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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
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FORM 10 - Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002
Commission File Number 0-11630
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TERAFORCE TECHNOLOGY CORPORATION
(exact name of registrant as specified in its charter)
DELAWARE 76-0471342
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) Identification No.)
1240 EAST CAMPBELL ROAD, RICHARDSON, TEXAS 75081
(Address of principal executive offices) (Zip code)
469-330-4960
(Registrant's telephone number, including area code)
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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 [ ]
There were 95,338,850 shares of Common Stock outstanding as of October 31, 2002.
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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES
INDEX
PAGE
PART I FINANCIAL INFORMATION
ITEM 1 FINANCIAL STATEMENTS
Consolidated Condensed Balance Sheets of the Company
at September 30, 2002 (unaudited) and December 31, 2001 2
Consolidated Condensed Statements of Operations of the
Company (unaudited) for the three months and nine months
ended September 30, 2002 and 2001
3
Consolidated Condensed Statements of Cash Flows of the
Company (unaudited) for the nine months ended September 30,
2002 and 2001 4
Notes to Consolidated Condensed Financial Statements 5
ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 10
ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 15
ITEM 4 CONTROLS AND PROCEDURES 16
PART II OTHER INFORMATION
ITEM 1 LEGAL PROCEEDINGS 16
ITEM 2 CHANGES IN SECURITIES AND USE OF PROCEEDS 17
ITEM 6 EXHIBITS AND REPORTS ON FORM 8-K 18
SIGNATURES 19
CERTIFICATIONS 20
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES
Consolidated Condensed Balance Sheets
(Thousands of dollars, except share data)
SEPTEMBER 30, DECEMBER 31,
2002 2001
------------- ------------
(UNAUDITED)
Assets
------
Current assets:
Cash and cash equivalents $ 5 $ 1
Temporary cash investments 662 53
Accounts receivable net of allowances of $1,658 in 2002
and $1,691 in 2001 578 869
Receivables from affiliate 779 816
Inventories 2,693 3,262
Prepaid services 321 -
Net current assets of discontinued operations - 2,880
Prepaid expenses and other current assets 764 224
--------- ---------
Total current assets 5,802 8,105
Property and equipment, net 623 638
Investment in affiliate 884 1,284
Other assets 281 169
--------- ---------
$ 7,590 $ 10,196
========= =========
Liabilities and Stockholders' Equity (Deficit)
----------------------------------------------
Current liabilities:
Notes payable $ 3,800 $ 7,554
Accounts payable 1,114 1,864
Accrued liabilities 1,435 2,389
--------- ---------
Total current liabilities 6,349 11,807
--------- ---------
Long-term notes payable 2,900 -
Other long-term liabilities 1,200 -
Stockholders' (deficit) equity:
Common stock, $.01 par value. Authorized 200,000,000 shares;
89,922,184 and 87,088,850 shares issued in 2002 and 2001,
respectively 899 871
Additional paid-in capital 181,979 181,898
Accumulated deficit (184,150) (182,793)
--------- ---------
(1,272) (24)
Less 400,474 shares of common stock in treasury - at cost (1,587) (1,587)
--------- ---------
Total stockholders' equity (deficit) (2,859) (1,611)
--------- ---------
$ 7,590 $ 10,196
========= =========
See accompanying notes to consolidated condensed financial statements.
2
TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES
Consolidated Condensed Statements of Operations
(Thousands of dollars, except per share data)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ ---------------------------
2002 2001 2002 2001
-------- ------- -------- --------
(UNAUDITED)
Net revenues $ 718 $ 925 $ 4,007 $ 5,871
Cost of revenue 625 1,510 2,344 6,637
------- ------- ------- --------
Gross profit (loss) 93 (585) 1,663 (766)
------- ------- ------- --------
Expenses:
Engineering and development 546 1,276 2,486 4,033
Selling and administrative 1,743 2,099 4,614 7,370
Costs related to sale of assets - 1,570 - 1,570
------- ------- ------- --------
2,289 4,945 7,100 12,973
------- ------- ------- --------
Operating loss (2,196) (5,530) (5,437) (13,739)
------- ------- ------- --------
Other income (expense):
Litigation settlement - - 6,300 -
Share of loss of unconsolidated affiliate (295) - (401) -
Interest expense (125) (69) (315) (88)
Interest income and other 62 (31) 16 (9)
------- ------- ------- --------
(358) (100) 5,600 (97)
------- ------- ------- --------
Income (loss) from continuing operations (2,554) (5,630) 163 (13,836)
Loss from discontinued operations (1,520) (1,117) (1,520) (2,161)
------- ------- ------- --------
Net loss $(4,074) $(6,747) $(1,357) $(15,997)
======= ======= ======= ========
Basic and diluted loss per share:
Continuing operations $ (.03) $ (.06) $ - $ (.16)
Discontinued operations (.02) (.02) (.02) (.03)
------- ------- ------- --------
Net loss per share $ (.05) $ (.08) $ (.02) $ (.19)
======= ======= ======= ========
Weighted average number of common shares
outstanding (thousands) basic and diluted 88,725 86,689 87,968 86,242
======= ======= ======= ========
See accompanying notes to consolidated condensed financial statements.
