UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

INTERPHASE CORPORATION

Parkway Centre I
2901 North Dallas Parkway, Suite 200
Plano, Texas 75093
(Address of Principal Executive Offices)

(214)-654-5000
(Registrant’s 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 þ  No o

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

INTERPHASE CORPORATION

Index to Form 10-Q
Quarterly Period Ended March 31, 2004

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PART I
FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

INTERPHASE CORPORATION

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

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INTERPHASE CORPORATION

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

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INTERPHASE CORPORATION

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

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INTERPHASE CORPORATION

NOTE 1. — BASIS OF PRESENTATION

Interphase Corporation and subsidiaries (“Interphase” or the “Company”) enables rapid platform design and integration for the global voice, video, and data communications markets through custom and off-the-shelf communications equipment, embedded software development suites, and systems integration and consulting services for carrier and private networks. The Company’s products provide communications computing and connectivity of telecommunications and computer systems to Wide Area Networks (WANs), Local Area Networks (LANs), and Storage Area Networks (SANs) using Asynchronous Transfer Mode (ATM), Ethernet, Signaling System 7 (SS7), IP, Fibre Channel, HDLC, Frame Relay and multi-protocol interworking technologies. See Note 8 for information regarding the Company’s revenues related to North America and foreign countries.

The accompanying condensed consolidated interim financial statements include the accounts of Interphase Corporation and its wholly owned subsidiaries. Significant intercompany accounts and transactions have been eliminated in consolidation. The Company has no involvement with any variable interest entity covered by the scope of FASB Interpretation (“FIN”) No. 46R, Consolidation of Variable Interest Entities.

While the accompanying condensed consolidated interim financial statements are unaudited, they have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of the Company, all material standard adjustments and disclosures necessary to fairly present the results of such periods have been made. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. Operating results for the three months ended March 31, 2004, are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2003.

Reclassifications

Certain reclassifications have been made to the condensed consolidated financial statements for the period ended March 31, 2003, to correspond with the presentation used at March 31, 2004, and for the periods then ended.

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INTERPHASE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Stock-Based Compensation

The Company has elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and related interpretations in accounting for its employee stock options. Under APB 25, compensation expense is recorded when the exercise price of employee stock options is less than the fair value of the underlying stock on the date of grant. The Company has implemented the disclosure-only provisions of Statement of Financial Accounting Standards No. (“SFAS”) 123, “Accounting for Stock-Based Compensation,” and SFAS 148, “Accounting for Stock-Based Compensation Transition and Disclosure.” Had the Company elected to adopt the expense recognition provisions of SFAS 123, the pro forma impact on net income and earnings per share would have been as follows (in thousands, except per share data):

NOTE 2. — INVENTORIES

Inventories are valued at the lower of cost or market and include material, labor and manufacturing overhead. Cost is determined on a first-in, first-out basis (in thousands):

Valuing inventory at the lower of cost or market involves an inherent level of risk and uncertainty due to technology trends in the industry and customer demand for the Company’s products. Future events may cause significant fluctuations in the Company’s operating results.

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INTERPHASE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 3. — DEFERRED TAXES

SFAS 109, “Accounting for Income Taxes,” requires that a valuation allowance be established when it is “more likely than not” that all or a portion of a deferred tax asset will not be realized. A review of all available positive and negative evidence needs to be considered, including a company’s current and past performance, the market environment in which the company operates, the utilization of past tax credits, length of carry back and carry forward periods, existing contracts or sales backlog that will result in future profits, as well as other factors.

Forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years. Cumulative losses weigh heavily in the overall assessment. As a result of a review undertaken at December 31, 2002, the Company concluded that it was appropriate to establish a full valuation allowance for its net deferred tax assets. The Company continues to maintain a full valuation allowance on the tax benefits. Until an appropriate level of profitability is sustained, the Company expects to continue to record a full valuation allowance on future tax benefits and does not expect to recognize any significant tax benefits in future results of operations.

During the third quarter of 2003, the Internal Revenue Service concluded a federal income tax audit of the Company related to the tax years 1996 through 2001, resulting in a refund due the Company. During the first quarter of 2004, after conducting a thorough review of the Company’s IRS transcripts, the Company discovered that the IRS had not paid allowable interest on this refund. As a result, the Company recognized a tax benefit of approximately $100,000 during the first quarter of 2004. This tax benefit is partially offset by taxes on foreign income.

NOTE 4. — CREDIT FACILITY

The Company maintains a $5 million revolving bank credit facility. The credit facility bears interest at the rate of LIBOR plus 2.0% (3.375% at March 31, 2004), matures on July 30, 2005 and all borrowings are secured by marketable securities. The borrowings of $3.5 million are classified as long-term debt on the accompanying balance sheet.

