SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                   ----------

                                    FORM 10-Q
                Quarterly Report Pursuant to Section 13 or 15(d)
                       of Securities Exchange Act of 1934

                      For Quarter Ended September 30, 1998
                                        ------------------

                          Commission File Number 1-4373
                                                 ------

                            THREE-FIVE SYSTEMS, INC.
             ------------------------------------------------------
             (Exact name of registrant as specified in its charter)


         Delaware                                               86-0654102
------------------------------                             ---------------------
(State or other jurisdiction of                               I.R.S. Employer
incorporation or organization)                             Identification Number


1600 North Desert Drive, Tempe, Arizona                             85281
---------------------------------------                           ---------
(Address of principal executive offices)                          (Zip Code)


                                 (602) 389-8600
              ----------------------------------------------------
              (Registrant's telephone number, including area code)


Indicate by check mark whether the registrant (1) has filed all reports required
to be filed  by  Section  13 or 15 (d) of the  Securities  Exchange  Act of 1934
during the preceding 12 months (or for such shorter  period that the  registrant
was  required  to file such  reports),  and (2) has been  subject to such filing
requirements for the past 90 days.

YES  [X]    NO  [ ]


Indicate the number of shares  outstanding  of each of the  issuer's  classes of
common stock, at the latest practical date.

CLASS                                       OUTSTANDING AS OF SEPTEMBER 30, 1998
-----                                       ------------------------------------

Common                                                  7,415,807
Par value $.01 per share
<PAGE>

                            THREE-FIVE SYSTEMS, INC.
                          QUARTERLY REPORT ON FORM 10-Q
                    FOR THE QUARTER ENDED SEPTEMBER 30, 1998
                                TABLE OF CONTENTS



                         PART I - FINANCIAL INFORMATION


                                                                            PAGE
                                                                            ----
ITEM 1.  FINANCIAL STATEMENTS:

         Consolidated Balance Sheets-
           September 30, 1998 and December 31, 1997..........................1

         Consolidated Statements of Income (Loss)-
           Three Months and Nine Months Ended September 30, 1998 and 1997....2

         Consolidated Statements of Cash Flows-
           Nine Months Ended September 30, 1998 and 1997.....................3

         Notes to Consolidated Financial Statements..........................4

ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
         OF OPERATIONS AND FINANCIAL CONDITION...............................5

                           PART II - OTHER INFORMATION

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K...................................14

SIGNATURES..................................................................14
<PAGE>
                            THREE-FIVE SYSTEMS, INC.
                           CONSOLIDATED BALANCE SHEETS
                                 (in thousands)

                                                  SEPTEMBER 30,    DECEMBER 31,
                                                  -------------    ------------
                                                      1998             1997
                                                      ----             ----
                                                  (Unaudited)
ASSETS

CURRENT ASSETS:
  Cash and cash equivalents                         $  6,706         $ 16,371
  Accounts receivable, net                            16,224           12,540
  Inventories, net                                    13,427            8,255
  Deferred tax asset                                   4,311            4,311
  Other current assets                                 1,377            1,228
                                                    --------         --------
     Total current assets                             42,045           42,705

PROPERTY, PLANT AND EQUIPMENT, net                    32,887           29,847

OTHER ASSETS                                           2,669              283
                                                    --------         --------
                                                    $ 77,601         $ 72,835
                                                    ========         ========
LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
  Accounts payable                                  $  6,866         $  8,513
  Accrued liabilities                                  4,055            5,079
  Current taxes payable                                  709               --
  Notes payable                                        5,000               --
                                                    --------         --------
     Total current liabilities                        16,630           13,592
                                                    --------         --------

LONG-TERM DEBT                                         4,600               --
                                                    --------         --------

DEFERRED TAX LIABILITY                                 2,718            2,718
                                                    --------         --------
COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY:
 Preferred stock                                          --               --
 Common stock                                             80               79
 Additional paid-in capital                           32,484           32,420
 Retained earnings                                    25,973           24,259
 Cumulative translation adjustment                        15               20
 Less - Treasury Stock, at cost (559,094 shares)      (4,899)            (253)
                                                    --------         --------
    Total stockholders' equity                        53,653           56,525
                                                    --------         --------

                                                    $ 77,601         $ 72,835
                                                    ========         ========

The accompanying notes are an integral part of these consolidated balance 
sheets.

                                       1
<PAGE>
                            THREE-FIVE SYSTEMS, INC.
                    CONSOLIDATED STATEMENTS OF INCOME (LOSS)
                                   (UNAUDITED)
                    (in thousands, except per share amounts)


                                         THREE MONTHS           NINE MONTHS
                                       ENDED SEPTEMBER 30,   ENDED SEPTEMBER 30,
                                      --------------------  --------------------
                                        1998       1997       1998       1997
                                        ----       ----       ----       ----

NET SALES                             $ 24,572   $ 24,074   $ 65,733   $ 58,940
                                      --------   --------   --------   --------
COSTS AND EXPENSES:
  Cost of sales                         22,243     18,511     53,025     45,376
  Selling, general and administrative    1,721      1,822      5,155      4,767
  Research and development               1,250      1,314      4,843      3,759
                                      --------   --------   --------   --------
                                        25,214     21,647     63,023     53,902
                                      --------   --------   --------   --------

     Operating income (loss)              (642)     2,427      2,710      5,038

OTHER INCOME (EXPENSE):
  Interest, net                             (4)       152        317        463
  Other, net                               (48)       (41)       (70)       (60)
                                      --------   --------   --------   --------
INCOME (LOSS) BEFORE PROVISION FOR
(BENEFIT FROM) INCOME TAXES               (694)     2,538      2,957      5,441
  Provision for (benefit from)
   income taxes                           (291)     1,010      1,242      2,084
                                      --------   --------   --------   --------

NET INCOME (L0SS)                     $   (403)  $  1,528   $  1,715   $  3,357
                                      ========   ========   ========   ========
EARNINGS (LOSS) PER COMMON SHARE
  Basic                               $  (0.05)  $   0.19   $   0.22   $   0.43
                                      ========   ========   ========   ========
  Diluted                             $  (0.05)  $   0.19   $   0.21   $   0.41
                                      ========   ========   ========   ========
WEIGHTED AVERAGE NUMBER OF
COMMON SHARES
  Basic                                  7,656      7,874      7,826      7,834
                                      ========   ========   ========   ========
  Diluted                                7,656      8,181      8,021      8,111
                                      ========   ========   ========   ========

The accompanying notes are an integral part of these consolidated statements.