3
TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES
Consolidated Condensed Statements of Cash Flows
(Thousands of dollars)
NINE MONTHS ENDED
SEPTEMBER 30,
-----------------------
2002 2001
-------- --------
(UNAUDITED)
Cash flows from operating activities:
Net loss $(1,357) $(15,997)
Adjustments to reconcile net loss to net cash used in operating activities:
Litigation settlement (6,300) -
Utilization of prepaid services 679 -
Depreciation and amortization 177 973
Share of loss of unconsolidated affiliate 401 -
Other 927 944
Changes in operating assets and liabilities:
Accounts receivable 29 3,630
Inventories 569 (1,777)
Assets held for sale - 2,643
Accounts payable and accrued liabilities (1,241) (1,300)
------- --------
Net cash used in operating activities (6,116) (10,884)
------- --------
Cash flows from investing activities:
Proceeds from litigation settlement 6,300 -
Capital expenditures (154) (321)
Investment in temporary cash investments (609) -
Net proceeds from disposal of discontinued operation 1,337 -
Proceeds from sale of assets - 2,250
Investment in joint venture - (1,250)
Other - 57
------- --------
Net cash provided by investing activities 6,874 736
------- --------
Cash flows from financing activities:
Proceeds from issuance of notes payable 500 4,750
Principal payments on notes payable (1,354) -
Proceeds from issuance of common stock 100 -
------- --------
Net cash provided by (used in) financing activities (754) 4,750
------- --------
Net increase (decrease) in cash and cash equivalents 4 (5,398)
Cash and cash equivalents, beginning of period 1 5,587
------- --------
Cash and cash equivalents, end of period $ 5 $ 189
======= ========
See accompanying notes to consolidated condensed financial statements.
4
TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
September 30, 2002
BASIS OF PRESENTATION
The accompanying consolidated financial statements have been prepared
by the Company without audit in accordance with accounting principles generally
accepted in the United States of America for interim financial statements and
with instructions to Form 10-Q and Rule 10-01 of Regulation S-X. In the opinion
of management, all adjustments (consisting only of normal recurring accruals)
considered necessary for a fair presentation have been included.
The accompanying consolidated financial statements do not include
certain footnotes and financial presentations normally required under accounting
principles generally accepted in the United States of America and, therefore,
should be read in conjunction with the audited financial statements included in
the Company's Annual Report on Form 10-K as of December 31, 2001.
The Company incurred an operating loss in the first nine months of 2002
and has incurred significant operating losses in 2001, 2000 and 1999. These
losses were funded by proceeds from the issuance of equity securities and notes
payable and the proceeds from the settlement of litigation. As of September 30,
2002, notes payable due within one year amounted to $3,800,000. In 2001 and
through January 2002, the Company disposed of certain operations and assets and
has reduced operating expenses. In addition, for the first nine months of 2002
revenues from the Company's defense electronics business exceeded those recorded
for the first nine months of 2001, have increased in each of the last three
years, and are expected to continue to increase. Accordingly, management expects
the Company to generate positive cash flow from operations in the near future.
However, there is no assurance that revenues will increase such that the Company
will generate positive cash flow from operations. Until that point, the Company
expects to generate losses and negative cash flow from operations. Furthermore,
should the Company not generate positive cash flow from operations within the
expected time frame, additional capital may be required to fund operating
losses.
In January 2002, the Company received cash proceeds of $1,660,000 from
the sale of its engineering design services business and in March 2002, received
cash proceeds of $6,300,000 from the settlement of litigation. In September,
October and November of 2002 the Company reduced and restructured its
outstanding debt and raised additional working capital from the sale of common
stock in a series of private placements.
In October 2002, the Company reduced amounts outstanding under its bank
facilities by $2,000,000 with proceeds from the sale of common stock. After this
reduction the Company's outstanding debt obligations amounted to approximately
$4,700,000. In October 2002, $2,500,000 of these remaining obligations was
amended such that $2,500,000 matures on March 26, 2004, with quarterly
reductions of $450,000 beginning December 31, 2002. The Company believes it has
reached an agreement in principle, subject to definitive documentation, to
extend the maturity of approximately $2,200,000 of remaining debt to September
2003.
Subsequent to September 30, 2002 and through October 31, 2002 the
Company has raised approximately $750,000 from the sale of common stock and
expects to sell additional common stock.
5
TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
September 30, 2002 (continued)
The Company believes that these amounts and other potential sales of
common stock will be sufficient to fund its expected operating losses. The
Company further believes that its restructured debt obligations can be satisfied
with cash flow generated from operations or from the issuance of other debt or
equity securities. However, there can be no assurance the Company can accomplish
this or that it can do so under acceptable terms. These financial statements
have been prepared assuming the Company will continue as a going concern and do
not include any adjustments that might result from the outcome of this
uncertainty.
