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SECURITIES AND EXCHANGE COMMISSION     FORM 10-Q 
 For the Quarter Ended September 30, 2004 Commission file number 1-4373    THREE-FIVE SYSTEMS, INC. 
  Delaware
    
    86-0654102(State or Other Jurisdiction
of Incorporation or Organization)
    
    (I.R.S. Employer Identification No.)
 1600 North Desert Drive, Tempe, Arizona                    85281(Address of Principal Executive Offices)                    (Zip Code)
 (602) 389-8600(Registrants telephone number, including area code)
 Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
YES [X] NO [  ] Indicate by check mark
whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). YES [X] NO [  ] 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 OCTOBER 31, 2004Common Stock,
    
    
    21,767,653par value $.01 per share




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THREE-FIVE SYSTEMS, INC. QUARTERLY REPORT ON FORM 10-Q FOR QUARTER ENDED SEPTEMBER 30, 2004 TABLE OF CONTENTS PagePART IITEM 1. FINANCIAL STATEMENTS (UNAUDITED):CONDENSED CONSOLIDATED BALANCE SHEETS-
DECEMBER 31, 2003 AND SEPTEMBER 30, 2004
    
    
    1CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS-
THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2004
    
    
    2CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS-
NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2004
    
    
    3NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
    
    
    4ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
    
    
    10ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
    
    
    22ITEM 4. CONTROLS AND PROCEDURES
    
    
    22PART IIITEM 5. OTHER INFORMATION
    
    
    24ITEM 6. EXHIBITS
    
    
    24SIGNATURES
    
    
    25Exhibit 10.32Exhibit 31.1Exhibit 31.2Exhibit 32.1Exhibit 32.2




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ITEM 1. FINANCIAL STATEMENTS THREE-FIVE SYSTEMS, INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (UNAUDITED)
  DECEMBER 31,
    
    SEPTEMBER 30,2003
    
    2004ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    27,976
    
    
    $
    13,951Short-term investments
    
    
    5,130
    
    
    
    Accounts receivable, net
    
    
    28,133
    
    
    
    24,346Inventories
    
    
    25,854
    
    
    
    26,265Income taxes receivable
    
    
    678
    
    
    
    Deferred tax asset
    
    
    130
    
    
    
    122Assets held for sale
    
    
    8,615
    
    
    
    52Other current assets
    
    
    2,782
    
    
    
    3,710Total Current Assets
    
    
    99,298
    
    
    
    68,446Property, Plant and Equipment, net
    
    
    25,323
    
    
    
    35,434Intangibles, net
    
    
    7,574
    
    
    
    4,171Goodwill
    
    
    34,606
    
    
    
    13,444Other Assets
    
    
    436
    
    
    
    210Total Assets
    
    $
    167,237
    
    
    $
    121,705LIABILITIES AND STOCKHOLDERS EQUITYCurrent Liabilities:Accounts payable
    
    $
    30,826
    
    
    $
    24,477Accrued liabilities
    
    
    4,917
    
    
    
    4,874Deferred revenue
    
    
    48
    
    
    
    1Current portion of long-term debt
    
    
    1,515
    
    
    
    1,537Current portion of capital leases
    
    
    2,352
    
    
    
    2,722Lines of credit
    
    
    
    
    
    
    7,416Total Current Liabilities
    
    
    39,658
    
    
    
    41,027Long-term Debt
    
    
    1,441
    
    
    
    Capital Leases
    
    
    6,543
    
    
    
    4,677Commitments and Contingencies (Note L)Minority Interest in Consolidated Subsidiary
    
    
    2,563
    
    
    
    Stockholders Equity:Common stock
    
    
    220
    
    
    
    220Additional paid-in capital
    
    
    200,930
    
    
    
    201,057Accumulated deficit
    
    
    (74,915
    )
    
    
    (123,553
    )Stock subscription note receivable
    
    
    (185
    )
    
    
    Accumulated other comprehensive loss
    
    
    (515
    )
    
    
    (552
    )Less  treasury stock, at cost
    
    
    (8,503
    )
    
    
    (1,171
    )Total Stockholders Equity
    
    
    117,032
    
    
    
    76,001$
    167,237
    
    
    $
    121,705
 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
    
    Nine MonthsEnded September 30,
    
    Ended September 30,2003
    
    2004
    
    2003
    
    2004Net Sales
    
    $
    41,778
    
    
    $
    42,356
    
    
    $
    113,094
    
    
    $
    118,432Costs and Expenses:Cost of sales
    
    
    42,050
    
    
    
    42,502
    
    
    
    111,297
    
    
    
    118,932Selling, general, and administrative
    
    
    4,941
    
    
    
    6,185
    
    
    
    12,753
    
    
    
    17,466Research, development, and engineering
    
    
    1,285
    
    
    
    808
    
    
    
    3,939
    
    
    
    2,166Impairment of goodwill
    
    
    
    
    
    
    21,350
    
    
    
    
    
    
    
    21,350Impairment of intangibles
    
    
    
    
    
    
    1,850
    
    
    
    
    
    
    
    1,850(Gain) loss on sale of assets
    
    
    (15
    )
    
    
    (80
    )
    
    
    (20
    )
    
    
    (304
    )Amortization of intangibles
    
    
    510
    
    
    
    510
    
    
    
    1,532
    
    
    
    1,53248,771
    
    
    
    73,125
    
    
    
    129,501
    
    
    
    162,992Operating Loss
    
    
    (6,993
    )
    
    
    (30,769
    )
    
    
    (16,407
    )
    
    
    (44,560
    )Other Income (Expense):Interest, net
    
    
    (475
    )
    
    
    (266
    )
    
    
    19
    
    
    
    (697
    )Other, net
    
    
    24
    
    
    
    301
    
    
    
    (13
    )
    
    
    1,052(451
    )
    
    
    35
    
    
    
    6
    
    
    
    355Minority Interest in (Income) Loss of Consolidated Subsidiary
    
    
    71
    
    
    
    
    
    
    
    28
    
    
    
    (22
    )Loss From Continuing Operations Before Income Taxes
    
    
    (7,373
    )
    
    
    (30,734
    )
    
    
    (16,373
    )
    
    
    (44,227
    )Provision for (benefit from) income taxes
    
    
    17,576
    
    
    
    16
    
    
    
    14,306
    
    
    
    (112
    )Loss From Continuing Operations
    
    
    (24,949
    )
    
    
    (30,750
    )
    
    
    (30,679
    )
    
    
    (44,115
    )Loss From Discontinued Operations, net of taxes
    
    
    (5,931
    )
    