                                       2
<PAGE>
                            THREE-FIVE SYSTEMS, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (UNAUDITED)
                                 (in thousands)

                                                             NINE MONTHS ENDED
                                                               SEPTEMBER 30,
                                                           --------------------
                                                              1998       1997
                                                              ----       ----
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net income                                               $  1,715    $  3,357
  Adjustments to reconcile net income to net cash
   provided by (used in) operating activities:
    Depreciation and amortization                             3,347       3,066
    Provision for (reduction of) accounts receivable
     valuation reserves                                          22        (108)
    Reduction of inventory valuation reserves                  (748)     (1,620)
    Loss on disposal of assets                                   --           3
  Changes in assets and liabilities:
    Increase in accounts receivable                          (3,707)     (6,854)
    Increase in inventories                                  (4,423)     (3,922)
    (Increase) decrease in other assets                        (490)      1,114
    Increase (decrease) in accounts payable and
     accrued liabilities                                     (2,671)      4,032
    Increase in taxes payable, net                            1,054         954
                                                           --------    --------
         Net cash provided by (used in) operating
          activities                                         (5,901)         22
                                                           --------    --------
CASH FLOWS FROM INVESTING ACTIVITIES:
  Purchases of property, plant and equipment                 (6,356)     (2,498)
  Investments                                                (2,420)         --
  Proceeds from sale of furniture and equipment                  --          16
                                                           --------    --------
     Net cash used in investing activities                   (8,776)     (2,482)
                                                           --------    --------
CASH FLOWS FROM FINANCING ACTIVITIES:
  Net borrowings on letters of credit to banks                9,600          --
  Stock options exercised                                        64          44
  Purchase of treasury stock, net                            (4,646)         --
                                                           --------    --------
     Net cash provided by financing activities                5,018          44
                                                           --------    --------
Effect of exchange rate changes on cash and
  cash equivalents                                               (6)         34
                                                           --------    --------

NET DECREASE IN CASH AND CASH EQUIVALENTS                    (9,665)     (2,382)
CASH AND CASH EQUIVALENTS, beginning of period               16,371      12,580
                                                           --------    --------

CASH AND CASH EQUIVALENTS, end of period                   $  6,706    $ 10,198
                                                           ========    ========

The accompanying notes are an integral part of these consolidated statements.

                                       3
<PAGE>

ITEM 1. (continued)

        THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED
        FINANCIAL STATEMENTS

Note A  The accompanying  unaudited  Consolidated Financial Statements have been
        prepared in accordance with generally accepted accounting principles for
        interim  financial  information  and  the  instructions  to  Form  10-Q.
        Accordingly,  they do not  include  all the  information  and  footnotes
        required  by  generally  accepted  accounting  principles  for  complete
        financial  statements.  In the opinion of  management,  all  adjustments
        (which include only normal recurring  adjustments)  necessary to present
        fairly the financial position, results of operations, and cash flows for
        all periods  presented have been made. The results of operations for the
        three  and  nine-month   periods  ended   September  30,  1998  are  not
        necessarily indicative of the operating results that may be expected for
        the entire year ending  December 31, 1998.  These  financial  statements
        should be read in  conjunction  with the  Company's  December  31,  1997
        financial statements and accompanying notes thereto.

Note B  Basic earnings per common share are computed by dividing net income by
        the weighted average number of shares of common stock outstanding during
        the three and nine-month periods.  Diluted earnings per common share for
        the three months ended  September 30, 1998, no common share  equivalents
        were  considered in the  calculation of earning (loss) as the effect was
        antidilutive. Diluted earnings per share for all other periods presented
        are determined assuming that the options were exercised at the beginning
        of the period or at the time of issuance, if later.

Note C  Inventories consist of the following at:

                                         September 30, 1998    December 31, 1997
                                         ------------------    -----------------
                                     (Unaudited)
                                                (in thousands)
        Raw Materials                         $10,217                $6,052
        Work-in-process                         1,707                 1,195
        Finished Good                           1,503                 1,008
                                              -------                ------
                                              $13,427                $8,255
                                              =======                ======

Note D  Property, plant, and equipment consist of the following at:

                                         September 30, 1998    December 31, 1997
                                         ------------------    -----------------
                                             (Unaudited)
                                                     (in thousands)
        Building and improvements          $12,631                   $10,431
        Furniture and equipment             35,961                    31,804
                                           -------                   -------
                                            48,592                    42,235

        Less accumulated depreciation      (15,705)                  (12,388)
                                           -------                   -------
                                           $32,887                   $29,847
                                           =======                   =======

                                       4
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF 
        FINANCIAL CONDITION AND RESULTS OF OPERATIONS

THREE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED WITH THREE MONTHS ENDED
SEPTEMBER 30, 1997.

         Net sales were $24.6 million for the quarter ended  September 30, 1998,
an  increase  of 2.1 percent  compared  with net sales of $24.1  million for the
quarter  ended  September 30, 1997.  The Company  believes that it may have some
seasonality  to its  sales.  Many  of the  company's  components  are in  retail
products such as cellular  telephones and office automation  equipment for which
sales in the first  calendar  quarter are  historically  slow.  During the third
quarter of 1998, sales to Motorola,  Inc.  ("Motorola") were 69.5 percent of the
Company's  revenue.  No other customer  accounted for greater than 10 percent of
the Company's revenue.

