e10vq

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended January 28, 2006


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

BROCADE COMMUNICATIONS SYSTEMS, INC.

(Exact name of Registrant as specified in its charter)


Delaware		77-0409517
(State or other jurisdiction of incorporation)		(I.R.S. employer identification no.)

1745 Technology Drive
San Jose, CA 95110
(408) 333-8000
(Address, including zip code, of Registrant’s
principal executive offices and telephone
number, including area code)

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

Yes R No £

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 R Accelerated filer £ Non-accelerated filer £

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes £ No R

The number of shares outstanding of the Registrant’s Common Stock on February 14, 2006 was 272,996,449 shares.

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

BROCADE COMMUNICATIONS SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)
(Unaudited)


	Three Months Ended
	January 28,			January 29,
	2006			2005
Net revenues	$	170,082		$	161,578
Cost of revenues (1)		69,381			64,406

Gross margin		100,701			97,172
Operating expenses:
Research and development (1)		38,119			31,674
Sales and marketing (1)		30,868			24,825
General and administrative (1)		7,801			6,663
Internal review and SEC investigation costs		4,029			3,741
Provision for SEC settlement		7,000			—
Amortization of acquisition related deferred stock compensation		623			107

Total operating expenses		88,440			67,010

Income from operations		12,261			30,162
Interest and other income, net		7,030			5,190
Interest expense		(1,777	)		(2,237	)
Gain on repurchases of convertible subordinated debt		—			150

Income before provision for income taxes		17,514			33,265
Income tax provision		7,854			5,322

Net income	$	9,660		$	27,943


Net income per share – Basic	$	0.04		$	0.10

Net income per share – Diluted	$	0.04		$	0.10

Shares used in per share calculation – Basic		269,400			266,218

Shares used in per share calculation – Diluted		272,101			271,422

(1) Amounts for the three months ended January 28, 2006 include stock-based compensation expense recognized under SFAS 123R for stock options and employee stock purchases (see Note 2, “Summary of Significant Accounting Policies,” of the Notes to Condensed Consolidated Financial Statements).

See accompanying notes to condensed consolidated financial statements.

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BROCADE COMMUNICATIONS SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par value)
(Unaudited)


	January 28,			October 29,
	2006			2005
Assets

Current assets:
Cash and cash equivalents	$	187,872		$	182,001
Short-term investments		262,465			209,865

Total cash, cash equivalents and short-term investments		450,337			391,866
Restricted short-term investments		277,040			277,230
Accounts receivable, net of allowances of $4,684 and $4,942 at January 28, 2006 and October 29, 2005, respectively		76,168			70,104
Inventories		8,164			11,030
Convertible subordinated debt issuance costs		1,025			1,430
Prepaid expenses and other current assets		20,433			18,478

Total current assets		833,167			770,138

Long-term investments		61,740			95,306
Property and equipment, net		106,814			108,118
Other assets		11,955			8,168

Total assets	$	1,013,676		$	981,730


Liabilities and Stockholders’ Equity

Current liabilities:
Accounts payable	$	28,040		$	23,778
Accrued employee compensation		36,879			37,762
Deferred revenue		50,964			45,488
Current liabilities associated with lease losses		4,470			4,659
Other accrued liabilities		73,692			69,832
Convertible subordinated debt		278,883			278,883

Total current liabilities		472,928			460,402

Non-current liabilities associated with lease losses		11,442			12,481
Commitments and contingencies (Note 7)

Stockholders’ equity:
Preferred stock, $0.001 par value 5,000 shares authorized, no shares outstanding		—			—
Common stock, $0.001 par value, 800,000 shares authorized:
Issued and outstanding: 272,925 and 269,695 shares at January 28, 2006 and October 29, 2005, respectively		273			270
Additional paid-in capital		862,708			855,563
Deferred stock compensation		—			(3,180	)
Accumulated other comprehensive loss		(3,503	)		(3,974	)
Accumulated deficit		(330,172	)		(339,832	)

Total stockholders’ equity		529,306			508,847

Total liabilities and stockholders’ equity	$	1,013,676		$	981,730

See accompanying notes to condensed consolidated financial statements.

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BROCADE COMMUNICATIONS SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)
(Unaudited)


	Three Months Ended
	January 28,			January 29,
	2006			2005
Cash flows from operating activities:
Net income	$	9,660		$	27,943
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		9,403			12,904
Loss on disposal of property and equipment		41			161
Amortization of debt issuance costs		405			398
Gain on repurchase of convertible subordinated debt		—			(150	)
Non-cash compensation expense (benefit)		6,938			(935	)
Provision for doubtful accounts receivable and sales returns		598			1,243
Provision for SEC settlement		7,000			—
Changes in operating assets and liabilities:
Accounts receivable		(6,662	)		(9,312	)
Inventories		2,866			(1,336	)
Prepaid expenses and other assets		(2,462	)		2,766
Accounts payable		4,262			(1,071	)
Accrued employee compensation		(883	)		(6,873	)
Deferred revenue		5,476			5,737
Other accrued liabilities and long-term debt		(3,391	)		5,095
Liabilities associated with lease losses		(1,217	)		(1,402	)

Net cash provided by operating activities		32,034			35,168


Cash flows from investing activities:
Purchases of property and equipment		(8,174	)		(5,827	)
Purchases of short-term investments		(60,835	)		(16,283	)
Proceeds from maturities and sale of short-term investments		52,649			195,452
Purchases of long-term investments		(11,068	)		(70,125	)
Proceeds from maturities and sale of long-term investments		—			7,500
Purchases of restricted short-term investments		(50	)		—
Proceeds from the maturities of restricted short-term investments		1,208			—
Purchases of non-marketable minority equity investments		(3,750	)		(500	)

Net cash provided by (used in) investing activities		(30,020	)		110,217


Cash flows from financing activities:
Purchases of convertible subordinated debt		—			(3,983	)
Proceeds from issuance of common stock, net		3,863			21,352

Net cash provided by financing activities		3,863			17,369


Effect of exchange rate fluctuations on cash and cash equivalents		(6	)		180


Net increase in cash and cash equivalents		5,871			162,934
Cash and cash equivalents, beginning of period		182,001			79,375

Cash and cash equivalents, end of period	$	187,872		$	242,309

See accompanying notes to condensed consolidated financial statements.

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BROCADE COMMUNICATIONS SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Organization and Operations of Brocade

Brocade Communications Systems, Inc. (“Brocade” or “the Company”) designs, develops, markets, sells, and supports data storage networking products and services, offering a line of storage networking products that enable companies to implement highly available, scalable, manageable, and secure environments for data storage applications. The Brocade SilkWorm^® family of storage area networking (“SAN”) products is designed to help companies reduce the cost and complexity of managing business information within a data storage environment. In addition, the Brocade Tapestry™ family of application infrastructure solutions extends the ability to proactively manage and optimize application and information resources across the enterprise. Brocade products and services are marketed, sold, and supported worldwide to end-user customers through distribution partners, including original equipment manufacturers (“OEMs”), value-added distributors, systems integrators, and value-added resellers.

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

Brocade, the Brocade B weave logo, Fabric OS, Secure Fabric OS, and SilkWorm are registered trademarks and Tapestry is a trademark of Brocade Communications Systems, Inc., in the United States and in other countries. All other brands, products, or service names are or may be trademarks or service marks of, and are used to identify, products or services of their respective owners.

2. Summary of Significant Accounting Policies

Fiscal Year

The Company’s fiscal year is the 52 or 53 weeks ending on the last Saturday in October. As is customary for companies that use the 52/53-week convention, every fifth year contains a 53-week year. Both fiscal years 2006 and 2005 are 52-week fiscal years.

Basis of Presentation

The accompanying financial data as of January 28, 2006, and for the three months ended January 28, 2006 and January 29, 2005, has been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. The October 29, 2005 Condensed Consolidated Balance Sheet was derived from audited consolidated financial statements, but does not include all disclosures required by U.S. generally accepted accounting principles. These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended October 29, 2005.

In the opinion of management, all adjustments (which include only normal recurring adjustments, except as otherwise indicated) necessary to present a fair statement of financial position as of January 28, 2006, results of operations for the three months ended January 28, 2006 and January 29, 2005, and cash flows for the three months ended January 28, 2006 and January 29, 2005 have been made. The results of operations for the three months ended January 28, 2006 are not necessarily indicative of the operating results for the full fiscal year or any future periods.

Reclassifications

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

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Cash and Cash Equivalents

The Company considers all highly liquid investments with an original or remaining maturity of three months or less at the date of purchase to be cash equivalents.

Investments and Equity Securities

Investment securities with original or remaining maturities of more than three months but less than one year are considered short-term investments. Investment securities with original or remaining maturities of one year or more are considered long-term investments. Short-term and long-term investments consist of auction rate securities, debt securities issued by United States government agencies, municipal government obligations, and corporate bonds and notes. The Company classifies its auction rate securities as short-term investments.

Short-term and long-term investments are maintained at three major financial institutions, are classified as available-for-sale, and are recorded on the accompanying Condensed Consolidated Balance Sheets at fair value. Fair value is determined using quoted market prices for those securities. Unrealized holding gains and losses are included as a separate component of accumulated other comprehensive income on the accompanying Condensed Consolidated Balance Sheets, net of any related tax effect. Realized gains and losses are calculated based on the specific identification method and are included in interest and other income, net, on the Condensed Consolidated Statements of Operations.

Restricted short-term investments consists of debt securities issued by the United States government. These investments are maintained at one major financial institution, and are recorded on the accompanying Consolidated Balance Sheets at fair value.

The Company recognizes an impairment charge when the declines in the fair values of its investments below the cost basis are judged to be other-than-temporary. The Company considers various factors in determining whether to recognize an impairment charge, including the length of time and extent to which the fair value has been less than the Company’s cost basis, the financial condition and near-term prospects of the investee, and the Company’s intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value.

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

From time to time the Company makes equity investments in non-publicly traded companies. These investments are included in other assets on the accompanying Condensed Consolidated Balance Sheets, and are generally accounted for under the cost method as the Company does not have the ability to exercise significant influence over the respective company’s operating and financial policies. The Company monitors its investments for impairment on a quarterly basis and makes appropriate reductions in carrying values when such impairments are determined to be other-than-temporary. Impairment charges are included in interest and other income, net on the Condensed Consolidated Statements of Operations. Factors used in determining an impairment include, but are not limited to, the current business environment including competition and uncertainty of financial condition; going concern considerations such as the rate at which the investee company utilizes cash, and the investee company’s ability to obtain additional private financing to fulfill its stated business plan; the need for changes to the investee company’s existing business model due to changing business environments and its ability to successfully implement necessary changes; and comparable valuations. If an investment is determined to be impaired, a determination is made as to whether such impairment is other-than-temporary. As of January 28, 2006 and October 29, 2005, the carrying values of the Company’s equity investments in non-publicly traded companies were $7.5 million and $3.8 million, respectively.

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Concentrations

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

A majority of the Company’s trade receivable balance is derived from sales to OEM partners in the computer storage and server industry. As of January 28, 2006, two customers accounted for 31 percent and 23 percent, respectively, of total accounts receivable. As of October 29, 2005, three customers accounted for 37 percent, 18 percent, and 10 percent, respectively, of total accounts receivable. The Company performs ongoing credit evaluations of its customers and generally does not require collateral on accounts receivable balances. The Company has established reserves for credit losses, sales returns, and other allowances. While the Company has not experienced material credit losses in any of the periods presented, there can be no assurance that the Company will not experience material credit losses in the future.

