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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, 2003
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 [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
There were 118,556,587 shares of Common Stock outstanding as of October 31,
2003.
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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES
INDEX
PAGE
----
PART I FINANCIAL INFORMATION
ITEM 1 FINANCIAL STATEMENTS
Consolidated Balance Sheets of the Company
at September 30, 2003 (unaudited) and December 31, 2002 2
Consolidated Statements of Operations of the Company
(unaudited) for the three months and nine months ended September 30, 2003 and 2002 3
Consolidated Statements of Cash Flows of the Company
(unaudited) for the nine months ended September 30, 2003 and 2002 4
Notes to Consolidated Financial Statements 5
ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 11
ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK 15
ITEM 4 CONTROLS AND PROCEDURES 15
PART II OTHER INFORMATION
ITEM 1 LEGAL PROCEEDINGS 16
ITEM 6 EXHIBITS AND REPORTS ON FORM 8-K 16
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,
2003 2002
------------- ------------
(unaudited)
Assets
Current assets:
Cash and cash equivalents $ 31 $ 55
Temporary cash investments -- 457
Accounts receivable net of allowance of $30 in 2003
and $0 in 2002 1,042 573
Receivable from affiliate -- 699
Inventories 1,790 2,354
Prepaid services -- 193
Prepaid expenses and other current assets 632 587
--------- ---------
Total current assets 3,495 4,918
Property and equipment, net 421 573
Investment in and receivable from affiliate 250 702
Other assets 2,102 531
--------- ---------
$ 6,268 $ 6,724
========= =========
Liabilities and Stockholders' Deficit
Current liabilities:
Notes payable $ 5,075 $ 4,047
Accounts payable 1,863 1,919
Accrued liabilities 1,603 1,392
--------- ---------
Total current liabilities 8,541 7,358
Long-term notes payable 3,960 900
Other long-term liabilities 725 1,100
Stockholders' deficit:
Common Stock, $.01 par value; authorized 200,000,000
shares; 118,556,587 and 114,255,518 shares issued
in 2003 and 2002, respectively 1,185 1,143
Additional paid-in capital 187,324 184,953
Accumulated deficit (193,880) (187,143)
--------- ---------
(5,371) (1,047)
Less 400,474 shares of common stock in treasury at cost (1,587) (1,587)
--------- ---------
Total stockholders' deficit (6,958) (2,634)
--------- ---------
$ 6,268 $ 6,724
========= =========
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,
------------------------- -------------------------
2003 2002 2003 2002
--------- --------- --------- ---------
(unaudited)
Net revenues $ 1,699 $ 718 $ 4,037 $ 4,007
Cost of revenue 1,108 625 2,765 2,344
--------- --------- --------- ---------
Gross profit 591 93 1,272 1,663
--------- --------- --------- ---------
Expenses:
Engineering and development 582 546 2,063 2,486
Selling and administrative 1,171 1,537 3,522 4,499
Write-off of receivable from unconsolidated
affiliate 449 -- 449 --
--------- --------- --------- ---------
2,202 2,083 6,034 6,985
--------- --------- --------- ---------
Operating loss (1,611) (1,990) (4,762) (5,322)
--------- --------- --------- ---------
Other income (expense):
Litigation settlement -- -- -- 6,300
Litigation costs, net of
insurance reimbursement (292) (206) (417) (115)
Share of loss and adjustment to carrying
value of unconsolidated affiliate (333) (295) (702) (401)
Interest expense (407) (130) (775) (388)
Interest income and other (16) 67 (81) 89
--------- --------- --------- ---------
(1,048) (564) (1,975) 5,485
--------- --------- --------- ---------
Income (loss) from continuing operations (2,659) (2,554) (6,737) 163
Loss from discontinued operations -- (1,520) -- (1,520)
--------- --------- --------- ---------
Net loss $ (2,659) $ (4,074) $ (6,737) $ (1,357)
========= ========= ========= =========
Basic and diluted loss per share:
Continuing operations $ (.02) $ (.03) $ (.06) $ --
Discontinued operations -- (.02) -- (.02)
--------- --------- --------- ---------
Net loss per share $ (.02) $ (.05) $ (.06) $ (.02)
========= ========= ========= =========
Weighted average number of common shares
outstanding (thousands) basic and diluted 118,138 88,725 117,102 87,968
========= ========= ========= =========
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,
-------------------------------
2003 2002
-------- --------
(unaudited)
Cash flows from operating activities:
Net loss $ (6,737) $ (1,357)
Adjustments to reconcile net loss to
net cash used in operating activities:
Litigation settlement -- (6,300)
Utilization of prepaid services 193 679
Depreciation and amortization 190 177
Amounts related to unconsolidated affiliate 1,151 401
Other 48 927
Changes in operating assets and liabilities:
