Item 1. Business.
Introduction
Interphase Corporation and subsidiaries (“Interphase” or the “Company”) is a leading provider of robust building blocks, highly integrated subsystems and innovative gateway appliances for the converged communications network. Building on a 30-year history of providing advanced I/O solutions for telecom and enterprise applications, and addressing the need for high speed connectivity, Interphase (NASDAQ: INPH) has established a key leadership role in delivering next generation AdvancedTCA® (ATCA) and AdvancedMC™ (AMC) solutions to the marketplace. Headquartered in Plano, Texas with sales offices across the globe, Interphase clients include Alcatel-Lucent, Emerson, Ericsson, Fujitsu Ltd., Hewlett Packard, Motorola Inc., Nokia, Nortel Networks Ltd. and Samsung. Interphase is a contributor member of the Scope Alliance and the Communications Platform Trade Association (CP-TA).
The Company maintains a Web site on the Internet with the address of www.interphase.com. Copies of this Annual Report on Form 10-K and copies of the Company’s Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and any amendments thereto, are or will be available free of charge as soon as reasonably practical after they are filed with Securities and Exchange Commission (“SEC”) at such Web site. The public may read and copy any materials the Company files with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. The general public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet Web site at www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC.
Key Terms and Definitions
Interphase is a technology company; as such, many terms used by the Company may be unfamiliar to those outside the industry. The following are some key terms that may be useful in helping the reader understand the products, technologies, and markets relevant for the Company.
3G - Third-generation mobile telephone technology. The services associated with 3G provide the ability to transfer both voice data (a telephone call) and non-voice data (such as downloading information, exchanging email, and instant messaging).
3GPP - 3rd Generation Partnership Project; a collaboration agreement that was established in December 1998. 3GPP is a co-operation among the following standards organizations: ETSI (Europe), ARIB/TTC (Japan), CCSA (China), ATIS (North America) and TTA (South Korea). The scope of 3GPP is to make a globally applicable 3G mobile phone system specification within the scope of the ITU’s IMT-2000 project. 3GPP specifications are based on evolved GSM specifications, now generally known as the UMTS system.
Adapter - Also called a host bus adapter (HBA) or network interface card (NIC). An adapter is a device that connects a computer server to one or more peripheral devices (such as switches, hubs, storage devices, etc.) or other computers. An adapter card typically plugs into the expansion bus of a system and communicates with the operating system controlling the system via the use of specific device drivers.
Adapters generally refer to passive (non-intelligent) printed circuit boards used for interfacing to a network.
AdvancedTCA® or ATCA (Advanced Telecom Computing Architecture) - The next generation of platform architecture beyond CompactPCI defined by the PICMG standards body as the PICMG 3.0 series of specifications. This architecture affords greater bandwidth, processing and board density, cooling abilities, and memory, while enabling delivery of highly reliable, scalable and manageable telecommunications products to meet the growing needs of next-generation applications for converged communications networks. AdvancedTCA is a registered trademark of PICMG.
AdvancedMC™ or AMC (Advanced Mezzanine Card) - AdvancedMC specifications define the mezzanine card form factor for use with ATCA platforms. AdvancedMC enhances ATCA flexibility by extending its high-bandwidth, multi-protocol interface to individual hot-swappable modules, which are optimized for packet-based telecom applications. Together, ATCA blades equipped with AdvancedMC modules give telecom equipment manufacturers (or TEMs) a versatile platform for quickly building modular telecom systems that could be designed, manufactured, scaled, upgraded and serviced at a much lower cost. AdvancedMC is a trademark of PICMG.
ASN Gateway or ASN-GW - The ASN Gateway is a logical entity in the WiMAX network architecture that represents an aggregation of control plane functional entities that are either paired with a corresponding function in the WiMAX Access Service Network (ASN) or a resident function in the WiMAX Core Service Network. The ASN-GW may also perform bearer plane routing or bridging function.
Asynchronous Transfer Mode (ATM) - A network technology used in Wide Area Networks that supports real-time voice, real-time video and data. The topology uses switches that establish a logical circuit from end to end, which guarantees a quality of service for that transmission. However, unlike telephone switches that dedicate circuits end-to-end, unused bandwidth in ATM circuits can be appropriated whenever available. For example, idle bandwidth in a videoconference circuit can be used to transfer data. ATM is also highly scalable and supports transmission speeds of 1.5, 25, 100, 155, 622 and 2488 Mbps.
Backplane - The interconnect mechanism that links all printed circuit boards within a system so various boards can communicate and work together for a common purpose as a system. The backplane extends perpendicularly across all boards in a system and offers sockets for boards to be plugged into.
Base Station Controller (BSC) - A robust network element that handles allocation of radio channels, receives measurements from mobile phones, and controls handovers from base station to base station, etc. Many BSCs act as a full switching center while also providing data for network management and measurement.
Blade - A subsystem within a system contained within a single system slot. A blade can operate as a single board in a slot or with a multitude of boards, including mezzanine cards on a carrier card.
Broadband - A transmission facility (communications link) that has bandwidth (capacity) greater than a traditional voice grade line.
Building Blocks - The basic board-level products used in a system; these products are combined with other hardware and software building blocks to build a network element, system and/or application.
Code Division Multiple Access (CDMA) - A form of multiplexing and a method of multiple access that does not divide up the channel by time or frequency, but instead encodes data with a certain code associated with a channel and uses the constructive interference properties of the signal medium to perform the multiplexing. CDMA is used in digital cellular telephony systems for delivery of very high bandwidth mobile access.
Communications Controller - Communications controller modules (similar to a network interface card) designed specifically for carrier-grade computer systems that often support signaling, switching and routing networks. Communication controllers must conform to specifications that maintain overall system compliance to the rigorous performance and reliability standards that apply to telecom service provider equipment into which they are integrated. Controllers are essentially intelligent network interface cards.
CompactPCI® (cPCI) - An industrial-grade variation of the PCI bus standard that utilizes the VME form factor. CompactPCI was widely adopted by telecom equipment suppliers because of its high-density connectors, support for front or rear I/O access and hot-swap capabilities important for “Five 9s” (99.999%) reliability. Often referred to as cPCI, it is a standardized architecture for printed circuit boards (governed by PICMG) used in the embedded systems industry, particularly in carrier communications and industrial computing market segments.
CompactPCI Packet Switching Backplane (cPSB) - The newest generation of the CompactPCI standard that enables an Ethernet-based interconnection fabric across a system backplane in lieu of the H.110 PCI bus. This backplane technology serves as the foundation for the new AdvancedTCA standard architecture from PICMG.
DS3 - A digital transmission link equivalent to 28 T1 lines. Providing a capacity of 45 Mbps, a DS3 link is capable of handling 672 voice conversations.
DSL or xDSL - DSL or xDSL is a family of technologies that provides digital data transmission over the wires of a local telephone network.
Digital Signal Processing - is the study of signals in a digital representation and the processing methods of these signals. A Digital Signal Processer (DSP) is a processer used for Digital Signal Processing.
Ethernet - A Local Area Network standard used for connecting computers, printers, workstations, and servers. Ethernet operates over twisted wire, coaxial cable and fiber optic cables at speeds starting at 10 Mbps. The original 10 Mbps specification was extended to a speed of 100 Mbps transmission bandwidth with Fast Ethernet and to 1 Gbps with gigabit Ethernet. Gigabit Ethernet is now the most popular variant being deployed. Ethernet itself has evolved to the next 10 Gbps transmission bandwidth capability. As network bandwidth usage continues to rapidly expand world-wide, 10 Gbps is expected to become a commonplace offering in enterprise and service provider networks.
European Telecommunications Standards Institute (ETSI) - An independent, non-profit organization, whose mission is to produce telecommunications standards for today and for the future for global networks. ETSI has been successful in standardizing the GSM mobile phone system.
Gateway Appliances - Network elements that provide translation functions between multiple protocols used for transfer of data and to control information across networks.
Gigabits per second (Gbps) - One thousand million bits per second.
Global System for Mobile Communications (GSM) - The most popular standard for mobile phones in the world. GSM differs significantly from its predecessors in that both signaling and speech channels are digital, which means that it is considered a second generation (2G) mobile phone system. This fact has also meant that data communication was built into the system from very early on. GSM is an open standard which is currently developed by the 3GPP. GSM service is used by over 1.5 billion people across more than 210 countries and territories. The ubiquity of the GSM standard makes international roaming very common between mobile phone operators, enabling subscribers to use their phones in many parts of the world.
Input/output (I/O) - The transfer of data or voice traffic into and out of a computing device. The main function of an adapter, communications controller, or network interface card is to regulate or control communications I/O.
International Mobile Telecommunications-2000 (IMT-2000) - The global standard for third generation (3G) wireless communications as defined by the International Telecommunication Union.
International Telecommunication Union (ITU) - An international organization established to standardize and regulate international radio and telecommunications. It was founded as the International Telegraph Union in Paris on May 17, 1865. Its main tasks include standardization, allocation of the radio spectrum, and organizing interconnection arrangements between different countries to allow international phone calls.
Internet Engineering Task Force (IETF) - Formed in 1986, the IETF sets technical standards that run the Internet such as routing, transport and security.
Internet Protocol (IP) - The standard method or protocol by which data is sent from one computer to another on the Internet.
Internet Protocol Television (IPTV) - A system where digital television is delivered over the internet.
Inverse Multiplexing over ATM (IMA) - A specification defined by the ATM forum that provides a way to combine an ATM cell stream over two or more circuits.
IP Multimedia Subsystem (IMS) - A standardized Next Generation Networking (NGN) architecture designed to enable both wireless and wireline carriers to create and deliver a full portfolio of new telecom services quickly and cost-effectively, and promises to be the cornerstone for fixed/mobile convergence within the telecom world. This network architecture based on the IETF SIP protocol was initially developed for delivering multi-media services in the 3G network by 3GPP but has been widely adopted and extended to enable fixed and mobile network convergence.
IP-PBX - An IP-PBX is a private branch exchange (telephone switching system within an enterprise) that switches calls between VoIP users on local lines while allowing all users to share a certain number of external phone lines.
IP Security (IPSec) - A security protocol from the Internet Engineering Task Force (IETF) that provides authentication and encryption over the Internet.
I-TDM - I-TDM is a PICMG standard optimized to transport and switch 64 Kbps low-latency communications traffic over gigabit Ethernet based packet backplanes.
Kilobits per second (Kbps) - One thousand bits per second.
Local Area Network (LAN) - A short-distanced data communications network that is contained within a building or complex. Its primary use is to link computers and peripheral devices (such as printers) and to provide individuals with access to databases and applications running on servers attached to the network. Anyone connected to the LAN can send messages to and work jointly with others on the network.
Media Gateway - A networking device that converts data from the format required for one type of network to the format required for another. The media gateway is controlled by the media gateway controller. Both are a component of Softswitch.
Megabits per second (Mbps) - One million bits per second, when used as a measurement for the speed of telecommunications, networking or local area networking.
MicroTCA - A set of standards that defines the ability to use AdvancedMC modules directly, without the need for an ATCA or custom carrier, enabling TEMs to achieve substantial reductions in size, cost and power requirements. MicroTCA is complementary to ATCA for small form-factor central office and outside plant applications like wireless base stations, WiMax radio boxes, next-generation digital loop carriers and optical network units.
Multilink PPP (MLPPP) - A bandwidth-on-demand protocol that can connect multiple links between two systems as needed to provide bandwidth on demand.
Network Elements - Equipment in the telecommunications network that provides various network functions.
OC-3/STM-1 - The American and European standards (respectively) for optical connections at 155.52 Mbps. This line speed is very common in telecommunications access networks.
OC-12/STM-4 - The American and European standards (respectively) for optical connections at 672 Mbps.
Operating System - The master control program that runs the computer. It is the first program loaded when the computer is turned on, and its main part, called the kernel, resides in memory at all times. It may be developed by the vendor of the computer it is running in or by a third party. It is an important component of the computer system because it sets the operational guidelines for all application programs
that run on the system. All programs must “talk to” the operating system. Popular network operating systems today include Windows® NT, XP, 2000, Vista, VxWorks®, Solaris™ and Linux.
Original Equipment Manufacturer (OEM) - Manufacturers who resell other companies’ products under its own name.
Packet Processing - Real time wire-speed analysis and processing of packets in the IP network.
PCI Industrial Computer Manufacturers Group (PICMG) - The technical standards governing body responsible for specifying technical requirements of specific systems architectures, including PCI, CompactPCI, CPSB, and AdvancedTCA. Standardized architectures are intended to provide a common set of rules and parameters for creating a system. The resulting benefit of such specifications is interoperability among multiple vendors for complementary system, thereby providing alternatives to market monopolies created by proprietary system architectures.
PCI Mezzanine Card (PMC) - A low profile mezzanine card that is electronically equivalent to the Peripheral Component Interconnect (PCI) specification. PMC cards are used as a quick and cost-effective method to add modular I/O to other card formats such as VME and CompactPCI, thus expanding the processing or I/O density of a single system slot.
