##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
   FORM 10 - Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2004 Commission File Number 0-11630  TeraForce Technology Corporation  Delaware
(State or Other Jurisdiction of
Incorporation or Organization)
    
    76-0471342
(I.R.S. Employer
Identification No.)1240 East Campbell Road, Richardson, Texas
(Address of Principal Executive Offices)
    
    75081
(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 133,161,052 shares of Common Stock outstanding as of July 31, 2004.




---



TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES INDEX PagePart I Financial InformationItem 1 Financial StatementsConsolidated Balance Sheets of the Company at June 30, 2004 (unaudited) and December 31, 2003
    
    
    2Consolidated Statements of Operations of the Company
(unaudited) for the three and six months ended June 30, 2004 and 2003
    
    
    3Consolidated Statements of Cash Flows of the Company
(unaudited) for the six months ended June 30, 2004 and 2003
    
    
    4Notes to Consolidated Financial Statements
    
    
    5Item 2 Managements Discussion and Analysis of Financial
Condition and Results of Operations
    
    
    8Item 3 Quantitative and Qualitative Disclosures About Market Risk
    
    
    12Item 4 Controls and Procedures
    
    
    12Part II Other InformationItem 2 Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities
    
    
    13Item 4 Submission of Matters to a Vote of Security Holders
    
    
    13Item 6 Exhibits and Reports on Form 8-K
    
    
    14Certificate of CEO Pursuant to Section 302Certificate of CFO Pursuant to Section 302Certification Pursuant to Section 906




---



##### Table of Contents



PART I - FINANCIAL INFORMATION 
 ITEM 1 - FINANCIAL STATEMENTS TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES 
   June 30,
    
    December 31,2004
    
    2003(unaudited)AssetsCurrent assets:Cash and cash equivalents
    
    $
    1
    
    
    $
    165Accounts receivable net of allowance of $30 in 2004
and 2003
    
    
    1,055
    
    
    
    1,935Inventories
    
    
    1,248
    
    
    
    1,595Prepaid expenses and other current assets
    
    
    609
    
    
    
    537Total current assets
    
    
    2,913
    
    
    
    4,232Property and equipment, net
    
    
    324
    
    
    
    378Investment in affiliate
    
    
    100
    
    
    
    250Other assets
    
    
    595
    
    
    
    488$
    3,932
    
    
    $
    5,348Liabilities and Stockholders DeficitCurrent liabilities:Current portion of notes payable
    
    $
    6,707
    
    
    $
    700Accounts payable
    
    
    1,252
    
    
    
    1,495Deferred revenue
    
    
    
    
    
    
    1,550Accrued liabilities
    
    
    1,434
    
    
    
    1,686Total current liabilities
    
    
    9,393
    
    
    
    5,431Long-term notes payable
    
    
    
    
    
    
    5,909Other long-term liabilities
    
    
    300
    
    
    
    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
    
    
    189,712
    
    
    
    189,194Accumulated deficit
    
    
    (195,222
    )
    
    
    (195,702
    )(4,174
    )
    
    
    (5,200
    )Less 400,474 shares of common stock in treasury at cost
    
    
    (1,587
    )
    
    
    (1,587
    )Total stockholders deficit
    
    
    (5,761
    )
    
    
    (6,787
    )$
    3,932
    
    
    $
    5,348
 See accompanying notes to consolidated condensed financial statements. 2




---



##### Table of Contents



TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES 
   Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(unaudited)Net revenues
    
    $
    2,368
    
    
    $
    1,385
    
    
    $
    6,975
    
    
    $
    2,338Cost of revenues
    
    
    1,163
    
    
    
    977
    
    
    
    2,044
    
    
    
    1,657Gross profit
    
    
    1,205
    
    
    
    408
    
    
    
    4,931
    
    
    
    681Expenses:Engineering and development
    
    
    518
    
    
    
    696
    
    
    
    1,019
    
    
    
    1,481Selling and administrative
    
    
    1,336
    
    
    
    1,147
    
    
    
    2,639
    
    
    
    2,3511,854
    
    
    
    1,843
    
    
    
    3,658
    
    
    
    3,832Operating profit (loss)
    
    
    (649
    )
    
    
    (1,435
    )
    
    
    1,273
    
    
    
    (3,151
    )Other income (expense):Litigation costs, net of
insurance reimbursement
    
    
    
    
    
    
    (48
    )
    
    
    
    
    
    
    (125
    )Share of loss and adjustment to carrying
value of unconsolidated affiliate
    
    
    (50
    )
    
    
    (152
    )
    
    
    (50
    )
    
    
    (369
    )Interest expense
    
    
    (400
    )
    
    
    (252
    )
    
    
    (735
    )
    
    
    (368
    )Interest income and other
    
    
    (8
    )
    
    
    
    
    
    
    (8
    )
    
