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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION    FORM 10-K
   For the Fiscal Year Ended December 31, 2003
    
    Commission File Number 0-13071
 INTERPHASE CORPORATION (Exact name of registrant as specified in its charter)
 Texas(State or other jurisdiction of
incorporation or organization)
    
    75-1549797(I.R.S. Employer
Identification No.)
 2901 North Dallas Parkway, Suite 200
Plano, Texas 75093
(Address of principal executive offices and zip code)
Registrants telephone number, including area code: (214) 654-5000
Securities registered pursuant to Section 12(b) of the Act:None
Securities registered pursuant to Section 12(g) of the Act:Title of Class   Indicate by check mark whether the registrant (1) has filed all reports
required 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 if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrants knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes
o No þ
 The aggregate market value of the voting stock held by non-affiliates of the
registrant as of June 30, 2003 was approximately $40,561,077. As of March 15, 2004, registrant had 5,696,099 shares of Common Stock
outstanding. DOCUMENTS INCORPORATED BY REFERENCE




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TABLE OF CONTENTS  PART IITEM 1. BUSINESSITEM 2. PROPERTIESITEM 3. LEGAL PROCEEDINGSITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSPART IIITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED SHAREHOLDER MATTERSITEM 6. SELECTED CONSOLIDATED FINANCIAL DATAITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATAITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSUREITEM 9A. CONTROLS AND PROCEDURESPART IIIITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTITEM 11. EXECUTIVE COMPENSATIONITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENTITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONSITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICESITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-KSIGNATURESREPORT OF INDEPENDENT AUDITORSREPORT OF INDEPENDENT PUBLIC ACCOUNTANTSCONSOLIDATED BALANCE SHEETSCONSOLIDATED STATEMENTS OF OPERATIONSCONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITYCONSOLIDATED STATEMENTS OF CASH FLOWSNOTES TO CONSOLIDATED FINANCIAL STATEMENTSINDEX TO EXHIBITSConsent of Independent Public AccountantsRule 13a-14(a)/15d-14(a) CertificationRule 13a-14(a)/15d-14(a) CertificationSection 1350 CertificationSection 1350 Certification    Table of Contents  
 PART I 
 ITEM 1. BUSINESS Introduction 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
professional 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,
IP, Fibre Channel, HDLC and multi-protocol interworking technologies. The Company maintains a website on the Internet with the address of
www.interphase.com. Copies of this Annual Report on Form 10-K for the year
ended December 31, 2003 and copies of the Companys Quarterly Reports on Form
10-Q for 2002 and 2003 and any current Reports on Form 8-K for 2002 and 2003,
and any amendments thereto, are or will be available free of charge as soon as
reasonably practical after they are filed with Securities and Exchange
Commission (SEC) at such website. The general public may obtain any
materials the Company files with the SEC at 1-800-SEC-0330, or since the
Company is an electronic filer, the SEC maintains an Internet website at
www.sec.gov that contains reports, proxy and information statements, and other
information regarding issuers that file electronically with the SEC. Key Terms and Definitions Interphase is a technology company and many terms used by the Company may be
unfamiliar to those outside the industry. The following are some key terms
that may be useful in helping the reader understand the products, technologies,
and markets relevant for the Company. Adapter Also called a host bus adapter (HBA) or network interface card (NIC).
An adapter is a device that connects a computer server to one or more
peripheral devices (such as switches, hubs, storage devices, etc.) or other
computers. An adapter card typically plugs into the expansion bus of a system
and communicates with the operating system controlling the system via the use
of specific device drivers. Adapters generally refer to passive
(non-intelligent) printed circuit boards used for interfacing to a network. AdvancedTCA or ATCA(Advanced Telecom Computing Architecture)  The next
generation of system architecture beyond CompactPCI. It affords greater
bandwidth, processing density, board real estate, cooling abilities, and memory
to meet the growing needs of next generation applications. ATM(Asynchronous Transfer Mode)  A network technology for both LANs and WANs
that supports real time voice, real time video, and data. The topology uses
switches that establish a 1




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logical circuit from end to end, which guarantees a quality of service (QoS)
for that transmission. However, unlike telephone switches that dedicate
circuits end to end, unused bandwidth in ATM circuits can be appropriated
whenever available. For example, idle bandwidth in a videoconference circuit
can be used to transfer data. ATM is also highly scalable and supports
transmission speeds of 1.5, 25, 100, 155, 622 and 2488 Mbps. Broadband- A transmission facility (communications link) that has bandwidth
(capacity) greater than a traditional voice grade line. Communications Controller- Communications controller modules (similar to a
network interface card) are designed specifically for carrier-grade computer
systems that often support signaling, switching and routing networks.
Communication controllers must conform to specifications that maintain overall
system compliance to the rigorous performance and reliability standards that
apply to telecom service provider equipment into which they are integrated.
Controllers are essentially intelligent network interface cards. CompactPCI- An industrial grade variation of the PCI bus standard that
utilizes the Eurocard (VME) form factor. CompactPCI has been widely adopted by
telecom equipment suppliers because of its high-density connectors, support for
front or rear I/O access and hot-swap capabilities important for Five 9s
(99.999%) reliability. Often referred to as CPCI or cPCI, it is a standardized
architecture for printed circuit boards used in the embedded systems industry. Fast Ethernet- A variation of the Ethernet standard (10Base-T) that provides
100 Mbps transmission bandwidth, and up to 200 Mbps total I/O throughput with
full duplex operation. Also known as 100Base-T. Often 10/100Base-T is used to
describe a link with the capability to support both Ethernet (10 Mbps) and Fast
Ethernet (100 Mbps). Fibre Channel- A high-speed transmission technology that can be used as a
front-end communications network, a back-end storage network, or both at the
same time. With Fibre Channel, servers can not only talk to the storage system
via SCSI (storage protocol, see below), but the hosts can talk to each other
via IP (Internet Protocol) over the same network. Fibre Channel supports
existing peripheral interfaces and communications protocols. Fibre Channel
supports coaxial cable and twisted pair copper wiring as well as single mode
and multimode fiber connections. Frame Relay- A high-speed packet switching protocol used in wide area networks
(WANs). Providing a granular service of up to DS3 speed (45 Mbps), it has
become very popular for LAN-to-LAN connections across remote distances. All the
major telecommunications carriers offer frame relay services. Frame relay is
much faster than X.25 networks, the first packet-switching WAN standard,
because frame relay was designed for todays reliable circuits and performs
less rigorous error detection. Gigabit Ethernet- An Ethernet technology that raises transmission speed to one
Gbps and is used primarily for backbone networks and high-speed
server-to-server connectivity. Also known as 1000Base-T. 2




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I/O(Input/output) - The transfer of data or voice traffic into and out of a
computing device. IPSec(IP SECurity) -A security protocol from the IETF that provides
authentication and encryption over the Internet. ISDN(Integrated Services Digital Network) - A system of digital connections
that has been available for over a decade and has gained increased use in the
last few years for high-speed data and video transmission. LAN(Local Area Network) - A short-distanced data communications network that
is contained within a building or complex. Its primary use is to link
computers and peripheral devices (such as printers) and to provide individuals
with access to databases and applications running on servers attached to the
network. Anyone connected to the LAN can send messages to and work jointly
with others on the network. Media Gateway- A networking device that converts data from the format required
for one type of network to the format required for another. The media gateway
is controlled by the media gateway controller. Both are a component of
softswitch. Node B -A component of a 3G wireless base station containing radio
transmitters and receivers. Often referred to as a wireless cell site. OC-3/STM-1 -The American and European standards (respectively) for ATM optical
interconnect 3 traffic, which is a digital transmission link with capacity of
155 Mbps. This line speed is very common in telecommunications access
networks. Operating System- The master control program that runs the computer. It is the
first program loaded when the computer is turned on, and its main part, called
the kernel, resides in memory at all times. It may be developed by the vendor
of the computer it is running in or by a third party. It is an important
component of the computer system because it sets the operational guidelines for
all application programs that run on the system. All programs must talk to
the operating system. Popular network operating systems today include Windows
NT, XP and 2000, VxWorks, Solaris and Linux. PCI- A bus standard (Peripheral Components Interconnect) that is currently the
main general-purpose bus in many desktop computers and a majority of enterprise
servers throughout the world. Telecom servers generally use the newer
generation of the PCI architecture-CompactPCI. PCI-X- A high-performance extension to the PCI Local Bus that is designed to
meet the increased I/O demands of technologies such as Fibre Channel, Gigabit
Ethernet, and Ultra3 SCSI. PMC(PCI Mezzanine Card) - a low profile mezzanine card that is electronically
equivalent to the Peripheral Component Interconnect (PCI) specification. PMC
cards are used as a quick and cost-effective method to add modular I/O to other
card formats such as VME and CompactPCI. 3




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PTMC(PCI Telecom Mezzanine Card)  A mezzanine card with connectors specific
to telecom applications, based on the industry standard PICMG 2.15. RAID(Redundant Array of Inexpensive Disks)  A set of physical disk drives
used for data storage viewed by the user as a single logical device. Data is
written to a number of disk drives in a RAID so that if one fails, the data can
be retrieved from one of the remaining drives. SAN(Storage Area Network)  A flexible any-to-any networking infrastructure
linking multiple servers to multiple storage devices. Based on Fibre Channel
technology, SANs have recently emerged as the highest performance data
communications environment available today to interconnect servers and storage.
Running at Gigabit speeds, SANs offer better scalability, fault recovery and
general manageability than current client-server LAN-based approaches for
real-time and data-intensive applications. Storage Area Networks are being
widely deployed for video editing, prepress, and data mining applications
throughout the general IT marketplace. SCSI(Small Computer System Interface)  Pronounced skuzzy, SCSI is a widely
used communications technology for connecting computer servers to storage
devices. The technology is especially popular in applications where network
servers are attached to numerous SCSI drives and configured as fault-tolerant
RAID clusters. In the event one drive fails, the system is still operational.
SCSI-based RAID is widely used in file servers, database servers and other
network servers. Interphase products utilize Ultra2 SCSI, which provides up to
80 Mbps data throughput and Ultra3 SCSI, which doubles the throughput to 160
Mbps. Security
Acceleration Adapters Modules that serve as co-processors assisting
a host CPU card by offloading security encryption and decryption processes,
thereby accelerating security processing performance. Server A computer in a network shared by multiple users. These are
typically more powerful than computers used by individuals (often referred to
as desktops) and require advanced I/O connectivity. In enterprise network
environments, some computers may be dedicated to a single task. For instance,
an Internet server is a computer that provides World Wide Web services on the
Internet. If the Web server is used internally and not by the public, it may
be known as an intranet server. Softswitch(Software Switch)  A generic term for an open application program
interface software used to bridge a public switched telephone network and the
Internet Protocol by separating the call control functions of a phone call from
the media gateway (transport layer). SS7(Signaling System 7)  The protocols used in the U.S. telephone system for
setting up calls and providing modern transaction services such as caller ID,
automatic recall and call forwarding. When you dial 1 in front of a number,
SS7 routes the call to your long distance carrier and it also routes local
calls based on the first three digits of the phone number. 4




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T1/E1- A digital transmission link with a capacity of 1.544 Mbps (1,544,000
bits per second) or 2.048 for the E1 standard. T1 links normally handle 24
voice conversations, but with digital encoding can handle many more voice
channels. T1 lines are also used to connect networks across remote distances.
E1 is the European equivalent and J1 is the Japanese equivalent to T1. T3/E3- A digital transmission link equivalent to 28 T1 lines. Providing a
capacity of 45 Mbps, a T3 link is capable of handling 672 voice conversations.
E3 is the European equivalent and J3 is the Japanese equivalent to T3. WAN(Wide Area Network) - A communications network that covers a wide
geographic area, such as state or country. A WAN typically extends a LAN
(Local Area Network, see above) outside the building, over telephone common
carrier lines to link to other LANs in remote locations, such as branch offices
or at-home workers and telecommuters. WANs typically run over leased phone
lines, but are increasingly also employing the Internet for VPN (virtual
private network) connectivity. 6U -A standard size and design of printed circuit boards and the chassis that
holds them. Mission The Companys mission is to provide innovative, high-performance connectivity
solutions for the telecommunications and enterprise embedded system markets.
To achieve this, Interphase pursues several key initiatives that include: Providing an advanced line of communication controllers for next-generation
telecom systems. The Company offers original equipment manufacturers (OEMs) in the
communications sector an advanced, high quality, high performing, feature-rich,
and broad portfolio of communications boards and subsystems at competitive
prices. The Company therefore maintains a valuestrategy while maintaining the
utmost commitment to customer service and flexibility to customer needs. OEMs, due to significant workforce reductions over the last two to three years,
have been outsourcing a greater and greater portion of the equipment that they
traditionally made in-house. To capitalize on this trend, Interphase offers a
comprehensive line of carrier-class communications controllers and network
interface solutions for:  
    
    2.5 and 3G Wireless- controllers that provide enhanced mobile services
and integration with other networks  
    
    Broadband/Network Telephony Access- controllers that enable
high-speed network connectivity, i.e. Internet access through ADSL,
cable and fixed wireless providers  
    
    Intelligent (SS7) and Converging Networks- controllers that help
service providers migrate their intelligent network facilities to more
scalable and cost-effective architectures and provide new platforms
for softswitch and media gateway convergence of voice and data
networks 5




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To further assist telecommunication server providers, Interphase launched its
professional services organization in 2001 responsible for customizing software
and third party applications to customer-specific designs. With
high-performance communication controllers, software development tools,
protocol support, experience with third party protocols and complementary
professional services, Interphase products and services help decrease costs and
improve time-to-market of OEMs building next-generation telecom equipment. A comprehensive private network I/O adaptersand modules In order to provide Interphase customers with effective storage networking
solutions, Interphase offers a comprehensive line of networking adapters and
security acceleration modules specifically designed for use in demanding,
enterprise class applications such as:  
    
    Private Networking/Enterprise Networking mission critical backbone
and Internet servers served with unique, slot-saving designs  
    
    Network Security Enterprise devices, such as virtual private
networks (VPNs), that provide encryption and decryption of data
traffic for preventing security breaches. Interphase serves this
segment with network security co-processor modules  
    
    Storage Area Networks servers providing high speed data storage and
retrieval in enterprise environments. Interphase serves this segment
with a portfolio of fibre channel host bus adapters Currently, the Company is developing only specialized enterprise equipment due
to the rapid commoditization of unspecialized (or standardized) equipment in
this segment. Delivering superior customer service Over the past 25 years, Interphase has established strong relationships with
key Fortune 500 suppliers of enterprise computer and telecommunication servers.
Much of this success has been due to the superior pre- and post-sale service
the Company delivers to customers. With a vertically integrated account
perspective, Interphase provides flexibility, timely response and other
customized account service features. Further, the Companys technical support
is staffed by experts for both Telecom and Enterprise products, allowing
Interphase to specifically focus its support efforts for the different needs
and requirements of its customers in these differing market segments. Developing strategic partnerships. Interphase is an acknowledged leader in designing products for multi-vendor
interoperability. The Company leverages this leadership position into
strategic partnerships with its partner program. Through this program,
Interphase builds synergistic marketing and technical relationships with other
key suppliers in its respective markets. Rigorous product testing and early
access to new partner product releases allows tighter product integration and
helps assure compatibility for end-users of the Companys products. Also,
Interphases joint software development, particularly with 6




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third party protocol vendors, decreases the integration time for customers by
offering a pre-integrated solution. Products Interphase offers an advanced line of telecom communication controllers, a
comprehensive portfolio of specialized enterprise connectivity and storage
adapters, and resource modules for security acceleration. Telecom Products Interphase products designed for use in next-generation Broadband
telecommunication networks include:  
    
    iNAV 9200 Multiprotocol Gateway Appliance- a specialized
appliance designed for bridging multiple protocols for converging
networks with dissimilar network protocols.  
    
    iNAV 4000 CompactPCI Network Processor Blade- a protocol
interworking, network protocol processing board with on-board
intelligence suited to broadband convergence applications such as
wireless gateways and media gateways.  
    
    iNAV 3000 CompactPCI Blade- a telecom carrier card designed to
enable PMC cards to function in a CompactPCI environment aimed at
narrowband applications.  
    
    1635 CompactPCI Packet Switched Backplane T1/E1/J1 Communications
Controller- a 6U CompactPCI communications controller, based on the
PICMG 2.16 Ethernet backplane standard, with an advanced architecture
featuring the Motorola MPC8264 RISC CPU that offers superior
performance over T1/E1/J1 communication links. The 1635 also offers
dual Ethernet interfaces to 2.16 backplanes, and can convert both SS7
and ATM to IP for converging different networks.  
    
    4531 PMC ATM over T3/E3 Communications Controller- a PCI Mezzanine
Card that provides reliable, high performance ATM communications over
T3/E3 connections for applications such as aggregating Internet traffic
for transport over the public ATM backbone network.  
    
    4531S PMC ATM over T3/E3 Communications Controller- an
intelligent, high-performance, PCI Mezzanine Card that provides
software selectable T3/E3 network access, and can support multiple
protocols on-board, improving overall system performance.  
    
    4532 PMC OC-3/STM-1 Communications Controller -an intelligent,
high-performance, PCI Mezzanine Card that provides direct access to
SONET networks and software selectable access to an OC-3/STM-1 ATM
network, as well as a 10/100 Ethernet interface. The Company believes
that the 4532 is the only product in its class, and is ideally suited
for 3G networks that define ATM as the interconnect between radio
network controllers and 7




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cell sites, for example. It also targets broadband access networks and
gateways that require on-board ATM to Ethernet interworking.  
    
    4532P PMC ATM over OC-3/STM-1 Communications Interface Card -A
passive interface module providing 155 Mbps connectivity for use with
the iNAV 4000.  
    
    4534 PMC Quad-port Serial Communications Controller- a PCI
Mezzanine Card that provides reliable, high performance serial
communications for multiple telecommunication protocols including ATM,
ISDN, Frame Relay, X.25 and PPP.  
    
    4535 PMC Multiprotocol T1/E1 Communications Controller- a
cost-effective PCI Mezzanine Card that provides two high-speed serial
communication links to provide connection to the Public Switch
Telephone Network to support advanced SS7 or AIN applications.  
    
    4537 PMC Multiprotocol T1/E1 Communications Controller- a PCI
Mezzanine Card targeted specifically for telecommunication applications
that require multiple T1/E1 interfaces. The 4537 supports multiple
frame-based protocols, such as ATM and SS7, provides options for front
or rear I/O access, and includes an integrated Channel Service Unit.  
    
