GADZOOX NETWORKS INC, 10-Q, 1999-11-12

GADZOOX NETWORKS INC
10-Q, 1999-11-12
ELECTRONIC COMPONENTS & ACCESSORIES

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<PAGE> 1
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1999

[ ] 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: 000-26541

GADZOOX NETWORKS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 77-0308899
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)

5850 HELLYER AVENUE
SAN JOSE, CA 95138
(408) 360-4950
(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 [X] No [ ]

The number of shares outstanding of the Registrant's Common Stock on September
30, 1999 was 25,663,806 shares.

Page 1 of 31 pages.
<PAGE> 2
GADZOOX NETWORKS, INC.

FORM 10-Q

QUARTER ENDED SEPTEMBER 30, 1999

INDEX

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

Condensed Balance Sheets as of September 30, 1999 and March 31, 1999

Condensed Statements of Operations for the Three Months and Six Months
Ended September 30, 1999 and 1998

Condensed Statements of Cash Flows for the Six Months Ended
September 30, 1999 and 1998

Notes to Condensed Financial Statements

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

Item 3. Quantitative and Qualitative Disclosures About Market Risks

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

Item 2. Changes in Securities and Use of Proceeds

Item 3. Defaults Upon Senior Securities

Item 4. Submission of Matters to a Vote of Security Holders

Item 5. Other Information

Item 6. Exhibits and Reports on Form 8-K

SIGNATURES
</TABLE>

This Form 10-Q contains forward-looking statements (as defined in the
Private Securities Litigation Reform Act of 1995), including but not limited to
statements regarding Gadzoox' expectations, hopes or intentions regarding the
future. Actual results and trends could differ materially from those discussed
in the forward-looking statements. In addition, past trends should not be
perceived as indicators of future performance. Among the factors that could
cause actual results to differ from the forward-looking statements are those
detailed elsewhere in this Quarterly Report in Management's Discussion and
Analysis of Financial Condition and Results of Operations and in Risk Factors,
as well as in Gadzoox' other filings with the Securities and Exchange
Commission.

Page 2 of 31 pages.
<PAGE> 3
PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

GADZOOX NETWORKS, INC.

CONDENSED BALANCE SHEETS
(IN THOUSANDS)

<TABLE>
<CAPTION>
September 30, March 31,
1999 1999
------------ ------------
(unaudited)
<S> <C> <C>

ASSETS
Current assets:
Cash and cash equivalents $ 35,203 $ 12,202
Short-term investments 47,793 -
Accounts receivable, net 8,817 5,981
Inventories 4,721 5,306
Prepaid expenses and other current assets 662 305
------------ ------------
Total current assets 97,196 23,794
Property and equipment, net 4,714 4,553
Other assets 258 251
------------ ------------
$ 102,168 $ 28,598
============ ============

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of note payable $ 385 $ 371
Current portion of capital lease obligations 1,287 1,080
Accounts payable 4,437 4,488
Compensation related accruals 978 705
Deferred revenue and other 1,025 1,238
------------ ------------
Total current liabilities 8,112 7,882
Convertible note 4,230 13,554
Note payable, net of current portion - 196
Capital lease obligations, net of current portion 1,206 1,307
------------ ------------
Total liabilities 13,548 22,939
------------ ------------

Stockholders' equity:
Convertible preferred stock - 69
Common stock 128 28
Additional paid-in capital 124,553 37,081
Deferred compensation (1,782) (2,425)
Accumulated deficit (34,279) (29,094)
------------ ------------
Total stockholders' equity 88,620 5,659
------------ ------------
$ 102,168 $ 28,598
============ ============
</TABLE>

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

Page 3 of 31 pages.
<PAGE> 4
GADZOOX NETWORKS, INC.

CONDENSED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
----------------------------- -----------------------------
Sept. 30, Sept. 30, Sept. 30, Sept. 30,
1999 1998 1999 1998
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Net revenues $ 11,081 $ 5,851 $ 20,292 $ 11,257
Cost of revenues 6,325 4,412 11,740 8,593
---------- ---------- ---------- ----------
Gross margin 4,756 1,439 8,552 2,664
---------- ---------- ---------- ----------
Operating expenses:
Research and development 4,540 3,411 8,458 6,523
Sales and marketing 1,914 1,240 3,802 2,587
General and administrative 866 301 1,629 563
Amortization of deferred compensation 321 87 643 115
---------- ---------- ---------- ----------
Total operating expenses 7,641 5,039 14,532 9,788
---------- ---------- ---------- ----------
Loss from operations (2,885) (3,600) (5,980) (7,124)
Total other income (expense), net 936 (40) 795 (61)
---------- ---------- ---------- ----------
Net Loss $ (1,949) $ (3,640) $ (5,185) $ (7,185)
========== ========== ========== ==========
Basic net loss per share $ (0.09) $ (0.77) $ (0.39) $ (1.56)
========== ========== ========== ==========
Weighted average shares used in computing
basic net loss per share 21,199 4,730 13,455 4,600
========== ========== ========== ==========

Pro forma basic net loss per share $ (0.08) $ (0.21) $ (0.24) $ (0.42)
========== ========== ========== ==========

Weighted average shares used in computing
pro forma basic net loss per share 24,222 17,051 21,891 17,202
========== ========== ========== ==========
</TABLE>

The condensed notes are an integral part to these condensed financial
statements.

Page 4 of 31 pages.
<PAGE> 5
GADZOOX NETWORKS, INC.

CONDENSED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

<TABLE>
<CAPTION>
Six Months Ended
September 30,
-----------------------------
1999 1998
---------- ----------
<S> <C> <C>
Cash Flows from Operating Activities:
Net Loss $ (5,185) $ (7,185)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization 1,169 566
Amortization of deferred compensation 643 115
Accrued interest 319 55
Changes in operating assets and liabilities:
Accounts receivable (2,836) (1,438)
Inventories 585 (1,180)
Prepaid expenses and other assets (364) (52)
Accounts payable and other accrued liabilities (18) (99)
---------- ----------
Net cash used in operating activities (5,687) (9,218)
---------- ----------
Cash Flows from Investing Activities:
Purchases of property and equipment (654) (492)
Purchase of available for sale investments (47,793) -
---------- ----------
Net cash used for investing activities (48,447) (492)
---------- ----------
Cash Flows from Financing Activities:
Proceeds from convertible note - 15,000
Payments on note payable (182) (169)
Payments on capital lease obligations (570) (359)
Proceeds from issuance of common stock to employees 392 29
Proceeds from issuance of common stock in the initial public offering 84,525 -
Offering costs relating to the issuance of common stock (7,030) -
Proceeds from issuance of preferred stock - 5,000
---------- ----------
Net cash provided by financing activities 77,135 19,501
---------- ----------
Net increase in cash and cash equivalents 23,001 9,791
Cash and cash equivalents at beginning of period 12,202 4,624
---------- ----------
Cash and cash equivalents at end of period $ 35,203 $ 14,415
========== ==========
Supplemental Cash Flow Information:
Cash paid for interest $ 118 $ 109
========== ==========
Property and equipment acquired under capital
lease obligations $ 676 $ 713
========== ==========
Partial conversion of convertible note to
common stock $ 9,617 $ -
========== ==========
Conversion of convertible preferred stock into common stock $ 34,129 $ -
========== ==========
</TABLE>

The condensed notes are an integral part to these condensed financial
statements.

Page 5 of 31 pages.
<PAGE> 6
GADZOOX NETWORKS, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS
(Information for the three and six months ended
September 30, 1999 is unaudited)

1. BASIS OF PRESENTATION

The condensed financial statements included herein have been prepared by
Gadzoox Networks, Inc. ("Gadzoox") without audit, pursuant to the rules and
regulations of the Securities and Exchange Commission. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted pursuant to such rules and regulations. In the opinion of management,
the disclosures are adequate to make the information not misleading. The
condensed balance sheet as of March 31, 1999 has been derived from the audited
financial statements as of that date, but does not include all disclosures
required by generally accepted accounting principles. These financial statements
and notes should be read in conjunction with the audited financial statements
and notes thereto, included in Gadzoox' Registration Statement on Form S-1 filed
with the Securities and Exchange Commission.

In the opinion of management, the unaudited condensed financial statements
reflect all adjustments, consisting only of normal recurring adjustments,
necessary for a fair presentation of financial position, results of operations
and cash flows for the periods indicated. The results of operations for the
three and six months ended September 30, 1999 are not necessarily indicative of
the results that may be expected for future quarters or the fiscal year ending
March 31, 2000.

2. NET INCOME (LOSS) PER SHARE

Basic and diluted net income (loss) per share are presented in conformity
with Statement of Financial Accounting Standards No. 128, "Earnings Per Share,"
("SFAS No. 128") for all periods presented. In accordance with the Securities
and Exchange Commission Staff Accounting Bulletin No. 98, common stock and
convertible preferred stock issued or granted for nominal consideration prior to
the anticipated effective date of an initial public offering must be included in
the calculation of basic and diluted net income (loss) per share as if such
stock has been outstanding for all periods presented. To date, Gadzoox has not
had any issuances or grants for nominal consideration.

In accordance with SFAS No. 128, basic net income (loss) per share has been
computed using the weighted-average number of shares of common stock outstanding
during the period, less shares subject to repurchase. Pro forma basic net loss
per share has been computed as described above and assuming the conversion of
convertible preferred stock into an equivalent number of common shares, as if
the shares had converted on the dates of their issuance.

