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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 
 FORM 10-Q 
 For the Quarter Ended September 30, 2004 Commission file number 0-50289 
 Brillian Corporation 
  Delaware
    
    05-0567906(State or Other Jurisdiction
    
    (I.R.S. Employer Identification No.)of Incorporation or Organization)
 1600 North Desert Drive, Tempe, Arizona
    
    85281(Address of Principal Executive Offices)
    
    (Zip Code)
 (602) 389-8888 
  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 whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
YES [  ]  NO [ X ] Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the latest practical date. CLASS
    
    
    OUTSTANDING AS OF OCTOBER 31, 2004Common
    
    
    6,941,432




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BRILLIAN CORPORATION
QUARTERLY REPORT ON FORM 10-Q
FOR QUARTER ENDED SEPTEMBER 30, 2004
TABLE OF CONTENTS PagePART I  FINANCIAL INFORMATIONITEM 1. FINANCIAL STATEMENTS:Condensed Balance Sheets (unaudited)  September 30, 2004 and December 31, 2003
    
    
    1Condensed Statements of Operations (unaudited)  Three Months and Nine Months Ended September 30, 2004 and 2003
    
    
    2Condensed Statements of Cash Flows (unaudited)  Nine Months Ended September 30, 2004 and 2003
    
    
    3Notes to Condensed Financial Statements
    
    
    4ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
    
    
    10ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
    
    
    19ITEM 4. CONTROLS AND PROCEDURES
    
    
    19PART II  OTHER INFORMATIONITEM 5. OTHER INFORMATION
    
    
    20ITEM 6. EXHIBITS
    
    
    20SIGNATURES
    
    
    21Exhibit 10.10Exhibit 31.1Exhibit 31.2Exhibit 32.1Exhibit 32.2




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PART I  FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS BRILLIAN CORPORATION 
 CONDENSED BALANCE SHEETS
 SEPTEMBER 30,
    DECEMBER 31,2004
    2003ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    10,016
    
    
    $
    2,417Short-term investments
    
    
    13
    
    
    
    12,000Accounts receivable, net
    
    
    709
    
    
    
    447Inventories
    
    
    4,859
    
    
    
    2,735Other current assets
    
    
    667
    
    
    
    828Total current assets
    
    
    16,264
    
    
    
    18,427Property, plant and equipment, net
    
    
    7,431
    
    
    
    6,267Intangibles, net
    
    
    8,756
    
    
    
    8,768Other investments
    
    
    6,200
    
    
    
    6,331Total Assets
    
    $
    38,651
    
    
    $
    39,793LIABILITIES AND STOCKHOLDERS EQUITYCurrent Liabilities:Accounts payable
    
    $
    2,382
    
    
    $
    457Accrued compensation
    
    
    516
    
    
    
    84Accrued liabilities
    
    
    761
    
    
    
    676Deferred revenue
    
    
    129
    
    
    
    21Total current liabilities
    
    
    3,788
    
    
    
    1,238Commitments and ContingenciesStockholders Equity:Common stock
    
    
    7
    
    
    
    5Additional paid-in capital
    
    
    58,007
    
    
    
    45,708Deferred compensation
    
    
    (696
    )
    
    
    (1,265
    )Accumulated deficit
    
    
    (22,455
    )
    
    
    (5,893
    )Total stockholders equity
    
    
    34,863
    
    
    
    38,555Total Liabilities and Stockholders Equity
    
    $
    38,651
    
    
    $
    39,793
 The accompanying notes are an integral part of these condensed financial statements. 1




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BRILLIAN CORPORATION 
 CONDENSED STATEMENTS OF OPERATIONS
 Three Months
    
    Nine MonthsEnded September 30,
    
    Ended September 30,2004
    
    2003
    
    2004
    
    2003Net product sales
    
    $
    673
    
    
    $
    602
    
    
    $
    2,048
    
    
    $
    1,411Design and engineering services
    
    
    60
    
    
    
    101
    
    
    
    297
    
    
    
    423Total net sales
    
    
    733
    
    
    
    703
    
    
    
    2,345
    
    
    
    1,834Costs and Expenses:Cost of sales  products
    
    
    4,338
    
    
    
    2,279
    
    
    
    9,186
    
    
    
    6,814Cost of sales  design and engineering services
    
    
    31
    
    
    
    97
    
    
    
    220
    
    
    
    380Selling, general, and administrative
    
    
    508
    
    
    
    1,169
    
    
    
    2,701
    
    
    
    3,434Research and development
    
    
    2,225
    
    
    
    1,814
    
    
    
    6,783
    
    
    
    5,2117,102
    
    
    
    5,359
    
    
    
    18,890
    
    
    
    15,839Operating loss
    
    
    (6,369
    )
    
    
    (4,656
    )
    
    
    (16,545
    )
    
    
    (14,005
    )Other Income (Expense):Interest, net
    
    
    47
    
    
    
    14
    
    
    
    155
    
    
    
    14Realized loss on short-term investment
    
    
    
    
    
    
    
    
    
    
    (41
    )
    
    
    Loss on investment in start-up company
    
    
    
    
    
    
    
    
    
    
    (131
    )
    
    
    47
    
    
    
    14
    
    
    
    (17
    )
    
    
    14Loss before income taxes
    
    
    (6,322
    )
    
    
    (4,642
    )
    
    
    (16,562
    )
    
    
    (13,991
    )Benefit from income taxes
    
    
    
    
    
    
    160
    
    
    
    
    
    
    
    160Net loss
    
    $
    (6,322
    )
    
    $
    (4,482
    )
    
    $
    (16,562
    )
    
    $
    (13,831
    )Loss per Common Share:Basic and diluted
    
    $
    (0.91
    )
    
    $
    (0.84
    )
    
    $
    (2.69
    )
    
    $
    (2.59
    )Weighted Average Number of Common Shares:Basic and diluted
    
    
    6,931
    
    
    
    5,333
    
    
    
    6,168
    
    
    
    5,333
 The accompanying notes are an integral part of these condensed financial statements. 2




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BRILLIAN CORPORATION 
 CONDENSED STATEMENTS OF CASH FLOWS
 Nine Months EndedSeptember 30,2004
    
    2003Cash Flows from Operating Activities:Net loss
    
    $
    (16,562
    )
    
    $
    (13,831
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization
    
    
    2,714
    
    
    
    2,683Stock compensation
    
    
    600
    
    
    
    67Deferred revenue
    
    
    108
    
    
    
    (263
    )Provision for doubtful accounts
    
    
    10
    
    
    
    Deferred income taxes
    
    
    
    
    
    
    (160
    )Loss on investment in start-up company
    
    
    131
    
    
    
    Changes in assets and liabilities:Increase in accounts receivable
    
    
    (272
    )
    
    
    (226
    )Increase in inventories
    
    
    (2,124
    )
    
    
    (264
    )(Increase) decrease in other assets
    
    
    161
    
    
    
    (338
    )Increase in accounts payable and accrued liabilities
    
    
    2,442
    
    
    
    243Net cash used in operating activities
    
    
    (12,792
    )
    
    
    (12,089
    )Cash Flows from Investing Activities:Purchases of property, plant, and equipment
    
    
    (2,980
    )
    
    
    (334
    )Proceeds from sale of assets
    
    
    
    
    
    
    114Purchase of intangibles
    
    
    (886
    )
    
    
    (337
    )Purchase of investments
    
    
    (79
    )
    
    
    Proceeds from maturities/sales of short-term investments
    
    
    12,066
    
    
    
    Net cash provided by (used in) investing activities.
    
