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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2004

For the transition period from ____________________ to ____________________.

Commission File Number 0-16423

SAN Holdings, Inc.
(Exact name of registrant as specified in its charter)

9800 Mt. Pyramid Ct., Suite 130, Englewood, CO 80112-2694
(Address of principal executive offices)

(303) 660-3933
(Registrant’s telephone number)

900 W. Castleton Rd., Suite 100, Castle Rock, CO 80109
(Former Address)

Check 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 past 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 [X]     No [   ]

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

As of August 13, 2004, 95,811,278 common shares, no par value per share, were outstanding.

SAN Holdings, Inc.

INDEX

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Part I. Financial Information

Item 1. Financial Statements

SAN Holdings, Inc.
Consolidated Balance Sheets
(In thousands, except for share data)

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

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SAN Holdings, Inc.
Consolidated Statements of Operations
(Unaudited)
(In thousands, except share and per share data)

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

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SAN Holdings, Inc.
Consolidated Statements of Cash Flows
(Unaudited)
(In thousands)

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

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SAN Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)

NOTE 1 – BASIS OF PRESENTATION

The accompanying consolidated financial statements have been prepared 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, or US GAAP, have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the unaudited consolidated financial statements have been prepared on the same basis as the annual consolidated financial statements, and reflect all adjustments, consisting only of normal, recurring adjustments, necessary for a fair presentation in accordance with US GAAP. The results of operations for interim periods presented are not necessarily indicative of the operating results for the full year. These consolidated financial statements should be read in connection with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-KSB for the year ended December 31, 2003.

Effective April 1, 2003, SAN Holdings, Inc. (“SANZ”) completed a business combination with Solunet Storage Holding Corp. (“Solunet Storage”) and, indirectly, its operating subsidiary Solunet Storage, Inc. (d/b/a “StorNet Solutions”). Solunet Storage was majority-owned by Sun Solunet LLC (“Sun Solunet”), an affiliate of Sun Capital Partners, Inc. (“Sun Capital”), a private investment fund. Upon the completion of the business combination, Sun Solunet became the majority stockholder of SANZ. The business combination was accounted for as a reverse acquisition, with Solunet Storage being treated as the acquirer for accounting purposes. As a result, for all periods prior to April 1, 2003, the financial statements of Solunet Storage have been adopted as SANZ’ historical financial statements. The financial statements presented in this Report as the financial statements of SANZ consist of the accounts of Solunet Storage for all periods presented, together with the assets, liabilities and results of operations of SAN Holdings, Inc., and its subsidiary from April 1, 2003. Accordingly, the information presented in the Statement of Operations and the Statement of Cash Flows for the six months ended June 30, 2003 consist of the results of operations and cash flows of Solunet Storage only for the period from January 1 to March 31, 2003, and of the combined entity (Solunet and SANZ) from April 1, 2003.

NOTE 2 – FINANCIAL CONDITION

The accompanying consolidated financial statements have been prepared in conformity with US GAAP (except with regard to omission of certain disclosures, as permitted by the SEC), which contemplate our continuation as a going concern. However, we have incurred substantial losses from operations since inception, including a net loss of $5,938,000 for the year ended December 31, 2003, and a net loss of $1,947,000 for the six months ended June 30, 2004. In addition, as of June 30, 2004, we have negative working capital (current liabilities in excess of current assets) of $14,020,000. Accordingly, as of June 30, 2004, the recoverability of a major portion of the recorded asset amounts, including “Goodwill,” is dependent on our continuing operations, which in turn is dependent on our ability to maintain our current financing arrangements and our ability to become profitable in our future operations. Our consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts and classification of liabilities that might be necessary if we were unable to continue as a going concern.