For the three months ended January 28, 2006 and January 29, 2005, three customers and four customers each represented ten percent or more of the Company’s total revenues for combined totals of 72 percent and 82 percent of total revenues, respectively. The level of sales to any one of these customers may vary, and the loss of, or a decrease in the level of sales to, any one of these customers could seriously harm the Company’s financial condition and results of operations.

The Company currently relies on single and limited supply sources for several key components used in the manufacture of its products. Additionally, the Company relies on one contract manufacturer for the production of its products. The inability of any single and limited source suppliers or the inability of the contract manufacturer to fulfill supply and production requirements, respectively, could have a material adverse effect on the Company’s future operating results.

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

Revenue Recognition

Product revenue. Product revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is probable. However, for newly introduced products, many of the Company’s large OEM customers require a product qualification period during which the Company’s 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. Revenue from sales to the Company’s master reseller customers is recognized in the same period in which the product is actually sold by the master reseller (sell through).

The Company reduces 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 upon historical experience, current trends, and the Company’s expectations regarding future experience. In addition, the Company maintains allowances for doubtful accounts, which are also accounted for as a reduction in revenue. The allowance for doubtful accounts is estimated based upon analysis of accounts receivable, historical collection patterns, customer concentrations, customer creditworthiness, current economic trends, and changes in customer payment terms and practices.

Service revenue. 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 the Company’s software operating system, 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

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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. Service and training revenue were not material in any of the periods presented.

Multiple-element arrangements. The Company’s multiple-element product offerings include computer hardware and software products, and support services. The Company also sells certain software products and support services separately. The Company’s software products are essential to the functionality of its hardware products and are, therefore, accounted for in accordance with Statement of Position 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended. The Company allocates revenue to each element based upon vendor-specific objective evidence (“VSOE”) of the fair value of the element or, if VSOE is not available, by application of the residual method. VSOE of the fair value for an element is based upon the price charged when the element is sold separately. Revenue allocated to each element is then recognized when the basic revenue recognition criteria are met for each element.

Warranty Expense. The Company provides warranties on its products ranging from one to three years. Estimated future warranty costs are accrued at the time of shipment and charged to cost of revenues based upon historical experience.

Stock-Based Compensation

Effective October 30, 2005 the Company began recording compensation expense associated with stock-based awards and other forms of equity compensation in accordance with Statement of Financial Accounting Standards No. 123-R, Share-Based Payment, (“SFAS 123R”) as interpreted by SEC Staff Accounting Bulletin No. 107. The Company adopted the modified prospective transition method provided for under SFAS 123R, and consequently has not retroactively adjusted results from prior periods. Under this transition method, compensation cost associated with stock-based awards recognized in the first quarter of 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 Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, (“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, the Company records expense over the offering period and vesting term in connection with 1) shares issued under its 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 an accelerated vesting method.

Prior to October 30, 2005, the Company accounted for stock-based awards using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“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 the Company’s Condensed Consolidated Statements of Operations when the exercise price of the Company’s 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, the Company recorded stock-based compensation expense using variable accounting under APB 25. From May 1999 through July 2003, the Company granted 98.8 million options that were subject to variable accounting under APB 25 because the measurement date of the options granted was not certain. Effective October 30 2005, if the measurement date is not certain, the Company records stock-based compensation expense under SFAS 123R. Under SFAS 123R, the Company remeasures the intrinsic value of the options at the end of each reporting period until the options are exercised, cancelled or expire unexercised. As of January 28, 2006, 3.1 million options with a weighted average exercise price of $13.06 and a weighted average remaining life of 5.8 years remain outstanding and continue to be remeasured at the intrinsic value. Compensation expense in any given period is calculated as the difference between total earned compensation at the end of the period, less total earned compensation at the beginning of the period. Compensation earned is calculated under an accelerated vesting method.

Employee Stock Plans

The Company has several stock-based compensation plans (the “Plans”) that are described in the Company’s Annual Report on Form 10-K for the fiscal year ended October 29, 2005. The Company, under the various equity plans, grants stock options for shares of common stock to employees and directors. In accordance with the Plans, the stated exercise price for

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non-qualified stock options shall not be less than 85 percent of the estimated fair market value of common stock on the date of grant. Incentive stock options may not be granted at less than 100 percent of the estimated fair market value of the common stock, and stock options granted to a person owning more than 10 percent of the combined voting power of all classes of stock of the Company must be issued at 110 percent of the fair market value of the stock on the date of grant. The Plans provide that the options shall be exercisable over a period not to exceed ten years. The majority of options granted under the Plans vest over a period of four years. Certain options granted under the Plans vest over shorter periods. At January 28, 2006, an aggregate of 131.1 million shares were authorized for future issuance under the Plans, which includes Stock Options, Employee Stock Purchase Plans, and Restricted Stock Awards. A total of 88.2 million shares of common stock were available for grant under the Plans as of January 28, 2006. Awards that expire, or are cancelled without delivery of shares, generally become available for issuance under the Plans.

Stock Options

When the measurement date is certain, the fair value of each option grant is estimated on the date of grant using the Black-Scholes valuation model and the assumptions noted in the following table. The expected term of stock options is based on the midpoint of the historical exercise behavior and uniform exercise behavior. The expected volatility is based on an equal weighted average of implied volatilities from traded options of the Company’s stock and historical volatility of the Company’s stock. The risk free interest rate is based on the implied yield on a U.S. Treasury zero-coupon issue with a remaining term equal to the expected term of the option. The dividend yield reflects that Brocade has not paid any cash dividends since inception and does not anticipate paying cash dividends in the foreseeable future.


	Three Months Ended
	January 28,			January 29,
	2006			2005
Stock Options
Expected dividend yield		0.0	%		0.0	%
Risk-free interest rate		4.5 – 4.6	%		3.0 – 3.7	%
Expected volatility		52.8	%		47.1	%
Expected term (in years)		3.3			2.9

The Company recorded $4.4 million of compensation expense relative to stock options for the quarter ended January 28, 2006 in accordance with SFAS 123R. A summary of stock option activity under the plans for the three months ended January 28, 2006 is presented as follows:


						Weighted
						Average
				Weighted		Remaining		Aggregate
				Average		Contractual		Intrinsic
	Shares			Exercise		Term		Value
	(in thousands)			Price		(Years)		($000)
Outstanding, October 29, 2005		45,179		$	6.59
Granted		1,165		$	4.19
Exercised		(204	)	$	0.68
Forfeited or Expired		(3,209	)	$	6.14

Outstanding, January 28, 2006		42,931		$	6.57		6.3	$	7,716

Ending Vested and Expected to Vest, January 28, 2006		40,776		$	6.66		6.4	$	7,079

Exercisable and Vested, January 28, 2006		26,516		$	7.46		6.4	$	3,356

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As of January 28, 2006, there was $15.9 million of total unrecognized compensation costs related to stock options. These costs are expected to be recognized over a weighted average period of 3.57 years.

Employee Stock Purchase Plan

Under Brocade’s Employee Stock Purchase Plan, eligible employees can participate and purchase shares semi-annually through payroll deductions at the lower of 85% of the fair market value of the stock at the commencement or end of the offering period, which is six months. The Purchase Plan permits eligible employees to purchase common stock through payroll deductions for up to 15% of qualified compensation. The Company accounts for the Employee Stock Purchase Plan as a compensatory plan and recorded compensation expense of $0.9 million for the quarter ended January 28, 2006 in accordance with SFAS 123R.

The fair value of the option component of the Employee Stock Purchase Plan shares were estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:


	Three Months Ended
	January 28,			January 29,
	2006			2005
Employee Stock Purchase Plan
Expected dividend yield		0.0	%		0.0	%
Risk-free interest rate		3.4 – 4.4	%		2.0 – 2.5	%
Expected volatility		44.3	%		50.3	%
Expected term (in years)		0.5			0.5

As of January 28, 2006, there was $1.5 million of total unrecognized compensation costs related to employee stock purchases. These costs are expected to be recognized over a weighted average period of 0.2 years.

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Information as Reported in the Financial Statements

Total stock-based compensation expense of $6.9 million has been included in the Company’s Condensed Consolidated Statement of Operations for the three months ended January 28, 2006. Included in this amount is stock-based compensation expense for restricted stock awards of $0.8 million, options remeasured at their intrinsic value of $0.3 million, amortization of stock compensation expense related to prior acquisitions of $0.6 million, and incremental stock-based compensation of $5.3 million related to the adoption of SFAS 123R. The table below sets out the $5.3 million incremental stock-based compensation expense for stock options and employee stock purchases recognized under the provisions of SFAS 123R (in thousands, except per share data) for the three months ended January 28, 2006.


	Three Months Ended
	January 28,
	2006
Stock-based compensation expense for stock options and employee stock purchases included in operations:
Cost of Revenues	$	(1,647	)
Research and Development		(1,734	)
Sales and Marketing		(1,259	)
General and Administrative		(653	)

Total		(5,293	)
Tax benefit		31

Net decrease in net income	$	(5,262	)

Effect on:
Net income per share- Basic	$	(0.02	)

Net income per share- Diluted	$	(0.02	)

Prior to our adoption of SFAS 123R, benefits of tax deductions in excess of recognized compensation costs were reported as operating cash flows. SFAS 123R requires that they be recorded as a financing cash inflow rather than as a reduction of taxes paid. For the three months ended January 28, 2006, there was no excess tax benefit generated from option exercises. While our estimate of fair value and the associated charge to earnings materially affects our results of operations, it has no impact on our cash position.

Information Calculated as if Fair Value Method Had Applied to All Awards

The table below sets out the pro forma amounts of net income and net income per share (in thousands, except per share data) that would have resulted for the three months ended January 29, 2005, if Brocade accounted for its employee stock plans under the fair value recognition provisions of SFAS 123.


	Three Months Ended
	January 29,
	2005
Net income – as reported	$	27,943
Add: Stock-based compensation expense (benefit) included in reported net income, net of tax		(935	)
Deduct: Stock-based compensation expense determined under the fair value based method, net of tax		(4,636	)

Pro forma net income	$	22,372

Basic net income per share:
As reported	$	0.10
Pro forma	$	0.08
Diluted net income per share:
As reported	$	0.10
Pro forma	$	0.08

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Restricted Stock Awards

For the three months ended January 28, 2006 and January 29, 2005, Brocade issued restricted stock awards of 1.9 million shares and 0.02 million shares, respectively, to certain eligible employees at a purchase price of $0.001 and $0.01 per share, respectively. These restricted shares are not transferable until fully vested and are subject to repurchase for all unvested shares upon termination. The fair value of each award is based on the Company’s closing stock price on the date of grant. Compensation expense computed under the fair value method for stock awards issued is being amortized over the awards’ vesting period and was $0.8 million and $0.3 million, for the three months ended January 28, 2006 and January 29, 2005, respectively.