    
    
    
    
    
    (10,552
    )
    
    
    Net Loss
    
    $
    (30,880
    )
    
    $
    (30,750
    )
    
    $
    (41,231
    )
    
    $
    (44,115
    )Loss Per Common Share  Basic and Diluted:Loss From Continuing Operations
    
    $
    (1.17
    )
    
    $
    (1.41
    )
    
    $
    (1.44
    )
    
    $
    (2.04
    )Loss From Discontinued Operations
    
    
    (0.28
    )
    
    
    
    
    
    
    (0.50
    )
    
    
    Net Loss
    
    $
    (1.45
    )
    
    $
    (1.41
    )
    
    $
    (1.94
    )
    
    $
    (2.04
    )Weighted Average Number of Common Shares:Basic and diluted
    
    
    21,305
    
    
    
    21,768
    
    
    
    21,295
    
    
    
    21,574
 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)
  NINE MONTHS ENDEDSEPTEMBER 30,2003
    
    2004CASH FLOWS FROM OPERATING ACTIVITIES:Net loss
    
    $
    (41,231
    )
    
    $
    (44,115
    )Less loss  discontinued operations
    
    
    (10,552
    )
    
    
    Loss  continuing operations
    
    
    (30,679
    )
    
    
    (44,115
    )Adjustments to reconcile net loss to net cash (used in) provided by operating
activities:Depreciation and amortization
    
    
    5,514
    
    
    
    6,551Stock compensation
    
    
    50
    
    
    
    54Minority interest in consolidated subsidiary
    
    
    (28
    )
    
    
    22Deferred revenue
    
    
    105
    
    
    
    (47
    )Provision for (reduction of) accounts receivable valuation reserves
    
    
    21
    
    
    
    (27
    )Loss on impairment of intangibles and goodwill
    
    
    
    
    
    
    23,200(Gain) loss on sale of assets
    
    
    (20
    )
    
    
    (304
    )Benefit from deferred taxes, net
    
    
    12,991
    
    
    
    8Foreign currency translation adjustments
    
    

    (80
    )
    
    
    (39
    )Accretion of interest on long-term debt
    
    
    96
    
    
    
    31Interest on employee loan
    
    
    (9
    )
    
    
    CHANGES IN ASSETS AND LIABILITIES:(Increase) decrease in accounts receivable
    
    
    (9,997
    )
    
    
    3,814(Increase) decrease in inventories
    
    
    2,353
    
    
    
    935(Increase) decrease in other assets
    
    
    124
    
    
    
    734Increase (decrease) in accounts payable and accrued liabilities
    
    
    9,794
    
    
    
    (6,392
    )Increase (decrease) in taxes payable/receivable
    
    
    (96
    )
    
    
    678Net cash (used in) provided by operating activities
    
    
    (9,861
    )
    
    
    (14,897
    )CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of property, plant, and equipment
    
    
    (2,131
    )
    
    
    (6,849
    )Proceeds from sale of assets
    
    
    606
    
    
    
    704Purchase of intangibles
    
    
    (433
    )
    
    
    (97
    )Purchase of investments
    
    
    (13,262
    )
    
    
    Proceeds from maturities/sales of short-term investments
    
    
    61,838
    
    
    
    5,132Payments on stock subscription note receivable
    
    
    
    
    
    
    185Acquisitions and strategic investments
    
    
    (9,680
    )
    
    
    (2,746
    )Net cash (used in) provided by investing activities
    
    
    36,938
    
    
    
    (3,671
    )CASH FLOWS FROM FINANCING ACTIVITIES:Borrowings from lines of credit
    
    
    
    
    
    
    7,416Payments on long-term debt
    
    
    (2,734
    )
    
    
    (1,450
    )Stock options exercised
    
    
    109
    
    
    
    73Payments on capital leases
    
    
    (1,135
    )
    
    
    (1,496
    )Receipt from minority interest
    
    
    2,527
    
    
    
    Net cash (used in) provided by financing activities
    
    
    (1,233
    )
    
    
    4,543NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 
CONTINUING OPERATIONS
    
    
    25,844
    
    
    
    (14,025
    )NET CASH USED IN AND CONTRIBUTED TO DISCONTINUED
OPERATIONS
    
    
    (28,908
    )
    
    
    NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    
    
    (3,064
    )
    
    
    (14,025
    )CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    18,389
    
    
    
    27,976CASH AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    15,325
    
    
    $
    13,951NONCASH 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
    
    
    2,723
    
    
    
    Capital lease due on purchase of Unico equipment
    
    
    9,375
    
    
    
    Capital leases due on purchase of ETMA equipment
    
    
    1,242
    
    
    
    Treasury stock issued to purchase Unico minority interest
    
    
    
    
    
    
    2,809Assets held for sale reinstated to property, plant, and equipment
    
    
    
    
    
    
    8,563
 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 AThree-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 computing, consumer,
industrial, medical, telecommunications and transportation
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 primarily
utilize liquid crystal displays, or LCDs. Those LCDs include small
form factor monochrome and color LCDs, including thin film
transistor LCDs, or TFTs, as well as large format flat panel
monitors, all of which are TFTs. To a smaller extent, we also
utilize organic light emitting diodes, or OLEDs. 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 BInventories: 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,
    
    September 30,2003
    
    2004Raw materials
    
    $
    14,188
    
    
    $
    18,396Work-in-process
    
    
    5,321
    
    
    
    2,145Finished goods
    
    
    6,345
    
    
    
    5,724$
    25,854
    
    
    $
    26,265
 Shipping terms with one of our major customers is FOB destination, and
many of those products are shipped by sea, taking four to six weeks to
reach their destinations. As a result, product in transit that was in our
finished goods inventory was $3.4 million as of September 30, 2004
compared with $3.6 million as of December 31, 2003. In 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 approximately $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. 4




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During the second quarter of 2004, a telecommunications customer declared
bankruptcy. As a result of that event, we wrote off $127,000 in accounts
receivable and recorded a $567,000 reserve against inventory relating to
specific programs for that customer. During the third quarter of 2004, we wrote off $435,000 of our Redmond
inventory due to the pending end-of-life of several long-running
programs. The conclusion of the move of the display module operations
from Manila to Beijing resulted in inventory write-offs and other charges
of $806,000. Lastly, in Manila we wrote off $202,000 of inventory related
to our RF programs. Note CProperty, Plant, and Equipment: Property, plant, and equipment consisted of the following at (in thousands): December 31,
    