Accounts receivable (469) 29
Inventories 564 569
Accounts payable and accrued liabilities 155 (1,241)
-------- --------
Net cash used in operating activities (4,905) (6,116)
-------- --------
Cash flows from investing activities:
Proceeds from litigation settlement -- 6,300
Capital expenditures (22) (154)
Investment in temporary cash investments 457 (609)
Net proceeds from disposal of discontinued operations -- 1,337
Software development costs (105) --
-------- --------
Net cash used in investing activities 330 6,874
-------- --------
Cash flows from financing activities:
Proceeds from issuance of notes payable 4,260 500
Proceeds from issuance of common stock 516 100
Principal payments on notes payable (225) (1,354)
-------- --------
Net cash provided by (used in) investing activities 4,551 (754)
-------- --------
Net increase (decrease) in cash and cash equivalents (24) 4
Cash and cash equivalents, beginning of period 55 1
-------- --------
Cash and cash equivalents, end of period $ 31 $ 5
======== ========
See accompanying notes to consolidated condensed financial statements.
4
TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
September 30, 2003
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 for the year ended December 31, 2002.
The Company incurred an operating loss in the first nine months of 2003
and has incurred significant operating losses in 2002, 2001 and 2000. These
losses were funded by proceeds from the issuance of equity securities and notes
payable, and as of September 30, 2003, notes payable due within one year
amounted to $5,075,000. The Company's continued existence is dependent on the
Company's ability to continue to fund any operating losses and on the
restructuring or refinancing of its debt obligations. In the first nine months
of 2003 the Company has generated additional capital amounting to approximately
$4,776,000 from the sale of equity securities and from the proceeds of new
credit facilities.
The Company's operating losses have declined over the three year period
ended December 31, 2002, primarily as a result of the disposal of certain
operations, specifically those related to the telecommunications industry, the
reduction of other operating expenses and increases in net revenues from the
Company's defense electronics business. Net revenues from the sale of defense
electronics products have increased in each of the last three years and
management expects net revenues to increase further in 2003. Therefore,
management believes that the Company's needs for capital to fund operating
losses will continue to decline.
The Company believes that it will be able to fund any further operating
losses and to refinance or otherwise restructure its outstanding debt
obligations through either the issuance of new equity securities, the incurrence
of new debt or the modification of the terms of its existing debt obligations.
There can be no assurance that the Company can accomplish these matters, or can
do so under acceptable terms. These financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
5
TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
September 30, 2003
INVENTORIES
The components of inventories are as follows:
September 30, December 31,
2003 2002
----------- -----------
($ Thousands)
Raw materials $ 1,172 $ 1,658
Work in process 244 408
Finished goods 374 288
----------- -----------
Total $ 1,790 $ 2,354
=========== ===========
SEGMENTS OF BUSINESS
In the three and nine month periods ended September 30, 2003 and 2002,
all of the Company's net revenues were generated from its defense electronics
business.
Segment-specific margins (gross profit less total engineering and
development costs, including capitalized software for the segment):
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -----------------------
2003 2002 2003 2002
------- ------- ------- -------
($ Thousands)
Defense electronics $ 9 $ (557) $ (791) $ (557)
Optical networking equipment -- 107 -- (88)
Other -- (3) -- (178)
------- ------- ------- -------
Subtotal segment specific 9 (453) (791) (823)
All other expenses (1,620) (1,537) (3,522) (4,499)
------- ------- ------- -------
Operating loss $(1,611) $(1,990) $(4,313) $(5,322)
======= ======= ======= =======
Assets are identifiable by segments as follows:
At September 30, At December 31,
2003 2002
---------------- ---------------
($ Thousands)
Defense electronics $ 3,747 $ 3,760
Optical networking equipment and other 300 1,501
Not allocable to a segment 2,221 1,463
--------- ---------
Total $ 6,268 $ 6,724
========= =========
INCOME TAXES
For the three and nine month periods ended September 30, 2003, the
Company's effective income tax rate differed from the federal statutory rate due
to current period tax expense offset by an offsetting change in the valuation
allowance for the same amount.
