Interphase (INPH) 10-Q 2006 Q2 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2006

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from            to           

Commission File Number 0-13071

INTERPHASE CORPORATION

(Exact name of registrant as specified in its charter)

Texas
(State or other jurisdiction of incorporation or organization) 75-1549797
(I.R.S. Employer Identification No.)

Parkway Centre I
2901 North Dallas Parkway, Suite 200
Plano, Texas 75093
(Address of Principal Executive Offices and Zip Code)

(214) 654-5000
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesþ Noo

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filero           Accelerated filero            Non-accelerated filerþ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ

As of August 8, 2006, shares of common stock outstanding totaled 6,071,560.

INTERPHASE CORPORATION

Index to Form 10-Q
Quarterly Period Ended June 30, 2006

Part I — Financial Information
Item 1. Condensed Consolidated Financial Statements (unaudited)
Condensed Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005	2
Condensed Consolidated Statements of Operations for the three months and six months ended June 30, 2006 and 2005	3
Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005	4
Notes to Condensed Consolidated Financial Statements	5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
Item 3. Quantitative and Qualitative Disclosures About Market Risk	15
Item 4. Controls and Procedures	16
Part II — Other Information
Item 1. Legal Proceedings	16
Item 1A. Risk Factors	16
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	16
Item 3. Defaults Upon Senior Securities	16
Item 4. Submission of Matters to a Vote of Security Holders	17
Item 5. Other Information	17
Item 6. Exhibits	17
Rule 13a-14(a)/15d-14(a) Certification
Rule 13a-14(a)/15d-14(a) Certification
Section 1350 Certification
Section 1350 Certification

PART I
FINANCIAL INFORMATION

Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

INTERPHASE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
(unaudited)

	June 30,			December 31,
	2006			2005
ASSETS
Cash and cash equivalents	$	7,107		$	3,180
Marketable securities		13,198			15,388
Trade accounts receivable, less allowances of $146 and $126, respectively		6,826			5,195
Inventories		2,400			3,109
Prepaid expenses and other current assets		933			754
Total current assets		30,464			27,626
Machinery and equipment		5,988			5,899
Leasehold improvements		417			411
Furniture and fixtures		547			545
		6,952			6,855
Less-accumulated depreciation and amortization		(5,980	)		(5,697	)
Total property and equipment, net		972			1,158
Capitalized software, net		544			229
Other assets		185			181
Total assets	$	32,165		$	29,194
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities
Accounts payable	$	1,240		$	255
Deferred revenue		108			118
Accrued liabilities		971			1,757
Accrued compensation		1,753			942
Total current liabilities		4,072			3,072
Other non-current liabilities		—			34
Deferred lease obligations		87			90
Long-term debt		3,500			3,500
Total liabilities		7,659			6,696
Commitments and Contingencies
Shareholders’ Equity
Common stock, $0.10 par value; 100,000,000 shares authorized; 6,070,560 and 5,901,895 shares issued and outstanding, respectively		607			590
Additional paid in capital		39,295			38,817
Retained deficit		(14,692	)		(16,145	)
Cumulative other comprehensive loss		(704	)		(764	)
Total shareholders’ equity		24,506			22,498
Total liabilities and shareholders’ equity	$	32,165		$	29,194

The accompanying notes are an integral part of these condensed consolidated financial statements.

2

INTERPHASE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2006			2005			2006			2005
Revenues	$	9,371		$	7,592		$	17,522		$	16,372
Cost of sales		3,971			3,542			8,001			7,570
Gross margin		5,400			4,050			9,521			8,802
Research and development		1,966			2,024			3,846			4,193
Sales and marketing		1,474			1,558			2,818			3,076
General and administrative		1,242			897			2,196			1,843
Total operating expenses		4,682			4,479			8,860			9,112
Income (loss) from operations		718			(429	)		661			(310	)
Interest income, net		125			89			240			165
Other income (expense), net		223			(50	)		360			(54	)
Income (loss) before income tax		1,066			(390	)		1,261			(199	)
Income tax (benefit) provision		(77	)		81			(192	)		117
Net income (loss)	$	1,143		$	(471	)	$	1,453		$	(316	)
Net income (loss) per share:
Basic EPS	$	0.20		$	(0.08	)	$	0.25		$	(0.05	)
Diluted EPS	$	0.19		$	(0.08	)	$	0.24		$	(0.05	)
Weighted average common shares		5,843			5,755			5,819			5,753
Weighted average common and dilutive shares		6,002			5,755			5,940			5,753

The accompanying notes are an integral part of these condensed consolidated financial statements.

3

INTERPHASE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

	Six Months Ended
	June 30,
	2006			2005
Cash flows from operating activities:
Net income (loss)	$	1,453		$	(316	)
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for uncollectible accounts and returns		20			57
Provision for excess and obsolete inventories		300			400
Depreciation and amortization		328			400
Amortization of restricted stock		179			19
Change in assets and liabilities:
Trade accounts receivable		(1,651	)		1,023
Inventories		409			(401	)
Prepaid expenses and other current assets		(162	)		(926	)
Income taxes receivable		—			235
Other assets		5			—
Accounts payable, deferred revenue and accrued liabilities		176			247
Accrued compensation		750			(188	)
Other non-current liabilities		(34	)		—
Deferred lease obligations		(3	)		11
Net cash provided by operating activities		1,770			561
Cash flows from investing activities:
Purchase of property and equipment		(83	)		(326	)
Purchase of capitalized software		(359	)		(13	)
Proceeds from the sale of marketable securities		5,525			5,928
Purchase of marketable securities		(3,320	)		(6,309	)
Net cash provided by (used in) investing activities		1,763			(720	)
Cash flows from financing activities:
Proceeds from the exercise of stock options		316			40
Net cash provided by financing activities		316			40
Effect of exchange rate changes on cash and cash equivalents		78			(181	)
Net increase (decrease) in cash and cash equivalents		3,927			(300	)
Cash and cash equivalents at beginning of period		3,180			4,928
Cash and cash equivalents at end of period	$	7,107		$	4,628

The accompanying notes are an integral part of these condensed consolidated financial statements.

