TERAFORCE TECHNOLOGY CORP - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

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FORM 10 - K

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

FOR THE YEAR ENDED DECEMBER 31, 2002

Commission File Number 0-11630

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TERAFORCE TECHNOLOGY CORPORATION
(Exact Name of Registrant as Specified in Its Charter)

DELAWARE 76-0471342
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)

1240 E. CAMPBELL, RICHARDSON, TEXAS
75081
(Address of Principal Executive Offices and Zip Code)

469-330-4960
(Registrant's Telephone Number, Including Area Code)

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Securities Registered Pursuant to Section 12 (b) of the Act
NONE

Securities Registered Pursuant to Section 12 (g) of the Act
COMMON STOCK PAR VALUE $0.01 PER SHARE
(Title of Class)

Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
------ -----

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K [ ]

Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities and Exchange Act of 1934). Yes No X
----- ------
The aggregate market value of voting stock held by non-affiliates of the
Registrant was approximately $19,872,133 as of June 28, 2002 (based upon the
average of the highest bid and lowest asked prices on such date as reported on
the OTC Bulletin Board). All directors, officers and 5% or greater shareholders
are presumed to be affiliates for purposes of this calculation.

There were 118,422,183 shares of Common Stock outstanding as of March 31, 2003.

DOCUMENTS INCORPORATED BY REFERENCE
None

TABLE OF CONTENTS

2

PART I

ITEM 1 - BUSINESS

FORWARD-LOOKING STATEMENT

The statements in this Annual Report on Form 10K of TeraForce
Technology Corporation (the "Company") regarding future financial and operating
performance and results, and other statements that are not historical facts, are
forward-looking statements, as defined in Section 27A of the Securities Act of
1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended. We use the words "may," "expect," "anticipate," "believe," "continue,"
"estimate," "project," "intend," "designed" or other similar expressions to
identify forward-looking statements. You should read statements that contain
such words carefully because they discuss future expectations, contain
projections of results of operations or of our financial condition, and/or state
other "forward-looking" information. These statements also involve risks and
uncertainties, including, but not limited to:

o events, conditions and financial trends that may affect the Company's
future plans and business strategy,

o results of expectations and estimates as to prospective events, and

o circumstances about which the Company can give no firm assurance.

Examples of types of forward-looking statements include statements on
future levels of net revenue and cash flow, new product development, strategic
plans and financing. These forward-looking statements involve risks and
uncertainties that could cause actual results to differ materially from those
projected or anticipated. Factors that might cause a difference include, but are
not limited to:

o general economic conditions in the markets the Company operates in;

o success in the development and market acceptance of new and existing
products;

o dependence on suppliers, third party manufacturers and channels of
distribution;

o customer and product concentration;

o fluctuations in customer demand;

o the ability to obtain and maintain access to external sources of
capital;

o the ability to control costs;

o overall management of the Company's expansion; and

o other risk factors detailed from time to time in the Company's filings
with the Securities and Exchange Commission.

We believe it is important to communicate our expectations of future
performance to our investors. However, events may occur in the future that we
are unable to accurately predict, or that we cannot control. Any forward-looking
statement speaks only as of the date the statement was made, and the Company
undertakes no obligation to update any forward-looking statement to reflect
events or circumstances after the date the statement was made. Because it is not
possible to predict every new factor that may emerge, forward-looking statements
should not be relied upon as a prediction of actual future financial condition
or results. When considering our forward-looking statements, keep in mind the
risk factors and other cautionary statements in this Annual Report on Form 10-K.
The risk factors noted in this section and other factors noted throughout this
prospectus provide examples of risks, uncertainties and events that may cause
our actual results to differ materially from those contained in any
forward-looking statement. If one or more of these risks or uncertainties
materialize, or if underlying assumptions prove incorrect, actual outcomes may
vary materially from those forward-looking statements included in this Annual
Report on Form 10-K. The terms "we," "our" and "us" and similar terms refer to
the Company and its consolidated subsidiaries, not to any individual or group of
individuals.

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OVERVIEW

TeraForce Technology Corporation, through its wholly-owned subsidiary,
DNA Computing Solutions, Inc. ("DNA-CS"), designs, develops, produces and sells
high-density, high-capacity embedded computing platforms and systems. Embedded
computing generally refers to the physical integration of computing nodes
(microprocessor and memory) into a host system or application. These nodes are
often deployed in arrays. Embedded computing platforms and systems are widely
applied in a number of industries including communications, medical imaging,
seismic processing, industrial control and defense electronics. Although we have
sold these products into a number of these industries, our primary focus is in
defense electronics; therefore, we refer to this as our Defense Electronics
Business. Prior to 2001 this business was referred to as the digital signal
processor ("DSP") business. In 2002, all of our net revenues related to the
defense electronics business.

Prior to 2002, we were also involved in providing design engineering
services through a wholly-owned subsidiary, DNA Enterprises, Inc. ("DNA"), and
in designing and producing telecommunications equipment through other
wholly-owned subsidiaries. (See Item 1- Business- Prior Operations.)

PRODUCTS

Embedded computing products, such as ours, are used for applications in
which there is a need for high-density and high-capacity computing, especially
in environments where limiting space, weight and power consumption are important
considerations. Examples of defense and intelligence gathering applications that
utilize embedded computing products include the following:

o Airborne radar o Ground based radar

o Signal intelligence o Image processing

o Unmanned aerial vehicles (UAV's) o Smart munitions

o Automated fire control o Battlefield control

o Airborne surveillance o Satellite communications

o Electronic countermeasures o Infrared search and tracking

o Ship based radar o Ship based sonar

o Submarine based sonar o Missile interception

Our products are organized in the following broad categories:

DSP Products - DSP products consist of single-board computers utilizing
digital signal processors produced by Texas Instruments Inc. These products are
produced in versions with one, two or four digital signal processors per board.
The boards include both VME and PCI versions, which are industry standard terms
and describe the manner in which electronic systems interconnect.

PowerPC Single Board Computers - PowerPC Single Board Computers
products are VME single board computers with one, two or four processors per
board. The microprocessors used in these products are the Motorola PowerPC(C)
line of reduced instruction set or "RISC" processors. We also sell "ruggedized"
versions of these products. "Ruggedized" products have been mechanically
modified to withstand harsh operating environments such as temperature, shock
and vibration.

Embedded Sub-Systems - Embedded Sub-Systems are products that comprise
an entire element of a larger system. These elements may include a number of
single board computers, deployed in arrays, as well as other system components
and enclosures. We have developed a new product that we call Eagle to be used as
an element in embedded sub-systems. Eagle is based on the Company's Matched
Heterogeneous Array Topology ("MHAT") technology. We anticipate that the Eagle
product will be available to customers in 2003.

WingSpan(TM) Software Suite - WingSpan is "midware" that we provide
with our products in order to enhance functionality and to facilitate the
customer's development process. WingSpan is a suite of software that includes
(a) a board support package to facilitate testing and integration into the
operating system, (b) a

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library of commonly used algorithms that have been optimized for our products
and (c) tools to facilitate the development of application software or the
porting of existing software to our products. We do not sell WingSpan separately
from our hardware products. We do not supply the application software to be
utilized on our products. The application software is generally designed to
operate under certain commercially available operating systems, most often VX
Works or Linux. Our products are generally offered in versions that will support
either of these two operating systems, as well as certain others.

As of March 31, 2003, our backlog of orders for defense electronic
products amounted to approximately $3,200,000, as compared to approximately
$500,000 at March 31, 2002. Included in backlog are orders for products for
which we have received a purchase order or similar commitment from the customer.
Generally, purchase orders are received for products that are to ship within a
relatively short period of time, usually 60 days or less. Of the backlog at
March 31, 2003, approximately $1,000,000 is not expected to ship during 2003 due
to the customer's required delivery schedule. We consider the backlog to be an
indicator, but not the sole predictor, of future revenue. A variety of
conditions, both specific to the individual customer and generally affecting the
customer's industry, may cause our customers to cancel, reduce or delay orders
that were previously made or anticipated. We cannot assure the timely
replacement of canceled, delayed or reduced orders. Significant or numerous
cancellations, reductions or delays in orders by a customer or group of
customers could materially adversely affect our business, financial condition
and results of operations. Our backlog alone should not be relied upon as
indicative of our revenues for any future period.

MARKETS AND CUSTOMERS

Our customers are generally large prime defense contractors and
subcontractors to the prime defense contractors. We also sell directly to
governmental agencies and to value added resellers who combine our products with
other system components for re-sale to the prime or subcontractors. Certain of
our DSP products are sold through an OEM arrangement with a reseller. Sales to
this reseller amounted to approximately 37% of consolidated net revenues for the
year ended December 31, 2002.

