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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION    FORM 10 - Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2004 Commission File Number 0-11630 
 TeraForce Technology Corporation  Delaware
    
    76-0471342(State or Other Jurisdiction of
    
    (I.R.S. EmployerIncorporation or Organization)
    
    Identification No.)1240 East Campbell Road, Richardson, Texas
    
    75081(Address of Principal Executive Offices)
    
    (Zip Code)
 469-330-4960
(Registrants Telephone Number, Including Area Code)  Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes þ No o . Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes o No þ There were 133,561,526 shares of Common Stock outstanding as of October 31,
2004.




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES INDEX  
 PagePart I Financial InformationItem 1 Financial StatementsConsolidated Balance Sheets of the Company at September 30, 2004 (unaudited) and December 31, 2003
    
    
    2Consolidated Statements of Operations of the Company (unaudited) for the three and nine months ended September 30, 2004 and 2003
    
    
    3Consolidated Statements of Cash Flows of the Company (unaudited) for the nine months ended September 30, 2004 and 2003
    
    
    4Notes to Consolidated Financial Statements
    
    
    5Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    9Item 3 Quantitative and Qualitative Disclosures About Market Risk
    
    
    13Item 4 Controls and Procedures
    
    
    13Part II Other InformationItem 1 Legal Proceedings
    
    
    14Item 2 Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    14Item 6 Exhibits
    
    
    15Warrant AgreementRegistration Rights AgreementTerm Promissory NoteCertificate of the CEO Pursuant to Section 302Certificate of the CFO Pursuant to Section 302Certification Pursuant to Section 906




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PART I  FINANCIAL INFORMATION 
 ITEM 1  FINANCIAL STATEMENTS TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES 
 
 September 30,
    
    December 31,2004
    
    2003(unaudited)AssetsCurrent assets:Cash and cash equivalents
    
    $
    1
    
    
    $
    165Accounts receivable net of allowance of $30 in 2004
and 2003
    
    
    660
    
    
    
    1,935Inventories
    
    
    1,161
    
    
    
    1,595Prepaid expenses and other current assets
    
    
    552
    
    
    
    537Total current assets
    
    
    2,374
    
    
    
    4,232Property and equipment, net
    
    
    293
    
    
    
    378Investment in affiliate
    
    
    100
    
    
    
    250Other assets
    
    
    804
    
    
    
    488$
    3,571
    
    
    $
    5,348Liabilities and Stockholders DeficitCurrent liabilities:Current portion of notes payable
    
    $
    6,520
    
    
    $
    700Accounts payable
    
    
    952
    
    
    
    552Deferred revenue
    
    
    
    
    
    
    1,550Accrued liabilities
    
    
    2,222
    
    
    
    2,629Total current liabilities
    
    
    9,694
    
    
    
    5,431Long-term notes payable
    
    
    765
    
    
    
    5,909Other long-term liabilities
    
    
    150
    
    
    
    795Stockholders deficit:Common Stock, $.01 par value; authorized 250,000,000 shares;
133,561,526 and 130,837,186 shares issued in 2004 and 2003,
respectively
    
    
    1,336
    
    
    
    1,308Additional paid-in capital
    
    
    189,994
    
    
    
    189,194Accumulated deficit
    
    
    (196,781
    )
    
    
    (195,702
    )(5,451
    )
    
    
    (5,200
    )Less 400,474 shares of common stock in treasury at cost
    
    
    (1,587
    )
    
    
    (1,587
    )Total stockholders deficit
    
    
    (7,038
    )
    
    
    (6,787
    )$
    3,571
    
    
    $
    5,348
 See accompanying notes to consolidated condensed financial statements. 2




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES 
 
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(unaudited)Net revenues
    
    $
    1,439
    
    
    $
    1,699
    
    
    $
    8,414
    
    
    $
    4,037Cost of revenues
    
    
    969
    
    
    
    1,108
    
    
    
    3,013
    
    
    
    2,765Gross profit
    
    
    470
    
    
    
    591
    
    
    
    5,401
    
    
    
    1,272Expenses:Engineering and development
    
    
    512
    
    
    
    582
    
    
    
    1,531
    
    
    
    2,063Selling and administrative
    
    
    1,101
    
    
    
    1,171
    
    
    
    3,740
    
    
    
    3,522Write-off of receivable from unconsolidated
affiliate
    
    
    
    
    
    
    449
    
    
    
    
    
