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SECURITIES AND EXCHANGE COMMISSION    FORM 10-Q Quarterly Report Pursuant To Section 13 or 15(d) of
the Securities Exchange Act Of 1934 For the Quarter Ended June 30, 2004 Commission file number 1-4373   THREE-FIVE SYSTEMS, INC. 
 Delaware
    
    86-0654102(State or Other Jurisdiction
    
    (I.R.S. Employer Identification No.)of Incorporation or Organization)
 1600 North Desert Drive,
Tempe, Arizona          85281 
  (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.  Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).  Indicate the number of shares outstanding of each of the issuers classes of
common stock, at the latest practicable date. CLASS
    
    OUTSTANDING AS OF JULY 31, 2004Common Stock, par value $.01 per share
    
    
    21,767,653




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THREE-FIVE SYSTEMS, INC. QUARTERLY REPORT ON FORM 10-Q FOR QUARTER ENDED JUNE 30, 2004 TABLE OF CONTENTS PagePART IITEM 1. FINANCIAL STATEMENTS (UNAUDITED):CONDENSED CONSOLIDATED BALANCE SHEETS  DECEMBER 31, 2003 AND JUNE 30, 2004
    
    
    1CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS  THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2003 AND 2004
    
    
    2CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS  SIX MONTHS ENDED JUNE 30, 2003 AND 2004
    
    
    3NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
    
    
    4ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
    
    
    9ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
    
    
    20ITEM 4. CONTROLS AND PROCEDURES
    
    
    20PART IIITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
    
    
    21ITEM 5. OTHER INFORMATION
    
    
    22ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
    
    
    22SIGNATURES
    
    
    23EX-10.21EX-10.31EX-31.1EX-31.2EX-32.1EX-32.2




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ITEM 1. FINANCIAL STATEMENTS THREE-FIVE SYSTEMS, INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (UNAUDITED)
  DECEMBER 31,
    
    JUNE 30,2003
    
    2004ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    27,976
    
    
    $
    18,700Short-term investments
    
    
    5,130
    
    
    
    Accounts receivable, net
    
    
    28,133
    
    
    
    24,722Inventories
    
    
    25,854
    
    
    
    28,213Income taxes receivable
    
    
    678
    
    
    
    13Deferred tax asset
    
    
    130
    
    
    
    122Assets held for sale
    
    
    8,615
    
    
    
    8,615Other current assets
    
    
    2,782
    
    
    
    4,329Total current assets
    
    
    99,298
    
    
    
    84,714Property, Plant and Equipment, net
    
    
    25,323
    
    
    
    27,901Intangibles, net
    
    
    7,574
    
    
    
    6,647Goodwill
    
    
    34,606
    
    
    
    34,805Other Assets
    
    
    436
    
    
    
    216Total Assets
    
    $
    167,237
    
    
    $
    154,283LIABILITIES AND STOCKHOLDERS EQUITYCurrent Liabilities:Accounts payable
    
    $
    30,826
    
    
    $
    25,147Accrued liabilities
    
    
    4,917
    
    
    
    4,403Deferred revenue
    
    
    48
    
    
    
    Current portion of long-term debt
    
    
    1,515
    
    
    
    1,527Current portion of capital leases
    
    
    2,352
    
    
    
    2,682Lines of credit
    
    
    
    
    
    
    8,416Total Current Liabilities
    
    
    39,658
    
    
    
    42,175Long-term Debt
    
    
    1,441
    
    
    
    Capital Leases
    
    
    6,543
    
    
    
    5,348Commitments and Contingencies (Note L)Minority Interest in Consolidated Subsidiary
    
    
    2,563
    
    
    
    Stockholders Equity:Common stock
    
    
    220
    
    
    
    220Additional paid-in capital
    
    
    200,930
    
    
    
    201,053Accumulated deficit
    
    
    (74,915
    )
    
    
    (92,803
    )Stock subscription note receivable
    
    
    (185
    )
    
    
    Accumulated other comprehensive loss
    
    
    (515
    )
    
    
    (539
    )Less  treasury stock, at cost
    
    
    (8,503
    )
    
    
    (1,171
    )Total stockholders equity
    
    
    117,032
    
    
    
    106,760$
    167,237
    
    
    $
    154,283
 The accompanying notes are an integral part of these condensed consolidated financial statements. 1




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THREE-FIVE SYSTEMS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (UNAUDITED)
  Three Months
    
    Six MonthsEnded June 30,
    
    Ended June 30,2003
    
    2004
    
    2003
    
    2004Net Sales
    
    $
    45,992
    
    
    $
    37,632
    
    
    $
    71,316
    
    
    $
    76,076Costs and Expenses:Cost of sales
    
    
    44,098
    
    
    
    37,765
    
    
    
    69,247
    
    
    
    76,430Selling, general, and administrative
    
    
    4,085
    
    
    
    5,682
    
    
    
    7,812
    
    
    
    11,281Research, development, and engineering
    
    
    1,388
    
    
    
    685
    
    
    
    2,654
    
    
    
    1,358(Gain) Loss on sale of assets
    
    
    8
    
    
    
    (57
    )
    
    
    (5
    )
    
    
    (224
    )Amortization of intangibles
    
    
    511
    
    
    
    511
    
    
    
    1,022
    
    
    
    1,02250,090
    
    
    
    44,586
    
    
    
    80,730
    
    
    
    89,867Operating Loss
    
    
    (4,098
    )
    
    
    (6,954
    )
    
    
    (9,414
    )
    
    
    (13,791
    )Other Income (Expense):Interest, net
    
    
    199
    
    
    
    (254
    )
    
    
    495
    
    
    
    (431
    )Other, net
    
    
    (47
    )
    
    
    413
    
    
    
    (38
    )
    
    
    751152
    
    
    
    159
    
    
    
    457
    
    
    
    320Minority Interest in (Income) Loss of Consolidated Subsidiary
    
    
    (43
    )
    
    
    58
    
    
    
    (43
    )
    
    
    (22
    )Loss From Continuing Operations Before Income Taxes
    
    
    (3,989
    )
    
    
    (6,737
    )
    
    
    (9,000
    )
    
    
    (13,493
    )Benefit from income taxes
    
    
    (1,456
    )
    
    
    (16
    )
    
    
    (3,270
    )
    
    
    (128
    )Loss From Continuing Operations
    
    
    (2,533
    )
    
    
    (6,721
    )
    
    
    (5,730
    )
    
    
    (13,365
    )Loss From Discontinued Operation, net of taxes
    
    
    (2,343
    )
    
    
    
    
    
    
    (4,621
    )
    
    
    Net Loss
    
    $
    (4,876
    )
    
    $
    (6,721
    )
    
    $
    (10,351
    )
    
    $
    (13,365
    )Loss Per Common Share  Basic and Diluted:Loss From Continuing Operations
    
    $
    (0.12
    )
    
    $
    (0.31
    )
    
    $
    (0.27
    )
    
    $
    (0.62
    )Loss From Discontinued Operations
    
    
    (0.11
    )
    
    
    
    
    
    
    (0.22
    )
    
    
    Net Loss
    
    $
    (0.23
    )
    
    $
    (0.31
    )
    
    $
    (0.49
    )
    
    $
    (0.62
    )Weighted Average Number of Common Shares:Basic and diluted
    
    
    21,293
    
    
    
    21,632
    
    
    
    21,289
    
    
    
    21,477
 The accompanying notes are an integral part of these condensed consolidated financial statements. 2




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THREE-FIVE SYSTEMS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (UNAUDITED)
  SIX MONTHS ENDEDJUNE 30,2003
    
    2004CASH FLOWS FROM OPERATING ACTIVITIES:Net loss
    
    $
    (10,351
    )
    
    $
    (13,365
    )Less loss  discontinued operations
    
    
    (4,621
    )
    
    
    Loss  continuing operations
    
    
    (5,730
    )
    
    
    (13,365
    )Adjustments to reconcile net loss to net cash (used in) provided by
operating
activities:Depreciation and amortization
    
    
    3,510
    
    
    
    3,853Stock compensation
    
    
    50
    
    
    
    50Minority interest in consolidated subsidiary
    
    
    43
    
    
    
    22Deferred revenue
    
    
    1
    
    
    
    (48
    )Provision for (reduction of) accounts receivable valuation reserves
    
    
    51
    
    
    
    (29
    )Gain on sale of assets
    
    
    (5
    )
    
    
    (224
    )Benefit from deferred taxes, net
    
    
    (5,889
    )
    
    
    Foreign currency translation adjustments
    
    
    (6
    )
    
    
    (26
    )Accretion of interest on long-term debt
    
    
    58
    
    
    
    21Interest on employee loan
    
    
    (6
    )
    
    
    CHANGES IN ASSETS AND LIABILITIES:(Increase) decrease in accounts receivable
    
    
    (11,167
    )
    
    
    3,440(Increase) decrease in inventories
    
    
    (4,615
    )
    
    
    (1,013
    )(Increase) decrease in other assets
    
    
    (110
    )
    
    
    109Increase (decrease) in accounts payable and accrued liabilities
    
    
    18,841
    
    
    
    (6,193
    )Increase (decrease) in taxes payable/receivable
    
    
    (43
    )
    