4

INTERPHASE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1. — BASIS OF PRESENTATION

Interphase Corporation and subsidiaries (“Interphase” or the “Company”) provide robust building blocks, highly integrated subsystems and innovative gateway appliances for the converged communications network. Building on a 30-year history of providing advanced Input/Output (I/O) solutions for telecommunications and enterprise applications, and addressing the need for high speed connectivity, Interphase has established a key role in delivering next generation AdvancedTCA^® (Advanced Telecommunications Computing Architecture or ATCA), MicroTCA and AdvancedMC™ (Advanced Mezzanine Card or AMC) solutions to the marketplace. The Company’s products enable telecommunications equipment manufacturers to deploy robust and highly scalable network infrastructure equipment into Third Generation Wireless (3G), IP Multimedia Subsystem (IMS), Voice over IP (VoIP) and Broadband Access Networks worldwide, enabling the delivery of advanced IPTV and Triple Play services. See Note 10 for information regarding the Company’s revenues related to North America and foreign countries.

The accompanying condensed consolidated financial statements include the accounts of Interphase Corporation and its wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated. While the accompanying condensed consolidated financial statements are unaudited, they have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of the Company, all material standard adjustments and disclosures necessary to fairly present the results of such periods have been made. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. Operating results for the three months and six months ended June 30, 2006, are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2005.

NOTE 2. — STOCK-BASED COMPENSATION

Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payments”, to account for stock-based compensation using the modified prospective transition method and therefore will not restate the prior period results. SFAS No. 123(R) supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and revises guidance in SFAS No. 123, “Accounting for Stock-Based Compensation”.

On December 19, 2005, the Board of Directors approved the acceleration of the vesting of all unvested options to purchase shares of common stock of the Company that were held by employees and executive officers as of December 19, 2005. Less than one percent of these unvested options consisted of “in-the-money” options. The number of shares and exercise prices of the options subject to the acceleration were unchanged. As a result of this action, the Company had no unvested stock options at December 31, 2005, and there have been no stock options granted since this action. The Company has recorded no stock-based compensation expense relating to stock options during the second quarter of 2006 as a result of the adoption of SFAS No. 123(R).

5

INTERPHASE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The Interphase Corporation 2004 Long-Term Stock Incentive Plan provides for grants of bonus stock awards (“restricted stock”) to its directors and certain employees at no cost to the recipient. Holders of restricted stock are entitled to cash dividends, if any, and to vote their respective shares. Restrictions limit the sale or transfer of these shares during a predefined vesting period, currently ranging from one to four years, and in some cases vesting is subject to the achievement of certain performance conditions. During the three months ended June 30, 2006, there were 30,000 restricted stock shares granted at a market price of $6.21 and during the six months ended June 30, 2006 there were 102,300 restricted stock shares granted at market prices ranging from $5.40 to $6.21. Upon issuance of restricted stock under the plan, unearned compensation equivalent to the market value at the date of grant is recorded as a reduction to shareholders’ equity and subsequently amortized to expense over the respective restriction periods. Compensation expense related to restricted stock was approximately $115,000 for the three months ended June 30, 2006 and $179,000 for the six months ended June 30, 2006. As of June 30, 2006, there is approximately $1.0 million of total unamortized compensation cost related to unvested restricted stock remaining to be recognized. The following summarizes the restricted stock activity for the first six months of 2006:

	Restricted Stock Shares			Weighted Average
	Shares			Grant Date Value
Nonvested Restricted Stock at January 1, 2006		136,052		$	5.61
Granted		102,300			5.66
Vested		(19,927	)		5.60
Cancelled/Forefeited		(800	)		5.47
Shares at June 30, 2006		217,625		$	5.63

Prior to 2006, the Company elected to follow APB 25, and related interpretations in accounting for its employee stock options. Under APB 25, compensation expense is recorded when the exercise price of employee stock options is less than the fair value of the underlying stock on the date of grant. The Company had implemented the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” and SFAS No. 148, “Accounting for Stock-Based Compensation Transition and Disclosure.” Had the Company elected to adopt the expense recognition provisions of SFAS No. 123, the pro forma impact on net income and earnings per share would have been as follows (in thousands, except per share data):

	Three months			Six months
	ended			ended
	June 30, 2005			June 30, 2005
Net loss as reported	$	(471	)	$	(316	)
Add: APB 25 expense		—			—
Less: Total stock-based employee compensation expense determined under fair value methods for all awards		(221	)		(581	)
Pro forma net loss	$	(692	)	$	(897	)
Net loss per common share:
As reported – basic	$	(0.08	)	$	(0.05	)
Pro forma – basic	$	(0.12	)	$	(0.16	)
As reported – diluted	$	(0.08	)	$	(0.05	)
Pro forma — diluted	$	(0.12	)	$	(0.16	)

6

INTERPHASE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 3. — INVENTORIES

Inventories are valued at the lower of cost or market and include material, labor and manufacturing overhead. Cost is determined on a first-in, first-out basis (in thousands):

	June 30, 2006		December 31, 2005
Raw materials	$	1,703	$	2,393
Work-in-process		524		549
Finished goods		173		167
Total	$	2,400	$	3,109

Valuing inventory at the lower of cost or market involves an inherent level of risk and uncertainty due to technology trends in the industry and customer demand for the Company’s products. Future events may cause significant fluctuations in the Company’s operating results. Inventories are written down when needed to ensure the Company carries inventory at the lower of cost or market. Writedowns for the three months ended June 30, 2006 and 2005 were $100,000 and $300,000, respectively. Writedowns for the six months ended June 30, 2006 and 2005 were $300,000 and $400,000, respectively.