Our sales and marketing activities are directed by in-house sales
managers and we utilize a network of manufacturer's representatives in the
United States. Most international sales prospects are handled through a U.K.
based value added reseller. International sales have not been material to date.

The selection by a customer of our products for use in a particular
system or program is referred to as a "design win." The sales cycle leading to a
design win will often take a long time. We will usually provide a customer with
a demonstration unit that they may evaluate and test. After the evaluation
period ends, the customer will either return the unit or purchase it. If the
potential customer determines that the initial evaluation is satisfactory, the
customer will often purchase a limited number of units to use in the design,
development and testing of the customer's larger system.

Even after a customer has elected to purchase our product, the customer
will not usually purchase a significant number of units immediately. Although
the production phase of a particular program may last several years and
ultimately involve a significant number of units, the customer will usually only
purchase the units it will need for a short period of time. At this stage, there
are still a number of factors that will determine whether the customer purchases
a significant number of products, and when these products are purchased. These
factors include:

o the suitability of our products for a particular application,
including performance and cost issues;

o the technical performance of the final system;

o the customer's ability to fund the final system;

o the performance of the customer's other suppliers for the
final system; and

o the overall development and integration of the system by the
customer.

Sales are typically not made under long-term contracts, but instead are
made under purchase orders.

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Historically, products similar to ours were often developed internally
by the large defense contractors. However, beginning about eight years ago the
Department of Defense implemented a program to force the contractors to utilize
commercial off the shelf ("COTS") components wherever possible. This has fueled
the growth in the Company's markets, and we anticipate that the growth will
continue. We expect the growth in the COTS market to continue as legacy systems
that were developed years ago are upgraded or replaced with systems with
significant COTS content.

COMPETITION

The market for our products is highly competitive and is characterized
by rapidly changing technology and frequent product performance improvements.
The market for our products in the defense electronics market is characterized
by a number of competitors. These include Mercury Computer Systems, Inc.,
Radstone Technology, PLC, CSPI Multi Computer Division of CSP Inc., and DY4
Systems, a Force Computer business unit. Our competitors also include in-house
design teams of large defense contractors. However, competition from in-house
design teams has diminished in recent years because of the increased use of COTS
products and the trend toward greater use of outsourcing. Despite this recent
change, there can be no assurance that in house developments will not return as
a major competitive force in the future. Increased use of in-house design teams
by defense contractors may have a material adverse effect on our business,
financial condition and results of operations.

All of the large defense contractors and majority of our other
competitors, have substantially greater research and development resources,
guaranteed long term supply capacity, marketing and financial resources,
manufacturing capability and customer support organizations than we have. We
believe our future ability to compete effectively will partially depend upon our
ability to continue to improve product and process technologies, to develop new
technologies that demonstrate performance advantages over our competitors, to
adapt products and processes to changes in technology, to identify and adopt
emerging industry standards and to adapt to our customer needs.

Most of our competitors have greater financial and other resources than
we have. We may be operating at a cost disadvantage compared to those
manufacturers who have greater direct buying power from component suppliers or
who have lower cost structures. There can be no assurance that we will be able
to compete successfully in the future with any of these competitors. In
addition, there can be no assurance that competitive pressures will not result
in price erosion, reduced margins, loss of market share or other factors that
could have a material adverse effect on our business, financial condition and
results of operations.

MANUFACTURING

We use third party electronic manufacturing service ("EMS") providers
to manufacture our products. Generally, we will acquire the components necessary
for the manufacture of the product and provide the components to the EMS
provider for assembly and initial testing. Completed units are normally then
delivered to our facility in Richardson, Texas for final testing and shipment.
Recently, we have shifted more of the product testing to the EMS providers. We
expect to rely more on the EMS provider for product testing. We expect that
moving the initial product testing to the EMS provider will allow us to use our
existing operations infrastructure to produce higher sales volumes. We also
expect that as production volumes increase and can be more accurately predicted,
the EMS providers will also buy many of the components required for our
products, which will allow us to use our resources in other ways.

We usually use a particular EMS provider for a specific product family.
A number of EMS providers are capable of producing our products; however,
switching from one provider to another involves significant costs and risks
related to product quality and timing.

Components are usually available from multiple sources. However, items
such as processors and memory chips may be available from limited or sole
sources. Historically, we have had to order some components a significant time
in advance of the date we plan to use the components. Sometimes components may
be discontinued by the manufacturer, requiring us to acquire a substantial
supply or to alter our product design. These design changes can result in the
obsolescence of other components in our inventory.

6

INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS

We believe we have a substantial base of intellectual property,
including software and hardware. We believe that factors such as technological
and creative skills of our personnel, new product developments, frequent product
enhancements, name recognition, and reliable product manufacturing are essential
to establishing and maintaining a technology leadership position.

We rely on a combination of patent, copyright, trademark and trade
secret laws to establish and protect our products' proprietary rights. In
addition, we currently require our employees and consultants to enter into
nondisclosure and assignment of invention agreements to limit the use of, access
to and distribution of, proprietary information. There can be no assurance that
our means of protecting our proprietary rights in the U.S. or abroad will be
adequate. The laws of some foreign countries may not protect our proprietary
rights as fully or in the same manner as do the laws of the U.S. Also, despite
the steps we take to protect our proprietary rights, it may be possible for
unauthorized third parties to copy or reverse engineer aspects of our products,
develop similar technology independently or otherwise obtain and use information
that we regard as proprietary. There can be no assurance that others will not
develop technologies similar or superior to our technology or design around the
proprietary rights we own.

Although we are not aware that our products infringe on the proprietary
rights of third parties, there can be no assurance that others will not assert
claims of infringement in the future or that, if made, such claims will not be
successful. We may seek to obtain a license under a third party's intellectual
property rights. There can be no assurance that a license will be available
under reasonable terms or that a license will be available at all.

Litigation to determine the validity of any claims against the Company,
whether or not such litigation is determined in favor of the Company, could
result in significant expense to us and divert the efforts of our technical and
management personnel from daily operations. In the event of any adverse ruling
in any litigation regarding intellectual property, we may be required to pay
substantial damages, discontinue the sale of infringing products, expend
significant resources to develop non-infringing technology or obtain licenses to
use infringing or substituted technology. The failure to develop, or license on
acceptable terms, a substitute technology could have a material adverse effect
on our business, financial condition and results of operations.

Litigation may also be necessary to enforce our patents and other
intellectual property rights, to protect our trade secrets, and to determine the
validity of and scope of the proprietary rights of others. Such litigation could
result in substantial costs and diversion of resources and could have a material
adverse effect on our business, financial condition or results of operations.

We currently hold 11 United States patents relating to
telecommunications and computing technology and have 18 currently pending
patents relating to telecommunications and computing technology. We seek to
protect our software, documentation and other written materials under trade
secret and copyright laws, which afford only limited protection. Patent
positions frequently are uncertain and involve complex and evolving legal and
factual questions. The coverage sought in a patent application may be denied or
significantly reduced before or after the patent is issued. There can be no
assurance that:

o any patents from pending patent applications or from any
future patent application will be issued,

o the scope of any patent protection will exclude competitors or
provide competitive advantages to us,

o any of our patents will be held valid if subsequently
challenged, or

o others will not claim rights in or ownership of the patents
and other proprietary rights held by us.

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Because patent applications are confidential until patents are issued
in the United States or corresponding applications are published in other
countries, and because publication of discoveries in the scientific or patent
literature often lags behind actual discoveries, we cannot be certain that we
were the first to make the inventions covered by each of our pending patent
applications or that we were the first to file patent applications for such
inventions. In addition, there can be no assurance that competitors, many of
which have substantial resources and have made substantial investments in
competing technologies, will not seek to apply for and obtain patents that will
prevent, limit or interfere with our ability to make, use or sell our products
either in the United States or in international markets.

EMPLOYEES

As of March 31, 2003 we had 48 full-time employees, of which fifteen
were engaged in engineering and development, 11 were engaged in sales,
marketing, and customer support, 11 were engaged in manufacturing operations,
and 11 were engaged in administration and finance. None of our employees are
represented by a labor organization. We have experienced no material work
stoppages and believe we have a good relationship with our employees.

PRIOR OPERATIONS

Our name was changed to TeraForce Technology Corporation on January 30,
2001, upon approval by its stockholders, from Intelect Communications, Inc. The
Company was incorporated in Delaware on May 23, 1995. Its predecessor, Intelect
Communications Systems Limited ("Intelect (Bermuda)") was incorporated under the
laws of Bermuda in April 1980 and operated under the name Coastal International,
Ltd. until September 1985 and as Challenger International Ltd. until December
1995. On December 4, 1997, the shareholders of Intelect (Bermuda) approved a
merger proposal that reincorporated Intelect (Bermuda) to Delaware and resulted
in Intelect (Bermuda) becoming a publicly traded corporation. The merger was
effected on December 4, 1997.