Peripheral Components Interconnect (PCI) - A printed circuit board bus standard that is currently the main general-purpose bus in many desktop computers and a majority of enterprise servers throughout the world. Telecom servers generally use the newer generation of the PCI architecture which is CompactPCI.
Peripheral Components Interconnect-Express (PCI-e) - An I/O interconnect bus standard that expands on and doubles the data transfer rates of original PCI. PCI-e is a two-way, serial connection that carries data in packets along two pairs of point-to-point data lanes, compared to the single parallel data bus of traditional PCI that routes data at a set rate.
Peripheral Components Interconnect-Extended (PCI-x) - An extension of the original PCI design, PCI-x increases the internal bus speed from 66 MHz to 133 MHz. PCI-x supports a maximum rate of data exchange of 1.06 Gbps. This level of bandwidth is critical for servers running gigabit Ethernet, Fibre Channel and other high-speed networking applications.
Point-to-Point Protocol (PPP) - A protocol defined for direct communication links between two nodes in a network.
Public Switched Telephone Network (PSTN) - The concentration of the world’s public circuit-switched telephone networks, in much the same way that the Internet is the concentration of the world’s public IP-based packet-switched networks. Originally a network of fixed-line analog telephone systems, the PSTN is now almost entirely digital, and now includes mobile as well as fixed telephones.
Protocol - A specific set of rules, procedures or conventions relating to format and timing of data transmission between two devices in a telecommunication connection.
Radio Network Controller (RNC) - The governing element in a 3G wireless radio access network responsible for control of base stations which are connected to the controller. The RNC carries out radio
resource management, some of the mobility management functions and is the point where encryption is done before user data is sent to and from the mobile device.
Router - A highly intelligent device that acts as a junction between two networks to transfer data packets among them.
RTP - Real-time Transport Protocol provides end-to-end network transport functions suitable for applications transmitting real-time data, such as audio, video or simulation data, over multicast or unicast network services.
Session Initiation Protocol (SIP) - A text-based protocol developed by the IETF for initiating, modifying, and terminating an interactive session between users that involves multimedia elements such as video, voice, instant messaging, online games, and virtual reality in an IP-based packet network. In November 2000, SIP was accepted as a 3GPP signaling protocol and permanent element of the IMS architecture. SIP is one of the leading signaling protocols for VoIP.
Signaling Gateway - A gateway appliance component solely responsible for translating signaling messages (i.e., information about call establishment and teardown) between one medium (usually IP) and another (PSTN). A signaling gateway is often part of a softswitch in modern VoIP deployments.
Signaling System 7 (SS7) - The protocols used in the PSTN for setting up calls and providing modern transaction services such as caller ID, automatic recall and call forwarding. When you dial “1” in front of a number, SS7 routes the call to your long distance carrier and it also routes local calls based on the first three digits of the phone number.
Signaling Transport (SIGTRAN) - A standard defined by IETF as “an architecture framework for transport of message-based signaling protocols over IP networks.”
Softswitch (Software Switch) - A generic term for an open application program interface software used to bridge a public switched telephone network and the Internet Protocol by separating the call control functions of a phone call from the media gateway (transport layer).
T1/E1 - A digital transmission link with a capacity of 1.544 Mbps (1,544,000 bits per second) or 2.048 Mbps for the European E1 standard. T1 links normally handle 24 voice conversations, but with digital encoding can handle many more voice channels. T1 lines are also used to connect networks across remote distances.
T3/E3/J3 - A digital transmission link equivalent to 28 T1 lines. Providing a capacity of 45 Mbps, a T3 link is capable of handling 672 voice conversations. E3 is the European equivalent and J3 is the Japanese equivalent to T3.
Time-division multiplexing (TDM) - TDM is a type of digital or analog multiplexing in which two or more signals or bit streams are transferred apparently simultaneously as sub-channels in one communication channel, but physically are taking turns on the channel.
Telecommunications Equipment Manufacturer (TEM) - A company that manufacturers telecom equipment for sale to telecommunications carriers.
Triple Play - The delivery of voice, video and data over a single broadband connection.
User Plane - An ATM term referring to the functions which address flow control and error control. The User Plane cuts through all 4 layers of the ATM Protocol Reference Model.
VersModule-Eurocard (VME) - A mechanical and electrical bus standard developed in the late 1970s, with a backplane that runs at 80 Mbps and is most commonly used in commercial, military and industrial applications.
Voice over Internet Protocol (VoIP) - A phone call transmitted over a data network. The “Internet Protocol” is a catch-all for the protocols and technology of encoding a voice call that allow the voice call to be slotted in between data calls on a data network.
Virtual Private Network (VPN) - A highly secure network service offering used for accessing a corporate local area network, server or corporate intranet using the resources of the public Internet. VPNs are highly effective for telecommuters, traveling employees, and/or to link branches or regions, vendors, partners, affiliates, etc. to a corporate office/network.
Wide Area Network (WAN) - A communications network that covers a wide geographic area, such as a state or country. A WAN typically extends a LAN outside the building, over telephone common carrier lines to link to other LANs in remote locations, such as branch offices or at-home workers and telecommuters. WANs typically run over leased phone lines, but are increasingly also employing the Internet for VPN connectivity.
Worldwide Interoperability of Microwave Access (WiMAX) - WiMAX was formed in June 2001 to promote conformance and interoperability of the IEEE 802.16 standard. The WiMAX Forum describes WiMAX as “a standards-based technology enabling the delivery of last mile wireless broadband access as an alternative to cable and DSL.”
Mission
The Company’s mission is to provide innovative, high-performance connectivity solutions for the telecommunications and enterprise networking markets and to become the leader in providing robust building blocks, highly integrated subsystems and innovative gateway appliances for the converged communications network.
The Company’s ongoing strategy is to become “Trusted Partner” and the vendor of choice for commercial off-the-shelf (COTS) product solutions as the standards-based COTS market emerges, giving Interphase a powerful foothold within the major tier 1 TEMs. During 2007, Interphase reinforced its position as a key building block solutions provider to the industry’s largest TEMs and also expanded its relationship with many of the key system integration partners that supply to these TEMs.
To achieve these objectives, Interphase is pursuing several key initiatives that include:
Building innovative and high quality building blocks and gateway appliances for the delivery of high performance communications infrastructure products
The Company’s diverse product portfolio includes versatile communications boards, integrated hardware and software subsystems and gateway appliances delivered to the TEMs for integration into a wide variety of wireline and wireless applications that enable ubiquitous end-to-end multimedia connectivity.
The Company has established a broad presence in this marketplace with a product portfolio based on various form factor technologies: PMC, cPCI/cPSB, AdvancedTCA, AdvancedMC, MicroTCA and PCI. The Company has differentiated its product offering by providing hardware products with integrated software to deliver solutions that enable ease-of-integration and help address the critical time-to-market constraints that the Company’s customers face in the highly competitive global markets.
The Company’s offerings have been further enhanced by offering gateway appliances that deliver robust and complete solutions targeting specific inter-working needs in the telecom infrastructure; these appliances integrate Interphase building block products and software into more robust and complete solution offerings.
The Company expanded its product portfolio with a comprehensive offering of packet accelerator modules to address the needs of packet processing and deep packet inspection in the IP/Ethernet based network infrastructure.
In 2007, the Company was focused on product delivery to adhere to the schedule and commitments to its customers based on the requests for proposal (RFP) and design win activity in previous years. This effort included the delivery of our first two AdvancedMC products for lab use and system integration purposes.
During the year, we also successfully delivered two new PCI-e standards based products for intelligent T1/E1 and media processing applications. The Company also completed successful delivery and integration of our media converter gateway product and initiated production deliveries of the product.
The Company has continued to enhance its presence in the user plane segment of the market. With a comprehensive portfolio of AdvancedMC, PCI-x/PCI-e and Gateway appliance products, the Company was able to obtain additional design wins during the year.
As the telecommunications network transitions from a circuit switched-based network to a packet, or IP, switched network, securing the transmission of information transported across the Internet has become very critical. Interphase has continued to build upon its successful security product portfolio in the PMC and PCI form-factors.
Professional Services
The Interphase professional services group continues to provide the ability to customize and tailor the Company’s standards-based product offerings to the specific and unique needs of its customers’ application solutions. During 2007, the services group was engaged in providing significant software enhancements and capabilities on our building block products to enhance their utility in a broad range of applications. In addition, the services group has played a key role in the interoperability testing of Interphase products together with complementary single board computer carriers, DSP blades and AdvancedTCA and MicroTCA platforms from other industry suppliers.
With a high performance and high quality product portfolio, ease of integration, highly capable development, post-development support and professional services for customization and integration, Interphase has established itself as a “trusted partner” to its global TEM customer base by delivering cost-effective and expedient time-to-market solutions that enable its customers to deliver advanced communications infrastructure solutions.
Delivering advanced slot-optimization and security products for enterprise class applications
As the enterprise server market has advanced to deliver high performance computing solutions, high throughput networking adaptor and security products have become essential to deliver end application performance needs.
Advances in the PCI interconnect technology to higher speeds (PCI-x) and serial connectivity (PCI-e) has enabled server solutions to meet ever-increasing connectivity and bandwidth requirements. During 2007, Interphase completed successful delivery of its 6 port Slot-Optimizer gigabit Ethernet adapter which also can be integrated with a security co-processor solution. The Company also enhanced its network security product portfolio with the delivery of advanced security adaptor products for integration into diverse applications such as firewalls and VPN security platforms.
Delivering a comprehensive environment-friendly product portfolio
Interphase continued its push to deliver environment-friendly products to the marketplace. During 2007, all new products delivered were compatible with Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (RoHS), the European directive, and we have enabled our customers across our broad portfolio to deliver environment-friendly products.
Delivering superior customer service
Throughout the Company’s 30-year history, Interphase has established strong relationships with top-tier global suppliers of enterprise computer and telecommunications equipment. With a vertically integrated account perspective, Interphase provides flexibility, timely response and other customized account service features. Further, the Company’s technical support is staffed by subject-matter experts for both telecom and enterprise products, allowing Interphase to deliver superior pre- and post-sales support and services.
Establishing key strategic alliances and partnerships
Interphase products are utilized by customers in conjunction with other companies’ products to enable the delivery of leading-edge network solutions. By delivering standards-compliant, interoperable products, Interphase helps to ease the integration efforts for our customers. A key to ensuring interoperability is the pre-testing of Interphase products with complementary products from other vendors in the supply chain.
In addition, with the emergence of standards-based platforms and products, such as AdvancedTCA, there have been significant changes in the telecommunications industry value chain. This has resulted in a rise in importance of systems integrators who have taken on a number of tasks which were previously performed in-house by the TEMs.
Interphase has recognized this trend and focused its sales and marketing efforts to establish strategic relationships with many of the component and systems integration vendors in the industry supply chain. The benefits of these alliances include exposure to new customer opportunities, additional higher value-add opportunities at existing customers and the increased ability to win competitive bids by emerging as the “I/O vendor of choice” where Interphase is the strategic supplier to all bidding parties. These relationships also provide Interphase the opportunity to leverage joint marketing efforts to increase market exposure in areas such as industry trade events, seminars, joint whitepapers, articles, etc.
During 2007, the Company solidified system integrator strategic relationships to help us expand an additional channel for delivery of our products, thus extending our market reach and opportunity. In addition to our traditional I/O products we have also been very active in promoting our packet accelerator product portfolio as a key complementary product offering that enhances the overall solution offering across a broad range of IP packet services applications.
Enhancing operational efficiencies
One of the key motivations for an industry to move to standards-based products is the ability to reduce overall system costs and re-use these products across multiple applications to maximize flexibility. The move to AdvancedTCA standards in the telecommunications industry is driven by the same needs for cost reduction and supply chain optimization. The emergence of low-cost Asian product manufacturers has increased the competitive landscape and the need for highly cost-effective solutions in the marketplace. For Interphase, these trends are expected to result in a compressing of product profit margins and will, in turn, dictate the need for the Company to increase product delivery and manufacturing efficiencies.
During 2007, we completed the initial phase of the implementation of a comprehensive Enterprise Performance Management system based on the SAP toolset to replace our enterprise resource planning (ERP) system. This tool set has been especially important in enabling us to implement the strict controls
required for Sarbanes-Oxley compliance. We have also made tremendous progress in our supply chain initiatives to ensure that we continue to be the price and cost leader in the market segments we operate in. The Company has judiciously invested into the R&D structure as required to ensure successful delivery to product commitments. The Company has carefully expanded in other areas to address our growth and revenue objectives. However, the Company will continue to monitor the level of our investments concurrently with actual revenue results.
Products
Interphase offers a comprehensive portfolio of products bundled with optimized software packages to address applications in the telecommunications and enterprise networking markets. These products span multiple form factors including PCI, PCI-x, PCI-e, PMC, cPCI, cPSB, AdvancedTCA and AdvancedMC.
Building Block Component Products
The building block products constitute the fundamental solutions offered by Interphase to meet the modularity, flexibility, high-performance and reliability requirements for delivery of advanced telecommunications and enterprise services. The modular design of these products enables their use across a wide variety of applications, creating cost-effective and high re-use value to customers. Building block products manufactured by Interphase include: integrated communications controllers, ATM network interface cards, security accelerator cards and gigabit ethernet network interface cards.
