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FORM 10-Q

(Mark One)

For the quarterly period ended January 25, 2003

OR

For the transition period from              to                 

Commission file number: 000-25601

BROCADE COMMUNICATIONS SYSTEMS, INC.

1745 Technology Drive
San Jose, CA 95110
(408) 487-8000
(Address, including zip code, of Registrant’s
principal executive offices and telephone
number, including area code)

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

Yes   þ   No   o

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

Yes   þ   No   o

The number of shares outstanding of the Registrant’s Common Stock on February 21, 2003 was 236,002,569 shares.

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BROCADE COMMUNICATIONS SYSTEMS, INC.

FORM 10-Q

QUARTER ENDED JANUARY 25, 2003

INDEX

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

BROCADE COMMUNICATIONS SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

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

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BROCADE COMMUNICATIONS SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

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

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BROCADE COMMUNICATIONS SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

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

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BROCADE COMMUNICATIONS SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Organization and Operations of Brocade

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

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

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

2. Summary of Significant Accounting Policies

Basis of Presentation

     The accompanying financial data as of January 25, 2003, and for the three months ended January 25, 2003 and January 26, 2002, has been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. The October 26, 2002 Condensed Consolidated Balance Sheet was derived from audited consolidated financial statements, but does not include all disclosures required by generally accepted accounting principles in the United States of America. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended October 26, 2002.

     In the opinion of management, all adjustments (which include only normal recurring adjustments, except as otherwise indicated) necessary to present a fair statement of financial position as of January 25, 2003, results of operations for the three months ended January 25, 2003 and January 26, 2002, and cash flows for the three months ended January 25, 2003 and January 26, 2002, have been made. The results of operations for the three months ended January 25, 2003 are not necessarily indicative of the operating results for the full fiscal year or any future periods.

Cash and Cash Equivalents

     The Company considers all highly liquid investments with an original or remaining maturity of three months or less at the date of purchase to be cash equivalents. Cash and cash equivalents are primarily maintained at four major financial institutions.

Investments and Marketable Equity Securities

     Investment securities with original or remaining maturities of more than three months but less than one year are considered short-term investments. Investment securities with original or remaining maturities of one year or more are considered long-term investments. Short-term and long-term investments consist of debt securities issued by United States government agencies. Short-term and long-term investments are maintained at two major financial institutions, are classified

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as available-for-sale, and are recorded on the accompanying Condensed Consolidated Balance Sheets at fair value. Unrealized holding gains and losses are included as a separate component of accumulated other comprehensive income on the accompanying Condensed Consolidated Balance Sheets, net of any related tax effect. Realized gains and losses are calculated based on the specific identification method and are included in gain on investments, net on the Condensed Consolidated Statements of Operations.

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

     The Company also has certain other minority equity investments in non-publicly traded companies. These investments are included in other assets on the accompanying Condensed Consolidated Balance Sheets, and are accounted for under the cost method. The Company holds less than 20 percent of the voting equity of such companies, and neither has nor seeks control or significant influence over the respective company’s operating and financial policies. The Company monitors its investments for impairment on a quarterly basis and makes appropriate reductions in carrying values when such impairments are determined to be other-than-temporary. Impairment charges are included in gain on investments, net on the Condensed Consolidated Statements of Operations. Factors used in determining an impairment include, but are not limited to, the current business environment including competition and uncertainty of financial condition; going concern considerations such as the rate at which the investee company utilizes cash to finance overhead, and the investee company’s ability to obtain additional private financing to fulfill its stated business plan; the need for changes to the investee company’s existing business model due to changing business environments and its ability to successfully implement necessary changes; and comparable valuations. If an investment is determined to be impaired, a determination is made as to whether such impairment is other-than-temporary.

Notes Receivable from Non-Executive Employees

     The Company occasionally provides loans to various employees principally related to the respective employees’ relocation to the San Francisco Bay area. The loans are evidenced by secured promissory notes to the Company and bear interest at prevailing rates. Notes receivable from employees are included in prepaid expenses and other current assets, and other assets in the accompanying Condensed Consolidated Balance Sheets depending upon their remaining term. As of January 25, 2003 and October 26, 2002, the Company had outstanding loans to various employees totaling $7.1 million and $9.0 million, respectively. None of these loans have been issued to executive officers.

Concentrations

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

     A majority of the Company’s trade receivable balance is derived from sales to OEM partners in the computer storage and server industry. As of January 25, 2003, and October 26, 2002, 75 percent and 73 percent of accounts receivable were concentrated with five customers, respectively. The Company performs ongoing credit evaluations of its customers and generally does not require collateral on accounts receivable balances. The Company has established reserves for credit losses and sales returns, and other allowances. The Company has not experienced material credit losses in any of the periods presented.

