|
|
|
|
(10.6)
|
|
Technology Rights Agreement dated as of October 1, 1997 by and
among the Company, EMC Corporation and McDATA Holdings Corporation
|
|
|
|
|
|
(10.7)
|
|
Amended and Restated Tax Sharing Agreement dated as of May 31,
2000 by and among EMC Corporation, McDATA Holdings Corporation and the
Company
|
|
|
|
|
|
(10.8)
|
|
Form of Master Transaction Agreement entered into by and among
the Company and EMC Corporation dated May 31, 2000
|
|
|
|
|
|
(10.9)
|
|
Form of Indemnification and Insurance Matters Agreement entered
into by and among the Company and EMC Corporation dated May 31, 2000
|
|
|
|
|
|
(10.10)
|
|
Master Confidential Disclosure and License Agreement dated as of
May 31, 2000 by and among the Company and EMC Corporation
|
|
|
|
|
|
(10.11)+
|
|
Reseller Agreement dated as of February 22, 2000 by and between
International Business Machines Corporation and the Company
|
|
|
|
|
|
(10.12)
|
|
Amendment Number One to the Resale Agreement dated September 30,
2000 by and between International Business Machines Corporation and the
Company
|
|
|
|
|
|
(10.13)+
|
|
OEM Purchase and License Agreement dated as of May 19, 2000 by
and between EMC Corporation and the Company
|
|
|
|
|
|
(10.13.1)+
|
|
Amendment to OEM Purchase and License Agreement dated as of
September 21, 2001, by and between EMC Corporation and the Company
|
|
|
|
|
|
(10.14)+
|
|
Development Agreement dated as of May 19, 2000 by and between
EMC Corporation and the Company
|
64
|
10.14.1+
|
|
Distribution Agreement dated as of December 15, 1999 by and
between the Company and Hitachi Data Systems Corporation
|
|
|
|
|
|
(10.15)+
|
|
Manufacturing Agreement dated as of September 17, 1992 by and
between SCI Systems, Inc. and the Company
|
|
|
|
|
|
(10.15.1)+
|
|
Manufacturing and Purchasing Agreement dated as of December 14,
2001 by and between SCI Systems, Inc. and the Company (Filed on
Form 8-K dated February 25, 2002)
|
|
|
|
|
|
(10.15.2)+
|
|
Manufacturing and Purchase Agreement effective as of March 1,
2003 by and between Sanmina-SCI Corporation and the Company (filed on Form
10-K for the year ended December 31, 2002)
|
|
|
|
|
|
(10.16)+
|
|
OEM and License Agreement dated as of April 27, 1999 by and
between Brocade Communication Systems, Inc. and the Company
|
|
|
|
|
|
(10.17)
|
|
Lease dated September 12, 1997 by and between the Company and
WHLNF Real Estate Limited Partnership
|
|
|
|
|
|
(10.18)
|
|
Lease dated November 2, 1999 by and between the Company and the
Mills Family LLC
|
|
|
|
|
|
(10.19)
|
|
Lease dated May 28, 1997 by and between the Company and 1211486
Ontario Limited
|
|
|
|
|
|
(10.19.1)
|
|
Lease dated October 6, 2000, by and between the Company and
Amber Drive I, LLC (Filed on Form 10-Q for the fiscal quarter ended
September 30, 2000)
|
|
|
|
|
|
(10.19.2)
|
|
Lease dated February 9, 2001 by and between the Company and
Deutsche Bank (Filed on Form 10-K for the fiscal year ended 2000)
|
|
|
|
|
|
(10.19.3)
|
|
Participation Agreement dated February 9, 2001 by and between
the Company and Deutsche Bank (Filed on Form 10-K for the fiscal year
ended 2000)
|
|
|
|
|
|
(10.19.4)
|
|
Second Amendment to Participation Agreement dated November 9,
2001 by and between the Company and Deutsche Bank (Filed on Form 10-Q
for the fiscal quarter ended September 30, 2001)
|
|
|
|
|
|
(10.19.5)
|
|
Third Amendment to Participation Agreement dated January 24,
2002 by and between the Company and Deutsche Bank (Filed on Form 8-K
dated February 25, 2002)
|
|
|
|
|
|
(10.20)*
|
|
Form of Change of Control Severance Agreement
|
|
|
|
|
|
(10.20.1)*
|
|
CEO Severance Agreement dated December 2003 (filed on Form 10-Q
for the fiscal quarter ended October 31, 2003)
|
|
|
|
|
|
(10.21)*
|
|
1997 Stock Option Plan
|
|
|
|
|
|
(10.21.1)*
|
|
2001 McDATA Equity Incentive Plan (Filed on Schedule 14A dated
July 3, 2003)
|
|
|
|
|
|
(10.21.2)*
|
|
Employee Stock Purchase Plan (Filed on Schedule 14A Proxy
Statement filed June 10, 2002)
|
|
|
|
|
|
(10.22)*
|
|
Form of Stock Option Agreement for 1997 Stock Option Plan
|
|
|
|
|
|
(10.23)*
|
|
Description of the Company’s Management Bonus Program
|
|
|
|
|
|
(10.24)
|
|
Asset Purchase Agreement dated August 3, 2001 by and among the
Company, SANavigator, Inc., Western Digital Corporation and Connex Inc.
(Filed on Form 10-Q for the fiscal quarter ended September 30, 2001)
|
|
|
|
|
|
(10.25)*
|
|
Performance Incentive Bonus Plan (filed on Form 10-K for the year
ended December 31, 2002)
|
|
|
|
|
|
(10.25.1)
|
|
Agreement and Plan of Merger dated August 25, 2003 by and among
the Company, Nice Acquisition, Inc. and Nishan Systems Inc. (filed on Form
8-K dated August 25, 2003 as Exhibit 99.4)
|
|
|
|
|
|
(10.25.2)
|
|
Agreement and Plan of Merger dated August 25, 2003 by and among
the Company, Whitney Acquisition, Inc. and Sanera Systems, Inc. (filed on
Form 8-K dated August 25, 2003 as Exhibit 99.5)
|
|
|
|
|
|
(10.26)*
|
|
Executive Performance Incentive Bonus Plan (filed on Form 10-K for
the year ended December 31, 2002)
|
65
|
(10.27)*
|
|
Chairman of the Board of Directors Performance Incentive Bonus Plan
(filed on Form 10-K for the year ended December 31, 2002)
|
|
|
|
|
|
21
|
|
Subsidiaries of Company
|
|
|
|
|
|
23.1
|
|
Consent of PricewaterhouseCoopers LLP
|
|
|
|
|
|
23.2**
|
|
Consent of KPMG LLP
|
|
|
|
|
|
24
|
|
Power of Attorney
|
|
|
|
|
|
31.1
|
|
Section 302 Certification of Principal Executive Officer
|
|
|
|
|
|
31.2
|
|
Section 302 Certification of Principal Financial Officer
|
|
|
|
|
|
32.1
|
|
Section 906 Certification of Principal Executive Officer
|
|
|
|
|
|
32.2
|
|
Section 906 Certification of Principal Financial Officer
|
|
|
|
|
|
99**
|
|
Audited Financial Statements of Aarohi Communications, Inc.
|
( ) Exhibits
previously filed in the Company’s Registration Statement on Form S-1, SEC
File No. 333-38106, declared effective on August 8, 2000 or filed in
the Company’s periodic filings as specifically noted.
+ Portions of
these Exhibits have been omitted and filed separately with the SEC pursuant to
an order or a request for confidential treatment.
* Executive
compensation plans and arrangements.
** To
be filed
66
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized, in the
City of Broomfield, State of Colorado, on April 2, 2004.
|
|
McDATA Corporation
|
|
|
|
|
|
|
|
|
By:
|
/s/ ERNEST J. SAMPIAS
|
|
|
|
Ernest J. Sampias
|
|
|
|
Senior Vice President of Finance and Chief
|
|
|
|
Financial Officer
|
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated.
|
Principal Executive Officer
|
|
|
|
|
|
|
|
|
/s/ JOHN A. KELLEY, JR.
|
|
April 2, 2004
|
|
John A. Kelley, Jr.
|
|
|
President and Chief Executive Officer
|
|
|
|
|
|
|
|
|
Principal Financial Officer
|
|
|
|
|
|
|
|
|
/s/ ERNEST J. SAMPIAS
|
|
April 2, 2004
|
|
Ernest J. Sampias
|
|
|
Senior Vice President of Finance and
|
|
|
Chief Financial Officer
|
|
|
|
|
|
|
|
|
Principal Accounting Officer
|
|
|
|
|
|
|
|
|
/s/ ERNEST J. SAMPIAS
|
|
April 2, 2004
|
|
Ernest J. Sampias
|
|
|
Senior Vice President of Finance and
|
|
|
Chief Financial Officer
|
|
67
|
Directors:
|
|
|
|
|
|
|
|
|
/s/ JOHN A. KELLEY, JR.
|
|
April 2, 2004
|
|
John A. Kelley, Jr.
|
|
|
Chairman and CEO
|
|
|
|
|
|
|
|
|
/s/ JOHN W. GERDELMAN
|
|
April 2, 2004
|
|
John W. Gerdelman
|
|
|
|
|
|
|
|
|
/s/ CHARLES C. JOHNSTON
|
|
April 2, 2004
|
|
Charles C. Johnston
|
|
|
|
|
|
|
|
|
/s/ D. VAN SKILLING
|
|
April 2, 2004
|
|
D. Van Skilling
|
|
|
|
|
|
|
|
|
/s/ THOMAS M. UHLMAN
|
|
April 2, 2004
|
|
Thomas M. Uhlman
|
|
|
|
|
|
|
|
|
/s/ LAURENCE G. WALKER
|
|
April 2, 2004
|
|
Laurence G. Walker
|
|
|
|
|
|
|
|
|
/s/ BETSY S. ATKINS
|
|
April 2, 2004
|
|
Betsy S. Atkins
|
|
|
|
|
|
|
|
|
/s/ MICHAEL J. SOPHIE
|
|
April 2, 2004
|
|
Michael J. Sophie
|
|
|
|
|
|
|
|
|
/s/ M. ALEX MENDEZ
|
|
April 2, 2004
|
|
M. Alex Mende
|
|
68
McDATA CORPORATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Note: All other financial statement schedules are omitted because they
are not applicable or the required information is included in the consolidated
financial statements or notes thereto.
F-1
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Stockholders
of McDATA Corporation:
In our opinion, the consolidated financial statements listed in the accompanying
index present fairly, in all material respects, the financial position of
McDATA Corporation and its subsidiaries at January 31, 2004 and
December 31, 2002, and the results of their operations and their cash
flows for the year ended January 31, 2004, month ended January 31,
2003 and the years ended December 31, 2002 and 2001, in conformity with
accounting principles generally accepted in the United States of America. In
addition, in our opinion, the financial statement schedule listed in the
accompanying index presents fairly, in all material respects, the information
set forth therein when read in conjunction with the related consolidated
financial statements. These financial statements and financial statement
schedule are the responsibility of the Company’s management; our responsibility
is to express an opinion on these financial statements and financial statement
schedule based on our audits. We conducted our audits of these statements in
accordance with auditing standards generally accepted in the United States of
America, which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
PricewaterhouseCoopers
LLP
Denver, Colorado
April 14, 2004
F-2
McDATA CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
|
|
|
January 31,
2004
|
|
December 31,
2002
|
|
|
Assets
|
|
|
|
|
|
|
Current assets:
|
|
|
|
|
|
|
Cash and cash equivalents
|
|
$
|
50,301
|
|
$
|
72,411
|
|
|
Securities lending collateral
|
|
126,681
|
|
—
|
|
|
Short-term investments
|
|
157,740
|
|
157,260
|
|
|
Accounts receivable, net of allowances for
doubtful accounts of $926 and $1,265,respectively
|
|
62,670
|
|
73,867
|
|
|
Inventories, net
|
|
11,364
|
|
8,097
|
|
|
Deferred tax asset
|
|
—
|
|
33,325
|
|
|
Prepaid expenses and other current assets
|
|
6,055
|
|
4,699
|
|
|
Total current assets
|
|
414,811
|
|
349,659
|
|
|
|
|
|
|
|
|
|
Property and equipment, net
|
|
99,225
|
|
99,927
|
|
|
Long-term investments
|
|
103,483
|
|
73,099
|
|
|
Restricted cash
|
|
5,130
|
|
—
|
|
|
Intangible assets, net of accumulated amortization
of $14,470 and $5,037, respectively
|
|
111,313
|
|
7,887
|
|
|
Goodwill
|
|
78,787
|
|
11,780
|
|
|
Other assets, net
|
|
18,219
|
|
12,839
|
|
|
Total assets
|
|
$
|
830,968
|
|
$
|
555,191
|
|
|
|
|
|
|
|
|
|
Liabilities and
Stockholders’ Equity
|
|
|
|
|
|
|
Current liabilities:
|
|
|
|
|
|
|
Accounts payable
|
|
$
|
16,532
|
|
$
|
16,530
|
|
|
Accrued liabilities
|
|
51,547
|
|
37,779
|
|
|
Securities lending collateral payable
|
|
126,681
|
|
—
|
|
|
Current portion of deferred revenue
|
|
19,775
|
|
7,337
|
|
|
Income taxes payable
|
|
1,783
|
|
2,782
|
|
|
Current portion of obligations under notes payable
|
|
1,408
|
|
—
|
|
|
Current portion of obligations under capital
leases
|
|
1,377
|
|
1,604
|
|
|
Total current liabilities
|
|
219,103
|
|
66,032
|
|
|
Obligations under notes payable, less current
portion
|
|
201
|
|
—
|
|
|
Obligations under capital leases, less current
portion
|
|
890
|
|
1,540
|
|
|
Deferred revenue, less current portion
|
|
20,632
|
|
13,114
|
|
|
Interest rate swap
|
|
349
|
|
—
|
|
|
Convertible subordinated debt
|
|
172,151
|
|
—
|
|
|
Total liabilities
|
|
413,326
|
|
80,686
|
|
|
Commitments and contingencies (Note 13)
|
|
|
|
|
|
|
Stockholders’ Equity:
|
|
|
|
|
|
|
Preferred stock, $0.01 par value, 25,000,000
shares authorized, no shares issued or outstanding
|
|
—
|
|
—
|
|
|
Common stock, Class A, $0.01 par value,
250,000,000 shares authorized, 81,000,000 shares issued
|
|
810
|
|
810
|
|
|
Common stock, Class B, $0.01 par value,
200,000,000 shares authorized, 36,051,473 and 32,962,212 shares issued,
respectively
|
|
361
|
|
330
|
|
|
Additional paid-in-capital
|
|
476,993
|
|
474,609
|
|
|
Treasury stock, at cost, 975,730 shares at
January 31, 2004
|
|
(8,752
|
)
|
—
|
|
|
Deferred compensation
|
|
(10,375
|
)
|
(6,812
|
)
|
|
Accumulated other comprehensive income
|
|
403
|
|
773
|
|
|
Retained earnings (deficit)
|
|
(41,798
|
)
|
4,795
|
|
|
Total stockholders’ equity
|
|
417,642
|
|
474,505
|
|
|
Total liabilities and stockholders’ equity
|
|
$
|
830,968
|
|
$
|
555,191
|
|
The accompanying notes are an integral part
of these consolidated financial statements.
