##### Table of Contents



SECURITIES AND EXCHANGE
COMMISSION    FORM 10-Q 
 For the Quarter Ended March 31, 2004 Commission file number 1-4373   THREE-FIVE SYSTEMS, INC.   Delaware
    
    86-0654102(State or Other Jurisdiction
of Incorporation or Organization)
    
    (I.R.S. Employer Identification No.)
 1600 North Desert Drive, Tempe, Arizona
    
    85281(Address of Principal Executive Offices)
    
    (Zip Code)
 (602) 389-8600   Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES [X] NO [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). YES [X] NO [  ] Indicate the number of shares outstanding of each of the issuers classes of
common stock, at the latest practical date. CLASS
    
    OUTSTANDING AS OF APRIL 30, 2004Common Stock,
    
    
    21,334,540par value $.01 per share




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THREE-FIVE SYSTEMS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR QUARTER ENDED MARCH 31, 2004
TABLE OF CONTENTS PagePART IITEM 1. FINANCIAL STATEMENTS (UNAUDITED):CONDENSED CONSOLIDATED BALANCE SHEETS - DECEMBER 31, 2003 AND MARCH 31, 2004
    
    
    1CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS - THREE MONTHS ENDED MARCH 31, 2003 AND 2004
    
    
    2CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS - THREE MONTHS ENDED MARCH 31, 2003 AND 2004
    
    
    3NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
    
    
    4ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
    
    
    9ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
    
    
    18ITEM 4. CONTROLS AND PROCEDURES
    
    
    18PART IIITEM 5.OTHER INFORMATION
    
    
    20ITEM 6.EXHIBITS AND REPORTS ON FORM 8-K
    
    
    20SIGNATURES
    
    
    21EX-31.1EX-31.2EX-32.1EX-32.2




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ITEM 1. FINANCIAL STATEMENTS THREE-FIVE SYSTEMS, INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
 DECEMBER 31,
    
    MARCH 31,2003
    
    2004ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    27,976
    
    
    $
    21,490Cash on deposit maintained as compensating balance
    
    
    
    
    
    
    5,000Short-term investments
    
    
    5,130
    
    
    
    Accounts receivable, net
    
    
    28,133
    
    
    
    24,253Inventories
    
    
    25,854
    
    
    
    28,268Income taxes receivable
    
    
    678
    
    
    
    Deferred tax asset
    
    
    130
    
    
    
    122Assets held for sale
    
    
    8,615
    
    
    
    8,615Other current assets
    
    
    2,782
    
    
    
    3,860Total current assets
    
    
    99,298
    
    
    
    91,608Property, Plant and Equipment, net
    
    
    25,323
    
    
    
    23,963Intangibles, net
    
    
    7,574
    
    
    
    7,156Goodwill
    
    
    34,606
    
    
    
    34,606Other Assets
    
    
    436
    
    
    
    454Total Assets
    
    $
    167,237
    
    
    $
    157,787LIABILITIES AND STOCKHOLDERS EQUITYCurrent Liabilities:Accounts payable
    
    $
    30,826
    
    
    $
    24,054Accrued liabilities
    
    
    4,917
    
    
    
    5,498Deferred revenue
    
    
    48
    
    
    
    108Current portion of long-term debt
    
    
    1,515
    
    
    
    1,518Current portion of capital leases
    
    
    2,352
    
    
    
    2,410Line of credit
    
    
    
    
    
    
    5,000Total Current Liabilities
    
    
    39,658
    
    
    
    38,588Long-term Debt
    
    
    1,441
    
    
    
    Capital Leases
    
    
    6,543
    
    
    
    6,003Commitments and Contingencies (Note K)Minority Interest in Consolidated Subsidiary
    
    
    2,563
    
    
    
    2,643Stockholders Equity:Common stock
    
    
    220
    
    
    
    220Additional paid-in capital
    
    
    200,930
    
    
    
    200,936Accumulated deficit
    
    
    (74,915
    )
    
    
    (81,559
    )Stock subscription note receivable
    
    
    (185
    )
    
    
    Accumulated other comprehensive loss
    
    
    (515
    )
    
    
    (541
    )Less  treasury stock, at cost
    
    
    (8,503
    )
    
    
    (8,503
    )Total stockholders equity
    
    
    117,032
    
    
    
    110,553$
    167,237
    
    
    $
    157,787
 The accompanying notes are an integral part of these condensed consolidated financial statements 1