We completed the business combination with Solunet Storage on April 1, 2003, described in Note 1, to achieve the economies that we believe are available by spreading our fixed cost base across a greater volume of sales. As anticipated, we have achieved cost reductions afforded by the combination, chiefly, the reduction of selling, general and administrative expenses. For the three months ended June 30, 2004, these expenses have decreased approximately $1.0 million from the three months ended June 30, 2003, which was the first reporting period of the combined companies. We continue to take actions to extract additional costs at the same time as we seek to increase our sales and gross profits in order to achieve sustained profitability. To address current market conditions, we have made further cost reductions in recent months and expect to make additional reductions in our operating cost structure.

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SAN Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)

As a result of the business combination with Solunet Storage, the Company has substantially increased its accounts receivable, which is the borrowing base for its principal borrowing facility with Wells Fargo Business Credit, Inc. (“Wells Fargo”). In September 2003, the Company executed an amendment to increase the maximum borrowing limit under this facility from $7 million to $12 million. At June 30, 2004, the Company had $2.6 million of undrawn availability on this line. The increased borrowing limit, the expanding supplier lines of credit and the Harris Trust debt facilities described below are anticipated to provide continued liquidity until we reach profitability. However, our ability to borrow under the Wells Fargo facility is subject to maintaining our accounts receivable balance at current levels, as well as complying with the financial covenants we have made to the lender. If we are unable to comply with our financial covenants to the lender, the facility could cease to be available to us. As of June 30, 2004, the Company was in compliance with all of the financial covenants under the Wells Fargo credit agreement. Pursuant to adjustment provisions in the credit agreement, effective May 1, 2004 we received a reduction of 0.5% in the interest rate (from Prime + 5.0% to Prime + 4.5%) based on our net income performance during the first quarter of 2004. Pursuant to those same provisions, effective July 1, 2004, the rate reverted to Prime + 5.0% based on our net income performance during the second quarter of 2004. Our Wells Fargo credit facility expires in May 2005.

Also in 2003, the Company further enhanced its liquidity through two additional revolving credit lines with Harris Trust and Savings Bank (“Harris Trust”). An affiliate of the Company’s majority stockholder has guaranteed both of these credit lines, $6.8 million and $4.2 million, respectively. The $6.8 million facility is maintained by SAN Holdings, Inc. and is unsecured, is not limited by availability under a borrowing base and does not stipulate financial covenants. The second facility is secured by substantially all of the assets of Solunet Storage, is not limited by availability under a borrowing base and does not stipulate financial covenants. While the Harris facilities are demand notes, they both expire in May 2005, unless called earlier by the lender. At June 30, 2004, the Company had borrowed $10.9 million on these two facilities. In July 2004, SANZ repaid $1.0 million in aggregate on the two lines, resulting in $9.9 million of borrowings outstanding. At this time, we believe that we may need to increase our borrowings on the Harris line, drawing all or a portion of the $1.0 million that we repaid in July 2004.

NOTE 3 – STOCK-BASED COMPENSATION

As permitted under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), the Company accounts for stock-based compensation using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations. Accordingly, no compensation expense has been recognized in connection with the grant of stock options to employees and directors during the periods presented, as all options granted had an exercise price equal to the market value of the underlying stock at the date of grant. The following table illustrates the effect on net earnings and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123:

NOTE 4 – EARNINGS (LOSS) PER SHARE

Basic earnings (loss) per share is based on the weighted average number of common shares outstanding. Diluted earnings (loss) per share is computed using the weighted average number of common shares outstanding plus the number of common shares that would be issued assuming exercise or conversion of all potentially dilutive common shares. Warrants and options outstanding to purchase an aggregate of 41,700,165 and 36,058,507 shares of common stock as of June 30, 2004 and 2003, respectively, have been excluded from the diluted share calculations for the three-month periods ending June 30, 2004 and 2003, respectively, and the six-month periods ending June 30, 2004 and 2003, respectively, as they were antidilutive as a result of the net losses incurred for all periods presented. Accordingly, basic shares equal diluted shares for all periods presented.

