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Brocade Communications Systems 10-K 2007
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Table of Contents

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
 
 
     
(Mark One)    
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended October 28, 2006
or
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period from          to          
 
Commission file number: 000-25601
 
 
     
Delaware   77-0409517
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)
 
1745 Technology Drive
San Jose, CA 95110
(408) 333-8000
(Address, including zip code, of Registrant’s principal executive offices and
 
Securities registered pursuant to Section 12(b) of the Act:
 
     
Title of Each Class
 
Name of Each Exchange on Which Registered
 
Common Stock, $0.001 par value   The NASDAQ Stock Market LLC
Preferred Stock Purchase Rights
  The NASDAQ Stock Market LLC
 
Securities registered pursuant to Section 12(g) of the Act:
None
 
 
Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o
 
Indicated by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ
 
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference to Part III of this Form 10-K or any amendment to this Form 10-K. þ
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ
 
The aggregate market value of voting and non-voting common equity held by non-affiliates of the Registrant was approximately $1,670,727,000 as of April 29, 2006 based upon the closing price on the Nasdaq National Market reported for such date. This calculation does not reflect a determination that certain persons are affiliates of the Registrant for any other purpose.
 
The number of shares outstanding of the Registrant’s Common Stock on December 22, 2006, was 277,359,000 shares.
 
 
Portions of the Registrant’s Proxy Statement for its 2007 Annual Meeting of Stockholders (the “Proxy Statement”), to be filed with the Securities and Exchange Commission, are incorporated by reference into Part III of this Form 10-K.
 


 

 
BROCADE COMMUNICATIONS SYSTEMS, INC.
FORM 10-K
 
 
                 
        Page
 
  Business   2
  Risk Factors   10
  Unresolved Staff Comments   25
  Properties   25
  Legal Proceedings   25
  Submission of Matters to a Vote of Security Holders   26
 
  Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities   26
  Selected Financial Data   28
  Management’s Discussion and Analysis of Financial Condition and Results of Operation   32
  Quantitative and Qualitative Disclosures About Market Risk   49
  Financial Statements and Supplementary Data   51
  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   90
  Controls and Procedures   90
  Other Information   93
 
  Directors and Executive Officers of the Registrant   93
  Executive Compensation   93
  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   93
  Certain Relationships and Related Transactions   93
  Principal Accountant Fees and Services   93
 
  Exhibits and Financial Statement Schedules   94
  103
 EXHIBIT 10.103
 EXHIBIT 10.104
 EXHIBIT 10.105
 EXHIBIT 10.106
 EXHIBIT 12.1
 EXHIBIT 21.1
 EXHIBIT 23.1
 EXHIBIT 31.1
 EXHIBIT 31.2
 EXHIBIT 32.1
 


Table of Contents

 
PART I
 
Item 1.   Business
 
 
Brocade develops, markets, sells, and supports data storage networking and data management solutions, offering a line of storage networking products, software and services that enable companies to implement highly available, scalable, manageable, and secure environments for shared data storage applications in enterprise data centers. The Brocade family of Storage Area Network (“SAN”) switches and directors is designed to help companies reduce the cost and complexity of managing business information within a data storage environment, ensure high availability of mission critical applications and serve as a platform for corporate data backup and disaster recovery. The Brocade family of file data management solutions addresses a range of additional information technology challenges within the data center and across a distributed enterprise, both within and around the SAN, through software systems and professional service offerings that complement and utilize a shared storage environment. Brocade products are installed around the world at companies, institutions, and other entities ranging from large enterprises to small and medium size businesses. Brocade products and services are marketed, sold, and supported worldwide to end-user customers through distribution partners, including Original Equipment Manufacturers (“OEMs”), distributors, systems integrators, value-added resellers and by Brocade directly.
 
Brocade was incorporated in California on August 24, 1995, and re-incorporated in Delaware on May 14, 1999. Brocade’s mailing address and executive offices are located at 1745 Technology Drive, San Jose, California 95110. Brocade’s telephone number is (408) 333-8000. Brocade’s corporate website is www.brocade.com. Brocade’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, are available free of charge on Brocade’s website when such reports are available on the SEC website. The public may read and copy any materials filed by Brocade with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at http://www.sec.gov. The contents of these websites are not incorporated into this filing. Further, Brocade’s references to the URLs for these websites are intended to be inactive textual references only.
 
 
Brocade’s products and services are designed to help companies reduce the cost and complexity of managing business information within a shared data storage environment while enabling high levels of availability of mission critical business applications. In addition, its products and services assist companies in the development and delivery of storage consolidation and disaster recovery programs, and in meeting compliance issues regarding data management. Brocade’s products are generally used in conjunction with servers and storage subsystems, SAN interconnection components such as host bus adapters, and storage management software applications and tools. By utilizing a shared storage, or networked storage solution, companies can more easily share and consolidate server and storage resources; centralize and simplify data management; scale and provision storage resources more effectively; and improve application efficiency, performance and availability. As a result, companies are able to better utilize information technology assets, improve productivity of information technology personnel, reduce capital and operational expenditures, and more reliably and securely store, manage, and administer business information.
 
Brocade believes that as the need for data storage grows, companies will look to further simplify the tasks of storing, managing, and administering their data, while looking to maximize their information technology investments and reduce both capital and operational expenditures. SANs, which have been installed at many of the world’s leading companies since the mid-1990s, provide a platform that helps companies optimize their information technology assets and support future data growth. Brocade also believes companies will continue to expand the size and scope of their SANs and the number and types of applications that their storage networks support.


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Since Brocade’s inception, Brocade has been a pioneer and innovator in developing the market for shared storage solutions, and has grown to be a market leader in storage networking infrastructure. Brocade believes that the future evolution of the storage networking and data management markets will be led by the providers of products and services that simplify the management of heterogeneous storage environments and maximize end-users’ information technology investments on an ongoing basis. Brocade also believes that storage networking infrastructure and data management solutions will evolve to provide increased capabilities that enable new types of storage management applications that simplify storage management, increase operational efficiencies, and reduce operating expense. As a result, many of Brocade’s initiatives and investments are aimed at expanding the capabilities enabled by storage networks, increasing end-to-end interoperability, protecting end-user investments in existing and new information technology resources, and making it easier for Brocade and its partners to deliver solutions that provide efficiencies in managing large and growing enterprise storage environments.
 
 
Brocade’s family of SAN fabric switches, directors and bladed switch products are predominantly based on the Fibre Channel protocol, and provide bandwidth and high-speed routing of data between servers and storage devices. They range from low cost entry-level 8-port switches to 384-port enterprise-class director switches and are available in different form-factors, including fixed-port services, modular chassis, and embedded blades. Brocade SAN directors are highly reliable solutions for deploying enterprise-class SANs in mission-critical environments. All switches support key applications such as data backup, remote mirroring, and high-availability clustering as well as high-volume transaction processing applications such as enterprise resource planning, or ERP, and data warehousing. They have been designed to meet the storage networking needs of end-users in environments ranging from small and medium-size businesses to large enterprises with SAN fabrics that scale to thousands of ports, spread across multiple locations around the world.
 
Brocade Fabric Operating System, or Fabric OS, is the operating system that provides the core infrastructure for deploying SANs. As the foundation for Brocade’s family of SAN switches, Fabric OS helps ensure the reliable and high-performance data transport which is critical for scalable SAN fabrics interconnecting multiple servers and storage devices. Brocade’s SAN management operating system also includes a common set of optional advanced fabric services that build upon the foundation of Fabric OS and help improve performance, availability, scalability, and the overall functionality of the network. These fabric services include the ability to proactively monitor the health and performance of the SAN, the ability to aggregate bandwidth between fabric switches to deliver higher performance for storage applications, and the ability to securely control data access in multi-vendor SAN environments. In addition, Brocade offers management tools that enable end-users to manage and administer their SANs. Brocade believes that its Fabric OS provides it with an advantage in the storage networking market, enabling differentiation and increasing optional licensable features and services.
 
 
Brocade believes that some of the next generation storage management applications will be fabric-based, rather than server or storage array-based. In general, this means that elements of certain storage related applications will reside in the network of storage area network switches, commonly referred to as the “fabric”, rather than in the server or storage array. Brocade believes this will allow for increased centralization of storage management functions and higher performance of storage related applications. Brocade also believes that these fabric-based applications, such as fabric-based routing services, storage volume management, data replication, and data migration, will accelerate the migration of intelligence into the SAN fabric and minimize operational cost and complexity for the end-user. The Brocade AP7420 is an intelligent switching platform designed to host SAN fabric-based storage management applications while integrating with existing Brocade SAN infrastructures. As a result, Brocade believes this platform can provide a highly scalable solution for managing server and storage environments much more efficiently. Brocade is working closely with certain of its OEM partners and independent software vendors to create new fabric-based applications and migrate existing storage management applications to these intelligent fabric application platforms. In addition, Brocade has invested in the internal development of certain types of applications which will run on these intelligent platforms.


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In fiscal year 2005, Brocade began introducing certain file data management solutions. These solutions are composed of software and/or systems that are typically connected to, or help to manage, a customer’s shared storage environment to provide new capabilities for the customer that extend and complement the efficiencies of a customer’s storage network and include the following categories: Application Resource Services, Data Migration Services and File Services.
 
Brocade Application Resource Manager, or ARM, provides the ability for customers to rapidly and flexibly provision their application servers with server operating systems (such as Microsoft Windows or Linux), applications, important software drivers, and application data that resides in a storage network. Brocade believes that this capability saves staff and operational time, provides for more flexible use of servers, and allows companies to better manage and track their software usage.
 
Brocade Data Migration Manager, or DMM, is a system that provides a fast and predictable way to migrate data across heterogeneous storage devices that are connected to a SAN.
 
Brocade File Services solutions are designed to help organizations consolidate access to file data while simplifying the availability and recovery of that data as part of a strategic File Area Network (FAN). As a result, these solutions help optimize server and storage assets, increase operational flexibility, and significantly reduce overall data management and storage costs. These solutions include the following:
 
  •  Brocade Wide Area File Services, or WAFS, which allows organizations to better centrally manage file-based data by allowing fast and easy sharing of file-based data from a central headquarters site to remote branch offices;
 
  •  Brocade StorageX, which is an integrated suite of applications designed to logically aggregate distributed file data across heterogeneous environments, providing administrators with policies to better manage and automate distributed file data;
 
  •  Brocade File Lifecycle Manager, or FLM, which provides a powerful way to automatically move files across tiers of storage based on company or administrative policies, Tapestry FLM helps to meet compliance requirements, while driving lower overall storage costs;
 
  •  Brocade MyView, which is a resource access management solution that provides personalized, secure access to Windows file resources across the enterprise, improving data security and compliance practices;
 
  •  Brocade Data on Demand Manager, or DDM, which simplifies data migration and reduces restoration time to significantly improve data recovery time objectives; and
 
  •  Brocade UNC Update, which helps support non-disruptive storage migration by accurately reporting and updating interdependent references in files.
 
 
Brocade also offers a range of professional and support services to facilitate customer projects, to assist customers in the design, implementation, and operation of their SAN, and to provide extended customer support. These services address a number of customer risk factors that must be managed during the life cycle of a storage network, and are valued because they bring valuable experience and expertise to a customer challenge. Brocade services may be delivered directly to end-user customers, or via partners as a component of a broader service and support offering.
 
 
Brocade works with industry-leading companies to facilitate the development of standards, technologies, products, and services that focus on the simplification of heterogeneous storage management, and the implementation and management of storage networking environments. Brocade has an open approach to SAN management and works with nearly every leading provider of storage and SAN management applications and technologies.


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Brocade is continuing this commitment with regard to its file related products. Brocade is actively involved with key file product partners and competitors to develop an industry based technical working group around the common architecture definitions for the File Area Network (FAN).
 
Since Brocade’s inception, it has been a major contributor to the evolution of industry standards ranging from Fibre Channel communication technology to SAN interoperability to storage and SAN management. Brocade contributes to related industry standards committees, and has authored or co-authored the majority of the Fibre Channel protocol standards in existence today.
 
 
As SANs have increased in size and comprise more and different types of server, storage, and interconnection devices, the need for interoperability among those devices has similarly increased. Brocade has invested a significant amount of resources for purposes of providing interoperability among Brocade solutions and the servers, storage, and storage management applications that run in the Brocade environment, as well as in driving standards for interoperability among SAN interconnection devices. Brocade also certifies its solutions in operational storage environments through its testing programs, its partners’ testing and qualification initiatives, and through certification programs for third party products, such as the Brocade Fabric Aware program, which it offers as a resource to its application and technology partners. Through Brocade’s testing initiatives, Brocade also certifies interoperability configurations of common customer environments, such as remote data backup in a multi-vendor server and storage environment.
 
 
An important aspect of managing storage environments is the management software used to administer, manage, and provision storage resources and data. Brocade products offer advanced fabric services that allow third-party developers of storage software applications to gain additional functionality and simplify the development of their applications.
 
 
Brocade’s education and training organization delivers high-quality, technical education and training on Brocade technology that encompasses design, implementation, and management solutions to its partners and their customers. Brocade curriculum is delivered worldwide using diverse methodologies, which include instructor led classes and a robust online web based training portfolio as well as a “live” virtual classroom capability. Brocade Education Services trains over 14,000 information technology professionals annually in this way. The Brocade SAN Certification Program offers certification on Brocade SANs for information technology professionals who have completed certain tests administered by an independent testing organization. This certification program is designed to measure the knowledge and proficiency of information technology professionals in SAN and FAN solutions and technologies, and to help ensure that Brocade’s customers receive superior customer service and support. Over 6,700 information technology professionals are now certified on Brocade solutions. Brocade’s education and training services are made available through its own education facilities and through its worldwide training provider network.
 
 
Brocade’s products are marketed, sold, and supported worldwide primarily through a wide range of distribution partners, including OEM partners, distributors, system integrators and value-added resellers, or VARs, and directly by Brocade.
 
  •  Brocade’s OEM partners are leading storage systems and subsystems providers who offer Brocade’s products under their own private label or as Brocade branded solutions. Sales of these products through OEM partners comprise the majority of Brocade’s business.


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  •  Other distribution partners include Brocade-authorized distributors, systems integrators, and VARs. These partners are authorized by Brocade to market, sell, and support its products and services. Some of these partners also sell training and other value-added services.
 
Brocade has OEM or distribution agreements with most of the major companies that sell enterprise storage systems and subsystems. In addition, Brocade employs a worldwide overlay sales force to assist its distribution partners in marketing Brocade solutions, assessing customer requirements and designing, implementing, and maintaining Brocade-based solutions.
 
 
Brocade’s major OEM customers for the fiscal year ended October 28, 2006 included Dell Computer Corporation, EMC Corporation, or EMC, Fujitsu Siemens, Hitachi Data Systems, Inc., Hewlett-Packard Company, or HP, IBM Corporation, or IBM, Network Appliance, Inc., Siemens AG, Sun Microsystems, Inc., and Unisys Corporation. Brocade’s primary non-OEM customers for the fiscal year ended October 28, 2006, included Bell Microproducts, GE Access Distribution, Tokyo Electron Limited, and XIOTech.
 
For the years ended October 28, 2006, October 29, 2005, and October 30, 2004, EMC, HP, and IBM each represented greater than ten percent of Brocade’s total revenues for combined totals of 73 percent, 71 percent, and 70 percent, of its total revenues, respectively. The level of sales to any OEM customer may vary from quarter to quarter, and Brocade expects that significant customer concentration will continue for the foreseeable future. The loss of, or a decrease in the level of sales to, or a change in the ordering pattern of, any one of these customers could have a material adverse impact on Brocade’s financial condition or results of operations. In addition, its OEM partners experience seasonal revenue patterns which Brocade experiences as well. These patterns are generally in-line with its OEMs on a calendar quarter basis. Historically, Brocade’s first and fourth fiscal quarters are seasonally stronger quarters than its second and third fiscal quarters.
 
 
Historically, domestic revenues have been between 60 percent and 75 percent of total revenues. For the year ended October 28, 2006, domestic and international revenues were approximately 64 and 36 percent of total revenues, respectively. For the year ended October 29, 2005, domestic and international revenues were approximately 63 percent and 37 percent of Brocade’s total revenues, respectively, and for the year ended October 30, 2004, domestic and international revenues were approximately 65 percent and 35 percent of its total revenues, respectively. Revenues are attributed to geographic areas based on the location of the customer to which Brocade’s products are shipped rather than where the products are ultimately used. International revenues primarily consist of sales to customers in Western Europe and the greater Asia Pacific region. For the year ended October 28, 2006, revenues in Europe have increased primarily as a result of faster growth in that region relative to North America and Asia Pacific region. For the years ended October 29, 2005 and October 30, 2004, international revenues decreased as a result of faster growth in the North America region. However, certain OEM customers take possession of Brocade’s products domestically and then distribute these products to their international customers. Because Brocade accounts for all of those OEM revenues as domestic revenues, Brocade cannot be certain of the extent to which its domestic and international revenue mix is impacted by the practices of its OEM customers. Nevertheless, data provided by OEM customers indicates that international customers may account for a higher percentage of end-user demand than that indicated by Brocade’s mix of domestic and international revenues (see Note 14 “Segment Information”, of the Notes to Consolidated Financial Statements).
 
 
Brocade’s acquisition and investment strategy is focused on facilitating the evolution and expansion of shared storage and data management. Brocade has made equity investments in companies that develop technology or provide services that are complementary to or broaden the markets for its products and further its business objectives. On January 27, 2003, Brocade completed its acquisition of Rhapsody Networks, Inc., or Rhapsody, a privately held technology company based in Fremont, California. This acquisition resulted in the addition of the Brocade AP7420.


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On May 3, 2005, Brocade completed its acquisition of Therion Software Corporation, or Therion, a privately held developer of software management solutions for the automated provisioning of servers over a storage network based in Redmond, Washington. As of the acquisition date, Brocade owned approximately 13% of Therion’s equity interest through investments totaling $1.0 million. Therion was a development stage company with no recognized revenue and a core technology that had not yet reached technological feasibility. Accordingly, the acquisition of Therion was accounted for as an asset purchase. Subsequently, the Therion technology came to market as Brocade Application Resource Manager, or ARM.
 
On May 3, 2005 Brocade announced a strategic relationship to deliver Wide Area File Services, or WAFS, to enterprise customers on Microsoft’s Windows Server 2003 platform with Tacit Networks, Inc., or Tacit, a leader in enterprise-wide remote office information technology solutions. Tacit was subsequently acquired by Packeteer, Inc. in May 2006 and Brocade’s equity investment in Tacit was recovered. The WAFS solution is part of Brocade’s File Services product portfolio. Under agreements entered into with Tacit, and subsequently Packeteer, the solutions are marketed by Brocade to its partners and customers worldwide, and Brocade is partnered with Packeteer in customer support and on product development programs.
 
On March 6, 2006, Brocade completed its acquisition of NuView, Inc., a privately held provider of a family of standards-based enterprise file management products based in Houston, Texas. The acquisition expanded Brocade’s File Services solutions to include software solutions that extend the benefits of shared storage architectures to file data environments.
 
On August 8, 2006, Brocade announced that it had entered into a definitive agreement to acquire McDATA Corporation, or McDATA, in an all stock transaction valued at approximately $634 million as of that date. Under the terms of the agreement, McDATA stockholders will receive 0.75 shares of Brocade common stock for each share of McDATA class A common stock and each share of McDATA class B common stock they hold. The acquisition is subject to obtaining approval from both Brocade and McDATA stockholders, regulatory approvals and certain other closing conditions.
 
As of October 28, 2006, October 29, 2005, and October 30, 2004, the carrying value of Brocade’s investments in non-publicly traded companies was $0.8 million, $3.8 million and $0.5 million, respectively.
 