The weighted-average fair value of the restricted stock awards granted in the three months ended January 28, 2006 and January 29, 2005 was $4.43 and $7.06, respectively. The total fair value of stock awards vested for both the three months ended January 28, 2006 and January 29, 2005 was zero. At January 28, 2006, unrecognized costs related to restricted stock awards totaled approximately $7.4 million. These costs are expected to be recognized over a weighted average period of 1.8 years. A summary of the nonvested shares for the three months ended January 28, 2006 is presented as follows:


				Weighted
				Average
	Shares			Grant-Date
	(in thousand)			Fair Value
Nonvested, October 29, 2005		13		$	7.05
Granted		1,923		$	4.43
Vested		(3	)	$	7.05
Forfeited		—			—

Nonvested, January 28, 2006		1,933		$	4.44

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

Comprehensive Income

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


	Three Months Ended
	January 28,			January 29,
	2006			2005
Net income	$	9,660		$	27,943
Other comprehensive income:
Change in net unrealized gains (losses) on marketable equity securities and investments		477			(2,299	)
Cumulative translation adjustments		(6	)		180

Total comprehensive income	$	10,131		$	25,824

3. Balance Sheet Details

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


	January 28,		October 29,
	2006		2005
Inventories:
Raw materials	$	1,399	$	1,517
Finished goods		6,765		9,513

Total	$	8,164	$	11,030


Property and equipment, net:
Computer equipment and software	$	69,649	$	68,294
Engineering and other equipment		129,708		123,811
Furniture and fixtures		4,353		4,136

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	January 28,			October 29,
	2006			2005
Leasehold improvements		42,028			41,696
Land and building		30,000			30,000

Subtotal		275,738			267,937
Less: Accumulated depreciation and amortization		(168,924	)		(159,819	)

Total	$	106,814		$	108,118


	January 28,		October 29,
	2006		2005
Other accrued liabilities:
Income taxes payable	$	35,591	$	36,923
Accrued warranty		1,987		1,746
Inventory purchase commitments		5,976		6,634
Accrued sales programs		9,963		8,327
Other		20,175		16,202

Total	$	73,692	$	69,832

Leasehold improvements as of January 28, 2006 and October 29, 2005, are shown net of estimated asset impairments related to facilities lease losses (see Note 5).

4. Investments and Equity Securities

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


			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
January 28, 2006
U.S. government and its agencies and municipal obligations	$	391,840	$	1	$	(2,486	)	$	389,355
Corporate bonds and notes		213,124		15		(1,249	)		211,890
Equity securities		34		6		—			40

Total	$	604,998	$	22	$	(3,735	)	$	601,285


Reported as:
Short-term investments								$	262,465
Restricted short-term investments									277,040
Other current assets									40
Long-term investments									61,740

Total								$	601,285


October 29, 2005
U.S. government and its agencies and municipal obligations	$	413,574	$	—	$	(2,629	)	$	410,945
Corporate bonds and notes		173,021		11		(1,576	)		171,456
Equity securities		34		2		—			36

Total	$	586,629	$	13	$	(4,205	)	$	582,437


Reported as:
Short-term investments								$	209,865
Restricted short-term investments									277,230
Other current assets									36
Long-term investments									95,306

Total								$	582,437

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For both the three months ended January 28, 2006 and January 29, 2005, no gains were realized on the sale of investments or marketable equity securities. As of January 28, 2006 and October 29, 2005, net unrealized holding losses of $3.7 million and $4.2 million, respectively, were included in accumulated other comprehensive income in the accompanying Condensed Consolidated Balance Sheets.

The following table summarizes the maturities of the Company’s investments in debt securities issued by United States government and its agencies, municipal government obligations, and corporate bonds and notes as of January 28, 2006 (in thousands):


	Amortized		Fair
	Cost		Value
Less than one year	$	542,239	$	539,505
Due in 1 – 2 years		60,265		59,319
Due in 2 – 3 years		2,460		2,421

Total	$	604,964	$	601,245

5. Liabilities Associated with Facilities Lease Losses

During the three months ended October 27, 2001, the Company recorded a charge of $39.8 million related to estimated facilities lease losses, net of expected sublease income, and a charge of $5.7 million in connection with the estimated impairment of certain related leasehold improvements. These charges represented the low-end of the then estimated range of $39.8 million to $63.0 million and may be adjusted upon the occurrence of future triggering events.

During the three months ended July 27, 2002, the Company completed a transaction to sublease a portion of these vacant facilities. Accordingly, based on then current market data, the Company revised certain estimates and assumptions, including those related to estimated sublease rates, estimated time to sublease the facilities, expected future operating costs, and expected future use of the facilities. The Company reevaluates its estimates and assumptions on a quarterly basis and makes adjustments to the reserve balance if necessary.

In November 2003 the Company purchased a previously leased building. In addition, the Company consolidated the engineering organization and development, test and interoperability laboratories into the purchased facilities and vacated other existing leased facilities. As a result, the Company recorded adjustments to the previously recorded facilities lease loss reserve, deferred rent and leasehold improvement impairments, and recorded additional reserves in connection with the facilities consolidation.

The following table summarizes the activity related to the facilities lease losses reserve, net of expected sublease income (in thousands), as of January 28, 2006:


	Lease Loss
	Reserve
Reserve balances at October 29, 2005	$	17,140
Cash payments on facilities leases		(1,185	)
Non-cash charges		(43	)

Reserve balance at January 28, 2006	$	15,912

Cash payments for facilities leases related to the above noted facilities lease losses will be paid over the respective lease terms through fiscal year 2010.

6. Convertible Subordinated Debt

On December 21, 2001, and January 10, 2002, the Company sold, in private placements pursuant to Section 4(2) of the Securities Act of 1933, as amended, an aggregate of $550 million in principal amount, two percent convertible subordinated notes due January 2007 (the notes or convertible subordinated debt). The initial purchasers purchased the notes from the Company at a discount of 2.25 percent of the aggregate principal amount. Under the original term of the Notes, holders of the notes may, in whole or in part, convert the notes into shares of the Company’s common stock at a conversion rate of 22.8571 shares per $1,000 principal amount of notes (approximately 6.4 million shares may be issued upon conversion based on outstanding debt of $278.9 million as of January 28, 2006) at any time prior to maturity on January 1, 2007, subject to earlier redemption. Additionally, under the original term of the Notes, at any time on or after January 5, 2005, the Company was entitled to redeem the notes in whole or in part at the following prices expressed as a percentage of the principal amount:

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Redemption Period	Price
Beginning on January 5, 2005 and ending on December 31, 2005		100.80	%
Beginning on January 1, 2006 and ending on December 31, 2006		100.40	%
On January 1, 2007 and thereafter		100.00	%

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”). Over the course of the next year, the Trustee, using the securities deposited with them, will pay 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 January 28, 2006, the Company had an aggregate of $277.0 million in interest-bearing U.S. government securities with the Trustee. The securities will remain on the Company’s balance sheet as restricted short-term investments until the Redemption Date.

The Company is required to pay interest on January 1 and July 1 of each year, beginning July 1, 2002. Under the original term of the notes, debt issuance costs of $12.4 million are being amortized over the term of the notes and will accelerate upon early redemption or conversion of the notes. As of January 28, 2006, the remaining balance of unamortized debt issuance costs was $1.0 million and is being amortized through the redemption date of August 22, 2006. The net proceeds of the convertible subordinated debt remain available for general corporate purposes, including working capital and capital expenditures.

During the three months ended January 28, 2006, the Company did not repurchase any of its convertible subordinated debt. To date, the Company has repurchased a total of $271.1 million in face value of its convertible subordinated notes. As of January 28, 2006, the remaining balance outstanding of the convertible subordinated debt was $278.9 million.

The notes are not listed on any securities exchange or included in any automated quotation system; however, the notes are eligible for trading on the Portal^SM Market. On January 27, 2006, the average bid and ask price on the Portal Market of the notes was 98.13, resulting in an aggregate fair value of approximately $273.7 million.

7. Commitments and Contingencies

Leases

The Company leases its facilities and certain equipment under various operating lease agreements expiring through August 2010. In connection with its facilities lease agreements, the Company has signed unconditional, irrevocable letters of credit totaling $8.3 million as security for the leases. Future minimum lease payments under all non-cancelable operating leases as of January 28, 2006 were $67.0 million. In addition to base rent, many of the facilities lease agreements require that the Company pay a proportional share of the respective facilities’ operating expenses.

As of January 28, 2006, the Company had recorded $15.9 million in facilities lease loss reserves related to future lease commitments, net of expected sublease income (see Note 5).

Product Warranties

The Company provides warranties on its products ranging from one to three years. Estimated future warranty costs are accrued at the time of shipment and charged to cost of revenues based upon historical experience. The Company’s accrued liability for estimated future warranty costs is included in other accrued liabilities on the accompanying Condensed Consolidated Balance Sheets. The following table summarizes the activity related to the Company’s accrued liability for estimated future warranty costs during the three months ended January 28, 2006 and January 29, 2005 (in thousands), respectively:

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	January 28,			January 29,
	2006			2005
Beginning Balance	$	1,746		$	4,669
Liabilities accrued for warranties issued during the period		394			281
Warranty claims paid during the period		(124	)		(104	)
Changes in liability for pre-existing warranties during the period		(29	)		(2,875	)

Ending Balance	$	1,987		$	1,971

In addition, the Company has standard indemnification clauses contained within its various customer contracts. As such, the Company indemnifies the parties to whom it sells its products with respect to the Company’s product infringing upon any patents, trademarks, copyrights, or trade secrets, as well as against bodily injury or damage to real or tangible personal property caused by a defective Company product. As of January 28, 2006, there have been no known events or circumstances that have resulted in a customer contract related indemnification liability to the Company.

Manufacturing and Purchase Commitments

The Company has a manufacturing agreement with Hon Hai Precision Industry Co. (“Foxconn”) under which the Company provides twelve-month product forecasts and places purchase orders in advance of the scheduled delivery of products to the Company’s customers. The required lead-time for placing orders with Foxconn depends on the specific product. As of January 28, 2006, the Company’s aggregate commitment to Foxconn for inventory components used in the manufacture of Brocade products was $51.5 million, net of purchase commitment reserves of $6.0 million, which the Company expects to utilize during future normal ongoing operations. The Company’s purchase orders placed with Foxconn are cancelable, however if cancelled, the agreement with Foxconn requires the Company to purchase from Foxconn all inventory components not returnable, usable by, or sold to, other customers of Foxconn. The Company’s purchase commitments reserve reflects the Company’s estimate of purchase commitments it does not expect to consume in normal operations.

Legal Proceedings

From time to time, claims are made against the Company 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 the Company 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 the Company’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 the Company, certain of its officers and directors, and certain of the underwriters for the Company’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 the Company’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 the Company 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 the Company. In June 2004, a stipulation of settlement for the claims against the issuer defendants, including the Company, was submitted to the Court for approval. On August 31, 2005, the Court granted preliminary approval of the settlement. The settlement is subject to a number of conditions, including final approval by the Court.

Beginning on or about May 19, 2005, several securities class action complaints were filed against the Company and certain of its current and former officers. These actions were filed on behalf of purchasers of the Company’s stock from February 2001 to May 2005. These complaints were filed in the United States District Court for the Northern District of California. On January 12, 2006, the Court appointed a lead plaintiff and lead counsel and ordered that a consolidated complaint be filed by March 3, 2006. The securities class action complaints allege, 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 complaints seek unspecified monetary damages and other relief against the defendants. The complaints generally allege that the Company and the individual

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defendants made false or misleading public statements regarding the Company’s business and operations. These lawsuits followed the Company’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 the Company’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 the Company’s officers and directors breached their fiduciary duties to the Company by engaging in alleged wrongful conduct including conduct complained of in the securities litigation described above. The Company 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 on October 7, 2005 and the Company filed a motion to dismiss that action on October 27, 2005. On January 6, 2006, Brocade’s motion was granted and the consolidated complaint was dismissed with leave to amend. The derivative actions pending in the Superior Court in Santa Clara County were consolidated. The derivative plaintiffs filed a consolidated complaint on September 19, 2005. The Company filed a motion to stay that action in deference to the substantially identical consolidated derivative action pending in the District Court, and on November 15, 2005, the Court stayed the action.

