Company's trade receivables. A considerable amount of judgment is required in assessing the realization of these receivables, including the current creditworthiness of each customer and related aging of the past due balances. Management evaluates all accounts periodically and a reserve is established based on the best facts available to management. This reserve is also partially determined by using percentages applied to certain aged receivable categories based on historical results and is reevaluated and adjusted as additional information is received. After all attempts to collect a receivable have failed, the receivable is written off against the allowance for doubtful accounts. Allowance for Returns: The Company estimates its allowance for returns based upon expected return rates. The estimates of expected return rates are generally a factor of historical returns. Changes in return rates could impact allowance for return estimates.
Inventories: Inventories are valued at the lower of cost or market and include material, labor and manufacturing overhead. Cost is determined on a first-in, first-out basis. Valuing inventories at the lower of cost or market involves an inherent level of risk and uncertainty due to technology trends in the industry and customer demand for our products. In assessing the ultimate realization of inventories, management is required to make judgments as to future demand requirements and compare that with the current or committed inventory levels. Reserve requirements generally increase as projected demand decreases due to market conditions, technological and product life cycle changes as well as longer than previously expected usage periods. The Company has experienced significant changes in required reserves in the past due to changes in strategic direction, such as discontinuances of product lines as well as declining market conditions. It is possible that significant changes in this estimate may occur in the future as market conditions change.
Long-Lived Assets: Property and equipment and other long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Such determination is made in accordance with the applicable Generally Accepted Accounting Principles in the United States ("GAAP") requirements associated with the long-lived asset, and is based upon, among other things, estimates of the amount of future net cash flows to be generated by the long-lived asset and estimates of the current fair value of the asset. Adverse changes in such estimates could result in an inability to recover the carrying value of the long-lived asset, thereby possibly requiring an impairment charge to be recognized in the future. All impairments are recognized in operating results when a permanent reduction in value occurs. Fair Value of Financial Instruments: Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 157, "Fair Value Measurements" which defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and expands disclosures about fair value measurements. SFAS No. 157 defines fair value as the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Stock-Based Compensation: The Company accounts for stock-based compensation under the provisions of SFAS No. 123(R), "Share-Based Payments." SFAS No. 123(R) superseded Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), and revises guidance in SFAS No. 123, "Accounting for Stock-Based Compensation."

Tax Assessments: The Company is periodically engaged in various tax audits by federal, state and foreign governmental authorities incidental to its business activities. The Company records reserves for its estimated probable losses of these proceedings, if applicable.
Income Taxes: The Company records a valuation allowance to reduce its deferred income tax assets to the amount that is believed to be realizable under the guidance of SFAS No. 109, "Accounting for Income Taxes." The Company considers recent historical losses, future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. Management is required to make a continuous assessment as to the realizability of the deferred tax assets. The Company adopted the provisions of Financial Accounting Standards Board ("FASB") Interpretation No. 48, "Accounting for Uncertainty in Income Taxes" ("FIN 48"), on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes within financial statements. Under FIN 48, the impact of an uncertain tax position taken or expected to be taken on an income tax return must be recognized in the financial statements at the amount that is more likely than not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized in the financial statements unless it is more likely than not of being sustained.

CONSOLIDATED STATEMENT OF OPERATIONS AS A PERCENTAGE OF REVENUE

                                                   Year ended December 31,
                                                2008         2007         2006

           Revenues                            100.0 %      100.0 %      100.0 %
           Cost of sales                        46.5 %       42.8 %       45.7 %


           Gross margin                         53.5 %       57.2 %       54.3 %

           Research and development             35.1 %       33.2 %       24.6 %
           Sales and marketing                  20.0 %       18.2 %       16.2 %
           General and administrative           15.6 %       15.2 %       11.8 %
           Restructuring charge                  1.5 %          -            -


           (Loss) income from operations       (18.7 )%      (9.5 )%       1.7 %


           Interest income, net                  2.0 %        2.5 %        1.9 %
           Other income, net                     0.4 %        1.2 %        1.4 %


           (Loss) income before income tax     (16.3 )%      (5.9 )%       5.0 %
           Income tax benefit                   (4.8 )%      (2.0 )%      (1.2 )%