    4538 PMC T1/E1/J1 Communications Controller- a PCI Mezzanine Card
with 2 software selectable T1/E1/J1 interfaces on the front faceplate
plus a 10/100 Ethernet port. It is targeted for signaling and control
plane applications in wireless and converged voice and data telecom
networks. With its on-board SS7 protocol processing, excellent SS7
performance, and its Ethernet access, it is a modular solution for
signaling platforms and signaling gateway applications.  
    
    4539 PMC Communications Controller- a PCI Mezzanine Card targeted
for signaling/control plane and broadband/user plane telecom networks.
The 4539 offers four software selectable T1/E1/J1 interfaces via rear
access, and a 10/100 Ethernet interface on the front. The 4539
supports multiple protocols on board, including ATM, and it can serve
both narrowband and broadband networks in one solution.  
    
    4575 PMC ATM Communications Interface Card- a PCI Mezzanine Card
that provides cost-effective, reliable, high performance ATM over
OC-3/STM-1 155 Mbps connectivity.  
    
    4576 PMC ATM Communications Interface Card- the next generation of
the 4575 product.  
    
    5539F PCI T1/E1/J1 Communications Controller- a PCI version of the
4539 for use in traditional PCI-based systems.  
    
    5575 PCI ATM Communications Interface Card- a PCI adapter card
that provides full duplex ATM connectivity for systems running Windows
NT, Novell NetWare, UnixWare, Solaris and AIX. 8




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
    
    5576 PCI ATM Communications Interface Card- the next generation of
the 5575 product.  
    
    6535 CompactPCI T1/E1/J1 Communications Controller- a 6U
CompactPCI communications controller with an advanced architecture
featuring the Motorola MPC8264 RISC CPU that offers superior
performance over T1/E1/J1 communication links.  
    
    6575 CompactPCI ATM Communications Controller- a 3U or 6U
CompactPCI adapter that provides full duplex ATM connectivity at
OC-3/STM-1 data rates for industrial and telecommunication systems.  
    
    iWARE -  a software development suite that complements the
intelligent communications controllers. It offers an application
programming interface for developers to develop applications on the
Interphase communications controllers and provides software for various
protocols to be run on the Interphase controllers. Enterprise Network Products Interphase enterprise products targeted for use in enterprise applications
include the following:  
    
    4526T PowerSAN PCI Fibre Channel Adapter- a new 33Mhz PMC adapter
which provides single port 1-Gbps Fibre Channel connectivity.  
    
    5540 PowerSAN PCI Fibre Channel Adapter- a 66Mhz PCI bus adapter
which provides price-effective 1-Gbps storage connectivity for basic
Fibre Channel SAN connectivity.  
    
    5541 PowerSAN PCI Fibre Channel Adapter -a low profile version of
the 5540 that is only half of the height of normal PCI cards, allowing
use in the new smaller profile (1U) servers being increasingly used in
Internet server and e-commerce applications.  
    
    5550 PowerSAN PCI Fibre Channel Adapter- a 66Mhz PCI bus adapter
which provides two independent 1-Gbps Fibre Channel connections for
high-reliability SAN applications.  
    
    5560 PowerSAN PCI Fibre Channel Adapter- a 66Mhz PCI bus adapter
which provides 2-Gbps Fibre Channel connectivity for applications
requiring maximized data throughput.  
    
    FibreView Enterprise- a JAVA-based management utility which allows
enterprise IT managers to control Fibre Channel server connections from
anywhere within the network via the Internet.  
    
    5570 SlotOptimizer (Combo) PCI Storage Networking Adapter -a
64-bit PCI multifunction adapter card providing full duplex Gigabit
Fibre Channel and high-performance Gigabit Ethernet connectivity. 9




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
    
    552C SlotOptimizer (Combo) PCI Storage Networking Adapter -a
64-bit PCI multifunction adapter card combining dual channel Ultra2
SCSI connectivity with two 10/100 Ethernet ports.  
    
    553C SlotOptimizer (Combo) PCI Storage Networking Adapter -a
64-bit PCI multifunction adapter card combining dual channel Ultra3
SCSI connectivity with two 10/100 Ethernet ports.  
    
    551E SlotOptimizer Single-port Fast Ethernet Adapter -a 64-bit PCI
adapter card with a Fast Ethernet interface.  
    
    554E SlotOptimizer (Combo) Quad-port Fast Ethernet Adapter -a
64-bit PCI adapter card that provides four independent full-duplex Fast
Ethernet ports.  
    
    45NS PMC Network Security Acceleration Adapter- a PCI mezzanine
card designed for IPSec processing acceleration for use in encryption
and decryption of security protocols.  
    
    55NS PCI Network Security Acceleration Adapter- a PCI card
designed for IPSec processing acceleration for use in encryption and
decryption of security protocols. New Product Development As stated previously, the primary target markets for the Companys products are
characterized by those areas of a telecom network that can reduce cost for
service providers (carriers), decrease their time to market for deployment of
new and existing services and finally, preserve carriers prior network
equipment investment. The economic downturn in the telecom business sector has
forced telecom service providers and network equipment providers, or NEPs, to
reexamine their areas of competitive value add and streamline their business
operations. In particular, NEPs, and carriers as well, have been consolidating
their product development and manufacturing groups, which actions generally
lead to an increase in the use of off-the-shelf products, such as the products
sold by Interphase. Consequently, the Companys new product development is
driven by the profitable growth areas in the market where NEPs use off the
shelf designs and emerging standards that improve the performance and
reliability of standard designs and the race to market. Enterprise/Private Network Initiatives In the enterprise network segment, Interphase will invest product development
resources for additions to the existing security acceleration product line.
These security modules are designed to work as co-processor resources for
servers required to perform compute-intensive security encryption and
decryption functions. Use of these security modules offloads host CPUs of
encryption/decryption burdens and therefore improves overall system performance
significantly. Based on interest from customers in the currently-available
45NS and 55NS security products, the new additions to this line are expected to
offer customers even greater throughput by way of a newer, more powerful
co-processor chipset. 10




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Additionally, Interphase seeks to enhance its SlotOptimizer® product line, a
portfolio of products that enable maximized port density, enabling OEMs and
enterprises alike to consolidate multiple network interfaces on to a single
slot. The end result is conservative usage of system slots for network I/O and
real estate preservation within the server chassis. The SlotOptimizer line will
be expanded to include PCI mezzanine card (PMC) architectures. With the
addition of a variety of new PMC-based designs, maximized slot density
solutions are brought to market for use with a broader set of system
architectures, including CompactPCI, VME, and proprietary systems. This move
is intended to broaden the list of suitable applications for the SlotOptimizer
line to include carrier-grade and military uses in addition to a wide variety
of enterprise networking applications. Telecom Segment Initiatives Interphase continues to build on its existing portfolio of telecom solutions by
diversifying into an even wider set of capabilities. The Company continues to
target three main carrier segments (via OEM channels) with the greatest
opportunity for intelligent communications solutions including wireless,
convergence/next generation public network equipment, and broadband
network/telephony access. Expansion of the iSPAN and iNAV lines will occur in
several ways, described below. Migration to Pre-integrated Frameworks.Interphase has evolved from offering
passive line interface modules to intelligent communications controllers in the
last few years. In keeping with the same initiative, Interphase has made
several pre-integrated frameworks available to customers. These solutions are
generally a combination of multiple hardware and software modules which enable
customers to spend less time and development resources for integrating their
blade-level subsystems. This affords OEMs a better focus on their true core
competencies (i.e. applications development), faster time to market, and a
reduction in development costs. More of these frameworks, using a combination
of Interphase products and partner components, will become available in the
coming year. AdvancedTCA.The widely accepted telecom platform form factor, CompactPCI, is
beginning to reach a performance peak, and NEPs and carriers alike are
developing applications that will outgrow the architecture. Vendors seeking
to provide solutions with greater bandwidth, processing density, board real
estate, cooling abilities, and memory to meet the needs of next generation
applications have initiated a new technology standard. Governed by the PICMG
standards body, the PICMG 3.0 subcommittee is standardizing the Advanced
Telecom Computing Architecture (AdvancedTCA or ATCA) specification. Interphase
is an active participant in this standards group, and it has under development
two AdvancedTCA products. This new architecture is beginning to gain
acceptance by network OEMs, and full production units are expected to slowly
replace CompactPCI systems in the coming years. Appliances.Interphase has maintained a specialty in interworking multiple
protocols and gateway-on-a-card technologies for several years and has begun to
expand its product line upon this concept. The Companys interworking solutions
based on a single card (as opposed to previous methods requiring the use of
multiple boards) have paved the way for compact, specialized appliances for
bridging multiple protocols. Interphase has announced the first product in a
new line of appliances, 11




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##### Table of Contents



the iNAV 9200 Multiprotocol Gateway Appliance, designed for bridging ATM and
Ethernet protocols. Based on network processors, this new line of products
offers numerous advantages to the network equipment OEMs and carriers alike,
including improved performance, a hardware-based architecture (a substantial
improvement in reliability and development time over software-based
alternatives), reduced footprint, and significantly reduced cycles for
applications development due to the pre-development of protocol software.
Protocol interworking is a widespread practice throughout the public network,
because it enables carriers to migrate existing infrastructures to next
generation technologies without forklift upgrades. Convergence of voice and
video is a common theme today and Interphase appliances provide a higher
performing, more cost effective solution in specific convergence applications
requiring simple protocol conversions. Industry Standards Participation The Company has been engaged in the development of new products and the
refinement of its existing products since its inception. Throughout its
history, Interphase has been active in the formulation of industry standards
sanctioned by groups such as the PCI Industrial Manufacturers Group (PCIMG) and
the AdvancedTCA subcommittee in particular, IEEE, ANSI, VME International Trade
Association (VITA), Fast Ethernet Alliance, SCSI Committee, the LADDIS Group,
ONC/NFS Consortium, and Storage Networking Interoperability Association (SNIA),
and FC-Open (Fibre Channel) Consortium. Marketing and Customers The Companys products are sold to network equipment OEMs for inclusion in
embedded systems designed for use in carrier networks and enterprise data
networks. These purchasers incorporate the Companys products into proprietary
or standards-based systems for resale to either telecom carriers directly, or
in cases of enterprise equipment, to distributors, system integrators or VARs
(which may add specially designed software) prior to resale to the enterprise
end-users. Also, the Company sells products directly to sophisticated
end-users such as the military. During 2003, sales to Lucent Technologies and
Hewlett Packard accounted for $13.5 million or 42% and $9.7 million or 30% of
the Companys consolidated revenues, respectively. During 2002, sales to
Hewlett Packard and Lucent Technologies accounted for $8.7 million or 35% and
$7.2 million or 29% of the Companys consolidated revenues, respectively.
During 2001, sales to Hewlett Packard and SCI Systems accounted for $8.5
million or 30% and $4.2 million or 15% of the Companys consolidated revenues,
respectively. No other customers accounted for more than 10% of the Companys
consolidated revenues in the periods presented. The Company markets its products through its direct sales force, manufacturers
representatives and value-added distribution partners. In addition to the
Companys headquarters in Plano, Texas; the Company has sales offices located
in or near Boca Raton, Florida; Santa Clara, California; Minneapolis,
Minnesota; Ottawa, Canada; Munich, Germany; Helsinki, Finland and Paris,
France. The Companys direct sales force market products directly to key
customers and support manufacturers representatives and the distribution
channel. In addition, the Company has entered into distribution agreements
with key national and international distribution partners located in countries
in North America, Asia and Europe. See Note 16 of the accompanying notes to
the 12




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##### Table of Contents



consolidated financial statements for information regarding the Companys
revenues related to North America and other foreign countries. Interphase emphasizes its extensive product, training and field support to its
customers. The Companys products are generally sold with a one-year warranty
covering components and labor, however, certain contracts with major OEM
customers allow for longer warranty periods. The Company also offers extended
warranties and support, however at December 31, 2003, a limited number of
agreements were in place. Therefore, the Company does not have significant
liabilities associated with these warranties. The Company and its major customers generally enter into written contracts
specifying, among other items standard in commercial agreements, product
specifications, failure rates, shipping requirements, shipment rescheduling
terms, price/volume schedules and manufacturer warranties. These agreements
generally do not contain determinable purchase commitments of the customers,
providing instead that actual purchase and shipments of products be made by
specific purchase order. Accordingly, any shipment dates stated in such
contracts are subject to rescheduling and/or cancellation and, therefore, are
not indicative of the future purchase orders to be submitted by such customer.
In addition, the actual terms of the contracts tend to be modified in the
ordinary course of business by means of subsequent purchase order terms and by
course of dealing. The Company does not believe that the level of backlog of orders is either
material or indicative of future results, since its contracts are subject to
revision through subsequent purchase orders and its customers are generally
permitted to cancel purchase orders, within certain parameters, prior to
shipment without penalty. The majority of the Companys sales are to OEMs with payment terms typically
being net 30-90 days from the date of invoice. Manufacturing and Supplies Manufacturing operations are currently conducted at the Companys manufacturing
facility located in Carrollton, Texas. The Companys products consist
primarily of various integrated circuits, other electronic components and
firmware assembled onto an internally designed printed circuit board. The Company uses internally designed applications or specific integrated
circuits (ASIC), some of which are sole-sourced, on some of its products, as
well as standard off-the shelf items presently available from two or more
suppliers. Historically, the Company has not experienced any significant
problems in maintaining an adequate supply of these parts sufficient to satisfy
customer demand. The Company believes that it has good relations with its
vendors. The Company generally does not manufacture products to stock in finished goods
inventory, as substantially all of the Companys production is dedicated to
specific customer purchase orders. As a result, the Company does not have any
material requirements to maintain significant finished goods inventories. 13




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Intellectual Property and Patents While the Company believes that its success is ultimately dependent upon the
innovative skills of its personnel and its ability to anticipate technological
changes, its ability to compete successfully will depend, in part, upon its
ability to protect proprietary technology contained in its products. The
Company does not currently hold any patents relative to its current product
lines. Instead, the Company relies upon a combination of trade secret,
copyright and trademark laws and contractual restrictions to establish and
protect proprietary rights in its products. The development of alternative,
proprietary and other technologies by third parties could adversely affect the
competitiveness of the Companys products. Further, the laws of some countries
do not provide the same degree of protection of the Companys proprietary
information, as do the laws of the United States. Finally, the Companys
adherence to industry-wide technical standards and specifications may limit the
Companys opportunities to provide proprietary product features capable of
protection. The Company is also subject to the risk of litigation alleging infringement of
third party intellectual property rights. Infringement claims could require
the Company to expend significant time and money in litigation, pay damages,
develop noninfringing technology or acquire licenses to the technology, which
is the subject of asserted infringement. The Company has entered into several nonexclusive software licensing agreements
that allow the Company to incorporate third-party software into its product
line thereby increasing its functionality, performance and interoperability. Employees At December 31, 2003, the Company had 151 full-time employees, of which 40 were
engaged in manufacturing and quality assurance, 59 in research and development,
28 in sales, sales support, customer service and marketing and 24 in general
management and administration. The Companys success to date has been significantly dependent on the
contributions of a number of its key technical and management employees. The
loss of the services of one or more of these key employees could have a
material adverse effect on the Company. In addition, the Company believes that
its future success will depend in a large part upon its ability to attract and
retain highly skilled and motivated technical, managerial, sales and marketing
personnel. Competition for such personnel is intense. None of the Companys employees are covered by a collective bargaining
agreement and there have been no work stoppages. The Company considers its
relationship with its employees to be good. Competition The Companys competition includes vendors specifically dedicated to the
enterprise I/O and telecommunication product markets. Most of the Companys
major OEM customers have chosen to outsource the design, manufacture and
software integration of communications controllers and 14




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##### Table of Contents



protocol processing, and the recent market conditions and reduction in
resources have forced some network equipment providers to utilize off the shelf
products for their product design. Increased competition and commoditization
of network interface technologies could result in price reductions, reduced
margins and loss of market share. Risk Factors Potential Fluctuations in Period-to-Period Results Interphase has experienced fluctuations in its period-to-period revenue and
operating results in the past and may experience fluctuations in the future.
The Companys sales on both an annual and a quarterly basis can fluctuate as a
result of a variety of factors, many of which are beyond its control. The
Company may have difficulty predicting the volume and timing of orders for
products, and delays in closing orders can cause the Companys operating
results to fall short of anticipated levels for any period. Delays by
Interphases OEM customers in producing products that incorporate the Companys
products could also cause operating results to fall short of anticipated
levels. Other factors that may particularly contribute to fluctuations in the
Companys revenue and operating results include success in achieving design
wins, the market acceptance of the OEM products that incorporate the Companys
products, the rate of adoption of new products, competition from new
technologies and other companies, and the variability of the life cycles of
Interphases customers products. Because fluctuations can happen, Interphase believes that comparisons of the
results of its operations for preceding quarters are not necessarily predictive
of future quarters and that investors should not rely on the results for any
one quarter as an indication of how Interphase will perform in the future.
Investors should also understand that, if the Companys revenue or operating
results for any quarter are less than the level expected by securities analysts
or the market in general, the market price for the Companys common stock could
immediately and significantly decline. Continued Computer and Communications Market Slowdown Since 2001, the global computer and communications market has significantly
deteriorated reflecting a significant reduction in capital spending in these
markets. The Companys sales and results of operations have been adversely
affected by this market deterioration. If capital investment levels in these markets continue to decline, or if the
computer and communications market does not improve or improves at a slower
pace than anticipated, the Companys revenues and profitability will continue
to be adversely affected. In addition, if the Companys sales volume and
product mix shift negatively, our gross margin percentage may not remain at its
present level, resulting in lower than expected results of operations. The significant slowdown in capital spending in the Companys target markets
has created uncertainty as to the level of demand in those markets. In
addition, the level of demand can change quickly and can vary over short
periods of time. As a result of the uncertainty and variations in these
markets, accurately forecasting revenues, results and cash flow is increasingly

difficult. 15




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##### Table of Contents



Technological Change and New Product Introductions The market for the Companys products is characterized by rapid technological
change and frequent introduction of products based on new technologies. As
these products are introduced, the industry standards change. Additionally, the
overall telecommunications and networking industry is volatile as the effects
of new technologies, new standards, new products and short life cycles
contribute to changes in the industry and the performance of industry
participants. The Companys future revenue will depend upon the Companys
ability to anticipate technological change and to develop and introduce
enhanced products of its own on a timely basis that comply with new industry
standards. New product introductions, or the delays thereof, could contribute
to quarterly fluctuations in operating results as orders for new products
commence and orders for existing products decline. Moreover, significant
delays can occur between a product introduction and commencement of volume
production. A typical time period from design in of one of our products to
actual production is 18 to 24 months. The inability to develop and manufacture
new products in a timely manner, the existence of reliability, quality or
availability problems in its products or their component parts, or the failure
to achieve market acceptance for its products could have a material adverse
effect on the Companys revenue and operating results. Competition The telecommunications, signaling and networking business is extremely
competitive, and the Company faces competition from a number of established and
emerging start-up companies. Many of the Companys principal competitors have
established brand name recognition and market positions and have substantially
greater financial resources to deploy on promotion, advertising and research
and product development than the Company. In addition, as the Company broadens
its product offerings, it may face competition from new competitors. Companies
in related markets could offer products with functionality similar or superior
to that offered by the Companys products. Increased competition could result
in price reductions, reduced margins and loss of market share, all of which
could materially and adversely affect the Companys revenue and operating
results. The Company expects that competition will increase as a result of
industry consolidations and alliances, as well as the emergence of new
competitors. There can be no assurance that the Company will be able to compete
successfully with its existing or new competitors or that competitive pressures
faced by the Company will not have a material adverse effect on the Companys
revenue and operating results. Dependence on Key Customers While the Company enjoys a very good relationship with its customers, there can
be no assurance that the Companys principal customers will continue to
purchase products from the Company at current levels. Customers typically do
not enter into long-term volume purchase contracts with the Company, and
customers have certain rights to extend or delay the shipment of their orders.
The loss of one or more of the Companys major customers, or the reduction,
delay or cancellation of orders or a delay in shipment of the Companys
products to such customers could have a material adverse effect on the
Companys revenue and operating results. 16