    
    (65
    )(458
    )
    
    
    (452
    )
    
    
    (793
    )
    
    
    (927
    )Net income (loss)
    
    $
    (1,107
    )
    
    $
    (1,887
    )
    
    $
    480
    
    
    $
    (4,078
    )Basic and diluted income (loss) per share
    
    $
    (.01
    )
    
    $
    (.02
    )
    
    $
    
    
    
    $
    (.03
    )Weighted average number of common shares
outstanding (thousands):Basic
    
    
    132,775
    
    
    
    118,080
    
    
    
    131,690
    
    
    
    116,575Diluted
    
    
    132,775
    
    
    
    118,080
    
    
    
    159,891
    
    
    
    116,575
 See accompanying notes to consolidated condensed financial statements. 3




---



##### Table of Contents



TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES 
   Six Months Ended June 30,2004
    
    2003(unaudited)Cash flows from operating activities:Net income (loss)
    
    $
    480
    
    
    $
    (4,078
    )Adjustments to reconcile net income (loss) to
net cash used in operating activities:Utilization of prepaid services
    
    
    
    
    
    
    167Depreciation and amortization
    
    
    111
    
    
    
    129Amortization of deferred financing costs
    
    
    480
    
    
    
    Amounts related to unconsolidated affiliate
    
    
    50
    
    
    
    369Other
    
    
    (75
    )
    
    
    375Changes in operating assets and liabilities:Accounts receivable
    
    
    881
    
    
    
    (7
    )Inventories
    
    
    347
    
    
    
    336Deferred revenue
    
    
    (1,550
    )
    
    
    Accounts payable and accrued liabilities
    
    
    (969
    )
    
    
    780Net cash used in operating activities
    
    
    (245
    )
    
    
    (1,929
    )Cash flows from investing activities:Capital expenditures
    
    
    (45
    )
    
    
    (7
    )Investment in temporary cash investments
    
    
    
    
    
    
    457Proceeds from sale of partial interest in affiliate
    
    
    100
    
    
    
    Software development costs
    
    
    (9
    )
    
    
    (83
    )Net cash provided by investing activities
    
    
    46
    
    
    
    367Cash flows from financing activities:Proceeds from issuance of notes payable
    
    
    
    
    
    
    997Proceeds from issuance of common stock
    
    
    35
    
    
    
    511Net cash provided by financing activities
    
    
    35
    
    
    
    1,508Net decrease in cash and cash equivalents
    
    
    (164
    )
    
    
    (54
    )Cash and cash equivalents, beginning of period
    
    
    165
    
    
    
    55Cash and cash equivalents, end of period
    
    $
    1
    
    
    $
    1
 See accompanying notes to consolidated condensed financial statements. 4




---



##### Table of Contents



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. 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 and that the Company will
generate cash from operating activities during 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. 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 through either the issuance of new
equity securities, the incurrence of new debt or the modification of the terms
of its existing debt obligations. There can be no assurance that the Company
can accomplish these matters, or can do so under acceptable terms. These
financial statements do not include any adjustments that might result from the
outcome of this uncertainty. 5




---



##### Table of Contents



TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
June 30, 2004 Inventories The components of inventories are as follows: June 30,
    
    December 31,2004
    
    2003($ Thousands)Raw materials
    
    $
    693
    
    
    $
    949Work in process
    
    
    180
    
    
    
    304Finished goods
    
    
    375
    
    
    
    342Total
    
    $
    1,248
    
    
    $
    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 the six months ended June 30, 2004, the Companys effective income tax
rate differed from the federal statutory rate due to current period tax expense
offset by an offsetting decrease in the valuation allowance for the same
amount. For the three months ended June 30, 2004 and June 30, 2003 and for the
six months ended June 30, 2003, 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
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003($ Thousands)Net income (loss) allocable to
common stockholders:As reported
    
    $
    (1,107
    )
    
    $
    (1,887
    )
    
    $
    480
    
    
    $
    (4,078
    )Additional compensation
expense
    
    
    143
    
    
    
    184
    
    
    
    275
    
    
    
    347Pro forma
    
    $
    (1,250
    )
    
    $
    (2,071
    )
    
    $
    205
    
    
    $
    (4,425
    )Income (loss) per share:As reported
    
    $
    (.01
    )
    
    $
    (.02
    )
    
    $
    
    
    
    $
    (.03
    )Pro Forma
    
    $
    (.01
    )
    
    $
    (.02
    )
    
    $
    
    
    
    $
    (.04
    )
 6




---



##### Table of Contents



TERAFORCE TECHNOLOGY CORPORATION
Notes to Consolidated Condensed Financial Statements
(Unaudited)
June 30, 2004 Earnings Per Share Basic and diluted earnings or loss per share are the same for the three
month periods ended June 30, 2004 and 2003 and for the six months ended June
30, 2003 because all potential common shares were anti-dilutive during those
periods. For the six months ended June 30, 2004 approximately 15,000,000
potential common shares are excluded from the calculation of diluted earnings
per share because such shares were out of the money. Notes Payable 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 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 and 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. 7