NOTE 4. — DERIVATIVE FINANCIAL INSTRUMENTS

The Company is exposed to adverse movements in foreign currency exchange rates because it conducts business on a global basis and in some cases in foreign currencies. The Company’s operations in France are transacted in the local currency and converted into U.S. Dollars based on published exchange rates for the periods reported and are therefore subject to risk of exchange rate fluctuations.

In an attempt to mitigate the risk described above, the Company may enter into, from time to time, foreign exchange contracts to purchase a fixed amount of Euros on a fixed date in the future at a fixed rate determined at the contract date. These derivative financial instruments do not meet the criteria to qualify as hedges under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” and therefore, any changes in the market value of these contracts are recognized as a gain or loss in the period of the change. For the three months and six months ended June 30, 2006, the Company recognized a gain of approximately $222,000 and $349,000 respectively related to these foreign exchange contracts. For the three and six months ended June 30, 2005, the Company recognized a loss of approximately $51,000 related to a foreign exchange contract. At June 30, 2006, the Company had four foreign exchange contracts outstanding to acquire approximately 1.1 million Euros for each contract on specified dates during the next ten months. At June 30, 2006, the Company carried a $211,000 asset on the balance sheet, classified in prepaid expenses and other current assets, related to the fair value of its outstanding foreign exchange contracts. There were five such contracts outstanding at December 31, 2005, classified as a $71,000 liability on the balance sheet.

NOTE 5. — INCOME TAXES

SFAS No. 109, “Accounting for Income Taxes,” requires that a valuation allowance be established when it is “more likely than not” that all or a portion of a deferred tax asset will not be realized. A review of all available positive and negative evidence needs to be considered, including a company’s current and past performance, the market environment in which the company operates, the utilization of past tax credits, length of carry back and carry forward periods, existing contracts or sales backlog that will result in future profits, as well as other factors.

Forming a conclusion on a valuation allowance is difficult when there is negative evidence such as cumulative losses in recent years. Cumulative losses weigh heavily in the overall assessment. As a result of a review undertaken at December 31, 2002, the Company concluded that it was appropriate to establish a full valuation allowance for its net deferred tax assets. Until an appropriate level of profitability is sustained, the Company

7

INTERPHASE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

expects to continue to record a full valuation allowance on future tax benefits except for those that may be generated in foreign jurisdictions.

The effective tax rate differed from the U.S. statutory rate as the Company continued to provide a full valuation allowance for our net deferred tax assets at June 30, 2006 and June 30, 2005. During the three months and six months ended June 30, 2006, the Company recorded a tax benefit related to our operations in France. This benefit was primarily the result of a 10% research and development tax credit. Prior to January 1, 2006, this credit was only 5%. We incurred taxes on our foreign income during the first and second quarter of 2005, partially due to the 5% credit not fully offsetting the tax liability.

NOTE 6. — RESTRUCTURING CHARGE

On November 10, 2005, Interphase adopted a plan to restructure its worldwide operations. The primary goal of the restructuring program was to improve the Company’s ability to continue to strategically fund research and development efforts, to balance the Company’s skills to align with the future directions of the marketplace, and to streamline the Company in its continued goal of being the most cost-effective company in the embedded systems marketplace. Under the restructuring plan, Interphase reduced its workforce by approximately 19%. The global workforce reduction impacted all functions within the Company. As a result of the restructuring program, the Company recorded a restructuring charge of approximately $600,000, classified as operating expense during the fourth quarter of 2005.

These amounts were completely paid out under the restructuring plan by the end of the second quarter of 2006. Approximately $586,000 of the charges related to severance and fringe benefits, approximately $8,000 of the charges related to a future lease obligation and approximately $6,000 related to non-utilized fixed assets. As of June 30, 2006, there was no liability on the Company’s balance sheet relating to future cash payments.

			Cash payments and				Cash
			non-cash charges		Cash payments		payments
			during quarter		during quarter		during		Remaining
	Restructuring		ended December		ended March		quarter ended		liability as of
Description	charge		31, 2005		31, 2006		June 30, 2006		June 30, 2006
Severance & Fringe Benefits	$	586	$	307	$	253	$	26	$	—
Lease Obligation		8		—		4		4		—
Non-Utlized Fixed Assets		6		6		—		—		—
Total	$	600	$	313	$	257	$	30	$	—

NOTE 7. — CREDIT FACILITY

The Company maintains a $5 million revolving bank credit facility with a maturity date of July 31, 2008 and interest rate of LIBOR plus 1.0% (6.3125% at June 30, 2006). All borrowings under this facility are secured by marketable securities. The borrowings of $3.5 million are classified as long-term debt on the accompanying balance sheets.