    
    
    4491,613
    
    
    
    2,202
    
    
    
    5,271
    
    
    
    6,034Operating profit (loss)
    
    
    (1,143
    )
    
    
    (1,611
    )
    
    
    130
    
    
    
    (4,762
    )Other income (expense):Litigation costs, net of
insurance reimbursement
    
    
    (50
    )
    
    
    (292
    )
    
    
    (50
    )
    
    
    (417
    )Share of loss and adjustment to carrying
value of unconsolidated affiliate
    
    
    
    
    
    
    (333
    )
    
    
    (50
    )
    
    
    (702
    )Interest expense
    
    
    (364
    )
    
    
    (407
    )
    
    
    (1,099
    )
    
    
    (775
    )Other
    
    
    (2
    )
    
    
    (16
    )
    
    
    (10
    )
    
    
    (81
    )(416
    )
    
    
    (1,048
    )
    
    
    (1,209
    )
    
    
    (1,975
    )Net loss
    
    $
    (1,559
    )
    
    $
    (2,659
    )
    
    $
    (1,079
    )
    
    $
    (6,737
    )Basic and diluted loss per share
    
    $
    (.01
    )
    
    $
    (.02
    )
    
    $
    (.01
    )
    
    $
    (.06
    )Weighted average number of common shares
outstanding (thousands)  basic and diluted
    
    
    133,161
    
    
    
    118,138
    
    
    
    132,184
    
    
    
    117,102
 See accompanying notes to consolidated condensed financial statements. 3




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TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES 
 
 Nine Months Ended September 30,2004
    
    2003(unaudited)Cash flows from operating activities:Net loss
    
    $
    (1,079
    )
    
    $
    (6,737
    )Adjustments to reconcile net loss to
net cash used in operating activities:Utilization of prepaid services
    
    
    
    
    
    
    193Depreciation and amortization
    
    
    165
    
    
    
    190Amortization of deferred financing costs
    
    
    713
    
    
    
    510Loss related to unconsolidated affiliate
    
    
    50
    
    
    
    1,151Other
    
    
    (248
    )
    
    
    (462
    )Changes in operating assets and liabilities:Accounts receivable
    
    
    1,275
    
    
    
    (469
    )Inventories
    
    
    434
    
    
    
    564Deferred revenue
    
    
    (1,550
    )
    
    
    Accounts payable and accrued liabilities
    
    
    (291
    )
    
    
    155Net cash used in operating activities
    
    
    (531
    )
    
    
    (4,905
    )Cash flows from investing activities:Capital expenditures
    
    
    (63
    )
    
    
    (22
    )Investment in temporary cash investments
    
    
    
    
    
    
    457Proceeds from sale of partial interest in affiliate
    
    
    100
    
    
    
    Software development costs
    
    
    (9
    )
    
    
    (105
    )Net cash provided by investing activities
    
    
    28
    
    
    
    330Cash flows from financing activities:Proceeds from issuance of notes payable
    
    
    575
    
    
    
    4,260Proceeds from issuance of common stock
    
    
    64
    
    
    
    516Principal payments on notes payable
    
    
    (300
    )
    
    
    (225
    )Net cash provided by financing activities
    
    
    339
    
    
    
    4,551Net decrease in cash and cash equivalents
    
    
    (164
    )
    
    
    (24
    )Cash and cash equivalents, beginning of period
    
    
    165
    
    
    
    55Cash and cash equivalents, end of period
    
    $
    1
    
    
    $
    31
 See accompanying notes to consolidated condensed financial statements. 4




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TERAFORCE TECHNOLOGY CORPORATION 
 