Integrated Communications Controllers
The integrated communications controller product family is designed to enable different types of physical connections within the telecommunications network. These products fall into the subcategories of T1/E1/J1 controllers and high-density interface controllers.
T1/E1/J1 Controllers
This flagship product line consists of multiple solutions designed to support prevalent physical connections in the network. These products typically support the T1 North American format, the E1 European format (adopted by many other countries worldwide, including Asia and Australia) and the J1 format (and derived formats) used in Japan. All of these products are offered together with the field-proven Interphase iWare® Software Development Suite. Key products include:
iSPAN 4538 - a PMC with two T1/E1/J1 interfaces on the front faceplate and a 10/100 Ethernet port
iSPAN 4539/4539F - a PMC with four T1/E1/J1 interfaces via front or rear access, and a 10/100 Ethernet interface on the front
iSPAN 5539F - a PCI card with four T1/E1/J1 interfaces for use in server systems
iSPAN 5539 - a native PCI card with four T1/E1/J1 interfaces for use in server systems
iSPAN 3639 - an AdvancedMC with 4 or 8 T1/E1/J1 interfaces via front and rear access with support for both signaling and media termination
iSPAN 5639 - a PCI-e 4 or 8 port T1/E1/J1 interface card for use in server systems with PCI-e host connectivity
Key network elements and applications enabled include:
High Density Interface Controllers
These products enable high bandwidth connections used in many different telecommunications network applications. These products support the North American DS-3, OC-3 and OC-12 connection formats and STM-1 and STM-4 European connection formats, both of which are used globally. Key products include:
iSPAN 4532 - an intelligent, high-performance single-port OC-3/STM-1 ATM PMC with a 10/100 Ethernet interface. This product is offered with the field-proven Interphase iWare® Software Development Suite.
iSPAN 4532Q - four-port OC-3/STM-1 passive PMCs with support for a variety of fiber optic connection types
iSPAN 4533P - a single-port OC-12/STM-4 passive interface PCM with support for a variety of fiber optic connection types
Key network elements and applications enabled include:
•
Radio Network Controller (RNC)
•
Mobile Switching Center (MSC)
•
DSL Access Multiplexers
•
Cable Modem Termination System (CMTS)
ATM Network Interface Cards
ATM network interface cards are used in many broadband networking elements for processing information transported on ATM networks. Key products include:
iSPAN 4575/4576 - a single or dual-port OC-3/STM-1 PMC for ATM processing
iSPAN 5575/5576 - PCI ATM Communications Interface Card - a single or dual-port OC-3/STM-1 PCI card for ATM processing
iSPAN 3676 - AdvancedMC ATM communications Interface Card - an OC-3/STM-1 single or dual-port card for ATM processing
Key network elements and applications enabled include:
•
Serving GPRS Service Node (SGSN)
•
Gateway GPRS Service Node (GGSN)
•
Operations, administration and management devices used for back-end services in the telecommunications infrastructure
Security Acceleration Cards
The Interphase security product portfolio provides encryption and decryption capabilities enabling customers to securely operate enterprise or telecommunications networks. Key products include:
45NS - a PMC designed to accelerate multiple security protocols, including IPSec, for use in encryption and decryption of information
5585 - PCI card based on the HiFn 8155 security processor designed to accelerate multiple security protocols, including IPSec, for use in encryption and decryption of information
5556 - low-end PCI card based on the HiFn 7956 security co-processor designed to accelerate multiple security protocols, including IPSec, for use in encryption and decryption of information
566GS - PCI card based on the HiFn 8155 security processor with support for six gigabit ethernet ports on the front panel designed for VPN and security appliances
Key network elements and applications enabled include:
•
Firewall and VPN solutions
•
On Line Transaction Processing (OLTP)
•
Network Management solutions
Gigabit Ethernet Network Interface Cards
Interphase offers a broad portfolio of multi-port gigabit Ethernet solutions that provide enhanced ethernet connectivity for a variety of telecommunications and enterprise networking solutions. Key products include:
454G SlotOptimizer™ - a quad-port PMC ethernet card for high-density ethernet connectivity
364G SlotOptimizer™ - a quad-port AdvancedMC ethernet card for high-density ethernet connectivity
554GB SlotOptimizer - a quad-port PCI ethernet card with PCI-x for high-density ethernet connectivity
564GB SlotOptimizer - a quad-port PCI-e ethernet card for high-density ethernet connections
Key network elements and applications enabled include:
•
High performance computing servers for engineering applications
•
Serving GPRS Service Node (SGSN)
•
Softswitches
Gateway Appliance Solutions
Interphase gateway appliances provide targeted high performance and easy-to-manage solutions to address the needs of interworking in the emerging transition from PSTN and ATM-based legacy networks to all-IP based networks. These appliances integrate Interphase building block products and software into more robust and complete solution offerings. Key products include:
iNAV® 9200 Broadband Access Gateway - an advanced, price/performance-maximized solution for applications requiring the translation of IP to/from ATM
iNAV 921x Media Converter - provides seamless media conversion from legacy TDM streams over T1/E1s to RTP streams for delivery over the IP network, with support for up to 16 T1/E1 ports and two gigabit Ethernet ports for IP connectivity
New Product Development
There are a number of major market trends in the telecom market that will affect Interphase solution offerings. Interphase must rapidly respond to these market trends with expansions in its product portfolio and offerings.
Of the major market trends, perhaps the most prominent is the move from circuit switched-based networks to IP/Ethernet packet-based networks. This move has a profound impact on the telecom markets served by Interphase. The industry’s embrace of IP/Ethernet-based networks is primarily fueled by the following factors:
•
Ethernet-based IP networks offer an inexpensive, ubiquitous broadband packet-based delivery approach for carriers. The simplicity of IP-based ethernet networks are expected to shorten the period of new service deployment and time to revenue.
•
The second promise of this network architecture is greatly reduced cost of purchasing, provisioning and maintaining their networks.
•
Another significant trend in the COTS market is the move to AdvancedTCA platforms. Sponsored primarily by Intel, a number of AdvancedTCA suppliers have emerged to address the ever-growing needs of TEMs. TEMs have been reducing their internal development infrastructure over the past several years and are now more dependent on outsourced solutions to meet their product development needs.
•
With the transition to the packet infrastructure modules that provide multi-gigabit ethernet and 10 gigabit Ethernet line rate switching, processing and classification of packet data are becoming very important for a wide range of applications including secure data transport, microbilling and high speed multi-media content delivery.
Interphase is focused on developing high performance, highly reliable COTS products, based on AdvancedTCA, AdvancedMC, MicroTCA and PCI-e standards, and appliances, which enable its customers to deliver cost-effective and expedient time-to-market solutions that address the above market trends.
Telecom Segment Initiatives
In the telecommunications market, Interphase continues to expand its product portfolio with the inclusion of new user plane and packet processing targeted products. These products are designed to address the needs of high bandwidth applications for 3G wireless networks, VoIP networks, broadband access networks and the advanced services capabilities promised by the emerging IMS network architecture.
Packet Accelerator Products
Interphase has identified a key emerging opportunity for packet processing solutions that enable multi-gigabit and 10 gigabit line rate termination, inspection, classification, processing and switching of Ethernet and IP packet data. These packet processing modules and blades are emerging as essential building blocks for a wide range of applications including security processing, deep packet inspection and classification of user traffic and data, billing applications, etc. These packet data modules are also finding use in the aggregation of multiple user data at the access into the core network infrastructure, as well as the delivery of multi-media content to multiple users from the core of the network.
During 2007, we began investing in the development of products that would position us as an IP “packet processing” leader. In order to further propel our position in the market and increase our revenue
opportunities, we have expanded our product portfolio to address native IP network application requirements of high performance line rate deep packet inspection and packet processing. The Interphase product portfolio of AdvancedMC and PCI adaptor products are well suited for use in AdvancedTCA, MicroTCA, rack-mount server and blade server platform products that are being used to deliver IP based broadband services. These Interphase products are based on the industry leading Cavium Octeon Plus® processor family that delivers high performance packet processing within the constraints of the module form-factors. The Octeon processors include co-processor and accelerator technology for many of the packet processing functions required in a network element. These functions include line rate encryption and decryption and compression and decompression of packets, high speed pattern matching on packet header content to help process application level protocols and deep packet inspection to deliver quality of service prioritization of packets, anti-virus and intrusion detection services. Interphase is also engaged in the delivery of a broad portfolio of software modules to enable acceleration of product development and time to market for our customers.
This new line of products enable line rate secure packet processing, packet inspection, classification, and QOS support. Interphase plans to deliver a comprehensive suite of software modules integrated together with the hardware offering to meet the high performance packet processing requirements in next generation networks. This line of products currently includes:
iSPAN 36CA - an AdvancedMC with quad gigabit ethernet connectivity on the front panel or on a Rear Transition Module with quad gigabit ethernet and PCI-e connectivity on the AdvancedMC connector
iSPAN 55CA - a PCI-x board with quad gigabit ethernet connectivity on the front panel and PCI-e connectivity on to the host processor
Key network elements and applications enabled include:
•
Radio Network Controller (RNC)
•
Packet Access Gateway in 4G wireless networks
•
ASN Gateway and BSC’s in WiMax networks
•
GGSN in WCDMA networks
•
Wireless LAN Access Concentrators
•
Content Processing Appliances
•
Security Appliances
AdvancedTCA and MicroTCA
AdvancedTCA standards define a highly reliable, manageable, high-performance and flexible platform architecture that enables the delivery of high throughput network solutions. Hence, TEMs have embraced AdvancedTCA as a common platform framework to deliver systems solutions to meet the needs of 3G wireless, IMS and VoIP network deployments.
The field-replaceable AdvancedMC module standards introduce additional flexibility for the delivery of application-specific functions to enhance a common platform vision and architecture.
Furthermore, the MicroTCA standards define a smaller platform that uses AdvancedMCs. MicroTCA can be used to deliver complete network elements such as base stations, NodeBs, DSL access multiplexers, WiMAX base stations and IP-PBXs.
During 2007, Interphase completed successful general market availability delivery of multiple products in its AdvancedMC portfolio. These products have already been delivered to key customers for lab use and system integration activity. The Interphase AdvancedTCA and AdvancedMC product portfolio includes:
•
iSPAN 3639 - an AdvancedMC with 4 or 8 T1/E1/J1 interfaces via front and rear access with support for both signaling and media termination
•
364G - an AdvancedMC with 4 gigabit ethernet interfaces
•
iSPAN 3650 - an AdvancedMC with 4 OC-3/STM-1 unchannelized interfaces via front and rear access for termination of ATM packets and interworking to IP
•
iSPAN 36CA - an AdvancedMC with 4 gigabit ethernet interfaces via front access for high performance line rate packet processing and packet switching solutions
•
iNAV 31K - an AdvancedTCA carrier with support for up to 4 mid-size or full size AdvancedMCs with 10 Gigabit fabric interface support for the integration and delivery of high-capacity and high performance subsystem solutions
•
iNAV 74PF - a quad processor dual-core Freescale 8641D based processor blade for high performance embedded packet and control processing
Interphase expects to complete general availability delivery of these products during 2008 for successful integration into next generation advanced network platforms.
All of the AdvancedMC solutions are also fully reusable in the emerging MicroTCA based platform architectures being adopted for network edge and access solutions. Interphase continues to see significant adoption of the MicroTCA platform architecture for a wide variety of telecommunications applications as well as in adjacent embedded markets such as the military segment for defense related networking applications.
Beyond AdvancedTCA and MicroTCA, AdvancedMC are also attracting the attention of TEM customers as a valuable building block to avail of the latest technology in their proprietary platforms. Many of the TEMs are looking at adding AdvancedMC carrier blades to their proprietary systems enabling them to reuse the AdvancedMC technology available in the market and refresh/upgrade the functionality of their proprietary systems. Interphase, with its broad AdvancedMC product portfolio, is well positioned to take advantage of these opportunities. In addition, blade server vendors are also introducing AdvancedMC carriers in their telecommunications blade server platforms to take advantage of the diverse I/O processing capabilities offered by the AdvancedMC form-factor. Interphase is working closely with these blade server manufacturers to ensure interoperability and integration of its AdvancedMCs to offer customers additional choices as they decide on the specific platform form-factor for the end network applications.
Cost Reduction Services
Another major trend in the worldwide communications infrastructure market is the increased business in the emerging markets for the delivery of basic communications and wireless services. These markets tend to be very cost sensitive and very competitive. Many of the TEMs are re-purposing their existing legacy platform infrastructure to address these markets with cost reduction initiatives that help reduce the cost of their overall solutions while extending the lifespan of the products. During 2007, Interphase successfully completed a significant cost reduction development for a key Tier 1 customer, delivering a high quality product in a very short time span. This product transitioned into production delivery and deployment during the fourth quarter of 2007. Interphase will seek to leverage its broad technology experience and expertise to support its customers in similar cost reduction projects and activities during the coming years.