6
TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
September 30, 2003
STOCK OPTION PLAN
The Company accounts for its stock option plan in accordance with the
provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting
for Stock Issued to Employees," and related interpretations. As such,
compensation expense is recorded on the date of grant only if the current market
price of the underlying stock exceeded the exercise price. SFAS No. 123,
"Accounting for Stock-Based Compensation," requires pro forma net income and pro
forma earnings per share disclosures for employee stock option grants as if the
fair-value-based method defined in SFAS No. 123 had been applied. There was no
stock based compensation expense recorded for any period.
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------- -------------------------
2003 2002 2003 2002
-------- -------- -------- --------
($ Thousands)
Net income (loss) allocable to common stockholders:
As reported $ (2,659) $ (4,074) $ (6,737) $ (1,357)
Additional compensation expense 163 354 510 747
-------- -------- -------- --------
Pro forma $ (2,822) $ (4,428) $ (7,247) $ (2,104)
Income (loss) per share:
As reported $ (.02) $ (.05) $ (.06) $ (.02)
Pro Forma $ (.02) $ (.05) $ (.06) $ (.02)
EARNINGS PER SHARE
Basic and diluted earnings or loss per share are the same for the three
and nine month periods ended September 30, 2003 and 2002 because all potential
common shares were anti-dilutive for those periods.
NOTES PAYABLE
The Company has amended its credit agreements with Bank One, NA ("Bank
One"). Amounts outstanding under the Company's $1.5 million credit agreement
with Bank One have been combined with the Company's $2.7 million credit
agreement with Bank One and the $1.5 million agreement has been terminated.
Amounts outstanding under the amended $4.2 million agreement are due June 27,
2004, with no mandatory reductions prior to that time. Interest is payable
monthly at LIBOR plus 1.75% (2.87% at September 30, 2003). This facility is
secured by a letter of credit provided by a private investor.
At September 30, 2003, principal and accrued interest outstanding
pursuant to a note payable to a private investor amounted to approximately
$700,000. In October 2003, this investor agreed to cancel the note in exchange
for 2,800,000 shares of the Company's common stock and the extension of the
maturity date of common stock warrants previously issued to the investor.
Warrants for the purchase of an aggregate of 2,790,000 shares of common stock at
a price of $0.12 per share had been issued in connection with previous financing
transactions. The expiration dates of the warrants, which ranged from December
31, 2003 to October 31, 2004, have been extended to October 31, 2005. Since
satisfaction of the outstanding principal and accrued interest will not require
the use of working capital, $700,000 has been reclassified from current
liabilities to long-term liabilities in the accompanying financial statements.
7
TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
September 30, 2003
In March 2003, the Company and its wholly-owned subsidiary, DNA
Computing Solutions, Inc. ("DNA-CS"), entered into a revolving line of credit
with a bank in order to provide working capital to DNA-CS. Under the facility,
DNA-CS may borrow up to $1,000,000. Outstanding amounts are due March 26, 2004;
however, DNA-CS may extend such date six months, provided certain conditions are
maintained. Interest is payable monthly at the greater of (i) prime plus 1% and
(ii) 5.25%. At September 30, 2003, approximately $775,000 was outstanding under
this facility.
This working capital facility is secured by the accounts receivable and
inventory of DNA-CS, the guarantee of the Company and by limited guarantees
provided by certain private investors. As consideration for providing the
guarantees that secure the facility, the Company has entered into a
Reimbursement Agreement with the guarantors. The Reimbursement Agreement
provides that the Company will reimburse the investors for any amounts that they
may be required to reimburse the bank pursuant to the guarantees. Pursuant to
the Reimbursement Agreement and related agreements, the investors have the right
to purchase up to 8,333,333 shares of the Company's common stock for $1,000,000
in cash, the proceeds of which will be used to repay amounts outstanding under
the facility and provide for the release of the guarantees. In addition, the
investors received warrants to purchase an aggregate of 9,583,333 shares of the
Company's common stock at a price of $0.15 per share. The warrants may be
exercised at any time through March 31, 2007. The Company has valued the
warrants at approximately $360,000, using the Black-Scholes pricing model. This
amount and a beneficial conversion feature in the amount of approximately
$408,000 related to the purchase rights have been recorded as deferred financing
costs.
