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 June 30, 1998
                                           ------------------
                          Commission File Number 1-4373
                                                 ------------

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

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

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


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


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

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

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

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

Common                                                  7,927,085
Par value $.01 per share
<PAGE>

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


                         PART I - FINANCIAL INFORMATION

                                                                       Page
                                                                       ----
ITEM 1.  FINANCIAL STATEMENTS:

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

         Consolidated Statements of Income-
            Three Months and Six Months Ended June 30, 1998 and 1997.....2

         Consolidated Statements of Cash Flows-
            Six Months Ended June 30, 1998 and 1997......................3

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

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


                           PART II - OTHER INFORMATION

ITEM 4.  SUBMISSIONS OF MATTERS TO A VOTE OF SECURITY HOLDERS............13

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K................................13

SIGNATURES...............................................................14

<PAGE>

ITEM 1.
                            THREE-FIVE SYSTEMS, INC.
                           CONSOLIDATED BALANCE SHEETS
                                 (in thousands)

                                                         JUNE 30,   DECEMBER 31,
                                                           1998        1997
                                                           ----        ----
                                                       (Unaudited)
                                     ASSETS
                                     ------
CURRENT ASSETS:
Cash and cash equivalents                                $  7,085    $ 16,371
Accounts receivable, net                                   14,349      12,540
Inventories, net                                           22,399       8,255
Deferred tax asset                                          4,113       4,311
Other current assets                                        1,058       1,228
                                                         --------    --------
Total current assets                                       49,004      42,705

PROPERTY, PLANT AND EQUIPMENT, net                         32,550      29,847

OTHER ASSETS                                                2,680         283
                                                         --------    --------
                                                         $ 84,234    $ 72,835
                                                         ========    ========

                      LIABILITIES AND STOCKHOLDERS' EQUITY
                      ------------------------------------

CURRENT LIABILITIES:
Accounts payable                                         $ 17,186    $  8,513
Accrued liabilities                                         4,323       5,079
Current taxes payable                                       1,308          --
                                                         --------    --------
Total current liabilities                                  22,817      13,592
                                                         --------    --------
DEFERRED TAX LIABILITY                                      2,718       2,718
                                                         --------    --------
COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY:
Preferred stock                                                --          --
Common stock                                                   79          79
Additional paid-in capital                                 32,468      32,420
Retained earnings                                          26,378      24,259
Cumulative translation adjustment                               5          20
Less - Treasury Stock at cost (20,496 shares)                (231)       (253)
                                                         --------    --------
Total stockholders' equity                                 58,699      56,525
                                                         --------    --------
                                                         $ 84,234    $ 72,835
                                                         ========    ========

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



                                         THREE MONTHS           SIX MONTHS
                                         ENDED JUNE 30,        ENDED JUNE 30,
                                       -----------------      ---------------
                                        1998        1997      1998       1997
                                        ----        ----      ----       ----

NET SALES                             $ 22,682   $ 18,737   $ 41,161   $ 34,866
                                      --------   --------   --------   --------
COSTS AND EXPENSES:

  Cost of sales                         17,095     14,377     30,782     26,865
  Selling, general and administrative    1,815      1,479      3,434      2,945
  Research and development               1,904      1,315      3,593      2,445
                                      --------   --------   --------   --------
                                        20,814     17,171     37,809     32,255
                                      --------   --------   --------   --------

Operating income                         1,868      1,566      3,352      2,611

OTHER INCOME (EXPENSE):
  Interest, net                            130        154        322        311
  Other, net                                (6)        (7)       (23)       (19)
                                      --------   --------   --------   --------
INCOME BEFORE PROVISION FOR
 INCOME TAXES                            1,992      1,713      3,651      2,903
  Provision for income taxes               869        685      1,533      1,074
                                      --------   --------   --------   --------

NET INCOME                            $  1,123   $  1,028   $  2,118   $  1,829
                                      ========   ========   ========   ========
EARNINGS PER COMMON SHARE
  Basic                               $   0.14   $   0.13   $   0.27   $   0.23
                                      ========   ========   ========   ========
  Diluted                             $   0.14   $   0.13   $   0.26   $   0.23
                                      ========   ========   ========   ========
WEIGHTED AVERAGE NUMBER OF
 COMMON SHARES
  Basic                                  7,918      7,855      7,913      7,807
                                      ========   ========   ========   ========
  Diluted                                8,128      8,071      8,141      8,063
                                      ========   ========   ========   ========

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

                                       2
<PAGE>
ITEM 1.

