SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    ---------

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

                        For Quarter Ended March 31, 1998

                          Commission File Number 1-4373

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

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

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

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


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

YES   X    NO
    -----     ----- 


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

CLASS                                           OUTSTANDING AS OF March 31, 1998
-----                                           --------------------------------

Common                                                      7,907,123
                                                       ------------------
Par value $.01 per share
<PAGE>
                            THREE-FIVE SYSTEMS, INC.
                          QUARTERLY REPORT ON FORM 10-Q
                      FOR THE QUARTER ENDED MARCH 31, 1998
                                TABLE OF CONTENTS







                         PART I - FINANCIAL INFORMATION


                                                                            Page

ITEM 1.           FINANCIAL STATEMENTS:

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

                  Consolidated Statements of Income-
                           Three Months Ended March 31, 1998 and 1997..........2

                  Consolidated Statements of Cash Flows-
                           Three Months Ended March 31, 1998 and 1997..........3

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

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


                           PART II - OTHER INFORMATION


ITEM 6.           EXHIBITS AND REPORTS ON FORM 8-K............................12

SIGNATURES....................................................................13
<PAGE>
                            THREE-FIVE SYSTEMS, INC.
                           CONSOLIDATED BALANCE SHEETS
                                 (in thousands)


                                                          MARCH 31, DECEMBER 31,
                                                            1998       1997
                                                            ----       ----
                                                         (Unaudited)

                                    ASSETS

CURRENT ASSETS:
      Cash and cash equivalents                           $ 13,943    $ 16,371
      Accounts receivable, net                              12,808      12,540
      Inventories, net                                      12,865       8,255
      Deferred tax asset                                     4,311       4,311
      Other current assets                                   1,134       1,228
                                                          --------    --------
         Total current assets                               45,061      42,705

PROPERTY, PLANT AND EQUIPMENT, net                          30,444      29,847


OTHER ASSETS                                                   272         283
                                                          --------    --------
                                                          $ 75,777    $ 72,835
                                                          ========    ========

                     LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
      Accounts payable                                    $ 10,370    $  8,513
      Accrued liabilities                                    4,350       5,079
      Current maturities of long term debt                    --          --
      Current taxes payable                                    813        --
                                                          --------    --------
         Total current liabilities                          15,533      13,592
                                                          --------    --------


DEFERRED TAX LIABILITY                                       2,718       2,718

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY:
      Preferred stock                                         --          --
      Common stock                                              79          79
      Additional paid-in capital                            32,423      32,420
      Retained earnings                                     25,254      24,259
      Cumulative translation adjustment                         23          20
      Less - Treasury Stock at cost (22,500 shares)           (253)       (253)
                                                          --------    --------
         Total stockholders' equity                         57,526      56,525
                                                          --------    --------

                                                          $ 75,777    $ 72,835
                                                          ========    ========


The accompanying notes are an integral part of these consolidated statements.
                                        1
<PAGE>
                            THREE-FIVE SYSTEMS, INC.
                        CONSOLIDATED STATEMENTS OF INCOME
                                   (UNAUDITED)
                    (in thousands, except per share amounts)



                                                            THREE MONTHS ENDED
                                                                MARCH 31,
                                                         -----------------------
                                                           1998          1997
                                                         --------      --------

NET SALES                                                $ 18,479      $ 16,129

COSTS AND EXPENSES:
      Cost of sales                                        13,687        12,488
      Selling, general and administrative                   1,619         1,466
      Research and development                              1,689         1,130
                                                         --------      --------
                                                           16,995        15,084
                                                         --------      --------

          Operating Income                                  1,484         1,045

OTHER INCOME (EXPENSE):
      Interest, net                                           192           157
      Other, net                                              (17)          (12)
                                                         --------      --------

INCOME BEFORE PROVISION FOR INCOME TAXES                    1,659         1,190
      Provision for income taxes                              664           389
                                                         --------      --------

NET INCOME                                               $    995      $    801
                                                         ========      ========

EARNINGS PER COMMON SHARE:
      Basic                                              $    .13      $    .10
                                                         ========      ========
      Diluted                                            $    .12      $    .10
                                                         ========      ========
 WEIGHTED AVERAGE NUMBER OF COMMON SHARES:
      Basic                                                 7,907         7,759
                                                         ========      ========
      Diluted                                               8,165         8,048
                                                         ========      ========