    September 30,2003
    
    2004Land and building
    
    $
    6,122
    
    
    $
    20,704Furniture and equipment
    
    
    40,907
    
    
    
    42,70047,029
    
    
    
    63,404Less accumulated depreciation
    
    
    (21,706
    )
    
    
    (27,970
    )$
    25,323
    
    
    $
    35,434
 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, or RBF, for a 50 year land right. Lastly, we executed an
agreement with RBF for an 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 seven years that was
remaining on our original ten year lease agreement. During the third quarter of 2004, our facility in Tempe was reclassified
as an asset held for sale back into property, plant, and equipment. This
reclassification added $10.4 million to land and building and $757,000 to
furniture and equipment and an amount equal to $2.6 million to
accumulated amortization. The remaining capital expenditures during the first nine months of 2004
related primarily to equipment purchased from Integrex, our ongoing ERP
implementation, and additions in China related to our TFT clean room. Note DAsset Held for Sale: In 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.
In the third quarter of 2004, we agreed to sell the Tempe building for
approximately $11 million and leaseback the entire facility for a period
of five years. The Tempe building, which had been previously classified
as an asset held for sale, is now considered to be an asset held for sale
and leaseback. Accordingly, depreciation costs in the amount of
$362,000, which would otherwise have been recorded during the period the
building was held for sale, were recorded in the third quarter. That
sale is expected to finalize near the end of 2004. Note EIntangibles: 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 5




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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. 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. In the third quarter of 2004, we wrote off the remaining $1.8 million of
the customer list associated with the AVT acquisition. This write-off
occurred as a result of numerous changes in the AVT business, including
notification during the quarter that a customer was not renewing a
program. That notification, along with the other cumulative changes that
have occurred since the acquisition, have now resulted in a complete
turnover in the customer base. Most of these changes were driven mainly
by the fact that the original business when acquired by us was selling
CRT displays and now is exclusively selling LCD flat panel displays.
Going forward, the amortization of intangibles will relate solely to the
ETMA customer lists, the mask sets and to the license agreement with Data
International, as described above. Intangible assets consisted of the following (in thousands): 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
    
    WeightedSeptember 30, 2004
    
    Value
    
    Amortization
    
    Value
    
    Avg LifeAmortized Intangible Assets:Mask works
    
    $
    988
    
    
    $
    (118
    )
    
    $
    870
    
    
    
    2.4Customer lists
    
    
    2,000
    
    
    
    (1,222
    )
    
    
    778
    
    
    
    3.0License
    
    
    3,882
    
    
    
    (1,359
    )
    
    
    2,523
    
    
    
    5.0$
    6,870
    
    
    $
    (2,699
    )
    
    $
    4,171
    
    
    
    4.0
 The acquisition value of the customer lists acquired from our AVT
acquisition was $3.0 million and the accumulated amortization was $1.2
million. Estimated annual amortization expense through 2008 and thereafter,
including actual amortization for the first nine months of 2004, related
to intangible assets reported as of September 30, 2004 is as follows (in
thousands): Fiscal Year
    
    Amortization2004
    
    $
    2,1182005
    
    
    1,8152006
    
    
    1,0562007
    
    
    8322008
    
    
    Thereafter
    
    
    $
    5,821
 Note FGoodwill: 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
with Unico Holdings interest of $2.6 million. As a result of that
transaction, we now own 100% of TFS-Malaysia. 6




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In the third quarter of 2004, we determined that the $27 million goodwill
balance associated with the acquisitions of ETMA, located in Redmond,
Washington, and TFS-Malaysia was impaired. Because of the ongoing
performance issues experienced by the Redmond location, including the
integration issues experienced in Redmond in the second and third
quarters of 2004, and because of the reduction in market comparables, we
engaged a professional valuation firm to assist us in determining the
fair value of the ETMA and TFS-Malaysia goodwill. The valuation included
a market comparable study and a present value valuation based on
managements best estimates of the future cash flows. The amount of the
impairment loss was $21.3 million, and was determined in accordance with
the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. We also conducted an analysis of the goodwill relating to the AVT
acquisition, and that analysis indicated no impairment to the AVT
goodwill asset. Changes in goodwill from December 31, 2003 to September 30, 2004 (in
thousands) were as follows: Balance at December 31, 2003
    
    $
    34,606Purchase of Unico and other adjustments
    
    
    188Goodwill impairment
    
    
    (21,350
    )Balance at September 30, 2004
    
    $
    13,444
 Note GSegment 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 include 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 and
organic light emitting diodes, or OLEDs. 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 into 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 September 30, 2003Net sales
    
    $
    24,877
    
    
    $
    6,518
    
    
    $
    10,383
    
    
    $
    41,778Three months ended September 30, 2004Net sales
    
    $
    26,717
    
    
    $
    9,206
    
    
    $
    6,433
    
    
    $
    42,356Nine months ended September 30, 2003Net sales
    
    $
    64,665
    
    
    $
    23,963
    
    
    $
    24,466
    
    
    $
    113,094Property, plant, equipment, and intangibles, net
    
    
    20,396
    
    
    
    22,679
    
    
    
    6
    
    
    
    43,081Goodwill
    
    
    34,299
    
    
    
    315
    
    
    
    
    
    
    
    34,614Nine months ended September 30, 2004Net sales
    
    $
    74,126
    
    
    $
    20,381
    
    
    $
    23,925
    
    
    $
    118,432Property, plant, equipment, and intangibles, net
    
    
    17,113
    
    
    
    22,481
    
    
    
    11
    
    
    
    39,605Goodwill
    
    
    12,897
    
    
    
    547
    
    
    
    
    
    
    
    13,444
 7




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##### Table of Contents



In the third quarter of 2004, our sales were distributed over six major
markets: computing, consumer, industrial, medical, telecommunications, and
transportation. During October 2004, we reclassified the 2004 sales to one of
our customers from the consumer market segment to the industrial market segment
as compared to previously reported results. This reclassified 2004 first
quarter market segment sales by $16,000, second quarter market segment sales by
$34,000, third quarter market segment sales by $169,000 and year-to-date market
segment sales by $219,000. On a 2004 percentage basis for the consumer and
industrial markets, there was no change in the first quarter percentage, a 0.1%
change in the second quarter percentage, a 0.4% change in the third quarter
percentage and a 0.1% change in the year-to-date percentage. Our net sales
distributed by market were as follows: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,Markets
    