PCI Rack Mounted Server Solutions
Telecommunications grade rack mount server and blade server solutions from server manufacturers such as IBM, Sun and HP continue to be an important platform of choice for delivery of operation, administration, management and provisioning applications as well as for network elements needing large databases and storage. The Company is therefore also engaged in delivering PCI/PCI-e based modules that take advantage of the equivalent AdvancedMC module designs to meet the I/O needs of these platforms. Key products slated for availability in the first two quarters of 2008 include the iSPAN 5639 4/8 port T1/E1/J1 communications controller module as well as the iSPAN 5639E 4/8 port T1/E1/J1 media interface module and the iSPAN 55CA Quad gigabit Ethernet Packet Accelerator Module.
Appliance Solutions
Interphase continues to expand and innovate with its appliance solutions, by delivering easy to use and easy to manage devices that address key transition requirements in the network infrastructure.
The iNAV 9200 broadband gateway solution was deployed successfully during 2006 for the delivery of ATM to IP interworking in a number of broadband access applications.
During 2007, Interphase also completed the delivery of its iNav 921x Media Converter appliance based on the iNAV 9200 platform for media interworking between TDM and IP media streams. The 921x Media Converter appliance provides up to 16 T1/E1 ports for TDM media stream termination and processing for conversion and transmission to an IP network.
In addition, Interphase is exploring additional opportunities that enable us to deliver subsystem solutions for target interworking and networking applications, with the broad portfolio of AdvancedMC’s integrated on the Interphase AdvancedTCA carrier blade.
Enterprise Networking Initiatives
In the enterprise networking market, Interphase has focused on delivery of specialized SlotOptimizer solutions for servers used in high performance computing, scientific lab environments and advanced enterprise applications. During 2007, the Company completed successful integration of its security line of PCI products into a key Tier 1 VPN and firewall appliance. The Company is working on additional
SlotOptimizer cards supporting up to 6 gigabit ethernet ports together with an onboard security co-processor solution.
Industry Standards Participation
Throughout its history, Interphase has been active in the formulation of industry standards sanctioned by groups such as PICMG and the AdvancedTCA subcommittee in particular. The Company has actively participated in the ATCA and AdvancedMC subcommittees and has worked with other key industry participants to help drive the standardization. In addition, Interphase has been an active participant in interoperability events to ensure that the Company’s products are standards compliant as well as fully interoperable with the ATCA carrier board solutions from other vendors to ensure ease of integration for its customers.
During the year, Interphase was an active participant in the SCOPE alliance and Communications Platform Trade Association (CP-TA) standards activities. SCOPE is an industry alliance committed to accelerating the deployment of carrier grade base platforms for service provider applications. Its mission is to help, enable and promote the availability of open carrier grade base platforms based on commercial off-the-shelf (COTS) hardware / software and free open source software (FOSS) building blocks, and to promote interoperability to better serve service providers and consumers. All the major TEMs are sponsor members of the SCOPE alliance organization. The CP-TA is an association of communications platform and building block providers dedicated to accelerate the adoption of PICMG governed, open specification based communications platforms through interoperability certification. With industry collaboration, the CP-TA plans to drive a mainstream market for open industry standards based communications platforms by certifying interoperable building blocks.
Marketing and Customers
The Company’s broadband telecommunications products are sold to TEMs for inclusion into telecommunications and networking infrastructure solutions designed for use in both wireline and wireless carrier networks. The enterprise products are delivered to server manufacturers for integration into server platforms for delivery of high performance application platforms for enterprise networking.
During 2007 the Company solidified its customer base with products delivered or under design win consideration at each of the major Tier 1 TEMs. In addition, with its strategic alliances with the system integrators, Interphase has been able to expand its customer footprint across the globe enabling us to diversify our revenue and customer base.
During 2007, sales to Alcatel-Lucent and Motorola accounted for $9.5 million or 31% and $5.1 million or 17%, of the Company’s consolidated revenues, respectively. During 2006, sales to Alcatel-Lucent, Motorola and Hewlett Packard accounted for $11.3 million or 34%, $7.5 million or 22% and $3.4 million or 10% of the Company’s consolidated revenues, respectively. During 2005, sales to Alcatel-Lucent, Hewlett Packard and Motorola accounted for $8.9 million or 29%, $6.0 million or 19% and $4.2 million or 14% of the Company’s consolidated revenues, respectively. No other customers accounted for more than 10% of the Company’s consolidated revenues in the periods presented.
The Company markets its products through its direct sales force, manufacturers’ representatives and value-added distributors. In addition to the Company’s headquarters in Plano, Texas, the Company has
sales offices located in or near Los Angeles, California; Minneapolis, Minnesota; Newark, New Jersey; Amsterdam, Holland; Helsinki, Finland; Sydney, Australia; and Paris, France. The Company’s direct sales force markets products directly to key customers and supports manufacturers’ representatives and the distribution channel. In addition, the Company has entered into distribution agreements with key international distributors located in countries in North America, Asia and Europe. See Note 14 of the accompanying Notes to the consolidated financial statements for information regarding the Company’s geographic assets and revenues.
Manufacturing and Supplies
Manufacturing operations are currently conducted at the Company’s manufacturing facility located in Carrollton, Texas. The Company’s products consist primarily of various integrated circuits, other electronic components and firmware assembled onto an internally designed printed circuit board.
The Company uses internally designed products utilizing application specific integrated circuits (ASIC), some of which are sole-sourced, on some of its products, as well as standard off-the-shelf items presently available from two or more suppliers. Historically, the Company has not experienced any significant problems in maintaining an adequate supply of these parts sufficient to satisfy customer demand. The Company believes that it has good relations with its vendors.
The Company generally does not manufacture products to stock finished goods inventory, as substantially all of the Company’s production is dedicated to specific customer purchase orders. As a result, the Company has limited requirements to maintain significant finished goods inventories.
Intellectual Property and Patents
While the Company believes that its success is ultimately dependent upon the innovative skills of its personnel and its ability to anticipate technological changes, its ability to compete successfully will depend, in part, upon its ability to protect proprietary technology contained in its products. The Company does not currently hold any patents relative to its current product lines. Instead, the Company relies upon a combination of trade secret, copyright and trademark laws and contractual restrictions to establish and protect proprietary rights in its products. The development of alternative, proprietary and other technologies by third parties could adversely affect the competitiveness of the Company’s products. Further, the laws of some countries do not provide the same degree of protection of the Company’s proprietary information, as do the laws of the United States. Finally, the Company’s adherence to industry-wide technical standards and specifications may limit the Company’s opportunities to provide proprietary product features capable of protection.
The Company is also subject to the risk of litigation alleging infringement of third party intellectual property rights. Infringement claims could require the Company to expend significant time and money in litigation, paying damages, developing non-infringing technology or acquiring licenses to the technology which is the subject of asserted infringement.
The Company has entered into several nonexclusive software licensing agreements that allow the Company to incorporate third-party software into its product line thereby increasing its functionality, performance and interoperability.
Employees
At December 31, 2007, the Company had 137 full-time employees, of which 43 were engaged in manufacturing and quality assurance, 52 in research and development, 22 in sales, sales support, customer service and marketing and 20 in general management and administration.
The Company’s success to date has been significantly dependent on the contributions of a number of its key technical and management employees. The loss of the services of one or more of these key employees could have a material adverse effect on the Company. In addition, the Company believes that its future success will depend, in large part, upon its ability to attract and retain highly skilled and motivated technical, managerial, sales and marketing personnel. Competition for such personnel is significant.
None of the Company’s employees are covered by a collective bargaining agreement and there have been no work stoppages. The Company considers its relationship with its employees to be good.
Competition
The Company’s competition includes vendors specifically dedicated to the telecommunication and enterprise I/O product markets. Most of the Company’s major TEM customers have chosen to outsource the design, manufacture and software integration of certain communications controllers and protocol processing, and the recent market conditions and reduction in resources have forced some network equipment providers to utilize off-the-shelf products for their product design. In the case of specific product offerings, Interphase may also face competition from the in-house design team at the TEMs. Increased competition and commoditization of network interface technologies could result in price reductions, reduced margins and loss of market share.
Item 1A.
Item 1A. Risk Factors.
The marketing and sale of our products involve lengthy sales cycles. This and other factors make business forecasting extremely difficult and can lead to significant fluctuations in period-to-period results.
We have experienced fluctuations in our period-to-period revenue and operating results in the past and may experience fluctuations in the future. Our sales on both an annual and a quarterly basis can fluctuate as a result of a variety of factors, many of which are beyond our control. We may have difficulty predicting the volume and timing of orders for products, and delays in closing orders can cause our operating results to fall short of anticipated levels for any period. Delays by our OEM customers in producing products that incorporate our products could also cause operating results to fall short of anticipated levels. Other factors that may particularly contribute to fluctuations in our revenue and operating results include success in achieving design wins, the market acceptance of the OEM products that incorporate our products, the rate of adoption of new products, competition from new technologies and other companies, and the variability of the life cycles of our customers’ products.
Because fluctuations can happen, we believe that comparisons of the results of our operations for preceding quarters are not necessarily predictive of future quarters and that investors should not rely on the results for any one quarter as an indication of how Interphase will perform in the future. Investors should also understand that, if the revenue or operating results for any quarter are less than the level
expected by securities analysts or the market in general, the market price of our common stock could immediately and significantly decline.
The telecommunications signaling and networking business is characterized by rapid technological change and frequent introduction of new products.
The market for our products is characterized by rapid technological change and frequent introduction of products based on new technologies. As these products are introduced, the industry standards change. Additionally, the overall telecommunications and networking industry is volatile as the effects of new technologies, new standards, new products and short life cycles contribute to changes in the industry and the performance of industry participants. Future revenue will depend upon our ability to anticipate technological change and to develop and introduce enhanced products of our own on a timely basis that comply with new industry standards. New product introductions, or the delays thereof, could contribute to quarterly fluctuations in operating results as orders for new products commence and orders for existing products decline. Moreover, significant delays can occur between a product introduction and commencement of volume production. A typical time period from design-in of one of our products to actual production is 18 to 30 months. Our inability to develop and manufacture new products in a timely manner, the existence of reliability, quality or availability problems in our products or their component parts, or the failure to achieve market acceptance for our products could have a material adverse effect on our operating results, financial condition and cash flows.
We operate in an intensely competitive marketplace and many of our competitors have greater resources than we do.
The telecommunications, signaling and networking business is extremely competitive, and we face competition from a number of established and emerging companies, both public and private. Our principal competitors have established brand name recognition and market positions and have substantially greater financial resources to deploy on promotion, advertising and research and product development. In addition, as we broaden our product offerings, we may face competition from new competitors. Companies in related markets could offer products with functionality similar or superior to our product offerings. Increased competition could result in significant pricing pressures. These pricing pressures could result in significantly lower average selling prices for our products. We may not be able to offset the effects of any price reductions with an increase in sales volumes, cost reductions or otherwise. We expect that competition will increase as a result of industry consolidations and alliances, as well as the potential emergence of new competitors. There can be no assurance that we will be able to compete successfully with existing or new competitors or that competitive pressures will not have a material adverse effect on our operating results, financial condition and cash flows.
The loss of one or more key customers or reduced spending by customers could significantly impact our operating results, financial condition and cash flows.
While we enjoy very good relationships with our customers, there can be no assurance that our principal customers will continue to purchase products from us at the current levels. Orders from our customers are affected by factors such as new product introductions, product life cycles, inventory levels, manufacturing strategies, contract awards, competitive conditions and general economic conditions. Customers typically do not enter into long-term volume purchase contracts with us, and customers have certain rights to extend
or delay the shipment of their orders. The loss of one or more of our major customers, or the reduction, delay or cancellation of orders or a delay in shipment of products to such customers could have a material adverse effect on our operating results, financial condition and cash flows.
Schedule delays, cancellations of programs and changes in customer markets can delay or prevent a design win from reaching the production phase, which could negatively impact our operating results, financial condition and cash flows.
A design win occurs when a customer or prospective customer notifies us that our product has been selected to be integrated with their product. Ordinarily, there are a number of steps between the design win and when customers initiate production shipments. Design wins reach production volumes at varying rates, typically beginning approximately 18 to 30 months after the design win occurs. A variety of risks such as schedule delays, cancellations of programs and changes in customer markets can delay or prevent the design win from reaching the production phase. The customer’s failure to bring their product to the production phase could have an adverse effect on our operating results, financial condition and cash flows.
Design defects, errors or problems in our products could harm our reputation, revenue and profitability.
If we deliver products with errors, defects or problems, our credibility and the market acceptance and sales of our products could be harmed. Further, if our products contain errors, defects or problems, then we may be required to expend significant capital and resources to alleviate such problems. Defects could also lead to product liability as a result of product liability lawsuits against us or our customers. We have agreed to indemnify our customers in some circumstances against liability from defects in our products. While no such litigation currently exists, product liability litigation arising from errors, defects or problems, even if it resulted in an outcome favorable to us, would be time consuming and costly to defend. Existing or future laws or unfavorable judicial decisions could negate any limitation of liability provisions that are included in our license agreements. A product liability claim, whether or not successful, could seriously harm our business, financial condition and results of operations.