INVENTORIES
The components of inventories are as follows:
SEPTEMBER 30, DECEMBER 31,
2002 2001
------------- ------------
($ THOUSANDS)
Raw materials $2,076 $2,615
Work in progress 330 493
Finished goods 287 154
------ ------
$2,693 $3,262
====== ======
SEGMENTS OF BUSINESS
Net revenues by business segment:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -----------------
2002 2001 2002 2001
------ ------ ------ ------
($ THOUSANDS)
Defense electronics $718 $814 $4,007 $3,243
Optical networking equipment - 86 - 2,368
Other - 25 - 260
---- ---- ------ ------
$718 $925 $4,007 $5,871
==== ==== ====== ======
Segment-specific margins (gross profit less total engineering and
development costs for the segment):
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ --------------------
2002 2001 2002 2001
-------- -------- -------- ---------
($ THOUSANDS)
Defense electronics $ (557) $(1,205) $ (557) $ (1,698)
Optical networking equipment 107 (386) (88) (1,079)
Other (3) (270) (178) (2,022)
------- ------- ------- --------
Subtotal segment specific (453) (1,861) (823) (4,799)
Selling and administrative expenses (1,743) (3,669) (4,614) (8,940)
------- ------- ------- --------
Operating loss $(2,196) $(5,530) $(5,437) $(13,739)
======= ======= ======= ========
6
TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
September 30, 2002 (continued)
Assets are identifiable only by combined segments as follows:
AT SEPTEMBER 30, AT DECEMBER 31,
2002 2001
---------------- ---------------
($ THOUSANDS)
Defense electronics $3,728 $ 4,052
Optical networking equipment and other 1,896 2,625
Not allocable to a segment 1,966 3,519
------ -------
Total $7,590 $10,196
====== =======
INCOME TAXES
For the nine months ended September 30, 2002 and 2001 the Company's
effective income tax rate differed from the federal statutory rate due to
taxable losses incurred for which no benefit was provided.
EARNINGS PER SHARE
Basic and diluted earnings per share are the same for the nine months
ended September 30, 2002 and 2001 because all potential common shares were
anti-dilutive for those periods.
NOTES PAYABLE
In October 2002, the Company amended its $4,500,000 Business Loan
Agreement with Bank One, NA ("Bank One") dated June 1, 2001, as amended. Amounts
outstanding under the facility were reduced by $2,000,000 with the proceeds from
the sale of common stock (See Stockholders' Equity) and the facility was
amended. Under the loan agreement, the Company may borrow up to $2,700,000 on a
revolving basis. The amount available for borrowing is reduced by $450,000 per
quarter beginning December 31, 2002. All amounts outstanding under the facility
are due on March 26, 2004. The amended facility is secured by a non-revocable
letter of credit provided by a private investor.
The Company believes it has reached an agreement in principle regarding
its $1,500,000 Loan Agreement with Bank One dated October 12, 2001, as amended.
Under the agreement the facility will be amended to provide for a maturity of
September 15, 2003, secured by the unconditional guarantee of the private
investor that provides the security for the Company's amended $2,700,000 credit
facility with Bank One. The Company also has outstanding $600,000 in notes
payable in favor of this same private investor and believes it has reached an
agreement in principle, subject to definitive documentation, to replace these
notes with a note payable with a maturity of September 15, 2003. The Company
expects to issue the private investor certain warrants as compensation for the
credit support provided (See Stockholders' Equity).
COMMITMENTS AND CONTINGENCIES
The Company is contingently liable for certain potential liabilities
related to discontinued operations. Specifically, under a stock purchase
agreement dated October 3, 1995, the Company
7
TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
September 30, 2002 (continued)
agreed to indemnify Savage Sports Corporation ("Savage Sports"), the purchaser
of Savage Arms, Inc. (a manufacturer of firearms), for certain product
liability, environmental clean-up costs and other contractual obligations,
including certain successor liability claims. One of the liabilities assumed
involves a firearms product liability lawsuit filed in Alaska Superior Court
(the "Taylor Litigation"). A defendant in the Taylor Litigation, Western Auto
Supply Co. ("Western Auto") settled the suit for $5,000,000. Western Auto
assigned its indemnification claims against Savage Arms, Inc. to its insurance
carriers who in turn asserted claims against Savage Arms, Inc. for the amount of
the settlement plus attorney's fees, interest and related costs. In August 2002
Savage Arms, Inc. entered into a Confidential Settlement Agreement and Release
with the insurance carriers related to these claims.
In October 2002 the Company and Savage Sports reached agreement in
principle regarding the Company's indemnification regarding this and any other
related matters. Pursuant to this agreement the Company will pay to Savage
Sports a total of $1,575,000 over a four year period, with $375,000 payable
through October 31, 2003. Under the settlement arrangement, Savage Sports will
fund the cost of insurance programs that are expected to respond to any other
such claims that may arise. The Company is aware of no such claims and Savage
Sports has advised the Company that they are aware of no additional claims. As a
result of the agreement in principle with Savage Sports the Company has recorded
a charge of $1,520,000 related to this matter in the three months ended
September 30, 2002.
