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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
 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, 2004
    
    Commission File Number 0-13071
 INTERPHASE CORPORATION (Exact Name of Registrant as Specified in Its Charter)
 Texas
    
    75-1549797(State of Incorporation)
    
    (IRS Employer Identification No.)
 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. Class
    
    Outstanding at November 5, 2004Common Stock, $.10 par value
    
    5,747,324




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INTERPHASE CORPORATION Index to Form 10-Q
Quarterly Period Ended September 30, 2004 Part I  Financial InformationItem 1.
    
    Condensed Consolidated Financial Statements (unaudited)Condensed Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for the three months and nine months ended September 30, 2004 and 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2.
    
    Management's Discussion and Analysis of Financial Condition and Results of Operations
    
    
    11Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    15Item 4.
    
    Controls and Procedures
    
    
    16Part II  Other InformationItem 1.
    
    Legal Proceedings
    
    
    16Item 2.
    
    Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    16Item 3.
    
    Defaults Upon Senior Securities
    
    
    16Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    16Item 5.
    
    Other Information
    
    
    16Item 6.
    
    Exhibits and Report on Form 8-K
    
    
    17Rule 13a-14(a)/15d-14(a) CertificationRule 13a-14(a)/15d-14(a) CertificationSection 1350 CertificationSection 1350 Certification
 2




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##### Table of Contents



PART I
FINANCIAL INFORMATION 
 Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 
 INTERPHASE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
(unaudited) September 30,
    
    December 31,2004
    
    2003ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    6,159
    
    
    $
    14,204Marketable securities
    
    
    15,553
    
    
    
    5,047Trade accounts receivable, less allowances for uncollectible
accounts and returns of $159 and $194, respectively
    
    
    4,088
    
    
    
    5,634Inventories
    
    
    3,594
    
    
    
    2,961Prepaid expenses and other current assets
    
    
    945
    
    
    
    751Income taxes receivable
    
    
    102
    
    
    
    Total current assets
    
    
    30,441
    
    
    
    28,597Machinery and equipment
    
    
    5,979
    
    
    
    5,626Leasehold improvements
    
    
    371
    
    
    
    392Furniture and fixtures
    
    
    555
    
    
    
    5606,905
    
    
    
    6,578Less-accumulated depreciation and amortization
    
    
    (5,473
    )
    
    
    (5,018
    )Total property and equipment, net
    
    
    1,432
    
    
    
    1,560Capitalized software, net
    
    
    335
    
    
    
    355Other assets
    
    
    184
    
    
    
    231Total assets
    
    $
    32,392
    
    
    $
    30,743LIABILITIES AND SHAREHOLDERS EQUITYCurrent Liabilities:Accounts payable
    
    $
    495
    
    
    $
    1,106Deferred revenue
    
    
    339
    
    
    
    373Accrued liabilities
    
    
    1,467
    
    
    
    1,684Accrued compensation
    
    
    1,563
    
    
    
    1,179Total current liabilities
    
    
    3,864
    
    
    
    4,342Deferred lease obligations
    
    
    55
    
    
    
    88Long-term debt
    
    
    3,500
    
    
    
    3,500Total liabilities
    
    
    7,419
    
    
    
    7,930Shareholders Equity:Common stock, $0.10 par value; 100,000,000 shares
authorized; 5,746,324 and 5,680,179 shares issued and
outstanding, respectively
    
    
    575
    
    
    
    568Additional paid in capital
    
    
    38,612
    
    
    
    38,218Accumulated deficit
    
    
    (13,694
    )
    
    
    (15,564
    )Cumulative other comprehensive loss
    
    
    (520
    )
    
    
    (409
    )Total shareholders equity
    
    
    24,973
    
    
    
    22,813Total liabilities and shareholders equity
    
    $
    32,392
    
    
    $
    30,743
 The accompanying notes are an integral part of these condensed consolidated financial statements. 3




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INTERPHASE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited) Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenue
    