     For the three-months ended January 25, 2003, and January 26, 2002, four customers each represented greater than ten percent of the Company’s total revenues for combined totals of 76 percent and 70 percent of total revenues, respectively. The level of sales to any single customer may vary and the loss of any single customer, or a decrease in the level of sales to any single customer, could seriously harm the Company’s financial condition and results of operations.

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

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

Revenue Recognition

     Product revenue. Product revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is probable. However, revenue recognition is deferred for shipments to new customers and for shipments to existing customers when significant support services are required to successfully integrate Brocade products into the customer’s products. These revenues, and related costs, are deferred and recognized when the customer has successfully integrated Brocade products into its product offerings and Brocade has met any support obligations. In addition, revenue from sales to master resellers is recognized upon reported sell-through.

     Service revenue. Service revenue consists of training, warranty, and maintenance arrangements, including post-contract customer support (PCS) services. PCS services are offered under renewable, annual fee-based contracts or as part of multiple element arrangements and typically include upgrades and enhancements to the Company’s software operating system, and telephone support. For multiple element arrangements, the Company allocates revenue to each element based upon vendor-specific objective evidence (VSOE) of the fair value of the element or application of the residual method. VSOE of the fair value for an element is based upon the price charged when the element is sold separately. Service revenue, including revenue allocated to undelivered elements, is deferred and recognized ratably over the contractual period. Service contracts are typically one to three years in length. Training revenue is recognized upon completion of the training. Service revenue was not material in any of the periods presented.

     Warranty Expense. The Company provides warranties on its products ranging from one to three years. The Company accrues for estimated warranty costs and reduces revenue for estimated sales returns and other allowances at the time of shipment. A provision for estimated future costs relating to warranty expense is recorded as cost of revenues when revenue is recorded. Warranty costs, sales returns and other allowances are estimated based upon historical experience.

Computation of Net Income (Loss) per Share

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

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Comprehensive Income (Loss)

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

Reclassifications

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

Recent Accounting Pronouncements

     In June 2002, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146). SFAS 146 requires the recording of costs associated with exit or disposal activities at their fair values only when a liability has been incurred. Under previous guidance, certain exit costs were accrued upon management’s commitment to an exit plan, which is generally before an actual liability has been incurred. The requirements of SFAS 146 were effective prospectively for exit or disposal activities initiated after December 31, 2002. The adoption of SFAS 146 did not have a material effect on the Company’s financial position, results of operations, or cash flows.

     In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (FIN 45). FIN 45 requires that upon issuance of a guarantee, the guarantor must recognize and disclose a liability for the fair value of the obligation assumed under the guarantee. FIN 45 also requires additional disclosure by a guarantor in its interim and annual financial statements about the obligations associated with guarantees issued. The recognition provisions of FIN 45 are effective for guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. The Company has determined that the requirements of FIN 45 apply to its accrued warranty and standard indemnification clauses contained within its various customer contracts.

     As of January 25, 2003 and October 26, 2002, the Company’s accrued warranty was $3.8 million and $4.0 million, respectively (see Note 8). To date, there have been no known events or circumstances that have resulted in an indemnification related liability to the Company.

     In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (SFAS 148). SFAS 148 amends SFAS 123 “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. SFAS 148 is effective for fiscal years beginning after December 15, 2002. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002.

     In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46). FIN 46 requires that if an entity has a controlling financial interest in a variable interest entity, the assets, liabilities and results of activities of the variable interest entity should be included in the consolidated financial statements of the entity. For arrangements entered into after January 31, 2003, FIN 46 is effective immediately. For arrangements entered into prior to January 31, 2003, FIN 46 is effective for the first interim or annual period beginning after June 15, 2003. The Company does not have any variable interest entities.

3. Restructuring Costs

     During the three months ended January 25, 2003, the Company completed a restructuring program to realign the organization and reduce the Company’s expense structure. The restructuring program included a workforce reduction of approximately 12 percent, consolidation of excess facilities, and the restructuring of certain business functions.