No amounts have been recorded in the accompanying Condensed Consolidated Financial Statements associated with these matters.

8. Segment Information

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

Revenues are attributed to geographic areas based on the location of the customer to which products are shipped. Domestic revenues include sales to certain OEM customers who take possession of Brocade products domestically and then distribute these products to their international customers. Domestic and international revenues were approximately 63 percent and 37 percent of total revenues, respectively, for the three months ended January 28, 2006 compared to 66 percent and 34 percent of total revenues, respectively, for the three months ended January 29, 2005. To date, service revenue has not exceeded 10 percent of total revenues. Identifiable assets located in foreign countries were not material as of January 28, 2006 and October 29, 2005. For the three months ended January 28, 2006, three customers accounted for 72 percent of our total revenues. For the three months ended January 29, 2005, four customers accounted for 82 percent of total revenues.

9. Net Income per Share

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


	Three Months Ended
	January 28,			January 29,
	2006			2005
Net income	$	9,660		$	27,943

Basic and diluted net income per share:
Weighted-average shares of common stock outstanding		271,335			266,391
Less: Weighted-average shares of common stock subject to repurchase		(1,935	)		(173	)

Weighted-average shares used in computing basic net income per share		269,400			266,218
Dilutive effect of common share equivalents		2,701			5,204

Weighted-average shares used in computing diluted net income per share		272,101			271,422

Basic net income per share	$	0.04		$	0.10

Diluted net income per share	$	0.04		$	0.10

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For the three months ended January 28, 2006 and January 29, 2005, potential common shares in the form of stock options to purchase 42.5 million and 3.0 million weighted-average shares of common stock, respectively, were antidilutive and, therefore, not included in the computation of diluted earnings per share. For the three months ended January 28, 2006 and January 29, 2005, potential common shares resulting from the potential conversion, on a weighted average basis, of the Company’s convertible subordinated debt of 6.4 million and 8.0 million common shares, respectively, were antidilutive and therefore not included in the computation of diluted earnings per share.

10. Subsequent Events

On March 6, 2006, the Company completed its acquisition of NuView, Inc. (“NuView”), a privately held software developer based in Houston, Texas. Under the terms of the acquisition agreement, Brocade has acquired all of the outstanding shares of NuView for approximately $60 million in cash, including estimated direct acquisition costs. As a result of this acquisition, the Company expects to record goodwill and other intangible assets in the second quarter of fiscal 2006.

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

Results of Operations

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


	Three Months Ended
	January 28,			January 29,
	2006			2005
Net revenues		100.0	%		100.0	%
Cost of revenues		40.8			39.9

Gross margin		59.2			60.1

Operating expenses:
Research and development		22.4			19.6
Sales and marketing		18.1			15.4
General and administrative		4.6			4.1
Internal review and SEC investigation costs		2.4			2.3
Provision for SEC settlement		4.1			—
Amortization of acquisition related deferred stock compensation		0.4			0.1
Total operating expenses		52.0			41.5

Income from operations		7.2			18.6
Interest and other income, net		4.1			3.3
Interest expense		(1.0	)		(1.4	)
Gain on repurchases of convertible subordinated debt		0.0			0.1

Income before provision for income taxes		10.3			20.6
Income tax provision		4.6			3.3

Net income		5.7	%		17.3	%

Revenues. Our revenues are derived primarily from sales of our SilkWorm family of products. Our SilkWorm products, which range in size from 8 ports to 256 ports, connect servers and storage devices creating a SAN. Net revenues for the three months ended January 28, 2006 were $170.1 million, an increase of five percent compared with net revenues of $161.6 million for the three months ended January 29, 2005. The increase in net revenues for the period reflected an 18 percent increase in the number of ports shipped, and an increase in software and service revenue, partially offset by a 17 percent decline in average selling price per port. The declines in average selling prices are the result of a continuing 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.

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Going forward, 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 consistent with the rates we experienced in fiscal year 2005, unless they are adversely affected by accelerated pricing pressures, new product introductions by us or our competitors, or other factors that may be beyond our control. We expect quarterly fluctuations in revenue to be consistent with historic seasonal trends. Historically, our second fiscal quarter is down from a seasonally strong first fiscal quarter due to a typically slower growth period.

Historically, domestic revenues have been between 60 percent and 75 percent of total revenues. Domestic and international revenues were approximately 63 percent and 37 percent of our total revenues, respectively, for the three months ended January 28, 2006 compared to 66 percent and 34 percent of total revenues, respectively, for the three months ended January 29, 2005. 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 three months ended January 28, 2006 and January 29, 2005, international revenues have increased primarily as a result of faster growth in the European region relative to North America. 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 relatively small number of OEM customers. For the three months ended January 28, 2006, three customers each represented ten percent or more of our total revenues for a combined total of 72 percent of our total revenues. For the three months ended January 29, 2005, four customers each represented ten percent or more of our total revenues for combined totals of 82 percent of total revenues. We expect that a significant portion of our future revenues will continue to come from sales of products to a relatively 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.

Gross margin. Gross margin for the three months ended January 29, 2006 was 59.2 percent, a decrease of 0.9 percent from 60.1 percent for the three months ended January 28, 2005. Cost of goods sold consists of product costs, which are variable, and manufacturing operations costs and service operations, which are generally fixed. For the three months ended January 28, 2006, product costs relative to net revenues decreased by 2.6 percent as compared to the three months ended January 29, 2005 due to the transition from 2 Gbit products to new 4 Gbit products and some favorable product mix of shipments. Manufacturing operation costs and service operations costs increased 4.4 percent relative to net revenues primarily due to the increase in headcount and higher engineering charges as products transitioned into sustaining engineering from development. In addition, stock-based compensation expense in the three months ended January 28, 2006 increased by 0.9 percent relative to net revenues primarily as a result of the company’s adoption of Statement of Financial Accounting Standards No. 123-R, Share-Based Payment, (“SFAS 123R”).

Gross margin is primarily affected by average selling price per port, number of ports shipped, and cost of goods sold. We expect that average selling price per port for our products will continue to decline at rates consistent with the rates we experienced in fiscal year 2005, unless they are further affected by accelerated pricing pressures, 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. 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.

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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; and IT and facilities expenses.

For the three months ended January 28, 2006, R&D expenses increased by $6.4 million, or 20 percent, to $38.1 million, compared with $31.7 million for the three months ended January 29, 2005. This increase is primarily due to a $3.8 million increase in salaries and headcount related expenses resulting from growth in our new Tapestry line of products and the buildout of our offshore development center, $2.7 million increase in stock-based compensation expense primarily attributable to the Company’s adoption of SFAS 123R, and $0.7 million increase in outside service providers due to the continued investment in offshore research and development.

Excluding any stock-based compensation expenses related to 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 for the three months ending April 29, 2006 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.

For the year three months ended January 28, 2006, sales and marketing expenses increased by $6.1 million, or 24 percent, to $30.9 million, compared with $24.8 million for the three months ended January 29, 2005. This increase is primarily due to a $2.7 million increase in salaries and headcount related expenses, including higher commissions expenses due to higher revenues, a $1.8 million increase in stock-based compensation expense primarily attributable to the Company’s adoption of SFAS 123R, and a $1.8 million increase in sales and marketing program expenses.

Excluding any stock-based compensation expenses related to 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 for the three months ended April 29, 2006 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 recruiting expenses, professional fees, corporate legal expenses, other corporate expenses, and IT and facilities expenses.

G&A expenses for the three months ended January 28, 2006 increased by $1.1 million, or 17 percent, to $7.8 million, compared with $6.7 million for the three months ended January 29, 2005. The increase in G&A is primarily due to a $1.0 million increase in stock based compensation primarily attributable to the Company’s adoption of SFAS 123R.

Excluding any stock-based compensation expenses related to 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 for the three months ending April 29, 2006 to remain flat in absolute dollars.

Internal review and SEC investigation costs. 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. Our Audit Committee review was completed in November 2005. In addition, we are undergoing an SEC and Department of Justice (“DOJ”) joint investigation regarding our historical stock option granting practices. As a result, for the three months ended January 28, 2006, and January 29, 2005 we recorded $4.0 million and $3.7 million, respectively for professional service fees related to the completed internal reviews and ongoing SEC investigation.

Provision for SEC settlement. During the three months ended January 28, 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 three months ended January 28, 2006 we recorded a $7.0 million provision for an estimated settlement expense. This is an increase of $2.0 million over the $5.0 million previously disclosed on February 16, 2006 as a result of further discussions with the Staff. 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 intends on recommending to the SEC’s Commissioners. The offer of settlement is contingent upon final approval by the SEC’s Commissioners.

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Stock compensation expense. Total stock-based compensation expense for the three months ended January 28, 2006 was $6.9 million. Of this amount, $1.8 million was included in cost of sales, $2.0 million in research and development, $1.6 million in sales and marketing, $0.8 million in general and administrative expenses, and $0.6 million in amortization of deferred stock-based compensation related to prior acquisitions. Total stock-based compensation expense (benefit) for the three months ended January 29, 2005 was $(0.9) million. Of this amount, of $(0.2) million was included in cost of sales, $(0.4) million in research and development, $(0.2) million in sales and marketing, $(0.2) million in general and administrative expenses, and $0.1 million in amortization of deferred stock-based compensation related to prior acquisitions. Total stock-based compensation benefit as of January 29, 2005 excludes certain stock-based awards which were previously reported as proforma compensation expense under APB 25 (see Note 2, “Summary of Significant Accounting Policies,” of the Notes to Condensed 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 three months ended January 28, 2006 stock-based compensation expense for stock options and employee stock purchases of $5.3 million is included in cost of sales, research and development, sales and marketing, or general and administrative expenses by employee.

We have stock-based compensation arising from stock option grants remeasured at their intrinsic value and subject to change in measurement date. For the three months ended January 28, 2006, total compensation expense of $0.3 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 expenses by employee. For the three months ended January 29, 2005, total compensation expense (benefit) of $(1.3) million resulting from stock option grants remeasured at their intrinsic value and subject to change in measurement date are included in cost of sales, research and development, sales and marketing, or general and administrative expenses, by employee. 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 three months ended January 28, 2006 as compared to the three months ended January 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 three months ended January 28, 2006 and January 29, 2005, we recorded $0.6 million and $0.1 million, respectively, in amortization of stock-based compensation in connection with prior acquisitions. 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 January 28, 2006, the remaining unamortized balance of stock-based compensation related to prior acquisitions was approximately $1.0 million.

Interest and other income, net. Interest and other income was $7.0 million and $5.2 million for three months ended January 28, 2006 and January 29, 2005, respectively. For the three months ended January 28, 2006, 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.

Interest expense. Interest expense was $1.8 million and $2.2 million for the three months ended January 28, 2006 and January 29, 2005, respectively. Interest expense primarily represents the interest cost associated with our convertible subordinated debt. The decrease in interest expense was primarily the result of the repurchases of our convertible subordinated debt, resulting in a lower debt outstanding. As of January 28, 2006 and January 29, 2005, the outstanding balance of our convertible subordinated debt was $278.9 million and $348.1 million, respectively (see Note 6, “Convertible Subordinated Debt,” of the Notes to Condensed Consolidated Financial Statements).

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Gain on repurchases of convertible subordinated debt. During the three months ended January 28, 2006 and January 29, 2005, we repurchased zero and $4.2 million in face value of our convertible subordinated debt, respectively, on the open market. For the three months ended January 29, 2005, we paid an average of $0.955 on each dollar of face value for an aggregate purchase price of $4.0 million, which resulted in a pre-tax gain of $0.2 million.