The Company has entered into an agreement for the design and
manufacture of a "ruggedized" version of its PowerPC products. Ruggedized
products are designed to be utilized in harsh environments such as extreme
temperature, shock and vibration. Under this agreement, a third party will
provide certain design services, testing equipment and will produce initial
production quantities of the product. The Company expects that payments by the
Company under this agreement will approximate $700,000 over the next six to nine
months. The majority of this amount relates to production quantities of the
product that the Company expects to sell to its customers as the product is
available from the manufacturer. The Company has provided a $185,000 standby
letter of credit to collateralize its obligations under this agreement.
STOCKHOLDERS' EQUITY
In April 2002, the Company issued 2,000,000 shares of common stock in
exchange for the return and cancellation of warrants to purchase a total of
26,017,308 shares of common stock. The warrants had an exercise price of $0.75
per share. Since the common stock was issued in exchange for other equity
securities, the transaction was recorded by crediting common stock for the par
value of the shares issued with offsetting debit to additional paid-in capital.
In October 2002, the Company issued 16,666,668 shares of common stock
to two private investors for an aggregate of $2,000,000 in cash. These two
private investors had previously provided letters of credit that secured a
portion of the Company's $4,500,000 Business Loan Agreement with Bank One. The
proceeds from the sale of this common stock were used to repay amounts
outstanding under this loan agreement. In addition, the Company issued to these
investors warrants for the purchase of 400,000 shares of common stock at $0.12
per share, exercisable until September 30, 2005. Other warrants, previously
issued to these investors, for the purchase of 780,000 shares of common stock
were amended to provide for an exercise price of $0.12 per share.
8
TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
September 30, 2002 (concluded)
In September 2002, the Company issued 833,334 shares of common stock to
a private investor for $100,000 in cash. Subsequent to September 30, 2002, the
Company has issued a total of 5,416,666 shares of common stock for $650,000 in
cash in a series of transactions with private investors. Proceeds from the sale
of this common stock have been used for working capital.
In connection with the completed and expected restructuring of its debt
obligations and in consideration for the debt support provided by the private
investor (See Notes Payable), the Company expects to issue warrants for the
purchase of 960,000 shares of common stock at a price of $0.12 per share to the
private investor. These warrants are exercisable until October 31, 2004. In
addition, the Company expects to amend warrants for the purchase of 1,830,000
shares of common stock, previously issued to this investor, to provide for an
exercise price of $0.12 per share.
9
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
FORWARD LOOKING STATEMENT
This Quarterly Report on Form 10-Q contains certain forward looking
statements within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended. In
this report, as well as in oral statements made by the Company or Management,
statements that are prefaced with the words "may," "will," "expect,"
"anticipate," "believe," "continue," "estimate," "project," "intend," "designed"
and similar expressions are intended to identify forward-looking statements
regarding events, conditions and financial trends that may affect the Company's
future plans, business strategy, results of operations, financing activities and
financial position. These statements are based on the Company's current
expectations and estimates as to prospective events and circumstances about
which the Company can give no firm assurance. Further, any forward-looking
statement speaks only as of the date the statement was made, and the Company
undertakes no obligation to update any forward-looking statement to reflect
events or circumstances after the date the statement was made. Because it is not
possible to predict every new factor that may emerge, forward-looking statements
should not be relied upon as a prediction of actual future financial condition
or results. Examples of types of forward-looking statements include statements
on future levels of net revenue, costs and cash flow, new product development,
strategic plans and financing. These forward -looking statements involve risks
and uncertainties that could cause actual results to differ materially from
those projected or anticipated. Factors that might cause such a difference
include, but are not limited to: general economic conditions in the markets the
Company operates in; success in the development and market acceptance of new and
existing products; dependence on suppliers, third party manufacturers and
channels of distribution; customer and product concentration; fluctuations in
customer demand; governmental regulations and controls; the ability to obtain
and maintain access to external sources of capital; the ability to control
costs; overall management of the Company's expansion; and other risk factors
detailed from time to time in the Company's filings with the Securities and
Exchange Commission. The terms "we," "our" and "us" and similar terms refer to
the Company and its consolidated subsidiaries, not to any individual or group of
individuals.
RESULTS OF OPERATIONS
Our engineering design services business was sold in January 2002. As
of December 31, 2001 this business is accounted for as a discontinued operation
in our financial statements. Accordingly, net revenues, cost of revenues and
expenses in the accompanying financial statements do not include any amounts
related to these operations. The net operating results of this business are
reflected as a loss from discontinued operations in the accompanying statements
of operations.