Engineering Design Services

Our engineering design services business was conducted through DNA. a
20-year old engineering design services organization located in Richardson,
Texas that we acquired in 1996. Over its history DNA provided high-end
engineering design services to both established companies and start-up
organizations, primarily related to the telecommunications industry. During the
course of 2001, DNA experienced a significant decline in the demand for its
services. This was caused by the continued down-turn and uncertainty in the
telecommunications business and the financing difficulties experienced by many
start-up organizations. We determined that there was no longer adequate
justification to continue to fund the costs associated with maintaining the DNA
organization in light of the uncertainty in future demand for its services.
Therefore, as of December 31, 2001 we commenced a plan to dispose of this
business and on January 11, 2002 sold substantially all of the assets related to
the design services business to Flextronics International, Ltd. ("Flextronics").
The operations related to the engineering design services business are treated
as discontinued operations in the accompanying consolidated financial
statements. (See Note 4 of the Notes to Consolidated Financial Statements -
included in Item 8 - "Financial Statements and Supplementary Data.")

Effective with the sale of substantially all the assets of DNA to
Flextronics we no longer provide contract engineering design services. These
services had been provided on a time and material basis and the customer
retained all rights to the developed intellectual property.

A variety of clients utilized our engineering design services, ranging
from start-up ventures seeking to launch new products to large multi-national
corporations looking to access key know-how for extending current product lines
or introducing new products and services. The products we developed for these
clients

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ranged from compact circuit boards to multi-board systems. We marketed our
services directly to prospects worldwide. Principal customers for our services
included board manufacturers, telecommunications equipment vendors,
semiconductor suppliers, and communications service providers. During 2001,
three customers accounted for 65% of net revenue from engineering design
services.

Telecommunications Equipment

Prior to 2001, a major focus of our business was the development,
design, production and sale of optical networking equipment for application in
telecommunication networks. We had specifically focused on our OmniLynx product
line. The business related to OmniLynx, and predecessor products SonetLynx(C)
and FibreTrax(C), was conducted through a wholly-owned subsidiary, Intelect
Network Technologies Company ("INT"). During 2000, opportunities in the
telecommunications market began to decline dramatically. As a result of this, we
determined that the long-term strategic value of the OmniLynx product line was
not as promising as the Company's other businesses and implemented a plan to
materially curtail the operations of INT and to sell INT or substantially all of
the assets related to the OmniLynx product line. In February 2001, a potential
sale of the OmniLynx business to a company in the United Kingdom did not
materialize, and we terminated the majority of the employees of INT. In August
2001, we completed a sale of the OmniLynx product line and substantially all of
the related assets to a newly formed entity, Intelect Technologies, Inc.
("ITI"). ITI is a corporation initially owned 67% by Singapore Technology
Electronics, Ltd. ("STE") and 33% by the Company. In February, 2003 STE made an
additional investment in ITI increasing its ownership to approximately 78% and
decreasing our ownership to approximately 22%. ITI is continuing with the active
production and sale of the OmniLynx product line, primarily for use in
purpose-built network applications such as highway systems, rail systems,
airport communication systems and pipeline networks. We have minority board of
director representation in ITI and have no involvement in day-to-day operations.
We account for its investment in ITI using the equity method of accounting. (See
Note 5 of the Notes to Consolidated Financial Statements - included in Item 8 -
"Financial Statements and Supplementary Data.")

During 2001, we continued development activities on a new generation of
optical networking equipment through another wholly-owned subsidiary, Aegean
Networks, Incorporated ("Aegean"). We funded all development activities, but had
sought strategic investors to provide funding in order to allow full-scale
development. We had received indications of interest from a number of potential
strategic investors, but the uncertainties surrounding the recovery of markets
for telecommunications equipment and other economic factors resulted in no firm
commitments to provide funding for Aegean. In the fourth quarter 2001 we
curtailed development activities related to Aegean and in the second quarter of
2002 ceased all development activity related to Aegean.

During 2001, we launched development activities related to a line of
products to provide high-density, telecommunications-grade solutions to the
Internet server and storage markets. These activities were conducted through a
wholly-owned subsidiary, Centauri NetSystems Corporation ("Centauri"). Economic
and industry conditions made obtaining third party financing for this project
difficult and in March, 2002 we suspended all development activity related to
the Centauri project.

See Item 7 - "Management's Discussion and Analysis of Financial
Condition and Results of Operations" for a discussion of research and
development expenditures over the past three years. See Note 16 of the Notes to
Consolidated Financial Statements - included in Item 8 - "Financial Statements
and Supplementary Data."- for information regarding revenue and profits by
segment and geographic region.

RISK FACTORS

In addition to the other information in this Annual Report on Form
10-K, the following are risk factors that should be considered in evaluating the
Company and an investment in our common stock. The trading price of the common
stock could decline due to any of these risks, and investors in our common stock
could lose all or part of their investment.

9

RISK FACTORS RELATED TO OUR BUSINESS

A Number of Factors Could Cause Operating Results to Fluctuate
Significantly.

Our revenues and operating results in any reporting period may
fluctuate significantly due to a variety of factors, including:

o changes in the price or availability of components for our
products;

o the mix of products sold to the defense electronics markets
and other markets;

o our ability to introduce new technologies and features ahead
of competitors;

o the timing and size of orders we receive from customers;

o fluctuations in demand for our products;

o delays in testing by customers;

o production delays due to quality problems with outsourced
components;

o changes in our pricing policies or the pricing policies of our
competitors;

o changes in customers' requirements, including changes or
cancellations of orders from customers;

o manufacturing and shipment delays and deferrals;

o our ability to efficiently produce and ship orders promptly on
a price-competitive basis;

o announcements or introductions of new products by our
competitors;

o changes in general economic conditions as well as those
specific to the defense electronics industry.

Current economic conditions have made it more difficult to make
reliable estimates of future revenues. Fluctuations in our revenue can lead to
greater fluctuations in our operating profits. In addition, we expect to incur
significant research and development expenses as we develop products to serve
our markets, all of which are subject to rapidly changing technology, frequent
product performance improvements and evolving industry standards. The ability to
deliver superior technological performance on a timely and cost effective basis
is a critical factor in securing design wins for future generations of defense
electronics systems. Significant research and development spending by the
Company does not ensure that our products will be designed into a customer's
system. Because future production orders are usually contingent upon securing a
design win, our operating results may fluctuate due to either obtaining or
failing to obtain design wins for significant customer systems.

We Have Incurred Significant Losses in the Past and Are Not Currently
Profitable.

We are not currently profitable. In 2002, 2001 and 2000 we have
incurred net losses of $4,350,000, $21,549,00 and, $29,572,000, respectively.
These losses have been funded from borrowings under credit facilities and sales
of common stock. It is not certain when we will become profitable. The ability
to become profitable will depend, in part, on our ability to increase net
revenue from sales of defense electronics products. Because of this we have
experienced a lack of liquidity from time to time, and therefore have not paid
our obligations in a timely manner in some cases. This in turn has impacted our
ability to operate our business. If our need for capital exceeds available
resources, there can be no assurance that additional capital will be available
through public or private equity or debt financing.

Debt Service Obligations May Adversely Affect Our Cash Flow and We May
Be Unable to Repay the Debt On Time.

We have approximately $4,900,000 of debt outstanding. Of this amount,
approximately $4,000,000 is due by December 31, 2003. It is unlikely that we
will be able to generate sufficient cash flow from operations to repay all of
this debt when it comes due. While we intend to restructure or refinance this
debt, there is no assurance that we will be able to do so in a timely manner.
Even if we are able to refinance or restructure this debt, we may still be
subject to substantial interest and principal repayment obligations.

10

Our Auditors Have Expressed Doubt as to Our Ability to Continue as a
Going Concern.

Our independent certified public accountants have added an explanatory
paragraph to their audit opinion issued in connection with our consolidated
financial statements. The opinion states that our ability to continue as a going
concern is uncertain due to the amount of debt that is due in 2003, the
uncertainty of refinancing or restructuring the debt and our history of
operating losses. Our consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty. These
adjustments might include changes in the possible future recoverability and
classification of assets or the amounts and classification of liabilities that
might result from the outcome of this uncertainty.

We May Not Be Able to Successfully Complete Development and Achieve
Customer Acceptance of New Defense Electronics Products.

We must continually enhance our products. Certain enhancements to our
products are in the development phase and are not yet ready for commercial
manufacturing or deployment. The successful development and deployment of these
products is subject to substantial risk. The development of these products, from
laboratory prototype to customer trial, and subsequently to general
availability, involves a number of steps including the following:

o completion of product development;

o the qualification and multiple sourcing of critical
components;

o validation of manufacturing methods and processes;

o extensive quality assurance and reliability testing, and
staffing of testing infrastructure;

o validation of embedded software; and

o establishment of systems integration and systems test
validation requirements.