         Cost of sales, as a percentage of net sales,  increased to 90.5 percent
for the quarter  ended  September 30, 1998 as compared with 76.9 percent for the
quarter ended September 30, 1997. The corresponding decrease in the gross margin
in the third quarter was the result of a number of factors.  First,  the Company
incurred  approximately $504,000 of incremental expenses in the cost of sales as
the result of starting  operations in China.  Those  incremental  China expenses
were  reflected as  under-absorbed  material  overhead in cost of sales  because
there was no significant manufacturing activity in the China facility during the
first two months of the quarter.  Second, as a result of high inventory balances
at the  beginning  of the  quarter,  the Company  had  unusually  low  inventory
purchases during the third quarter of 1998 which resulted in under-absorption of
the material  overhead.  Third,  the Company started several new programs during
the  quarter  and  encountered  some yield  start-up  issues  with some of those
programs.  Finally,  the Company's  standard  margin on its products sold in the
quarter ended September 30, 1998 was lower than the standard margin for products
sold in the quarter ended  September 30, 1997.  This lower standard  margin is a
result of pricing pressures in the LCD module industry.

         Selling,  general, and administrative expense decreased to $1.7 million
for the quarter ended September 30, 1998 from $1.8 million for the quarter ended
September 30, 1997. Selling,  general, and administrative expense decreased as a
percentage of net sales to 7.0 percent for the quarter ended  September 30, 1998
from 7.6 percent for the quarter ended September 30, 1997.

         Research and development  expense totaled $1.3 million,  or 5.3 percent
of net sales,  for the quarter  ended  September  30, 1998 as compared with $1.3
million,  or 5.4 percent of net sales, for the quarter ended September 30, 1997.
Research and development  expenses consist  principally of salaries and benefits
to scientists and other personnel, related facilities costs, process development
costs, and various expenses for projects, including new product development. The
Company  has  focused  its  research  and  development  expenditures  on display
products and technologies while continuing with its in-house process development
efforts  related to the  high-volume  manufacturing  LCD line  located in Tempe,
Arizona.  The research and  development  expense for the quarter ended September
30, 1998 was significantly  lower than the research and development  expense for
the quarter ended June 30, 1998 primarily because of process developments on its
LCD manufacturing line in the second quarter.

         Interest  expense  (net) for the quarter  ended  September 30, 1998 was
$4,000, as compared with $152,000 of interest income (net) for the quarter ended
September 30, 1997. This difference was primarily as a result of investing lower
average cash balances during the quarter as well as incurring  interest  expense
on the Company's line of credit. Other expense (net) was $48,000 for the quarter
ended  September  30,  1998,  as compared  with  $41,000  for the quarter  ended
September 30, 1997.

         There was a benefit for income taxes of $291,000 for the quarter  ended
September 30, 1998 as compared with a provision for income taxes of $1.0 million
for the quarter ended  September 30, 1997. This  difference  resulted  primarily
from having a loss for the quarter ended September 30, 1998 as compared with net
income for the same period in 1997.
                                       5
<PAGE>
         The Company reported a loss of $403,000,  or $0.05 per share (diluted),
for the quarter  ended  September  30, 1998 as compared  with net income of $1.5
million, or $0.19 per share (diluted), for the quarter ended September 30, 1997.
Without China-related incremental expenses, the quarter ended September 30, 1998
would have been essentially break-even.

NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED WITH NINE MONTHS ENDED
SEPTEMBER 30, 1997.

         Net sales were $65.7  million for the nine months ended  September  30,
1998,  an increase of 11.5 percent over net sales of $58.9  million for the nine
months ended  September  30, 1997.  The sales  increase is primarily a result of
several new programs for new and existing  customers,  which offset decreases in
sales to  Hewlett-Packard  Company  ("Hewlett-Packard").  During  the nine month
period ended  September 30, 1998, (a) Motorola  accounted for net sales of $37.4
million  compared  with  sales of $19.1  million to that  customer  for the nine
months ended September 30, 1997, and (b) Hewlett-Packard accounted for net sales
of $5.5 million  compared  with net sales of $19.3  million to that customer for
the nine months ended September 30, 1997.

         Cost of sales,  as a percentage of net sales,  was 80.7 percent for the
nine months ended  September 30, 1998 as compared with 77.0 percent for the nine
months ended September 30, 1997. The corresponding  decrease in the gross margin
was the  result  of a number of  factors,  including  China-related  incremental
expenses and overall lower margins on LCD modules.

         Selling,  general, and administrative expense increased to $5.2 million
for the nine months  ended  September  30,  1998 from $4.8  million for the nine
months ended  September  30, 1997,  with such increase  primarily  attributed to
increased  selling expenses and additional  administrative  personnel.  Selling,
general,  and  administrative  expense decreased as a percentage of net sales to
7.9 percent for the nine months  ended  September  30, 1998 from 8.1 percent for
the nine months ended  September  30,  1997,  primarily as a result of increased
sales.

         Research and development  expense totaled $4.8 million,  or 7.3 percent
of net sales, for the nine months ended September 30, 1998 as compared with $3.8
million,  or 6.5 percent of net sales,  for the nine months ended  September 30,
1997.  The  increase in  research  and  development  expense was a result of the
Company's  continued focus on the development of advanced  display  technologies
and   development  of  its  in-house   efforts   relating  to  the   high-volume
manufacturing LCD line.

         Interest  income (net) for the nine months ended September 30, 1998 was
$317,000,  down from $463,000 for the nine months ended  September 30, 1997. The
decrease in  interest  income was the result of  investing  lower  average  cash
balances  during the nine months ended  September  30, 1998 and as the result of
increased  interest  expense.  Other expense (net)  increased to $70,000 for the
nine months  ended  September  30, 1998 from  $60,000 for the nine months  ended
September 30, 1997. The increase was due primarily to increased foreign exchange
loss for the nine months ended September 30, 1998.

         The  provision  for income  taxes was $1.2  million for the nine months
ended  September  30, 1998 as compared  with a provision of $2.1 million for the
nine months ended September 30, 1997. This  difference  resulted  primarily from
having  lower  pre-tax  income in the nine months  ended  September  30, 1998 as
compared with the same period in 1997.  The Company will have an  approximate 42
percent tax rate in 1998 as a result of the losses it has incurred in China. The
income tax rate structure in China is lower;  therefore,  losses in China do not
provide as great a tax  benefit as losses in a higher tax rate  country  such as
the United States.  In 1999,  the Company's  overall tax rate should drop as the
Company  increases  manufacturing  operations in China. The actual worldwide tax
rate at that time will depend upon a variety of factors, including inter-company
transfer pricing,  the amount of sales in China, the profitability of operations
in China, and whether any inter-company dividends are declared.