10
- --------------------------------------------------------------------------------
COMPARISON OF THIRD QUARTER AND NINE MONTHS 2002 TO 2001
- --------------------------------------------------------------------------------
The following table shows the net revenue and gross profit for the
Company's products:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -----------------
2002 2001 2002 2001
---- ----- ------ ------
($ THOUSANDS)
Net revenues:
Defense electronics $718 $ 814 $4,007 $3,243
Optical networking equipment - 86 - 2,368
Other - 25 - 260
---- ----- ------ ------
$718 $ 925 $4,007 $5,871
==== ===== ====== ======
Gross profit (loss):
Defense electronics $ 93 $(547) $1,663 $ (36)
Optical networking equipment - - - -
Other - (38) - (730)
---- ----- ------ ------
$ 93 $(585) $1,663 $ (766)
==== ===== ====== ======
NET REVENUES
Net revenues from defense electronics decreased 12% in the third
quarter of 2002 and increased 24% for the first nine months of 2002, as compared
to the same periods last year. The year-to-date increase reflects an increasing
demand for our products, including our PowerPC based products that we began
shipping to customers in the fourth quarter of 2000. The first nine months of
2002 also reflects continued sales of our products that are based on Texas
Instruments' digital signal processors that we have been shipping to customers
since 1997. While net revenues have generally trended to increase over the past
several periods, the Company did experience a decline in net revenues in the
third quarter of 2002 as compared to the second quarter of 2002 and the third
quarter of 2001. We believe this is attributable to delays in certain programs
moving into full production phases and to delays in funding for many defense and
intelligence gathering programs. We expect our net revenues generally to
increase as our products are selected for additional programs and as production
demands increase related to programs for which our products have previously been
selected. However, due to the uncertainty as to the award of new programs and
the timing of specific orders, we cannot be sure that net revenues will increase
sequentially in each quarter. Net revenues could decrease from quarter to
quarter.
Net revenues from optical networking products during 2001 represent
sales related to our OmniLynx product line. In August 2001, we sold the OmniLynx
product line to Intelect Technologies, Inc.
GROSS PROFIT
Gross profit from defense electronics increased in the third quarter of
2002 as compared to the third quarter of 2001, despite the lower net revenues.
For the first nine months of 2002, gross profit from defense electronics also
increased as compared to the same period in 2001. The increase in gross profit
is a result of higher utilization of fixed production costs and the sale of
products with lower material costs than in prior periods. Gross profit in the
three and nine months ended September 30,
11
2002 was reduced by approximately $87,000 and $117,000, respectively, due to the
revaluation of component inventories to the lower of cost or net realizable
value.
As of December 31, 2000, all assets related to the OmniLynx product
line were adjusted to the lower of cost and net realizable value. Accordingly,
sales of OmniLynx products during 2001 produced no gross profit.
ENGINEERING AND DEVELOPMENT (E&D) EXPENSE
Engineering and development expense decreased 57% to $546,000 in the
third quarter of 2002 from $1,276,000 in the same period in 2001. For the first
nine months of 2002, these expenses decreased 38% from the comparable period in
2001. Costs by product line are as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -----------------
2002 2001 2002 2001
------- ------ ------ ------
($ THOUSANDS)
Defense electronics $ 650 $ 658 $2,220 $1,662
Optical networking equipment (107) 385 88 1,078
Other 3 233 178 1,293
----- ------ ------ ------
E & D expense $ 546 $1,276 $2,486 $4,033
===== ====== ====== ======
Engineering and development expenses related to defense electronics in
the third quarter of 2002 and first nine months of 2002 reflect on-going
enhancements of our PowerPC based products, including "ruggedized" versions of
these products, our WingSpan(TM) software environment and other product
initiatives. The reduced expenses related to optical networking products reflect
the recoupment of certain third party costs related to our Aegean project. As of
July 31, 2002 we suspended essentially all activity related to this project.
Other engineering and development expenses were primarily incurred in the first
quarter of 2002 related to our Centauri project. We suspended essentially all
activity related to the Centauri project in March 2002. Engineering and
development expenses during the third quarter and first nine months of 2002
include approximately $119,000 and $679,000, respectively, of non-cash costs
related to design services provided by Flextronics International, Ltd.
("Flextronics"). These services are provided under the engineering design
services agreements we entered into when we sold our engineering design services
business in January 2002. Other engineering and development expenses in the
first nine months of 2001 include approximately $657,000 related to the
engineering organization involved with the OmniLynx product line.
SELLING AND ADMINISTRATIVE EXPENSE
Selling and administrative expenses decreased $356,000, or 17%, in the
third quarter of 2002 as compared to the third quarter of 2001. For the nine
months ended September 30, 2002, selling and administrative expenses decreased
$2,756,000, or 37%, from the same period last year. Approximately $2,490,000 of
this decrease for the first nine months of 2002 relates to costs associated with
the OmniLynx product line. The balance of the reduction relates primarily to
reduced headcount.
LITIGATION SETTLEMENT
In March 2002, we settled our litigation against Cadence Design
Systems, Inc. We received $6,300,000, net of attorney fees, from this
settlement.