In July and August 2003, the Company issued $3,010,000 principal amount
of 12% convertible subordinated notes in a private placement to qualified
investors and $250,000 principal amount of such notes to an officer and a
director. The purchasers of the notes also received warrants to purchase
2,037,500 shares of the common stock at $0.16 per share. Net proceeds to the
Company, after paying commissions to the placement agent and legal costs,
amounted to approximately $3,059,000 which will be used for working capital. The
Company also issued warrants for the purchase of 1,881,250 shares of common
stock to the placement agent for the notes. The Company has valued the warrants
issued in this transaction at approximately $258,000 using the Black-Scholes
pricing model. This amount and a beneficial conversion feature in the amount of
approximately $870,000 have been recorded as deferred financing costs.
The notes are subordinated unsecured obligations of the Company and are
subordinated to the rights of holders of all existing and future senior
indebtedness. The terms of the Note Agreement limit the ability of the Company
to incur additional senior indebtedness. Pursuant to the Note Agreement, the
Company shall not directly or indirectly create, incur or suffer to exist any
indebtedness senior to the Notes ("Senior Indebtedness") in an aggregate
principal amount exceeding at any time the sum of one million dollars
($1,000,000) without the prior written consent of at least 51% of the aggregate
principal amount of the Notes outstanding at the time the transaction is
authorized by the Company's board of directors. For purposes of calculating the
limitation on incurring Senior Indebtedness, the following indebtedness shall
not be included in calculating the aggregate amount of Senior Indebtedness: (a)
Bank One, NA in the amount of $4.2 million, (b) a private investor in the amount
of $650,000, (c) FirstCapital Bank, SSB in the amount of $1,000,000, and (d) any
restructuring or refinancing of the Senior Indebtedness described in (a), (b)
and (c).
The Company will pay all outstanding principal balances on the Notes at
maturity, which is June 30, 2005. Interest on the Notes will accrue at a rate of
12% per annum, computed on the basis of a 360-day year of twelve 30-day months.
Interest will be due annually on June 15 and at maturity on June 30, 2005. The
Company may redeem all or any portion of the outstanding Notes at any time
beginning December 2, 2003. Each Note to be so redeemed shall be redeemed
against payment of an amount in cash equal to: 110% of the outstanding principal
balance of the Note, plus accrued interest, if redeemed after June 15, 2003 but
on or before June 1, 2004, and 105% of the outstanding principal balance of the
Note, plus accrued interest, if redeemed after June 1, 2004.
8
TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
September 30, 2003
A Noteholder may convert any or all of the principal and accrued
interest of his Notes into shares of common stock at any time after August 4,
2003. The number of shares of common stock issuable upon conversion shall be
determined by dividing the outstanding indebtedness and accrued interest to be
converted by the conversion price in effect at the time of conversion. The
initial conversion price of the Notes is $0.16 per share. The conversion price
is subject to anti-dilution provisions and therefore may be adjusted from time
to time upon the occurrence of certain events.
The number of shares to be issued upon exercise of the Warrants to the
purchasers of the notes and the placement agent is subject to anti-dilution
provisions and therefore may be adjusted from time to time. The exercise price
of the Warrants is equal to the conversion price of the notes upon the closing
of this offering, which was $0.16 per share. The initial exercise price will be
subject to anti-dilution provisions and therefore may be adjusted from time to
time upon the occurrence of certain events. The warrants may be exercised at the
option of the holder at any time prior to their expiration. The warrants will
expire four years after their issuance.
The Company entered into a registration rights agreement with each
noteholder, and has agreed to file a registration statement with the SEC under
the Securities Act of 1933, as amended (the "Securities Act"), registering the
shares of Common Stock underlying the notes and the warrants within 90 days of
the final closing of the Offering. The Company will use its best efforts to have
the registration statement declared effective by the SEC as soon as practicable
thereafter. The Company and Noteholders each agreed with the other to indemnify
the other for certain liabilities arising under the Securities Act.