 
The industry in which Brocade competes is subject to rapid technological developments, evolving industry standards, changes in customer requirements, and new product introductions. As a result, Brocade’s success depends, in part, on its ability to continue to enhance its existing solutions and to develop and introduce new solutions that improve performance and reduce the total cost of ownership in the storage environment. Brocade has invested significantly in product research and development. It continues to enhance and extend its products, and increase the speed, performance, and port-density of its switching platform. Brocade also continues to expand the value-added services of its intelligent platform to enable more functionality for end customers, OEM partners, and application partners and to further simplify storage management.
 
Brocade products are designed to support current industry standards and will continue to support emerging standards that are consistent with its product strategy. Brocade products have been designed around a common platform architecture, which facilitates the product design, development, and testing cycle, and reduces the time to market for new products and features. Brocade intends to continue to leverage this common architecture to develop and introduce additional hardware and software products and enhancements in the future.
 
Brocade’s product development process includes the certification of certain of its products by its OEM partners, which is referred to as the product qualification process. During this process, Brocade supports its OEM partners in the testing of its new products to insure they meet quality and functionality, and inoperability requirements. The process is completed once the OEM partner has certified the product and announced general availability of that product to their customers. This process generally is completed in a range of two to four months.
 
For the years ended October 28, 2006, October 29, 2005, and October 30, 2004, Brocade’s research and development expenses totaled $164.8 million, $132.4 million, and $142.5 million, respectively. All expenditures for


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research and development costs have been expensed as incurred. In fiscal 2007, Brocade expects to increase its level of investment, in absolute dollars, in research and development.
 
 
The markets for storage network and data management solutions and technologies are competitive and subject to rapid technological change. Major storage systems and server providers are continually introducing new solutions and products into these markets, and enhancing their existing networked storage and data management solutions and products. Brocade believes its primary competition is from providers of SAN switching products for interconnecting servers and storage, including Cisco Systems Inc., or Cisco, QLogic Corporation, or QLogic, and McDATA (see Note 10 “Commitments and Contingencies”, of the Notes to Consolidated Financial Statements), as well as from other private and public companies who have invested various aspects of networked storage and data management hardware, software, and service offerings.
 
In addition, as the storage network and data management markets evolve, additional technologies are, and may increasingly become available for interconnecting servers and storage. To the extent that products based upon these technologies provide the ability to network servers and storage and support high-performance, block-data storage applications, they are likely to compete with Brocade’s current and future products. Competitive products include, but are not limited to, non-Fibre Channel emerging products based on Gigabit Ethernet, 10 Gigabit Ethernet, InfiniBand, and iSCSI, as well as other storage solutions such as Network Attached Storage (“NAS”), and Direct Attached Storage (“DAS”). In addition, networking companies, manufacturers of networking equipment, and other companies may develop competitive products and technologies. Brocade’s OEM partners or other partners could also develop and introduce products that compete with its product offerings. Brocade believes the competitive factors in this market include product performance and features, product reliability, price, size and extent of installed base, ability to meet delivery schedules, customer service, technical support, and distribution channels.
 
Some of Brocade’s competitors have longer operating histories and significantly greater human and financial resources than it does. These competitors may have the ability to devote a larger number of sales personnel to focus on the networked storage and data management markets, compete with Brocade and potentially change the current distribution model. Brocade’s competitors could also adopt more aggressive pricing policies and devote greater resources to the development, promotion, and sale of their products than Brocade. As a result, they may be able to respond more quickly to changes in customer or market requirements. Brocade may not have the financial resources, technical expertise or marketing, manufacturing, distribution, and support capabilities to compete successfully against current or future competitors. This could materially harm Brocade’s business.
 
 
Brocade uses a third-party contract manufacturer, Hon Hai Precision Industry Co., Ltd., or Foxconn, to manufacture its products. Foxconn invoices Brocade based on prices and payment terms mutually agreed upon and set forth in purchase orders it issues to them. Although the purchase orders Brocade places with its contract manufacturer are cancelable, Brocade could be required to purchase all unused material not cancelable, returnable or usable by other customers.
 
Brocade uses Foxconn for final turnkey product assembly, but Brocade also maintains key component selection and qualification expertise internally. Brocade designs and develops the key components of its products, including application-specific integrated circuits, or ASICs, and operating system and other software, as well as certain details in the fabrication and enclosure of its products. In addition, Brocade determines the components that are incorporated into its products, and Brocade selects appropriate suppliers of those components.
 
Although Brocade uses standard parts and components for its products where possible, Brocade’s contract manufacturer, Foxconn, currently purchases, on its behalf, several key components used in the manufacture of its products from single and limited supplier sources. Brocade’s principal single source components are application-specific integrated circuits, or ASICs. Brocade’s principal limited source components include ASICs, printed circuit boards, microprocessors, certain connectors, certain logic chips, small form-factor pluggable transceivers, or SFPs, power supplies, and programmable logic devices. In addition, Brocade licenses certain software from third parties that is incorporated into its fabric operating system and other software. If Brocade is unable to buy or license these


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components on a timely basis, it may not be able to deliver its products to customers in a timely manner. Brocade uses rolling forecasts based on anticipated product orders to determine component requirements. If Brocade overestimates component requirements, it may have excess inventory, which would increase its costs. If Brocade underestimates component requirements, it may have inadequate inventory, which could interrupt the manufacturing process and result in lost or deferred revenue. In addition, lead times for components vary significantly and depend on factors such as the specific supplier, contract terms, and demand for a component at a given time. Brocade also may experience shortages of certain components from time to time, which also could delay the manufacturing and sales processes.
 
Brocade is also subject to various environmental and other regulations governing product safety, materials usage, packaging and other environmental impacts in the various countries where its products are sold. For example, many of Brocade’s products are subject to laws and regulations that restrict the use of mercury, hexavalent chromium, cadmium and other substances, and require producers of electrical and electronic equipment to assume responsibility for collecting, treating, recycling and disposing of its products when they have reached the end of their useful life. In Europe, substance restrictions apply to products sold. In addition, recycling, labeling, financing and related requirements apply to products Brocade sells in Europe. Brocade may be required to redesign its products to ensure that they comply with any new requirements as well as related requirements imposed by its OEM customers. Brocade also continues to work with its suppliers to provide it with compliant materials, parts and components. If Brocade’s products do not comply with the European substance restrictions, it could become subject to fines, civil or criminal sanctions, and contract damage claims. In addition, Brocade could be prohibited from shipping non-compliant products into the European Union, and required to recall and replace any products already shipped, if such products were found to be non-compliant, which would disrupt its ability to ship products and result in reduced revenue, increased obsolete or excess inventories and harm to its business and customer relationships. Brocade’s suppliers may also fail to provide it with compliant materials, parts and components, which could impact its ability to timely produce compliant products and may disrupt its business. Various other countries and states in the United States have issued, or are in the process of issuing, other environmental regulations that may impose additional restrictions or obligations and require further changes to its products.
 
 
Brocade relies on a combination of patents, copyrights, trademarks, trade secrets, confidentiality agreements, and other contractual restrictions with employees and third parties to establish and protect its proprietary rights. Despite these precautions, the measures Brocade undertakes may not prevent misappropriation or infringement of its proprietary technology. These measures may not preclude competitors from independently developing products with functionality or features similar to its products.
 
Brocade maintains a program to identify and obtain patent protection for its inventions. As of December 19, 2006, Brocade has been issued 22 patents in the United States that are currently in force and have over 100 patent applications pending in the United States. The normal expiration dates of its issued patents in the United States range from 2012 to 2023. It is possible that Brocade will not receive patents for every application it files. Furthermore, Brocade’s issued patents may not adequately protect its technology from infringement or prevent others from claiming that its products infringe the patents of those third parties. Brocade’s failure to protect its intellectual property could materially harm its business. In addition, Brocade’s competitors may independently develop similar or superior technology, duplicate Brocade’s products, or design around its patents. It is possible that litigation may be necessary in the future to enforce Brocade’s intellectual property rights, to protect its trade secrets, or to determine the validity and scope of the proprietary rights of others. Litigation could result in substantial costs and diversion of resources and could materially harm Brocade’s business.
 
Some of Brocade’s products are designed to include software or other intellectual property licensed from third parties. While it may be necessary in the future to seek or renew licenses relating to various aspects of its products, Brocade believes that such licenses generally could be obtained on commercially reasonable terms. However, failure to obtain such licenses on commercially reasonable terms could materially harm Brocade’s business.
 
Brocade has received, and may receive in the future, notice of claims of infringement of other parties’ proprietary rights. Infringement or other claims could be asserted or prosecuted against Brocade in the future, and it


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is possible that past or future assertions or prosecutions could harm its business. Any such claims, with or without merit, could be time-consuming, result in costly litigation and diversion of technical and management personnel, cause delays in the development and release of its products, or require Brocade to develop non-infringing technology or enter into royalty or licensing arrangements. Such royalty or licensing arrangements, if required, may require Brocade to license back its technology or may not be available on terms acceptable to Brocade, or at all. For these reasons, infringement claims could materially harm Brocade’s business.
 
 
Brocade’s business is characterized by short lead-time orders and fast delivery schedules. Sales of its products are generally made pursuant to contracts and purchase orders that are cancelable without significant penalties. These commitments are subject to price negotiations and to changes in quantities of products and delivery schedules in order to reflect changes in customers’ requirements and manufacturing availability. In addition, actual shipments depend on the manufacturing capacity of suppliers and the availability of products from such suppliers. As a result of the foregoing factors, Brocade does not believe that backlog at any given time is a meaningful indicator of its ability to achieve any particular level of revenue or financial performance.
 
 
As of October 28, 2006, Brocade had 1,440 employees. Brocade has not experienced any work stoppages and considers its relations with employees to be good. Employees are currently located in our United States headquarters in San Jose, California; our European headquarters in Geneva, Switzerland; our Asia Pacific headquarters in Singapore; and offices throughout North America, Europe, and Asia Pacific. Competition for technical personnel in the computing industry continues to be significant. We believe that our success depends in part on our ability to hire, assimilate, and retain qualified personnel. We cannot assure you that we will continue to be successful at hiring, assimilating, and retaining employees in the future.
 
Item 1A.   Risk Factors
 
 
 
Brocade believes that the acquisition of McDATA will result in certain benefits, including certain cost synergies, product innovations, and operational efficiencies. However, Brocade’s ability to realize these anticipated benefits depends on successfully combining the businesses of Brocade and McDATA. Challenges of integration include the combined company’s ability to incorporate acquired products and business technology into its existing product lines, including consolidating technology with duplicative functionality or designed on a different technological architecture and provide for interoperability, and its ability to sell the acquired products through Brocade’s existing or acquired sales channels. The combined company may fail to realize the anticipated benefits of the merger for a variety of reasons, including the following:
 
  •  revenue attrition in excess of anticipated levels;
 
  •  Brocade’s inability to conduct extensive integration planning with McDATA prior to the completion of the merger;
 
  •  failure to successfully execute on our integration plan;
 
  •  failure of customers to accept new products or to continue as customers of the combined company;
 
  •  failure to successfully manage relationships with original equipment manufacturers, or OEMs, end-users, distributors and suppliers;
 
  •  failure to qualify the combined company’s products with OEM customers on a timely basis or at all;
 
  •  failure to successfully develop interoperability between the products of Brocade and McDATA;


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  •  failure to leverage the increased scale of the combined company quickly and effectively;
 
  •  potential difficulties integrating and harmonizing financial reporting systems;
 
  •  the loss of key employees;
 
  •  failure to effectively coordinate sales and marketing efforts to communicate the capabilities of the combined company; and
 
  •  failure to combine product offerings and product lines quickly and effectively.
 
The integration of McDATA into Brocade will result in significant expenses and accounting charges that adversely affect Brocade’s operating results and financial condition. Additional costs may include: costs of employee redeployment; relocation and retention, including salary increases or bonuses; accelerated amortization of deferred equity compensation and severance payments; reorganization or closure of facilities; taxes; advisor and professional fees and termination of contracts that provide redundant or conflicting services. Some of these costs may have to be accounted for as expenses that would decrease Brocade’s net income and earnings per share for the periods in which those adjustments are made. Brocade may also experience additional and unforeseen expenses or delays. The price of Brocade’s common stock could decline to the extent Brocade’s financial results are materially affected by the foregoing charges and costs, or if the foregoing charges and costs are larger than anticipated. If Brocade is not able to successfully integrate McDATA’s business and operations, or if there are delays in combining the businesses, the anticipated benefits of the merger may not be realized fully or at all or may take longer to realize than expected.
 
 
Uncertainty about the effect of the merger on customers, employees, distributors and suppliers may have an adverse effect on Brocade and, following the merger, on the combined company. Brocade and McDATA’s customers may, in response to the announcement of the proposed merger, or due to concerns about the completion of the proposed merger, delay or defer purchasing decisions. Further, customer concerns about changes or delays in Brocade’s product roadmap may negatively affect customer purchasing decisions. Customers could also be reluctant to purchase the products and services of McDATA or Brocade due to uncertainty about the direction of their technology, products and services, and willingness to support and service existing products which may be discontinued. This uncertainty may also be used as a competitive advantage by Brocade’s competitors during the pendency of the merger and cause customers to purchase a competitor’s products in lieu of Brocade’s products. As a result, there may be a loss of revenue opportunities and market share for Brocade. In addition, customers, OEMs, distributors, resellers, value added resellers, or VARs, and others may also seek to change existing agreements with McDATA or Brocade as a result of the proposed merger, including possibly reallocating orders between Brocade and its competitors. OEMs, resellers, distributors, VARs and other third parties of strategic importance may delay or refuse to certify, support or promote McDATA’s or Brocade’s technology, products and services due to uncertainty created by the proposed merger. If Brocade or McDATA’s customers delay or defer purchasing decisions, or choose to purchase from a competitor, the revenues of Brocade and McDATA, respectively, and the revenues of the combined company, could materially decline or any anticipated increases in revenue could be lower than expected.
 
 
Completion of the merger is conditioned upon the receipt of certain governmental approvals, including the expiration or termination of the applicable waiting periods under the Hart-Scott-Rodino Act. Although Brocade and McDATA have agreed in the merger agreement to use their reasonable best efforts to obtain the requisite governmental approvals, there can be no assurance that these approvals will be obtained. In addition, the governmental entities from which these approvals are required may impose conditions on the completion of the merger or require changes to the terms of the merger. While Brocade does not currently expect that any such conditions or changes would be imposed, there can be no assurance that they will not be, and such conditions or changes could have the effect of jeopardizing or delaying completion of the merger or reducing the anticipated benefits of the merger. If Brocade becomes subject to any material conditions in order to obtain any approvals


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required to complete the merger, the business and results of operations of the combined company may be adversely affected. Brocade may also elect to challenge and litigate conditions or changes proposed by governmental authorities. Any such litigation could be costly and divert management’s attention from the business. There is also no assurance that Brocade will be successful in any such litigation.
 
 
Completion of the merger is subject to a number of closing conditions, including obtaining requisite regulatory and stockholder approvals, and McDATA and Brocade may be unable to obtain such approvals on a timely basis or at all. If the merger is not completed, the price of Brocade common stock may decline. If the merger is not completed, the ongoing business of Brocade may be adversely affected and without realizing any of the benefits of having completed the merger. Brocade is also subject to pay certain fees and costs if the merger is not consummated, including the following: (i) a termination fee of $22 million or $60 million if the merger is terminated under certain circumstances, and (ii) certain costs relating to the merger, such as legal, accounting, financial advisor and printing fees whether or not the merger is completed. Brocade and McDATA could also be subject to litigation related to any failure to complete the transaction. If the merger is not completed, these risks may materialize and may adversely affect Brocade’s and McDATA’s business, financial results and stock price.
 
 
Successful integration of Brocade’s and McDATA’s operations, products and personnel will place a significant burden on the combined company’s management and internal resources. Brocade may also experience difficulty in effectively integrating the different cultures and practices of McDATA, as well as in assimilating McDATA’s broad and geographically dispersed personnel. Further, the difficulties of integrating McDATA could disrupt the combined company’s ongoing business, and distract its management focus from other opportunities and challenges. The diversion of management attention and any difficulties encountered in the transition and integration process could harm the combined company’s business, financial condition and operating results.
 
 
Upon the completion of the merger, each share of McDATA Class A and Class B common stock outstanding immediately prior to the merger will be converted into the right to receive 0.75 of a share of Brocade’s common stock. Because the exchange ratio for Brocade common shares to be issued in the merger has been fixed, the value of the merger consideration will depend upon the market price of Brocade common stock. The value of Brocade’s common stock to be issued in the merger could be considerably higher or lower than it was at the time the merger consideration was negotiated. The share prices of Brocade common stock, McDATA Class A common stock and McDATA Class B common stock are subject to the general price fluctuations in the market for publicly-traded equity securities, and the prices of both companies’ common stock have experienced significant volatility in the past. Neither Brocade nor McDATA is permitted to terminate the merger agreement or resolicit the vote of their respective stockholders solely because of changes in the market prices of either company’s stock.
 
Risks Related to Brocade’s Business
 
 
The market for storage networks and data management is characterized by rapidly changing technology and accelerating product introduction cycles. Brocade’s future success depends upon its ability to address the rapidly changing needs of its customers by developing and supplying high-quality, cost-effective products, product enhancements and services on a timely basis, and by keeping pace with technological developments and emerging industry standards. This risk will become more pronounced as the storage network and data management markets becomes more competitive and as demand for new and improved technologies increases.


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Brocade has introduced a significant number of new products in recent history, including products across its SAN product family, which accounts for a substantial portion of Brocade’s revenues. Brocade has also launched a number of File Area Network solutions as well as new service and support offerings. For example, as of the third quarter of fiscal year 2006, approximately 68% of our products had been in the market less than six quarters. New offerings in fiscal year 2006 include the Brocade 4900 64-port switch, and the enhanced Brocade 48000 director, which now supports up to 384 ports in a single chassis as well as the addition of iSCSI capabilities.
 
Brocade must achieve widespread market acceptance of Brocade’s new products and service offerings in order to realize the benefits of Brocade’s investments. The rate of market adoption is also critical. The success of Brocade’s product and service offerings depends on numerous factors, including its ability to:
 
  •  properly define the new products and services;
 
  •  timely develop and introduce the new products and services;
 
  •  differentiate Brocade’s new products and services from its competitors’ technology and product offerings; and
 
  •  address the complexities of interoperability of Brocade’s products with its OEM partners’ server and storage products and its competitors’ products.
 
Various factors impacting market acceptance are outside of Brocade’s control, including the availability and price of competing products, and alternative technologies; product qualification requirements by Brocade’s OEM partners, which can cause delays in the market acceptance; and the ability of its OEM partners to successfully distribute, support and provide training for its products. If Brocade is not able to successfully develop and market new and enhanced products and services, its business and results of operations will be harmed.
 
 
Brocade has made a series of investments, and plans to continue to invest, in offerings focused on new markets that are adjacent or parallel to Brocade’s traditional market, including new and emerging markets. For instance, Brocade has recently made a series of introductions in the emerging File Area Network (FAN) market with several enhancements to existing products in its family of file management software solutions which includes Brocade StorageX, Brocade Wide Area File Services, or WAFS, and Brocade File Lifecycle Manager, or FLM. In addition, Brocade has added ten new professional service offerings to its solution portfolio.
 
Brocade’s strategy is to derive competitive advantage and drive incremental revenue growth through such investments. As a result, Brocade believes these new markets could substantially increase its total available market opportunities. However, Brocade cannot be certain that it has accurately identified and estimated these market opportunities. Moreover, Brocade cannot assure you that its new strategic offerings will achieve market acceptance, or that Brocade will benefit fully from the substantial investments it has made and plans to continue to make in them. Brocade may also have only limited experience in these new markets given that such markets are adjacent or parallel to Brocade’s core market. As a result, Brocade may not be able to successfully penetrate or realize anticipated revenue from these new potential market opportunities. Brocade also faces greater challenges in accurately predicting its revenue and margins with respect to these other markets.
 