Each of these steps in turn presents serious risks of failure, rework
or delay. Any one of these setbacks could decrease the speed and scope of
product introduction and marketplace acceptance of the product. In addition,
unexpected intellectual property disputes, failure of critical design elements,
and other setbacks may delay or even prevent the introduction of these products.
A lack of working capital may also negatively impact our ability to enhance our
products in a timely manner.

Additionally, the markets for our new products may be undeveloped. The
commercial acceptance of these types of products is uncertain. We cannot assure
you that our sales and marketing efforts for these products will be successful.

We are a Party to Lawsuits and May Be Subject to Other Contingent
Liabilities.

We are a named party in a lawsuit and may be subject to significant
other contingent liabilities. Defending these matters may require a substantial
amount of our resources, and any judgments may materially affect our financial
condition and results of operations. For more information see" Item 3 - Legal
Proceedings."

Our Failure to Quickly Adopt to Rapidly Changing Competitive and
Economic Conditions Could Have a Material Adverse Effect on Our Business and
Results of Operations.

We operate in a rapidly changing and competitive and economic
environment. Our future success will depend, in part, on our ability to enhance
our current products and to develop new products on a timely and cost-effective
basis that respond to technological developments and changing customer needs.
The markets for sophisticated technology are constantly undergoing rapid
competitive and economic changes. The full scope and nature of these changes are
difficult to predict. The defense electronics market, in particular, demands
constant technological improvements as a means of gaining military advantage. We
believe that technological change will continue to attract new entrants to our
market. Industry consolidation among competitors may increase their financial
resources, which may allow our competitors to reduce their prices. This would
require us to reduce the prices of our products or risk losing market share.

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We Have a Limited Customer Base.

We are dependent on a small number of customers for a large portion of
our revenues. In fiscal 2002, three customers accounted for 65% of our revenues.
Customers in the defense electronics market purchase our products in connection
with government programs that may have limited duration, leading to fluctuating
sales to any particular customer in the defense electronics market from year to
year. A significant decrease in our sales to any of our major customers, or the
loss of any of our major customers, would have a material adverse effect on our
business, financial condition and results of operations. In addition, our
revenues are largely dependent upon the ability of our customers to develop and
sell products and systems that incorporate our products. There is no assurance
that our customers will not experience financial or other difficulties that
could adversely affect our operations and, in turn, our results of operations.

We May Not Be Successful if We Do Not Attract New Customers.

Our future success will depend on our attracting additional customers.
The growth of our customer base could be adversely affected by:

o customer unwillingness to implement our defense electronics
technology;

o any delays or difficulties that we may incur in completing the
development, introduction and production manufacturing of our
planned products or product enhancements;

o new product introductions by our competitors;

o any failure of our products to perform as expected;

o any difficulty we may incur in meeting customers' delivery,
installation or performance requirements; or

o customer concerns over our financial condition.

We Must Attract, Retain and Motivate Key Technical and Management
Personnel in a Competitive Market in Order to Sustain and Grow Our Business.

Our success depends to a significant extent upon key technical and
management employees. Competition for highly qualified employees can be intense
and the process of locating key technical and management personnel with the
required combination of skills and attributes can be lengthy and expensive.
There can be no assurance that we will be successful in retaining our existing
key personnel or in attracting and retaining the additional employees we may
require. We must continue to recruit, train, assimilate, motivate, and retain
qualified managers and employees to manage our operations effectively. If we do
not successfully recruit, hire and retain key employees, we may be unable to
execute our business plan effectively and our results of operations could be
significantly adversely affected.

We May Be Unable to Secure Necessary Components and Support Because We
Depend Upon a Limited Number of Third-Party Manufacturers and Support
Organizations.

We depend on a limited number of suppliers for components of our
products, as well as for equipment used to design and test our products. Certain
components used in our products are only available from a single source or
limited number of vendors. Some of the sole source and limited source vendors
are companies who, from time to time, allocate parts to equipment manufacturers
due to market demand for components and equipment. Many of our competitors are
much larger and may be able to obtain priority allocations from these shared
vendors, thereby limiting or making our sources of supply unreliable for these
components. Any delay in component availability for any of our products could
result in delays in deployment of these products and in our ability to recognize
revenues. Suppliers may be concerned regarding our financial condition and
therefore may be unwilling to sell components to us, or to grant trade credit to
us.

12

If we are unable to obtain a sufficient supply of components from
alternative sources, reduced supplies and higher prices of components will
significantly limit our ability to meet scheduled product deliveries to
customers. A delay in receiving certain components or the inability to receive
certain components could harm our customer relationships and our results of
operations.

Failures of components affect the reliability and performance of our
products, can reduce customer confidence in our products, and may adversely
affect our financial performance. From time to time, we have experienced delays
in receipt of components and have received components that do not perform
according to their specifications. Any future difficulty in obtaining sufficient
and timely delivery of components could result in delays or reductions in
product shipments that could harm our business. In addition, a consolidation
among suppliers of these components or adverse developments in their businesses
that affect their ability to meet our supply demands could adversely impact the
availability of components that we depend on. Delayed deliveries from these
sources could adversely affect our business.

Our defense electronics products are manufactured by a limited number
of third-party manufacturers. If we were required to find alternative
third-party manufacturers, we may be forced to incur significant costs and
risks. There is no assurance that the alternative manufacturers could produce
our products with quality or costs comparable to the existing manufacturers. In
addition, the transfer of the manufacturing process to an alternative provider
could result in significant delays that could cause us to miss deadlines imposed
by our customers.

Defense Electronics Products Business Is Subject to Special Risks.

We expect that the majority of our net revenues in the future will come
from the sale of our defense electronics products. We supply products to
sub-contractors and prime contractors whose ultimate customer is often an agency
of the United States government. Reductions in government spending on programs
that incorporate our products could have a material adverse effect on our
business, financial condition and results of operations. The contracts with the
United States government are subject to special risks including the following:
delays or cancellations of funding for programs; ability of the government to
unilaterally cancel the contract; reduction or modification as a result of
budgetary restraints or political changes; and other factors not under the
control of us or the prime contractor.

The Failure to Develop and Introduce New Products That Meet Changing
Customer Requirements and Address Technological Advances Would Limit Our Ability
to Sell Our Products and Services.

New product development often requires long-term forecasting of market
trends, and development and implementation of new technologies. If we fail or
are late to respond to new technological developments, market acceptance of our
products may be significantly reduced or delayed. The markets we participate in
are characterized by rapidly changing technology, evolving industry standards,
changes in end user requirements, and frequent new product introductions and
enhancements. The introduction of products embodying new technologies or the
emergence of new industry standards can render our existing products obsolete or
unmarketable. There can be no assurance that we will be able to develop and
introduce new products ahead of our competitors, or that our products will not
be rendered obsolete.

We May Not Be Able to Secure an Adequate Number of Design Wins.

Before buying our products, a customer will evaluate our products, and
those of our competitors, as a part of designing a larger system. When a product
is selected by a customer to be utilized in its system we refer to it as a
"design win." The design-win process is typically lengthy and expensive, and
there can be no assurance that we will be able to continue to meet the product
specifications of our customers in a timely and adequate manner. In the defense
electronics market, military planners have historically funded significantly
more design projects than actual deployments of new equipment. There can be no
assurance that we will secure an adequate number of design wins. Failure to
secure future design wins could have a material adverse effect on our business,
financial condition and results of operations.

13

Product Performance Problems Could Limit Sales Prospects.

The production of new products with high technology content involves
occasional problems as the technology and manufacturing methods mature. If
significant reliability, quality or network monitoring problems develop,
including those due to faulty components, a number of negative effects on our
business could result, including:

o costs associated with reworking the manufacturing processes;

o high service and warranty expenses;

o high inventory obsolescence expense;

o high levels of product returns;

o delays in collecting accounts receivable;

o reduced orders from existing customers; and

o declining interest from potential customers.

Although we maintain accruals for product warranties, actual costs
could exceed these amounts. From time to time, there will be interruptions or
delays in the activation of products at a customer's site. These interruptions
or delays may result from product performance problems or from aspects of the
installation and activation activities, some of which are outside our control.
If we experience significant interruptions or delays that cannot be promptly
resolved, confidence in our products could be undermined, which could have a
material adverse effect on operations.

Failure to Protect Our Intellectual Property Will Adversely Affect Our
Ability to Compete in the Industry and Our Profitability.