    
    673Net cash (used in) provided by operating activities
    
    
    (5,017
    )
    
    
    (12,730
    )CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of property, plant, and equipment
    
    
    (996
    )
    
    
    (5,822
    )Proceeds from sale of assets
    
    
    353
    
    
    
    636Purchase of intangibles
    
    
    (1,326
    )
    
    
    (94
    )Purchase of investments
    
    
    (8,263
    )
    
    
    Proceeds from maturities/sales of short-term investments
    
    
    35,458
    
    
    
    5,132Payments on stock subscription note receivable
    
    
    
    
    
    
    185Acquisitions and strategic investments
    
    
    (8,516
    )
    
    
    (2,757
    )Net cash (used in) provided by investing activities
    
    
    16,710
    
    
    
    (2,720
    )CASH FLOWS FROM FINANCING ACTIVITIES:Borrowings from lines of credit
    
    
    
    
    
    
    8,416Payments on long-term debt
    
    
    (28
    )
    
    
    (1,450
    )Stock options exercised
    
    
    
    
    
    
    73Payments on capital leases
    
    
    (390
    )
    
    
    (865
    )Receipt from minority interest
    
    
    2,527
    
    
    
    Net cash (used in) provided by financing activities
    
    
    2,109
    
    
    
    6,174NET
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS CONTINUING OPERATIONS
    
    
    13,802
    
    
    
    (9,276
    )NET CASH USED IN AND CONTRIBUTED TO DISCONTINUED
OPERATIONS
    
    
    (3,773
    )
    
    
    NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    
    
    10,029
    
    
    
    (9,276
    )CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    18,389
    
    
    
    27,976CASH AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    28,418
    
    
    $
    18,700NONCASH INVESTING AND FINANCING ACTIVITIES:Note payable due on purchase of distribution rights license
    
    $
    2,882
    
    
    $
    Note payable due on purchase of Microtune inventory and equipment
    
    
    2,594
    
    
    
    Capital lease due on purchase of Unico equipment
    
    
    9,375
    
    
    
    Treasury stock issued to purchase Unico minority interest
    
    
    
    
    
    
    2,809
 The accompanying notes are an integral part of these condensed consolidated financial statements. 3




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THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Note A
    
    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, display modules and systems, and
complete systems for customers in the transportation, computing,
consumer, industrial, medical, 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,
turn-key packaging, fulfillment services, 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. Our design and manufacturing services include a
distinctive competence in display modules and systems and the
integration of display modules and systems into other products.
The display modules and systems we design and manufacture include
monochrome and color liquid crystal display, or LCD, components,
organic light emitting diodes, or OLEDs, cathode ray tubes, or
CRTs, and flat panel monitors.On September 1, 2003, we transferred all of the net assets of our
microdisplay division, plus approximately $20.9 million in cash,
into a newly created Delaware corporation called Brillian
Corporation. On September 15, 2003, we spun off Brillian by
distributing all of the outstanding common stock of Brillian to our
stockholders on a pro rata basis, with each of our stockholders
receiving one share of Brillian common stock for every four shares
of our common stock. Brillian is now traded on the Nasdaq National
Market under the symbol BRLC. Brillian had $44.1 million of net
assets on the spin-off date. The microdisplay business that we
transferred to Brillian is now reported in these consolidated
financial statements as Discontinued Operations.Note B
    
    Inventories:Inventories are stated at the lower of cost (first-in, first-out)
or net realizable value and consisted of the following at (in
thousands):
 December 31,
    
    June 30,2003
    
    2004Raw materials
    
    $
    14,188
    
    
    $
    19,413Work-in-process
    
    
    5,321
    
    
    
    3,687Finished goods.
    
    
    6,345
    
    
    
    5,113$
    25,854
    
    
    $
    28,213
 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, product in transit that was in our
finished goods inventory was $2.8 million as of June 30, 2004 compared to
$3.6 million as of December 31, 2003.During the fourth quarter of 2003, we learned from a customer that a
product shipped by us to them contained potentially defective parts.
Those potentially defective parts were printed circuit boards supplied to
us by a vendor specified by our customer. At year-end 2003, we believed
the parts could be repaired or that the component supplier would
reimburse us for the damages. We determined in the first quarter of 2004
that the latent defect in the materials purchased was not repairable. As
a result, we established a reserve for the value of that inventory, which
included other component parts that had already been included on those
boards less the $158,000 value of the boards for which the supplier is
obligated to repay at a minimum. The amount reserved was just over $1.0
million.At year-end 2003, we held $778,000 of inventory relating to a program
cancelled by a customer. At that time, we believed we would recover the
carrying value of this inventory and did not establish a reserve. After
further discussions and negotiations with this customer during the first
quarter of 2004, we wrote off $332,000 of this inventory while receiving
settlement against the remainder of the inventory.
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During the second quarter of 2004, a telecommunications customer declared
bankruptcy. As a result of that event, we had to write off $127,000 in
accounts receivable and take a $567,000 reserve against inventory
relating to specific programs for that customer.
 Note C
    
    Property, Plant, and Equipment:Property, plant, and equipment consisted of the following at (in thousands):
 December 31,
    
    June 30,2003
    
    2004Land and building
    
    $
    6,122
    
    
    $
    10,124Furniture and equipment
    
    
    40,907
    
    
    
    42,22847,029
    
    
    
    52,352Less accumulated depreciation
    
    
    (21,706
    )
    
    
    (24,451
    )$
    25,323
    
    
    $
    27,901
 In April, 2004, we purchased our facility in Manila from our lessor and
paid $3.8 million. Of the $3.8 million paid, $2.9 million was assigned
to the carrying value of the building and $846,000 was applied to accrued
rent liabilities. We also paid $614,000 to the RBF Development
Corporation (RBF) for a 50 year land right. The 50 year land right is
still awaiting formal approval by the Philippine Department of Trade and
Industry. If not approved, the land right agreement will be changed to a
25 year lease agreement with RBF. Lastly, we also executed an agreement
with RBF for the option to purchase the leased land for $1 at any time
until April 23, 2014. As a result of the building purchase and land
right agreement, we will no longer be required to pay the $7.8 million in
lease payments due over the next 7 years that was remaining on our
original ten year lease agreement.The remaining capital expenditures related primarily to equipment
purchased from Integrex and our ongoing ERP implementation.Note D
    
    Asset Held for Sale:During the fourth quarter of 2003, we formalized plans to sell our Tempe,
Arizona corporate facility; therefore, we reclassified $8.6 million of
our building and improvements to assets held for sale. The building was
listed and actively marketed for sale at the beginning of October 2003;
therefore, no depreciation expense has been recorded since the third
quarter of 2003.Note E
    
    Intangibles:In January 2003, we signed licensing and manufacturing agreements
with Data International Co., Ltd. of Taiwan. Under those
agreements, we became the exclusive channel in the Americas for
standard and custom LCD products manufactured by Data
International. We also have the right to sell those products
through our worldwide channels. The agreements provide us with
access to a full suite of standard display products that round out
our existing standard product portfolio. The cost of the license
was $3.9 million, of which $1.0 million was paid upon signing and
we entered into a $2.9 million term loan. In the first quarter of
2004, we paid $1.4 million against the term loan. The unpaid $1.5
million is due in January 2005 and is subject to reduction if
certain margin targets are not met.Intangibles consist of mask works, trademarks, customer lists, and
distribution rights. SFAS No. 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 range
from two to five years. Our policy is to commence amortization
of intangibles when their related benefits begin to be realized.Intangible assets consisted of the following (in thousands):
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Acquisition
    
    Accumulated
    
    Book
    
    WeightedDecember 31, 2003
    
    Value
    
    Amortization
    
    Value
    
    Avg LifeAmortized Intangible Assets:Mask works
    
    $
    991
    
    
    $
    
    
    
    $
    991
    
    
    
    3.0Customer lists
    
    
    5,000
    
    
    
    (1,523
    )
    
    
    3,477
    
    
    
    4.2License
    
    
    3,882
    
    
    
    (776
    )
    
    
    3,106
    
    
    
    5.0$
    9,873
    
    
    $
    (2,299
    )
    
    $
    7,574
    
    
    
    4.4
 Acquisition
    
    Accumulated
    
    Book
    
    WeightedJune 30, 2004
    
    Value
    
    Amortization
    
    Value
    
    Avg LifeAmortized Intangible Assets:Mask works
    
    $
    1,086
    
    
    $
    
    
    
    $
    1,086
    
    
    
    2.5Customer lists
    
    
    5,000
    
    
    
    (2,156
    )
    
    
    2,844
    
    
    
    4.2License
    
    
    3,882
    
    
    
    (1,165
    )
    
    
    2,717
    
    
    
    5.0$
    9,968
    
    
    $
    (3,321
    )
    
    $
    6,647
    
    
    
    4.3
 Intangible asset amortization expense for both the six months ended June
30, 2004 and June 30, 2003 was $1.0 million.Estimated annual amortization expense through 2008 and thereafter related
to intangible assets reported as of June 30, 2004 is as follows (in
thousands):
 Fiscal Year
    