Page 6 of 31 pages.
<PAGE> 7
The following table presents the calculation of basic and pro forma basic
net loss per share (in thousands, except per share data):

Net loss $ (1,949) $ (3,640) $ (5,185) $ (7,185)
========== ========== ========== ==========
Basic:
Weighted average shares of common
stock outstanding 21,434 5,366 13,740 5,285
Less: Weighted average shares of
common stock subject to repurchase (235) (636) (285) (685)
---------- ---------- ---------- ----------
Weighted average shares used in
computing basic net loss per share 21,199 4,730 13,455 4,600
========== ========== ========== ==========
Basic net loss per share $ (0.09) $ (0.77) $ (0.39) $ (1.56)
========== ========== ========== ==========
Pro forma:
Net loss $ (1,949) $ (3,640) $ (5,185) $ (7,185)
========== ========== ========== ==========
Shares used above 21,199 4,730 13,455 4,600
Pro forma adjustment to reflect
weighted average effect of assumed
conversion of convertible preferred
stock 3,023 12,321 8,436 12,602
---------- ---------- ---------- ----------
Weighted average shares used in
computing pro forma basic net
loss per shares 24,222 17,051 21,891 17,202
========== ========== ========== ==========
Pro forma basic net loss per share $ (0.08) $ (0.21) $ (0.24) $ (0.42)
========== ========== ========== ==========
</TABLE>

3. CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

All highly liquid investment securities with original maturities of three
months or less are considered cash equivalents. Available for sale investments
not intended to be held to maturity with original maturities of more than three
months are considered short-term investments. Management determines the
appropriate classification of investments in debt and equity securities at the
time of purchase. All of Gadzoox' investments are classified as available for
sale. At September 30, 1999, Gadzoox held $35,203,000 and $47,793,000 in cash
and cash equivalents and short-term investments, respectively. All investments
are stated at fair market value.

Page 7 of 31 pages.
<PAGE> 8
4. INVENTORIES

Inventories are stated at the lower of cost or market, on a first in, first out
method. Inventories consist of the following (in thousands):

<TABLE>
<CAPTION>
September 30, March 31,
1999 1999
------------ ------------
(unaudited)
<S> <C> <C>

Raw materials $ 1,165 $ 2,565
Work-in-pro 1,976 210
Finished Goods 1,580 2,531
------------ ------------
$ 4,721 $ 5,306
============ ============
</TABLE>

5. CONVERTIBLE NOTE

In September 1998, Gadzoox entered into a $15,000,000 convertible note
purchase agreement (the "Agreement") with Seagate Technology, Inc. ("Seagate").
Under this Agreement, Seagate purchased a convertible subordinated promissory
note in the aggregate principal amount of $15,000,000 (the "Convertible Note"),
bearing simple interest on the unpaid balance at a rate equal to 5.75% per annum
with principal and interest maturing September 2001. As further outline and
defined in the Agreement, Gadzoox may convert, at its sole option, any portion
or all of the outstanding balance of principal and interest on the Convertible
Note into shares of common stock at a price of $7.65 per share. Accrued interest
is converted prior to any principal owing under the Convertible Note. The
Agreement also provides that without Gadzoox' consent, conversion of the
Convertible Note may not result in Seagate holding more than 19.9% of Gadzoox'
outstanding shares. In the event of a default, as defined in the Agreement,
Seagate may declare all outstanding interest and principal immediately due and
payable in cash. Gadzoox may, upon 30 days written notice to Seagate, prepay the
Convertible Note in whole or in part.

In July 1999, in connection with the closing of Gadzoox' initial public
offering, Gadzoox converted approximately $9,617,000 of outstanding principal
and interest into 1,257,074 shares of common stock. At September 30, 1999, there
was approximately $4,230,000 of unpaid principal and interest outstanding under
the Convertible Note which, if converted, would have converted into 552,941
shares of common stock.

6. LEGAL PROCEEDINGS

From time to time, Gadzoox may become involved in various lawsuits and legal
proceedings which arise in the ordinary course of business. In May 1999, a
former employee filed a complaint against Gadzoox. Management believes this
claim is without merit and that the resolution of this claim will not have a
material adverse effect on Gadzoox' financial condition or results of
operations. However, litigation is subject to inherent uncertainties, and an
adverse result in this or other matters could arise from time to time that may
harm Gadzoox' business and, financial condition and results of operations.

Page 8 of 31 pages.
<PAGE> 9
7. INITIAL PUBLIC OFFERING

On July 20, 1999, Gadzoox completed its initial public offering of 4,025,000
shares of its common stock, including 525,000 shares sold to the underwriters
upon the exercise of their over-allotment option. The aggregate offering price
of the shares registered was $84,525,000, $5,917,000 of which was applied toward
the underwriters' discounts and commissions. Other expenses related to the
offering were approximately $1,113,000. Gadzoox received net proceeds of
approximately $77,495,000 from the sale of common stock in the initial public
offering.

Concurrent with the closing of the initial public offering, 13,907,399
shares of convertible preferred stock were converted into 13,907,399 shares of
common stock.

8. COMMON STOCK

1999 EMPLOYEE STOCK PURCHASE PLAN

In May 1999, the Board of Directors approved the adoption of Gadzoox' 1999
Employee Stock Purchase Plan (the "Stock Purchase Plan"). The Stock Purchase
Plan was approved by the stockholders on June 19, 1999. A total of 150,000
shares of common stock have been reserved for issuance under the Stock Purchase
Plan. The number of shares reserved for issuance under the Stock Purchase Plan
will be subject to an annual increase to be added on the first day of Gadzoox'
fiscal year, beginning in 2000, and equal to the lesser of (a) 250,000 shares,
(b) 0.5% of the outstanding shares on such date, or (c) a lesser amount
determined by the Board of Directors. The Stock Purchase Plan allows eligible
employees to purchase shares of common stock through payroll deductions at 85%
of the fair market value of the common stock.

1993 STOCK OPTION PLAN

In May 1999, the Board of Directors approved and adopted an Amended and
Restated 1993 Stock Option Plan (the "Amended Plan"). The Amended Plan was
approved by the stockholders on June 19, 1999 and was effective upon the closing
of Gadzoox' initial public offering on July 20, 1999. Under the Amended Plan,
the number of shares authorized for issuance is increased to 8,180,000. The
number of shares reserved for issuance under the Amended Plan will be subject to
an annual increase to be added on the first day of Gadzoox' fiscal year,
beginning in 2000, and equal to the lesser of (a) 1,500,000 shares, (b) 1% of
the outstanding shares on such date, or (c) a lesser amount determined by the
Board of Directors.

1999 DIRECTOR STOCK OPTION PLAN

In May 1999, the Board of Directors approved the adoption of the 1999
Director Stock Option Plan (the "Director Plan"). The Director Plan was approved
by the stockholders on June 19, 1999. The Director Plan provides for the
automatic grant of 5,000 shares of common stock to each non-employee director on
the later of the date of adoption of the Director Plan or the date on which such
person first becomes a director (the "Initial Grant"). After the Initial Grant,
the non-employee director will receive an automatic annual grant of 2,500 shares
of common stock. All shares granted under the Director Plan are 100% vested at
the grant date and expire upon the earlier of three years or the resignation of
the director from the Board of Directors. A total of 50,000 shares of common
stock have been reserved for issuance under the Director Plan. The number of
shares reserved for issuance under the Director Plan will be subject to annual
increases, beginning with the fiscal year beginning in 2000, sufficient to bring
the number of shares available for future issuance to 50,000 shares. As of
September 30, 1999, options to acquire 25,000 shares of common stock were
outstanding under the Director Plan.

Page 9 of 31 pages.
<PAGE> 10
9. BUSINESS SEGMENTS

During the year ended March 31, 1999, Gadzoox adopted Statement of Financial
Accounting Standards No. 131 "Disclosures About Segments of an Enterprise and
Related Information ("SFAS No. 131") which requires a new basis of determining
reportable business segments, i.e., the management approach. This approach
requires that business segment information used by management to assess
performance and manage company resources be the source for information
disclosure. On this basis, Gadzoox is organized and operates as one business
segment, the development, manufacture, marketing and sales of hubs and switches
for storage area networks.

Page 10 of 31 pages.
<PAGE> 11
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following information should be read in conjunction with the condensed
interim financial statements and the notes thereto included in Item 1 of this
Quarterly Report and with Management's Discussion and Analysis of Financial
condition and Results of Operations contained in Gadzoox' Registration Statement
on Form S-1 filed with the Securities and Exchange Commission and dated July 19,
1999.

FORWARD-LOOKING INFORMATION IS SUBJECT TO RISK AND UNCERTAINTY

Except for the historical information contained herein, the discussions on
this Form 10-Q in general may contain certain forward-looking statements. In
addition, when used in this Form 10-Q, the words "anticipates," "believes,"
"expects" and similar expressions are intended to identify forward-looking
statements. Actual future results could differ materially from those described
in the forward-looking statements as a result of factors discussed in "Risk
Factors" set forth herein, and in Gadzoox' Prospectus filed with the Securities
and Exchange Commission and dated July 19, 1999. Gadzoox cautions the reader,
however, that these lists of risk factors may not be exhaustive. All
forward-looking statements included in this Form 10-Q are based on information
available to Gadzoox on the date hereof. Gadzoox expressly disclaims any
obligation or undertaking to release publicly any updates or changes to these
forward-looking statements that may be made to reflect any future events or
circumstances.