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THREE-FIVE SYSTEMS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
 THREE MONTHS ENDEDMARCH 31,2003
    
    2004Net Sales
    
    $
    25,324
    
    
    $
    38,444Costs and Expenses:Cost of sales
    
    
    25,149
    
    
    
    38,665Selling, general and administrative
    
    
    3,727
    
    
    
    5,599Research, development and engineering
    
    
    1,266
    
    
    
    673Gain on sale of assets
    
    
    (13
    )
    
    
    (167
    )Amortization of intangibles
    
    
    511
    
    
    
    51130,640
    
    
    
    45,281Operating loss
    
    
    (5,316
    )
    
    
    (6,837
    )Other Income (Expense):Interest, net
    
    
    296
    
    
    
    (177
    )Other, net
    
    
    9
    
    
    
    338305
    
    
    
    161Minority Interest in Income of Consolidated Subsidiary
    
    
    
    
    
    
    (80
    )Loss From Continuing Operations Before Income Taxes
    
    
    (5,011
    )
    
    
    (6,756
    )Benefit from income taxes
    
    
    (1,814
    )
    
    
    (112
    )Loss From Continuing Operations
    
    
    (3,197
    )
    
    
    (6,644
    )Loss From Discontinued Operation, net of taxes
    
    
    (2,278
    )
    
    
    Net Loss
    
    $
    (5,475
    )
    
    $
    (6,644
    )Loss Per
Common Share  Basic and Diluted:Loss From Continuing Operations
    
    $
    (0.15
    )
    
    
    (0.31
    )Loss From Discontinued Operation
    
    
    (0.11
    )
    
    
    Net Loss
    
    $
    (0.26
    )
    
    $
    (0.31
    )Weighted Average Number of Common Shares:Basic and Diluted
    
    
    21,286
    
    
    
    21,321
 The accompanying notes are an integral part of these condensed consolidated financial statements 2




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THREE-FIVE SYSTEMS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 THREE MONTHS ENDEDMARCH 31,2003
    
    2004CASH FLOWS FROM OPERATING ACTIVITIES:Net loss
    
    $
    (5,475
    )
    
    $
    (6,644
    )Less loss
 discontinued operations
    
    
    (2,278
    )
    
    
    Loss  continuing operations
    
    
    (3,197
    )
    
    
    (6,644
    )Adjustments to reconcile net loss to net cash (used in) provided by
operating activities:Depreciation and amortization
    
    
    1,547
    
    
    
    2,078Minority interest in consolidated subsidiary
    
    
    
    
    
    
    80Deferred revenue
    
    
    352
    
    
    
    60Provision for (reduction of) accounts receivable valuation reserves
    
    
    22
    
    
    
    (5
    )Gain on disposal of assets
    
    
    (13
    )
    
    
    (167
    )Benefit from deferred taxes, net
    
    
    (3,051
    )
    
    
    Foreign currency translation adjustments
    
    
    (9
    )
    
    
    (28
    )Interest on notes payable
    
    
    17
    
    
    
    12Interest on employee loan
    
    
    (3
    )
    
    
    CHANGES IN ASSETS AND LIABILITIES:(Increase) decrease in accounts receivable
    
    
    (305
    )
    
    
    3,885Decrease in inventories
    
    
    (1,488
    )
    
    
    (1,068
    )(Increase) decrease in other assets
    
    
    666
    
    
    
    (58
    )Increase (decrease) in accounts payable and accrued liabilities
    
    
    7,248
    
    
    
    (6,459
    )Increase (decrease) in taxes payable/receivable
    
    
    (92
    )
    
    
    954Net cash (used in) provided by operating activities
    
    
    1,694
    
    
    
    (7,360
    )CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of property, plant, and equipment
    
    
    (241
    )
    
    
    (619
    )Proceeds from sale of assets
    
    
    325
    
    
    
    579Purchase of intangibles
    
    
    (1,025
    )
    
    
    (93
    )Purchase of investments
    
    
    (5,263
    )
    
    
    Proceeds from maturities/sales of short-term investments
    
    
    12,922
    
    
    
    5,132Payments on stock subscription note receivable
    
    
    
    
    
    
    185Acquisitions and strategic investments
    
    
    (5,524
    )
    
    
    (2,384
    )Net cash provided by investing activities
    
    
    1,194
    
    
    