           Net (loss) income                   (11.5 )%      (3.9 )%       6.2 %

OVERVIEW
2008 was a year of considerable challenge for Interphase. A slowdown in all of the major economies throughout the world has stagnated deployments of telecommunications equipment and services, and this has led to a commensurate slowdown in our business activity in supplying the large tier I TEMs. The product demand picture in 2008 was very difficult to predict and the telecommunications industry as a whole has struggled. We have worked very hard to manage our resources and working capital in an effort to maintain a strong balance sheet for these uncertain times. We reduced spending early in the year in an effort to conserve cash as the market picture grew dimmer, and reallocated resources toward high value opportunities throughout the year. As we look to 2009, we have a number of new revenue generating design wins which we believe will bolster our revenues in the relatively near term.
RESULTS OF OPERATIONS
Revenues: Total revenues for the years ended December 31, 2008, 2007 and 2006 were $26.2 million, $30.8 million and $33.4 million, respectively. Revenues decreased by 15% in 2008 compared to 2007. This decrease was primarily attributable to our broadband telecom revenues which decreased by 11% to $23.2 million in 2008 from $26.1 million in 2007. The global economic slowdown had an impact on our customers and resulted in a significant telecommunications market slowdown. In addition, as expected our enterprise product line revenues decreased by 74% to $867,000 for 2008 compared to $3.4 million in 2007. All other revenues, composed primarily of professional services, cancellation charges and storage products increased 60% to $2.1 million in 2008 compared to $1.3 million in 2007. We had a one-time cancellation fee of $973,000 included in other revenue during 2008 for unique customer requirements for product development work that was discontinued. There were no similar fees earned in 2007.
Revenues decreased by 8% in 2007 compared to 2006. This decrease was primarily attributable to our enterprise product revenues. As expected, enterprise product revenues decreased approximately 29% to $3.4 million in 2007 from $4.7 million in 2006. In addition to our enterprise product revenue decrease, broadband telecom revenues decreased by approximately 2% to $26.1 million in 2007 from $26.5 million in 2006 primarily as a result of the significant reduction in revenues experienced in the first quarter of 2007 due to the general telecommunications market slowdown, which included the impact of the merger activity experienced in the businesses of our top tier I customers. All other revenues, composed primarily of storage products, professional services, project cancellation charges and raw material sales, decreased by approximately 38% to $1.3 million for the year ended December 31, 2007 compared to $2.2 million for the year ended December 31, 2006. Included in all other revenues for the year ended December 31, 2006 was approximately $400,000 of raw material parts sold at cost, which reduced our exposure to potential excess and obsolete inventory charges and approximately $600,000 of project cancellation charges, neither of which occurred in 2007.
Gross Margin: Gross margin as a percentage of revenue for the years ended December 31, 2008, 2007 and 2006 was 53%, 57% and 54%, respectively. The decrease in gross margin percentage in 2008 compared to 2007 is primarily driven by product mix as we saw an increase in purchases of our lower margin products within our broadband telecom product portfolio. Also, contributing to the decrease in our gross margin percentage was a decrease in factory utilization in 2008 compared to 2007. The negative factors to our gross margin were partially offset by a reduction in excess and obsolete inventory charges, as we recorded $200,000 in excess and obsolete inventory charges for the year ended December 31, 2008 compared to $300,000 for the year ended December 31, 2007. Approximately 75% of the 2008 excess