COMPANY OVERVIEW

We are a leading provider of hardware and software products for storage area
networks, or SANs. Our SAN hub and switch products are designed to leverage the
capabilities of fibre channel technology to enable companies to better manage
the growth in mission-critical data by overcoming the limitation of traditional
captive storage architecture. We sell our SAN products primarily through leading
original equipment manufacturers ("OEM"), including Hewlett-Packard Company,
Compaq Computer Corporation, Avid Technology and Data General Corporation. We
also sell our products through distribution channel partners.

We were founded in April 1992 and initially developed electronic test
equipment. Since October 1995, we have focused on developing fibre channel
network products that address the needs of the SAN market. In fiscal 1997, we
sold our patent rights to the electronic test equipment. Prior to fiscal 1998,
our operating activities related primarily to increasing our research and
development capabilities, designing and developing hardware and software
products which we currently sell and staffing our administrative, marketing and
sales organizations. Since our inception, we have incurred significant losses,
and as of September 30, 1999 we had an accumulated deficit of $34.3 million and
our net loss for the quarter ended September 30, 1999 was approximately $1.9
million. We have not achieved profitability on a quarterly or annual basis and
anticipate that we will incur net losses for the foreseeable future. We expect
to continue to incur significant sales and marketing, product development and
administrative expenses, and as a result, we need to generate significant net
revenues to achieve and maintain profitability. Although our net revenues have
grown, we may not be able to sustain these growth rates, and we may not realize
sufficient net revenues to achieve profitability.

We currently derive substantially all of our net revenues from sales of a
limited number of products within the same product line. During fiscal 1999,
substantially all of our net revenues were derived from sales of our hub
products. We plan to commence full commercial shipment of our Capellix switch
products during the quarter ending December 31, 1999. However, we expect that
the majority of our net

Page 11 of 31 pages.
<PAGE> 12
revenues in fiscal 2000 will continue to be generated from sales of our hub
products. We may not be successful in our efforts to diversify our product base.
Also, we may not be successful in the adoption of new products, in particular
our Capellix switch. Additionally, even if our customers adopt Capellix, we can
not assure you that our net revenues will increase.

We depend on a few key customers. In fiscal 1999, approximately 68% of our
net revenues came from three customers with sales to Compaq Computer
Corporation, Digital Equipment Corporation and Hewlett-Packard Company each
accounting for more than 10% of our net revenues. For the six months ended
September 30, 1999, approximately 62% of our net revenues came from two
customers with approximately 17% from Compaq Computer Corporation and
approximately 45% from Hewlett-Packard Company.

We record product net revenues upon shipment, with the exception of sales to
several distribution channel partners whose product return rates we cannot
reasonably estimate. Where product return rates cannot be reasonably estimated,
revenue is recognized upon sell-through to the end user by the distribution
channel partner. Allowances for estimated sales returns and stock rotation are
provided at the time of revenue recognition.

Our contracts with our distribution channel partners usually contain
additional provisions for stock rotation, which generally provide for a right of
return for up to 10% of the value of purchases during the prior three months, to
be offset with an immediately deliverable order in an amount equal to or greater
than the stock to be rotated. For these customers, we record a stock rotation
reserve equal to the amount returnable. Two of our distribution customers have
had broader rights of return. During the quarter ended September 30, 1999, these
two distribution customers amended their agreements with us removing their
original rights of return provisions, permanently in one case and for a limited
amount of time in the other case. Although we also provide a reserve for general
product returns, we have not experienced significant product returns from any of
our customers. However, our past product return experience may not be indicative
of future product return rates.

Our gross margins are affected by fluctuations in demand for our products,
the mix of products sold, the mix of sales channels through which our products
are sold, the timing and size of customer orders and product implementations,
new product introductions both by us and by our competitors, changes in our
pricing policies and those of our competitors, component costs, the volume
manufacturing pricing we are able to obtain from our contract manufacturer and
other factors.

Although we enter into general sales contracts with our customers, none of
our customers are obligated to purchase any amount of our products, pursuant to
these contracts. We rely on our customers to submit purchase orders for specific
quantities of our products. All of our sales contracts contain provisions
regarding the following:

- products and pricing;

- order dates, rescheduling and cancellations;

- warranties and repair procedures; and

- marketing and/or sales support and training obligations.

Our OEM contracts generally contain additional provisions regarding product
technical specifications, labeling and boxing instructions and other
customization instructions. Several of our OEM sales contracts contain favored
pricing provisions as well as confidentiality provisions. Two of our OEM

Page 12 of 31 pages.
<PAGE> 13
sales contracts provide the OEM the right to manufacture our product in the
event of a material default we are unable to cure within a specified time
period.

We currently outsource substantially all of our product manufacturing to
Sanmina Corporation, a third-party manufacturer and manufacture our products in
two of their locations in the United States. Our agreement with Sanmina
Corporation provides for two months of rolling purchase orders and rolling
forecasts for nine months immediately following the purchase order period.
Purchase prices are negotiable throughout the three-year contract period. We are
liable for materials that Sanmina Corporation purchases on our behalf that we
cannot use, cannot be cancelled before receipt or are unique parts otherwise
unusable by Sanmina Corporation. The agreement restricts our ability to
reschedule orders and allows us to cancel existing orders subject to penalties
of up to the total purchase price. Sanmina Corporation provides warranties on
workmanship and pass-through warranties on component parts. Sanmina Corporation
purchases most of the components used to manufacture our products. Gadzoox
obtains some key components, such as our application specific integrated
circuits, or ASICs, from sole sources and other components, such as optical
transceivers. If we inaccurately forecast demand for our products, Sanmina
Corporation may be unable to provide us with adequate manufacturing capacity. In
addition, Sanmina Corporation may not be able to obtain adequate supplies of
components to meet our customers' delivery requirements. Alternatively, excess
inventories may be accumulated by Sanmina Corporation for our account. In order
to reduce the cost of sales, during the quarter ended September 30, 1999, we
relocated substantially all of our manufacturing operations from Sanmina
Corporation's manufacturing facility in Santa Clara, California to its
manufacturing facility in Guntersville, Alabama. Additionally, we may consider
moving the outsourced manufacturing to other new locations or to a new contract
manufacturer. These relocations could be time consuming and expensive and there
can be no assurance that such moves would not disrupt the manufacturing of our
products. Such disruptions could cause us to lose net revenues and damage our
customer relationships.

Page 13 of 31 pages.
<PAGE> 14
QUARTERLY RESULTS OF OPERATIONS

The following table presents our operating results, the three and six month
periods ended September 30, 1999 and 1998 as a percentage of net revenues
represented by selected items from the unaudited Condensed Statements of
Operations. This table should be read in conjunction with the Condensed
Financial Statements included elsewhere herein.

<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
-------------------------- --------------------------
Sept. 30, Sept. 30, Sept. 30, Sept. 30,
1999 1998 1999 1998
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Net revenues 100% 100% 100% 100%
Cost of revenues 57 75 58 76
---------- ---------- ---------- ----------
Gross margin 43 25 42 24
---------- ---------- ---------- ----------
Operating expenses:
Research and development 41 58 42 58
Sales and marketing 17 22 19 23
General and administrative 8 5 8 5
Amortization of deferred compensation 3 1 3 1
---------- ---------- ---------- ----------
Total operating expenses 69 86 72 87
---------- ---------- ---------- ----------
Loss from operations (26) (61) (30) (63)

Total other income (expense), net 8 1 4 (1)
---------- ---------- ---------- ----------

Net Loss (18)% (62)% (26)% (64)%
========== ========== ========== ==========
</TABLE>

Net Revenues

Net revenues for the three months ended September 30, 1999, increased by
approximately $5,230,000 or 89% to $11,081,000 compared to net revenues of
$5,851,000 in the same period in fiscal 1998. Net revenues for the six months
ended September 30, 1999, increased by approximately $9,035,000 or 80% to
$20,292,000 from $11,257,000 in the same period of fiscal 1998. For the quarter
ended September 30, 1999, approximately 45% of our net revenues came from sales
to Hewlett-Packard Company and approximately 17% of our net revenues came from
sales to Compaq Computer Corporation. For the quarter ended September 30, 1998,
approximately 47%, 19% and 13% of our net revenues came from sales to
Hewlett-Packard Company, Compaq Computer Corporation and Bell Microproducts,
Inc., respectively.

The increase in net revenues is primarily attributable to greater sales of
our hub products. For the quarter and six months ended September 30, 1999, 71%
and 72%, respectively, of our revenues came from sales to OEM customers as
compared to 72% and 81% of net revenues represented by sales to OEM customers
during the quarter and six months ended September 30, 1998, respectively.
International sales represented 30% and 33% of our net revenues for the quarter
ended September 30, 1999 and September 30, 1998, respectively.

Page 14 of 31 pages.
<PAGE> 15
Gross Margin

Gross margin increased 231% to $4,756,000 for the quarter ended September
30, 1999, up from $1,439,000 for quarter ended September 30, 1998. For the six
months ended September 30, 1999, gross margin increased by 221% to $8,552,000,
up from $2,664,000 in the six months ended September 30, 1998. The increase in
gross margin is primarily due to higher sales volumes which have resulted in
economies of scale, cost savings relating to our transition to Sanmina
Corporation's Guntersville, Alabama facility, higher sales volume to
distribution channel partners for which gross margins are typically higher than
for OEM customers and the mix of products sold, some of which derive higher
gross margins. For the quarter ended September 30, 1998, Gadzoox used the
services of a prior contract manufacturer and completed the transition to
Sanmina Corporation for all manufacturing during the quarter ended March 31,
1999. Prior cost savings may not be indicative of cost savings in the future.