    Amortization2004
    
    $
    2,2632005
    
    
    2,4432006
    
    
    1,6862007
    
    
    1,2662008
    
    
    4Thereafter
    
    
    7$
    7,669
 Note F
    
    Goodwill:Goodwill increased $199,000 primarily from the purchase of the ownership
interest in TFS Electronic Manufacturing Services Sdn. Bhd.
(TFS-Malaysia).In the second quarter of 2004, we agreed with Unico Holdings to exchange
its ownership interest in TFS-Malaysia for approximately 423,000 shares
of our common stock in a transaction valued at $2.8 million
compared, to Unico Holdings interest of $2.6 million.
As a result of that transaction, we now own 100% of TFS-Malaysia.Changes in goodwill from December 31, 2003 to June 30, 2004 (in
thousands) were as follows:
 Balance at December 31, 2003
    
    $
    34,606Change
    
    
    199Balance at June 30, 2004
    
    $
    34,805
 Note G
    
    Segment Information:We offer advanced design and manufacturing services with an emphasis on
displays. Historically, we focused on display-oriented products,
although we have always performed extended manufacturing in conjunction
with the display module. In the past two years, we expanded the
value-added manufacturing services we provide through several
acquisitions. As a result, we now provide printed circuit board assembly,
or PCBA, radio frequency, or RF, module assembly, new product
introduction, or NPI, box build, and order fulfillment, even in products
that do not need displays. In products that do include displays, we
specialize in custom and standard display solutions utilizing various
display technologies, including liquid crystal displays, or LCDs, organic
light emitting diodes, or OLEDs, and cathode ray tubes, or CRTs.
 6




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The products we manufacture for customers are of varying sizes and have
varying levels of integration.As a result of the spin-off of our microdisplay division through
Brillian, we now report only one operating segment, although we also
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 assets are based
upon physical location of the assets. The following includes net sales
(in thousands) for our designated geographic areas:
 NorthAmerica
    
    Asia
    
    Europe
    
    TotalThree months ended June 30, 2003Net sales
    
    $
    24,028
    
    
    $
    10,775
    
    
    $
    11,189
    
    
    $
    45,992Three months ended June 30, 2004Net sales
    
    $
    25,808
    
    
    $
    5,782
    
    
    $
    6,042
    
    
    $
    37,632Six months ended June 30, 2003Net sales
    
    $
    39,788
    
    
    $
    17,445
    
    
    $
    14,083
    
    
    $
    71,316Property, plant, equipment, and intangibles, net
    
    
    19,492
    
    
    
    22,994
    
    
    
    7
    
    
    
    42,493Goodwill
    
    
    34,123
    
    
    
    315
    
    
    
    
    
    
    
    34,438Six months ended June 30, 2004Net sales
    
    $
    47,409
    
    
    $
    11,175
    
    
    $
    17,492
    
    
    $
    76,076Property, plant, equipment, and intangibles, net
    
    
    16,483
    
    
    
    18,053
    
    
    
    12
    
    
    
    34,548Goodwill
    
    
    34,258
    
    
    
    547
    
    
    
    
    
    
    
    34,805
 In the second quarter of 2004, our sales were distributed over six major
markets: computing, consumer, industrial, medical, telecommunications,
and transportation. Our net sales distributed by market were as follows:
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,Markets
    
    2003
    
    2004
    
    2003
    
    2004Computing
    
    
    34.3
    %
    
    
    49.8
    %
    
    
    37.3
    %
    
    
    48.8
    %Consumer
    
    
    6.9
    %
    
    
    12.0
    %
    
    
    5.3
    %
    
    
    10.2
    %Industrial
    
    
    8.8
    %
    
    
    14.7
    %
    
    
    9.3
    %
    
    
    13.0
    %Medical
    
    
    14.1
    %
    
    
    11.8
    %
    
    
    15.2
    %
    
    
    10.6
    %Telecommunications
    
    
    30.3
    %
    
    
    4.9
    %
    
    
    29.0
    %
    
    
    11.0
    %Transportation
    
    
    5.6
    %
    
    
    6.8
    %
    
    
    3.9
    %
    
    
    6.4
    %
 Note H
    
    Comprehensive loss (in thousands) for the periods was as follows:
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2003
    
    2004
    
    2003
    
    2004Net loss
    
    $
    (4,876
    )
    
    $
    (6,721
    )
    
    $
    (10,351
    )
    
    $
    (13,365
    )Other comprehensive income (loss):Foreign currency translation
adjustment
    
    
    3
    
    
    
    2
    
    
    
    (6
    )
    
    
    (26
    )Unrealized gain (loss) on
securities, net of tax
securities, net of tax
    
    
    (29
    )
    
    
    
    
    
    
    (46
    )
    
    
    2Comprehensive loss
    
    $
    (4,902
    )
    
    $
    (6,719
    )
    
    $
    (10,403
    )
    
    $
    (13,389
    )
 Note I
    
    Stock 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
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following weighted assumptions: risk-free interest rates of 2.46% and
3.81% for the three months ended June 30, 2003, and 2004; expected
dividend yields of zero for all scenarios; expected lives of 6.1 years
for 2003 and 5.7 years for 2004; and expected volatility (a measure of
the amount by which a price has fluctuated or is expected to fluctuate
during a period) of 74.2% and 79.2% for the three months ended June 30,
2003 and 2004, respectively. The compensation costs for the three and
six months ended June 30, 2003 are tax-effected and the compensation
costs for the three and six months ended June 30, 2004 are not
tax-effected because a full valuation allowance was recorded in the third
quarter of 2003. 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 (in thousands, except per share data):
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2003
    
    2004
    
    2003
    
    2004Net loss:As reported
    
    $
    (4,876
    )
    
    $
    (6,721
    )
    
    $
    (10,351
    )
    
    $
    (13,365
    )Total stock-based compensation
expenses determined under fair
value based method for all
awards, net of related tax
effects
    
    
    (930
    )
    
    
    (941
    )
    
    
    (1,694
    )
    
    
    (2,791
    )Pro forma net loss
    
    $
    (5,806
    )
    
    $
    (7,662
    )
    
    $
    (12,045
    )
    
    $
    (16,156
    )Basic and diluted net loss per share:As reported
    
    $
    (0.23
    )
    
    $
    (0.31
    )
    
    $
    (0.49
    )
    
    $
    (0.62
    )Pro forma
    
    $
    (0.27
    )
    
    $
    (0.35
    )
    
    $
    (0.57
    )
    
    $
    (0.75
    )
 Note J
    
    Earnings 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 and warrants 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 and warrants considered to be
dilutive common stock equivalents. Set forth below (in thousands,
except per share data) are the disclosures required pursuant to
SFAS No. 128, Earnings per Share:
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2003
    
    2004
    
    2003
    
    2004Basic and diluted loss per share:Net Loss
    
    $
    (4,876
    )
    
    $
    (6,721
    )
    
    $
    (10,351
    )
    
    $
    (13,365
    )Weighted average common shares
    
    
    21,293
    
    
    
    21,632
    
    
    
    21,289
    
    
    
    21,477Basic and diluted loss per share amount:
    
    $
    (0.23
    )
    
    $
    (0.31
    )
    
    $
    (0.49
    )
    
    $
    (0.62
    )
 For the three months ended June 30, 2003 and 2004, the effect of 63,545
and 433,298 shares, respectively, and for the six months ended June 30,
2003 and 2004, the effect of 24,575 and 334,239 shares, respectively,
were excluded from the calculation of loss per share as their effect
would have been antidilutive and decreased the loss per share.Note K
    
    Debt:We entered into a temporary credit facility with First National Bank in
the first quarter of 2004 under which we borrowed $5 million secured by
restricted cash deposits. In the second quarter 2004, we repaid and
terminated that credit facility.In the second quarter of 2004, we entered into a $10.0 million secured
revolving line of credit with Silicon Valley Bank, which matures on June
25, 2005. The line of credit bears interest at the banks prime rate plus
0.75%, subject to a minimum of 4.75%. The revolving line of credit
contains restrictive covenants that include, among other things,
restrictions on the declaration of payment of dividends, restrictions on
the sale or transfer of assets, and maintenance of specified net worth
and quick ratio. We borrowed $6.0 million under that line of credit as
of June 30, 2004.
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As of the second quarter 2004, our Beijing subsidiary also has secured a
$2.4 million line of credit with Hua Xia Bank secured principally by our
building in Beijing. As of June 30, 2004, we borrowed $2.4 million under
that facility, which accrues simple annual interest payable at 5.31%.In January 2003, we signed a term loan of $2.9 million to Data
International. In the first quarter of 2004, we paid $1.4 million against
the term loan. The unpaid $1.5 million is due in January 2005 and is
subject to reduction if certain margin targets are not met.Note L
    
    Commitments and Contingencies: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. As we have not yet been released from our obligation on
the guarantee, if Brillian becomes required to pay on the guarantee and
is unable to satisfy its obligation, we would be secondarily liable and
would be required to pay this guarantee to the lender. As of June 30,
2004, the outstanding balance on the debt was $372,000. This loan
guarantee has a five-year term and matures in January 2007.We are also involved in certain legal and administrative proceedings
arising in the normal course of business. In our opinion, the ultimate
settlement of these legal and administrative proceedings will not
materially impact our financial position or results of operations.Note M
    
    Acquisitions and Strategic Investments:In February 2004, we entered into a transaction with Integrex, a Seattle-based
electronics manufacturing services company liquidating its business. Under
that transaction, we bought the raw materials inventory of Integrex for $1.4
million and hired certain of its employees. We also obtained the rights to
most of its customers and agreed with those customers that we would manufacture
those customers products in our Redmond manufacturing facility. In exchange
for those customer rights, we agreed to pay a license fee for between 15 and 24
months based on revenue receipts from former Integrex customers. In February
2004 and at a second closing in April 2004, we paid $1.3 million in
non-refundable license fees to Integrex. At the second closing in April, we
also acquired $300,000 of capital equipment.Note N
    
    Recently Issued Accounting Standards:In November 2002, the FASB issued FASB Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities, which clarifies the application
of Accounting Research Bulletin No. 51, Consolidated Financial Statements,
relating to consolidation of certain entities. This interpretation was
subsequently revised by FIN 46 (Revised 2003) (FIN 46(R)) in December 2003.
This interpretation states that consolidation of variable interest entities
will be required by the primary beneficiary if the entities do not effectively
disperse risk among the parties involved. The requirements are effective for
fiscal years ending after December 15, 2003. We have no variable interest
entities and do not believe that FIN 46(R) will impact our future financial
results.
 
 ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS AND FACTORS THAT MAY AFFECT RESULTS The statements contained in this report on Form 10-Q that are not purely
historical are forward-looking statements within the meaning of applicable
securities laws. Forward-looking statements include statements regarding our
expectations, anticipation, intentions, beliefs, or strategies
regarding the future. Forward-looking statements also include statements
regarding revenue, margins, expenses, and earnings analysis for fiscal 2004 and
thereafter; 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 9




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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 Current Operations We are a global provider of electronics manufacturing services, or EMS. We
design and manufacture printed circuit board assemblies, radio frequency, or
RF, modules, display modules and systems, and complete systems for customers in
the transportation, computing, consumer, industrial, medical, 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,
turnkey packaging, fulfillment services, and turnkey supply chain management
services, all of which enable our customers to outsource all stages of product
engineering, design, development, materials procurement and management,
manufacturing, and testing. Our design and manufacturing services include a
distinctive competence in display modules and systems and the integration of
display modules and systems into other products. These display modules and
systems we design and manufacture include monochrome and color liquid crystal
display, or LCD, components, organic light emitting diodes, or OLEDs, cathode
ray tubes, or CRTs, and flat panel monitors. The products we manufacture for customers are of varying sizes and have
varying levels of integration. The typical design program life cycle of a
custom-designed product is three to 15 months and includes technical design,
prototyping, pilot manufacturing, and high-volume manufacturing. The cycle is
shorter in products where no display is involved and/or where the customer has
already completed the design. Several factors impact our gross margins, including manufacturing
efficiencies, product mix, product differentiation, product uniqueness,
inventory management, and volume pricing. We have factories in Washington and
Massachusetts in the United States and in the Philippines, Malaysia, and China.
In Washington and in Malaysia, we provide engineering support, automated
printed circuit board assembly, in-circuit and functional testing, systems
integration and box build, complete supply chain management, and turnkey
packaging and fulfillment services. In Massachusetts, we provide aftermarket
customization of flat panel displays and CRTs. In China, we assemble displays
into modules and are adding some of the manufacturing services offered in
Washington and Malaysia. In the Philippines, we assemble and test RF modules. Selling, general, and administrative expense consists principally of
administrative and selling costs; salaries, commissions, and benefits to
personnel; and related facility costs. In general, these costs have risen as a
result of the acquisitions we have completed in the last two years. We make
substantially all of our sales directly to customers through a sales force that
consists mainly of direct technical sales persons, but also includes a small
representative network. As a result, there is no material cost of distribution
in our selling, general, and administrative expense. Research, development, and engineering expense consists principally of
salaries and benefits to design engineers and other technical personnel,
related facility costs, process development costs, and various expenses for
projects, including new product development. In general, these costs have
declined in the last few years because we no longer do any pure research work.
Thus, most of our expense relates to the development engineering costs
associated with preproduction design and prototyping of custom products and the
conceptual formulation and design of potential standard display products. We
also have moved some of our engineering resources to Asia, resulting in lower
costs. We also incur expenses relating to the amortization of intangibles. Those
expenses relate to amortizable intangibles acquired in acquisitions as
described below. Future Operations Our long-term goal is to have gross margins of 12 percent to 14 percent
and operating costs of between six percent and eight percent of revenue. Our
goal is to achieve an interim model within 12 months of 10 percent to 12
percent gross margins with operating costs of between eight percent and 11
percent of revenue. The drivers to achieving our long-term and interim models
are improving the utilization of our off-shore factories through 10




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increased revenue and improving our gross margins by focusing on markets,
like gaming and medical, that value our unique combination of global EMS
capabilities and display expertise. Historic Operations Prior to 2002, our business strategy was to seek large-volume display
programs from major original equipment manufacturers, or OEMs, typically
100,000 units per year or higher, with selling prices of approximately $7 per
unit. Although our focus was designing and manufacturing display modules, we
often engaged in extended contract manufacturing services for other items
related to the display modules, such as printed circuit boards, keyboards,
microphones, speakers, plastic housing, and other similar components. We also
manufactured liquid crystal display glass cells from 1995 to 2002. From 1998
to 2002, substantially all of our large-volume business was in providing
display modules for Motorola handsets. In 2001, new
monochrome design wins in that business became unprofitable; thus, we began to
refocus our strategy to expand our customer base and our product and service
offering. We further modified our strategy in late 2002 to expand our
manufacturing services to include products that do not need displays. As a result of the foregoing, we have substantially changed our business
since late in 2002. We have reduced our concentration in Motorola revenue. The
selling price of the products we manufacture and sell now range up to $8,000
per unit. We have numerous customers in six principal markets. We have expanded
our business both through organic growth and through the acquisitions of AVT,
ETMA, and Unico. We have also expanded through the license arrangements with
Data International and Integrex and through our manufacturing agreement with
Microtune. The substantial shift in our business strategy has resulted in increased
selling and administrative costs. By previously focusing on one market and one
customer, we were able to maintain selling, general and administrative costs at
a very low level. By contrast, we now have many more customers requiring more
sales interface. In addition, administrative costs have increased as we have
increased the number of operating locations in the United States and around the
world. In addition, as a result of the Sarbanes-Oxley Act of 2002, we have
incurred additional administrative expenses, such as additional auditing fees
and the costs related to the establishment of an internal auditing function.
In addition, the shift in sales strategy from a high-volume focus to a more
value-add focus has resulted in reduced volumes at higher selling prices. The
reduced volumes have resulted in excess capacity at our factories overseas. Acquisitions and Strategic Transactions In September 2002, we purchased the assets and ongoing business of AVT,
Advanced Video Technologies, located in Marlborough, Massachusetts, a privately
held company that specializes in the design and integration of complex,
high-resolution display systems. As a result, we now design and provide
customized and ruggedized flat panel, touchscreen, and rackmount systems for
OEMs in the industrial and medical markets. We outsource display components
from a variety of companies, including Sony, Sharp, NEC, LG, and Samsung. The
purchase price of the acquisition was $12.0 million, which we paid entirely in
cash. In December 2002, we purchased the stock of ETMA Corporation, located in
Redmond, Washington, a privately held electronic manufacturer for OEM customers
in the computer peripheral, medical monitoring, and Internet security
industries. As a result, we now offer the manufacturing capabilities of five
surface mount manufacturing lines, including one dedicated to new product
introduction and prototyping activity. We also provide engineering support,
automated printed circuit board assembly, in-circuit and functional testing,
systems integration and box build, complete supply chain management, and
turnkey packaging and fulfillment services. The purchase price of the ETMA
acquisition was $38.1 million, which we paid entirely in cash. In January 2003, we signed licensing and manufacturing agreements with
Data International Co., Ltd. of Taiwan. Under those agreements, we became the
exclusive channel in the Americas for standard and custom LCD products
manufactured by Data International. We also have the right to sell those
products through our worldwide channels. The agreements provide us with access
to a full suite of standard display products that round out our existing
standard product portfolio. In conjunction with the agreement, we established a
sales office in Orlando, Florida, and hired sales and applications engineering
personnel from a distributor that had previously supported Data Internationals
products. The cost of the license was $3.9 million, of which $1.0 million was
paid upon signing and we entered into a $2.9 million term loan. In the first
quarter of 2004, we paid $1.4 million against the term loan. The remaining $1.5
million is due in January 2005 and is subject to reduction if certain margin
targets are not met. 11