The accompanying notes are an integral part of these consolidated statements.
                                        2
<PAGE>
                            THREE-FIVE SYSTEMS, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (UNAUDITED)
                                 (in thousands)
<TABLE>
<CAPTION>
                                                                        THREE MONTHS ENDED
                                                                              MARCH 31,
                                                                       --------------------
                                                                         1998        1997
                                                                       --------    --------
<S>                                                                    <C>         <C>     
CASH FLOWS FROM OPERATING ACTIVITIES:
      Net income                                                       $    995    $    801
      Adjustments to reconcile net income to net cash
      provided by operating activities:
         Depreciation and amortization                                    1,078         972
         Provision for (reduction of) accounts receivable valuation           
           reserves                                                           9          (4)
         (Reduction of) inventory valuation reserves                     (1,114)       (117)
         Change in assets and liabilities:
         (Increase) in accounts receivable                                 (278)       (300)
         (Increase) in inventories                                       (3,496)     (1,068)
         (Increase) decrease in other assets                               (240)        457
         Increase in accounts payable and accrued liabilities             1,128       1,060
         Increase (decrease) in taxes payable, net                        1,160        (202)
                                                                       --------    --------
         Net cash (used in) provided operating activities                  (758)      1,599
                                                                       --------    --------

CASH FLOWS FROM INVESTING ACTIVITIES:
      Purchases of property, plant and equipment                         (1,675)     (1,395)
                                                                       --------    --------
         Net cash (used in) investing activities                         (1,675)     (1,395)
                                                                       --------    --------

CASH FLOWS FROM FINANCING ACTIVITIES:
      Stock options exercised                                                 3          30
                                                                       --------    --------
         Net cash provided by  financing activities                           3          30
                                                                       --------    --------

Effect of exchange rate changes                                               2           1
                                                                       --------    --------

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                     (2,428)        235
CASH AND CASH EQUIVALENTS, beginning of period                           16,371      12,580
                                                                       --------    --------

CASH AND CASH EQUIVALENTS, end of period                               $ 13,943    $ 12,815
                                                                       ========    ========
</TABLE>
The accompanying notes are an integral part of these consolidated statements.
                                        3
<PAGE>
ITEM 1. (continued)

              Three-Five  Systems,  Inc. and Subsidiaries  Notes to Consolidated
              ------------------------------------------------------------------
              Financial Statements
              --------------------


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

Note B        Basic  earnings  per common  share are  computed by  dividing  net
              income by the  weighted  average  number of shares of common stock
              outstanding  during the three month period.  Diluted  earnings per
              common  share for the three month period are  determined  assuming
              that options were  exercised at the  beginning of the period or at
              the time of issuance, if later.

Note C        Inventories consist of the following at:

                                        March 31, 1998         December 31, 1997
                                        --------------         -----------------
                                          (Unaudited)
                                                   (in thousands)

              Raw Materials               $  10,404                 $  6,052
              Work-in-process                 1,353                    1,195
              Finished Good                   1,108                    1,008
                                          ---------                 --------
                                          $  12,865                 $  8,255
                                          =========                 ========


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

                                              March 31, 1998   December 31, 1997
                                              --------------   -----------------
                                                (Unaudited)
                                                      (in thousands)

              Building and improvements          $ 10,431           $ 10,431
              Furniture and equipment              33,479             31,804
                                                 --------           --------
                                                   43,910             42,235

              Less - accumulated depreciation     (13,466)           (12,388)
                                                 --------           ---------
                                                 $ 30,444           $  29,847
                                                 ========           =========


Note E        Recently issued accounting standard:

              The  Financial  Accounting  Standard  Board  issued  SFAS No. 130,
              Reporting  Comprehensive  Income, which establishes  standards for
              reporting and display of  comprehensive  income and its components
              in a full set of general  purpose  financial  statements.  The new
              statement  did  not  have  a  material  impact  on  the  Company's
              financial statements.
                                        4
<PAGE>
ITEM 2.           MANAGEMENT'S DISCUSSION AND ANALYSIS

Three  Months  Ended March 31, 1998  Compared  with Three Months Ended March 31,
1997.

         Net sales were $18.5  million for the quarter  ended March 31, 1998, an
increase  of 14.9  percent  compared  with net  sales of $16.1  million  for the
quarter  ended  March  31,  1997.  The  Company  believes  that it may have some
seasonality  to its sales.  Many of the  Company's  products are  components  in
retail  products  such as cellular  phones and office  automation  equipment for
which sales in the first calendar  quarter are  historically  slow. In addition,
several new programs,  previously  expected to begin  manufacturing in the first
quarter of 1998, were delayed by customers for a variety of reasons.  During the
first  quarter of 1998,  sales to Motorola  were 45.2  percent of the  Company's
revenue,  sales to  Hewlett-Packard  were 14.7 percent of the Company's revenue,
and sales to all other customers were 40.1 percent of the Company's revenue.