We maintain insurance coverage for product liability claims. Although we believe this coverage is adequate, we are not assured that coverage under insurance policies will be adequate to cover specific product liability claims made against us. In addition, product liability insurance could become more expensive and difficult to maintain and may not be available in the future on commercially reasonable terms or at all. The amount and scope of any insurance coverage may be inadequate if a product liability claim is successfully asserted against us.
If our third party suppliers fail to produce quality products or parts in a timely manner, we may not be able to meet our customers’ demands.
Certain components used in our products are currently available from one or a limited number of sources. There can be no assurance that future supplies will be adequate for our needs or will be available with acceptable prices and terms. Inability in the future to obtain sufficient limited-source components, or to develop alternative sources, could result in delays in product introduction or shipments, and increased component prices could negatively affect gross margins, either of which could have a material adverse effect on operating results, financial condition and cash flows.
We are dependent on one manufacturing facility and if there is an interruption in production we may not be able to deliver products on a timely basis.
We manufacture our products at our Carrollton, Texas facility, and have established alternative manufacturing capabilities through a third party in the event of a disaster in the current facility. Even though we have been successful in establishing an alternative third-party contract manufacturer, there can be no assurance that we would be able to retain their services at the same costs that we currently enjoy. In the event of an interruption in production, we may not be able to deliver products on a timely basis, which could have a material adverse effect on our revenue and operating results. Although we currently have business interruption insurance and a disaster recovery plan to mitigate the effect of the interruption, no assurances can be given that such insurance or recovery plan will adequately cover lost business as a result of such an interruption.
If we fail to accurately forecast demand for our products, we would be exposed to risk associated with inventory.
We must identify the right product mix and maintain sufficient inventory on hand to meet customer orders. Failure to do so could adversely affect our sales and earnings. However, if circumstances change there could be a material impact on the net realizable value of inventory which could adversely affect our results.
We may be unable to effectively protect our proprietary technology, which would negatively affect our ability to compete. Also, if our products are alleged to violate the proprietary rights of others, our ability to compete would be negatively impacted.
Our success depends partly upon certain proprietary technologies developed within our products. To date, we have relied principally upon trademark, copyright and trade secret laws to protect our proprietary technologies. We generally enter into confidentiality or license agreements with our customers, distributors and potential customers, which limit access to and distribution of the source code to our software and other proprietary information. Our employees are subject to our employment policy regarding confidentiality. There can be no assurance that the steps taken by us in this regard will be adequate to prevent misappropriation of our technologies or to provide an effective remedy in the event of a misappropriation by others.
Although we believe that our products do not infringe on the proprietary rights of third parties, there can be no assurance that infringement claims will not be asserted, possibly resulting in costly litigation in which we may not ultimately prevail. Adverse determinations in such litigation could result in the loss of proprietary rights, subject us to significant liabilities, require that we seek licenses from third parties or prevent us from manufacturing or selling our products, any of which could have a material adverse effect on our operating results, financial condition and cash flows.
It may be necessary to obtain technology licenses from others due to the large number of patents in the telecommunications and computer networking industry and the rapid rate of issuance of new patents and new standards or to obtain important new technology. There can be no assurance that these third party technology licenses will be available on commercially reasonable terms. The loss of or inability to obtain any of these technology licenses could result in delays or reductions in product shipments. Such delays or
reductions in product shipments could have a material adverse effect on our operating results, financial condition and cash flows.
We depend on key personnel to manage our business effectively.
Our success depends on the continued contributions of our personnel and on our ability to attract and retain skilled employees. Changes in personnel could adversely affect our operating results, financial condition and cash flows.
We have substantial international activities, which expose us to additional business risks including political, economic and currency risks.
We derive approximately 59% of our revenues from sales outside of North America. Economic and political conditions in some of these markets as well as different legal, tax, accounting and other regulatory requirements may adversely affect our operating results, financial condition and cash flows. We are exposed to adverse movements in foreign currency exchange rates because we conduct business on a global basis and in some cases in foreign currencies. Our 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 (See Item 7A - Foreign Currency Risk).
We may require additional working capital to fund operations and expand our business.
We believe our current financial resources will be sufficient to meet our present working capital and capital expenditure requirements for the next twelve months. However, we may need to raise additional capital before this period ends to further:
•
fund research and development of new products beyond what is expected in 2008;
•
expand product and service offerings beyond what is contemplated in 2008 if unforeseen opportunities arise; or
•
respond to unforeseen competitive pressures.
Our future liquidity and capital requirements will depend upon numerous factors, including the success of the existing and new product and service offerings and potentially competing technological and market developments. However, any projections of future cash flows are subject to substantial uncertainty. From time to time, we expect to evaluate the acquisition of, or investment in businesses and technologies that complement our current operations. If current cash, marketable securities, lines of credit and cash generated from operations are insufficient to satisfy the liquidity requirements, we may seek to sell additional equity securities, issue debt securities or increase our working capital line of credit. The sale of additional equity securities could result in additional dilution to shareholders. There can be no assurance that financing will be available in amounts or on terms acceptable, if at all. If adequate funds are not available on acceptable terms, our ability to develop or enhance products and services, take advantage of future opportunities or respond to competitive pressures would be limited. This limitation could negatively impact our results of operations, financial condition and cash flows.
We have incurred significant losses.
Although we posted net income of approximately $2.1 million and $1.7 million for the years ended December 31, 2006 and 2004, respectively, we posted a net loss of approximately $1.2 million, $2.3 million and $769,000 for the years ended December 31, 2007, 2005 and 2003, respectively. In order to achieve profitability consistently, we will need to generate higher revenues while containing costs and operating expenses. We cannot be certain that our revenues will grow or that we will generate sufficient revenues to achieve and maintain profitability on a long-term, sustained basis. If we fail to achieve and maintain profitability, then the market price of our common stock will likely be negatively impacted.
We may experience significant period-to-period quarterly and annual fluctuations in our revenue and operating results, which may result in volatility in our stock price.
The trading price of our common stock is subject to wide fluctuations in response to quarter-to-quarter fluctuations in operating results, general conditions in the telecommunications and networking industry and other events or factors. In addition, stock markets have experienced extreme price and trading volume volatility in recent years. This volatility has had a substantial effect on the market price of the securities of many high technology companies for reasons frequently unrelated to the operating performance of the specific companies. These broad market fluctuations may adversely affect the market price of our common stock. Our common stock has historically had relatively small trading volumes. As a result, small transactions in common stock can have a disproportionately large impact on the price of the common stock.
2008 will be the first year that our internal controls over financial reporting will be audited by our independent registered public accounting firm in accordance with Section 404 of the Sarbanes-Oxley Act of 2002.
The year ending December 31, 2007, was the first year of management assessment of our internal controls in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”). The year ending December 31, 2008, will be the first year that our internal controls over financial reporting will be audited by our independent registered public accounting firm in accordance with Section 404. As a result of the ongoing interpretation of new guidance issued by the standards-setting community and the audit testing yet to be completed, our internal controls over financial reporting may include one or more unidentified material weaknesses which would result in us receiving an adverse opinion on internal controls over financial reporting from our independent registered public accounting firm. This could result in significant additional expenditures responding to the Section 404 internal control audit, heightened regulatory scrutiny and potentially an adverse effect to the price of the common stock.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
The Company’s executive offices are located in a 22,000-square foot leased facility located in Plano, Texas. The executive offices serve as the primary location for the Company’s administrative and marketing functions. The Company’s manufacturing and operations center is located in a 24,000-square
foot leased facility in Carrollton, Texas. The executive offices lease extends through the end of 2008 and the manufacturing and operations center lease extends through January 2009. The Company also leases a 3,000-square foot facility in Lisle, Illinois that supports an engineering laboratory. The Lisle, Illinois lease extends through October 2008. In addition, the Company leases a 9,000-square foot facility in Chaville, France (near Paris) that primarily supports an engineering team. The Chaville, France lease extends through June 2011. The Company believes that its facilities and equipment are in good operating condition and are adequate for its operations. The Company owns most of the equipment used in its operations. Such equipment consists primarily of engineering equipment, manufacturing and test equipment, computer equipment and fixtures.
Item 3.
Item 3. Legal Proceedings.
None.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Since January 1984, shares of the Company’s common stock have been traded on the NASDAQ Global Market, or its predecessors, under the symbol INPH. The following table summarizes its high and low closing price for each quarter during 2006 and 2007 as reported by the NASDAQ Global Market.
The Company had approximately 1,700 beneficial owners of its common stock, of which 92 were of record as of March 10, 2008.
The Company has not paid dividends on its common stock since its inception. The Board of Directors does not anticipate payment of any dividends in the foreseeable future and intends to continue its present policy of retaining earnings for reinvestment in the operations of the Company.
The Board of Directors has adopted a Shareholder Rights Plan whereby each holder of record as of December 29, 2000 received a right to purchase from the Company one share of common stock of the Company at a price of $93 per share for each share held. These rights can only be exercised after certain events occur, such as if a person or entity acquires, or makes a tender or exchange offer to acquire 15% or more of the Company’s common stock, and the rights expire ten years from the record date. Upon acquisition of 15% or more of the Company’s common stock, each right not owned by the acquiring person or group will be adjusted to allow the purchase for $93 of a number of shares having a then market value of $186. These rights are intended to provide the Company certain anti-takeover protections. The Board of Directors may terminate the Rights Plan, or redeem the rights for $0.01 per right, at any time until the tenth business day following a public announcement of a 15% or more stock acquisition. The Company has reserved 7,000,000 shares of common stock for this plan. The rights were distributed to shareholders as of the record date as a nontaxable dividend. The rights are attached to and trade with Interphase common stock until the occurrence of one of the triggering events, at which time the rights would become detached from the common stock.
See Note 9 of the accompanying notes to the consolidated financial statements for information regarding the Company’s shareholder approved stock incentive plans.
Stock Performance Graph
The following chart compares the cumulative total shareholder return on Common Stock during the years ended December 31, 2007, 2006, 2005, 2004 and 2003 with the cumulative total return on the NASDAQ composite index and the DJ Wilshire Telecommunications Equipment Index The Company believes the DJ Wilshire Telecommunication Index provides a representative comparison. The Company relied upon information provided by another firm with respect to the stock performance graph. The Company did not attempt to validate the information supplied to it other than review it for reasonableness. The comparison assumes $100 was invested on December 31, 2002 in the Common Stock of the Company and in each of the foregoing indices and assumes reinvestment of dividends.
Item 6.
Item 6. Selected Consolidated Financial Data.
The selected consolidated financial data presented below under the captions “Statement of Operations Data” and “Balance Sheet Data” have been derived from the consolidated balance sheets and the related statements of operations for the years ended December 31, 2007, 2006, 2005, 2004, and 2003, and the notes thereto appearing elsewhere herein, as applicable.
It is important that you also read “Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
This report contains forward-looking statements about the business, financial condition and prospects of the Company. These statements are made under the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. The actual results of the Company could differ materially from those indicated by the forward-looking statements because of various risks and uncertainties, including without limitation, our reliance on a limited number of customers, failure to see spending improvements in the telecommunications and computer networking industries, significant changes in product demand, the availability of products, changes in competition, various inventory risks due to changes in market conditions and other risks and uncertainties indicated in the Company’s filings and reports with the Securities and Exchange Commission. All the foregoing risks and uncertainties are beyond the ability of the Company to control, and in many cases, the Company cannot predict the risks and uncertainties that could cause its actual results to differ materially from those indicated by the forward-looking statements. When used in this report, the words “believes,” “plans,” “expects,” “intends,” and “anticipates” and similar expressions as they relate to the Company or its management are intended to identify forward-looking statements.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
The Company’s consolidated financial statements are based on the selection and application of significant accounting policies, which require management to make significant estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Management believes the following are some of the more critical judgment areas in the application of the Company’s accounting policies that affect the Company’s financial condition and results of operations. Management has discussed the application of these critical accounting policies with the Board of Directors and Audit Committee.
Revenue Recognition: Revenues consist of product and service revenues and are recognized in accordance with SEC Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition.” Product revenues are recognized upon shipment, provided fees are fixed and determinable, a customer purchase order is obtained (when applicable), and collection is probable. Revenues from reseller arrangements are recognized when the product is sold through to the end customer unless an established return history supports recognizing revenue upon shipment, less a provision for estimated sales returns. Sales tax collected from customers and remitted to the applicable taxing authorities is accounted for on a net basis, with no impact to revenues. Service revenue is recognized as the services are performed. Deferred revenue consists primarily of revenue from service revenue.
Warranty Reserve: The Company offers to its customers a limited warranty that its products will be free from defect in the materials and workmanship for a specified period. The Company has established a warranty reserve, as a component of accrued liabilities, for any potential claims. The Company estimates its warranty reserve based upon an analysis of all identified or expected claims and an estimate of the cost to resolve those claims. Changes in claim rates and differences between actual and expected warranty costs could impact the warranty reserve estimates.