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SAN Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)

At the Annual Meeting of Shareholders held on April 12, 2004, SANZ’ shareholders voted to amend the Company’s Articles of Incorporation to increase the authorized common stock from 75,000,000 shares to 200,000,000 shares. An amendment to the Company’s Articles of Incorporation implementing that increase was filed and became effective on April 13, 2004. The terms of the previously outstanding Series B Preferred Stock provided that all of those shares would convert into common stock — automatically and at a fixed conversion ratio — at such time as SANZ had sufficient authorized common shares to permit that conversion. Accordingly, the increase in our authorized shares of common stock on April 13, 2004 caused all of the Company’s previously outstanding Series B Preferred Stock to convert into common stock at a ratio of 50,000:1, or into a total of 37,403,653 shares of common stock. Following this conversion, and as of April 13, 2004, there are now 95,811,278 shares of common stock outstanding and zero shares of Series B Preferred Stock outstanding.

NOTE 5 – DEBT

In March 2004, the Company amended one of its two revolving credit facilities with Harris Trust, increasing the borrowing availability from $4.8 million to $6.8 million. Borrowing availability on the other Harris credit facility remains at $4.2 million, resulting in aggregate availability under the two facilities of $11.0 million at June 30, 2004. During the six months ended June 30, 2004, the Company borrowed $2.7 million on the Harris facilities. As a result, the total outstanding debt with Harris Trust at June 30, 2004 was $10.9 million. In July 2004, the Company repaid $1.0 million in aggregate on the two lines, resulting in $9.9 million of borrowings outstanding. At this time, we believe that we may need to increase our borrowings on the Harris line, drawing all or a portion of the $1.0 million that we repaid in July 2004.

NOTE 6 – INCOME TAXES

In June 2004, the Company received a Federal income tax refund in the amount of $352,000. The refund was the result of the carryback of the net operating loss for 2002 for StorNet Inc., whose assets, including rights to tax refunds, we acquired in 2002. This net operating loss carryback was allowed under a recent law change, which increased the carryback period from two to five years for net operating losses generated in 2001 and 2002. The Company filed the amended income tax return in February 2004; however, because the Company carries a deferred tax valuation allowance equal to 100% of total deferred tax assets, the Company did not record the benefit until the cash refund was received.

NOTE 7 – COMMITMENTS AND CONTINGENCIES

As discussed in Note 2 above, the Harris Trust debt facility term extends until May 2005. If we are unsuccessful in reducing the amount of the guaranteed debt to $3.0 million by November 16, 2004, we will be obligated to issue additional warrants with an exercise price of $0.001 per share to our majority shareholder, Sun Solunet (an affiliate of which is the guarantor of the Harris Trust debt). The issuance of these warrants would result in dilution of the other shareholders of the Company. The number of warrants to be issued is dependent on the amount by which the remaining guaranteed debt exceeds $3.0 million, according to the following formula:

The Guaranteed Debt level in November will depend on a number of variables, including but not limited to:

NOTE 8 – RECENT ACCOUNTING PRONOUNCEMENTS

We have evaluated all recent accounting pronouncements and believe that such accounting pronouncements do not have a material effect on our consolidated financial statements.

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

Forward-looking statements. Certain statements in this Quarterly Report on Form 10-Q constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, and are subject to numerous risks and uncertainties. Statements that are not historical or current facts are “forward-looking statements,” which often (but not always) can be identified by the use of terms such as “may,” “will,” “expect,” “anticipate,” “estimate,” or “continue,” or the negative of those terms. The Company intends that all forward-looking statements be subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and other applicable federal securities laws. Any such forward-looking statements, which speak only as of the date made, represent management’s best judgment as to what may occur in the future. However, forward-looking statements are subject to known and unknown risks, uncertainties and important factors beyond the control of the Company that could cause actual results, performance, achievements or events to differ materially from historical results of operations and events and those presently anticipated or projected. Factors that may cause such differences include, but are not limited to: the rate of growth in the market for data storage products generally and for the types of products we sell in particular; the continued and future acceptance of the products we sell; the presence of competitors with greater technical, marketing and financial resources; our ability to promptly and effectively respond to technological change to meet evolving customer needs; our ability to successfully expand our operations; our success at integrating with our own operations the operations and management of any business we acquire; our continued access to our credit facilities and to equity capital; and potential volatility with interest rates. Additional factors are discussed in the Company’s Form 10-KSB for the year ended December 31, 2003 and its other reports filed with the Securities and Exchange Commission, to which reference should be made.