 Basis of Presentation The accompanying consolidated financial statements have been prepared by
the Company without audit in accordance with accounting principles generally
accepted in the United States of America for interim financial statements and
with instructions to Form 10-Q and Rule 10-01 of Regulation S-X. In the
opinion of management, all adjustments (consisting only of normal recurring
accruals) considered necessary for a fair presentation have been included. The
accompanying consolidated financial statements do not include certain footnotes
and financial presentations normally required under accounting principles
generally accepted in the United States of America and, therefore, should be
read in conjunction with the audited financial statements included in the
Companys Annual Report on Form 10-K for the year ended December 31, 2003.
Certain prior period balances have been reclassified to conform to the current
period presentation. The Company incurred significant operating losses in 2003, 2002 and 2001;
however, the amount of these losses decreased in each of those years. These
losses were funded with the proceeds from the sale of debt and equity
securities, proceeds from borrowings, proceeds from the sale of assets and, in
2002, with proceeds from the settlement of certain litigation. The decrease in
operating losses is the result of the disposal of certain operations,
specifically those related to the telecommunications industry, the reduction of
other operating expenses and increases in net revenues from the Companys
defense electronics business. Net revenues from the sale of defense electronic
products have increased in each of the last three years. Management expects
net revenues to increase further in 2004. There can be no assurance, however,
that net revenues will increase or will increase to the extent anticipated and
that the Company will generate sufficient cash from operating activities.
Additionally, the Company has debt obligations totaling approximately
$6,760,000 that are due within the next twelve months. Should the Company not generate sufficient cash from operating activities
the Company could require additional capital. The Company believes that it
will be able to raise additional capital and satisfy its existing debt
obligations through (i) the issuance of new equity securities, (ii) the
incurrence of new debt, (iii) the conversion of existing debt into equity, (iv)
the modification of the terms of its existing debt obligations, or (v) a
combination of these source. There can be no assurance that the Company can
accomplish these matters, or can do so under acceptable terms. These financial
statements do not include any adjustments that might result from the outcome of
this uncertainty. 5




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TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
September 30, 2004 Inventories The components of inventories are as follows: September 30,
    
    December 31,2004
    
    2003($ Thousands)Raw materials
    
    $
    774
    
    
    $
    949Work in process
    
    
    121
    
    
    
    304Finished goods
    
    
    266
    
    
    
    342Total
    
    $
    1,161
    
    
    $
    1,595
 Segment of Business The Company currently operates in one business segment, defense
electronics and all of the Companys net revenues have been generated by the
defense electronics business. Income Taxes For all periods presented, the Companys effective income tax rate
differed from the federal statutory rate due to taxable losses incurred for
which no benefit was provided. Stock Option Plan The Company accounts for its stock option plan in accordance with the
provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting
for Stock Issued to Employees, and related interpretations. As such,
compensation expense is recorded only if the current market price of the
underlying stock on the date of grant exceeded the exercise price. SFAS No.
123, Accounting for Stock-Based Compensation, requires pro forma net income
and pro forma earnings per share disclosures for employee stock option grants
as if the fair-value-based method defined in SFAS No. 123 had been applied.
There was no stock based compensation expense recorded for any period. Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003($ Thousands)Net loss allocable to
common stockholders:As reported
    
    $
    (1,559
    )
    
    $
    (2,659
    )
    
    $
    (1,079
    )
    
    $
    (6,737
    )Less: total stock
based
compensation
determined under fair
value based methods,
net of tax
    
    
    147
    
    
    
    163
    
    
    
    423
    
    
    
    510Pro forma net loss
    
    $
    (1,706
    )
    
    $
    (2,822
    )
    
    $
    (1,502
    )
    
    $
    (7,247
    )Net loss per share:As reported
    
    $
    (.01
    )
    
    $
    (.02
    )
    
    $
    (.01
    )
    
    $
    (.06
    )Pro forma
    
    $
    (.01
    )
    
    $
    (.02
    )
    
    $
    (.01
    )
    
    $
    (.06
    )
 6




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TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
September 30, 2004 Earnings Per Share Basic and diluted earnings or loss per share are the same for all periods
presented because all potential common shares were anti-dilutive during those
periods. Potential common shares excluded from the calculation of diluted
earnings per share are as follows: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003( in Thousands)Out of the money
potential common
shares
    
    
    12,000
    
    
    
    6,000
    
    
    
    12,000
    
    
    
    6,000Other anti-dilutive
potential common
shares
    
    
    52,000
    
    
    
    48,000
    
    
    
    52,000
    
    
    
    48,000
 Notes Payable Notes payable consist of the following (in thousands): September 30,
    
    December 31,2004
    
    2003Guaranteed bank facility
    
    $
    3,900
    
    
    $
    4,20012% convertible subordinate notes
    
    
    2,860
    
    
    
    3,130Subsidiary revolving credit facility
    
    
    575
    
    
    
    Other
    
    
    290
    
    
    
    1007,625
    
    
    
    7,430Unamortized discount
    
    
    (340
    )
    
    
    (821
    )7,285
    
    
    
    6,609Due within one year
    
    
    (6,520
    )
    