Provision for income taxes. 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 the last seven fiscal years represented sufficient negative evidence to require a full valuation allowance. As of January 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.

In the three months ended January 28, 2006, we have recorded an income tax provision of $7.9 million, compared to income tax provision of $5.3 million for the three months ended January 29, 2005. For the three months ended January 28, 2006, our income tax provision is based on both domestic and international operations. We expect to continue to record an income tax provision for our international and domestic operations in the future. Our effective tax rate for the three months ended January 28, 2006 was higher due to the provision for SEC settlement recorded in the period. We expect our effective tax rate for the three months ending April 29, 2006 to be lower. 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 US 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.

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. The IRS Audit is ongoing and we believe our reserves are adequate to cover any potential assessments that may result from the examination.

Liquidity and Capital Resources

Cash, cash equivalents, restricted short-term investments, and short-term and long-term investments were $789.1 million as of January 28, 2006, an increase of $24.7 million over the prior quarter total of $764.4 million. For the three months ended January 28, 2006, we generated $32.0 million in cash from operating activities. Cash from operations significantly exceeded net income for the three months ended January 28, 2006 due to non-cash expense items, primarily related to depreciation and amortization, non-cash compensation expense, and the provision for SEC settlement, offset by an increase in accounts receivable. Days sales outstanding in receivables for the three months ended January 28, 2006 was 41 days, compared with 58 days for the three months ended January 29, 2005.

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Net cash used in investing activities for the three months ended January 28, 2006 totaled $30.0 million and was the result of $75.7 million in cash used for purchases of short-term, restricted short-term, and long-term investments and other non-marketable minority equity investments and $8.2 million invested in capital equipment, offset by $53.9 million in net proceeds from sales and maturities of short-term and short-term restricted investments.

Net cash provided by financing activities for the three months ended January 28, 2006 totaled $3.9 million. Net cash provided by financing activities was primarily the result of proceeds from the issuance of common stock.

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. As a result of our voluntary stock options exchange program, which was completed in July 2003, we do not expect to generate significant cash flow from the issuance of common stock related to the employee participation in employee stock programs during fiscal year 2006 unless our future common stock price exceeds $6.54 per share, which is the exercise price of the stock options granted under the exchange program.

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 January 28, 2006, our aggregate commitment to Foxconn for inventory components used in the manufacture of Brocade products was $51.5 million, net of purchase commitment reserves of $6.0 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.

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 8, “Convertible Subordinated Debt,” of the Notes to Condensed Consolidated Financial Statements). Holders of the Notes may, in whole or in part, convert the Notes into shares of our common stock at a conversion rate of 22.8571 shares per $1,000 principal amount of notes (approximately 6.4 million shares may be issued upon conversion based on outstanding debt of $278.9 million as of January 28, 2006) at any time prior to maturity on January 1, 2007, subject to earlier redemption. Under the original term of the Notes, at any time on or after January 5, 2005, we were entitled to redeem the notes in whole or in part at the following prices expressed as a percentage of the principal amount:


Redemption Period	Price
Beginning on January 5, 2005 and ending on December 31, 2005		100.80	%
Beginning on January 1, 2006 and ending on December 31, 2006		100.40	%
On January 1, 2007		100.00	%

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”). Over the course of the next year, the Trustee, using the securities deposited with them, will pay 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 January 28, 2006, the Company had an aggregate of $277.0 million in interest-bearing U.S. securities with the Trustee. The securities will remain on the Company’s balance sheet as restricted short-term investments until the Redemption Date.

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

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During the three months ended January 28, 2006 we did not purchase any of our Convertible Subordinated Debt on the open market. For the three months ended January 29, 2005, we purchased $4.2 million in face value of our Convertible Subordinated Debt on the open market and paid an average of $0.955 on each dollar of face value for an aggregate purchase price of $4.0 million, which resulted in a pre-tax gain of $0.2 million. As of January 28, 2006, the remaining balance outstanding of the convertible subordinated debt was $278.9 million.

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 agreements.

The following table summarizes our contractual obligations (including interest expense) and commitments as of January 28, 2006 (in thousands):


				Less than						More than
	Total			1 Year		1-3 Years		3-5 Years		5 Years
Contractual Obligations:
Convertible subordinated notes, including interest	$	277,040		$	277,040	$	—	$	—	$	—
Non-cancelable operating leases		67,008			15,981		29,106		21,921		—
Purchase commitments, gross		51,534	(1)		51,534		—		—		—

Total contractual obligations	$	395,582		$	344,555	$	29,106	$	21,921	$	—

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 reflects total gross purchase commitments under our manufacturing agreement with a third party contract manufacturer. Of this amount, we have reserved $6.0 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 1.2 million shares and $92.9 million remains available for future repurchases under this program.

Other. Under the terms of a certain licensing agreement, we may be required to pay up to $3.7 million of prepaid license fees if certain milestones are met.

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.

Critical Accounting Policies

Our discussion and analysis of financial condition and results of operations is based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these Condensed 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

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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 Condensed 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 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 Condensed 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;

	•		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 are essential to the functionality of our

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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 based upon vendor-specific objective evidence (“VSOE”) of the fair value of the element or, if VSOE is not available, by application of the residual method. VSOE of the fair value for an element is based upon the price charged when the element is sold separately. 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 in the first quarter of 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 an accelerated 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 Condensed 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.

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. 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 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. 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.

Item 3. Quantitative and Qualitative Disclosures About Market Risks

We are exposed to market risk related to changes in interest rates and equity security prices.

Interest Rate Risk

Our exposure to market risk due to changes in the general level of United States interest rates relates primarily to our cash equivalents and short-term and long-term investment portfolios. Our cash, cash equivalents, and short-term and long-term investments are primarily maintained at five major financial institutions in the United States. As of January 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 as of January 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						January 28,		Increase of X Basis Points
Issuer	(150 BPS)		(100 BPS)		(50 BPS)		2006		50 BPS		100 BPS		150 BPS
U.S. government agencies and municipal obligations	$	393,033	$	391,912	$	390,782	$	389,355	$	388,518	$	387,396	$	386,281
Corporate bonds and notes	$	214,601	$	213,418	$	212,253	$	211,890	$	209,979	$	208,867	$	207,771

Total	$	607,634	$	605,330	$	603,035	$	601,245	$	598,497	$	596,263	$	594,052

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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 equivalents, short-term, restricted short-term, and long-term investments subject to interest rate risk and their related weighted average interest rates as of January 28, 2006. Carrying value approximates fair value.


			Weighted
			Average
	Amount		Interest Rate
Cash and cash equivalents	$	187,872		3.7%
Restricted short-term investments		277,040		3.8%
Short-term investments		262,465		3.2%
Long-term investments		61,740		3.5%

Total	$	789,117		3.6%

Our convertible subordinated debt is subject to a fixed interest rate and the notes are based on a fixed conversion ratio into common stock. Therefore, we are not exposed to changes in interest rates related to our long-term debt instruments. The notes are not listed on any securities exchange or included in any automated quotation system; however, the notes are eligible for trading on the Portal^SM Market. On January 27, 2006, the average bid and ask price on the Portal Market of our convertible subordinated notes due 2007 was 98.13, resulting in an aggregate fair value of approximately $273.7 million. Our common stock is quoted on the Nasdaq National Market under the symbol “BRCD.” On January 27, 2006, the last reported sale price of our common stock on the Nasdaq National Market was $4.62 per share.

Item 4. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer and Interim Chief Financial Officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this Quarterly Report on Form 10-Q (the “Evaluation Date”).

The purpose of this evaluation is to determine if, as of the Evaluation Date, our disclosure controls and procedures were operating effectively such that the information relating to Brocade, required to be disclosed in our Securities and Exchange Commission (“SEC”) reports (i) was recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) was accumulated and communicated to our management, including our Chief Executive Officer and Interim Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Based on this evaluation, our Chief Executive Officer and Interim Chief Financial Officer concluded that, as of the Evaluation Date, our disclosure controls and procedures were operating effectively.

(b) Changes in Internal Control Over Financial Reporting.

There were no changes in our internal controls over financial reporting during the first quarter of fiscal 2006 that materially affected or are reasonably likely to materially affect our internal control over financial reporting.

Limitations on the Effectiveness of Disclosure Controls and Procedures.

Our management, including our Chief Executive Officer and Interim Chief Financial Officer, do not expect that our disclosure controls and procedures or internal control over financial reporting will prevent all errors and all fraud. A control system no matter how well designed and implemented, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues within a company are detected. The inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur

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because of simple error or mistakes. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

No amounts have been recorded in the accompanying Condensed Consolidated Financial Statements associated with these matters.

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Item 1A. Risk Factors

Our future revenue growth depends on our ability to introduce new products and services on a timely basis and achieve market acceptance of these new products and services.

The market for SANs is characterized by rapidly changing technology and accelerating product introduction cycles. Our future success depends upon our ability to address the rapidly changing needs of our 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 SAN market becomes more competitive and subject to increased demand for new and improved technologies.

We have recently introduced a significant number of new products, primarily in our SilkWorm product family, which accounts for a substantial portion of our revenues. For example, during fiscal year 2005 we introduced the SilkWorm 48000 Director, the SilkWorm 200E entry level fabric switch, four new switch modules for bladed server solutions, and a new release of Fabric Manager software. We also recently launched three new software products, the Tapestry Application Resource Manager solution, the Tapestry Data Migration Manager, and the Tapestry Wide Area File Services solution, as well as new service and support offerings. We must achieve widespread market acceptance of our new products and service offerings in order to realize the benefits of our investments. The rate of market adoption is also critical. The success of our product and service offerings depend on numerous factors, including our ability:

	•		to properly define the new products and services;

	•		to timely develop and introduce the new products and services;

	•		to differentiate our new products and services from our competitors’ offerings; and

	•		to address the complexities of interoperability of our products with our OEM partners’ server and storage products and our competitors’ products.

Some factors impacting market acceptance are also outside of our control, including the availability and price of competing products, technologies; product qualification requirements by our OEM partners, which can cause delays in the market acceptance; and the ability of our OEM partners to successfully distribute, support and provide training for our products. If we are not able to successfully develop and market new and enhanced products and services, our business and results of operations will be harmed.

We are currently diversifying our product and service offerings to include software applications and support services, and our operating results will suffer if these initiatives are not successful.

Starting in the second half of fiscal year 2004, we began making a series of investments in the development and acquisition of new technologies and services, including new switch modules for bladed server solutions, new hardware and software solutions for information technology infrastructure management and new service and support offerings. Some of these offerings are focused on new markets that are adjacent or parallel to our traditional market. Our strategy is to derive competitive advantage and drive incremental revenue growth through such investments. However, we cannot be certain that our new strategic offerings will achieve market acceptance, or that we will benefit fully from the substantial investments we have made and plan to continue to make in them. In addition, these investments have caused, and will likely continue to result in, higher operating expenses and if they are not successful, our operating income and operating margin will deteriorate.

For instance, we have hired a number of additional employees, and plan to continue to add additional personnel and resources, to further develop and market software applications, including three recently introduced solutions, a Tapestry Application Resource Manager solution, a Tapestry Data Migration Manager solution and a Tapestry Wide Area File Services solution, and our service offerings. In addition, our acquisition of Therion Software Corporation and our investment in a strategic partnership contributed to the software applications associated with these solutions. In addition, because some of these offerings may be different from the areas that we have historically focused on, we may face a number of additional challenges, such as:

	•		successfully identifying market opportunities;

	•		developing new customer relationships;

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	•		expanding our relationship with our existing OEM partners and end-users;

	•		managing different sales cycles;

	•		hiring qualified personnel 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.