12
SHARE OF LOSS OF UNCONSOLIDATED AFFILIATE
These amounts represent our proportionate share of the losses of
Intelect Technologies, Inc. ("ITI") for the third quarter and first nine months
of 2002. ITI was formed in August 2001, and acquired our OmniLynx product line
and related assets at that time. We own 33% of the common stock of ITI.
INTEREST EXPENSE
Due to increased borrowings in 2002, interest expense increased by
$56,000 and $227,000 in the third quarter and first nine months of 2002,
respectively, as compared to the comparable periods last year.
LOSS FROM DISCONTINUED OPERATIONS
In the third quarter of 2002 we recorded a charge of $1,520,000
resulting from the settlement of our indemnity obligations to Savage Sports
Corporation. (See Part II - Other Information - Item 1- Legal Proceedings) Our
operations that were the subject of this matter have previously been accounted
for as discontinued operations.
- --------------------------------------------------------------------------------
LIQUIDITY AND CAPITAL RESOURCES
- --------------------------------------------------------------------------------
As of September 30, 2002 the Company had cash and temporary investments
of $667,000 and a working capital deficit of $547,000. Subsequent to September
30, 2002 we reduced and restructured our funded debt as follows:
o Our $4,500,000 credit facility with Bank One was reduced by
$2,000,000 with the proceeds from the sale of common stock.
o The $4,500,000 credit facility with Bank One was amended to
provide for total borrowings of $2,700,000, a final maturity of
March 26, 2004 and provide for quarterly reductions of $450,000
in the amount available for borrowing, beginning December 31,
2002. This facility is secured by an irrevocable letter of credit
provided by a private investor.
o We expect to amend our $1,500,000 credit facility with Bank One
to provide for a maturity of September 15, 2003. This facility is
secured by the unconditional guarantee of the private investor
mentioned above.
o We expect to amend notes payable totaling $600,000 in favor of
the above private investor to provide for a maturity of September
15, 2003.
o The amendments to the credit facilities will not provide us
significant new borrowing capacity.
The amendments of the $1,500,000 Bank One facility and the $600,000 in
notes payable are subject to the completion of definitive documentation. In
September and October, 2002 we have issued a total of 6,250,000 shares of common
stock in a series of private placements. Net proceeds to us from these
transactions total $750,000. We also are engaged in other discussions regarding
the possible sale of additional shares of common stock. We expect that any
proceeds from these transactions will be used for working capital, to meet the
scheduled reductions in our debt obligations or to reduce the debt obligations
prior to their maturity.
13
OPERATING ACTIVITIES
Net cash used in operating activities amounted to $6,116,000 for the
nine months ended September 30, 2002. Significant items contributing to the
$6,116,000 include the operating loss of $5,437,000 and a net increase in
working capital of $643,000, offset by utilization of prepaid services from
Flextronics amounting to $679,000. The net increase in working capital arose
primarily from a decrease in accounts payable and accrued liabilities of
$1,241,000, offset by the utilization of $569,000 in inventory.
INVESTING ACTIVITIES
For the nine months ended September 30, 2002, investing activities
provided $6,874,000 in cash flow. This amount consists primarily of $6,300,000
from the settlement of litigation and $1,337,000 from the disposal of
discontinued operations, which amount is net of $462,000 of costs related to the
operations. The above amounts were offset by $154,000 of capital expenditures,
primarily for test equipment, and $609,000 used to acquire temporary cash
investments. The temporary cash investments are used to collateralize letters of
credit supporting insurance programs and vendor obligations.
FINANCING ACTIVITIES
In the first quarter of 2002, we borrowed $500,000 for general working
capital under a demand note. We repaid a total of $1,354,000 in demand notes
from the proceeds of the litigation settlement and the disposal of discontinued
operations.
LIQUIDITY OUTLOOK
As discussed above we have recently reduced our debt obligations and
have restructured, or expect to restructure, the remaining obligations to extend
their maturity. We also have completed a series of private placements of common
stock and expect to complete additional private placements. We expect the
proceeds from these transactions, and potentially other similar transactions,
will be sufficient to provide the working capital we expect to need until such
time as we produce cash flow from operations. We also expect the proceeds from
these transactions and cash flow generated by our operations in the future to
meet the scheduled reduction in our debt obligations. We cannot be sure that the
pending debt restructuring transactions will be completed as expected or as to
the amounts of the proceeds from the future sales of common stock, if any, or
the price per share at which we will sell the stock. The issuance of common
stock could result in significant dilution to existing common shareholders.
We may also consider the sale of additional debt or equity securities
to financial or strategic investors. Possible use of proceeds from such
transactions might include general working capital, expanded or accelerated
product development and marketing and reduction of our debt obligations.
If we are unable to meet the scheduled reductions and maturities of our
debt obligations, we may be forced to further restructure these obligations.