F-3
McDATA
CORPORATION
CONSOLIDATED INCOME STATEMENTS
(in thousands, except per share data)
|
|
|
Year Ended
January 31,
|
|
Years
Ended
December 31,
|
|
Month
Ended
January 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
2003
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Revenue
|
|
$
|
418,860
|
|
$
|
328,279
|
|
$
|
344,406
|
|
$
|
17,045
|
|
|
Cost of revenue
|
|
177,329
|
|
178,114
|
|
215,751
|
|
8,475
|
|
|
Gross profit
|
|
241,531
|
|
150,165
|
|
128,655
|
|
8,570
|
|
|
Operating expenses:
|
|
|
|
|
|
|
|
|
|
|
Research and development
|
|
88,826
|
|
59,324
|
|
49,166
|
|
5,068
|
|
|
Selling and marketing
|
|
95,820
|
|
75,213
|
|
70,489
|
|
5,837
|
|
|
General and administrative
|
|
39,057
|
|
29,495
|
|
20,337
|
|
2,424
|
|
|
Acquired in-process research and
development and other acquisition-related costs
|
|
11,410
|
|
—
|
|
9,327
|
|
—
|
|
|
Amortization of deferred compensation
(excludes amortization of deferred compensation included in cost of revenue
of $739, $601, $1,437 and $50, respectively)
|
|
11,969
|
|
8,280
|
|
7,259
|
|
575
|
|
|
Restructuring charges
|
|
2,258
|
|
—
|
|
—
|
|
—
|
|
|
Operating expenses
|
|
249,340
|
|
172,312
|
|
156,578
|
|
13,904
|
|
|
Loss from operations
|
|
(7,809
|
)
|
(22,147
|
)
|
(27,923
|
)
|
(5,334
|
)
|
|
Interest and other income
|
|
6,832
|
|
6,924
|
|
14,532
|
|
28
|
|
|
Interest expense
|
|
(2,760
|
)
|
(293
|
)
|
(349
|
)
|
(17
|
)
|
|
Loss before income taxes
|
|
(3,737
|
)
|
(15,516
|
)
|
(13,740
|
)
|
(5,323
|
)
|
|
Income tax expense (benefit)
|
|
38,412
|
|
(5,529
|
)
|
(5,084
|
)
|
(1,863
|
)
|
|
Loss before equity in net loss of
affiliated company
|
|
(42,149
|
)
|
(9,987
|
)
|
(8,656
|
)
|
(3,460
|
)
|
|
Equity in net loss of affiliated company
|
|
(984
|
)
|
—
|
|
—
|
|
—
|
|
|
Net loss
|
|
$
|
(43,133
|
)
|
$
|
(9,987
|
)
|
$
|
(8,656
|
)
|
$
|
(3,460
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic net loss per share
|
|
$
|
(0.38
|
)
|
$
|
(0.09
|
)
|
$
|
(0.08
|
)
|
$
|
(0.03
|
)
|
|
Shares used in computing basic net loss per
share
|
|
114,682
|
|
113,185
|
|
111,475
|
|
114,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted net loss per share
|
|
$
|
(0.38
|
)
|
$
|
(0.09
|
)
|
$
|
(0.08
|
)
|
$
|
(0.03
|
)
|
|
Shares used in computing diluted net loss
per share
|
|
114,682
|
|
113,185
|
|
111,475
|
|
114,000
|
|
The accompanying notes are an integral part
of these consolidated financial statements.
F-4
McDATA
CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES
IN STOCKHOLDERS’ EQUITY
(in thousands)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Accumulated
|
|
|
|
|
|
|
|
|
|
|
Common
Stock
|
|
Additional
|
|
|
|
Other
|
|
|
|
Retained
|
|
Total
|
|
|
|
|
Class A
|
|
Class B
|
|
Paid-In
|
|
Deferred
|
|
Comprehensive
|
|
Treasury
|
|
Earnings
|
|
Stockholders’
|
|
|
|
|
Shares
|
|
Amount
|
|
Shares
|
|
Amount
|
|
Capital
|
|
Compensation
|
|
Income
|
|
Stock
|
|
(Deficit)
|
|
Equity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balances at December 31, 2000
|
|
81,000
|
|
$
|
810
|
|
28,908
|
|
$
|
289
|
|
$
|
454,009
|
|
$
|
(24,850
|
)
|
$
|
117
|
|
$
|
—
|
|
$
|
23,438
|
|
$
|
453,813
|
|
|
Shares issued
|
|
—
|
|
—
|
|
2,654
|
|
27
|
|
6,797
|
|
(1,896
|
)
|
—
|
|
—
|
|
—
|
|
4,928
|
|
|
Forfeitures of deferred compensation
|
|
—
|
|
—
|
|
—
|
|
—
|
|
(3,280
|
)
|
3,280
|
|
—
|
|
—
|
|
—
|
|
—
|
|
|
Compensation expense
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
8,696
|
|
—
|
|
—
|
|
—
|
|
8,696
|
|
|
Tax benefit of stock options
|
|
—
|
|
—
|
|
—
|
|
—
|
|
10,607
|
|
—
|
|
—
|
|
—
|
|
—
|
|
10,607
|
|
|
Comprehensive income (loss):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loss
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
(8,656
|
)
|
(8,656
|
)
|
|
Unrealized gain on investments, net of tax of $234
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
403
|
|
—
|
|
—
|
|
403
|
|
|
Total comprehensive loss
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
|
|
(8,253
|
)
|
|
Balances at December 31, 2001
|
|
81,000
|
|
810
|
|
31,562
|
|
316
|
|
468,133
|
|
(14,770
|
)
|
520
|
|
—
|
|
14,782
|
|
469,791
|
|
|
Shares issued
|
|
—
|
|
—
|
|
1,407
|
|
14
|
|
4,274
|
|
(1,867
|
)
|
—
|
|
—
|
|
—
|
|
2,421
|
|
|
Forfeitures of deferred compensation
|
|
—
|
|
—
|
|
(7
|
)
|
—
|
|
(944
|
)
|
944
|
|
—
|
|
—
|
|
—
|
|
—
|
|
|
Compensation expense
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
8,881
|
|
—
|
|
—
|
|
—
|
|
8,881
|
|
|
Tax benefit of stock options
|
|
—
|
|
—
|
|
—
|
|
—
|
|
3,146
|
|
—
|
|
—
|
|
—
|
|
—
|
|
3,146
|
|
|
Comprehensive income (loss):
|
|
—
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loss
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
(9,987
|
)
|
(9,987
|
)
|
|
Unrealized gain on investments, net of tax of $188
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
253
|
|
—
|
|
—
|
|
253
|
|
|
Total comprehensive loss
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
(9,734
|
)
|
|
Balances at December 31, 2002
|
|
81,000
|
|
810
|
|
32,962
|
|
330
|
|
474,609
|
|
(6,812
|
)
|
773
|
|
—
|
|
4,795
|
|
474,505
|
|
|
Shares issued
|
|
—
|
|
—
|
|
321
|
|
3
|
|
1,327
|
|
(747
|
)
|
—
|
|
—
|
|
—
|
|
583
|
|
|
Compensation expense
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
625
|
|
—
|
|
—
|
|
—
|
|
625
|
|
|
Tax benefit of stock options
|
|
—
|
|
—
|
|
—
|
|
—
|
|
39
|
|
—
|
|
—
|
|
—
|
|
—
|
|
39
|
|
|
Comprehensive income (loss):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loss
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
(3,460
|
)
|
(3,460
|
)
|
|
Unrealized loss on investments,net of tax of $40
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
(62
|
)
|
—
|
|
—
|
|
(62
|
)
|
|
Total comprehensive loss
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
(3,522
|
)
|
|
Balances at January 31, 2003
|
|
81,000
|
|
810
|
|
33,283
|
|
333
|
|
475,975
|
|
(6,934
|
)
|
711
|
|
—
|
|
1,335
|
|
472,230
|
|
|
Shares issued
|
|
—
|
|
—
|
|
2,880
|
|
29
|
|
23,155
|
|
(17,357
|
)
|
—
|
|
—
|
|
—
|
|
5,827
|
|
|
Forfeitures of deferred compensation
|
|
—
|
|
—
|
|
(112
|
)
|
(1
|
)
|
(1,207
|
)
|
1,208
|
|
—
|
|
—
|
|
—
|
|
—
|
|
|
Purchase of call options, net
|
|
—
|
|
—
|
|
—
|
|
—
|
|
(20,510
|
)
|
—
|
|
—
|
|
—
|
|
—
|
|
(20,510
|
)
|
|
Compensation expense
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
12,708
|
|
—
|
|
—
|
|
—
|
|
12,708
|
|
|
Tax benefit (expense) of stock options
|
|
—
|
|
—
|
|
—
|
|
—
|
|
(420
|
)
|
—
|
|
—
|
|
—
|
|
—
|
|
(420
|
)
|
|
Acquisition of treasury stock
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
(8,752
|
)
|
—
|
|
(8,752
|
)
|
|
Comprehensive income (loss):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loss
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
(43,133
|
)
|
(43,133
|
)
|
|
Unrealized loss on investments,net of tax of $453
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
(308
|
)
|
—
|
|
—
|
|
(308
|
)
|
|
Total comprehensive loss
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
—
|
|
(43,441
|
)
|
|
Balances at January 31, 2004
|
|
81,000
|
|
$
|
810
|
|
36,051
|
|
$
|
361
|
|
$
|
476,993
|
|
$
|
(10,375
|
)
|
$
|
403
|
|
$
|
(8,752
|
)
|
$
|
(41,798
|
)
|
$
|
417,642
|
|
The accompanying notes are an integral part
of these consolidated financial statements.
F-5
McDATA
CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
|
|
|
Year Ended
January 31
|
|
Years
Ended
December 31,
|
|
Month
Ended
January 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
2003
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash flows from
operating activities:
|
|
|
|
|
|
|
|
|
|
|
Net loss
|
|
$
|
(43,133
|
)
|
$
|
(9,987
|
)
|
$
|
(8,656
|
)
|
$
|
(3,460
|
)
|
|
Adjustments to reconcile net loss to cash
flows from operating activities
|
|
|
|
|
|
|
|
|
|
|
Depreciation and amortization
|
|
44,589
|
|
25,524
|
|
16,383
|
|
2,527
|
|
|
Bad debt provision
|
|
(474
|
)
|
525
|
|
707
|
|
25
|
|
|
Loss from write-off of collateralized lease
costs
|
|
—
|
|
1,256
|
|
—
|
|
—
|
|
|
Equity in net loss of affiliate
|
|
984
|
|
—
|
|
—
|
|
—
|
|
|
Net realized and unrealized (gain)/loss on
investments
|
|
48
|
|
723
|
|
(262
|
)
|
17
|
|
|
Net loss on retirement of assets
|
|
400
|
|
1,196
|
|
102
|
|
77
|
|
|
Acquired in-process research and
development
|
|
11,410
|
|
—
|
|
7,200
|
|
—
|
|
|
Inventory and inventory commitment
provisions
|
|
2,608
|
|
15,199
|
|
26,788
|
|
384
|
|
|
Non-cash compensation expense
|
|
12,708
|
|
8,881
|
|
8,696
|
|
625
|
|
|
Deferred tax asset
|
|
38,815
|
|
(11,560
|
)
|
(14,715
|
)
|
(1,902
|
)
|
|
Tax benefit (expense) from stock options
exercised
|
|
(420
|
)
|
3,146
|
|
10,607
|
|
39
|
|
|
Changes in net assets and liabilities, net
of acquired amounts:
|
|
|
|
|
|
|
|
|
|
|
Accounts receivable
|
|
(26,105
|
)
|
(30,587
|
)
|
14,452
|
|
38,740
|
|
|
Inventories
|
|
(6,150
|
)
|
2,870
|
|
(33,244
|
)
|
418
|
|
|
Prepaid expenses and other current assets
|
|
29
|
|
400
|
|
(1,632
|
)
|
(488
|
)
|
|
Other assets, net
|
|
(7,682
|
)
|
(10,929
|
)
|
(970
|
)
|
(1,092
|
)
|
|
Accounts payable
|
|
7,091
|
|
4,986
|
|
(8,714
|
)
|
(9,548
|
)
|
|
Accrued liabilities
|
|
9,621
|
|
8,338
|
|
6,717
|
|
(1,083
|
)
|
|
Deferred revenue
|
|
17,782
|
|
12,997
|
|
(324
|
)
|
92
|
|
|
Accrued income taxes
|
|
(1,061
|
)
|
7,478
|
|
(14,799
|
)
|
—
|
|
|
Net cash provided by operating activities
|
|
61,060
|
|
30,456
|
|
8,336
|
|
25,371
|
|
|
Cash flows from
investing activities:
|
|
|
|
|
|
|
|
|
|
|
Acquisitions, net of cash acquired
|
|
(171,421
|
)
|
—
|
|
(29,750
|
)
|
—
|
|
|
Purchase of equity investment in Aarohi
|
|
(6,000
|
)
|
—
|
|
—
|
|
—
|
|
|
Purchases of property and equipment
|
|
(17,999
|
)
|
(71,937
|
)
|
(21,473
|
)
|
(371
|
)
|
|
Payment of collateralized lease costs
|
|
—
|
|
(1,256
|
)
|
—
|
|
—
|
|
|
Restricted cash related to interest rate
swap
|
|
(5,130
|
)
|
—
|
|
—
|
|
—
|
|
|
Purchases of investments
|
|
(654,238
|
)
|
(481,078
|
)
|
(614,064
|
)
|
(11,600
|
)
|
|
Maturities of investments
|
|
509,444
|
|
403,123
|
|
446,929
|
|
21,970
|
|
|
Sales of investments
|
|
101,085
|
|
124,109
|
|
102,670
|
|
—
|
|
|
Net cash provided (used) in investing
activities
|
|
(244,259
|
)
|
(27,039
|
)
|
(115,688
|
)
|
9,999
|
|
|
Cash flows from
financing activities:
|
|
|
|
|
|
|
|
|
|
|
Proceeds from issuance of convertible
subordinated debt
|
|
172,500
|
|
—
|
|
—
|
|
—
|
|
|
Costs of debt issuance
|
|
(5,567
|
)
|
—
|
|
—
|
|
—
|
|
|
Purchase of call options
|
|
(53,455
|
)
|
—
|
|
—
|
|
—
|
|
|
Sale of call options
|
|
32,945
|
|
—
|
|
—
|
|
—
|
|
|
Purchase of treasury stock
|
|
(8,752
|
)
|
—
|
|
—
|
|
—
|
|
|
Payment of notes payable
|
|
(15,469
|
)
|
—
|
|
—
|
|
—
|
|
|
Payment of obligations under capital leases
|
|
(2,697
|
)
|
(2,712
|
)
|
(2,921
|
)
|
(196
|
)
|
|
Proceeds from the issuance of stock
|
|
5,827
|
|
2,421
|
|
4,928
|
|
583
|
|
|
Net cash provided by (used in) financing
activities
|
|
125,332
|
|
(291
|
)
|
2,007
|
|
387
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net increase (decrease) in cash and cash
equivalents
|
|
(57,867
|
)
|
3,126
|
|
(105,345
|
)
|
35,757
|
|
|
Cash and cash equivalents, beginning of
period
|
|
108,168
|
|
69,285
|
|
174,630
|
|
72,411
|
|
|
Cash and cash equivalents, end of period
|
|
$
|
50,301
|
|
$
|
72,411
|
|
$
|
69,285
|
|
$
|
108,168
|
|
|
Supplemental Disclosure of Non-cash Investing
and Financing Activities
|
|
|
|
|
|
|
|
|
|
|
Interest paid
|
|
$
|
2,325
|
|
$
|
293
|
|
$
|
350
|
|
$
|
—
|
|
|
Income taxes paid (received)
|
|
1,095
|
|
(3,285
|
)
|
13,505
|
|
(59
|
)
|
|
Capital lease obligations incurred, net of
trade-ins
|
|
1,783
|
|
4,634
|
|
1,574
|
|
186
|
|
|
Transfer of inventory to fixed assets
|
|
1,859
|
|
5,679
|
|
4,549
|
|
614
|
|
|
Fixed assets exchanged for capital leases
|
|
(1,364
|
)
|
(1,501
|
)
|
—
|
|
—
|
|
|
Restricted stock grant
|
|
17,357
|
|
1,867
|
|
1,896
|
|
747
|
|
|
Unrealized gain (loss) on investments
|
|
(761
|
)
|
441
|
|
637
|
|
(102)
|
|
The accompanying notes are an integral part
of these consolidated financial statements.
F-6
McDATA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per
share data)
NOTE 1 OVERVIEW
AND BASIS OF PRESENTATION
McDATA
Corporation (McDATA or the Company) provides Multi-Capable Storage Network
Solutions™ (integrating multiple platforms, networks,
protocols and locations) that enables end-customers around the world to better
utilize their storage infrastructure, easily manage the storage network and
implement best-in-class business continuance solutions allowing them to be more
efficient and effective. McDATA solutions are an integral part of data services
infrastructures sold by most major storage and system vendors, including Dell
Products L.P (Dell), EMC Corporation (EMC), Hewlett-Packard (HP), Hitachi Data
Systems (HDS), International Business Machines Corporation (IBM),
StorageTechnology Corporation (STK) and Sun Microsystems, Inc. (Sun).
