##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
    FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 For the quarter ended March 31, 2005 Commission file number 1- 4373
____________________ THREE-FIVE SYSTEMS, INC.  Delaware
    
    86 - 0654102(State or Other Jurisdiction
of Incorporation or Organization)
    
    (I.R.S. Employer Identification No.)
 1600 North Desert Drive, Tempe, Arizona
    
    85281(Address of Principal Executive Offices)
    
    (Zip Code)
 (602) 389-8600   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 þ No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange
Act Rule 12b-2). Yes þ No o Securities registered pursuant to Section 12(b) of the Exchange Act: Title of Each Class
    
    Outstanding as of April 29, 2005Common Stock, par value $.01 per share
    
    21,767,653




---



THREE-FIVE SYSTEMS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2005 TABLE OF CONTENTS PagePART IITEM 1. FINANCIAL STATEMENTS (UNAUDITED):CONDENSED CONSOLIDATED BALANCE SHEETS 
DECEMBER 31, 2004 AND MARCH 31, 2005
    
    
    3CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS 
THREE MONTHS ENDED MARCH 31, 2004 AND 2005
    
    
    4CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS 
THREE MONTHS ENDED MARCH 31, 2004 AND 2005
    
    
    5NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
    
    
    6ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
    
    
    17ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
    
    
    25ITEM 4. CONTROLS AND PROCEDURES
    
    
    25PART IIITEM 1. LEGAL PROCEEDINGS
    
    
    26ITEM 5. OTHER INFORMATION
    
    
    26ITEM 6. EXHIBITS
    
    
    27SIGNATURES
    
    
    28Exhibit 31.1Exhibit 31.2Exhibit 32.1Exhibit 32.2
  2




---



##### Table of Contents



ITEM 1. FINANCIAL STATEMENTS 
 THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(Dollars in thousands) December 31,
    
    
    March 31,2004
    
    
    2005ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    16,198
    
    
    $
    11,816Cash on deposit maintained for compensating balances
    
    
    
    
    
    
    600Accounts receivable, net
    
    
    12,095
    
    
    
    8,016Inventories
    
    
    17,549
    
    
    
    17,328Income taxes receivable
    
    
    4
    
    
    
    6Other current assets
    
    
    1,810
    
    
    
    1,392Short-term assets of discontinued operations
    
    
    18,025
    
    
    
    20,028Total Current Assets
    
    
    65,681
    
    
    
    59,186Property, Plant and Equipment, net
    
    
    11,447
    
    
    
    9,448Intangibles, net
    
    
    611
    
    
    
    444Goodwill
    
    
    13,444
    
    
    
    500Other Assets
    
    
    2,258
    
    
    
    2,225Long-term Assets of Discontinued Operations
    
    
    18,360
    
    
    
    Total Assets
    
    $
    111,801
    
    
    $
    71,803LIABILITIES
AND STOCKHOLDERS EQUITY
    
    
    
    
    
    
    
    

Current Liabilities:Accounts payable
    
    $
    14,700
    
    
    $
    12,499Accrued liabilities
    
    
    3,190
    
    
    
    5,067Customer deposits
    
    
    3,043
    
    
    
    3,515Deferred revenue
    
    
    69
    
    
    
    39Deferred sale leaseback gain, short-term portion
    
    
    545
    
    
    
    545Current portion of capital leases
    
    
    2,757
    
    
    
    2,957Current liabilities of discontinued operations
    
    
    14,487
    
    
    
    13,931Total Current Liabilities
    
    
    38,791
    
    
    
    38,553Deferred Sale Leaseback Gain, Long-term Portion
    
    
    2,178
    
    
    
    2,042Capital Leases, Long-term Portion
    
    
    3,985
    
    
    
    3,108Other Long-Term Liabilities
    
    
    1,010
    
    
    
    1,098Total Long-Term Liabilities
    
    
    7,173
    
    
    
    6,248Commitments and Contingencies (Note P)Common Stock
    
    
    220
    
    
    
    220Additional Paid-in Capital
    
    
    201,065
    
    
    
    201,066Accumulated Deficit
    
    
    (133,730
    )
    
    
    (173,113
    )Accumulated Other Comprehensive Loss
    
    
    (547
    )
    
    
    Less  Treasury Stock, at Cost
    
    
    (1,171
    )
    
    
    (1,171
    )Total Stockholders Equity
    
    
    65,837
    
    
    
    27,002$
    111,801
    
    
    $
    71,803
 The accompanying notes are an integral part of these condensed consolidated financial statements 3




---



##### Table of Contents



THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(Dollars in thousands, except per share data) Three
Months EndedMarch 31,2004
    
    
    2005Net Sales
    
    $
    22,962
    
    
    $
    20,161Costs and Expenses:Cost of sales
    
    
    22,270
    
    
    
    22,064Selling, general and administrative
    
    
    4,165
    
    
    
    6,721Research, development and engineering
    
    
    248
    
    
    
    233Impairment of goodwill
    
    
    
    
    
    
    12,944Loss on impairment and disposal of long-lived assets
    
    
    2
    
    
    
    2,477Amortization of intangibles
    
    
    318
    
    
    
    16627,003
    
    
    
    44,605Operating loss
    
    
    (4,041
    )
    
    
    (24,444
    )Other Income (Expense):Interest, net
    
    
    (176
    )
    
    
    (132
    )Other, net
    
    
    345
    
    
    
    391169
    
    
    
    259Minority Interest in Loss (Income) of Consolidated Subsidiary
    
    
    (80
    )
    
    
    Loss from Continuing Operations before Income Taxes
    
    
    (3,952
    )
    
    
    (24,185
    )Provision for (benefit from) income taxes
    
    
    (112
    )
    
    
    15Loss from Continuing Operations
    
    
    (3,840
    )
    
    
    (24,200
    )Loss from
Discontinued Operations, net of taxes
    
    
    (2,804
    )
    
    
    (15,183
    )Net Loss
    
    $
    (6,644
    )
    
    $
    (39,383
    )Loss Per Common Share  Basic and Diluted:Loss from Continuing Operations
    
    $
    (0.18
    )
    
    $
    (1.11
    )Loss from
Discontinued Operations
    
    
    (0.13
    )
    
    
    (0.70
    )Net Loss
    
    $
    (0.31
    )
    
    $
    (1.81
    )Weighted Average Number of Common Shares:Basic and Diluted
    
    
    21,321
    
    
    
    21,768
 The accompanying notes are an integral part of these condensed consolidated financial statements 4




---



##### Table of Contents



THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(Dollars in thousands) Three
Months Ended
March 31,2004
    
    
    2005CASH FLOWS FROM OPERATING ACTIVITIES:Net loss
    
    $
    (6,644
    )
    
    $
    (39,383
    )Less loss  discontinued operations
    
    
    (2,804
    )
    
    
    (15,183
    )Loss  continuing operations
    
    
    (3,840
    )
    
    
    (24,200
    )Adjustments to reconcile net loss to net cash (used in) provided by operating activities:Depreciation and amortization
    
    
    1,094
    
    
    
    968Stock compensation
    
    
    
    
    
    
    1Minority interest in consolidated subsidiary
    
    
    80
    
    
    
    Deferred revenue
    
    
    60
    
    
    
    (30
    )Provision for (reduction of) accounts receivable valuation reserves
    
    
    (22
    )
    
    
    (56
    )Loss on impairment of intangibles and goodwill
    
    
    
    
    
    
    12,944Loss on impairment and disposal of assets
    
    
    2
    
    
    
    2,477CHANGES IN OPERATING ASSETS AND LIABILITIES:(Increase) decrease in accounts receivable
    
    
    (622
    )
    
    
    4,135(Increase) decrease in inventories
    
    
    1,295
    
    
    
    221(Increase) decrease in other assets
    
    
    747
    
    
    
    451Increase (decrease) in accounts payable and accrued liabilities
    
    
    (2,284
    )
    
    
    236Increase (decrease) in taxes payable/receivable
    
    
    686
    
    
    
    (2
    )Net cash (used in) operating activities
    
    
    (2,804
    )
    
    
    (2,855
    )CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of property, plant, and equipment
    
    
    (611
    )
    
    
    (1,442
    )Proceeds from sale of assets
    
    
    
    
    
    
    27Purchase of intangibles
    
    
    (2
    )
    
    
    Proceeds from maturities/sales of short-term investments
    
    
    5,132
    
    
    
    Acquisitions and strategic investments
    
    
    (2,384
    )
    
    
    Net cash provided by (used in) investing activities
    
    
    2,135
    
    
    
    (1,415
    )CASH FLOWS FROM FINANCING ACTIVITIES:Borrowings from lines of credit
    
    
    5,000
    
    
    
    Cash pledged for compensating cash arrangement
    
    
    (5,000
    )
    
    
    (600
    )Stock options exercised
    
    
    6
    
    
    
    Payments on capital leases
    
    
    (482
    )
    
    
    (677
    )Payments on stock subscription note receivable
    
    
    185
    
    
    
    Net cash used in financing activities
    
    
    (291
    )
    
    
    (1,277
    )NET (DECREASE) IN CASH AND CASH EQUIVALENTS 
CONTINUING OPERATIONS
    
    
    (960
    )
    