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##### Table of Contents



Design Wins A design win occurs when a customer or prospective customer notifies the
Company that its product has been selected to be integrated with their product.
Ordinarily, there are a number of steps between the design win and when
customers initiate production shipments. Design wins reach production volumes
at varying rates, typically beginning approximately 12 to 24 months after the
design win occurs. A variety of risks such as schedule delays, cancellations
of programs and changes in customer markets can delay or prevent the design win
from reaching the production phase. The customers failure to bring their
product to the production phase could have an adverse effect on the Companys
revenue and operating results. Product Liability If the Company delivers products with errors, defects or problems, its
credibility and the market acceptance and sales of its products could be
harmed. Further, if Interphases products contain errors, defects and
problems, then the Company may be required to expend significant capital and
resources to alleviate such problems. Defects could also lead to product
liability as a result of product liability lawsuits against Interphase or
against its customers. Interphase has agreed to indemnify its customers in some
circumstances against liability from defects in its products. While no such
litigation currently exists, product liability litigation arising from errors,
defects or problems, even if it resulted in an outcome favorable to Interphase,
would be time consuming and costly to defend. Existing or future laws or
unfavorable judicial decisions could negate any limitation of liability
provisions that are included in the Companys license agreements. A successful
product liability claim could seriously harm the Companys business, financial
condition and results of operations. Interphase maintains insurance coverage for product liability claims. Although
management believes this coverage is adequate, it is not assured that coverage
under insurance policies will be adequate to cover product liability claims
against the Company. In addition, product liability insurance could become
more expensive and difficult to maintain and may not be available in the future
on commercially reasonable terms or at all. The amount and scope of any
insurance coverage may be inadequate if a product liability claim is
successfully asserted against the Company. Dependence on Third-Party Suppliers Certain components used in the Companys products are currently available to
the Company from one or a limited number of sources. There can be no assurance
that future supplies will be adequate for the Companys needs or will be
available on prices and terms acceptable to the Company. The Companys
inability in the future to obtain sufficient limited-source components, or to
develop alternative sources, could result in delays in product introduction or
shipments, and increased component prices could negatively affect the Companys
gross margins, either of which could have a material adverse effect on the
Companys revenue and operating results. 17




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##### Table of Contents



Dependence on Internal Manufacturing The Company manufactures its products at its Carrollton, Texas facility, and is
currently in negotiations to establish alternative manufacturing capabilities
through a third party. If the Company is successful in establishing
alternative third-party contract manufacturers, there can be no assurance that
the Company would be able to retain their services at the same costs that the
Company currently enjoys. In the event of an interruption in production, the
Company may not be able to deliver products on a timely basis, which could have
a material adverse effect on the Companys revenue and operating results.
Although the Company currently has business interruption insurance and a
disaster recovery plan to minimize the effect of the interruption, no
assurances can be given that such insurance or recovery plan will adequately
cover the Companys lost business as a result of such an interruption. Dependence on Proprietary Technology The Companys success depends upon its proprietary technologies. To date, the
Company has relied principally upon trademark, copyright and trade secret laws
to protect its proprietary technologies. The Company generally enters into
confidentiality or license agreements with its customers, distributors and
potential customers and limits access to and distribution of the source code to
its software and other proprietary information. The Companys employees are
subject to the Companys employment policy regarding confidentiality. There can
be no assurance that the steps taken by the Company in this regard will be
adequate to prevent misappropriation of its technologies or to provide an
effective remedy in the event of a misappropriation by others. Although management believes that the Companys products do not infringe on the
proprietary rights of third parties, there can be no assurance that
infringement claims will not be asserted, possibly resulting in costly
litigation in which the Company may not ultimately prevail. Adverse
determinations in such litigation could result in the loss of the Companys
proprietary rights, subject the Company to significant liabilities, require the
Company to seek licenses from third parties or prevent the Company from
manufacturing or selling its products, any of which could have a material
adverse effect on the Companys revenue and operating results. It may be necessary for the Company to enter into technology licenses from
others due to the large number of patents in the computer networking industry
and the rapid rate of issuance of new patents and new standards or to obtain
important new technology. There can be no assurance that these third party
technology licenses will be available to the Company on commercially reasonable
terms. The loss of or inability to obtain any of these technology licenses
could result in delays or reductions in product shipments. Such delays or
reductions in product shipments could have a material adverse effect on the
Companys revenue and operating results. Dependence on Employees The Companys success depends on the continued contributions of its personnel
and on its ability to attract and retain skilled employees. Changes in
personnel could adversely affect the Companys operating results. 18




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##### Table of Contents



The Company has Incurred Significant Losses in the Past The Company has incurred net losses of approximately $769,000 for the year
ended December 31, 2003, $8.4 million for the year ended December 31, 2002, and
$9.6 million for the year ended December 31, 2001. As part of a broader
strategic refocusing, the Company developed a strategy to end-of-life many of
its legacy products in an effort to focus its resources on its new product
lines. This strategy resulted in increased sales of legacy products in 2000,
however legacy product revenues have consistently declined since. Management
does not expect significant revenues from its legacy product lines in future
periods. However, management does expect to continue revenue growth in 2004
driven by the design wins of the Companys high performance controllers in
previous years. In order to achieve sustainable profitability, the Company
will need to generate higher revenues while containing costs and operating
expenses. Management cannot be certain that the Companys revenues will
continue to grow or that the Company will achieve sufficient revenues to become
profitable on a long-term, sustained basis. The Company May Need More Working Capital to Fund Operations and Expand the
Business Management believes the Companys current financial resources will be
sufficient to meet the present working capital and capital expenditure
requirements for the next twelve months. However, the Company may need to
raise additional capital before this period ends to further:  
    
    fund research and development of new products beyond what is
expected in 2004;  
    
    expand the Companys product and service offerings beyond what is
contemplated in 2004 if unforeseen opportunities arise;  
    
    respond to unforeseen competitive pressures. The Companys future liquidity and capital requirements will depend upon
numerous factors, including the success of the existing and new product and
service offerings and potentially competing technological and market
developments. However, any projections of future cash flows are subject to
substantial uncertainty. If current cash, marketable securities, lines of
credit and cash generated from operations are insufficient to satisfy the
liquidity requirements, the Company may seek to sell additional equity
securities, issue debt securities or increase the Companys working capital
line of credit. The sale of additional equity securities could result in
additional dilution to the Companys shareholders. From time to time,
management expects to evaluate the acquisition of, or investment in businesses
and technologies that complement the Company. Acquisitions or investments
might impact the Companys liquidity requirements or cause the Company to sell
additional equity securities or issue debt securities. There can be no
assurance that financing will be available in amounts or on terms acceptable to
the Company, if at all. If adequate funds were not available on acceptable
terms, the Companys ability to develop or enhance products and services, take
advantage of future opportunities or respond to competitive pressures would be
limited. This limitation could negatively impact the results of operations and
financial condition of the Company. 19




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##### Table of Contents



ITEM 2. PROPERTIES The Companys executive offices are located in a 22,000-square foot leased
facility located in Plano, Texas. The executive offices serve as the primary
location for the Companys administrative, engineering and marketing functions.
The Companys manufacturing and operations center is located in a
24,000-square foot leased facility in Carrollton, Texas. The executive offices
and the manufacturing and operations center leases extend through the end of
2005. The Company also leases a 3,000-square foot facility in Lisle, Illinois
that supports an engineering laboratory. The Lisle, Illinois lease extends
through November 2006. In addition, the Company leases a 9,000-square foot
facility in Chaville, France (near Paris) that supports the European markets.
The Chaville, France lease extends through June 2005. The Company believes
that its facilities and equipment are in good operating condition and are
adequate for its operations. The Company owns most of the equipment used in
its operations. Such equipment consists primarily of engineering equipment,
manufacturing and test equipment and fixtures. 
 ITEM 3. LEGAL PROCEEDINGS None 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable 
 PART II 
 ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED SHAREHOLDER MATTERS Since January 1984, shares of the Companys common stock have been traded on
the Nasdaq National Market, or its predecessors, under the symbol INPH. The
following table summarizes its high and low closing price for each quarter
during 2003 and 2002 as reported by Nasdaq. 2003
    
    High
    
    LowFirst Quarter
    
    
    4.25
    
    
    
    3.17Second Quarter
    
    
    7.69
    
    
    
    3.97Third Quarter
    
    
    10.58
    
    
    
    6.50Fourth Quarter
    
    
    18.05
    
    
    
    8.77
 2002
    
    High
    
    LowFirst Quarter
    
    
    5.97
    
    
    
    4.02Second Quarter
    
    
    4.87
    
    
    
    3.50Third Quarter
    
    
    4.64
    
    
    
    3.00Fourth Quarter
    
    
    4.18
    
    
    
    3.06
 20




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##### Table of Contents



The Company had approximately 2,900 beneficial owners of its common stock, of
which 58 were of record as of March 10, 2004. The Company has not paid dividends on its common stock since its inception.
The Board of Directors does not anticipate payment of any dividends in the
foreseeable future and intends to continue its present policy of retaining
earnings for reinvestment in the operations of the Company. The Board of Directors has adopted a Shareholder Rights Plan whereby each
holder of record as of December 29, 2000 received a right to purchase from the
Company one share of common stock of the Company at a price of $93 per share
for each share held. These rights can only be exercised after certain events
occur, such as if a person or entity acquires, or makes a tender or exchange
offer to acquire 15% or more of the Companys common stock and the rights
expire ten years from the record date. Upon acquisition of 15% or more of the
Companys common stock, each right not owned by the acquiring person or group
will be adjusted to allow the purchase for $93 of a number of shares having a
then market value of $186. These rights are intended to provide the Company
certain anti-takeover protections. The Board of Directors may terminate the
Rights Plan, or redeem the rights for $0.01 per right, at any time until the
tenth business day following a public announcement of a 15% or more stock
acquisition. The Company has reserved 7,000,000 shares of common stock for
this plan. The rights were distributed to shareholders as of the record date
as a nontaxable dividend. The rights are attached to and trade with Interphase
common stock until the occurrence of one of the triggering events, at which
time the rights would become detached from the common stock. In November 2001, the Board of Directors authorized the repurchase of up to $5
million of the Companys common stock. Purchases were authorized to be made
from time to time during a twenty-four month period, ending in November 2003,
in the open market or in privately negotiated transactions depending on market
conditions. The Company canceled all shares that it repurchased. See Note 11 of the accompanying notes to the consolidated financial statements
for information regarding the Companys shareholder approved stock option
plans. 
 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The selected consolidated financial data presented below under the captions
Statement of Operations Data and Balance Sheet Data have been derived from
the consolidated balance sheets and the related statements of operations for
the years ended December 31, 2003, 2002, 2001, 2000 and 1999, and the notes
thereto appearing elsewhere herein, as applicable. It is important that you also read Item 7. Managements Discussion and
Analysis of Financial Condition and Results of Operations and the financial
statements, including the notes, for the years ended December 31, 2003, 2002
and 2001. 21




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##### Table of Contents



Statement of Operations Data:
(In thousands, except per share data) Year ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999Revenue
    
    $
    32,490
    
    
    $
    25,123
    
    
    $
    28,732
    
    
    $
    55,697
    
    
    $
    73,502Gross margin
    
    
    16,909
    
    
    
    9,792
    
    
    
    9,004
    
    
    
    29,688
    
    
    
    34,702Research and development
    
    
    7,719
    
    
    
    7,005
    
    
    
    7,757
    
    
    
    10,359
    
    
    
    10,590Sales and marketing
    
    
    6,929
    
    
    
    5,991
    
    
    
    6,812
    
    
    
    10,731
    
    
    
    11,036General and administrative
    
    
    3,547
    
    
    
    3,285
    
    
    
    3,759
    
    
    
    4,824
    
    
    
    5,366Restructuring costs and other
special charges
    
    
    
    
    
    
    
    
    
    
    2,091
    
    
    
    
    
    
    
    Goodwill impairment charge
    
    
    
    
    
    
    
    
    
    
    2,350
    
    
    
    
    
    
    
    (Loss) income from operations
    
    
    (1,286
    )
    
    
    (6,489
    )
    
    
    (13,765
    )
    
    
    3,774
    
    
    
    7,710Other, net
    
    
    305
    
    
    
    611
    
    
    
    (20
    )
    
    
    333
    
    
    
    (1,030
    )(Loss) income from continuing
operations before income
taxes
    
    
    (981
    )
    
    
    (5,878
    )
    
    
    (13,785
    )
    
    
    4,107
    
    
    
    6,680(Loss) income from continuing
operations
    
    
    (769
    )
    
    
    (8,401
    )
    
    
    (9,572
    )
    
    
    2,400
    
    
    
    4,291Discontinued operations, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    571
    
    
    
    (867
    )Net (loss) income
    
    $
    (769
    )
    
    $
    (8,401
    )
    
    $
    (9,572
    )
    
    $
    2,971
    
    
    $
    3,424(Loss) income from continuing
operations per shareBasic EPS
    
    $
    (0.14
    )
    
    $
    (1.51
    )
    
    $
    (1.68
    )
    
    $
    0.41
    
    
    $
    0.77Diluted EPS
    
    $
    (0.14
    )
    
    $
    (1.51
    )
    
    $
    (1.68
    )
    
    $
    0.38
    
    
    $
    0.70Net (loss) income per shareBasic EPS
    
    $
    (0.14
    )
    
    $
    (1.51
    )
    
    $
    (1.68
    )
    
    $
    0.51
    
    
    $
    0.61Diluted EPS
    
    $
    (0.14
    )
    
    $
    (1.51
    )
    
    $
    (1.68
    )
    
    $
    0.48
    
    
    $
    0.56Weighted average common shares
    
    
    5,544
    
    
    
    5,551
    
    
    
    5,705
    
    
    
    5,805
    
    
    
    5,593Weighted average common and
dilutive shares
    
    
    5,544
    
    
    
    5,551
    
    
    
    5,705
    
    
    
    6,237
    
    
    
    6,113
 Balance Sheet Data:
(In thousands) December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999Working capital
    
    $
    24,255
    
    
    $
    24,254
    
    
    $
    31,601
    
    
    $
    37,502
    
    
    $
    35,314Total assets
    
    
    30,743
    
    
    
    30,749
    
    
    
    39,243
    
    
    
    54,473
    
    
    
    54,671Total liabilities
    
    
    7,930
    
    
    
    7,931
    
    
    
    7,323
    
    
    
    12,534
    
    
    
    14,536Redeemable common stock
    
    
    
    
    
    
    
    
    
    
    762
    
    
    
    1,780
    
    
    
    2,796Shareholders equity
    
    
    22,813
    
    
    
    22,818
    
    
    
    31,158
    
    
    
    40,159
    
    
    
    37,339
 22




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##### Table of Contents



ITEM 7.
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS 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, our 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. APPLICATION OF CRITICAL ACCOUNTING POLICIES The Companys consolidated financial statements are based on the selection and
application of significant accounting policies, which require management to
make significant estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates. Management believes the following are some of the more critical
judgment areas in the application of the Companys accounting policies that
affect the Companys financial condition and results of operations. Management
has discussed the application of these critical accounting policies with the
Board of Directors and Audit Committee. Revenue Recognition:Revenues consist of product and service revenues and are
recognized in accordance with SEC Staff Accounting Bulletin (SAB) 104,
Revenue Recognition. Product revenues are recognized upon shipment, provided
fees are fixed and determinable, a customer purchase order is obtained (when
applicable), and collection is probable. Revenues from reseller agreements are
recognized when the product is sold through to the end customer unless an
established return history supports recognizing revenue upon shipment, less a
provision for estimated sales returns. Deferred revenue consists of revenue
from reseller arrangements and certain arrangements with extended payment
terms. Revenue from extended payment terms is recognized in the period the
payment becomes due if all other revenue recognition criteria have been met.
Service revenue is recognized as the services are performed. Revenue derived from the development and installation of highly customized
software packages under a professional services contract is recognized on a
percentage of completion basis measured by the relationship of hours worked to
total estimated contract hours and the costs incurred as of the date of
measurement. The Company follows this method since reasonably dependable
estimates of 23