8

INTERPHASE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 8. — COMPREHENSIVE INCOME

The following table shows the Company’s comprehensive income (in thousands):

	Three months ended						Six months ended
	June 30,						June 30,
	2006			2005			2006		2005
Net income (loss)	$	1,143		$	(471	)	$	1,453	$	(316	)
Other comprehensive income:
Unrealized holding (loss) gain arising during period, net of tax		(1	)		19			6		(15	)
Foreign currency translation adjustment		68			(154	)		54		(152	)
Comprehensive income (loss)	$	1,210		$	(606	)	$	1,513	$	(483	)

NOTE 9. — EARNINGS PER SHARE

Basic earnings per share are computed by dividing reported earnings available to common shareholders by weighted average common shares outstanding. Diluted earnings per share give effect to dilutive potential common shares. Earnings per share are calculated as follows (in thousands, except per share data):

	Three months ended					Six months ended
	June 30,					June 30,
	2006		2005			2006		2005
Basic earnings per share:
Net income (loss)	$	1,143	$	(471	)	$	1,453	$	(316	)
Weighted average common shares outstanding		5,843		5,755			5,819		5,753
Basic earnings (loss) per share	$	0.20	$	(0.08	)	$	0.25	$	(0.05	)
Diluted earnings per share:
Net income (loss)	$	1,143	$	(471	)	$	1,453	$	(316	)
Weighted average common shares outstanding		5,843		5,755			5,819		5,753
Dilutive stock options and restricted stock		159		—			121		—
Weighted average common shares outstanding — assuming dilution		6,002		5,755			5,940		5,753
Diluted earnings (loss) per share	$	0.19	$	(0.08	)	$	0.24	$	(0.05	)
Outstanding stock options that were not included in the diluted calculation because their effect would be anti-dilutive
		1,407		1,812			1,789		1,807

NOTE 10. — SEGMENT INFORMATION

The Company is principally engaged in the design, development, and manufacturing of high-performance connectivity products utilizing advanced technologies being used in next generation telecommunication networks and enterprise data networks. Except for revenue performance, which is monitored by product line, the chief operating decision-makers review financial information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance. Accordingly, the Company considers itself to be in a single industry segment.

9

INTERPHASE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Geographic revenues related to North America and foreign countries is as follows (in thousands):

	Three months ended				Six months ended
	June 30,				June 30,
	2006		2005		2006		2005
Revenues:
North America	$	3,564	$	3,702	$	6,512	$	8,418
Europe		3,353		2,841		6,938		5,646
Pacific Rim		2,454		1,049		4,072		2,308
Total	$	9,371	$	7,592	$	17,522	$	16,372

Additional information regarding revenues by product-line is as follows (in thousands):

	Three months ended				Six months ended
	June 30,				June 30,
	2006		2005		2006		2005
Product Revenues:
Broadband telecom	$	7,670	$	5,155	$	13,605	$	10,870
Enterprise SlotOptimizer		1,228		1,694		2,155		3,747
Storage		179		173		410		297
Professional services		25		123		143		336
LAN/WAN		24		185		105		334
Other		245		262		1,104		788
Total	$	9,371	$	7,592	$	17,522	$	16,372

NOTE 11. — RECENTLY ISSUED ACCOUNTING PROUNOUCEMENTS

In July 2006, the FASB issued FASB Interpretation No. 48 (FIN 48) “Accounting for Uncertainty in Income Taxes” which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the recognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN 48 will be effective for the Company beginning January 1, 2007. The Company is in the process of determining the effect, if any; the adoption of FIN 48 will have on its consolidated financial statements.

10

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements about the business, financial condition and prospects of the Company. These statements are made under the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. The actual results of the Company could differ materially from those indicated by the forward-looking statements because of various risks and uncertainties, including without limitation, our reliance on a limited number of customers, failure to see spending improvements in the telecommunications and computer networking industries, significant changes in product demand, the availability of products, changes in competition, various inventory risks due to changes in market conditions and other risks and uncertainties indicated in the Company’s filings and reports with the Securities and Exchange Commission. All the foregoing risks and uncertainties are beyond the ability of the Company to control, and in many cases, the Company cannot predict the risks and uncertainties that could cause its actual results to differ materially from those indicated by the forward-looking statements. When used in this report, the words “believes”, “plans”, “expects”, “intends”, and “anticipates” and similar expressions as they relate to the Company or its management are intended to identify forward-looking statements.

RESULTS OF OPERATIONS

Revenue

Total revenue increased to $9.4 million for the three months ended June 30, 2006, compared to $7.6 million for the same period in the prior year. The increase was primarily attributable to Broadband telecom revenue, which increased approximately 49% to $7.7 million for the three months ended June 30, 2006, compared to $5.2 million in the comparable period in the prior year. The increase in Broadband telecom revenue was partially offset by an expected decrease in Enterprise SlotOptimizer revenue of 28% to $1.2 million for the three months ended June 30, 2006, compared to $1.7 million for the same period in the previous year. We have completed an end of life process on the product which contributed the bulk of the revenue for this product line in the comparable period for the prior year and do not expect significant orders going forward on this product. We are working with our customers to provide follow-on high speed Ethernet products which help offset a portion of this revenue decline, but will not likely offset the entire decline. All other revenues, composed primarily of security, legacy networking, professional services and storage product lines, decreased to approximately $475,000 for the three months ended June 30, 2006, compared to approximately $750,000 for the same period in the prior year.