These new product and service offerings also may contain some features that are currently offered by our OEM partners, which could cause conflicts with partners on whom we rely to bring our current products to customers and thus negatively impact our relationship with such partners. In addition, if we are unable to successfully integrate new offerings that we develop, license or otherwise acquire into our existing base of products and services, our business and results of operations may be harmed.

We are also investing in an expanded service initiative, which may be costly and may not gain market acceptance. For instance, we recently announced the availability of new professional services designed to assist customers in designing, installing, operating and supporting shared storage infrastructures. Traditionally, we have relied on our OEM partners and third parties to provide such support for end-users of our products and services, and we cannot be sure that this change in our business model will result in anticipated revenues. For instance, staffing support centers involves cost and revenue structures that are different from those used in selling hardware and licensing software. We also intend to significantly increase headcount to provide these services and staff support centers. Revenue will be dependent on our ability to utilize service providers, and if we do not effectively manage costs relative to revenue, our services initiative will not be successful. In addition, bringing the service initiative to market may be competitive with our OEM partners and other distribution channel partners.

Increased market competition may lead to reduced sales, margins, profits and market share.

The SAN market is 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. Moreover, new competitive products could be based on existing technologies or new technologies that may or may not be compatible with our SAN technology. Competitive products include, but are not limited to, non-Fibre Channel based emerging products utilizing Gigabit Ethernet, 10 Gigabit Ethernet, InfiniBand, and iSCSI (Internet Small Computer System Interface).

Currently, we believe that we principally face competition from providers of Fibre Channel switching products for interconnecting servers and storage. These competitors include Cisco Systems, McDATA Corporation (which completed its acquisition of Computer Network Technology Corporation (“CNT”) on June 1, 2005) and QLogic Corporation. In addition, our OEM partners, who also have relationships with some of our current competitors, could become new competitors by developing and introducing products competitive with our product offerings, choosing to sell our competitors’ products instead of our products, or offering preferred pricing or promotions on our competitors’ products. Competitive pressure will likely intensify as our industry experiences further consolidation in connection with acquisitions by us, our competitors and our OEM partners.

Some of our competitors have longer operating histories and significantly greater human, financial and capital resources than us. Our competitors could adopt more aggressive pricing policies than us. We believe that competition based on price may become more aggressive than we have traditionally experienced. Our competitors could also devote greater resources to the development, promotion, and sale of their products than we may be able to support and, as a result, be able to respond more quickly to changes in customer or market requirements. Our failure to successfully compete in the market would harm our business and financial results.

Our competitors may also pressure our 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 our competitors has formed a strategic partnership with a provider of network storage systems, which includes an agreement whereby our competitor resells the storage systems of its partner in exchange for sales by the partner of our competitor’s products. Such strategic partnerships, if successful, may influence us to change our traditional distribution model.

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If our assumptions regarding our revenues and margins do not materialize, our future profitability could be adversely affected.

We incurred a net loss of $7.2 million in the third quarter of fiscal year 2005 and were not profitable for the full fiscal years 2004 or 2003, and we may not be profitable in the future. We make our investment decisions and plan our operating expenses based in part on future revenue projections. However, our ability to accurately forecast quarterly and annual revenues is limited, as discussed below in “Our quarterly and annual revenues and operating results may fluctuate in future periods due to a number of factors, which could adversely affect the trading price of our stock.” In addition, we are diversifying our product and service offerings and expanding into other markets that we have not historically focused on, including new and emerging markets. As a result, we face greater challenges accurately predicting our revenue and margins with respect to these other markets. Developing new offerings will also require significant, upfront, incremental investments that may not result in revenue for an extended period of time, if at all. Particularly as we seek to diversify our product and service offerings, we expect 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. As a result, in the short-term, we may not be able to decrease our spending to offset any unexpected shortfall in revenues. If our projected revenues and margins do not materialize, our future profitability could be adversely affected.

The prices of our products have declined in the past, and we expect the price of our products to continue to decline, which could reduce our revenues, gross margins and profitability.

The average selling price per port for our products has declined in the past, and we expect 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 us or our competitors, the entrance of new competitors or other factors. For example, since the second half of fiscal year 2004, we have introduced and began shipping a number of new products that expand and extend the breadth of our product offerings. Several of these new products have lower per unit revenues, gross margin, and profitability characteristics than our traditional products. If we are unable to offset any negative impact that changes in product mix, competitive pricing pressures, increased sales discounts, enhanced marketing programs, new product introductions by us or our competitors, or other factors may have on us by increasing the number of ports shipped or reducing product manufacturing cost, our total revenues and gross margins will decline.

In addition, to maintain our gross margins we must maintain or increase the number of ports shipped, develop and introduce new products and product enhancements, and continue to reduce the manufacturing cost of our products. While we have successfully reduced the cost of manufacturing our products in the past, we may not be able to continue to reduce cost of production at historical rates. Moreover, most of our expenses are fixed in the short-term or incurred in advance of receipt of corresponding revenue. As a result, we may not be able to decrease our spending to offset any unexpected shortfall in revenues. If this occurs, we could incur losses, our operating results and gross margins could be below our expectations and the expectations of investors and stock market analysts, and our stock price could be negatively affected.

We depend on OEM partners for a majority of our revenues, and the loss of any of these OEM partners or a decrease in their purchases could significantly reduce our revenues and negatively affect our financial results.

We depend on recurring purchases from a limited number of large OEM partners for the majority of our revenue. As a result, these large OEM partners have a significant influence on our quarterly and annual financial results. Our agreements with our OEM partners are typically cancelable, non-exclusive, have no minimum purchase requirements and have no specific timing requirements for purchases. For the first quarter ended January 28, 2006, three customers each represented ten percent or more of our total revenues for a combined total of 72 percent. We anticipate that our revenues and operating results will continue to depend on sales to a relatively small number of customers. The loss of any one significant customer, or a decrease in the level of sales to any one significant customer, or unsuccessful quarterly negotiation on key terms, conditions or timing of purchase orders placed during a quarter, could seriously harm our business and financial results.

In addition, some of our OEM partners purchase our 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 we maintain inventories of our products in hubs adjacent to their manufacturing

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facilities and purchase our products only as necessary to fulfill immediate customer demand. If more of our OEM partners transition to a hub model, form partnerships, alliances or agreements with other companies that divert business away from us; 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 our reported revenues. The timing of sales to our OEM partners, and consequently the timing and volatility of our reported revenues, may be further affected by the product introduction schedules of our OEM partners. We also may be exposed to higher risks of obsolete or excess inventories. For example, during the third and fourth quarters of fiscal year 2005, we recorded write-downs for excess and obsolete inventory of $3.4 million and $1.8 million, respectively, due to the faster than expected transition from our 2 Gbit products to our 4 Gbit products.

Our OEM partners evaluate and qualify our products for a limited time period before they begin to market and sell them. Assisting these distribution partners through the evaluation process requires significant sales, marketing and engineering management efforts on our part, particularly if our products are being qualified with multiple distribution partners at the same time. In addition, once our products have been qualified, our customer agreements have no minimum purchase commitments. We may not be able to effectively maintain or expand our distribution channels, manage distribution relationships successfully, or market our products through distribution partners. We must continually assess, anticipate and respond to the needs of our distribution partners and their customers, and ensure that our products integrate with their solutions. Our failure to successfully manage our distribution relationships or the failure of our distribution partners to sell our products could reduce our revenues significantly. In addition, our ability to respond to the needs of our distribution partners in the future may depend on third parties producing complementary products and applications for our products. If we fail to respond successfully to the needs of these groups, our business and financial results could be harmed.

Our quarterly and annual revenues and operating results may fluctuate in future periods due to a number of factors, which could adversely affect the trading price of our stock.

Our quarterly and annual revenues and operating results may vary significantly in the future due to a number of factors, any of which may cause our stock price to fluctuate. Factors that may affect the predictability of our annual and quarterly results include, but are not limited to, the following:

	•		announcements, introductions, and transitions of new products by us and our competitors or our OEM partners;

	•		the timing of customer orders, product qualifications, and product introductions of our OEM partners;

	•		seasonal fluctuations;

	•		changes, disruptions or downturns in general economic conditions, particularly in the information technology industry;

	•		declines in average selling price per port for our products as a result of competitive pricing pressures or new product introductions by us or our competitors;

	•		the emergence of new competitors in the SAN market;

	•		deferrals of customer orders in anticipation of new products, services, or product enhancements introduced by us or our competitors;

	•		our ability to timely produce products that comply with new environmental restrictions or related requirements of our OEM customers;

	•		our ability to obtain sufficient supplies of sole- or limited-sourced components, including application-specific integrated circuits (or ASICs), microprocessors, certain connectors, certain logic chips, and programmable logic devices;

	•		increases in prices of components used in the manufacture of our products;

	•		our ability to attain and maintain production volumes and quality levels;

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	•		variations in the mix of our products sold and the mix of distribution channels through which they are sold;

	•		pending or threatened litigation;

	•		stock-based compensation expense that is affected by our stock price;

	•		new legislation and regulatory developments; and

	•		other risk factors detailed in this section entitled “Risk Factors.”

Accordingly, the results of any prior periods should not be relied upon as an indication of future performance. We cannot assure you that in some future quarter our revenues or operating results will not be below our projections or the expectations of stock market analysts or investors, which could cause our stock price to decline.

If we lose key personnel or are unable to hire additional qualified personnel, our business may be harmed.

Our 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. We believe our future success will also depend, in large part, upon our 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. We have 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, our past reductions in force could potentially make attracting and retaining qualified employees more difficult in the future. Our ability to hire qualified personnel may also be negatively impacted by our recent internal reviews and financial statement restatements, related investigations by the SEC and Department of Justice (“DOJ”), and current level of our stock price. The loss of the services of any of our 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 our ability to sell our 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. We may be subject to such claims in the future as we seek to hire additional qualified personnel. Such claims could result in material litigation. As a result, we 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 us.

The loss of our third-party contract manufacturer would adversely affect our ability to manufacture and sell our products.

The loss of our third-party contract manufacturer could significantly impact our ability to produce our products for an indefinite period of time. Qualifying a new contract manufacturer and commencing volume production is a lengthy and expensive process. If we are required to change our contract manufacturer, if we fail to effectively manage our contract manufacturer, or if our contract manufacturer experiences delays, disruptions, capacity constraints, component parts shortages or quality control problems in its manufacturing operations, shipment of our products to our customers could be delayed resulting in loss of revenues and our competitive position and relationship with customers could be harmed.

Our failure to successfully manage the transition between our new products and our older products may adversely affect our financial results.

As we introduce new or enhanced products, we 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. When we introduce new or enhanced products, we face 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.

For example, we recently introduced 4 Gigabit per second (“Gbit”) technology solutions that replace many of our 2 Gbit products. During the third quarter of fiscal year 2005, our net revenue was $122.3 million, down 16 percent from $144.8 million reported in the second quarter of fiscal year 2005 and 19 percent from $150.0 million reported in the third quarter of fiscal year 2004. We believe that the transition from 2 Gbit products to 4 Gbit products was a significant factor

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contributing to the drop in our revenue in the third quarter of fiscal year 2005. We also recorded a $3.4 million and $1.8 million write-down during the third and fourth quarters of fiscal year 2005, respectively, for excess and obsolete inventory due largely to the faster than expected product transition.