    
    (5,547
    )CASH FLOW FROM DISCONTINUED OPERATIONSNet cash (used in) provided from discontinued operating activities
    
    
    (4,556
    )
    
    
    1,234Net cash (used in) provided from discontinued operations investing activities
    
    
    480
    
    
    
    (68
    )Net cash (used in) provided from discontinue operations financing activities
    
    
    (1,450
    )
    
    
    (1
    )NET CASH USED IN AND CONTRIBUTED BY DISCONTINUED OPERATIONS
    
    
    (5,526
    )
    
    
    1,165NET (DECREASE) IN CASH AND CASH EQUIVALENTS
    
    
    (6,486
    )
    
    
    (4,382
    )CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    27,976
    
    
    
    16,198CASH AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    21,490
    
    
    $
    11,816
 The accompanying notes are an integral part of these condensed consolidated financial statements 5




---



##### Table of Contents



THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Note AOrganization and Operations: Three-Five Systems, Inc. (together with its subsidiaries, herein
referred to as we, us, or the Company) is a global provider of
electronics manufacturing services, or EMS. We design and
manufacture electronic printed circuit board assemblies, radio
frequency, or RF, modules, and complete systems for customers in the
computing, consumer, industrial, medical, military, and
telecommunications industries. Until recently, our design and
manufacturing services included a distinctive competence in display
modules and systems and the integration of display modules and
systems into other products. We refer to the business involving
displays as the Display business. All business other than the
Display business is referred to herein as the EMS business. We sustained substantial losses in the past several years. Those
losses and certain acquisitions we completed had the effect of
reducing our cash balances. As a result, we retained SG Cowen &
Company to review strategic alternatives aimed at maximizing
stockholder value. Based on that review, we sold or closed down two
portions of our Display business in the first quarter of 2005. As a
result, at the end of the first quarter we were no longer in the
Display business except for the large display panel operations in
Marlborough, Massachusetts. In May 2005, we sold those large
display panel operations. We have also signed a letter of intent to sell our business in
Manila, which is the radio frequency, or RF, portion of our EMS
business, in exchange for cash. This letter of intent is nonbinding;
therefore, there is no assurance that any business transaction will
be effected or what the timing and terms of any such business
transaction could be. If the sale of Manila is completed, our only
remaining business will be the Redmond and Penang portions of our
EMS business. We continue to use SG Cowen to review strategic
alternatives with our remaining business. In the meantime, we
continue to focus on cost reductions in that business, including
moving our corporate headquarters to Redmond. As a result of the foregoing, all of our Display business other than
the large display panel operation business in Marlborough,
Massachusetts is reported in our financial statements this quarter
as discontinued operations, as further described below. In addition,
since the RF portion of our business was held for sale in the first
quarter of 2005, that business is also included in discontinued
operations. The accompanying condensed unaudited financial statements have been prepared by management.
They should be read in conjunction with our December 31, 2004 financial statements, which
were included in our Form 10-K Report filed on April 1, 2005 with the Securities Exchange
Commission (SEC) and our Form 10-K/A Amendment No. 1 filed on April 22, 2005 with the SEC.
Our financial statements for the year ended December 31, 2004 received an unqualified
opinion and included an explanatory paragraph regarding our ability to continue as a going
concern at December 31, 2004. Our recurring operating losses and use of cash in our
operating activities during 2004 and the first quarter of 2005 are indicators that led our
auditors to believe that we may be unable to continue as a going concern for a reasonable
period of time. The financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or the amounts and
classifications of liabilities that might be necessary should we be unable to continue as a
going concern. Our continuation as a going concern is dependent upon a combination of our
ability to generate sufficient cash flows from operations, to obtain additional debt or
equity financing, or to sell additional assets to meet our obligations on a timely basis,
and ultimately to attain successful operations. Notwithstanding the foregoing, and based upon our cash balances at the end of the first
quarter, our expected use of cash in 2005, and the $9.4 million that we recently received
upon the sales of operations to International DisplayWorks, Inc. and Video Display Corp., we
believe that we have adequate sources to fund our remaining operations and planned
expenditures through 2005, as well as to meet our contractual obligations. We also expect to
obtain a line of credit in Penang for $4 million. The expected use of funds through the rest
of 2005, however, is based on our current judgments and forecasts. Actual results could
prove materially different and, in such instances, may require additional funds. We cannot
provide assurance that additional asset sales, such 6




---



##### Table of Contents



as the sale of the Manila operations, loan commitments, or other methods of financing will
be available for any such unexpected additional requirements or, if available, that they
will be on terms acceptable to us. Note BDiscontinued Operations: In March 2005, we determined to discontinue our distribution of certain display products
that we licensed from Data International. The decision follows the exercise by us of our
right to rescind a technology licensing agreement, or TLA, that was entered into during
January 2003 with Data International Co, Ltd. Revenue from those Data International products
in 2004 equaled approximately $17 million. The TLA designated us as the exclusive
distributor of certain Data International display products in the Americas in return for
deferred payments to Data International of $3.9 million. Through the end of 2004, we had
paid approximately $2.4 million to Data International, and a final payment of approximately
$1.5 million was due in January 2005. We determined in the first quarter of 2005 that certain of the specified Data International
display products have been simultaneously available in the United States through a third
party and that we had not been provided exclusive distribution rights to the United States
market as required by the TLA. Based on that determination, we believe that the TLA was
breached, and we exercised our rights of rescission. We notified Data International in
February 2005 that we would not make the final $1.5 million payment to Data International
that was due in January 2005. We also asserted damages of at least $2.5 million, plus
interest and other expenses, against Data International. We notified Data International
that we offset our claimed damages against money owed by us to Data International for
product purchases. We recently filed a complaint against Data International in Arizona
requesting a declaratory judgment for breach of contract. Data International also filed a
lawsuit against us in federal district court in Arizona asserting breach of contract. On March 30, 2005, we signed a definitive agreement to sell the assets of our small form
factor display business to International DisplayWorks, Inc. That transaction closed in
April. The small form factor display assets sold included 100% of the outstanding shares of
Three-Five Systems, Beijing, Inc., our former China-based display subsidiary, and
display-related equipment housed at our Manila, Philippines factory. The sale did not
include the large panel display business operated out of our Marlborough, Massachusetts
facility and our electronic manufacturing services (EMS) business located in Redmond,
Washington, Penang, Malaysia, and Manila, Philippines. We estimate the total value of the transaction to be in the range of between $8 and $20
million, which will come from a variety of components. These components include the
following:  
    $8 million in cash recently paid to us upon closing and government approval in
China;
    Up to an estimated $3 million in additional cash to be paid to us over time based
upon working capital adjustments; and
    An estimated zero to $9 million in the common stock of International DisplayWorks,
Inc. to be paid to us in May 2006, based on a percentage of the transferred display
business revenue for the preceding 12-month period, if certain minimum revenue targets
are met. At closing, International DisplayWorks, Inc. assumed the obligations of TFS Beijing,
including a $2.4 million line of credit we had previously established with a bank located in
China. Our display business of products from Data International and our small form factor business
were previously part of our Display segment. Sales from these two businesses were $5.8
million and $12.9 million for the first quarters of 2005 and 2004, respectively. These two
businesses generated $9.5 million and $2.4 million of the loss included in discontinued
operations for the first quarter of 2005 and 2004, respectively. As it relates to our discontinuation of our business related to products supplied by Data
International, we recorded a charge of $2.1 million for the write-off of the distribution
right purchased from Data International. Since the litigation has not been concluded,
however, we have not adjusted the note payable and outstanding accounts payable. 7




---



##### Table of Contents



In connection with the sale of assets to International DisplayWorks, Inc., we recorded a
loss of $5.0 million from the write down of assets, which considered only the initial $8
million received when calculating the write down on these assets. The various earn-outs were
classified as contingent gains and will be recorded by us, if and when received. As a
result, we wrote off $2.5 million of inventory, $0.7 million of mask sets and $1.8 million
of property, plant, and equipment. We have also included our RF business under discontinued operations because during the first
quarter we had established a plan to sell this business in the next 12 months. This business
was previously part of our EMS segment. We have signed a non-binding letter of intent to
sell this business and expect to close by the end of the second quarter. Although the sale
cannot be assured, we have used the current estimated sales price of approximately $3.0
million to determine the impairment of assets currently in this business. Sales from this
business were $2.1 million and $2.6 million in the first quarter of 2005 and 2004,
respectively. The total loss from discontinued operations for the RF business was $5.8
million and $0.4 million in the first quarter of 2005 and 2004, respectively. The impairment
of assets totaled $5.2 million in the first quarter of 2005. In May 2005, we sold the large panel display business operated out of our Marlborough,
Massachusetts facility for $1.4 million to Video Display Corp. At March 31, 2005, we had not
finalized our plans for this business and not yet committed to a plan to sell the business.
As a result, that business will be reported as discontinued operations commencing in the
second quarter of 2005. In part based on the lower than expected operating results of this
business in the first quarter of 2005, forecasted revenue revisions, and the sale price
realized in May 2005, we determined that $7.2 million of goodwill associated with the
display monitor business was impaired. This charge appears under Impairment of Goodwill. Net loss from all discontinued operations was $15.2 million and $2.8 million in the first
quarter of 2005 and 2004, respectively. There was no tax benefit in 2004 or 2005 for the
discontinued operations. Sales from all discontinued operations were $7.9 million and $15.5
million in the first quarter of 2005 and 2004, respectively. During 2004, we entered into a series of agreements with Vitelcom, a former European
customer, with regard to its payment of an outstanding balance due us. As of March 31, 2005
and December 31, 2004, $1.4 million remained unpaid under that revised payment schedule.
During the first quarter of 2005, we reserved $0.4 million against this unpaid amount. In
addition, we filed a lawsuit against Vitelcom in Spain for the outstanding balance due us. In February 2005, we vacated our office space in Swindon, England. A charge of
approximately $15,400 was recorded in February 2005 to recognize future costs associated
with the continuing lease obligation for this vacated facility. We have undertaken efforts
to sublease this facility, and the charge is net of estimated future rental income we expect
to receive. At March 31, 2005, the amount to be amortized was all considered to be current. In March 2005, we vacated our office space in Orlando, Florida. A charge of approximately
$26,000 was recorded in March 2005 to recognize future costs associated with the continuing
lease obligation for this vacated facility. We have undertaken efforts to sublease this
facility, and the charge is net of estimated future rental income we expect to receive. At
March 31, 2005, the amount to be amortized was all considered to be current. 8