NOTE 5. — EXIT ACTIVITIES

During the second quarter of 2003, the Company committed to an exit plan regarding one of its leased facilities which expires during the first quarter of 2005. The Company had previously held this facility open for storage, overflow use, and anticipated growth. However, it has been determined that the facility will not be needed for overflow space and the Company is pursuing subleasing opportunities. As a result of this exit plan, the Company recorded a charge of approximately $109,000 during the second quarter of 2003, classified as operating expenses, related to net termination costs associated with the lease of the facility. As of March 31, 2004, the facility had not been subleased. Additional costs may continue to be incurred in future periods if the Company is not successful in subleasing the facility. A reconciliation showing the changes to the liability account during the quarter is as follows (in thousands):

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INTERPHASE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 6. — COMPREHENSIVE INCOME (LOSS)

The following table shows the Company’s comprehensive income (loss) (in thousands):

NOTE 7. — EARNINGS PER SHARE

Basic earnings per share are computed by dividing reported earnings available to common shareholders by weighted average common shares outstanding. Diluted earnings per share give effect to dilutive potential common shares. Earnings per share are calculated as follows (in thousands, except per share data):

NOTE 8. — SEGMENT INFORMATION

The Company is principally engaged in the design, development, and manufacturing of high-performance connectivity products utilizing advanced technologies being used in next generation telecommunication networks and enterprise data/storage networks. Except for revenue performance, which is monitored by product line, the chief operating decision-makers review financial information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance. Accordingly, the Company considers itself to be in a single industry segment.

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INTERPHASE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Geographic revenue related to North America and foreign countries for the three months ended March 31, 2004 and 2003 is as follows (in thousands):

Additional information regarding revenue by product-line is as follows (in thousands):

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD LOOKING STATEMENTS

This report contains forward-looking statements about the business, financial condition and prospects of the Company. These statements are made under the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. The actual results of the Company could differ materially from those indicated by the forward-looking statements because of various risks and uncertainties, including without limitation, the Company’s reliance on a limited number of customers, failure to see spending improvements in the telecommunications and computer networking industries, significant changes in product demand, the availability of products, changes in competition, various inventory risks due to changes in market conditions and other risks and uncertainties indicated in the Company’s filings and reports with the Securities and Exchange Commission. All the foregoing risks and uncertainties are beyond the ability of the Company to control, and in many cases, the Company cannot predict the risks and uncertainties that could cause its actual results to differ materially from those indicated by the forward-looking statements. When used in this report, the words “believes,” “plans,” “expects,” “intends,” and “anticipates” and similar expressions as they relate to the Company or its management are intended to identify forward-looking statements.

RESULTS OF OPERATIONS

Revenue

Total revenue increased approximately 22% to $9.2 million for the three months ended March 31, 2004, compared to $7.5 million for the same period in the prior year. The increase was primarily attributable to Broadband telecom product revenue, which increased approximately 69% to $5.8 million for the three months ended March 31, 2004, compared to $3.4 million in the comparable period. In addition, during the first quarter of 2004, the Company recognized $173,000 of revenue related to contract manufacturing while

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there was no such revenue during the first quarter of 2003. The increase in revenue was partially offset by a decrease in revenue related to SlotOptimizer product sales, which decreased approximately 14% to $2.4 million during the first quarter of 2004, compared to $2.8 million for the comparable period in the prior year. In addition, the Company’s revenues related to professional services decreased to $95,000 for the three months ended March 31, 2004, compared to $497,000 for the same period in the prior year. The professional services revenue recognized in 2003 related to a single software customization contract. The Company expects to see professional services revenue from time to time but not on a consistent basis. Revenue related to storage and legacy networking product lines continued their decline and were $362,000 for the first quarter 2004 compared to $585,000 for the same period in the prior year. The Company believes that if the telecommunication industry continues to stabilize, it will continue to experience growth in revenue.

During the first quarter of 2004, sales to two customers accounted for approximately 52% and 21% of total revenue. During the first quarter of 2003, sales to three customers accounted for approximately 35%, 29% and 13% of total revenue. No other customer accounted for more than 10% of the Company’s consolidated revenue for the periods then ended.

Gross Margin

For the three months ended March 31, 2004, gross margin, as a percentage of sales, was 53% compared to 50% for the same period in the prior year. The increase in the gross margin percentage primarily relates to the continued shift in product mix towards more complex, and thus, higher margin products. In addition, the Company improved manufacturing efficiencies and achieved reductions in material costs for certain product lines due to increased production volumes and lower overall overhead costs. The Company believes that its gross margin, as a percentage of sales, will be near 50% for the near future.