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In March 2003, we signed an agreement with Microtune, Inc. in which we
agreed to manufacture, assemble, and test Microtunes radio frequency, or RF,
tuner modules and wireless module products in our manufacturing facility in
Manila, the Philippines. As part of the agreement, Microtune sold to us certain
of its own equipment and inventory for $8.2 million, of which $2.7 million was
a note payable due in September 2003, and contracted with us to provide 100% of
Microtunes current demand for fully assembled RF subsystems. We also hired
approximately 500 Microtune employees in Manila. In October 2003, we paid off
approximately $300,000 of the $2.7 million note payable to Microtune and
entered into an agreement to cancel the remaining $2.4 million balance on that
note in exchange for the return of certain excess inventory to Microtune. As a
result of this transaction, we now provide 100% of the manufacturing
outsourcing for Microtunes RF module products. In April 2003, we acquired the business and certain assets of Unico
Technology Bhd., a privately held Malaysian company located in Penang. Unico
was an electronic manufacturer for OEM customers in the computer, computer
peripheral, and communications industries. The Unico business was acquired by
TFS Electronics Manufacturing Services Sdn. Bhd., or TFS-Malaysia, a joint
venture owned 60% by an overseas TFS subsidiary and 40% by Unico Holdings Bhd.,
the former parent of Unico. Unico Holdings is the investment arm of the Chinese
Chamber of Commerce of Malaysia. Our share of the initial cost of capitalizing
TFS-Malaysia was $3.8 million and Unico Holdings share was $2.5 million, most
of which was used for working capital. TFS-Malaysia purchased $4.1 million in
inventory from Unico, of which $2.7 million was paid at the time of the
purchase and $1.4 million was subsequently paid. No advance payment was
required for the acquisition of the property, plant, and equipment of Unico,
all of which is leased from the seller. The equipment lease is accounted for as
a capital lease payable by TFS-Malaysia. The principal balance on that lease
was $7.1 million as of June 30, 2004. In the second quarter of 2004, Unico
Holdings exchanged its ownership interest in TFS-Malaysia for approximately
423,000 shares of our common stock in a transaction valued at $2.8 million,
compared to Unico Holdings interest of $2.6 million. As a result of that transaction, we now own 100% of
TFS-Malaysia. In February 2004, we entered into a transaction with Integrex, a
Seattle-based electronics manufacturing services company liquidating its
business. Under that transaction, we bought the raw materials inventory of
Integrex for $1.4 million and hired certain of its employees. We also obtained
the rights to most of its customers and agreed with those customers that we
would manufacture those customers products in our Redmond manufacturing
facility. In exchange for those customer rights, we agreed to pay a license
fee for between 15 and 24 months based on revenue receipts from former Integrex
customers. In February 2004 and at a second closing in April 2004, we paid $1.3
million in non-refundable license fees to Integrex. At the second closing in
April, we also acquired $300,000 of capital equipment. Discontinued Operations On September 1, 2003, we transferred all of the net assets of our
microdisplay division, plus approximately $20.9 million in cash, into a newly
created Delaware corporation called Brillian Corporation. On September 15,
2003, we spun off Brillian by distributing all of the outstanding common stock
of Brillian to our stockholders on a pro rata basis, with each of our
stockholders receiving one share of Brillian common stock for every four shares
of our common stock. Brillian is now traded on the Nasdaq National Market under
the symbol BRLC. Brillian had $44.1 million of net assets on the spin-off
date. For more information on the reasons for the spin-off, as well as the
description of business and risks associated with the spin-off, please refer to
the Form 10 and other filings by Brillian with the Securities and Exchange
Commission. The microdisplay business that we transferred to Brillian is now
reported in our consolidated financial statements as Discontinued Operations. 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 on-going basis, we evaluate our estimates and judgments,
including those related to sales returns, bad debts, inventories, fixed assets,
intangible assets, income taxes, and contingencies. We base our estimates on
historical experience and on various other assumptions that we believe are
reasonable under the circumstances. The results form the basis for making
judgments about the carrying values of assets and liabilities 12




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that are not readily apparent from other sources. Actual results may differ
from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our financial
statements. We recognize revenue from product sales when persuasive evidence of a sale
exists; that is, a product is shipped under an agreement with a customer; risk
of loss and title has 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 FOB Destination then the risk of loss during transit is
maintained by 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 at the end of each quarter and in our finished
goods inventory. We recognize revenue related to engineering and tooling services after
service has been rendered, which is determined based upon completion of
agreed-upon milestones or deliverables. Sales allowances are estimated 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. We write down our inventory for estimated obsolescence or unmarketable
inventory. We write down our inventory to estimated market value 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. During the fourth quarter of 2003, we learned from a customer that a
product shipped by us to them contained potentially defective parts. Those
potentially defective parts were printed circuit boards supplied to us by a
vendor specified by our customer. At year-end 2003, we believed the parts
could be repaired or that the component supplier would reimburse us for the
damages. We determined in the first quarter of 2004 that the latent defect in
the materials purchased was not repairable. As a result, we established a
reserve for the value of that inventory, which included other component parts
that had already been included on those boards less the $158,000 value of the
boards for which the supplier is obligated to repay at a minimum. The amount
reserved was just over $1.0 million. At year-end 2003, we held $778,000 of inventory relating to a program
cancelled by a customer. At that time, we believed we would recover the
carrying value of this inventory and did not establish a reserve. After further
discussions and negotiations with this customer during the first quarter of
2004, we wrote off $332,000 of this inventory while receiving settlement
against the remainder of the inventory. During the second quarter of 2004, a telecommunications customer declared
bankruptcy. As a result of that event, we had to write off $127,000 in accounts
receivable and take a $567,000 reserve against inventory relating to specific
programs for that customer. 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. At the
end of the second quarter of 2003, we had $19.8 million of net deferred tax
assets, resulting primarily from net operating loss and tax credit
carryforwards. SFAS No. 109 requires 13




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that a valuation allowance be established when it is more likely than not
that all or a portion of a deferred tax asset will not be realized. In
determining whether a valuation allowance is required, we are required to take
into account all positive and negative evidence with regard to the utilization
of a deferred tax asset, including our past earnings history, market
conditions, management forecasts of future profitability, the character and
jurisdiction of such earnings, unsettled circumstances that, if unfavorably
resolved, would adversely affect utilization of a deferred tax asset, carryback
and carryforward periods, and tax strategies that could potentially enhance the
likelihood of realization of a deferred tax asset. SFAS No. 109 further states
that it is difficult to conclude that a valuation allowance is not needed when
there is negative evidence such as cumulative losses in recent years.
Therefore, despite the fact that a major portion of the losses came from our
spun-off microdisplay division, the expectation in the third quarter of 2003
was that we would have three years of cumulative losses. Those cumulative
losses weighed heavily in the overall required assessment and outweighed our
forecasted future profitability and expectation that we will be able to utilize
all of our net operating loss carryforwards. As a result, in the third quarter
of 2003, we recorded a charge to establish a full valuation allowance against
our deferred tax asset. We expect to continue to record a full valuation
allowance on future tax benefits until we return to sustained profitability. Long-term assets, such as property, plant, and equipment, intangibles,
goodwill, and other investments, are originally recorded at cost. On an
on-going basis, we assess these assets to determine if their current recorded
value is impaired. When assessing these assets, we consider projected future
cash flows to determine if impairment is applicable. These cash flows are
evaluated for objectivity by using weighted probability techniques and also
comparisons of past performance against projections. 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 was impaired, we would write
down the carrying value of the identified asset and charge the impairment as an
expense in the period in which the determination was made. Results of Operations Three months ended June 30, 2004 compared to three months ended June 30,
2003 Net Sales.Net sales decreased 18% to $37.6 million in the second quarter
of 2004 from $46.0 million in the second quarter of 2003. The decrease was
primarily a result of reduced sales of our monochrome display modules, a
substantial portion of which were sold to Motorola in 2003. In fact, Motorola
accounted for 3% of our net sales in the second quarter of 2004 compared to 13%
in the second quarter of 2003. We had two customers that accounted for more
than 10% of our net sales in the second quarter of 2004. One of these
customers is in the computer peripherals business and the other is in the RF
business, and those two customers accounted for 35% and 12% of our net sales,
respectively. The sales in our six markets (in thousands) are broken down as
follows: Three Months Ended June 30,2003
    
    2004Computing
    
    $
    15,758
    
    
    $
    18,751Consumer
    
    
    3,179
    
    
    
    4,510Industrial
    
    
    4,031
    
    
    
    5,564Medical
    
    
    6,474
    
    
    
    4,422Telecommunications
    
    
    13,935
    
    
    
    1,844Transportation
    
    
    2,615
    
    
    
    2,541Net sales
    
    $
    45,992
    
    
    $
    37,632
 Gross Margin.Our gross margin in the second quarter of 2004 was a
negative $133,000 compared to a positive $1.9 million in the second quarter of
2003. The gross margin in the second quarter of 2004 was lower than we
originally expected, primarily due to product pricing and mix issues at our
Redmond, Washington facility and the integration of Integrex, whose customers
we recently acquired. The integration issues of Integrex primarily related to
handling the unexpected volume of new programs that transferred over from
Integrex. In addition, many of those programs had quality issues left over from
Integrex that required a longer and more extensive new product introduction and
qualification schedule than expected. These two items contributed to the
negative gross margin dollars in the Redmond facility of $1.0 million in the
three months ended June 30, 2004 compared to positive gross margin dollars of
$854,000 in the three months ended June 30, 2003. We also wrote off inventory
valued at $567,000 relating to the sudden bankruptcy and dissolution of one of
our telecommunications customers. Offsetting some of those costs, we made
significant strides in our RF module business, generating gross margin dollars
in the second quarter that were almost $500,000 greater than in the first
quarter. Our gross margin continues to be 14