    2003
    
    2004
    
    2003
    
    2004Computing
    
    
    37.9
    %
    
    
    51.9
    %
    
    
    37.6
    %
    
    
    49.9
    %Consumer
    
    
    5.8
    %
    
    
    13.5
    %
    
    
    5.5
    %
    
    
    11.4
    %Industrial
    
    
    10.7
    %
    
    
    13.8
    %
    
    
    9.8
    %
    
    
    13.3
    %Medical
    
    
    14.7
    %
    
    
    12.3
    %
    
    
    15.0
    %
    
    
    11.2
    %Telecommunications
    
    
    22.6
    %
    
    
    3.4
    %
    
    
    26.6
    %
    
    
    8.2
    %Transportation
    
    
    8.3
    %
    
    
    5.1
    %
    
    
    5.5
    %
    
    
    6.0
    %
 Note HComprehensive loss (in thousands) for the periods was as follows: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004Net loss
    
    $
    (30,880
    )
    
    $
    (30,750
    )
    
    $
    (41,231
    )
    
    $
    (44,115
    )Other comprehensive income (loss):Foreign currency translation
adjustment
    
    
    (74
    )
    
    
    (13
    )
    
    
    (80
    )
    
    
    (39
    )Unrealized gain (loss) on
securities
    
    
    (16
    )
    
    
    
    
    
    
    (62
    )
    
    
    2Comprehensive loss
    
    $
    (30,970
    )
    
    $
    (30,763
    )
    
    $
    (41,373
    )
    
    $
    (44,152
    )
 Note IStock Compensation: Pursuant to the provisions of SFAS No. 123, Accounting for
Stock-Based Compensation, we account for options granted to our
employees pursuant to Accounting Principles Board Opinion (APB) No.
25, Accounting for Stock Issued to Employees, under which no
compensation cost has been recognized. However, we have computed
compensation cost, for pro forma disclosure purposes, based on the
fair value of all options awarded on the date of grant, utilizing
the Black-Scholes option pricing method with the following weighted
assumptions: risk-free interest rates of 2.46% and 3.38% for the
nine months ended September 30, 2003, and 2004; expected dividend
yields of zero for all scenarios; expected lives of 6.1 years for
2003 and 3.86 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 78.5% for the nine months
ended September 30, 2003 and 2004, respectively. The pro forma
compensation costs are not tax-effected because a full valuation
allowance was recorded in the third quarter of 2004. 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
    
    Nine Months EndedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004Net loss:As reported
    
    $
    (30,880
    )
    
    $
    (30,750
    )
    
    $
    (41,231
    )
    
    $
    (44,115
    )Total stock-based compensation
expenses determined under fair
value based method for all awards
    
    
    (1,892
    )
    
    
    (788
    )
    
    
    (3,586
    )
    
    
    (3,579
    )Pro forma net loss
    
    $
    (32,772
    )
    
    $
    (31,538
    )
    
    $
    (44,817
    )
    
    $
    (47,694
    )Basic and diluted net loss per share:As reported
    
    $
    (1.45
    )
    
    $
    (1.41
    )
    
    $
    (1.94
    )
    
    $
    (2.04
    )Pro forma
    
    $
    (1.54
    )
    
    $
    (1.45
    )
    
    $
    (2.10
    )
    
    $
    (2.21
    )
 8




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Note JEarnings 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
    
    Nine Months EndedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004Basic and diluted loss per share:Net Loss
    
    $
    (30,880
    )
    
    $
    (30,750
    )
    
    $
    (41,231
    )
    
    $
    (44,115
    )Weighted average common shares
    
    
    21,305
    
    
    
    21,768
    
    
    
    21,295
    
    
    
    21,574Basic and diluted loss per share:
    
    $
    (1.45
    )
    
    $
    (1.41
    )
    
    $
    (1.94
    )
    
    $
    (2.04
    )
 For the three months ended September 30, 2003 and 2004, the effect of
304,525 and 11,196 shares, respectively, and for the nine months ended
September 30, 2003 and 2004, the effect of 78,398 and 175,704 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 KDebt: 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 of 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, or SVB, which matures
on June 25, 2005. Initially, that line of credit bore interest at the
banks prime rate plus 75 basis points, subject to a minimum rate of
4.75%. The SVB line also contained restrictive covenants that included,
among other things, restrictions on the declaration of payments of
dividends, restrictions on the sale or transfer of assets, and
maintenance of specified net worth and quick ratio. We owed $5.0 million
under that line of credit as of September 30, 2004. As of September 30,
2004, we did not meet some of the required covenants, although SVB did
not call a default on the SVB line. Recently, we signed an amendment to
the original SVB line that substantially revises its terms and
conditions. Under those new terms, the first $2.5 million of borrowings
under that line of credit bears interest at the banks prime rate plus
125 basis points subject to a minimum rate of 4.75%, and borrowings above
$2.5 million are subject to a factoring arrangement, bearing an initial
discount fee and interest of prime plus 450 basis points on the factored
receivables. The credit limit remains at $10 million, but there are fewer
receivables that qualify as factorable as compared to the original
borrowing base, resulting in a potentially lower borrowing base. Many of
the restrictive covenants previously contained in the SVB line documents
have been removed, although covenants do remain relating to cash
earnings, revenue, and the Tempe building sale. Currently, SVBs prime
rate is 4.75%. We had borrowed $5.0 million under the facility as of
September 30, 2004. In addition, in the second quarter of 2004, our Beijing subsidiary
secured a $2.4 million line of credit with Hua Xia Bank secured
principally by our building in Beijing. We have borrowed $2.4 million
under that facility, which accrues simple, annual interest at 5.31%. In January 2003, we signed a term loan of $2.9 million with Data
International. In the first quarter of 2004, we paid $1.4 million against
the term loan. The unpaid $1.5 million is due in January 2005 and is
subject to reduction if certain margin targets are not met. Note LCommitments 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 9




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Brillian cannot 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 September 30, 2004, the outstanding
balance on the debt was $345,000. 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 MAcquisitions 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 NRecently 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®) 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 involvement with
variable interest entities and do not believe that FIN 46® 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
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 10




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and the integration of display modules and systems into other products.
The display modules and systems we design and manufacture primarily utilize
liquid crystal displays, or LCDs. Those LCDs include small form factor
monochrome and color LCDs, including thin film transistor LCDs, or TFTs, as
well as large format flat panel monitors, all of which are TFTs. To a smaller
extent, we also utilize organic light emitting diodes, or OLEDs. 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 and from
increased costs related to complying with the Sarbanes-Oxley Act of 2002. 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 conduct any pure research.
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 related to the amortization of 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 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 increased revenue and improving
our gross margins by focusing on markets, such as gaming and medical, that
value our unique combination of global EMS capabilities and display expertise.
The most important factor in achieving this model, however, is successful
implementation of our display platform strategy in 2005. The key element of
that strategy is the sale of TFT color display modules in the mobile handset
market. We have been working with several potential customers, including one of
the largest handset providers in the world. We originally expected those sales
to ramp in the fourth quarter of 2004. For a variety of reasons, primarily
related to technology demand issues, our expectations for the first significant
ramp of sales in this market have been revised to the second quarter of 2005. 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 11