         Net income was $1.7 million,  or $0.21 per share (diluted) for the nine
months ended September 30, 1998, as compared with net income of $3.4 million, or
$0.41 per share (diluted), for the nine months ended September 30, 1997.

                                       6
<PAGE>
LIQUIDITY AND CAPITAL RESOURCES

         During the first nine months of 1998,  the Company had $5.9  million in
negative cash flow from  operations as compared with  break-even  cash flow from
operations  during the first nine months of 1997.  The  negative  cash flow from
operations  was  primarily  due to the  increase  in  inventories  and  accounts
receivable.  The Company purchased inventories in expectation of the start-up of
several  new  programs in the second and third  quarters  of 1998.  All of those
programs have since commenced and the inventory  balance  decreased by over $9.0
million during the third quarter.  Accounts  receivable are higher at the end of
the third quarter because sales were weighted towards the end of the quarter.

         The Company's  working capital was $25.4 million at September 30, 1998,
down from $29.1  million at December 31, 1997.  The  Company's  current ratio at
September 30, 1998 was 2.5-to-1, as compared with a current ratio of 3.1-to-1 at
December  31,  1997.  The  reduction  in working  capital and the current  ratio
occurred  primarily because of the substantial  investments made in fixed assets
and in Siliscape,  Inc. In addition,  the Company has an outstanding  balance of
$5.0 million in its line of credit,  which is currently  classified as a current
liability.  The Company also  incurred  $4.6  million of debt to purchase  stock
under the Company's stock  repurchase  program (see below).  As explained below,
the  Company  has a new loan  commitment,  the  result of which is that all debt
incurred to purchase  stock  through the stock  repurchase  program  will become
long-term debt.

         In May 1998,  the Company  entered into a new $15.0  million  unsecured
revolving  line of credit with  Imperial  Bank,  which  matures in May 2000.  At
September  30, 1998,  $9.6 million of  borrowings  were  outstanding  under this
credit  facility.  Advances  under the revolving  line may be made as Prime Rate
Advances,  which accrue  interest  payable  monthly at the bank's prime  lending
rate,  or as LIBOR Rate  Advances,  which bear  interest at 175 basis  points in
excess of the LIBOR Base Rate.  The  Company's  subsidiary,  Three-Five  Systems
Limited,  has  established an annually  renewable  credit facility with a United
Kingdom  bank,  Barclays  Bank  PLC,  in  order  to  fund  its  working  capital
requirements.  The facility provides  $350,000 of borrowing  capacity secured by
accounts  receivable  of  Three-Five  Systems  Limited.  Advances  are  based on
accounts  receivable,  as defined.  Advances  under the credit  facility  accrue
interest,  which is payable  quarterly,  at the bank's  base rate plus 200 basis
points.  The United Kingdom  credit  facility  matures in June 1999.  Three-Five
Systems  Limited  had no  borrowings  outstanding  under  this line of credit at
September 30, 1998.

         The Company has received a new  commitment  from  Imperial Bank and the
National Bank of Canada for a $25.0  million  credit  facility.  That new credit
facility will have two tranches: a $15.0 million revolving line of credit, which
is similar to the  existing  credit  facility  and which will be  available  for
general  corporate  purposes,  and a $10.0 million term loan, which will provide
available  funds  to  repurchase  the  Company's   stock.   Including  cash  and
pre-existing  loan  commitments,  the  Company  had  $12.4  million  in  readily
available  funds at September  30, 1998.  The new credit  facility  would add an
additional $10.0 million in available funds to that amount.

         In August 1996, the Board of Directors  authorized the repurchase  from
time to time of up to one million  shares of the  Company's  common stock on the
open market or negotiated  transactions depending on market conditions and other
factors.  During the quarter  ended  September 30, 1998,  the Company  purchased
approximately  539,000  shares under the  repurchase  program at a total cost of
$4.6 million.  Taking into account previous purchases, as of September 30, 1998,
a total of approximately 561,000 shares have been purchased by the Company under
the repurchase program at a cost of $4.9 million.

         Capital  expenditures  during the nine months ended  September 30, 1998
were approximately  $6.4 million,  as compared with $2.5 million during the same
period of 1997. Capital expenditures for the first nine months of 1998 consisted
primarily of manufacturing and office equipment for the Company's  operations in
Beijing,  Manila and Tempe,  including  laboratory  equipment  for  research and
development  and nearly  $2.0  million of  equipment  necessary  to  manufacture
LCoS(TM)  microdisplays.  The Company  anticipates that it will have substantial
additional  capital  expenditures  during the remainder of 1998 and during 1999.
Those  expenditures will primarily relate to advanced  manufacturing  processes,
the  high-volume  LCD line,  and necessary  manufacturing  equipment for its new
manufacturing  facility in Beijing,  China. The Company  anticipates the initial
facilities  and capital cost for its  operations in China in 1998 and 1999 to be
approximately   $10.0   million.   The  China   operations   will  also  require

                                       7
<PAGE>
approximately $4.0 million of working capital.  Additional capital costs will be
incurred as additional  manufacturing lines are added. Thus far, the Company has
expended  approximately  $3.8  million  in China  for  manufacturing  equipment,
building  materials  and land costs.  Although the Company is operating out of a
leased  facility in the Beijing area, the Company has purchased  land-use rights
nearby upon which it is expected to complete construction of its own building in
1999.

         In April 1998,  the Company  invested  approximately  $2.4 million in a
minority equity interest in Siliscape,  Inc.  ("Siliscape"),  a start-up company
involved in developing various  technologies for microdisplays.  Under the terms
of the  investment,  the Company is obligated to purchase an  additional  equity
interest in Siliscape for $900,000 in the fourth  quarter of 1998. The Company's
ownership  interest  in  Siliscape  is  accounted  for under the cost  method of
accounting.