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



                                                              SIX MONTHS ENDED
                                                                  JUNE 30,
                                                            -------------------
                                                               1998      1997
                                                               ----      ----
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net income                                                $  2,118   $  1,829
  Adjustments to reconcile net income to net cash
   (used in) provided by operating activities:
     Depreciation and amortization                             2,178      2,034
     Reduction of accounts receivable valuation reserves         (15)      (174)
     Reduction of inventory valuation reserves                  (803)      (980)
     Loss on disposal of assets                                   --          3
  Change in assets and liabilities:
     Increase in accounts receivable                          (1,794)    (2,773)
     Increase in inventories                                 (13,341)    (2,278)
     (Increase) decrease in other assets                        (153)       712
     Increase in accounts payable and accrued liabilities      7,917      2,439
     Increase in taxes payable, net                            1,851        332
                                                            --------   --------
        Net cash provided by (used in) operating activities   (2,042)     1,144
                                                            --------   --------

CASH FLOWS FROM INVESTING ACTIVITIES:
  Purchase of property, plant and equipment, net              (4,880)    (2,100)
  Investments                                                 (2,420)        --
                                                            --------   --------
        Net cash used in investing activities                 (7,300)    (2,100)
                                                            --------   --------

CASH FLOWS FROM FINANCING ACTIVITIES:
  Issue of treasury stock                                         22         --
  Stock options exercised                                         48         37
                                                            --------   --------
        Net cash provided by financing activities                 70         37
                                                            --------   --------

Effect of exchange rate changes on cash and cash equivalents     (14)        --
                                                            --------   --------

NET (DECREASE) IN CASH AND CASH EQUIVALENTS                   (9,286)      (919)
CASH AND CASH EQUIVALENTS, beginning of period                16,371     12,580
                                                            --------   --------

CASH AND CASH EQUIVALENTS, end of period                    $  7,085   $ 11,661
                                                            ========   ========

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

                                       3
<PAGE>

ITEM 1.

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

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

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

Note C    Inventories consist of the following at:

                                   June 30, 1998          December 31, 1997
                                   -------------          -----------------
                                    (Unaudited)
                                               (in thousands)
          Raw Materials               $ 16,711                 $ 6,052
          Work-in-process                2,304                   1,195
          Finished Good                  3,384                   1,008
                                      --------                 -------
                                      $ 22,399                 $ 8,255
                                      ========                 =======


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

                                     June 30, 1998          December 31, 1997
                                     -------------          -----------------
                                      (Unaudited)
                                                (in thousands)
          Building and improvements      $ 10,431               $ 10,431
          Furniture and equipment          36,685                 31,804
                                         --------               --------
                                         $ 47,116               $ 42,235

          Less accumulated depreciation   (14,566)               (12,388)
                                         --------               --------
                                         $ 32,550               $ 29,847
                                         ========               ========

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

Three Months Ended June 30, 1998 Compared with Three Months Ended June 30, 1997.

         Net sales were $22.7  million for the quarter  ended June 30, 1998,  an
increase  of 21.4  percent  compared  with net  sales of $18.7  million  for the
quarter  ended  June 30,  1997.  The  Company  believes  that it may  have  some
seasonality  to its  sales.  Many  of the  Company's  components  are in  retail
products such as cellular  telephones and office automation  equipment for which
sales in the first calendar quarter are historically slow. In addition,  several
new  programs,  previously  expected to begin  manufacture  in the first half of
1998,  were  delayed by  customers  for a variety of reasons.  During the second
quarter of 1998,  sales to Motorola were 52.9 percent of the Company's  revenue,
sales to Hewlett-Packard were 9.1 percent of the Company's revenue, and sales to
all other customers were 38 percent of the Company's revenue.