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crystal display glass cells from 1995 to 2002. 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 offerings. 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. The selling price of the products we manufacture now range
from below $10 to as high as $8,000 per unit. We have numerous customers in six
principal markets. We have expanded our capabilities both through organic
growth, such as moving into the color display business, 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 primarily 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, a privately held company located in Marlborough,
Massachusetts, 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 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. In March 2003, we signed an agreement with Microtune, Inc. under 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 we paid $2.7
million with 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 agreement, we now provide 100% of the
manufacturing outsourcing for Microtunes RF module products. 12




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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 former
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 $6.6 million as of September 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 with 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 that was 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, to 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 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, or 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, goodwill, intangible assets, income taxes, and contingencies. We
base our estimates on historical experience and on various other assumptions
that we believe are reasonable under the circumstances. The results form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results may differ
from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our financial
statements. We 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 facilities under the title
transfer terms Factory then the risk of loss passes to the customer when the
product leaves our facility and we recognize revenue at that time. On the other
hand, when a product is shipped under title transfer terms of Destination
then the risk of loss during transit is maintained by us. Thus, we 13




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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 included in our finished goods inventory
balance. 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. We estimate sales allowances based upon historical experience of sales
returns. To establish our allowance for doubtful accounts, we perform credit
evaluations of our customers financial condition, along with analyzing past
experience, and make provisions for doubtful accounts based on the outcome of
our credit valuations and analysis. We evaluate the collectability of our
accounts receivable based on specific customer circumstances, current economic
trends, historical experience with collections, and the age of past due
receivables. We believe the allowances that we have established are adequate
under the circumstances; however, a change in the economic environment or a
customers financial condition could cause our estimates of allowances, and
consequently the provision for doubtful accounts, to change. 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. In 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
approximately $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. In the second quarter of 2004, a telecommunications customer declared
bankruptcy. As a result of that event, we wrote off $127,000 in accounts
receivable and recorded a $567,000 reserve against inventory relating to
specific programs for that customer. In the third quarter of 2004, we wrote off $435,000 of our Redmond
inventory due to the pending end-of-life of several long-running programs. The
conclusion of the move of the display module operations from Manila to Beijing
resulted in inventory write-offs and other charges of $806,000. We wrote off
$202,000 of inventory in Manila related to our RF programs. 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 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 14




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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. Assets may also be
evaluated by identifying independent market values of assets that we believe to
be comparable. If we believe that an assets value is impaired, we write down
the carrying value of the identified asset and charge the impairment as an
expense in the period in which the determination is made. In the third quarter of 2004, we determined that the $27 million goodwill
balance associated with the acquisitions of ETMA, located in Redmond,
Washington, and TFS-Malaysia was impaired. Because of the ongoing performance
issues experienced by the Redmond location, including the integration issues
experienced in Redmond in the second and third quarters of 2004, and because of
the reduction in market comparables, we engaged a professional valuation firm
to assist us in determining the fair value of the ETMA and TFS-Malaysia
goodwill. The valuation included a market comparable study and a present value
valuation based on managements best estimates of the future cash flows. The
amount of the impairment loss was $21.3 million, and was determined in
accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible
Assets. We also conducted an analysis of the goodwill relating to the AVT
acquisition, and that analysis indicated no impairment to the AVT goodwill
asset. In the third quarter of 2004, we wrote off the remaining $1.8 million of
the customer list associated with the AVT acquisition. This write-off occurred
as a result of numerous changes in the AVT business, including notification
during the quarter that a customer was not renewing a program. That
notification, along with the other cumulative changes that have occurred since
the acquisition, have now resulted in a complete turnover in the customer base.
Most of these changes were driven mainly by the fact that the original
business when acquired by us was selling CRT displays and now is exclusively
selling flat panel displays. Results of Operations Three months ended September 30, 2004 compared to three months ended
September 30, 2003 Net Sales.Net sales of $42.4 million in the third quarter of 2004 were
slightly up from sales of $41.8 million in the third quarter of 2003. Two
customers accounted for more than 10% of our net sales in the third quarter of
2004. One of these customers is in the computer peripherals business and the
other is in the RF business. Those two customers accounted for 36% and 11% of
our net sales, respectively. A European customer in the mobile handset market
that accounted for more than 10% of our sales in the third quarter of 2003
accounted for none of our sales in the third quarter of 2004. The large
reduction in telecommunication sales resulted from our strategy of changing the
focus of our display module business from offering passive color display
modules to developing the capability of offering TFT display modules. We are
still in the development phase of that effort. The sales (in thousands) in our
six markets were as follows: 15




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Three Months EndedSeptember 30,2003
    
    2004Computing
    
    $
    15,840
    
    
    $
    21,997Consumer
    
    
    2,447
    
    
    
    5,732Industrial
    
    
    4,460
    
    
    
    5,855Medical
    
    
    6,138
    
    
    
    5,190Telecommunications
    
    
    9,439
    
    
    
    1,438Transportation
    
    
    3,454
    
    
    