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the revenue and contract hours applicable to various elements of a contract can
be made. Since the financial reporting of these contracts depends upon
estimates, which are assessed continually during the term of these contracts,
recognized revenue and profit are subject to revisions as the contract
progresses to completion. Revisions in profit estimates are reflected in the
period in which the facts that give rise to the revisions become known.
Accordingly, favorable changes in estimates result in additional revenue
recognition and net income, and unfavorable changes in estimates result in a
reduction of recognized revenue and net income. If estimates were to indicate
that a loss would be incurred on a contract upon completion, a provision for
the expected loss would be recorded in the period in which the loss became
evident. Warranty Reserve:The Company offers to its customers a limited warranty that
its products will be free from defect in the materials and workmanship for a
specified period. The Company has established a warranty reserve, as a
component of accrued liabilities, for any potential claims. The Company
estimates its warranty reserve based upon an analysis of all identified or
expected claims and an estimate of the cost to resolve those claims. Changes
in claim rates and differences between actual and expected warranty costs could
impact the warranty reserve estimates. Allowance for Doubtful Accounts:Management is required to estimate the
collectibility of the Companys trade receivables. A considerable amount of
judgment is required in assessing the realization of these receivables,
including the current creditworthiness of each customer and related aging of
the past due balances. Management evaluates all accounts periodically and a
reserve is established based on the best facts available to management and
reevaluated and adjusted as additional information is received. The reserves
also are determined by using percentages applied to certain aged receivable
categories based on historical results. Allowance for Returns:The Company estimates its allowance for returns based
upon expected return rates. The estimates of expected return rates are
generally a factor of historical returns. Changes in return rates could impact
allowance for return estimates. 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. Valuing inventory at the lower of cost or market involves an
inherent level of risk and uncertainty due to technology trends in the industry
and customer demand for our products. In assessing the ultimate realization of
inventories, management is required to make judgments as to future demand
requirements and compare that with the current or committed inventory levels.
Reserve requirements generally increase as projected demand requirements
decrease due to market conditions, technological and product life cycle changes
as well as longer than previously expected usage periods. The Company has
experienced significant changes in required reserves in recent periods due to
changes in strategic direction, such as discontinuances of product lines as
well as declining market conditions. It is possible that significant changes
in required inventory reserves may continue to occur in the future if there is
a further decline in market conditions. Long-Lived Assets:Property and Equipment and other long-lived assets are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount may not be recoverable. Such determination is made in
accordance with the applicable GAAP requirements 24




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associated with the long-lived asset, and is based upon, among other things,
estimates of the amount of future net cash flows to be generated by the
long-lived asset and estimates of the current fair value of the asset. Adverse
changes in such estimates could result in an inability to recover the carrying
value of the long-lived asset, thereby possibly requiring an impairment charge
to be recognized in the future. All impairments are recognized in operating
results when a permanent reduction in value occurs. Tax Assessments:The Company is periodically engaged in various tax audits by
federal and state governmental authorities incidental to its business
activities. The Company records reserves for its estimated probable losses of
these proceedings if applicable. Deferred Taxes:The Company records a valuation allowance to reduce its
deferred income tax assets to the amount that is believed to be realizable
under the guidance of Statement of Financial Accounting Standards No. 109
Accounting for Income Taxes. The Company considers recent historical losses,
future taxable income and ongoing prudent and feasible tax planning strategies
in assessing the need for a valuation allowance. Management is required to
make a continuous assessment as to the realizability of the deferred tax
assets. CONSOLIDATED STATEMENT OF OPERATIONS AS A PERCENTAGE OF REVENUE Year ended December 31,2003
    
    2002
    
    2001Revenue
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of sales
    
    
    48.0
    %
    
    
    61.0
    %
    
    
    68.7
    %Gross margin
    
    
    52.0
    %
    
    
    39.0
    %
    
    
    31.3
    %Research and development
    
    
    23.8
    %
    
    
    27.9
    %
    
    
    27.0
    %Sales and marketing
    
    
    21.3
    %
    
    
    23.8
    %
    
    
    23.7
    %General and administrative
    
    
    10.9
    %
    
    
    13.1
    %
    
    
    13.0
    %Restructuring costs and other special charges
    
    
    
    
    
    
    
    
    
    
    7.3
    %Goodwill impairment charge
    
    
    
    
    
    
    
    
    
    
    8.2
    %Loss from operations
    
    
    (4.0
    )%
    
    
    (25.8
    )%
    
    
    (47.9
    )%Interest income, net
    
    
    0.7
    %
    
    
    2.0
    %
    
    
    1.9
    %Other income, net
    
    
    0.3
    %
    
    
    0.4
    %
    
    
    (2.0
    )%Loss before income taxes
    
    
    (3.0
    )%
    
    
    (23.4
    )%
    
    
    (48.0
    )%Income tax (benefit) provision
    
    
    (0.6
    )%
    
    
    10.0
    %
    
    
    (14.7
    )%Net loss
    
    
    (2.4
    )%
    
    
    (33.4
    )%
    
    
    (33.3
    )%
 25




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OVERVIEW In the midst of the Companys efforts to provide the telecommunications
industry with the same high-performance and reliability that Interphase had
traditionally delivered in enterprise network environments, the global
telecommunications and computer networking industries, as a whole,
significantly deteriorated in fiscal year 2001 and continued to decline through
2002 and much of 2003. The Companys revenue and profitability were adversely
impacted due to these market conditions as its target customers delayed or
canceled projects while reducing resource levels through downsizing and
layoffs. In the longer term, we believe that these actions will enhance our
ability to sell these customers our solutions. Over the past three years, we have worked closely with our customers to
consider their needs and position our current and future product and services
offerings. We have also continued to manage our overall cost structure to keep
our quarterly break even point at a low level. This effort enabled us to grow
revenue in 2003 to its highest level since 2000 while reducing operating costs
as a percentage of revenue. We expect to be able to continue this trend in
2004 as it appears that the most difficult market conditions are behind us and
our customers begin to move their programs into production stages. Our gross
margin has improved in each of the three years due to lower excess and obsolete
inventory charges, improved product mix, improved manufacturing efficiencies
and reductions in manufacturing overhead and material costs. During the second
half of 2003 the Company recorded its first and second profitable quarter since
2000. We expect this trend to continue, and to reach profitability for the
full year of 2004. RESULTS OF OPERATIONS Revenue:Total revenue for the years ended December 31, 2003, 2002 and 2001
were $32.5 million, $25.1 million and $28.7 million, respectively. Revenue increased 29% in 2003 compared to 2002. The increase was primarily
attributable to broadband telecom and SlotOptimizer product revenue. Broadband
telecom revenue increased approximately 51% to $17.8 million for the year ended
December 31, 2003 compared to $11.8 million for the year ended December 31,
2002. In addition, SlotOptimizer revenue increased approximately 33% to $11.4
million for the year ended December 31, 2003 compared to $8.6 million for the
year ended December 31, 2002. The increase in revenue related to these product
lines was partially offset by the continued decrease in revenue related to
legacy networking and storage product lines, which decreased approximately 72%
to $1.0 million for the year ended December 31, 2003, compared to $3.7 million
for the year ended December 31, 2002. The Company believes that if the
telecommunications industry continues to stabilize, it will continue to
experience growth in revenue. However, this growth will continue to be
impacted by decreased sales related to legacy networking and storage product
lines. Revenues decreased 13% in 2002 compared to 2001. Among other factors such as
the expected decline of revenues from legacy and storage products as the
Company concentrated its sales efforts on its next-generation solutions, the
reduction in revenues was primarily due to the continued telecommunications and
computer networking market downturn. This downturn has resulted in 26




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reduced equipment purchasing and delayed or cancelled programs in various
existing customers and targeted accounts. Legacy technology revenues decreased
from $8.8 million for the year ended December 31, 2001 to $2.2 million for the
year ended December 31, 2002. In addition to the decrease in legacy
technologies, revenues from Fibre Channel products decreased from $5.9 million
for the year ended December 31, 2001 to $1.5 million for the year ended
December 31, 2002. The decrease in legacy and Fibre Channel revenues was
partially offset by revenue growth in combo and telecom technologies. Combo
product revenues increased to $8.6 million for the year ended December 31, 2002
from $6.8 million for the year ended December 31, 2001. Telecom technology
revenues increased to $11.8 million for the year ended December 31, 2002 from
$6.4 million for the year ended December 31, 2001. Gross Margin:Gross margin as a percentage of sales for the years ended
December 31, 2003, 2002 and 2001 was 52%, 39% and 31%, respectively. The
increase in the gross margin percentage in 2003 compared to 2002 is partially
due to a continued shift in product mix toward higher margin products. In
addition, the Companys excess and obsolete inventory charges decreased to
$700,000 for the year ended December 31, 2003, compared to $1.8 million for the
year ended December 31, 2002. The Company also improved manufacturing
efficiencies and achieved reductions in material costs for certain product
lines due to increased production volumes and lower overall overhead costs. The increase in the gross margin percentage in 2002 compared to 2001 primarily
relates to an excess and obsolete inventory charge of $4.4 million incurred
during the second quarter 2001 compared to an excess and obsolete inventory
charge of $1.1 million incurred during the second quarter 2002. Gross margin
as a percentage of revenues, before considering these excess and obsolete
inventory charges, was 43% and 47% for the years ended December 31, 2002 and
2001, respectively. For the five-year period prior to 2001, the Companys annual gross margin rates
were between 47% and 53%. A large part of the deterioration in margin during
2002 and 2001 was due to significant excess and obsolete inventory charges
incurred as a result of an accelerated decline of legacy and storage revenues.
It is difficult to predict our future margins based on the current economic and
political environment and the condition of the telecommunications and computer
industries, however, over the past year we have focused on design cost
improvements, manufacturing costs and purchasing practices that we expect will
enable us to remain price competitive and keep margin rates at levels in line
with our pre-2001 trends if current forecasts are realized. Research and Development:The Companys investment in the development of new
products through research and development was $7.7 million, $7.0 million and
$7.8 million in 2003, 2002 and 2001, respectively. As a percentage of revenue,
research and development expenses were 24%, 28% and 27% for 2003, 2002 and
2001, respectively. We anticipate that spending on research and development
will continue to increase in the future as we continue 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. 27




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Research and development expenses increased $714,000 in 2003 compared to 2002.
Approximately 78% of the increase in research and development expenses year
over year is due to foreign currency changes as the dollar dropped
significantly in value relative to the Euro (see Item 7A  Foreign Currency
Risk). The remaining portion of the increase is primarily due to an increase
in the development of new Broadband telecom products. 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 costs for the year. Research and development expenses decreased $752,000 in 2002 compared to 2001.
Approximately 69% of the decrease in research and development expenses was due
to a reduction in headcount associated with the Companys restructuring program
and other cost reduction initiatives implemented at the end of the second
quarter 2001. The remaining portion of the decrease primarily related to the
decreased spending on legacy sustaining engineering, partially offset by an
increase in telecommunications development spending. Research and development
expenses as a percentage of sales increased slightly during the period due to
the decrease in revenues. Sales and Marketing:Sales and marketing expenses were $6.9 million, $6.0
million and $6.8 million in 2003, 2002 and 2001, respectively. As a percentage
of revenue, sales and marketing expenses were 21%, 24% and 24% for 2003, 2002
and 2001, respectively. Sales and marketing expense increased $938,000 in 2003 compared to 2002.
Approximately 66% of the increase in sales and marketing year over year is due
to higher sales commissions and bonuses due to higher revenue levels and other
headcount related expenses in the sales organization. Additionally,
approximately 23% of the increase in sales and marketing expense relates to
higher marketing expenditures, including headcount. The remaining portion of
the increase is due to increased travel and related expenses. The decrease in
sales and marketing expense as a percentage of total revenue is due to revenue
increasing at a higher rate than sales and marketing expense for the year. Sales and marketing expense decreased $821,000 in 2002 compared to 2001.
Approximately 89% of the decrease was related to reductions in marketing
headcount and activities associated with the Companys restructuring program
and other cost reduction initiatives implemented at the end of the second
quarter 2001. The remaining portion of the decrease is primarily related to
other cost reduction initiatives within the sales organization. General and Administrative:General and administrative expenses were $3.5
million, $3.3 million and $3.8 million in 2003, 2002 and 2001, respectively.
As a percentage of revenue, general and administrative expenses were 11%, 13%
and 13% for 2003, 2002 and 2001, respectively. General and administrative expenses increased $262,000 in 2003 compared to
2002. Approximately 84% of the increase in general and administrative expenses
year over year is due to an increase in insurance premiums and other legal and
accounting related expenses. The remaining portion of the increase is due to
headcount related expenses partially offset by reductions in corporate spending
related to the change in facilities in November of 2002. The decrease as a 28




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percentage of total revenue is due to revenue for the period increasing at a
higher rate than general and administrative expenses. General and administrative expenses decreased $474,000 in 2002 compared to
2001. Approximately 63% of the reduction is due to decreases in legal and
accounting expenditures. The remaining portion of the decrease is primarily the
result of the Companys restructuring program and other cost reduction
initiatives implemented at the end of the second quarter 2001. Restructuring Costs and Other Special Charges:In the second quarter 2001, the
Company announced a restructuring program designed to allow the Company to
continue aggressive funding of its development organizations, while preserving
cash levels and securing new design-ins. As a result of the restructuring
program, continued decline in predicted revenue and customers cautious
expectations regarding market recovery, the Company recorded restructuring
costs and other special charges of $2.1 million, classified as operating
expenses, and an additional excess and obsolete inventory charge of $4.4
million, classified as cost of sales. The restructuring program resulted in the reduction of approximately 22% of the
Companys workforce, impacting all business functions in North America. As a
result, the Company recorded a workforce reduction charge of $483,000 relating
to severance and fringe benefits. In addition, the Company wrote off $123,000
of nonutilized fixed assets. Due to the decline in business conditions, decline in legacy product revenues
and the diminished expected future benefits from the purchased intangibles
related to the acquisition of Synaptel, S.A. in 1996, the Company recorded a
charge of $1.5 million related to the impairment of developed technology and
assembled workforce during the second quarter 2001. These intangible assets,
purchased in the acquisition of Synaptel, S.A., relate to the Companys legacy
product lines. In the second quarter 2000, the Company developed a strategy to
end-of-life many of its legacy products in an effort to focus its resources on
its new product lines. This strategy resulted in increased sales of legacy
products in 2000, as many customers placed last time buy orders; however,
legacy product revenues declined in the first quarter of 2001, and continued to
decline through the end of 2003. Management does not expect significant
revenues from its legacy product lines in future periods. Goodwill Impairment Charge:All of the Companys goodwill was associated with
the entire Company rather than any specific identifiable asset or product line.
Each quarter, during which goodwill was carried on the Companys books, the
Company evaluated whether an impairment of the enterprise goodwill may exist by
comparing the book value of its common stock to the product of (i) the number
of shares of common stock issued and outstanding at the end of the quarter and
(ii) the market price of the common stock at the end of the quarter. If the
product of shares and market price exceeds the book value, impairment does not
exist. If the product of shares and market price is less than book value, the
Company evaluates whether the condition is other than temporary based (i)
primarily on whether fluctuations in the Companys stock price subsequent to
the quarter-end result in a product of shares and market price that exceeds
book value and (ii) on all other available evidence. If the product of shares
and market price is continuously less than book value based on daily closing
market prices for the prior six months, the Company evaluates whether the 29




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condition is other than temporary considering all other available evidence. If
the Company determines the condition is other than temporary, additional
amortization is recorded for the impairment, equal to the excess book value at
the end of the quarter. The Company recorded an impairment charge, at the end of the fourth quarter
2001 by writing-off the remaining $2.4 million of goodwill. At December 31,
2001, the Company had 5.5 million common shares issued and outstanding with a
book value of $33.5 million. The common stock price at December 31, 2001 was
$5.44, resulting in a market capitalization of $30 million. The Companys
market capitalization had consistently been less than book value since June 30,
2001, and continued to remain below book value after year-end 2001. As a
result of the Companys market capitalization continuously remaining below book
value for a period of greater than six months and the uncertainty related to
the timing of a technology sector market recovery, the Company, following its
stated policy, recorded the impairment charge of $2.4 million at the end of the
fourth quarter 2001. Interest, Net:Interest income, net of interest expense, was $226,000,
$517,000 and $554,000 in 2003, 2002 and 2001, respectively. The decrease in
interest income, net of interest expense in 2003 compared to 2002 is primarily
due to lower cash levels during 2003 as well as lower investment rates of
return. The decrease in interest income, net of interest expense in 2002 compared to
2001 primarily relates to lower investment rates of return. Other Income (Expense), Net:Other income (expense), net, was $79,000, $94,000
and ($574,000) in 2003, 2002 and 2001, respectively. Other income, net was $94,000 in 2002 compared to other (expense), net of
($574,000) in 2001. Other (expense), net in 2001 included charges for the
amortization of goodwill of $240,000 and purchased intangibles of $330,000. As
the carrying value of the Companys goodwill and purchased intangibles exceeded
its fair value, the Company wrote off the carrying amount of its goodwill in
the fourth quarter of 2001 and its purchased intangibles in the second quarter
of 2001. In addition to the elimination of amortization expense related to
goodwill and purchased intangibles during the third quarter 2001, the Company
recorded a charge of $334,000 due to the other than temporary impairment of
certain marketable securities received in the sale of the Companys VOIP
business. These expenses were partially offset by proceeds received in the
first quarter of 2001 related to the settlement of a lawsuit for approximately
$130,000. Income Taxes:The Companys effective income tax rates were (22%) in 2003, 43%
in 2002 and (31%) in 2001. The Company continues to provide a full valuation allowance for its net
deferred tax assets at December 31, 2003. During the third quarter 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 30




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audits, the Company recognized a benefit of approximately $245,000 during the
year ended December 31, 2003. This benefit was partially offset by taxes on
foreign income. The effective tax provision rate for 2002 was significantly more than the U.S.
statutory rate due to a non-cash charge of approximately $4.9 million to
provide a full valuation allowance for the net deferred tax assets at December
31, 2002. The effective tax benefit rate excluding this charge would have been
(40%), which differed from the U.S. statutory rate primarily due to the benefit
of a foreign tax loss carry forward. The foreign tax loss carry forward
expired at December 31, 2002. Net Loss:The Company reported a net loss of $769,000 in 2003, $8.4 million in
2002, and $9.6 million in 2001. LIQUIDITY AND CAPITAL RESOURCES Consolidated Cash Flows Cash and cash equivalents increased $4.3 million for the year ended December
31, 2003, decreased $558,000 for the year ended December 31, 2002 and decreased
$172,000 for the year ended December 31, 2001. Cash flows are impacted by
operating, investing and financing activities. Operating Activities:Trends in cash flows from operating activities for 2003,
2002 and 2001, are generally similar to the trends in the Companys earnings
except for noncash realized holding period loss on marketable securities,
provision for uncollectible accounts and returns, provision for excess and
obsolete inventory, depreciation and amortization, deferred income taxes, tax
benefit from stock option exercises, noncash restructuring costs and other
special charges and goodwill impairment charge. Cash provided by operating
activities totaled $732,000, $1.9 million and $4.8 million for the years ended
December 31, 2003, 2002 and 2001, respectively, compared to net loss of
$769,000, $8.4 million and $9.6 million in 2003, 2002 and 2001, respectively.
The Company incurred noncash realized holding period losses on marketable
securities in 2002 and 2001 related to the other than temporary impairment of
certain marketable securities received in the sale of the Companys VOIP
business. Provisions for uncollectible accounts and returns decreased during
all three years due to the reduction in accounts receivable, an increased focus
on credit evaluation and improved returns experience. Provision for excess and
obsolete inventory has decreased in 2003 as the Companys inventory turns
continue to improve. Depreciation and amortization increased slightly in 2003.
Depreciation and amortization decreased in 2002 due to the write-offs of the
Companys goodwill and other intangible assets in 2001 (See Notes 3 and 4).
Deferred income taxes decreased in 2002, due to the establishment of a full
valuation allowance for the Companys deferred tax assets (See Note 8). The
Companys tax benefit from stock option exercises increased in 2003 due to the
increase in stock option exercises as a result of the Companys increased stock
price during the second half of 2003. The Company incurred significant noncash
restructuring costs and other special charges and a goodwill impairment charge
in 2001 (See Notes 2 and 3). Changes in assets and liabilities result primarily from the timing of
production, sales and purchases. 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. 31