    
    (700
    )Amount due after one year
    
    $
    765
    
    
    $
    5,909
 The Companys $4,200,000 credit facility with Bank One, NA provided for
the facility to be reduced by $300,000 by June 30, 2004. During June 2004 the
facility was amended to provide for this $300,000 reduction to be made by July
31, 2004. In July 2004 the Company repaid $300,000 and the maximum amount
available under the facility was reduced to $3,900,000. Terms of the credit
facility provide for a further reduction of $300,000 by December 31, 2004 and
for all amounts outstanding to be due on April 30, 2005. The note agreement related to the Companys 12% Convertible Subordinated
Notes due June 2005 contains a provision that the Company will have reported
net revenues of not less than $15,000,000
for the twelve month period ended June 30, 2004. In July 2004 compliance with
this provision was waived by the holders of the notes, as provided for in the
note agreement. In July 2004 the Company and its wholly-owned subsidiary, DNA Computing
Solutions, Inc. (DCS) entered into a $575,000 revolving credit facility with
FirstCapital Bank. Borrowings under 7




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TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
September 30, 2004 the facility bear interest at prime plus
1% and all amounts outstanding are due January 30, 2006, but may be prepaid at
anytime without penalty. The facility is secured by the fixed assets, accounts
receivable and inventory of DCS and by limited guarantees provided by a group
of private investors, including one of the Companys directors. As
consideration for providing the guarantees the Company has entered into a
Reimbursement Agreement with the guarantors. The Reimbursement Agreement
provides that the Company will reimburse the guarantors for any amounts that
they may be required to reimburse the bank pursuant to the underlying
guarantees. Pursuant to the Reimbursement Agreement, the guarantors have the
right to purchase up to 3,194,444 shares of the Companys common stock for
$575,000 in cash, the proceeds of which will be used to repay amounts
outstanding under the credit agreement and provide for the release of the
guarantees. The guarantors have also received warrants to purchase 1,597,222
shares of common stock, which have been valued at approximately $110,000 and
recorded as an asset in the accompanying consolidated balance sheet.
Additionally, the guarantors may receive warrants for up to an additional
1,597,222 shares of common stock if the Company does not meet certain goals
related to outstanding debt. All warrants have an exercise price of $0.21 per
share and may be exercised at any time from their issuance through July 31,
2008. In October 2004 the DCS facility was expanded to provide for additional
borrowings of up to $600,000, or $1,175,000 in total. The group of private
investors provided additional limited guarantees to secure the additional
borrowings pursuant to a new Reimbursement Agreement. Pursuant to the new
Reimbursement Agreement, the guarantors have the right to purchase of up to
3,333,333 shares of the Companys common stock for $600,000 in cash, the
proceeds of which will be used to repay amounts outstanding under the credit
agreement and provide for the release of the guarantees. The guarantors have
received additional warrants to purchase 6,666,667 shares of common stock which
have been valued at approximately $495,000 and recorded as an asset in the
accompanying balance sheet. These warrants have an exercise price of $0.20 per
share and may be exercised at any time from their issuance through October 30,
2010. The Company has agreed to file a registration statement related to the
potential resale of the shares of common stock issuable upon the exercise of
the stock purchase rights and upon exercise of the warrants no later than
December 31, 2004. As of September 30, 2004 there was $575,000 outstanding
under the total facility. Supplemental Disclosure of Cash Flow Information Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003($ Thousands)Cash paid during the period for:Interest
    
    $
    37
    
    
    $
    64
    
    
    $
    387
    
    
    $
    153
 8




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ITEM 2  MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS FOR THE PERIOD ENDED SEPTEMBER 30, 2004 Forward Looking Statements The statements in this Quarterly Report on Form 10-Q of TeraForce
Technology Corporation (the Company) regarding future financial and operating
performance and results, and other statements that are not historical facts,
are forward-looking statements, as defined in Section 27A of the Securities Act
of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended. We use the words may, expect, anticipate, believe,
continue, estimate, project, intend, designed or other similar
expressions to identify forward-looking statements. You should read statements
that contain such words carefully because they discuss future expectations,
contain projections of results of operations or of our financial condition,
and/or state other forward-looking information. These statements also
involve risks and uncertainties, including, but not limited to:  
    
    events, conditions and financial trends that may affect the
Companys future plans and business strategy,
    
    results of expectations and estimates as to prospective events, and
    
    circumstances about which the Company can give no firm assurance. Examples of types of forward-looking statements include statements on
future levels of net revenue and cash flow, new product development, strategic
plans and financing. These forward-looking statements involve risks and
uncertainties that could cause actual results to differ materially from those
projected or anticipated. Factors that might cause a difference include, but
are not limited to:  
    
    general economic conditions in the markets in which the Company operates;
    
    success in the development and market acceptance of new and existing products;
    
    dependence on suppliers, third party manufacturers and channels of distribution;
    
    customer and product concentration;
    
    fluctuations in customer demand;
    
    the ability to obtain and maintain access to external sources of capital;
    
    the ability to control costs;
    