Such restructuring could involve the issuance of additional equity securities
which could result in further dilution to existing shareholders. If we do not
meet the scheduled reductions or maturities of our debt obligations, we will
default on those obligations and the party that has guaranteed them will be
obligated to repay those borrowings. In that case, we will have demand
obligations to that party equal to the debt repaid. In that event, the
14
party will have collateral rights in most of our accounts receivable and
inventory. In addition, that party will be our largest creditor and could demand
payment at any time. Accordingly, this party could be in a position to obtain a
judgment against the Company and exert influence over our actions.
Our consolidated financial statements have been prepared on the basis
of a going concern and do not include any adjustments that might be necessary if
we were not a going concern. These adjustments include changes in the possible
future recoverability and classification of assets or the amount and
classification of liabilities.
Our estimates of capital and liquidity needs are subject to a number of
risks and uncertainties that could result in additional capital needs that have
not been anticipated. An important aspect of our estimated capital and liquidity
requirements is our ability to generate positive cash flow from operations. We
believe the primary factor in generating positive cash flow from operations is
increased net revenue from our defense electronics business. We have increased
revenues from these operations over the past year; however, there is no
assurance that we will be able to continue to do so. Other factors contributing
to our ability to generate positive operating cash flow include generating
adequate gross profit on net revenues and controlling other costs and expenses.
Our capital needs could increase materially if any of our contingent liabilities
are resolved adversely to us. In addition, we could require more working capital
if our defense electronics business increases more rapidly than we currently
anticipate.
As discussed above, in the accompanying financial statements and in our
Annual Report on Form 10-K for 2001, we are obligated under various contracts
and commercial commitments. The following table summarizes these obligations:
PERIOD IN WHICH PAYMENTS DUE (IN THOUSANDS)
-------------------------------------------
12 MONTHS ENDED SEPTEMBER 30:
-------------------------------------------
NATURE OF OBLIGATION 2003 2004 2005 2006
- ------------------------- ------ ------ ---- ----
Notes payable $3,800 $2,900 $ - $ -
Operating leases 491 354 156 -
Purchase commitments 700 - - -
Settlement payments 590 475 575 150
------ ------ ---- ----
Total $5,581 $3,729 $731 $150
====== ====== ==== ====
CONTINGENT LIABILITIES
As discussed in "ITEM 3 - Legal Proceedings" in the Company's Annual
Report on Form 10-K for 2001 and in the accompanying financial statements, the
Company is exposed to certain contingent liabilities which, if resolved
adversely to the Company, would adversely affect its liquidity, its results of
operations, and/or its financial position.
ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We have outstanding debt that bears interest at a variable interest
rate amounting to $4,000,000 as of September 30, 2002. This interest is based on
a widely used reference interest rate known as LIBOR. For example, an increase
of 50 basis points in LIBOR would result in an increase in our annual interest
expense of $20,000.
As of September 30, 2002, we have cash and temporary investments of
$660,000. The majority of this amount is invested in money market funds that pay
interest at rates that fluctuate with market
15
conditions. For example, a decrease of 50 basis points in the interest rate
which these investments pay would result in a decrease in our annual interest
income of approximately $3,000.
ITEM 4 - CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
The term "disclosure controls and procedures" is defined in Rule
13a-14(c) of the Securities Exchange Act of 1934, or the Exchange Act. This term
refers to the controls and procedures of a company that are designed to ensure
that information required to be disclosed by a company in the reports that it
files under the Exchange Act is recorded, processed, summarized and reported
within required time periods. Our Chief Executive Officer and our Chief
Financial Officer have evaluated the effectiveness of our disclosure controls
and procedures as of a date within 90 days before the filing of this quarterly
report, and they have concluded that as of that date, our disclosure controls
and procedures were effective at ensuring that required information will be
disclosed on a timely basis in our reports filed under the Exchange Act.
CHANGES IN INTERNAL CONTROLS
We maintain a system of internal controls that are designed to provide
reasonable assurance that our books and records accurately reflect our
transactions and that our established policies and procedures are followed.
There were no significant changes to our internal controls or in other factors
that could significantly affect our internal controls subsequent to the date of
their evaluation by our Chief Executive Officer and our Chief Financial Officer,
including any corrective actions with regard to significant deficiencies and
material weaknesses.
PART II - OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS
SAVAGE SPORTS SETTLEMENT
The Company is contingently liable for certain potential liabilities
related to discontinued operations. Specifically, under a stock purchase
agreement dated October 3, 1995, the Company agreed to indemnify Savage Sports
Corporation ("Savage Sports"), the purchaser of Savage Arms, Inc. (a
manufacturer of firearms), for certain product liability, environmental clean-up
costs and other contractual obligations, including certain successor liability
claims. One of the liabilities assumed involves a firearms product liability
lawsuit filed in Alaska Superior Court (the "Taylor Litigation"). A defendant in
the Taylor Litigation, Western Auto Supply Co. ("Western Auto") settled the suit
for $5,000,000. Western Auto assigned its indemnification claims against Savage
Arms, Inc. to its insurance carriers who in turn asserted claims against Savage
Arms, Inc. for the amount of the settlement plus attorney's fees, interest and
related costs. In August 2002 Savage Arms, Inc. entered into a Confidential
Settlement Agreement and Release with the insurance carriers related to these
claims.