    
    8,121
    
    
    
    (557
    )Cash Flows from Financing Activities:Net transfers from TFS
    
    
    
    
    
    
    11,317Cash transfer from TFS at spin-off
    
    
    
    
    
    
    20,853Proceeds of public stock offering
    
    
    11,969
    
    
    
    Issuance of shares related to Employee Stock Purchase Plan
    
    
    241
    
    
    
    Stock options exercised
    
    
    60
    
    
    
    13Net cash provided by financing activities
    
    
    12,270
    
    
    
    32,183Net increase in cash and cash equivalents
    
    
    7,599
    
    
    
    19,537Cash and cash equivalents, beginning of period
    
    
    2,417
    
    
    
    Cash and cash equivalents, end of period
    
    $
    10,016
    
    
    $
    19,537
 The accompanying notes are an integral part of these condensed financial statements. 3




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BRILLIAN CORPORATION 
 NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED)
 Note A Organization and Basis of Presentation We design and develop large-screen, rear-projection,
high-definition televisions, or HDTVs, utilizing our proprietary
liquid crystal on silicon, or LCoS®, microdisplay technology. We
market our HDTVs for sale under the brand names of retailers,
including consumer electronics retailers, consumer retail stores,
personal computer manufacturers, and high-end audio/video
manufacturers. We have established a virtual manufacturing model
utilizing third-party contract manufacturers to produce our HDTVs,
which incorporate the LCoS microdisplays that we manufacture. We
also offer a broad line of LCoS microdisplay products and
subsystems that original equipment manufacturers, or OEMs, can
integrate into proprietary HDTV products, home theater projectors,
and near-to-eye applications, such as head-mounted monocular or
binocular headsets and viewers, for industrial, medical, military,
commercial, and consumer applications. Historically, we operated as a division of Three-Five Systems,
Inc., or TFS. On March 17, 2003, TFS announced that its board of
directors had approved a decision to incorporate us as a wholly
owned subsidiary of TFS, to transfer our business and assets into
this subsidiary, and to distribute the common stock of this
subsidiary to its stockholders in a spin-off. We were formed on
May 7, 2003 in anticipation of this spin-off. The spin-off was
completed on September 15, 2003 as a special dividend to the
stockholders of TFS. On September 1, 2003, we and TFS entered into a Master Separation
and Distribution Agreement under which TFS transferred to us
substantially all of the assets of, and we assumed substantially
all of the corresponding liabilities of, TFS microdisplay
business. On September 15, 2003, TFS distributed all outstanding
shares of Brillian common stock owned by TFS to TFS stockholders as
a dividend (the spin-off). Each TFS stockholder of record as of
September 4, 2003 received one share of our stock for every four
shares of TFS common stock owned. In addition, we entered into
ancillary agreements that govern various ongoing relationships
between us and TFS. In connection with the spin-off, TFS received
a ruling from the Internal Revenue Service, or the IRS, that the
spin-off would be tax free. In connection with the spin-off, TFS
provided initial cash funding in the amount of $20.9 million, net
of $1.1 million of spin-off related costs incurred prior to the
spin-off. On May 14, 2004, we completed an underwritten public offering of
1.5 million shares of our common stock at a public offering price
of $9.00 per share. We received net proceeds from the offering of
approximately $12.0 million. The accompanying unaudited Condensed Financial Statements have been
prepared in accordance with accounting principles generally accepted in
the United States for interim financial information and the instructions
to Form 10-Q. Accordingly, they do not include all the information and
footnotes required by accounting principles generally accepted in the
United States for complete financial statements. In our opinion, all
adjustments, which include only normal recurring adjustments, necessary
to present fairly the financial position, results of operations, and cash
flows for all periods presented have been made. The results of operations
for the three-month and nine-month periods ended September 30, 2004 are
not necessarily indicative of the operating results that may be expected
for the entire year ending December 31, 2004. These financial statements
should be read in conjunction with our December 31, 2003 financial
statements included in our Annual Report on Form 10-K and the
accompanying notes thereto. The financial statements for periods prior to the spin-off have been
prepared using TFS historical basis in the assets and liabilities and
the historical results of operations of Brillian. 4




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Note BInventories consisted of the following (in thousands): September 30,
    
    December 31,2004
    
    2003Raw
materials
    
    $
    3,515
    
    
    $
    2,473Work-in-process
    
    
    860
    
    
    
    51Finished
goods
    
    
    484
    
    
    
    211$
    4,859
    
    
    $
    2,735
 Note CProperty, plant, and equipment consisted of the following (in
thousands): September 30,
    
    December 31,2004
    
    2003Leasehold improvements
    
    $
    977
    
    
    $
    971Equipment
    
    
    16,453
    
    
    
    13,495Furniture
    
    
    78
    
    
    
    6217,508
    
    
    
    14,528Less accumulated depreciation
    
    
    (10,077
    )
    
    
    (8,261
    )$
    7,431
    
    
    $
    6,267
 Note DIntangibles: Intangibles consist of mask works, patents, licenses, and other
intangible assets acquired from third parties. Intangibles are recorded
at cost and amortized using the straight-line method over the estimated
useful lives of the respective assets, which range from two to five
years. Intangible assets consisted of the following at September 30, 2004 (in
thousands): Gross Carrying
    
    Accumulated
    
    BookAmount
    
    Amortization
    
    ValueAmortized Intangible Assets:Mask works
    
    
    $
    6,491
    
    
    
    
    
    $
    (2,208
    )
    
    $
    4,283Patents, patents pending, and other
intangible assets
    
    
    
    3,994
    
    
    
    
    
    
    (653
    )
    
    
    3,341Licenses
    
    
    
    2,954
    
    
    
    
    
    
    (1,822
    )
    
    
    1,132$
    13,439
    
    
    
    
    
    $
    (4,681
    )
    
    $
    8,756
 Intangible assets consisted of the following at December 31, 2003 (in
thousands): Gross Carrying
    
    Accumulated
    
    BookAmount
    
    Amortization
    
    ValueAmortized Intangible Assets:Mask works
    
    $
    5,839
    
    
    $
    (2,206
    )
    
    $
    3,633Patents, patents pending, and other
intangible assets
    
    
    3,758
    
    
    
    (198
    )
    
    
    3,560Licenses
    
    
    2,954
    
    
    
    (1,379
    )
    
    
    1,575$
    12,551
    
    
    $
    (3,783
    )
    
    $
    8,768
 5




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Intangible asset amortization expense for the nine months ended September
30, 2004 was $898,000 compared with $1.0 million for the nine months
ended September 30, 2003. Estimated future annual amortization expense
through 2008 and thereafter related to intangible assets reported as of
September 30, 2004 is as follows (in thousands): Fiscal Year
    
    Amount2004
    
    $
    3042005
    
    
    2,7142006
    
    
    2,6142007
    
    
    2,2102008
    
    
    621Thereafter
    
    
    293$
    8,756
 Note E  Loss per Share Basic and diluted loss per common share was computed by dividing net loss by the weighted average number of shares of
common stock outstanding during the three- and nine-month periods ended September 30, 2004. For the three- and
nine-month periods ended September 30, 2004, the effect of approximately 1.6 million stock options was excluded from the
calculation of diluted loss per share as their effect would have been antidilutive and would have decreased the loss per
share. Per share information presented for the three- and nine-month periods ended September 30, 2003 was calculated based on
the number of shares issued in the spin-off. The calculation of loss per share for this period assumed that the common
            shares were outstanding for the entire period. Note F  Segment Reporting, Sales to Major Customers, and Geographic Information SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information establishes standards for the reporting by public business
enterprises of information about operating segments, products and
services, geographic areas, and major customers. Because the products we sell for use in near-to-eye and projection
devices share the same underlying technology and have similar economic
characteristics, production processes, and customer types, we operate and
report internally as one segment in accordance with SFAS No. 131. All of
our assets are located in the United States. Projection device sales for the three-month period ended September 30,
2004 were $526,000, or 72% of sales, while near-to-eye sales were
$207,000, or 28% of sales. During the three-month period ended September
30, 2003, projection device sales were $385,000, or 55% of sales, and
near-to-eye sales were $318,000, or 45% of sales. Projection device sales for the nine-month period ended September 30,
2004 were $1.2 million, or 54% of sales, while near-to-eye sales were
$1.1 million, or 46% of sales. During the nine-month period ended
September 30, 2003, projection device sales were $1.1 million, or 60% of
sales, and near-to-eye sales were $738,000, or 40% of sales. For the three months ended September 30, 2004, sales to Sears, I-O
Display Systems, and Zhejiang Jincheng accounted for approximately 32%,
17%, and 16%, respectively, of our net sales. For the three months ended
September 30, 2003, sales to Kodak, Kaiser, and Brashear accounted for
approximately 23%, 19%, and 7%, respectively, of our net sales. For the nine months ended September 30, 2004, sales to I-O Display
Systems, TQ Systems, Zhejiang Jincheng, Kodak, and Sears accounted for
approximately 21%, 19%, 13%, 12%, and 10%, respectively, of our 6