Prior to February 7, 2001, McDATA was a majority-owned
subsidiary of EMC. On February 7, 2001, EMC distributed all of the shares
it held of McDATA Class A common stock to EMC’s shareholders of record as
of January 24, 2001 (the Distribution). EMC has received a ruling from the
Internal Revenue Service that the Distribution to EMC stockholders was tax free
for U.S. federal income tax purposes. The Company continues to believe that the
distribution of its Class A common stock by EMC was tax-free. As a result
of the Distribution, EMC no longer has any ownership in or voting power over
McDATA and, therefore, is no longer considered a related party.
On January 15, 2003, the Company changed its
fiscal year end to January 31, from December 31. The Company believes
that the twelve months ended December 31, 2002 and 2001 provide a
meaningful comparison to the twelve months ended January 31, 2004. There
are no factors, of which the Company is aware, seasonal or otherwise, that
would impact the comparability of information or trends, if results for the
twelve months ended January 31, 2003 and 2002 were presented in lieu of
results for the twelve months ended December 31, 2002 and 2001. References
in these footnotes to 2003 represent the twelve months ended January 31,
2004. References to 2002 and 2001 represent the twelve months ended
December 31, 2002 and 2001.
NOTE 2
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the assets, liabilities,
results of operations, cash flows and changes in stockholders’ equity of the
Company and its wholly-owned subsidiaries. The equity method of accounting is
used for investments in affiliates in which we have significant influence. All material intercompany transactions and
balances have been eliminated.
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that effect the reported amounts
of assets, liabilities, revenues and expenses and disclosure of contingent
assets and liabilities. Actual results could differ from these estimates.
Cash and Cash Equivalents
Cash equivalents are short-term, highly liquid investments that are
readily convertible to cash and have remaining maturities of ninety days
or less at date of purchase.
F-7
Valuation of Accounts Receivable
Accounts receivable are reviewed to determine which are doubtful of
collection. Estimates are also made for potential future product returns. In
making the determination of the appropriate allowance for doubtful accounts and
product returns, the Company considers specific accounts, analysis of accounts
receivable agings, changes in customer payment terms, historical write-offs and
returns, changes in customer demand and relationships, concentrations of credit
risk and customer credit worthiness.
Inventories
Inventories, which include material, labor, factory overhead and
purchased finished goods, are stated using standard costs which approximate the
lower of cost (first-in, first-out method) or market. The Company evaluates the
need for reserves associated with obsolete, slow-moving and non-salable
inventory by reviewing net realizable values on a quarterly basis. The
Company’s inventories do not include materials purchased and held by the
Company’s component subcontractors, as the Company does not own this inventory.
Investments
The Company’s short- and long-term investments consist primarily of
marketable debt and equity securities, all of which are classified as
available-for-sale and recorded at fair value. Fair values are determined using
quoted market prices. Unrealized holding gains and losses are recorded, net of
any tax effect, as a separate component of accumulated other comprehensive
income. Securities with stated maturities of one year or less at time of
purchase are classified as short-term investments. Securities with remaining
maturities longer than one year are classified as long-term investments.
Included in investment balances are certain derivatives used as
fair-value hedges against positions held in certain marketable equity
securities. Any ineffectiveness in
these hedged instruments or the loss of hedge-accounting treatment could result
in significant fluctuations to earnings.
Fair Value of Financial Instruments
The carrying value of financial instruments, including cash
equivalents, accounts receivable, accounts payable and accrued liabilities,
approximate fair value due to their short maturities. Based upon borrowing
rates currently available to the Company, with similar terms, the carrying
values of the capital lease obligations approximate their fair values. The fair
values of the Company’s investments and convertible debt are determined using
quoted market prices for those securities.
The Company recognizes all derivatives as either assets or liabilities
in the statement of financial position and measures those instruments at fair
value.
Interest Rate Swaps
The Company has entered into an interest rate swap to address interest
rate market risk exposure. The interest rate swap is designated and qualifies
as a fair value hedge under Statement of Financial Standards (SFAS) No. 133,
“Accounting for Derivative Instruments and Hedging Activities.” For derivative
instruments that are designated and qualify as a fair value hedge, the gains
and losses on the derivative instrument, as well as the offsetting gain or loss
on the hedged item attributable to the hedged risk, are recognized in current
earnings during the period of change in fair values. If the change in the value
of the hedging instrument offsets the change in the value of the hedged item,
the hedge is considered perfectly effective. The accounting for hedge
effectiveness is measured at least quarterly based on the relative change in
fair value between the derivative contract and the hedged item over time. Any
change in fair value resulting from ineffectiveness, the amount by which the
change in the value of the hedge does not exactly offset the change in the
value of the hedged item, is recognized immediately in earnings. The Company’s
interest rate swap qualifies as a perfectly effective fair value hedge. As
such, there is no ineffective portion to the hedge recognized in earnings.
Adjustments to the fair value of the interest rate swap agreement are recorded
as either an other asset or long-term liability. The differential to be paid or
received under these agreements is accrued consistently with the terms of the
agreements and is recognized in interest expense over the term of the related
debt. The related amounts payable to or receivable from counterparties are
F-8
included in accounts receivable or accrued liabilities.
Property and Equipment
Property and equipment is stated at cost less accumulated depreciation.
Expenditures that substantially extend the useful life of an asset are
capitalized. Ordinary repair and maintenance expenditures are expensed as
incurred. For financial reporting purposes, depreciation is recorded
principally on a straight-line method over the estimated useful lives of the
asset as follows:
|
Building
|
|
39 years
|
|
Building equipment
|
|
5-39 years
|
|
Equipment and furniture
|
|
3-5 years
|
|
Computer software
|
|
2-5 years
|
|
Capital lease equipment
|
|
The shorter of the useful life of 3-5 years or lease term
|
|
Leasehold improvements
|
|
The shorter of the useful life of 3-5 years or lease term
|
Depreciation expense was approximately $26,933,000, $18,648,000,
$14,297,000 and $1,979,000 in 2003, 2002, 2001 and for the month ended
January 31, 2003, respectively. Equipment and furniture at
January 31, 2004 and December 31, 2002 includes assets under capitalized
leases of $8,361,000 and $10,679,000, respectively, with related accumulated
amortization of approximately $4,627,000 and $6,436,000, respectively.
In accordance with American Institute of Certified Public Accountants
(AICPA) Statement of Position (SOP) 98-1, “Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use,” certain costs incurred in
connection with the application development state of internal-use software
projects are capitalized and amortized over the estimated useful life of the
asset. Amortization expense related to
these costs are included in depreciation expense.
Long-Lived Assets, Including Goodwill and
Other Acquired Intangible Assets
The Company periodically evaluates the carrying value of long-lived
assets, excluding goodwill, for impairment when events and circumstances
indicate the carrying amount of an asset may not be recoverable. The carrying
value of a long-lived asset is considered impaired when the anticipated
undiscounted cash flows from such asset (or asset group) are separately
identifiable and less than the asset’s (or asset group’s) carrying value. In
that event, a loss is recognized to the extent that the carrying value exceeds
the fair value of the long-lived asset. Fair value is determined primarily using
the anticipated cash flows discounted at a rate commensurate with the risk
involved. For the three years ended
2003, 2002, 2001 and the month ended January 31, 2003, the Company has
made no material adjustments to its long-lived assets.
The Company has adopted SFAS No. 142, “Goodwill and Other
Intangible Assets” for the year ended December 31, 2002. As the Company’s
goodwill at that time resulted from acquisitions subsequent to July 1,
2001, no significant amortization was incurred in 2001. See Note 5 – Acquisitions and Intangible
Assets. Under SFAS No. 142,
goodwill and other indefinite lived intangible assets are not subject to
amortization, but are subject to an impairment test upon adoption and at least
annually thereafter. The Company completed its annual impairment analysis of
goodwill in the first quarter of 2003 and found no impairment. SFAS No. 142 also requires that intangible
assets with definite lives be amortized over their estimated useful lives and
reviewed for impairment in accordance with SFAS No. 144, “Accounting for the
Impairment of Long-Lived Assets to Be Disposed Of.” The Company is currently amortizing its acquired intangible
assets with definite lives over periods ranging from one to six years.
Revenue Recognition
The Company recognizes revenue when (a) persuasive evidence of an
arrangement exists (b) products are delivered or services rendered
(c) the sales price is fixed or determinable and (d) collectibility
is assured. Revenue from product sales to our resellers and end-user customers
is recognized when title and risk of loss transfer to the customer, generally
at the time the product is delivered. Revenue from product sales to our
OEMs and distributors is recognized when title and risk of loss transfer
to the customer in accordance with the master agreement, generally upon
sell-through
F-9
to the end-user. Revenue is reduced for estimated customer returns,
price protection, rebates, and other offerings that occur under sales programs
established with the Company’s OEMs, distributors and resellers. The Company
accrues for warranty costs and sales returns at the time of shipment based on
its experience. Revenue from support or maintenance contracts is recognized
ratably over the contractual period. Amounts invoiced to customers in excess of
revenue recognized on these contracts are recorded as deferred revenue until
all revenue recognition criteria are met. Revenue from software is comprised of
software licensing and post-contract customer support. Software revenue is
allocated to the license and support elements using vendor specific objective
evidence of fair value (VSOE). Revenue allocated to software licenses is
recognized when the four basic criteria above have been met. Revenue allocated
to post-contract support is recognized ratably over the term of the support
contract, assuming the four basic criteria are met.
In transactions that include multiple products, services and/or
software, the Company allocates the revenue to each element based on their
relative fair value (or in the absence of fair value, the residual method) and
recognizes the associated revenue when all revenue recognition criteria have
been met for each element.
Research and Development
Research and development (R&D) costs are expensed as incurred.
R&D costs consist primarily of salaries and related expenses of 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 test equipment; and IT and
facilities expenses.
Software Development Costs
The Company capitalizes eligible computer software development costs
upon the establishment of technological feasibility, which it has defined as
completion of designing, coding and testing activities or the completion of a
working model as defined by our software and hardware engineering development
processes. Costs incurred prior to the establishment of technological
feasibility are expensed to research and development. The establishment of
technological feasibility and the ongoing assessment of recoverability of
capitalized software development costs require considerable judgment by
management with respect to certain external factors, including, but not limited
to, anticipated future revenues, estimated economic life and changes in
software and hardware technologies. Upon the general release of the software
product to customers, capitalization ceases and such costs are amortized (using
the straight-line method) on a product-by-product basis over the estimated
life, which is generally one to three years. Capitalized software costs
and accumulated amortization included in other assets at January 31, 2004,
were approximately $15,079,000 and $7,312,000, respectively. Capitalized
software costs and accumulated amortization included in other assets at
December 31, 2002, were approximately $9,220,000 and $1,546,000,
respectively. Capitalized software amortization expense for 2003, 2002 and 2001
were approximately $5,506,000, $1,520,000 and $27,000, respectively. Capitalized software amortization expense
for the month ended January 31, 2003 was approximately $260,000.
Advertising
The Company expenses advertising costs as incurred. Advertising
expenses for 2003, 2002, and 2001 were approximately $3,225,000, $6,222,000,
and $6,941,000, respectively.
Advertising expenses for the month ended January 31, 2003 were
approximately $556,000.
Restructuring Charges
In July 2002, the Financial Accounting Standards Board (FASB)
issued SFAS No. 146, “Accounting for Costs Associated with Exit or
Disposal Activities.” SFAS No. 146 supercedes Emerging Issues Task Force (EITF)
Issue No. 94-3, “Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring)” and requires that costs related to exiting an activity or
to a restructuring not be recognized until the liability is incurred as opposed
to when management commits to an exit plan. This statement was effective for
exit or disposal activities initiated after December 31, 2002. The provisions of SFAS No. 146 were required
to be applied prospectively after the adoption date to newly initiated exit
activities. See Note 4 for
F-10
discussion of 2003 restructuring activities.
Earnings Per Share
Basic
net income (loss) per share excludes dilution and is computed by dividing
income available to common stockholders by the weighted-average number of
common shares outstanding for the period. Diluted net income (loss) per share
is based on the weighted-average number of shares outstanding during each
period and the assumed exercise of dilutive stock options less the number of
treasury shares assumed to be purchased from the proceeds using the average
market price of the Company’s common stock for each of the periods presented.
No dilutive effect has been included for the convertible subordinated debt
issued February 7, 2003 (see Note 8) because the Company currently has the
ability and intent to settle the conversion in cash. Additionally, no dilutive
effect has been included for the share options sold in relation to the
convertible subordinated debt because the exercise price was higher than the
average stock price for the period.
Following is a reconciliation between basic and diluted earnings per
share:
|
|
|
Year
Ended
January 31,
|
|
Years Ended
December 31,
|
|
Month
Ended
January 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
2003
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loss
|
|
$
|
(43,133
|
)
|
$
|
(9,987
|
)
|
$
|
(8,656
|
)
|
$
|
(3,460
|
)
|
|
Weighted average shares of common stock
outstanding used in computing basic net loss per share
|
|
114,682
|
|
113,185
|
|
111,475
|
|
114,000
|
|
|
Net effect of dilutive stock options
|
|
—
|
|
—
|
|
—
|
|
—
|
|
|
Weighted average shares of common stock
used in computing diluted net loss per share
|
|
114,682
|
|
113,185
|
|
111,475
|
|
114,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic net loss per share
|
|
$
|
(0.38
|
)
|
$
|
(0.09
|
)
|
$
|
(0.08
|
)
|
$
|
(0.03
|
)
|
|
Diluted net loss per share
|
|
$
|
(0.38
|
)
|
$
|
(0.09
|
)
|
$
|
(0.08
|
)
|
$
|
(0.03
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
Options not included in diluted share base
because of the exercise prices
|
|
8,459
|
|
4,840
|
|
1,344
|
|
6,092
|
|
|
Options and restricted stock not included
in diluted share because of net loss
|
|
6,422
|
|
6,984
|
|
9,520
|
|
6,401
|
|
Stock-Based Compensation
At January 31, 2004, the Company has stock-based employee
compensation and employee purchase plans, which are described more fully in
Note 9. The Company accounts for these plans according to Accounting
Principles Board Opinion No. 25, Accounting for Stock Issues to Employees
(APB 25), and related interpretations and has adopted the disclosure-only
alternative of SFAS No. 123, “Accounting for Stock-Based Compensation”(SFAS
No. 123), as amended by SFAS No. 148, “Accounting for Stock-Based
Compensation - Transition and Disclosure an amendment of FASB Statement No.
123” (SFAS No. 148). Any deferred stock compensation calculated pursuant to APB
25 is amortized ratably over the vesting period of the individual options,
generally two to four years. The following table illustrates the effect on
net loss and earnings per share if the Company had applied the fair value
recognition provisions of SFAS No. 123.
F-11
|
|
|
Year
Ended
January 31,
|
|
Years
Ended
December 31,
|
|
Month
Ended
January 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
2003
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net loss, as reported
|
|
$
|
(43,133
|
)
|
$
|
(9,987
|
)
|
$
|
(8,656
|
)
|
$
|
(3,460
|
)
|
|
Add: Total stock-based employee
compensation expense included in net income as determined under the intrinsic
value method, net of related tax effects
|
|
12,708
|
|
5,542
|
|
5,426
|
|
406
|
|
|
Deduct: Total stock-based employee
compensation expense determined under the fair value based method for all
awards, net of related tax effects
|
|
(34,050
|
)
|
(16,879
|
)
|
(15,894
|
)
|
(1,481
|
)
|
|
Pro forma net loss
|
|
$
|
(64,475
|
)
|
$
|
(21,324
|
)
|
$
|
(19,124
|
)
|
$
|
(4,535
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss per share:
|
|
|
|
|
|
|
|
|
|
|
Basic-as reported
|
|
$
|
(0.38
|
)
|
$
|
(0.09
|
)
|
$
|
(0.08
|
)
|
$
|
(0.03
|
)
|
|
Basic-pro forma
|
|
$
|
(0.56
|
)
|
$
|
(0.19
|
)
|
$
|
(0.17
|
)
|
$
|
(0.04
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted-as reported
|
|
$
|
(0.38
|
)
|
$
|
(0.09
|
)
|
$
|
(0.08
|
)
|
$
|
(0.03
|
)
|
|
Diluted-pro forma
|
|
$
|
(0.56
|
)
|
$
|
(0.19
|
)
|
$
|
(0.17
|
)
|
$
|
(0.04
|
)
|
The fair value of each option granted during 2003, 2002, 2001, and the
month ended January 31, 2003 is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted average
assumptions:
|
|
|
Year
Ended
January 31,
|
|
Years
Ended
December 31,
|
|
Month
Ended
January 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
2003
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Dividend yield
|
|
—
|
%
|
—
|
%
|
—
|
%
|
—
|
%
|
|
Expected volatility
|
|
90
|
%
|
90
|
%
|
125
|
%
|
90
|
%
|
|
Risk-free interest rate
|
|
2.1%-3.5
|
%
|
2.5%-4.9
|
%
|
3.7%-5.0
|
%
|
3.0%-3.1
|
%
|
|
Expected life, in years
|
|
2.0 – 4.0
|
|
2.0 - 4.0
|
|
4.0
|
|
2.0 - 4.0
|
|
Comprehensive Income (Loss)
Comprehensive income (loss) includes net earnings as well as additional
other comprehensive income. McDATA’s other comprehensive income consists of
unrealized gains and losses on available-for-sale securities, recorded net of
any related tax, that are recorded as changes in equity and not an element of
the Company’s income statement.