During the second quarter of 2006, sales to three customers individually accounted for approximately 37%, 23% and 11% of total revenues, respectively. During the second quarter of 2005, sales to four customers accounted for approximately 28%, 19%, 13% and 10% of total revenue, respectively. No other customer accounted for more than 10% of our consolidated revenue in the periods presented.

Total revenue increased to $17.5 million for the six months ended June 30, 2006, compared to $16.4 million in the comparable period for the prior year. The increase in revenue is primarily attributable to Broadband telecom product revenue which increased 25% to $13.6 million for the six months ended June 30, 2006 compared to $10.9 million for the same period in the prior year. The increase in Broadband telecom revenue was partially offset by an expected decrease in Enterprise SlotOptimizer revenue of 41% to $2.2 million for the six months ended June 30, 2006, compared to $3.7 million for the same period in the previous year. All other revenues composed primarily of security, legacy networking, professional services and storage product lines were $1.7 million and $1.8 million for the six months ended June 30, 2006 and June 30, 2005.

Gross Margin

For the three months ended June 30, 2006, gross margin, as a percentage of sales, was 58% compared to 53% for the same period in the prior year. The increase in gross margin percentage primarily relates to a decrease in our excess and obsolete inventory charges to $100,000 for the three months ended June 30, 2006, compared to $300,000 for the same period in the prior year. Our gross margin percentage in the second quarter of 2006 was also aided by a revenue mix shift toward higher margin products and increased utilization of our manufacturing facility.

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Gross margin as a percentage of sales was 54% for the six months ended June 30, 2006 and 2005. We believe that pricing pressures in the industry may dampen gross margin in future periods and it may become increasingly challenging to offset these pressures with incremental supplier cost reductions and factory productivity improvements.

Research and Development

Our investment in the development of new products through research and development was $2.0 million for the three months ended June 30, 2006 and 2005. Research and development cost have remained flat year over year despite the actions taken as part of the restructuring plan initiated in the fourth quarter of 2005 (See Note 6 in the Notes to Condensed Consolidated Financial Statements for more information). This is primarily due to some strategic reinvestment in the area of variable, project related research and development activities. We expect to continue to reinvest in these areas as we seek to develop and deploy the skills necessary to enable our Company to successfully meet customer needs. As a percentage of total revenue, research and development expense was approximately 21% in the second quarter of 2006 as compared to approximately 27% for the same period for the prior year. The decrease in research and development costs as a percentage of total revenue is due to research and development expense remaining flat while revenue has increased. We anticipate that spending on research and development will increase slightly in the near future, subject to fluctuations in currency exchange rates because much of our development expense is associated with our engineering lab in France (see Item 3 – Foreign Currency Risk).

Our investment in the development of new products through research and development was $3.8 million and $4.2 million for the six months ended June 30, 2006 and 2005, respectively. The restructuring plan we undertook in the fourth quarter of 2005 was the primary contributor to the reduction in research and development cost. Approximately 42% of the decrease in research and development expenses for the six months ended June 30, 2006 compared to the same period last year related to a stronger dollar relative to the Euro in 2006. As a percentage of total revenue research and development expense was approximately 22% for the six months ended June 30, 2006 and 26% for the six months ended June 30, 2005. The decrease in research and development expense as a percentage of total revenue is due to research and development costs decreasing while revenue increased.

Sales and Marketing

Sales and marketing expenses were $1.5 million and $1.6 million for the three months ended June 30, 2006 and 2005, respectively. The decrease in sales and marketing expense is primarily due to the restructuring plan we undertook in the fourth quarter of 2005 (See Note 6 in the Notes to Condensed Consolidated Financial Statements for more information) partially offset by variable compensation awards including sales commissions. As a percentage of total revenue, sales and marketing expense was approximately 16% for the second quarter of 2006 and 21% for the second quarter of 2005. The decrease in sales and marketing costs as a percentage of total revenue is due to sales and marketing cost decreasing slightly while revenue has increased. We will continue to monitor the level of sales and marketing costs concurrently with actual revenue and profit results.

Sales and marketing expenses were $2.8 million and $3.1 million for the six months ended June 30, 2006 and 2005, respectively. The decrease in sales and marketing expense is primarily due to the restructuring plan we undertook in the fourth quarter of 2005 (See Note 6 in the Notes to Condensed Consolidated Financial Statements for more information) partially offset by variable compensation awards including sales commissions. As a percentage of total revenue, sales and marketing expense was approximately 16% for the six months ended June 30, 2006 and 19% for the six months ended June 30, 2005. The decrease in sales and marketing expense as a percentage of total revenue is due to sales and marketing costs decreasing while revenue increased.

General and Administrative

General and administrative expenses were $1.2 million and $897,000 for the three months ended June 30, 2006 and 2005, respectively. The increase in general and administrative expense period over period primarily relates to an increase in headcount related expenses including the funding of potential variable compensation awards that are being accrued for as it is more likely than not that we will achieve the stretch targets outlined in the variable compensation plan . As a percentage of total revenue, general and administrative expenses were approximately 13% in the second quarter 2006 and 12% for the same period in the prior year. The increase as a percentage of

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revenue is due to increasing general and administrative expenses at a higher rate than revenues. We will continue to monitor the level of general and administrative costs concurrently with actual revenue and profit results.

General and administrative expenses were $2.2 million and $1.8 million for the six months ended June 30, 2006 and 2005, respectively. The increase in general and administrative expenses period over period primarily relates to an increase in headcount related expenses including the funding of potential variable compensation awards that are being accrued for as it is more likely than not that we will achieve the stretch targets outlined in the variable compensation plan. As a percentage of total revenue, general and administrative expense was approximately 13% for the six months ended June 30, 2006 and 11% for the six months ended June 30, 2005. The increase as a percentage of revenue is due to increasing general and administrative expenses at a higher rate than revenues.