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Investing Activities:The Companys investing activities resulted in a net
cash use of $484,000 and $1.8 million in 2003 and 2002, respectively and a net
cash increase of $1 million in 2001. Cash flows from investing activities in
each of the three years related principally to additions to property,
equipment, capitalized software and leasehold improvements and the Companys
investments in marketable securities. Additions to property, equipment,
capitalized software and leasehold improvements in each of the three years
focused on the manufacturing, sales and engineering functions of the Company.
The expenditures in 2003 related primarily to manufacturing equipment and
capitalized software used in the engineering and sales functions. Expenditures
in 2002 related primarily to leasehold improvements made to the Companys new
corporate offices and manufacturing facility and to the purchase of new
manufacturing equipment which utilizes new technologies and increases
automation of the manufacturing process to provide improved productivity and
efficiency. Expenditures in 2001 related primarily to general equipment
upgrades and modernization. Financing Activities:Net cash provided by financing activities totaled $4.0
million for the year ended December 31, 2003. Net cash used by financing
activities totaled $783,000 and $5.9 million for the years ended December 31,
2002 and 2001, respectively. Cash provided by financing activities in 2003
includes the removal of $3.5 million of restrictions on cash in 2003 (See Note
7) and $584,000 in proceeds from the exercise of stock options due to the
increase in stock option exercises as a result of the Companys increased stock
price during the second half of 2003. Cash used from financing activities in
2001 includes restrictions placed on $3.5 million of cash related to borrowings
under the Companys prior credit facility, the purchase of redeemable common
stock of approximately $1.0 million and payments on debt of approximately $1.7
million partially offset by proceeds from the exercise of stock options of
approximately $328,000. Commitments and Contingencies At December 31, 2003, the Company had no material commitments to purchase
capital assets, however, planned capital expenditures for 2004 are estimated at
approximately $1 million, the majority of which relate to the Companys
engineering tools and general office equipment. The Companys significant
long-term obligations are its operating leases on its facilities and future
debt payments. The Company has not paid any dividends since its inception and
does not anticipate paying any dividends in 2004. 32




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The following table summarizes the Companys future contractual obligations and
payment commitments as of December 31, 2003: ContractualObligations
    
    2004
    
    2005
    
    2006
    
    Thereafter
    
    TotalOperating leases (1)
    
    $
    861
    
    
    $
    653
    
    
    $
    29
    
    
    $
    
    
    
    $
    1,543Long-term debt (2)
    
    
    
    
    
    
    3,500
    
    
    
    
    
    
    
    
    
    
    
    3,500Total
    
    $
    861
    
    
    $
    4,153
    
    
    $
    29
    
    
    $
    
    
    
    $
    5,043
  (1)
    
    The Company leases its facilities under noncancelable
operating leases with the longest terms extending to December
2006.  (2)
    
    At December 31, 2003, the Company had borrowings of
$3.5 million under a $5 million revolving credit facility with a
bank. The revolving credit facility matures on July 30, 2005 and
is secured throughout the term of the credit facility by
marketable securities. Other Management believes that cash generated from operations and borrowing
availability under the revolving credit facility, together with cash on hand,
will be sufficient to meet the Companys liquidity needs for working capital,
capital expenditures and debt service. To the extent that the Companys actual
operating results or other developments differ from the Companys expectations,
Interphases liquidity could be adversely affected. The Company periodically evaluates its liquidity requirements, alternative uses
of capital, capital needs and available resources in view of, among other
things, its capital expenditure requirements, and estimated future operating
cash flows. As a result of this process, the Company has in the past and may
in the future seek to raise additional capital, refinance or restructure
indebtedness, issue additional securities, repurchase shares of its common
stock or take a combination of such steps to manage its liquidity and capital
resources. In the normal course of business, the Company may review
opportunities for acquisitions, joint ventures or other business combinations
in the component products industry. In the event of any such transaction, the
Company may consider using available cash, issuing additional equity securities
or increasing the indebtedness of the Company or its subsidiaries. Recently Issued Accounting Pronouncements EITF Issue 00-21, Accounting for Revenue Arrangements with Multiple
Deliverables, addresses the accounting treatment for an arrangement to provide
the delivery or performance of multiple products and/or services where the
delivery of a product or system or performance of services may occur at
different points in time or over different periods of time. The arrangements
are often accompanied by initial installation, initiation, or activation
services and involve either a fixed fee or a fixed fee coupled with a
continuing payment stream, which may be fixed or variable. The EITF reached
conclusions regarding, among other issues, the applicability of the provisions
regarding separation of contract elements in EITF Issue 00-21 to contracts
where one or more elements fall 33




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##### Table of Contents



within the scope of other authoritative literature, such as SOP 81-1. The
proposed EITF does not impact the use of SOP 81-1 for contracts that fall
within the scope of SOP 81-1, such as for implementation or building of an
information technology system or product to client specifications for a client
under a long-term contract. Where an implementation or development project is
contracted with a client, and the vendor will also provide services or operate
the system over a period of time, EITF Issue 00-21 provides the methodology for
separating the contract elements and earnings processes. The provisions of
EITF Issue 00-21 are applicable on a prospective basis to transactions entered
into in fiscal periods beginning after June 15, 2003. The impact on our future
results of operations and financial position depends on the terms and
conditions of contracts, if any, which include elements of the EITF entered
into or modified in the future. 
 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE 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 a charge of
approximately $595,000 for the year ended December 31, 2003, compared to a
benefit of $255,000 for the year ended December 31, 2002. Market Price Risk In 2002 and 2001, the Company maintained a minority equity investment in a
publicly traded company and recorded a net after tax loss on this investment in
those years of $20,000 and $334,000, respectively. The Company has no equity
hedge contracts outstanding as of December 31, 2003 or December 31, 2002. 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. 34




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##### Table of Contents



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Item 15 (a) below. 
  ITEM 9.
    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE None. 
 ITEM 9A. CONTROLS AND PROCEDURES 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 annual report.
Based on that evaluation, the CEO and CFO concluded that the Companys
disclosure controls and procedures are effective. 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 III 
 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Directors See information regarding the directors and nominees for director under the
heading Election of Directors of the Proxy Statement for the Annual Meeting
of Shareholders to be held May 5, 2004, which is incorporated herein by
reference. Executive Officers See information regarding the executive officers under the heading Executive
Officers of the Proxy Statement for the Annual Meeting of Shareholders to be
held May 5, 2004, which is incorporated herein by reference. 35




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##### Table of Contents



Code of Ethics The Company has adopted a Code of Business Conduct, which applies to all of its
employees, including its Chairman and Chief Executive Officer, its Chief
Financial Officer and its Controller. The Code of Ethics is available on the
Companys website at www.interphase.com. The Company intends to satisfy the
disclosure requirement under Item 10 of Form 8-K regarding an amendment to, or
waiver from, a provision of this Code of Ethics by posting such information on
its website, at the address specified above, and to the extent required by the
listing standards of the Nasdaq Stock Market, by filing a Current Report on
Form 8-K with the Securities and Exchange Commission disclosing such
information. 
 ITEM 11. EXECUTIVE COMPENSATION See information regarding executive compensation under the heading Executive
Compensation of the Proxy Statement for the Annual Meeting of Shareholders to
be held May 5, 2004, which is incorporated herein by reference. 
 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT See information regarding security ownership of certain beneficial owners and
management under the headings Principal Shareholders and Executive
Compensation of the Proxy Statement for the Annual Meeting of Shareholders to
be held May 5, 2004, which is incorporated herein by reference. 
 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS See information regarding certain relationships and related transactions under
the headings Principal Shareholders and Certain Related Transactions of the
Proxy Statement for the Annual Meeting of Shareholders to be held May 5, 2004,
which is incorporated herein by reference. 
 ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES See information regarding principal accountant fees and services under the
heading Relationship with Independent Public Accountants of the Proxy
Statement for the Annual Meeting of Shareholders to be held May 5, 2004, which
is incorporated herein by reference. 36




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##### Table of Contents



ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K  (a)
    
    (i) and (ii) Financial Statements and Schedules. Reference is made to the listing on page F-1 of all financial statements and
schedules filed as a part of this report.  (iii) Exhibits. Reference is made to the Index to Exhibits on page E-1 for a list of all
exhibits filed during the period covered by this report.  (b)
    
    Reports on Form 8-K. The Registrant has filed no Reports on Form 8-K during the quarter ended
December 31, 2003. 37




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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 CORPORATIONDate: March 23, 2004
    By:
    /s/ Gregory B.
KalushGregory B. KalushChairman of the Board,     
Chief  Executive Officer and President Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated on March 23, 2004. Name
    
    Title/s/ Gregory B. Kalush

Gregory B. Kalush
    
    Chairman of the Board,
Chief Executive Officer and President
(Principal executive officer)/s/ Steven P. Kovac
Steven P. Kovac
    
    Chief Financial Officer, Treasurer and
Vice President of Finance
(Principal financial officer)/s/ Paul N. Hug

Paul N. Hug
    
    
    
    Director/s/ Randall D. Ledford

Randall D. Ledford
    
    
    
    Director/s/ Michael J. Myers

Michael J. Myers
    
    
    
    Director/s/ David H. Segrest

David H. Segrest
    
    
    
    Director/s/ Kenneth V. Spenser

Kenneth V. Spenser
    
    
    
    Director/s/ S. Thomas Thawley

S. Thomas Thawley
    
    
    
    Vice Chairman, Director
and Secretary
 38




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##### Table of Contents



INDEX TO FINANCIAL STATEMENTS Report of Independent Auditors -
PricewaterhouseCoopers LLP
    
    
    F-2Report of Independent Public Accountants -
Arthur Andersen LLP
    
    
    F-3Consolidated Balance Sheets  As of December 31, 2003 and 2002
    
    
    F-4Consolidated
Statements of Operations - Years Ended
December 31, 2003, 2002 and 2001
    
    
    F-5Consolidated
Statements of Shareholders Equity - Years Ended
December 31, 2003, 2002 and 2001
    
    
    F-6Consolidated
Statements of Cash Flows -  Years Ended December 31, 2003, 2002 and 2001
    
    
    F-7Notes to Consolidated Financial Statements
    
    F-8 to F-26
 * All schedules are omitted because they are not applicable or the required
information is presented in the consolidated financial statements or notes
thereto. F-1




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##### Table of Contents



REPORT OF INDEPENDENT AUDITORS To the Board of Directors and Shareholders of Interphase Corporation: In our opinion, the accompanying consolidated balance sheets as of December 31,
2003 and 2002 and the related consolidated statements of operations, of
shareholders equity, and of cash flows present fairly, in all material
respects, the financial position of Interphase Corporation and its subsidiaries
(the Company) at December 31, 2003 and 2002, and the results of their
operations and their cash flows for the years then ended in conformity with
accounting principles generally accepted in the United States of America. These
financial statements are the responsibility of the Companys management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with
auditing standards generally accepted in the United States of America, which
require that we plan and perform the audits to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion. The Companys consolidated financial
statements as of December 31, 2001, and for the period ended December 31, 2001,
prior to the revisions described in Note 15 to the consolidated financial
statements, were audited by other independent accountants who have ceased
operations. Those independent accountants expressed an unqualified opinion on
those financial statements in their report dated February 6, 2002. As discussed above, the Companys consolidated financial statements as of
December 31, 2001, and for the period ended December 31, 2001, were audited by
other independent accountants who have ceased operations. As described in Note
15, those financial statements have been revised to include the transitional
disclosures required by Statement of Financial Accounting Standards No. 142,
Goodwill and Other Intangible Assets, which was adopted by the Company as of
January 1, 2002. We audited the transitional disclosures for 2001 included in
Note 15. In our opinion, the transitional disclosures for 2001 in Note 15 are
appropriate. However, we were not engaged to audit, review, or apply any
procedures to the 2001 financial statements of the Company other than with
respect to such disclosures and, accordingly, we do not express an opinion or
any other form of assurance on the 2001 financial statements taken as a whole.  /s/ PricewaterhouseCoopers LLPDallas, Texas
March 5, 2004 F-2




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##### Table of Contents



REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS The following report is a copy of a report previously issued by Arthur Andersen
LLP and has not been reissued by Arthur Andersen LLP. As discussed in Note 15,
the Company has presented the transitional disclosures for 2001 required by in
the Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets (SFAS No.142). The Arthur Andersen LLP report does not
extend to these changes to the 2001 consolidated financial statements. The
adjustments to the 2001 consolidated financial statements were reported on by
PricewaterhouseCoopers LLP as stated in their report appearing herein. To the Shareholders and Board of Directors of Interphase Corporation: We have audited the accompanying consolidated balance sheets of Interphase
Corporation, a Texas corporation, and subsidiaries as of December 31, 2001* and
2000*, and the related consolidated statements of operations, shareholders
equity, and cash flows for each of the three years in the period ended December
31, 2001*. These consolidated financial statements are the responsibility of
the Companys management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the consolidated
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the consolidated financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as
well as evaluating the overall consolidated financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Interphase
Corporation and subsidiaries as of December 31, 2001* and 2000*, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2001*, in conformity with accounting principles
generally accepted in the United States.  /s/ ARTHUR ANDERSEN LLPArthur Andersen LLPDallas, Texas
February 6, 2002 * The 2001 and 2000 consolidated balance sheets and the 2000 and 1999
consolidated statement of operations and cash flows are not presented in the
2003 annual report. F-3




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##### Table of Contents



INTERPHASE CORPORATIONCONSOLIDATED BALANCE SHEETS
(in thousands, except number of shares data) December 31,2003
    
    2002ASSETSCash and cash equivalents
    
    $
    14,204
    
    
    $
    9,857Marketable securities
    
    
    5,047
    
    
    
    5,518Restricted cash
    
    
    
    
    
    
    3,500Trade accounts receivable, less allowances for uncollectible
accounts and returns of $194 and $230, respectively
    
    
    5,634
    
    
    
    5,683Inventories
    
    
    2,961
    
    
    
    3,121Prepaid expenses and other current assets
    
    
    751
    
    
    
    674Income taxes receivable
    
    
    
    
    
    
    247Total current assets
    
    
    28,597
    
    
    
    28,600Machinery and equipment
    
    
    5,626
    
    
    
    5,731Leasehold improvements
    
    
    392
    
    
    
    380Furniture and fixtures
    
    
    560
    
    
    
    5496,578
    
    
    
    6,660Less-accumulated depreciation and amortization
    
    
    (5,018
    )
    
    
    (4,921
    )Total property and equipment, net
    
    
    1,560
    
    
    
    1,739Capitalized software, net
    
    
    355
    
    
    
    199Other assets
    
    
    231
    
    
    
    211Total assets
    
    $
    30,743
    
    
    $
    30,749LIABILITIES AND SHAREHOLDERS EQUITYLiabilitiesAccounts payable
    
    $
    1,106
    
    
    $
    1,437Deferred revenue
    
    
    373
    
    
    
    595Accrued liabilities
    
    
    1,684
    
    
    
    1,291Accrued compensation
    
    
    1,179
    
    
    
    1,023Total current liabilities
    
    
    4,342
    
    
    
    4,346Deferred lease obligations
    
    
    88
    
    
    
    85Long-term debt
    
    
    3,500
    
    
    
    3,500Total liabilities
    
    
    7,930
    
    
    
    7,931Shareholders EquityCommon stock, $.10 par value; 100,000,000 shares authorized;
5,680,179 and 5,514,276 shares issued and outstanding, respectively
    
    
    568
    
    
    
    551Additional paid in capital
    
    
    38,218
    
    
    
    37,304Retained deficit
    
    
    (15,564
    )
    
    
    (14,795
    )Cumulative other comprehensive loss
    
    
    (409
    )
    
    
    (242
    )Total shareholders equity
    
    
    22,813
    
    
    
    22,818Total liabilities and shareholders equity
    
    $
    30,743
    
    
    $
    30,749
 The accompanying notes are an integral part of these consolidated financial statements. F-4




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##### Table of Contents



INTERPHASE CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts) Years ended December 31,2003
    
    2002
    
    2001Revenue
    
    $
    32,490
    
    
    $
    25,123
    
    
    $
    28,732Cost of sales
    
    
    15,581
    
    
    
    15,331
    
    
    
    19,728Gross margin
    
    
    16,909
    
    
    
    9,792
    
    
    
    9,004Research and development
    
    
    7,719
    
    
    
    7,005
    
    
    
    7,757Sales and marketing
    
    
    6,929
    
    
    
    5,991
    
    
    
    6,812General and administrative
    
    
    3,547
    
    
    
    3,285
    
    
    
    3,759Restructuring costs and other special charges
    
    
    
    
    
    
    
    
    
    
    2,091Goodwill impairment charge
    
    
    
    
    
    
    
    
    
    
    2,350Total operating expenses
    
    
    18,195
    
    
    
    16,281
    
    
    
    22,769Loss from operations
    
    
    (1,286
    )
    
    
    (6,489
    )
    
    
    (13,765
    )Interest income, net
    
    
    226
    
    
    
    517
    
    
    
    554Other income, net
    
    
    79
    
    
    
    94
    
    
    
    (574
    )Loss before income taxes
    
    
    (981
    )
    
    
    (5,878
    )
    
    
    (13,785
    )Income tax (benefit) provision
    
    
    (212
    )
    
    
    2,523
    
    
    
    (4,213
    )Net loss
    
    $
    (769
    )
    
    $
    (8,401
    )
    
    $
    (9,572
    )Net loss per share:Basic EPS
    
    $
    (0.14
    )
    
    $
    (1.51
    )
    
    $
    (1.68
    )Diluted EPS
    
    $
    (0.14
    )
    
    $
    (1.51
    )
    