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negatively impacted by our excess capacity offshore. Currently, we are at
approximately 60% factory utilization in Manila, 45% in Penang, and 27% in
Beijing. Selling, General, and Administrative Expense.Selling, general, and
administrative expense increased to $5.7 million in the second quarter of 2004
from $4.1 million in the second quarter of 2003. SG&A expense was 15% of net
sales in the second quarter of 2004 compared to 9% in the second quarter of
2003. This increase in SG&A expense occurred primarily for the following
reasons. First, we had additional finance and administrative expenses of
$706,000 as a result of increased infrastructure and with increased costs
associated with our compliance with the Sarbanes-Oxley Act of 2002. We also
had additional selling costs of $891,000 as a result of personnel added from
acquisitions and expanding our market focus. Research, Development, and Engineering Expense.Research, development,
and engineering expense decreased to $685,000 in the second quarter of 2004
from $1.4 million in the second quarter of 2003. Research, development, and
engineering expense was 2% of net sales in the second quarter of 2004 compared
to 3% in the second quarter of 2003. The decrease in the second quarter of
2004 was due to two reasons. First, we have significantly reduced our pure
research efforts in displays as we have spun off our microdisplay business and
become more of a manufacturing services company versus a product company.
Second, we have continued to move our engineering efforts to Asia, resulting in
lower overall costs. Amortization of Intangibles.The amortization of customer lists of
$511,000 was identical for the second quarter of 2004 and 2003. The
amortization relates to the acquisitions of AVT and ETMA and to the license
agreement with Data International, all described above in Overview. The
amortizable asset associated with AVT is $3.0 million and is being amortized
over five years. The amortizable asset associated with ETMA is $2.0 million and
is being amortized over three years. The amortizable asset associated with Data
International is $3.9 million and is being amortized over five years. Other Income, Net.Other income was $159,000 in the second quarter of
2004 compared to $152,000 in the second quarter of 2003. The composition and
differences of the items that make up other income are as follows (in
thousands): Three Months Ended June 30,2003
    
    2004Interest Income
    
    $
    283
    
    
    $
    37Interest Expense
    
    
    (84
    )
    
    
    (291
    )Rental and Service Income from Brillian
    
    
    
    
    
    
    345Foreign Exchange and Other Gain (Loss)
    
    
    (47
    )
    
    
    68Other Income, net
    
    $
    152
    
    
    $
    159
 Interest income decreased as a result of lower cash and short-term investment
balances. Interest expense increased as a result of the capital leases. The
rental and service income from Brillian increased as a result of the spin-off
of our microdisplay business to Brillian Corporation, which is renting part of
our existing building and paying for some information technology services.
Also included in other income is approximately $150,000 from a legal
settlement. Minority Interest.In April 2004, we agreed with Unico Holdings to
exchange its ownership interest in TFS Electronic Manufacturing Services Sdn.
Bhd. (TFS - Malaysia) for approximately 423,000 shares of our common stock in
a transaction valued at $2.8 million. As a result of that transaction, we now
own 100% of TFS - Malaysia. In the second quarter of 2004, we recorded a
benefit of $58,000 to account for the losses allocated to the minority interest
holder during the period of time preceding the stock exchange. In the second
quarter of 2003, we controlled and owned 60% of the business in TFS - Malaysia
and we recorded an expense of $43,000 to account for the profits allocated to
the minority interest holder. Benefit from Income Taxes.We recorded a benefit from income taxes of
$16,000 in the second quarter of 2004 compared to a benefit from income taxes
of $1.5 million for the second quarter of 2003. The benefit in the second
quarter of 2004 related to tax refunds received. The $1.5 million benefit from
taxes in 2003 added to our deferred tax asset that we later wrote off during
the third quarter of 2003. We recorded a charge in the third quarter of 2003
to establish a valuation allowance against our deferred tax asset, which
consists primarily of net operating loss carryforwards, or NOLs. A further
description of that allowance is described above in Critical Accounting
Policies and Estimates. As a result, we generally no longer record a tax
benefit for losses. 15




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Net Loss.Our net loss was $6.7 million, or $0.31 per diluted share, in
the second quarter of 2004 compared to a net loss of $4.9 million, or $0.23 per
diluted share, in the second quarter of 2003. The net loss in the second
quarter of 2003 included $2.3 million, or $0.11 per share, from discontinued
operations relating to our former microdisplay business. As described above in
Discontinued Operations, our microdisplay division was spun off as a separate
public company, as of September 15, 2003. Results of Operations Six months ended June 30, 2004 compared to six months ended June 30, 2003 Net Sales.Net sales increased 7% to $76.1 million in the first six
months of 2004 from $71.3 million in the first six months of 2003. The
increase in year over year revenue was primarily a result of growth in (1) our
box build/PCBA business in the computing market and (2) our RF module business
in the transportation and consumer markets. We had only one customer that
accounted for more than 10% of our net sales in the first six months of 2004,
and that customer, which is in the computer peripherals business, accounted for
35% of our net sales. The sales (in thousands) in our six markets on a
comparative year over year basis are broken down as follows: Six Months Ended June 30,2003
    
    2004Computing
    
    $
    26,630
    
    
    $
    37,089Consumer
    
    
    3,755
    
    
    
    7,763Industrial
    
    
    6,620
    
    
    
    9,886Medical
    
    
    10,828
    
    
    
    8,086Telecommunications
    
    
    20,735
    
    
    
    8,348Transportation
    
    
    2,748
    
    
    
    4,904Net sales
    
    $
    71,316
    
    
    $
    76,076
 Gross Margin.Our gross margin in the first six months of 2004 was a
negative $354,000 compared to a positive $2.1 million in the first six months
of 2003. The reasons for the differences are as follows: first, we sold more
products at a lower gross margin at our Redmond, Washington facility due
primarily to a change in customer and product mix. Second, we brought over a
substantial number of new programs from Integrex and the new product
introduction process for each of those programs was extensive and costly.
Third, we incurred an unplanned inventory write-off of just over $1.0 million
at our Redmond facility relating to a suppliers defective component. These
three items contributed to the negative gross margin dollars in the Redmond
facility of $1.9 in the first half of 2004 compared to positive gross margin
dollars of $1.9 million in the first half of 2003. Fourth, in the first half
of 2004, we consolidated our display module operations in China by moving the
display module operations from Manila to China. This resulted in a one-time
expense of approximately $1.0 million in the first half of 2004. Finally, in
the first half of 2004 we wrote off inventory valued at approximately $899,000
million for various reasons, including end-of-life programs and the bankruptcy
of a customer. If all of these one-time items are not considered, then gross
margins actually improved in the first six months of 2004 compared to the first
six months of 2003. Overall gross margins continue to be negatively impacted,
however, by our excess capacity offshore. Currently, we are at approximately
60% factory utilization in Manila, 45% in Penang, and 27% in Beijing. These
currently reduced manufacturing volumes result in under-absorption of our fixed
manufacturing costs. As we begin to ramp new product builds overseas, we
expect gross margins to steadily improve. Selling, General, and Administrative Expense.Selling, general, and
administrative expense increased to $11.3 million in the first six months of
2004 from $7.8 million in the first six months of 2003. SG&A expense was 15%
of net sales in the first six months of 2004 and 11% in the first six months of
2003. This increase in SG&A expense occurred primarily because of additional
finance and administrative expenses of $1.7 million associated with our
increased infrastructure and additional selling costs of $1.8 million
associated with personnel added from acquisitions and as we expand our market
focus along with increased costs associated with our compliance with the
Sarbanes-Oxley Act of 2002. Research, Development, and Engineering Expense.Research, development,
and engineering expense decreased to $1.4 million in the first six months of
2004 from $2.7 million in the first six months of 2003. Research, development,
and engineering expense was 2% of net sales in the first six months of 2004
compared to 4% in the first six months of 2003. The decrease in the first six
months of 2004 was due to two reasons. First, we have significantly reduced our
pure research efforts in displays as we have spun off our microdisplay business
and 16




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become more of a manufacturing services company versus a product company.
Second, we have continued to move our engineering efforts to Asia, resulting in
lower overall costs. Amortization of Intangibles.The amortization of customer lists of $1.0
million was identical for the first six months of 2004 and 2003. The
amortization relates to the acquisitions of AVT and ETMA and to the license
agreement with Data International, all described above in Overview. The
amortizable asset associated with AVT is $3.0 million and is being amortized
over five years. The amortizable asset associated with ETMA is $2.0 million and
is being amortized over three years. The amortizable asset associated with Data
International is $3.9 million and is being amortized over five years. Other Income, Net.Other income was $320,000 in the first six months of
2004 compared to $457,000 in the first six months of 2003. The composition and
differences of the items that make up other income are as follows (in
thousands): Six Months Ended June 30,2003
    
    2004Interest Income
    
    $
    639
    
    
    $
    145Interest Expense
    
    
    (144
    )
    
    
    (576
    )Rental and Service Income from Brillian
    
    
    
    
    
    
    651Foreign Exchange and Other Gain (Loss)
    
    
    (38
    )
    