Developing new offerings also requires significant, upfront, incremental investments that may not result in revenue for an extended period of time, if at all. Particularly as Brocade seeks to diversify its product and service offerings, Brocade expects to incur significant costs and expenses for product development, sales, marketing and customer services, most of which are fixed in the short-term or incurred in advance of receipt of corresponding revenue. In addition, these investments have caused, and will likely continue to result in, higher operating expenses and if they are not successful, Brocade’s operating income and operating margin will deteriorate. These new offerings may also involve cost and revenue structures that are different from those used in Brocade’s historical business, which would impact Brocade’s operating results.


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Because these new offerings may address different market needs than those it has historically addressed, Brocade may face a number of additional challenges, such as:
 
  •  successfully identifying market opportunities and new technologies;
 
  •  developing new customer relationships both with new and existing customers;
 
  •  expanding Brocade’s relationships with its existing OEM partners and end-users;
 
  •  managing different sales cycles;
 
  •  hiring qualified personnel with appropriate skill sets on a timely basis;
 
  •  establishing effective distribution channels and alternative routes to market; and
 
  •  estimating the level of customer acceptance and rate of market adoption.
 
Brocade’s new product and service offerings also may contain some features that are currently offered by Brocade’s OEM partners, which could cause conflicts with partners on whom Brocade relies to bring its current products to customers and thus negatively impact Brocade’s relationship with such partners.
 
Brocade’s business and operations are also experiencing rapid change as it diversifies its product and service offerings. For instance, Brocade has hired a number of additional employees, and plans to continue to add additional personnel and resources, to further develop and market these new offerings. If Brocade fails to effectively manage these changes and implement necessary changes, Brocade’s business and operating results could be harmed and Brocade may have to incur significant expenditures to address the additional operational and control requirements from these changes.
 
 
The storage network and data management markets are becoming increasingly more competitive as new products, services and technologies are introduced by existing competitors and as new competitors enter the market. Increased competition in the past has resulted in greater pricing pressure, and reduced sales, margins, profits and market share. For example, Brocade expects to experience increased competition in future periods as other companies gain market traction with recently released 4 Gbit products that are intended to compete with Brocade’s 4 Gbit products. Moreover, new competitive products could be based on existing technologies or new technologies that may or may not be compatible with Brocade’s storage network technology. Competitive products include, but are not limited to, non-Fibre Channel based emerging products utilizing Gigabit Ethernet, 10 Gigabit Ethernet, InfiniBand, and Internet Small Computer System Interface (“iSCSI”).
 
Currently, Brocade believes that it principally faces competition from providers of Fibre Channel switching products for interconnecting servers and storage. These competitors include Cisco Systems, McDATA (with which Brocade will continue to be a competitor until Brocade’s pending acquisition of McDATA closes) and QLogic Corporation. In addition, Brocade’s OEM partners, who also have relationships with some of Brocade’s current competitors, could become new competitors by developing and introducing products that compete with Brocade’s product offerings, by choosing to sell Brocade’s competitors’ products instead of Brocade’s products, or by offering preferred pricing or promotions on Brocade’s competitors’ products. Competitive pressure will likely intensify as Brocade’s industry experiences further consolidation in connection with mergers by Brocade, its competitors and its OEM partners.
 
Some of Brocade’s competitors have longer operating histories and significantly greater human, financial and capital resources than Brocade does. Brocade’s competitors could adopt more aggressive pricing policies than Brocade. Brocade believes that competition based on price may become more aggressive than it has traditionally experienced. Brocade’s competitors could also devote greater resources to the development, promotion, and sale of their products than Brocade may be able to support and, as a result, be able to respond more quickly to changes in customer or market requirements. Brocade’s failure to successfully compete in the market would harm Brocade’s business and financial results.


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Brocade’s competitors may also put pressure on Brocade’s distribution model of selling products to customers through OEM solution providers by focusing a large number of sales personnel on end-user customers or by entering into strategic partnerships. For example, one of Brocade’s competitors has formed a strategic partnership with a provider of network storage systems, which includes an agreement whereby Brocade’s competitor resells the storage systems of its partner in exchange for sales by the partner of Brocade’s competitor’s products. Such strategic partnerships, if successful, may influence Brocade to change Brocade’s traditional distribution model.
 
 
Brocade depends on recurring purchases from a limited number of large OEM partners for the majority of its revenue. As a result, these large OEM partners have a significant influence on Brocade’s quarterly and annual financial results. Brocade’s agreements with its OEM partners are typically cancelable, non-exclusive, have no minimum purchase requirements and have no specific timing requirements for purchases. For fiscal year 2006, three customers each represented ten percent or more of Brocade’s total revenues for a combined total of 73 percent. Brocade anticipates that its revenues and operating results will continue to depend on sales to a relatively small number of OEM partners. The loss of any one significant OEM partner, or a decrease in the level of sales to any one significant OEM partner, or unsuccessful quarterly negotiation on key terms, conditions or timing of purchase orders placed during a quarter, would likely cause serious harm to Brocade’s business and financial results.
 
In addition, some of Brocade’s OEM partners purchase Brocade’s products for their inventories in anticipation of customer demand. These OEM partners make decisions to purchase inventory based on a variety of factors, including their product qualification cycles and their expectations of end customer demand, which may be affected by seasonality and their internal supply management objectives. Others require that Brocade maintain inventories of Brocade’s products in hubs adjacent to their manufacturing facilities and purchase Brocade’s products only as necessary to fulfill immediate customer demand. If more of Brocade’s OEM partners transition to a hub model, form partnerships, alliances or agreements with other companies that divert business away from Brocade; or otherwise change their business practices, their ordering patterns may become less predictable. Consequently, changes in ordering patterns may affect both the timing and volatility of Brocade’s reported revenues. The timing of sales to Brocade’s OEM partners, and consequently the timing and volatility of Brocade’s reported revenues, may be further affected by the product introduction schedules of Brocade’s OEM partners.
 
Brocade’s OEM partners evaluate and qualify Brocade’s products for a limited time period before they begin to market and sell them. Assisting Brocade’s OEM partners through the evaluation process requires significant sales, marketing and engineering management efforts on Brocade’s part, particularly if Brocade’s products are being qualified with multiple distribution partners at the same time. In addition, once Brocade’s products have been qualified, its customer agreements have no minimum purchase commitments. Brocade may not be able to effectively maintain or expand its distribution channels, manage distribution relationships successfully, or market its products through distribution partners. Brocade must continually assess, anticipate and respond to the needs of its distribution partners and their customers, and ensure that its products integrate with their solutions. Brocade’s failure to successfully manage its distribution relationships or the failure of its distribution partners to sell Brocade’s products could reduce Brocade’s revenues significantly. In addition, Brocade’s ability to respond to the needs of its distribution partners in the future may depend on third parties producing complementary products and applications for Brocade’s products. If Brocade fails to respond successfully to the needs of these groups, its business and financial results could be harmed.
 
 
The average selling price for Brocade’s products has declined in the past, and Brocade expects it to continue to decline in the future as a result of changes in product mix, competitive pricing pressure, increased sales discounts, new product introductions by Brocade or Brocade’s competitors, the entrance of new competitors or other factors. For example, in 2005, Brocade introduced and began shipping a number of new products that expand and extend the breadth of Brocade’s product offerings. Several of these new products have lower revenue per port and lower gross


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margin than Brocade’s traditional products. If Brocade is unable to offset any negative impact that changes in product mix, competitive pricing pressures, increased sales discounts, enhanced marketing programs, new product introductions by Brocade or Brocade’s competitors, or other factors may have on it by increasing the volume of products shipped or reducing product manufacturing cost, Brocade’s total revenues and gross margins will be negatively impacted.
 
In addition, to maintain Brocade’s gross margins Brocade must maintain or increase the number of products shipped, develop and introduce new products and product enhancements, and continue to reduce the manufacturing cost of Brocade’s products. While Brocade has successfully reduced the cost of manufacturing Brocade’s products in the past, Brocade may not be able to continue to reduce cost of production at historical rates. Moreover, most of Brocade’s expenses are fixed in the short-term or incurred in advance of receipt of corresponding revenue. As a result, Brocade may not be able to decrease its spending quickly enough or in sufficient amounts to offset any unexpected shortfall in revenues. If this occurs, Brocade could incur losses, Brocade’s operating results and gross margins could be below its expectations and the expectations of investors and stock market analysts, and its stock price could be negatively affected.
 
 
The loss of Brocade’s third-party contract manufacturer could significantly impact Brocade’s ability to produce its products for an indefinite period of time. Qualifying a new contract manufacturer and commencing volume production is a lengthy and expensive process. If Brocade is required to change its contract manufacturer or if its contract manufacturer experiences delays, disruptions, capacity constraints, component parts shortages or quality control problems in its manufacturing operations, shipment of Brocade’s products to Brocade’s customers could be delayed resulting in loss of revenues and Brocade’s competitive position and relationship with customers could be harmed.
 
 
Brocade purchases certain key components used in the manufacture of its products from single or limited sources. Brocade purchases specific ASICs from a single source, and Brocade purchases microprocessors, certain connectors, small form-factor pluggable transceivers, or SFP’s, logic chips, power supplies and programmable logic devices from limited sources. Brocade also licenses certain third-party software that is incorporated into Brocade’s operating system software and other software products. If Brocade is unable to obtain these and other components when required or Brocade experiences significant component defects, Brocade may not be able to deliver Brocade’s products to Brocade’s customers in a timely manner. As a result, Brocade’s business and financial results could be harmed.
 
Brocade uses rolling forecasts based on anticipated product orders to determine component requirements. If Brocade overestimates component requirements, Brocade may have excess inventory, which would increase Brocade’s costs. If Brocade underestimates component requirements, Brocade may have inadequate inventory, which could interrupt the manufacturing process and result in lost or delayed revenue. In addition, lead times for components vary significantly and depend on factors such as the specific supplier, contract terms, and demand for a component at a given time. Brocade also may experience shortages of certain components from time to time, which also could delay the manufacturing and sales processes. If Brocade overestimates or underestimates Brocade’s component requirements, or if Brocade experiences shortages, Brocade’s business and financial results could be harmed.
 
 
Many of Brocade’s OEM partners experience uneven sales patterns in their businesses due to the cyclical nature of information technology spending. For example, some of Brocade’s partners close a disproportionate percentage of their sales transactions in the last month, weeks and days of each fiscal quarter, and other partners experience spikes in sales during the fourth calendar quarter of each year. Because the majority of Brocade’s sales are derived from a small number of OEM partners, when they experience seasonality, Brocade typically experiences


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similar seasonality. Historically, Brocade’s first and fourth fiscal quarters are seasonally stronger quarters than its second and third fiscal quarters. In addition, Brocade has experienced quarters where uneven sales patterns of Brocade’s OEM partners have resulted in a significant portion of Brocade’s revenue occurring in the last month of Brocade’s fiscal quarter. This exposes Brocade to additional inventory risk as it has to order products in anticipation of expected future orders and additional sales risk if Brocade is unable to fulfill unanticipated demand. Brocade is not able to predict the degree to which the seasonality and uneven sales patterns of Brocade’s OEM partners or other customers will affect Brocade’s business in the future particularly as Brocade release new products.
 
Brocade has been named as a party to several class action and derivative action lawsuits arising from Brocade’s internal reviews and related restatements of Brocade’s financial statements during 2005, and Brocade may be named in additional litigation, all of which could require significant management time and attention and result in significant legal expenses as well as result in an unfavorable outcome which could have a material adverse effect on Brocade’s business, financial condition, results of operations and cash flows.
 
Brocade is subject to a number of lawsuits arising from Brocade’s internal reviews and the related restatements of Brocade’s financial statements in 2005, some purportedly filed on behalf of a class of Brocade’s stockholders, against Brocade and certain of its executive officers claiming violations of securities laws and others purportedly filed on behalf of Brocade against certain of Brocade’s executive officers and board members, and Brocade may become the subject of additional private or government actions. The expense of defending such litigation may be significant. The amount of time to resolve these lawsuits is unpredictable and defending Brocade may divert management’s attention from the day-to-day operations of Brocade’s business, which could adversely affect Brocade’s business, results of operations and cash flows. In addition, an unfavorable outcome in such litigation, such as a court judgment against the Company resulting in monetary damages or penalties, could have a material adverse effect on Brocade’s business, results of operations and cash flows.
 
As a result of Brocade’s internal reviews and related restatements, Brocade is subject to investigations by the SEC and Department of Justice, or DOJ, which may not be resolved favorably and have required, and will continue to require, a significant amount of management time and attention and accounting resources and legal expense, which could adversely affect Brocade’s business, results of operations and cash flows.
 
The SEC and the DOJ are currently conducting investigations of Brocade. The period of time necessary to resolve the SEC and DOJ investigations is uncertain, and these matters could require significant management and financial resources which could otherwise be devoted to the operation of Brocade’s business. If Brocade is subject to an adverse finding resulting from the SEC and DOJ investigation, Brocade could be required to pay damages or penalties or have other remedies imposed upon Brocade. During the three months ended January 28, 2006 Brocade began active settlement discussions with the Staff of the SEC’s Division of Enforcement, or the Staff. As a result of these discussions, for the three months ended January 28, 2006 Brocade recorded $7.0 million provision for an estimated settlement expense. The $7.0 million estimated settlement expense is based on an offer of settlement that Brocade made to the Staff and for which the Staff has stated it intends to recommend to the SEC’s Commissioners. The offer of settlement is contingent upon final approval by the SEC’s Commissioners. The restatements of Brocade’s financial results in 2005, the ongoing SEC and DOJ investigations and any negative outcome that may occur from these investigations could impact Brocade’s relationships with customers and Brocade’s ability to generate revenue. In addition, considerable legal and accounting expenses related to these matters have been incurred to date and significant expenditures are expected to continue to be incurred in the future. The SEC and DOJ investigations could adversely affect Brocade’s business, results of operations, financial position and cash flows.
 
In July 2006, the United States Attorney’s Office for the Northern District of California, the SEC, and the Federal Bureau of Investigation announced the filing of civil and, in some cases criminal, charges against certain former executive officers of Brocade. While those actions are targeted against former executive officers and not Brocade, those actions may nevertheless have an adverse impact on Brocade. In addition to the risks noted above, Brocade has certain indemnification obligations to such former officers in connection with such actions, which may result in significant expense to Brocade.


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Brocade’s quarterly and annual revenues and operating results may vary significantly in the future due to a number of factors, any of which may cause Brocade’s stock price to fluctuate. Factors that may affect the predictability of Brocade’s annual and quarterly results include, but are not limited to, the following:
 
  •  announcements, introductions, and transitions of new products by Brocade and its competitors or its OEM partners;
 
  •  the timing of customer orders, product qualifications, and product introductions of Brocade’s OEM partners;
 
  •  seasonal fluctuations;
 
  •  changes, disruptions or downturns in general economic conditions, particularly in the information technology industry;
 
  •  declines in average selling prices for Brocade’s products as a result of competitive pricing pressures or new product introductions by Brocade or its competitors;
 
  •  the emergence of new competitors and new technologies in the storage network and data management markets;
 
  •  deferrals of customer orders in anticipation of new products, services, or product enhancements introduced by Brocade or its competitors;
 
  •  Brocade’s ability to timely produce products that comply with new environmental restrictions or related requirements of its OEM customers;
 
  •  Brocade’s ability to obtain sufficient supplies of sole- or limited-sourced components, including ASICs, microprocessors, certain connectors, certain logic chips, and programmable logic devices;
 
  •  increases in prices of components used in the manufacture of Brocade’s products;
 
  •  Brocade’s ability to attain and maintain production volumes and quality levels;
 
  •  variations in the mix of Brocade’s products sold and the mix of distribution channels and geographies through which they are sold;
 
  •  pending or threatened litigation;
 
  •  stock-based compensation expense that is affected by Brocade’s stock price;
 
  •  new legislation and regulatory developments; and
 
  •  other risk factors detailed in this section entitled “Risks Related to Brocade’s Business.”
 
Accordingly, the results of any prior periods should not be relied upon as an indication of future performance. Brocade cannot assure you that in some future quarter Brocade’s revenues or operating results will not be below Brocade’s projections or the expectations of stock market analysts or investors, which could cause Brocade’s stock price to decline.
 
The failure to accurately forecast demand for Brocade’s products or the failure to successfully manage the production of Brocade’s products could negatively affect the supply of key components for Brocade’s products and Brocade’s ability to manufacture and sell Brocade’s products.
 
Brocade provides product forecasts to its contract manufacturer and places purchase orders with it in advance of the scheduled delivery of products to Brocade’s customers. Moreover, in preparing sales and demand forecasts, Brocade relies largely on input from its OEM partners. Therefore, if Brocade or its OEM partners are unable to accurately forecast demand, or if Brocade fails to effectively communicate with its distribution partners about end-user demand or other time-sensitive information, sales and demand forecasts may not reflect the most accurate, up-to-date information. If these forecasts are inaccurate, Brocade may be unable to obtain adequate manufacturing


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capacity from its contract manufacturer to meet customers’ delivery requirements, or Brocade may accumulate excess inventories. Furthermore, Brocade may not be able to identify forecast discrepancies until late in its fiscal quarter. Consequently, Brocade may not be able to make adjustments to its business model. If Brocade is unable to obtain adequate manufacturing capacity from its contract manufacturer, if Brocade accumulates excess inventories, or if Brocade is unable to make necessary adjustments to Brocade’s business model, revenue may be delayed or even lost to Brocade’s competitors, and Brocade’s business and financial results may be harmed.
 
In addition, although the purchase orders placed with Brocade’s contract manufacturer are cancelable, in certain circumstances Brocade could be required to purchase certain unused material not returnable, usable by, or sold to other customers if Brocade cancels any of Brocade’s orders. This purchase commitment exposure is particularly high in periods of new product introductions and product transitions. If Brocade is required to purchase unused material from Brocade’s contract manufacturer, Brocade would incur unanticipated expenses and Brocade’s business and financial results could be negatively affected.
 
 
Brocade has in the past, and may in the future, acquire or make strategic investments in additional companies, products or technologies. Most recently, Brocade announced that Brocade entered into an agreement to acquire McDATA in August 2006. Other examples include the acquisition of NuView, Inc. in March 2006 and Therion Software Corporation in May 2005, and a strategic investment in Tacit Networks in May 2005 (acquired by Packeteer, Inc. in May 2006). Brocade may not realize the anticipated benefits of these or any other mergers or strategic investments, which involve numerous risks, including:
 
  •  problems integrating the purchased operations, technologies, personnel or products over geographically disparate locations;
 
  •  assumption of debt and contingent liabilities;
 
  •  unanticipated costs, litigation and other contingent liabilities;
 
  •  diversion of management’s attention from Brocade’s daily operations and business;
 
  •  adverse effects on existing business relationships with suppliers and customers;
 
  •  risks associated with entering into markets in which Brocade have limited, or no prior experience;
 
  •  failure to successfully manage additional remote locations, including the additional infrastructure and resources necessary to support and integrate such locations;
 
  •  incurrence of significant exit charges if products acquired in business combinations are unsuccessful;
 
  •  incurrence of merger-related costs or amortization costs for acquired intangible assets that could impact Brocade’s operating results;
 
  •  potential write-down of goodwill and/or acquired intangible assets, which are subject to impairment testing on a regular basis, and could significantly impact Brocade’s operating results;
 
  •  inability to retain key customers, distributors, vendors and other business partners of the acquired business;
 
  •  dilution of the percentage of Brocade’s stockholders to the extent equity is used as consideration or option plans are assumed; and
 
  •  potential loss of Brocade’s key employees or the key employees of an acquired organization.
 
If Brocade is not able to successfully integrate businesses, products, technologies or personnel that Brocade acquires, or to realize expected benefits of Brocade’s mergers or strategic investments, Brocade’s business and financial results may be adversely affected.