Research and Development Expenses

Research and development expenses consist primarily of salaries and related
personnel costs, fees paid to consultants and outside service providers,
material costs for prototype and test units and other expenses related to the
design, development, testing and enhancements of our products. We expense our
research and development costs as they are incurred.

Research and development expenses increased by 33% to $4,540,000 for the
quarter ended September 30, 1999, up from $3,411,000 for the quarter ended
September 30, 1998. For the six months ended September 30, 1999, research and
development expenses increased by 30% to $8,458,000 from $6,523,000 in to the
same period in fiscal 1998. These increases are primarily due to additional
research and development personnel, including the addition of our strategic
research and development team and our two ASIC development teams, and the cost
of development of the Capellix switch product and other future products. We
believe that a significant level of investment in product research and
development is required to remain competitive. Accordingly, we expect to
continue to devote substantial resources to product research and development
such that research and development expenses will continue to increase in
absolute dollars.

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of salaries, commissions and
other related expenses for personnel engaged in marketing, sales and customer
engineering support functions, as well as costs associated with trade shows,
promotional activities, travel expenses and other related expenses.

Sales and marketing expenses increased by 54% to $1,914,000 during the
quarter ended September 30, 1999, up from $1,240,000 for the quarter ended
September 30, 1998. For the six months ended September 30, 1999, sales and
marketing expenses increased by 47% to $3,802,000 from $2,587,000 in the same
period in fiscal 1998. The increases are primarily attributable to increased
staffing, the cost of supporting OEM customers, providing sales support for
distribution customers through Gadzoox Associates in Networking ("GAIN")
program, comprehensive sales tools, in-depth training and other marketing and
sales activities.

We intend to continue to significantly expand our sales and marketing
operations and efforts, both domestically and internationally, in order to
increase market awareness and to generate additional sales of our products.
However, we cannot be certain that any increased expenditures will result in
higher net revenues. In addition, we believe our future success depends upon
establishing additional successful

Page 15 of 31 pages.
<PAGE> 16
relationships with a variety of channel partners. We believe that continued
investment in sales and marketing is critical to our success and expect these
expenses to continue to increase in absolute dollars in the future.

General and Administrative Expenses

General and administrative expenses consist primarily of salaries and
related expenses for executive, finance, accounting, information technology,
facilities and human resources personnel, recruiting expenses, professional fees
and costs associated with expanding our information systems.

General and administrative expenses increased by 188% to $866,000 for the
quarter ended September 30, 1999, up from $301,000 for the quarter ended
September 30, 1998. For the six months ended September 30, 1999, general and
administrative expenses increased by 189% to $1,629,000 from $563,000 in the
same period in fiscal 1998. These increases are primarily attributable to
increased facility costs related to Gadzoox relocating our corporate
headquarters to a new facility in November 1998 and increased costs associated
with operating as a public company.

We expect general and administrative expenses to continue to increase in
absolute dollars as we add personnel and incur additional costs related to the
growth of our business, expansion of our information infrastructure and our
operation as a public company.

Amortization of Deferred Compensation

In connection with the grant of stock options to employees, we recorded
deferred compensation within stockholders' equity of approximately $3.0 million,
representing the difference between the estimated fair value of the common stock
for accounting purposes and the option exercise price of these options at the
date of grant. We recorded amortization of deferred compensation of
approximately $321,000 and $87,000 for the quarters ended September 30, 1999 and
1998, respectively. For the six months ended September 30, 1999 compared to
September 30, 1998, we amortized deferred compensation of approximately $643,000
and $115,000, respectively. The amortization expense relates to options awarded
to employees in all operating expense categories. The amount of deferred
compensation expense to be recorded in future periods could decrease if options
for which accrued but unvested compensation has been recorded are forfeited.

Other Income (Expense), net

Interest income, net of interest expense related to our debt and lease
obligations, includes income from our cash and cash equivalents and short-term
investments, net of expenses related to our financing obligations.

Interest income, net of interest expense, totaled $936,000 for the quarter
ended September 30, 1999. For the quarter ended September 30, 1998, interest
expense, net of interest income, totaled $40,000. This increase is primarily due
to interest income earned from investment of the net proceeds received from the
issuance of common stock from our initial public offering in July 1999 and by
lower interest expense charged on the convertible note due to partial conversion
of the note in connection with our initial public offering. This increase was
partially offset by increased interest expense charged on higher capital lease
obligations. For the six months ended September 30, 1999, interest income, net
of interest expense totaled $795,000 compared to interest expense net of
interest income of $61,000 for the same period in 1998.

Liquidity and Capital Resources

Page 16 of 31 pages.
<PAGE> 17
Since inception, we have financed our operations primarily through private
sales of convertible preferred stock, the issuance of a convertible note,
equipment financing and proceeds from our initial public offering.

For the six months ended September 30, 1999, we used $5,687,000 in net cash
for operations compared to $9,218,000 for the same period in 1998. This
represents a decrease of 38% and is primarily due to a decrease in our net loss
to $5,185,000 in the six months ended September 30, 1999 compared to our net
loss of $7,185,000 for the same period in fiscal 1998.

For the six months ended September 30, 1999, Gadzoox used $654,000 in cash
from investing activities to acquire property and equipment compared to $492,000
used in the same period in 1998. Additionally, we invested $47,793,000 of the
proceeds from our initial public offering during the six months ended September
30, 1999 in short-term investments.

Net cash provided by financing activities was $77,135,000 and $19,501,000
for the six months ended September 1999 and 1998, respectively. For the six
months ended September 30, 1999, the primary source of cash generation was from
the sale of common stock in our initial public offering. Additionally, we used
debt and leases to partially finance operations and capital purchases and plans
to continue this practice.

For the six months ended September 30, 1999 and 1998, we acquired $676,000
and $713,000, respectively, in equipment under capitalized leases. At September
30, 1999, we had $2,493,000 in outstanding capitalized lease obligations.

Cash, cash equivalents and short-term investments totaled $82,996,000 at
September 30, 1999, up from $12,202,000 at March 31, 1999. This increase is
primarily due to the cash raised from the sale of common stock in our initial
public offering. This increase was partially offset by net cash used in
operations of $5,687,000 and capital expenditures of $647,000.

Our capital requirements depend on numerous factors, including market
acceptance of our products, the resources we devote to developing, marketing,
selling and supporting our products, the timing and expense associated with
expanding our distribution channels, and other factors. We expect to devote
substantial capital resources to continue our research and development efforts,
to hire and expand our sales, support, marketing and product development
organizations, to expand marketing programs, to establish additional facilities
worldwide and for other general corporate activities. We believe that our
existing cash balances, credit facilities and cash generated from future
operations will be sufficient to fund our operations for at least the next 12
months. However, we may require additional financing within this time frame and
there can be no assurances that this additional funding, if needed, will be
available on terms acceptable to us or at all.

Year 2000 Readiness

The year 2000 issue refers to the potential for disruption to business
activities caused by system failures or miscalculations which are triggered by
advancement of date records past the year 1999.

Readiness of our Products. We have designed our products to be ready for the
year 2000 calendar change. We represent to our customers that each hardware,
software and firmware product supplied by us will accurately process date data
from, into and between the 20th and 21st centuries and the years 1999 and 2000,
including leap year calculations, when used in accordance with the product
documentation provided

Page 17 of 31 pages.
<PAGE> 18
by us. We also represent to our customers that upon notification of any year
2000 problems with our products, we will remedy it by product repair or
replacement.

We do not represent to our customers that storage area networks and local
area networks that incorporate our products will not have problems with year
2000 issues, since these networks incorporate hardware and software products
supplied by other companies. We cannot evaluate the readiness of our products
for year 2000 with the innumerable combinations possible with other companies'
products. We may, therefore, face claims or complaints based on year 2000
problems related to our customers' networks, even when our products are not the
source of their problems. We are not aware of any such claims or complaints
about us or other companies building products for storage area networks, but we
may incur the cost of legal or other defense and explanation of our product
regardless of the merits of such claims.

Readiness of Our Systems and Facilities. Our business may be affected by
year 2000 issues. We have completed the identification of year 2000 issues and
have made system updates, upgrades and replacements of non-ready systems.
Systems include internal hardware and software as well as external service
provided by other companies, including contract manufacturing, product
development, information processing and facility services. We will complete the
preparation of contingency plans for unexpected internal system failures and
failures of external systems by the end of December 1999. We do not believe that
we have any problems relating to any of our internal systems. We do not believe
that we have any significant systems that are not year 2000 compliant. The
majority of our software, hardware and operating systems have been acquired as
new products in the last two years. Most of it is shrink-wrapped product and is
still maintained by existing vendors. We do not believe that we have any
significant systems that contain embedded chips that are not year 2000
compliant. Most of our hardware is made of branded components that have been
acquired in the last two years from manufacturers that are still in business. We
are not using legacy hardware or software that would be more likely to have
calendar issues because of its age.

Based on our efforts to date, we do not expect the total cost of year 2000
preparation and remediation to be material to our business. To date, our costs
of analysis of our year 2000 readiness have not been material.

Year 2000 Risks. An internal or external business disruption caused by the
year 2000 issue could interrupt our operations and damage our relationships with
our customers. An internal disruption unique to us could give competitive
advantages to our competitors. Failure of our internal systems and critical
external services to be ready for the year 2000 could delay order processing,
issuing invoices or development and shipment of products. The cost of recovery
from failures could be significant.