We rely on a combination of patents, copyright, trademark and trade
secret laws, and restrictions on disclosure to protect our intellectual
property. We also enter into confidentiality or license agreements with our
employees, consultants and corporate partners and control access to and
distribution of our software, documentation and other proprietary information.
These intellectual property protection measures may not be sufficient to prevent
wrongful misappropriation of our technology. In addition, these measures will
not prevent competitors from independently developing technologies that are
substantially equivalent or superior to our technology. The laws of many foreign
countries do not protect intellectual property rights to the same extent as the
laws of the United States. Failure to protect proprietary information could
result in, among other things, loss of competitive advantage, loss of customer
orders and decreased revenues. Monitoring the unauthorized use of our products
is difficult and we cannot be certain that the steps we have taken will prevent
unauthorized use of our technology, particularly in foreign countries where the
laws may not protect our proprietary rights as fully as in the United States. If
competitors are able to use our technology, our ability to compete effectively
could be impaired. This litigation could result in substantial costs and
diversion of resources and may not ultimately be successful.

We May Be Subject to Intellectual Property Infringement Claims That Are
Costly to Defend and Could Limit Our Ability to Use Some Technologies in the
Future.

Like other participants in our industry, we expect that we will
continue to be subject to infringement claims and other intellectual property
disputes as competition in the marketplace continues to intensify. In the
future, we may be subject to litigation and may be required to defend against
claimed infringements of the rights of others or to determine the scope and
validity of the proprietary rights of others. Any such litigation could be
costly and divert management's attention from operations. In addition, adverse
determinations in such litigation could:

o result in the loss of our proprietary rights to use the
technology;

o subject us to significant liabilities;

o require us to seek licenses from third parties;

o require us to redesign the products that use the technology;
or

o prevent manufacturing or sale of our products that employ the
technology.

14

If we are forced to take any of the foregoing actions, our business may be
seriously harmed.

We May Be Unable to License Third-Party Technology at a Reasonable
Cost.

From time to time we may be required to license technology from third
parties to develop new products or product enhancements. We cannot ensure that
third-party licenses will be available to us on commercially reasonable terms.
The inability to obtain any third-party license required to develop new products
and product enhancements could require us to obtain substitute technology of
lower quality or performance standards, or to license such technology at a
greater cost. Both licensing inferior technology at a reasonable cost and
licensing necessary technology at a higher cost could seriously harm the
competitiveness of our products.

Our Products Are Subject to Government Regulation.

The export of our products and related technology may be subject at
times to regulation and restriction by the Department of Commerce. Because our
products are utilized in defense and intelligence gathering related
applications, in some cases the export of our products and related technology
may be subject to further regulation and restriction by the Department of State.
Sales to foreign countries have not been material to date, but the export
controls could limit our ability to sell our products outside the United States
or could delay such sales in the future. We also may be required to spend
substantial time and resources in order to comply with the regulations and
restrictions. We could be subject to fines if we fail to properly comply with
these regulations.

In addition, our business and operating results may also be adversely
affected by the imposition of certain tariffs, duties and other import
restrictions on components that we obtain from non-domestic suppliers or by the
imposition of export restrictions on products that we sell internationally. We
do not believe we have material exposure to environmental laws. Changes in
current or future laws or regulations, in the United States or elsewhere, could
materially and adversely affect our business and results of operations.

RISK FACTORS RELATED TO THE SECURITIES MARKET

Our Common Stock Is Subject to Price Volatility.

The price of our common stock is volatile. Fluctuations in operating
results, such as revenues or operating results being below the expectations of
public market analysts and investors, may cause additional volatility in the
price of the common stock. In such event, the market price of our common stock
could decline significantly. A significant decline in the market price of the
common stock could result in litigation that could also result in increased
costs and a diversion of management's attention and resources from operations.

There May Not Be a Liquid Market for our Common Stock.

Our common stock currently is traded on the OTC Bulletin Board operated
by Nasdaq. This market generally has less liquidity than the Nasdaq SmallCap
Market and certain institutional investors are precluded from buying stock in
this market. There can be no assurance that our investors will be able to sell
the Common Stock at prices and times that are desirable.

Additional Capital May Dilute Current Stockholders.

In order to provide capital for the operation of our business we may
enter into additional financing arrangements. These arrangements may involve the
issuance of new common stock, preferred stock that is convertible into common
stock, debt securities that are convertible into common stock or warrants for
the purchase of common stock. Any of these items could result in a material
increase in the number of shares of

15

common stock outstanding which would in turn result in a dilution of the
ownership interest of existing common shareholders. In addition these new
securities could contain provisions, such as priorities on distributions and
voting rights, which could affect the value of our existing common stock.

We May Propose a Reverse-Split of Our Common Stock.

In order to reduce the number of shares outstanding, increase the
trading price of our common stock and possibly attract additional groups of
investors we may at some time in the future propose a reverse-split of our
common stock. Such a proposal would require the approval of the majority of the
outstanding shares of voting stock to be implemented. There can be no assurance
that a reverse split would have the intended effect and therefore it could
dilute the value of our common stock.

ITEM 2 - PROPERTIES

All of our facilities are leased and are located in Richardson, Texas.
We lease approximately 50,000 square feet, and we currently utilize
approximately 25,000 feet. These facilities include production, engineering,
sales, marketing and administrative offices and we believe it to be suitable for
our current operations.

ITEM 3 - LEGAL PROCEEDINGS

We are involved in various legal proceedings and claims arising in the
ordinary course of business.

Shareholder Action. A shareholder class action lawsuit was filed in the
U. S. District Court for the Northern District of Texas in November 1999 on
behalf of all persons and entities who purchased the Company's common stock
during the period between February 24, 1998 and November 17, 1998. The named
defendants include the Company and certain former and present officers and
directors of the Company. The complaint alleges that the defendants violated
Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5
promulgated thereunder by making false and misleading statements concerning the
Company's reported financial results during the period, primarily relating to
revenue recognition, asset impairment and capitalization issues. The plaintiffs
seek monetary damages, interest, costs and expenses. In March 2001, our motion
to dismiss the case was denied. In December 2002, the Court denied the
plaintiffs' motion for class certification. The plaintiffs appealed this ruling
to the 5th Circuit Court of Appeals and in March 2003 the appellate court
refused to hear the appeal. Certain motions are now pending before the U. S.
District Court to determine the extent of individual plaintiffs' claims in this
matter.

United Pacific Insurance Company, an affiliate of Reliance Insurance
Company, the insurance carrier that provides the primary $2 million of insurance
coverage for this matter, has been ordered liquidated by the insurance
commissioner of the State of Pennsylvania. At this time we are unable to
determine what amounts, if any, may be available under this insurance coverage
and it could be some period of time before we can determine this. We received
$300,000 related to this claim from guarantee funds maintained by the insurance
commissioner of the State of Texas. If we don't receive the full benefit of this
coverage, there could be a material adverse impact on the Company.

Savage Matters. We are contingently liable for certain potential claims
that arise out of Savage Arms, Inc., a manufacturer of sporting bolt action
rifles ("Savage Arms"). We sold Savage Arms to the Savage Sports Corporation
("Savage Sports"), and pursuant to the Stock Purchase Agreement we executed on
October 3, 1995, we agreed to indemnify Savage Sports for certain product
liability claims, environmental clean-up costs and other contractual
liabilities, including certain asserted successor liability claims, that Savage
Sports incurred because of Savage Arms.

A firearms product liability lawsuit was filed in Alaska Superior Court
("the Taylor litigation"). Western Auto Supply Co. is a defendant in the Taylor
litigation, and has settled the claim for $5 million. Western Auto Supply Co.
asserted a third-party claim against Savage Sports seeking indemnification in
the amount of the settlement, plus attorneys' fees and related costs. During
2002 Savage reached a settlement on this matter pursuant to which it agreed to
pay a total of $1,000,000 over a period of four years. Savage then sought
indemnification from the Company for these amounts.

16

In October, 2002 we reached an agreement in principle with Savage
regarding this and indemnification matters, including the balance of amounts due
Savage pursuant to a settlement agreement reached in January, 2001. Under this
agreement we have agreed to pay Savage a total of $1,575,000, which includes the
remaining balance of the prior settlement, over a four year period. Savage has
agreed to fund the cost of insurance programs that are expected to respond to
any other such claim that may arise in the future. We are aware of no such
claims and Savage has advised us that they are not aware of any additional
claims. We recorded a charge of $1,520,000 related to this matter in the third
quarter of 2002.