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Brocade’s success depends to a significant degree upon the continued contributions of key management, engineering, sales and other personnel, many of whom would be difficult to replace. Brocade believes its future success will also depend, in large part, upon Brocade’s ability to attract and retain highly skilled managerial, engineering, sales and other personnel, and on the ability of management to operate effectively, both individually and as a group, in geographically disparate locations. Brocade has experienced difficulty in hiring qualified personnel in areas such as application specific integrated circuits, software, system and test, sales, marketing, service, key management and customer support. In addition, Brocade’s past reductions in force could potentially make attracting and retaining qualified employees more difficult in the future. Brocade’s ability to hire qualified personnel may also be negatively impacted by Brocade’s internal reviews and financial statement restatements in 2005, related investigations by the SEC and DOJ, and Brocade’s stock price. The loss of the services of any of Brocade’s key employees, the inability to attract or retain qualified personnel in the future, or delays in hiring required personnel, particularly engineers and sales personnel, could delay the development and introduction of, and negatively affect Brocade’s ability to sell its products.
 
In addition, companies in the computer storage and server industry whose employees accept positions with competitors may claim that their competitors have engaged in unfair hiring practices or that there will be inappropriate disclosure of confidential or proprietary information. Brocade may be subject to such claims in the future as Brocade seeks to hire additional qualified personnel. Such claims could result in material litigation. As a result, Brocade could incur substantial costs in defending against these claims, regardless of their merits, and be subject to additional restrictions if any such litigation is resolved against Brocade.
 
 
Brocade is subject to various environmental and other regulations governing product safety, materials usage, packaging and other environmental impacts in the various countries where Brocade’s products are sold. For example, many of Brocade’s products are subject to laws and regulations that restrict the use of mercury, hexavalent chromium, cadmium and other substances, and require producers of electrical and electronic equipment to assume responsibility for collecting, treating, recycling and disposing of Brocade’s products when they have reached the end of their useful life. For example, in Europe substance restrictions apply to products sold, and certain of Brocade’s OEM partners require compliance with these or more stringent requirements. In some cases Brocade redesigned Brocade’s products to comply with these substance restrictions as well as related requirements imposed by Brocade’s OEM customers. In addition, recycling, labeling, financing and related requirements apply to products Brocade sells in Europe. Brocade is also coordinating with Brocade’s suppliers to provide Brocade with compliant materials, parts and components. Despite Brocade’s efforts to ensure that Brocade’s products comply with new and emerging requirements, Brocade cannot provide absolute assurance that its products will, in all cases comply with such requirements. If Brocade’s products do not comply with the European substance restrictions or other applicable environmental laws, Brocade could become subject to fines, civil or criminal sanctions, and contract damage claims. In addition, Brocade could be prohibited from shipping non-compliant products into one or more jurisdictions, and required to recall and replace any non-compliant products already shipped, which would disrupt Brocade’s ability to ship products and result in reduced revenue, increased obsolete or excess inventories and harm to Brocade’s business and customer relationships. Brocade’s suppliers may also fail to provide it with compliant materials, parts and components despite Brocade’s requirement to them to provide compliant materials, parts and components, which could impact Brocade’s ability to timely produce compliant products and, accordingly could disrupt Brocade’s business. In addition, various other countries and states in the United States have issued, or are in the process of issuing, other environmental regulations that may impose additional restrictions or obligations and require further changes to Brocade’s products.


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In the past, unfavorable or uncertain economic conditions and reduced global information technology spending rates have adversely affected Brocade’s operating results. Brocade is unable to predict changes in general economic conditions and when information technology spending rates will be affected. If there are future reductions in either domestic or international information technology spending rates, or if information technology spending rates do not improve, Brocade’s revenues, operating results and financial condition may be adversely affected.
 
Even if information technology spending rates increase, Brocade cannot be certain that the market for storage network and data management solutions will be positively impacted. Brocade’s storage networking products are sold as part of storage systems and subsystems. As a result, the demand for Brocade’s storage networking products has historically been affected by changes in storage requirements associated with growth related to new applications and an increase in transaction levels. Although in the past Brocade has experienced historical growth in Brocade’s business as enterprise-class customers have adopted storage area network technology, demand for storage network products in the enterprise-class sector could be adversely affected if the overall economy weakens or experiences greater uncertainty, or if larger businesses were to decide to limit new equipment purchases. If information technology spending levels are restricted, and new products improve Brocade’s customers’ ability to utilize their existing storage infrastructure, the demand for storage network products may decline. If this occurs, Brocade’s business and financial results will be harmed.
 
 
As Brocade introduces new or enhanced products, Brocade must successfully manage the transition from older products to minimize disruption in customers’ ordering patterns, avoid excessive levels of older product inventories and provide sufficient supplies of new products to meet customer demands. For example, Brocade’s introduction of 4 Gigabit per second, or Gbit, technology solutions that replaced many of Brocade’s 2 Gbit products contributed to a quarterly drop in revenue in the third quarter of fiscal year 2005 and write-downs of $3.4 million and $1.8 million for excess and obsolete inventory during the third and fourth quarters of fiscal year 2005, respectively. When Brocade introduces new or enhanced products, Brocade faces numerous risks relating to product transitions, including the inability to accurately forecast demand, and manage different sales and support requirements due to the type or complexity of the new products.
 
 
Brocade is subject to rules and regulations of federal and state government as well as the stock exchange on which Brocade’s common stock is listed. These entities, including the Public Company Accounting Oversight Board, or PCAOB, the SEC, the Internal Revenue Service and Nasdaq, have issued a significant number of new and increasingly complex requirements and regulations over the course of the last several years and continue to develop additional regulations and requirements in response to laws enacted by Congress, most notably the Sarbanes-Oxley Act of 2002. Brocade’s efforts to comply with these requirements have resulted in, and are likely to continue to result in, increased expenses and a diversion of management time and attention from revenue-generating activities to compliance activities.
 
Brocade is subject to periodic audits or other reviews by such governmental agencies. For example, in November 2005, Brocade was notified by the Internal Revenue Service that Brocade’s domestic federal income tax return for the year ended October 25, 2003 was subject to audit. Additionally, in May 2006, the Franchise Tax Board notified Brocade that its California income tax returns for the years ended October 25, 2003 and October 30, 2004 are subject to audit. The SEC also periodically reviews Brocade’s public company filings. Any such examination or review frequently requires management’s time and diversion of internal resources and, in the event of an unfavorable outcome, may result in additional liabilities or adjustments to Brocade’s historical financial results.


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A portion of Brocade’s outstanding stock options are subject to variable accounting. Under variable accounting, Brocade is required to remeasure the value of the options, and the corresponding compensation expense, at the end of each reporting period until the option is exercised, cancelled or expires unexercised. As a result, the stock-based compensation expense Brocade recognizes in any given period can vary substantially due to changes in the market value of Brocade’s common stock. Volatility associated with stock price movements has resulted in compensation benefits when Brocade’s stock price has declined and compensation expense when Brocade’s stock price has increased. For example, the market value of Brocade’s common stock at the end of the third and fourth quarters of fiscal year 2005 and the first quarter of 2006 was $4.48, $3.60 and $4.62 per share, respectively. Accordingly, Brocade recorded compensation expense (benefit) in the fourth quarter of fiscal year 2005 and the first quarter of fiscal year 2006 of approximately $(0.2) million and $0.3 million, respectively. Brocade is unable to predict the future market value of Brocade’s common stock and therefore is unable to predict the compensation expense or benefit that Brocade will record in future periods.
 
 
The U.S. generally accepted accounting principles are subject to interpretation by the Financial Accounting Standards Board, or FASB, the American Institute of Certified Public Accountants, the PCAOB, the SEC, and various bodies formed to promulgate and interpret appropriate accounting principles. A change in these principles or interpretations could have a significant effect on Brocade’s reported financial results.
 
On December 15, 2004, the FASB issued SFAS 123R, Share-Based Payment, which requires Brocade to measure compensation expense for employee stock options using the fair value method beginning the first quarter of fiscal year 2006, which is the quarter ended January 28, 2006. SFAS 123R applies to all outstanding stock options that are not vested at the effective date and grants of new stock options made subsequent to the effective date. As a result of SFAS 123R, Brocade recorded higher levels of stock based compensation due to differences between the valuation methods of SFAS 123R and APB 25. In prior periods, Brocade recorded any compensation expense associated with stock option grants to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25.
 
 
A significant portion of Brocade’s sales occur in international jurisdictions and Brocade’s contract manufacturer has significant operations in China. Brocade also plans to continue to expand its international operations and sales activities. Expansion of international operations will involve inherent risks that Brocade may not be able to control, including:
 
  •  supporting multiple languages;
 
  •  recruiting sales and technical support personnel with the skills to design, manufacture, sell, and support Brocade’s products;
 
  •  increased complexity and costs of managing international operations;
 
  •  increased exposure to foreign currency exchange rate fluctuations;
 
  •  commercial laws and business practices that favor local competition;
 
  •  multiple, potentially conflicting, and changing governmental laws, regulations and practices, including differing export, import, tax, labor, anti-bribery and employment laws;
 
  •  longer sales cycles and manufacturing lead times;
 
  •  difficulties in collecting accounts receivable;
 
  •  reduced or limited protection of intellectual property rights;


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  •  managing a development team in geographically disparate locations, including China and India; and
 
  •  more complicated logistics and distribution arrangements.
 
In addition, international political instability may halt or hinder Brocade’s ability to do business and may increase Brocade’s costs. Various events, including the occurrence or threat of terrorist attacks, increased national security measures in the United States and other countries, and military action and armed conflicts, can suddenly increase international tensions. In addition, concerns about other international crises, such as the spread of severe acute respiratory syndrome, avian influenza, or bird flu, and West Nile viruses, may have an adverse effect on the world economy and could adversely affect Brocade’s business operations or the operations of Brocade’s OEM partners, contract manufacturer and suppliers.
 
To date, no material amount of Brocade’s international revenues and costs of revenues have been denominated in foreign currencies. As a result, an increase in the value of the United States dollar relative to foreign currencies could make Brocade’s products more expensive and, thus, not competitively priced in foreign markets. Additionally, a decrease in the value of the United States dollar relative to foreign currencies could increase Brocade’s operating costs in foreign locations. In the future, a larger portion of Brocade’s international revenues may be denominated in foreign currencies, which will subject Brocade to additional risks associated with fluctuations in those foreign currencies. Brocade currently does not have hedging program in place to offset its foreign currency risk.
 
 
Networking products frequently contain undetected software or hardware errors, or bugs, when first introduced or as new versions are released. Brocade’s products are becoming increasingly complex and, particularly as Brocade continues to expand Brocade’s product portfolio to include software-centric products, including software licensed from third parties, errors may be found from time to time in Brocade’s products. Some types of errors also may not be detected until the product is installed in a heavy production or user environment. In addition, Brocade’s products are often combined with other products, including software, from other vendors. As a result, when problems occur, it may be difficult to identify the source of the problem. These problems may cause Brocade to incur significant warranty and repair costs, divert the attention of engineering personnel from product development efforts and cause significant customer relations problems. Moreover, the occurrence of hardware and software errors, whether caused by another vendor’s storage network and data management products or Brocade’s, could delay market acceptance of Brocade’s new products.
 
 
Many of Brocade’s products are designed to include software or other intellectual property licensed from third parties. While it may be necessary in the future to seek or renew licenses relating to various aspects of Brocade’s products, Brocade believes that, based upon past experience and standard industry practice, such licenses generally could be obtained on commercially reasonable terms. Nonetheless, there can be no assurance that the necessary licenses would be available on acceptable terms, if at all. Brocade’s inability to obtain certain licenses or other rights on favorable terms could have a material adverse effect on Brocade’s business, operating results and financial condition. In addition, if Brocade fails to carefully manage the use of “open source” software in Brocade’s products, Brocade may be required to license key portions of Brocade’s products on a royalty free basis or expose key parts of source code.
 
 
In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. Brocade has in the past been involved in intellectual property-related disputes, including lawsuits with Vixel Corporation, Raytheon Company and McDATA, and Brocade may be involved in such disputes in the future, to protect Brocade’s intellectual property or as a result of an alleged infringement of the intellectual property


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of others. Brocade also may be subject to indemnification obligations with respect to infringement of third party intellectual property rights pursuant to Brocade’s agreements with OEM partners or customers. These claims and any resulting lawsuit could subject Brocade to significant liability for damages and invalidation of proprietary rights. Any such lawsuits, even if ultimately resolved in Brocade’s favor, would likely be time-consuming and expensive to resolve and would divert management’s time and attention. Any potential intellectual property dispute also could force Brocade to do one or more of the following:
 
  •  stop selling, incorporating or using products or services that use the challenged intellectual property;
 
  •  obtain from the owner of the infringed intellectual property a license to the relevant intellectual property, which may require Brocade to pay royalty or license fees, or to license Brocade’s intellectual property to such owner, and which may not be available on commercially reasonable terms or at all; and
 
  •  redesign those products or services that use technology that is the subject of an infringement claim.
 
If Brocade is forced to take any of the foregoing actions, Brocade’s business and results of operations could be materially harmed.
 
 
Brocade’s operations and the operations of its suppliers, contract manufacturer and customers are vulnerable to interruption by fire, earthquake, hurricanes, power loss, telecommunications failure and other events beyond Brocade’s control. For example, a substantial portion of Brocade’s facilities, including its corporate headquarters, is located near major earthquake faults. In the event of a major earthquake, Brocade could experience business interruptions, destruction of facilities and loss of life. Brocade does not carry earthquake insurance and has not set aside funds or reserves to cover such potential earthquake-related losses. In addition, Brocade’s contract manufacturer has a major facility located in an area that is subject to hurricanes. In the event that a material business interruption occurs that affects Brocade or its suppliers, contract manufacturer or customers, shipments could be delayed and Brocade’s business and financial results could be harmed.
 
 
Provisions of Brocade’s certificate of incorporation and bylaws may discourage, delay or prevent a merger or merger that a stockholder may consider favorable. These provisions include:
 
  •  authorizing the issuance of preferred stock without stockholder approval;
 
  •  providing for a classified board of directors with staggered, three-year terms;
 
  •  prohibiting cumulative voting in the election of directors;
 
  •  limiting the persons who may call special meetings of stockholders;
 
  •  prohibiting stockholder actions by written consent; and
 
  •  requiring super-majority voting to effect amendments to the foregoing provisions of Brocade’s certificate of incorporation and bylaws.
 
Certain provisions of Delaware law also may discourage, delay, or prevent someone from acquiring or merging with Brocade, and Brocade’s agreements with certain of Brocade’s customers require that Brocade give prior notice of a change of control and grant certain manufacturing rights following a change of control. Brocade’s various anti-takeover provisions could prevent or delay a change in control of Brocade, which could hinder stockholders’ ability to receive a premium for Brocade’s stock.
 
In addition, Brocade currently has in place a stockholder rights plan; however, in November 2006, Brocade’s board of directors determined to terminate the rights plan, which is expected to be done in the near future.


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Item 1B.   Unresolved Staff Comments.
 
None.
 
Item 2.   Properties
 
Brocade’s principal administrative, sales and marketing, education, customer support, and research and development facilities are located in approximately 405,000 square feet of office space in San Jose, California. Approximately 211,000 square feet of such office space is leased, and the remaining 194,000 square feet is owned by Brocade. The leases on Brocade’s leased office space will expire in August 2010. In addition to the San Jose facilities, Brocade also leases sales, marketing, and administrative office space in various locations throughout the world.
 
Item 3.   Legal Proceedings
 
From time to time, claims are made against Brocade in the ordinary course of its business, which could result in litigation. Claims and associated litigation are subject to inherent uncertainties and unfavorable outcomes could occur, such as monetary damages, fines, penalties or injunctions prohibiting Brocade from selling one or more products or engaging in other activities. The occurrence of an unfavorable outcome in any specific period could have a material adverse affect on Brocade’s results of operations for that period or future periods.
 
On July 20, 2001, the first of a number of putative class actions for violations of the federal securities laws was filed in the United States District Court for the Southern District of New York against Brocade, certain of its officers and directors, and certain of the underwriters for Brocade’s initial public offering of securities. A consolidated amended class action captioned In Re Brocade Communications Systems, Inc. Initial Public Offering Securities Litigation was filed on April 19, 2002. The complaint generally alleges that various underwriters engaged in improper and undisclosed activities related to the allocation of shares in Brocade’s initial public offering and seeks unspecified damages on behalf of a purported class of purchasers of common stock from May 24, 1999 to December 6, 2000. The lawsuit against Brocade is being coordinated for pretrial proceedings with a number of other pending litigations challenging underwriter practices in over 300 cases as In Re Initial Public Offering Securities Litigation, 21 MC 92(SAS). In October 2002, the individual defendants were dismissed without prejudice from the action, pursuant to a tolling agreement. On February 19, 2003, the Court issued an Opinion and Order dismissing all of the plaintiffs’ claims against Brocade. In June 2004, a stipulation of settlement for the claims against the issuer defendants, including Brocade, was submitted to the Court for approval. On August 31, 2005, the Court granted preliminary approval of the settlement. On April 24, 2006 the Court held a fairness hearing in connection with the motion for final approval of the settlement. The Court has yet to issue a ruling on the motion for final approval. The settlement remains subject to a number of conditions, including final approval by the Court. On December 5, 2006, the Court of Appeals for the Second Circuit reversed the court’s October 2004 order certifying a class in six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceeding. Brocade is not one of the test cases and it is unclear what impact this will have on the class certified in Brocade’s case.
 
On May 16, 2005, Brocade announced that the SEC and the Department of Justice, or the DOJ, are conducting an investigation regarding Brocade’s historical stock option granting processes. Brocade has been cooperating with the SEC and DOJ. During the first quarter of fiscal year 2006, Brocade began active settlement discussions with the Staff of the SEC’s Division of Enforcement, or the Staff, regarding its financial restatements related to stock option accounting. As a result of these discussions, for the three months ended January 28, 2006, Brocade recorded $7.0 million provision for an estimated settlement expense. The $7.0 million estimated settlement expense is based on an offer of settlement that Brocade made to the Staff and for which the Staff has noted it intends on recommending to the SEC’s Commissioners. The offer of settlement is contingent upon final approval by the SEC’s Commissioners.
 
Beginning on or about May 19, 2005, several securities class action complaints were filed against Brocade and certain of its current and former officers. These actions were filed in the United States District Court for the Northern District of California on behalf of purchasers of Brocade’s stock from February 2001 to May 2005. These lawsuits followed Brocade’s restatement of certain financial results due to stock-based compensation accounting issues. On January 12, 2006, the Court appointed a lead plaintiff and lead counsel. On April 14, 2006, the lead


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plaintiff filed a consolidated complaint on behalf of purchasers of Brocade’s stock from May 2000 to May 2005. The consolidated complaint alleges, among other things, violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The consolidated complaint generally alleges that Brocade and the individual defendants made false or misleading public statements regarding Brocade’s business and operations and seeks unspecified monetary damages and other relief against the defendants. These lawsuits followed Brocade’s restatement of certain financial results due to stock-based compensation accounting issues.
 
Beginning on or about May 24, 2005, several derivative actions were also filed against certain of Brocade’s current and former directors and officers. These actions were filed in the United States District Court for the Northern District of California and in the California Superior Court in Santa Clara County. The complaints allege that certain of Brocade’s officers and directors breached their fiduciary duties to Brocade by engaging in alleged wrongful conduct including conduct complained of in the securities litigation described above. Brocade is named solely as a nominal defendant against whom the plaintiffs seek no recovery. The derivative actions pending in the District Court for the Northern District of California were consolidated and the Court created a Lead Counsel structure. The derivative plaintiffs filed a consolidated complaint in the District Court for the Northern District of California on October 7, 2005, and Brocade filed a motion to dismiss that action on October 27, 2005. On January 6, 2006, Brocade’s motion was granted and the consolidated complaint in the District Court for the Northern District of California was dismissed with leave to amend. The parties to this action subsequently reached a preliminary settlement, which remains subject to approval by the Court.
 