    $
    8,294
    
    
    $
    8,571
    
    
    $
    27,621
    
    
    $
    23,441Cost of sales
    
    
    3,628
    
    
    
    4,092
    
    
    
    12,439
    
    
    
    11,475Gross margin
    
    
    4,666
    
    
    
    4,479
    
    
    
    15,182
    
    
    
    11,966Research and development
    
    
    1,938
    
    
    
    1,797
    
    
    
    5,944
    
    
    
    5,710Sales and marketing
    
    
    1,497
    
    
    
    1,782
    
    
    
    4,684
    
    
    
    5,143General and administrative
    
    
    767
    
    
    
    807
    
    
    
    2,835
    
    
    
    2,530Total operating expenses
    
    
    4,202
    
    
    
    4,386
    
    
    
    13,463
    
    
    
    13,383Income (loss) from operations
    
    
    464
    
    
    
    93
    
    
    
    1,719
    
    
    
    (1,417
    )Interest income, net
    
    
    69
    
    
    
    42
    
    
    
    158
    
    
    
    169Other (expense) income, net
    
    
    (8
    )
    
    
    11
    
    
    
    
    
    
    
    47Income (loss) before income tax
    
    
    525
    
    
    
    146
    
    
    
    1,877
    
    
    
    (1,201
    )Income tax provision (benefit)
    
    
    25
    
    
    
    (220
    )
    
    
    7
    
    
    
    (220
    )Net income (loss)
    
    $
    500
    
    
    $
    366
    
    
    $
    1,870
    
    
    $
    (981
    )Earnings (loss) per share  basic
    
    $
    0.09
    
    
    $
    0.07
    
    
    $
    0.33
    
    
    $
    (0.18
    )Earnings (loss) per share  diluted
    
    $
    0.08
    
    
    $
    0.06
    
    
    $
    0.29
    
    
    $
    (0.18
    )Weighted average common shares
    
    
    5,732
    
    
    
    5,527
    
    
    
    5,709
    
    
    
    5,519Weighted average common and
dilutive shares
    
    
    6,298
    
    
    
    5,920
    
    
    
    6,375
    
    
    
    5,519
 The accompanying notes are an integral part of these condensed consolidated financial statements. 4




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INTERPHASE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited) Nine Months EndedSeptember 30,2004
    
    2003Cash flows from operating activities:Net income (loss)
    
    $
    1,870
    
    
    $
    (981
    )Adjustments to reconcile net income (loss) to net cash provided by
(used in) operating activities:Provision for uncollectible accounts and returns
    
    
    14
    
    
    
    Provision for excess and obsolete inventories
    
    
    200
    
    
    
    600Depreciation and amortization
    
    
    591
    
    
    
    682Change in assets and liabilities:Trade accounts receivable
    
    
    1,532
    
    
    
    (1,169
    )Inventories
    
    
    (833
    )
    
    
    (398
    )Prepaid expenses and other current assets
    
    
    (196
    )
    
    
    121Income taxes receivable
    
    
    (102
    )
    
    
    (306
    )Other assets
    
    
    45
    
    
    
    (4
    )Accounts payable, deferred revenues and accrued liabilities
    
    
    (859
    )
    
    
    119Accrued compensation
    
    
    397
    
    
    
    20Deferred lease obligations
    
    
    (33
    )
    
    
    14Net cash provided by (used in) operating activities
    
    
    2,626
    
    
    
    (1,302
    )Cash flows from investing activities:Purchase of property and equipment
    
    
    (358
    )
    
    
    (316
    )Purchase of capitalized software
    
    
    (85
    )
    
    
    (323
    )Proceeds from sale of marketable securities
    
    
    1,750
    
    
    
    1,668Purchase of marketable securities
    
    
    (12,389
    )
    
    
    (1,755
    )Net cash used in investing activities
    
    
    (11,082
    )
    