         Cost of sales, as a percentage of net sales,  decreased to 75.4 percent
for the  quarter  ended June 30,  1998 as  compared  with 76.7  percent  for the
quarter ended June 30, 1997. The  corresponding  increase in the gross margin in
the second quarter is mainly attributed to positive material overhead absorption
occurring  as a result of  significantly  increased  material  purchases.  Since
inventory  balances  are  now  unusually  high,   purchases  of  inventory  will
significantly  slow in the third quarter of 1998,  and  under-absorption  of the
material  overhead  will  likely  occur,  which will have the impact of reducing
gross margins in that quarter.  See "Business  Outlook and Risk Factors"  below.
The positive material overhead absorption in the second quarter more than offset
the $543,000 of incremental  expenses the Company incurred in cost of sales as a
result of starting up operations in China.  Those incremental China expenses are
reflected  as  under-absorbed  overhead  in costs  of  sales  as a result  of no
significant manufacturing activity in the China facility.

         Selling,  general,  and administrative  expense of $1.8 million for the
quarter  ended June 30, 1998 was higher than the expense of $1.5 million for the
quarter ended June 30, 1997. Selling,  general, and administrative  expense as a
percentage  of net sales was 7.9 percent for the quarter  ended June 30, 1998 as
compared with 8.0 percent for the quarter ended June 30, 1997.

         Research and development  expense totaled $1.9 million,  or 8.4 percent
of net sales, for the quarter ended June 30, 1998 as compared with $1.3 million,
or 7.0 percent of net sales,  for the quarter ended June 30, 1997.  Research and
development  expenses consist principally of salaries and benefits to scientists
and other personnel,  related facilities costs,  process  development costs, and
various expenses for projects,  including new product development.  Research and
development  expense has  continued to increase as the Company  works to develop
new display products and technologies while continuing with its in-house process
development efforts related to the high-volume manufacturing LCD line located in
Tempe,   Arizona.   Most  of  the  increase  this  quarter  related  to  process
developments on the LCD line.

         Interest income (net) for the quarter ended June 30, 1998 was $130,000,
down from $154,000 for the quarter ended June 30, 1997. The decrease in interest
income was the result of investing lower cash balances during the quarter. Other
expense  (net) was $6,000 for the quarter  ended June 30, 1998 as compared  with
$7,000 for the quarter ended June 30, 1997.

         The  provision  for income taxes  increased to $869,000 for the quarter
ended June 30, 1998 from  $685,000  for the quarter  ended June 30,  1997.  This
increase resulted primarily from higher pre-tax income in the quarter ended June
30, 1998 as  compared  with the same period in 1997.  In  addition,  the Company
applied a tax rate of 43.6  percent for this  quarter  (versus a 40% rate in the
quarter  ended  June 30,  1997) in order to bring the tax rate for the first six
months up to 42 percent.  The Company  will have an  approximate  42 percent tax
rate in the  remainder  of 1998 as a result  of the  losses it is  incurring  in
China.  The income tax rate  structure in China is lower;  therefore,  losses in
China do not  provide  as great a tax  benefit  as losses  in a higher  tax rate
country like the United States.  In 1999, the Company's  overall tax rate should
drop as the Company  increases  manufacturing  operations,  in China. The actual
world-wide  tax  rate at that  time  will  depend  upon a  variety  of  factors,
including  inter-company  transfer  pricing,  the  amount  of China  sales,  the
profitability of China operations,  and whether any inter-company  dividends are
declared.
                                       5
<PAGE>
         Net income increased to $1.1 million, or $0.14 per share (diluted), for
the quarter ended June 30, 1998 from $1.0 million, or $0.13 per share (diluted),
for the quarter ended June 30, 1997. Without China-related  incremental expenses
in the costs of sales, net income for the quarter ended June 30, 1998 would have
been approximately $1.4 million or $0.18 per share (diluted).

Six Months Ended June 30, 1998 Compared with Six Months Ended June 30, 1997.