Our customers' purchasing plans could be affected by year 2000 issues if
they need to expend significant resources to fix their existing systems. This
situation could divert funds and resources otherwise available for new product
purchases. In addition, some customers may wait to purchase our products until
after the year 2000, which may reduce our net revenues in the near future.

We are unable to determine at this time whether these or other year 2000
failures will occur and will have a material impact on our business, results of
operations, or financial condition. This inability is particularly due to the
potential scope of the year 2000 problem and the inability to assure the
readiness of external service providers, including utilities, government
entities and other vendors. We have not developed and we have no current plant
to develop in the near future, a contingency plan to deal with the effects of
this worst case scenario.

Page 18 of 31 pages.
<PAGE> 19
RISK FACTORS

You should carefully consider the following risk factors and all other
information contained in this Form 10-Q for the quarter ended September 30,
1999. Risks and uncertainties, in addition to those we describe below, that are
not presently known to us, or that we currently believe are immaterial may also
impair our business operations. If any of the following risks occurs, our
business, operating results and financial condition could be seriously harmed.
In addition, the trading price of our common stock could decline due to the
occurrence of any of these risks. See also page 2 of this document for
discussion of forward-looking statements.

WE HAVE INCURRED SIGNIFICANT LOSSES IN EVERY FISCAL YEAR AND FISCAL QUARTER
SINCE OUR INCEPTION AND MAY NEVER BECOME PROFITABLE.

We have incurred significant losses since inception and expect to continue
to incur losses on both a quarterly and annual basis for the foreseeable future.
As of September 30, 1999, our accumulated deficit was $34.3 million. For the
fiscal year ended March 31, 1999, our net loss was $29.1 million, and for the
six months ended September 30, 1999, our net loss was $5.2 million. Although our
net revenues have grown in recent quarters, we may not be able to sustain this
growth, and we may not realize sufficient net revenues to achieve profitability.
We also expect to incur significant product development, sales and marketing and
administrative expenses and, as a result, we will need to generate increased net
revenues to achieve profitability. Further, even if we achieve profitability,
given the competition in, and the evolving nature of the storage area networking
market, we may not be able to sustain or increase profitability on a quarterly
or annual basis.

DUE TO OUR LIMITED OPERATING HISTORY, WE MAY HAVE DIFFICULTY ACCURATELY
PREDICTING REVENUES FOR FUTURE PERIODS AND APPROPRIATELY BUDGETING FOR EXPENSES,
AND, BECAUSE MOST OF OUR EXPENSES ARE FIXED IN THE SHORT-TERM, WE MAY NOT BE
ABLE TO DECREASE OUR EXPENSES IN A TIMELY MANNER TO OFFSET ANY UNEXPECTED
SHORTFALL IN REVENUES.

We have generated net revenues for less than five years and, thus, we have
only a short history from which to predict future net revenues. This limited
operating experience, combined with the rapidly evolving nature of the storage
area network market in which we sell our products, reduces our ability to
accurately forecast our quarterly and annual revenue. Further, we plan our
operating expenses based primarily on these revenue projections. Because most of
our expenses are fixed in the short-term or incurred in advance of anticipated
revenue, we may not be able to decrease our expenses in a timely manner to
offset any unexpected shortfall in revenue. For example, in July 1998, Digital
Equipment Corporation cancelled orders for our Bitstrip product, which resulted
in a corresponding decrease in net revenues. If a similar situation were to
occur in the future, we may incur additional unexpected losses which could
seriously harm our business. For further financial information relating to our
business, see "Notes to Condensed Financial Statements" and "Management's
Discussion and Analysis of Financial Condition and Results of Operations."

WE HAVE A HISTORY OF QUARTERLY AND ANNUAL FLUCTUATIONS IN OUR NET REVENUES AND
OPERATING RESULTS, AND EXPECT THESE FLUCTUATIONS TO CONTINUE, WHICH MAY RESULT
IN VOLATILITY IN OUR STOCK PRICE.

Our quarterly and annual net revenues and operating results have varied
significantly in the past and are likely to vary significantly in the future due
to a number of factors, many of which are outside of our control. The primary
factors that may cause our quarterly net revenues and operating results to
fluctuate include the following:

Page 19 of 31 pages.
<PAGE> 20
- fluctuations in demand for our products and services

- the timing of customer orders and product implementations,
particularly large orders from our customers

- our ability to develop, introduce, ship and support new products and
product enhancements

- the rate of adoption of storage area networks as an alternative to
existing data storage and management systems

- announcements and new product introductions by our competitors and
deferrals of customer orders in anticipation of new products,
services or product enhancements introduced by us or our competitors

- decreases in the prices at which we can sell our products

- our ability to obtain sufficient supplies of components, including
sole or limited source components, at expected prices

- the mix of our hub and switch products sold and the mix of
distribution channels through which they are sold.

Accordingly, you should not rely on the results of any past periods as an
indication of our future performance. It is likely that in some future periods,
our operating results may be below expectations of public market analysts or
investors. If this occurs, our stock price may drop.

BECAUSE WE DEPEND ON A FEW KEY ORIGINAL EQUIPMENT MANUFACTURER CUSTOMERS, THE
LOSS OF ANY OF THESE CUSTOMERS COULD SIGNIFICANTLY REDUCE OUR NET REVENUES.

We depend on a few key original equipment manufacturer customers. In fiscal
1999, approximately 68% of our net revenues came from three customers with sales
to Compaq Computer Corporation, Digital Equipment Corporation and
Hewlett-Packard Company each accounting for more than 10% of our net revenues.
For the six months ended September 30, 1999, approximately 17% of our net
revenues came Compaq Computer Corporation and approximately 45% from
Hewlett-Packard Company. In fiscal 1998, approximately 69% of our net revenues
came from sales to Hewlett-Packard Company and Digital Equipment Corporation.
Although we intend to expand our original equipment manufacture customer base,
we anticipate that our operating results will continue to depend on sales to a
relatively small number of customers. None of our current customers have any
minimum purchase obligations, and they may stop placing orders with us at any
time, regardless of any forecast they may have previously provided. The loss of
any of our key customers, or a significant reduction in sales to those
customers, could significantly reduce our net revenues. For example, in July
1998, Digital Equipment Corporation cancelled orders for our Bitstrip product,
and in December 1998, Hewlett-Packard Company unexpectedly reduced orders for
our Gibraltar 10-port product. Digital Equipment Corporation's order
cancellation resulted in a reduction of anticipated net revenues by
approximately 12% for the fiscal year ended March 31, 1999.

THE STORAGE AREA NETWORK MARKET IN WHICH WE COMPETE IS NEW AND UNPREDICTABLE,
AND IF THIS MARKET DOES NOT DEVELOP AND EXPAND AS WE ANTICIPATE, OUR BUSINESS
WILL SUFFER.

The market for storage area networks and related hub and switch products has
only recently begun to develop and is rapidly evolving. Because this market is
new, it is difficult to predict its potential size or future growth rate. Our
products are used exclusively in storage area networks. Accordingly, wide spread
adoption of storage area networks as an integral part of data-intensive
enterprise computing environments is critical to our future success. Potential
end-user customers who have invested substantial resources in their existing
data storage and management systems may be reluctant or slow to adopt a new
approach, like storage area networks. Our success in generating net revenues in
this emerging market will depend on, among other things, our ability to:

Page 20 of 31 pages.
<PAGE> 21
- educate potential original equipment manufacturer customers,
distribution channel partners and end users about the benefits of
storage area networks and hub and switch technology

- maintain and enhance our relationships with leading original
equipment manufacturer customers and channel partners

- predict and base our products on standards which ultimately become
industry standards.

In addition, storage area networks are often implemented in connection with
deployment of new storage systems and servers. Accordingly, our future success
is also substantially dependent on the market for new storage systems and
servers.

WE HAVE LIMITED PRODUCT OFFERINGS AND OUR BUSINESS MAY SUFFER IF DEMAND FOR ANY
OF THESE PRODUCTS DECLINES OR FAILS TO DEVELOP AS WE EXPECT.

We derive a substantial portion of our net revenues from a limited number of
products. Specifically, in fiscal 1999 and the first six months of fiscal 2000,
we derived substantially all our net revenues from our hub products. We expect
that net revenues from our hub products will continue to account for a
substantial portion of our total net revenues for the foreseeable future.
Although we introduced our Capellix switch in May 1999, there is no assurance
that this product will be adopted by our OEM or distribution customers or that
significant net revenues would be derived if adopted. As a result, for the
foreseeable future, we will continue to be subject to the risk of a significant
decrease in net revenues if demand for our hub products declines. Therefore,
continued market acceptance of our hub products and market acceptance of our
switch products is critical to our future success. Factors that may affect the
market acceptance of our products, some of which are beyond our control, include
the following:

- growth and changing requirements of the storage area network and hub
and switch product markets

- availability, price, quality and performance of competing products
and technologies

- performance, quality, price and total cost of ownership of our
products

- successful development of our relationships with existing and
potential original equipment manufacturer customers and distribution
channel partners.

OUR BUSINESS WILL SUFFER IF WE FAIL TO DEVELOP AND SUCCESSFULLY INTRODUCE NEW
AND ENHANCED PRODUCTS THAT MEET THE CHANGING NEEDS OF OUR CUSTOMERS.