Accounts Receivable and Allowance for Doubtful Accounts: The Company records accounts receivable at their net realizable value and management is required to estimate the collectibility of the
Company’s trade receivables. A considerable amount of judgment is required in assessing the realization of these receivables, including the current creditworthiness of each customer and related aging of the past due balances. Management evaluates all accounts periodically and a reserve is established based on the best facts available to management, which reserve is reevaluated and adjusted as additional information is received. After all attempts to collect a receivable have failed, the receivable is written off against the allowance for doubtful accounts. The reserves also are determined by using percentages applied to certain aged receivable categories based on historical results.
Allowance for Returns: The Company estimates its allowance for returns based upon expected return rates. The estimates of expected return rates are generally a factor of historical returns. Changes in return rates could impact allowance for return estimates.
Inventories: Inventories are valued at the lower of cost or market and include material, labor and manufacturing overhead. Cost is determined on a first-in, first-out basis. Valuing inventories at the lower of cost or market involves an inherent level of risk and uncertainty due to technology trends in the industry and customer demand for our products. In assessing the ultimate realization of inventories, management is required to make judgments as to future demand requirements and compare that with the current or committed inventory levels. Reserve requirements generally increase as projected demand decreases due to market conditions, technological and product life cycle changes as well as longer than previously expected usage periods. The Company has experienced significant changes in required reserves in the past due to changes in strategic direction, such as discontinuances of product lines as well as declining market conditions. It is possible that significant changes in this estimate may occur in the future as market conditions change.
Long-Lived Assets: Property and Equipment and other long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Such determination is made in accordance with the applicable Generally Accepted Accounting Principles (“GAAP”) requirements associated with the long-lived asset, and is based upon, among other things, estimates of the amount of future net cash flows to be generated by the long-lived asset and estimates of the current fair value of the asset. Adverse changes in such estimates could result in an inability to recover the carrying value of the long-lived asset, thereby possibly requiring an impairment charge to be recognized in the future. All impairments are recognized in operating results when a permanent reduction in value occurs.
Derivative Financial Instruments and Hedging: All derivative instruments are recorded as assets or liabilities on the balance sheet at fair value. Changes in the fair value of derivatives are either recorded in income or other comprehensive income, as appropriate. The gain or loss on derivatives that have not been designated as hedging instruments is included in current income in the period that changes in fair value occur.
Stock-Based Compensation: On 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 did 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.” 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.”
Tax Assessments: The Company is periodically engaged in various tax audits by federal and state governmental authorities incidental to its business activities. The Company records reserves for its estimated probable losses of these proceedings, if applicable.
Income Taxes: The Company records a valuation allowance to reduce its deferred income tax assets to the amount that is believed to be realizable under the guidance of Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes.” The Company considers recent historical losses, future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. Management is required to make a continuous assessment as to the realizability of the deferred tax assets. The Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes within financial statements. Under FIN 48, the impact of an uncertain tax position taken or expected to be taken on an income tax return must be recognized in the financial statement at the amount that is more likely than not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized in the financial statements unless it is more likely than not of being sustained.
CONSOLIDATED STATEMENT OF OPERATIONS AS A PERCENTAGE OF REVENUE
OVERVIEW
2007 was a year of considerable investment for Interphase. During 2007, we continued our heavy resource investment in the development of new products that expand our product portfolio to position us as an IP “packet processing” leader. Further investment has been made in developing new products and features that address the user plane of growing multimedia markets, aimed primarily at supporting voice over IP and voice protocol interworking in MicroTCA and AdvancedTCA systems. We invested in a new Enterprise Performance Management system to streamline our processes and make us more responsive to customer needs. We invested human capital to ensure we were globally positioned for the expanding European market and around the world. We invested these additional resources while maintaining operational excellence in serving our current customers with our extensive line of products. We focused on solidifying our position as a key provider of building block solutions for the emerging AdvancedTCA, AdvancedMC and MicroTCA platform architectures being deployed into next generation telecommunications networks.
RESULTS OF OPERATIONS
Revenue: Total revenue for the years ended December 31, 2007, 2006 and 2005 were $30.8 million, $33.4 million and $30.9 million, respectively. Revenue decreased by 8% in 2007 compared to 2006. This decrease was primarily attributable to our enterprise product revenues. As expected, enterprise product revenues decreased approximately 29% to $3.4 million in 2007 from $4.7 million in 2006. In addition to our enterprise revenue decrease, broadband telecom revenues decreased by approximately 2% to $26.1 million in 2007 from $26.5 million in 2006 primarily as a result of the significant reduction in revenues experienced in the first quarter of 2007 due to the general telecommunications market slowdown, which included the impact of the merger activity experienced in the businesses of our top Tier 1 customers. All other revenue, composed primarily of storage products, professional services, project cancellation charges and raw material sales, decreased by approximately 38% to $1.3 million for the year ended December 31, 2007 compared to $2.2 million for the year ended December 31, 2006. Included in all other revenues for the year ended December 31, 2006 was approximately $400,000 of raw material parts sold at cost, which reduced our exposure to potential excess and obsolete inventory charges and approximately $600,000 of project cancellation charges neither of which occurred in 2007.
Revenue increased 8% in 2006 compared to 2005. This increase was primarily attributable to broadband telecom revenue. Broadband telecom revenue increased approximately 29% to $26.5 million for the year ended December 31, 2006 compared to $20.5 million for the year ended December 31, 2005. As expected, our enterprise product revenue decreased to $4.7 million for the year ended December 31, 2006 compared to $8.2 million for the year ended December 31, 2005. All other revenue, composed primarily of storage products, professional services, project cancellation charges and raw material sales, increased slightly to $2.2 million for the year ended December 31, 2006 compared to $2.1 million for the year ended December 31, 2005.
Gross Margin: Gross margin as a percentage of revenue for the years ended December 31, 2007, 2006 and 2005 was 57%, 54% and 52%, respectively. The increase in gross margin percentage in 2007 compared to 2006 is primarily driven by product mix as our higher margin broadband telecom products accounted for approximately 85% of our revenue compared to 79% in the preceding year. We recorded $300,000 in excess and obsolete charges for the year ended December 31, 2007 compared to $500,000 for the year ended December 31, 2006. The $200,000 reduction in excess and obsolete charges was partially
offset by reduced plant utilization. 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.
Approximately 71% of the increase in gross margin percentage in 2006 compared to 2005 is driven by reductions in excess and obsolete inventory charges. We recorded approximately $500,000 in excess and obsolete inventory charges for the year ended December 31, 2006 compared to approximately $1.0 million for the year ended December 31, 2005. The decrease in excess and obsolete inventory charges primarily relates to product end of life activities that proceeded more rapidly than anticipated in 2005. The remaining portion of the increase in gross margin percentage is due to improved plant utilization partially offset by product mix and pricing changes.
Research and Development: Our investment in the development of new products through research and development was $10.2 million, $8.2 million and $8.0 million in 2007, 2006 and 2005, respectively. As a percentage of revenue, research and development expenses were 33%, 25% and 26% for 2007, 2006 and 2005, respectively. Research and development expenses increased in 2007 compared to 2006 by approximately $2.0 million. Approximately 52% of this increase was due to our strategic reinvestment in the area of project related research and development activities on a variable basis. The weaker dollar relative to the Euro in 2007 contributed approximately 26% to our increase in research and development expense. Additionally, there was an expense of approximately $220,000 or 11% related to the write-off of a previously capitalized software license related to a product that was subsequently discontinued. The increase in research and development expense as a percentage of total revenue is due to revenue decreasing while research and development costs increased. We anticipate that spending on research and development will decrease slightly in the near future as certain project related research and development activities conclude. Research and development expenses will continue to be subject to the fluctuations in currency and exchange rates because much of our development expense is associated with our engineering lab in France (see Item 7A
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Foreign Currency Risk
We are exposed to adverse movements in foreign currency exchange rates because we conduct 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. The Euro to U.S. Dollar translation accounted for charges of approximately $2.0 million, $1.2 million and $1.1 million for the years ended December 31, 2007, 2006 and 2005, respectively.
In an attempt to mitigate the risk described above, we 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 year ended December 31, 2007, we recognized a gain of approximately $346,000 related to these foreign exchange contracts. For the year ended December 31, 2006, we recognized a gain of approximately $442,000 related to these foreign exchange contracts. For the year ended December 31, 2005, we recognized a loss of approximately $125,000 related to these foreign exchange contracts. At December 31, 2007, we had one foreign exchange contract outstanding to acquire approximately 1.1 million Euros during January 2008. At December 31, 2007, we carried a $167,000 asset on the balance sheet, classified as other current assets, related to the fair value of our outstanding foreign exchange contract. There were three such contracts outstanding at December 31, 2006, classified as a $185,000 asset on the balance sheet.
Market Price Risk
We had no equity hedge contracts outstanding as of December 31, 2007, 2006 or 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.
A hypothetical 50 basis point increase in interest rates would result in an approximate decrease of less than 1% in the fair value of our available-for-sale securities at December 31, 2007. This potential change is based on sensitivity analyses performed on our marketable securities at December 31, 2007. Actual results may differ materially. 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, 2006.
The Company maintains a $5.0 million revolving bank credit facility maturing July 31, 2009 with an interest rate of London Interbank Offered Rate (LIBOR) plus 1.0% (6.25% and 6.375% at December 31, 2007 and 2006, respectively). In an attempt to mitigate interest rate fluctuations, we from time to time may enter into agreements with our lender to fix the interest rate; our agreement at December 31, 2007 expires on July 31, 2008. A hypothetical 100 basis point increase in LIBOR would increase annual interest expense on this credit facility by approximately $35,000. 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 sheet.
Item 8.
Item 8. Financial Statements and Supplementary Data.
See Item 15 (a) below.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
The Company’s management, under the supervision of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), performed an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this annual report. Based on that evaluation, the CEO and CFO concluded that the Company’s disclosure controls and procedures are designed, and 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.
Changes in Internal Controls
The Company maintains a system of internal controls that is 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.
Management’s Report on Internal Control Over Financial Reporting
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) under the Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s board of directors, management and other associates, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
(1)
Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company;
(2)
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and
(3)
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2007. In making this assessment, the Company’s management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission, known as COSO, in “Internal Control - Integrated Framework.” Based on the results of its evaluation, the Company’s management has concluded that the internal control over financial reporting was effective as of December 31, 2007. This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.
Item 9B.
Item 9B. Other Information.
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
Directors
See information regarding the directors and nominees for director under the heading “Election of Directors” in the Proxy Statement for the Annual Meeting of Shareholders to be held May 7, 2008, which is incorporated herein by reference.
Executive Officers
See information regarding the executive officers under the heading “Executive Officers” in the Proxy Statement for the Annual Meeting of Shareholders to be held May 7, 2008, which is incorporated herein by reference.
Code of Ethics
The Company has adopted a Code of Business Conduct, which applies to all of its employees, including its Chairman and Chief Executive Officer, its Chief Financial Officer and its Corporate Controller. The Code of Ethics is available on the Company’s website at www.interphase.com. The Company intends to satisfy the disclosure requirement under Item 5.05 of Form 8-K regarding an amendment to, or waiver from, a provision of this Code of Ethics by posting such information on its website, at the address specified above, and to the extent required by the listing standards of the NASDAQ Global Market, by filing a Current Report on Form 8-K with the Securities and Exchange Commission disclosing such information.
Item 11.
Item 11. Executive Compensation.
See information regarding executive compensation under the heading “Executive Compensation” in the Proxy Statement for the Annual Meeting of Shareholders to be held May 7, 2008, which is incorporated herein by reference.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
See information regarding security ownership of certain beneficial owners and management under the headings “Principal Shareholders” and “Executive Compensation” in the Proxy Statement for the Annual Meeting of Shareholders to be held May 7, 2008, which is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
See information regarding certain relationships and related transactions under the headings “Principal Shareholders” and “Certain Related Transactions” in the Proxy Statement for the Annual Meeting of Shareholders to be held May 7, 2008, which is incorporated herein by reference.
Item 14.
Item 14. Principal Accounting Fees and Services.
See information regarding principal accounting fees and services under the heading “Relationship with Independent Public Auditors” in the Proxy Statement for the Annual Meeting of Shareholders to be held May 7, 2008, which is incorporated herein by reference.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules.
(a) (1)
Financial Statements.
Reference is made to the listing on page of all financial statements filed as a part of this report.
(2)
Financial Statement Schedules
All schedules are omitted because they are not applicable or the required information is presented in the consolidated financial statements or notes hereto.
Reference is made to the Index to Exhibits on page E-1 for a list of all exhibits filed with this report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 24, 2008.
Name
Title
/s/ Gregory B. Kalush
Gregory B. Kalush
Chairman of the Board,
Chief Executive Officer and President
(Principal executive officer)
/s/ Thomas N. Tipton, Jr.
Thomas N. Tipton, Jr.