         Net sales were $41.2 million for the six months ended June 30, 1998, an
increase of 18.1 percent  compared  with net sales of $34.9  million for the six
months ended June 30,  1997.  The sales  increase was  primarily a result of the
increased production of several new programs for new and existing customers.  In
the six-month  period ended June 30, 1998, (a) Motorola  accounted for net sales
of $20.3  million  compared with net sales of $12.2 million to that customer for
the six months ended June 30, 1997, (b) Hewlett-Packard  accounted for net sales
of $4.8 million compared with net sales of $9.0 million to that customer for the
six months ended June 30, 1997, and (c) other customers  accounted for net sales
of $16.1  million,  compared  with the net sales of $13.7 million to those other
customers for the six months ended June 30, 1997.

         Cost of sales, as a percentage of net sales,  decreased to 74.8 percent
for the six months ended June 30, 1998 as compared with 77.1 percent for the six
months ended June 30, 1997. The  corresponding  increase in the gross margin was
primarily  due to positive  material  overhead  absorption  as the result of the
significantly increased inventory purchases.

         Selling,  general,  and administrative  expense of $3.4 million for the
six months  ended June 30, 1998 was greater than the expense of $2.9 million for
the six months ended June 30, 1997. Selling, general, and administrative expense
as a  percentage  of net sales was 8.3 percent for the six months ended June 30,
1998, which was the same percentage for the six months ended June 30, 1997.

         Research and development  expense totaled $3.6 million,  or 8.7 percent
of net sales,  for the six  months  ended June 30,  1998 as  compared  with $2.4
million,  or 6.9 percent of net sales,  for the six months  ended June 30, 1997.
The  increase  in  research  and  development  expense  was as a  result  of the
Company's  continued focus on the development of advanced  display  technologies
and   development  of  its  in-house   efforts   relative  to  the   high-volume
manufacturing LCD line.

         Interest  income  (net)  for the six  months  ended  June 30,  1998 was
$322,000,  up from $311,000 for the six months ended June 30, 1997. The increase
in interest  income was the result of investing  higher  average  cash  balances
during the six months.  Other  expense  (net)  increased  to $23,000 for the six
months ended June 30, 1998 from $19,000 for the six months ended June 30, 1997.

         The provisions  for income taxes  increased to $1.5 million for the six
months  ended June 30, 1998 from $1.1  million for the six months ended June 30,
1997. This resulted primarily from higher pre-tax income in the six months ended
June 30, 1998 as compared with the same period in 1997. In addition, the Company
used a tax rate of 42 percent for the first six months versus a 37% rate for the
six month period ending June 30, 1998.

         Net income increased to $2.1 million, or $0.26 per share (diluted), for
the six  months  ended  June 30,  1998  from  $1.8  million,  or $0.23 per share
(diluted),  for the six  months  ended  June  30,  1997.  Without  China-related
incremental  expenses in the cost of sales,  net income for the six months ended
June 30, 1998 would have been  approximately  $2.6  million,  or $0.32 per share
(diluted).

Liquidity and Capital Resources

         During the first six months of 1998,  the Company  had $2.0  million in
negative  cash flow from  operations  as compared  with $1.1 million in positive
cash flow  during  the first six  months of 1997.  The  negative  cash flow from
operations was primarily due to the  significant  increase in  inventories.  The
Company  purchased  inventories  in  expectation  of the start-up of several new
programs in the second and third  quarters of 1998.  A delay in the  start-up of
those programs resulted in a substantial inventory balance on June 30, 1998. The
                                       6
<PAGE>
Company believes that it will receive orders for the new programs  sufficient to
utilize  the  unreserved  inventory  because  most of the  unreserved  inventory
balance is for programs which are at the beginning of the production  cycle.  If
some or all of those  programs are  cancelled,  however,  the Company may end up
holding excess inventory. See "Business Outlook and Risk Factors" below.

         The Company's  working capital was $26.2 million at June 30, 1998, down
from $29.1 million at December 31, 1997. The Company's current ratio at June 30,
1998 was 2.1-to-1 as compared  with a current  ratio of 3.1-to-1 at December 31,
1997. The reduction in working capital and the current ratio occurred  primarily
because of the  substantial  investments  made in fixed assets and in Siliscape,
Inc. (see below). Including its cash and loan commitments,  the Company had over
$21 million in readily available funds on June 30, 1998.

         In May 1998,  the Company  entered  into a new $15  million  unsecured,
revolving line of credit with Imperial Bank,  which matures in May 2000. At June
30, 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 in June 1999.  Three-Five Systems Limited had no borrowings  outstanding
under this line of credit at June 30, 1998.

