Product sales increased in the first quarter of 2004 as compared to the first quarter of 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 first quarter of 2004 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 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 March 31, 2004 we had met substantially all of our delivery requirements under the agreement. We expect to recognize approximately $550,000 of additional license fees related to this agreement during the course of 2004. We received payment of $1,550,000 related to these fees in December 2003, $1,400,000 in April 2004 and expect to receive the remainder during the balance 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.
The increase in gross profit between the first quarters of 2003 and 2004 results from the license fees recognized in 2004 for which we incurred little incremental cost and from increased product sales. Gross profit in the first quarter of 2004, excluding the effect of the license fees was approximately $776,000, or 47% of product sales and services. In the first quarter of 2003 gross profit was $273,000, or 29% of product sales and services. As product sales increase, we 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.
Engineering and development expenses declined $284,000 in the first quarter of 2004 as compared to the first quarter of 2003. The first quarter of 2003 included approximately $119,000 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 $99,000 in the first quarter of 2004 as compared to the same period in 2003. The increase related 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.
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.
Share of Loss of Unconsolidated Affiliate
In the third quarter of 2003 we adjusted the carrying value of our 22% investment in Intelect Technologies, Inc. to net realizable value based on an agreement in principle to sell this investment to a third party for $250,000.
Interest Expense
Interest expense for the first quarter of 2004 includes approximately $201,000 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 first quarter of 2003 these non-cash charges amounted to approximately $52,000. The warrants were valued when they were issued using the Black-Scholes option pricing model.
Liquidity and Capital Resources
As of March 31, 2004, our working capital was $258,000, which included $700,000 of notes payable due within one year. As of March 31, 2004, our long term notes payable total $6,108,000, net of unamortized debt discount of $622,000. Subsequent to March 31, 2004 convertible notes with a principal balance of $270,000 were converted into common stock. Therefore, as of April 30, 2004 we had long-term debt of $3,600,000 due April 30, 2005 and $1,587,000 due June 30, 2005.
Operating Activities
Net cash used in operations for the three months ended March 31, 2004 amounted to $129,000. This amount arose primarily from the net income of $1,937,000, offset by the reduction in deferred revenue of $1,200,000 related to license fees from VISTA. During 2004 we expect to receive $1,950,000 from VISTA related to these license fees, $1,400,000 of which we received in April 2004. We expect to produce cash flow from operating activities in 2004; however, we may not do so in every quarter.
Investing Activities
For the three months ended March 31, 2004, investing activities used cash in the amount of $29,000, primarily for capital expenditures for computer equipment. We expect capital expenditures to remain near this level for the balance of 2004.
Financing Activities
In the first quarter of 2004 there were no material financing activities. During the balance of 2004 we may generate cash flow from the issuance of debt or equity securities.
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Liquidity Outlook
Since the third quarter of 2003 we have generated cumulative positive cash flow from operating activities, 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, again due in part to the receipt of license fees from VISTA. We received a $1,400,000 payment related to these fees in April 2004. We expect increases in net revenues from product shipments and services will contribute to our ability to generate positive cash flow from operating activities during the balance of 2004. We believe that we will generate sufficient cash flow from operation to satisfy our debt and other obligations.
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 in 2004 we believe that we will be able to secure it. Potential sources of additional capital include the sale of additional debt or equity securities and other debt, such as bank debt. A sale of additional securities could result in dilution to existing common stockholders. There is no assurance that additional capital will be available under terms that are acceptable to us
Contingent Liabilities
As discussed in “ITEM 3 – Legal Proceedings” in 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 its liquidity, its results of operations, and/or its financial position. There were no material changes to these matters in the first quarter of 2004.
ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We have outstanding debt at March 31, 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 15(d)-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.
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PART II - OTHER INFORMATION
ITEM 2 – CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES
During the first quarter of 2004, certain holders of warrants to purchase our common stock elected to exercise certain of those warrants. Warrants for the purchase of 806,859 shares of our common stock were exercised on a cashless basis, resulting in the issuance of 383,168 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.
In March 2004, our $4.2 million credit facility with Bank One, NA was amended to extend the maturity date to April 30, 2005. The letter of credit securing the credit facility was extended to reflect the extended maturity date. As consideration for this extension, on February 27, 2004 we issued warrants to the private investor, Oscar S. Wyatt, who provides the letter of credit. The warrants provide for the purchase of 3,250,000 shares of our common stock at $0.29 per share and 3,250,000 shares of our common stock at $0.55 per share. The warrants are exercisable at any time through April 30, 2006. The issuance of the warrants was exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended.
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
A. Listed below are all Exhibits filed as part of this report.
| Exhibit | Description of Exhibit |
| | |
| 31.1 | Certificate of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | |
| 31.2 | Certificate of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | |
| 32.1 | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
B. The Company has not filed any report on Form 8-K during the period covered by this Report.
On March 18, 2004, we furnished information under Item 12 of Form 8-K.
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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: | May 11, 2004 | | /s/ ROBERT P. CAPPS |
| |
| |
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| | | | Robert P. Capps |
| | | | Chief Financial Officer |
| | | | (Principal Financial and Accounting Officer) |
| | | | |
| | | | |
| Date: | May 11, 2004 | | /s/ HERMAN M. FRIETSCH |
| |
| |
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| | | | Herman M. Frietsch |
| | | | Chief Executive Officer and Director |
| | | | (Principal Executive Officer) |
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