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     The following table summarizes the restructuring costs incurred and charged to restructuring expense during the three months ended January 25, 2003, costs paid or otherwise settled, and the remaining unpaid or otherwise unsettled accrued liabilities (in thousands):

     Severance and benefits charges of $8.5 million consisted of severance and associated employee termination costs related to the reduction of the Company’s workforce, including outplacement services and the write-off of employee loans of certain terminated employees. Contract termination charges of $0.9 million were primarily related to the cancellation of certain contracts in connection with the restructuring of certain business functions and the consolidation of excess facilities. Equipment impairment charges of $0.6 million were related to excess computer equipment resulting from the workforce reduction, consolidation of excess facilities, and the restructuring of certain business functions.

     Remaining accrued liabilities related to the restructuring program are included in other accrued liabilities on the accompanying Condensed Consolidated Balance Sheets. Remaining accrued liabilities related to severance and benefits are expected to be substantially paid or otherwise settled during the second quarter of fiscal year 2003. Remaining accrued liabilities related to contract terminations are expected to be paid or otherwise settled over their respective remaining contract terms through July of 2003.

4. Balance Sheet Details

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

     Leasehold improvements as of January 25, 2003 and October 26, 2002, are shown net of estimated asset impairments related to facilities lease losses (see Note 6).

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5. Investments and Marketable Equity Securities

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

     No gains or losses were realized on the sale of investments or marketable equity securities for either of the three months ended January 25, 2003, or January 26, 2002. As of January 25, 2003, and October 26, 2002, net unrealized holding gains of $12.8 million and $10.7 million, respectively, were included in accumulated other comprehensive income in the accompanying Condensed Consolidated Balance Sheets.

     The following table summarizes the maturities of the Company’s investments in debt securities issued by United States government agencies as of January 25, 2003 (in thousands):

6. Liabilities Associated with Facilities Lease Losses

     During the three months ended October 27, 2001, the Company recorded a charge of $39.8 million related to estimated facilities lease losses, net of expected sublease income, and a charge of $5.7 million in connection with the estimated impairment of certain related leasehold improvements. These charges represented the low-end of an estimated range that may be adjusted upon the occurrence of future triggering events. Triggering events may include, but are not limited to, changes in estimated time to sublease the facilities, sublease terms, sublease rates, expected future operating costs, and expected future use of the facilities.

     During the three months ended July 27, 2002, the Company completed a transaction to sublease a portion of these vacant facilities. Accordingly, based on then current market data, the Company revised certain estimates and assumptions, including those related to estimated sublease rates, estimated time to sublease the facilities, expected future operating costs, and expected future use of the facilities. The Company reevaluates its estimates and assumptions on a quarterly basis and makes adjustments to the reserve balance if necessary. No material adjustments were made to the facilities lease losses reserve for the three months ended January 25, 2003.

     Should there be changes in real estate market conditions or should it take longer than expected to find a suitable tenant to sublease the remaining vacant facilities, adjustments to the facilities lease losses reserve may be necessary in future periods based upon then current actual events and circumstances.

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

     Cash payments for facilities leases related to the above noted facilities lease losses will be paid over the respective lease terms through fiscal year 2006.

7. Convertible Subordinated Debt

     On December 21, 2001, and January 10, 2002, the Company sold, in private placements pursuant to Section 4(2) of the Securities Act of 1933, as amended, $550 million in aggregate principal amount, two percent convertible subordinated notes due 2007. The initial purchasers purchased the notes from the Company at a discount of 2.25 percent of the aggregate principal amount. Holders of the notes may, in whole or in part, convert the notes into shares of the Company’s common stock at a conversion rate of 22.8571 shares per $1,000 principal amount of notes (aggregate of approximately 12.6 million shares) at any time prior to maturity on January 1, 2007. At any time on or after January 5, 2005, the Company may redeem the notes in whole or in part at the following prices expressed as a percentage of the principal amount:

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

     The notes are not listed on any securities exchange or included in any automated quotation system; however, the notes are eligible for trading on the Portal^SM Market. On January 24, 2003, the average bid and ask price on the Portal Market of the notes was 74.56, resulting in an aggregate fair value of approximately $410.1 million.

8. Commitments and Contingencies

Leases

     The Company leases its facilities and certain equipment under various operating lease agreements expiring through November 2013. In connection with its facilities lease agreements, the Company has signed unconditional, irrevocable letters of credit totaling $18.7 million as security for the leases. Future minimum lease payments under all non-cancelable operating leases as of January 25, 2003 were $261.2 million. In addition to base rent, many of the facilities lease agreements require that the Company pay a proportional share of the respective facilities’ operating expenses.

     As of January 25, 2003, the Company had recorded $28.3 million in facilities lease loss reserves related to future lease commitments, net of expected sublease income (see Note 6).