Reclassifications
Certain prior year amounts have been reclassified to conform to the
2003 presentation.
Recent Accounting Pronouncements
The
FASB issued Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest
Entities” in January 2003, and a revised interpretation of FIN 46 (FIN
46-R) in December 2003. FIN 46 provides guidance on how to identify a
variable interest entity (VIE) and determine when the assets, liabilities, and
results of operations of a VIE need to be included in a company’s consolidated
financial statements. FIN 46 also requires additional disclosures by primary
beneficiaries and other significant variable interest holders in a VIE. FIN46-R
applies at different dates to different types of enterprises and entities, and
special provisions apply to enterprises that have fully or partially applied
FIN 46 prior to issuance of FIN 46-R.
Generally, application of FIN 46-R is required in financial statements
of public entities that have interest in variable interest entities or
potential variable interest entities commonly referred to as special-purpose
entities for periods ending after December 15, 2003. Application by public entities for all other
types of entities is required in
F-12
financial statements for
periods ending after March 15, 2004.
The adoption of FIN 46 and FIN 46-R did not have a material impact on
the Company’s results of operations or financial condition.
In
April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on
Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and
clarifies financial accounting and reporting for derivative instruments,
including certain derivative instruments embedded in other contracts and for
hedging activities under SFAS No. 133, “Accounting for Derivative Instruments
and Hedging Activities.” SFAS No. 149 is generally effective for contracts entered
into or modified after June 30, 2003, and for hedging relationships
designated after June 30, 2003. The adoption of SFAS No. 149 did not have
a significant impact on the Company’s financial position or results of
operations.
In October 2003, the Emerging Issues Task Force (EITF) reached a
consensus on its tentative conclusions for EITF 03-05, “Applicability of SOP
97-2 to Non-Software Deliverables in an Arrangement Containing More-Than
Incidental Software” (EITF 03-05). EITF 03-05 discusses that software
deliverables are within the scope of SOP 97-2 as are non-software deliverables.
The Company is required to adopt this consensus for fiscal periods beginning
after August 2003. The Company believes the adoption of EITF 03-05 will
not have an impact on the Company’s consolidated financial statements.
In December 2003, the Staff of the Securities and Exchange
Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 104, “Revenue
Recognition,” which supercedes SAB No. 101, “Revenue Recognition in Financial
Statements.” SAB No. 104’s primary
purpose is to rescind accounting guidance contained in SAB No. 101 related to
multiple-element revenue arrangements and to rescind the SEC’s “Revenue
Recognition in Financial Statements Frequently Asked Questions and Answers”
(FAQ) issued with SAB No. 101. Selected
portions of the FAQ have been incorporated into SAB No. 104. The adoption of SAB No. 104 did not have a
material impact on the Company’s revenue recognition policies.
NOTE 3
COMPONENTS OF SELECTED BALANCE SHEET ACCOUNTS
|
|
|
Year Ended
January 31,
|
|
Year Ended
December 31,
|
|
|
|
|
2004
|
|
2002
|
|
|
Inventories:
|
|
|
|
|
|
|
Raw materials
|
|
$
|
7,037
|
|
$
|
8,070
|
|
|
Work-in-progress
|
|
920
|
|
1,123
|
|
|
Finished goods
|
|
7,883
|
|
6,316
|
|
|
Total inventories at cost
|
|
15,840
|
|
15,509
|
|
|
Less reserves (1)
|
|
(4,476
|
)
|
(7,412
|
)
|
|
Total inventories, net
|
|
$
|
11,364
|
|
$
|
8,097
|
|
|
|
|
|
|
|
|
|
Property and equipment:
|
|
|
|
|
|
|
Land
|
|
$
|
16,091
|
|
$
|
16,091
|
|
|
Building
|
|
32,410
|
|
29,712
|
|
|
Equipment and furniture
|
|
85,680
|
|
74,608
|
|
|
Computer software for internal use
|
|
25,492
|
|
18,877
|
|
|
Leasehold improvements
|
|
3,271
|
|
4,805
|
|
|
Construction in progress
|
|
958
|
|
2,361
|
|
|
|
|
163,902
|
|
146,454
|
|
|
Less accumulated depreciation and
amortization
|
|
(64,677
|
)
|
(46,527
|
)
|
|
|
|
$
|
99,225
|
|
$
|
99,927
|
|
|
|
|
|
|
|
|
|
Accrued liabilities:
|
|
|
|
|
|
|
Wages and employee benefits
|
|
$
|
17,489
|
|
$
|
16,643
|
|
|
Purchase commitments and other supply
obligations (1)(2)
|
|
7,829
|
|
12,022
|
|
|
Warranty reserves (3)
|
|
4,522
|
|
3,461
|
|
|
Taxes, other than income tax
|
|
2,534
|
|
1,050
|
|
|
Interest payable
|
|
1,773
|
|
—
|
|
|
Customer obligations
|
|
4,729
|
|
349
|
|
|
ESCON agency funds
|
|
8,373
|
|
2,366
|
|
|
Other accrued liabilities
|
|
4,298
|
|
1,888
|
|
|
|
|
$
|
51,547
|
|
$
|
37,779
|
|
F-13
(1) During the year ended
December 31, 2002, the Company recorded net inventory-related charges of
$9.5 million, primarily for excess 1 gigabit (Gb) components used in the
Company’s director-class products. The excess inventory resulted primarily from
the Company’s introduction of 2 Gb products in the second quarter of 2002 and
the unanticipated reduction in demand for the 1 Gb product orders prior to the
new product release. These charges were
in excess of the routine excess and obsolete reserves recorded by the Company
during the year.
(2) During the fiscal 2003 year, the Company
released recorded obligations of approximately $1.3 million relating to the
expiration of certain customer sales obligations which were provided for in
fiscal 2001.
(3) Activity in the
warranty reserves is as follows:
|
|
|
Year Ended
|
|
One Month
Ended
|
|
|
|
|
January 31,
|
|
December 31,
|
|
January 31,
|
|
|
|
|
2004
|
|
2002
|
|
2003
|
|
|
Balance at beginning of period
|
|
$
|
3,485
|
|
$
|
2,174
|
|
$
|
3,461
|
|
|
Warranty expense
|
|
2,104
|
|
1,853
|
|
24
|
|
|
Warranty claims
|
|
(1,294
|
)
|
(566
|
)
|
—
|
|
|
Acquisition of warranty liability
|
|
227
|
|
—
|
|
—
|
|
|
Balance at end of period
|
|
$
|
4,522
|
|
$
|
3,461
|
|
$
|
3,485
|
|
NOTE 4
RESTRUCTURING CHARGES
In January 2004, the Company announced that it was taking certain
cost improvement actions, which included a workforce reduction and facility
consolidation. As a result, in the fiscal fourth quarter of 2003, the Company
recorded to accrued liabilities an approximate $2.3 million restructuring
charge related to the reduction in workforce. The reduction in workforce
represented approximately nine percent primarily in the engineering, sales and
marketing organizations. In addition, the Company announced the anticipated
first quarter 2004 closure of its Canadian leased engineering facility. All of
these charges are to be paid in fiscal year 2004. In addition, the Company expects to incur an approximate $2.2
million restructuring charge in its fiscal first quarter 2004, primarily
related to the facilities closure, as well as additional severance costs.
NOTE 5 ACQUISITIONS AND INTANGIBLE ASSETS
Nishan Systems, Inc.
On September 19, 2003, the Company completed its acquisition of
the stock of Nishan Systems, Inc. (Nishan), a provider of next generation
native IP storage solutions that builds open storage networking products based
on IP and
F-14
Ethernet, the international networking standards. The Nishan
transaction is intended to accelerate McDATA’s delivery of inter-networking
capabilities that scale data center storage networks and extend storage network
benefits across the enterprise. Nishan’s comprehensive family of IP storage
switching products allows customers to leverage their fibre channel storage
network infrastructure and their IP networks to consolidate storage
infrastructures across the campus, the enterprise and geographies. These
solutions allow for integrated disaster recovery architectures, and cost
effective integration of low-end servers and applications into the storage
network. These factors contributed to a purchase price in excess of fair value
of Nishan’s net tangible and intangible assets acquired. As a result, the
Company has recorded goodwill in connection with this transaction. The
consolidated financial statements include the operating results of Nishan from
the date of the acquisition.
The total purchase price of approximately $69.3 million consisted of
$65.0 million in cash consideration and direct transaction costs paid of
approximately $4.3 million. Based on estimates and assumptions of management,
the preliminary allocation of the purchase price to the assets acquired and
liabilities assumed was as follows:
|
Cash
|
|
$
|
668
|
|
|
Other tangible assets
|
|
4,905
|
|
|
Amortizable
intangible assets:
|
|
|
|
|
Customer relationships
|
|
1,622
|
|
|
Developed technology
|
|
8,337
|
|
|
Customer backlog
|
|
454
|
|
|
Goodwill
|
|
67,007
|
|
|
Liabilities
|
|
(5,680
|
)
|
|
Debt
|
|
(15,816
|
)
|
|
In-process research and development
|
|
7,774
|
|
|
Total
|
|
$
|
69,271
|
|
Amortizable intangible assets consist of customer-related intangible
assets and developed technology.
Customer relationships represent existing contracts that relate
primarily to customers such as Hitachi Data Systems, IBM, EMC, Tokyo Electron,
Sun Microsystems, and Bell Microproducts. The Company is amortizing the fair
value of these assets on a straight-line basis over an estimated useful life of
approximately 3 years. Developed
technology, which consists of products that have reached technological
feasibility, includes products which support various protocols (iSCSI, iFCP and
E_Port for trunking) to connect IP backbones to legacy Fibre Channel fabrics.
The technology has a non-blocking architecture that supports Ethernet Layer 2
switching, IP Layer 3 switching, and Fibre Channel switching over extended
distances at full gigabit wire speed. These products also support standard IP
routing protocols such as OSPF and DVMRP and can be fully integrated into
existing IP networks. The Company is amortizing the developed technology and
related patents on a straight-line basis over an estimated useful life of
approximately 5 years.
A preliminary estimate of $67 million has been allocated to goodwill.
Goodwill represents the excess of the purchase price over the fair value of the
net tangible and intangible assets acquired, and will not be deductible for tax
purposes. Goodwill will not be amortized and will be tested for impairment at
least annually. The preliminary purchase price allocation for Nishan is subject
to revision after a more detailed analysis is completed and additional
information on the fair value of assets and liabilities becomes available. Any
change in the fair value of the net assets of Nishan will change the amount of
the purchase price allocable to goodwill.
In addition, as this was the purchase of stock, the tax basis of
Nishan’s assets and liabilities carry over resulting in temporary differences
and a net deferred tax asset of $35.1 million.
In light of the Company’s tax position (see Note 12) a full
valuation allowance of $35.1 million was recorded against the net acquired
deferred tax asset. Pursuant to the provisions of SFAS No. 109,
“Accounting for Income Taxes,” if this valuation allowance is released in
subsequent periods, goodwill will be decreased by the amount released up to a
maximum of $35.1 million.
Of the total purchase price, $7.8 million was allocated to IPR&D
and expensed in fiscal 2003. Projects that qualify as IPR&D represent those
that have not yet reached technological feasibility and for which no future
alternative uses existed at the date of acquisition. Technological feasibility
is defined as being equivalent to a final working prototype or detailed program
design in which there is no remaining risk relating to the development. Three
IPR&D projects were identified
F-15
relating to Nishan’s multiple-protocol switches. The value assigned to IPR&D was
determined by evaluating the importance of each project to the overall
development plan, estimating costs to develop the purchased IPR&D into
commercially viable products, and then estimating the resulting future revenues
and net cash flows from the projects when completed and discounting the net
cash flows to their present value. The revenue estimates used to value the
purchased IPR&D were based on estimates of the relevant market sizes and
growth factors, expected trends in technology and the nature and expected
timing of new product introductions by the Company and its competitors.
Overall, the IPR&D projects were determined to be approximately 70%
complete with estimated full completion in the first half of 2004, at which
time the Company is expected to begin generating economic benefits. In total,
costs to complete the IPR&D are expected to be approximately $5.2 million.
The rates utilized to discount the net cash flows to their present values were based
on an industry weighted average cost of capital adjusted to reflect the
difficulties and uncertainties in completing each project and risks related to
the impact of potential changes in future target markets. Based on these
factors, discount rates that range from 21% - 23% were used to value the
IPR&D. The estimates used in valuing IPR&D were based upon assumptions
believed to be reasonable but which are inherently uncertain and unpredictable.
As a result, actual results may differ from such estimates.
The nature of the efforts to develop the acquired technologies into
commercially viable products consist principally of designing and testing
activities, including qualification. Failure to bring these products to market
in a timely manner could result in a loss of market share or a lost opportunity
to capitalize on emerging markets and could have a material adverse impact on
our business and operating results.
Sanera Systems, Inc.
On September 30, 2003, the Company completed its acquisition of
the stock of Sanera Systems, Inc. (Sanera), a producer of next generation
intelligent switching platform technologies. The company was formed in order to
bring to market multi-protocol, high performance, highly scaleable switches
delivering storage services over the network infrastructure. The acquisition of
Sanera, when combined with McDATA technologies, extends the Company’s Multi-Capable
Storage Network Solutions™ platform and believe it will accelerate its vision of
delivering a real-time storage services infrastructure. The technology acquired
from Sanera will help McDATA extend its reach at the core of the data center,
and integrated with McDATA’s products and technology, will create a product
that allows enterprises to securely consolidate their separate SAN networks and
integrate intelligent storage utility services on one platform, significantly
lowering storage networking costs and simplifying SAN management. These factors
contributed to a purchase price in excess of the fair value of the Sanera net
tangible and intangible assets acquired. The condensed consolidated financial
statements include the operating results of Sanera from the date of the
acquisition.
The total purchase price of approximately $113.2 million consisted of
$110.2 million in cash consideration and direct transaction costs paid of
approximately $3.0 million.
As of the acquisition date, Sanera was a development stage company with
no recognized revenue and no established customer base. Sanera had
substantially completed all the planning, designing, coding and testing
activities necessary to establish that the technology underlying the developed
products could be utilized to meet the design specifications intended. The
Company currently believes that revenues related to this product will commence
during fiscal year 2004. Based upon these factors, the Company concluded that,
for accounting purposes, it was not purchasing a business with an existing
revenue stream, but rather a group of assets related to a developed technology
that the Company believes will ultimately be developed into a scalable product.