SCI Action. In July 2002, the Company's wholly-owned subsidiary, DNA
Enterprises, Inc. ("DNA") filed suit against SCI Technology, Inc. and SCI
Systems, Inc. (collectively "SCI") for breach of contract and fraudulent
inducement. The suit alleges that SCI has failed to pay DNA royalties related to
a Licensing Agreement involving the joint development of certain circuit card
assembly ("CCA") boards. The suit is currently pending in United States District
Court for the Northern District of Texas. In August 2002, SCI filed a counter
claim against DNA alleging breach of contract, fraudulent inducement and
negligent misrepresentation. In April 2003, the Company and SCI reached a
settlement of these matters whereby all claims will be dismissed and SCI will
pay the Company an undisclosed amount. This settlement will not have a material
effect on the Company's financial condition or results of operations.

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

During the quarter ended December 31, 2002, no matters were submitted
to a vote of our stockholders.

17

PART II

ITEM 5 - MARKETS FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock is traded on the OTC Bulletin Board operated by Nasdaq
under the symbol "TERA." Prior to June 19, 2001, our common stock was traded on
the Nasdaq SmallCap Market. Our common stock was de-listed from the Nasdaq
SmallCap Market on June 19, 2001 for failure to maintain a minimum bid price of
$1.00. On January 30, 2001, we changed our trading symbol to "TERA" from "ICOM"
to reflect our name change to TeraForce Technology Corporation from Intelect
Communications, Inc.

The high and low bid prices for our common stock for each full quarter
of the last two fiscal years, as reported on the OTC Bulletin Board and Nasdaq,
are as follows (these prices are inter-dealer prices, without mark-up, mark-down
or commission included and may not necessarily represent actual transactions):

As of March 31, 2003, there were approximately 45,000 owners of record
of our common stock, including nominee holders such as banks and brokerage firms
who hold shares for the benefit of beneficial owners of our common stock.

The closing bid price of our common stock on the OTC Bulletin Board on
March 31, 2003 was $0.195.

DIVIDEND POLICY

No dividends were paid on any class of equity in 2002 or 2001. We do
not currently plan to pay any dividends on our common stock. Delaware law would
restrict our ability to pay any dividends on our common stock.

SECURITIES SOLD

From October, 2002 through March, 2003 we issued a total of 29,333,333
of our common stock in a series of private placements. We received proceeds
totaling $3,520,000 from these sales. We used $2,000,000 of this amount to repay
debt outstanding under a bank credit facility and the balance for working
capital.

These sales of common stock were exempt from registration pursuant to
Section 4(2) of the Securities Act of 1933 (the Securities Act), as amended, and
pursuant to Rule 506 of Regulation D of the Securities Act. A Rule 506 exemption
was available for these sales because the Company sold only to accredited
investors; the Company did not solicit or advertise the sales; a registered
restrictive legend was placed on each certificate issued describing the
restrictions against resale; and a Form D was filed with the Securities and
Exchange Commission and in each state where the individual investors reside.

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ITEM 6 - SELECTED FINANCIAL DATA

The following tables set forth certain historical consolidated
financial data for the Company.

*Certain amounts have been reclassified to conform to current classifications.

19

ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following discussion should be read in conjunction with the
Consolidated Financial Statements and their related notes found on pages 33
through 55 of this Form 10-K. Except for historical facts, all statements
included in the following discussion about our financial position, business
strategy, and plans of management for future operations are forward looking
statements. Forward-looking statements involve risks and uncertainties and
actual results could materially differ from those expressed in or implied by the
forward-looking statements.

RESULTS OF OPERATIONS

The following discussions of revenues, gross profit (loss), engineering
and development expenses, and selling and administrative expenses do not include
amounts related to our engineering design services business for any period
presented.

The following table shows the revenue and gross profit (loss) for our
products:

Net revenues

Net revenue from the sale of defense electronics products increased 20%
between 2001 and 2002 and 17% between 2000 and 2001. The increased product sales
reflect our continued penetration of the market for these products and customer
acceptance of our products. The majority of the increase in net revenues results
from sales of our PowerPC-based product line. We have sold these products into
an increasing number of programs; however, these programs have not yet reached
their full production phase. In the full production phase, orders tend to be
larger and more predictable. In the first quarter of 2003 we have received new
orders, or "bookings," for our products amounting to approximately $4,000,000.
We believe this is an indication of continuing increased demand for these
products.

While the majority of our defense electronics products are utilized in
defense and intelligence related applications, they have also been utilized in
commercial telecommunications applications. The severe downturn in the
telecommunications industry resulted in a sharp decline in demand for our
products in these applications. Therefore, revenues in 2001 from sales to the
telecommunications market were less than we had anticipated. Revenue from sales
of products for defense and intelligence related applications in 2001 was also
less than we had expected. Prior to September 11, 2001, funding for various
defense and intelligence related programs had been delayed pending the Bush
administration's assessment of the military and its priorities. This resulted in
delays in new orders throughout the industry. The events of September 11, 2001
compounded these delays.

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Net revenue from optical networking equipment relates almost
exclusively to the OmniLynx product line. In August 2001, we sold essentially
all of the assets related to the OmniLynx product line to ITI, of which we
continue to own a portion. Prior to the completion of this transaction we had
significantly curtailed the OmniLynx operations. Accordingly, revenues from
optical networking equipment declined significantly in 2001. Subsequent to
August 2001, we had no revenues from optical networking equipment. The decision
to dispose of the OmniLynx related assets and operations was made in reaction to
rapidly changing market conditions that resulted in very significant declines in
the actual and expected demand for the OmniLynx product line. A significant
factor in our decision to curtail the OmniLynx operations was the decline in
demand from small to medium sized competitive local exchange carriers, which had
been one of our target markets.

Other revenues consist primarily of the voice and data switching
products used in air traffic control applications and video network products,
which we no longer sell.

Gross profit (loss)

Our gross profit from sales of defense electronics products increased
because of higher sales levels and certain fixed production costs. Furthermore,
this increase reflects higher sales of our PowerPC-based products that tend to
produce higher gross margins than our other products. In the fourth quarter of
2002 we recorded a charge of approximately $270,000 to adjust the carrying value
of component and finished goods inventories. This adjustment resulted primarily
from our on-going analysis of component obsolescence.

The gross loss related to defense electronics products for 2001
includes approximately $750,000 of charges related to the adjustment of the
carrying value of component and finished goods inventories. These charges
resulted from an evaluation of current component costs and the adjustment of
certain finished goods to net realizable value. Without the effect of these
charges, the gross profit related to defense electronic products in 2001
amounted to approximately $326,000, as compared to $375,000 in 2000. The decline
in gross profit, despite the increase in related net revenue between the
periods, reflects the costs of certain fixed infrastructure established to
handle higher production levels expected in the future, higher testing and
re-work costs in the early phases of PowerPC-based product production and higher
unit costs related to relatively low volume production runs during this early
phase.

As of December 31, 2000, our assets related to the OmniLynx product
line, including inventories, were reduced to estimated net realizable value.
Therefore, revenue from the sales of such OmniLynx products in 2001 produced no
gross profit or loss. The gross loss in 2001 represents manufacturing and
production overhead costs incurred in 2001. During 2000, gross loss from optical
networking equipment reflects the effect of relatively low production levels for
our manufacturing operations. The lower production levels resulted in unabsorbed
overhead of approximately $1,400,000 in 2000. The amortization of technology
costs and capitalized software development costs of approximately $1,300,000 in
2000 also affected the gross loss.

Engineering and development expenses

Engineering and development ("E&D") expense decreased to $3,065,000 in
2002 from $5,096,000 in 2001 and $5,258,000 in 2000. In 2000, certain amounts of
software development costs were capitalized. Including those capitalized
amounts, the total E&D expenditures were $6,153,000 in 2000. Total E&D expense
by product line were distributed as follows:

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E&D costs related to our defense electronics products have increased in
each of the past three years. This increase reflects our on-going product
development efforts. Activities in 2000 and 2001 primarily involved our PowerPC
products that were first introduced in late 2000. Activities in 2002 included
enhancements of these products, including the development of a "ruggedized"
version of these products. In addition, during 2001 and 2002 we expended
considerable effort in the development of our Eagle product line. Included in
E&D expenses for 2002 is approximately $800,000 related to engineering design
services provided by Flextronics pursuant to the arrangement entered into with
Flextronics concurrent with the sale of our engineering design services
business.

In 2000, we incurred E&D costs relating to optical networking equipment
primarily from enhancements and extensions of the OmniLynx product line. The E&D
costs in 2001 relate to the Aegean product line that we began developing in
2000. In the fourth quarter of 2001, we curtailed activity related to the Aegean
product line because we were unable to arrange outside funding for these
activities. We ceased all activities related to Aegean in the second quarter of
2002.

Other E&D costs in 2001 included approximately $670,000 related to the
engineering organization involved with the OmniLynx product line, which was
eliminated during 2001. The balance of other E&D costs in 2001 arose from
development activities on the Centauri product line. In the first quarter of
2002, we suspended all development activities related to the Centauri project.