STOCKHOLDERS' EQUITY
In January and March 2003, the Company completed private placement
transactions in which it issued a total of 4,166,667 shares of common stock and
warrants for the purchase of an additional 4,333,333 shares of common stock for
aggregate proceeds of $500,000. The warrants have an exercise price of $0.15 per
share and are exercisable at any time through March 31, 2007.
9
TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
September 30, 2003
SUBSEQUENT EVENTS
In October 2003, the Company reached an agreement in principle to
dispose of its approximate 22% interest in its unconsolidated affiliate,
Intelect Technologies, Inc. ("ITI") and to settle all outstanding obligations
between the Company and ITI for a cash payment to the Company of $250,000.
Accordingly, as of September 30, 2003 the carrying value of the accounts
receivable has been written-down to $250,000 and the carrying value of the
Company's investment in ITI has been adjusted to zero.
In November 2003, the Company entered into a Technology Licensing and
Marketing Agreement with Vista Controls, Inc. ("Vista"), a subsidiary of
Curtiss-Wright Corporation. Pursuant to this agreement, and certain ancillary
agreements, the Company has licensed to Vista certain technology related to the
Company's VQG4 and Eagle I products. The Company and Vista have agreed to
jointly develop and market variations of these products, which will be designed
to meet the requirements of harsh operating environments also know as "rugged
products." Vista will produce the rugged products. For products it sells, the
Company will source the products from Vista, at prices determined by a formula
specified in the agreements. For products sold by Vista to third parties, Vista
will pay the Company residual rights fees pursuant to a formula specified in the
agreements. In addition, Vista will pay License and Transfer Fees to the Company
aggregating up to $3,500,000. These fees will be paid as certain milestones are
met, as specified in the agreements.
10
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS FOR THE PERIOD ENDED SEPTEMBER 30, 2003
Forward Looking Statements
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, 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
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; the ability of the
Company to execute its plan in strategic direction; 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; 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, and do not refer to any individual or
group of individuals.
--------------------------------------------------------------------------------
COMPARISON OF THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2003 TO
THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2002
--------------------------------------------------------------------------------
NET REVENUE
For the first nine months of 2003 and 2002 all of our net revenues were
generated by our defense electronics business. Net revenue from defense
electronics increased 137% in the third quarter of 2003 as compared to the third
quarter of 2002 and 1% in the first nine months of 2003 as compared to the same
period in 2002. The increase in the third quarter of 2003 relates to increased
sales of our VQG4 products, initial sales of our Eagle I product and the effect
of prior design wins beginning to move into the production phase. Despite these
increases, our sales in the first three quarters of 2003 were less than we had
expected. This was due in large part to delays in the receipt of production
orders from programs related to some of our previous design wins. Due to our
increased working capital needs related to the increase in orders and unexpected
delays in completing financing arrangements in the first quarter of 2003, we
experienced delays in payments to some of our vendors. These delays in payment
temporarily affected our ability to complete orders. Management believes that
the financing arrangements that have been completed have alleviated the
liquidity difficulties. Additionally, we noted a decline in customer purchasing
activity during the second quarter of 2003, which we believe was common in our
industry. We believe that this decline in activity was temporary and was in
reaction to funding issues arising from the war in Iraq. Recently, we have noted
a resumption of activity from certain customers. While this may impact the
timing of certain orders and shipments to customers, we believe that net
revenues in the fourth quarter of 2003 will increase over the third quarter of
2003. Recently we have noted an increase in the lead-time for some components
required to produce our products. While the effect of these increases has not
been significant to date, it could in the
11
future impact our ability to complete customer orders or the timing of future
shipments and net revenues in any particular period.
GROSS PROFIT
In the third quarter of 2003, gross profit increased to $591,000 as
compared to $93,000 in the third quarter of 2002 due to increased net revenues
and the sale of products with higher gross margins. For the first nine months of
2003, gross profit declined to $1,272,000 versus $1,663,000 in the same period
of 2002, despite slightly higher net revenues in the 2003 period. This decline
was due to differences in the mix of products sold in each of the periods.