         The Company  anticipates  that cash flow from  operations in the fourth
quarter  of 1998 will allow the  Company  to retire  the  portion of its line of
credit that is unrelated to the stock repurchase  program.  The Company believes
that its existing capital, anticipated cash flows from operations, and available
and anticipated  credit lines will provide  adequate  sources to fund operations
and planned  expenditures through 1999. The Company may have to pursue alternate
methods of financing or raise  capital,  however,  should the Company  encounter
additional cash requirements.  For example,  the Company has considered entering
into  alliances  with  regard  to  the  strategic  development  of  various  new
technologies,  especially LCoS(TM)  miscrodisplays.  Some of these alliances may
result  in a capital  investment  by the  Company  in other  companies,  such as
Siliscape.  The Company also has considered  acquisitions  of other  businesses.
Such investments and/or  acquisitions would likely require the Company to pursue
additional financing mechanisms, such as debt or equity placements.

EFFECTS OF INFLATION AND FOREIGN CURRENCY EXCHANGE FLUCTUATIONS

         The results of operations of the Company for the periods discussed have
not been significantly  affected by inflation or foreign currency  fluctuations.
The Company  generally  sells its products and services and negotiates  purchase
orders with its foreign suppliers in United States dollars.  An exception is the
Company's sub-assembly  agreement in the Philippines,  which is based on a fixed
conversion  rate,  exposing the Company to exchange rate  fluctuations  with the
Philippine  peso.  The Company has not incurred any material  exchange  gains or
losses to date and there has been some minor  benefit as a result of last year's
peso  devaluation,  although  the Company is now  required to pay  approximately
one-third  of  any  peso  devaluation  gain  to  its  lessor  and  direct  labor
subcontractor in Manila.

         The Company commenced operations in China in 1998. Although the Chinese
currency  is  currently  stable,  its value in  relation  to the U.S.  dollar is
determined by the Chinese  government.  There is general  speculation that China
may devalue its currency in response to the current  Asian  economic  situation.
Devaluation of the Chinese  currency could result in translation  adjustments to
the Company's  balance sheet as well as reportable  losses depending on monetary
balances  and loans of the  Company  at the time of  devaluation.  Although  the
Company  from  time to time may  enter  into  hedging  transactions  in order to
minimize its exposure to currency rate fluctuations, the Chinese currency is not
freely  traded and thus is difficult to hedge.  In addition,  the  government of
China  has  recently   imposed   restrictions  on  Chinese   currency  loans  to
foreign-operated  entities  in China.  Based on the  foregoing,  there can be no
assurance that  fluctuations and currency  exchange rates in the future will not
have an adverse affect on the Company's operations.

BUSINESS OUTLOOK AND RISK FACTORS

BUSINESS OUTLOOK

         This Business Outlook section has numerous forward-looking  statements.
Some of the risk factors  associated with those  forward-looking  statements are
set forth in "Risk Factors" below. Other important risk factors are set forth in
the Company's other filings with the Securities and Exchange Commission.

                                       8
<PAGE>
         The  Company  offers  advanced  design and  manufacturing  services  to
original equipment manufacturers. The Company specializes in custom displays and
front panel displays  utilizing  liquid crystal  display (LCD)  technology.  The
Company  experienced  substantial growth from 1993 through 1995 with such growth
dependent  primarily upon the Company's  participation in the substantial growth
of the wireless  communications  market and sales to a single major  customer in
that industry. In 1996, the Company's sales declined, largely as a result of the
early 1996 phase-out by that major customer of a significant family of programs.
In 1997,  sales returned to pre-1996 levels primarily as a result of several new
programs and customers.

         The Company had substantial  growth in its revenues in 1997 with a 39.4
percent rate of growth over 1996. In 1998,  the Company is  experiencing  strong
growth over 1997,  with an expected 40 to 50 percent  increase in unit  volumes.
Revenue  growth has not kept up with unit  growth in 1998,  however,  because of
pricing  pressures  from customers and  competition in the LCD module  industry.
Thus,  the  Company  expects its yearly  revenue  growth from 1997 to 1998 to be
approximately  8 to 12 percent.  As customers  attempt to increase  market share
through   pricing,   those   customers   expect  their  vendors  to  offer  more
competitively  priced  products.  In addition,  weakened Asian  currencies  have
contributed to pricing pressures in the LCD module industry because most vendors
are Asian  companies.  The Company  also is  experiencing  some effects from the
Asian economic situation as sales in the Company's medical  instrumentation  and
office automation areas have slowed down and been pushed out.

         The Company has undertaken  efforts to diversify its business,  broaden
its  customer  base,  and expand its markets.  The  Company's  historical  major
customer,  Motorola,  which  accounted  for  approximately  80  percent  of  the
Company's revenue in 1995,  accounted for 65 percent of the Company's revenue in
1996 and slightly less than 35 percent of the Company's  revenue in 1997.  These
reduced  percentages  occurred  as a  result  of the  increased  sales  to other
customers  and  reduced  product  selling  prices and  revenues  from that major
customer.  In 1998, the Company's business with Motorola has increased at a rate
faster  than  business  with  other  customers  is  increasing.  Therefore,  the
percentage  of revenue  attributed  to Motorola is expected to increase in 1998,
and the current  business  plan of the Company  targets that customer to account
for just over 60 percent of its 1998 revenue.  Hewlett-Packard  accounted for 32
percent of the  Company's  revenue in 1997,  but this  percentage  has  declined
significantly in 1998 as current programs have matured. Replacement programs may
not have the type of LCD modules supplied by the Company and those that do often
have significantly lower selling prices.

         The Company's gross margins are impacted by several factors,  including
manufacturing   efficiencies,   product  differentiation,   product  uniqueness,
billings  for  non-recurring   engineering   services,   inventory   management,
engineering costs, product mix, and volume pricing. As mentioned earlier,  there
is   significant   pricing   pressure   in  higher   volume   programs   in  the
telecommunications and office automation industries. As the production levels of
some of the Company's new  high-volume  programs  increase,  the lower  standard
gross margins on those  programs  will have an impact on the  Company's  overall
margins.  In  addition,  in an  effort  to  secure  sales to  certain  strategic
customers,  the Company may  aggressively  price its products.  Depending on the
size of the programs achieved, such pricing strategies could also have an effect
on overall margins.