Our future success depends upon our ability to address the rapidly changing
storage area network market including changes in relevant industry standards and
the changing needs of our customers by developing and introducing high-quality,
technologically-progressive, cost-effective products, product enhancements and
services on a timely basis. For example, in May 1999, we announced the launch of
our Capellix switch and commenced initial shipments in the third calendar
quarter of 1999. Our future net revenue growth will be dependent on the success
of these and other new products, and we may not be able to develop and introduce
these or other new products successfully in the timeframe we expect. Further, we
cannot be certain of the demand for, and market acceptance of, these and other
new products. In addition, we must manage successfully the introduction of new
or enhanced products to minimize disruption in our customers' ordering patterns,
avoid excessive levels of older product inventories and ensure that adequate
supplies of new products can be delivered to meet our customers' demands. Our
net revenues may be reduced if we fail to develop product enhancements, if we
fail to introduce new products or if any new products or product enhancements
that we develop and introduce are not broadly accepted.

Page 21 of 31 pages.
<PAGE> 22
WE WILL BE UNABLE TO MANUFACTURE OR SELL OUR PRODUCTS IF OUR SOLE CONTRACT
MANUFACTURER IS UNABLE TO MEET OUR MANUFACTURING NEEDS.

Sanmina Corporation, a third-party manufacturer for numerous companies,
manufactures all of our products at its Santa Clara, California and
Guntersville, Alabama facilities. Sanmina Corporation is not obligated to supply
products to us for any specific period, or in any specific quantity, except as
may be provided in a particular purchase order which has been accepted by
Sanmina Corporation. If Sanmina Corporation experiences delays, disruptions,
capacity constraints or quality control problems in its manufacturing
operations, then product shipments to our customers could be delayed, which
would negatively impact our net revenues and our competitive position and
reputation. Further, our business would be harmed if we fail to effectively
manage the manufacture of our products. We generally place orders with Sanmina
Corporation at least two months prior to scheduled delivery of products to our
customers. Accordingly, if we inaccurately forecast demand for our products, we
may be unable to obtain adequate manufacturing capacity from Sanmina Corporation
or adequate quantities of components to meet our customers' delivery
requirements or we may accumulate excess inventories. In addition, we anticipate
that we may relocate our manufacturing operations to other Sanmina Corporation
manufacturing facilities in the future. We could experience difficulties and
disruptions in the manufacture of our products while we transition to new
facilities. Manufacturing disruption could prevent us from achieving timely
delivery of products and could result in lost net revenues. Additionally, we
must coordinate our efforts with those of our suppliers and Sanmina Corporation,
or other third party manufacturers, to rapidly achieve volume production.
Although we have not experienced supply problems with Sanmina Corporation, we
have experienced delays in product deliveries from one of our former contract
manufacturers. Moreover, we may in the future need to find a new contract
manufacturer that can manufacture our products in higher volume and at lower
costs. We may not find a contract manufacturer that meets our needs.
Additionally, qualifying a new contract manufacturer and commencing volume
production is expensive and time consuming. If we are required or choose to
change contract manufacturers, we may lose net revenues and our customer
relationships may suffer.

BECAUSE WE DEPEND ON SOLE SOURCE AND LIMITED SOURCE SUPPLIERS FOR KEY
COMPONENTS, WE ARE SUSCEPTIBLE TO SUPPLY SHORTAGES THAT COULD ADVERSELY AFFECT
OUR OPERATING RESULTS.

We depend upon a single source for each type of our application-specific
integrated circuits, or ASICs, and limited sources of supply for several key
components, including power supplies, chassis and optical transceivers. We have
in the past experienced and may in the future experience shortages of, or
difficulties in acquiring, these components. If we are unable to buy these
components, we will not be able to manufacture our products on a timely basis
which would harm our business.

BECAUSE WE ORDER COMPONENTS AND MATERIALS BASED ON ROLLING FORECASTS, WE MAY
OVERESTIMATE OR UNDERESTIMATE OUR COMPONENT AND MATERIAL REQUIREMENTS, WHICH
COULD INCREASE OUR COSTS OR PREVENT US FROM MEETING CUSTOMER DEMAND.

We use rolling forecasts based on anticipated product orders to determine
our component requirements. Lead times for materials and components that we
order vary significantly and depend on factors such as specific supplier
requirements, contract terms and current market demand for such components. As a
result, our component requirement forecasts may not be accurate. If we
overestimate our component requirements, we may have excess inventory, which
would increase our costs. If we underestimate our component requirements, we may
have inadequate inventory, which could interrupt our manufacturing and delay
delivery of our products to our customers. Any of these occurrences would
negatively impact our business and operating results.

Page 22 of 31 pages.
<PAGE> 23
OUR RELIANCE ON ORIGINAL EQUIPMENT MANUFACTURER CUSTOMERS AND DISTRIBUTION
CHANNEL PARTNERS AND THE LENGTHY PROCESS REQUIRED TO ADD THESE PARTNERS MAY
IMPEDE THE GROWTH OF OUR NET REVENUES.

We rely on original equipment manufacturer customers and distribution
channel partners to distribute and sell our products. As a result, our success
depends substantially on (1) our ability to initiate, manage and expand our
relationships with significant original equipment manufacturer customers, (2)
our ability to attract distribution channel partners that will sell our products
and (3) the sales efforts of these original equipment manufacturer customers and
distribution channel partners. Our original equipment manufacturer customers
typically conduct significant evaluation, testing, implementation and acceptance
procedures before they begin to market and sell new technologies, including our
products. Based on our experience with our larger original equipment
manufacturer customers, this evaluation process is lengthy and has historically
been as long as nine months. This process is also complex and may require
significant sales, marketing and management efforts on our part. The complexity
of this process increases if we must qualify our products with multiple
customers at the same time. In addition, once our products have been qualified,
the length of the sales cycle of each of our original equipment manufacturer
customers may vary depending upon whether our products are being bundled with
another product or are being sold as an option or add-on. Sales to distribution
channel partners may also require lengthy sales and marketing cycles. As a
result, we may expend significant resources in developing partner relationships
before recognizing any revenue. We may not be able to manage and expand our
relationships with original equipment manufacturer customers and distribution
channel partners successfully and they may not market our products successfully.
Moreover, our agreements with original equipment manufacturer customers and
distribution channel partners have no minimum purchase commitments. Our failure
to manage and expand our relationships with original equipment manufacturer
customers and distribution channel partners or their failure to market our
products could substantially reduce our net revenues and seriously harm our
business.

OUR OPERATING RESULTS MAY SUFFER BECAUSE OF COMPETITION IN THE STORAGE AREA
NETWORK MARKET, AS WELL AS ADDITIONAL COMPETITION FROM DATA NETWORKING COMPANIES
AND ENTERPRISE SOFTWARE DEVELOPERS.

The market for our storage area network hub and switch products is
competitive, and is likely to become even more competitive. In the storage area
network market, our current competitors include Ancor Communications, Inc.,
Brocade Communications Systems, Inc., Emulex Corporation and Vixel Corporation.
In addition to these companies, we expect new storage area network competitors
to emerge. In the future, we may also compete against data networking companies
which may develop storage area network products. Furthermore, although we
currently offer products that complement the software products offered by Legato
Systems, Inc. and Veritas Software Corporation, they and other enterprise
software developers may in the future compete with us. We also compete with
providers of data storage solutions that employ traditional storage
technologies, including small computer system interface-based technology such as
Adaptec, Inc., LSI Logic Corporation and QLogic Corporation. Increased
competition could result in pricing pressures, reduced sales, reduced margins,
reduced profits, reduced market share or the failure of our products to achieve
or maintain market acceptance. Some of our competitors and potential competitors
have longer operating histories, greater name recognition, access to larger
customer bases, more established distribution channels or substantially greater
resources than we have. As a result, they may be able to respond more quickly
than we can to new or changing opportunities, technologies, standards or
customer requirements. Moreover, we have only recently begun to offer storage
area network switch products. Therefore, we may not be able to compete
successfully in the storage area network switch product market.

Page 23 of 31 pages.
<PAGE> 24
IF WE CANNOT INCREASE OUR SALES VOLUMES, REDUCE OUR COSTS OR INTRODUCE HIGHER
MARGIN PRODUCTS TO OFFSET ANTICIPATED REDUCTIONS IN THE AVERAGE UNIT PRICE OF
OUR PRODUCTS, OUR OPERATING RESULTS MAY SUFFER.

Although we have not experienced an overall decrease in the average selling
prices of our products, we anticipate that as products in the storage area
market become more commoditized, the average unit price of our products may
decrease in the future in response to changes in product mix, competitive
pricing pressures, new product introductions by us or our competitors or other
factors. If we are unable to offset the anticipated decrease in our average
selling prices by increasing our sales volumes, our net revenues will decline.
In addition, to maintain our gross margins, we must continue to reduce the
manufacturing cost of our products. Further, as average unit prices of our
current products decline, we must develop and introduce new products and product
enhancements with higher margins. If we cannot maintain our gross margins, our
business could be seriously harmed, particularly if the average selling price of
our products decreases significantly.

OUR PRODUCTS ARE COMPLEX AND MAY CONTAIN UNDETECTED SOFTWARE OR HARDWARE ERRORS,
WHICH COULD LEAD TO AN INCREASE IN OUR COSTS OR A REDUCTION IN OUR NET REVENUES.