ENGINEERING AND DEVELOPMENT EXPENSE
Costs by product line are as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------ ------------------------
2003 2002 2003 2002
-------- -------- -------- --------
($ Thousands)
Defense electronics $ 582 $ 650 $ 2,063 $ 2,220
Optical networking products -- (107) -- 88
Other -- 3 -- 178
-------- -------- -------- --------
$ 582 $ 546 $ 2,063 $ 2,486
======== ======== ======== ========
Engineering and development expenses related to defense electronics in
the third quarter and first nine months of 2003 reflect on-going enhancements of
the VQG4 product line and our new Eagle product that was introduced at the end
of the first quarter of 2003. All development activities, other than those
related to our defense electronics products, were terminated in 2002. Included
in engineering and development expenses during the third quarter and first nine
months of 2003 is approximately $26,000 and $193,000, respectively, related to
design services provided by Flextronics International, Ltd. During the third
quarter and first nine months of 2002 such amounts were $119,000 and $679,000,
respectively. These non-cash services were provided under the engineering design
services agreements we entered into when we sold our engineering design services
business in January 2002. As of September 30, 2003 all obligations under this
agreement had been completed.
SELLING AND ADMINISTRATIVE EXPENSE
Selling and administrative expenses decreased approximately 24% in the
third quarter of 2003 as compared to the third quarter of 2002 and 22% in the
first nine months of 2003 as compared to that same period in 2002. These
declines result from reduced administrative expenses, including personnel costs
and professional fees.
12
LITIGATION SETTLEMENT
In March 2002, we settled our outstanding litigation against Cadence
Design Systems, Inc. We received $6,300,000, net of attorney fees, from this
settlement.
LITIGATION COSTS
Litigation costs represent legal fees and expenses related to the
shareholder action. These amounts are net of approximately $300,000 of insurance
reimbursement we received in the second quarter of 2002. In the third quarter of
2003, we recorded a charge of approximately $260,000, which represents our
estimate of additional costs and expenses required to settle this matter. See
Part II - Other Information - Item 1 - Legal Proceedings.
INTEREST EXPENSE
Interest expense for the third quarter and first nine months of 2003
includes approximately $277,000 and $510,000, respectively, from the
amortization of the value of warrants issued in connection with various debt
transactions and beneficial conversion features related to convertible debt
obligations. The warrants were valued when they were issued using the
Black-Scholes option pricing model.
OTHER
In the third quarter of 2003 we recorded a charge of approximately
$449,000 to adjust the carrying value of our receivable from Intelect
Technologies, Inc. ("ITI") to $250,000 and a charge of approximately $333,000 to
write-off the balance of our investment in ITI. In October 2003, we reached an
agreement in principle to dispose of our approximate 22% interest in ITI and to
settle all outstanding obligations between the Company and ITI for a cash
payment to the Company of $250,000.
--------------------------------------------------------------------------------
LIQUIDITY AND CAPITAL RESOURCES
--------------------------------------------------------------------------------
As of September 30, 2003, our working capital deficit was $5,046,000,
which included $5,075,000 of notes payable due within one year. As of September
30, 2003, our Notes Payable total $9,035,000. Of this amount, $4,200,000 is due
on June 27, 2004, $775,000 is due September 26, 2004 and $3,260,000 is due June
30, 2005. Approximately $700,000 in notes payable was exchanged for common stock
subsequent to September 30, 2003.
OPERATING ACTIVITIES
Net cash used in operations for the nine months ended September 30,
2003 amounted to $4,905,000. This amount arose primarily from the net loss of
$6,737,000, offset by non-cash charges of $193,000 from the utilization of
prepaid services, and approximately $1,151,000 related to our share of the loss
from our unconsolidated affiliate and adjustments to the carrying value of the
investment.
INVESTING ACTIVITIES
For the nine months ended September 30, 2003, investing activities
provided cash in the amount of $457,000, primarily from the liquidation of
temporary cash investments.
13
FINANCING ACTIVITIES
In July and August 2003, we issued $3,260,000 principal amount of
convertible subordinated notes. We received net proceeds of approximately
$3,059,000, after paying sales commissions and legal costs related to the
offering. The notes are due June 30, 2005 and bear interest at 12%, payable
annually. The holders of the notes may convert outstanding principal and accrued
interest on the notes into our common stock at the rate of $0.16 per share. We
may redeem the notes at any time beginning in November 2003. To redeem the notes
before June 1, 2004, we must pay the holders 110% of the outstanding principal
amount and all accrued interest. If we redeem the notes after June 1, 2004, we
must pay 105% of the outstanding principal amount and all accrued interest. We
also issued warrants to purchase an aggregate of 1,881,250 shares of our common
stock to the purchasers of the notes. The warrants have a four-year term and an
exercise price of $0.16 per share.