Product Warranties

     The Company provides warranties on its products ranging from one to three years. Estimated future warranty costs are accrued at the time of shipment and charged to cost of revenues based upon historical experience. The Company’s accrued liability for estimated future warranty costs is included in other accrued liabilities on the accompanying Condensed Consolidated Balance Sheets. The following table summarizes the activity related to the Company’s accrued liability for estimated future warranty costs during the three months ended January 25, 2003 (in thousands):

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     In addition, the Company has standard indemnification clauses contained within its various customer contracts. As such, the Company indemnifies the parties to whom it sells its products with respect to the Company’s product infringing upon any patents, trademarks, copyrights, or trade secrets, as well as against bodily injury or damage to real or tangible personal property caused by a defective Company product. As of January 25, 2003, there have been no known events or circumstances that have resulted in an indemnification related liability to the Company.

Manufacturing and Purchase Commitments

     The Company has a manufacturing agreement with Solectron Corporation (Solectron) under which the Company provides to Solectron a twelve-month product forecast and places purchase orders with Solectron sixty calendar days in advance of the scheduled delivery of products to the Company’s customers. As of January 25, 2003, the Company’s commitment to Solectron for inventory components used in the manufacture of Brocade products was $30.7 million, net of purchase commitment reserves of $1.7 million, which the Company expects to utilize during future normal ongoing operations. Although the Company’s purchase orders placed with Solectron are cancelable, the terms of the agreement require the Company to purchase from Solectron all inventory components not returnable or usable by other Solectron customers.

     In addition, the Company purchases several key components used in the manufacture of its products. As of January 25, 2003, the Company had non-cancelable purchase commitments for various components totaling $11.3 million, net of purchase commitment reserves of $0.1 million, which the Company expects to utilize during future normal ongoing operations.

Legal Proceedings

     On January 10, 2003, a suit captioned Raytheon Company v. Brocade Communications Systems, Inc. et al. was filed against Brocade and various other companies in the United States District Court for the Eastern District of Texas. The complaint alleges that Brocade products infringe United States Patent No. 5,412,791, entitled “Mass Data Storage Library.” On February 6, 2003, Raytheon filed an amended complaint stating their original claim with more particularity. The Company believes that it has meritorious defenses to the claims and intends to defend the action vigorously.

     On February 14, 2002, a suit captioned McDATA Corp. v. Brocade Communications Systems, Inc. was filed against the Company in the United States District Court for the District of Colorado. The complaint alleged that the Brocade SilkWorm 3800 Enterprise Fibre Channel Fabric Switch and Brocade SilkWorm 12000 Core Fabric Switch infringe United States Patent No. 6,233,236, entitled “Method and Apparatus for Measuring Traffic Within a Switch.” The complaint seeks unspecified compensatory and exemplary damages and to permanently enjoin the Company from infringing the patent in the future. On March 4, 2002, McDATA Corporation (McDATA) filed an amended complaint, in which it additionally alleged that the Brocade SilkWorm 3200 Entry Fabric Switch infringed this patent. In connection with this suit, on March 4, 2002, McDATA filed a motion for a preliminary injunction against the Company with regard to the patent. On April 8, 2002, the Company filed an answer and counterclaims asserting, among other things, no infringement, and that the patent is invalid, unenforceable and covered by an existing covenant not to sue between the parties. A hearing on McDATA’s motion for preliminary injunction was held during the week of July 15, 2002. In an order dated December 6, 2002, the Court denied McDATA’s motion for a preliminary injunction. On December 23, 2002, McDATA filed a demand for arbitration to move this matter from the United States District Court for the District of Colorado to arbitration. The matter has been referred to arbitration. No arbitration date has been set. The Company believes that it has meritorious defenses to the claims and intends to defend the action vigorously.

     On July 20, 2001, the first of a number of putative class actions was filed in the United States District Court for the Southern District of New York against the Company, certain of its officers and directors, and certain of the underwriters for the Company’s initial public offering. Those cases were consolidated under the caption Chae v. Brocade Communications Systems, Inc. et al. The complaints generally alleged that various underwriters engaged in improper and undisclosed activities related to the allocation of shares in the Company’s initial public offering of securities. On March 1, 2002, the Court entered

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an order dismissing without prejudice all claims against the Company and its officers and directors named in the consolidated proceeding. On April 19, 2002, a consolidated amended class action captioned In Re Brocade Communications Systems, Inc. Initial Public Offering Securities Litigation was filed which makes claims against the Brocade parties that are substantially similar to those alleged in the earlier case. The complaint seeks unspecified damages on behalf of a purported class of purchasers of common stock from May 24, 1999 to December 6, 2000. In October 2002, the individual defendants were dismissed without prejudice from the action. On February 19, 2003, the Court entered an order dismissing all of the plaintiffs’ claims against the Company. No appeal has been filed.