    $
    (1.68
    )Weighted average common shares
    
    
    5,544
    
    
    
    5,551
    
    
    
    5,705Weighted average common and dilutive shares
    
    
    5,544
    
    
    
    5,551
    
    
    
    5,705
 The accompanying notes are an integral part of these consolidated financial statements. F-5




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##### Table of Contents



INTERPHASE CORPORATIONCONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
(in thousands) Common Stock
    
    AdditionalPaid in
    
    RetainedEarnings
    
    CumulativeOtherComprehensive
    
    
    
    
    
    ComprehensiveShares
    
    Amount
    
    Capital
    
    (Deficit)
    
    Income (Loss)
    
    Total
    
    Income (Loss)Balance at December 31, 2000
    
    
    5,481
    
    
    $
    548
    
    
    $
    36,805
    
    
    $
    3,178
    
    
    $
    (372
    )
    
    $
    40,159Option exercises, including related tax benefit
    
    
    38
    
    
    
    4
    
    
    
    523
    
    
    
    
    
    
    
    
    
    
    
    527
    
    
    $
    Stock repurchase
    
    
    (1
    )
    
    
    
    
    
    
    (4
    )
    
    
    
    
    
    
    
    
    
    
    (4
    )Comprehensive income:Foreign currency translation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (120
    )
    
    
    (120
    )
    
    
    (120
    )Unrealized holding period gain, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    168
    
    
    
    168
    
    
    
    168Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (9,572
    )
    
    
    
    
    
    
    (9,572
    )
    
    
    (9,572
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (9,524
    )Balance at December 31, 2001
    
    
    5,518
    
    
    $
    552
    
    
    $
    37,324
    
    
    $
    (6,394
    )
    
    $
    (324
    )
    
    $
    31,158Stock repurchase
    
    
    (4
    )
    
    
    (1
    )
    
    
    (20
    )
    
    
    
    
    
    
    
    
    
    
    (21
    )Comprehensive loss:Foreign currency translation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    32
    
    
    
    32
    
    
    
    32Unrealized holding period gain, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    50
    
    
    
    50
    
    
    
    50Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (8,401
    )
    
    
    
    
    
    
    (8,401
    )
    
    
    (8,401
    )Total comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (8,319
    )Balance at December 31, 2002
    
    
    5,514
    
    
    $
    551
    
    
    $
    37,304
    
    
    $
    (14,795
    )
    
    $
    (242
    )
    
    $
    22,818Option exercises, including related tax benefit
    
    
    166
    
    
    
    17
    
    
    
    914
    
    
    
    
    
    
    
    
    
    
    
    931
    
    
    $
    Comprehensive loss:Foreign currency translation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (46
    )
    
    
    (46
    )
    
    
    (46
    )Unrealized holding period loss, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (121
    )
    
    
    (121
    )
    
    
    (121
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (769
    )
    
    
    
    
    
    
    (769
    )
    
    
    (769
    )Total comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (936
    )Balance at December 31, 2003
    
    
    5,680
    
    
    $
    568
    
    
    $
    38,218
    
    
    $
    (15,564
    )
    
    $
    (409
    )
    
    $
    22,813
 The accompanying notes are an integral part of these consolidated financial statements. F-6




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##### Table of Contents



INTERPHASE CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands) Years ended December 31,2003
    
    2002
    
    2001Cash flows from operating activities:Net loss
    
    $
    (769
    )
    
    $
    (8,401
    )
    
    $
    (9,572
    )Adjustments to reconcile net loss to net cash (used in) provided by operating activities:Noncash realized holding period loss on marketable securities
    
    
    
    
    
    
    20
    
    
    
    334Provision for uncollectible accounts and returns
    
    
    (42
    )
    
    
    (77
    )
    
    
    (60
    )Provision for excess and obsolete inventory
    
    
    700
    
    
    
    1,849
    
    
    
    700Depreciation and amortization
    
    
    902
    
    
    
    845
    
    
    
    1,846Deferred income taxes
    
    
    
    
    
    
    4,009
    
    
    
    (2,019
    )Tax benefit from stock option exercises
    
    
    347
    
    
    
    
    
    
    
    199Noncash restructuring costs and other special charges
    
    
    
    
    
    
    
    
    
    
    6,002Goodwill impairment charge
    
    
    
    
    
    
    
    
    
    
    2,350Change in assets and liabilities:Trade accounts receivable
    
    
    91
    
    
    
    (558
    )
    
    
    9,097Inventories
    
    
    (540
    )
    
    
    1,685
    
    
    
    1,444Prepaid expenses and other current assets
    
    
    (62
    )
    
    
    (185
    )
    
    
    454Income taxes receivable
    
    
    247
    
    
    
    2,229
    
    
    
    (2,476
    )Other assets
    
    
    1
    
    
    
    (25
    )
    
    
    Accounts payable, deferred revenue and accrued liabilities
    
    
    (183
    )
    
    
    638
    
    
    
    (2,644
    )Accrued compensation
    
    
    37
    
    
    
    (252
    )
    
    
    (740
    )Deferred lease obligations
    
    
    3
    
    
    
    85
    
    
    
    Income taxes payable
    
    
    
    
    
    
    
    
    
    
    (78
    )Net adjustments
    
    
    1,501
    
    
    
    10,263
    
    
    
    14,409Net cash provided by operating activities
    
    
    732
    
    
    
    1,862
    
    
    
    4,837Cash flows from investing activities:Purchase of property and equipment
    
    
    (504
    )
    
    
    (1,448
    )
    
    
    (324
    )Purchase of capitalized software
    
    
    (329
    )
    
    
    (34
    )
    
    
    (153
    )Proceeds from the sale of marketable securities
    
    
    2,068
    
    
    
    2,219
    
    
    
    6,667Purchases of marketable securities, net of unrealized holding period gain or loss
    
    
    (1,719
    )
    
    
    (2,491
    )
    
    
    (5,163
    )Net cash (used) provided by investing activities
    
    
    (484
    )
    
    
    (1,754
    )
    
    
    1,027Cash flows from financing activities:Decrease (increase) in restricted cash
    
    
    3,500
    
    
    
    
    
    
    
    (3,500
    )Purchase of redeemable common stock
    
    
    
    
    
    
    (762
    )
    
    
    (1,018
    )Purchase of common stock
    
    
    
    
    
    
    (21
    )
    
    
    (4
    )Proceeds from the exercise of stock options
    
    
    584
    
    
    
    
    
    
    
    328Repayment of long-term debt
    
    
    (3,500
    )
    
    
    
    
    
    
    (1,683
    )Borrowings under new revolving credit facility
    
    
    3,500
    
    
    
    
    
    
    
    Net cash provided (used) by financing activities
    
    
    4,084
    
    
    
    (783
    )
    
    
    (5,877
    )Effect of exchange rate changes on cash and cash equivalents
    
    
    15
    
    
    
    117
    
    
    
    (159
    )Net increase (decrease) in cash and cash equivalents
    
    
    4,347
    
    
    
    (558
    )
    
    
    (172
    )Cash and cash equivalents at beginning of year
    
    
    9,857
    
    
    
    10,415
    
    
    
    10,587Cash and cash equivalents at end of year
    
    $
    14,204
    
    
    $
    9,857
    
    
    $
    10,415Supplemental Disclosure of Cash Flow Information:Income taxes paid
    
    $
    
    
    
    $
    22
    
    
    $
    229Interest paid
    
    $
    72
    
    
    $
    88
    
    
    $
    311
 The accompanying notes are an integral part of these consolidated financial statements. F-7




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INTERPHASE CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of the Business:Interphase Corporation and subsidiaries
(Interphase or the Company) enables rapid platform design and integration
for the global voice, video, and data communications markets through custom and
off-the-shelf communications equipment, embedded software development suites,
and systems integration and consulting services for carrier and private
networks. The Companys products provide communications computing and
connectivity of telecommunications and computer systems to Wide Area Networks
(WANs), Local Area Networks (LANs), and Storage Area Networks (SANs) using
Asynchronous Transfer Mode (ATM), Ethernet, Signaling System 7 (SS7), IP, Fibre
Channel, HDLC, Frame Relay and multi-protocol interworking technologies. See
Note 16 for information regarding the Companys revenues related to North
America and foreign countries. Principles of Consolidation and Basis of Presentation:The accompanying
consolidated financial statements include the accounts of Interphase
Corporation and its wholly owned subsidiaries. Significant intercompany
accounts and transactions have been eliminated. The Company has no involvement
with any variable interest entity covered by the scope of FASB Interpretation
(FIN) No. 46R, Consolidation of Variable Interest Entities. Cash and Cash Equivalents:The Company considers cash and temporary
investments with original maturities of less than three months, as well as
interest bearing money market accounts, to be cash equivalents. Investments:Investments in debt and equity securities are classified as
available for sale with unrealized holding gains and losses reported in other
comprehensive income. Gains and losses from securities sold are calculated
using the specific identification method. Management determines the
appropriate classification of securities at the time of purchase. Earnings
from debt securities are calculated on a yield to maturity basis and recorded
in the results of operations. Allowance for Doubtful Accounts:The Company provides an allowance for
doubtful accounts for known and potential losses arising from sales to
customers based on a periodic review of these accounts. As of December 31,
2003, 2002 and 2001, the allowance for doubtful accounts was $89,000, $30,000
and $170,000. The activity in this account was as follows (in thousands): Balance at
    
    
    
    
    
    Write-offs,
    
    BalanceBeginning
    
    Charged to
    
    Net of
    
    at EndYear Ended:
    
    of Period
    
    (Income) Expense
    
    Recoveries
    
    of PeriodDecember 31, 2003
    
    $
    30
    
    
    $
    53
    
    
    $
    6
    
    
    $
    89December 31, 2002
    
    
    170
    
    
    
    (77
    )
    
    
    (63
    )
    
    
    30December 31, 2001
    
    
    273
    
    
    
    (60
    )
    
    
    (43
    )
    
    
    170
 F-8




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##### Table of Contents



Allowance for Returns:The Company maintains an allowance for returns based on
historical returns experience. As of December 31, 2003, 2002 and 2001, the
allowance for returns was $105,000, $200,000 and $200,000 maintained as a
reduction to accounts receivable. 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): Years ended December 31,2003
    
    2002Raw Materials
    
    $
    1,907
    
    
    $
    2,325Work-in-Process
    
    
    745
    
    
    
    670Finished Goods
    
    
    309
    
    
    
    126Total
    
    $
    2,961
    
    
    $
    3,121
 Valuing inventory at the lower of cost or market involves an inherent level of
risk and uncertainty due to technology trends in the industry and customer
demand for the Companys products. Future events may cause significant
fluctuations in the Companys operating results. Property and Equipment:Property and equipment are recorded at cost.
Depreciation is provided over the estimated useful lives of depreciable assets
using the straight-line method. When property and equipment are sold or
otherwise retired, the cost and accumulated depreciation applicable to such
assets are eliminated from the accounts, and any resulting gain or loss is
reflected in current operations. Related depreciation expense was as follows
(in thousands): Year ended December 31:
    
    Depreciation Expense2003
    
    $
    7212002
    
    $
    6712001
    
    $
    1,039
 The depreciable lives of property and equipment are as follows: Machinery and equipment
    
    3-5 yearsLeasehold improvements
    
    Term of the respective leasesFurniture and fixtures
    
    3-10 years
 Capitalized Software:Capitalized software represents various software
licenses purchased by the Company and utilized in connection with the Companys
network and mass storage products as well as the general operations of the
Company. Capitalized software is amortized over three to five years utilizing
the straight-line method. Related amortization expense and accumulated
amortization were as follows (in thousands): Year ended December 31:
    
    Amortization Expense
    
    Accumulated Amortization2003
    
    $
    181
    
    
    $
    2,2682002
    
    $
    174
    
    
    $
    2,1902001
    
    $
    237
    
    
    $
    2,040
 F-9




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##### Table of Contents



Long-Lived Assets:Property and equipment and other long-lived assets are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount may not be recoverable. All impairments are
recognized in operating results when a permanent reduction in value occurs. Revenue Recognition:Revenues consist of product and service revenues and are
recognized in accordance with SEC Staff Accounting Bulletin (SAB) 104,
Revenue Recognition. Product revenues are recognized upon shipment, provided
fees are fixed and determinable, a customer purchase order is obtained (when
applicable), and collection is probable. Revenues from reseller agreements are
recognized when the product is sold through to the end customer unless an
established return history supports recognizing revenue upon shipment, less a
provision for estimated sales returns. Deferred revenue consists of revenue
from reseller arrangements and certain arrangements with extended payment
terms. Revenue from extended payment terms is recognized in the period the
payment becomes due if all other revenue recognition criteria have been met.
Service revenue is recognized as the services are performed. Revenue derived from the development and installation of highly customized
software packages under a professional services contract is recognized on a
percentage of completion basis measured by the relationship of hours worked to
total estimated contract hours and the costs incurred as of the date of
measurement. The Company follows this method since reasonably dependable
estimates of the revenue and contract hours applicable to various elements of a
contract can be made. Since the financial reporting of these contracts depends
upon estimates, which are assessed continually during the term of these
contracts, recognized revenue and profit are subject to revisions as the
contract progresses to completion. Revisions in profit estimates are reflected
in the period in which the facts that give rise to the revisions become known.
Accordingly, favorable changes in estimates result in additional revenue
recognition and net income, and unfavorable changes in estimates result in a
reduction of recognized revenue and net income. If estimates were to indicate
that a loss would be incurred on a contract upon completion, a provision for
the expected loss would be recorded in the period in which the loss became
evident. At December 31, 2002, the Company had recognized revenue of approximately
$247,000 and had deferred revenue of $272,000 related to a fixed price contract
to provide services at a price of approximately $996,000. In January 2003, the
Company received notice as to the cancellation of the contract, effective in
February 2003. Under the terms of the contract, the Company completed another
deliverable related to this contract in the first quarter 2003, and recognized
all revenue related to the completed deliverables at that time. Warranty Reserve:The Company offers to its customers a limited warranty that
its products will be free from defect in the materials and workmanship for a
specified period. The Company has established a warranty reserve, as a
component of accrued liabilities, for any potential claims. The Company
estimates its warranty reserve based upon an
analysis of all identified or expected claims and an estimate of the cost to
resolve those claims. F-10




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##### Table of Contents



Concentration of Credit Risk:Financial instruments which potentially expose
the Company to concentrations of credit risk consist primarily of trade
accounts receivable. The majority of the Companys sales have been to original
equipment manufacturers of computer systems or telecommunication networks. The
Company conducts credit evaluations of its customers financial condition and
limits the amount of trade credit extended when necessary. Research and Development:Research and development costs are charged to
expense as incurred. Advertising Expense:Advertising costs are charged to expense as incurred.
Advertising expense was approximately $156,000, $102,000 and $173,000 during
the years ended December 31, 2003, 2002 and 2001, respectively. Foreign Currency Translation:Assets and liabilities of the Companys French
subsidiary, whose functional currency is other than the U.S. Dollar, are
translated at year-end rates of exchange, and revenues and expenses are
translated at average exchange rates prevailing during the year. Foreign
currency transaction gains and losses are recognized in income as incurred. The Company accounts for unrealized gains or losses on its foreign currency
translation adjustments in accordance with Statement of Financial Accounting
Standards No. 130, Reporting Comprehensive Income, which requires the
adjustments be accumulated in shareholders equity as part of other
comprehensive income. Income Taxes:The Company determines its deferred taxes using the liability
method. Deferred tax assets and liabilities are based on the estimated future
tax effects of differences between the financial statement and tax basis of
assets and liabilities given the provisions of enacted tax law. The Companys
consolidated financial statements include deferred income taxes arising from
the recognition of revenues and expenses in different periods for income tax
and financial reporting purposes. The Company records a valuation allowance to reduce its deferred income tax
assets to the amount that is believed to be realizable under the guidance of
Statement of Financial Accounting Standards No. 109 Accounting for Income
Taxes. The Company considers recent historical losses, future taxable income
and ongoing prudent and feasible tax planning strategies in assessing the need
for a valuation allowance. Management is required to make a continuous
assessment as to the realizability of the deferred tax assets. Other Comprehensive Income (Loss):Other comprehensive income (loss) is
recorded directly to a separate section of shareholders equity in accumulated
other comprehensive loss and includes unrealized gains and losses excluded from
the Consolidated Statements of Operations. These unrealized gains and losses
consist of holding period gains and losses related to marketable securities,
net of income taxes, and foreign currency
translation, which are not adjusted for income taxes since they relate to
indefinite investments in a non-U.S. subsidiary. F-11




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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 Board 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): Years ended December 31,2003
    
    2002
    
    2001Net loss as reported
    
    $
    (769
    )
    
    $
    (8,401
    )
    
    $
    (9,572
    )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
    
    
    (2,084
    )
    
    
    (4,192
    )
    
    
    (3,151
    )Pro forma net loss
    
    $
    (2,853
    )
    
    $
    (12,593
    )
    
    $
    (12,723
    )Loss per common share:As reported  basic
    
    $
    (0.14
    )
    
    $
    (1.51
    )
    
    $
    (1.68
    )Pro forma  basic
    
    $
    (0.53
    )
    
    $
    (2.88
    )
    
    $
    (2.48
    )As reported  diluted
    
    $
    (0.14
    )
    
    $
    (1.51
    )
    
    $
    (1.68
    )Pro forma  diluted
    
    $
    (0.53
    )
    
    $
    (2.88
    )
    
    $
    (2.48
    )
 Certain Reclassifications:Certain reclassifications have been made for
consistent presentation among periods presented. Use of Estimates: The preparation of financial statements, in conformity with
accounting principles generally accepted in the United States of America,
requires Company management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. Actual results
could differ from those estimates. Areas involving estimates are the allowance
for doubtful accounts and returns, warranty and inventory reserves and income
tax accounts. 2. RESTRUCTURING COSTS AND OTHER SPECIAL CHARGES In the second quarter 2001, the Company announced a restructuring program
designed to allow the Company to continue aggressive funding of its development
organizations, while preserving cash levels and securing new design-ins. As a
result of the restructuring program, continued decline in predicted revenue and
customers cautious expectations regarding market recovery, the Company
recorded restructuring costs and other special F-12