The purchase price was allocated to the assets acquired and liabilities
assumed based on their respective fair values. The excess of purchase price
over the fair value of net assets received was allocated to the acquired
non-monetary assets. The preliminary
purchase price allocation for Sanera is subject to revision after a more
detailed analysis is completed and additional information on the fair value of
assets and liabilities becomes available. Any change in the fair value of the
net assets of Sanera will change the amount of the purchase price allocable to
intangible assets. The following table
summarizes the allocation of purchase price for the acquisition of Sanera:
F-16
|
|
|
Fair Value
of Assets and
Liabilities
|
|
Allocation
of
Excess Purchase
Price
|
|
Allocated
Fair
Value of Assets
and
Liabilities
|
|
|
|
|
|
|
|
|
|
|
|
Cash
|
|
$
|
10,547
|
|
$
|
—
|
|
$
|
10,547
|
|
|
Other tangible assets
|
|
4,492
|
|
—
|
|
4,492
|
|
|
Amortizable
intangible assets:
|
|
|
|
|
|
|
|
|
Developed technology
|
|
48,098
|
|
49,833
|
|
97,931
|
|
|
Customer Relationships
|
|
1,399
|
|
—
|
|
1,399
|
|
|
Patents pending
|
|
434
|
|
450
|
|
884
|
|
|
Assembled workforce
|
|
1,104
|
|
1,144
|
|
2,248
|
|
|
Liabilities assumed
|
|
(4,272
|
)
|
—
|
|
(4,272
|
)
|
|
Excess purchase price
|
|
51,427
|
|
(51,427
|
)
|
—
|
|
|
Total purchase price
|
|
$
|
113,229
|
|
$
|
—
|
|
$
|
113,229
|
|
Amortizable intangible assets consist of customer relationships,
patents pending, an assembled workforce and developed technology. Customer relationships represent an existing
contract that relates primarily to an outstanding purchase order for future
product, when and if available. The Company is amortizing the fair value of
this asset on a straight-line basis over an estimated useful life of
approximately three years. Developed
technology represents next-generation intelligent switching platform
technologies and consists of products that have reached technological
feasibility. The Company is amortizing the developed technology on a
straight-line basis over an estimated useful life of approximately six
years. Patents pending and the
assembled workforce intangible assets are being amortized over lives of six and
two years, respectively.
Consolidation of Facilities
In conjunction with the acquisitions of Nishan and Sanera, management
completed a facilities consolidation plan during the fourth quarter of
2003. In accordance with the provisions
of EITF95-3 “Recognition of Liabilities in Connection With a Purchase Business
Combination,” a liability of $1.2 million has been recorded as part of purchase
accounting to reflect the estimated obligation related to uncancellable leases
for both Nishan and Sanera through the expected cease-use date. The Company
estimates that the consolidation will be completed by the third quarter of
2004.
Purchase of SANavigator, Inc.
On September 21, 2001, the Company acquired the assets of
SANavigator, Inc. (SANavigator) for a cash purchase price of
$29.75 million. In addition, one-time costs associated with the
acquisition were approximately $2.1 million. The results of SANavigator’s
operations have been included in the consolidated financial statements since
that date. SANavigator is a software company that designs and develops a
scalable and stable SAN management tool that manages entry-level through complex
SAN environments utilizing vendor- and platform-independent software. As a
result of the acquisition, the Company is expected to be in a leading position
in offering storage network management software that provides visibility and
discovery in a multi-vendor fabric environment.
The estimated excess of the purchase price over the fair value of the
tangible net assets acquired was valued at $29.2 million. Of this excess,
$10.5 million was allocated to developed technology (5 year average
useful life), $7.2 million was allocated to in-process research and
development (IPR&D), and the remaining $11.5 million was allocated to
goodwill. Of the total goodwill amount, $11.5 million is deductible for
tax purposes. In conjunction with the
acquisition, the Company issued approximately 192,000 shares of Class B
common stock, with a fair value of $1.9 million, for the completion of
ongoing employment arrangements with certain SANavigator employees. The stock
awards were contingent upon the continued employment of these employees. As
such, these awards were recorded as deferred compensation and recognized
ratably through the expiration date of the employee agreements. At
January 31, 2004, all awards were fully vested.
The IPR&D was expensed at the time of purchase because
technological feasibility had not been established and no future alternative
use existed. The IPR&D arose from SANavigator’s on-going development of the
next-generation of
F-17
SANavigator software. This software was intended to significantly
enhance the features of the current version of SANavigator software. The status
of the development at the acquisition date was dependent on several factors
including the complexity of working with diverse servers and storage devices
and integrating with other applications. Overall, SANavigator’s IPR&D
project was estimated to be approximately 40% complete at the time of
acquisition and it was expected that the remaining 60% would be completed
during the Company’s 2002 fiscal year at a cost of approximately
$2.1 million. The remaining efforts, which were completed during 2002,
included completion of coding, finalizing user interface design and
development, and testing. The amount allocated to in-process research and
development was determined using the discounted cash flow method. This model
employed cash flow projections for revenue based on the projected incremental
increase in revenue that the Company expected to receive from the completed
IPR&D. Estimated operating expenses, capital charges and applicable income
taxes were deducted to arrive at an estimated after-tax cash flow. The Company
discounted the after-tax cash flow projections using a risk-adjusted rate of
return of 75%.
Pro Forma Information
The unaudited pro forma information presented below assumes that the
acquisitions were completed at the beginning of the year acquired and the
immediate preceding year and includes the effect of amortization of identified
intangibles and costs from those dates. The impact of charges for IPR&D has
been excluded. This is presented for informational purposes only and is not
necessarily indicative of the results of future operations or results that
would have been achieved had the acquisition taken place at the beginning of
the periods presented.
|
|
|
Year Ended
January 31,
|
|
Years
Ended
December 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
|
Revenue
|
|
$
|
426,959
|
|
$
|
344,106
|
|
$
|
344,636
|
|
|
Net income (loss)
|
|
$
|
(110,500
|
)
|
$
|
(93,183
|
)
|
$
|
(9,248
|
)
|
|
Basic net income (loss) per share
|
|
$
|
(0.96
|
)
|
$
|
(0.82
|
)
|
$
|
(0.08
|
)
|
|
Diluted net income (loss) per share
|
|
$
|
(0.96
|
)
|
$
|
(0.82
|
)
|
$
|
(0.08
|
)
|
Goodwill and Other Intangible Assets
Changes in the carrying amounts of goodwill are as follows:
|
Goodwill as of December 31, 2001 and
2001 and January 31, 2003, net
|
|
$
|
11,780
|
|
|
Acquisitions (Note 5)
|
|
67,007
|
|
|
Goodwill as of January 31, 2004, net
|
|
$
|
78,787
|
|
The Company is currently amortizing its acquired intangible assets with
definite lives over periods ranging from 1 to 6 years. The following table summarizes the components
of gross and net intangible asset balances:
|
|
|
January 31,
2004
|
|
December 31,
2002
|
|
|
|
|
Gross
Carrying
Amount
|
|
Accumulated
Amortization
|
|
Net
Carrying
Amount
|
|
Gross
Carrying
Amount
|
|
Accumulated
Amortization
|
|
Net
Carrying
Amount
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Developed technology
|
|
$
|
116,769
|
|
$
|
11,133
|
|
$
|
105,636
|
|
$
|
10,501
|
|
$
|
2,666
|
|
$
|
7,835
|
|
|
Customer relationships
|
|
3,021
|
|
340
|
|
2,681
|
|
—
|
|
—
|
|
—
|
|
|
Workforce
|
|
2,248
|
|
375
|
|
1,873
|
|
—
|
|
—
|
|
—
|
|
|
Other
|
|
3,745
|
|
2,622
|
|
1,123
|
|
2,423
|
|
2,371
|
|
52
|
|
|
Total intangible assets
|
|
$
|
125,783
|
|
$
|
14,470
|
|
$
|
111,313
|
|
$
|
12,924
|
|
$
|
5,037
|
|
$
|
7,887
|
|
Expected annual amortization expense related to acquired intangible
assets is as follows:
F-18
|
Fiscal Years:
|
|
|
|
|
2004
|
|
$
|
22,995
|
|
|
2005
|
|
22,068
|
|
|
2006
|
|
19,781
|
|
|
2007
|
|
17,757
|
|
|
2008
|
|
17,421
|
|
|
Thereafter
|
|
11,291
|
|
|
Total expected annual amortization expense
|
|
$
|
111,313
|
|
Amortization expense related to acquired intangible assets was $9.4
million, $2.1 million, $565,000 and $175,000 for 2003, 2002, 2001 and the month
ended January 31, 2003, respectively.
NOTE 6 EQUITY INVESTMENT
On
August 22, 2003, the Company purchased 13.6 million shares of preferred
stock of Aarohi Communications (Aarohi) for $6 million cash. At January 31,
2004, this represented approximately 17.3% of the total outstanding shares of
Aarohi. Aarohi is a privately owned
provider of next-generation intelligent storage networking technology. As
of the investment date, the purchase price paid by McDATA exceeded the
Company’s underlying proportionate equity in Aarohi’s net assets by $3.6
million. Aarohi is a development stage company with no recognized product
revenue and a core ASIC technology that has not yet reached technical
feasibility. Management of Aarohi currently believes that revenues related to
this technology will commence during fiscal year 2004. The Company has
concluded that the $3.6 million difference between the purchase price of the
investment and the underlying share of equity in the net assets of Aarohi
represents in-process research and development and, as such, has expensed this
amount during fiscal year 2003.
In
addition to the equity investment, the Company has entered into a non-exclusive
supply arrangement with Aarohi to purchase their ASIC chip for inclusion in the
Company’s new product launches when, and if, Aarohi’s product becomes generally
available.
The
Company has recorded its share of Aarohi’s net loss of approximately $984,000
from the date of purchase through January 31, 2004. The remaining net
equity investment of approximately $1.4 million is recorded as an Other Asset
at January 31, 2004.
Summarized
financial information for Aarohi is as follows:
|
Year Ended December 31, 2003
|
|
|
|
|
Net sales
|
|
$
|
126
|
|
|
Gross profit
|
|
$
|
48
|
|
|
Operating loss
|
|
$
|
(10,231
|
)
|
|
Net loss
|
|
$
|
(9,908
|
)
|
|
|
|
|
|
|
As of December 31, 2003
|
|
|
|
|
Current assets
|
|
$
|
14,524
|
|
|
Noncurrent assets
|
|
$
|
1,581
|
|
|
Current liabilities
|
|
$
|
1,253
|
|
|
Noncurrent liabilities
|
|
$
|
2,020
|
|
|
Redeemable convertible preferred stock
|
|
$
|
34,249
|
|
|
Stockholders’ deficit
|
|
$
|
(21,417
|
)
|
NOTE 7
INVESTMENTS
Short and long-term investments consisted of the following
available-for-sale securities at January 31, 2004 and December 31,
2003 (in thousands):
F-19
|
|
|
Amortized
Cost
|
|
Unrealized
Holding
Gains
|
|
Unrealized
Holding
Losses
|
|
Fair
Values
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2003
|
|
|
|
|
|
|
|
|
|
|
U.S. Government obligations
|
|
$
|
126,250
|
|
$
|
418
|
|
$
|
67
|
|
$
|
126,601
|
|
|
State and local government obligations
|
|
48,459
|
|
18
|
|
—
|
|
48,477
|
|
|
Corporate obligations
|
|
44,788
|
|
145
|
|
4
|
|
44,929
|
|
|
U.S. Treasury options
|
|
66
|
|
—
|
|
34
|
|
32
|
|
|
Marketable equity securities
|
|
31,109
|
|
—
|
|
64
|
|
31,045
|
|
|
Fixed income mutual funds
|
|
10,246
|
|
—
|
|
107
|
|
10,139
|
|
|
|
|
$
|
260,918
|
|
$
|
581
|
|
$
|
276
|
|
$
|
261,223
|
|
|
Reported as:
|
|
|
|
|
|
|
|
|
|
|
Short-term investments
|
|
|
|
|
|
|
|
$
|
157,740
|
|
|
Long-term investments
|
|
|
|
|
|
|
|
103,483
|
|
|
|
|
|
|
|
|
|
|
$
|
261,223
|
|
|
2002
|
|
|
|
|
|
|
|
|
|
|
U.S. Government obligations
|
|
$
|
87,570
|
|
$
|
1,026
|
|
$
|
—
|
|
$
|
88,596
|
|
|
State and local government obligations
|
|
89,614
|
|
118
|
|
—
|
|
89,732
|
|
|
Mutual funds
|
|
18,954
|
|
127
|
|
—
|
|
19,081
|
|
|
Marketable equity securities
|
|
32,956
|
|
—
|
|
6
|
|
32,950
|
|
|
|
|
$
|
229,094
|
|
$
|
1,271
|
|
$
|
6
|
|
$
|
230,359
|
|
|
Reported as:
|
|
|
|
|
|
|
|
|
|
|
Short-term investments
|
|
|
|
|
|
|
|
$
|
157,260
|
|
|
Long-term investments
|
|
|
|
|
|
|
|
73,099
|
|
|
|
|
|
|
|
|
|
|
$
|
230,359
|
|
Amortized cost is determined based on specific
identification. As of January 31,
2004 and December 31, 2002, net unrealized holding gains of $403,000 and
$1,265,000 million, respectively, were included in accumulated other
comprehensive income in the accompanying condensed consolidated balance sheets.
For the fiscal year ended January 31, 2004, approximately $98,000 of
unrealized losses related to hedged securities were included in investment
income. These unrealized losses represent the net ineffectiveness of a
fair-value hedge comprised of certain marketable equity securities and put
options on U.S. Treasury futures. At January 31, 2004, the Company held
approximately $32,000 of purchase put options for U.S. Treasury futures. These
investments were purchased to hedge the interest rate risk related to a
portfolio of preferred equity securities, included in marketable equity
securities above, with a market value of approximately $8.2 million at
January 31, 2004.
Realized gains and losses on sales of securities were
recorded as other income as follows:
|
|
|
Year
Ended
January 31,
|
|
Years
Ended
December 31,
|
|
Month
Ended
January 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
2003
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Realized gains
|
|
$
|
863
|
|
$
|
3
|
|
$
|
396
|
|
$
|
—
|
|
|
Realized losses
|
|
(834
|
)
|
(343
|
)
|
(134
|
)
|
(6
|
)
|
|
Net realized gains (losses)
|
|
$
|
29
|
|
$
|
(340
|
)
|
$
|
262
|
|
$
|
(6
|
)
|
The amortized cost and estimated fair value of debt securities held at
January 31, 2004, by contractual maturity, are shown below. Expected
maturities will differ from contractual maturities because the issuers of
securities may have the right to repay obligations without prepayment
penalties. Certain instruments, although possessing a contractual maturity
greater than a year, are classified as short-term investments based on methods
of trade and availability for current
F-20
operations.
|
|
|
Amortized
Cost
|
|
Fair
Values
|
|
|
Less than one year
|
|
$
|
65,037
|
|
$
|
65,412
|
|
|
Greater than one year through
five years
|
|
96,211
|
|
96,345
|
|
|
Greater than five years through
ten years
|
|
1,950
|
|
1,950
|
|
|
Greater than ten years
|
|
56,299
|
|
56,300
|
|
|
|
|
$
|
219,497
|
|
$
|
220,007
|
|
In fiscal year 2003, the Company began a securities lending program
whereby certain Company securities from the portfolio are loaned to other
institutions for short periods of time. The market value of the loaned
securities is monitored on a daily basis, with additional collateral obtained
or refunded as the market value of the loaned securities changes. The Company’s
policy is to require initial cash collateral equal to 102 percent of the fair
value of the loaned securities. Securities lending collateral is recorded
separately as a current asset and corresponding current liability. The Company
maintains ownership of the securities loaned, and continues to earn income on
them. The Company shares a portion of the interest earned on the collateral
with Wells Fargo Bank Minnesota, N.A. (the Lending Agent). In addition, the
Company has the ability to sell the securities while they are on loan. The
Company has an indemnification agreement with the lending agents in the event a
borrower becomes insolvent or fails to return securities. At January 31, 2004, the amount of
securities on loan equaled $124.5 million.
Financial instruments that potentially subject the Company to
concentrations of credit risk are cash equivalents, short and long-term
investments and accounts receivable. The Company maintains cash and cash
equivalents and short- and long-term investments with various financial
institutions. These financial institutions are geographically dispersed and
company policy restricts investments and limits the amount invested with any
single financial institution. The Company has not sustained material credit
losses from instruments held at financial institutions.
NOTE 8 CONVERTIBLE SUBORDINATED DEBT
On
February 7, 2003, the Company sold $172.5 million of 2.25% convertible
subordinated notes (the “Notes”) due February 15, 2010, raising net
proceeds of approximately $167 million. The Notes are convertible into Class A
common stock at a conversion rate of 93.3986 shares per $1,000 principal amount
of notes (aggregate of approximately 16.1 million shares) at any time prior to
February 15, 2010, subject to adjustments. In addition, holders of the
Notes may require the Company to purchase all or a portion of the Notes upon a
change in control of the Company. Upon a conversion, the Company may choose to
deliver, in lieu of shares of Class A common stock, cash or a combination of
cash and Class A common stock. The Notes do not contain any restrictive
covenants. 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 PortalSM Market. On January 31, 2004, the approximate bid price of our
notes was $116.0 and the approximate ask price of our notes was $116.5,
resulting in an aggregate fair value of between $200.1 million and $201.0
million. Our Class A common stock is quoted on the NASDAQ National Market under
the symbol, “MCDTA.”