---



##### Table of Contents



ITEM 2  MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS FOR THE PERIOD ENDED JUNE 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. 8




---



##### Table of Contents



Comparison of Three and Six Months Ended June 30, 2004 to
Three and Six Months Ended June 30, 2003 Net Revenue Net revenues, all of which relate to our defense electronics business,
were derived from the following sources: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003($ Thousands)Product sales and services
    
    $
    1,918
    
    
    $
    1,385
    
    
    $
    3,575
    
    
    $
    2,338License fees
    
    
    450
    
    
    
    
    
    
    
    3,400
    
    
    
    $
    2,368
    
    
    $
    1,385
    
    
    $
    6,975
    
    
    $
    2,338
 Product sales increased in the second quarter of 2004 as compared to the
second quarter of 2003 and in the first six 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. 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,
although there may not be sequential increases in each quarter. This expected
increase 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 by 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
do so. 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 during the balance of 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
during 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 between the second quarters of 2003 and 2004 and in
the first six months of 2004 compared to the first six 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
second quarter of 2004, excluding the effect of the license fees, was
approximately $755,000, or 39% of product sales and services. In the second
quarter of 2003 gross profit was $408,000, or 29% of product sales and
services. In the first six months of 2004 gross profit, excluding the effect
of the license fees, was approximately $1,531,000, or 43% of product sales. In
the first six months of 2003 gross profit was $681,000, or 29% of 9




---



##### Table of Contents



product sales. 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 effected by
the mix of particular products sold during a period. Engineering and Development Expense Engineering and development expenses declined $178,000 in the second
quarter of 2004 as compared to the second quarter of 2003 and $462,000 in the
first six months of 2004 as compared to the first six months of 2003. The
second quarter and first six months of 2003 included approximately $48,000 and
$167,000, 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 reduced 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 increased by $189,000 in the second
quarter of 2004 and $288,000 in the first six months of 2004 as compared to the
same periods in 2003. These increases relate 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 in
the second quarter 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 in 2003 represent legal fees and expenses related to the
shareholder action. During the fourth quarter of 2003 we reached an agreement
in principle to settle this matter. 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 15% 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 second quarter and first six months of 2004
include approximately $279,000 and $480,000, 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 second quarter and first six months of 2003 these non-cash
charges amounted to approximately $181,000 and $233,000, respectively. The
warrants were valued when they were issued using the Black-Scholes option
pricing model. Liquidity and Capital Resources As of June 30, 2004, our working capital deficit was $6,480,000. This
includes the effect of notes payable totaling approximately $6,707,000, all of
which is due within one year. Notes at June 30, 2004 consist of (i) $4,200,000
related to our guaranteed bank facility, (ii) $2,407,000 related to our 12%
convertible subordinated notes, net of unamortized discount and (iii) a
$100,000 convertible demand note payable to an officer and director. 10




---



##### Table of Contents



Our $4,200,000 guaranteed bank 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 we repaid $300,000 under the facility and the maximum
amount available under the facility was reduced to $3,900,000. 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 June 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 $453,000 in unamortized discount. Operating Activities Net cash used in operations for the six months ended June 30, 2004
amounted to $245,000. This amount arose primarily from the net income of
$480,000 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. We expect to produce cash flow from operating
activities in 2004; however, we may not do so in every quarter. Investing Activities For the six months ended June 30, 2004, investing activities provided cash
in the amount of $46,000. 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 six months ended June 30, 2004 financing activities produced
$35,000 in cash as a result of the exercise of warrants and options to purchase
our common stock. 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 Since the third quarter of 2003 our net cash used in operating activities
has aggregated approximately $116,000. 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 during the balance of
2004 and for 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 and over the next 12 months. 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 2004 we entered into a $575,000 revolving credit facility
to provide additional working capital. 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
July 31, 2004. To the extent that these obligations are not converted into
common stock and to the extent that cash flow provided from operations is not
sufficient to satisfy these obligations, we believe that we will be able to
refinance or restructure the obligations. 11




---



##### Table of Contents



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
continue to generate positive cash flow from operations. Our ability to
generate cash flow from operations is dependent upon our ability to increase
revenues from our defense electronics business, to generate adequate gross
profit from those sales and to control other costs and expenses. Our capital
needs could increase materially if any of our contingent liabilities are
resolved adversely to the Company. In addition, we could require additional
working capital if the defense electronics business increases more rapidly than
we currently anticipate. Should we need additional capital over the next 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. There were no
material changes to these matters in the first six months of 2004. 
 ITEM 3  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We have outstanding debt at June 30, 2004 amounting to approximately
$4,200,000 that bears interest at a variable interest rate and subjects us to
interest rate risk. This interest is based on widely used reference interest
rates known as prime and LIBOR. For example, an increase of 50 basis points in
these rates would result in an increase in our annual interest expense of
approximately $21,000. 
 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. 12