Selling and administrative expenses

Selling and administrative expenses decreased $2,516,000, or 30%,
between 2001 and 2002 and decreased $4,660,000, or 36%, between 2000 and 2001.
These expenses decreased because of the curtailment and sale of the operations
related to the OmniLynx product line. The decrease was offset by increased
general and administrative expenses related to our defense electronics business.
We have reduced other selling and administrative costs, including headcount, in
response to the elimination of various business operations.

Asset write downs and costs related to sale of assets

In the fourth quarter of 2000, we determined that, due to changes in
certain target customer markets in telecommunications, our OmniLynx line of
optical networking products no longer fit within our long-term objectives and
began plans to sell the product line and related operations. A transaction for
the sale of the OmniLynx business failed in the first quarter of 2001 due to
business difficulties experienced by the potential purchaser. At that time, we
significantly curtailed the ongoing operations of the OmniLynx business and
began to pursue other methods of disposing of the business, including
liquidating the assets. As of December 31, 2000, the carrying values of the
assets related to the OmniLynx product line were adjusted to the lower of cost
and estimated net realizable value. A charge to operations was recorded as of
December 31, 2000 as follows:

22

In August 2001 we sold substantially all of the OmniLynx assets to ITI.
We received a cash payment of $1,000,000 and are entitled to receive additional
amounts from ITI based upon the utilization of inventory acquired from us and
based on the financial position of ITI at specific points in time. The total
additional amount to be received cannot be determined at this time. The amounts
due from ITI have been recorded at the carrying value of the assets disposed of,
less amounts received from ITI. Accordingly, no gain or loss has been recorded
as a result of this transaction.

In 2001, we recognized non-recurring costs in connection with the sale
of the OmniLynx assets that amounted to $2,101,000. These costs related to
maintaining the assets until the sale and the settlement of certain contractual
obligations related to those assets such as warranty obligations, employee
retention agreements and lease obligations.

Litigation settlement

In April 2002, we settled litigation that we had brought against
Cadence. See "Item 3 - Legal Proceedings." Pursuant to this settlement we
received $6,300,000, net of fees paid to our attorneys related to this matter.

Litigation costs

Litigation costs represent legal fees and expenses related to a
shareholder suit. See "Item 3 - Legal Proceedings." The allegations in the suit
relate to operations that have been sold or otherwise discontinued; therefore,
these costs are reflected as non-operating expenses. Amounts incurred by the
Company in excess of $200,000 are reimbursable under an insurance policy.
However, the insurance carrier that provides the first $2,000,000 of such
coverage is in receivership and has not paid any amounts to us. We have received
$300,000 from a guarantee fund maintained by the State of Texas. The costs for
2002 have been reduced by $300,000. We may be able to recover some amounts from
the estate of our insurance carrier, but the amount and timing of such recovery
is uncertain. Therefore, no estimate of any such recovery has been recorded.

Earnings (loss) of unconsolidated affiliate

Subsequent to the sale to ITI of substantially all of the assets
related to the OmniLynx product line, ITI has conducted all operations related
to the OmniLynx product. We have a 33% equity interest in ITI, which decreased
to 22% in February 2003, minority board of director representation, no funding
obligations and no involvement in day-to-day operations. We account for our
investment in ITI using the equity method of accounting. Earnings (loss) of
unconsolidated affiliate for the years ended December 31, 2002 and 2001
represent our proportionate share of the net earnings or loss of ITI for each
period.

Interest expense

Interest expense, including non-cash financing charges, consists of the
following:

23

Interest on debt instruments in 2002 and 2001 relates to amounts
borrowed under bank credit agreements and short-term notes. In 2000, these
amounts were primarily attributable to amounts borrowed from St. James Capital
Corp., SJMB, L.P., and the Coastal Corporation Second Pension Trust.

Non-cash financing costs in 2002, 2001 and 2000 were the result of
warrants to purchase common stock issued in connection with various financings.
The reported expense amount is amortization of the value of the warrants
determined by using the Black-Scholes pricing model.

Interest income and other

Interest income and other includes interest on the temporary investment
of cash balances of approximately $47,000 in 2001 and $1,028,000 in 2000. The
year 2000 also includes approximately $1,070,000 from the settlement of a
dispute with a professional service provider offset by a charge of approximately
$875,000 related to the settlement of certain litigation.

Discontinued operations

The loss from discontinued operations of $1,520,000 in 2002 results
from a charge recorded in the third quarter of 2002 relating to the settlement
of certain indemnification obligations. These obligations arose from the sale of
certain operations to Savage Sports. See "Item 3 - Legal Proceedings."

Effective December 31, 2001 we commenced a plan to dispose of our
engineering design services business and on January 11, 2002 sold substantially
all of the assets related to this business for total consideration of
$2,800,000. Accordingly, this business segment has been accounted for as a
discontinued operation.

24

The loss on disposal of discontinued operations in 2001 is computed
based on the consideration received less the net book value of the assets
disposed of, including goodwill, and the operating loss of the business from
December 31, 2001 to the date of disposal, which amount includes severance costs
related to certain employees, and an estimate of the costs related to a real
estate lease utilized by the discontinued operation. The amount of the loss is
as follows:

The results of operations related to our engineering design services
business are reflected as loss from discontinued operations in 2001 and 2000.

Between 2000 and 2001, the loss related to the engineering design
services operations increased to $3,412,000 from $782,000, primarily as a result
of a decline in revenues from these operations to $3,405,000 in 2001 as compared
to $7,002,000 in 2000. This decline resulted from the drastic downturn in the
telecommunications industry over this same period of time. The majority of our
engineering design services were provided to companies involved in the
telecommunications industry. During the course of 2001, there was a significant
decline in demand for our services as customers reduced or eliminated product
development programs. This situation was also impacted by the inability of many
start-up organizations that utilized our services to obtain additional funding.

OUTLOOK FOR 2003 -

Net revenue from the sale of our defense electronic products has
increased in each of the last three years and we expect it to further increase
in 2003. Net revenue from these sales amounted to $5,036,000 in 2002. In the
first quarter of 2003 we received new orders for these products amounting to
approximately $4,000,000 and at March 31, 2003 our backlog of orders amounted to
approximately $3,200,000, as compared to approximately $500,000 at this same
time in 2002. Accordingly, we expect net revenues in 2003 to be significantly
higher than in 2002. We had expected net revenues in 2002 to be higher than they
were, primarily due to the anticipated commencement of full production in
certain programs that our products had been selected for. Our customers,
however, experienced delays in these programs and therefore delayed their orders
to us. We believe that certain of these delays have now been overcome and these
programs will contribute to our anticipated increase in net revenues in 2003.
However, there can be no assurance that this increase will occur or that there
will not be further delays in these and other programs.

Due to our increased working capital needs related to the increase in
orders and unexpected delays in completing financing arrangements in the first
quarter of 2003, we experienced delays in payments to some of our vendors. These
delays in payment temporarily affected our ability to complete orders. As a
result, revenues in the first quarter of 2003 are expected to be lower than we
had originally anticipated. Management believes that the financing arrangements
that have been concluded will alleviate the liquidity difficulties and that
revenues in the second quarter 2003 will increase significantly as compared to
the first quarter of 2003. However, if we are not successful in amending our
outstanding debt obligations in an acceptable manner, or if working capital
requirements increase further, the financing arranged to date may not be
sufficient for our needs.

Our ability to generate a profit from operations and to generate
positive cash flow from operations largely depends on the continued growth in
revenue from sales of defense electronics products. Our ability to achieve
higher levels of net revenue depends upon a number of factors, including
customer acceptance of

25

our products, including new and enhanced products, our ability to meet customer
demands as to product availability, price and performance, availability of
funding for programs in which our products will be deployed, the performance of
other companies who provide products or services to these programs and our
access to adequate working capital, as well as other factors that may not be
within our control (See Item 1 - Business - Risk Factors).

In order to execute our business plan we need access to capital. See
Liquidity and Capital Resources - Financing activities for a discussion of these
requirements and how we expect to meet them.

LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2002, we had cash and temporary investments of
$512,000, negative working capital of $2,440,000, funded debt of $4,947,000 and
other long-term liabilities of $1,100,000. For the year ended December 31, 2002,
cash flow used in operations amounted to $730,000.

Operating activities

Net cash applied in operations primarily reflects the operating loss of
$7,235,000, a gain of $6,300,000 from the settlement of litigation, net non-cash
charges of $2,785,000 and a decrease in working capital of $603,000. Significant
items contributing to these amounts are as follows:

o Inventory decreased $908,000.

o Accounts receivable decreased $415,000.

o Accounts payable and accrued liabilities decreased by $730,000

o Non-cash charges include the following:

o Utilization of prepaid services of $807,000

o Loss from unconsolidated affiliate of $582,000

o Accrued settlement obligation of $1,445,000

Investing activities

Cash flow from investing activities in 2002 includes $6,300,000 from
the settlement of the Cadence litigation and $1,243,000 of proceeds from the
sale of our engineering design services business.