The derivative actions pending in the Superior Court in Santa Clara County were consolidated. The derivative plaintiffs filed a consolidated complaint in the Superior Court in Santa Clara County on September 19, 2005. Brocade filed a motion to stay that action in deference to the substantially identical consolidated derivative action pending in the District Court for the Northern District of California, and on November 15, 2005, the Court stayed the action. In October 2006, the Court partially lifted the stay and granted plaintiffs leave to file an amended complaint. On November 13, 2006, plaintiffs filed an amended complaint.
 
No amounts have been recorded in Brocade’s Consolidated Financial Statements associated with these matters as the amounts are not probable or estimable other than the $7.0 million provision for an estimated settlement expense with the SEC as noted above.
 
Item 4.   Submission of Matters to a Vote of Security Holders
 
None.
 
 
Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities
 
Our common stock has been quoted on the Nasdaq Global Select Market under the symbol “BRCD” since our initial public offering on May 24, 1999. Prior to this time, there was no public market for the stock. See “Item 6 — Selected Financial Data” for the high and low sales prices per share of our common stock as reported on the Nasdaq Global Select Market, for the periods indicated.
 
According to records of our transfer agent, we had 621 stockholders of record at December 12, 2006 and we believe there are a substantially greater number of beneficial holders. We did not pay dividends in fiscal year 2005 or fiscal year 2006. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. See Note 11, “Stockholders’ Equity,” of the Notes to Consolidated Financial Statements for equity compensation plan information.


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The following table summarizes stock repurchase activity for the three months ended October 28, 2006 (in thousands, except per share amounts):
 
                                 
                Total Number of
    Approximate Dollar
 
                Shares Purchased
    Value of Shares that
 
    Total Number
          as Part of Publicly
    May Yet be
 
    of Shares
    Average Price
    Announced
    Purchased Under
 
    Purchased(1)     Paid per Share     Program     the Program(2)  
 
July 30, 2006 —
August 26, 2006
                    $ 52,743  
August 27, 2006 — September 23, 2006
    1       6.00           $ 52,737  
September 24, 2006 — October 28, 2006
                    $ 52,737  
                                 
Total
    1       6.00           $ 52,737  
                                 
 
 
(1) The total number of shares repurchased includes those shares of Brocade common stock that employees surrender for tax withholding purposes in connection with vesting of restricted stock. As of October 28, 2006, approximately 1.9 million shares are subject to repurchase by Brocade.
 
(2) In August 2004, our board of directors approved a share repurchase program for up to $100.0 million of our common stock. The purchases may be made, from time to time, in the open market and will be funded from available working capital. The number of shares to be purchased and the timing of purchases will be based on the level of our cash balances, general business and market conditions, and other factors, including alternative investment opportunities. As of October 28, 2006, we have purchased 7.9 million shares at an average price of $5.93 per share, and under this program $52.7 million remains available for future repurchases.


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Item 6.   Selected Financial Data
 
The following selected financial data should be read in conjunction with our consolidated financial statements and related notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and other financial information appearing elsewhere in this Annual Report on Form 10-K.
 
The consolidated statement of operations data set forth below for each of the years in the three-year period ended October 28, 2006, the consolidated balance sheet data as of October 28, 2006 and October 29, 2005, are derived from, and qualified by reference to, the audited financial statements appearing elsewhere in this Annual Report on Form 10-K. The consolidated balance sheet data as of October 30, 2004 is derived from audited financial statements not included herein. The consolidated statement of operations data for the years ended October 25, 2003, and October 26, 2002, and the balance sheet data as of October 25, 2003 and October 26, 2002, are derived from unaudited financial statements not included herein.
 
                                         
    Fiscal Year Ended  
    October 28,
    October 29,
    October 30,
    October 25,
    October 26,
 
    2006(1)     2005(2)     2004(3)     2003(4)     2002  
    (In thousands, except per share amounts)  
 
Statement of Operations Data:
                                       
Net revenues
  $ 750,592     $ 574,120     $ 596,265     $ 525,277     $ 562,369  
Cost of revenues
    305,184       251,161       268,974       241,163       226,933  
                                         
Gross margin
    445,408       322,959       327,291       284,114       335,436  
                                         
Operating expenses (benefits):
                                       
Research and development
    164,843       132,448       142,535       146,545       126,027  
Sales and marketing
    139,434       101,202       102,445       115,075       108,784  
General and administrative
    31,089       25,189       24,593       21,306       7,583  
Legal fees associated with indemnification obligations, SEC investigation and other related costs
    13,654       14,027                    
Provision for SEC settlement
    7,000                          
Amortization of intangible assets
    2,294                          
Acquisition and integration costs
    9,646                          
Restructuring and facilities lease losses, net
    3,775       (670 )     84,557       20,828        
Settlement of an acquisition-related claim
                6,943              
In-process research and development
          7,784             134,898        
                                         
Total operating expenses
    371,735       279,980       361,073       438,652       242,394  
                                         
Income (loss) from operations
    73,673       42,979       (33,782 )     (154,538 )     93,042  
Interest and other income, net
    29,098       22,656       18,786       18,424       22,668  
Interest expense
    (7,082 )     (7,693 )     (10,677 )     (13,339 )     (11,427 )
Gain on repurchases of convertible subordinated debt
          2,318       5,613       11,118        
Gain (loss) on investments, net
    2,663       (5,062 )     436       3,638       7,095  
                                         
Income (loss) before provision for income taxes
    98,352       55,198       (19,624 )     (134,697 )     111,378  
Income tax provision
    30,723       12,077       14,070       11,852       5,343  
                                         
Net income (loss)
  $ 67,629     $ 43,121     $ (33,694 )   $ (146,549 )   $ 106,035  
                                         
Net income (loss) per share — basic
  $ 0.25     $ 0.16     $ (0.13 )   $ (0.58 )   $ 0.46  
                                         
Net income (loss) per share — diluted
  $ 0.25     $ 0.16     $ (0.13 )   $ (0.58 )   $ 0.44  
                                         
Shares used in per share calculation — basic
    269,602       268,176       260,446       250,610       231,591  
                                         
Shares used in per share calculation — diluted
    274,142       270,260       260,446       250,610       240,761  
                                         
Balance Sheet Data:
                                       
Cash, cash equivalents, investments and restricted short-term investments
  $ 582,554     $ 764,402     $ 736,908     $ 835,565     $ 888,388  
Working capital(5)
    428,233       317,819       434,162       355,634       534,777  
Total assets
    900,718       981,730       987,382       1,063,174       1,171,367  
Non-current liabilities associated with lease losses
    11,105       12,481       16,799       16,518       22,602  
Convertible subordinated debt and capital lease obligations
          278,883       352,279       442,950       550,000  
Total stockholders’ equity
    616,230       508,847       445,652       447,868       446,255  


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Note: We report our fiscal year on a 52/53-week period ending on the last Saturday in October of each year. Accordingly, the fiscal year ends for fiscal years 2006, 2005, and 2004, were October 28, 29, and 30, respectively. As is customary for companies that use the 52/53-week convention, every 5th year contains a 53-week fiscal year. As a result, our fiscal year 2004 was a 53-week fiscal year. Also as a result, our second quarter of fiscal year 2004 included one extra week and was 14 weeks in length. Fiscal years 2006, 2005, 2003 and 2002 were 52-week fiscal years.
 
 
(1) The fiscal year ended October 28, 2006 includes the impact of the acquisition of NuView, which was completed in the second quarter of fiscal year 2006 (see Note 3, “Acquisitions,” of the Notes to Consolidated Financial Statements). In addition, in the fiscal year ended October 28, 2006 we recorded a $2.7 million gain on investments on the disposition of portfolio investments primarily associated with non-marketable private strategic investments (see Note 16, “Gain on Investment, net,” of the Notes to Consolidated Financial Statements). The fiscal year ended October 28, 2006 also includes legal fees associated with applicable indemnification obligations, SEC investigation and other related costs of $13.7 million. Further, during the first fiscal quarter we began active settlement discussions with the SEC’s Division of Enforcement regarding our financial restatements related to stock option accounting. As a result of these discussions, we recorded a provision of $7.0 million for an estimated settlement expense (see Note 10 “Commitments and Contingencies”, of the Notes to Consolidated Financial Statements). During the second fiscal quarter, we recorded a charge of $3.8 million related to estimated facilities lease losses, net of expected sublease income (see Note 6, “Liabilities Associated with Facilities Lease Losses,” of the Notes to Consolidated Financial Statements). Moreover, during the fourth quarter, and related to prior acquisitions and the potential acquisition of McDATA, we recorded acquisition and integration costs for a total of $9.6 million (see Note 10 “Commitments and Contingencies”, of the Notes to the Consolidated Financial Statements).
 
(2) The fiscal year ended October 29, 2005 includes the impact of the acquisition of Therion, which was completed in the third quarter of fiscal year 2005. In connection with our acquisition of Therion, we recorded in-process research and development expense of $7.8 million (see Note 3, “Acquisitions,” of the Notes to Consolidated Financial Statements). The fiscal year ended October 29, 2005 also includes Audit Committee internal review and SEC investigation costs of $14.0 million. In January 2005 we announced that our Audit Committee completed an internal review regarding historical stock option granting practices. Following the January 2005 Audit Committee internal review, on May 16, 2005, we announced that additional information came to our attention that indicated that certain guidelines regarding stock option granting practices were not followed and our Audit Committee had commenced an internal review of our stock option accounting focusing on leaves of absence and transition and advisory roles. Our Audit Committee review was completed in November 2005. In addition, in the fiscal year ended October 29, 2005 we recorded a $5.1 million net loss on investments on the disposition of portfolio investments primarily associated with the defeasance of the indenture agreement relating to our 2% Convertible Notes (see Note 9, “Convertible Subordinated Debt,” of the Notes to Consolidated Financial Statements) and recorded a total of $2.3 million gain on repurchases of convertible subordinated debt.
 
(3) The fiscal year ended October 30, 2004 includes the impact of restructuring costs of $9.0 million related to a restructuring plan implemented during the three months ended May 1, 2004 (see Note 5, “Restructuring Costs,” of the Notes to Consolidated Financial Statements). The fiscal year ended October 30, 2004 also includes a net lease termination charge and other of $75.6 million. During the three months ended January 24, 2004, we purchased a previously leased building located near our San Jose headquarters for $106.8 million in cash. The $106.8 million consisted of $30.0 million for the purchase of land and a building and $76.8 million for a lease termination fee (see Note 6, “Liabilities Associated with Facilities Lease Losses,” of the Notes to Consolidated Financial Statements). In addition, in the fiscal year ended October 30, 2004 we recorded a $6.9 million charge in settlement of a claim relating to our acquisition of Rhapsody and recorded a total of $5.6 million gain on repurchases of convertible subordinated debt.
 
(4) The fiscal year ended October 25, 2003 includes the impact of our acquisition of Rhapsody, which was completed in the second quarter of fiscal year 2003. In connection with our acquisition of Rhapsody, we recorded in-process research and development expense of $134.9 million. The fiscal year ended October 25, 2003 also includes restructuring costs of $20.8 million (see Note 5, “Restructuring Costs,” of the Notes to


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Consolidated Financial Statements), gain on repurchases of convertible subordinated debt of $11.1 million, and net gains on the disposition of non-marketable private strategic investments of $3.6 million.
 
(5) The calculation of working capital for the fiscal year ended October 30, 2005 also includes the balance of convertible subordinated debt of $278.9 million.
 
                                 
    First
    Second
    Third
    Fourth
 
    Quarter     Quarter     Quarter     Quarter  
    (In thousands, except per share and stock price amounts)  
 
Quarterly Data:                                
Fiscal Year Ended October 28, 2006                                
Net revenues   $ 170,082     $ 182,742     $ 188,947     $ 208,821  
Gross margin   $ 100,701     $ 105,144     $ 111,914     $ 127,649  
Income from operations   $ 12,261     $ 15,357     $ 21,575     $ 24,480  
Net income   $ 9,660     $ 13,513     $ 24,498     $ 19,958  
Per share amounts:                                
Basic
  $ 0.04     $ 0.05     $ 0.09     $ 0.07  
Diluted
  $ 0.04     $ 0.05     $ 0.09     $ 0.07  
Shares used in computing per share amounts:                                
Basic
    269,400       270,564       269,417       269,027  
Diluted
    272,101       274,393       273,959       276,113  
Closing prices:                                
High
  $ 4.63     $ 6.97     $ 6.69     $ 8.92  
Low
  $ 3.44     $ 4.56     $ 5.52     $ 5.01  
Fiscal Year Ended October 29, 2005                                
Net revenues   $ 161,578     $ 144,753     $ 122,273     $ 145,516  
Gross margin   $ 97,172     $ 82,834     $ 62,386     $ 80,567  
Income (loss) from operations   $ 30,162     $ 19,448     $ (14,311 )   $ 7,680  
Net income (loss)   $ 27,943     $ 21,357     $ (7,235 )   $ 1,056  
Per share amounts:                                
Basic
  $ 0.10     $ 0.08     $ (0.03 )   $ 0.00  
Diluted
  $ 0.10     $ 0.08     $ (0.03 )   $ 0.00  
Shares used in computing per share amounts:                                
Basic
    266,218       268,043       268,765       269,679  
Diluted
    271,422       269,823       268,765       270,311  
Closing prices:                                
High
  $ 7.99     $ 6.42     $ 4.49     $ 4.49  
Low
  $ 5.83     $ 4.35     $ 3.88     $ 3.51  


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    First
    Second
    Third
    Fourth
 
    Quarter     Quarter     Quarter     Quarter  
    (In thousands, except per share and stock price amounts)  
 
Fiscal Year Ended October 30, 2004
                               
Net revenues
  $ 145,040     $ 145,579     $ 150,040     $ 155,606  
Gross margin
  $ 77,404     $ 78,793     $ 84,213     $ 86,881  
Income (loss) from operations
  $ (68,154 )   $ (6,214 )   $ 18,635     $ 21,951  
Net income (loss)
  $ (69,485 )   $ 1,883     $ 13,620     $ 20,288  
Per share amounts:
                               
Basic
  $ (0.27 )   $ 0.01     $ 0.05     $ 0.08  
Diluted
  $ (0.27 )   $ 0.01     $ 0.05     $ 0.08  
Shares used in computing per share amounts:
                               
Basic
    257,796       259,265       261,481       263,242  
Diluted
    257,796       263,373       263,541       265,194  
Closing prices:
                               
High
  $ 7.95     $ 7.44     $ 6.14     $ 6.80  
Low
  $ 5.49     $ 5.35     $ 4.41     $ 4.04  

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Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Results of Operations
 
We report our fiscal year on a 52/53-week period ending on the last Saturday in October of each year. Accordingly, the fiscal year ends for fiscal years 2006, 2005, and 2004 were October 28, 29, and 30, respectively. As is customary for companies that use the 52/53-week convention, every 5th year contains a 53-week fiscal year. As a result, our fiscal year 2004 was a 53-week fiscal year. Also as a result, our second quarter of fiscal year 2004 included one extra week and was 14 weeks in length. Fiscal years 2006 and 2005, were 52-week fiscal years. The following table sets forth certain financial data for the periods indicated as a percentage of total net revenues:
 
                         
    Fiscal Years Ended  
    October 28,
    October 29,
    October 30,
 
    2006     2005     2004  
 
Net revenues
    100.0 %     100.0 %     100.0 %
Cost of revenues
    40.7       43.7       45.1  
                         
Gross margin
    59.3       56.3       54.9  
                         
Operating expenses:
                       
Research and development
    22.0       23.1       23.9  
Sales and marketing
    18.6       17.6       17.2  
General and administrative
    4.1       4.4       4.1  
Legal fees associated with indemnification obligations, SEC investigation and other related costs
    1.8       2.4        
Provision for SEC settlement
    0.9                  
Amortization of intangible assets
    0.3              
Acquisition and integration costs
    1.3              
Restructuring and facilities lease losses, net
    0.5       (0.1 )     14.2  
Settlement of an acquisition-related claim
                1.2  
In-process research and development
          1.4        
Total operating expenses
    49.5       48.8       60.6  
                         
Income (loss) from operations
    9.8       7.5       (5.7 )
Interest and other income, net
    3.9       3.9       3.2  
Interest expense
    (0.9 )     (1.3 )     (1.8 )
Gain on repurchases of convertible subordinated debt
    0.0       0.4       0.9  
Gain (loss) on investments, net
    0.4       (0.9 )     0.1  
                         
Income (loss) before provision for income taxes
    13.1       9.6       (3.3 )
Income tax provision
    4.1       2.1       2.4  
                         
Net income (loss)
    9.0 %     7.5 %     (5.7 )%
                         
 
Revenues.  Our revenues are derived primarily from sales of our family of SAN products. Our fabric switches and directors, which range in size from 8 ports to 384 ports, connect servers and storage devices creating a SAN.
 
From a geographical perspective, our total net revenues for the year ended October 28, 2006 and October 29, 2005 were as follows (in thousands):
 
                                                 
    Year Ended     Increase/
    %
 
    October 28, 2006     October 29, 2005     (Decrease)     Change  
 
Domestic
  $ 478,138       64 %   $ 363,761       63 %   $ 114,377       31 %
International
    272,454       36 %     210,359       37 %     62,095       30 %
                                                 
Total Net Revenue
  $ 750,592       100 %   $ 574,120       100 %   $ 176,472       31 %


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In addition, from a geographical perspective, net revenues for the year ended October 29, 2005 and October 30, 2004 were as follows (in thousands):
 
                                                 
    Year Ended     Increase/
    %
 
    October 29, 2005     October 30, 2004     (Decrease)     Change  
 
Domestic   $ 363,761       63 %   $ 384,650       65 %   $ (20,889 )     (5 )%
International     210,359       37 %     211,615       35 %     (1,256 )     (1 )%
                                                 
Total Net Revenue   $ 574,120       100 %   $ 596,265       100 %   $ (22,145 )     (4 )%
 
For the year ended October 28, 2006, the increase in net revenues reflected a 47 percent increase in the number of ports shipped partially offset by a 12 percent decline in average selling price per port. For the year ended October 29, 2005, the decrease in net revenues reflected a 21 percent decline in average selling price per port, partially offset by an 11 percent increase in the number of ports shipped. For the year ended October 30, 2004, the increase in net revenues reflected a 42 percent increase in the number of ports shipped, partially offset by a 22 percent decline in average selling price per port. The declines in average selling prices for the year ended October 30, 2004 are the result of a more competitive pricing environment. We believe the increase in the number of ports shipped reflects higher demand for our products as end-users continue to consolidate storage and servers infrastructures using SANs, expand SANs to support more applications, and deploy SANs in new environments.
 
We expect the number of ports shipped to fluctuate depending on the demand for our existing and recently introduced products as well as the timing of product transitions by our OEM customers. We also expect that average selling price per port will likely decline at rates higher than we experienced in the year ended October 28, 2006, primarily due to accelerated pricing pressures, or new product introductions by us or our competitors.
 
Historically, domestic revenues have been between 60 percent and 75 percent of total revenues. Revenues are attributed to geographic areas based on the location of the customer to which our products are shipped. International revenues primarily consist of sales to customers in Western Europe and the greater Asia Pacific region. For the year ended October 28, 2006, international revenues have increased primarily as a result of faster growth in Europe relative to North America and Asia Pacific region. For the years ended October 29, 2005 and October 30, 2004, international revenues decreased as a result of faster growth in the North America region. However, certain OEM customers take possession of our products domestically and then distribute these products to their international customers. Because we account for all of those OEM revenues as domestic revenues, we cannot be certain of the extent to which our domestic and international revenue mix is impacted by the practices of our OEM customers.
 
A significant portion of our revenue is concentrated among a small number of OEM customers. For the year ended October 28, 2006, three customers, EMC, HP and IBM, each represented greater than ten percent or more of our total revenues and together represented a total of 73 percent of our total revenues. For the years ended October 29, 2005 and October 30, 2004, the same three customers each represented greater than ten percent of our total revenues for combined totals of 71 percent and 70 percent of our total revenues, respectively. We expect that a significant portion of our future revenues will continue to come from sales of products to a small number of OEM customers. Therefore, the loss of, or a decrease in the level of sales to, or a change in the ordering pattern of, any one of these customers could seriously harm our financial condition and results of operations.
 