         Cost of sales, as a percentage of net sales,  decreased to 74.1 percent
for the  quarter  ended March 31,  1998 as  compared  with 77.4  percent for the
quarter  ended  March 31,  1997.  Historically,  at these  revenue  levels,  the
Company's  gross  margin is usually  lower  than its  desired  range  because of
absorption issues relating to under-utilization of its facilities.  In the first
quarter  of 1998,  however,  those  unabsorbed  costs  were more than  offset by
inventory management strategies. Specifically, the increased backlog reduced the
need for certain inventory reserves taken in the fourth quarter of 1997 pursuant
to the Company's inventory reserve policies.  The gross margin is expected to be
significantly  lower in the next few quarters.  See  "Business  Outlook and Risk
Factors" below.

         Selling,  general,  and administrative  expense of $1.6 million for the
quarter ended March 31, 1998 was slightly higher than the selling,  general, and
administrative  expense of $1.5  million for the quarter  ended March 31,  1997.
Selling,  general, and administrative expenses have increased as the Company has
expanded its  infrastructure  to accommodate the increasing  number of customers
and the expected  increase in sales and  production  throughout the remainder of
the year.

         Research and  development  expense totaled $1.7 million for the quarter
ended March 31, 1998 as compared  with $1.1 million for the quarter  ended March
31, 1997,  for an overall  increase of 55%.  Research and  development  expenses
consist  principally of salaries and benefits to scientists and other personnel,
related facilities costs, and various expenses for projects.  During the current
quarter,  expenses relating to process  developments on the high volume LCD line
were higher than normal.  Research and development  expense has increased as the
Company has invested in new technologies,  such as LCoS(TM)  microdisplays,  and
manufacturing  processes and has continued with its in-house process development
efforts  related to the  high-volume  manufacturing  LCD line  located in Tempe,
Arizona.  The Company  believes  that  continued  investments  in  research  and
development relating to manufacturing processes and new display technologies are
necessary to remain competitive in its marketplace and provide opportunities for
growth.

         Interest  income  (net)  for the  quarter  ended  March  31,  1998  was
$192,000, up from $157,000 for the quarter ended March 31, 1997. The increase in
interest income was the result of investing  higher average cash balances during
the quarter.  Other  expense  (net) was $17,000 for the quarter  ended March 31,
1998 as  compared  with  $12,000 for the quarter  ended March 31,  1997.  Income
before taxes was $1.7 million for the quarter  ended March 31, 1998, an increase
of  approximately  42% over the income before taxes of $1.2 million  dollars for
the quarter ended March 31, 1997.

         The  provision  for income taxes  increased to $664,000 for the quarter
ended March 31, 1998 from $389,000 for the quarter ended March 31, 1997. The tax
rate for the first  quarter was 40% as compared with 32.7% for the first quarter
of 1997.  The tax rate was lower in the  first  quarter  of 1997 due to  certain
accrual adjustments. The Company expects that the overall tax rate for 1998 will
approximate  its  historical  rate of 40%. This rate  eventually  may drop a few
percentage  points as the  Company  increases  manufacturing  operations  in the
People's  Republic of China,  where the  Company's  tax rate will  initially  be
substantially  less than 40%. The actual  world-wide  tax rate at that time will
depend on a variety of factors  including  intercompany  transfer  pricing,  the
amount of China sales, the  profitability of China  operations,  and whether any
intercompany dividends are declared.
                                        5
<PAGE>
         Net income  increased to $995,000,  or $0.12 per share, for the quarter
ended March 31, 1998 from  $801,000,  or $0.10 per share,  for the quarter ended
March 31, 1997 for an overall increase of 24.2%.