    
    (726
    )Cash flows from financing activities:Decrease in restricted cash
    
    
    
    
    
    
    3,500Repayment of long-term debt
    
    
    
    
    
    
    (3,500
    )Borrowings under new revolving credit facility
    
    
    
    
    
    
    3,500Proceeds from the exercise of stock options
    
    
    401
    
    
    
    70Net cash provided by financing activities
    
    
    401
    
    
    
    3,570Effect of exchange rate changes on cash and cash equivalents
    
    
    10
    
    
    
    24Net (decrease) increase in cash and cash equivalents
    
    
    (8,045
    )
    
    
    1,566Cash and cash equivalents at beginning of period
    
    
    14,204
    
    
    
    9,857Cash and cash equivalents at end of period
    
    $
    6,159
    
    
    $
    11,423
 The accompanying notes are an integral part of these condensed consolidated financial statements. 5




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INTERPHASE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) 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 networking technologies. See Note 9 for information regarding
the Companys revenues related to North America and foreign countries. The accompanying condensed consolidated financial statements include the
accounts of Interphase Corporation and its wholly owned subsidiaries.
Significant intercompany accounts and transactions have been eliminated in
consolidation. While the accompanying condensed consolidated 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 and nine months ended September 30, 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 Companys
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 periods ended September 30, 2003, to correspond
with the presentation used at September 30, 2004, and for the periods then
ended. 6




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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): Three months ended
September 30,
    
    Nine months ended
September 30,2004
    
    2003
    
    2004
    
    2003Net income (loss) as reported
    
    $
    500
    
    
    $
    366
    
    
    $
    1,870
    
    
    $
    (981
    )Add: APB 25 expense, net of related tax effects
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Less: Total stock-based employee compensation
expense determined under fair value methods for
all awards, net of related tax effects
    
    
    (449
    )
    
    
    (517
    )
    
    
    (1,428
    )
    
    
    (1,630
    )Pro forma net income (loss)
    
    $
    51
    
    
    $
    (151
    )
    
    $
    442
    
    
    $
    (2,611
    )Earnings (loss) per common share:As reported
 basic
    
    $
    0.09
    
    
    $
    0.07
    
    
    $
    0.33
    
    
    $
    (0.18
    )Pro forma
 basic
    
    $
    0.01
    
    
    $
    (0.03
    )
    
    $
    0.08
    
    
    $
    (0.50
    )As reported
 diluted
    
    $
    0.08
    
    
    $
    0.06
    
    
    $
    0.29
    
    
    $
    (0.18
    )Pro forma
 diluted
    
    $
    0.01
    
    
    $
    (0.03
    )
    
    $
    0.07
    
    
    $
    (0.50
    )
 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): September 30,
2004
    
    December 31,
2003Raw materials
    
    $
    1,908
    
    
    $
    1,907Work-in-process
    
    
    1,031
    
    
    
    745Finished goods
    
    
    655
    
    
    
    309Total
    
    $
    3,594
    
    
    $
    2,961
 Valuing inventories 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. 7




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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 and alternative minimum tax on domestic income. NOTE 4.    LOSS CONTINGENCY The Company has agreed to perform a minor repair, at no cost to a customer, of
approximately 1,800 units that were shipped between December 2003 and April
2004. The actual cost to repair the units is insignificant. However, the
Company has estimated that other costs including shipping related charges and
installation related charges could be more significant. The Company has
estimated that the range of the potential liability is between approximately
$225,000 and $650,000 but cannot determine an amount within that range which is
more likely than another. Therefore, in accordance with Financial Accounting
Standards Board Interpretation No. 14 Reasonable Estimation of the Amount of a
Loss  an Interpretation of FASB Statement No. 5, the Company has recorded, in
accrued liabilities, the minimum liability amount of approximately $225,000 at
September 30, 2004. NOTE 5.    CREDIT FACILITY The Company maintains a $5 million revolving bank credit facility. During the
quarter ended September 30, 2004, the credit facility provided for interest at
the rate of LIBOR plus 2.0% (3.375% at September 30, 2004). Effective November
5, 2004, the Company extended the maturity date of the credit facility to July
31, 2007 and obtained a reduction in the interest rate to LIBOR plus 1.0%. All
borrowings under this facility are secured by marketable securities. The
borrowings of $3.5 million are classified as long-term debt on the accompanying
balance sheet. 8