---



##### Table of Contents



The major classes of discontinued assets and liabilities included in the Condensed
Consolidated Balance Sheet as of March 31, 2005 were as follows: (Dollars in thousands)
    
    March 31, 2005Assets:Accounts receivable, net
    
    $
    7,117Inventories
    
    
    2,787Taxes receivable
    
    
    178Deferred tax asset
    
    
    122Other current assets
    
    
    1,421Property, plant and equipment, net
    
    
    8,402Other long-term assets
    
    
    1Total assets from discontinued operations
    
    $
    20,028Liabilities:Accounts payable
    
    $
    8,135Accrued liabilities
    
    
    1,841Income taxes payable
    
    
    44Note payable to Data International
    
    
    1,481Capital leases
    
    
    14Line of credit in China
    
    
    2,416Total liabilities from discontinued operations
    
    $
    13,931
 Note CCash and Cash Equivalents: For purposes of the statements of cash flows, all highly liquid investments with an original
maturity of three months or less are considered to be cash equivalents. Cash equivalents
consist of investments in money market mutual funds. A portion of our funds held in money
market mutual funds are invested in repurchase agreements. These repurchase agreements are
collateralized by U.S. Treasury and Government obligations.
In the first quarter of 2005, Silicon Valley Bank (SVB) required us to make a cash deposit
to secure a $600,000 letter of credit, which SVB had issued to the lessor of our building in
Redmond. This cash deposit is shown on our Balance Sheet at March 31, 2005 as Cash on
Deposit Maintained for Compensating Balances. Cash and cash equivalents at December 31, 2004
and March 31, 2005 consisted of the following: December 31,
    
    
    March 31,(Dollars in thousands)
    
    2004
    
    
    2005Cash and cash equivalents:Cash
    
    $
    16,198
    
    
    $
    11,816Cash on deposit maintained as
compensating balances
    
    
    
    
    
    
    600$
    16,198
    
    
    $
    12,416
 Note DAccounts Receivable, net: We estimate sales allowances based upon historical experience of sales returns. To establish
our allowance for doubtful accounts, we perform credit evaluations of our customers
financial condition, along with analyzing past experience, and make provisions for doubtful
accounts based on the outcome of our credit valuations and analysis. Our allowance for
doubtful accounts was $83,000 and $53,000 as of March 31, 2005 and December 31, 2004,
respectively. Allowance for sales returns was $120,000 and $208,000 as of March 31, 2005
and December 31, 2004, respectively. 9




---



##### Table of Contents



Note EInventories: Inventories are stated at the lower of cost (first-in, first-out) or net realizable value
and consisted of the following at: December 31,
    
    
    March 31,(Dollars in thousands)
    
    2004
    
    
    2005Raw materials
    
    $
    11,030
    
    
    $
    12,465Work-in-process
    
    
    1,546
    
    
    
    1,199Finished goods
    
    
    4,973
    
    
    
    3,664$
    17,549
    
    
    $
    17,328
 Shipping terms with one of our major customers is FOB destination, and many of those
products are shipped by sea, taking four to six weeks to reach their destinations. As a
result, product in transit that was in our finished goods inventory was $2.5 million as of
March 31, 2005 compared with $3.1 million as of December 31, 2004. We scrap inventory when materials are determined to be defective, damaged, or no longer
required. We also write down our inventory for estimated obsolescence or un-marketability
based upon assumptions and estimates about future demand and market conditions. If actual
market conditions are less favorable than those assumed by us, additional inventory
write downs may be required. We have had a significant history of inventory charges and
write-offs. In 2004, we wrote off $2.1 million as excess inventory. In the first quarter
of 2005, we wrote off $0.7 million of excess inventory, primarily in our EMS segment, which
related primarily to discontinued programs and excess inventories at our Redmond, Washington
facility. Note FProperty, Plant, and Equipment: Property, plant, and equipment is recorded at cost and is depreciated using the
straight-line method over the estimated useful lives of the respective assets. Lives for
the major asset categories are as follows: LivesBuildings
    
    35  39 yearsBuilding Improvements
    
    10  35 yearsEquipment
    
    3  7 yearsFurniture
    
    3  10 years
 Major additions and betterments are capitalized, while replacements, maintenance, and
repairs that do not extend the useful lives of the assets are charged to expense as
incurred. Property, plant, and equipment consisted of the following at the dates indicated: December 31,
    
    
    March 31,(Dollars in thousands)
    
    2004
    
    
    2005Furniture, equipment and leasehold improvements
    
    $
    17,992
    
    
    $
    16,615Less accumulated depreciation
    
    
    (6,545
    )
    
    
    (7,167
    )$
    11,447
    
    
    $
    9,448
 As of December 31, 2004, we had invested $2.1 million in our ERP software and
implementation. During the first quarter of 2005, we made additional investments of $0.4
million into the ERP project. In February, this project was put on hold as we evaluated our
situation regarding the sale of our Manila facility, the move of our corporate headquarters
to Redmond, Washington, and our other strategic alternatives to maximize stockholder value.
During the second quarter of 2005, we determined that we would not proceed with the
implementation. As a result of that decision, and as part of our ongoing review of assets,
we wrote off the total investment of $2.5 million in the first quarter of 2005. 10




---



##### Table of Contents



Note GIntangibles: Intangibles consist of customer lists of our EMS segment that were acquired during our
acquisition of ETMA in December 2002. SFAS 142, Goodwill and Other Intangible Assets,
requires purchased intangible assets with finite lives to be amortized over their useful
lives. Purchased intangibles are recorded at cost and amortized using the straight-line
method over the estimated useful lives of the respective assets, which is three years. Intangible assets consisted of the following: Accumulated
    
    
    Book
    
    
    Weighted(Dollars in thousands)
    
    Acquisition Value
    
    
    Amortization
    
    
    Value
    
    
    Avg LifeDecember 31, 2004Amortized Intangible Assets:Customer lists
    
    $
    2,000
    
    
    $
    (1,389
    )
    
    $
    611
    
    
    
    3.0$
    2,000
    
    
    $
    (1,389
    )
    
    $
    611
    
    
    
    3.0Accumulated
    
    
    Book
    
    
    Weighted(Dollars in thousands)
    
    Acquisition Value
    
    Amortization
    
    
    Value
    
    
    Avg LifeMarch 31, 2005Amortized Intangible Assets:Customer lists
    
    $
    2,000
    
    
    $
    (1,556
    )
    
    $
    444
    
    
    
    3.0$
    2,000
    
    
    $
    (1,556
    )
    
    $
    444
    
    
    
    3.0
 Intangible asset amortization expense for the three months ended March 31, 2005 and 2004 was
$166,000 and $318,000, respectfully. Amortization expense in 2004 also included
amortization of customer lists acquired in our acquisition of AVT in September 2002. Estimated annual amortization expense through 2009 and thereafter related to intangible
assets reported as of March 31, 2005 was as follows: Fiscal Year
    

(Dollars
in thousands)2005
    
    $
    4442006
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    Thereafter
    
    
    $
    444
 Note HGoodwill: In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, goodwill is
analyzed for impairment, on at least an annual basis, or more frequently under certain
circumstances, and written down when impaired rather than being amortized. Changes in goodwill from December 31, 2004 to March 31, 2005 were as follows: (Dollars in thousands)Balance at December 31, 2004
    
    $
    13,444Goodwill impairment
    
    
    (12,944
    )Balance at March 31, 2005
    
    $
    500
 In the first quarter of 2005, we determined that $5.7 million of goodwill in our EMS
reporting unit and $7.2 million of goodwill in our Display reporting unit had been impaired.
The amount of the impairment was determined in accordance with the provisions of SFAS No.
142, Goodwill and Other Intangible Assets. The 11