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##### Table of Contents



charges of $2.1 million,
classified as operating expenses, and an additional excess and obsolete
inventory charge of $4.4 million, classified as cost of sales. The restructuring program resulted in the reduction of approximately 22% of the
Companys workforce, impacting all business functions in North America. As a
result, the Company recorded a workforce reduction charge of $483,000 relating
to severance and fringe benefits. In addition, the Company wrote off $123,000
of nonutilized fixed assets. Due to the decline in business conditions and legacy product revenues and the
diminished expected future benefits from the purchased intangibles related to
the acquisition of Synaptel, S.A. (Synaptel) in 1996, the Company recorded a
charge of $1.5 million related to the impairment of developed technology and
assembled workforce during the second quarter 2001. These intangible assets,
purchased in the acquisition of Synaptel, S.A., relate to the Companys legacy
product lines. In the second quarter 2000, the Company developed a strategy to
end-of-life many of its legacy products in an effort to focus its resources on
its new product lines. This strategy resulted in increased sales of legacy
products in 2000; however, legacy product revenues declined in the first
quarter of 2001, and continued to decline through the end of 2003. Management
did not expect significant revenues from its legacy product lines in future
periods. The Company wrote off $5.9 million of excess and obsolete inventory during the
second quarter of 2001, resulting in an additional charge to cost of sales of
$4.4 million. Approximately 74% of the write-off relates to the Companys
legacy product lines. The remaining $1.5 million of excess and obsolete
inventory written off was charged against the already established reserve.
This additional excess and obsolete inventory charge was due to a sudden and
significant decrease in predicted revenue and was calculated in accordance with
the Companys established policy. Only the severance and fringe benefit
payments relating to the workforce reduction impacted cash flow. A summary of
the restructuring costs and other special charges is outlined as follows (in
thousands): SecondQuarterCashPayments
    
    Third
    
    Fourthand
    
    Quarter
    
    Quarter
    
    AccrualTotal
    
    Noncash
    
    Cash
    
    Cash
    
    Balance atCharge
    
    Charges
    
    Payments
    
    Payments
    
    Dec. 31, 2001Workforce reduction
    
    $
    483
    
    
    $
    17
    
    
    $
    384
    
    
    $
    82
    
    
    $
    Fixed asset
write-off
    
    
    123
    
    
    
    123
    
    
    
    
    
    
    
    
    
    
    
    Impairment of
purchased
intangibles
    
    
    1,485
    
    
    
    1,485
    
    
    
    
    
    
    
    
    
    
    
    Excess and obsolete inventory charge
    
    
    4,394
    
    
    
    4,394
    
    
    
    
    
    
    
    
    
    
    
    $
    6,485
    
    
    $
    6,019
    
    
    $
    384
    
    
    $
    82
    
    
    $
    
 F-13




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3. GOODWILL IMPAIRMENT CHARGE All of the Companys goodwill was associated with the entire company rather
than any specific identifiable asset or product line. Each quarter, during
which goodwill was carried on the Companys books, the Company evaluated
whether an impairment of this enterprise goodwill may exist by comparing the
book value of its common stock to the product of (i) the number of shares of
common stock issued and outstanding at the end of the quarter and (ii) the
market price of the common stock at the end of the quarter. If the product of
shares and market price exceeds the book value, impairment does not exist. If
the product of shares and market price is less than book value, the Company
evaluates whether the condition is other than temporary based (i) primarily on
whether fluctuations in the Companys stock price subsequent to the quarter-end
result in a product of shares and market price that exceeds book value and (ii)
on all other available evidence. If the product of shares and market price is
continuously less than book value based on daily closing market prices for the
prior six months, the Company evaluates whether the condition is other than
temporary considering all other available evidence. If the Company determines
the condition is other than temporary, additional amortization is recorded for
the impairment, equal to the excess book value at the end of the quarter. The Company recorded an impairment charge, at the end of the fourth quarter
2001 by writing-off the remaining $2.4 million of goodwill. At December 31,
2001, the Company had 5.5 million common shares issued and outstanding with a
book value of $33.5 million. The common stock price at December 31, 2001 was
$5.44, resulting in a market capitalization of $30 million. The Companys
market capitalization had consistently been less than book value since June 30,
2001, and continued to remain below book value after year-end 2001. As a
result of the Companys market capitalization continuously remaining below book
value for a period of greater than six months and the uncertainty related to
the timing of a technology sector market recovery, the Company, following its
stated policy, recorded the impairment charge of $2.4 million at the end of the
fourth quarter 2001. F-14




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##### Table of Contents



4. INTANGIBLE ASSETS As a result of the acquisition of Synaptel the Company acquired intangible
assets related to developed technologies, assembled workforce and goodwill.
Developed technology and assembled workforce were amortized on a straight-line
basis over a seven-year period. As described in Note 2, at the end of the
second quarter 2001, the Company recorded an impairment charge for assembled
workforce and developed technology. Goodwill was amortized on a straight-line
basis over a 15-year period. As described in Note 3, at the end of the fourth
quarter 2001, the Company recorded an impairment charge for goodwill. The
December 31, 2003 intangible balances at historical cost and related
amortization expense, impairment charge and accumulated amortization were as
follows (in thousands): Amortization Expense
    
    Accumulated
    
    Impairment
    
    EndingIntangibles
    
    2003
    
    2002
    
    2001
    
    Amortization
    
    Charge
    
    BalanceDeveloped technology
    
    $
    4,230
    
    
    $
    
    
    
    $
    
    
    
    $
    300
    
    
    $
    2,850
    
    
    $
    1,380
    
    
    $
    Assembled workforce
    
    
    390
    
    
    
    
    
    
    
    
    
    
    
    30
    
    
    
    285
    
    
    
    105
    
    
    
    Goodwill-Synaptel
    
    
    3,596
    
    
    
    
    
    
    
    
    
    
    
    240
    
    
    
    1,246
    
    
    
    2,350
    
    
    
    
 5. MARKETABLE SECURITIES Marketable securities consist of investments in equity and debt securities. As
of December 31, 2003 and 2002, the fair market value of marketable securities
was $5 million and $5.5 million, respectively. The Company recorded charges
due to the other than temporary impairment of certain marketable securities
received in the sale of the Companys VOIP business of $20,000 and $334,000 in
2002 and 2001, respectively. Gains and losses on marketable securities sold
are recognized on a specific identification basis. The Company recorded an
unrealized loss, net of taxes, with respect to certain available-for-sale
securities of $121,000 in 2003 and an unrealized gain, net of taxes, of $50,000
in 2002. 6. ACCRUED LIABILITIES Accrued liabilities consisted of the following (in thousands): Years ended December 31,2003
    
    2002Accrued outside commissions
    
    $
    191
    
    
    $
    187Accrued property tax
    
    
    185
    
    
    
    121Accrued other
    
    
    1,308
    
    
    
    983$
    1,684
    
    
    $
    1,291
 7. CREDIT FACILITY On July 25, 2003, the Company entered into a new $5 million revolving bank
credit facility designed to replace an older credit facility maturing on June
30, 2004. In September of 2003, the Company borrowed $3.5 million under the
new credit facility and F-15




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##### Table of Contents



used the proceeds to repay the amounts outstanding
under the old credit facility. The new credit facility bears interest at the
rate of LIBOR plus 2.0% (3.375% at December 31, 2003), matures on July 30, 2005
and all borrowings are secured by marketable securities. The borrowings of
$3.5 million are classified as long-term debt on the accompanying balance
sheet. 8. INCOME TAXES The provision for income taxes applicable to continuing operations for each
period presented was as follows (in thousands): Year ended December 31,2003
    
    2002
    
    2001Current benefit
    
    $
    (212
    )
    
    $
    (1,486
    )
    
    $
    (2,194
    )Deferred provision (benefit)
    
    
    
    
    
    
    4,009
    
    
    
    (2,019
    )Income tax (benefit) expense
    
    $
    (212
    )
    
    $
    2,523
    
    
    $
    (4,213
    )
 Tax effect of temporary differences that give rise to significant components of
the deferred tax assets as of December 31, 2003 and 2002, are presented as
follows (in thousands): Year ended December 31,2003
    
    2002Current deferred tax assets:Inventory
    
    $
    1,278
    
    
    $
    1,029Accounts receivable
    
    
    34
    
    
    
    12Deferred revenue
    
    
    46
    
    
    
    15Other accruals
    
    
    510
    
    
    
    366Total current deferred tax assets
    
    $
    1,868
    
    
    $
    1,422Noncurrent deferred tax assets (liabilities), net:Assets:Depreciation
    
    $
    191
    
    
    $
    959Amortization
    
    
    496
    
    
    
    573Other
    
    
    
    
    
    
    192Net operating loss
    
    
    3,844
    
    
    
    1,720Total noncurrent deferred tax assets, net
    
    $
    4,531
    
    
    $
    3,444Valuation allowance for deferred tax assets
    
    
    (6,399
    )
    
    
    (4,866
    )Deferred tax assets, net of valuation allowance
    
    $
    
    
    
    $
    
 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. F-16




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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. At December 31, 2003, the amount of valuation
allowance is approximately $6.4 million. A portion of this total, if reversed,
would be allocated directly to additional paid-in capital. 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. This benefit was partially
offset by taxes on foreign income. The differences between the provision for income taxes computed on income
before income taxes at the U.S. federal statutory income tax rate (34%) and the
amount shown in the Consolidated Statements of Operations are presented below
(in thousands): Year ended December 31,2003
    
    2002
    
    2001Income taxes at statutory rate
    
    $
    (334
    )
    
    $
    (1,999
    )
    
    $
    (4,687

    )State income taxes
    
    
    
    
    
    
    
    
    
    
    (551
    )Nondeductible goodwill amortization
    
    
    
    
    
    
    
    
    
    
    1,674Benefit of foreign tax loss
carry-forward
    
    
    
    
    
    
    (383
    )
    
    
    (342
    )Change in effective tax rate
    
    
    
    
    
    
    
    
    
    
    (235
    )Benefit recorded for favorable
outcome of tax audits
    
    
    (245
    )
    
    
    
    
    
    
    French permanent items
    
    
    (292
    )
    
    
    
    
    
    
    Extraterritorial income exclusion
benefit
    
    
    (386
    )Other
    
    
    
    
    
    
    39
    
    
    
    (72
    )Change in valuation allowance
    
    
    1,045
    
    
    
    4,866
    
    
    
    Provision for income taxes
    
    $
    (212
    )
    
    $
    2,523
    
    
    $
    (4,213
    )
 At December 31, 2003, the Company had net operating loss carryforwards for
federal income tax purposes of approximately $11.3 million that will begin to
expire in 2022. A valuation allowance against the entire net operating loss
carryforward has been established as the relizability of this asset is
uncertain. The earnings of the Companys foreign subsidiary are considered to be
indefinitely reinvested and, accordingly, no provision for U.S. federal and
state income taxes have been provided thereon. Upon distribution of those
earnings in the form of dividends or otherwise, the Company would be subject to
both U.S. income taxes (subject to foreign tax credits) and withholding taxes
payable to foreign countries. F-17




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9. EXIT ACTIVITIES During the second quarter of 2003, the Company committed to an exit plan
regarding one of its leased facilities which expires during the first quarter
of 2005. The Company had previously held this facility open for storage,
overflow use, and anticipated growth. However, it has been determined that the
facility will not be needed for overflow space and the Company is pursuing
subleasing opportunities. As a result of this exit plan, the Company recorded
a charge of approximately $109,000 during the second quarter of this year,
classified as operating expenses, related to net termination costs associated
with the lease of the facility. As of December 31, 2003, the facility had not
been subleased. Additional costs may continue to be incurred in future periods
if the Company is not successful in subleasing the facility. A reconciliation
showing the changes to the liability account during the year is as follows (in
thousands): Liability at December 31, 2002
    
    $
    Exit plan net termination costs
    
    
    109Rent payments
    
    
    (78
    )Cost of not subleasing
    
    
    45Liability at December 31, 2003
    
    $
    76Total costs to date
    
    $
    154
 10. EARNINGS PER SHARE Basic earnings per share are computed by dividing reported earnings available
to common stockholders by weighted average common shares outstanding. Diluted
earnings per share give effect to dilutive potential common shares. Earnings
per share are calculated as follows (in thousands, except per share data): Years ended December 31,2003
    
    2002
    
    2001Basic loss per share:Net loss
    
    $
    (769
    )
    
    $
    (8,401
    )
    
    $
    (9,572
    )Weighted average commons shares
outstanding
    
    
    5,544
    
    
    
    5,551
    
    
    
    5,705Basic loss per share
    
    $
    (0.14
    )
    
    $
    (1.51
    )
    
    $
    (1.68
    )Diluted loss per share:Net loss
    
    $
    (769
    )
    
    $
    (8,401
    )
    
    $
    (9,572
    )Weighted average common shares outstanding
    
    
    5,544
    
    
    
    5,551
    
    
    
    5,705Dilutive stock options
    
    
    
    
    
    
    
    
    
    
    Weighted average common shares
outstanding  assuming dilution
    
    
    5,544
    
    
    
    5,551
    
    
    
    5,705Diluted loss per share
    
    $
    (0.14
    )
    
    $
    (1.51
    )
    
    $
    (1.68
    )Outstanding stock options that were not
included in the diluted calculation because
their effect would be anti-dilutive
    
    
    1,199
    
    
    
    2,091
    
    
    
    1,889
 F-18




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##### Table of Contents



11. COMMON STOCK Amended and Restated Stock Option Plan:In 2002, the Company amended and
restated its Stock Option Plan which, as amended, authorizes the issuance to
employees of up to 4,500,000 shares of common stock in incentive stock options
(as defined in section 422 of the Internal Revenue Code of 1986, as amended)
and nonqualified stock options. The exercise price of the incentive stock
options must be at least equal to the fair market value of the Companys common
stock on the date of the grant, while the exercise price of nonqualified stock
options may be less than fair market value on the date of grant, as determined
by the Board of Directors. The Board of Directors may provide for the exercise
of options in installments and upon such terms, conditions and restrictions as
it may determine. Options granted prior to January 1, 1999 generally vest
ratably over a five-year period from the date of grant. Options granted since
January 1, 1999 generally vest ratably over a three-year period from the date
of grant. The term of option grants may be up to ten years. Options are
canceled upon the lapse of three months following termination of employment
except in the event of death or disability, as defined. United Kingdom Stock Option Sub-Plan:This plan was adopted in 1988 for the
benefit of the Companys employees located in the United Kingdom. This plan
authorizes the issuance of options to purchase common stock of the Company at
prices at least equal to the fair market value of the common stock on the date
of the grant. The Board may provide for the exercise of options in
installments and upon such terms, conditions and restrictions as it may
determine. Options granted prior to January 1, 1999 generally vest ratably
over a five-year period from the date of grant. Options granted since January
1, 1999 generally vest ratably over a three-year period from the date of grant.
The term of option grants may be up to ten years. The options are canceled
upon termination of employment, except in the event of death, retirement or
injury, as defined. France Stock Option Sub-Plan:This plan was adopted in 2000 for the benefit of
the Companys employees located in France. This plan authorizes the issuance
of options to purchase common stock of the Company at prices at least equal to
the fair market value of the common stock on the date of the grant. Unless
otherwise decided at the sole discretion of the Board, the options vest (i) 75%
after the expiration of a two-year period
from the date of grant and (ii) 25% after the expiration of a three-year period
from the date of grant. Except for the events provided under the French tax
code, the shares cannot be sold or otherwise disposed of for a period of four
years from the date of grant. The term of option grants may be up to ten years.
Options are canceled upon the lapse of three months following termination of
employment except in the event of death or disability, as defined. F-19




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The following table summarizes the transactions under the Stock Option Plan and
the Stock Option Sub-Plans (in thousands, except option prices): Number of
    
    Weighted AverageOptions
    
    Option PriceBalance, December 31, 2000
    
    
    1,601
    
    
    $
    13.85Granted
    
    
    753
    
    
    
    6.65Exercised
    
    
    (38
    )
    
    
    6.34Canceled
    
    
    (504
    )
    
    
    15.45Balance, December 31, 2001
    
    
    1,812
    
    
    
    10.57Granted
    
    
    302
    
    
    
    4.74Exercised
    
    
    
    
    
    
    Canceled
    
    
    (47
    )
    
    
    10.08Balance, December 31, 2002
    
    
    2,067
    
    
    
    9.73Granted
    
    
    343
    
    
    
    6.38Exercised
    
    
    (98
    )
    
    
    6.13Canceled
    
    
    (54
    )
    
    
    11.95Balance, December 31, 2003
    
    
    2,258
    
    
    
    9.32Exercisable at December 31, 2003
    
    
    1,542
    
    
    $
    10.89
 The following table summarizes information about options granted under the Plan
and the Stock Option Sub-Plans that were outstanding at December 31, 2003: Options Outstanding
    
    Options ExercisableWeighted-AverageNumber
    
    Remaining
    
    
    
    
    
    NumberOutstanding
    
    Contractual
    
    Weighted
    
    Exercisable
    
    WeightedRange of
    
    at 12/31/03
    
    Life
    
    Average
    
    at 12/31/03
    
    AverageExercise Prices
    
    (000)
    
    (years)
    
    Exercise Price
    
    (000)
    
    Exercise Price$  3.09-$  4.59
    
    
    258
    
    
    
    7.77
    
    
    $
    4.06
    
    
    
    150
    
    
    $
    4.10$  4.65-$  6.50
    
    
    682
    
    
    
    7.98
    
    
    
    5.58
    
    
    
    202
    
    
    
    5.69$  7.04-$10.25
    
    
    609
    
    
    
    5.98
    
    
    
    7.93
    
    
    
    512
    
    
    
    7.92$10.63-$15.75
    
    
    428
    
    
    
    6.70
    
    
    
    13.10
    
    
    
    399
    
    
    
    13.13$16.44-$24.06
    
    
    270
    
    
    
    5.88
    
    
    
    20.07
    
    
    
    268
    
    
    
    20.09$25.88-$31.00
    
    
    11
    
    
    
    5.93
    
    
    
    30.53
    
    
    
    11
    
    
    
    30.53Total
    
    
    2,258
    
    
    
    6.91
    
    
    $
    9.32
    
    
    
    1,542
    
    
    $
    10.89
 Amended and Restated Director Stock Option Plan:In 2000, the Company amended
and restated its Director Stock Option Plan, which, as amended, authorizes the
issuance to directors of up to 750,000 shares of common stock. Stock option
grants pursuant to the directors plan will vest in one year and have a term of
ten years. The exercise prices related to these options are equal to the
market value of the Companys stock on the date of grant. F-20




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The following table summarizes the transactions under the Director Stock Option
Plan (in thousands, except option prices): Number of
    
    Weighted AverageOptions
    
    Option PriceBalance, December 31, 2000
    
    
    238
    
    
    $
    10.64Granted
    
    
    80
    
    
    
    7.53Exercised
    
    
    
    
    
    
    Cancellations
    
    
    (35
    )
    