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INTERPHASE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) NOTE 6.    EXIT ACTIVITIES During the second quarter of 2003, the Company committed to an exit plan
regarding one of its leased facilities, the lease for which was scheduled to
expire during the first quarter of 2005. The Company had previously held this
facility open for storage, overflow use, and anticipated growth. However, it
was determined that the facility would not be needed for such uses and the
Company began 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. In May 2004, the Company
entered into a sublease termination agreement with the landlord of the leased
facility resulting in an additional charge of approximately $42,000. A
reconciliation showing the changes to the liability account during the nine
month period is as follows (in thousands): Liability at December 31, 2003
    
    $
    76Rent and settlement payments
    
    
    (178
    )Cost of not subleasing
    
    
    60Sublease termination charge
    
    
    42Liability at September 30, 2004
    
    $
    0Total costs to date
    
    $
    256
 NOTE 7.    COMPREHENSIVE INCOME (LOSS) The following table shows the Companys comprehensive income (loss) (in
thousands): Three months ended
September 30,
    
    Nine months ended
September 30,2004
    
    2003
    
    2004
    
    2003Net income (loss)
    
    $
    500
    
    
    $
    366
    
    
    $
    1,870
    
    
    $
    (981
    )Other comprehensive income (loss):Unrealized holding gain (loss) arising
during period, net of tax
    
    
    11
    
    
    
    (43
    )
    
    
    (132
    )
    
    
    (79
    )Foreign currency translation adjustment
    
    
    (11
    )
    
    
    8
    
    
    
    21
    
    
    
    (4
    )Comprehensive income (loss)
    
    $
    500
    
    
    $
    331
    
    
    $
    1,759
    
    
    $
    (1,064
    )
 9




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INTERPHASE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) NOTE 8.    EARNINGS (LOSS) PER SHARE Basic earnings (loss) per share are computed by dividing reported earnings
available to common shareholders by weighted average common shares outstanding.
Diluted earnings (loss) per share give effect to dilutive potential common
shares. Earnings per share are calculated as follows (in thousands, except per
share data): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Basic earnings per share:Net income (loss)
    
    $
    500
    
    
    $
    366
    
    
    $
    1,870
    
    
    $
    (981
    )Weighted average common shares outstanding
    
    
    5,732
    
    
    
    5,527
    
    
    
    5,709
    
    
    
    5,519Basic earnings (loss) per share
    
    $
    0.09
    
    
    $
    0.07
    
    
    $
    0.33
    
    
    $
    (0.18
    )Diluted earnings per share:Net income (loss)
    
    $
    500
    
    
    $
    366
    
    
    $
    1,870
    
    
    $
    (981
    )Weighted average common shares outstanding
    
    
    5,732
    
    
    
    5,527
    
    
    
    5,709
    
    
    
    5,519Dilutive stock options
    
    
    566
    
    
    
    393
    
    
    
    666
    
    
    
    Weighted average common shares
outstanding  assuming dilution
    
    
    6,298
    
    
    
    5,920
    
    
    
    6,375
    
    
    
    5,519Diluted earnings (loss) per share
    
    $
    0.08
    
    
    $
    0.06
    
    
    $
    0.29
    
    
    $
    (0.18
    )Outstanding stock options that were not
included in the diluted calculation because
their effect would be anti-dilutive
    
    
    920
    
    
    
    882
    
    
    
    652
    
    
    