and obsolete inventory charges was the result of stranded inventory related to a future project, cancelled by Nortel Networks in connection with their reorganization under Chapter 11 in late January 2009. We believe that pricing pressures in the industry may continue to dampen our gross margin percentage in future periods and it may become increasingly challenging to offset these pressures with incremental supplier cost reductions and factory productivity improvements.
The increase in gross margin percentage in 2007 compared to 2006 is primarily driven by product mix as our higher margin broadband telecom products accounted for approximately 85% of our revenue compared to 79% in the preceding year. We recorded $300,000 in excess and obsolete inventory charges for the year ended December 31, 2007 compared to $500,000 for the year ended December 31, 2006. The $200,000 reduction in excess and obsolete inventory charges was partially offset by reduced plant utilization.
Research and Development: Our investment in the development of new products through research and development was $9.2 million, $10.2 million and $8.2 million in 2008, 2007 and 2006, respectively. As a percentage of revenue, research and development expenses were 35%, 33% and 25% for 2008, 2007 and 2006, respectively. Research and development expenses decreased in 2008 compared to 2007 by approximately $1.0 million. The decrease in research and development expense is primarily due to the restructuring plan we undertook in the first quarter of 2008 (See Note 8 in the Notes to the Consolidated Financial Statements for more information). The reduced headcount and facility expense resulted in a decrease in research and development expense of approximately $769,000. In addition, we reduced our project related headcount expense by approximately $535,000 in 2008 compared to 2007. These two factors were partially offset by the impact that the Euro to Dollar exchange rate had on research and development expense. Much of our research and development resources are located in France and as such those costs are subject to exchange rate fluctuations with the Euro and the Dollar. The Euro was stronger against the Dollar in 2008 compared to 2007. This exchange rate fluctuation resulted in an increase to research and development expense of approximately $345,000. We anticipate that spending on research and development will begin to level in the near future as a result of the restructuring plan we undertook in the first quarter of 2008, subject to fluctuations in currency exchange rates. We will continue to take steps, when appropriate to attempt to mitigate the impact of currency exposure by strategically acquiring foreign exchange contracts to purchase a fixed amount of Euros on a specific date in the future at a predetermined rate established by contract (see Item 7A - Foreign Currency Risk). In addition to our foreign exchange contracts, our total cost of performing research and development activities in France is reduced by the effect of a 30% research and development tax credit offered by the French tax administration. See Note 7 in the Notes to the Consolidated Financial Statements for more information. The increase in research and development expense as a percentage of total revenue is due to revenue decreasing at a higher rate than research and development expense. We will continue to monitor the level of our investments in research and development concurrently with actual revenue results.
Research and development expenses increased in 2007 compared to 2006 by approximately $2.0 million. Approximately 52% of this increase was due to our strategic reinvestment in the area of project related research and development activities on a variable basis. The weaker dollar relative to the Euro in 2007 contributed approximately 26% to our increase in research and development expense. Additionally, there was an expense of approximately $220,000 or 11% related to the write-off of a previously capitalized software license related to a product that was subsequently discontinued. The increase in research and development expense as a percentage of total revenue is due to revenue decreasing while research and development costs increased.

Sales and Marketing: Sales and marketing expenses were $5.2 million, $5.6 million and $5.4 million in 2008, 2007 and 2006, respectively. As a percentage of revenue, sales and marketing expenses were 20%, 18% and 16% for 2008, 2007 and 2006, respectively. Sales and marketing expenses decreased approximately $400,000 in 2008 compared to 2007. The decrease in sales and marketing expense is primarily due to the restructuring plan we undertook in the first quarter of 2008 (See Note 8 in the Notes to the Consolidated Financial Statements for more information). The reduced headcount expense resulted in a decrease in sales and marketing expense of approximately $385,000. Additionally, we saw a decrease in variable sales compensation of approximately $95,000 due to the decrease in revenue in 2008 compared to 2007. The reductions were partially offset by approximately $125,000 as a result of the stronger Euro against the Dollar in 2008 compared to 2007. The increase in sales and marketing expenses as a percentage of total revenue is due to revenue decreasing at a higher rate than sales and marketing expenses.
Sales and marketing expenses were relatively flat in 2007 compared to 2006. The increase in sales and marketing expenses as a percentage of total revenue is due to revenue decreasing while sales and marketing costs increased slightly. General and Administrative: General and administrative expenses were $4.1 million, $4.7 million and $3.9 million in 2008, 2007 and 2006, respectively. As a percentage of revenue, general and administrative expenses were 16%, 15% and 12% in the years ended December 31, 2008, 2007 and 2006, respectively. General and administrative expenses decreased approximately $600,000 in 2008 compared to 2007. The decrease in general and administrative expenses is primarily due to the reduction in utilization of outside consulting, legal and accounting services of approximately $330,000. In addition, the organizational changes related to our French subsidiary, which were completed in 2007, resulted in reduced expenses of approximately $250,000 in 2008. The increase in general and administrative expenses as a percentage of total revenues is due to revenue decreasing at a higher rate than general and administrative expenses.
General and administrative expenses increased approximately $770,000 in 2007 compared to 2006. The increase in general and administrative expenses related to a number of factors including some organizational changes related to our French subsidiary which accounted for approximately 58% of the increase. An additional 17% of the increase related to our use of outside services as part of our first year management assessment for Sarbanes-Oxley Section 404 compliance. Finally, we began incurring additional support costs and amortization expense in 2007 related to our new Enterprise Performance Management system installed in the second quarter of 2007 which was approximately 12% of the increase. The increase in general and administrative expenses as a percentage of total revenue is due to revenue decreasing while general and administrative costs increased. Restructuring Charge: On March 27, 2008, we adopted a plan to restructure our United States based business operations to balance our current spending with recent revenue trends. The primary goal of the restructuring program was to improve our ability to invest in future business opportunities that are designed to provide us with increased growth potential and greater revenue diversification in the coming years and better align our skills with our future direction. Under the restructuring plan, we reduced our workforce by 14 employees. As a result of the restructuring program, we recorded a restructuring charge of $403,000, classified as an operating expense in 2008 (See Note 8 of the accompanying Notes to the Consolidated Financial Statements for more information). There were no such activities in 2007 or 2006.