Cost of Goods Sold Cost of goods sold consists of product costs, which are variable, and manufacturing operations costs, which are generally fixed.
 
Costs of goods sold for the years ended October 28, 2006 and October 29, 2005 was as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$ 305,184       41%     $ 251,161       44%       22%  
 
In addition, cost of goods sold for the years ended October 29, 2005 and October 30, 2004 was as follows (in thousands):
 
                                     
October 29,
    % of Net
    October 30,
    % of Net
       
2005
    Revenue     2004     Revenue     % Change  
 
$ 251,161       44%     $ 268,974       45%       (7 )%


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For the year ended October 28, 2006, product costs relative to revenue decreased by 4.0 percent as compared to the year ended October 29, 2005, due to the transition from 2 Gbit products to new 4 Gbit products and relatively stable pricing, more efficient production with higher volumes, and a favorable mix of products shipped. Manufacturing operation costs and service operation costs decreased by 0.4 percent relative to net revenues primarily due to the increase in revenue partially offset by an increase in headcount and higher sustaining engineering charges, as products transitioned into sustaining engineering from development. In addition, stock-based compensation expense for the year ended October 28, 2006 increased by 1.2 percent relative to net revenues primarily as a result of our adoption of SFAS 123R. For the year ended October 29, 2005, product costs relative to net revenues decreased by 0.7 percent as compared to the year ended October 30, 2004 due to decreases in component and manufacturing operations costs. Manufacturing operations costs relative to net revenues decreased by 0.5 percent principally due to increases in number of ports shipped. In addition, gross margin relative to net revenues for the year ended October 29, 2005, increased by 0.2 percent due to higher stock compensation expense in the year ended October 30, 2004 primarily as a result of changes in the market value of our common stock.
 
Gross margin is primarily affected by average selling price per port, number of ports shipped, and cost of goods sold. Over the last fiscal year, declines in average selling price per port have been lower than in the immediately preceding fiscal year, primarily due to our 4 Gbit product cycle and a more favorable market environment than is typically the case. Going forward, we expect that the decline in average selling price per port for our products to decline at the rates we experienced in fiscal year 2005, unless they are further affected by a stronger or weaker than anticipated competitive environment, new product introductions by us or our competitors, or other factors that may be beyond our control. We believe that we have the ability to partially mitigate the effect of declines in average selling price per port on gross margins through our product and manufacturing operations cost reductions. However, the average selling price per port could decline at a faster pace than we anticipate. In addition, manufacturing operation costs could be negatively affected by variable stock-based compensation. If this dynamic occurs, we may not be able to reduce our costs fast enough to prevent a decline in our gross margins. In addition, we must also maintain or increase current volume of ports shipped to maintain our current gross margins. If we are unable to offset future reductions of average selling price per port with reductions in product and manufacturing operations costs, or if as a result of future reductions in average selling price per port our revenues do not grow, our gross margins would be negatively affected.
 
We recently introduced several new products and expect to introduce additional new products in the future. As new or enhanced products are introduced, we must successfully manage the transition from older products in order to minimize disruption in customers’ ordering patterns, avoid excessive levels of older product inventories, and provide sufficient supplies of new products to meet customer demands. Our gross margins may be adversely affected if we fail to successfully manage the introductions of these new products.
 
Research and development expenses.  Research and development (“R&D”) expenses consist primarily of salaries and related expenses for personnel engaged in engineering and R&D activities; fees paid to consultants and outside service providers; nonrecurring engineering charges; prototyping expenses related to the design, development, testing and enhancement of our products; depreciation related to engineering and test equipment, amortization of deferred stock compensation; and IT and facilities expenses.
 
Research and development expenses for the years ended October 28, 2006 and October 29, 2005 were as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$ 164,843       22%     $ 132,448       23%       24%  
 
In addition, research and development expenses for the years ended October 29, 2005 and October 30, 2004 were as follows (in thousands):
 
                                     
October 29,
    % of Net
    October 30,
    % of Net
       
2005
    Revenue     2004     Revenue     % Change  
 
$ 132,448       23%     $ 142,535       24%       (7 )%


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For the year ended October 28, 2006, R&D expenses increased by $32.4 million, or twenty four percent, to $164.8 million, compared with $132.4 million for the year ended October 29, 2005. This increase is primarily due to a $23.1 million increase in salaries and headcount-related expenses resulting from continuing investment in our line of File Services products and from the acquisitions of NuView, as well as $12.2 million increase in stock-based compensation expense primarily attributable to our adoption of SFAS 123R.
 
For the year ended October 29, 2005, R&D expenses decreased by $10.1 million, or seven percent, to $132.4 million, compared with $142.5 million for the year ended October 30, 2004. This decrease is primarily due to a $14.0 million decrease in salaries and head count related expenses as a result of the restructuring programs we implemented in the second quarter of fiscal year 2004, partially offset by a $6.4 million increase in outside service providers due to continued investment in offshore research and development. In addition, R&D expenses decreased by $2.6 million due to lower stock compensation expense in the year ended October 29, 2005 primarily as a result of changes in the market value of our common stock. Further, the decrease in R&D expenses reflects the effect of the extra week in the second quarter of fiscal year 2004.
 
Excluding any stock-based compensation expenses related to stock awards remeasured at their intrinsic value, which will vary depending on the changes in the market value of our common stock, we currently anticipate that R&D expenses in fiscal year 2007 will increase in absolute dollars as a result of increased headcount.
 
Sales and marketing expenses.  Sales and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged in marketing and sales; costs associated with promotional and travel expenses; and IT and facilities expenses.
 
Sales and marketing expenses for the years ended October 28, 2006 and October 29, 2005 were as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$ 139,434       19%     $ 101,202       18%       38%  
 
In addition, sales and marketing expenses for the years ended October 29, 2005 and October 30, 2004 were as follows (in thousands):
 
                                     
October 29,
    % of Net
    October 30,
    % of Net
       
2005
    Revenue     2004     Revenue     % Change  
 
$ 101,202       18%     $ 102,445       17%       (1 )%
 
For the year ended October 28, 2006, sales and marketing expenses increased by $38.2 million, or thirty eight percent, to $139.4 million, compared with $101.2 million for the year ended October 29, 2005. This increase is primarily due to a $18.8 million increase in salaries and headcount-related expenses, including higher commission expenses due to higher revenues, a $7.7 million increase in sales and marketing program expenses primarily related to our line of File Services products, and a $7.2 million increase in stock based compensation expense primarily attributable to our adoption of SFAS 123R.
 
For the year ended October 29, 2005, sales and marketing expenses decreased by $1.2 million, or one percent, to $101.2 million, compared with $102.4 million for the year ended October 30, 2004. This decrease is primarily due to a $3.5 million decrease in salaries and head count related expenses, including lower commissions expenses due to lower revenues, and a $1.7 million decrease in stock compensation expense primarily due to compensation for certain employees on leaves of absences and in transition or advisory roles in the year ended October 30, 2004, partially offset by a $3.1 million increase in sales and marketing program expenses. In addition, the decrease in sales and marketing expenses reflects the effect of the extra week in the second quarter of fiscal year 2004.
 
Excluding any stock-based compensation expenses related to stock awards remeasured at their intrinsic value, which will vary depending on the changes in the market value of our common stock, we currently anticipate that sales and marketing expenses in fiscal year 2007 will increase in absolute dollars as a result of increased headcount.
 
General and administrative expenses.  General and administrative (“G&A”) expenses consist primarily of salaries and related expenses for corporate executives, finance, human resources and investor relations, as well as


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recruiting expenses, professional fees, corporate legal expenses, other corporate expenses, and IT and facilities expenses.
 
General and administrative expenses for the years ended October 28, 2006 and October 29, 2005 were as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$ 31,089       4%     $ 25,189       4%       23%  
 
In addition, general and administrative expenses for the years ended October 29, 2005 and October 30, 2004 were as follows (in thousands):
 
                                     
October 29,
    % of Net
    October 30,
    % of Net
       
2005
    Revenue     2004     Revenue     % Change  
 
$ 25,189       4%     $ 24,593       4%       2%  
 
G&A expenses for the year ended October 28, 2006 increased by $5.9 million, or twenty three percent, to $31.1 million compared with $25.2 million for the year ended October 29, 2005. The increase in G&A for fiscal year 2006 is primarily due to a $3.6 million increase in stock-based compensation primarily attributable to our adoption of SFAS 123R and $3.2 million increase in salaries and headcount-related expenses to support ongoing initiatives.
 
For the year ended October 29, 2005, G&A expenses increased by $0.6 million, or two percent, to $25.2 million, compared with $24.6 million for the year ended October 30, 2004. The increase in G&A for fiscal year 2005 is primarily due to a $1.5 million increase in professional service fees, partially offset by a $0.6 million decrease in stock compensation expense primarily as a result of changes in the market value of our common stock.
 
Excluding any stock-based compensation expenses related to stock awards remeasured at their intrinsic value, which will vary depending on the changes in the market value of our common stock, we currently anticipate that G&A expenses in fiscal year 2007 to increase in absolute dollars.
 
Legal fees associated with indemnification obligations, SEC investigation and other related costs.  These expenses consist of professional legal and accounting service fees for various matters, including applicable indemnification obligations, the completed internal reviews and the ongoing SEC and Department of Justice (“DOJ”) joint investigations.
 
Legal fees associated with applicable indemnification obligations, SEC investigation and other related costs for the years ended October 28, 2006 and October 29, 2005 were as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$ 13,654       2%     $ 14,027       2%       (3 )%
 
In addition, legal fees associated with indemnification obligations, SEC investigation and other related costs for the years ended October 29, 2005 and October 30, 2004 were as follows (in thousands):
 
                                     
October 29,
    % of Net
    October 30,
    % of Net
       
2005
    Revenue     2004     Revenue     % Change  
 
$ 14,027       2%     $       —%       100%  
 
On January 24, 2005, we announced that our Audit Committee completed an internal review regarding historical stock option granting practices. Following the January 2005 Audit Committee internal review, on May 16, 2005, we announced that additional information had come to our attention that indicated that certain guidelines regarding stock option granting practices were not followed and our Audit Committee had commenced an internal review of our stock option accounting focusing on leaves of absence and transition and advisory roles. This Audit Committee review was completed in November 2005. We are currently undergoing an SEC and DOJ joint investigation regarding our historical stock option granting practices.
 
We did not incur any internal review or SEC investigation costs during the year ended October 30, 2004.


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Provision for SEC settlement for the years ended October 28, 2006 and October 29, 2005 was as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$ 7,000       1%     $       —%       100%  
 
During the first quarter of fiscal year 2006, we began active settlement discussions with the Staff of the SEC’s Division of Enforcement (the “Staff”) regarding our financial restatements related to stock option accounting. As a result of these discussions, for the fiscal years ended October 28, 2006 and October 29, 2005, we recorded a $7.0 million and $0.0 million provision, respectively, for an estimated settlement expense. The $7.0 million estimated settlement expense is based on an offer of settlement that the Company made to the Staff and for which the Staff has stated that it intends to recommend to the SEC’s Commissioners. The offer of settlement is contingent upon final approval by the SEC’s Commissioners. No other provision amounts have been recorded in the Consolidated Financial Statements for the periods presented as the amounts are not estimable.
 
 
Stock compensation expense for the years ended October 28, 2006 and October 29, 2005 was as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$ 31,407       4%     $ (616 )     (0.1 )%     5199%  
 
In addition, stock compensation expense for the years ended October 29, 2005 and October 30, 2004 was as follows (in thousands):
 
                                     
October 29,
    % of Net
    October 30,
    % of Net
       
2005
    Revenue     2004     Revenue     % Change  
 
$ (616 )     (0.1 )%   $ 5,007       0.8%       (112 )%
 
Total stock-based compensation expense for the year ended October 28, 2006 was $31.4 million. Of this amount, $8.6 million was included in cost of sales, $11.9 million in research and development, $7.4 million in sales and marketing, and $3.5 million in general and administrative expenses. Total stock-based compensation expense (benefit), net of tax, for the year ended October 29, 2005 was $(0.6) million. Of this amount, $(0.4) million was included in cost of sales, $(0.3) million in research and development, $0.2 million in sales and marketing and $(0.1) million in general and administrative. Total stock-based compensation expense (benefit) for the year ended October 29, 2005 excludes certain stock-based awards which were previously reported as pro forma compensation expense under APB 25 (see Note 2, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements).
 
Effective October 30, 2005, we began recording compensation expense associated with stock-based awards and other forms of equity compensation in accordance with SFAS 123R. Under the fair value recognition provisions of SFAS 123R, stock-based compensation expense is measured at the grant date based on the fair value of the award and is recognized as expense over the vesting period. Determining the fair value of stock-based awards and other forms of equity compensation at the grant date requires judgment, including estimating our stock price volatility and employee stock option exercise behaviors. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially impacted. For the year ended October 28, 2006, stock-based compensation expense for stock options and employee stock purchases of $15.4 million and $4.4 million, respectively, is included in cost of sales, research and development, sales and marketing, or general and administrative expenses, by employee.
 
We also have stock-based compensation arising from stock option grants that are remeasured at their intrinsic value and subject to changes in measurement date and restricted stock awards. For the year ended October 28, 2006, total compensation expense of $3.9 million resulting from stock option grants remeasured at their intrinsic value was included in cost of sales, research and development, sales and marketing, or general and administrative


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expenses and $3.9 million resulting from restricted stock awards issued during the fiscal year. For the year ended October 29, 2005, there was no compensation expense resulting from stock option grants remeasured at their intrinsic value and subject to change in measurement date. Accordingly, amortization of stock-based compensation does not include the compensation expense arising from these awards. The stock-based compensation expense associated with remeasuring awards at their intrinsic value each reporting period will vary significantly as a result of future changes in the market value of our common stock. The change in stock-based compensation related to awards remeasured at their intrinsic value during the year ended October 28, 2006, as compared to the year ended October 29, 2005, is due to a change in market values of our common stock during the reported periods.
 
In addition to the stock-based compensation expense recorded for stock-based awards, for the year ended October 28, 2006 and October 29, 2005, we recorded $1.8 million and $0.5 million, respectively, in acquisition-related amortization of stock compensation. The amortized stock-based compensation expense represents the fair value of unvested restricted common stock and assumed stock options, and is being amortized over the respective remaining service periods on a straight-line basis. As of October 28, 2006, the remaining unamortized balance of acquisition-related stock compensation was approximately $0.7 million.
 
Further, on June 12, 2006, the Company completed a tender offer that allowed employees to amend or cancel certain options to remedy potential adverse personal tax consequences. As a result, the Company amended certain options granted after August 14, 2003 that were or may have been granted at a discount and were tendered by employees to increase the option grant price to the fair market value on the date of grant, and to give the employee a cash payment for the difference in option grant price between the amended option and the original discounted price. In addition, the Company cancelled certain options granted prior to August 14, 2003 that were or may have been granted at a discount, and were tendered by employees in exchange for a cash payment based on the Black-Scholes value of the option. The Company has accounted for these modifications and settlements in accordance with SFAS 123R and as a result recorded incremental compensation expense of $2.1 million during the three months ended July 29, 2006. No tender offer was completed in prior fiscal years.
 
 
Amortization of intangible assets for the years ended October 28, 2006 and October 29, 2005 was as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$ 2,294       0.3%     $       —%       100%  
 
During the year ended October 28, 2006, we recorded amortization of intangible assets of $2.3 million related to the acquisition of NuView. We account for intangible assets in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). Intangible assets are recorded based on estimates of fair value at the time of the acquisition and identifiable intangible assets are amortized on a straight line basis over their estimated useful lives (see Note 4: “Goodwill and Identifiable Intangible Assets,” of the Notes to Consolidated Financial Statements).
 
No other intangible amounts have been recorded in the Consolidated Financial Statements for the periods presented.
 
 
Restructuring and facilities lease losses, net, for the years ended October 28, 2006 and October 29, 2005 was as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$ 3,775       0.5%     $ (670 )     (0.1 )%     663%  


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In addition, restructuring and facilities lease losses, net, for the years ended October 29, 2005 and October 30, 2004 were as follows (in thousands):
 
                                     
October 29,
    % of Net
    October 30,
    % of Net
       
2005
    Revenue     2004     Revenue     % Change  
 
$ (670 )     (0.1 )%   $ 84,557       14%       (101 )%
 
During the year ended October 28, 2006, we recorded a charge of $3.8 million related to estimated facilities lease losses, net of expected sublease income. This charge represents an estimate based on current market data. No other facilities lease loss expenses have been recorded in the Consolidated Financial Statements for the periods presented. For the year ended October 29, 2005, we recorded a reduction of $0.7 million to restructuring costs related to recovery of previously recorded restructuring costs. For the year ended October 30, 2004, restructuring costs consist of $10.5 million related to a restructuring plan implemented during the three months ended May 1, 2004, and a reduction of $1.5 million to restructuring costs related to our previously recorded restructuring liabilities, primarily due to lower than expected costs related to outplacement costs and severance (see Note 5, “Restructuring Costs,” of the Notes to Consolidated Financial Statements).
 
During the year ended October 30, 2004, we recorded a lease termination charge of $75.6 million. During the three months ended January 24, 2004, we purchased a previously leased building located near our San Jose headquarters for $106.8 million. Of the $106.8 million, $30.0 million was allocated to the purchase of land and building and $76.8 million was considered a lease termination fee (see Note 6, “Liabilities Associated with Facilities Lease Losses and Asset Impairment Charges,” of the Notes to Consolidated Financial Statements). No lease termination charge was recorded in any of the other periods presented.
 
 
Settlement of an acquisition related claim for the years ended October 29, 2005 and October 30, 2004 was as follows (in thousands):
 
                                     
October 29,
    % of Net
    October 30,
    % of Net
       
2005
    Revenue     2004     Revenue     % Change  
 
$       —%     $ 6,943       1.2%       (100 )%
 
During the second quarter of fiscal year 2004, the Company recorded a $6.9 million charge in settlement of a claim relating to its acquisition of Rhapsody. Under the terms of the settlement, in the third quarter of fiscal year 2004, the Company issued 1.3 million shares of its common stock to the former Rhapsody shareholders in exchange for a release of claims.
 
We did not record any settlement of an acquisition related claim for the years ended October 28, 2006 and October 29, 2005.
 
 
In-process research and development for the years ended October 28, 2006 and October 29, 2005 was as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$       —%     $ 7,784       1%       (100 )%
 
On May 3, 2005, we completed our acquisition of Therion, a privately held company based in Redmond, Washington that developed software management solutions for the automated provisioning of servers over a storage network. As of the acquisition date, Therion was a development stage company with no recognized revenue and a core technology that had not yet reached technological feasibility. Accordingly, the acquisition of Therion was accounted for as an asset purchase. In connection with this acquisition, we recorded a $7.8 million in-process research and development charge, and allocated the remaining purchase price to net assets of $2.9 million, deferred stock compensation of $1.5 million, and net liabilities of $0.1 million, based on fair values (see Note 3, “Acquisitions,” of the Notes to Consolidated Financial Statements).


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We did not record any acquired in-process R&D for the years ended October 28, 2006 and October 30, 2004.
 
   Acquisition and integration costs.
 
Acquisition and integration costs for the years ended October 28, 2006 and October 29, 2005 were as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$ 9,646       1%     $       —%       100%  
 
On August 8, 2006, the Company announced that it had entered into a definitive agreement to acquire McDATA in an all stock transaction valued at approximately $634 million as of such date. Under the terms of the agreement, McDATA stockholders will receive 0.75 shares of Brocade common stock for each share of McDATA class A common stock and each share of McDATA class B common stock they hold. The acquisition is subject to obtaining approval from both Brocade and McDATA stockholders, regulatory approvals and certain other closing conditions.
 