Liquidity and Capital Resources

         During the first three  months of 1998,  the  Company  had  $758,000 in
negative  cash flow from  operations  as compared  with $1.6 million in positive
cash flow during the first three  months of 1997.  The  negative  cash flow from
operations  was primarily due to a significant  increase in  inventories,  which
occurred primarily as a result of the increase in the Company's overdue backlog.
Overall,  the Company's  depreciation expense has risen approximately 11 percent
since the first quarter of 1997.  The  high-volume  LCD line is depreciated on a
units-of-production  method  based  on units  started.  It is  anticipated  that
depreciation  will  sharply  rise in  1998 as a  result  of  additional  capital
expenditures  and an expected  higher number of starts for the  high-volume  LCD
manufacturing  line in 1998 versus 1997. Capital  expenditures  expected in 1998
include a new building and equipment for the proposed  manufacturing facility in
China and the  installation  of additional  equipment in its Tempe,  Arizona and
Manila  manufacturing  locations,  including  equipment  to  manufacture  liquid
crystal on silicon (LCoS(TM))  microdisplays.  The Company's working capital was
$29.5 million at March 31, 1998, up from $29.1 million at December 31, 1997. The
Company's  current  ratio at March  31,  1998 was 2.9 -to-1 as  compared  with a
current  ratio of 3.1-to-1 at December  31,  1997.  Including  its cash and loan
commitments,  the  Company had over $29  million in readily  available  funds on
March 31, 1998.

         In May 1997, the Company entered into a new $15 million  revolving line
of credit with  Imperial  Bank,  which  matures May 22, 1998.  At maturity,  the
Company expects to renew that line for another year upon similar terms. At March
31, 1998, no borrowings were outstanding  under this credit  facility.  Advances
under  the  revolving  line may be made as Prime  Rate  Advances,  which  accrue
interest  payable  monthly at the bank's prime  lending  rate,  or as LIBOR Rate
Advances,  which bear  interest at 175 basis  points in excess of the LIBOR Base
Rate. The Company's  subsidiary,  Three-Five Systems Limited, has established an
annually  renewable  credit  facility with a United Kingdom bank,  Barclays Bank
PLC, in order to fund its working capital  requirements.  The facility  provides
$350,000 of borrowing  capacity  secured by accounts  receivable  of  Three-Five
Systems Limited. Advances are based on accounts receivable, as defined. Advances
under the credit facility accrue interest,  which is payable  quarterly,  at the
bank's  base rate plus 200 basis  points.  The United  Kingdom  credit  facility
matures June 20, 1998. Three-Five Systems Limited had no borrowings  outstanding
under this line of credit at March 31, 1998.

         Capital   expenditures   during   the  first   quarter   of  1998  were
approximately  $1.7  million,  as compared  with $1.4  million  during the first
quarter of 1997.  Capital  expenditures  for the first quarter of 1998 consisted
primarily of manufacturing and office equipment for the Company's  operations in
Manila  and  Arizona,  including  over $1  million  of  equipment  necessary  to
manufacture  LCoS(TM)  microdisplays,  and laboratory equipment for research and
development.  The  Company  anticipates  that it will have  substantial  capital
expenditures  during 1998. Those  expenditures will primarily relate to advanced
manufacturing  processes,  the high-volume LCD line, and necessary manufacturing
equipment.  In the near term,  the Company  anticipates  spending  approximately
another $1 to $2 million on the capital equipment needed to manufacture LCoS(TM)
microdisplays.  The Company has also decided to expand it oversees manufacturing
capabilities in 1998 by opening a manufacturing facility in Beijing,  China. The
Company  anticipates the initial  facilities and capital cost for its operations
in China in 1998 to be approximately $8 million.  The China operations will also
need approximately $4 million of working capital.  Additional capital costs will
be incurred as additional  manufacturing  lines are added.  Although the Company
initially will operate out of a leased facility,  the Company is purchasing land
and will be constructing its own building in the Beijing area, which is expected
to be ready late in 1998. The Company also expects to expend $3 to $5 million in
Manila  and  Tempe  on  capital  for  general  manufacturing  and  research  and
development needs.

         In April 1998, after the end of the first quarter, the Company invested
approximately  $2.4 million in a minority equity interest in Siliscape,  Inc., a
start-up company involved in developing various  technologies for microdisplays.
Under the terms of the  investment,  the  Company is  obligated  to  purchase an
additional  equity  interest in Siliscape for $900,000 in the fourth  quarter of
1998.