Research and Development

The Company’s investment in the development of new products through research and development was $2.1 million for the three months ended March 31, 2004 and $2.0 million for the same period in the prior year. The increase in research and development expenses is primarily due to foreign currency changes as the dollar dropped significantly in value relative to the Euro (see Item 3 – Foreign Currency Risk). As a percentage of total revenue, research and development expense was approximately 23% in the first quarter of 2004 as compared to approximately 26% for the same period for the prior year. The decrease in research and development costs as a percentage of total revenue is due to increased revenue. The Company anticipates that spending on research and development will remain steady in the near future as the Company continues to invest in development of our current and future products, however, the Company will continue to monitor the level of its investments concurrently with actual revenue results.

Sales and Marketing

Sales and marketing expenses were $1.6 million and $1.8 million for the three months ended March 31, 2004 and 2003, respectively. Approximately 75% of the decrease in sales and marketing expense quarter over quarter is due to reduced headcount and travel related costs with the remaining portion of the decrease primarily related to a reduction in expenditures on marketing activities. As a percentage of total revenue, sales and marketing expense was approximately 17% for the first quarter of 2004 down from approximately 24% for the comparable period. The decrease in sales and marketing expense as a percentage of total revenue is due to revenue increasing while sales and marketing expenses decreased.

General and Administrative

General and administrative expenses were $1.0 million and $888,000 for the three months ended March 31, 2004 and 2003, respectively. The increase in general and administrative expense period over period is primarily related to an increase in salaries and related expenses. As a percentage of total revenue, general and administrative expenses decreased to approximately 11% for the first quarter of 2004 compared to approximately 12% for the same period in the prior year. The decrease as a percentage of total revenue is due to revenue increasing at a higher rate than general and administrative expenses.

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Interest Income, Net

Interest income, net of interest expense, decreased to $28,000 for the three months ended March 31, 2004 from $70,000 in the comparable period. The decrease in interest income, net period over period is primarily due to lower investment rates of return.

Other Income, Net

Other income, net of other expense, decreased to $3,000 for the three months ended March 31, 2004 from $17,000 in the comparable period.

Income Taxes

The Company’s effective tax benefit rate was 26% for the three months ended March 31, 2004 compared to a tax provision rate of 7% for the same period in the prior year.

During the third quarter of 2003, the Internal Revenue Service concluded a federal income tax audit of the Company related to the tax years 1996 through 2001, resulting in a refund due the Company. During the first quarter of 2004, after conducting a thorough review of the Company’s IRS transcripts, the Company discovered that the IRS had not paid allowable interest on this refund. As a result, the Company recognized a tax benefit of approximately $100,000 during the first quarter of 2004. This tax benefit is partially offset by taxes on foreign income.

The effective tax provision rate for the comparable period differed from the U.S. statutory rate as the Company continued to provide a full valuation allowance for its net deferred tax assets at March 31, 2003. The Company also incurred taxes on foreign income during the period.

Net Income (Loss)

The Company reported net income of $275,000 for the three months ended March 31, 2004, as compared to a net loss of $(826,000) for the same period in the prior year. Basic and diluted earnings per share for the three months ended March 31, 2004 were $0.05 and $0.04, respectively, compared to $(0.15) and $(0.15), respectively for the comparable period.

LIQUIDITY AND CAPITAL RESOURCES

Consolidated Cash Flows

Cash and cash equivalents increased $2.1 million in the three months ended March 31, 2004 and decreased $1.7 million in the three months ended March 31, 2003. Cash flows are impacted by operating, investing and financing activities.

Operating Activities

Trends in cash flows from operating activities for the three months ended March 31, 2004 and 2003 are generally similar to the trends in the Company’s earnings except for provision for excess and obsolete inventory, depreciation and amortization. Cash provided by operating activities totaled $1.9 million for the three months ended March 31, 2004, compared to a net income of $275,000. Cash used by operating activities was $1.3 million for the three months ended March 31, 2003, compared to a net loss of $826,000. Provision for excess and obsolete inventory has decreased period over period as the Company’s inventory turns continue to improve. Depreciation and amortization decreased slightly for the three months ended March 31, 2004 compared to the three months ended March 31, 2003.

Changes in assets and liabilities result primarily from the timing of production, sales, purchases and payments. Such changes in assets and liabilities generally tend to even out over time and result in trends in cash flows from operating activities generally reflecting earnings trends.

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Investing Activities

Cash provided by investing activities totaled $73,000 for the three months ended March 31, 2004 compared to a net cash use of $462,000 for the three months ended March 31, 2003. Cash flows from investing activities in each of the periods related principally to additions to property, equipment, capitalized software and leasehold improvements and the Company’s investments in marketable securities. Additions to property, equipment, capitalized software and leasehold improvements in each of the periods focused on the sales and engineering functions of the Company.

Financing Activities

Net cash provided by financing activities totaled $111,000 for the three months ended March 31, 2004 and related to proceeds from the exercise of stock options. There were no exercises of stock options for the three months ended March 31, 2003.