9. Common Stock

     On December 9, 2002, the Company announced that its Board of Directors approved a voluntary stock option exchange program (the Exchange Program) for employees. Under the Exchange Program, employees were offered the opportunity to exchange an aggregate of approximately 67.3 million outstanding stock options with exercise prices equal to or greater than $12.00 per share for new stock options to be granted at an exchange ratio determined by the date the exchanged stock options were granted. Participating employees other than the Chief Executive Officer (CEO) would receive new stock options in exchange for their eligible outstanding stock options at an exchange ratio of either 1 for 1, 1 for 2, or 1 for 3, depending on the grant date of the exchanged stock option. The CEO would receive new stock options in exchange for eligible outstanding stock options at an exchange ratio of 1 for 10.

     On January 9, 2003, and in accordance with the Exchange Program, the Company cancelled 58.6 million outstanding stock options and issued promises to grant 29.9 million new stock options to participating employees. The new stock options will be granted on July 10, 2003, which is the first business day that is six months and one day after the cancellation of the exchanged options. The exercise price per share of the new stock options will be equal to the fair market value of the Company’s common stock at the close of regular trading on July 10, 2003. However, the exercise price per share of the new stock options granted to the Company’s officers will not be less than $5.21 per share, which is 110 percent of the average closing price of the Company’s common stock during the offer period. The 29.9 million new stock options to be granted on July 10, 2003, represent approximately 12.7 percent of the Company’s total shares of common stock outstanding as of January 25, 2003, and could have a dilutive impact on the Company’s future earnings per share to the extent that the future market price of the Company’s common stock exceeds the exercise price of the new stock options. No financial or accounting impact to the Company’s financial position, results of operations, or cash flows for the three months ended January 25, 2003, was associated with this transaction.

10. Segment Information

     The Company is organized and operates as one operating segment: the design, development, marketing and selling of infrastructure for storage area networks (SANs). The CEO is the Company’s Chief Operating Decision Maker (CODM), as defined by SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” The CODM allocates resources and assesses the performance of the Company based on revenues and overall profitability.

     Revenues are attributed to geographic areas based on the location of the customer to which products are shipped. Domestic revenues include sales to certain OEM customers who take possession of Brocade products domestically and then distribute these products to their international customers. Domestic and international revenues were approximately 69 percent and 31 percent of total revenues, respectively, for the three months ended January 25, 2003. Domestic and international revenues were approximately 70 percent and 30 percent of total revenues, respectively, for the three months ended January 26, 2002. To date, service revenue has not exceeded 10 percent of total revenues. Identifiable assets located in foreign countries were not material as of January 25, 2003, and October 26, 2002. For the three months ended January 25, 2003 and January 26, 2002, four customers each represented greater than ten percent of the Company’s total revenues for combined totals of 76 percent and 70 percent of total revenues, respectively.

11. Gain on Investments, net

     Net gain on investments for the three months ended January 25, 2003 consisted of a gain of $2.5 million resulting from a publicly traded company’s acquisition of 100 percent of the equity of a non-publicly traded company in which Brocade had a minority equity investment. As a result of this acquisition, Brocade received common shares of the publicly traded company in exchange for its minority equity investment in the non-publicly traded company. In addition, during the three months ended January 25, 2003, the Company recorded an impairment charge of $2.2 million related to an other-than-temporary decline in the estimated fair value of a minority equity investment in a different non-publicly traded company that supplies semiconductors and

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related software based on an alternative transport protocol. During the three months ended January 25, 2003, several developers of this alternative transport protocol abandoned their development programs due to a lack of general demand for the alternative transport protocol. The impairment charge reduced the carrying value of the Company’s investment to zero, which is the estimated fair value.

12. Net Income (Loss) per Share

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

     For the three months ended January 25, 2003 and January 26, 2002, potential common shares in the form of stock options to purchase a weighted-average of 65.7 million and 29.4 million shares of common stock, respectively, were antidilutive and therefore not included in the computation of diluted earnings per share. In addition, for the three months ended January 25, 2003 and January 26, 2002, potential common shares resulting from the potential conversion on a weighted-average basis, of the Company’s convertible subordinated debt, of 12.6 million and 5.0 million common shares, respectively, were antidilutive and therefore not included in the computation of diluted earnings per share.