    2,800CASH FLOWS FROM FINANCING ACTIVITIES:Borrowings from line of credit
    
    
    
    
    
    
    5,000Cash pledged for compensating cash arrangement
    
    
    
    
    
    
    (5,000
    )Payments on notes payable
    
    
    (1
    )
    
    
    (1,450
    )Stock options exercised
    
    
    
    
    
    
    6Payments on capital leases
    
    
    
    
    
    
    (482
    )Net cash used in financing activities
    
    
    (1
    )
    
    
    (1,926
    )NET
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 
CONTINUING OPERATIONS
    
    
    2,887
    
    
    
    (6,486
    )NET CASH USED IN AND CONTRIBUTED TO DISCONTINUED
OPERATIONS
    
    
    (1,375
    )
    
    
    NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    
    
    1,512
    
    
    
    (6,486
    )CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    18,389
    
    
    
    27,976CASH AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    19,901
    
    
    $
    21,490NONCASH INVESTING AND FINANCING ACTIVITIES:Note payable due on purchase of distribution rights license
    
    
    2,882
    
    
    
    
 The accompanying notes are an integral part of these condensed consolidated financial statements 3




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THREE-FIVE SYSTEMS, INC. AND
SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)Note A
    
    Three-Five Systems, Inc. (together with its subsidiaries, herein
referred to as we, us, or the Company) is a global provider
of electronics manufacturing services, or EMS. We design and
manufacture electronic circuit printed board assemblies, radio
frequency, or RF, modules, display modules and systems, and
complete systems for customers in the transportation, computing,
consumer, industrial, medical, and telecommunications industries.
Our services include advanced engineering support, designed for
services, automated printed circuit board assembly, in-circuit and
functional testing, systems level integration and box build,
turn-key packaging, fulfillment services, and turn-key supply chain
management services, all of which enable our customers the ability
to outsource all stages of product engineering, design,
development, materials procurement and management, manufacturing,
and testing. Our design and manufacturing services include a
distinctive competence in display modules and systems and the
integration of display modules and systems into other products.
The display modules and systems we design and manufacture include
monochrome and color liquid crystal display, or LCD, components,
organic light emitting diodes, or OLEDs, cathode ray tubes, or
CRTs, and flat panel monitors.On September 1, 2003, we transferred all of the net assets of our
microdisplay division, plus approximately $20.9 million in cash,
into a newly created Delaware corporation called Brillian
Corporation. On September 15, 2003, we spun off Brillian by
distributing all of the outstanding common stock of Brillian to our
stockholders on a pro rata basis, with each of our stockholders
receiving one share of Brillian common stock for every four shares
of our common stock. Brillian is now traded on the Nasdaq National
Market under the symbol BRLC. Brillian had $44.1 million of net
assets on the spin-off date. The microdisplay business that we
transferred to Brillian is now reported in these consolidated
financial statements as Discontinued Operations.Note B
    
    Inventories:Inventories are stated at the lower of cost (first-in, first-out)
or net realizable value and consisted of the following at (in
thousands):
 December 31,
    
    March 31,2003
    
    2004Raw materials
    
    $
    14,188
    
    
    $
    18,825Work-in-process
    
    
    5,321
    
    
    
    3,371Finished goods
    
    
    6,345
    
    
    
    6,072$
    25,854
    
    
    $
    28,268
 Shipping terms with one of our major customers is FOB destination, and
many of those products are shipped by sea, taking four to six weeks to
reach their destination. As a result, product in transit that was in our
finish goods inventory was $3.4 million as of March 31, 2004 compared to
$3.6 million as of December 31, 2003.During the fourth quarter of 2003, we learned from a customer that a
product shipped by us to them contained potentially defective parts.
Those potentially defective parts were printed circuit boards supplied to
us by a vendor specified by our customer. At year-end 2003, we believed
the parts could be repaired or that the component supplier would
reimburse us for the damages. We determined in the first quarter of 2004
that the latent defect in the materials purchased is not repairable. As a
result, we established a reserve for the value of that inventory, which
included other component parts that had already been included on those
boards less the $158,000 value of the boards for which the supplier is
obligated to repay at a minimum. The amount reserved was just over $1.0
million. It is our belief that that the liability for such inventory lies
with the vendor of the defective printed circuit board; therefore, we
will pursue recovery for such liability. Such recovery is still
uncertain, so, we have not taken into account any potential recovery when
establishing the reserve amount.
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At year-end 2003, we held $778,000 of inventory relating to a program
cancelled by a customer. At that time, we believed we would recover the
carrying value of this inventory and did not establish a reserve. After
further discussions and negotiations with this customer during the first
quarter of 2004, we wrote off $332,000 of this inventory while receiving
settlement against the remainder of the inventory.Note C
    