---



##### Table of Contents



decision to impair the goodwill was the result of first quarter 2005 operating results,
forecasted revenue revisions, the recent sale of the Marlborough business in May 2005, and
valuations set forth in indications of interest we have recently received with respect to
one or more of our businesses in our EMS segment. In May 2005, we completed the sale of our
Marlborough business for $1.4 million, which indicated that $500,000 of goodwill should be
recorded at March 31, 2005. Note IOther Assets: Other assets consist primarily of the $2.0 million note receivable that we received in
connection with the sale and leaseback of the Tempe building. Note JOther Accrued Liabilities: Accrued liabilities include, among other things, accrued
compensation, current portion of deferred building rent and current
portion of lease abandonment costs. See Footnote O for additional
details. Note KCustomer Deposits: As of March 31, 2005 and December 31, 2004, customer deposits included approximately $3.3
million and $2.9 million, respectively, of invoices issued to a specific customer in
accordance with the terms and conditions of that customers purchase order. The invoices
are to cover costs associated with the establishment of the supply chain and the long lead
times required for materials used in the manufacturing process. Note LDeferred Sale Leaseback Gain: In December 2004, we sold our Tempe building for approximately $11.3 million less selling
costs of approximately $500,000. Under the terms of the sale, we received net cash (after
expenses) of $8.8 million and a promissory note of $2.0 million payable in five years,
resulting in a $2.7 million gain on the sale of that building. The $2.7 million deferred
gain on the sale and leaseback of our Tempe, Arizona corporate facility will be amortized
over the five-year term of the lease. During the first quarter of 2005, we recognized $0.1
million of the gain. Note MStock Compensation: 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, under which no compensation cost has
been recognized. However, 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 2.80%, and 4.18% for the three months ended March 31, 2004, and 2005;
expected dividend yields of zero for all scenarios; expected lives of 5.7 years for 2004,
and 3.9 years for 2005; and expected volatility (a measure of the amount by which a price
has fluctuated or is expected to fluctuate during a period) of 79.6%, and 77.8% for the
three months ended March 31, 2004, and 2005, respectively. The compensation costs for the
three months ended March 31, 2004 and 2005 are not tax-effected. Had compensation cost for
these plans been determined consistent with SFAS No. 123, our net loss and loss per share
would have been as follows: 12




---



##### Table of Contents



Three Months EndedMarch 31,(In thousands, except per share data)
    
    2004
    
    
    2005Net loss:As reported
    
    $
    (6,644
    )
    
    $
    (39,383
    )Total stock-based compensation expenses
determined under fair value based method for
all awards, net of related tax effects
    
    
    (1,851
    )
    
    
    (463
    )Pro forma net loss
    
    $
    (8,495
    )
    
    $
    (39,846
    )Basic and diluted net loss per share:As reported
    
    $
    (0.31
    )
    
    $
    (1.81
    )Pro forma
    
    
    (0.40
    )
    
    
    (1.83
    )
 Note NEarnings Per Share: Basic net (loss) per common share is computed by dividing net (loss) by the weighted average
number of common shares outstanding during the year before giving effect to stock options
considered to be dilutive common stock equivalents. Diluted net (loss) per common share is
computed by dividing net (loss) by the weighted average number of common shares outstanding
during the year after giving effect to stock options considered to be dilutive common stock
equivalents. Set forth below are the disclosures required pursuant to SFAS No. 128 
Earnings per Share: Three Months EndedMarch 31,2004
    
    
    2005Basic earnings (loss) per share:Net income (loss)
    
    $
    (6,644
    )
    
    $
    (39,383
    )Weighted average common shares
    
    
    21,321
    
    
    
    21,768Basic earnings (loss) per share amount
    
    $
    (0.31
    )
    
    $
    (1.81
    )Diluted earnings (loss) per share:Net income (loss)
    
    $
    (6,644
    )
    
    $
    (39,383
    )Weighted average common shares
    
    
    21,321
    
    
    
    21,768Dilutive stock options
    
    
    
    
    
    
    Total common shares plus common stock equivalents
    
    
    21,321
    
    
    
    21,768Diluted earnings (loss) per share amount
    
    $
    (0.31
    )
    
    $
    (1.81
    )
 For the three months ended March 31, 2004 and 2005, the effect of 224,004 and 722 shares
from stock options, respectively, were excluded from the calculation of loss per share as
their effect would have been antidilutive and decreased the loss per share. 13




---



##### Table of Contents



Note OOther Long-Term Liabilities: Other Long-term balances were as follows at: December 31,
    
    
    March 31,(Dollars in thousands)
    
    2004
    
    
    2005Deferred building lease incentive
    
    $
    920
    
    
    $
    884Lease abandonment
    
    
    382
    
    
    
    1,0721,302
    
    
    
    1,956Less current portion (included in accrued liabilities)
    
    
    292
    
    
    
    858Long term portion
    
    $
    1,010
    
    
    $
    1,098
 In the fourth quarter of 2004, we moved into a new facility in Redmond and signed a
seven-year lease with a five-year renewal option. As a part of that transaction, we
received $900,000 from the landlord as an inducement to enter into the new lease and to
cover costs associated with the move. We are required to amortize the $900,000 against rent
expense over the term of the lease. Therefore, at March 31, 2005 and December 31, 2004, the
long-term portion of the amount to be amortized was approximately $757,000 and $763,000,
respectively. We refer to the building in Redmond as Building 4. We also lease three other
buildings in the Redmond area. In the fourth quarter of 2004, we vacated a facility we refer to as Building 1 in Redmond,
Washington. We recorded a charge of $382,000 in the fourth quarter of 2004 to recognize
future costs associated with the continuing lease obligations for this vacated facility.
The charge is net of any future rental income we will receive. The long-term portion
attributable to the charge was approximately $213,000 and $247,000, at March 31, 2005 and
December 31, 2004, respectively. In January 2005, we vacated approximately 30,020 square feet in a facility we refer to as
Building 2 in Redmond, Washington. We moved all of the operations in that building to our
new Building 4. We had 12 months remaining on our lease on Building 2 at the end of January
2005. A charge of approximately $194,000 was recorded in the first quarter of 2005 to
recognize future costs associated with the continuing lease obligation for this vacated
facility (Building 2). We have undertaken efforts to sublease this facility, and the charge
is net of estimated future rental income we expect to receive. At March 31, 2005, the
amount to be amortized was all considered to be current. At the end of March 2005, we vacated an additional 32,650 square feet in a facility we refer
to as Building 3 in Redmond, Washington. We moved all of the operations in that building to
our new Building 4. A charge of approximately $500,000 was recorded in the first quarter of
2005 to recognize future costs associated with the continuing lease obligation for this
vacated facility (Building 3). We have undertaken efforts to sublease this facility, and
the charge is net of estimated future rental income we expect to receive. At March 31,
2005, the long-term portion to be amortized was approximately $128,000. Note PCommitments and Contingencies: Rent and Lease In December 2004, we sold our Tempe, Arizona building for approximately $11.3 million, less
selling costs of approximately $500,000. At the time of the sale, we entered into an
agreement with the buyer to leaseback the entire facility for a period of five years, which
extends through December 2009. This facility currently houses our U.S.-based corporate
functions. We subleased approximately 56,000 square feet of that Tempe facility to Brillian
Corp. for the same five-year period. Brillian pays to us the same lease rate that we pay the
lessor on the master lease. If Brillian were to default on its obligation to us, we would
still be obligated on the master lease to continue to make payments on the Brillian space.
The sublease income we receive from Brillian is recorded as other income. 14




---



##### Table of Contents



Letter of Credit In accordance with the terms of the lease for one of our facilities in Redmond, Washington,
we have issued an unconditional, sight draft letter of credit in the amount of $600,000 to
the landlord. The landlord letter of credit is security for our performance of all of our
covenants and obligations under the lease. In the first quarter of 2005, Silicon Valley
Bank (SVB) required us to make a cash deposit to secure the $600,000 letter of credit. This
cash deposit is shown on our Balance Sheet at March 31, 2005 as Cash on Deposit Maintained
for Compensating Balances. Guarantee In February 2002, we guaranteed up to $500,000 of the debt of a private start-up company,
VoiceViewer Technology, Inc., which is developing microdisplay products. This guarantee was
assumed by Brillian Corporation in the spin-off. We have not yet been released from our
obligation on the guarantee, so if Brillian is unable to satisfy its obligation, then we are
secondarily liable and will be required to pay this guarantee to the lender. As of March 31,
2005, our maximum liability under this guarantee was $292,000. This loan guarantee has a
five-year term and matures in January 2007. Note QSegment Information: At the end of 2004, we began to review our business performance using two segments: Display
and EMS. Within the Display business, our design and manufacturing services included a
distinctive competence in display modules and systems and the integration of display modules
and systems into other products. Within the EMS business, we design and/or manufacture
electronic printed circuit board assemblies, display modules and systems, and complete
systems for customers in the computing, consumer, industrial,
medical, military, and telecommunications industries. Corporate costs not allocated to operating segments include
administrative costs for the chief executive officer, chief financial officer and investor
relations as well as accounting, legal and human resource costs in Tempe, Arizona. In the
first quarter of 2005, we included facility, information technology and quality assurance
costs incurred at our Tempe facility in our unallocated corporate costs. We have restated 2004 segment data to conform
with this new presentation methodology. The following results are for our Display and EMS
segments and unallocated corporate costs: (Dollars in thousands)Display
    