         Capital  expenditures  during the first half of 1998 were approximately
$4.9  million,  as  compared  with $2.1  million  during the first half of 1997.
Capital  expenditures  for  the  first  half  of  1998  consisted  primarily  of
manufacturing  and office  equipment  for the  Company's  operations in Beijing,
Manila and Tempe,  including  laboratory  equipment for research and development
and  over  $1  million  of   equipment   necessary   to   manufacture   LCoS(TM)
microdisplays.  The Company anticipates that it will have substantial additional
capital  expenditures  during 1998. Those  expenditures will primarily relate to
advanced  manufacturing  processes,  the  high-volume  LCD line,  and  necessary
manufacturing  equipment for its new manufacturing  facility in Beijing,  China.
The  Company  anticipates  the  initial  facilities  and  capital  cost  for its
operations in China in 1998 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.  Thus far,
the Company has expended  approximately $3 million in Beijing for manufacturing,
equipment  and land costs.  Although  the Company is  operating  out of a leased
facility in the Beijing area, the Company has purchased  land-use  rights nearby
and has begun  construction  of its own building,  which is expected to be ready
early in 1999.  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,  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's ownership
interest in Siliscape will be accounted for on the cost method of accounting.

         The Company  anticipates that accounts  receivable will increase during
1998 if revenue levels increase. The Company believes that its existing capital,
anticipated  cash flows from  operations,  and available and anticipated  credit
lines will provide adequate sources to fund operations and planned  expenditures
throughout  1998. The Company may have to expand its loan  commitments or pursue
alternate methods of financing or raising capital,  however,  should the Company
encounter additional cash requirements.  For example, the Company has considered
entering into alliances with regard to the strategic  development of various new
technologies,  especially LCoS(TM)  miscrodisplays.  Some of these alliances may
result  in a capital  investment  by the  Company  in other  companies,  such as
Siliscape.  The Company also has considered  acquisitions  of other  businesses.
Such investments and/or  acquisitions would likely require the Company to pursue
additional financing mechanisms, such as debt or equity placements.
                                       7
<PAGE>

Effects of Inflation and Foreign Currency Exchange Fluctuations

         The results of operations of the Company for the periods discussed have
not been significantly  affected by inflation or foreign currency  fluctuations.
The Company  generally  sells its products and services and negotiates  purchase
orders with its foreign suppliers in United States dollars.  An exception is the
Company's sub-assembly  agreement in the Philippines,  which is based on a fixed
conversion  rate,  exposing the Company to exchange rate  fluctuations  with the
Philippine  peso.  The Company has not incurred any material  exchange  gains or
losses to date and there has been some minor  benefit as a result of last year's
peso  devaluation,  although  the Company is now  required to pay  approximately
one-third  of  any  peso  devaluation  gain  to  its  lessor  and  direct  labor
subcontractor  in  Manila.  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  commenced  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 in total 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  is
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.  At
this time,  the  Company  has an  intercompany  loan  balance  with its  Chinese
subsidiary of  approximately  $2 million,  and that balance will likely increase
over the next few months. The Company believes, however, that it will eventually
obtain loans in Chinese currency to replace the inter-company  loans.  Until the
Company can obtain loans in the Chinese  currency,  however,  a Chinese currency
devaluation would result in the Company recording a reportable loss.

Business Outlook and Risk Factors

Business Outlook

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

         The  Company  offers  advanced  design and  manufacturing  services  to
original equipment manufacturers. The Company specializes in custom displays and
front panel displays  utilizing  liquid crystal  display (LCD)  technology.  The
Company  experienced  substantial growth from 1993 through 1995 with such growth
dependent  primarily upon the Company's  participation in the substantial growth
of the wireless  communications  market and sales to a single major  customer in
that industry. In 1996, the Company's sales declined, largely as a result of the
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.

         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, nearly
59 percent of revenue occurred in the third and fourth  quarters.  In 1998, this
type of revenue  pattern  is  expected  to be  repeated,  possibly  with an even
greater percentage of the overall 1998 revenue occurring in the 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  and  second
quarters of 1998 are now not  expected to begin to ramp up until the second half
of 1998.