    
    100Other Income, net
    
    $
    457
    
    
    $
    320
 Interest income decreased as a result of lower cash and short-term investment
balances. Interest expense increased as a result of the capital leases. The
rental and service income from Brillian increased as a result of the spin-off
of our microdisplay business to Brillian Corporation, which is renting part of
our existing building and paying for some information technology services.
Also included in other income is approximately $150,000 from a legal settlement
which occurred in the second quarter of 2004. Minority Interest.In April 2004, we agreed with Unico Holdings to
exchange its ownership interest in TFS - Malaysia for approximately 423,000
shares of our common stock in a transaction valued at $2.8 million. As a
result of that transaction, we now own 100% of TFS -Malaysia. In the first
six month of 2004 we recorded an expense of $22,000 to account for the profits
allocated to the minority interest holder during the period of time preceding
the stock exchange. In the first six months of 2003, we controlled and owned
60% of the business in TFS - Malaysia and we recorded an expense of $43,000 to
account for the profits allocated to the minority interest holder. Benefit from Income Taxes.We recorded a benefit from income taxes of
$128,000 in the first six months of 2004 compared to a benefit from income
taxes of $3.3 million for the first six months of 2003. The benefit in the
first six months of 2004 related to tax refunds received. The $3.3 million
benefit from taxes in 2003 added to our deferred tax asset that we later wrote
off during the third quarter of 2003. We recorded a charge in the third quarter
of 2003 to establish a valuation allowance against our deferred tax asset,
which consists primarily of net operating loss carryforwards, or NOLs. A
further description of that allowance is described above in Critical
Accounting Policies and Estimates. As a result, we generally no longer record
a tax benefit for losses. Net Loss.Our net loss was $13.4 million, or $0.62 per diluted share, in
the first six months of 2004 compared to a net loss of $10.4 million, or $0.49
per diluted share, in the first six months of 2003. The net loss in the first
six months of 2003 included $4.6 million, or $0.22 per share, from discontinued
operations relating to our former microdisplay business. As described above in
Discontinued Operations, our microdisplay division was spun off as a separate
public company, as of September 15, 2003. Liquidity and Capital Resources At June 30, 2004, we had cash of $18.7 million compared to cash and
short-term investments of $33.1 million at December 31, 2003. The reductions to
these balances over the last six months can be summarized as follows: Operating Cash Outflows
    
    $
    (12,730
    )Capital Expenditures, Acquisitions and Strategic Investments(a)
    
    $
    (8,037
    )Cash from Borrowings, Net of Debt and Capital Lease Repayments
    
    $
    6,174
 17




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(a)
    
    Includes the following line items from the Condensed
Consolidated Statements of Cash Flows appearing on page 3 of this
Form 10-Q: purchases of property, plant, and equipment; proceeds
from sale of assets; purchase of intangibles; acquisitions and
strategic investments. In the second quarter of 2004, we had $5.4 million in net cash outflow
from operations compared to $6.7 million in net cash outflow from operations in
the second quarter of 2003. The principal difference is greater working
capital requirements in the second quarter of 2003. Our inventory turns were 5.4 and day sales outstanding, or DSOs, were 59
days in the second quarter of 2004 compared with 6.2 inventory turns and 44
DSOs in the second quarter of 2003. Our inventory turns were negatively
affected in the second quarter of 2004 because we purchased buffer stock to
insure a smooth transition of our module operations from Manila to Beijing and
because we had more finished goods inventory as a result of shipping terms.
DSOs were within our historic range, but increased in the second quarter of
2004 because of a chronically late-paying European customer. Our depreciation
and amortization expense was $1.8 million in the second quarter of 2004
compared with $2.0 million in the second quarter of 2003. During the second quarter of 2004, we incurred capital and intangible
additions of $5.2 million. This was principally related to the purchase of our
previously leased Manila facility for $3.5 million. The remaining capital
expenditures related primarily to equipment purchased from Integrex and our
ongoing ERP implementation. In the first six months of 2004, we made a $1.4
million payment to Data International on the term loan that related to the
license to resell certain standard products. A final estimated $1.5 million
payment on that note is due to Data International in January 2005. During the
first six months of 2004, we also consummated the Integrex transaction,
described above, for an initial cash outlay of $2.3 million for inventory and
prepaid license fees. In the second quarter of 2004, we paid an additional
$713,000 to Integrex for license fees and equipment. In the second quarter of 2004, we purchased our facility in Manila from
our lessor for a total payment of $3.8 million, of which $2.9 million was
assigned to the carrying value of the building and $846,000 was applied to
accrued rent liabilities. We also paid $614,000 to the RBF Development
Corporation (RBF) for a 50 year land right. The 50 year land right is still
awaiting formal approval by the Philippine Department of Trade and Industry.
If not approved, the land right agreement will be changed to a 25 year lease
agreement with the RBF. Lastly, we also executed an agreement with the RBF for
the option to purchase the leased land for $1 at any time until April 23, 2014.
As a result of the building purchase and land right agreement, we will no
longer be required to pay the $7.8 million in the lease payments due over the
next 7 years that was remaining on our original ten year lease agreement. Our working capital was $42.5 million and our current ratio was 2.0-to-1
at June 30, 2004, down from working capital of $59.6 million and a current
ratio of 2.5-to-1 at December 31, 2003. These decreases are primarily because
of reduced cash balances and borrowing on our new lines of credit. While we transact business predominantly in U.S. dollars and bill 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,
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 38% of our
net sales in the first six months of 2004 and 44% of our net sales in 2003.
Sales in foreign markets, primarily Europe and Asia, to OEMs based in the
United States accounted for almost all of our international sales in each of
these periods. We entered into a temporary credit facility with First National Bank in
the first quarter of 2004 under which we borrowed $5.0 million secured by
restricted cash deposits. In the second quarter 2004, we repaid and terminated
that credit facility. In the second quarter of 2004, we entered into a $10.0
million secured revolving line of credit with Silicon Valley Bank, which
matures on June 25, 2005. The line of credit bears interest at the banks prime
rate plus 0.75%, subject to a minimum of 4.75%. Currently, the banks prime
rate is 4.0%. We borrowed $6.0 million under the facility as of June 30, 2004.
In addition, as of the second quarter of 2004, our Beijing 18




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subsidiary also has secured a $2.4 million line of credit with Hua Xia
Bank secured principally by our building in Beijing. We have borrowed $2.4
million under that facility, which accrues simple, annual interest at 5.31%. The following tables list our contractual obligations and commercial
commitments as of June 30, 2004: Payments due by PeriodContractual Obligations
    
    Total
    
    Less
    
    
    
    
    
    
    
    
    
    6 Years(in thousands)
    
    Obligations
    
    than 1 Year
    
    1-3 Years
    
    4-5 Years
    
    and OverNotes Payable
    
    $
    1,527
    
    
    $
    1,527
    
    
    $
    
    
    
    $
    
    
    
    $
    Operating Leases
    
    
    12,459
    
    
    
    3,199
    
    
    
    3,185
    
    
    
    200
    
    
    
    5,875Capital Leases
    
    
    8,030
    
    
    
    2,682
    
    
    
    5,333
    
    
    
    14
    
    
    
    Lines of Credit
    
    
    8,416
    
    
    
    8,416
    
    
    
    
    
    
    
    
    
    
    
    Total Contractual Cash Obligations
    
    $
    30,432
    
    
    $
    15,824
    
    
    $
    8,518
    
    
    $
    214
    
    
    $
    5,875
 Amount of Commitment Expiration Per PeriodOther Commercial Commitments
    
    Total
    
    Less
    
    
    
    
    
    
    
    
    
    6 Years(in thousands)
    
    Commitments
    
    than 1 Year
    
    1-3 Years
    
    4-5 Years
    
    and OverGuarantee
    
    $
    372
    
    
    $
    372
    
    
    $
    
    
    
    $
    
    
    
    $
    
 The operating leases listed above include leases for our factories in
Penang, Washington, and Massachusetts, our ground lease in Arizona, and our
sales office in Florida. In the second quarter of 2004, we purchased our
leased building in Manila. As a result of the building purchase, we will no
longer be required to pay the $7.8 million over the next 7 years that was
remaining on our original ten year operating lease agreement. The capital
leases listed above are for our manufacturing equipment in Malaysia and
Washington. 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 assumed this guarantee in
the spin-off. If the lending institution were to declare VoiceViewer to be in
default under the loan, however, and 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 was $18.7 million as of June 30, 2004. We expect
operating cash outflow to consume only a small portion of our cash reserves for
the remainder of 2004, but based on our revenue forecast, we will need
substantial working capital in the second half of 2004. We believe that our
existing cash balances plus our expected loan commitments will provide adequate
sources to fund our operations and planned expenditures through 2004, as well
as to meet our contractual obligations. Our currently planned remaining cash
outflows for 2004 include capital expenditures of less than $2.0 million. It is possible that stronger second half sales would require additional
funding for working capital. In addition, we expect to continue our acquisition
strategy. As a result, we have an effective Form S-3 registration statement for
six million shares of our common stock for possible sale. There is no assurance
there will be a market for our shares or that any such equity offering of
shares will raise sufficient amounts to fund all of our requirements. As a
result, we may be required to pursue alternative methods of financing or
raising capital. We cannot provide assurance that adequate additional loan
commitments or alternative methods of financing will be available or, if
available, that they will be on terms acceptable to us. Impact of Recently Issued Standards In November 2002, the FASB issued FASB Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities, which clarifies the application
of Accounting Research Bulletin No. 51, Consolidated Financial Statements,
relating to consolidation of certain entities. This interpretation was
subsequently revised by FIN 46 (Revised 2003) (FIN 46®) in December 2003.
This interpretation states that consolidation of variable interest entities
will be required by the primary beneficiary if the entities do not effectively
disperse risk among the parties 19