Overview

SANZ (the “Company” or “we”) provides sophisticated enterprise-level data storage and data management solutions to commercial and government clients. We focus on the design, delivery and management of data storage systems, especially those that are built using a network architecture. Because we typically design integrated solutions for our clients rather than merely selling them hardware, we are known in the industry as a “storage solution provider.”

In the course of our business, we provide the following products and services:

SANZ’ current line of business operations commenced in 2000. Effective April 1, 2003, we completed the acquisition of Solunet Storage. As previously discussed, the transaction was accounted for as a reverse acquisition, and as a result the financial statements of Solunet Storage have been adopted as the historical financial statements of SANZ for all periods prior to April 1, 2003.

Recent Developments

Storage Solutions Market

While the general demand for data storage capacity continues to increase, the current market is marred by price erosion and a high rate of change in user preference for product class and technology mix. Disk prices in general are down 30-50% per unit capacity over the past eighteen months and high-end disk systems are losing share to mid-range offerings with a much lower price point per unit capacity. Demand for tape systems has seen a general decline as many of the large disaster recovery projects initiated in the past two years have been completed. Further, larger tape capacities have cannibalized unit volume sales, and the increased adoption of virtual tape and disk-to-disk backup technologies has undermined demand for traditional tape systems.

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SANZ was somewhat insulated from the disk price decline in 2003 as our product mix remained heavily weighted to tape systems. However, beginning in very late 2003 and accelerating in 2004, our tape system business has dropped off dramatically in favor of disk, which has increased our exposure to the revenue compression from falling disk prices. In general, our available margins are not as high on disk product sales as they are on tape product sales.

The drop in disk prices and improved reliability of mid-range products has generated increased customer interest in what is known as Information Lifecycle Management (ILM) technology. ILM is shorthand for using different classes of storage technology and software to address different data storage needs, but doing so in an “integrated” or automated fashion. As this approach often involves multiple products from multiple vendors, it plays to the strength of independent storage solution providers such as SANZ. However, the sales cycles are longer than those of more traditional, single technology solutions.

Preferred Equity Conversion

As part of the consideration paid in our April 2003 acquisition of Solunet Storage, we issued certain shares of Series B Preferred Stock. In April 2004, the Series B Preferred Stock automatically converted into a total of 37,403,653 shares of common stock, upon amendment of our Articles of Incorporation to increase the number of common shares we are authorized to issue. After this conversion, and effective April 13, 2004, there are a total of 95,811,278 issued and outstanding shares of common stock.

Results of Operations

It is important to note that the consolidated financial statements do not include the operations of SANZ prior to April 1, 2003 (referred to as “legacy SANZ”). As such, we believe that a comparison of the results of operations of both Solunet Storage and legacy SANZ combined on a pro forma basis for the six months ended June 30, 2003, giving effect to pro forma adjustments as if the companies had been combined as of January 1, 2003, and as reported in our Form 10-QSB for the quarterly period ended June 30, 2003, is important to the understanding of our results for the six months ended June 30, 2004. Accordingly, we have included a discussion and analysis below of 2003 to 2004 reported results and 2003 pro forma combined results to 2004 reported results.

Results of Operations for the Three Months Ended June 30, 2004
Compared to the Three Months Ended June 30, 2003

Sales. Our sales for three months ended June 30, 2004 were $15.2 million as compared to $17.4 million for the three months ended June 30, 2003, a decrease of $2.2 million or 12%. The decrease is attributed primarily to a broad general softening in the market for data storage products in the current quarter, continued price compression on a per unit basis on both disk and tape system products, and a significant change in product mix for SANZ that has increased effective exposure to disk system price declines. In addition, we experienced some impact of increased sales cycles as the market began to look more seriously at what is known as Informa