Networking products frequently contain undetected software or hardware
errors when first introduced or as new versions are released. Our products are
complex and we have from time to time found errors in existing products, and we
may from time to time find errors in our existing, new or enhanced products. In
addition, our products are combined with products from other vendors. As a
result, should problems occur, it may be difficult to identify the source of the
problem. The occurrence of hardware and software errors, whether caused by our
or other vendors' storage area network products, could adversely affect sales of
our products, cause us to incur significant warranty and repair costs, divert
the attention of our engineering personnel from our product development efforts
and cause significant customer relationship problems.

IF WE DO NOT HIRE, RETAIN AND INTEGRATE HIGHLY SKILLED MANAGERIAL, ENGINEERING,
SALES, MARKETING, FINANCE AND OPERATIONS PERSONNEL, OUR BUSINESS MAY SUFFER.

Our success depends to a significant degree upon the continued contributions
of our key personnel in engineering, sales, marketing, finance and operations,
many of whom would be difficult to replace. We do not maintain key person life
insurance on most of our key personnel and do not have employment contracts with
any of our key personnel. The loss of the services of any of our key personnel
could have a negative impact on our business. We also believe that our success
depends to a significant extent on the ability of our key personnel to operate
effectively, both individually and as a group. Many of our employees have only
recently joined us. If we are unable to integrate new employees in a timely and
cost-effective manner, our operating results may suffer. We believe our future
success will also depend in large part upon our ability to attract and retain
highly skilled managerial, engineering, sales, marketing, finance and operations
personnel. Competition for these people is intense, especially in the San
Francisco Bay area where our operations are headquartered. In particular, we
have experienced difficulty in hiring qualified ASIC, software, system, test and
customer support engineers and we may not be successful in attracting and
retaining individuals to fill these positions. If we are unable to attract or
retain qualified personnel in the future, or if we experience delays in hiring
required personnel, particularly qualified engineers and sales personnel, our
ability to develop, introduce and sell our products could be harmed. In
addition, companies in our industry whose employees accept positions with
competitors frequently claim that their competitors have engaged in unfair
hiring practices. We may be subject to such claims in the future as we seek to
hire qualified personnel. Any claim of this nature could result in material
litigation. We could incur substantial costs in defending ourselves against
these claims, regardless of their merits.

Page 24 of 31 pages.
<PAGE> 25
WE HAVE EXPERIENCED A PERIOD OF RAPID GROWTH, AND IF WE ARE NOT ABLE TO
SUCCESSFULLY MANAGE THIS AND FUTURE GROWTH, OUR BUSINESS MAY SUFFER.

We have recently experienced a period of rapid growth. At March 31, 1997, we
had a total of 38 employees, and at September 30, 1999, we had a total of 157
employees. We plan to continue to hire new employees to expand our operations
significantly to pursue existing and potential market opportunities. This growth
will place a significant demand on our management and our operational resources.
In order to manage growth effectively, we must implement and improve our
operational systems, procedures and controls on a timely basis. Our key
personnel have limited experience managing this type of growth. If we cannot
manage growth effectively, our business could suffer.

BECAUSE OUR INTELLECTUAL PROPERTY IS CRITICAL TO THE SUCCESS OF OUR BUSINESS,
OUR OPERATING RESULTS WOULD SUFFER IF WE ARE UNABLE TO ADEQUATELY PROTECT OUR
INTELLECTUAL PROPERTY.

Because our products rely on proprietary technology and will likely continue
to rely on technological advancements for market acceptance, we believe that the
protection of our intellectual property rights will be critical to the success
of our business. To protect our intellectual property rights, we rely on a
combination of patent, copyright, trademark and trade secret laws and
restrictions on disclosure. We also enter into confidentiality or license
agreements with our employees, consultants and corporate partners, and control
access to and distribution of our software, documentation and other proprietary
information. Despite our efforts to protect our proprietary rights, unauthorized
parties may copy or otherwise obtain and use our products or technology.
Monitoring unauthorized use of our products is difficult and the steps we have
taken may not prevent unauthorized use of our technology, particularly in
foreign countries where the laws may not protect our proprietary rights as fully
as in the United States. If we are unable to protect our intellectual property
from infringement, other companies may be able to use our intellectual property
to offer competitive products at lower prices. We may not be able to effectively
compete against these companies.

WE RELY HEAVILY ON OUR INTELLECTUAL PROPERTY, AND EFFORTS TO PROTECT IT MAY
CAUSE US TO BECOME INVOLVED IN COSTLY AND LENGTHY LITIGATION WHICH COULD
SERIOUSLY HARM OUR BUSINESS.

Although we are not currently involved in any intellectual property
litigation, we may be a party to litigation in the future either to protect our
intellectual property or as a result of an alleged infringement of others'
intellectual property. These claims and any resulting litigation could subject
us to significant liability for damages and could cause our proprietary rights
to be invalidated. Litigation, regardless of the merits of the claim or outcome,
would likely be time-consuming and expensive to resolve and would divert
management time and attention. Any potential intellectual property litigation
could also force us to do one or more of the following:

- stop using the challenged intellectual property or selling our
products or services that incorporate it

- obtain a license to use the challenged intellectual property or to
sell products or services that incorporate it, which license may not
be available on reasonable terms, or at all

- redesign those products or services that are based on or incorporate
the challenged intellectual property.

If we are forced to take any of the foregoing actions, we may be unable to
manufacture and sell our products, and our net revenues would be substantially
reduced.

Page 25 of 31 pages.
<PAGE> 26
IF WE, OUR KEY SUPPLIERS OR OUR CUSTOMERS FAIL TO BE READY FOR THE YEAR 2000
CALENDAR CHANGE, OUR BUSINESS MAY BE DISRUPTED AND OUR NET REVENUES MAY DECLINE.

The year 2000 issue refers to the potential for disruption to business
activities caused by system failures or miscalculations that are triggered by
advancement of date records past the year 1999. A failure due to year 2000
issues involves numerous risks including:

- potential product warranty or other claims from our customers

- negative impact on market demand for storage area networks or
related hub and switch products until preparations for the calendar
change by existing and potential customers are complete

- manufacturing, information, facility and development systems
problems, both those that are unique to us and those that affect
geographical areas where our business and employees reside.

Although we have completed testing our products' readiness for the year 2000
calendar change and believe that our products are ready for that event, we may
yet discover that our current products, any of our new products or any product
enhancements we develop in the future have problems because of the year 2000
calendar change. In this event, our business may be adversely affected and our
customer relationships may suffer. We may find that our internal systems are not
ready for the year 2000 calendar change. In this event, our business may be
adversely affected and we may experience delays or disruptions in sales or
deliveries of our product.

INDUSTRY STANDARDS AND GOVERNMENT REGULATIONS AFFECTING OUR BUSINESS EVOLVE
RAPIDLY, AND IF WE CANNOT DEVELOP PRODUCTS THAT ARE COMPATIBLE WITH THESE
EVOLVING STANDARDS, OUR BUSINESS WILL SUFFER.

Our products must comply with industry standards. For example, in the United
States, our products must comply with various regulations and standards defined
by the Federal Communications Commission. Internationally, our products are also
required to comply with standards established by authorities in various
countries. Any new products and product enhancements that we introduce in the
future must also meet industry standards at the time they are introduced.
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. Our products comprise only a part of the entire storage area
network. All components of the storage area network must comply with the same
standards in order to operate efficiently together. We depend on companies that
provide other components of the storage area network to support the industry
standards as they evolve. Many of these companies are significantly larger and
more influential in effecting industry standards than we are. Some industry
standards may not be widely adopted or they may not be implemented uniformly,
and competing standards may emerge that may be preferred by original equipment
manufacturer customers or end users. If larger companies do not support the same
industry standards that we do, or if competing standards emerge, market
acceptance of our products could suffer.

WE PLAN TO INCREASE OUR INTERNATIONAL SALES ACTIVITIES WHICH WILL SUBJECT US TO
ADDITIONAL BUSINESS RISKS.

For the six months ended September 30, 1999, 30% of our net revenues were
from international sales activities, and for the fiscal year ended March 31,
1999, 21% of our net revenues were from international sales activities. We plan
to increase our international sales activities. Our international sales will be
limited if we cannot establish relationships with international distributors,
establish additional foreign operations, expand international sales channel
management, hire additional personnel and develop relationships with
international service providers. Even if we are able to successfully continue
international operations, we may not be able to maintain or increase
international market demand for our products. Our international operations are
subject to a number of risks, including:

Page 26 of 31 pages.
<PAGE> 27
- multiple protectionist, adverse and changing governmental laws and
regulations

- reduced or limited protections of intellectual property rights

- potentially adverse tax consequences resulting from changes in tax
laws

- political and economic instability.

To date, none of our international net revenues and costs have been
denominated in foreign currencies. As a result, an increase in the value of the
U.S. dollar relative to foreign currencies could make our products more
expensive and thus less competitive in foreign markets. A portion of our
international net revenues may be denominated in foreign currencies in the
future, which would subject us to risks associated with fluctuations in those
foreign currencies.

WE MAY BECOME INVOLVED IN COSTLY AND TIME-CONSUMING LITIGATION THAT MAY
SUBSTANTIALLY INCREASE OUR COSTS AND THEREBY HARM OUR BUSINESS.

We may from time to time become involved in various lawsuits and legal
proceedings which arise in the ordinary course of our business. For example, in
May 1999, a former employee filed a complaint against us. We believe this claim
is without merit and that resolution of this claim will not have a material
adverse effect on our financial condition. However, litigation is subject to
inherent uncertainties, and an adverse result in this or other matters that may
arise from time-to-time may harm our business.