         The Company  anticipates  that accounts  receivable  and inventory will
rise in 1998 if revenue levels  increase as currently  anticipated.  The Company
believes that its existing capital,  anticipated cash flow from operations,  and
available and  anticipated  credit lines will provide  adequate  sources to fund
operations  and  planned  expenditures   throughout  1998.  Should  the  Company
encounter additional cash requirements, however, the Company may have to
                                        6
<PAGE>
expand its loan commitments or pursue alternate  methods of financing or raising
capital. For example, the Company has considered entering into various alliances
with regard to the strategic development of various new technologies, especially
LCoS(TM)  miscrodisplays.  Some of  these  alliances  may  result  in a  capital
investment by the Company in other  companies,  such as  Siliscape.  The Company
also has considered  acquisitions of other businesses.  Such investments  and/or
acquisitions  would likely  require the Company to pursue  additional  financing
mechanisms, such as debt or equity placements.

Effects of Inflation and Foreign Currency Exchange Fluctuations

         The results of operations of the Company for the periods discussed have
not been significantly  affected by inflation or foreign currency  fluctuations.
The Company  generally  sells its products and services and negotiates  purchase
orders with its foreign suppliers in United States dollars.  An exception is the
Company's sub-assembly  agreement in the Philippines,  which is based on a fixed
conversion  rate,  exposing the Company to exchange rate  fluctuations  with the
Philippine  peso.  Although the Company has not  incurred any material  exchange
gains or losses to date,  there has been some  minor  benefit as a result of the
recent Peso devaluation. If the peso devaluation were to continue, a substantial
portion of the  benefit to the  Company  will likely be offset by an increase in
the Philippine  labor rates and costs. In addition,  the Company is now required
to pay  approximately  one-third of any peso  devaluation gain to its lessor and
direct  labor   subcontractor  in  Manila.   There  can  be  no  assurance  that
fluctuations and currency  exchange rates in the future will not have an adverse
affect  on the  Company's  operations.  The  Company  is  planning  to  commence
operations in China in 1998.  Although the Chinese currency is currently stable,
there is no  assurance  that it will  remain  so in the  future.  The  Company's
Chinese  subsidiary will be capitalized with  approximately  one-half equity and
one-half debt. If the Company lends funds to the  subsidiary,  such U.S.  dollar
loans could result in a loss on the consolidated income statement if the Chinese
currency  was  devalued.  Although  the Company from time to time may enter into
hedging  transactions  in  order to  minimize  its  exposure  to  currency  rate
fluctuations, the Chinese currency is not freely traded and thus is difficult to
hedge. Thus, unless the Company can obtain loans in the Chinese currency,  there
is a substantial risk of recording a loss upon a Chinese currency devaluation.

Business Outlook and Risk Factors

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

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

         The Company had substantial  growth in its revenues in 1997 with a 39.4
percent rate of growth over 1996.  This growth  occurred  because several strong
new programs  began  production  in the second and third  quarters of 1997 while
many existing programs were in the middle of their life cycles. In 1997, over 80
percent of revenue occurred in the second,  third, and fourth quarters. In 1998,
this type of revenue  pattern is  expected to be  repeated,  likely with an even
greater  percentage of the overall 1998 revenue occurring in the second,  third,
and fourth  quarters.  A pattern of  seasonality  may be developing as OEMs with
retail  products  develop shorter product life cycles and introduce new programs
early in the year  after  the  winter  holiday  season.  In  addition,  some new
programs,  previously  expected  to begin  to ramp up  production  in the  first
quarter of 1998,  are now not expected to begin to ramp up until after the first
quarter.  As a result,  the revenue from those new programs was not available in
the first quarter to offset the loss of revenue occurring from the completion of
certain older programs.  Thus,  although sales in the first quarter of 1998 were
14.9 percent higher than sales in the first quarter of 1997,  sales in the first
quarter of 1998 declined over sales in the fourth quarter of 1997.
                                        7
<PAGE>
         The  Company's  actual  backlog  at the end of March 31,  1998 of $39.2
million is substantially higher than the $17.8 million that existed at March 31,
1997.  In addition,  at the  beginning of 1998,  the  Company's  estimated  1998
backlog  of  manufacturing   revenue  for  programs   currently  in  design  was
substantially  greater than the  estimated  1997 backlog was at the beginning of
1997. Therefore,  if additional programs moving out of development begin to ramp
their production  levels up in 1998 as anticipated,  the Company should continue
its year-over-year growth rate in 1998.