    Property, Plant, and Equipment:Property, plant, and equipment consisted of the following at (in thousands):
 December 31,
    
    March 31,2003
    
    2004Land and building
    
    $
    6,122
    
    
    $
    6,060Furniture and equipment
    
    
    40,907
    
    
    
    41,08947,029
    
    
    
    47,149Less accumulated depreciation
    
    
    (21,706
    )
    
    
    (23,186
    )$
    25,323
    
    
    $
    23,963
 Note D
    
    Asset Held for Sale:During the fourth quarter of 2003, we formalized plans to sell our Tempe,
Arizona corporate facility; therefore, we reclassified $8.6 million of
our building and improvements to assets held for sale. The building was
listed and actively marketed for sale at the beginning of October 2003;
therefore, no depreciation expense has occurred since the third quarter
of 2003Note E
    
    Intangibles:In January 2003, we signed licensing and manufacturing agreements with Data International Co., Ltd. of Taiwan. Under
those agreements, we became the exclusive channel in the Americas for standard and custom LCD products manufactured by
Data International. We also have the right to sell those products through our worldwide channels. The agreements
provide us with access to a full suite of standard display products that round out our existing standard product
portfolio. The cost of the license was $3.9 million, of which $1.0 million was paid upon signing and we entered into a
$2.9 million term loan. In the first quarter of 2004, we paid $1.4 million against the term loan. The unpaid $1.5
million is due in January 2005 and is subject to reduction if certain margin targets are not met.Intangibles consist of mask works, trademarks, customer lists, and distribution rights. SFAS 142, Goodwill and Other
Intangible Assets, requires purchased intangible assets with definitive lives to be amortized over their useful lives.
Purchased intangibles are recorded at cost and amortized using the straight-line method over the estimated useful lives
of the respective assets, which range from three to five years. Our policy is to commence amortization of intangibles
when their related benefits begin to be realized.Intangible assets consisted of the following (in thousands) at December 31, 2003 and March 31, 2004:
 Accumulated
    
    Book
    
    WeightedDecember 31, 2003
    
    Acquisition Value
    
    Amortization
    
    Value
    
    Avg LifeAmortized Intangible Assets:Mask works
    
    $
    991
    
    
    $
    
    
    
    $
    991
    
    
    
    3.0Customer lists
    
    
    5,000
    
    
    
    (1,523
    )
    
    
    3,477
    
    
    
    4.2License
    
    
    3,882
    
    
    
    (776
    )
    
    
    3,106
    
    
    
    5.0$
    9,873
    
    
    $
    (2,299
    )
    
    $
    7,574
    
    
    
    4.4
 5




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Accumulated
    
    Book
    
    WeightedMarch 31, 2004
    
    Acquisition Value
    
    Amortization
    
    Value
    
    Avg LifeAmortized Intangible Assets:Mask works
    
    $
    1,084
    
    
    $
    
    
    
    $
    1,084
    
    
    
    3.0Customer lists
    
    
    5,000
    
    
    
    (1,839
    )
    
    
    3,161
    
    
    
    4.2License
    
    
    3,882
    
    
    
    (971
    )
    
    
    2,911
    
    
    
    5.0$
    9,966
    
    
    $
    (2,810
    )
    
    $
    7,156
    
    
    
    4.4
 Intangible asset amortization expense for both the three months ended
March 31, 2003 and 2004 was $511,000.Estimated annual amortization expense through 2008 and thereafter related
to intangible assets reported as of March 31, 2004 is as follows (in
thousands):
 Fiscal Year2004
    