         The  Company's  backlog at June 30, 1998 was $25.9  million as compared
with $39.2  million  at March 31,  1998.  This  reduction  in  backlog  occurred
primarily  because several  significant new programs were delayed by a customer.
As a result,  the net additions to the backlog (after being reduced by the sales
in the second quarter) were lower than normal while these programs were on hold.
If these programs are released and begin to ramp up their  production  levels in
1998 as anticipated, the backlog would increase.
                                       8
<PAGE>

         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  did 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 just over  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  later
in this year. For the first half of 1998, Motorola accounted for 49.4 percent of
revenue and Hewlett-Packard accounted for 11.6 percent of revenue.

         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 the second half of 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 secure sales to certain
strategic customers, the Company may aggressively price its products.  Depending
on the size of the programs achieved, such pricing strategies could also have an
effect on overall margins.

         The Company has begun the start-up of its China-based  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 continues ramping up its manufacturing  operations in China, it will
incur costs in advance of the  receipt of  significant  revenues.  In the second
quarter of 1998,  the  Company  incurred  $543,000  of  incremental  China-based
expenses  in the total cost of sales.  Those  incremental  expenses,  which were
somewhat lower than expected,  arise mainly from  under-absorption  of the China
facility  and are included in the cost of sales,  thus  reducing  overall  gross
margins.  The  Company's  expectation  is that  there  will also be  incremental
China-based expenses in the third quarter but that the China facility will begin
to operate  profitably  in the  fourth  quarter,  although  gross  margins  will
initially  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 maintaining  operations in
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.

         The large inventory  balance as of June 30, 1998 means that the Company
will have lower than normal inventory  purchases during the third quarter.  As a
result,   under-absorption   of  material  overhead  costs  will  likely  occur,
increasing the costs of goods sold and reducing margins.

         Serving a variety  of  customers  with  complex  and  differing  issues
requires  increased  personnel  committed  to those  customers.  As the  Company
expands and  diversifies  its product and customer  base, the Company has had to
increase its  selling,  general,  and  administrative  expenses.  The volume and
complexity of the Company's  business is expected to continue to grow throughout
the remainder of 1998. Therefore,  the Company anticipates that it will increase
its selling and administrative expenses over those incurred in 1997.
                                       9
<PAGE>
        The  Company  believes  that  continued  investments  in  research  and
development  relating to new display technology and manufacturing  processes are
necessary to remain competitive in the marketplace and provide opportunities for
growth.  The Company continues to expand and intensify its internal research and
development  to focus on  proprietary  display  products as well as continue LCD
manufacturing process improvements.  Use of the LCD manufacturing line in Tempe,
Arizona as a  resource  for  testing  new ideas is key to  development  of these
products, some of which will be proprietary and not available from other display
manufacturers.  Further,  the development of the high-volume  manufacturing  LCD
line has helped  reduce the  Company's  dependence  on foreign  suppliers of LCD
glass.

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

         In August  1997,  National  Semiconductor  Corporation  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 research and development  expenditures in 1998 will increase over
1997 by at least 30 percent.

         As  mentioned   previously,   the  Company  has  decided  to  establish
manufacturing  operations  in The  People's  Republic of China.  An  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.  During  the first
quarter of 1998,  a temporary  leased site was  selected in Beijing,  as was the
permanent  site.  The Company has moved into the  temporary  site and set up two
manufacturing lines.

         The Company has  established a China-based  manufacturing  operation in
1998 for several reasons.  First, based upon growth expectations in the European
and United States marketplaces, the Company anticipates a need for manufacturing
capacity  beyond what is available  at its  Philippine  manufacturing  facility.
China was selected  because of the desire to diversify  manufacturing  locations
and  because of the cost  benefits  that are  expected  to be achieved in China.
China is also  expected to be a  synergistic  business  location for the Company
because many of the components  used by the Company are  manufactured  in China.
Second,  many  of  the  Company's  existing  and  potential  customers  maintain
manufacturing  operations  near the China  location.  Despite the current  Asian
economic  situation,  those  customers  continue  to require LCD modules and the
Company has limited  participation in that market.  There currently are very few
LCD module  manufacturers  in China.  Under current  Chinese  government  rules,
however,  OEMs in China have a strong motivation to utilize locally manufactured
components.  As mentioned  above, the Company start-up costs associated with its
China-based  operations will 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,
inventory balances and production orders. The Company's future operating results
may be affected by various  trends,  developments,  and factors that the Company
must successfully  manage in order to achieve its goals. In addition,  there are
                                       10
<PAGE>