    U. S. Government budget, procurement and contracting trends;
    
    overall management of the Companys expansion; and
    
    other risk factors detailed from time to time in the Companys
filings with the Securities and Exchange Commission. We believe it is important to communicate our expectations of future
performance to our investors. However, events may occur in the future that we
are unable to accurately predict, or that we cannot control. Any
forward-looking statement speaks only as of the date the statement was made,
and the Company undertakes no obligation to update any forward-looking
statement to reflect events or circumstances after the date the statement was
made. Because it is not possible to predict every new factor that may emerge,
forward-looking statements should not be relied upon as a prediction of actual
future financial condition or results. When considering our forward-looking
statements, keep in mind the risk factors and other cautionary statements in
our Annual Report on Form 10-K for the year ended December 31, 2003 and other
filings with the Securities and Exchange Commission. Risk factors provide
examples of risks, uncertainties and events that may cause our actual results
to differ materially from those contained in any forward-looking statement. If
one or more of these risks or uncertainties materialize, or if underlying
assumptions prove incorrect, actual outcomes may vary materially from those
forward-looking statements included in this Quarterly Report on Form 10-Q. The
terms we, our and us and similar terms refer to the Company and its
consolidated subsidiaries, not to any individual or group of individuals. 9




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Comparison of Three and Nine Months Ended September 30, 2004 to
Three and Nine Months Ended September 30, 2003 Net Revenue Net revenues, all of which relate to our defense electronics business,
were derived from the following sources: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003($ Thousands)Product sales and services
    
    $
    1,439
    
    
    $
    1,699
    
    
    $
    5,014
    
    
    $
    4,037License fees
    
    
    
    
    
    
    
    
    
    
    3,400
    
    
    
    $
    1,439
    
    
    $
    1,699
    
    
    $
    8,414
    
    
    $
    4,037
 Product sales increased in the first nine months of 2004 as compared to
the same period in 2003 due to increased shipments of our VQG4 product line and
integrated sub-systems. The shipments relate, in large part, to design wins
that we had secured in prior periods and which began to move into a production
phase beginning in the fourth quarter of 2003. For the three months ended
September 30, 2004 product sales declined as compared to the third quarter of
2003. This decrease is primarily the result of the timing of shipments. Our
customer concentration in the 2004 periods was not materially different from
that in 2003. We expect net revenues from product sales to generally increase
over the balance of 2004 and for net revenues from product sales for all of
2004 to exceed those in 2003. However, as in the third quarter of 2004, the
specific timing of the receipt and shipment of particular customer orders can
have a material effect on product sales in a quarter. The expected increase
in product sales results from continued shipments related to prior design wins
and other design wins we anticipate securing during 2004. Some of the
increased shipments, we believe, will be related to our VQCG4 and Eagle I
products. We expect the VQCG4 product and certain enhancements to the Eagle I
product to be available to customers in the fourth quarter of 2004. We also
expect to have a new product family, Nexus, available for customers in the
fourth quarter of 2004; however, we do not expect material sales of this
product in 2004. We believe that general factors in our industry have contributed to the
historical increase in our net revenues and that these factors will continue to
positively affect net revenues. The demand for products such as ours has been
increasing as defense expenditures have increased and, more importantly, as the
portion of those expenditures related to defense electronics has increased. We
believe that even if overall defense expenditures were to decrease,
expenditures related to defense electronics will continue to increase. License fees are attributable to our technology licensing and marketing
agreement with VISTA Controls, Inc. (VISTA). As of June 30, 2004 we had met
all of our delivery requirements under the agreement, except for those that are
perfunctory. We recognized net revenues related to these license fees in the
amount of $2,950,000 in the first quarter of 2004 and $450,000 in the second
quarter of 2004. We expect to recognize and receive the remaining $100,000
related to this agreement in the fourth quarter 2004. We received payment of
$1,550,000 related to these fees in December 2003, $1,400,000 in April 2004,
$450,000 in July 2004 and expect to receive the remaining balance of $100,000
in the fourth quarter of 2004. We also believe that the agreement with VISTA
will have a positive effect on our net revenues through access to new products
and access to additional market channels. There is no assurance, however, as
to the timing or amount of this effect, if any. Gross Profit Gross profit increased in the first nine months of 2004 compared to the
first nine months of 2003 due in part to the license fees recognized in 2004
for which we incurred little incremental cost and also due to increased product
sales. Gross profit in the first nine months of 2004, excluding the effect of
the license fees, was approximately $2,001,000, or 40% of product sales and
services. In the first nine months of 2003 10