Chief Financial Officer,
Vice President of Finance and Treasurer
(Principal financial and accounting officer)
/s/ Paul N. Hug
Paul N. Hug
Director
/s/ Michael J. Myers
Michael J. Myers
Director
/s/ Kenneth V. Spenser
Kenneth V. Spenser
Director
/s/ Christopher B. Strunk
Christopher B. Strunk
Director
/s/ S. Thomas Thawley
S. Thomas Thawley
Vice Chairman, Director
and Secretary
*
All schedules are omitted because they are not applicable or the required information is presented in the consolidated financial statements or notes thereto.
Report of Independent Registered Public Accounting Firm
The Board of Directors
Interphase Corporation
We have audited the accompanying consolidated balance sheets of Interphase Corporation and subsidiaries (the Company) as of December 31, 2007 and 2006, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Interphase Corporation and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the Consolidated Financial Statements, the Company changed its method of accounting for unrecognized tax benefits as of January 1, 2007, in connection with the adoption of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes: an interpretation of FASB Statement No. 109.” Also, as discussed in Note 1 to the Consolidated Financial Statements, the Company adopted Statement of Financial Accounting Standards No. 123R, “Share-Based Payment,” effective January 1, 2006.
/s/ GRANT THORNTON LLP
Dallas, Texas
March 24, 2008
INTERPHASE CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
INTERPHASE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
INTERPHASE CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
INTERPHASE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
INTERPHASE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of the Business: 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 14 for information regarding the Company’s revenues related to North America and foreign countries.
Principles of Consolidation and Basis of Presentation: The accompanying consolidated financial statements include the accounts of Interphase Corporation and its wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated.
Reclassification: Certain prior period amounts on the Consolidated Balance Sheets, Consolidated Statements of Cash Flows and in Note 14 have been reclassified to conform with current period classifications.
Fair Value of Financial Instruments: The carrying value of the Company’s cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities estimate fair value due to their relative short-term nature. The carrying value of the Company’s marketable securities approximates fair value as they are marked to market at the balance sheet date. The Company’s debt approximates fair value due to the nature of the floating interest rates being charged.
Cash and Cash Equivalents: The Company considers cash and temporary investments with original maturities of less than three months, as well as interest bearing money market accounts, to be cash equivalents.
Marketable Securities: Investments in debt and equity securities are classified as available for sale with unrealized holding gains and losses reported in other comprehensive income. Gains and losses from securities are calculated using the specific identification method. Management determines the appropriate classification of securities at the time of purchase. Earnings from debt securities are calculated on a yield to maturity basis and recorded in the results of operations.
Accounts Receivable and Allowance for Doubtful Accounts: The Company records accounts receivable at their net realizable value and management is required to estimate the collectibility of the Company’s trade receivables. A considerable amount of judgment is required in assessing the realization of these receivables, including the current creditworthiness of each customer and related aging of the past due balances. Management evaluates all accounts periodically and a reserve is established based on the best facts available to management and re-evaluated and adjusted as additional information is received. After all attempts to collect a receivable have failed, the receivable is written off against the allowance for doubtful accounts. The reserves also are determined by using percentages applied to certain aged receivable categories based on historical results. The activity in this account was as follows (in thousands):
Allowance for Returns: The Company maintains an allowance for returns based upon expected return rates. The estimates of expected return rates are generally a factor of historical returns experience. Changes in return rates could impact allowance for return estimates. As of December 31, 2007, 2006 and 2005, the allowance for returns was $96,000, $85,000, and $90,000, respectively, and maintained as a reduction to accounts receivable.
Inventories: Inventories are valued at the lower of cost or market and include material, labor and manufacturing overhead. Cost is determined on a first-in, first-out basis (in thousands):
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 in 2007, 2006 and 2005 were $300,000, $500,000 and $1.0 million, respectively.
Property and Equipment: Property and equipment are recorded at cost. Depreciation is provided over the estimated useful lives of depreciable assets using the straight-line method. When property and equipment are sold or otherwise retired, the cost and accumulated depreciation applicable to such assets are eliminated from the accounts, and any resulting gain or loss is reflected in current operations. Related depreciation expense was as follows (in thousands):
The depreciable lives of property and equipment are as follows:
Machinery and equipment
3-5 years
Leasehold improvements
Term of the respective leases
Furniture and fixtures
3-10 years
Capitalized Software: Capitalized software represents various software licenses purchased by the Company and utilized in connection with the Company’s network and mass storage products as well as the general operations of the Company. Capitalized software is amortized over three to five years utilizing the straight-line method. Related amortization expense and accumulated amortization were as follows (in thousands):
Long-Lived Assets: Property and equipment and other long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. All impairments are recognized in operating results when a permanent reduction in value occurs. During 2007, there was determined to be impairment with certain software licenses which resulted in a writedown of $218,000 of capitalized software. No impairments were recorded in 2006 or 2005.
Revenue Recognition: Revenues consist of product and service revenues and are recognized in accordance with SEC Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition.” Product revenues are recognized upon shipment, provided fees are fixed and determinable, a customer purchase order is obtained (when applicable), and collection is probable. Revenues from reseller arrangements are recognized when the product is sold through to the end customer unless an established return history supports recognizing revenue upon shipment, less a provision for estimated sales returns. Sales tax collected from customers and remitted to the applicable taxing authorities is accounted for on a net basis, with no impact to revenues. Service revenue is recognized as the services are performed. Deferred revenue consists primarily of service revenue not yet performed.
Warranty Reserve: The Company offers to its customers a limited warranty that its products will be free from defect in the materials and workmanship for a specified period. The Company has established a warranty reserve, as a component of accrued liabilities, for any potential claims. The
Company estimates its warranty reserve based upon an analysis of all identified or expected claims and an estimate of the cost to resolve those claims.
Concentration of Credit Risks: Financial instruments, which potentially expose the Company to concentrations of credit risk, consist primarily of trade accounts receivable. The majority of the Company’s sales have been to original equipment manufacturers who produce computer systems or telecommunication networks. The Company conducts credit evaluations of its customers’ financial condition and limits the amount of trade credit extended when necessary.
Research and Development: Research and development costs are charged to expense as incurred.
Interest Income, net: Interest income from investment in securities and cash balances was approximately $988,000, $853,000, and $507,000 for the years ended December 31, 2007, 2006, and 2005, respectively. Interest expense related to the Company’s credit facility was approximately $224,000, $216,000 and $137,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
Advertising Expense: Advertising costs are charged to expense as incurred. Advertising expense was approximately $38,000, $37,000 and $23,000 during the years ended December 31, 2007, 2006 and 2005, respectively.
Foreign Currency Translation: Assets and liabilities of the Company’s French subsidiary, whose functional currency is other than the U.S. Dollar, are translated at year-end rates of exchange, and revenues and expenses are translated at average exchange rates prevailing during the year. Foreign currency transaction gains and losses are recognized in the Consolidated Statements of Operations as incurred.
The Company accounts for unrealized gains or losses on its foreign currency translation adjustments in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 130, “Reporting Comprehensive Income,” which requires the adjustments be accumulated in shareholders’ equity as part of other comprehensive income.
Income Taxes: The Company determines its deferred taxes using the liability method. Deferred tax assets and liabilities are based on the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities given the provisions of enacted tax law. The Company’s consolidated financial statements include deferred income taxes arising from the recognition of revenues and expenses in different periods for income tax and financial reporting purposes.
The Company records a valuation allowance to reduce its deferred income tax assets to the amount that is believed to be realizable under the guidance of SFAS No. 109, “Accounting for Income Taxes.” The Company considers recent historical losses, future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. Management is required to make a continuous assessment as to the realizability of the deferred tax assets.
The Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes within financial statements. Under FIN 48, the impact of an uncertain tax position taken or expected to be taken on an income tax return must
be recognized in the financial statement at the amount that is more likely than not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized in the financial statements unless it is more likely than not of being sustained.
Other Comprehensive Income (loss): Other comprehensive income (loss) is recorded directly to a separate section of shareholders’ equity in cumulative other comprehensive income (loss) and includes unrealized gains and losses excluded from the Consolidated Statements of Operations. These unrealized gains and losses consist of holding period gains and losses related to marketable securities, net of income taxes, and foreign currency translation, which are not adjusted for income taxes since they relate to indefinite investments in a non-U.S. subsidiary.
Stock-Based Compensation: On January 1, 2006, the Company adopted the provisions of 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.” 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):
Use of Estimates: The preparation of financial statements, in conformity with accounting principles generally accepted in the United States of America, requires Company management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Areas involving estimates are the allowance for doubtful accounts and returns, warranties, inventory impairment charges and income tax accounts.
2. MARKETABLE SECURITIES
Marketable securities primarily consist of investments in debt securities, which are classified as current assets on the balance sheet as the investments are available-for-sale. As of December 31, 2007, the fair market value of marketable securities was $14.2 million, of which $6.6 million matures in one year or less and; $7.6 million matures in 5 years or less. As of December 31, 2006, the fair market value of marketable securities was $13.5 million, of which $8.9 million matures in one year or less and; $4.6 million matures in five years or less. Gains and losses on marketable securities sold are recognized on a specific identification basis. The Company recorded an unrealized gain with respect to certain available-for-sale securities in 2007 and 2006 of $91,000 and $63,000, respectively. The Company recorded an unrealized loss with respect to certain available-for-sale securities of $33,000 in 2005.
3. ACCRUED LIABILITIES
Accrued liabilities consisted of the following (in thousands):
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 year ended December 31, 2007, the Company recognized a gain of approximately $346,000 related to these foreign exchange contracts. For the year ended December 31, 2006, the Company recognized a gain of approximately $442,000 related to these foreign exchange contracts. For the year ended December 31, 2005, the Company recognized a loss of approximately $125,000 related to these foreign exchange contracts. At December 31, 2007, the Company had one foreign exchange contract outstanding to acquire approximately 1.1 million Euros during January 2008. At December 31, 2007, the Company carried a $167,000 asset on the balance sheet, classified as other current assets, related to the fair value of its outstanding foreign exchange contract. There were three such contracts outstanding at December 31, 2006, classified as a $185,000 asset on the balance sheet.
5. CREDIT FACILITY
The Company maintains a $5.0 million revolving bank credit facility maturing July 31, 2009 with an interest rate of LIBOR plus 1.0% (6.25% and 6.375% at December 31, 2007 and 2006, respectively). 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 sheet.
6. INCOME TAXES
The provision for income taxes applicable to continuing operations for each period presented was as follows (in thousands):
The tax effect of temporary differences that give rise to significant components of the deferred tax assets as of December 31, 2007 and 2006, are presented as follows (in thousands):
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 that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years. Cumulative losses weigh heavily in the overall assessment. As a result of a review undertaken at December 31, 2002, the Company concluded that it was appropriate to establish a full valuation allowance for its net deferred tax assets. The Company continues to maintain a valuation allowance on all of the net deferred tax assets. Until an appropriate level of profitability is sustained, the Company expects to continue to maintain a valuation allowance on substantially all of the future tax benefits and does not expect to recognize any significant tax benefits in future results of operations.
At December 31, 2007, the Company has recorded a valuation allowance against its net deferred tax assets because management believes that, after considering all the available objective evidence, the realization of the assets is not reasonably assured.
The differences between the actual income tax (benefit) provision and the amount computed by applying the statutory federal tax rate to the (loss) income before income taxes shown in the Consolidated Statements of Operations are as follows (in thousands):
At December 31, 2007, the Company had approximately $20.8 million of federal net operating loss carryforwards, $3.2 million of which were related to non-qualified stock option deductions. The Company also had state net operating losses of $4.2 million. The valuation allowance recorded on the portion of net operating losses related to stock options will reverse as a credit to stockholder’s equity once management believes that these losses are more likely than not to be realized. At December 31, 2007 and 2006, the Company’s French subsidiary has a research tax credit of approximately $1.1 million and $600,000, respectively, of which approximately $440,000 and $310,000, respectively, was classified on the balance sheet as an other current asset. Tax credits generated are refundable in cash if it is not used within three years after the year generated. The Company’s unused tax credit balance was generated in the years 2006 and 2007.
The earnings of the Company’s foreign subsidiary are considered to be indefinitely reinvested and, accordingly, no provision for U.S. federal and state income taxes have been provided thereon. Upon distribution of those earnings in the form of dividends or otherwise, the Company would be subject to both U.S. income taxes (subject to foreign tax credits) and withholding taxes payable to foreign countries.
The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), on January 1, 2007. As a result of the adoption of FIN 48, the Company made an adjustment to equity of $49,000. At December 31, 2007, the Company had an uncertain U.S. tax position of approximately $80,000 related to foreign operations. Due to the net operating loss position in the U.S., the Company would not incur tax, interest or penalty currently or in the near future. As such, no adjustment was made to equity and there is no impact on the Company’s effective tax rate. The Company does not anticipate any event in the next twelve months that would cause a change to this position. The Company will recognize any penalties and interest when necessary as tax expense. The U.S. federal returns for the years ending December 31, 2004 and after are open for IRS examination. The Company recognized a $139,000 benefit, which was previously unrecognized pending the expiration of the statute of limitations on the 2003 tax return related to a transfer pricing arrangement with our foreign subsidiary. The Company’s operations during the year ended December 31, 2002 generated a loss, and the 2002 net operating loss (NOL) is still being used by the Company. The IRS may audit up to the NOL amount generated during the year ended December 31, 2002 until the expiration of the statute of limitations for open tax years.