Also in July 2003 we restructured some of our outstanding debt. We
amended our $1.5 million and $2.7 million credit agreements with Bank One to
combine them into a single $4.2 million credit agreement. The maturity of the
amended agreement was extended to June 27, 2004, with no mandatory reductions
prior to that date. The amended credit agreement is secured by a letter of
credit provided by a private investor. At September 30, 2003 principal and
accrued interest outstanding pursuant to a note payable to a private investor
amounted to approximately $700,000. In October 2003, this investor agreed to
cancel the note in exchange for 2,800,000 shares of the Company's common stock
and the extension of the maturity date of common stock warrants previously
issued to the investor. Warrants are for the purchase of an aggregate of
2,790,000 shares of common stock at a price of $0.12 per share and had been
issued to the investor in connection with previous financing transactions. The
expiration dates of the warrants, which ranged from December 31, 2003 to October
31, 2004, have been extended to October 31, 2005. Since satisfaction of the
outstanding principal and accrued interest will not require the use of working
capital, $700,000 has been reclassified from current liabilities to long-term
liabilities in the accompanying financial statements.
LIQUIDITY OUTLOOK
We have satisfied our needs for capital during 2003 with proceeds from
sales of equity and convertible debt securities and from the proceeds of credit
arrangements. We have restructured our debt obligations such that there are no
principal payments required before June 2004. We expect our need for capital to
decline as a result of improved operating results in the fourth quarter of 2003
and in 2004. This belief is based on our backlog of orders and on other orders
that we expect to receive in the future.
In November 2003, we entered into a technology licensing agreement with
Vista Controls, Inc. ("Vista"), a subsidiary of Curtiss-Wright Corporation.
Under this arrangement we have granted Vista a license in technology related to
our VQG4 and Eagle I products. We have agreed with Vista to jointly develop and
market variations of these products, which will be designed to meet the
requirements of harsh operating environments, or "rugged products." For these
products sold through our sales channels, we will source the products from Vista
at prices determined by a formula specified in the agreements. For products sold
through Vista's sales channels, Vista will pay us a residual rights fee, also
determined by a formula specified in the agreements. In addition, Vista will pay
us license fees of up to $3,500,000 as certain milestones related to delivery of
technology to Vista are met. We expect to complete these milestones over
approximately the next nine months.
We believe the arrangement with Vista could have a material effect on
our business and results of operations. We believe the addition of the modified
products and the access to Vista's market channels will significantly expand our
addressable market. In addition, we believe that the combination of the
abilities and products of Vista with ours will enhance our ability to meet the
requirements of our customers and to attract new customers. However, there can
be no assurance that such benefits will be realized.
While we believe we will have adequate liquidity to operate our
business, our estimate of capital needs is subject to a number of risks and
uncertainties that could result in additional capital needs that we
14
have not anticipated. An important aspect of our estimated capital requirements
is our ability to begin to generate positive cash flow from operations. Our
ability to generate cash flow from operations is dependent upon our ability to
increase revenues from our defense electronics business, to generate adequate
gross profit from those sales and to control other costs and expenses. Our
capital needs could increase materially if any of our contingent liabilities are
resolved adversely to the Company. In addition, we could require additional
working capital if the defense electronics business increases more rapidly than
we currently anticipate.
Potential sources of additional capital include the sale of additional
debt or equity securities and other debt, such as bank debt. A sale of
additional securities could result in dilution to existing common stockholders.
There is no assurance that additional capital will be available under terms that
are acceptable to us.
CONTINGENT LIABILITIES
As discussed in "ITEM 3 - Legal Proceedings" in the Company's Annual
Report on Form 10-K, 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 at September 30, 2003 amounting to
approximately $5,200,000 that bears interest at a variable interest rate and
subjects us to interest rate risk. This interest is based on widely used
reference interest rates known as prime and LIBOR. For example, an increase of
50 basis points in these rates would result in an increase in our annual
interest expense of approximately $26,000.