Financing activities

During 2002 we raised $3,020,000 from the sale of common stock in
private placements. Of this amount, $2,000,000 was used to repay notes payable.
In addition, we reduced notes payable by an additional $1,355,000 from the
proceeds of the litigation settlement.

Subsequent to December 31, 2002, we have completed a series of
financing transactions and are seeking to complete other transactions and to
effect amendments to our credit agreements.

In January and March 2003, we completed private placement transactions
in which we issued a total of 4,166,667 shares of common stock and warrants for
the purchase of an additional 4,333,333 shares of common stock for aggregate
proceeds of $500,000. The warrants have an exercise price of $0.15 per share and
are exercisable at any time through March 31, 2007.

In March 2003, the Company and DNA-CS entered into a revolving line of
credit with a bank in order to provide working capital to DNA-CS. Under the
facility, DNA-CS may borrow up to $1,000,000. Outstanding amounts are due March
26, 2004; however, DNA-CS may extend the maturity date six months, provided
certain conditions are maintained. Interest is payable monthly at the greater of
prime plus 1% and 5.25%. At March 31, 2003 $600,000 was outstanding under this
facility. This working capital facility is secured by the accounts receivable
and inventory of DNA-CS, the guarantee of the Company and by limited guarantees
provided by certain private investors. As consideration for providing the
guarantees that secure

26

the Note the Company has entered into a Reimbursement Agreement with the
guarantors. The Reimbursement Agreement provides that the Company will reimburse
the investors for any amounts that may be required to reimburse the bank
pursuant to the guarantees. Pursuant to the Reimbursement Agreement and related
agreements, the investors have the right to purchase up to 8,333,333 shares of
the Company's common stock for $1,000,000 in cash, and the proceeds will be used
to repay amounts outstanding under the Note and provide for the release of the
guarantees. In addition, the investors have received warrants to purchase an
aggregate of 9,582,334 shares of the Company's common stock at a price of $0.15
per share. The warrants may be exercised at any time through March 31, 2007.

We also have had a series of discussions with potential financial and
strategic investors regarding additional financing activities. These activities
might include the repayment of all or a portion of our currently outstanding
debt, as well as providing us with additional working capital. These financing
activities might include the issuance of convertible preferred stock or
convertible debt securities. The discussions have not resulted in definitive
agreements or arrangements to date and there is no assurance that any additional
financing can be arranged on terms acceptable to all parties involved.

In connection with the financing activities described above, we have
been negotiating amendments to our credit agreements with Bank One NA ("Bank
One") and a private investor who has provided security to Bank One related to
these agreements. Currently, the Company has $1,500,000 outstanding under a Loan
Agreement with Bank One that is secured by the guarantee of the private
investor. These amounts were due January 31, 2003; however, Bank One has agreed
to extend the maturity to June 30, 2003. In addition, the Company has
outstanding $2,700,000 under a Credit Agreement with Bank One that is secured by
a letter of credit provided by this same private investor. Amounts outstanding
under this facility are due March 31, 2004, with periodic reductions beginning
April 30, 2003. The Company, Bank One and the private investor are currently
engaged in discussion to amend these agreements in order to extend the
maturities of these obligations. These discussions have not yet been concluded
and there is no assurance that the Company will be able to reach agreements
acceptable to all parties involved. If we are unable to reach agreements related
to our debt obligations and if we are unable to obtain required additional
working capital, it may have a material adverse effect on our operations.

Due to uncertainties regarding the restructuring or refinancing of our
outstanding debt and our access to other sources of capital, our auditors have
added an explanatory paragraph to their audit opinion that states there is
substantial doubt concerning our ability to continue as a going concern. Our
consolidated financial statements have been prepared on the basis that we are a
going concern and do not include any adjustments that might be necessary if this
were not the case. These adjustments include changes in the possible future
recoverability and classification of assets or the amount and classification of
liabilities.

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As discussed above we are obligated under various contracts and
commercial commitments. The following table summarizes these obligations:

Our estimate of capital needs is subject to a number of risks and
uncertainties that could result in additional capital needs that have not been
anticipated. An important aspect of our estimated capital requirements is our
ability to begin to generate positive cash flow from operations. As discussed
above, this in turn is dependent upon our ability to increase revenues from our
defense electronics business, to generate adequate gross profit from those sales
and to control other costs and expenses. Our capital needs could increase
materially if any of our contingent liabilities are resolved adversely to the
Company. In addition, we could require additional working capital if the defense
electronics business increases more rapidly than we currently anticipate.

Potential sources of additional capital include the sale of additional
debt or equity securities, other debt, such as bank debt, and the sale of
assets. A sale of additional securities could result in dilution to existing
common shareholders. There is no assurance that additional capital will be
available under terms which are acceptable.

Contingent liabilities

As discussed in Item 3 - "Legal Proceedings," we are exposed to certain
contingent liabilities which, if resolved adversely to us, could adversely
affect our liquidity, our results of operations, and/or our financial position.

CRITICAL ACCOUNTING POLICIES

We have identified the policies below as critical to our business
operations and the understanding of our results operations. The impact and any
associated risks related to these policies on our business operations is
discussed below. For a more detailed discussion on the application of these and
other accounting policies, see the Notes to the Consolidated Financial
Statements included in this Annual Report on Form 10-K. The preparation of
financial statements in accordance with generally accepted accounting principles
requires management to make estimates and assumptions that affect the reported
amount of assets, liabilities, revenue and expenses and the disclosure of
contingent assets and liabilities. There can be no assurance that the actual
results will not differ from those estimates.

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Estimates

Management has made estimates regarding the following matter which
could have a material effect on our consolidated financial statements:

o The recoverability of amounts due from ITI and any potential
impairment to our investment in ITI.

Inventories

Our inventories consist primarily of electronic components that are
subject to obsolescence and variations in market prices. We have adjusted the
amount of excess and obsolete inventory based on current and expected sales
trends, the number of parts on hand, the current market value for those parts
and the viability and potential technical obsolescence of the components.

Revenue recognition

We generally recognize revenue when our products are shipped to the
customer. This is normally the point when all of the following factors have been
achieved:

o Persuasive evidence of a sales arrangement exists, such as a
contract or binding purchase order,

o The product has been delivered to the customer,

o The price is fixed or determinable, and

o Collection of the resulting receivable is reasonably assured.

In some cases the product is shipped to a customer for evaluation or
testing. In such cases, revenue is not recognized until the customer has
evidenced intent to purchase the product by issuing a non-cancelable purchase
order to us for the product.

ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We have outstanding debt amounting to $4,200,000 that bears interest at
a variable interest rate. This interest rate is based on a widely used reference
interest rate known as LIBOR. An increase of 50 basis points in LIBOR would
result in an increase in our annual interest expense of $21,000.

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ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Report of Independent Certified Public Accountants ................. 31
Consolidated Balance Sheets ........................................ 32
Consolidated Statements of Operations .............................. 33
Consolidated Statements of Stockholders' Equity .................... 34
Consolidated Statements of Cash Flows .............................. 35
Notes to Consolidated Financial Statements ......................... 36

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REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

Board of Directors and Stockholders
TeraForce Technology Corporation

We have audited the accompanying consolidated balance sheets of TeraForce
Technology Corporation and subsidiaries as of December 31, 2002 and 2001, and
the related consolidated statements of operations, stockholders' equity
(deficit), and cash flows for each of the three years in the period ended
December 31, 2002. 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 auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes 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 financial statements referred to above present fairly, in
all material respects, the consolidated financial position of TeraForce
Technology Corporation and subsidiaries as of December 31, 2002 and 2001, and
the consolidated results of their operations and their consolidated cash flows
for each of the three years in the period ended December 31, 2002 in conformity
with accounting principles generally accepted in the United States of America.

The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As discussed in Note 3 to the
financial statements, the Company has incurred significant operating losses in
2002, 2001 and 2000. As of December 31, 2002, notes payable in the amount of
$4,047,000 are due within one year. The Company's continued existence is
dependent on restructuring or refinancing these obligations and continued access
to external sources of capital, none of which is assured. These matters raise
substantial doubt about the Company's ability to continue as a going concern.
Management's plans with respect to these matters are also discussed in Note 3.
The financial statements do not include any adjustments that might result from
the outcome of this uncertainty.

/s/ Grant Thornton LLP

Dallas, Texas
March 25, 2003

31

TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 2002 and 2001
(Thousands of dollars, except share data)

See accompanying notes to consolidated financial statements.

32

TERAFORCE TECHNOLOGY CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
(Thousands of dollars, except share data)