Interest Income, Net

Interest income, net of interest expense, increased to $125,000 for the three months ended June 30, 2006 from $89,000 in the comparable period in the prior year. Interest income, net of interest expense, was $240,000 for the six months ended June 30, 2006 and $165,000 for the six months ended June 30, 2005. The increase in interest income, net for each period primarily relates to higher investment rates of returns.

Other Income (Expense), Net

Other income (expense), net, was an income of $223,000 for the three months ended June 30, 2006, compared to an expense of $50,000 for the same period in the prior year. Other income (expense), net, was an income of $360,000 for the six months ended June 30, 2006 and an expense of $54,000 for the six months ended June 30, 2005. The increase in other income for each of the periods presented primarily relates to the change in market value of our foreign exchange derivative financial instruments which resulted in income of approximately $222,000 and $349,000 for the three and six months ended June 30, 2006, respectively. In the second quarter of 2005, there was an expense charge of approximately $51,000 related to the change in market value of our foreign exchange derivative financial instruments (See Note 4 in the Notes to Condensed Consolidated Financial Statements for more information).

Income Taxes

Our tax benefit rate was 15% for the six months ended June 30, 2006. Although we were in a net loss position for the six months ended June 30, 2005, we recorded a $117,000 tax provision due to taxes on foreign income.

The effective tax rate differed from the U.S. statutory rate as we continued to provide a full valuation allowance for our net deferred tax assets at June 30, 2006 and June 30, 2005. During the six months ended June 30, 2006, we recorded a tax benefit related to our operations in France. This benefit was primarily the result of a 10% research and development tax credit. Prior to January 1, 2006, this credit was only 5%. We incurred taxes on our foreign income during the first half of 2005, partially due to the 5% credit not fully offsetting the tax liability.

Net Income (Loss)

We reported net income of $1.1 million for the three months ended June 30, 2006 compared to a net loss of $471,000 in the second quarter of 2005. Basic and diluted earnings per share for the three months ended June 30, 2006 were $0.20 and $0.19, respectively. Basic loss per share for the three months ended June 30, 2005 was ($0.08). The Company reported a net income of $1.5 million for the six months ended June 30, 2006, as compared to a net loss of $316,000 for the six months ended June 30, 2005. Basic and diluted earnings per share for the six months ended June 30, 2006 were $0.25 and $0.24, respectively. Basic loss per share for the six months ended June 30, 2005 was ($0.05).

LIQUIDITY AND CAPITAL RESOURCES

Consolidated Cash Flows

Cash and cash equivalents increased $3.9 million for the six months ended June 30, 2006 and decreased $300,000 for the same period in the prior year. Cash flows are impacted by operating, investing and financing activities.

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Operating Activities

Trends in cash flows from operating activities for the six months ended June 30, 2006 and 2005 are generally similar to the trends in our earnings except for provision for uncollectible accounts and returns, provision for excess and obsolete inventories, depreciation and amortization and amortization of restricted stock. Cash provided by operating activities totaled $1.8 million for the six months ended June 30, 2006, compared to a net income of $1.5 million. Provision for uncollectible accounts and returns decreased slightly for the six months ended June 30, 2006 compared to the same period in 2005. Provision for excess and obsolete inventories decreased $100,000 for the six months ended June 30, 2006 compared to the same period in 2005. Depreciation and amortization decreased slightly for the six months ended June 30, 2006 compared to the same period in 2005. Amortization of restricted stock increased for the six months ended June 30, 2006, compared to the six months ended June 30, 2005 as we issued restricted stock to employees and directors for the first time in the second quarter of 2005. The additional shares outstanding in 2006 due to new grants also increased the amortization amount during the six months ended June 30, 2006 compared to the prior period (See Note 2 in Notes to the Condensed Consolidated Financial Statements for more information on restricted stock).

Changes in assets and liabilities result primarily from the timing of production, sales, purchases and payments. Such changes in assets and liabilities generally tend to even out over time and result in trends in cash flows from operating activities generally reflecting earnings trends.

Investing Activities

Cash provided by investing activities totaled $1.8 million for the six months ended June 30, 2006 compared to cash used in investing activities of $720,000 in the same period of the prior year. Additions to property and equipment and capitalized software were $442,000 for the six months ended June 30, 2006 compared to $339,000 for the six months ended June 30, 2005. The additions for the six months ended June 30, 2006 primarily related to software and equipment purchases for our engineering and manufacturing functions. The additions for the six months ended June 30, 2005 were primarily related to equipment purchases for the engineering, manufacturing and information technology function. Purchases of marketable securities were $3.3 million and $6.3 million for the six months ended June 30, 2006 and 2005, respectively. Proceeds from the sale of marketable securities decreased to $5.5 million for the six months ended June 30, 2006 compared to $5.9 million for the same period in 2005.

Financing Activities

Net cash provided by financing activities totaled $316,000 for the six months ended June 30, 2006 compared to $40,000 for the six months ended June 30, 2005. Net cash provided by financing activities for both periods presented related to proceeds from employees exercising stock options.

Commitments

Commitments

At June 30, 2006, we had no material commitments to purchase capital assets. However, planned capital expenditures for 2006 are estimated at approximately $850,000, the majority of which relates to engineering tools and general office equipment. Our significant long-term obligations as of June 30, 2006, are our operating leases on facilities and future debt payments related to our credit facility. To date, we have not paid any dividends and do not anticipate paying any dividends in 2006.