         In the past several  quarters,  the Company has undertaken  substantial
efforts to diversify its  business,  broaden its customer  base,  and expand its
markets,  and the  Company  intends to continue  those  efforts.  The  Company's
historical  major  customer,  Motorola,  which  accounted for  approximately  80
percent  of the  Company's  revenue  in 1995,  accounted  for 65  percent of the
Company's  revenue in 1996,  and slightly  less than 35 percent of the Company's
revenue in 1997. These reduced percentages occurred as a result of the increased
sales to other  customers and reduced  product  selling prices and revenues from
that major customer. Late in 1997, Motorola instituted an allocation process for
awarding 1998 LCD module  business.  Although the allocation  does not provide a
guarantee of business,  the Company  anticipates that its business with Motorola
will  increase in 1998 at a rate faster than  business  with other  customers is
increasing.  Therefore,  the  percentage  of revenue  attributed  to Motorola is
expected  to  increase in 1998,  and the  current  business  plan of the Company
targets that customer to account for approximately one-half of its 1998 revenue.
Hewlett-Packard  accounted for 32 percent of the Company's  revenue in 1997, but
this percentage is expected to decline significantly in 1998 as current programs
mature and replacement programs with lower selling prices are introduced.

         The Company's gross margins are impacted by several factors,  including
manufacturing   efficiencies,   product  differentiation,   product  uniqueness,
billings  for  non-recurring   engineering   services,   inventory   management,
engineering  costs,  product mix, and volume pricing.  Generally,  higher-volume
programs  using more  generic,  low-information  content LCD displays have lower
margins. Gross margins generally increase, however, as a program matures because
yields rise and component costs generally fall. As the production levels of some
of the Company's new high-volume  programs  increase in 1998, the lower standard
gross margins on those  programs  will have an impact on the  Company's  overall
margins. In addition, in an effort to penetrate certain strategic customers, the
Company  may  aggressively  price  its  products.  Depending  on the size of the
programs  won,  such  pricing  strategies  could  also have an effect on overall
margins.

         The Company has accelerated the start-up of the China  operations,  and
over  the next  several  quarters  the  Company's  gross  margins  will  also be
adversely affected by the start-up of those China manufacturing  operations.  As
the Company begins ramping up its China  manufacturing  operations in the second
quarter, it will incur costs in advance of the receipt of significant  revenues.
The  Company  expects  that it could have as much as $1  million of  incremental
China  expenses  in the second  quarter.  Those  expenses,  arising  mainly from
under-absorption of the China facility and yield issues, will be included in the
cost of sales and thus will reduce overall gross margins.  In the third quarter,
the Company's plan is for China to be at a break-even  point at the gross margin
level, which means that the Company's overall margins would still be impacted by
those break-even  margins.  The Company expects the China facility will begin to
operate profitably after moving into the permanent facility, which is planned to
occur in the fourth  quarter,  although  gross margins will  initially  still be
lower than U.S. gross margins. In the long run, however, the Company expects the
China  operations  to  positively   impact  gross  margins  because  of  certain
competitive cost advantages provided by China.

         Another  potential impact on the Company's gross margins could occur as
a result of the Asian currency situation.  Many of the Company's competitors are
Asian suppliers,  and a strong U.S. dollar gives a competitive pricing advantage
to those suppliers.  Thus, the Company may see competitive  margin pressure from
Asian suppliers, particularly those in Korea and Japan.

         Despite the various factors potentially  impacting gross margins, it is
the goal of the Company for increased manufacturing efficiencies to occur on the
high-volume  programs  to help  maintain  its gross  margins  in the  mid-twenty
percent  range,  although those gross margin levels should not occur until after
the China  facility is fully  operational.  The Company  also  expects that more
advanced display modules  commanding higher margins should enable the Company to
eventually maintain its gross margins in the desired mid-twenty percent range.

         As the Company  expands and  diversifies its product and customer base,
the  Company  has had to  increase  its  selling,  general,  and  administrative
expenses.  Although  those  expenses in the first quarter of 1998 decreased over
the
                                        8
<PAGE>
fourth  quarter of 1997, the decrease was mainly due to an adjustment of certain
accruals.  Generally,  those  expenses  are  somewhat  inelastic;   accordingly,
selling,  general, and administrative expenses have increased as a percentage of
sales in the first  quarter of 1998 as a result of the reduced  revenue from the
fourth quarter of last year. The volume and complexity of the Company's business
is expected to continue to grow throughout the remainder of 1998. Therefore, the
Company  anticipates  that it  will  increase  its  selling  and  administrative
expenses over those incurred in 1997. Serving a myriad of customers with complex
and differing issues requires increased  personnel committed to those customers.
The actual dollar amount of the selling, general, and administrative expenses in
1998 could be 20 to 25 percent greater than in 1997,  although SG&A expenditures
as a percentage of net sales should decrease in 1998 over the 1997 levels.