The failure to accurately forecast demand for our products or the failure to successfully manage the production of our products could negatively affect the supply of key components for our products and our ability to manufacture and sell our products.

We provide product forecasts to our contract manufacturer and place purchase orders with it in advance of the scheduled delivery of products to our customers. Moreover, in preparing sales and demand forecasts, we rely largely on input from our distribution partners. Therefore, if we or our distribution partners are unable to accurately forecast demand, or if we fail to effectively communicate with our 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, we may be unable to obtain adequate manufacturing capacity from our contract manufacturer to meet customers’ delivery requirements, or we may accumulate excess inventories. Furthermore, we may not be able to identify forecast discrepancies until late in our fiscal quarter. Consequently, we may not be able to make adjustments to our business model. If we are unable to obtain adequate manufacturing capacity from our contract manufacturer, if we accumulate excess inventories, or if we are unable to make necessary adjustments to our business model, revenue may be delayed or even lost to our competitors, and our business and financial results may be harmed. In addition, although the purchase orders placed with our contract manufacturer are cancelable, in certain circumstances we could be required to purchase certain unused material not returnable, usable by, or sold to other customers if we cancel any of our orders. This purchase commitment exposure is particularly high in periods of new product introductions and product transitions. If we are required to purchase unused material from our contract manufacturer, we would incur unanticipated expenses and our business and financial results could be negatively affected.

Our business is subject to cyclical fluctuations and uneven sales patterns.

Many of our OEM partners experience uneven sales patterns in their businesses due to the cyclical nature of information technology spending. For example, some of our 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 our sales are derived from a small number of OEM partners, when they experience seasonality, we experience similar seasonality. Historically, our second fiscal quarter is down from a seasonally strong first fiscal quarter due to a typically slower growth period for most of our major OEM partners. For instance, we were exposed to significant seasonality in the second fiscal quarter of fiscal year 2005 in part due to weaker spending in the enterprise product line during the first calendar quarter of 2005. In addition, we have experienced quarters where uneven sales patterns of our OEM partners have resulted in a significant portion of our revenue occurring in the last month of our fiscal quarter. This exposes us to additional inventory risk as we have to order products in anticipation of expected future orders and additional sales risk if we are unable to fulfill unanticipated demand. We are not able to predict the degree to which the seasonality and uneven sales patterns of our OEM partners or other customers will affect our business in the future particularly as we release new products.

We are dependent on sole source and limited source suppliers for certain key components.

We purchase certain key components used in the manufacture of our products from single or limited sources. We purchase ASICs from a single source, and we purchase microprocessors, certain connectors, logic chips, power supplies and programmable logic devices from limited sources. We also license certain third-party software that is incorporated into our operating system software and other software products. If we are unable to timely obtain these and other components or experience significant component defects, we may not be able to deliver our products to our customers in a timely manner. As a result, our business and financial results could be harmed.

We use rolling forecasts based on anticipated product orders to determine component requirements. If we overestimate component requirements, we may have excess inventory, which would increase our costs. If we underestimate component requirements, we 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. We also may experience shortages of certain components from time to time, which also could delay the manufacturing and sales processes. If we overestimate or underestimate our component requirements, or if we experience shortages, our business and financial results could be harmed.

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We have been named as a party to several class action and derivative action lawsuits arising from our recent internal reviews and related restatements of our financial statements, and we may be named in additional litigation, all of which could require significant management time and attention and result in significant legal expenses and may result in an unfavorable outcome which could have a material adverse effect on our business, financial condition, results of operations and cash flows.

We are subject to a number of lawsuits arising from our recent internal reviews and the related restatements of our financial statements that have been filed, some purportedly on behalf of a class of our stockholders, against us and certain of our executive officers claiming violations of securities laws and others purportedly on behalf of Brocade against certain of our executive officers and board members, and we 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 ourselves may divert management’s attention from the day-to-day operations of our business, which could adversely affect our business, results of operations and cash flows. In addition, an unfavorable outcome in such litigation could have a material adverse effect on our business, results of operations and cash flows.

As a result of our internal reviews and related restatements, we are subject to investigations by the SEC and DOJ, which may not be resolved favorably and have required, and may continue to require, a significant amount of management time and attention and accounting and legal resources, which could adversely affect our business, results of operations and cash flows.

The SEC and the DOJ are currently conducting investigations of the Company. 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 our business. If we are subject to an adverse finding resulting from the SEC and DOJ investigation, we could be required to pay damages or penalties or have other remedies imposed upon us. During the three months ended January 28, 2006 we began active settlement discussions with the Staff of the SEC’s Division of Enforcement (the “Staff’’). As a result of these discussions, for the three months ended January 28, 2006 we recorded $7.0 million provision for an estimated settlement expense. This is an increase of $2.0 million over the $5.0 million amount previously disclosed on February 16, 2006 as a result of further discussions with the Staff. 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 intends on recommending to the SEC’s Commissioners. The offer of settlement is contingent upon final approval by the SEC’s Commissioners. The recent restatements of our financial results, the ongoing SEC and DOJ investigations and any negative outcome that may occur from these investigations could impact our relationships with customers and our ability to generate revenue. In addition, considerable legal and accounting expenses related to these matters have been incurred to date and significant expenditures may continue to be incurred in the future. The SEC and DOJ investigations could adversely affect our business, results of operations, financial position and cash flows.

We may engage in future acquisitions and strategic investments that dilute the ownership percentage of our stockholders and require the use of cash, incur debt or assume contingent liabilities.

As part of our business strategy, we expect to continue to review opportunities to buy or invest in other businesses or technologies that we believe would complement our current products, expand the breadth of our markets or enhance our technical capabilities, or that may otherwise offer growth opportunities. If we buy or invest in other businesses, products or technologies in the future, we could:

	•		incur significant unplanned expenses and personnel costs;

	•		issue stock, or assume stock option plans that would dilute our current stockholders’ percentage ownership;

	•		use cash, which may result in a reduction of our liquidity;

	•		incur debt;

	•		assume liabilities; and

	•		spend resources on unconsummated transactions.

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In addition, we are not currently eligible to file short-form registration statements on Form S-3. Although registration statement on other forms are available, it could increase the cost of future acquisitions involving the issuance of stock until such time that we regain eligibility on Form S-3.

We may not realize the anticipated benefits of past or future acquisitions and strategic investments, and integration of acquisitions may disrupt our business and management.

We have in the past and may in the future acquire or make strategic investments in additional companies, products or technologies. Most recently, we completed the acquisition of Therion Software Corporation and a strategic investment in Tacit Networks in May 2005. We may not realize the anticipated benefits of these or any other acquisitions or strategic investments, which involve numerous risks, including:

	•		problems integrating the purchased operations, technologies, personnel or products over geographically disparate locations, including San Jose, California; Redmond, Washington; and India;

	•		unanticipated costs, litigation and other contingent liabilities;

	•		diversion of management’s attention from our core business;

	•		adverse effects on existing business relationships with suppliers and customers;

	•		risks associated with entering into markets in which we have no, or limited, prior experience;

	•		incurrence of significant exit charges if products acquired in business combinations are unsuccessful;

	•		incurrence of acquisition-related costs or amortization costs for acquired intangible assets that could impact our operating results;

	•		inability to retain key customers, distributors, vendors and other business partners of the acquired business; and

	•		potential loss of our key employees or the key employees of an acquired organization.

If we are not be able to successfully integrate businesses, products, technologies or personnel that we acquire, or to realize expected benefits of our acquisitions or strategic investments, our business and financial results may be adversely affected.

Our revenues will be affected by changes in domestic and international information technology spending and overall demand for storage area network solutions.

In the past, unfavorable or uncertain economic conditions and reduced global information technology spending rates have adversely affected our operating results. We are 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, our revenues, operating results and financial condition may be adversely affected.

Even if information technology spending rates increase, we cannot be certain that the market for SAN solutions will be positively impacted. Our storage networking products are sold as part of storage systems and subsystems. As a result, the demand for our 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 we have experienced historical growth in our business as enterprise-class customers have adopted SAN technology, demand for SAN products in the enterprise-class sector continues to be adversely affected by weak or uncertain economic conditions, and because larger businesses are focusing on using their existing information technology infrastructure more efficiently rather than making new equipment purchases. If information technology spending levels are restricted, and new products improve our customers’ ability to utilize their existing storage infrastructure, the demand for SAN products may decline. If this occurs, our business and financial results will be harmed.

Our business is subject to increasingly complex corporate governance, public disclosure, accounting, and tax requirements that has increased both our costs and the risk of noncompliance.

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We are subject to rules and regulations of federal and state government as well as the stock exchange on which our common stock is listed. These entities, including the Public Company Accounting Oversight Board, 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. Our 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.

We are subject to periodic audits or other reviews by such governmental agencies. For example, 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. The SEC also periodically reviews our 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 our historical financial results.

We are subject to environmental regulations that could have a material adverse effect on our business.

We are subject to various environmental and other regulations governing product safety, materials usage, packaging and other environmental impacts in the various countries where our products are sold. For example, many of our 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 our products when they have reached the end of their useful life. In Europe, substance restrictions will apply to products sold after July 1, 2006, and one or more of our OEM partners may require compliance with these or more stringent requirements by an earlier date. In addition, recycling, labeling, financing and related requirements have already begun to apply to products we sell in Europe. Where necessary, we are redesigning our products to ensure that they comply with these requirements as well as related requirements imposed by our OEM customers. We are also working with our suppliers to provide us with compliant materials, parts and components. If our products do not comply with the European substance restrictions, we could become subject to fines, civil or criminal sanctions, and contract damage claims. In addition, we could be prohibited from shipping non-compliant products into the EU, and required to recall and replace any products already shipped, if such products were found to be non-compliant, which would disrupt our ability to ship products and result in reduced revenue, increased obsolete or excess inventories and harm to our business and customer relationships. Our suppliers may also fail to provide us with compliant materials, parts and components, which could impact our ability to timely produce compliant products and may disrupt our 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 our products.

Recent changes in accounting rules, including the expensing of stock options granted to our employees, could have a material impact on our reported business and financial results.

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 our reported financial results.

On December 15, 2004, the FASB issued SFAS 123R, Share-Based Payment, which requires us 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, we recorded higher levels of stock based compensation due to differences between the valuation methods of SFAS 123R and APB 25. In prior periods, we 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.

Our future operating expenses may be adversely affected by changes in our stock price.

A portion of our outstanding stock options are subject to variable accounting. Under variable accounting, we are 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 we recognize in

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any given period can vary substantially due to changes in the market value of our common stock. Volatility associated with stock price movements has resulted in compensation benefits when our stock price has declined and compensation expense when our stock price has increased. For example, the market value of our 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, we 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. We are unable to predict the future market value of our common stock and therefore are unable to predict the compensation expense or benefit that we will record in future periods.

International political instability and concerns about other international crises may increase our cost of doing business and disrupt our business.

International political instability may halt or hinder our ability to do business and may increase our 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. Increases in energy prices will also impact our costs and could harm our operating results. In addition, concerns about other international crises, such as the spread of severe acute respiratory syndrome (“SARS”), avian influenza, or bird flu, and West Nile viruses, may have an adverse effect on the world economy and could adversely affect our business operations or the operations of our OEM partners, contract manufacturer and suppliers. This political instability and concerns about other international crises may, for example:

	•		negatively affect the reliability and cost of transportation;

	•		negatively affect the desire and ability of our employees and customers to travel;

	•		disrupt the production capabilities of our OEM partners, contract manufacturers and suppliers;

	•		adversely affect our ability to obtain adequate insurance at reasonable rates; and

	•		require us to take extra security precautions for our operations.