Concurrent
with the issuance of the Notes, the Company entered into share option
transactions using approximately $20.5 million of net proceeds. As part of
these share option transactions, the Company purchased options that cover
approximately 16.1 million shares of Class A common stock, at a strike price of
$10.71. The Company also sold options that cover approximately 16.9 million
shares of Class A common stock, at a strike price of $15.08. The net cost of
the share option transactions was recorded against additional paid in capital.
These share option transactions are intended to give the Company the ability to
significantly mitigate dilution as a result of the Notes being converted to
common shares up to the $15.08 price per common share and mitigate dilution if
the share price exceeds $15.08 at that time. Should there be an early unwind of
either of the share option transactions, the amount of cash or net shares
potentially received or paid by the Company will be dependent on then existing
overall market conditions, the stock price, the volatility of the stock, and
the amount of time remaining until expiration of the options.
F-21
In
July 2003, the Company entered into an interest-rate swap agreement with a
notional amount of $155.3 million that has the economic effect of modifying
that dollar portion of the fixed interest obligations associated with the Notes
so that the interest payable effectively becomes variable based on the six
month London Interbank Offered Rate (LIBOR) minus 152 basis points. The reset
dates of the swap are February 15 and August 15 of each year until
maturity on February 15, 2010. At January 31, 2004, the six-month
LIBOR setting for the swap was 1.1283%, creating a rate of approximately minus
0.39%, which was effective until February 15, 2004. On February 15, 2004, the six-month
LIBOR setting was reset to 1.175%, resulting in a rate of approximately minus
0.345%, which is effective until August 15, 2004. The swap was designated as a fair value
hedge and, as such, the gain or loss on the swap, as well as the fully
offsetting gain or loss on the Notes attributable to the hedged risk, were
recognized in earnings. At January 31, 2004, the fair value of the
interest rate swap had decreased from inception to $349,000 and is included in
other long-term liabilities. Corresponding to this change, the carrying value
of the Notes has decreased by $349,000. As part of the agreement, the Company
is also required to post collateral based on changes in the fair value of the
interest rate swap. This collateral, in the form of restricted cash, was $5.1
million at January 31, 2004.
NOTE 9
STOCKHOLDERS’ EQUITY
The Company has both Class A and Class B common stock.
Holders of Class A and Class B common stock have voting rights equal
to one vote and one-tenth vote, respectively, for each share held. Holders of
Class A and Class B common stock share equal rights as to dividends.
No dividends attributable to common stock were declared or paid during 2003,
2002, 2001 or the month ended January 31, 2003.
The Board of Directors is authorized to issue preferred stock with
voting, conversion and other rights and preferences that may differ from the
Class A and Class B common stock. At January 31, 2004, there is
no outstanding preferred stock.
Stock Repurchase Plan
In
May 2003, the Company’s Board of Directors authorized a plan for the Company to
repurchase up to $50 million of its common stock (Class A, Class B or a
combination thereof). This repurchase plan does not obligate the Company to
acquire any specific number of shares or acquire shares over any specified
period of time. At January 31, 2004, approximately 976,000 shares have been
repurchased under the plan with a total cost at $8.8 million.
Stockholders’ Rights Plan
Effective June 5, 2001, the Company’s Board of Directors approved
a Stockholder Rights Plan in which preferred stock purchase rights were
distributed as a dividend. Each Right, expiring June 5, 2011, represents a
right to buy from the Company one ten-thousandth (1/10,000) of a share of
Series A Junior Participating Preferred Stock, $0.01 par value, at a price
of $200 per Right. This dividend distribution of the Rights was not taxable to
the Company or its stockholders.
Separate certificates for Rights will not be distributed, nor will the
Rights be exercisable, unless a person or group acquires 15 percent or
more, or announces an offer that could result in acquiring 15 percent or
more, of the aggregate number of votes entitled to be cast by all then
outstanding shares of Common Stock (a Stock Acquisition). Following a Stock
Acquisition, each Right holder, except the 15 percent or more stockholder,
has the right to receive, upon exercise, common shares valued at twice the then
applicable exercise price of the Right (or, under certain circumstances, cash,
property or other Company securities), unless the 15 percent or more
stockholder has offered to acquire all of the outstanding shares of the Company
under terms that a majority of the independent directors of the Company have
determined to be fair and in the best interest of the Company and its
stockholders. Similarly, unless certain conditions are met, if the Company engages
in a merger or other business combination following a Stock Acquisition where
it does not survive or survives with a change or exchange of its common shares
or if 50 percent or more of its assets, earning power, or cash flow is
sold or transferred, the Rights will become exercisable for shares of the
acquirer’s stock having a value of twice the exercise price (or under certain
circumstances, cash or property). The Rights are not exercisable, however,
until the Company’s right of redemption described below has expired. Generally,
Rights
F-22
may be redeemed for $0.01 each (in cash, common shares or other
consideration the Company deems appropriate) until the earlier of (i) the
tenth day following public announcement that a 15 percent or greater
position has been acquired in the Company’s stock or (ii) the final
expiration of the Rights. Until exercise, a Right holder, as such, has no
rights as a stockholder of the Company.
Stock Options
The Company maintains a stock option and restricted stock plan known as
the 2001 McDATA Equity Incentive Plan (the 2001 Plan) which provides for the
grant of Class B stock options, restricted stock and other stock based awards
to directors, officers, other employees, and consultants as determined by the
compensation committee of the Board of Directors. A maximum of 30,000,000
shares of common stock were issuable under the terms of the 2001 Plan as of
January 31, 2004, of which no more than 3,000,000 shares may be issued as
restricted stock or other stock based awards. On August 27, 2003, the
Company’s stockholders approved the addition of 6,000,000 shares to the 2001
Plan (included in the maximum amount noted above).
In August 2003 and in connection with the
acquisitions of Nishan and Sanera, the Company adopted the 2003 McDATA
Acquisition Equity Incentive Plan (the 2003 Plan). The 2003 Plan is a limited
purpose plan that allows for the issuance of inducement grants of restricted
and unrestricted Class B common stock to new employees in connection with a
merger or acquisition of a company or business by McDATA. Stock awards may only
be granted to new employees resulting from a merger or acquisition by the
Company. A maximum of 3,000,000 shares of common stock are issuable under the
terms of the 2003 Plan. Approximately 1,300,000 restricted stock shares were
issued under this 2003 Plan in connection with the acquisitions discussed in
Note 5. As of January 31, 2004,
there were approximately 8.3 million shares of common stock available for
future grants under these plans.
All stock option grants under the plans since August 2000 have
been granted at an exercise price equal to the fair market value of the
Company’s stock. Prior to 2001, in connection with the grant of certain stock
options to employees, the Company recorded deferred stock-based compensation,
net of forfeitures, of $36,110,000, representing the difference between the
exercise price and the deemed fair market value of the Company’s common stock
on the dates these stock options were granted. Deferred compensation related to
these grants is included as a reduction of stockholders’ equity and is being
amortized on a straight-line basis over the vesting periods of the related
options, which is generally four years. During 2003, 2002, 2001, and the
month ended January 31, 2003, the Company recorded amortization expense
related to these grants of approximately $4,279,000, $7,218,000, $8,195,000,
and $572,000, respectively (of which $377,000, $584,000, $1,437,000, and $44,000
is included in the cost of revenue for 2003, 2002, 2001, and the month ended
January 31, 2003, respectively).
The following summarizes stock option transactions for the period from
January 1, 2001 to January 31, 2004:
|
|
|
Year Ended
January 31,
|
|
Years Ended
December 31,
|
|
Month
Ended
January 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
2003
|
|
|
Options
|
|
Shares
|
|
Weighted
Average
Exercise
Price
|
|
Shares
|
|
Weighted
Average
Exercise
Price
|
|
Shares
|
|
Weighted
Average
Exercise
Price
|
|
Shares
|
|
Weighted
Average
Exercise
Price
|
|
|
Outstanding at beginning of period
|
|
12,324
|
|
$
|
11.43
|
|
10,672
|
|
$
|
11.32
|
|
11,891
|
|
$
|
7.41
|
|
11,654
|
|
$
|
11.56
|
|
|
Granted
|
|
3,683
|
|
10.47
|
|
3,296
|
|
11.44
|
|
2,526
|
|
19.29
|
|
1,073
|
|
8.24
|
|
|
Exercised
|
|
(805
|
)
|
2.75
|
|
(1,234
|
)
|
1.97
|
|
(2,462
|
)
|
2.00
|
|
(238
|
)
|
2.45
|
|
|
Forfeited or expired
|
|
(1,554
|
)
|
14.17
|
|
(1,080
|
)
|
19.89
|
|
(1,283
|
)
|
8.64
|
|
(165
|
)
|
12.41
|
|
|
Outstanding end of period
|
|
13,648
|
|
$
|
11.38
|
|
11,654
|
|
$
|
11.56
|
|
10,672
|
|
$
|
11.32
|
|
12,324
|
|
$
|
11.43
|
|
|
|
|
|
|
|
|
5,194
|
|
$
|
8.17
|
|
4,377
|
|
$
|
4.70
|
|
5,061
|
|
$
|
8.95
|
|
|
Exercisable at end of period
|
|
6,602
|
|
$
|
10.76
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average fair value of options
granted with an exercise price equal to fair market value
|
|
|
|
$
|
6.84
|
|
|
|
$
|
7.52
|
|
|
|
$
|
15.55
|
|
|
|
$
|
5.39
|
|
F-23
The status of total stock options outstanding and exercisable at
January 31, 2004 was as follows:
|
|
|
Options
Outstanding
|
|
Options
Exercisable
|
|
|
Exercise Prices
|
|
Number of
Shares
|
|
Weighted
Average
Remaining
Contractual
Life (Years)
|
|
Weighted
Average
Exercise
Price
|
|
Number
of
Shares
|
|
Weighted
Average
Exercise Price
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$1.00—$9.99
|
|
6,831
|
|
6.9
|
|
$
|
5.35
|
|
3,697
|
|
$
|
2.74
|
|
|
$10.00—$19.99
|
|
5,281
|
|
8.0
|
|
12.44
|
|
1,906
|
|
13.15
|
|
|
$20.00—$29.99
|
|
1,177
|
|
7.1
|
|
26.41
|
|
748
|
|
26.71
|
|
|
$30.00—$39.99
|
|
79
|
|
7.3
|
|
34.99
|
|
41
|
|
34.98
|
|
|
$40.00—$49.99
|
|
47
|
|
6.9
|
|
45.60
|
|
35
|
|
45.60
|
|
|
$50.00—$59.99
|
|
13
|
|
7.0
|
|
54.43
|
|
7
|
|
54.21
|
|
|
$60.00—$69.99
|
|
44
|
|
6.9
|
|
63.51
|
|
33
|
|
63.51
|
|
|
$70.00—$79.99
|
|
168
|
|
6.8
|
|
76.01
|
|
129
|
|
76.04
|
|
|
$80.00—$93.36
|
|
8
|
|
6.6
|
|
93.36
|
|
6
|
|
93.36
|
|
|
|
|
13,648
|
|
7.4
|
|
$
|
11.38
|
|
6,602
|
|
$
|
10.76
|
|
Restricted Stock
Restricted stock issued under the plans are recorded at fair market
value on the date of the grant and generally vest over a one to four year
period. Vesting for some grants may be accelerated if certain performance
criteria are achieved. Compensation expense is recognized over the applicable
vesting period. During the years ended January 31, 2004, and
December 31, 2002, and 2001, and the month ended January 31, 2003 the
Company issued approximately 1,532,000, 182,000, 192,000 and 107,000 of
restricted shares, respectively, having an aggregate fair market value of
$17,357,000, $1,867,000, $1,896,000 and $747,000, respectively. Compensation
expense recognized for restricted shares in 2003, 2002 and 2001 and the month
ended January 31, 2003 was $8,429,000, $1,663,000, $501,000, and $53,000,
respectively.
Employee Stock Purchase Plan
On August 1, 2002, the Board of Directors approved the 2002
Employee Stock Purchase Plan (the Purchase Plan). The Purchase Plan allows
eligible employees an opportunity to purchase an aggregate of 1,200,000 shares
of the Company’s Class B common stock at a price per share equal to 85% of
the lesser of the fair market value of the Company’s common stock at the
beginning or the end of each six-month purchase period. Under the terms of the
Purchase Plan, no participant may acquire more than more than $25,000 in
aggregate fair market value of common stock during any one-year calendar
period. As of December 31, 2002 and January 31, 2004, 0 and 521,000
shares had been issued under the plan.
NOTE 10
OTHER COMPREHENSIVE INCOME
Other comprehensive income consisted solely of unrealized gains
(losses) on investments. The changes in the components of other comprehensive
income, net of taxes were as follows:
F-24
|
|
|
Year
Ended
January 31,
|
|
Years
Ended
December 31,
|
|
Month
Ended
January 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
2003
|
|
|
Change in net unrealized gains (losses) on
investments, net of related income tax expense (benefit) of $(401), $(94),
$331,and $(42), respectively
|
|
$
|
(227
|
)
|
$
|
(189
|
)
|
$
|
570
|
|
$
|
(66
|
)
|
|
Reclassification adjustment for net
realized (gains) losses included in net income, net of related income tax
(expense) benefit of $(52), $282, $(97), and $2, respectively
|
|
(81
|
)
|
442
|
|
(167
|
)
|
4
|
|
|
|
|
$
|
(308
|
)
|
$
|
253
|
|
$
|
403
|
|
$
|
(62
|
)
|
NOTE 11 EMPLOYEE BENEFIT PLANS
Defined Contribution Plan
The Company has a defined contribution plan (the McDATA Retirement
Savings Plan) that covers eligible employees. The Company matches 50% of an
employee’s contribution up to 6% of annual eligible compensation, subject to
restrictions of such plans. Such Company contributions are made in cash, and
amounted to approximately $2,049,000, $1,803,000, and $1,359,000 in 2003, 2002
and 2001, respectively. Contributions
for the month ended January 31, 2003 totaled $313,000.
Profit Sharing and Bonus Plans
The Company has various employee bonus plans. A profit sharing plan
provides for the contribution of a portion of each year’s profits to a profit
sharing pool that is distributed to all employees not eligible for other
performance-based incentive plans. The profit sharing amount is determined
annually by the Board of Directors and is paid in cash. Other bonus plans award
quarterly bonuses to the Company’s executives and other members of management
based on the achievement of pre-defined performance measures and other specific
performance criteria. Compensation charges related to these plans were approximately
$3,046,000, $2,991,000, and $981,000 for 2003, 2002, and 2001,
respectively. Compensation charges for
the month ended January 31, 2003 were immaterial.