    
    EMS
    
    
    Corporate
    
    
    TotalMarch 31, 2004Net Sales
    
    $
    2,161
    
    
    $
    20,801
    
    
    $
    
    
    
    $
    22,962Gross margin (loss)
    
    
    497
    
    
    
    388
    
    
    
    (193
    )
    
    
    692Operating income (loss)
    
    
    24
    
    
    
    (1,394
    )
    
    
    (2,671
    )
    
    
    (4,041
    )Amortization expense
    
    
    150
    
    
    
    168
    
    
    
    
    
    
    
    318Goodwill
    
    
    7,773
    
    
    
    26,833
    
    
    
    
    
    
    
    34,606March 31, 2005Net Sales
    
    $
    751
    
    
    $
    19,410
    
    
    $
    
    
    
    $
    20,161Gross margin (loss)
    
    
    (38
    )
    
    
    (1,277
    )
    
    
    (588
    )
    
    
    (1,903
    )Operating income (loss)
    
    
    (7,566
    )
    
    
    (9,999
    )
    
    
    (6,879
    )
    
    
    (24,444
    )Amortization expense
    
    
    
    
    
    
    166
    
    
    
    
    
    
    
    166Goodwill
    
    
    500
    
    
    
    
    
    
    
    
    
    
    
    500
 We have not disclosed total assets, liabilities, cost of property, plant and equipment
acquired, and depreciation expense by segment as this information is not reviewed by the
chief operating decision maker, is not produced internally and is not practical to prepare. We do, however, track net sales and certain property, plant, equipment, and intangibles by
geographic location. Net sales by geographic area are determined based upon the location of
the end customer, while long-lived 15




---



##### Table of Contents



assets are based upon physical location of the assets. The following includes net sales,
property, plant and equipment for our designated geographic areas: (Dollars in thousands)NorthAmerica
    
    
    Asia
    
    
    Europe
    
    
    TotalMarch 31, 2004Net sales
    
    $
    14,489
    
    
    $
    1,487
    
    
    $
    6,986
    
    
    $
    22,962Property, plant and equipment
    
    
    3,286
    
    
    
    7,774
    
    
    
    
    
    
    
    11,060March 31, 2005Net sales
    
    $
    13,473
    
    
    $
    1,896
    
    
    $
    4,792
    
    
    $
    20,161Property, plant and equipment
    
    
    2,992
    
    
    
    6,456
    
    
    
    
    
    
    
    9,448
 For the quarters end March 31, 2004 and 2005, our sales were distributed over six major
markets: computing, consumer, industrial, medical, military and telecommunications. In the
first quarter of 2005, 76% of our sales came from the computing market and 10% came from the
medical market. In first quarter of 2004, 72% of our sales came from the computing market
and 15% came from medical. Our net sales distributed by market were as follows: Three Months EndedMarch 31,Markets
    
    2004
    
    
    2005Computing
    
    
    72
    %
    
    
    76
    %Consumer
    
    
    1
    %
    
    
    2
    %Industrial
    
    
    9
    %
    
    
    4
    %Medical
    
    
    15
    %
    
    
    10
    %Military
    
    
    2
    %
    
    
    3
    %Telecommunications
    
    
    1
    %
    
    
    5
    %
 Note RRecently Issued Accounting Standards: In November 2004, the FASB issued SFAS No. 151, Inventory Costs  An Amendment of ARB No.
43, Chapter 4. SFAS No. 151 amends the guidance in Accounting Research Bulletin (ARB) No.
43, Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle
facility expense, freight, handling costs, and wasted material (spoilage). Among other
provisions, the new rule requires that items such as idle facility expense, excessive
spoilage, double freight, and rehandling costs be recognized as current-period charges
regardless of whether they meet the criterion of so abnormal as stated in ARB No. 43.
Additionally, SFAS No. 151 requires that the allocation of fixed production overheads to the
costs of conversion be based on the normal capacity of the production facilities. SFAS No.
151 is effective for fiscal years beginning after June 15, 2005 and is required to be
adopted by us effective January 1, 2006. We are currently evaluating the impact SFAS No. 151
will have on our consolidated results of operations and financial condition. In
December 2004, the FASB issued Statement 123 (R), Share-Based Payment, which replaces
FASB Statement No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion
No. 25, Accounting for Stock Issued to Employees. FASB Statement
123 (R) will require
compensation costs related to share-based payment transactions to be recognized in the
financial statements. With limited exceptions, the amount of compensation cost will be
measured based on the grant-date fair value of the equity instruments issued. Compensation
cost will be recognized over the period that an employee provides service in exchange for
the award. FASB Statement 123 (R) becomes effective for annual periods beginning after June
15, 2005 and is 16




---



##### Table of Contents



required to be adopted by us effective January 1, 2006. At this time, we are in the process
of evaluating the impact this will have on our financial statements. We adopted the provisions of FASB Interpretation No. 46 (Revised), Consolidation of Variable
Interest Entities (Interpretation No. 46 (Revised)) in our interim period ending March 31,
2004. Interpretation
No. 46 (Revised) clarifies the application of existing consolidation requirements to
entities where a controlling financial interest is achieved through arrangements that do not
involve voting interests. The
application of Interpretation No. 46 (Revised) did not have an impact on our financial
statements. Note SSubsequent Events: In May 2005, we sold the large panel display business operated out of our Marlborough,
Massachusetts facility for $1.4 million to Video Display Corp. At March 31, 2005, we had not
finalized our plans for this business and not yet committed to a plan to sell the business.
As a result, that business will be reported as discontinued operations commencing in the
second quarter of 2005. In part based on the lower than expected operating results of this
business in the first quarter of 2005, forecasted revenue revisions, and the sale price
realized in May 2005, we determined that $7.2 million of goodwill associated with the
display monitor business was impaired. This charge appears under Impairment of Goodwill. 
 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 2005 and thereafter;
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 are a global provider of electronics manufacturing services, or EMS. We design and/or
manufacture electronic printed circuit board assemblies, radio frequency, or RF, modules, and
complete systems for customers in the computing, consumer, industrial, medical, military, and
telecommunications industries. Our services include advanced engineering support, designed for
services, automated printed circuit board assembly, in-circuit and functional testing, systems
level integration and box build, and turn-key supply chain management services, all of which enable
our customers the ability to outsource all stages of product engineering, design, development,
materials procurement and management, manufacturing, and testing. Until recently, our design and
manufacturing services included a distinctive competence in display modules and systems and the
integration of display modules and systems into other products. We refer to the business involving
displays as the Display business. All other business other than the Display business is referred
to herein as the EMS business. Current Strategic Plans Regarding the Sale of Remaining Businesses We have sustained substantial losses in the past several years. Those losses and certain
acquisitions we completed had the effect of reducing our cash balances. As a result, we retained SG
Cowen & Company to review 17




---



##### Table of Contents



strategic alternatives aimed at maximizing stockholder value. Based on that review, and as
further described below, we have sold or closed down our Display business. We have also signed a
letter of intent to sell our business in Manila, which is the radio frequency, or RF, portion of
our EMS business, in exchange for cash. This letter of intent is nonbinding; therefore, there is no
assurance that any business transaction will be effected or what the timing and terms of any such
business transaction will be. If the sale of Manila is completed, our only remaining business will
be the Redmond and Penang portions of our EMS business. We continue to use SG Cowen to review
strategic alternatives with our remaining business. In the meantime, we continue to focus on cost
reductions in that business, including moving our corporate headquarters to Redmond. As a result of the foregoing, all of our Display business other than the large format display
business in Marlborough, Massachusetts is reported in our financial statements this quarter as
discontinued operations, as further described below. In addition, since the RF portion of our
business was held for sale in the first quarter, that business is also included in discontinued
operations in the first quarter. Recent Sale Transactions and Discontinued Operations In March 2005, we determined to discontinue our distribution of certain display products that
we licensed from Data International. The decision follows the exercise by us of our right to
rescind a technology licensing agreement, or TLA, that was entered into during January 2003 with
Data International Co, Ltd. Revenue from those Data International products in 2004 equaled
approximately $17 million. The TLA designated us as the exclusive distributor of certain Data
International display products in the Americas in return for deferred payments to Data
International of $3.9 million. Through the end of 2004, we had paid approximately $2.4 million to
Data International, and a final payment of approximately $1.5 million was due in January 2005. We determined in the first quarter of 2005 that certain of the specified Data International
display products have been simultaneously available in the United States through a third party and
that we had not been provided exclusive distribution rights to the United States market as required
by the TLA. Based on that determination, we believe that the TLA was breached, and we exercised
our rights of rescission. We notified Data International in February 2005 that we would not make
the final $1.5 million payment to Data International that was due in January 2005. We also
asserted damages of at least $2.5 million, plus interest and other expenses, against Data
International. We notified Data International that we have off-set our claimed damages against
money owed by us to Data International for product purchases. We recently filed a complaint
against Data International in Arizona requesting a declaratory judgment for breach of contract.
Data International also filed a lawsuit against us in federal district court in Arizona asserting
breach of contract. On March 30, 2005, we signed a definitive agreement to sell the assets of our small form
factor display business to International DisplayWorks, Inc. That transaction closed in April. The
small form factor display assets sold included 100% of the outstanding shares of Three-Five
Systems, Beijing, Inc., our former China-based display subsidiary, and display-related equipment
housed at our Manila, Philippines factory. The sale did not include the large panel display
monitor business operated out of our Marlborough, Massachusetts facility and our electronic
manufacturing services (EMS) business located in Redmond, Washington, Penang, Malaysia, and Manila,
Philippines. We estimate the total value of the transaction to be in the range of between $8 and $20
million, which will come from a variety of components. These components include the following:  
    $8 million in cash recently paid to us upon closing and government approval in
China;
    Up to an estimated $3 million in additional cash to be paid to us over time based
upon working capital adjustments; and
    An estimated zero to $9 million in the common stock of International DisplayWorks,
Inc. to be paid to us in May 2006, based on a percentage of the transferred display
business revenue for the preceding 12-month period, if certain minimum revenue targets
are met. At closing, International DisplayWorks, Inc. assumed the obligations of TFS Beijing, including
a $2.4 million line of credit we had previously established with a bank located in China. Our display business of products from Data International and our small form factor business
were previously part of our Display segment. Sales from these two businesses were $5.8 million and
$12.9 million in the first quarters of 18