    1,805
 NOTE 9.    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. Geographic revenue related to North America and foreign countries for the three
months and nine months ended September 30, 2004 and 2003 is as follows (in
thousands): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenue:North America
    
    $
    4,081
    
    
    $
    6,765
    
    
    $
    18,009
    
    
    $
    16,925Europe
    
    
    2,987
    
    
    
    863
    
    
    
    5,870
    
    
    
    2,786Pacific Rim
    
    
    1,226
    
    
    
    943
    
    
    
    3,742
    
    
    
    3,730Total
    
    $
    8,294
    
    
    $
    8,571
    
    
    $
    27,621
    
    
    $
    23,441
 10




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INTERPHASE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) Additional information regarding revenue by product-line is as follows (in
thousands): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Product Revenue:Broadband telecom
    
    $
    4,674
    
    
    $
    5,899
    
    
    $
    17,123
    
    
    $
    13,140SlotOptimizer
    
    
    2,652
    
    
    
    2,235
    
    
    
    7,656
    
    
    
    7,855Professional Services
    
    
    181
    
    
    
    
    
    
    
    450
    
    
    
    497LAN
    
    
    313
    
    
    
    294
    
    
    
    786
    
    
    
    1,086Storage
    
    
    130
    
    
    
    28
    
    
    
    354
    
    
    
    423WAN
    
    
    29
    
    
    
    14
    
    
    
    156
    
    
    
    111Other
    
    
    315
    
    
    
    101
    
    
    
    1,096
    
    
    
    329Total
    
    $
    8,294
    
    
    $
    8,571
    
    
    $
    27,621
    
    
    $
    23,441
 
 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 Revenues:Total revenue decreased slightly to $8.3 million for the three
months ended September 30, 2004, compared to $8.6 million for the same period
in the prior year. The decline in revenue was primarily attributable to lower
levels of broadband telecom product revenue, which decreased approximately 21%
to $4.7 million for the three months ended September 30, 2004, compared to $5.9
million in the comparable period. Broadband telecom product revenue was down
due to a more sudden than expected shift by a large customer to a board
developed by the Company to significantly reduce the cost for the customer.
Based on discussions with the customer, the Company believed that additional
volume would offset the impact of this shift, and that the cutover would be
phased in over a longer period of time. The customer implemented the board
change quicker than expected and the anticipated offsetting volumes did not
occur. Further adding to this issue, this customer moved its assembly location
during the quarter which may also have contributed to the lack of offsetting
volumes. The decrease in broadband telecom product revenue was partially
offset by an increase of approximately 19% in SlotOptimizer product revenue to
$2.7 million for the three months ended September 30, 2004 from $2.2 million
for the same period in the prior year. During the third quarter of 2004, the
Company recognized $181,000 in professional services revenue. There was no
revenue from professional services during the third quarter of 2003. The
professional services revenue recognized during the three months ended
September 30, 2004 relates to a single software customization contract. The
Company expects to receive similar revenue levels from this contract for the
remainder of 2004. All other revenues increased to $787,000 for the three
months ended September 30, 2004 from $437,000 for the three months ended
September 30, 2003. The Company believes that it will experience revenue
growth again if 11