NOTE 12
INCOME TAXES
Income (loss) before income taxes consisted of the following:
|
|
|
Year Ended
January 31,
|
|
Years
Ended December 31,
|
|
Month
Ended
January 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
2003
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Domestic
|
|
$
|
(5,526
|
)
|
$
|
(16,620
|
)
|
$
|
(14,270
|
)
|
$
|
(5,445
|
)
|
|
Foreign
|
|
1,789
|
|
1,104
|
|
530
|
|
122
|
|
|
|
|
$
|
(3,737
|
)
|
$
|
(15,516
|
)
|
$
|
(13,740
|
)
|
$
|
(5,323
|
)
|
Income tax expense (benefit) consisted of the following:
|
|
|
Year Ended
January 31,
|
|
Year Ended
December 31,
|
|
Month
Ended
January 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
2003
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Current:
|
|
|
|
|
|
|
|
|
|
|
Federal
|
|
$
|
(974
|
)
|
$
|
3,190
|
|
$
|
8,894
|
|
$
|
—
|
|
|
State
|
|
(39
|
)
|
442
|
|
508
|
|
—
|
|
|
Foreign
|
|
610
|
|
185
|
|
—
|
|
—
|
|
|
|
|
(403
|
)
|
3,817
|
|
9,402
|
|
—
|
|
|
Deferred:
|
|
|
|
|
|
|
|
|
|
|
Federal
|
|
34,943
|
|
(8,328
|
)
|
(13,423
|
)
|
(1,716
|
)
|
|
State
|
|
3,872
|
|
(1,018
|
)
|
(1,063
|
)
|
(147
|
)
|
|
|
|
38,815
|
|
(9,346
|
)
|
(14,486
|
)
|
(1,863
|
)
|
|
Total expense (benefit)
|
|
$
|
38,412
|
|
$
|
(5,529
|
)
|
$
|
(5,084
|
)
|
$
|
(1,863
|
)
|
F-25
The total income tax expense (benefit) differs from the amount computed
using the federal income tax rate of 35% for the following reasons:
|
|
|
Year Ended
January 31,
|
|
Years
Ended December 31,
|
|
Month
Ended
January 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
2003
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Federal income tax expense (benefit) at
statutory rate
|
|
$
|
(1,308
|
)
|
$
|
(5,430
|
)
|
$
|
(4,809
|
)
|
$
|
(1,863
|
)
|
|
Research and development credit
|
|
(1,400
|
)
|
(1,970
|
)
|
—
|
|
(100
|
)
|
|
State taxes, net of federal benefit
|
|
(131
|
)
|
(373
|
)
|
(346
|
)
|
(147
|
)
|
|
Foreign taxes
|
|
126
|
|
185
|
|
—
|
|
33
|
|
|
Convertible debt discount
|
|
(2,028
|
)
|
—
|
|
—
|
|
—
|
|
|
Stock-based compensation
|
|
1,083
|
|
2,958
|
|
1,803
|
|
267
|
|
|
Write-off of acquired in-process R&D
|
|
1,273
|
|
—
|
|
—
|
|
—
|
|
|
Benefit from export sales
|
|
(158
|
)
|
(247
|
)
|
(305
|
)
|
(13
|
)
|
|
Municipal interest income
|
|
(140
|
)
|
(872
|
)
|
(1,625
|
)
|
(53
|
)
|
|
Increase in valuation allowance
|
|
41,332
|
|
—
|
|
—
|
|
—
|
|
|
Other
|
|
(237
|
)
|
220
|
|
198
|
|
13
|
|
|
Income tax expense (benefit)
|
|
$
|
38,412
|
|
$
|
(5,529
|
)
|
$
|
(5,084
|
)
|
$
|
(1,863
|
)
|
Deferred income taxes reflect the tax effect of temporary differences
between the amount of assets and liabilities for financial reporting purposes
and income tax purposes. The tax effects of each type of temporary difference
that give rise to significant portions of the net deferred tax assets are as
follows:
|
|
|
Year Ended
January 31
2004
|
|
Year Ended
December 31,
2002
|
|
|
|
|
|
|
|
|
|
Current deferred
tax assets (liabilities):
|
|
|
|
|
|
|
Inventory reserves and costs
|
|
$
|
6,931
|
|
$
|
10,726
|
|
|
Revenue recognition
|
|
8,743
|
|
10,368
|
|
|
Net operating loss carry forward
|
|
12,323
|
|
7,373
|
|
|
Warranty reserves
|
|
1,727
|
|
1,321
|
|
|
Reserves related to employee benefits
|
|
2,140
|
|
1,993
|
|
|
Stock-based compensation
|
|
1,253
|
|
1,544
|
|
|
Restructuring reserves
|
|
855
|
|
—
|
|
|
Other
|
|
(149
|
)
|
—
|
|
|
|
|
33,823
|
|
33,325
|
|
|
Non-current
deferred tax assets (liabilities):
|
|
|
|
|
|
|
Capitalized research expenditures
|
|
40,999
|
|
—
|
|
|
Capitalized acquired intangible assets
|
|
(40,381
|
)
|
—
|
|
|
Tax credit carry forward
|
|
16,796
|
|
3,537
|
|
|
Revenue recognition
|
|
8,005
|
|
—
|
|
|
Stock compensation
|
|
1,476
|
|
—
|
|
|
Difference between book and tax
depreciation
|
|
4,994
|
|
2,485
|
|
|
Capitalized software, net of amortization
|
|
(2,966
|
)
|
(2,930
|
)
|
|
Foreign earnings
|
|
(1,374
|
)
|
—
|
|
|
Net operating loss carry forward
|
|
15,769
|
|
—
|
|
|
Other
|
|
229
|
|
—
|
|
|
|
|
43,547
|
|
3,092
|
|
|
|
|
77,370
|
|
36,417
|
|
|
Valuation allowance
|
|
(77,370
|
)
|
—
|
|
|
Total deferred tax asset, net
|
|
$
|
—
|
|
$
|
36,417
|
|
F-26
The $77.4 million valuation allowance was recorded against deferred tax
assets as follows:
|
Opening balance of deferred tax asset at
February 1, 2003
|
|
$
|
38,815
|
|
|
Additional deferred tax asset arising
during 2003
|
|
2,517
|
|
|
Acquired deferred tax assets
|
|
35,070
|
|
|
Deferred tax asset for stock-based
compensation in 2003 (net of alternative minimum tax effect)
|
|
968
|
|
|
|
|
$
|
77,370
|
|
Gross operating loss carry forwards and tax credit carry forwards will
expire as follows:
|
Year of Expiration
|
|
Federal
Net Operating
Loss Carry
Forward
|
|
Research
& Development
Tax Credit
Carry Forward
|
|
|
|
|
|
|
|
|
|
2019
|
|
$
|
99
|
|
$
|
104
|
|
|
2020
|
|
—
|
|
1,074
|
|
|
2021
|
|
11,718
|
|
4,579
|
|
|
2022
|
|
22,686
|
|
3,540
|
|
|
2023
|
|
41,501
|
|
4,358
|
|
|
2024
|
|
—
|
|
1,400
|
|
|
|
|
$
|
76,004
|
|
$
|
15,055
|
|
Approximately $51 million of the net operating loss carryforward and
$10 million of the research and development tax credit carry forward are
subject to annual limitations on the amount that can be utilized in the
Company’s tax returns, pursuant to Internal Revenue Code Section 382, as these
amounts were accumulated in the tax returns of Nishan Systems and Sanera
Systems for tax periods prior to the date those companies were acquired by
McDATA.
In
fiscal 2003, the Company recorded an income tax provision of $38.4 million,
which included a non-cash charge of $38.8 million related to recording of a
valuation allowance against the deferred tax assets. In evaluating the ability
to realize the benefits of the recorded deferred tax assets, management
considers all available positive and negative evidence including past operating
results, the existence of cumulative losses in the most recent fiscal years and
forecasts of future taxable income. In determining future taxable income,
management is responsible for assumptions utilized including the amount of
state, federal and international pre-tax operating income, the reversal of
temporary differences and the implementation of feasible and prudent tax
planning strategies. These assumptions require significant judgment about the
forecasts of future taxable income and are consistent with the plans and
estimates used to manage the underlying businesses.
In
performing the analysis of the realizability of the recorded deferred tax
assets, the specific evidence considered by management included cumulative
accounting losses over the past three years, tax net operating losses
previously reported, net operating losses acquired, estimated future taxable
income, ongoing prudent and feasible tax planning strategies, progress against
the forecast of operating results, and continuing market uncertainties. Through
this analysis, management assessed the likelihood that the net deferred tax
assets will be recovered against future taxable income. After considering all
of the evidence and applying the provisions of SFAS No. 109, “Accounting for
Income Taxes” (SFAS
F-27
109), management concluded
that it was not more likely than not that the deferred tax assets would be
realized and that a valuation allowance for the entire deferred tax asset was
required.
The Company is subject to audit by federal, state and foreign tax
authorities. These audits may result in
additional tax liabilities. The Company
accounts for such contingent liabilities in accordance with SFAS No. 5,
“Accounting for Contingencies”, and believes that it has appropriately provided
for taxes for all years. Several
factors drive the calculation of the tax reserves including (i) the expiration
of statutes of limitations, (ii) changes in tax law and regulations, and (iii)
settlements with tax authorities.
Changes in any of these factors may result in adjustments to these
reserves which could impact our reported financial results.
Prior to the initial public offering on August 9, 2000, the
Company was included in a consolidated Federal income tax return with EMC. As of the Distribution, the Company is no
longer eligible to be included in EMC’s consolidated tax returns and has
consequently filed separate income tax returns for the tax periods, which began
immediately following the Distribution.
Under the terms of a tax sharing agreement between the Company and EMC,
the Company is obligated to indemnify EMC for any taxes arising out of the
failure of the Distribution to be tax free if that failure results from, among
other things, (i) any act or omission by the Company that would cause such
Distribution to fail to qualify as a tax free distribution under the Internal
Revenue Code of 1986, as amended; (ii) any act or omission by the Company that
is inconsistent with any representation made to the Internal Revenue Service in
connection with the request for a private letter ruling regarding the tax-free
nature of the Distribution; (iii) any acquisition by a third party of the
Company’s stock or assets; or (iv) any issuance by the Company of stock or any
change in ownership of the Company’s stock.
If the distribution of the Company’s Class A common stock fails to
qualify as a tax-free distribution, EMC would incur tax liability as if the
Company’s Class A common stock that was distributed by EMC had been sold by EMC
for its fair market value in a taxable transaction. In the event that the Company is required to indemnify EMC
because the distribution of the Company’s Class A common stock fails to qualify
as a tax-free distribution, the Company’s liability could exceed 35% of the
value of the Company’s Class A common stock distributed by EMC as determined on
the date of the distribution.
Although the Company is no longer a member of EMC’s consolidated tax
group, the tax sharing agreement between the Company and EMC continues to
affect the Company. If a taxing
authority effects a change to the EMC consolidated return, the Company is
required to reimburse EMC for the tax of any Company-related unfavorable
adjustment. Conversely, the Company is
entitled to any refund for any Company-related favorable adjustment. Second, the Company is required to remit to
EMC any tax savings generated by the tax deductions, if any, related to the
issuance or sale of EMC stock upon the exercise of options held by Company
employees. Included in the Company’s
2001 federal tax return was a stock-based compensation deduction of $25 million
related to the issuance or sale of EMC stock.
Subsequent to the receipt of its IRS refund of its 2001 net operating
loss carry back into 2000, the Company remitted to EMC $9.5 million pursuant to
the tax sharing agreement.
NOTE 13
COMMITMENTS AND CONTINGENCIES
Operating and Capital Leases
The Company had various operating and capital leases in effect at
January 31, 2004 for certain buildings, office space and machinery and
equipment. Future minimum lease payments under non-cancelable capital and
operating leases with terms of one year or more are as follows at
January 31, 2004:
|
|
|
Capital
Leases
|
|
Operating
Leases
|
|
|
2004
|
|
$
|
1,453
|
|
$
|
8,097
|
|
|
2005
|
|
739
|
|
5,655
|
|
|
2006
|
|
184
|
|
2,554
|
|
|
2007
|
|
—
|
|
1,359
|
|
|
2008
|
|
—
|
|
1,250
|
|
|
Thereafter
|
|
—
|
|
1,380
|
|
|
Total minimum lease payments
|
|
2,376
|
|
$
|
20,295
|
|
|
Less portion representing interest
|
|
109
|
|
|
|
|
|
|
2,267
|
|
|
|
|
Less: current portion
|
|
1,377
|
|
|
|
|
|
|
$
|
890
|
|
|
|
F-28
Operating rent expense in 2003, 2002, 2001 and the month ended
January 31, 2003 totaled approximately $10,414,000, $8,946,000,
$7,671,000, and $771,000, respectively.
As part of the Company’s move to the new office and engineering
building in 2002, the Company performed a review of its real estate facility
requirements and identified excess leased facility space, which was offered for
sublease. Based upon the results of this analysis, the Company recorded a
charge of $83,000 and $941,000 included in selling and marketing expense
related to facility lease losses for the years ended December 31,
2002 and 2001, respectively. In determining the anticipated lease losses,
various assumptions were made, including, the time period over which the excess
space will be under contract; expected sublease terms; and expected sublease
rates and anticipated recoveries from sublease income. The new office and
engineering building was completed in July 2002. Lease charges of
$589,000, $341,000 and $57,000 were recorded against the loss accrual during
the years ended January 31, 2004 and December 31, 2002 and the month
ended January 31, 2003, respectively.
As of January 31, 2004, the balance of this accrual was $0.
Collateralized Lease
On February 9, 2001, the Company entered into an operating lease
and associated agreements with Deutsche Bank AG, New York Branch (“Deutsche
Bank”) for the lease of an approximately 167,000 square foot multi-story office
and engineering building to be constructed on a 106 acre parcel of land located
in Broomfield, Colorado. Construction of the building commenced in the first
half of 2001 and was completed in July 2002, at which time lease payments
were scheduled to commence. As part of the transaction, the Company guaranteed
a residual value of the facility to Deutsche Bank of approximately 89% during
the construction period and 85% thereafter of the $60 million total
original cost and agreed to restrict up to $63 million of its investment
securities as collateral for specified obligations under the lease. During the
first quarter of 2002, the Company elected to terminate the lease under the
provisions of the agreements. On May 9, 2002, the Company entered into a Termination
Agreement with Deutsche Bank and recorded approximately $39 million in
construction costs as property and equipment. $41 million in restricted
assets were used to pay off the lease obligation and construction costs. In
addition, a loss of $1.25 million was recorded during the first quarter of
2002 to reflect the write-off of certain lease costs that could not be
capitalized.
Manufacturing and Purchase Commitments
The
Company has contracted with Sanmina SCI Systems, Inc. (SSCI) and Solectron Corporation
(Solectron) (collectively, Contract Manufacturers) for the manufacture of
printed circuit boards and box build assembly and configuration for specific
multi-protocol directors and switches. The agreements require the Company to
submit purchasing forecasts and place orders sixty calendar days in advance of
delivery. At January 31,
2004, the Company’s commitment with the Contract Manufacturers for purchases
over the next sixty days totaled $48.1 million. The Company may be liable for materials that the
Contract Manufacturers purchase on McDATA’s behalf if the Company’s actual
requirements do not meet or exceed its forecasts and those materials cannot be
redirected to other uses. At January 31, 2004, the Company had recorded
obligations of approximately $8 million (See Note 3) primarily related to
materials purchased by the Contract Manufacturers for certain end-of-life and
obsolete material. Management does not expect the remaining commitments under
these agreements to have a material adverse effect on the Company’s business,
results of operations, financial position or cash flows.
The Company has various other commitments for sales and purchases in
the ordinary course of business. In the aggregate, such commitments do not
differ significantly from current market prices or anticipated usage
requirements.
Litigation
Class Action Laddering Lawsuits
The
Company, Mr. John F. McDonnell, the former Chairman of the board of directors,
Mrs. Dee J. Perry, a former officer and Mr. Thomas O. McGimpsey a current
officer were named as defendants in purported securities class-action lawsuits
filed in the United States District Court, Southern District of New York. The
first of these lawsuits, filed on July 20, 2001, is captioned Gutner v.
McDATA Corporation, Credit Suisse First Boston (CSFB), Merrill Lynch,
F-29
Pierce Fenner & Smith
Incorporated, Bear, Stearns & Co., Inc., FleetBoston Robertson Stephens et
al., No. 01 CIV. 6627. Three other similar suits were filed against the Company
and the individuals. The complaints are substantially identical to numerous
other complaints filed against other companies that went public in 1999 and
2000. These lawsuits generally allege, among other things, that the
registration statements and prospectus filed with the SEC by such companies
were materially false and misleading because they failed to disclose (a) that
certain underwriters had allegedly solicited and received excessive and
undisclosed commissions from certain investors in exchange for which the
underwriters allocated to those investors material portions of shares in
connection with the initial public offerings, or IPOs, and (b) that certain of
the underwriters had allegedly entered into agreements with customers whereby
the underwriters agreed to allocate IPO shares in exchange for which the
customers agreed to purchase additional company shares in the aftermarket at
pre-determined prices. The complaints allege claims against the Company, the
named individuals, and CSFB, the lead underwriter of the Company’s
August 9, 2000 initial public offering, under Sections 11 and 15 of the
Securities Act. The complaints also allege claims solely against CSFB and the
other underwriter defendants under Section 12(a)(2) of the Securities Act,
and claims against the individual defendants under Section 10(b) of the
Securities Exchange Act. Although management believes that all of the lawsuits
are without legal merit and they intend to defend against them vigorously,
there is no assurance that the Company will prevail.
In
September 2002, plaintiffs’ counsel in the above-mentioned lawsuits
offered to individual defendants of many of the public companies being sued,
including the Company, the opportunity to enter into a Reservation of Rights
and Tolling Agreement that would dismiss without prejudice and without costs
all claims against such persons if the company itself had entity coverage
insurance. This agreement was signed by Mr. John F. McDonnell, the former
Company Chairman, Mrs. Dee J. Perry, the former chief financial officer, and
Mr. Thomas O. McGimpsey, the current Vice President and General Counsel and the
plaintiffs’ executive committee. Under the Reservation of Rights and Tolling
Agreement, the plaintiffs dismissed the claims against such individuals.