---



##### Table of Contents



2005 and 2004, respectively. These two businesses generated $9.5 million and $2.4 million of the
loss included in discontinued operations in the first quarter of 2005
and 2004, respectively. As it relates to our discontinuation of our business related to products supplied by Data
International, we recorded a charge of $2.1 million for the write-off of the distribution right
purchased from Data International. Since the litigation has not been concluded, however, we have
not adjusted the write down of the note payable and outstanding accounts payable. In connection with the sale of assets to International DisplayWorks, Inc., we recorded a loss
of $5.0 million from the write down of assets, which considered only the initial $8 million
received at the closing when calculating the write down on these assets. The various earn-outs were
classified as contingent gains and will be recorded by us, if and when received. As a result, we
wrote off $2.5 million of inventory, $0.7 million of mask sets, and $1.8 million of property,
plant, and equipment. We also included our RF business under discontinued operations because during the first
quarter we had established a plan to sell this business in 2005. This business was previously part
of our EMS segment. As noted previously, we have signed a non-binding letter of intent to sell this
business and expect to close by the end of the second quarter. Although the sale cannot be
assured, we have used the current estimated sales price of approximately $3.0 million to determine
the impairment of assets currently in this business. Sales from this business were $2.1 million and
$2.6 million in the first quarter of 2005 and 2004, respectively. The total loss from discontinued
operations for the RF business was $5.8 million and $0.4 million in the first quarter of 2005 and
2004, respectively. The impairment of assets totaled $5.2 million in the first quarter of 2005. In May 2005, we sold the large panel display monitor business operated out of our Marlborough,
Massachusetts facility for $1.4 million to Video Display Corp. At March 31, 2005, we had not
finalized our plans for this business and not yet committed to a plan to sell the business. As a
result, that business will be reported as discontinued operations commencing in the second quarter
of 2005. In part based on the lower than expected operating results of this business in the first
quarter of 2005, forecasted revenue revisions, and the sale price realized in May 2005, we
determined that $7.2 million of goodwill associated with the display monitor
business was impaired. This charge appears under Impairment of Goodwill. Refer to our Form 10-K filed April 1, 2005 for a detailed description of Acquisitions and
Strategic Transactions that occurred in 2004 and prior years. 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 generally accepted
accounting principles (GAAP) 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 ongoing basis, we evaluate our estimates and judgments, including those related
to sales returns, bad debts, inventories, fixed assets, goodwill, 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 assemble and manufacture products for our customers and recognize revenue 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 or determinable; and collection of
the resulting receivable is reasonably assured. This means that when a product is shipped from one
of our factories under the terms FOB Factory then the risk of loss passes to the customer when
the product leaves our factory and we recognize revenue at that time. On the other hand, when a
product is shipped under the title transfer terms of FOB Destination then the risk of loss during
transit is maintained by 19




---



##### Table of Contents



us. Thus, we recognize revenue when the product is accepted by the customer. Shipping terms
with one of our major customers is FOB Destination, and many of those products are shipped by sea,
taking four to six weeks to reach their destination. As a result, we frequently have a significant
amount of product in transit recorded in our finished goods inventory. At March 31, 2005, we had
$2.5 million of product in transit compared with $3.1 million at December 31, 2004. We estimate sales allowances based upon historical experience of sales returns. To establish
our allowance for doubtful accounts, we perform credit evaluations of our customers financial
condition, along with analyzing past experience, and make provisions for doubtful accounts based on
the outcome of our credit valuations and analysis. We evaluate the collectability of our accounts
receivable based on specific customer circumstances, current economic trends, historical experience
with collections, and the age of past due receivables. We believe the allowances that we have
established are adequate under the circumstances; however, a change in the economic environment or
a customers financial condition could cause our estimates of allowances, and consequently the
provision for doubtful accounts, to change. In the first quarter of 2005, we reserved $0.4 million
of our receivable from Vitelcom, a former European customer. This adjustment is included under
discontinued operations. We scrap inventory when materials are determined to be defective, damaged, or no longer
required. We also write down our inventory for estimated obsolescence or unmarketable inventory
based upon assumptions and estimates 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. In the first quarter of 2005, we wrote off $0.7 million of inventory, primarily in our
EMS segment, which primarily related to discontinued programs and excess inventories in our
Redmond, Washington facility. Pursuant to Financial Accounting Standards Board (FASB) Statement of Financial Accounting
Standards (SFAS) No. 109, Accounting for Income Taxes, income taxes are recorded based on
current year amounts payable or refundable, as well as the consequences of events that give rise to
deferred tax assets and liabilities. We base our estimate of current and deferred taxes on the tax
laws and rates that are currently in effect in the appropriate jurisdiction. Changes in tax laws
or rates may affect the current amounts payable or refundable as well as the amount of deferred tax
assets or liabilities. Long-term assets, such as property, plant, and equipment, intangibles, goodwill, and other
investments, are originally recorded at cost. On an ongoing 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. Assets may also be evaluated
by identifying independent market values of assets that we believe to be comparable. If we believe
that an assets value is impaired, we write down the carrying value of the identified asset and
charge the impairment as an expense in the period in which the determination is made. In the first
quarter of 2005, we determined that $5.7 million of goodwill in our EMS reporting unit and $7.2
million of goodwill in our Display reporting unit had been impaired. The amount of the impairment
was determined in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible
Assets. The decision to impair the goodwill was the result of first quarter 2005 operating
results, forecasted revenue revisions, the recent sale of the Marlborough business in May 2005 and
valuations set forth in indications of interest we have recently received with respect to one or
more of our businesses in our EMS segment. In May 2005, we completed the sale of our Marlborough
business for $1.4 million which indicated that $500,000 of goodwill should be recorded at March 31,
2005. During the first quarter of 2005 within our discontinued operations, we also impaired $5.2
million of assets related to our RF business, and $7.1 million of assets (including inventory)
related to our two discontinued Display businesses. Results of Operations Three months ended March 31, 2005 compared to three months ended March 31, 2004 Net Sales.Net sales decreased 12.2% to $20.2 million in the first quarter of 2005 from $23.0
million in the first quarter of 2004. The decrease in year-over-year quarterly revenue was
primarily a result of reduced sales in the 20




---



##### Table of Contents



computing, industrial, and medical markets. Sales in both our Display and EMS segments were
lower in the first quarter of 2005 compared with the first quarter of 2004. Geographically, our
sales were lower in both the US and European markets. We had only one customer that accounted for
more than 10% of our net sales in the first quarter of 2005 and 2004, and that customer, which is
in the computer peripherals business, accounted for 66% and 59% of our net sales, respectively. The
sales in our top six markets (in thousands) on a comparative quarterly basis are broken down as
follows: Three Months EndedMarch 31,Industry
    
    2004
    
    
    2005Computing
    
    $
    16,545
    
    
    $
    15,403Consumer
    
    
    324
    
    
    
    357Industrial
    
    
    2,013
    
    
    
    867Medical
    
    
    3,313
    
    
    
    1,890Military
    
    
    453
    
    
    
    606Telecommunications
    
    
    314
    
    
    
    1,038Total
    
    $
    22,962
    
    
    $
    20,161
 Sales in our two segments, in millions, were as follows: Three Months EndedMarch 31,2004
    
    
    2005Display
    
    $
    2.2
    
    
    $
    0.8EMS
    
    
    20.8
    
    
    
    19.4$
    23.0
    
    
    $
    20.2
 Gross Margin.Our gross margin equals the difference between our revenue and our cost of
sales. Our gross margin in the first quarter of 2005 was a negative $1.9 million, or 9.4%,
compared with a positive $0.7 million, or 3.0% in the first quarter of 2004. The negative
gross margins in the first quarter of 2005 were caused by several factors, including excess
capacity in the manufacturing facilities and operational issues. In addition, our reduced
manufacturing volumes resulted in under-absorption of our fixed manufacturing costs. In the
first quarter of 2005, we wrote off $0.7 million of excess inventory, primarily in our EMS
segment, which related primarily to discontinued programs and excess inventories at our
Redmond, Washington facility. In the first quarter of 2004, we wrote off just over $1.0
million of inventory relating to a suppliers defective component. The gross margin dollars
in our two segments and for unallocated corporate costs for the periods ended March 31, 2004
and 2005, respectively, in millions, were as follows: Three Months EndedMarch 31,2004
    