In connection with our proposed acquisition of McDATA (see Note 10 “Commitments and Contingencies”, of the Notes to Consolidated Financial Statements), we recorded acquisition and integration costs of $9.6 million in fiscal 2006, which consisted primarily of costs incurred for consulting services and other professional fees.
 
No other integration or acquisition-related compensation amounts have been recorded in the Consolidated Financial Statements for the periods years ended October 29, 2005 and October 30, 2004.
 
 
Interest and other income, net, for the years ended October 28, 2006 and October 29, 2005 was as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$ 29,098       4%     $ 22,656       4%       28%  
 
In addition, interest and other income, net, for the years ended October 29, 2005 and October 30, 2004 was as follows (in thousands):
 
                                     
October 29,
    % of Net
    October 30,
    % of Net
       
2005
    Revenue     2004     Revenue     % Change  
 
$ 22,656       4%     $ 18,786       3%       21%  
 
Interest and other income, net increased to $29.1 for the year ended October 28, 2006, compared to $22.7 million for the year ended October 29, 2005 and $18.8 million for the year ended October 30, 2004. For the year ended October 28, 2006, the increase was primarily due to higher average rates of return due to investment mix and an increase in interest rates, as well as increase in cash invested. For the year ended October 29, 2005, the increase was primarily due to higher average rates of return due to investment mix and increase in interest rates, as well as increased average cash, cash equivalent, restricted short-term investments and short-term and long-term investment balances. On August 22, 2006, as contemplated by the irrevocable letter of instruction to the Trustee, the short-term investments deposited with the Trustee, which fully collateralized the outstanding convertible debt were liquidated and $280.8 million, which included debt principal, accrued interest and the call premium, was paid to redeem all outstanding convertible debt.
 
 
Interest expense for the years ended October 28, 2006 and October 29, 2005 was as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$ (7,082 )     (0.9 )%   $ (7,693 )     (1 )%     (8 )%


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In addition, interest expense for the years ended October 29, 2005 and October 30, 2004 was as follows (in thousands):
 
                                     
October 29,
    % of Net
    October 30,
    % of Net
       
2005
    Revenue     2004     Revenue     % Change  
 
$ (7,693 )     (1 )%   $ (10,677 )     (2 )%     (28 )%
 
Interest expense primarily represents the interest cost associated with our convertible subordinated debt, which we liquidated during the last quarter of the 2006 fiscal year. The decrease in interest expense for both the years ended October 28, 2006 and October 29, 2005, compared with the year ended October 30, 2004 was primarily the result of the repurchases of our convertible subordinated debt, resulting in a lower debt outstanding. As of October 28, 2006 and October 29, 2005, the outstanding balance of our convertible subordinated debt was $0.0 million and $278.9 million, respectively (see Note 9, “Convertible Subordinated Debt,” of the Notes to Consolidated Financial Statements).
 
 
Gain on repurchases of convertible subordinated debt for the years ended October 28, 2006 and October 29, 2005 was as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$  —       —%     $ 2,318       0.4%       (100 )%
 
In addition, gain on repurchase of convertible subordinated debt for the years ended October 29, 2005 and October 30, 2004 was as follows (in thousands):
 
                                     
October 29,
    % of Net
    October 30,
    % of Net
       
2005
    Revenue     2004     Revenue     % Change  
 
$ 2,318       0.4%     $ 5,613       0.9%       (59 )%
 
During the years ended October 28, 2006 and October 29, 2005, and October 30, 2004, we repurchased $0.0 million, $73.4 million, and $90.7 million in face value of our convertible subordinated debt, respectively, on the open market. For the year ended October 29, 2005, we paid an average of $0.96 for each dollar of face value for an aggregate purchase price of $70.5 million, which resulted in a pre-tax gain of $2.3 million. For the year ended October 30, 2004, we paid an average of $0.93 for each dollar of face value for an aggregate purchase price of $84.4 million, which resulted in a pre-tax gain of $5.6 million.
 
 
Gain (loss) on investments, net, for the years ended October 28, 2006 and October 29, 2005 was as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$ 2,663       0.4%     $ (5,062 )     (0.9 )%     153%  
 
In addition, gain (loss) on investments, net, for the years ended October 29, 2005 and October 30, 2004 was as follows (in thousands):
 
                                     
October 29,
    % of Net
    October 30,
    % of Net
       
2005
    Revenue     2004     Revenue     % Change  
 
$ (5,062 )     (0.9 )%   $ 436       0.1%       (1,261 )%
 
For the year ended October 28, 2006, gain on sale of investment was $2.7 million due to the disposition of non-marketable private strategic investments at amounts above the carrying value. The carrying value of our equity investments in non-publicly traded companies at October 28, 2006 was $0.8 million. For the year ended October 29, 2005, net loss on investments was $5.1 million, consisting of $5.2 million losses on the disposition of portfolio investments primarily associated with the defeasance of the indenture agreement relating to our 2% Convertible Notes, offset by $0.1 million gains on the disposition of non-marketable private strategic investments. For the year


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ended October 30, 2004, net gain on investments was $0.4 million consisting of gains on the disposition of previously written down non-marketable private strategic investments. As of October 28, 2006 and October 29, 2005, we had net unrealized holding gains (losses) of $(1.1) million and $(4.2) million, respectively, associated with our remaining investment portfolio. The carrying value of our equity investments in non-publicly traded companies at October 28, 2006 and October 29, 2005 was $0.8 million and $3.8 million, respectively.
 
 
Provision for income taxes for the years ended October 28, 2006 and October 29, 2005 was as follows (in thousands):
 
                                     
October 28,
    % of Net
    October 29,
    % of Net
       
2006
    Revenue     2005     Revenue     % Change  
 
$ 30,723       4%     $ 12,077       2%       154%  
 
Provision for income taxes for the years ended October 29, 2005 and October 30, 2004 was as follows (in thousands):
 
                                     
October 29,
    % of Net
    October 30,
    % of Net
       
2005
    Revenue     2004     Revenue     % Change  
 
$ 12,077       2%     $ 14,070       2%       (14 )%
 
Estimates and judgments are required in the calculation of certain tax liabilities and in the determination of the recoverability of certain of the deferred tax assets, which arise from variable stock option expenses, net operating losses, tax carryforwards and temporary differences between the tax and financial statement recognition of revenue and expense. SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”), also requires that the deferred tax assets be reduced by a valuation allowance, if based on the weight of available evidence, it is more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods.
 
In evaluating our ability to recover our deferred tax assets, in full or in part, we consider all available positive and negative evidence including our past operating results, the existence of cumulative losses in the most recent fiscal years and our forecast of future taxable income on a jurisdiction by jurisdiction basis. In determining future taxable income, we are responsible for assumptions utilized including the amount of state and federal pre-tax operating income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgments about the forecasts of future taxable income and are consistent with the plans and estimates we are using to manage the underlying businesses. Cumulative losses incurred in four of the last seven fiscal years represented sufficient negative evidence to require a full valuation allowance. As of October 28, 2006, we had a valuation allowance against the deferred tax assets, which we intend to maintain until sufficient positive evidence exists to support reversal of the valuation allowance. Future reversals or increases to our valuation allowance could have a significant impact on our future earnings.
 
In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations in a multitude of jurisdictions. We recognize potential liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes will be due. If events occur and the payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary. If our estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result.
 
For the year ended October 28, 2006, we have recorded an income tax provision of $30.7 million, compared to income tax provisions of $12.1 million and $14.1 million in the years ended October 29, 2005 and October 30, 2004, respectively. For the year ended October 28, 2006, the Company had a change in valuation allowance of $16.2 million. The cumulative valuation allowance has been placed against the gross deferred tax assets with the exception of future benefits of non-U.S. stock options. The valuation allowance will be reduced in the period in which the Company is able to utilize the deferred tax assets on its tax return, resulting in a reduction in income tax payable. In the year ended October 28, 2006, our income tax provision is primarily for international and domestic operations. In the year ended October 29, 2005, our income tax provision is primarily for our international


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operations, a one-time U.S. tax liability associated with the earnings repatriated pursuant to the American Jobs Creation Act of 2004 (the “AJCA”), and domestic operations. We expect to continue to record an income tax provision for our international and domestic operations in the future. Since we have a full valuation allowance against deferred tax assets which result from U.S. operations, U.S. income tax expense or benefits are offset by releasing or increasing, respectively, the valuation allowance. Our U.S. federal income tax liability is reduced by the utilization of net operating loss and credit carry forwards from prior years such that only alternative minimum tax results. To the extent these carryforwards are fully utilized against future earnings, our US federal effective tax rate is expected to increase. 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 income tax provision could change.
 
The AJCA was enacted on October 22, 2004. One provision of the AJCA effectively reduces the tax rate on qualifying repatriation of earnings held by foreign-based subsidiaries to approximately 5.25 percent. Normally, such repatriations would be taxed at a rate of up to 35 percent. In the fourth quarter of fiscal year 2005, we made the decision that we would repatriate approximately $78.2 million under the AJCA. This repatriation of earnings triggered a U.S. federal tax payment of approximately $3.4 million and a state tax payment of approximately $0.6 million. Prior to the AJCA, we did not provide deferred taxes on undistributed earnings of foreign subsidiaries as we intended to utilize these earnings through expansion of our business operations outside the United States for an indefinite period of time. Going forward, we intend to indefinitely reinvest prospective foreign earnings.
 
In November 2005, we were notified by the Internal Revenue Service that our domestic federal income tax return for the year ended October 25, 2003 was subject to audit. We believe we have adequate reserves to cover any potential assessments that may result from the examination.
 
In April 2006, we were notified by the Franchise Tax Board (“FTB”) that our California income tax returns for the years ended October 25, 2003 and October 30, 2004 were subject to audit. The FTB Audit is ongoing and we believe our reserves are adequate to cover any potential assessments that may result from the examination.
 
 
                         
    Year Ended  
    October 28,
    October 29,
    Increase/
 
    2006     2005     (Decrease)  
    (In thousands)  
 
Cash and cash equivalents
  $ 274,368     $ 182,001     $ 92,367  
Short-term investments
    267,694       209,865       57,829  
Restricted short-term investments
          277,230       (277,230 )
Long-term investments
    40,492       95,306       (54,814 )
                         
Total
  $ 582,554     $ 764,402     $ (181,848 )
                         
Percentage of total assets
    65 %     78 %        
 
Cash, cash equivalents, restricted short-term investments, and short-term and long-term investments were $582.6 million as of October 28, 2006, a decrease of $181.8 million over prior year total of $764.4 million. For the year ended October 28, 2006, we generated $166.9 million in cash from operating activities. Cash from operations significantly exceeded net income for the year ended October 28, 2006 due to non-cash expense items, primarily related to depreciation and amortization, an increase in non-cash compensation expense and an increase in accounts payable and accrued compensation. Days sales outstanding in receivables for the year ended October 28, 2006 was 43 days, compared with 44 days for the year ended October 29, 2005.
 
Net cash provided by investing activities for the year ended October 28, 2006 totaled $194.4 million and was primarily the result of $650.9 million in net proceeds from sales and maturities of short, restricted short and long-term investments and other non-marketable investments, partially offset by $366.2 million cash used for purchases of restricted short and long-term investments $30.4 million invested in capital equipment, and $59.9 million cash used in connection with an acquisition.


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Net cash used in financing activities for the year ended October 28, 2006 totaled $269.0 million. Net cash used in financing activities was primarily the result of $278.9 million cash used for the redemption of outstanding convertible debt and $40.2 million cash used to repurchase our common stock under the stock repurchase program approved in August 2004 by our Board of Directors, partially offset by $34.3 million in net proceeds from employee participation in employee stock programs and exercises of stock options and $15.8 excess tax benefit related employee stock plans.
 
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 flow resulting from the issuance of common stock related to employee participation in employee stock programs will vary.
 
Manufacturing and Purchase Commitments We have a manufacturing agreement with Foxconn under which we provide twelve-month product forecasts and place purchase orders in advance of the scheduled delivery of products to our customers. The required lead-time for placing orders with Foxconn depends on the specific product. As of October 28, 2006, our aggregate commitment to Foxconn for inventory components used in the manufacture of Brocade products was $87.9 million, net of purchase commitment reserves of $6.1 million, which we expect to utilize during future normal ongoing operations. Although the purchase orders we place with Foxconn are cancelable, the terms of the agreement requires us to purchase from Foxconn all inventory components not returnable or usable by, or sold to, other customers of Foxconn. Our purchase commitments reserve reflects our estimate of purchase commitments we do not expect to consume in normal operations.
 
Convertible Subordinated Debt On December 21, 2001, and January 10, 2002, we sold an aggregate of $550 million in principal amount of two percent convertible subordinated notes due January 2007 (the “Notes” or “Convertible Subordinated Debt”) (see Note 9, “Convertible Subordinated Debt,” of the Notes to Consolidated Financial Statements). Holders of the Notes may, in whole or in part, have converted the Notes into shares of our common stock at a conversion rate of 22.8571 shares per $1,000 principal amount of notes at any time prior to maturity on January 1, 2007, subject to earlier redemption.
 
On August 23, 2005, in accordance with the terms of the indenture agreement dated December 21, 2001 with respect to the Convertible Subordinated Debt, the Company elected to deposit securities with the trustee of the Notes (the “Trustee”), which fully collateralized the outstanding notes, and to discharge the indenture agreement. Pursuant to this election, the Company provided an irrevocable letter of instruction to the Trustee to issue a notice of redemption on June 26, 2006 and to redeem the Notes on August 22, 2006 (the “Redemption Date”). Following August 23, 2005, the Trustee, using the securities deposited with them, paid to the noteholders (1) all the interest scheduled to become due per the original note prior to the Redemption Date, and (2) all the principal and remaining interest, plus a call premium of 0.4% of the face value of the Notes, on the Redemption Date. As of October 29, 2005, the Company had an aggregate of $277.2 million in interest-bearing U.S. securities with the Trustee. The securities remained on the Company’s balance sheet as restricted short-term investments until the Redemption Date. The Company recorded a loss on investments of $4.7 million in the three months ended October 29, 2005 with respect to the disposition of certain short-term and long-term investments that was necessary to deposit the securities with the Trustee.
 
The notes were redeemed on August 22, 2006 as contemplated by the irrevocable letter of instruction to the Trustee. As of October 28, 2006, the remaining balance outstanding of the convertible subordinated debt was $0.0 million.
 
Other Contractual Obligations On November 18, 2003, we purchased a previously leased building located near our San Jose headquarters, and issued a $1.0 million guarantee as part of the purchase agreement.


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The following table summarizes our contractual obligations (including interest expense) and commitments as of October 28, 2006 (in thousands):
 
                                         
          Less Than
                More Than
 
    Total     1 Year     1-3 Years     3-5 Years     5 Years  
 
Contractual Obligations:
                                       
Non-cancelable operating leases
    57,603 (1)     16,702       28,943       11,958        
Purchase commitments, gross
    87,897 (2)     87,897                    
                                         
Total contractual obligations
  $ 145,500     $ 104,599     $ 28,943 943     $ 11,958     $  
                                         
Other Commitments:
                                       
Standby letters of credit
  $ 8,343     $ n/a     $ n/a     $ n/a     $ n/a  
                                         
Guarantee
  $ 1,015     $ n/a     $ n/a     $ n/a     $ n/a  
                                         
 
 
(1) Amount excludes sublease income of $5.4 million, which consist of $1.1 million to be received in less than 1 year, $3.0 million to be received in 1 through 3 years, and $1.3 million to be received in 3 to 5 years.
 
(2) Amount reflects total gross purchase commitments under our manufacturing agreement with Foxconn. Of this amount, we have reserved $6.1 million for estimated purchase commitments that we do not expect to consume in normal operations.
 
Share Repurchase Program.  In August 2004, our board of directors approved a share repurchase program for up to $100.0 million of our common stock. The purchases may be made, from time to time, in the open market and will be funded from available working capital. The number of shares to be purchased and the timing of purchases will be based on the level of our cash balances, general business and market conditions, and other factors, including alternative investment opportunities. To date, we have repurchased 7.9 million shares and $52.7 million remains available for future repurchases under this program.
 
We believe that our existing cash, cash equivalents, short-term and long-term investments, and cash expected to be generated from future operations will be sufficient to meet our capital requirements at least through the next 12 months, although we may elect to seek additional funding prior to that time, if available. Our future capital requirements will depend on many factors, including our rate of revenue growth, the timing and extent of spending to support our product development efforts and the expansion of our sales and marketing programs, the timing of introductions of new products and enhancements to our existing products, and market acceptance of our products.
 
 
Our discussion and analysis of financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these Consolidated Financial Statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate, on an on-going basis, our estimates and judgments, including those related to sales returns, bad debts, excess inventory and purchase commitments, investments, warranty obligations, restructuring costs, lease losses, income taxes, and contingencies and litigation. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.
 
The methods, estimates, and judgments we use in applying our most critical accounting policies have a significant impact on the results that we report in our Consolidated Financial Statements. The SEC considers an entity’s most critical accounting policies to be those policies that are both most important to the portrayal of a company’s financial condition and results of operations, and those that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about matters that are inherently


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uncertain at the time of estimation. We believe the following critical accounting policies, among others, require significant judgments and estimates used in the preparation of our Consolidated Financial Statements:
 
  •  Revenue recognition, and allowances for sales returns, sales programs, and doubtful accounts;
 
  •  Stock-based compensation;
 
  •  Warranty reserves;
 
  •  Inventory and purchase commitment reserves;
 
  •  Restructuring charges and lease loss reserves;
 
  •  Goodwill and intangible assets;
 
  •  Litigation costs; and
 
  •  Accounting for income taxes.
 
Revenue recognition, and allowances for sales returns, sales programs, and doubtful accounts.  Product revenue is generally recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is probable. However, for newly introduced products, many of our large OEM customers require a product qualification period during which our products are tested and approved by the OEM customer for sale to their customers. Revenue recognition, and related cost, is deferred for shipments to new OEM customers and for shipments of newly introduced products to existing OEM customers until satisfactory evidence of completion of the product qualification has been received from the OEM customer. In addition, revenue from sales to our master reseller customers is recognized in the same period in which the product is sold by the master reseller (sell-through).
 
We reduce revenue for estimated sales returns, sales programs, and other allowances at the time of shipment. Sales returns, sales programs, and other allowances are estimated based on historical experience, current trends, and our expectations regarding future experience. Reductions to revenue associated with sales returns, sales programs, and other allowances include consideration of historical sales levels, the timing and magnitude of historical sales returns, claims under sales programs, and other allowances, and a projection of this experience into the future. In addition, we maintain allowances for doubtful accounts, which are also accounted for as a reduction in revenue, for estimated losses resulting from the inability of our customers to make required payments. We analyze accounts receivable, historical collection patterns, customer concentrations, customer creditworthiness, current economic trends, changes in customer payment terms and practices, and customer communication when evaluating the adequacy of the allowance for doubtful accounts. If actual sales returns, sales programs, and other allowances exceed our estimate, or if the financial condition of our customers was to deteriorate, resulting in an impairment of their ability to make payments, additional allowances and charges may be required.
 
Service revenue consists of training, warranty, and maintenance arrangements, including post-contract customer support (“PCS”) and other professional services. PCS services are offered under renewable, annual fee-based contracts or as part of multiple element arrangements and typically include upgrades and enhancements to our software operating system software, and telephone support. Service revenue, including revenue allocated to PCS elements, is deferred and recognized ratably over the contractual period. Service contracts are typically one to three years in length. Professional services are offered under fee based contracts or as part of multiple element arrangements. Professional service revenue is recognized as delivery of the underlying service occurs. Training revenue is recognized upon completion of the training.
 