WE MAY ENGAGE IN FUTURE ACQUISITIONS THAT DILUTE OUR STOCKHOLDERS' EQUITY AND
CAUSE US TO INCUR DEBT OR ASSUME CONTINGENT LIABILITIES.

As part of our strategy, we expect to review opportunities to buy other
businesses or technologies that would complement our current products, expand
the breadth of our market or enhance our technical capabilities, or that may
otherwise offer growth opportunities. While we have no current agreements or
negotiations underway, we may buy businesses, products or technologies in the
future. In the event of any future purchases, we could:

- issue stock that would dilute our current stockholders' percentage
ownership

- incur debt

- assume liabilities.

These purchases could also involve numerous risks, including:

- problems integrating the purchased operations, technologies or
products

- unanticipated costs

- diversion of management's attention from our core business

- adverse effects on existing business relationships with suppliers
and customers

- risks associated with entering markets in which we have no or
limited prior experience

- potential loss of key employees of purchased organizations.

We may not be able to successfully integrate any businesses, products,
technologies or personnel that we might purchase in the future.

OUR PRINCIPAL STOCKHOLDERS HAVE SIGNIFICANT VOTING POWER AND MAY TAKE ACTIONS
THAT MAY NOT BE IN THE BEST INTERESTS OF OUR OTHER STOCKHOLDERS.

As of September 30, 1999, our executive officers and directors and their
affiliates beneficially owned, in the aggregate, approximately 64% of our
outstanding common stock. As a result, these stockholders may be able to
exercise significant control over all matters requiring stockholder approval,
including the election of directors and approval of significant corporate
transactions, which could delay or prevent an outside party from acquiring or
merging with us.

Page 27 of 31 pages.
<PAGE> 28
PROVISIONS IN OUR CHARTER DOCUMENTS AND DELAWARE LAW COULD PREVENT OR DELAY A
CHANGE IN CONTROL OF OUR COMPANY AND MAY REDUCE THE MARKET PRICE OF OUR COMMON
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:

- authorizing our board of directors to issue 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

- requiring super-majority voting to effect significant amendments to
our certificate of incorporation and bylaws

- limiting the ability of stockholders to call special meetings

- prohibiting stockholder actions by written consent

- establishing advance notice requirements for nominations for
election to the board of directors or for proposing matters that can
be acted on by stockholders at stockholder meetings.

Certain provisions of Delaware law also may discourage, delay or prevent
someone from acquiring or merging with us, which may cause the market price of
our common stock to decline.

OUR STOCK PRICE MAY BE VOLATILE AND YOU MAY NOT BE ABLE TO RESELL YOUR SHARES AT
OR ABOVE THE INITIAL PUBLIC OFFERING PRICE OR YOUR PURCHASE PRICE.

If you purchase shares of common stock, you may not be able to resell those
shares at or above your purchase price. The market price of our common stock may
fluctuate significantly in response to factors, some of which are beyond our
control, including the following:

- actual or anticipated fluctuations in our operating results

- changes in market valuations of other technology companies

- announcements by us or our competitors of significant technical
innovations, contracts, acquisitions, strategic partnerships, joint
ventures or capital commitments

- losses of major original equipment manufacturer customers, value
added resellers or distributors

- additions or departures of key personnel

- sales of common stock in the future.

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 our performance.

IF WE ARE UNABLE TO MEET OUR FUTURE CAPITAL REQUIREMENTS, WE MAY BE UNABLE TO
DEVELOP OR ENHANCE OUR PRODUCTS, TAKE ADVANTAGE OF FUTURE OPPORTUNITIES OR
RESPOND TO COMPETITIVE PRESSURES OR UNANTICIPATED REQUIREMENTS, EACH OF WHICH
WOULD MATERIALLY HARM OUR BUSINESS.

We believe that the net proceeds of our initial public offering in July
1999, together with our existing cash balances, credit facilities and cash flow
expected to be generated from future operations, will be sufficient to meet our
capital requirements at least through the next 12 months. However, we may be
required, or could elect, to seek additional funding prior to that time. In the
event we are required to raise additional funds we may not be able to do so on
favorable terms, if at all. Further, if we issue new equity securities,
stockholders may experience additional dilution or the new equity securities may
have rights, preferences o privileges senior to those of existing holders of
common stock. If we cannot raise funds on acceptable terms, we may be unable to
develop or enhance our products, take advantage of future

Page 28 of 31 pages.
<PAGE> 29
opportunities or respond to competitive pressures or unanticipated requirements.
For additional information on our anticipated future capital requirements, see
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources."

FUTURE SALES OF OUR COMMON STOCK IN THE PUBLIC MARKET MAY DEPRESS OUR STOCK
PRICE.

Our executive officers, directors and their affiliates hold a substantial
number of shares, which they will be able to sell in the public market in the
near future. Sales of a substantial number of shares of our common stock could
cause our stock price to fall. In addition, the sale of these shares could
impair our ability to raise capital through the sale of additional stock.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS.

The primary objective of our investment activities is to preserve principal
while at the same time maximizing the income we receive from our investments
without significantly increasing risk. Some of the securities that we may invest
in may be subject to market risk. This means that a change in prevailing
interest rates may cause the principal amount of the investment to fluctuate.
For example, if we hold a security that was issued with a fixed interest rate at
the then-prevailing rate and the prevailing interest rate later rises, the
principal amount of our investment will probably decline. To minimize this risk
in the future, we intend to maintain our portfolio of cash equivalents and
short-term investments in a variety of securities, including commercial paper,
money market funds, government and non-government debt securities. In general,
money market funds are not subject to market risk because the interest paid on
such funds fluctuates with the prevailing interest rate. As of September 30,
1999, all of our investments were in cash equivalents and short-term
investments. See Note 3 of the Notes to the Condensed Financial Statements.

We have operated primarily in the United States and all sales to date have
been made in U.S. dollars. Accordingly, we have not had any material exposure to
foreign currency rate fluctuations.

Page 29 of 31 pages.
<PAGE> 30
PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

From time to time, Gadzoox may become involved in various lawsuits and legal
proceedings which arise in the ordinary course of business. For example, in May
1999, a former employee filed a complaint against Gadzoox. Management believes
this claim is without merit and that resolution of this claim will not have a
material adverse effect on Gadzoox' financial position or statements of
operation. However, litigation is subject to inherent uncertainties, and an
adverse result in this or other matters may arise from time to time that may
harm Gadzoox' business.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

In connection with its initial public offering in July of 1999, Gadzoox
filed a Registration Statements on Form S-1, SEC File No. 333-78029 (the
"Registration Statement"), which was declared effective by the Securities and
Exchange Commission on July 19, 1999. Pursuant to the Registration Statement,
Gadzoox registered 4,025,000 shares of its common stock, par value of $0.005 per
share, including 525,000 shares sold to the underwriters upon the exercise of
their over-allotment option. The aggregate offering price of the shares
registered was $84,525,000, $5,916,750 of which was applied toward the
underwriters discounts and commissions. Other expenses related to the offering
were approximately $1,113,000. Gadzoox received net proceeds of approximately
$77,495,000 from the sale of common stock in the initial public offering.
Managing underwriters of the offering were Credit Suisse First Boston, Hambrecht
& Quist, and Morgan Keegan & Company, Inc.

Gadzoox invested the proceeds from the offering in short-term investment
grade, interest bearing securities and intends to use the proceeds for working
capital and general corporate purposes, including expenditures for research and
development of new products, sales channel development and other corporate
purposes. In addition, we may use a portion of the net proceeds to acquire
businesses, products or technologies that are complementary to our current or
future business and product lines. The use of proceeds from the offering does
not represent a material change in the use of proceeds described in the
prospectus.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

ITEM 5. OTHER INFORMATION

None

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits:

27.1 Financial Data Schedule

(b) Reports on Form 8-K:

None

Page 30 of 31 pages.
<PAGE> 31
SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on behalf by the undersigned
thereunto duly authorized.

Dated: November 11, 1999 GADZOOX NETWORKS, INC.
-------------------------- (Registrant)

/s/ K. William Sickler
--------------------------------------------
K. WILLIAM SICKLER

President and Chief Executive Officer

/s/ Christine E. Munson
--------------------------------------------
CHRISTINE E. MUNSON

Chief Financial Officer and
Vice President of Administration

Page 31 of 31 pages.

<PAGE> 32
EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT # DESCRIPTION
- --------- -----------
<S> <C>

27.1 Financial Data Schedule
</TABLE>

<ARTICLE> 5
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> MAR-31-1999
<PERIOD-START> APR-01-1999
<PERIOD-END> SEP-30-1999
<CASH> 35,203
<SECURITIES> 47,793
<RECEIVABLES> 8,817
<ALLOWANCES> 0
<INVENTORY> 4,721
<CURRENT-ASSETS> 97,196
<PP&E> 4,714
<DEPRECIATION> 0
<TOTAL-ASSETS> 102,168
<CURRENT-LIABILITIES> 8,112
<BONDS> 0
0
0
<COMMON> 128
<OTHER-SE> 88,492
<TOTAL-LIABILITY-AND-EQUITY> 102,168
<SALES> 11,081
<TOTAL-REVENUES> 11,081
<CGS> 6,325
<TOTAL-COSTS> 7,641
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (0)
<INCOME-PRETAX> (1,949)
<INCOME-TAX> 0
<INCOME-CONTINUING> (1,949)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (1,949)
<EPS-BASIC> (0.09)
<EPS-DILUTED> (0.09)

</TABLE>