    
    2005Display
    
    $
    0.5
    
    
    $
    EMS
    
    
    0.4
    
    
    
    (1.3
    )Corporate costs
    
    
    (0.2
    )
    
    
    (0.6
    )$
    0.7
    
    
    $
    (1.9
    )
 Corporate costs include corporate manufacturing costs, plus costs related to facility,
information technology and quality assurance allocations incurred at
our Tempe facility. Selling, General, and Administrative Expense.Selling, general, and administrative expense
increased to $6.7 million in the first quarter of 2005 from $4.2 million in the first quarter of
2004. SG&A expense was 33.3% of net sales in the first quarter of 2005 compared with 18.1% of net
sales in the first quarter of 2004. This increase in SG&A expense occurred primarily due to the
$0.9 million cost of vacating and moving to a new facility in Redmond, Washington, $0.3 million
cost incurred due to the cancellation of a hosting contract that will no longer be needed as a 21




---



##### Table of Contents



result of terminating the ERP implementation, $0.6 million increased severance, and
consulting, and $0.3 million of higher accounting and legal expenses. The SG&A expense in our two segments and for unallocated corporate costs for the periods ended
March 31, 2004 and 2005, respectively, in millions, were as follows: Three Months EndedMarch 31,2004
    
    
    2005Display
    
    $
    0.3
    
    
    $
    0.3EMS
    
    
    1.6
    
    
    
    2.6Corporate costs
    
    
    2.3
    
    
    
    3.8$
    4.2
    
    
    $
    6.7
 The increase in EMS costs in the first quarter of 2005, compared with the first quarter of
2004 was primarily the result of expenses associated with vacating and moving our operations in
Buildings 2 and 3 in Redmond, Washington, to our new Building 4. Those costs totaled $0.9 million. Corporate costs include all unallocated finance, IT, HR, and administrative costs. Those costs
increased primarily because of the costs associated with the cancellation of the hosting contract
related to the ERP implementation of $0.3 million, as well as the increased costs of severance and
consulting of $0.6 million and higher accounting and legal expenses of $0.3 million. Research, Development, and Engineering Expense.Research, development, and engineering
expense decreased to $233,000 in the first quarter of 2005 from $248,000 in the first quarter of
2004. Research, development, and engineering expense was 1.2% of net sales in the first quarter of
2005 compared with 1.1% in the first quarter of 2004. The RD&E expense in our two segments and for unallocated corporate costs for the periods ended
March 31, 2004 and 2005, respectively, in millions, were as follows: Three Months EndedMarch 31,2004
    
    
    2005Display
    
    $
    
    
    
    $
    EMS
    
    
    0.1
    
    
    
    0.1Corporate costs
    
    
    0.1
    
    
    
    0.1$
    0.2
    
    
    $
    0.2
 Impairment of Goodwill.During the first quarter of 2005, we reduced the goodwill on our
balance sheet relating to our EMS and Display reporting units. The write-off of goodwill (Display
segment, $7.2 million, EMS segment, $5.7 million) was $12.9 million. Loss on Impairment and Disposal of Long-Lived Assets.In the first quarter of 2005, we made
the determination that we would not proceed with the implementation of a new ERP system. This
decision resulted in a loss of $2.5 million from the write-off of the ERP software and
implementation costs. Amortization of Intangibles.Amortization expense was $166,000 for the first quarter of 2005
compared with $318,000 for the first quarter of 2004. The amortization in 2005 related to the
acquisition of ETMA customer lists in December 2002. Amortization expense in 2004 also included
amortization of customer lists acquired in our acquisition of AVT in September 2002. Other Income, Net.Other income was $259,000 in the first quarter of 2005 compared with
$169,000 in the first quarter of 2004. The composition of the items that make up other income was
as follows (in thousands): 22




---



##### Table of Contents



Three Months EndedMarch 31,2004
    
    
    2005Interest Income
    
    $
    98
    
    
    $
    79Interest Expense
    
    
    (274
    )
    
    
    (211
    )Rental and Service Income
    
    
    306
    
    
    
    355Foreign Exchange and Other Gain (Loss)
    
    
    39
    
    
    
    36Other Income
    
    $
    169
    
    
    $
    259
 Interest income decreased as a result of lower cash and short-term investment balances.
Interest expense decreased primarily due to our capital leases. The rental and service income
increased as a result of the sublease of our facilities which includes sub-leasing part of our
Tempe building to Brillian Corporation. Minority Interest.As of March 31, 2004, we controlled and owned only 60% of the business in
Malaysia, and we recorded an expense of $80,000 to account for the profits allocated to the
minority interest holder. We now own 100% of the business in Malaysia and thus no longer have a
minority interest adjustment. Provision for (Benefit from) Income Taxes.We recorded a provision for income taxes of $15,000
in the first quarter of 2005 compared with a benefit from income taxes of $112,000 in the first
quarter of 2004. The benefit in the first quarter of 2004 was for tax refunds. Net Loss.Our net loss was $39.4 million in the first quarter of 2005, or $1.81 per diluted
share, compared with $6.6 million, or $0.31 per diluted share in the first quarter of 2004. Our
loss from continuing operations in the first quarter of 2005 was $24.2 million, or $1.11 per
diluted share, compared with a loss from continuing operations in the first quarter of 2004 of $3.8
million, or $0.18 per diluted share. Our net loss in the first quarter of 2005 from discontinued
operations was $15.2 million, or $0.70 per share, compared with a net loss from discontinued
operations of $2.8 million, or $0.13 per diluted share, in the first quarter of 2004. Liquidity and Capital Resources At March 31, 2005, we had cash and restricted cash, of $12.4 million, compared with $16.2
million at December 31, 2004. In reviewing our condensed consolidated statement of cash flows, we had $2.9 million in net
cash outflow from operations in the first quarter of 2005, compared with $2.8 million in net cash
outflow from operations in the first quarter of 2004. Our inventory turns were 5.1 and day sales
outstanding, or DSOs, were 46 days in the first quarter of 2005 compared with 5.1 inventory turns
and 38 DSOs in the first quarter of 2004. Our depreciation and amortization expense was $1.0
million in the first quarter of 2005 compared with $1.1 million in the first quarter of 2004. We
had purchases of property, plant and equipment of approximately $1.4 million, which included $0.4
million invested in our ERP implementation project and $1.0 million of equipment purchased in
Redmond and Penang. During the first quarter of 2005, we had payments on our capital leases of $0.7 million. Most
of those payments related to our capital leases for our manufacturing equipment in Penang. Our working capital was $20.6 million at March 31, 2005, down from $26.9 million at December
31, 2004. Our current ratio at March 31, 2005 was 1.5-to-1 compared with 1.7-to-1 at December 31,
2004. The decrease in working capital was primarily because of reduced cash and accounts receivable
balances. While we transact business predominantly in U.S. dollars and invoice and collect most of our
sales in U.S. dollars, we collect a portion of our revenue in non-U.S. currencies, such as the
Chinese Renminbi. In the future, customers increasingly may make payments in non-U.S. currencies,
such as the Euro. In addition, we account for a portion of our costs, such as payroll, rent, and
indirect operating costs, in non-U.S. currencies, including Philippine Pesos, British Pounds
Sterling, Malaysian Ringgit, and Chinese Renminbi. Thus, fluctuations in foreign currency exchange
rates could affect our cost of goods and operating margins and could result in exchange losses. In
addition, 23




---



##### Table of Contents



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 cannot
predict the impact of future exchange rate fluctuations on our operating results. These currency
risks are particularly important since sales outside North America represented 33% of our net sales
in the first quarter of 2005 and 37% of our net sales in the first quarter of 2004. Sales in
foreign markets, primarily Europe and Asia, to OEMs based in the United States accounted for almost
all of our international sales in both of these periods. In the second quarter of 2004, we entered into a $10.0 million secured revolving line of
credit with Silicon Valley Bank, or SVB, which matures on June 25, 2005. Although there were no
borrowings under the SVB line as of December 31, 2004, we were in violation of our covenants
relating to cash earnings and revenue. SVB did not declare a default on the line, but we are
currently under discussion with SVB with regard to a re-negotiation of the terms of the line.
During this re-negotiation period, SVB has issued a forbearance letter under which we are precluded
access to the line. In addition, SVB required us to make a cash deposit in the first quarter of
2005 to secure a $600,000 letter of credit, which SVB had issued to the lessor of our building in
Redmond. In the second quarter of 2004, our Beijing subsidiary secured a $2.4 million line of credit
with Hua Xia Bank secured principally by our building in Beijing. We had borrowed $2.4 million
under that facility at March 31, 2005 and at December 31, 2004, which accrues simple, annual
interest at 5.31%. The loan is included in Current Liabilities of Discontinued Operations and was
assumed by International DisplayWorks, Inc. upon the sale of our Beijing subsidiary. The following tables list our contractual obligations and commercial commitments as of March
31, 2005: Payments due by PeriodContractual Obligations
    