13. Subsequent Events

     On January 27, 2003, the Company completed its acquisition of Rhapsody Networks, Inc. (Rhapsody), a provider of next-generation intelligent switching platforms. In exchange for all of the outstanding securities of Rhapsody, the Company issued 20.5 million shares of its common stock, including assumed warrants and stock options. In addition, the Company will issue up to an additional 2.9 million shares of its common stock if the Rhapsody business successfully completes specified product milestones by November 30, 2003.

     The final purchase price of this transaction will be based on several factors including the average price of the Company’s common stock at the time the definitive agreement was signed, the calculated value of assumed warrants and stock options, direct acquisition costs, and the intrinsic value of unvested assumed stock options and common stock subject to repurchase by the Company. The Company currently anticipates the final purchase price will be in the range of $135 million to $145 million.

     The acquisition of Rhapsody will be accounted for as an asset purchase. Accordingly, the final purchase price will be allocated to the assets acquired, liabilities assumed, and acquired in-process research and development based on their respective fair values. The excess of purchase price over the fair value of net assets received will be allocated to acquired in-process research and development and acquired intangible and non-monetary assets. The final purchase price allocation will depend upon the final valuation of the assets acquired and liabilities assumed based upon independent appraisals and an audit of the Rhapsody balance sheet as of the closing date. Although this analysis is not yet complete, the Company currently expects to incur a charge in the range of $125 million to $135 million related to the write-off of acquired in-process research and development expenses.

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

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

	•		revenues and profits;
	•		customer concentration;
	•		research and development expenses;
	•		sales and marketing expenses;
	•		general and administrative expenses;
	•		amortization of deferred stock compensation;
	•		interest income and expense;
	•		income taxes;
	•		liquidity and sufficiency of existing cash, cash equivalents, and short-term investments for near-term requirements; and
	•		the effect of recent accounting pronouncements on our financial condition and results of operations.

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

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

     The following information should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Condensed Consolidated Financial Statements and notes thereto included in Item 1 of this Quarterly Report, and with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and notes thereto contained in our Annual Report on Form 10-K filed with the SEC on January 22, 2003.

Recent Events

     On January 27, 2003, we completed our acquisition of Rhapsody, a provider of next-generation intelligent switching platforms. In exchange for all of the outstanding securities of Rhapsody, we issued 20.5 million shares of our common stock, including assumed warrants and stock options. Additional details related to the acquisition are noted below under the heading “Results of Operations.”

Results of Operations

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

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     Revenues. Our revenues are derived primarily from sales of our SilkWorm family of products. Net revenues for the three months ended January 25, 2003, and January 26, 2002, were each $123.1 million. Revenue growth was negatively impacted by declines in average selling prices, offset by an increase in total volume. Revenue growth was also negatively impacted by the continuing unfavorable economic conditions and reduced IT spending environment that began in fiscal year 2001, and by recent reductions in the supply of our product maintained by our primary OEM customers. We are unable to predict when the IT spending environment will improve, if at all. As a result, our growth rates may continue to be negatively impacted.

     Domestic and international revenues were approximately 69 percent and 31 percent of total revenues, respectively, for the three months ended January 25, 2003. Domestic and international revenues were approximately 70 percent and 30 percent of total revenues, respectively, for the three months ended January 26, 2002. Revenues are attributed to geographic areas based on the location of the customer to which our products are shipped. International revenues primarily consisted 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. Our mix of international and domestic revenue can therefore vary depending on the relative mix of sales to certain OEM customers.

     A significant portion of our revenues is concentrated among a relatively small number of customers. For the three months ended January 25, 2003, and January 26, 2002, four customers each represented greater than ten percent of our total revenues for combined totals of 76 percent and 70 percent of total revenues, respectively. We expect that a significant portion of our future revenues will continue to come from sales of products to a relatively small number of customers. Therefore, the loss of any one significant customer, or a decrease in the level of sales to any one significant customer, could seriously harm our financial condition and results of operations. In addition, during fiscal year 2002, HP and Compaq, two of our significant OEM customers, merged. While to date the impact of this merger has not been material, we are unable to predict the impact this merger may have on our business. It is possible that, as a result of this merger, sales of our products to the combined company could be disrupted or decline.

     Gross margin. Gross margin for the three months ended January 25, 2003 was 53.7 percent, compared with 60.2 percent for the three months ended January 26, 2002. The reduction in gross margin was primarily related to an increase in fixed manufacturing costs and declines in the average selling prices of our products.