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the telecommunications equipment market continues to improve. However,
customer forecasts continue to be unreliable and therefore, unpredictable. The Companys customer base is beginning to diversify as two customers
individually accounted for 39% and 25% of the Companys third quarter 2004
revenues. For the same period in 2003, two customers individually accounted
for 60% and 23% of the Companys revenues. Total revenue increased approximately 18% to $27.6 million for the nine months
ended September 30, 2004, compared to $23.4 million in the comparable period of
the prior year. The increase in revenue was primarily attributable to
Broadband telecom product revenue, which increased approximately 30% to $17.1
million for the nine months ended September 30, 2004, from $13.1 million for
the same period in the prior year. In addition, during the nine months ended
September 30, 2004, the Company recognized $440,000 of revenue related to
contract manufacturing while there was no such revenue during the same period
in the prior year. The Company does not expect to receive revenue from
contract manufacturing in the future. The increases to revenue were partially
offset by a slight decrease in SlotOptimizer product revenue to $7.7 million
for the nine months ended September 30, 2004 from $7.9 million for the nine
months ended September 30, 2003. All other revenues including professional
services, legacy and storage product revenues were flat at approximately $2.4
million for both the nine months ended September 30, 2004 and 2003. Gross Margin:Gross margin as a percentage of sales was 56% for the third
quarter 2004 and 52% for the same period in 2003. The increase in the gross
margin percentage primarily relates to the continued shift towards more
complex, and thus, higher margin products. In addition, the Company improved
manufacturing efficiencies and achieved reductions in material costs of certain
product lines due to increased production volumes. The Company believes that
pricing pressures in the industry may dampen gross margins in future quarters
and it may become increasingly challenging to offset these pressures with
incremental factory productivity improvements. Gross margin for the nine months ended September 30, 2004 and 2003 was 55% and
51%, respectively. The increase in the gross margin percentage primarily
relates to the continued shift towards more complex, and thus, higher margin
products. In addition, the Company improved manufacturing efficiencies and
achieved reductions in material costs of certain product lines due to increased
production volumes. Research and Development:The Companys investment in the development of new
products through research and development was $1.9 million and $1.8 million for
the three months ended September 30, 2004 and 2003, respectively. As a
percentage of revenues, research and development expenses were 23% in the third
quarter 2004 and 21% for the same period in the prior year. The increase in
research and development costs as a percentage of total revenue is due to
revenue decreasing slightly while research and development expenses increased.
The Company anticipates that spending on research and development will remain
steady in the near future, except for fluctuations in currency exchange rates
as much of the Companys development costs reside in France (see
Item 3 
Foreign Currency Risk), 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. The Companys investment in the development of new products through research
and development was $5.9 million and $5.7 million for the nine months ended
September 30, 2004 and 2003, respectively. As a percentage of revenues,
research and development expenses were 22% for the nine months ended September
30, 2004 and 24% for the nine months ended September 30, 2003. The decrease in
research and development costs as a percentage of total revenue is due to
revenue increasing at a higher rate than research and development expenses. Sales and Marketing:Sales and marketing expenses were $1.5 million in the
third quarter of 2004 compared to $1.8 million in the third quarter of 2003.
Approximately 78% of the decrease related to a reduction in sales and marketing
headcount related expenses, including sales commissions and contract labor.
The remaining portion of the decrease primarily relates to reductions in
variable marketing communication activities and general overhead spending. As
a percentage of revenues, sales and marketing expenses were 18% in the third
quarter 2004 and 21% for the same period in the prior year. The decrease in
sales and marketing expense as a percentage of total revenue is due to revenue
decreasing at a slower rate than sales and marketing expenses. 12