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net sales. For the nine months ended September 30, 2003, sales to TQ
Systems, Kaiser Electronics, and Brashear LP accounted for approximately
14%, 12%, and 10%, respectively, of our net sales. We also track net sales by geographic location. Net sales by geographic
area are determined based upon the location of the end customer. The
following sets forth net sales (in thousands) for our geographic areas: NorthAmerica
    
    Asia
    
    Europe
    
    TotalThree months ended
September 30, 2004Net sales
    
    $
    499
    
    
    $
    142
    
    
    $
    92
    
    
    $
    733Three months ended
September 30, 2003Net sales
    
    $
    229
    
    
    $
    155
    
    
    $
    319
    
    
    $
    703Nine months ended
September 30, 2004Net sales
    
    $
    1,246
    
    
    $
    491
    
    
    $
    608
    
    
    $
    2,345Nine months ended
September 30, 2003Net sales
    
    $
    925
    
    
    $
    372
    
    
    $
    537
    
    
    $
    1,834
 Note G Transactions with TFS Prior to the spin-off, our costs and expenses included allocations from
TFS for centralized legal, accounting, treasury, quality assurance, real
estate, information technology, engineering, and other TFS corporate
services and infrastructure costs. These allocations were determined on
the basis that we and TFS considered to be reasonable reflections of the
utilization of services provided to, or the benefits received by, us.
Allocated costs included in our cost of sales totaled $301,000 and $1.1
million for the three- and nine-month periods ended September 30, 2003.
Allocated costs included in selling, general, and administrative expenses
totaled $45,000 and $1.5 million for the three- and nine-month periods
ended September 30, 2003. Allocated costs included in our research and
development expenses totaled $207,000 and $795,000 for the three- and
nine-month periods ended September 30, 2003. The basis for the amounts
allocated to us included the following: legal, accounting, treasury,
quality assurance, and other TFS corporate functions, including officers
salaries, were allocated based on managements estimation of time devoted
to the microdisplay business for these functions; facility costs and
information technology services were allocated on the basis of headcount
of the microdisplay business, which is most representative of utilization
of these resources; and engineering services were allocated to us based
on the actual hours of services used. The allocation methodologies
utilized represent managements best estimate of the actual hours
utilized by the microdisplay business of TFS. On the spin-off date, we and TFS entered into a series of agreements to
facilitate our separation from TFS. These agreements included certain
transitional services, leases, intellectual property transfers, and tax
sharing agreements. These agreements require us to pay a negotiated fee.
We paid TFS $225,000 and $659,000 for rent and IT management services in
the three- and nine-month periods ended September 30, 2004, and $41,000
and $149,000 for engineering services in the same periods. In addition,
we paid $497,000 and $1.1 million for engineering and design services
related to the development of printed circuit board assemblies and for
purchases of these assemblies for our HDTV product during the three- and
nine-month periods ended September 30, 2004. Tax Sharing Agreement Under the Tax Sharing Agreement, we have agreed to indemnify TFS against
any taxes (other than Separation Taxes) that are attributable to us since
our formation, even while we were a member of TFS federal 7




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consolidated tax group. TFS has indemnified us against any taxes (other
than Separation Taxes) that are attributable to the businesses retained
by TFS. The Tax Sharing Agreement sets forth rules for determining taxes
attributable to us and taxes attributable to the businesses retained by
TFS. We have agreed not to take any action that would cause the spin-off not
to qualify under Section 355 of the Internal Revenue Code of 1986, as
amended (the Code). We have agreed not to take certain actions for two
years following the spin-off unless we obtain an IRS ruling or an opinion
of counsel to the effect that these actions will not affect the tax-free
nature of the spin-off. These actions include certain issuances of our
stock, a liquidation or merger of our company, and dispositions of assets
outside the ordinary course of our business. If any of these
transactions were to occur, the spin-off could be deemed to be a taxable
distribution to TFS. This would subject TFS to a substantial tax
liability. We have agreed to indemnify TFS and its affiliates to the
extent that any action we take or fail to take gives rise to a tax
incurred by TFS or any of its affiliates with respect to the spin-off.
In addition, we have agreed to indemnify TFS for any tax resulting from
an acquisition by one or more persons of a 50% or greater interest in our
company. Transition Services Agreement We and TFS have entered into a Transition Services Agreement under which
TFS provides to us certain administrative services that may be necessary
to our business. The most significant service that TFS provides to us
relates to document control. TFS charges us mutually agreed upon hourly
rates for these services. This agreement expired on August 31, 2004. Intellectual Property Agreement We and TFS have entered into an Intellectual Property Agreement under
which we granted to TFS a nonexclusive, royalty-free, worldwide,
perpetual, fully paid up license in and to all intellectual property that
was assigned to us and that is used in all fields other than in the field
of microdisplays. This intellectual property includes all patents,
copyrights, trademarks, trade names, trade dress, trade secrets, know
how, and show how whether or not legal protection has been sought or
obtained. In addition, the license granted to TFS is non-assignable and
non-licensable to third parties except that TFS may sublicense its rights
to the intellectual property to any party or entity in which TFS owns at
least a 50% equity interest. Real Property Sublease Agreement We and TFS have entered into a Real Property Sublease Agreement under
which we lease office and manufacturing space in the TFS headquarters
building. The initial term of the sublease expires August 31, 2005, with
automatic one-year renewal terms thereafter unless either party elects to
terminate the sublease upon notice delivered at least six months prior to
the expiration of the then applicable sublease term. The agreement also
sets forth certain circumstances under which all or a portion of the
sublease may be terminated without penalty. We lease approximately
34,000 square feet of the building from TFS and share certain common
areas in the building with TFS. Our fixed monthly rent payable to TFS is
approximately $40,000. This amount includes all normal and customary
services in connection with the operation and maintenance of the
building. This amount, however, does not include water or electrical
utilities, which we pay separately based on our use of those items. The
sublease also requires that TFS provide us with facilities-related
information technology management services, for which we pay a minimum
monthly fee of approximately $38,000. The sublease is not assignable by
us without the prior written consent of TFS, which consent may be
withheld by TFS in its sole discretion. Note H Commitments and Contingencies: In February 2002, we guaranteed up to $500,000 of the debt of VoiceViewer
Technology, Inc., a private start-up company developing microdisplay
products. This loan guarantee has a five-year term and matures in
January 2007. VoiceViewer is unable to meet its current obligations
under the loan agreement. We and the other guarantors are making
payments as they become due. As of September 30, 2004, our maximum
liability under this guarantee was $345,000. We have determined that it
is probable that VoiceViewer will be unable to meet its future
obligations under the loan agreement. Accordingly, we have accrued
$345,000 8