In October 2002 the Company and Savage Sports reached agreement in
principle regarding the Company's indemnification regarding this and any other
related matters. Pursuant to this agreement the Company will pay to Savage
Sports a total of $1,575,000 over a four year period, with $375,000 payable
through October 31, 2003. Under the settlement arrangement, Savage Sports has
agreed to
16
fund the cost of insurance programs that are expected to respond to any other
such claims that may arise in the future. The Company is aware of no such
claims, and Savage Sports has advised the Company that they are aware of no
additional claims. As a result of the agreement in principle with Savage Sports,
the Company has recorded a charge of $1,520,000 related to this matter in the
third quarter of 2002.
SCI ACTION
In July 2002, the Company's wholly-owned subsidiary, DNA Enterprises,
Inc. ("DNA") filed suit against SCI Technology, Inc. and SCI Systems, Inc.
(collectively "SCI") for breach of contract and fraudulent inducement. The suit
alleges that SCI has failed to pay DNA royalties related to a Licensing
Agreement involving the joint development of certain circuit card assembly
("CCA") boards. The suit is currently pending in United States District Court
for the Northern District of Texas. In August 2002, SCI filed a counter claim
against DNA alleging breach of contract, fraudulent inducement and negligent
misrepresentation. The Company believes that the counter claims by SCI are
without basis and intends to vigorously pursue this matter. Discovery has
commenced and a trial date has been preliminarily set for June 16, 2003.
SHAREHOLDER CLASS ACTION
A shareholder class action lawsuit was filed in the U. S. District
Court for the Northern District of Texas in November 1999 on behalf of all
persons and entities who purchased the Company's common stock during the period
between February 24, 1998 and November 17, 1998. The named defendants include
the Company and certain former and present officers and directors of the
Company. The complaint alleges that the defendants violated Sections 10(b) and
20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated
thereunder by making false and misleading statements concerning the Company's
reported financial results during the period, primarily relating to revenue
recognition, asset impairment and capitalization issues. The plaintiffs seek
monetary damages, interest, costs and expenses. In March 2001, our motion to
dismiss the case was denied. Since that date discovery has been proceeding and
is essentially completed. The plaintiffs' motion for class certification and our
opposition to that motion are currently pending before the court. The court has
set a preliminary trial date of April 7, 2003. We believe the case is without
merit and intend to defend the case vigorously in all respects.
United Pacific Insurance Company, an affiliate of Reliance Insurance
Company ("Reliance"), the insurance carrier which provides the primary $2
million of insurance coverage for this matter, has been ordered liquidated by
the insurance commissioner of the State of Pennsylvania. At this time we are
unable to determine what amounts, if any, may be available under this insurance
coverage. We expect that it will be a matter of two years or more before it can
be determined if any amounts can be recovered from Reliance. We have insurance
coverage for up to $8 million in claims in excess of the initial $2 million.
Through September 30, 2002 we have incurred approximately $1.2 million in costs
related to this matter, of which we have been reimbursed $300,000 by the Texas
Property and Casualty Insurance Guarantee Association.
ITEM 2 - CHANGES IN SECURITIES AND USE OF PROCEEDS
See Current Report on Form 8-K dated October 3, 2002, as amended.
17
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
A. Listed below are all Exhibits filed as part of this report.
None
B. The Company has not filed any report on Form 8-K during the period
covered by this Report, except as follows:
Current report on Form 8-K dated August 12, 2002 reporting the
filing of a certification of certain officers pursuant to "Item 9 -
Regulation FD Disclosure" and the filing of an exhibit pursuant to
"Item 7 - Financial Statements and Exhibits"
Current report on Form 8-K dated October 3, 2002, as amended
on Form 8-K/A filed November 12, 2002
18
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
TERAFORCE TECHNOLOGY CORPORATION
(Registrant)
Date: November 14, 2002 By: /s/ ROBERT P. CAPPS
-------------------- --------------------------------
Robert P. Capps
Chief Financial Officer
(Principal Financial and Accounting Officer)
Date: November 14, 2002 By: /s/ HERMAN M. FRIETSCH
-------------------- --------------------------------
Herman M. Frietsch
Chairman of the Board and Chief Executive Officer
(Principal Executive Officer)
19
CERTIFICATIONS
I, Herman M. Frietsch certify that:
1. I have reviewed this quarterly report on Form 10-Q of TeraForce Technology
Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ HERMAN M. FRIETSCH
-------------------------
Herman M. Frietsch
Chief Executive Officer
20
I, Robert P. Capps certify that:
1. I have reviewed this quarterly report on Form 10-Q of TeraForce Technology
Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ ROBERT P. CAPPS
-------------------------
Robert P. Capps
Chief Financial Officer
21