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Sales and marketing expenses were $4.7 million and $5.1 million for the nine
months ended September 30, 2004 and 2003, respectively. As a percentage of
revenues, sales and marketing expenses were 17% for the nine months ended
September 30, 2004 and 22% for the nine months ended September 30, 2003.
Approximately 69% of the decrease in sales and marketing expenses for the nine
months ended September 30, 2004 related to a reduction in sales and marketing
headcount related expenses, including sales commissions and contract labor.
The remaining portion of the decrease primarily relates to reductions in
variable marketing communication activities and general overhead spending. 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 flat at
$767,000 for the third quarter 2004 compared to $807,000 for the same period in
the prior year. As a percentage of revenues, general and administrative
expenses were 9% in both the third quarter 2004 and 2003. General and administrative expenses were $2.8 million and $2.5 million for the
nine months ended September 30, 2004 and 2003, respectively. As a percentage
of revenues, general and administrative expenses were 10% for the nine months
ended September 30, 2004 and 11% for the nine months ended September 30, 2003.
The increase in general and administrative expenses primarily relates to
increased employee compensation and variable expenses tied to increased
revenues. The decrease as a percentage of total revenue is due to revenue
increasing at a higher rate than general and administrative expenses. Interest Income, Net:Interest income, net of interest expense, was $69,000 in
the third quarter 2004 and $42,000 for the same period in the prior year. The
increase in interest income for the three months ended September 30, 2004 is
due to the Company converting a large portion of its cash to marketable
securities during the second quarter of 2004 thus improving the overall
investment rate of return. Interest income, net of interest expense, was
$158,000 for the nine months ended September 30, 2004 and $169,000 for the nine
months ended September 30, 2003. Other (Expense) Income, Net:Other (expense) income, net, was an expense of
$8,000 in the third quarter 2004, compared to income of $11,000 for the same
period in the prior year. Other (expense) income, net was zero for the nine
months ended September 30, 2004 and income of $47,000 for the nine months ended
September 30, 2003. The decrease in other (expense) income, net for the nine
months ended September 30, 2004 is primarily due to a decline in realized gains
on the sale of marketable securities. Income Taxes:The Companys effective tax rate was 0.4% for the nine months
ended September 30, 2004 compared to a benefit rate of 18% for the nine months
ended September 30, 2003. 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. In addition, the French Tax Administration also concluded a tax audit of
the Companys French subsidiary covering the same periods resulting in a
finding of no tax due. Due to the finalization of both tax audits, the Company
recognized a tax benefit of approximately $245,000 during the third quarter of
2003. This benefit was partially offset by taxes on foreign income. 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 the refund from the IRS audit described above. As a
result, the Company recognized a tax benefit of approximately $100,000 during
the first quarter of 2004. This tax benefit is offset by taxes on foreign
income and domestic alternative minimum tax. The effective tax rates for the periods presented differ from the U.S.
statutory rate as the Company continues to provide a full valuation allowance
for its net deferred tax assets at September 30, 2004 and September 30, 2003. Net Income (Loss):The Company reported net income of $500,000 in the third
quarter 2004 compared to $366,000 for the same period in the prior year. The
Company reported net income of $1.9 million for the nine months ended September
30, 2004 and a net loss of $981,000 for the nine months ended September 30,
2003. 13




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LIQUIDITY AND CAPITAL RESOURCES Consolidated Cash Flows Cash and cash equivalents decreased $8 million in the nine months ended
September 30, 2004 primarily due to the purchase of approximately $12.4 million
of marketable securities partially offset by cash provided by operating
activities. Cash and cash equivalents increased $1.6 million in the nine
months ended September 30, 2003. Cash flows are impacted by operating,
investing and financing activities. Operating Activities Trends in cash flows from operating activities for the nine months ended
September 30, 2004 and 2003 are generally similar to the trends in the
Companys earnings except for provision for uncollectible accounts and returns,
provision for excess and obsolete inventory, depreciation and amortization.
Cash provided by operating activities totaled $2.6 million for the nine months
ended September 30, 2004, compared to a net income of $1.9 million. Cash used
by operating activities was $1.3 million for the nine months ended September
30, 2003, compared to a net loss of $981,000. Provision for uncollectible
accounts and returns increased slightly for the nine month period ended
September 30, 2004 compared to the same period in 2003. 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 nine months ended September 30, 2004 compared to the nine
months ended September 30, 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. Investing Activities Cash used in investing activities totaled $11.1 million for the nine months
ended September 30, 2004 compared to $726,000 for the nine months ended
September 30, 2003. Cash used in investing activities in each of the periods
related principally to additions to property and equipment, capitalized
software and the Companys investments in marketable securities. Additions to
property and equipment and capitalized software decreased to $443,000 for the
nine months ended September 30, 2004 compared to $639,000 for the nine months
ended September 30, 2003. The additions in each of the periods were focused on
software and equipment purchases for the sales, engineering and information
technology functions of the Company. Purchases of marketable securities
significantly increased to $12.4 million for the nine months ended September
30, 2004 compared to $1.8 million for the same period in the prior year.
Proceeds from the sale of marketable securities increased slightly and was $1.8
million for the nine month period ended September 30, 2004 compared to $1.7
million for the same period in 2003. Financing Activities Net cash provided by financing activities totaled $401,000 for the nine months
ended September 30, 2004 and related to proceeds from the exercise of stock
options. Net cash provided by financing activities totaled $3.6 million for
the nine months ended September 30, 2003 and related primarily to the removal
of restrictions on cash associated with the old credit facility. Commitments and Contingencies At September 30, 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 and
marketable securities 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 14