---



##### Table of Contents



PART II - OTHER INFORMATION 
 ITEM 2  CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES During the second quarter of 2004, certain holders of our 12% convertible
subordinated notes elected to convert those notes into common stock. Notes
with a principal amount of $270,000 and accrued interest in the amount of
approximately $22,000 were converted, resulting in the issuance of 1,824,205
shares of common stock. The shares of common stock issued upon conversion of
the notes constituted exempt securities under Section 3(a)(9) of the Securities
Act of 1933, as amended. During the second quarter of 2004 warrants for the purchase of 480,000
shares of common stock were exercised, resulting in net proceeds to us of
approximately $57,000. These proceeds were used for working capital. The
issuance of the common stock was exempt from registration pursuant to Section
3(a)(9) of the Securities Act of 1933, as amended. In July 2004 the Company and its wholly-owned subsidiary, DNA Computing
Solutions, Inc., entered into a $575,000 revolving credit facility with
FirstCapital Bank. The facility is secured, in part, by limited guarantees
provided by a group of investors, including one of our directors. As
consideration for providing the guarantees, we entered into a Reimbursement
Agreement with the guarantors. Pursuant to the Reimbursement Agreement, the
guarantors have the right to purchase up to 3,194,444 shares of our common
stock for $575,000 in cash. The guarantors have also received warrants to
purchase 1,597,222 shares of our common stock and may received warrants to
purchase up to an additional 1,597,222 shares of common stock if we do 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. The issuance of the rights to purchase common stock and the
warrants are exempt from registration pursuant to Section 4(2) of the
Securities Act of 1933, as amended. 
 ITEM 4  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On May 19, 2004 we held our annual meeting of stockholders. Matters
submitted to a vote of our stockholders at that meeting were (1) the election
of four directors of the Company, (2) a proposal to increase the number of
shares reserved for issuance under our Amended and Restated Stock Incentive
Plan, (3) a proposal to amend our Amended and Restated Certificate of
Incorporation to increase the number of shares of our common stock authorized
for issuance from 200,000,000 to 250,000,000, and (4) a proposal to ratify the
selection of Grant Thornton LLP as our independent certified public accountants
for 2004. All of the matters were approved. The results of the votes were as follows: VotesVotes For
    
    Votes Against
    
    Withheld
    
    Abstentions
    
    Broker NonvotesElection of directors (Item 1):Prinz Anton von Liechtenstein
    
    
    114,972,733
    
    
    
    1,536,402
    
    
    
    25,693,132
    
    
    
    
    
    
    
    Robert E. Garrison II
    
    
    114,013,193
    
    
    
    1,495,942
    
    
    
    25,693,132
    
    
    
    
    
    
    
    Herman M. Frietsch
    
    
    114,920,506
    
    
    
    1,588,629
    
    
    
    25,693,132
    
    
    
    
    
    
    
    David H. Yedwab
    
    
    114,012,983
    
    
    
    1,496,152
    
    
    
    25,693,132
    
    
    
    
    
    
    
    Amended and Restated Stock
Incentive Plan (Item 2)
    
    
    27,207,454
    
    
    
    24,430,405
    
    
    
    25,693,132
    
    
    
    225,039
    
    
    
    63,807,586Amend Amended and Restated
Certificate of Incorporation
(Item 3)
    
    
    92,644,940
    
    
    
    22,538,603
    
    
    
    25,693,132
    
    
    
    323,092
    
    
    
    Ratify appointment of certified
public accountants (Item 4)
    
    
    114,755,991
    
    
    
    526,274
    
    
    
    25,693,132
    
    
    
    224,170
    
    
    
    
 13




---



##### Table of Contents



ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K A. Listed below are all Exhibits filed as part of this report. Exhibit
    
    Description of Exhibit31.1
    
    Certificate of the Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certificate of the Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.
 B. The Company has not filed any report on Form 8-K during the period
covered by this Report, except as follows: On May 4, 2004 we furnished information under Item 9 of Form 8-K. On May 11, 2004, we furnished information under Item 12 of Form 8-K. On June 14, 2004 we filed a report on Form 8-K/A, amending the Form 8-K
filed on November 24, 2003 and filing exhibits under Item 7. 14




---



##### Table of Contents



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: August 6, 2004
    
    /s/ ROBERT P. CAPPSRobert P. CappsChief Financial Officer(Principal Financial and Accounting Officer)Date: August 6, 2004
    
    /s/ HERMAN M. FRIETSCHHerman M. FrietschChief Executive Officer and Director(Principal Executive Officer)
 15