Commitments and Contingencies

At March 31, 2004, the Company had no material commitments to purchase capital assets. The Company’s significant long-term obligations for the period then ended are its operating leases on facilities and future debt payments related to the Company’s credit facility. To date, the Company has not paid any dividends and does not anticipate paying any for the remainder of 2004.

Other

Management believes that cash generated from operations and borrowing availability under the revolving credit facility, together with cash on hand, will be sufficient to meet the Company’s liquidity needs for working capital, capital expenditures and debt service. To the extent that the Company’s actual operating results or other developments differ from the Company’s expectations, Interphase’s liquidity could be adversely affected.

The Company periodically evaluates its liquidity requirements, alternative uses of capital, capital needs and available resources in view of, among other things, its capital expenditure requirements, and estimated future operating cash flows. As a result of this process, the Company has in the past and may in the future seek to raise additional capital, refinance or restructure indebtedness, issue additional securities, repurchase shares of its common stock or take a combination of such steps to manage its liquidity and capital resources. In the normal course of business, the Company may review opportunities for acquisitions, joint ventures or other business combinations in the component products industry. In the event of any such transaction, the Company may consider using available cash, issuing additional equity securities or increasing the indebtedness of the Company or its subsidiaries.

Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-Q should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and other material included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Foreign Currency Risk

The Company is exposed to adverse movements in foreign currency exchange rates because it conducts business on a global basis and in some cases in foreign currencies. The Company’s operations in France are measured in the local currency and converted into U.S. Dollars based on published exchange rates for the periods reported and are therefore subject to risk of exchange rate fluctuations. The Euro to U.S. Dollar translation accounted for charges of approximately $290,000 and $87,000 for the three months ended March 31, 2004 and 2003, respectively.

Market Price Risk

The Company had no equity hedge contracts outstanding as of March 31, 2004 or December 31, 2003.

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Interest Rate Risk

The Company’s investments are subject to interest rate risk. Interest rate risk is the risk that the Company’s financial condition and results of operations could be adversely affected due to movements in interest rates. The Company invests its cash in a variety of interest-earning financial instruments, including bank time deposits, money market funds, and variable rate and fixed rate obligations of corporations and national governmental entities and agencies. Due to the demand nature of the Company’s money market funds and the short-term nature of the Company’s time deposits and debt securities portfolio, these assets are particularly sensitive to changes in interest rates. The Company manages this risk through investments with shorter-term maturities and varying maturity dates. If the Company’s short-term assets were reinvested in a declining interest rate environment, the Company would experience an immediate negative impact on interest income. The opposite holds true in a rising interest rate environment.

Item 4. CONTROLS AND PROCEDURES

(a)		Evaluation of Disclosure Controls and Procedures. The Company’s management, under the supervision of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), performed an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on that evaluation, the CEO and CFO concluded that the Company’s disclosure controls and procedures are effective.
(b)		Changes in Internal Controls. The Company maintains a system of internal controls that are designed to provide reasonable assurance that its books and records accurately reflect, in all material respects, the transactions of the Company and that its established policies and procedures are adhered to. There were no significant changes to the Company’s internal controls or in other factors that could significantly affect the Company’s internal controls subsequent to the date of the evaluation by the Company’s CEO and CFO, including any corrective actions with regard to significant deficiencies and material weaknesses.

PART II
OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

None.

Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

None.

Item 3. DEFAULTS UPON SENIOR SECURITIES

None.

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

None.

Item 5. OTHER INFORMATION

None.

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Item 6. EXHIBITS AND REPORT ON FORM 8-K

Exhibits

Report on Form 8-K

None.

SIGNATURE

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.

		INTERPHASE CORPORATION (Registrant)
	By:	/s/ Steven P. Kovac
		Steven P. Kovac
		Chief Financial Officer, Vice President of Finance and Treasurer (Principal Financial and Accounting Officer)

Plano, Texas
May 13, 2003

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INDEX TO EXHIBITS

(1)		Filed as an exhibit to Report on Form 8-K on August 6, 1996, and incorporated herein by reference.
(2)		Filed as an exhibit to Registration Statement No. 2-86523 on Form S-1 and incorporated herein by reference.
(3)		Filed as an exhibit to Report on Form 10-K for the year ended December 31, 1999, and incorporated herein by reference.
(4)		Filed as an exhibit to Report on Form 10-K for the year ended December 31, 2001, and incorporated herein by reference.
(5)		Filed as an exhibit to Form 8-K on January 9, 2001, and incorporated herein by reference.
(6)		Filed as an exhibit to Report on Form 10-Q for the quarter ended June 30, 2003, and incorporated herein by reference.
(7)		Filed herein.