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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 $230,000 and $129,000 for the three months ended September 30,
2004 and 2003, respectively. The Euro to U.S. Dollar translation accounted for
a charge of approximately $737,000 and $366,000 for the nine months ended
September 30, 2004 and 2003, respectively. Market Price Risk The Company had no equity hedge contracts outstanding as of September 30, 2004
or December 31, 2003. 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. 15




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##### Table of Contents



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, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES 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. 16




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##### Table of Contents



Item 6. EXHIBITS AND REPORT ON FORM 8-K Exhibits 2 (a)
    
    Stock Purchase Agreement, dated June 29, 1996, between Interphase
Corporation, Synaptel and Philippe Oros, Xavier Sutter, Francois Lecerf,
Schroder Ventures French Enterprise Fund LPI (USA), Schroder ventures
French Enterprise Fund UKLP (UK) and Schroder Ventures Holding Limited
(UK). (1)3 (a)
    
    Articles of Incorporation of the Registrant. (2)3 (b)
    
    Amendment to Articles of Incorporation of the Registrant. (3)3 (c)
    
    Amended and Restated Bylaws of the Registrant adopted on December 5,
1995 and amended on January 19, 1999. (4)4 (a)
    
    Rights Agreement dated December 7, 2000 by and between the Company
and Computershare Investor Services, LLC as Rights Agent. (5)10 (a)
    
    Master Revolving Note and Credit Agreement dated July 25, 2003 (6)31 (a)
    
    Rule 13a-14(a)/15d-14(a) Certification (7)31 (b)
    
    Rule 13a-14(a)/15d-14(a) Certification (7)32 (a)
    
    Section 1350 Certification (7)32 (b)
    
    Section 1350 Certification (7)
   (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. 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. KovacSteven P. KovacChief Financial Officer,
Vice President of Finance
and Treasurer
(Principal Financial and Accounting Officer) Plano, Texas
November 12, 2004 17




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##### Table of Contents



INDEX TO EXHIBITS 2 (a)
    
    Stock Purchase Agreement, dated June 29, 1996, between Interphase
Corporation, Synaptel and Philippe Oros, Xavier Sutter, Francois Lecerf,
Schroder Ventures French Enterprise Fund LPI (USA), Schroder ventures
French Enterprise Fund UKLP (UK) and Schroder Ventures Holding Limited
(UK). (1)3 (a)
    
    Articles of Incorporation of the Registrant. (2)3 (b)
    
    Amendment to Articles of Incorporation of the Registrant. (3)3 (c)
    
    Amended and Restated Bylaws of the Registrant adopted on December 5,
1995 and amended on January 19, 1999. (4)4 (a)
    
    Rights Agreement dated December 7, 2000 by and between the Company
and Computershare Investor Services, LLC as Rights Agent. (5)10 (a)
    
    Master Revolving Note and Credit Agreement dated July 25, 2003 (6)31 (a)
    
    Rule 13a-14(a)/15d-14(a) Certification (7)31 (b)
    
    Rule 13a-14(a)/15d-14(a) Certification (7)32 (a)
    
    Section 1350 Certification (7)32 (b)
    
    Section 1350 Certification (7)
   (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.