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

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

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

         In April 1998,  the  Company  invested  $2.4  million in  Siliscape,  a
start-up  company with numerous patents and proprietary  technology  relating to
microdisplays. The Company and Siliscape also entered into a strategic agreement
under  which they will focus on the  development  of  hand-held  products  using
microdisplays  with the  Company  providing  certain  proprietary  manufacturing
capabilities   and  Siliscape   providing   certain   patented  and  proprietary
technologies and components.

         The  Company  also is  considering  licensing  technologies  from other
companies  that  could be  optimized  on the LCD  manufacturing  line as well as
entering into further  alliances.  This internal and external  focus on research
and  development  will  continue  indefinitely.  As a result,  the actual dollar
amount of such  expenditures in 1998 may increase by 10 to 20 percent over 1997,
although R&D expenditures as a percentage of net sales should decrease in 1998.

         As  mentioned   previously,   the  Company  has  decided  to  establish
manufacturing  operations in The People's  Republic of China. A very experienced
individual  was  hired  in early  1998 to act as the  General  Manager  and Vice
President for the China  operations.  Three Five Systems (Beijing) Co., Ltd. was
incorporated  in China  during the first  quarter of 1998 and  business  license
approval was received from the governmental authorities. A temporary leased site
was recently  selected in Beijing,  as was the permanent site. The Company plans
to  establish  Chinese  manufacturing  operations  in 1998 for several  reasons.
First, based upon growth expectations for 1998 in the European and United States
marketplaces,  the Company anticipates a need for manufacturing  capacity beyond
what is available at its Philippine location.  China was selected because of the
desire to diversify  manufacturing  locations  and because of the cost  benefits
that  are  expected  to be  achieved  in  China.  China is also  expected  to be
synergistic for the Company  because many of its components are  manufactured in
China.

         Second, many of the Company's existing and potential customers maintain
manufacturing  operations near the proposed China location.  Despite the current
Asian economic  situation,  those customers  continue to require LCD modules and
the Company  participates  very little in that market.  There currently are very
few LCD module  manufacturers in China.  Under current Chinese government rules,
however, OEMs in China have a strong motivation
                                        9
<PAGE>
to utilize locally  manufactured  components.  As mentioned  above,  the Company
expects  start up costs  associated  with China to occur in advance of the first
significant  revenues  from  China,  which  are  expected  to occur in the third
quarter of 1998.

Risk Factors

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

         A few core  customers are currently  responsible  for a majority of the
Company's  revenue.  Thus,  any material  delay,  cancellation,  or reduction of
orders from one or more of those core  customers  could have a material  adverse
effect  on  the   Company's   operations.   The  Company   expects  the  current
concentration levels from those core customers to continue through 1998.

         Although  the trend of the Company is to enter into more  manufacturing
contracts with its  customers,  the principal  benefit of these  contracts is to
clarify order lead times, inventory risk allocation, and similar matters and not
to provide firm, long-term volume purchase commitments.  The Company has no firm
long-term  volume  purchase  commitments  from  its  customers.  Thus,  customer
commitments  can be  canceled,  and  expected  volume  levels  can be changed or
delayed.  The timely replacement of canceled,  delayed,  or reduced  commitments
cannot be assured and, among other things,  could result in the Company  holding
excess and obsolete inventory or having unfavorable manufacturing variances as a
result of  under-absorption.  These  risks are  exacerbated  because the Company
expects  that a  majority  of its  sales  will  be to  customers  in the  retail
electronics industry,  which is subject to severe competitive  pressures,  rapid
technological change, and obsolescence.

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

         The Company is expected to introduce several new products over the next
few years. These new products will require significant  expenditures,  including
development  expenses,  such as those for custom integrated circuits, as well as
various  capital   expenditures  and  investments.   For  example,  the  Company
anticipates that LCoS(TM)  microdisplays will initially require approximately $2
to $3 million of capital  expenditures,  and the Company has committed to a $3.3
million  investment  in  Siliscape  for the purposes of further  developing  the
LCoS(TM) microdisplay product. There could be a materially adverse impact on the
Company if one or more of the new technologies were unsuccessful for any reason,
especially LCoS(TM) microdisplays.