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gross profit was $1,272,000, or 32%
of product sales and services. For the third quarter of 2004 gross profit was
approximately 33% of product sales versus 35% in the third quarter of 2003.
This change resulted from the slightly lower sales in the third quarter of 2004
and in changes in product mix. As product sales increase, we generally
expect gross profit as a percent of those sales to increase due to the effect
of fixed costs which are included as cost of revenue. However, this
relationship will be affected by the mix of particular products sold during a
period. Engineering and Development Expense Engineering and development expenses declined $70,000 in the third quarter
of 2004 as compared to the second quarter of 2003 and $532,000 in the first
nine months of 2004 as compared to the first nine months of 2003. The third
quarter and first nine months of 2003 included approximately $26,000 and
$193,000, respectively, in charges related to our engineering services
agreement with Flextronics Incorporated that was completed in 2003. The
balance of the decrease related primarily to a reduction in outsourced
services. We do not expect engineering and development expense to increase or
decrease materially over the balance of 2004. Selling and Administrative Expense Selling and administrative expense decreased by $70,000 in the third
quarter of 2004 compared to the third quarter of 2003 and increased $218,000
in the first nine months of 2004 compared to the same periods in 2003. The
decrease in the third quarter of 2004 versus the third quarter of 2003 is due
primarily to lower sales commission. The increase in the first nine months of
2004 relates primarily to increased sales and marketing expenses, particularly
increased sales commissions resulting from the increase in net revenues. We
generally expect these expenses to increase as net revenues increase in the
future. In addition, administrative expenses for the first nine months of 2004
include approximately $115,000 in costs related to our annual stockholders
meeting and the related proxy solicitation, which we did not incur in 2003. Litigation Costs Litigation costs represent legal fees and expenses related to the
shareholder action that was brought in 1999 against the Company and certain
former officers and directors. During the fourth quarter of 2003 we reached an
agreement in principle to settle this matter and the settlement agreement was
completed in the third quarter of 2004. Unconsolidated Affiliate In the third quarter of 2003 we adjusted the carrying value of our 22%
investment in Intelect Technologies, Inc. (ITI) to net realizable value based
on an agreement in principle to sell this investment to a third party for
$250,000. In June 2004 we determined that it was unlikely that this
transaction would be completed and we settled all obligations between ITI and
the Company and sold one third of our interest in ITI to the management of ITI
for cash payments aggregating $100,000. In June 2004 we adjusted the carrying
value of our remaining approximate 13% interest in ITI to $100,000, based on
the consideration received for the interest sold, and recorded a charge of
$50,000. Interest Expense Interest expense for the third quarter and first nine months of 2004
include approximately $233,000 and $713,000, respectively, related to the
amortization of the value of warrants issued in connection with various debt
transactions and beneficial conversion features related to convertible debt
obligations. In the third quarter and first nine months of 2003 these non-cash
charges amounted to approximately $277,000 and $510,000, respectively. The
warrants were valued when they were issued using the Black-Scholes option
pricing model and the amount is being amortized over the life of term of the
underlying debt. 11