ITEM 4 - CONTROLS AND PROCEDURES
The term "disclosure controls and procedures" is defined in Rules
13a-15(e) and 15(d)-(e) 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 the time periods specified by the Securities and Exchange
Commission. Our management, including our Chief Executive Officer and our Chief
Financial Officer, has evaluated the effectiveness of our disclosure controls
and procedures as of the end of the period covered by this quarterly report.
Based upon that evaluation, our Chief Executive Officer and Chief Financial
Officer have concluded that our disclosure controls and procedures were
effective as of the end of the period covered by this quarterly report.
There were no changes to our internal control over financial reporting
during our last fiscal quarter that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting.
15
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Shareholder Action. In November 1999, a shareholder class action
lawsuit was filed in U.S. District Court for the Northern District of Texas. The
suit named the Company and certain former and current officers and directors of
the Company as defendants and alleged violations of Sections 10(b) and 20(a) of
the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. In
December 2002, the Court denied the plaintiffs' motion for class certification
and the 5th Circuit Court of Appeals subsequently refused to hear an appeal of
this ruling. After additional discovery and certain rulings by the Court, the
complaint is now pending with 12 individual plaintiffs. We have been engaged in
discussions with these plaintiffs concerning the settlement of this matter. We
believe we have reached agreement in principle with six of the plaintiffs. As of
September 30, 2003, we recorded a charge of approximately $250,000 related to
this matter. This amount represents our estimate of the cost of settlement and
additional costs and expenses to be incurred in resolving this litigation.
Reliance Insurance Company ("Reliance") provides the primary $2,000,000
of insurance coverage for this matte,. Reliance has been ordered liquidated by
the insurance commissioner of the State of Pennsylvania. We have previously
received $300,000 from the Texas Property and Casualty Guaranty Association
related to this claim. We believe that we have a claim against Reliance of
approximately $1,600,000 and have filed a proof of claim for this amount with
the Statutory Liquidator for Reliance. We do expect some recovery pursuant to
this claim, however, the amount of such recovery cannot be estimated at this
time and there is no assurance as to any recovery. In addition, the timing of
any recovery is uncertain and could be a matter of years. Accordingly, any such
recovery has not been reflected in our financial statements.
Contract Dispute. In March 2002, we entered into an agreement with
LaBarge, Inc. ("LaBarge") for the development and manufacture of a "conduction
cooled" version of a model of our VQG4 product. In January 2003, we terminated
the contract because we believe LaBarge did not fully perform under the contract
and defaulted. Subsequent to January 2003, we engaged in a series of discussions
with LaBarge regarding the settlement of outstanding issues, including claims of
monies owed. We have been unable to resolve these issues and in October 2003
litigation was commenced in the Circuit Court of the County of St. Louis in the
State of Missouri. In these proceedings LaBarge has alleged that we improperly
terminated the contract and seeks recovery costs and lost profits amounting to
approximately $700,000. We have alleged that LaBarge breached the contract and
are seeking recovery of amounts previously paid to LaBarge, costs incurred
resulting from the breach and lost profits. Such items aggregate in excess of
$1,000,000. The ultimate resolution of this matter cannot be determined at this
time.
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
A. Listed below are all Exhibits filed as part of this report.
Exhibit Description of Exhibit
------- ----------------------
31.1 Certificate of the Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certificate of the Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
B. The Company has not filed any report on Form 8-K during the period
covered by this Report, except as follows:
16
On July 30, 2003, we filed a Current Report on Form 8-K dated July 3,
2003, disclosing information under Item 5 and filing exhibits under Item 7.
On August 8, 2003, we filed a Current Report on Form 8-K/A, amending
the Current Report on Form 8-K dated July 3, 2003, disclosing information under
Item 5 and filing exhibits under Item 7.
On August 19, 2003, we filed a Current Report on Form 8-K dated August
14, 2003, furnishing information under Item 12.
17
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, 2003 /s/ ROBERT P. CAPPS
--------------------- -----------------------------------------
Robert P. Capps
Chief Financial Officer
(Principal Financial and Accounting
Officer)
Date: November 14, 2003 /s/ HERMAN M. FRIETSCH
--------------------- -----------------------------------------
Herman M. Frietsch
Chief Executive Officer and Director
(Principal Executive Officer)
18