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for our estimated obligation under this guarantee. We have a security
interest in, and second rights to, the intellectual property of
VoiceViewer, while the lending institution has the first rights. We would
obtain the VoiceViewer intellectual property if in the future we are
required to pay amounts under the guarantee. However, we do not believe
that it would be possible to realize any significant value from the
intellectual property. Note I  Stock Compensation: Our 2003 Incentive Compensation Plan was adopted by our board of
directors and approved by our stockholder on August 26, 2003. Under the
2003 Incentive Compensation Plan, an aggregate of 1,650,000 shares of
common stock were originally available for issuance pursuant to options
granted to acquire common stock, the direct granting of restricted common
stock and deferred stock, the granting of stock appreciation rights, and
the granting of dividend equivalents. On the first day of each fiscal
year, an additional number of shares equal to 4% of the total number of
shares then outstanding is added to the number of shares that may be
subject to the granting of awards. Prior to the spin-off, certain of our employees were granted options to
purchase TFS stock under TFS stock-based compensation plans. In
connection with the spin-off, each outstanding TFS option granted prior
to the spin-off was converted into both an adjusted TFS option and a
substitute Brillian option. The treatment of such TFS options and the
substitute Brillian options is identical for those employees who remained
employees of TFS immediately after the spin-off and for those employees
who became employees of Brillian in connection with the spin-off. These
TFS options were converted in a manner that preserved the aggregate
exercise price of each option, which was allocated between the adjusted
TFS option and the substitute Brillian option, and each preserved the
ratio of the exercise price to the fair market value of the stock subject
to the option. For employees who remained employees of TFS after the
spin-off, employment with TFS will be taken into account in determining
when each substitute Brillian option becomes exercisable and when it
terminates, and in all other respects the terms of the substitute option
is substantially the same as the original TFS option. Under this
arrangement, on September 15, 2003, we issued options to purchase 750,275
shares of Brillian common stock. Of these options, 600,410 were issued
to employees who remained employees of TFS after the spin-off. Options
granted under TFS plans generally vest over a four-year period and are
exercisable for a term of 10 years. In addition to the Brillian substitute options granted under the terms of
the Master Separation and Distribution Agreement, on September 4, 2003,
we granted options to our employees to purchase approximately 526,000
shares of our common stock. Options with respect to approximately
300,000 shares have a vesting period of 32 months, and the remaining
options have a vesting period of 50 months. Additionally, on September
4, 2003, we granted approximately 56,000 shares of restricted common
stock to employees with a vesting period of one year. At September 30,
2004, all of this restricted common stock had vested and been issued. On
September 4, 2003, the spin-off had not been completed and, therefore, no
market had developed for our common stock. For purposes of setting the
exercise price of the options granted on that date, fair market value was
estimated by our board of directors. Based on the initial trading prices
of our common stock, we recorded deferred compensation of approximately
$1.5 million related to the stock option and restricted stock grants of
September 4, 2003. The total amount of deferred compensation will be
expensed over the vesting terms of the options and shares of restricted
stock. During the three- and nine-month periods ended September 30,
2004, we recorded non-cash compensation expense of $168,000, and
$569,000, respectively, related to these restricted stock and option
grants. Pursuant to the provisions of SFAS No. 123, Accounting for Stock-Based
Compensation, we account for options granted to our employees pursuant to
Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock
Issued to Employees. In December 2002, the FASB issued SFAS No. 148,
Accounting for Stock-Based Compensation -Transition and Disclosure.
This Statement amends SFAS No. 123 to provide alternative methods of
transition for a voluntary change to the fair value method of accounting
for stock-based employee compensation. In addition, this Statement
amends the disclosure requirements of SFAS No. 123 to require prominent
disclosures in both annual and interim financial statements about the
method of accounting for stock-based employee compensation and the effect
of the method used on reported results. We have adopted the disclosure
requirements of SFAS No. 148. 9




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We have computed compensation cost, for pro forma disclosure purposes,
based on the fair value of all options awarded on the date of grant,
utilizing the Black-Scholes option pricing method with the following
weighted assumptions: risk-free interest rates of 2.99% for all
scenarios; expected dividend yields of zero for all scenarios; expected
lives of 5.0 years for all scenarios; and expected volatility (a measure
of the amount by which a price has fluctuated or is expected to fluctuate
during a period) of 74% for all scenarios. Had compensation cost for
these plans been determined consistent with SFAS No. 123, our net loss
and loss per share for the three- and nine-month periods ended September
30 would have been as follows (in thousands, except per share data): Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss:As reported
    
    $
    (6,322
    )
    
    $
    (4,482
    )
    
    $
    (16,562
    )
    
    $
    (13,831
    )Total stock-based compensation
expenses determined under fair
value based method for all
awards, net of related tax
effects
    
    
    (385
    )
    
    
    (52
    )
    
    
    (922
    )
    
    
    (52
    )Pro forma net loss
    
    $
    (6,707
    )
    
    $
    (4,534
    )
    
    $
    (17,484
    )
    
    $
    (13,883
    )Basic and diluted net loss per share:As reported
    
    $
    (0.91
    )
    
    $
    (0.84
    )
    
    $
    (2.69
    )
    
    $
    (2.59
    )Pro forma
    
    $
    (0.97
    )
    
    $
    (0.85
    )
    
    $
    (2.83
    )
    
    $
    (2.60
    )
 
 ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS AND FACTORS THAT MAY AFFECT RESULTS The statements contained in this report on Form 10-Q that are not purely
historical are forward-looking statements within the meaning of applicable
securities laws. Forward-looking statements include statements regarding our
expectations, anticipation, intentions, beliefs, or strategies
regarding the future. Forward-looking statements also include statements
regarding revenue, margins, expenses, and earnings analysis for fiscal 2004 and
thereafter; the amounts, prices, timing, or terms under which we sell HDTVs;
technological innovations; future products or product development; our product
development strategies; potential acquisitions or strategic alliances; the
success of particular product or marketing programs; the amounts of revenue
generated as a result of sales to significant customers; and liquidity and
anticipated cash needs and availability. All forward-looking statements
included in this report are based on information available to us as of the
filing date of this report, and we assume no obligation to update any such
forward-looking statements. Our actual results could differ materially from
the forward-looking statements. Overview We design and develop large-screen, rear-projection, high-definition
televisions, or HDTVs, utilizing our proprietary liquid crystal on silicon, or
LCoS®, microdisplay technology. We market our HDTVs for sale under the brand
names of retailers, including consumer electronics retailers, consumer retail
stores, personal computer manufacturers, and high-end audio/video
manufacturers. In April 2004, we announced our first customer and orders for
our HDTV product, and, in August 2004, we commenced shipments of HDTVs to that
customer. During the three months ended September 30, 2004, we recorded
revenue from the sale of HDTVs totaling approximately $235,000. We have established a virtual manufacturing model utilizing third-party
contract manufacturers to produce our HDTVs, which incorporate the LCoS
microdisplays that we manufacture. In late August and early September 10