         The Company's gross margins on its products are also typically lower at
the start of a program as a result of yield and other  start-up  issues.  In the
third  quarter of 1998,  the Company  started  several new programs and incurred
substantial start-up costs.

         The Company  started  operations  in China in 1998,  and the  Company's
gross  margins  have been  adversely  affected  by the  start-up  of those China
manufacturing  operations. As the Company ramped up its manufacturing operations
in China,  it incurred costs in advance of the receipt of significant  revenues.
In the third  quarter of 1998,  the  Company  incurred  incremental  China-based
expenses in the total cost of sales.  Those  incremental  expenses  arise mainly
from  under-absorption  of the costs of  operating  the China  facility  and are
included  in the  cost of  sales,  thus  reducing  overall  gross  margins.  The
Company's expectation is that the incremental China-based expenses in the fourth
quarter  will be  significantly  reduced  as a result  of yield  and  absorption
issues.  In the long run, the Company expects the China operations to positively
impact gross margins because of certain  competitive cost advantages provided by
maintaining operations in China.
                                       9
<PAGE>
         The Company  anticipates that the Asian currency  situation will have a
continued impact on gross margins.  Many of the Company's  competitors are Asian
suppliers,  and a strong U.S.  dollar gives a competitive  pricing  advantage to
those  suppliers.  Thus,  the Company may  continue  to see  competitive  margin
pressure from Asian suppliers, particularly those in Korea and Japan.

         Serving a variety  of  customers  with  complex  and  differing  issues
requires  increased  personnel  committed  to those  customers.  As the  Company
expands and  diversifies  its product and customer  base, the Company has had to
increase its  selling,  general,  and  administrative  expenses.  The volume and
complexity of the Company's business is expected to continue to grow. Therefore,
the  Company  anticipates  that it will  continue  to  increase  its selling and
administrative expenses on a quarter-by-quarter basis.

         The  Company  believes  that  continued  investments  in  research  and
development  relating to new display technology and manufacturing  processes are
necessary to remain competitive in the marketplace and provide opportunities for
growth.  The Company continues to expand and intensify its internal research and
development  to focus on  proprietary  display  products as well as continue LCD
manufacturing process improvements.  Use of the LCD manufacturing line in Tempe,
Arizona as a  resource  for  testing  new ideas is key to  development  of these
products, some of which will be proprietary and not available from other display
manufacturers.  Further,  the development of the high-volume  manufacturing  LCD
line has helped  reduce the  Company's  dependence  on foreign  suppliers of LCD
glass.

         The Company  also  intends to pursue  technologies  being  developed in
related  fields.  The Company  operates the highest  volume fully  automated LCD
manufacturing  line in  North  America.  As a  result,  several  companies  have
approached the Company about potential  alliances.  The Company  believes that a
strategic  alliance with one or more of those  companies could minimize the cost
of entry into new markets and new technologies.

         In August 1997, National Semiconductor Corporation ("National") and the
Company entered into a strategic supplier alliance agreement for the development
and manufacture of LCoS(TM) microdisplays. Under the alliance, the two companies
are working  together in developing the LCoS(TM)  technology,  with each company
focusing  on its  core  competency  of  silicon  and  LCDs,  respectively.  Once
manufacturing  begins, the companies will act as suppliers to one another,  with
National supplying the silicon and the Company supplying the LCD manufacturing.

         In April 1998, the Company  acquired an approximate 19 percent interest
in  Siliscape,   a  start-up  company  with  numerous  patents  and  proprietary
technology  relating to  microdisplays.  The Company and Siliscape  also entered
into a strategic  agreement  under which they will focus on the  development  of
microdisplay   products,   with  the  Company  providing   certain   proprietary
manufacturing   capabilities  and  Siliscape   providing  certain  patented  and
proprietary technologies and components.

         The  Company  also is  considering  licensing  technologies  from other
companies  that  could be  optimized  on the LCD  manufacturing  line as well as
entering into further  alliances.  This internal and external  focus on research
and  development  will  continue  indefinitely.  As a result,  the actual dollar
amount of such research and development  expenditures in 1998 will increase over
1997.

         As  previously  described,  the Company has  established  manufacturing
operations in The People's Republic of China.  Three-Five Systems (Beijing) Co.,
Ltd. was  incorporated  in China  during the first  quarter of 1998 and business
license  approval was received  from the  governmental  authorities.  During the
first quarter of 1998, a temporary  leased site was selected in Beijing,  as was
the permanent site. The Company has now moved into the temporary site and set up
manufacturing lines.

         The Company has established a China-based  manufacturing  operation for
several  reasons.  First,  based upon growth  expectations  in the  European and
United States  marketplaces,  the Company  anticipates a need for  manufacturing
capacity  beyond what is available  at its  Philippine  manufacturing  facility.

                                       10
<PAGE>
China was selected  because of the desire to diversify  manufacturing  locations
and  because of the cost  benefits  that are  expected  to be achieved in China.
China is also  expected to be a  synergistic  business  location for the Company
because many of the components  used by the Company are  manufactured  in China.
Second,  many  of  the  Company's  existing  and  potential  customers  maintain
manufacturing  operations  near the Company's  operations in China.  Despite the
current  Asian  economic  situation,  those  customers  continue  to require LCD
modules  and  the  Company  has  limited  participation  in that  market.  There
currently are very few LCD module  manufacturers in China. Under current Chinese
government  rules,  however,  OEMs in China have a strong  motivation to utilize
locally manufactured components.

RISK FACTORS

         Forward-looking  statements  in this report  include  revenue,  margin,
expense,  and earnings  analysis for 1998 as well as the Company's  expectations
relating  to  operations  in China;  future  technologies;  and future  designs,
inventory  balances,  and  production  orders.  The Company's  future  operating
results may be affected by various  trends,  developments,  and factors that the
Company  must  successfully  manage in order to achieve its goals.  In addition,
there are trends,  developments,  and factors beyond the Company's  control that
may affect its operations.  The cautionary statements and risk factors set forth
below and elsewhere in this  document,  and in the Company's  other filings with
the Securities and Exchange Commission, especially Form 10-K, identify important
trends,  factors,  and  currently  known  developments  that could cause  actual
results  to  differ  materially  from  those in any  forward-looking  statements
contained in this report and in any written or oral statements of the Company.