    
    15.45Balance, December 31, 2001
    
    
    283
    
    
    
    9.17Granted
    
    
    100
    
    
    
    4.60Exercised
    
    
    
    
    
    
    Cancellations
    
    
    (35
    )
    
    
    7.02Balance, December 31, 2002
    
    
    348
    
    
    
    8.07Granted
    
    
    70
    
    
    
    5.61Exercised
    
    
    (68
    )
    
    
    4.87Cancellations
    
    
    (30
    )
    
    
    8.09Balance, December 31, 2003
    
    
    320
    
    
    
    8.21Exercisable at December 31, 2003
    
    
    250
    
    
    $
    8.94
 The following table summarizes information about options granted under the Plan
that were outstanding at December 31, 2003: Options Outstanding
    
    Options ExercisableWeighted-AverageNumber
    
    Remaining
    
    
    
    
    
    NumberOutstanding
    
    Contractual
    
    Weighted
    
    Exercisable
    
    WeightedRange of
    
    at 12/31/03
    
    Life
    
    Average
    
    at 12/31/03
    
    AverageExercise Prices
    
    (000)
    
    (years)
    
    Exercise Price
    
    (000)
    
    Exercise Price$4.60-$  5.61
    
    
    160
    
    
    
    8.78
    
    
    $
    5.04
    
    
    
    90
    
    
    $
    4.60$7.50-$17.81
    
    
    160
    
    
    
    6.09
    
    
    
    11.38
    
    
    
    160
    
    
    
    11.38Total
    
    
    320
    
    
    
    7.43
    
    
    $
    8.21
    
    
    
    250
    
    
    $
    8.94
 Rights Agreement:The Board of Directors has adopted a Shareholder Rights Plan
whereby each holder of record as of December 29, 2000 received a right to
purchase from the Company one share of common stock of the Company at a price
of $93 per share for each share held. These rights can only be exercised after
certain events occur, such as if a person or entity acquires, or makes a tender
or exchange offer to acquire, 15% or more of the Companys common stock and the
rights expire ten years from the record date. Upon acquisition of 15% or more
of the Companys common stock, each right not owned by the acquiring person or
group will be adjusted to allow the purchase for $93 of a number of shares
having a then market value of $186. These rights are intended to provide the
Company certain antitakeover protections. The Board of Directors may terminate
the Rights Plan, or redeem the rights for $0.01 per right, at any time until
the tenth business day following a public announcement of a 15% or more stock
acquisition. The Company had reserved 7,000,000 shares of common stock for
this plan. F-21




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The rights were distributed to shareholders as of the record date as a
nontaxable dividend. The rights are attached to and trade with Interphase
common stock until the occurrence of one of the triggering events, at which
time the rights would become detached from the Companys common stock. Pro Forma Net Income (Loss):The Black-Scholes model was not developed for use
in valuing employee stock options, but was developed for use in estimating the
fair value of traded options that have no vesting restrictions and are fully
transferable. In addition, it requires the use of subjective assumptions
including expectations of future dividends and stock price volatility. Such
assumptions are only used for making the required fair value estimate and
should not be considered as indicators of future dividend policy or stock price
appreciation. Because changes in the subjective assumptions can materially
affect the fair value estimate, and because employee stock options have
characteristics significantly different from those of traded options, the use
of the Black-Scholes option-pricing model may not provide a reliable estimate
of the fair value of employee stock options. The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted-average
assumptions used for options granted in 2003, 2002 and 2001: 2003
    
    2002
    
    2001Weighted average risk free interest rates
    
    
    2.36
    %
    
    
    3.51
    %
    
    
    4.39
    %Weighted average life (in years)
    
    
    3.87
    
    
    
    6.81
    
    
    
    6.99Volatility
    
    
    130
    %
    
    
    160
    %
    
    
    180
    %Expected dividend yield
    
    
    
    
    
    
    
    
    
    
    Weighted average grant-date fair value per
share of options granted
    
    $
    5.02
    
    
    $
    4.54
    
    
    $
    6.62
 12. RELATED-PARTY TRANSACTIONS The Company paid approximately $68,000, $146,000 and $161,000 for the years
ended December 31, 2003, 2002 and 2001, respectively, to certain outside
directors of the Company or their firms for professional services. The Company
believes the terms were equivalent to those of unrelated parties. 13. EMPLOYEE BENEFIT PLAN The Company maintains a defined contribution plan for those employees who meet
the plans length of service requirements. Under the defined contribution
plan, employees may make voluntary contributions to the plan, subject to
certain limitations, and the Company matches 50% up to 6% of the employees
contributions up to a maximum of $6,000 per employee for the year ended
December 31, 2003. The total expense under this plan was $270,000, $261,000
and $103,000 for the years ended December 31, 2003, 2002 and 2001,
respectively. The Company offers no post-retirement or postemployment
benefits. F-22




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##### Table of Contents



14. OTHER FINANCIAL INFORMATION Major Customers: During 2003, sales to Lucent Technologies and Hewlett Packard
accounted for $13.5 million or 42% and $9.7 million or 30% of the Companys
consolidated revenues, respectively. During 2002, sales to Hewlett Packard and
Lucent Technologies accounted for $8.7 million or 35% and $7.2 million or 29%
of the Companys consolidated revenues, respectively. During 2001, sales to
Hewlett Packard and SCI Systems accounted for $8.5 million or 30% and $4.2
million or 15% of the Companys consolidated revenues, respectively. No other
customers accounted for more than 10% of the Companys consolidated revenues in
the periods presented. Included in accounts receivable at December 31, 2003, was approximately $2.5
million due from Lucent Technologies and approximately $1.2 million due from
Hewlett Packard. Included in accounts receivable at December 31, 2002, was
approximately $2 million due from Lucent Technologies and approximately $1.5
million due from Hewlett Packard. No other customers accounted for more than
10% of the Companys accounts receivable at the balance sheet dates presented. Commitments:The Company leases its facilities under noncancelable operating
leases with the longest terms extending to December of 2006. Rent expense
related to these leases is recorded on a straight-line basis. As of December
31, 2003, operating lease commitments having noncancelable terms of more than
one year are as follows (in thousands): Year ending December 31:2004
    
    $
    8612005
    
    $
    6532006
    
    $
    29
 Total rent expense for operating leases was approximately as follows (in
thousands): Year ending December 31:2003
    
    $
    9322002
    
    $
    1,3362001
    
    $
    1,345
 Contingencies:The Company is involved in various legal actions and claims
arising in the ordinary course of business. Management believes that such
litigation and claims will be resolved without material effect on the Companys
financial position or results of operations. 15. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) No. 141, Business Combinations, and
SFAS No. 142, Goodwill and Other Intangible Assets. The most significant
changes made by SFAS No. 141 are: 1) requiring that the purchase method of
accounting be used for all business combinations initiated after June 30, 2001;
and 2) establishing specific criteria for the F-23




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##### Table of Contents



recognition of intangible assets
separately from goodwill. SFAS No. 142 primarily addresses the accounting for
acquired goodwill and intangible assets. The most significant changes made by
SFAS No. 142 are: 1) goodwill and indefinite-lived intangible assets are no
longer amortized; 2) goodwill will be tested annually and whenever events or
circumstances occur indicating that goodwill might be impaired; and 3) the
amortization period of intangible assets with finite lives will no longer be
limited to forty years. In the current year, accordance with the adoption of
these pronouncements, the Company would have been required to transfer the
balance of the intangible defined as Workforce into Goodwill. The Company
adopted SFAS No. 141 effective July 1, 2001, and SFAS No. 142 effective January
1, 2002, however, as the Companys goodwill and assembled workforce were
determined to be impaired and were written off in the fourth quarter of 2001,
the adoption of these standards did not have a material effect on the Companys
financial position or results of operations for the periods ended December 31,
2003 and 2002. The following tables present net income and earnings per share assuming
goodwill and assembled workforce would not have been amortized in accordance
with SFAS No. 142 as if adopted as of the beginning of the periods presented:
(in thousands) 2003
    
    2002
    
    2001Net (loss) income
    
    $
    (769
    )
    
    $
    (8,401
    )
    
    $
    (9,572
    )Goodwill and
workforce amortization
    
    
    
    
    
    
    
    
    
    
    270Adjusted net (loss) income
    
    $
    (769
    )
    
    $
    (8,401
    )
    
    $
    (9,302
    )
 2003
    
    2002
    
    2001Basic loss per share:Net loss
    
    $
    (0.14
    )
    
    $
    (1.51
    )
    
    $
    (1.68
    )Goodwill and workforce
amortization
    
    
    
    
    
    
    
    
    
    
    0.05Adjusted basic net loss per share
    
    $
    (0.14
    )
    
    $
    (1.51
    )
    
    $
    (1.63
    )
 2003
    
    2002
    
    2001Diluted loss per share:Net loss
    
    $
    (0.14
    )
    
    $
    (1.51
    )
    
    $
    (1.68
    )Goodwill and workforce
amortization
    
    
    
    
    
    
    
    
    
    
    0.05Adjusted diluted net loss per
share
    
    $
    (0.14
    )
    
    $
    (1.51
    )
    
    $
    (1.63
    )
 EITF Issue 00-21, Accounting for Revenue Arrangements with Multiple
Deliverables, addresses the accounting treatment for an arrangement to provide
the delivery or performance of multiple products and/or services where the
delivery of a product or system or performance of services may occur at
different points in time or over different periods of time. The arrangements
are often accompanied by initial installation, initiation, or activation
services and involve either a fixed fee or a fixed fee coupled with a
continuing payment stream, which may be fixed or variable. The EITF reached
conclusions regarding, among other issues, the applicability of the provisions
regarding separation of contract elements in EITF Issue 00-21 to contracts
where one or more elements fall within the scope of other authoritative
literature, such as SOP 81-1. The proposed EITF does not impact the use of SOP
81-1 for contracts that fall within the scope of SOP 81-1, such as for
implementation or building of an information technology system or product to
client specifications for a client under a long-term contract. Where an
implementation or development project is contracted with a client, and the
vendor will also provide services or operate the system over a period of time,
EITF Issue 00-21 F-24




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##### Table of Contents



provides the methodology for separating the contract elements
and earnings processes. The provisions of EITF Issue 00-21 are applicable on a
prospective basis to transactions entered into in fiscal periods beginning
after June 15, 2003. The adoption of this consensus has not had a material
impact on results of operations and financial position for the year ended
December 31, 2003. The impact on future results of operations and financial
position depends on the terms and conditions of contracts, if any, which
include elements of the EITF entered into or modified in the future. 16. SEGMENT DATA 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 long lived assets and revenue related to North America and foreign
countries as of December 31, 2003 and 2002 and for the years ended December 31,
2003, 2002 and 2001 is as follows (in thousands): Long lived assets
    
    2003
    
    2002North America
    
    $
    1,639
    
    
    $
    1,791Europe
    
    
    276
    
    
    
    145Pacific Rim
    
    
    
    
    
    
    2Total
    
    $
    1,915
    
    
    $
    1,938
 Revenues
    
    2003
    
    2002
    
    2001North America
    
    $
    23,037
    
    
    $
    18,525
    
    
    $
    22,919Europe
    
    
    4,312
    
    
    
    4,011
    
    
    
    5,173Pacific Rim
    
    
    5,141
    
    
    
    2,587
    
    
    
    640Total
    
    $
    32,490
    
    
    $
    25,123
    
    
    $
    28,732
 Additional information regarding revenue by product-line is as follows (in
thousands): Product Revenue
    
    2003
    
    2002
    
    2001Broadband telecom
    
    $
    17,773
    
    
    $
    11,767
    
    
    $
    6,417SlotOptimizer
    
    
    11,422
    
    
    
    8,589
    
    
    
    6,776LAN
    
    
    1,368
    
    
    
    2,027
    
    
    
    5,636Storage
    
    
    522
    
    
    
    1,505
    
    
    
    8,366WAN
    
    
    152
    
    
    
    167
    
    
    
    606Other
    
    
    1,253
    
    
    
    1,068
    
    
    
    931Total
    
    $
    32,490
    
    
    $
    25,123
    
    
    $
    28,732
 F-25




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17. QUARTERLY FINANCIAL DATA (Unaudited) Quarterly results of
operations for 2003 (unaudited)
(In thousands, except per share amounts) Quarter EndedMarch 31
    
    June 30
    
    September 30
    
    December 31Revenues
    
    $
    7,513
    
    
    $
    7,357
    
    
    $
    8,571
    
    
    $
    9,049Gross margin
    
    
    3,791
    
    

    
    3,696
    
    
    
    4,479
    
    
    
    4,943(Loss) income before
income taxes
    
    
    (769
    )
    
    
    (578
    )
    
    
    146
    
    
    
    220Net (loss) income
    
    
    (826
    )
    
    
    (521
    )
    
    
    366
    
    
    
    212(Loss) earnings per shareBasic EPS
    
    $
    (0.15
    )
    
    $
    (0.09
    )
    
    $
    0.07
    
    
    $
    0.04Diluted EPS
    
    $
    (0.15
    )
    
    $
    (0.09
    )
    
    $
    0.06
    
    
    $
    0.03
 Quarterly results of operations for 2002 (unaudited)
(In thousands, except per share amounts) Quarter EndedMarch 31
    
    June 30
    
    September 30
    
    December 31Revenues
    
    $
    6,300
    
    
    $
    6,016
    
    
    $
    6,022
    
    
    $
    6,785Gross margin
    
    
    2,492
    
    
    
    1,562
    
    
    
    2,608
    
    
    
    3,130Loss before income taxes
    
    
    (1,033
    )
    
    
    (2,497
    )
    
    
    (1,384
    )
    
    
    (964
    )Net loss
    
    
    (566
    )
    
    
    (1,493
    )
    
    
    (721
    )
    
    
    (5,621
    )Loss per shareBasic EPS
    
    $
    (0.10
    )
    
    $
    (0.27
    )
    
    $
    (0.13
    )
    
    $
    (1.02
    )Diluted EPS
    
    $
    (0.10
    )
    
    $
    (0.27
    )
    
    $
    (0.13
    )
    
    $
    (1.02
    )
 Due to changes in the weighted average common shares outstanding per quarter,
the sum of basic and diluted earnings per common share per quarter may not
equal the basic and diluted earnings per common share for the applicable year. * See earlier notes and Item 7 Managements Discussion and Analysis of
Financial Condition and Results of Operations for explanations regarding major
changes in amounts or trends. F-26




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##### Table of Contents



INDEX TO EXHIBITS Exhibits2 (a)
    
    Stock Purchase Agreement, dated as of June 29, 1996, among
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). (7)3 (a)
    
    Certificate of Incorporation of the registrant. (1)3 (b)
    
    Amendment to Articles of Incorporation of the registrant. (10)3 (c)
    
    Amended and Restated Bylaws of the registrant adopted on December 5, 1995 and
amended on January 19, 1999. (12)4 (a)
    
    Rights Agreement dated as of December 7, 2000 by and between the Company and
Computershare Investor Services, LLC as Rights Agent. (11)10 (a)
    
    Registrants Amended and Restated Stock Option Plan and Amendment No. 1 and 2 thereto. (9)10 (b)
    
    Registrants Amended and Restated Stock Option Plan Amendment No. 4. (10)10 (c)
    
    Registrants United Kingdom Incentive Stock Option Sub-Plan. (3)10 (d)
    
    Stock Purchase Warrant issued to Motorola, Inc. (4)10 (e)
    
    Lease on Dallas facility. (5)10 (f)
    
    Directors Stock Option Plan and Amendment No. 1 thereto. (6)10 (g)
    
    Directors Stock Option Plan Amendment No. 2. (10)10 (h)
    
    Loan Agreement between Interphase Corporation and BankOne Texas, N.A. (8)10 (i)
    
    Purchase Agreement between Interphase Corporation and Cisco Systems Inc. (9)10 (j)
    
    Motorola Stock Repurchase Agreement. (2)10 (k)
    
    Registrants France Incentive Stock Option Sub-Plan (12)10 (l)
    
    Sublease on Plano facility. (12)10 (m)
    
    Credit Agreement between Interphase Corporation and Bank One, NA. (12)10 (n)
    
    Lease on Facility at Parkway Center, Phase I, Plano, Texas (13)10 (o)
    
    Lease on Facility at 2105 Luna Road, Carrolton, Texas (13)21 (a)
    
    Subsidiaries of the Registrant (14)23 (a)
    
    Consent of Independent Public Accountants. (15)31 (a)
    
    Rule 13a-14(a)/15d-14(a) Certification. (15)31 (b)
    
    Rule 13a-14(a)/15d-14(a) Certification. (15)32 (a)
    
    Section 1350 Certification. (15)32 (b)
    
    Section 1350 Certification. (15)
   (1)
    
    Filed as an exhibit to Registration Statement No. 2-86523 on Form S-1 and
incorporated herein by reference.
(2) Filed as an exhibit to Report on Form 8-K on October 15, 1998, and
incorporated herein by reference.(2)
    
    Filed as an exhibit to Report on Form 8-K on October 15, 1998, and
incorporated herein by reference. E-1




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##### Table of Contents



(3)
    
    Filed as an exhibit to Report on Form 10-K for the year ended
October 31,1988, and incorporated herein by reference.(4)
    
    Filed as an exhibit to Report on Form 10-Q for the quarter ended
April 30, 1989, and incorporated herein by reference.(5)
    
    Filed as an exhibit to Report on Form 10-K for the year ended October 31,
1994, and incorporated herein by reference.(6)
    
    Filed as an exhibit to Report on Form 10-K for the year ended October 31,
1995, and incorporated herein by reference.(7)
    
    Filed as an exhibit to Report on Form 8-K on August 6, 1996, and
incorporated herein by reference.(8)
    
    Filed as an exhibit to Report on Form 8-KA on October 4, 1996, and
incorporated herein by reference.(9)
    
    Filed as an exhibit to Report on Form 10-K for the year ended
December 31, 1996, and incorporated herein by reference.(10)
    
    Filed as an exhibit to Report on Form 10-K for the year ended December
31, 1999, and incorporated herein by reference.(11)
    
    Filed as an exhibit to Form 8-K on January 9, 2001, and incorporated
herein by reference.(12)
    
    Filed as an exhibit to Report on Form 10-K for the year ended December
31, 2001, and incorporated herein by reference.(13)
    
    Filed as an exhibit to Report on Form 10-Q for the quarter ended
September 30, 2002, and incorporated herein by reference.(14)
    
    Filed as an exhibit to Report on Form 10-K for the year ended December
31, 2002, and incorporated herein by reference.(15)
    
    Filed herein. E-2