    Total
    
    
    Less
    
    
    
    
    
    
    
    
    
    
    6 Years(Dollars in thousands)
    
    Obligations
    
    
    than 1Year
    
    
    1-3 Years
    
    
    4-5 Years
    
    
    and OverNotes Payable
    
    
    1,481
    1
    
    
    1,481
    
    
    
    
    
    
    
    
    
    
    
    Lines of Credit
    
    
    2,416
    2
    
    
    2,416
    
    
    
    
    
    
    
    
    
    
    
    Operating Leases
    
    
    23,963
    3
    
    
    4,714
    
    
    
    6,197
    
    
    
    4,961
    
    
    
    8,091Capital Leases
    
    
    6,905
    4
    
    
    3,563
    
    
    
    3,319
    
    
    
    23
    
    
    
    Other Contractual Obligations
    
    
    743
    
    
    
    540
    
    
    
    203
    
    
    
    
    
    
    
    Total
    
    $
    35,508
    
    
    $
    12,714
    
    
    $
    9,719
    
    
    $
    4,984
    
    
    $
    8,091
 Amount of Commitment Expiration Per PeriodOther Commercial Commitments
    
    Total
    
    
    Less
    
    
    
    
    
    
    
    
    
    
    6 Years(Dollars in thousands)
    
    Commitments
    
    
    than 1 Year
    
    
    1-3 Years
    
    
    4-5 Years
    
    
    and OverGuarantee
    
    $
    292
    
    
    $
    
    
    
    $
    292
    
    
    $
    
    
    
    
    
 1 This obligation is included in Current Liabilities of Discontinued
Operations as of March 31, 2005. In January 2003, we signed a term loan of $2.9 million with Data
International. In the first quarter of 2004, we paid $1.4 million against the term loan. The
remaining $1.5 million was due in January 2005. We notified Data International in February 2005
that we would not make the final $1.5 million payment and have filed a complaint against Data
International in Arizona requesting a declaratory judgment for breach of contract. In April 2005,
Data International filed a complaint against us alleging we have breached the license agreement.
(See Part II, Item 1. Legal Proceedings, for additional disclosures). 2 This obligation is included in Current Liabilities of Discontinued Operations as
of March 31, 2005. This obligation will be assumed by International DisplayWorks, Inc. at the
closing of our sale of our small form factor display business. That transaction closed in April. 3Includes approximately $173,000 of obligations that will be assumed by
International DisplayWorks, Inc. at the closing of our sale of our small form factor display
business. That transaction closed in April. 24




---



##### Table of Contents



4 Includes approximately $14,000 of obligations that will be assumed by
International DisplayWorks, Inc. at the closing of our sale of our small form factor display
business. That transaction closed in April. The operating leases include leases for our factories in Penang and Washington, our former
factory in Massachusetts, our lease in Arizona, and our sales offices in Florida and in the United
Kingdom. The capital leases are for our equipment in Malaysia and Washington. One of the capital
leases includes certain financial covenants that we were not in compliance with at December 31,
2004. The lessor has advised us they are accelerating the payments due on the lease obligations.
As of March 31, 2005, we were in negotiations with the lessor to resolve the non-compliance. The
guarantee relates to our guarantee in connection with a Small Business Administration loan to
VoiceViewer Technology, Inc., a privately held company developing microdisplay products. Brillian
Corporation assumed this guarantee in the spin-off. If Brillian Corporation were unable to satisfy
its obligation as primary guarantor, then we would be required to pay the guaranteed amount. We have no other long-term debt, capital lease obligations, unconditional purchase
obligations, or other long-term obligations, and we do not have any other commercial commitments or
other off-balance sheet arrangements. Our cash balance (including compensating balances) as of March 31, 2005 was $12.4 million. We
recently received $8 million for the sale of our small form factor display operations to
International DisplayWorks, Inc and $1.4 million for the sale of our large format display
operations to Video Display Corp. We believe that our cash on hand will provide adequate liquidity
to fund our remaining operations and planned expenditures through 2005, as well as to meet our
contractual obligations. In addition, we are expecting to obtain a $4 million line of credit in
Malaysia, which could then be used in the Malaysian EMS business. We also have signed a nonbinding
letter of intent to sell our RF business in Manila, which will provide additional cash if such
transaction closes. Although we believe that we have adequate sources of funds through the rest of
2005, this belief is based on our judgments and forecasts. Actual results could prove materially
different and, in such instances, may require additional funds. We cannot provide assurance that
additional asset sales, such as the sale of the Manila operations, loan commitments, or other
methods of financing will be available for any such unexpected additional requirements or, if
available, that they will be on terms acceptable to us. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There are no material changes in the reported market risks since our most recent filing on
Form 10-K for the year ended December 31, 2004. 
 ITEM 4. CONTROLS AND PROCEDURES Evaluation of Disclosure Control and Procedures Our management, with the participation of our principal executive officer and principal
financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as
defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the
Exchange Act)), as of the end of the period covered by this Quarterly Report on Form 10-Q. Based
on such evaluation, our principal executive officer and principal financial officer have concluded
that as of such date, our disclosure controls and procedures were designed to ensure that
information required to be disclosed by us in reports that we file or submit under the Exchange Act
is recorded, processed, summarized and reported with the time periods specified in applicable SEC
rules and forms were effective. Changes in Internal Control over Financial Reporting There have been no significant changes in our internal control or in other factors that could
significantly affect those controls subsequent to our evaluation, including corrective actions with
regard to significant deficiencies and material weaknesses. While we have not identified any material weaknesses or conditions in our disclosure controls
and procedures, we continually monitor those controls and procedures to identify deficiencies and
weaknesses and correct those items as necessary. It should also be noted that we are planning to
move our corporate headquarters to Redmond, Washington 25




---



##### Table of Contents



during the second and third quarters of 2005. That move, along with the consolidation of our
operations, has resulted in recent and substantial turnover in the finance and operations
functions, including the chief financial officer, chief manufacturing officer, director of internal
audit, and others. 
 PART II 
 ITEM 1. LEGAL PROCEEDINGS Data International Company, Ltd. In January 2003, we signed licensing and manufacturing agreements with Data International Co.,
Ltd. of Taiwan. Under those agreements, we agreed to pay $3.9 million to become the exclusive
channel in the Americas for LCD products manufactured by Data International. During the first
quarter of 2005, we determined that certain of the specified Data International display products
have been simultaneously available in the United States through a third party and that we had not
been provided exclusive distribution rights to the United States market as required by the license.
Based on that determination, we believe that the license was breached and we exercised our rights
of rescission. In April 2005, we filed a Compliant for breach of contract in the Maricopa County
Superior Court in Phoenix, Arizona. In April 2005, Data International filed a Complaint in the
United States District Court in Arizona. Data International alleges that we have breached the
license agreement and we owe Data International monies due under the license and manufacturing
agreement. Neither party has responded to the Complaint of the other and no discovery has yet been
taken. Vitelcom In the first quarter of 2005, we filed a lawsuit against Vitelcom in Spain for the amounts due
to us under a revised payment schedule. As of December 31, 2004, $1.4 million remained unpaid. At
March 31, 2005, the amount remained outstanding. During the first quarter of 2005, we reserved
$0.4 million against this unpaid amount. We are also involved in certain administrative proceedings arising in the normal course of
business. In our opinion, the ultimate settlement of these administrative proceedings will not
materially impact our financial position or results of operations. 
 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. 26




---



##### Table of Contents



ITEM 6. EXHIBITS Exhibit Number
    
    Exhibits31.1
    
    Certification of Chief Executive Officer of the Registrant
pursuant to Rule 13a-14(a) and Rule 15d-14(a) promulgated
under the Securities Exchange Act of 1934, as amended.*31.2
    
    Certification of Chief Financial Officer of the Registrant
pursuant to Rule 13a-14(a) and Rule 15d-14(a) promulgated
under the Securities Exchange Act of 1934, as amended.*32.1
    
    Certification of the Chief Executive Officer of the
Registrant pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*32.2
    
    Certification of the Chief Financial Officer of the
Registrant, pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*
   *Filed herein. 27




---



##### Table of Contents



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. THREE-FIVE SYSTEMS, INC.Date:  May 19, 2005
    By:
    /s/ Jack L. SaltichJack L. SaltichPresident and Chief Executive OfficerDate: May 19, 2005
    By:
    /s/ James E. JurgensJames E. JurgensInterim Chief Financial Officer (Principal Financial Officer) 28




---



##### Table of Contents



Exhibit Number
    
    Exhibits31.1
    
    Certification of Chief Executive Officer of the Registrant
pursuant to Rule 13a-14(a) and Rule 15d-14(a) promulgated
under the Securities Exchange Act of 1934, as amended.*31.2
    
    Certification of Chief Financial Officer of the Registrant
pursuant to Rule 13a-14(a) and Rule 15d-14(a) promulgated
under the Securities Exchange Act of 1934, as amended.*32.1
    
    Certification of the Chief Executive Officer of the
Registrant pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*32.2
    
    Certification of the Chief Financial Officer of the
Registrant, pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*
 * Filed herein.