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2004, we were unable to obtain a sufficient quantity of light engines from
our supplier, JDS Uniphase, to allow us to meet the required shipments to our
customer. As a result, on September 9, 2004, we announced a disruption in HDTV
shipments and that JDS Uniphase was working on a plan to re-commence production
of light engines in early October. On September 20, 2004, we announced that,
as a result of this delay, our customer, Sears, Roebuck, and Company, had
terminated its agreement to purchase HDTVs from us. In late October, we were
informed by JDS Uniphase that the problems were more significant than had been
anticipated and, therefore, they will be unable to start volume production
until the second quarter of 2005. We also offer a broad line of LCoS microdisplay products and subsystems
that original equipment manufacturers, or OEMs, can integrate into proprietary
HDTV products, home theater projectors, and near-to-eye applications, such as
head-mounted monocular or binocular headsets and viewers, for industrial,
medical, military, commercial, and consumer applications. We derive revenue from the sale of our microdisplay products and from
providing design and engineering services. For the year ended December 31,
2003, we recorded revenue from product sales of $1.6 million, or 74% of net
sales, and revenue from design and engineering services of $565,000, or 26% of
net sales. We have never been profitable. In 2003, 2002, and 2001, we had
net losses of $18.7 million, $23.2 million, and $22.3 million, respectively. We started the development of LCoS microdisplays in 1997 as a division of
Three-Five Systems, Inc., or TFS, under which we operated until our spin-off in
September 2003. In anticipation of our spin-off to the stockholders of TFS,
TFS organized us as a wholly owned subsidiary. In connection with the
spin-off, TFS transferred to us its LCoS microdisplay business, including the
related manufacturing and business assets, personnel, and intellectual
property. TFS also provided initial cash funding to us in the amount of $20.9
million. The spin-off was completed on September 15, 2003 as a special
dividend to the stockholders of TFS. We share occupancy with TFS in a building owned by TFS in Tempe, Arizona.
We manufacture all of our LCoS microdisplays on our high-volume liquid crystal
on silicon manufacturing line in that Tempe facility, where we also maintain
our corporate headquarters. In addition, we conduct all testing and assembly
of LCoS modules and conduct research and development activities in Tempe. We
also operate a facility in Boulder, Colorado. In Boulder, we conduct sales and
marketing activities and research and development activities. Net Sales.Our sales result from both design and engineering services and
product sales. Until early 2002, substantially all of our sales were for use
in projection-based applications. After the purchase of certain assets in
early 2002, however, we became equally focused on the near-to-eye market. In
the fourth quarter of 2003, we announced our intention to develop, manufacture,
and sell a complete HDTV product based on our Gen II LCoS microdisplay. Since
this announcement, most of our efforts have been focused on the design of this
product, the establishment of a supply chain to source the components that we
do not manufacture, and the establishment of a selling channel for the
marketing and sale of our HDTV product. In addition to designing and developing our own HDTVs, we will continue to
seek selective OEM customers for our projection displays. We typically sell
three displays and associated electronics for products in the projection
market. In the near-to-eye market, we sell either one or two displays and
associated electronics. The displays and electronics are sold together as a
kit. We also sell optical modules in the near-to-eye market. The selling
prices of these products range between $90 and $1,000 per unit. Cost of Sales.Our gross margins are influenced by various factors,
including manufacturing efficiencies, yields, and absorption issues, product
mix, product differentiation, product uniqueness, inventory management, and
volume pricing. The manufacturing-related issues have the most significant
impact on our gross margins. To date, our manufacturing capacity has exceeded
our manufacturing volume, resulting in the inability to absorb fully the cost
of our manufacturing infrastructure. As a result, we expect it will be
difficult to attain significant improvements in gross margin until we can
operate at higher production volumes. Selling, General, and Administrative Expense.Selling, general, and
administrative expense consists principally of administrative and selling
costs; salaries, commissions, and benefits to personnel; and related facilities
costs. We make substantially all of our sales directly to OEMs through a very
small sales force that consists 11




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primarily of direct technical sales persons. Therefore, there is no
material cost of distribution in our selling, general, and administrative
expense. Research and Development Expense.Research and development expense
consists principally of salaries and benefits to scientists, engineers, and
other technical personnel; related facilities costs; process development costs;
and various expenses for projects, including new product development. Research
and development expense continues to be very high as we continue to develop our
LCoS technology and manufacturing processes, and refine our HDTV products. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of
operations are based upon our financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
During preparation of these financial statements, we are required to make
estimates and judgments that affect the reported amounts of assets,
liabilities, revenue, and expenses, and related disclosure of contingent assets
and liabilities. On an on-going basis, we evaluate our estimates and judgments,
including those related to bad debts, inventories, investments, fixed assets,
intangible assets, income taxes, and contingencies. We base our estimates on
historical experience and on various other assumptions that we believe are
reasonable under the circumstances. The results form the basis for making
judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our financial
statements. We recognize revenue from product sales when persuasive evidence of a sale
exists; that is, a product is shipped under an agreement with a customer; risk
of loss and title have passed to the customer; the fee is fixed and
determinable; and collection of the resulting receivable is reasonably assured.
Sales allowances are estimated based upon historical experience of sales
returns. We recognize revenue related to design and engineering services depending
on the relevant contractual terms. Under fixed-price contracts that contain
project milestones, revenue is recognized as milestones are met. For contracts
under which revenue is recognized based on milestones, the fair value of
milestones completed equals the fair value of work performed. Under a prior
fixed price contract under which we were paid based on performance of tasks, we
recognized revenue based on the estimated percentage of completion of the
entire project as measured by the costs for man hours and materials. Any
anticipated losses on fixed price contracts are recorded in the period they are
determinable. Revenue related to design and engineering services is recognized
based on these methods and is non-refundable. We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. We
determine the adequacy of this allowance by regularly evaluating individual
customer receivables and considering a customers financial condition, credit
history, and current economic conditions. If the financial condition of our
customers were to deteriorate, additional allowances could be required. We write down our inventory for obsolete inventory. We write down our
inventory to estimated market value based upon assumptions about future demand
and market conditions. If actual market conditions are less favorable than
those projected by us, additional inventory write-downs may be required. Financial Accounting Standards Board (FASB) Statement of Financial
Accounting Standards (SFAS) No. 109, Accounting for Income Taxes, requires
that a valuation allowance be established when it is more likely than not that
all or a portion of a deferred tax asset will not be realized. Changes in
valuation allowances from period to period are included in our tax provision in
the period of change. In determining whether a valuation allowance is
required, we take into account all evidence with regard to the utilization of a
deferred tax asset, including our past earnings history, expected future
earnings, the character and jurisdiction of such earnings, unsettled
circumstances that, if unfavorably resolved, would adversely affect utilization
of a deferred tax asset, 12




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carryback and carryforward periods, and tax strategies that could
potentially enhance the likelihood of realization of a deferred tax asset.
Deferred tax assets resulting from net operating losses and tax credits
generated by our pre-spin-off operations were retained by TFS in accordance
with applicable tax law. In the near term, we do not expect to record a tax
benefit on any losses that we incur. Long-term assets, such as property, plant, and equipment, and intangibles,
are originally recorded at cost. On an on-going basis, we assess these assets
to determine if their current recorded value is impaired. When assessing these
assets, we consider projected future cash flows to determine if impairment is
applicable. These cash flows are evaluated for objectivity by using weighted
probability techniques and also comparisons of past performance against
projections. We may also identify and consider independent market values of
assets that we believe are comparable. If we were to believe that an assets
value was impaired, we would write down the carrying value of the identified
asset and charge the impairment as an expense in the period in which the
determination was made. Non-marketable equity securities are accounted for at the lower of
estimated fair value or historical cost. All of our investments are subject to
a periodic impairment review; the impairment analysis requires significant
judgment to identify events or circumstances that would likely have a
significant adverse effect on the fair value of the investment. The indicators
we use to identify those events and circumstances include the investees
revenue and earnings trends relative to predefined milestones and overall
business prospects; the technological feasibility of the investees products
and technologies; the general market conditions in the investees industry; the
investees liquidity, debt ratios, and rate at which the investee is using
cash; and the valuation of the investees most recent financing round.
Investments identified as having an indicator of impairment are subject to
further analysis to determine if the investment is other than temporarily
impaired, in which case the investment is written down to its impaired value.
When an investee is not considered viable from a financial or technological
point of view, the entire investment would be written down. If an investee
obtains additional funding at a valuation lower than our carrying amount or
requires a new round of equity funding to stay in operation, and the new
funding does not appear imminent, it would be presumed that the investment is
other than temporarily impaired, unless specific facts and circumstances
indicate otherwise. During the second quarter of 2004, we recorded a
write-down of $131,000 due to the impairment in the value of non-marketable
equity securities. This impairment occurred when one of our investee companies
obtained equity funding at a valuation lower than our carrying amount. Our historical financial statements for periods prior to our spin-off from
TFS include those assets, liabilities, revenues, and expenses directly
attributable to our operations and allocations of certain TFS corporate
expenses to us. These amounts have been allocated to us on the basis that we
and TFS considered to reflect most fairly or reasonably the utilization of the
services provided to, or the benefits received by, us. We believe the methods
used to allocate these amounts are reasonable. The financial information included herein for periods prior to the
spin-off is not necessarily indicative of our future financial position,
results of operations, or cash flows, nor is it necessarily indicative of what
the financial position, results of operations, and cash flows would have been
had we operated as a stand-alone public entity during the periods covered. Prior to the spin-off, our costs and expenses included allocations from
TFS for centralized legal, accounting, treasury, quality assurance, real
estate, information technology, engineering, and other TFS corporate services
and infrastructure costs. These allocations were determined on the basis that
we and TFS considered to be reasonable reflections of the utilization of
services provided to, or the benefits received by, us. Allocated costs
included in our cost of sales totaled $301,000 and $1.1 million for the three-
and nine-month periods ended September 30, 2003. Allocated costs included in
selling, general, and administrative expenses totaled $45,000 and $1.5 million
for the three- and nine-month periods ended September 30, 2003. Allocated
costs included in our research and development expenses totaled $207,000 and
$795,000 for the three- and nine-month periods ended September 30, 2003. The
basis for the amounts allocated to us included the following: legal,
accounting, treasury, quality assurance, and other TFS corporate functions,
including officers salaries, were allocated based on managements estimation
of time devoted to the microdisplay business for these functions; facility
costs and information technology services were allocated on the basis of
headcount of the microdisplay business, which is most representative of
utilization of these resources; and engineering services were allocated to us
based on the actual hours of services used. The allocation methodologies
utilized represent managements best estimate of the actual hours utilized by
the microdisplay business of TFS. 13