On
February 19, 2003, the court in the above-mentioned lawsuits entered a
ruling on the pending motions to dismiss, which dismissed some, but not all, of
the plaintiffs’ claims against the Company. These lawsuits have been consolidated
as part of In Re Initial Public Offering Securities Litigation (SDNY). The
Company has considered and agreed to enter into a proposed settlement offer
with representatives of the plaintiffs in the consolidated proceeding, and we
believe that any liability on behalf of the Company that may accrue under that
settlement offer would be covered by our insurance policies. Until that
settlement is fully effective, Management intends to defend against the
consolidated proceeding vigorously.
Patent Infringement Lawsuit
On
February 14, 2002, the Company filed a patent infringement lawsuit against
Brocade in the United States District Court for the District of Colorado
alleging that Brocade’s Frame Filtering feature in their products infringed the
Company’s U.S. Patent No. 6,233,236 “Method and apparatus for measuring traffic
within a switch.” On March 5, 2002, the Company filed for a preliminary
injunction against Brocade to immediately stop infringing the patent after
Brocade announced another product containing its advanced performance
monitoring feature. On April 8, 2002, Brocade filed an answer to the
motion for preliminary injunction generally alleging that Brocade has not
infringed and is not infringing the patent. Brocade alleged various
counterclaims in its answer including a claim that the patent is invalid and
unenforceable, and that the Company misappropriated trade secret information
from Brocade under prior agreements and that a 1999 OEM agreement contained a
covenant not to sue. The United States District Court for the District of
Colorado on December 6, 2002 denied the Company’s motion for a preliminary
injunction. The Company filed documents on December 23, 2002 with the
American Arbitration Association to initiate an arbitration proceeding to
resolve contract and patent issues relating to the 1999 OEM agreement with
Brocade. On January 24, 2003, Brocade, in response to the initiation of
the arbitration proceeding, filed an answer and counterclaim with the American
Arbitration Association that objected to the inclusion of the patent
infringement claims in the arbitration, claims the patent is invalid and
unenforceable and claims the Company misappropriated trade secret information
from Brocade.
On March 5, 2004, the Company and Brocade entered into a confidential
settlement agreement whereby both parties agreed to dismiss without prejudice
their respective claims against each other in the pending infringement case in
the United States District Court for the District of Colorado entitled McDATA Corp. v. Brocade Communications
Systems, Inc., Civil Action No. 02-K-303 and the related
arbitration proceedings before the
F-30
American
Arbitration Association entitled McDATA
Corp. v. Brocade Communications Systems, Inc., Case No. 74
133 00025 03 SAT. Under the confidential settlement agreement both parties
preserved their respective rights, no licenses were granted and they agreed to
a three-year standstill during which neither party may initiate litigation against
the other party with respect to their respective patents
Raytheon Lawsuit
On
May 5, 2003, the Company was added as the ninth defendant to a
January 2003 patent infringement lawsuit that was filed by Raytheon
Company (Raytheon) in the United States District Court for the Eastern District
of Texas—Marshall Division (Civil Action No. 2:03CV13). The complaint alleged
that the our products infringed and/or we actively induced the infringement of
Raytheon’s United States Patent No. 5,412,791, entitled “Mass Data Storage
Library.” On January 8, 2004, we settled this lawsuit with Raytheon and
the parties agreed to dismiss with prejudice their respective claims and
counterclaims against each other.
Nishan Acquisition Related
Lawsuit
In
connection with the Company’s acquisition of Nishan, the Company was named
along with Nishan, various investors of Nishan, CSFB and former board members
and officers of Nishan in a lawsuit brought by Aamer Latif, a former board
member and ex-CEO of Nishan, in the Superior Court of California, County of
Santa Clara on September 11, 2003 (as amended on October 10, 2003 and
March 24, 2004) entitled Aamer Latif v.
Nishan Systems, Inc. et al (103 CV 004 939). The Complaint makes
various allegations against the other defendants such as fraud, directors’
breach of the duty of care, shareholders’ breach of fiduciary duty, unjust
enrichment, and conspiracy to commit unjust enrichment. The allegations made
against the Company are vote buying, unjust enrichment, and conspiracy to
commit unjust enrichment. The allegation made against Nishan is breach of
Section 1602 of the California Corporations Code (a provision dealing with
books and records inspection). The complaint primarily seeks compensatory
damages of approximately $11.5 million and other relief. The defendants have
agreed that lawsuit expenses are covered by indemnification under the merger
agreement from the selling shareholders of Nishan. The defendants filed a
demurer to dismiss this action, which was denied by the Court in January 2004. After significant review of the allegations
made by the plaintiff, the Company strongly believes that the lawsuit is wholly
without legal merit and the Company intends to vigorously defend against this
action.
Indemnifications and Guarantees
During its normal course of business, the Company may enter into
agreements with, among others, customers, resellers, OEMs, systems integrators
and distributors. These agreements
typically require the Company to indemnify the other party against third party claims
or product infringements on patents or copyrights. The Company provides indemnifications of varying scope and size
to certain customers against claims of intellectual property infringement made
by third parties arising for the use of our products.
The Company has also indemnified its former parent, EMC, for any income
taxes arising out of the Distribution as discussed in Note 12.
In addition, the majority of these indemnities, commitments and
guarantees do not provide for any limitation of the maximum potential future
payments the Company could be obligated to make. The Company evaluates and estimates losses from such
indemnification under SFAS 5, Accounting for Contingencies, as interpreted by
FIN 45. To date, the Company has not
incurred any material costs as a result of such obligations and has not accrued
any liabilities related to such indemnification and guarantees in our financial
statements.
NOTE 14 RELATED PARTY TRANSACTIONS
In
January 2004, the Company entered into a three-year litigation support and
consulting agreement with John F. McDonnell, the Company’s former Chairman,
pursuant to which Mr. McDonnell will render litigation support and consulting
services to McDATA. Under the agreement, the Company is assured on-demand
access to Mr. McDonnell at a
F-31
rate of $250 per hour and the reimbursement of out-of-pocket expenses.
The agreement was reviewed and approved by a committee of independent directors
of the Board of Directors. As of January 31, 2004, there was no liability or
related expense recorded from this agreement.
In
February 2004, the Company entered into a six-month standard lab services
agreement with JRBM Incorporated (JRBM), a company partially owned by John F.
McDonnell, the Company’s former Chairman. Under this arrangement, the Company
leases approximately 155 square feet of unused lab space and equipment to JRBM
at an arms-length market rate, and JRBM may purchase McDATA products under our
standard OpenReady™ equipment discount program. The arrangement was reviewed
and approved by a committee of independent directors of the Board of Directors.
JRBM also made a business proposal to McDATA to review the SANavigator®
software, over a nine month period, for the purpose of potentially reselling,
licensing or utilizing certain features or modules of SANavigator®
and potentially developing application program interfaces. The agreement
evidencing such an arrangement was signed on February 25, 2004 (with a
February 27, 2004 effective date) by both parties after review and
approval by a committee of independent directors of the Board of Directors.
NOTE 15
SEGMENT INFORMATION
The Company has one reporting segment relating to the design,
development, manufacture and sales of open storage networking solutions that
provide highly available, scalable and centrally managed storage area networks
(SANs). The Company’s Chief Operating
Decision Makers, as defined by SFAS 131, “Disclosures about Segments of an
Enterprise and Related Information,” allocate resources and assess the
performance of the Company based on revenue and overall profitability.
For the year ended January 31, 2004, the Company had three
customers who each contributed greater than 10% of the Company’s total
revenues. For the fiscal years ended
December 31, 2002 and 2001, and the one-month ended January 31, 2003,
the Company had two customers each who contributed greater than 10% of the
Company’s total revenues as follows:
|
|
|
Year Ended
January 31,
|
|
Years
Ended
December 31,
|
|
Month
Ended
January 31,
|
|
|
|
|
2004
|
|
2002
|
|
2001
|
|
2003
|
|
|
|
|
|
|
|
|
|
|
|
|
|
EMC
|
|
56
|
%
|
54
|
%
|
69
|
%
|
54
|
%
|
|
IBM
|
|
21
|
%
|
25
|
%
|
17
|
%
|
21
|
%
|
|
HDS
|
|
10
|
%
|
<10
|
%
|
<10
|
%
|
<10
|
%
|
At January 31, 2004 and December 31, 2002, 73% and 80% of
accounts receivable were concentrated with our two largest customers, EMC and
IBM. The Company performs ongoing evaluations of its customers’ financial
condition and, generally, requires no collateral from its customers. The level of sales to any single customer
may vary and the loss of any one of these customers, or a decrease in the level
of sales to any one of these customers, could have a material impact on the
Company’s financial condition or results of operations
The Company’s operations are conducted in the United States with sales
offices throughout the European Community and Asia Pacific, none of which are
individually significant to the Company’s overall operations. The Company has not incurred any foreign
currency translation adjustments as all of its sales are settled in U.S.
dollars.
Certain information related to the Company’s operations by geographic
area is presented below. The Company’s
revenues are attributed to the geographic areas according to the location of
the customers. Long-lived assets
include property and equipment and other non-current assets.
F-32
|
|
|
Net Sales
|
|
Long-Lived
Assets
|
|
|
|
|
|
|
|
|
|
2003
|
|
|
|
|
|
|
United States
|
|
$
|
282,503
|
|
$
|
115,450
|
|
|
Foreign countries
|
|
136,357
|
|
1,994
|
|
|
Total
|
|
$
|
418,860
|
|
$
|
117,444
|
|
|
|
|
|
|
|
|
|
2002
|
|
|
|
|
|
|
United States
|
|
$
|
207,015
|
|
$
|
111,479
|
|
|
Foreign countries
|
|
121,264
|
|
1,287
|
|
|
Total
|
|
$
|
328,279
|
|
$
|
112,766
|
|
|
|
|
|
|
|
|
|
2001
|
|
|
|
|
|
|
United States
|
|
$
|
263,416
|
|
|
|
|
Foreign countries
|
|
80,990
|
|
|
|
|
Total
|
|
$
|
344,406
|
|
|
|
|
|
|
|
|
|
|
|
Month
Ended January 31, 2003
|
|
|
|
|
|
|
United States
|
|
$
|
12,582
|
|
—
|
|
|
Foreign countries
|
|
4,463
|
|
|
|
|
Total
|
|
$
|
17,045
|
|
|
|
NOTE 16 SELECTED QUARTERLY FINANCIAL DATA
(UNAUDITED)
The following summarizes selected financial information for each of the
two years in the period ended January 31, 2004:
|
|
|
Q1
|
|
Q2
|
|
Q3(6)
|
|
Q4(6)
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2003(1)
|
|
|
|
|
|
|
|
|
|
|
|
|
Total revenue(2)
|
|
$
|
103,179
|
|
$
|
107,014
|
|
$
|
94,659
|
|
$
|
114,008
|
|
$
|
418,860
|
|
|
Gross profit
|
|
58,591
|
|
63,307
|
|
54,647
|
|
64,986
|
|
241,531
|
|
|
Net income (loss)(3)
|
|
5,312
|
|
9,133
|
|
(50,048
|
)
|
(7,530
|
)
|
(43,133
|
)
|
|
Basic net income (loss) per share
|
|
$
|
0.05
|
|
$
|
0.08
|
|
$
|
(0.44
|
)
|
$
|
(0.07
|
)
|
$
|
(0.38
|
)
|
|
Diluted net income (loss) per share
|
|
$
|
0.05
|
|
$
|
0.08
|
|
$
|
(0.44
|
)
|
$
|
(0.07
|
)
|
$
|
(0.38
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2002
|
|
|
|
|
|
|
|
|
|
|
|
|
Total revenue
|
|
$
|
64,543
|
|
$
|
77,254
|
|
$
|
80,941
|
|
$
|
105,541
|
|
$
|
328,279
|
|
|
Gross profit(4)
|
|
13,890
|
|
35,091
|
|
42,580
|
|
58,604
|
|
150,165
|
|
|
Net income (loss)(4)(5)
|
|
(17,071
|
)
|
(3,858
|
)
|
2,343
|
|
8,599
|
|
(9,987
|
)
|
|
Basic net income (loss) per share
|
|
$
|
(0.15
|
)
|
$
|
(0.03
|
)
|
$
|
0.02
|
|
$
|
0.08
|
|
$
|
(0.09
|
)
|
|
Diluted net income (loss) per share
|
|
$
|
(0.15
|
)
|
$
|
(0.03
|
)
|
$
|
0.02
|
|
$
|
0.07
|
|
$
|
(0.09
|
)
|
(1) On January 15, 2003, we changed our
fiscal year end to January 31, rather than December 31.
(2) Revenues
for the quarter ended October 31, 2003, were significantly impacted by a
decline in sales to our largest customer, EMC. This revenue decline was driven
by an inability to reach an agreement in a timely manner, which reduced the
shipment of products during the quarter.
(3) Net income for the quarter ended
October 31, 2003 includes the impacts of a $38.8 million valuation
allowance recorded against the deferred tax asset and a $11.4 million charge
for IPR&D related to the equity acquisitions of Nishan and Aarohi.
(4) Gross profit and net loss for the quarter
ended March 31, 2002 includes the impact of a $14.0 million charge to cost
of revenues primarily as a result of identified excesses 1 Gb components user
in the Director-class products. During
the quarters ended June 30, 2002, September 30, 2002 and
December 31, 2002, approximately $1.1 million, $2.5 million and $0.9
million, respectively, of these reserves were reversed as the Company
experienced higher-than-expected sales of discontinued 1 Gb products and, therefore,
realized 100% margins for these product sales.
(5) Net loss for the quarter ended
March 31, 2002 includes the impact of a $1.25 million charge to general
and
F-33
administrated expenses associated with the
termination of the collateralized lease with Deutsche Bank.
(6) Total revenue, gross profit and net income
for the third and fourth quarters of 2003 reflect our acquisitions of Nishan
and Sanera on September 19, 2003 and September 30, 2003,
respectively.
F-34
MCDATA CORPORATION
SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
|
|
|
Balance at
Beginning
of Period
|
|
Charged to
Costs and
Expenses
|
|
Deductions
|
|
Other
|
|
Balance at
End of
Period
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year ended
December 31, 2001
|
|
|
|
|
|
|
|
|
|
|
|
|
Allowance for doubtful accounts
|
|
$
|
284
|
|
$
|
707
|
|
$
|
(208)
|
(a)
|
$
|
—
|
|
$
|
783
|
|
|
Inventory reserves
|
|
4,315
|
|
29,919
|
|
(15,269)
|
(b)
|
—
|
|
18,965
|
|
|
Year ended
December 31, 2002
|
|
|
|
|
|
|
|
|
|
|
|
|
Allowance for doubtful accounts
|
|
$
|
783
|
|
$
|
25
|
|
$
|
43)
|
(a)
|
$
|
—
|
|
$
|
1,265
|
|
|
Inventory reserves
|
|
18,965
|
|
11,332
|
|
(22,885)
|
(b)
|
—
|
|
7,412
|
|
|
Month ended
January 31, 2003
|
|
|
|
|
|
|
|
|
|
|
|
|
Allowance for doubtful accounts
|
|
$
|
1,265
|
|
$
|
25
|
|
$
|
—
|
(a)
|
$
|
—
|
|
$
|
1,290
|
|
|
Inventory reserves
|
|
7,412
|
|
316
|
|
(613)
|
(b)
|
—
|
|
7,115
|
|
|
Year ended
January 31, 2004
|
|
|
|
|
|
|
|
|
|
|
|
|
Allowance for doubtful accounts
|
|
$
|
1,290
|
|
$
|
(474
|
)
|
$
|
(64)
|
(a)
|
$
|
174
|
(c)
|
$
|
926
|
|
|
Inventory reserves
|
|
7,115
|
|
1,923
|
|
(5,870)
|
(b)
|
1,308
|
(c)
|
4,476
|
|
(a) Reflects uncollectible amounts written-off, net of recoveries.
(b) Reflects disposals of obsolete inventory and reductions to
lower-of-cost or market reserves.
(c) Reflects the acquisition of Nishan in fiscal year 2003.
S-1