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Liquidity and Capital Resources As of September 30, 2004, our working capital deficit was $7,320,000.
This includes the effect of notes payable totaling approximately $6,520,000
that are due within one year. Notes at September 30, 2004 consist of (i)
$3,900,000 related to our guaranteed bank facility, (ii) $2,521,000 related to
our 12% convertible subordinated notes, net of unamortized discount, (iii)
$575,000 in a guaranteed working capital facility, (iv) approximately $189,000
related to a promissory note issued in connection with the settlement of
certain litigation and (v) a $100,000 convertible demand note payable to an
officer and director. Our guaranteed bank facility with Bank One, NA was reduced by $300,000 in
July 2004. The terms of the facility provide for a further reduction of
$300,000 by December 31, 2004 and for all amounts to be due on April 30, 2005. As of September 30, 2004 the outstanding principal amount of our 12%
convertible subordinated debentures amounted to $2,860,000, including $250,000
held by an officer and a director. These amounts are presented in our
unaudited balance sheet net of approximately $339,000 in unamortized discount.
The notes mature on June 30, 2005. Operating Activities Net cash used in operations for the nine months ended September 30, 2004
amounted to $531,000. This amount arose primarily from the net loss of
$1,079,000 and the effect of non-cash charges related to depreciation and
amortization, offset by the reduction in deferred revenue of $1,550,000 related
to license fees from VISTA. Investing Activities For the nine months ended September 30, 2004, investing activities
provided cash in the amount of $28,000. This resulted from the proceeds of the
sale of a partial interest in ITI, offset by capital expenditures, primarily
for computer equipment. We expect capital expenditures to remain near this
level for the balance of 2004. Financing Activities In the nine months ended September 30, 2004 financing activities produced
$339,000 in cash as a result of the proceeds from notes payable, the exercise
of warrants and options to purchase our common stock, offset by repayments of
notes payable. During the balance of 2004 we may generate cash flow from the
issuance of debt or equity securities or from the proceeds of credit
facilities. Liquidity Outlook For the nine months ended September 30, 2004 our net cash used in
operating activities was $531,000, as compared to $4,905,000 in the same
period of 2003. This is a significant decline from prior periods, due in part
to the receipt of license fees from VISTA. We expect to generate cash flow
from operating activities over the next 12 months. We expect that increases in
net revenues from product shipments and services will contribute to our ability
to generate positive cash flow from operating activities over the next 12
months. Should we not receive orders that we anticipate from our customers, or
if we do not receive them within the timeframe we expect, we will not generate
positive cash flow from operations. The timing of expected product shipments is difficult to predict with
accuracy. Accordingly, from time to time we may require additional working
capital in order to offset the effect of potential delays of product shipments.
Therefore, in July and October 2004 we entered into a revolving credit
facility to provide up to $1,175,000 of additional working capital. At
November 1, 2004 there was $775,000 outstanding under this facility. 12




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We have approximately $6,760,000 in notes payable that are due within the
next twelve months. Of this amount, $2,860,000 relates to our 12% convertible
subordinated notes that are convertible into our common stock at a rate that is
below recent market prices. The balance of the notes payable relates to our
guaranteed bank facility that has an outstanding balance of $3,900,000 as of
September 30, 2004. We believe that we will be able to satisfy these
obligations through (i) the possible conversion into common stock , (ii)
restructuring the obligations, (iii) refinancing with the issuance of other
debt or equity securities, (iv) the reduction of the obligations with cash flow
from operations, or (v) a combination of these sources. While we believe we will have adequate liquidity to operate our business,
our estimate of capital needs is subject to a number of risks and uncertainties
that could result in additional capital needs that we have not anticipated. An
important aspect of our estimated capital requirements is our ability to
generate positive cash flow from operations. Our ability to generate positive
cash flow from operations is dependent upon our ability to increase revenues
from our defense electronics business, to generate adequate gross profit from
those sales and to control other costs and expenses. Our capital needs could
increase materially if any of our contingent liabilities are resolved adversely
to the Company. In addition, we could require additional working capital if
the defense electronics business increases more rapidly than we currently
anticipate. Should we need additional capital over the next several months we believe
that we will be able to secure it. Likely sources of additional capital
include the sale of additional debt or equity securities. A sale of additional
securities could result in dilution to existing common stockholders. There is
no assurance that additional capital will be available under terms that are
acceptable to us. Contingent Liabilities As discussed in ITEM 3  Legal Proceedings in our Annual Report on Form
10-K for the year ended December 31, 2003, we are exposed to certain contingent
liabilities which, if resolved adversely to us, would adversely affect our
liquidity, results of operations, and/or financial position. Other than as
discussed in PART II  ITEM 1  LEGAL PROCEEDINGS herein, there were no
material changes to these matters in the first nine months of 2004. 
 ITEM 3  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We have outstanding debt at September 30, 2004 amounting to approximately
$4,475,000 that bears interest at a variable interest rate and subjects us to
interest rate risk. This interest is based on widely used reference interest
rates known as prime and LIBOR. For example, an increase of 50 basis points in
these rates would result in an increase in our annual interest expense of
approximately $22,000. 
 ITEM 4  CONTROLS AND PROCEDURES The term disclosure controls and procedures is defined in Rules
13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, or the Exchange
Act. This term refers to the controls and procedures of a company that are
designed to ensure that information required to be disclosed by a company in
the reports that it files under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified by the Securities and
Exchange Commission. Our management, including our Chief Executive Officer and
our Chief Financial Officer, has evaluated the effectiveness of our
disclosure controls and procedures as of the end of the period covered by this
quarterly report. Based upon that evaluation, our Chief Executive Officer and
Chief Financial Officer have concluded that our disclosure controls and
procedures were effective as of the end of the period covered by this quarterly
report. There were no changes to our internal control over financial reporting
during our last fiscal quarter that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting. 13