    2,144Net sales
    
    $
    41,778
    
    
    $
    42,356
 Gross Margin.Our gross margin in the third quarter of 2004 was a
negative $146,000 compared with a negative $272,000 in the third quarter of
2003. The gross margin in the third quarter of 2004 was negatively impacted in
the amount of $1.5 million by inventory write-offs and other charges due to end
of life programs in Redmond and the completion of the transfer of the display
module business from Manila to Beijing. In addition, the gross margin in
Redmond was negative because it did a lower volume of business in 2004 as
compared with 2003 because the largest customer of that facility is moving most
of its high volume business to Penang. As a result, we are changing the focus
of Redmond to doing new product introductions, or NPI, gaming (which is in the
industrial segment), and medical. Each of those areas, however, will not see
significant revenue increases until mid-2005. We also have added business
acquired from Integrex into that facility, but the Integrex business currently
contributes very little to the gross margin because of the royalty paid to
Integrex. That royalty expires on all but one customer on June 30, 2005. Our
gross margin continues to be negatively impacted by our excess capacity in
Beijing. We expect that excess capacity in Beijing will be substantially
reduced upon the ramp-up of the TFT mobile handset business. Selling, General, and Administrative Expense.Selling, general, and
administrative expense increased to $6.2 million in the third quarter of 2004
from $4.9 million in the third quarter of 2003. SG&A expense was 15% of net
sales in the third quarter of 2004 compared with 12% in the third quarter of
2003. This increase in SG&A expense occurred primarily for the following
reasons. First, we had additional finance and administrative expenses of
$689,000 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 $555,000 as a result of personnel added from
acquisitions and expanding our market focus. The SG&A expense in the third
quarter of 2004 was slightly higher than we originally expected primarily
because of the outsourcing costs associated with implementation of the new
internal audit function. In addition, we had a depreciation catch-up charge of
$238,000 in the third quarter relating to the potential sale of our Tempe
corporate headquarters building. The Tempe building, which had been
previously classified as an asset held for sale, is now considered to be an
asset held for sale and leaseback. Accordingly, depreciation costs that would
otherwise have been recorded during the period the building was held for sale
were recorded in the third quarter. TFS agreed to sell the Tempe building for
approximately $11 million and leaseback the entire facility for a period of
five years. That sale is expected to finalize near the end of 2004. Research, Development, and Engineering Expense.Research, development,
and engineering expense decreased to $808,000 in the third quarter of 2004 from
$1.3 million in the third quarter of 2003. Research, development, and
engineering expense was 2% of net sales in the third quarter of 2004 compared
with 3% in the third quarter of 2003. The decrease in the third 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. Offsetting these decreases, we had a depreciation
catch-up charge of $91,000 in the third quarter relating to our Tempe corporate
headquarters. Impairment of Goodwill.The impairment during the third quarter of 2004
was due to the ongoing performance issues experienced by the Redmond
manufacturing facility, including the integration issues, and the reduction in
market comparables. We engaged a professional valuation firm to assist us in
determining the fair market value of the ETMA and TFS-Malaysia goodwill. The
amount of the impairment loss was $21.3 million. Impairment of Intangibles. In the third quarter of 2004, we wrote off
$1.8 million for customer lists associated with the AVT acquisition. This
write-off occurred as a result of numerous changes in the AVT business,
including notification during the quarter that a customer was not renewing a
program. That notification, along with the other cumulative changes that have
occurred since the acquisition, have now resulted in a complete turnover in 16




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the customer base. Most of these changes were driven mainly by the fact
that the original business when acquired by us was selling CRT displays and now
is exclusively selling LCD flat panel displays. Amortization of Intangibles.The amortization of customer lists was
$510,000 in the third quarter of both 2004 and 2003. Going forward, the
amortization of intangibles will relate solely to the ETMA customer list and
to the license agreement with Data International, which are described above in
Overview, as we wrote off the intangible related to AVTs customer list. The
original balance of the amortizable asset associated with ETMA and TFS-Malaysia
was $2.0 million and is being amortized over three years starting in 2002. The
original amortizable asset associated with Data International was $3.9 million
and is being amortized over five years starting in 2003. Other Income, Net.Other income was $35,000 in the third quarter of 2004
compared with other expense of $451,000 in the third quarter of 2003. The
composition and differences of the items that make up other income are as
follows (in thousands): Three Months Ended September 30,2003
    
    2004Interest Income
    
    $
    157
    
    
    $
    38Interest Expense
    
    
    (640
    )
    
    
    (304
    )Rental and Service Income from Brillian
    
    
    50
    
    
    
    330Foreign Exchange and Other Gain (Loss)
    
    
    (18
    )
    
    
    (29
    )Other Income (Loss)
    
    $
    (451
    )
    
    $
    35
 Interest income decreased as a result of lower cash and short-term investment
balances. Interest expense primarily relates to our capital leases. The rental
and service income from Brillian increased as a result of the spin-off of our
microdisplay business to Brillian Corporation in September of 2003, which is
renting part of our existing building and paying for some information
technology services. 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 and no longer have a minority interest adjustment.
In the third quarter of 2003, we controlled and owned 60% of the business in
TFS  Malaysia, and we recorded a benefit of $71,000 to account for the losses
allocated to the minority interest holder. Benefit from Income Taxes.We recorded a provision for income taxes of
$16,000 in the third quarter of 2004 compared with a provision for income taxes
of $17.6 million in the third quarter of 2003. The $17.6 million related to 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 $30.8 million, or $1.41 per diluted share, in
the third quarter of 2004 compared with a net loss of $30.9 million, or $1.45
per diluted share, in the third quarter of 2003. As noted previously, the net
loss in the third quarter of 2004 included $23.1 million from impairment and
write-offs associated with the goodwill of ETMA and the customer list of AVT.
The net loss in the third quarter of 2003 included $5.9 million, or $0.28 per
diluted 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 Nine months ended September 30, 2004 compared to nine months ended
September 30, 2003 Net Sales.Net sales increased 5% to $118.4 million in the first nine
months of 2004 from $113.1 million in the first nine 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. During the same period, we had a
substantial decrease in our display module business as we transition from
products using passive color and monochrome displays to products using TFT
active color displays. 17




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Two customers accounted for 10% or more of our net sales in the first nine
months of 2004. One of these customers is in the computer peripherals business
and the other is in the RF business. These two customers accounted for 36% and
10% of our net sales, respectively. The sales (in thousands) in our six
markets on a comparative year over year basis were as follows: Nine Months Ended September 30,2003
    
    2004Computing
    
    $
    42,470
    
    
    $
    59,092Consumer
    
    
    6,202
    
    
    
    13,454Industrial
    
    
    11,079
    
    
    
    15,800Medical
    
    
    16,966
    
    
    
    13,282Telecommunications
    
    
    30,174
    
    
    
    9,755Transportation
    
    
    6,203
    
    
    