trends,  developments,  and factors beyond the Company's control that may affect
its operations.  The cautionary  statements and risk factors set forth below and
elsewhere  in  this  document,  and in the  Company's  other  filings  with  the
Securities and Exchange  Commission,  especially Form 10-K,  identify  important
trends,  factors,  and  currently  known  developments  that could cause  actual
results  to  differ  materially  from  those in any  forward-looking  statements
contained in this report and in any written or oral statements of the Company.

         A few core  customers are currently  responsible  for a majority of the
Company's revenue,  and the Company expects the high  concentration  levels with
its  core  customers  to  continue  through  1998.  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.  In May 1998,
the  Company  announced  that  delays in certain  digital  cellular  programs by
Motorola would  contribute to lower than expected sales in the second quarter of
1998. Some of those programs are still delayed, and it is generally acknowledged
that Motorola has lost market share in the digital cellular market.

         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.

         The Company  currently holds a very large inventory balance as a result
of delays in certain  programs by customers  announced during the second quarter
of 1998.  The Company has analyzed the  inventory  balance and believes that the
inventory will be utilized because most of the unreserved  inventory  relates to
new  programs.  There is a risk  that if some or all of those new  programs  are
canceled, however, the Company could be left with excess inventory.

         Another  risk  inherent  in custom  manufacturing  is the  satisfactory
completion of design services and securing of production  orders.  A significant
portion of the  Company's  anticipated  revenue  for the  future  will come from
programs  currently in the design or pilot production  stage.  Completion of the
design is dependent on a variety of factors,  including the customer's  changing
needs,  and not every design is successful in meeting those needs.  In addition,
some  designs  test new  theories or  applications  and may not meet the desired
results.  Failure of a design order to achieve the  customer's  desired  results
could result in a material  adverse  effect on the  Company's  operations if the
expected production order for that product was significant. Finally, even when a
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
                                       11
<PAGE>

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.

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

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

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

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

         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.
                                       12
<PAGE>
                           PART II. OTHER INFORMATION

ITEM 4.       SUBMISSIONS OF MATTERS TO A VOTE OF SECURITY HOLDERS

         The  Company's  Annual  Meeting of  Stockholders  was held on April 23,
1998.  All of the nominees were elected to the  Company's  Board of Directors as
set forth in the Proxy Statement as follows:

         Nominees                   Votes in Favor                Against
         --------                   --------------                -------
         David R. Buchanan             6,787,632                  284,566
         David C. Malmberg             6,787,112                  285,086
         Burton E. McGillivray         6,791,712                  280,486
         Kenneth M. Julien             6,738,837                  332,361
         Gary R. Long                  6,747,552                  324,646

There were 55,075  exceptions  (abstentions) in total on the Board of Director's
nominee voting.

         The  following   items  were  also  voted  upon  and  approved  by  the
Stockholders:

         (a) To approve  the  Company's  new 1998 Stock  Option  Plan (the "1998
Plan").
                       Votes in Favor             Opposed          Abstain
                       --------------             -------          -------
                         6,571,622                398,811          101,765

         (b) To ratify the  appoint of Arthur  Andersen  LLP as the  independent
auditors of the Company for the fiscal year ending December 31, 1998.

                       Votes in Favor             Opposed          Abstain
                       --------------             -------          -------
                         6,972,951                 67,409           31,838

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

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

              EXHIBIT 27:  Financial Data Schedule

         (b)  Reports on Form 8-K:  None

                                       13
<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: July 17, 1998                          By:  /s/ Jeffrey D. Buchanan
       -------------                             ----------------------------
                                              Name: Jeffrey D. Buchanan
                                              Its:  Executive Vice President; 
                                                    Chief Financial Officer



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