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On the spin-off date, we and TFS entered into a series of agreements to
facilitate our separation from TFS. These agreements included certain
transitional services, leases, intellectual property transfers, and tax sharing
agreements. These agreements require us to pay a negotiated fee. We paid TFS
$225,000 and $659,000 for rent and IT management services in the three- and
nine-month periods ended September 30, 2004, and $41,000 and $149,000 for
engineering services in the same periods. In addition, we paid $497,000 and
$1.1 million for engineering and design services related to the development of
printed circuit board assemblies and for purchases of these assemblies for our
HDTV product during the three- and nine-month periods ended September 30, 2004. Our financial results subsequent to the spin-off may differ materially
from those recorded historically. These potential differences are the result
of several factors, including the following: 1. actual costs for services needed by our business may differ from
amounts historically allocated to us from TFS; 2. certain items, including facilities charges, that were recorded by
the TFS combined entity as depreciation are now be recorded as rent
expense by us, for which we need to pay cash; and 3. changes in the way we manage our business as a stand-alone entity as
opposed to a division may result in different business decisions. Since the spin-off, the actual costs for services needed by our business
have not differed materially from amounts historically allocated to us from
TFS. However, we are no longer part of a larger organization; therefore,
certain expense items may increase more rapidly. If this occurs and we are
unable to decrease other expense items or increase revenue to offset this
increased expense, our results of operations will be adversely affected. We and TFS entered into a series of agreements to facilitate our
separation from TFS. These agreements include certain transitional services,
leases, intellectual property transfers, and tax sharing agreements. Certain
of these agreements require us to pay a negotiated fee. If we are unable to
build an infrastructure to provide these services internally, our operating
results could be adversely affected. Because our business serves new and developing markets, is based on a
relatively new technology, and is expected to be significantly influenced by
the introduction of new HDTV products, accurately forecasting revenue for a
particular future period is difficult. To date, the majority of our product
sales to customers have been for their use in designing their end products or
for improving their production processes as opposed to volume production lots.
Therefore, the amount of revenue recorded in any given period may fluctuate
significantly, and predictable revenue trends have not yet developed. While we
anticipate that our revenue will increase, there can be no assurances that this
will occur or when it will occur. Because a significant amount of our expenses
are fixed in nature and we still experience low manufacturing yields, the
amount of revenue recognized during the first nine months of 2004 did not
result in a material impact to our cash consumption rate. We do anticipate,
however, that as we move into volume production, we will improve our
manufacturing yields and more fully absorb our fixed costs, which will result
in improved gross margins and results of operations. However, as we increase
our revenue and shift our product mix predominantly to the HDTVs, we will use
cash to finance increases in inventory and accounts receivable. Results of Operations Three months ended September 30, 2004 compared to three months ended
September 30, 2003 Net Sales.Net sales increased 4% to $733,000 in the third quarter of
2004 from $703,000 in the third quarter of 2003. Product sales increased to
$673,000 in the third quarter of 2004 from $602,000 in the third quarter of
2003. Design and engineering services revenue decreased to $60,000 in the
third quarter of 2004 from $101,000 in the third quarter of 2003. 14




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Net sales in the projection market totaled $526,000, or 72% of total net
sales, in the third quarter of 2004, compared with $385,000, or 55% of total
net sales, in the third quarter of 2003. The remaining net sales were in the
near-to-eye market. Net sales in North America totaled $499,000, or 68% of total net sales, in
the third quarter of 2004 compared with $229,000, or 33% of total net sales, in
the third quarter of 2003. Net sales in Asia totaled $142,000, or 19% of total
net sales, in the third quarter of 2004 compared with $155,000, or 22% of total
net sales, in the third quarter of 2003. Net sales in Europe totaled $92,000,
or 13% of total net sales, in the third quarter of 2004 compared with $319,000,
or 45% of total net sales, in the third quarter of 2003. Cost of Sales.Cost of sales was $4.4 million, or 596% of net sales, in
the third quarter of 2004 compared with $2.4 million, or 338% of net sales, in
the third quarter of 2003. During the third quarter of 2004, we incurred
substantial incremental costs in our efforts to commence production of our
HDTVs. These incremental costs included costs for contract assembly, scrap,
freight, and increased depreciation. The large negative gross margin in each
period resulted primarily from the low volume of shipments and low
manufacturing yields in the shipped products. To date, our manufacturing
capacity has exceeded our manufacturing volume, resulting in the inability to
absorb fully the cost of our manufacturing infrastructure. Cost of sales for
design and engineering services decreased to $31,000 in the third quarter of
2004 from $97,000 in the third quarter of 2003. As is typical in most segments of the high-technology industry, we
anticipate downward pressure on the prices of our products. A significant
portion of our manufacturing costs are fixed in nature and consist of items
such as utilities, depreciation, and amortization. The amounts of these costs
do not vary period to period based on the number of units produced nor can the
amounts of these costs be adjusted in the short term. Therefore, in periods of
lower production volume, these fixed costs are absorbed by a lower number of
units, thus increasing the cost per unit. As a result, we expect it will be
difficult to attain significant improvements in gross margins until we can
operate at higher production volumes. Selling, General, and Administrative Expense.Selling, general, and
administrative expense totaled $508,000 in the third quarter of 2004 compared
with $1.2 million in the third quarter of 2003. Selling, general, and
administrative expenses for the third quarter of 2004 were reduced by
approximately $300,000 due to the reversal of a bonus accrual. Selling,
general, and administrative expense for the third quarter of 2003 included
expenses of $699,000 associated with our spin-off from TFS. No such expenses
were incurred in the third quarter of 2004. Research and Development Expense.Research and development expense
increased 23% to $2.2 million in the third quarter of 2004 from $1.8 million in
the third quarter of 2003. This increase is the result of increased engineering
personnel costs related to the development of our HDTV product. Benefit from Income Taxes.During the third quarter of 2003, we recorded
a benefit from income taxes of $160,000. When the assets and liabilities were
transferred to us from TFS, we recorded a net deferred tax liability of $1.1
million related to differences between the book and tax basis of the assets
transferred to us. As we incurred tax losses subsequent to the spin-off, we
recorded a benefit from income taxes until we had offset this entire net
deferred tax liability. No such benefit was recorded in the third quarter of
2004. Net Loss.Net loss was $6.3 million in the third quarter of 2004 compared
with a net loss of $4.5 million in the third quarter of 2003. Nine months ended September 30, 2004 compared to nine months ended September
30, 2003 Net Sales.Net sales increased 28% to $2.3 million in the first nine
months of 2004 from $1.8 million in the first nine months of 2003. Product
sales increased to $2.0 million in the first nine months of 2004 from $1.4
million in the first nine months of 2003. Design and engineering services
revenue decreased to $297,000 in the first nine months of 2004 from $423,000 in
the first nine months of 2003. Net sales in the projection market totaled $1.2 million, or 54% of total
net sales, in the first nine months of 2004 compared with $1.1 million, or 60%
of total net sales, in the first nine months of 2003. The remaining net sales
were in the near-to-eye market. 15