         A few core customers  currently are  responsible  for a majority of the
Company's revenue,  and the Company expects the high  concentration  levels with
its  core  customers  to  continue  through  1999.  Thus,  any  material  delay,
cancellation,  or reduction  of orders from one or more of those core  customers
could have a material adverse effect on the Company's  operations.  For example,
previously  announced  delays in certain  Motorola  programs have contributed to
lower than expected sales for the Company in 1998.

         Although  the trend of the Company is to enter into more  manufacturing
contracts with its  customers,  the principal  benefit of these  contracts is to
clarify order lead times, inventory risk allocation, and similar matters and not
to provide firm, long-term volume purchase commitments.  The Company has no firm
long-term  volume  purchase  commitments  from  its  customers.  Thus,  customer
commitments  can be  canceled,  and  expected  volume  levels  can be changed or
delayed.  The timely replacement of canceled,  delayed,  or reduced  commitments
cannot be assured and, among other things,  could result in the Company  holding
excess and obsolete inventory or having unfavorable manufacturing variances as a
result of  under-absorption.  These  risks are  exacerbated  because the Company
expects  that a  majority  of its  sales  will  be to  customers  in the  retail
electronics industry,  which is subject to severe competitive  pressures,  rapid
technological  change, and obsolescence.  A few of the Company's  customers have
inquired about inventory hubbing  agreements  pursuant to which the Company will
maintain  stocks of finished goods on or near the customer's  factory.  Although
such  agreements  have  not  yet  been  implemented,  the  use of  such  type of
agreements  could result in higher  inventory  balances  for the Company  and/or
excess inventory.

         The  Company  held a large  inventory  balance as of June 30, 1998 as a
result of delays in certain  programs  announced by customers  during the second
quarter of 1998. That balance has been substantially reduced as of September 30,
1998. The Company has analyzed the remaining inventory balance and believes that
the inventory will be utilized because all of the unreserved  inventory  relates
to ongoing  programs.  There is a risk that if some or all of those new programs
are canceled, however, the Company could be left with excess inventory.

         Another  risk  inherent  in custom  manufacturing  is the  satisfactory
completion of design services and securing of production  orders.  A significant
portion of the  Company's  anticipated  revenue  for the  future  will come from
programs  currently in the design or pilot production  stage.  Completion of the
design is dependent on a variety of factors,  including the customer's  changing
needs,  and not every design is successful in meeting those needs.  In addition,
some  designs  test new  theories or  applications  and may not meet the desired
results.  Failure of a design order to achieve the  customer's  desired  results
could result in a material  adverse  effect on the  Company's  operations if the
expected production order for that product was significant. Finally, even when a

                                       11
<PAGE>
design is  satisfactorily  completed,  the customer  may  terminate or delay the
program as a result of marketing or other pressures.

         The Company is currently  spending research and development  dollars on
several new  technologies  that it plans to introduce in the future.  There is a
risk  that  some or all of  those  technologies  may not  successfully  make the
transition   from  the   research   and   development   lab  to   cost-effective
manufacturability,  and such failure could have a material adverse effect on the
Company.  Risks include technology problems,  competitive cost issues, and yield
problems. In addition, even if a new technology proves to be manufacturable,  it
may not be accepted by the Company's  customers and the customers'  marketplaces
because  of  price or  technology  issues  or it may  compare  unfavorably  with
products  introduced by others.  These new technologies will require significant
expenditures,   including  development  expenses,   such  as  those  for  custom
integrated  circuits,  as well as various capital  expenditures and investments.
For example, the Company anticipates that LCoS(TM)  microdisplays will initially
require  approximately  $2.0 to $3.0  million of capital  expenditures,  and the
Company has also  invested in Siliscape  for the purposes of further  developing
the LCoS(TM) microdisplay product. There could be material adverse impact on the
Company  if  one  or  more  of  the  new   technologies,   especially   LCoS(TM)
microdisplays, were unsuccessful for any reason.

         The Company  designs and  manufactures  products  based on firm quotes.
Thus,  the Company  bears the risk of  component  price  increases,  which could
adversely affect the Company's gross margins.  In addition,  the Company depends
on certain  suppliers,  and the  unavailability  or shortage of materials  could
cause delays or lost orders.  Material components of some of the Company's major
programs have from time to time been subject to allocation  because of shortages
by vendors and continued or increased  shortages  could have a material  adverse
effect  on  the  Company  in the  future.  In  addition,  although  most  of the
components  purchased  by the  Company  are  purchased  from  vendors  in  Asian
countries  unaffected by the current currency  crisis, a significant  portion of
the silicon  drivers  purchased  by the Company  are  manufactured  in Korea and
Japan.  Economic  instability  in certain  Asian  countries  could cause  supply
problems with respect to these components.

         The  Company's  primary  competitors  are  located in Asia,  including,
Japan, Korea, and Hong Kong, and most of the Company's customers are U.S.-based.
The  recent  currency  devaluation  of  several  Asian  countries  could have an
negative impact on the gross margins of the Company as the competitors' products
become less expensive to purchase with a stronger dollar.

         The Company has  established a  manufacturing  operation in China.  The
Company's  operations  and  assets  will be subject  to  significant  political,
economic,  legal and other  uncertainties in China. The Company's  operations in
China also could be adversely  affected by the imposition of austerity  measures
intended to reduce  inflation;  the  inadequate  development  or  maintenance of
infrastructure,  including  the  unavailability  of  adequate  power  and  water
supplies,  transportation,  raw materials,  and parts; or a deterioration of the
general political, economic or social environment in China.

         The  Company  has set up  manufacturing  operations  in  Beijing  in an
interim leased facility.  If there are delays in the completion of the permanent
facility,  the Company  may run into  capacity  issues in the  interim  facility
because of space constraints and/or power requirements. In addition, the Company
has a short-term lease on the interim facility and could be required to move out
if there are  delays  in the  completion  of the  permanent  facility,  severely
interrupting the Company's manufacturing operations in China.