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PART II  OTHER INFORMATION 
 ITEM 1 LEGAL PROCEEDINGS In August 2004 we completed the previously announced settlement of a
lawsuit that had been brought against the Company and certain current and
former officers and directors in November 1999. Pursuant to the settlement
agreement we paid an aggregate of $189,298 to the twelve individual plaintiffs
in this matter in exchange for a release of all claims. Zurich American Insurance Company (Zurich) provides excess liability
coverage of up to $3,000,000 for amounts in excess of $2,000,000 related to
this matter. The Companys incurred costs related to this matter, including
defense costs and the settlement payments, total approximately $1,900,000.
Accordingly, the coverage provided by Zurich has not been invoked. Zurich has
none the less agreed to advance the settlement payments to the plaintiffs in
return for the Companys promissory note in the amount of $189,298. The note
is due July 21, 2006 and bears interest at 7% annually. Accrued interest is
payable quarterly. The note is secured by warrants to purchase 948,517 shares
of our common stock. The warrants expire upon the repayment of the note and
any proceeds from the sale of common stock issued upon exercise of the warrants
will be used to repay the promissory note. Our costs related to this matter are also subject to a liability insurance
policy issued by Reliance Insurance Company (Reliance). Reliance has been
ordered liquidated by the insurance commissioner of the State of Pennsylvania.
We have previously received reimbursement of $300,000 of our costs from the
Texas Property and Casualty Guaranty Association and have filed a proof of
claim for the remaining approximately $1,600,000 with the Statutory Liquidator
for Reliance. The Statutory Liquidator has indicated that there will be funds
available for distribution to policy holders of Reliance; however, the amount
of these funds and the timing of the distribution, if any, is uncertain.
Therefore, we have not reflected any further recovery from Reliance in our
financial statements. 
 ITEM 2  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS In connection with the arrangements related to the settlement of certain
litigation (See Item 1  Legal Proceedings), we issued to Zurich a warrant for
the purchase of 948,517 shares of common stock on August 19, 2004. The warrant
was issued as collateral for a promissory note in the amount of $189,298 issued
by the Company to Zurich and expires upon the repayment of the promissory note.
The warrant has an exercise price of $0.01 per share. The number of shares of
common stock subject to the warrant is subject to adjustment in certain
circumstances. The warrant was issued pursuant to an exemption claimed under
Section 4(2) of the Securities Act of 1933 in a private placement to a
sophisticated institutional purchaser. The warrant and the shares issuable
thereunder contain legends restricting their resale. We have entered into a
Registration Rights Agreement with Zurich whereby we have agreed to file a
registration statement for the resale of the common stock to be issued upon the
exercise of the warrant not later than December 31, 2004. 14




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ITEM 6  EXHIBITS Listed below are all Exhibits filed as part of this report. Exhibit
    
    Description of Exhibit4.1
    
    Warrant Agreement issued to Zurich American Insurance Company4.2
    
    Registration Rights Agreement with Zurich American Insurance Company10.1
    
    Term Promissory Note dated August 19, 200431.1
    
    Certificate of the Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certificate of the Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.
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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. TERAFORCE TECHNOLOGY CORPORATION
(Registrant) Date: November 12, 2004
    
    /s/ ROBERT P. CAPPSRobert P. CappsChief Financial Officer(Principal Financial and Accounting Officer)Date: November 12, 2004
    
    /s/ HERMAN M. FRIETSCHHerman M. FrietschChief Executive Officer and Director(Principal Executive Officer)
 16