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Net sales in North America totaled $1.2 million, or 53% of total net
sales, in the first nine months of 2004 compared with $925,000, or 51% of total
net sales, in the first nine months of 2003. Net sales in Asia totaled
$491,000, or 21% of total net sales, in the first nine months of 2004 compared
with $372,000, or 20% of total net sales, in the first nine months of 2003.
Net sales in Europe totaled $608,000, or 26% of total net sales, in the first
nine months of 2004 compared with $537,000, or 29% of total net sales, in the
first nine months of 2003. Cost of Sales.Cost of sales was $9.4 million, or 400% of net sales, in
the first nine months of 2004 compared with $7.2 million, or 392% of net sales,
in the first nine months of 2003. The large negative gross margin in each
period resulted primarily from the low volume of shipments and low
manufacturing yields in the shipped products. To date, our manufacturing
capacity has exceeded our manufacturing volume, resulting in the inability to
absorb fully the cost of our manufacturing infrastructure. Cost of sales for
design and engineering services decreased to $220,000 in the first nine months
of 2004 from $380,000 in the first nine months of 2003. As is typical in most segments of the high-technology industry, we
anticipate downward pressure on the prices of our products. A significant
portion of our manufacturing costs are fixed in nature and consist of items
such as utilities, depreciation, and amortization. The amounts of these costs
do not vary period to period based on the number of units produced nor can the
amounts of these costs be adjusted in the short term. Therefore, in periods of
lower production volume, these fixed costs are absorbed by a lower number of
units, thus increasing the cost per unit. As a result, we expect it will be
difficult to attain significant improvements in gross margins until we can
operate at higher production volumes. Selling, General, and Administrative Expense.Selling, general, and
administrative expense decreased 21% to $2.7 million in the first nine months
of 2004 from $3.4 million in the first nine months of 2003. Selling, general,
and administrative expense for the first nine months of 2003 included expenses
of $1.5 million associated with our spin-off from TFS. No such expenses were
incurred in the first nine months of 2004. Research and Development Expense.Research and development expense
increased 30% to $6.8 million in the first nine months of 2004 from $5.2
million in the first nine months of 2003. Research and development expense in
the first nine months of 2004 includes costs totaling approximately $1.2
million associated with the development of our HDTV products. Loss on Investment in Start-up Company.During the first nine months of
2004, we recorded a write-down of $131,000 due to the impairment in the value
of non-marketable equity securities. This impairment occurred when one of our
investee companies obtained equity funding at a valuation lower than our
carrying amount. No such loss was recorded in the first nine months of 2003. Benefit from Income Taxes.During the first nine months of 2003, we
recorded a benefit from income taxes of $160,000. When the assets and
liabilities were transferred to us from TFS, we recorded a net deferred tax
liability of $1.1 million related to differences between the book and tax basis
of the assets transferred to us. As we incurred tax losses subsequent to the
spin-off, we recorded a benefit from income taxes until we had offset this
entire net deferred tax liability. No such benefit was recorded in the first
nine months of 2004. Net Loss.Net loss was $16.6 million in the first nine months of 2004
compared with a net loss of $13.8 million in the first nine months of 2003. Liquidity and Capital Resources At September 30, 2004, we had cash, cash equivalents, and short-term
investments of $10.0 million compared with $14.4 million at December 31, 2003. In the first nine months of 2004, we used $12.8 million of cash for
operating activities compared with $12.1 million in the first nine months of
2003. Most of the cash outflow in each period related to our losses, since we
had little change in our other working capital balances in each period. Our
depreciation and amortization expense was $2.7 million in the first nine months
of 2004 and $2.7 million in the first nine months of 2003. Prior to the
spin-off, our entire cash outflow was funded by TFS on an as-needed basis. 16




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In the first nine months of 2004, net cash provided by investing
activities totaled $8.1 million. During this period, we received proceeds from
the sale of short-term investments of $12.1 million. Purchases of property and
equipment totaled $3.0 million and purchases of intangibles totaled $888,000 in
the first nine months of 2004. During the first nine months of 2003, net cash used in investing
activities totaled $557,000. During the first nine months of 2003, we used
$334,000 for the purchase of property and equipment, received proceeds from the
sale of property and equipment of $114,000, and used $337,000 for the purchase
of intangibles. We have incurred recurring operating losses and negative cash flows since
our inception as a division of TFS. Our net loss was $18.7 million, $23.2
million, and $22.3 million in 2003, 2002, and 2001, respectively. At September
30, 2004, we had $12.5 million of working capital, including $10.0 million of
cash, cash equivalents, and short-term investments. A key element of our business involves the ongoing commercialization of
our LCoS microdisplay technology. LCoS microdisplays are an emerging
technology with target markets that could be slow to develop or could utilize
competing technologies. Therefore, accurately forecasting revenue for any
given future period is difficult. We are currently focusing a majority of our
resources on penetrating the premium segment of the HDTV market. HDTV has only
recently become available to consumers, and widespread market acceptance is
uncertain. Because our business serves new and developing markets, is based on a
relatively new technology, and is expected to be significantly influenced by
the introduction of new HDTV products, accurately forecasting revenue for a
particular future period is difficult. To date, the majority of our product
sales to customers have been for their use in designing their end products or
for improving their production processes as opposed to volume production lots.
Therefore, the amount of revenue recorded in any given period may fluctuate
significantly, and predictable revenue trends have not yet developed. While we
anticipate that our revenue will increase, there can be no assurances that this
will occur or when it will occur. Because a significant amount of our expenses
are fixed in nature and we still experience low manufacturing yields, the
amount of revenue recognized during the first nine months of 2004 did not
result in a material impact to our cash consumption rate. We do anticipate,
however, that as we move into volume production, we will improve our
manufacturing yields and more fully absorb our fixed costs, which will result
in improved gross margins and results of operations. However, as we increase
our revenue and shift our product mix predominantly to the HDTVs, we will use
cash to finance increases in inventory and accounts receivable. The successful introduction of an HDTV product to market and securing
volume orders from consumer electronics retailers for HDTVs represent a key
ingredient to our success. In April 2004, we announced our first customer and
orders for our HDTV product, and, in August 2004, we commenced shipments of
HDTVs to that customer. During the three months ended September 31, 2004, we
recorded revenue from the sale of HDTVs totaling approximately $235,000. In
late August and early September 2004, we were unable to obtain a sufficient
quantity of light engines from our supplier, JDS Uniphase, to allow us to meet
the required shipments to our customer. As a result, on September 9, 2004, we
announced a disruption in HDTV shipments and that JDS Uniphase was working on a
plan to re-commence production of light engines in early October. On
September 20, 2004, we announced that, as a result of this delay, our customer,
Sears, Roebuck, and Company, had terminated its agreement to purchase HDTVs
from us. In late October, we were informed by JDS Uniphase that the problems
were more significant than had been anticipated and, therefore, they will be
unable to start volume production until the second quarter of 2005. In order for us to continue operating beyond March 31, 2005, it will be
necessary for us to reduce substantially our operating losses (through
increased sales, reduced expenses, or both) or raise additional funds. We are
currently exploring our opportunities to raise additional funds through asset
sales, or debt or equity financing. We have no commitments for or
understandings regarding any additional funding with any person or firm. We
can provide no assurance that we will be able to obtain any necessary financing
on satisfactory terms. If we are unable to increase our sales or obtain additional financing, the
primary cost component that can be reduced in a timely manner is personnel
related costs, the majority of which relate to our research and development
efforts. If we were to significantly reduce our research and development
efforts, our ability to bring our HDTV 17