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involved. The requirements are effective for fiscal years ending after
December 15, 2003. We have no variable interest entities and do not believe
that FIN. 46(R) will impact our future financial results. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There are no material changes in reported market risks since our most
recent filing on Form 10-K for the year ended December 31, 2003. 
 ITEM 4. CONTROLS AND PROCEDURES Controls Evaluation and Related CEO and CFO Certifications We conducted an evaluation of the effectiveness of the design and
operation of our disclosure controls and procedures (Disclosure Controls) as
of the end of the period covered by this Quarterly Report. The controls
evaluation was done under the supervision and with the participation of
management, including our Chief Executive Officer (CEO) and Chief Financial
Officer (CFO). Attached as exhibits to this Quarterly Report are certifications
of the CEO and the CFO, which are required in accordance with Rule 13a-14 of
the Exchange Act. This Controls and Procedures section includes the
information concerning the controls evaluation referred to in the
certifications and it should be read in conjunction with the certifications for
a more complete understanding of the topics presented. Definition of Disclosure Controls Disclosure Controls are controls and procedures designed to reasonably
assure that information required to be disclosed in our reports filed under the
Exchange Act, such as this Quarterly Report, is recorded, processed, summarized
and reported within the time periods specified in the Securities and Exchange
Commissions rules and forms. Disclosure Controls are also designed to
reasonably assure that such information is accumulated and communicated to our
management, including the CEO and CFO, as appropriate to allow timely decisions
regarding required disclosure. Limitations on the Effectiveness of Controls Our management, including the CEO and CFO, cannot assure that our
Disclosure Controls will prevent all errors. A control system, no matter how
well designed and operated, can provide only reasonable, not absolute,
assurance that the control systems objectives will be met. Further, the design
of a control system must reflect the fact that there are resource constraints,
and the benefits of controls must be considered relative to their costs.
Because of the inherent limitations in all control systems, no evaluation of
controls can provide absolute assurance that all control issues within the
company have been detected. These inherent limitations include the realities
that judgments in decision-making can be faulty and that breakdowns can occur
because of simple error or mistake. Controls can also be circumvented by the
individual acts of some persons, by collusion of two or more people, or by
management override of the controls. The design of any system of controls is
based in part on certain assumptions about the likelihood of future events, and
there can be no assurance that any design will succeed in achieving its stated
goals under all potential future conditions. Over time, controls may become
inadequate because of changes in conditions or deterioration in the degree of
compliance with policies or procedures. Because of the inherent limitations in
a cost-effective control system, misstatements due to error may occur and not
be detected. Scope of the Controls Evaluation The evaluation of our Disclosure Controls included a review of the
controls objectives and design, the companys implementation of the controls,
and the effect of the controls on the information generated for use in this
Quarterly Report. In the course of the controls evaluation, we sought to
identify issues and confirm that appropriate corrective action, including
process improvements, were being undertaken. Many of the components of our
Disclosure Controls are also evaluated on an ongoing basis by our independent
auditors, who evaluate them in connection with determining their auditing
procedures related to their report on our annual financial statements and not
to provide assurance on our controls. The overall goals of these various
evaluation activities are to monitor our Disclosure Controls, and to modify
them as necessary. 20




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Among other matters, we also considered whether our evaluation identified
any significant deficiencies or material weaknesses in our internal control
over financial reporting, and whether the company had identified any acts of
fraud involving personnel with a significant role in our internal control over
financial reporting. This information was important both for the controls
evaluation generally, and because item 5 in the certifications of the CEO and
CFO requires that the CEO and CFO disclose that information to our Boards
Audit Committee and to our independent auditors. In the professional auditing
literature, significant deficiencies are a single deficiency, or combination
of control deficiencies, that results in more than a remote likelihood that a
misstatement of the annual or interim financial statements that is more than
inconsequential will not be prevented or detected. Auditing literature defines
material weakness as a significant control deficiency, or combination of
significant control deficiencies, that results in more than a remote likelihood
that a material misstatement of the annual or interim financial statements will
not be prevented or detected. We also sought to address other controls matters
in the controls evaluation, and in each case if a problem was identified, we
considered what revision, improvement and/or correction to make in accordance
with our ongoing procedures. Conclusions Based upon the controls evaluation, our CEO and CFO have concluded that,
subject to the limitations noted above, as of the end of the period covered by
this Quarterly Report, our Disclosure Controls were effective to provide
reasonable assurance that material information relating to us and our
consolidated subsidiaries is accumulated and communicated to management,
including the CEO and CFO, as appropriate to allow timely decisions regarding
financial disclosure. 
 PART II 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Our Annual Meeting of Stockholders was held on May 7, 2004. All of the
nominees were elected to our Board of Directors as set forth in the Proxy
Statement as follows: Nominees
    
    Votes in Favor
    
    Votes AgainstDavid C. Malmberg
    
    
    17,552,579
    
    
    
    2,198,302Jack L. Saltich
    
    
    17,828,469
    
    
    
    1,922,412Jeffrey D. Buchanan
    
    
    17,907,799
    
    
    
    1,843,082Thomas H. Werner
    
    
    17,806,014
    
    
    
    1,944,867David P. Chavoustie
    
    
    17,982,767
    
    
    
    1,768,114Murray A. Goldman
    
    
    17,547,273
    
    
    
    2,203,608Henry L. Hirvela
    
    
    17,799,090
    
    
    
    1,951,791
 The following items were also voted upon and approved by our stockholders: (a) Approval of our 2004 Incentive Compensation Plan. Votes in Favor
    
    Opposed
    
    Abstain
    
    Broker Non-Vote9,616,132
    
    
    3,832,513
    
    
    
    49,898
    
    
    
    6,252,338
 (b) Ratification of the appointment of Deloitte & Touche LLP as our
independent auditors for the fiscal year ending December 31, 2004. Votes in Favor
    
    Opposed
    
    Abstain19,403,080
    
    
    329,812
    
    
    
    17,989
 21




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ITEM 5. OTHER INFORMATION Our Insider Trading Policy permits our directors, officers, and other key
personnel to establish purchase and sale programs in accordance with Rule
10b5-1 adopted by the Securities and Exchange Commission. The rule permits
employees to adopt written plans at a time before becoming aware of material
nonpublic information and to sell shares according to a plan on a regular basis
(for example, weekly or monthly), regardless of any subsequent nonpublic
information they receive. In our view, Rule 10b5-1 plans are beneficial
because systematic, pre-planned sales that take place over an extended period
should have a less disruptive influence on the price of our stock. We also
believe plans of this type are beneficial because they inform the marketplace
about the nature of the trading activities of our directors and officers. In
the absence of such information, the market could mistakenly attribute
transactions as reflecting a lack of confidence in our company or an indication
of an impending event involving our company. We recognize that our directors
and officers may have reasons totally apart from the company in determining to
effect transactions in our common stock. These reasons could include the
purchase of a home, tax and estate planning, the payment of college tuition,
the establishment of a trust, the balancing of assets, or other personal
reasons. The establishment of any trading plan involving our company requires
the pre-clearance by our Chief Executive Officer or Chief Financial Officer.
An individual adopting a trading plan must comply with all requirements of Rule
10b5-1, including the requirement that the individual not possess any material
nonpublic information regarding our company at the time of the establishment of
the plan. In addition, sales under a trading plan may be made no earlier than
30 days after the plan establishment date. No officers currently maintain trading plans. 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K  (a)
    
    Exhibits  10.21
    
    First Amended and Restated Real Property Sublease Agreement
between the Registrant and Brillian Corporation.10.31
    
    Loan and Security Agreement between the Registrant and
Silicon Valley Bank.31.1
    
    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.  (b)
    
    Reports on Form 8-K  1)
    
    Report on Form 8-K dated April 27, 2004, furnishing Item 12
Results of Operations and Financial Condition disclosure.2)
    
    Report on Form 8-K dated May 7, 2004, furnishing Item 9
Regulation FD disclosure.3)
    
    Report on Form 8-K dated May 7, 2004, furnishing Item 9
Regulation FD disclosure, as amended by report on Form 8K/A dated
May 7, 2004, furnishing Item 9 Regulation FD disclosure.4)
    
    Report on Form 8-K dated May 18, 2004, furnishing Item 9
Regulation FD disclosure. 22




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. THREE-FIVE SYSTEMS, INC.Date: August 9, 2004
    
    By:
    
    /s/ Jeffrey D. BuchananJeffrey D. BuchananChief Financial Officer, Secretary, and
Treasurer
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Exhibit Index 10.21
    
    
    First Amended and Restated Real Property Sublease Agreement
between the Registrant and Brillian Corporation.10.31
    
    
    Loan and Security Agreement between the Registrant and
Silicon Valley Bank.31.1
    
    
    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.