Interest Income, Net: Interest income, net of interest expense, was $526,000, $764,000 and $637,000 in 2008, 2007 and 2006, respectively. The decrease in interest income, net of interest expense in 2008 compared to 2007 is primarily due to a lower average investment balance in 2008 when compared to 2007. In addition, we experienced lower investment rates of return in 2008 compared to 2007. The increase in interest income, net of interest expense in 2007 compared to 2006 is primarily due to an increase in the investment rates of return in 2007 compared to 2006.
Other Income, Net: Other income, net was $92,000, $364,000 and $475,000 in 2008, 2007 and 2006, respectively. Other income, net in 2008, 2007 and in 2006 is primarily due to the change in market value of our foreign exchange derivative financial instruments which resulted in a gain of approximately $130,000, $346,000 and $442,000 for the years ended December 31, 2008, 2007 and 2006, respectively. See Note 5 of the accompanying Notes to the Consolidated Financial Statements for more information regarding our derivative financial instruments. Income Taxes: The effective income tax rates for the periods presented differ from the U.S. statutory rate as we continue to provide a full valuation allowance for our net deferred tax assets at December 31, 2008, 2007, and 2006. The effective income tax benefit rate for 2008 was 29%. This income tax benefit was primarily due to a research and development tax credit earned by our operations in France that increased for 2008 to 30% from the previous rate of 10% used for 2007. During 2008, the benefit from the research and development tax credit was partially offset by tax expense related to income generated in France due to the impact of foreign currency fluctuations.
The effective income tax benefit rate for 2007 was 34%. Approximately 78% of this income tax benefit was due to a 10% research and development tax credit earned by our operations in France. The remainder of the tax benefit was the result of a previously unrecognized benefit in the U.S. which had been pending the expiration of the statute of limitations on the 2003 tax return related to a transfer pricing arrangement with our foreign subsidiary.
The effective income tax benefit rate for 2006 was 24%. This income tax benefit was primarily due to a 10% research and development tax credit earned by our operations in France.
Net (Loss) Income: We reported a net loss of approximately $3.0 million and $1.2 million for the twelve months ended December 31, 2008 and 2007, respectively. We reported net income of approximately $2.1 million for the twelve months ended December 31, 2006.
LIQUIDITY AND CAPITAL RESOURCES
Consolidated Cash Flows
Cash and cash equivalents increased by $999,000 for the year ended December 31, 2008. Cash and cash equivalents decreased $2.7 million for the year ended December 31, 2007. Cash and cash equivalents increased $5.9 million for the year ended December 31, 2006.
Operating Activities: Trends in cash flows from operating activities for 2008, 2007 and 2006, are generally similar to the trends in our earnings except for provision for uncollectible accounts and returns, provision for excess and obsolete inventories, depreciation and amortization, amortization of restricted stock and write-off of impaired capitalized software. Cash used in operating activities totaled $805,000

for the year ended December 31, 2008, compared to a net loss of $3.0 million. Cash used in operating activities totaled $2.5 million for the year ended December 31, 2007, compared to a net loss of $1.2 million. Cash provided by operating activities totaled $4.6 million for the year ended December 31, 2006, compared to net income of $2.1 million. Provisions for uncollectible accounts and returns decreased during 2008 as we experienced strong collection efforts throughout the year and improved returns experience. Provisions for uncollectible accounts and returns increased during 2007 due to a shift in our customer base requiring longer payment terms, which resulted in additional requirements for a reserve against potential uncollectible accounts. Provision for excess and obsolete inventories decreased by $100,000 for 2008 compared to 2007. Provision for excess and obsolete inventories decreased by $200,000 for 2007 compared to 2006. Depreciation and amortization decreased by approximately $48,000 in 2008, primarily related to portions of our manufacturing line equipment becoming fully depreciated during the year. Depreciation and amortization increased by approximately $220,000 in 2007 primarily due to the increased depreciation related to a new Enterprise Performance Management system. Amortization of restricted stock remained relatively consistent in 2008 compared to 2007. Amortization of restricted stock increased approximately $80,000 for 2007 compared to 2006 due to the cumulative effect of restricted . . .