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product to market and to develop new products would be diminished, which
would further hamper our ability to achieve profitability. Aggregate Contractual Obligations The following table lists our commercial commitments (in thousands): Amount of Commitment Expiration Per PeriodTotalOther Commercial Commitments
    
    Amounts
    
    Less than 1
    
    
    
    
    
    
    
    
    
    6 Years(in thousands)
    
    Committed
    
    Year
    
    1-3 Years
    
    4-5 Years
    
    and OverFacilities leases
    
    $
    913
    
    
    $
    913
    
    
    $
    
    
    
    $
    
    
    
    $
    Development, maintenance,
and minimum royalty
agreements
    
    $
    1,215
    
    
    $
    688
    
    
    $
    340
    
    
    $
    37
    
    
    $
    Purchase orders
    
    $
    5,823
    
    
    $
    5,823
    
    
    $
    
    
    
    $
    
    
    
    $
    Guarantee
    
    $
    345
    
    
    $
    345
    
    
    $
    
    
    
    $
    
    
    
    $
    
 We have contractual commitments for property leases for our Tempe
headquarters and for our development center in Boulder, Colorado. In addition,
we have contractual commitments for development, software maintenance, and
minimum royalties related to the development and production of our HDTV
products. We have issued purchase orders to vendors for the purchase of
materials totaling approximately $5.8 million. If we are not able to resume
production of our HDTVs, much of this material will be in excess of our
requirements. In such case, if we are unable to cancel or otherwise
restructure these purchase commitments, any materials purchased in excess of
our requirements will be written off as excess inventory. The guarantee
relates to our guarantee in connection with a Small Business Administration
loan to VoiceViewer Technology, Inc., a private company developing microdisplay
products. VoiceViewer is unable to meet its current obligations under the loan
agreement. We and the other guarantors are making payments as they become due.
We have determined that it is probable that VoiceViewer will be unable to meet
its future obligations under the loan agreement. Therefore, we have accrued
$345,000, which represents our maximum obligation under the guarantee amount.
We have a security interest in, and second rights to, the intellectual property
of VoiceViewer, while the lending institution has the first rights. We would
obtain the VoiceViewer intellectual property if in the future we are required
to pay amounts under the guarantee. However, we do not believe we can realize
any significant value from VoiceViewers intellectual property. Under the Tax Sharing Agreement, we have agreed to indemnify TFS against
any taxes, other than Separation Taxes, that are attributable to us since our
formation, even while we were a member of TFS federal consolidated tax group.
TFS has agreed to indemnify us against any taxes, other than Separation Taxes,
that are attributable to the businesses retained by TFS. The Tax Sharing
Agreement sets forth rules for determining taxes attributable to us and taxes
attributable to the businesses retained by TFS. Pursuant to the Tax Sharing Agreement, we have agreed not to take any
action that would cause the spin-off not to qualify under Section 355 of the
Internal Revenue Code. We have agreed not to take certain actions for two
years following the spin-off, unless we obtain an IRS ruling or an opinion of
counsel to the effect that these actions will not affect the tax-free nature of
the spin-off. These actions include certain issuances of our stock, a
liquidation or merger of our company, and dispositions of assets outside the
ordinary course of our business. If any of these transactions were to occur,
the spin-off could be deemed to be a taxable distribution to TFS. This would
subject TFS to a substantial tax liability. We have agreed to indemnify TFS
and its affiliates to the extent that any action we take or fail to take gives
rise to a tax incurred by TFS or any of its affiliates with respect to the
spin-off. In addition, we have agreed to indemnify TFS for any tax resulting
from an acquisition by one or more persons of a 50% or greater interest in our
company. We have no debt. In addition, we have no capital lease obligations, other
long-term obligations, or any other commercial commitments except as noted
above. 18




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Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements. 
 ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments At September 30, 2004, we did not participate in any derivative financial
instruments, or other financial or commodity instruments for which fair value
disclosure would be required under Statement of Financial Accounting Standards
No. 107. We hold no investment securities that would require disclosure of
market risk. Primary Market Risk Exposures Our primary market risk exposures are in the areas of foreign currency
exchange rate risk. Foreign currency devaluations, especially in Asian
currencies, such as the Japanese yen, the Korean won, and the Taiwanese dollar,
may cause a foreign competitors products to be priced significantly lower than
our products. Fluctuations in foreign currency exchange rates could affect our cost of
goods and operating margins. In addition, currency devaluation can result in a
loss to us if we hold deposits of that currency. Hedging foreign currencies
can be difficult, especially if the currency is not freely traded. We have not attempted to hedge or otherwise mitigate this risk because our
exposure to any given currency is nominal. A change in the currency exchange
rate of 10% in any given currency would not have a material impact on our
results of operations. If, in the future, our exposure to a given currency
increases, we would contemplate hedging at that time. Based on the foregoing,
we cannot provide assurance that fluctuations and currency exchange rates in
the future will not have an adverse effect on our operations. 
 ITEM 4.  CONTROLS AND PROCEDURES As of the end of the period covered by this report, our Chief Executive
Officer and Chief Financial Officer have reviewed and evaluated the
effectiveness of our disclosure controls and procedures, which included
inquiries made to certain other of our employees. Based on their evaluation,
our Chief Executive Officer and Chief Financial Officer have each concluded
that our disclosure controls and procedures are effective and sufficient to
ensure that we record, process, summarize, and report information required to
be disclosed by us in our periodic reports filed under the Securities Exchange
Act within the time periods specified by the Securities and Exchange
Commissions rules and forms. During the quarterly period covered by this
report, there have not been any changes in our internal controls over financial
reporting that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting. 19




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PART II  OTHER INFORMATION 
 ITEM 5. OTHER INFORMATION Our Insider Trading Policy permits our directors, officers, and other key
personnel to establish purchase and sale programs in accordance with Rule
10b5-1 adopted by the Securities and Exchange Commission. The rule permits
employees to adopt written plans at a time before becoming aware of material
nonpublic information and to sell shares according to a plan on a regular basis
(for example, weekly or monthly), regardless of any subsequent nonpublic
information they receive. In our view, Rule 10b5-1 plans are beneficial
because systematic, pre-planned sales that take place over an extended period
should have a less disruptive influence on the price of our stock. We also
believe plans of this type are beneficial because they inform the marketplace
about the nature of the trading activities of our directors and officers. In
the absence of such information, the market could mistakenly attribute
transactions as reflecting a lack of confidence in our company or an indication
of an impending event involving our company. We recognize that our directors
and officers may have reasons totally apart from the company in determining to
effect transactions in our common stock. These reasons could include the
purchase of a home, tax and estate planning, the payment of college tuition,
the establishment of a trust, the balancing of assets, or other personal
reasons. The establishment of any trading plan involving our company requires
the pre-clearance by our Chief Executive Officer or Chief Financial Officer.
An individual adopting a trading plan must comply with all requirements of Rule
10b5-1, including the requirement that the individual not possess any material
nonpublic information regarding our company at the time of the establishment of
the plan. In addition, sales under a trading plan may be made no earlier than
30 days after the plan establishment date. No officers currently maintain
trading plans. 
 ITEM 6. EXHIBITS Exhibit Number
    
    Exhibit10.10
    
    Amendment No. 1 to the First Amended and Restated Real
Property Sublease Agreement between the Registrant and Three-Five
Systems, Inc.31.1
    
    Certification of President and Chief Executive Officer
pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the
Securities Exchange Act of 1934, as amended31.2
    
    Certification of Chief Financial Officer pursuant to Rule
13a-14(a) and Rule 15d-14(a), promulgated under the Securities Act
of 1934, as amended32.1
    
    Certification of President and Chief Executive Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 200232.2
    
    Certification of Chief Financial Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. BRILLIAN CORPORATION(Registrant)Date: November 15, 2004
    
    By:
    
    /s/ Vincent F. Sollitto Jr.Vincent F. Sollitto Jr.President and Chief Executive OfficerBy:
    
    /s/ Wayne A. PrattWayne A. PrattChief Financial Officer, Secretary, and
Treasurer
 21