     Research and development expenses. Research and development (R&D) expenses increased to $31.9 million for the three months ended January 25, 2003, compared with $29.3 million for the three months ended January 26, 2002. R&D expenses consist primarily of salaries and related expenses for personnel engaged in engineering and R&D activities; fees paid to consultants and outside service providers; nonrecurring engineering charges; prototyping expenses related to the design, development, testing and enhancement of our products; depreciation related to engineering and other test equipment; and IT

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and facilities expenses. The increase in R&D expenses reflects our belief that continued investment in R&D is a critical factor in maintaining our competitive position. We currently anticipate that R&D expenses for the next three months will increase on an absolute dollars basis primarily resulting from incremental spending associated with our acquisition of Rhapsody.

     Sales and marketing expenses. Sales and marketing expenses increased to $30.8 million for the three months ended January 25, 2003, compared with $25.6 million for the three months ended January 26, 2002. Sales and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged in marketing and sales; costs associated with promotional and travel expenses; and IT and facilities expenses. The increase in sales and marketing expenses was primarily due to the expansion of our sales and marketing organizations. We currently anticipate that sales and marketing expenses for the next three months will decrease on an absolute dollar basis, primarily resulting from our restructuring program completed during the three months ended January 25, 2003.

     General and administrative expenses. General and administrative (G&A) expenses were $5.0 million for the three months ended January 25, 2003, compared with $4.5 million for the three months ended January 26, 2002. G&A expenses consist primarily of salaries and related expenses for corporate executives, finance, human resources and investor relations, as well as recruiting expenses, professional fees, corporate legal expenses, other corporate expenses, and IT and facilities expenses. The increase in G&A expenses was primarily due to an increase in G&A related personnel. We currently anticipate that G&A expenses for the next three months will increase slightly on an absolute dollar basis.

     Restructuring costs. During the three months ended January 25, 2003, we completed a restructuring program to realign the organization and reduce our expense structure. The restructuring program included a workforce reduction of approximately 12 percent, consolidation of excess facilities, and the restructuring of certain business functions. As a result of the restructuring program, we recorded restructuring costs of $10.1 million during the three months ended January 25, 2003 (see Note 3 “Restructuring Costs,” of the Notes to Condensed Consolidated Financial Statements).

     Amortization of deferred stock compensation. Amortization of deferred stock compensation was $0.1 million and $0.2 million for the three months ended January 25, 2003 and January 26, 2002, respectively. As of January 25, 2003, all previously recorded deferred stock compensation had been fully amortized. During the next three months we anticipate recording additional deferred stock compensation in connection with our acquisition of Rhapsody.

     Interest and other income, net. Net interest and other income was $5.0 million for the three months ended January 25, 2003, compared with $3.3 million for the three months ended January 26, 2002. The increase was primarily the result of increased average cash and investment balances. The increase in cash and investment balances was primarily related to cash generated from operations and the proceeds from the $550 million in aggregate principal amount of two percent convertible subordinated notes due 2007 that we issued in December 2001 and January 2002 (see Note 7, “Convertible Subordinated Debt,” of the Notes to Condensed Consolidated Financial Statements).

     Interest expense. Interest expense was $3.4 million for the three months ended January 25, 2003, compared with $1.3 million for the three months ended January 26, 2002. Interest expense primarily represents the interest cost associated with our convertible subordinated notes issued during the three months ended January 26, 2002.

     Gain on investments, net. Net gain on investments for the three months ended January 25, 2003, consisted of a gain of $2.5 million resulting from a publicly traded company’s acquisition of 100 percent of the equity of a non-publicly traded company in which we had a minority equity investment. In addition, during the three months ended January 25, 2003, we recorded an impairment charge of $2.2 million related to an other-than-temporary decline in the estimated fair value of a minority equity investment in a different non-publicly traded company (see Note 11, “Gain on Investments, net,” of the Notes to Condensed Consolidated Financial Statements).

     Income tax (benefit) provision. Our effective tax rate for the three months ended January 25, 2003 was a benefit of 29 percent, compared with a provision of 29 percent for the three months ended January 26, 2002. Our ability to maintain our current effective tax rate requires that international revenues and earnings as a percentage of total revenues and earnings be consistent with historical levels. To the extent that international revenues and earnings differ from those historically achieved, a factor largely influenced by the buying behavior of our OEM partners, or unfavorable changes in tax laws and regulations occur, our effective tax rate could change. We currently anticipate that our effective tax rate for the next three months will be negatively impacted as a result of nondeductible expenses incurred in connection with our acquisition of Rhapsody.