         The Company is currently  spending research and development  dollars on
several new  technologies  that it plans to introduce in the future.  There is a
risk  that  some or all of  those  technologies  may not  successfully  make the
transition   from  the   research   and   development   lab  to   cost-effective
manufacturability,  and such failure could have a material adverse effect on the
Company.  Risks include technology problems,  competitive cost issues, and yield
problems. In addition, even if a new technology proves to be manufacturable,  it
may not be accepted by the Company's  customers and the customers'  marketplaces
because  of  price or  technology  issues  or it may  compare  unfavorably  with
products previously introduced by others.
                                       10
<PAGE>
         The Company  designs and  manufactures  products  based on firm quotes.
Thus,  the Company  bears the risk of  component  price  increases,  which could
adversely affect the Company's gross margins.  In addition,  the Company depends
on certain  suppliers,  and the  unavailability  or shortage of materials  could
cause delays or lost orders. On occasions,  several material  components of some
of the  Company's  major  programs  have been subject to  allocation  because of
shortages by vendors and continued or increased  shortages could have a material
adverse effect on the Company in the future.  In addition,  although most of the
components  purchased  by the  Company  are  purchased  from  vendors  in  Asian
countries  unaffected by the current currency  crisis, a significant  portion of
the silicon  drivers  purchased  by the Company  are  manufactured  in Korea and
Japan.  Economic  instability  in certain  Asian  countries  could cause  supply
problems with respect to these components.

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

         The Company is planning to begin a manufacturing  operation in China in
1998.  The  Company's  operations  and assets  will be  subject  to  significant
political,  economic,  legal and other  uncertainties in China. The Company also
could be adversely  affected by the imposition of austerity measures intended to
reduce inflation;  the inadequate  development or maintenance of infrastructure,
including   the   unavailability   of   adequate   power  and  water   supplies,
transportation,  raw materials,  and parts;  or a  deterioration  of the general
political, economic or social environment in China.

         The  Company  is  starting  up China  operations  because  the  Company
believes that its Manila  manufacturing  facility may have  occasional  capacity
issues as early as the fourth  quarter of 1998.  Failure to begin  operations in
the China  facility on a timely  basis could result in capacity  restraints  and
late  or  canceled  customer  deliveries.   Manufacturing  yields  and  delivery
schedules  also  may be  affected  as the  Company  ramps  up its  manufacturing
capabilities  in  China.  Other  companies  in  the  industry  have  experienced
difficulty in expanding or relocating  manufacturing  output and capacity,  with
such difficulty resulting in reduced yields or delays in product deliveries.  No
assurance can be given that the Company will not experience  manufacturing yield
or delivery  problems in the future.  Such problems could materially  affect the
Company's operating results.

         Finally,  the Company's success,  especially in penetrating new markets
and increasing its OEM customer base, depends to a large extent upon the efforts
and abilities of key managerial and technical employees. The loss of services of
certain key personnel could have a material  adverse effect on the Company.  The
Company's  business  also  depends  upon its  ability to continue to attract and
retain senior managers and skilled employees.
Failure to do so could adversely affect the Company's operations.

         As a result of the foregoing  and other  factors,  the Company's  stock
price may be subject to  significant  volatility,  particularly  on a  quarterly
basis.  Any shortfall in revenue or earnings from levels  expected by investors,
analysts,  and brokers could have an immediate and significant adverse effect on
the  trading  price  of  the  Company's   common  stock  in  any  given  period.
Additionally,  the  Company  may not learn of such  shortfalls  until  late in a
fiscal quarter,  which could result in an even more immediate and adverse effect
on the trading price of the  Company's  common stock.  Finally,  other  factors,
which generally affect the market for stocks of high technology companies, could
cause the price of the Company's  common stock to fluctuate  substantially  over
short periods for reasons unrelated to the Company's performance.
                                       11
<PAGE>
                           PART II. OTHER INFORMATION


ITEM 6.       Exhibits and Reports on Form 8-K
              --------------------------------


              (a)  EXHIBIT 27: Financial Data Schedule

              (b) Reports on Form 8-K: None
                                       12
<PAGE>
                                   SIGNATURES


              Pursuant to the  requirements  of the  Securities  Exchange Act of
1934,  the  Registrant has duly caused this report to be signed on its behalf by
the undersigned thereunto duly authorized.


                            THREE-FIVE SYSTEMS, INC.
                            ------------------------
                                  (Registrant)



Dated:  May 01, 1998                    By:  /s/ Jeffrey D. Buchanan
       -----------------                     -----------------------------------
                                             Jeffrey D. Buchanan

                                        Its: Vice President Finance, 
                                             Administration and Legal; Chief 
                                             Financial Officer
                                       13