Our multiple-element product offerings include computer hardware and software products, and support services. We also sell certain software products and support services separately. Our software products, including those that are embedded in our hardware products and are essential to the functionality of our hardware products and are, therefore, accounted for in accordance with Statement of Position 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended. We allocate revenue to each element in a multiple element arrangement based upon vendor-specific objective evidence (“VSOE”) of the fair value of the element or, if VSOE is not available for the delivered elements, by application of the residual method. In the application of the residual method, we allocate revenue to the undelivered elements based on VSOE for those elements and allocate the residual revenue to the


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delivered elements. VSOE of the fair value for an element is based upon the price charged when the element is sold separately. Revenue allocated to each element is then recognized when the basic revenue recognition criteria are met for each element. Changes in the allocation of revenue to each element in a multiple element arrangement may affect the timing of revenue recognition.
 
Stock-Based Compensation.  Effective October 30, 2005 we began recording compensation expense associated with stock-based awards and other forms of equity compensation in accordance with SFAS 123R. We adopted the modified prospective transition method provided for under SFAS 123R, and consequently have not retroactively adjusted results from prior periods. Under this transition method, compensation cost associated with stock-based awards recognized for fiscal year 2006 now includes 1) quarterly amortization related to the remaining unvested portion of stock-based awards granted prior to October 30, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123; and 2) quarterly amortization related to stock-based awards granted subsequent to October 30, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. In addition, we record expense over the offering period and vesting term in connection with 1) shares issued under our employee stock purchase plan and 2) stock options and restricted stock awards. The compensation expense for stock-based awards includes an estimate for forfeitures and is recognized over the expected term of the award under a graded vesting method.
 
Prior to October 30, 2005, we accounted for stock-based awards using the intrinsic value method of accounting in accordance with APB 25, whereby the difference between the exercise price and the fair market value on the date of grant is recognized as compensation expense. Under the intrinsic value method of accounting, no compensation expense was recognized in our Consolidated Statements of Operations when the exercise price of our employee stock option grant equals the market price of the underlying common stock on the date of grant, and the measurement date of the option grant is certain. The measurement date is certain when the date of grant is fixed and determinable. Prior to October 30, 2005 when the measurement date was not certain, we recorded stock-based compensation expense using variable accounting under APB 25. Effective October 30 2005, for awards where the measurement date is not certain, we record stock-based compensation expense under SFAS 123R. Under SFAS 123R, we remeasure the intrinsic value of the options at the end of each reporting period until the options are exercised, cancelled or expire unexercised.
 
Warranty reserves.  We provide warranties on our products ranging from one to three years. Estimated future warranty costs are accrued at the time of shipment and charged to cost of revenues based upon historical experience, current trends and our expectations regarding future experience. If actual warranty costs exceed our estimate, additional charges may be required.
 
Inventory and purchase commitment reserves.  We write down inventory and record purchase commitment reserves for estimated excess and obsolete inventory equal to the difference between the cost of inventory and the estimated fair value based upon forecast of future product demand, product transition cycles, and market conditions. Although we strive to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and commitments, and our reported results. If actual market conditions are less favorable than those projected, additional inventory write-downs, purchase commitment reserves, and charges against earnings might be required.
 
Restructuring charges and lease loss reserves.  We monitor and regularly evaluate our organizational structure and associated operating expenses. Depending on events and circumstances, we may decide to take additional actions to reduce future operating costs as our business requirements evolve. In determining restructuring charges, we analyze our future operating requirements, including the required headcount by business functions and facility space requirements. Our restructuring costs, and any resulting accruals, involve significant estimates made by management using the best information available at the time the estimates are made, some of which may be provided by third parties. In recording severance reserves, we accrue liability when all of the following conditions have been met: employees’ rights to receive compensation for future absences is attributable to employees’ services already rendered; the obligation relates to rights that vest or accumulate; payment of the compensation is probable; and the amount can be reasonably estimated. In recording facilities lease loss reserves, we make various assumptions, including the time period over which the facilities are expected to be vacant, expected sublease terms, expected sublease rates, anticipated future operating expenses, and expected future use of the facilities. Our


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estimates involve a number of risks and uncertainties, some of which are beyond our control, including future real estate market conditions and our ability to successfully enter into subleases or lease termination agreements with terms as favorable as those assumed when arriving at our estimates. We regularly evaluate a number of factors to determine the appropriateness and reasonableness of our restructuring and lease loss accruals including the various assumptions noted above. If actual results differ significantly from our estimates, we may be required to adjust our restructuring and lease loss accruals in the future.
 
Goodwill and intangible assets.  We account for goodwill in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). SFAS 142 requires that goodwill be capitalized at cost and tested annually for impairment. We evaluate goodwill on an annual basis during our second fiscal quarter, or whenever events and changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impairment loss is recognized to the extent that the carrying amount exceeds the assets implied fair value. Events which might indicate impairment include, but are not limited to, strategic decisions made in response to economic and competitive conditions, the impact of economic environment on our customer base, material negative changes in relationships with significant customers, and/or a significant decline in our stock price for a sustained period. No goodwill impairment was recorded for the periods presented.
 
Intangible assets other than goodwill are amortized over their useful lives, unless these lives are determined to be indefinite. Intangible assets are carried at cost less accumulated amortization. Amortization is computed over the estimated useful life of the respective asset. Intangible assets are reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). We perform an impairment tests for long-lived assets on an annual basis or whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Examples of such events or circumstances include significant underperformance relative to historical or projected future operating results, significant changes in the manner of use of acquired assets or the strategy for its business, significant negative industry or economic trends, and/or a significant decline in the Company’s stock price for a sustained period. Impairments are recognized based on the difference between the fair value of the asset and its carrying value, and fair value is generally measured based on discounted cash flow analyses. No intangible asset impairment was recorded for the periods presented.
 
Litigation costs.  We are subject to the possibility of legal actions arising in the ordinary course of business. We regularly monitor the status of pending legal actions to evaluate both the magnitude and likelihood of any potential loss. We accrue for these potential losses when it is probable that a liability has been incurred and the amount of loss, or possible range of loss, can be reasonably estimated. If actual results differ significantly from our estimates, we may be required to adjust our accruals in the future.
 
Accounting for income taxes.  We use the asset and liability method of accounting for income taxes. Under this method, income tax expense is recognized for the amount of taxes payable or refundable for the current year. Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts, along with net operating loss carryforwards and credit carryforwards. A valuation allowance is recognized to the extent that it is more likely than not that the tax benefits will not be realized. Income tax contingencies are accounted for in accordance with SFAS No. 5, “Accounting for Contingencies” (“SFAS 5”).
 
The determination of our tax provision is subject to judgments and estimates due to operations in multiple tax jurisdictions inside and outside the United States. Sales to our international customers are principally taxed at rates that are lower than the United States statutory rates. The ability to maintain our current effective tax rate is contingent upon existing tax laws in both the United States and in the respective countries in which our international subsidiaries are located. Future changes in domestic or international tax laws could affect the continued realization of the tax benefits we are currently receiving and expect to receive from international sales. In addition, an increase in the percentage of our total revenue from international customers or in the mix of international revenue among particular tax jurisdictions could change our overall effective tax rate. Also, our current effective tax rate assumes that United States income taxes are not provided for undistributed earnings of certain non-United States subsidiaries. These earnings could become subject to United States federal and state income taxes and foreign withholding


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taxes, as applicable, should they be either deemed or actually remitted from our international subsidiaries to the United States.
 
The carrying value of our net deferred tax assets is subject to a full valuation allowance with the exception of non-US stock option expense. At some point in the future, the Company may have sufficient United States taxable income to release the valuation allowance and accrue United States tax. We evaluate the expected realization of our deferred tax assets and assess the need for valuation allowances quarterly.
 
 
In July 2006, the FASB issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 prescribes detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” Tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. FIN 48 will be effective for fiscal years beginning after December 15, 2006, and the provisions of FIN 48 will be applied to all tax positions upon initial adoption of the Interpretation. The cumulative effect of applying the provisions of this Interpretation will be reported as an adjustment to the opening balance of retained earnings for that fiscal year. We are currently evaluating the impact of FIN 48 on our financial statements and have not yet determined the impact.
 
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measures” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), expands disclosures about fair value measurements, and applies under other accounting pronouncements that require or permit fair value measurements. SFAS No. 157 does not require any new fair value measurements. However, the FASB anticipates that for some entities, the application of SFAS 157 will change current practice. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We do not expect the adoption of SFAS 157 will have a material impact on our financial position, results of operations, and cash flows.
 
In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108 (Topic 1N), “Quantifying Misstatements in Current Year Financial Statements,” (“SAB 108”). SAB 108 addresses how the effect of prior-year uncorrected misstatements should be considered when quantifying misstatements in current-year financial statements. SAB 108 requires SEC registrants (i) to quantify misstatements using a combined approach which considers both the balance-sheet and income-statement approaches, (ii) to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors, and (iii) to adjust their financial statements if the new combined approach results in a conclusion is that an error is material. SAB 108 addresses the mechanics of correcting misstatements that include effects from prior years. It indicates that the current-year correction of a material error that includes prior-year effects may result in the need to correct prior-year financial statements even if the misstatement in the prior year or years is considered immaterial. Any prior-year financial statements found to be materially misstated in years subsequent to the issuance of SAB 108 would be restated in accordance with SFAS No. 154, “Accounting Changes and Error Corrections.” Because the combined approach represents a change in practice, the SEC staff will not require registrants that followed an acceptable approach in the past to restate prior years’ historical financials statements. Rather, these registrants can report the cumulative effect of adopting the new approach as an adjustment to the current year’s beginning balance of retained earnings. If the new approach is adopted in a quarter other than the first quarter, financial statements for prior interim periods within the year of adoption may need to be restated. SAB 108 is effective for fiscal years ending after November 15, 2006. We do not expect the adoption of SAB 108 will have a material impact on our financial position, results of operations, and cash flows.
 
Item 7A.   Quantitative and Qualitative Disclosures About Market Risk
 
Our exposure to market risk due to changes in the general level of United States interest rates relates primarily to our cash equivalents, short-term and long-term investment portfolios, and restricted short-term investments. Our cash, cash equivalents, short-term and long-term investments are primarily maintained at five major financial


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institutions in the United States. As of October 28, 2006, we did not hold any derivative instruments. The primary objective of our investment activities is the preservation of principal while maximizing investment income and minimizing risk.
 
The following table presents the hypothetical changes in fair values of our investments in debt securities issued by United States government and its agencies as of October 28, 2006 that are sensitive to changes in interest rates (in thousands):
 
                                                         
    Valuation of Securities
    Fair Value
    Valuation of Securities
 
    Given an Interest Rate
    as of
    Given an Interest Rate
 
    Decrease of X Basis Points     October 28,
    Increase of X Basis Points  
Issuer
  (150 BPS)     (100 BPS)     (50 BPS)     2006     50 BPS     100 BPS     150 BPS  
 
U.S. government, U.S. government agencies and municipal obligations
  $ 129,791     $ 127,525     $ 125,455     $ 123,554     $ 121,818     $ 120,217     $ 118,740  
Corporate bonds and notes
  $ 185,959     $ 185,532     $ 185,087     $ 184,631     $ 184,180     $ 183,730     $ 183,283  
                                                         
Total
  $ 315,750     $ 313,057     $ 310,542     $ 308,185     $ 305,998     $ 303,947     $ 302,023  
                                                         
 
These instruments are not leveraged and are classified as available-for-sale. The modeling technique used measures the change in fair values arising from selected potential changes in interest rates. Market changes reflect immediate hypothetical parallel shifts in the yield curve of plus or minus 50 basis points (BPS), 100 BPS, and 150 BPS, which are representative of the historical movements in the Federal Funds Rate.
 
The following table (in thousands) presents our cash and cash equivalents, short-term and long-term investments subject to interest rate risk and their related weighted average interest rates at October 28, 2006. Carrying value approximates fair value.
 
                 
          Average
 
    Amount     Interest Rate  
 
Cash and cash equivalents
  $ 274,368       4.8 %
Short-term investments
    267,694       4.3 %
Long-term investments
    40,492       4.7 %
                 
Total
  $ 582,554       4.6 %
                 
 
Our common stock is quoted on the Nasdaq National Market under the symbol “BRCD.” On October 28, 2006, the last reported sale price of our common stock on the Nasdaq National Market was $8.43 per share.


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THE BOARD OF DIRECTORS AND STOCKHOLDERS
BROCADE COMMUNICATIONS SYSTEMS, INC:
 
We have audited the accompanying consolidated balance sheets of Brocade Communications Systems, Inc. and subsidiaries (the Company) as of October 28, 2006 and October 29, 2005, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended October 28, 2006. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule as listed in Item 15(2). These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Brocade Communications Systems, Inc. and subsidiaries as of October 28, 2006 and October 29, 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended October 28, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
 
As discussed in Note 2 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No.  123(R), Share-Based Payments, applying the modified prospective method at the beginning of the year ended October 28, 2006.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of October 28, 2006, based on the criteria established in “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated January 9, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
 
/s/  KPMG LLP
 
Mountain View, California
January 9, 2007


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BROCADE COMMUNICATIONS SYSTEMS, INC.
 
 
                         
    Fiscal Year Ended  
    October 28,
    October 29,
    October 30,
 
    2006     2005     2004  
    (In thousands, except per share amounts)  
 
Net revenues
  $ 750,592     $ 574,120     $ 596,265  
Cost of revenues
    305,184       251,161       268,974  
                         
Gross margin
    445,408       322,959       327,291  
                         
Operating expenses:
                       
Research and development
    164,843       132,448       142,535  
Sales and marketing
    139,434       101,202       102,445  
General and administrative
    31,089       25,189       24,593  
Legal fees associated with indemnification costs, SEC investigation and other related costs
    13,654       14,027        
Provision for SEC settlement
    7,000              
Amortization of intangible assets
    2,294              
Acquisition and integration costs
    9,646              
Restructuring and facilities lease losses, net
    3,775       (670 )     84,557  
Settlement of an acquisition-related claim
                6,943  
In-process research and development
          7,784        
                         
Total operating expenses
    371,735       279,980       361,073  
                         
Income (loss) from operations
    73,673       42,979       (33,782 )
Interest and other income, net
    29,098       22,656       18,786  
Interest expense
    (7,082 )     (7,693 )     (10,677 )
Gain on repurchases of convertible subordinated debt
          2,318       5,613  
Gain (loss) on investments, net
    2,663       (5,062 )     436  
                         
Income (loss) before provision for income taxes
    98,352       55,198       (19,624 )
Income tax provision
    30,723       12,077       14,070  
                         
Net income (loss)
  $ 67,629     $ 43,121     $ (33,694 )
                         
Net income (loss) per share — basic
  $ 0.25     $ 0.16     $ (0.13 )
                         
Net income (loss) per share — diluted
  $ 0.25     $ 0.16     $ (0.13 )
                         
Shares used in per share calculation — basic
    269,602       268,176       260,446  
                         
Shares used in per share calculation — diluted
    274,142       270,260       260,446  
                         
 
See accompanying notes to consolidated financial statements.


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BROCADE COMMUNICATIONS SYSTEMS, INC.
 
 
                 
    October 28,
    October 29,
 
    2006     2005  
    (In thousands,
 
    except par value)  
 
ASSETS
Current assets:
               
Cash and cash equivalents
  $ 274,368     $ 182,001  
Short-term investments
    267,694       209,865  
                 
Total cash, cash equivalents and short-term investments
    542,062       391,866  
Restricted short-term investments
          277,230  
Accounts receivable, net of allowances of $4,842 and $4,942 in 2006 and 2005, respectively
    98,394       70,104  
Inventories
    8,968       11,030  
Prepaid expenses and other current assets
    43,365       19,908  
                 
Total current assets
    692,789       770,138  
Long-term investments
    40,492       95,306  
Property and equipment, net
    104,299       108,118  
Goodwill
    41,013        
Intangible assets, net
    15,465        
Other assets
    6,660       8,168  
                 
Total assets
  $ 900,718     $ 981,730  
                 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
               
Accounts payable
  $ 56,741     $ 23,778  
Accrued employee compensation
    62,842       37,762  
Deferred revenue
    52,051       37,405  
Current liabilities associated with lease losses
    4,931       4,659  
Other accrued liabilities
    87,991       69,832  
Convertible subordinated debt
          278,883  
                 
Total current liabilities
    264,556       452,319  
Non-current liabilities associated with lease losses
    11,105       12,481  
Non-current deferred revenue
    8,827       8,083  
                 
Total liabilities
    284,488       472,883  
Commitments and contingencies (Note 10)
               
Stockholders’ equity:
               
Preferred stock, $0.001 par value 5,000 shares authorized, no shares issued and outstanding
           
Common stock, $0.001 par value, 800,000 shares authorized:
               
Issued and outstanding: 272,141 and 269,695 shares at October 28, 2006 and October 29, 2005, respectively
    272       270  
Additional paid-in capital
    888,978       855,563  
Deferred stock compensation
          (3,180 )
Accumulated other comprehensive loss
    (817 )     (3,974 )
Accumulated deficit
    (272,203 )     (339,832 )
                 
Total stockholders’ equity
    616,230       508,847  
                 
Total liabilities and stockholders’ equity
  $ 900,718     $ 981,730  
                 
 
See accompanying notes to consolidated financial statements.


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BROCADE COMMUNICATIONS SYSTEMS, INC.
 
 
                                                                 
                            Accumulated
                   
                Additional
    Deferred
    Other
          Total
    Comprehensive
 
    Common Stock     Paid-In
    Stock
    Comprehensive
    Accumulated
    Stockholders’
    Income
 
    Shares     Amount     Capital     Compensation     Income     Deficit     Equity     (Loss)  
    (In thousands)  
 
Balances at October 25, 2003
    257,641       258       795,294       (4,222 )     5,797       (349,259 )     447,868       (146,830 )
Issuance of common stock
    5,461       5       24,747                         24,752        
Issuance of common stock for acquisition-related claim
    1,346       1       6,942                         6,943        
Repurchase and retirement of common stock
    (206 )           (288 )                       (288 )      
Change in deferred stock compensation
                3,335       (3,335 )                        
Deferred stock compensation related to restricted stock grants
                1,705       (1,705 )                        
Amortization of deferred stock compensation
                      4,088                   4,088        
Stock-based compensation expense
                920                         920        
Change in unrealized gain (loss) on marketable equity securities and investments, net of tax
                            (5,219 )           (5,219 )     (5,219 )
Change in cumulative translation adjustments
                            282             282       282  
Net loss
                                  (33,694 )     (33,694 )     (33,694 )
                                                                 
Balances at October 30, 2004
    264,242       264       832,655       (5,174 )     860       (382,953 )     445,652       (38,631 )
                                                                 
Issuance of common stock
    6,665       7       30,032                         30,039        
Repurchase and retirement of common stock
    (62 )           (326 )                       (326 )      
Common stock repurchase program
    (1,150 )     (1 )     (7,049 )                       (7,050 )      
Tax benefits from employee stock option transactions
                2,571                         2,571        
Change in deferred stock compensation
                (4,231 )     4,231                          
Deferred stock compensation related to restricted stock grants and Therion acquisition
                1,911       (1,622 )                 289        
Amortization of deferred stock compensation
                      (615 )                 (615 )      
Change in unrealized gain (loss) on marketable equity securities and investments, net of tax
                            (4,270 )           (4,270 )     (4,270 )
Change in cumulative translation adjustments
                            (564 )           (564 )     (564 )
Net income
                                  43,121       43,121       43,121  
                                                                 
Balances at October 29, 2005
    269,695     $ 270     $ 855,563     $ (3,180 )   $ (3,974 )   $ (339,832 )   $ 508,847     $ 38,287  
                                                                 
Issuance of common stock
    9,644       10       34,266                               34,276        
Repurchase and retirement of common stock
    (421 )           (3,328 )                       (3,328 )      
Common stock repurchase program
    (6,777 )     (8 )     (40,200 )                       (40,208 )      
Tax benefits from employee stock option transactions
                15,792                         15,792        
Stock-based compensation
                30,065                           30,065        
Elimination of deferred stock compensation upon adoption of SFAS 123R
                (3,180 )     3,180                          
Change in unrealized gain (loss) on marketable equity securities and investments, net of tax
                            3,037             3,037       3,037  
Change in cumulative translation adjustments
                            120