Off-Balance Sheet Arrangements

At June 30, 2006 we had four foreign exchange contracts outstanding to acquire approximately 1.1 million Euros for each contract on specified dates during the next 10 months. At June 30, 2006, we carried a $211,000 asset on the balance sheet, classified in prepaid expenses and current assets, related to the fair value of our outstanding foreign exchange contracts. There were five such contracts outstanding at December 31, 2005 classified as a $71,000 liability on the balance sheet.

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Other

Management believes that cash generated from operations and borrowing availability under the revolving credit facility, together with cash on hand, will be sufficient to meet our liquidity needs for working capital, capital expenditures and debt service. To the extent that our actual operating results or other developments differ from our expectations, our liquidity could be adversely affected.

We periodically evaluate our liquidity requirements, alternative uses of capital, capital needs and available resources in view of, among other things, our capital expenditure requirements and estimated future operating cash flows. As a result of this process, we have in the past, and may in the future, seek to raise additional capital, refinance or restructure indebtedness, issue additional securities, repurchase shares of our common stock or take a combination of such steps to manage our liquidity and capital resources. In the normal course of business, we may review opportunities for acquisitions, joint ventures or other business combinations. In the event of any such transaction, we may consider using available cash, issuing additional equity securities or increasing our indebtedness or our subsidiaries’ indebtedness.

Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-Q should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and other material included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Foreign Currency Risk

The Company is exposed to adverse movements in foreign currency exchange rates because it conducts business on a global basis and in some cases in foreign currencies. The Company’s operations in France are measured in the local currency and converted into U.S. Dollars based on published exchange rates for the periods reported and are therefore subject to risk of exchange rate fluctuations. The Euro to U.S. Dollar translation accounted for charges of approximately $300,000 and $291,000 for the three months ended June 30, 2006, and 2005, respectively. The Euro to U.S. Dollar translation accounted for charges of approximately $529,000 and $680,000 for the six months ended June 30, 2006 and 2005, respectively.

In an attempt to mitigate the risk described above, the Company may enter into, from time to time, foreign exchange contracts to purchase a fixed amount of Euros on a fixed date in the future at a fixed rate determined at the contract date. These derivative financial instruments do not meet the criteria to qualify as hedges under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” and therefore any changes in the market value of these contracts are recognized as a gain or loss in the period of the change. For the three months and six months ended June 30, 2006, the Company recognized a gain of approximately $222,000 and $349,000, respectively related to these foreign exchange contracts. At June 30, 2006, the Company had four foreign exchange contracts outstanding to acquire approximately 1.1 million Euros for each contract on specified dates during the next ten months. At June 30, 2006, the Company carried a $211,000 asset on the balance sheet, classified in prepaid expenses and other current assets, related to the fair value of its outstanding foreign exchange contracts. There were five such contracts outstanding at December 31, 2005 classified as a $71,000 liability on the balance sheet.

Market Price Risk

We had no equity hedge contracts outstanding as of June 30, 2006 or December 31, 2005.

Interest Rate Risk

Our investments are subject to interest rate risk. Interest rate risk is the risk that our financial condition and results of operations could be adversely affected due to movements in interest rates. We invest our cash in a variety of interest-earning financial instruments, including bank time deposits, money market funds, and variable rate and fixed rate obligations of corporations and national governmental entities and agencies. Due to the demand nature of our money market funds and the short-term nature of our time deposits and debt securities portfolio, these assets are particularly sensitive to changes in interest rates. We manage this risk through investments with shorter-term maturities and varying maturity dates.

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A hypothetical 50 basis point increase in interest rates would be expected to result in an approximate decrease of less than 1% in the fair value of our available-for-sale securities at June 30, 2006. This potential change is based on sensitivity analyses performed on our marketable securities at June 30, 2006. Actual results may differ materially. We estimate that the same hypothetical 50 basis point increase in interest rates would have resulted in an approximate decrease of less than 1% in the fair value of our available-for-sale securities at December 31, 2005.

Our credit facility bears interest at a variable rate tied to the London Interbank Offered Rate (LIBOR). The current interest rate on our credit facility is 6.3125% (LIBOR + 1%). In an attempt to mitigate interest rate fluctuations, we from time to time may enter into agreements to lock the interest rate; our current agreement will expire on November 6, 2006. A hypothetical 100 basis point increase in LIBOR would increase annual interest expense on this credit facility by approximately $35,000.

Item 4. CONTROLS AND PROCEDURES

(a)

Evaluation of Disclosure Controls and Procedures. The Company’s management, under the supervision of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), performed an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on that evaluation, the CEO and CFO concluded that the Company’s disclosure controls and procedures are effective, to give reasonable assurance that the information required to be disclosed by the Company in reports that it files under the Exchange Act is accumulated and communicated to management, including the CEO and CFO, to allow timely decisions regarding disclosure and that information is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC.

(b)

Changes in Internal Controls. The Company maintains a system of internal controls that are designed to provide reasonable assurance that its books and records accurately reflect, in all material respects, the transactions of the Company and that its established policies and procedures are adhered to. There were no changes to the Company’s internal controls or in other factors that could significantly affect the Company’s internal controls subsequent to the date of the evaluation by the Company’s CEO and CFO, including any corrective actions with regard to significant deficiencies and material weaknesses.

PART II
OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

None.

Item 1A. RISK FACTORS

There have been no material changes from the risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2005.

Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

Item 3. DEFAULTS UPON SENIOR SECURITIES

None.

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Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On May 3, 2006, the annual meeting of shareholders of the Company was held. An election of directors of the Company to serve until the next annual meeting for the Company was held. The following six individuals were elected as directors of the Company:

Nominee	Votes cast for		Votes withheld
Paul N. Hug		4,628,357		426,884
Gregory B. Kalush		4,931,380		123,861
Randall D. Ledford		4,931,813		123,428
Michael J. Myers		4,642,413		412,828
Kenneth V. Spenser		4,642,413		412,828
S. Thomas Thawley		4,986,514		68,727

Item 5. OTHER INFORMATION

None.

Item 6. EXHIBITS

Exhibits

2 (a)	Stock Purchase Agreement, dated as of June 29, 1996, among Interphase Corporation, Synaptel and Philippe Oros, Xavier Sutter, Francois Lecerf, Schroder Ventures French Enterprise Fund LPI (USA), Schroder ventures French Enterprise Fund UKLP (UK) and Schroder Ventures Holding Limited (UK). (3)
3 (a)	Certificate of Incorporation of the registrant. (1)
3 (b)	Amendment to Articles of Incorporation of the registrant. (5)
3 (c)	Amended and Restated Bylaws of the registrant adopted on December 5, 1995 and amended on January 19, 1999. (7)
4 (a)	Rights Agreement dated as of December 7, 2000 by and between the Company and Computershare Investor Services, LLC as Rights Agent. (6)
10 (a)	Registrant’s Amended and Restated Stock Option Plan and Amendment No. 1 and 2 thereto.*(4)
10 (b)	Registrant’s Amended and Restated Stock Option Plan Amendment No. 4. *(5)
10 (c)	Directors Stock Option Plan and Amendment No. 1 thereto. *(2)
10 (d)	Directors Stock Option Plan Amendment No. 2. *(5)
10 (e)	Registrant’s France Incentive Stock Option Sub-Plan. *(7)
10 (f)	Lease on Facility at Parkway Center, Phase I, Plano, Texas. (8)
10 (g)	Lease on Facility at 2105 Luna Road, Carrollton, Texas. (8)
10 (h)	Note and Credit Agreement between Interphase Corporation and Comerica Bank, including Amendment dated November 5, 2004. (11)
10 (i)	Employment Agreement with Gregory B. Kalush, dated March 12, 1999. *(13)
10 (j)	Employment Agreement for Chief Technology Officer with Felix V. Diaz, dated May 22, 1996. *(13)
10 (k)	Employment, Confidentiality, and Non-Competition Agreement with Thomas N. Tipton, Jr., dated December 19, 2005. *(13)
10 (l)	Employment, Confidentiality, and Non-Competition Agreement with Randall E. McComas, dated February 15, 2002. *(13)
10 (m)	Employment Agreement with Deborah A. Shute, dated November 24, 1999. *(13)
10 (n)	Employment, Confidentiality, and Non-Competition Agreement with James W. Gragg, dated November 1, 2004. *(13)
10 (o)	Employment, Confidentiality, and Non-Competition Agreement with Prasad Kallur, dated May 23, 2005. *(13)
10 (p)	Employment Agreement with Steven P. Kovac, dated May 11, 1999. *(13)
10 (q)	Interphase Corporation 2004 Long-Term Stock Incentive Plan *(12)
31 (a)	Rule 13a-14(a)/15d-14(a) Certification. (14)
31 (b)	Rule 13a-14(a)/15d-14(a) Certification. (14)
32 (a)	Section 1350 Certification. (14)
32 (b)	Section 1350 Certification. (14)

17

(1)	Filed as an exhibit to Registration Statement No. 2-86523 on Form S-1 and incorporated herein by reference.
(2)	Filed as an exhibit to Report on Form 10-K for the year ended October 31, 1995, and incorporated herein by reference.
(3)	Filed as an exhibit to Report on Form 8-K on August 6, 1996, and incorporated herein by reference.
(4)	Filed as an exhibit to Report on Form 10-K for the year ended December 31, 1996, and incorporated herein by reference.
(5)	Filed as an exhibit to Report on Form 10-K for the year ended December 31, 1999, and incorporated herein by reference.
(6)	Filed as an exhibit to Form 8-K on January 9, 2001, and incorporated herein by reference. (7) Filed as an exhibit to Report on Form 10-K for the year ended December 31, 2001, and incorporated herein by reference.
(8)	Filed as an exhibit to Report on Form 10-Q for the quarter ended September 30, 2002, and incorporated herein by reference.
(9)	Filed as an exhibit to Report on Form 10-K for the year ended December 31, 2002, and incorporated herein by reference.
(10)	Filed as an exhibit to Form 8-K on September 13, 2004, and incorporated herein by reference.
(11)	Filed as an exhibit to Report on Form 10-K for the year ended December 31, 2004, and incorporated herein by reference.
(12)	Filed as an exhibit to Schedule 14a on March 31, 2005 and incorporated herein by reference.
(13)	Filed as an exhibit to Report on Form 10-K for the year ended December 31, 2005 and incorporated herein by reference.
(14)	Filed herewith
* Management contract or compensatory plan or arrangement.

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	INTERPHASE CORPORATION
	(Registrant)
Date: August 11, 2006	By:	/s/ Thomas N. Tipton Jr.Thomas N. Tipton Jr.
		Chief Financial Officer,
		Vice President of Finance and Treasurer
		(Principal Financial and Accounting Officer)

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