    7,049Net sales
    
    $
    113,094
    
    
    $
    118,432
 Gross Margin.Our gross margin in the first nine months of 2004 was a
negative $500,000 compared with a positive $1.8 million in the first nine
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. That change in mix was
primarily because the largest customer of that facility is moving most of its
high volume business to Penang. As a result, we are changing the focus of
Redmond to new product introductions, or NPI, gaming (which is in the
industrial segment), and medical. None of those areas, however, will see
significant revenue increases until mid-2005. We also have added business
acquired from Integrex into that facility, but the Integrex business currently
contributes very little to the gross margin because of the royalty paid to
Integrex. That royalty expires on all but one customer on June 30, 2005.
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
approximately $1.0 million relating to a suppliers defective component. We
continue to seek remuneration from that supplier for that loss. Fourth, in the
first nine months 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 nine
months of 2004. Finally, in the first nine months of 2004, we had inventory
write-offs and other charges of approximately $2.4 million for various reasons,
including end-of-life programs, the move of the module operations from Manila
to Beijing, and the bankruptcy of a customer. In addition, overall gross
margins continue to be negatively impacted by our excess capacity offshore,
especially in Beijing. We expect that excess capacity in Beijing will be
substantially reduced upon the ramp-up of the TFT mobile handset business. Selling, General, and Administrative Expense.Selling, general, and
administrative expense increased to $17.5 million in the first nine months of
2004 from $12.8 million in the first nine months of 2003. SG&A expense was 15%
of net sales in the first nine months of 2004 and 11% in the first nine months
of 2003. This increase in SG&A expense occurred primarily because of
additional finance and administrative expenses of $2.3 million associated with
our increased infrastructure and additional selling costs of $2.4 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 $2.2 million in the first nine months of
2004 from $3.9 million in the first nine months of 2003. Research, development,
and engineering expense was 2% of net sales in the first nine months of 2004
compared with 3% in the first nine months of 2003. The decrease in the first
nine 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 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. Impairment of Goodwill.The impairment during the third quarter of 2004
was due to the ongoing performance issues experienced by the Redmond
manufacturing facility, including the integration issues, and the reduction in
market comparables. We engaged a professional valuation firm to assist us in
determining the fair market value of the ETMA and TFS-Malaysia goodwill. The
amount of the impairment loss was $21.3 million. Impairment of Intangibles. In the third quarter of 2004, we wrote off
$1.8 million for customer lists associated with the AVT acquisition. This
write-off occurred as a result of numerous changes in the AVT business, 18




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including notification during the quarter that a customer was not renewing
a program. That notification, along with the other cumulative changes that
have occurred since the acquisition, have now resulted in a complete turnover
in the customer base. Most of the changes were driven mainly by the fact that
the original business when acquired by us was selling CRT displays and now is
exclusively selling flat panel displays. Amortization of Intangibles.The amortization of customer lists was $1.5
million in both 2004 and 2003. Going forward, the amortization of intangibles
will relate solely to the ETMA customer list and to the license agreement with
Data International which are described above in Overview, as we wrote off the
intangible related to AVTs customer lists. The original balance of the
amortizable asset associated with ETMA was $2.0 million and is being amortized
over three years starting in 2002. The original amortizable asset associated
with Data International was $3.9 million and is being amortized over five years
starting in 2003. Other Income, Net.Other income was $355,000 in the first nine months of
2004 compared with $6,000 in the first nine months of 2003. The composition
and differences of the items that make up other income are as follows (in
thousands): Nine Months Ended September 30,2003
    
    2004Interest Income
    
    $
    796
    
    
    $
    183Interest Expense
    
    
    (784
    )
    
    
    (880
    )Rental and Service Income from Brillian
    
    
    50
    
    
    
    981Foreign Exchange and Other Gain (Loss)
    
    
    (56
    )
    
    
    71Other Income, net
    
    $
    6
    
    
    $
    355
 Interest income decreased as a result of lower cash and short-term investment
balances. Interest expense primarily relates to our capital leases. The rental
and service income from Brillian increased as a result of the spin-off of our
microdisplay business to Brillian Corporation in September 2003, 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 that 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
nine 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 nine months of 2003, we controlled
and owned 60% of the business in TFS  Malaysia and we recorded a benefit of
$28,000 to account for the losses allocated to the minority interest holder. Benefit from Income Taxes.We recorded a benefit from income taxes of
$112,000 in the first nine months of 2004 compared with a provision for income
taxes of $14.3 million in the first nine months of 2003. The benefit in the
first nine months of 2004 related to tax refunds received. 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 $44.1 million, or $2.04 per diluted share, in
the first nine months of 2004 compared with a net loss of $41.2 million, or
$1.94 per diluted share, in the first nine months of 2003. As noted previously,
the net loss in the third quarter of 2004 included $23.1 million from
impairments and write-offs associated with the goodwill of ETMA and
TFS-Malaysia and the customer list of AVT. The net loss in the first nine
months of 2003 included $10.6 million, or $0.50 per diluted 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 In the third quarter of 2004, we had $2.4 million in net cash outflow from
operations compared with $4.8 million in net cash outflow from operations in
the third quarter of 2003. The principal difference was reduced working
capital requirements in the third quarter of 2004. 19




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Our inventory turns were 6.3 and day sales outstanding, or DSOs, were 53
days in the third quarter of 2004, an improvement over the 5.9 inventory turns
and 58 DSOs in the third quarter of 2003. We also saw similar quarterly
sequential improvement in inventory turns and DSOs as we continue to focus
operational resources on improving those metrics. Our depreciation and
amortization expense was $2.5 million in the third quarter of 2004 compared
with $2.0 million in the third quarter of 2003. The depreciation expense was
slightly higher than normal because of the depreciation catch-up charge
relating to the Tempe corporate headquarters. That building has been held for
sale since the third quarter of 2003 and, as required by GAAP, no depreciation
was taken on that building for a period of time. We have agreed to sell the
Tempe building for approximately $11 million and leaseback the entire facility
for a period of five years. The Tempe building, which had been previously
classified as an asset held for sale, is now considered to be an asset held for
sale and leaseback. Accordingly, depreciation costs in the amount of $362,000,
which would otherwise have been recorded during the period the building was
held for sale, were recorded in the third quarter. That sale is expected to
finalize near the end of 2004. During the third quarter of 2004, we incurred capital additions of
approximately $800,000. This was principally related to our ongoing ERP
implementation and additions in China related to our TFT clean room. In the
first nine months of 2004, we incurred capital additions of $6.8 million. We
made a $1.4 million payment during the first quarter of 2004 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 nine 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, or RBF for a 50-year land right. Lastly, we 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 seven years that was remaining on our original ten
year lease agreement. At September 30, 2004, we had cash of $13.9 million compared with cash of
$18.7 million at June 30, 2004. The primary reductions to these balances over
the last quarter can be summarized as follows: Operating Cash Outflows
    
    $(2.4) millionCapital Expenditures (net of asset sales)
    
    $(0.8) millionCash used to Repay Borrowings and Capital Leases
    
    $(1.6) million
 At September 30, 2004, we had cash of $13.9 million compared with cash and
short-term investments of $33.1 million at December 31, 2003. The primary
reductions to these balances over the last nine months can be summarized as
follows: Operating Cash Outflows
    
