UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

     (Mark One)

COMMISSION FILE NUMBER: 0-13994

COMPUTER NETWORK TECHNOLOGY CORPORATION

6000 Nathan Lane North, Minneapolis, Minnesota 55442

Telephone Number: (763) 268-6000

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

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

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

COMPUTER NETWORK TECHNOLOGY CORPORATION

INDEX

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PART I. FINANCIAL INFORMATION

Item 1.

COMPUTER NETWORK TECHNOLOGY CORPORATION

See accompanying notes to Consolidated Financial Statements

3

COMPUTER NETWORK TECHNOLOGY CORPORATION

See accompanying notes to Consolidated Financial Statements

4

COMPUTER NETWORK TECHNOLOGY CORPORATION

See accompanying notes to Consolidated Financial Statements

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

(1) BASIS OF PRESENTATION

     The accompanying consolidated financial statements have been prepared in accordance with instructions to Form 10-Q and do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. These consolidated financial statements should be read in conjunction with the consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 31, 2004 as filed with the Securities and Exchange Commission. References to fiscal 2004 and 2003, represent the twelve months ended January 31, 2005 and 2004, respectively.

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

(2) MARKETABLE SECURITIES

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

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

(3) INVENTORIES

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

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(4) ACQUISITIONS

Inrange

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

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

     The acquisition was accounted for as a purchase and the consolidated financial statements of the Company include the results of Inrange since May 5, 2003. The purchase price was allocated to the fair value of the assets and liabilities acquired as follows:

     The following table presents the unaudited pro forma consolidated results of operations of the Company for the three months ended April 30, 2004 and 2003 as if the acquisition of Inrange took place on February 1, 2003:

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

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

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

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

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

     A summary of severance and facility accrual activity follows:

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BI-Tech

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

     The original purchase agreement required payments of additional consideration to the former stockholders and the BI-Tech employees based on achievement of certain earnings for each of the two years beginning July 1, 2002. A modification to the purchase agreement was made during the second quarter of fiscal 2003, whereby the first earn out period ended April 30, 2003. It also guarantees the former stockholders a minimum payment for the second earn out period, which ends June 30, 2004, of at least $3.9 million. The portion payable to the former stockholders is recorded as goodwill. The portion payable to BI-Tech employees is recorded as compensation expense. No additional goodwill and compensation expense has been recorded under this earn out agreement since February 1, 2004.

(5) GOODWILL AND INTANGIBLE ASSETS

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

     The components of other amortizable intangible assets were as follows:

     Amortization expense for intangible assets during the first quarter of 2004 was $1.7 million. Amortization expense for the remainder of 2004 is estimated to be $5.2 million. Amortization expense is estimated to be $6.8 million in 2005 and 2006, $6.2 million in 2007 and $3.2 million in 2008.

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(6) COMPREHENSIVE LOSS

     Comprehensive loss consists of the following:

(7) CONVERTIBLE SUBORDINATED DEBT

     In February 2002, the Company sold $125 million of 3% convertible subordinated notes due February 15, 2007, raising net proceeds of $121.6 million. The notes are convertible into the Company’s common stock at a price of $19.17 per share. The Company may redeem the notes upon payment of the outstanding principal balance, accrued interest and a make whole payment if the closing price of its common stock exceeds 175% of the conversion price for at least 20 consecutive trading days within a period of 30 consecutive trading days ending on the trading day prior to the date the redemption notice is mailed. The make whole payment represents additional interest payments that would be made if the notes were not redeemed prior to the due date.

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

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(8) STOCK-BASED COMPENSATION

     The estimated per share weighted average fair value of all stock options granted during the three months ended April 30, 2004 and 2003 was $5.92 and $5.01, respectively. The fair value of each option grant was estimated using the Black-Scholes option pricing model with the following weighted average assumptions:

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

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(9) WARRANTY

     The Company records a liability for warranty claims at the time of sale. The amount of the liability is based on contract terms and historical warranty costs, which is periodically adjusted for recent actual experience. Warranty terms on the Company’s equipment range from 90 days to 13 months. The changes in warranty reserve balances for the three months ended April 30, 2004 and 2003 were as follows:

(10) NEW ACCOUNTING PRONOUNCEMENTS

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

(11) DISCONTINUED OPERATIONS

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

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

(12) ENTERPRISE-WIDE INFORMATION

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

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(13) LITIGATION

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