The Company is also subject to income tax in France. At December 31, 2007, the Company had an uncertain tax position of approximately $266,000 of which $249,000 is related to a potential tax liability, $13,000 is related to possible interest, and $4,000 is related to a potential penalty. During the nine months since March 31, 2007, approximately $65,000 of this uncertain tax position was accounted for as a reduction to income tax benefit. Prior to March 31, 2007, this position had been accounted for as a reduction in shareholders’ equity. The uncertain tax position in France is expected to have a favorable impact in the amount of $249,000, resulting in a favorable impact on the effective tax rate. The Company does not anticipate any event in the next twelve months that would cause a change to this position. The French income tax returns for the years ended December 31, 2004 and subsequent remain open for examination.
A reconciliation of the beginning and ending amount of unrecognized tax benefit is as follows:
7. 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.
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 December 31, 2006, there was no liability on the Company’s balance sheet relating to future cash payments under this plan.
8. 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):
9. COMMON STOCK
2004 Long-Term Stock Incentive Plan: The Interphase Corporation Amended and Restated Stock Option Plan and the Interphase Corporation Directors Stock Option Plan have been collectively amended and restated as the “Interphase Corporation 2004 Long-Term Stock Incentive Plan”, effective May 5, 2004. Options granted under the separate plans prior to the effective date shall be subject to the terms and conditions of the separate plans in effect with respect to such options prior to the effective date and awards granted after the effective date shall be subject to the terms and conditions of the 2004 Long-Term Stock Incentive Plan. Awards granted under this plan may be (a) incentive stock options, (b) non-qualified stock options, (c) bonus stock awards, (d) stock appreciation rights, (e) performance share awards and performance unit awards, (f) phantom stock awards, and (g) any other type of award established by the committee which is consistent with the Plan’s purposes, as designated at the time of grant. The total amount of Common Stock with respect to which awards may be granted under the Plan is 5,250,000 shares.
Amended and Restated Stock Option Plan: The exercise price of the incentive stock options must be at least equal to the fair market value of the Company’s common stock on the date of the grant, while the exercise price of nonqualified stock options may be less than fair market value on the date of grant, as determined by the Board of Directors. The Board of Directors may provide for the exercise of options in installments and upon such terms, conditions and restrictions as it may determine. Options granted prior to January 1, 1999 generally vest ratably over a five-year period from the date of grant. Options granted since January 1, 1999 generally vest ratably over a three-year period from the date of grant. The term of option grants may be up to ten years. Options are canceled upon the lapse of three months, in most cases, following termination of employment except in the event of death or disability, as defined.
France Stock Option Sub-Plan: This plan was adopted in 2000 for the benefit of the Company’s employees located in France. This plan authorizes the issuance of options to purchase common stock of the Company at prices at least equal to the fair market value of the common stock on the date of the grant. Unless otherwise decided at the sole discretion of the Board, the options vest (i) 75% after the expiration of a two-year period from the date of grant and (ii) 25% after the expiration of a three-year period from the date of grant. Except for the events provided under the French tax code, the shares cannot be sold or otherwise disposed of for a period of four years from the date of grant. The term of option grants may be up to ten years. Options are canceled upon the lapse of three months following termination of employment except in the event of death or disability, as defined.
Amended and Restated Director Stock Option Plan: Stock option grants pursuant to the directors’ plan will vest in one year and have a term of ten years. The exercise prices related to these options are equal to the market value of the Company’s stock on the date of grant.
The following table summarizes the combined stock option activity under the all of the plans (in thousands, except option prices):
The total intrinsic value of share options exercised during 2007, 2006 and 2005 were approximately $1.2 million, $496,000 and $28,000, respectively.
The following table summarizes information about options granted under the plans that were outstanding at December 31, 2007 (in thousands, except option prices):
Stock Option Acceleration: 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 those unvested options consisted of “in-the-money” options. The number of shares and exercise prices of the options subject to the acceleration were unchanged. The Company elected to take this action to eliminate approximately $350,000 of future compensation expense that would have been recorded over a two year period. The Company’s board and executive management believed this action is in the best interest of the Company and its shareholders. The following table summarizes the outstanding options that were subject to accelerated vesting:
Restricted Stock: 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 2007, the Company issued 106,000 restricted stock shares granted at market prices ranging from $8.95 to $11.80. During 2006, the Company issued 112,300 restricted stock shares granted at market prices ranging from $5.40 to $14.65. 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 $376,000, $295,000 and $135,000 for the years ended December 31, 2007, 2006 and 2005,
respectively. As of December 31, 2007, there is approximately $1.3 million of total unamortized compensation cost related to unvested restricted stock remaining to be recognized. The expense is expected to be recognized over a weighted-average period of 2.7 years. As of December 31, 2006, there was $698,000 of total unamortized compensation cost. The following summarizes the restricted stock activity for 2007 and 2006:
Rights Agreement: The Board of Directors has adopted a Shareholder Rights Plan whereby each holder of record as of December 29, 2000 received a right to purchase from the Company one share of common stock of the Company at a price of $93 per share for each share held. These rights can only be exercised after certain events occur, such as if a person or entity acquires, or makes a tender or exchange offer to acquire, 15% or more of the Company’s common stock and the rights expire ten years from the record date. Upon acquisition of 15% or more of the Company’s common stock, each right not owned by the acquiring person or group will be adjusted to allow the purchase for $93 of a number of shares having a then market value of $186. These rights are intended to provide the Company certain antitakeover protections. The Board of Directors may terminate the Rights Plan, or redeem the rights for $0.01 per right, at any time until the tenth business day following a public announcement of a 15% or more stock acquisition. The Company had reserved 7,000,000 shares of common stock for this plan.
The rights were distributed to shareholders as of the record date as a nontaxable dividend. The rights are attached to and trade with Interphase common stock until the occurrence of one of the triggering events, at which time the rights would become detached from the Company’s common stock.
Option Valuation: The Black-Scholes model was not developed for use in valuing employee stock options, but was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, it requires the use of subjective assumptions including expectations of future dividends and stock price volatility. Such assumptions are only used for making the required fair value estimate and should not be considered as indicators of future dividend policy or stock price appreciation. Because changes in the subjective assumptions can materially affect the fair value estimate, and because employee stock options have characteristics significantly different from those of traded options, the use of the Black-Scholes option-pricing model may not provide a reliable estimate of the fair value of employee stock options.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with weighted-average assumptions based on the grant date. There were no options granted in 2005, 2006 or 2007.
10. RELATED PARTY TRANSACTIONS
During the years ended December 31, 2007, 2006 and 2005, the Company had no related party transactions.
11. EMPLOYEE BENEFIT PLAN
The Company maintains a defined contribution plan for those employees who meet the plan’s length of service requirements. Under the defined contribution plan, employees may make voluntary contributions to the plan, subject to certain limitations, and the Company may make a discretionary matching contribution at the end of the plan year. The total expense under this plan was $306,000, $214,000 and $313,000 for the years ended December 31, 2007, 2006 and 2005, respectively. The Company offers no post-retirement or post-employment benefits.
12. OTHER FINANCIAL INFORMATION
Major Customers: During 2007, sales to Alcatel-Lucent and Motorola were $9.5 million or 31% and $5.1 million or 17% of the Company’s consolidated revenues, respectively. During 2006, sales to Alcatel-Lucent, Motorola and Hewlett Packard accounted for $11.3 million or 34%, $7.5 million or 22% and $3.4 million or 10%, of the Company’s consolidated revenues, respectively. During 2005, sales to Alcatel-Lucent, Hewlett Packard and Motorola accounted for $8.9 million or 29%, $6.0 million or 19% and $4.2 million or 14% of the Company’s consolidated revenues, respectively. No other customers accounted for more than 10% of the Company’s consolidated revenues in the periods presented.
Included in accounts receivable at December 31, 2007, was approximately $2.2 million due from Nokia-Siemens Networks, approximately $1.5 million due from Alcatel-Lucent and approximately $1.2 million due from Motorola. Included in accounts receivable at December 31, 2006, was approximately $2.1 million due from Motorola, and approximately $1.5 million due from Alcatel-Lucent. No other customers accounted for more than 10% of the Company’s accounts receivable at the balance sheet dates presented.
Commitments: The Company leases its facilities under noncancelable operating leases with the longest terms extending to June 2011. Rent expense related to these leases is recorded on a straight-line basis. As of December 31, 2007, operating lease commitments having noncancelable terms of more than one year are as follows (in thousands):
Total rent expense for operating leases was as follows (in thousands):
Contingencies: The Company is involved in various legal actions and claims arising in the ordinary course of business. Management believes that such litigation and claims will be resolved without material effect on the Company’s financial position or results of operations.
13. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS No. 157 “Fair Value Measurements”. SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with accounting principles generally accepted in the United States, and expands disclosures about fair value measurements. The Company is subject to the provisions of SFAS 157 beginning January 1, 2008. The Company’s adoption of SFAS 157 will not have a material impact on its Consolidated Financial Statements.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”. SFAS 159 allows entities the option to measure eligible financial instruments at fair value as of specified dates. Such election, which may be applied on an instrument by instrument basis, is typically irrevocable once elected. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company’s adoption of SFAS 159 will not have a material impact on its Consolidated Financial Statements as it did not elect the fair value option for any financial assets or liabilities.
In December 2007, the FASB issued SFAS No. 141, “Business Combinations” (Revised 2007). SFAS 141R will change the accounting for business combinations. Under SFAS 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition date fair value with limited exceptions. SFAS 141R will change the accounting treatment and disclosure for certain specific items in a business combination. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. SFAS 141R will have an impact on accounting for business combinations once adopted but the effect is dependent upon acquisitions at that time.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements - An amendment of ARB No.51”. SFAS 160 establishes new accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008. The Company does not believe the adoption of this statement will have a material impact on its financial statements.
14. SEGMENT DATA
The Company is principally engaged in the design, development, and manufacturing of high-performance connectivity products utilizing advanced technologies being used in next generation telecommunication networks and enterprise data/storage networks. Except for revenue performance, which is monitored by product line, the chief operating decision-makers review financial information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance. Accordingly, the Company considers itself to be in a single industry segment.
Geographic long lived assets, determined by physical location, and revenue, determined by location of the customer, related to North America and foreign countries as of December 31, 2007 and 2006 and for the years ended December 31, 2007, 2006 and 2005 is as follows (in thousands):
Additional information regarding revenue by product-line is as follows (in thousands):
15. QUARTERLY FINANCIAL DATA (Unaudited)
Quarterly results of operations for 2007 (unaudited)
(In thousands, except per share amounts)
Quarterly results of operations for 2006 (unaudited)
(In thousands, except per share amounts)
Due to changes in the weighted average common shares outstanding per quarter, the sum of basic and diluted earnings per common share per quarter may not equal the basic and diluted earnings (loss) per common share for the applicable year.
INDEX TO EXHIBITS
Exhibits
(a)
Certificate of Incorporation of the registrant. (1)
(b)
Amendment to Articles of Incorporation of the registrant. (2)
(c)
Amended and Restated Bylaws of the registrant adopted on July 27, 2007. (4)
(a)
Rights Agreement dated as of December 7, 2000 by and between the Company and Computershare Investor Services, LLC as Rights Agent. (3)
(a)
Lease on Facility at Parkway Center, Phase I, Plano, Texas. (5)
(b)
Lease on Facility at 2105 Luna Road, Carrollton, Texas. (5)
(c)
Note and Credit Agreement between Interphase Corporation and Comerica Bank, including Amendment dated November 5, 2004. (8)
(d)
Employment Agreement with Gregory B. Kalush, dated March 12, 1999. *(9)
(e)
Employment, Confidentiality, and Non-Competition Agreement with Thomas N. Tipton, Jr., dated December 19, 2005. *(9)
(f)
Employment, Confidentiality, and Non-Competition Agreement with Randall E. McComas, dated February 15, 2002. *(9)
(g)
Employment Agreement with Deborah A. Shute, dated November 24, 1999. *(9)
(h)
Employment, Confidentiality, and Non-Competition Agreement with James W. Gragg, dated November 1, 2004. *(9)
(i)
Employment, Confidentiality, and Non-Competition Agreement with Prasad Kallur, dated May 23, 2005. *(9)
(j)
Interphase Corporation 2004 Long-Term Stock Incentive Plan *(8)
(k)
Employment, Confidentiality, and Non-Competition Agreement with Marc E. DeVinney dated August 31, 2007. *(10)
(a)
Subsidiaries of the Registrant. (6)
(a)
Consent of Independent Registered Public Accounting Firm. (11)
(a)
Rule 13a-14(a)/15d-14(a) Certification. (11)
(b)
Rule 13a-14(a)/15d-14(a) Certification. (11)
(a)
Section 1350 Certification. (11)
(b)
Section 1350 Certification. (11)
E-1
E-2