Furthermore, to the extent that air or sea transportation is delayed or disrupted, the operations of our contract manufacturers and suppliers may be disrupted, particularly if shipments of components and raw materials are delayed.

We have extensive international operations, which subjects us to additional business risks.

A significant portion of our sales occur in international jurisdictions and our contract manufacturer has significant operations in China. We also plan to continue to expand our international operations and sales activities. Expansion of international operations will involve inherent risks that we 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 our 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;

	•		more complicated logistics and distribution arrangements; and

	•		political and economic instability.

To date, no material amount of our 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 our 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 our operating costs in foreign locations. In the future, a larger portion of our international revenues may be denominated in foreign currencies, which will subject us to additional risks associated with fluctuations in those foreign currencies. We currently do not have hedging program in place to offset our foreign currency risk.

Undetected software or hardware errors could increase our costs, reduce our revenues and delay market acceptance of our products.

Networking products frequently contain undetected software or hardware errors, or “bugs,” when first introduced or as new versions are released. Our products are becoming increasingly complex and, particularly as we continue to expand our product portfolio to include software-centric products, including software licensed from third parties, errors may be found from time to time in our products. Some types of errors also may not be detected until the product is installed in a heavy production or user environment. In addition, our 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 us 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 SAN products or ours, could delay market acceptance of our new products.

We rely on licenses from third parties and the loss or inability to obtain any such license could harm our business.

Many of our 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 our products, we believe, based upon past experience and standard industry practice, that 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. Our inability to obtain certain licenses or other rights on favorable terms could have a material adverse effect on our business, operating results and financial condition.

If we fail to carefully manage the use of “open source” software in our products, we may be required to license key portions of our products on a royalty free basis or expose key parts of source code.

Certain of our products or technologies acquired, licensed or developed by us may incorporate so-called “open source” software. Open source software is typically licensed for use at no initial charge, but certain open source software licenses impose on the licensee of the applicable open source software certain requirements to license or make available to others both the open source software as well as the software that relates to, or interacts with, the open source software. Our ability to commercialize products or technologies incorporating open source software or otherwise fully realize the anticipated benefits of any such acquisition may be restricted as a result of using such open source software.

We may be unable to protect our intellectual property, which could negatively affect our ability to compete.

We rely on a combination of patent, copyright, trademark, and trade secret laws, confidentiality agreements, and other contractual restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality or license agreements with our employees, consultants, and corporate partners, and control access to and distribution of our technology, software, documentation, and other confidential information. These measures may not preclude the disclosure of our confidential or propriety information, or prevent competitors from independently developing products with functionality or features similar to our products. Despite efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. Monitoring unauthorized use of our products is difficult, and we cannot

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be certain that the steps we take to prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect proprietary rights as fully as in the United States, will be effective.

Third-parties may bring infringement claims against us, which could be time-consuming and expensive to defend.

In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. We have in the past been involved in intellectual property-related disputes, including lawsuits with Vixel Corporation, Raytheon Company and McData Corporation, and we may be involved in such disputes in the future, to protect our intellectual property or as a result of an alleged infringement of the intellectual property of others. We also may be subject to indemnification obligations with respect to infringement of third party intellectual property rights pursuant to our agreements with customers. These claims and any resulting lawsuit could subject us to significant liability for damages and invalidation of proprietary rights. Any such lawsuits, even if ultimately resolved in our 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 us 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 us to license our intellectual property to such owner, or may not be available on reasonable terms or at all; and

	•		redesign those products or services that use technology that is the subject of an infringement claim.

If we are forced to take any of the foregoing actions, our business and results of operations could be materially harmed.

Our failure, or the failure of our customers, to comply with evolving industry standards and government regulations could harm our business.

Industry standards for SAN products are continuing to evolve and achieve acceptance. To remain competitive, we must continue to introduce new products and product enhancements that meet these industry standards. All components of the SAN must interoperate together. Industry standards are in place to specify guidelines for interoperability and communication based on standard specifications. Our products encompass only a part of the entire SAN solution utilized by the end-user, and we depend on the companies that provide other components of the SAN solution, many of whom are significantly larger than we are, to support the industry standards as they evolve. The failure of these providers to support these industry standards could adversely affect the market acceptance of our products.

In addition, in the United States, our products comply with various regulations and standards defined by the Federal Communications Commission and Underwriters Laboratories. Internationally, products that we develop will be required to comply with standards established by authorities in various countries. Failure to comply with existing or evolving industry standards or to obtain timely domestic or foreign regulatory approvals or certificates could materially harm our business.

Business interruptions could adversely affect our business.

Our operations and the operations of our suppliers, contract manufacturer and customers are vulnerable to interruption by fire, earthquake, hurricanes, power loss, telecommunications failure and other events beyond our control. For example, a substantial portion of our facilities, including our corporate headquarters, is located near major earthquake faults. In the event of a major earthquake, we could experience business interruptions, destruction of facilities and loss of life. We do not carry earthquake insurance and have not set aside funds or reserves to cover such potential earthquake-related losses. In addition, our 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 us or our suppliers, contract manufacturer or customers, shipments could be delayed and our business and financial results could be harmed.

Provisions in our charter documents, customer agreements, Delaware law, and our stockholder rights plan could prevent or delay a change in control of Brocade, which could hinder stockholders’ ability to receive a premium for our stock.

Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include:

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	•		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 our certificate of incorporation and bylaws.

Certain provisions of Delaware law also may discourage, delay, or prevent someone from acquiring or merging with us, and our agreements with certain of our customers require that we give prior notice of a change of control and grant certain manufacturing rights following a change of control. In addition, we currently have in place a stockholder rights plan. Our various anti-takeover provisions could prevent or delay a change in control of Brocade, which could hinder stockholders’ ability to receive a premium for our stock.

We expect to experience volatility in our stock price, which could negatively affect stockholders’ investments.

The market price of our common stock has experienced significant volatility in the past and will likely continue to fluctuate significantly in response to the following factors, some of which are beyond our control:

	•		macroeconomic conditions;

	•		actual or anticipated fluctuations in our operating results;

	•		changes in financial estimates and ratings by securities analysts;

	•		changes in market valuations of other technology companies;

	•		announcements of financial results by us or other technology companies;

	•		announcements by us, our competitors, customers, or similar businesses of significant technical innovations, contracts, acquisitions, strategic partnerships, joint ventures or capital commitments;

	•		losses of major OEM partners;

	•		additions or departures of key personnel;

	•		adverse finding resulting from the SEC and DOJ investigation or related litigation;

	•		sales by us of common stock or convertible securities;

	•		incurring additional debt; and

	•		other risk factors detailed in this section.

In addition, the stock market has experienced extreme volatility that often has been unrelated to the performance of particular companies. These market fluctuations may cause our stock price to fall regardless of how the business performs.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

The following table summarizes employee stock repurchase activity for the three months ended January 28, 2006 (in thousands excluding per share data):

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					Total Number		Approximate
					of Shares		Dollar Value of
					Purchased as		Shares that May
	Total Number				Part of Publicly		Yet Be Purchased
	of Shares		Average Price		Announced		Under the
	Purchased (1)		Paid Per Share		Program		Program (2)
October 30, 2005 – November 26, 2005		1	$	4.44		—	$	92,950

November 27, 2005 – December 24, 2005		—		—		—	$	92,950

December 25, 2005 – January 28, 2006		—		—		—	$	92,950


Total		1	$	4.44		—	$	92,950


(1)		The total number of shares repurchased include those shares of Brocade common stock that employees deliver back to Brocade to satisfy tax-withholding obligations at the settlement of restricted stock exercises, and upon the termination of an employee, the forfeiture of either restricted shares or unvested common stock as a result of early exercises. As of January 28, 2006, approximately 1,935,000 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 January 28, 2006, we have purchased 1,150,000 shares at an average price of $6.13 per share, and under this program $92.9 million remains available for future repurchases.

Item 6. Exhibits


Exhibit
Number		Description of Document
10.1		Fifth Amendment to Credit Agreement between Comerica Bank-California and Brocade dated January 5, 2006.

10.2		Tolling Agreement dated as of January 1, 2006, between Gregory L. Reyes and Brocade, David House, William Krause, Nicholas Moore, William O’Brien, Christopher Paisley, Larry Sonsini, Seth Neiman, Neal Dempsey and Sanjay Vaswani.

10.3 +		Amendment 23 to Statement of Work #1 of the IBM/Brocade Goods Agreement ROC-P-68, dated December 15, 2005, by and between IBM Corporation and Brocade.

10.4		Amendment 24 to Statement of Work #1 of the IBM/Brocade Goods Agreement ROC-P-68, dated December 15, 2005, by and between IBM Corporation and Brocade.

10.5		Amended Director Cash Compensation Plan.

31.1		Rule 13a-14(a)/15d-14(a) Certification by the Chief Executive Officer.

31.2		Rule 13a-14(a)/15d-14(a) Certification by the Chief Financial Officer.

32.1		Certification by the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


+		Confidential treatment requested as to certain portions, which portions were omitted and filed separately with the Securities and Exchange Commission.

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EXHIBIT INDEX


Exhibit
Number		Description of Document
10.1		Fifth Amendment to Credit Agreement between Comerica Bank-California and Brocade dated January 5, 2006.

10.2		Tolling Agreement dated as of January 1, 2006, between Gregory L. Reyes and Brocade, David House, William Krause, Nicholas Moore, William O’Brien, Christopher Paisley, Larry Sonsini, Seth Neiman, Neal Dempsey and Sanjay Vaswani.

10.3 +		Amendment 23 to Statement of Work #1 of the IBM/Brocade Goods Agreement ROC-P-68, dated December 15, 2005, by and between IBM Corporation and Brocade.

10.4		Amendment 24 to Statement of Work #1 of the IBM/Brocade Goods Agreement ROC-P-68, dated December 15, 2005, by and between IBM Corporation and Brocade.

10.5		Amended Director Cash Compensation Plan.

31.1		Rule 13a-14(a)/15d-14(a) Certification by the Chief Executive Officer.

31.2		Rule 13a-14(a)/15d-14(a) Certification by the Chief Financial Officer.

32.1		Certification by the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


+		Confidential treatment requested as to certain portions, which portions were omitted and filed separately with the Securities and Exchange Commission.


		BROCADE COMMUNICATIONS SYSTEMS, INC.

Date: March 8, 2006	By:	/s/ Richard Deranleau

		Richard Deranleau
		VP, Interim Chief Financial Officer and Treasurer


		Page
PART I — FINANCIAL INFORMATION

Item 1.	Financial Statements

	Condensed Consolidated Statements of Operations for the Three Months Ended January 28, 2006 and January 29, 2005		3

	Condensed Consolidated Balance Sheets as of January 28, 2006 and October 29, 2005		4

	Condensed Consolidated Statements of Cash Flows for the Three Months Ended January 28, 2006 and January 29, 2005		5

	Notes to Condensed Consolidated Financial Statements		6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		19

Item 3.	Quantitative and Qualitative Disclosures About Market Risks		28

Item 4.	Controls and Procedures		29

PART II — OTHER INFORMATION

Item 1.	Legal Proceedings		30

Item 1A.	Risk Factors		31

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		43

Item 6.	Exhibits		44

SIGNATURES			45
EXHIBIT 10.1
EXHIBIT 10.2
EXHIBIT 10.3
EXHIBIT 10.4
EXHIBIT 10.5
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1