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     Acquisition of Rhapsody. On January 27, 2003, we completed our acquisition of Rhapsody, a provider of next-generation intelligent switching platforms. In exchange for all of the outstanding securities of Rhapsody, we issued 20.5 million shares of our common stock, including assumed warrants and stock options. In addition, we will issue up to an additional 2.9 million shares of our common stock if the Rhapsody business successfully completes specified product milestones by November 30, 2003.

     The final purchase price of this transaction will be based on several factors including the average price of our common stock at the time the definitive agreement was signed, the calculated value of assumed warrants and stock options, direct acquisition costs, and the intrinsic value of unvested assumed stock options and common stock subject to repurchase by us. We currently anticipate the final purchase price will be in the range of $135 million to $145 million.

     The acquisition of Rhapsody will be accounted for as an asset purchase. Accordingly, the final purchase price will be allocated to the assets acquired, liabilities assumed, and acquired in-process research and development based on their respective fair values. The excess of purchase price over the fair value of net assets received will be allocated to acquired in-process research and development and acquired intangible and non-monetary assets. The final purchase price allocation will depend upon the final valuation of the assets acquired and liabilities assumed based upon independent appraisals and an audit of the Rhapsody balance sheet as of the closing date. Although this analysis is not yet complete, we currently expect to incur a charge in the range of $125 million to $135 million related to the write-off of acquired in-process research and development expenses.

     In addition, for the next three months, we currently expect to incur estimated incremental operating expenses, which will be primarily R&D expenses, of approximately $7.0 million in connection with the acquisition of Rhapsody. For the next three months, we also expect to incur non-cash charges of approximately $0.5 million to $1.5 million associated with the amortization of estimated acquired intangible assets and deferred stock compensation.

Liquidity and Capital Resources

     Cash, cash equivalents, short-term investments and long-term investments were $893.4 million as of January 25, 2003. For the three months ended January 25, 2003, we generated $8.6 million in cash from operating activities, primarily related to a decrease in accounts receivable. Days sales outstanding in receivables for the three months ended January 25, 2003 was 53 days, compared with 58 days for the three months ended October 26, 2002.

     Net cash used in investing activities for the three months ended January 25, 2003 totaled $108.6 million and was the result of $100.5 million in purchases of short and long-term investments, and $8.1 million invested in capital equipment. Net cash provided by financing activities for the three months ended January 25, 2003 totaled $3.4 million, and was the result of net proceeds from the issuance of common stock related to employee participation in employee stock programs.

     Net proceeds from the issuance of common stock related to employee participation in employee stock programs have historically been a significant component of our liquidity. The extent to which our employees participate in these programs generally increases or decreases based upon changes in the market price of our common stock. As a result, our cash flows resulting from the issuance of common stock related to employee participation in employee stock programs will vary. We do not expect to generate significant cash flows from the issuance of common stock related to employee participation in employee stock programs during fiscal year 2003 as a result of our voluntary stock option exchange program.

     We have a manufacturing agreement with Solectron under which we provide to Solectron a twelve-month product forecast and place purchase orders with Solectron sixty calendar days in advance of the scheduled delivery of products to our customers. As of January 25, 2003, our commitment to Solectron for inventory components used in the manufacture of our products was $30.7 million, net of purchase commitment reserves of $1.7 million, which we expect to utilize during future normal ongoing operations. Although the purchase orders we place with Solectron are cancelable, the terms of the agreement require us to purchase from Solectron all inventory components not returnable or usable by other Solectron customers.

     In addition, we purchase several key components used in the manufacture of our products. As of January 25, 2003, we had non-cancelable purchase commitments for various components totaling $11.3 million, net of purchase commitment reserves of $0.1 million, which we expect to utilize during future normal ongoing operations.

     On December 21, 2001, and January 10, 2002, we sold $550 million in aggregate principal amount of two percent convertible subordinated notes due 2007 (see note 7, “Convertible Subordinated Debt,” of the Notes to Condensed Consolidated Financial Statements). Holders of the notes may, in whole or in part, convert the notes into shares of our

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common stock at a conversion rate of 22.8571 shares per $1,000 principal amount of notes (aggregate of approximately 12.6 million shares) at any time prior to maturity on January 1, 2007. At any time on or after January 5, 2005, we may redeem the notes in whole or in part at the following prices expressed as a percentage of the principal amount:

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

     The following table summarizes our contractual obligations (including interest expense) and commitments as of January 25, 2003 (in thousands):