         One of the reasons the  Company is starting up  operations  in China is
because the Company  believes  that its Manila  manufacturing  facility may have
occasional  capacity issues within the next year. Failure to begin operations in
the China  facility on a timely  basis could result in capacity  restraints  and
late  or  canceled  customer  deliveries.   Manufacturing  yields  and  delivery
schedules  also  may be  affected  as the  Company  ramps  up its  manufacturing
capabilities  in  China.  Other  companies  in  the  industry  have  experienced
difficulty in expanding or relocating  manufacturing  output and capacity,  with
such difficulty resulting in reduced yields or delays in product deliveries.  No
assurance can be given that the Company will not experience  manufacturing yield
or delivery  problems in the future.  Such problems could materially  affect the
Company's operating results.
                                       12
<PAGE>
         Finally,  the Company's success,  especially in penetrating new markets
and increasing its OEM customer base, depends to a large extent upon the efforts
and abilities of key managerial and technical employees. The loss of services of
certain key personnel could have a material  adverse effect on the Company.  The
Company's  business  also  depends  upon its  ability to continue to attract and
retain senior managers and skilled  employees.  Failure to do so could adversely
affect the Company's operations.

         As a result of the foregoing  and other  factors,  the Company's  stock
price may be subject to  significant  volatility,  particularly  on a  quarterly
basis.  Any shortfall in revenue or earnings from levels  expected by investors,
analysts,  and brokers could have an immediate and significant adverse effect on
the  trading  price  of  the  Company's   common  stock  in  any  given  period.
Additionally,  the  Company  may not learn of such  shortfalls  until  late in a
fiscal quarter,  which could result in an even more immediate and adverse effect
on the trading price of the  Company's  common stock.  Finally,  other  factors,
which generally affect the market for stocks of high technology companies, could
cause the price of the Company's  common stock to fluctuate  substantially  over
short periods for reasons unrelated to the Company's performance.

YEAR 2000 COMPLIANCE DISCLOSURE.

         Many  existing  computer  programs and databases use only two digits to
identify  a year in the date  field  (I.E.,  99  would  represent  1999).  These
programs and  databases  were  designed and developed  without  considering  the
impact  of  the  upcoming  millennium.  Consequently,  date  sensitive  computer
programs may interpret the date "00" as 1900 rather than 2000. If not corrected,
many computer systems could fail or create erroneous results in 2000.
The following disclosure is as required by SEC Release No. 33-7558.

COMPANY'S STATE OF READINESS

         The Company has  completed  an  assessment  of all of its  internal and
external  systems  and  processes  with  respect to the "Year  2000"  issue.  In
response to this  assessment,  the Company has created a  multi-functional  Year
2000 task force to resolve any non-compliant Year 2000 systems or processes.  To
date,  this group is on schedule to complete this task prior to January 1, 1999.
The Company plans to continuously  test all of its internal and external systems
and processes  (and the associated  Year 2000 "fixes") for Year 2000  compliance
during 1999.  As part of this  process,  the Company has assessed the  potential
impact of Year 2000 failures from vendors and outside  parties upon its business
and is currently  taking  steps to minimize  that risk.  Based on the  Company's
current state of readiness and the steps currently being taken (I.E., installing
backup  processes and systems),  the Company does not believe that the Year 2000
problem will have a material adverse effect on the Company's financial position,
liquidity, or operations.

COMPANY'S COSTS OF YEAR 2000 COMPLIANCE

         The Company  estimates that its total cost of Year 2000 compliance will
be less than  $100,000.  Those costs include  updating of computer  software and
hardware manufacturing  equipment, as well as employment and other out-of-pocket
costs.

COMPANY'S RISKS OF YEAR 2000 ISSUES

         The Company procures a significant  amount of raw materials used in its
manufacturing processes from foreign vendors. As a result, the Company may be at
risk from foreign  companies and countries that are not taking adequate measures
to  insure  Year  2000  compliance  or that  may  not be at the  same  level  of
preparedness as the United States.  For example,  economic  problems in Asia may
affect or divert resources with respect to the Year 2000 issue. Failure of those
foreign countries and companies to be Year 2000 compliant may cause new material
shortages that would adversely impact the Company's manufacturing operations. In
addition,  the Company  currently has  significant  manufacturing  operations in
Manila,  the Philippines and Beijing,  China. As a result, the Company may be at
risk with respect to suppliers of necessary  resources  (such as power or water)
that may not be Year 2000  compliant.  For example,  brownouts or blackouts  may

                                       13
<PAGE>
occur due to lack of Year 2000 compliance.  In addition, the Company's customers
may have catastrophic Year 2000 failures,  including prolonged  interruptions in
factory  productions,  in which  case  they may have a  reduced  demand  for the
Company's products.

COMPANY'S CONTINGENCY PLANS

         The Company is developing contingency plans with respect to significant
Year 2000 issues within its control.  For example, the Company is in the process
of assessing  and verifying the Year 2000  compliance of its  international  and
domestic raw material vendors. Verification will be accomplished through the use
of written  certifications  and audits.  Any  vendors  found not to be Year 2000
compliant  will be replaced  with vendors that are Year 2000  compliant.  In the
construction  of its new Beijing  facility,  the Company will procure  material,
processes and equipment that are Year 2000 compliant.  The Company also plans to
have stand-by  generators  for its plants in the event of a local power failure.
The  Company  is  investigating  transferring  all  manufacturing  processes  to
alternate  manufacturing  facilities  if  external  factors  beyond its  control
relative  to  the  Year  2000  issue  occur  and  the  Company   cannot  conduct
manufacturing operations at any particular facility.


                           PART II. OTHER INFORMATION

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

        (a)  EXHIBIT 11: Statement Re:  Computation of Per Share Earnings.

             EXHIBIT 27: Financial Data Schedule

        (b)  Reports on Form 8-K:  None

                                   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.
                                 ------------------------
                                       (Registrant)


Dated: October 29, 1998             By: /s/ Jeffrey D. Buchanan
                                            ------------------------------------
                                    Name:   Jeffrey D. Buchanan
                                    Its:    Executive Vice President Finance,
                                            Administration and Legal;
                                            Chief Financial Officer

                                       14