    $(14.9) millionCapital Expenditures, Acquisitions and Strategic Investments(a)
    
    $  (9.0) millionCash from Borrowings, Net of Debt and Capital Lease Repayments
    
    $    4.5  million(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.
 Our working capital was $27.4 million and our current ratio was 1.7-to-1
at September 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 20




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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 37% of our net sales in the first nine months of 2004
and 43% 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, or SVB, which matures on
June 25, 2005. Initially, that line of credit bore interest at the banks prime
rate plus 75 basis points, subject to a minimum rate of 4.75%. The SVB line
also contained restrictive covenants that included, among other things,
restrictions on the declaration of payments of dividends, restrictions on the
sale or transfer of assets, and maintenance of specified net worth and quick
ratio. We owed $5.0 million under that line of credit as of September 30,
2004. As of September 30, 2004, we did not meet some of the required
covenants, although SVB did not call a default on the SVB line. Recently, we
signed an amendment to the original SVB line that substantially revises its
terms and conditions. Under those new terms, the first $2.5 million of
borrowings under that line of credit bears interest at the banks prime rate
plus 125 basis points subject to a minimum rate of 4.75%, and borrowings above
$2.5 million are subject to a factoring arrangement, bearing an initial
discount fee and interest of prime plus 450 basis points on the factored
receivables. The credit limit remains at $10 million, but there are fewer
receivables that qualify as factorable as compared to the original borrowing
base, resulting in a potentially lower borrowing base. Many of the restrictive
covenants previously contained in the SVB line documents have been removed,
although covenants do remain relating to cash earnings, revenue, and the Tempe
building sale. Currently, SVBs prime rate is 4.75%. We had borrowed $5.0
million under the facility as of September 30, 2004. In addition, in the second quarter of 2004, our Beijing subsidiary secured
a $2.4 million line of credit with Hua Xia Bank secured principally by our
building in Beijing. We 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 September 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
    
    $
    1,537
    
    
    $
    1,537
    
    
    $
    
    
    
    $
    
    
    
    $
    Operating Leases
    
    
    11,872
    
    
    
    3,202
    
    
    
    2,611
    
    
    
    209
    
    
    
    5,850Capital Leases
    
    
    7,399
    
    
    
    2,722
    
    
    
    4,670
    
    
    
    7
    
    
    
    Lines of Credit
    
    
    7,416
    
    
    
    7,416
    
    
    
    
    
    
    
    
    
    
    
    Total Contractual Cash Obligations
    
    $
    28,224
    
    
    $
    14,877
    
    
    $
    7,281
    
    
    $
    216
    
    
    $
    5,850
 TFS has agreed to sell the Tempe building for approximately $11 million
and lease back the entire facility for a period of five years. That sale is
expected to finalize near the end of 2004. 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
    
    $
    345
    
    
    $
    345
    
    
    $
    
    
    
    $
    
    
    
    $
    
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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 seven 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 $13.9 million as of September 30, 2004. We expect
operating cash outflow to consume only a small portion of our cash reserves for
the remainder of 2004. As noted above, we have signed an agreement to sell our
Tempe corporate headquarters for approximately $11.0 million. Under that
transaction, we would sign a lease for five years on that building. At the same
time, we would enter into a sublease agreement with Brillian Corporation for
approximately 60% of the building. Based upon our cash balances, expected use
of cash in the fourth quarter of 2004, and the expected sale of the building,
we believe that our existing cash balances plus our expected loan commitments
will provide adequate sources to fund our operations and planned expenditures
through mid-2005, as well as to meet our contractual obligations. Based on our internal revenue forecast, however, we believe that we will
need substantial additional cash to meet working capital needs beginning in
mid-2005. 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(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 involvement with
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 22




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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. Section 404 Internal Controls Evaluation We are now completing a comprehensive evaluation of internal control over
financial reporting for the year ending December 31, 2004, as required by
Section 404 of the Sarbanes-Oxley Act of 2002. As a part of this evaluation,
we have identified certain deficiencies in the design and/or operating
effectiveness of internal controls. While we believe none are material, some
may be considered to be significant. We are actively remediating all
identified internal control deficiencies, and many have already been corrected. We currently believe there are no material control weaknesses impacting
financial reporting. However, until our evaluation is complete, there can be
no assurance that none will be identified. 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, our 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, which 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. 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 we 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 23




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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 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. 24




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##### Table of Contents



ITEM 5. OTHER INFORMATION Our Insider Trading Policy permits our directors, officers, and other key
personnel to establish purchase and sale programs in accordance with Rule
10b5-1 adopted by the Securities and Exchange Commission. The rule permits
employees to adopt written plans at a time before becoming aware of material
nonpublic information and to sell shares according to a plan on a regular basis
(for example, weekly or monthly), regardless of any subsequent nonpublic
information they receive. In our view, Rule 10b5-1 plans are beneficial
because systematic, pre-planned sales that take place over an extended period
should have a less disruptive influence on the price of our stock. We also
believe plans of this type are beneficial because they inform the marketplace
about the nature of the trading activities of our directors and officers. In
the absence of such information, the market could mistakenly attribute
transactions as reflecting a lack of confidence in our company or an indication
of an impending event involving our company. We recognize that our directors
and officers may have reasons totally apart from the company in determining to
effect transactions in our common stock. These reasons could include the
purchase of a home, tax and estate planning, the payment of college tuition,
the establishment of a trust, the balancing of assets, or other personal
reasons. The establishment of any trading plan involving our company requires
the pre-clearance by our Chief Executive Officer or Chief Financial Officer.
An individual adopting a trading plan must comply with all requirements of Rule
10b5-1, including the requirement that the individual not possess any material
nonpublic information regarding our company at the time of the establishment of
the plan. In addition, sales under a trading plan may be made no earlier than
30 days after the plan establishment date. No officers currently maintain trading plans. 
 ITEM 6. EXHIBITS Exhibit Number
    
    Exhibits10.32
    
    Amendment No. 1 to the First Amended and Restated Real Property
Sublease Agreement between the Registrant and Brillian Corporation.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.
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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: November 9, 2004
    
    By:
    
    /s/ Jeffrey D. BuchananJeffrey D. BuchananExecutive Vice President, ChiefFinancial Officer,Secretary, and Treasurer
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INDEX TO EXHIBITS Exhibit Number
    
    Exhibits10.32
    
    Amendment No. 1 to the First Amended and Restated Real Property
Sublease Agreement between the Registrant and Brillian Corporation.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.
 27