    $
    2,2632005
    
    
    2,3442006
    
    
    1,7352007
    
    
    1,3152008
    
    
    4Thereafter
    
    
    6$
    7,667
 Note F
    
    Segment Information:We offer advanced design and manufacturing services with an emphasis on
displays. Historically, we focused on display-oriented products,
although we have always performed extended manufacturing in conjunction
with the display module. In the past 15 months, we expanded the
value-added manufacturing services we provide through several
acquisitions. As a result, we now provide printed circuit board assembly,
or PCBA, radio frequency, or RF, module assembly, new product
introduction, or NPI, box build, and order fulfillment, even in products
that do not need displays. In products that do include displays, we
specialize in custom and standard display solutions utilizing various
display technologies, including liquid crystal displays, or LCDs, organic
light emitting diodes, or OLEDs, and cathode ray tubes, or CRTs. The
products we manufacture for customers are of varying sizes and have
varying levels of integration.As a result of the spin-off of our microdisplay division through
Brillian, we now report only one operating segment, although we also
track net sales and certain property, plant, equipment, and intangibles
by geographic location. Net sales by geographic area are determined based
upon the location of the end customer, while long-lived assets are based
upon physical location of the assets. The following includes net sales
(in thousands) for our designated geographic areas:
 NorthAmerica
    
    Asia
    
    Europe
    
    TotalMarch 31, 2003Net sales
    
    $
    15,760
    
    
    $
    6,670
    
    
    $
    2,894
    
    
    $
    25,324Property, plant, equipment, and intangibles, net
    
    
    20,066
    
    
    
    14,072
    
    
    
    4
    
    
    
    34,142Goodwill
    
    
    34,094
    
    
    
    
    
    
    
    
    
    
    
    34,094March 31, 2004Net sales
    
    $
    21,601
    
    
    $
    5,393
    
    
    $
    11,450
    
    
    $
    38,444Property, plant, equipment, and intangibles, net
    
    
    10,855
    
    
    
    20,252
    
    
    
    12
    
    
    
    31,119Goodwill
    
    
    34,291
    
    
    
    315
    
    
    
    
    
    
    
    34,606
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In the first quarter of 2004, our sales were distributed over six major
markets: transportation, computing, consumer, industrial, medical, and
telecommunications. Our net sales distributed by market were as follows:
 Three Months EndedMarch 312003
    
    2004Computing
    
    
    42.9
    %
    
    
    47.7
    %Telecom
    
    
    26.9
    %
    
    
    16.8
    %Industrial
    
    
    10.2
    %
    
    
    11.3
    %Medical
    
    
    17.2
    %
    
    
    9.6
    %Consumer
    
    
    2.3
    %
    
    
    8.5
    %Transportation
    
    
    0.5
    %
    
    
    6.1
    %
 Note G
    
    Comprehensive loss (in thousands) for the periods was as follows:
 Three Months EndedMarch 31,2003
    
    2004Net loss
    
    $
    (5,475
    )
    
    $
    (6,644
    )Other comprehensive income (loss):Foreign currency translation adjustment
    
    
    (9
    )
    
    
    (28
    )Unrealized gain (loss) on securities, net of
tax securities, net of tax
    
    
    (17
    )
    
    
    2Comprehensive loss
    
    $
    (5,501
    )
    
    $
    (6,670
    )
 Note H
    
    Stock Compensation:Pursuant to the provisions of SFAS No. 123, Accounting for
Stock-Based Compensation, we account for options granted to our
employees pursuant to Accounting Principles Board Opinion (APB) No.
25, Accounting for Stock Issued to Employees, under which no
compensation cost has been recognized. However, we have computed
compensation cost, for pro forma disclosure purposes, based on the
fair value of all options awarded on the date of grant, utilizing
the Black-Scholes option pricing method with the following weighted
assumptions: risk-free interest rates of 2.78% and 2.80% for the
three months ended March 31, 2003, and 2004; expected dividend
yields of zero for all scenarios; expected lives of 6.1 years for
2003 and 5.7 years for 2004; and expected volatility (a measure of
the amount by which a price has fluctuated or is expected to
fluctuate during a period) of 74.4% and 79.6% for the three months
ended March 31, 2003 and 2004, respectively. The compensation
costs for the three months ended March 31, 2003 are tax-effected
and the compensation costs for the three months ended March 31,
2004 are not tax-effected. Had compensation cost for these plans
been determined consistent with SFAS No. 123, our net loss and loss
per share would have been as follows (in thousands, except per
share data):
 Three Months EndedMarch 31,2003
    
    2004Net loss:As reported
    
    $
    (5,475
    )
    
    $
    (6,644
    )Total stock-based compensation expenses
determined under fair value based method for
all awards, net of related tax effects
    
    
    (764
    )
    
    
    (1,851
    )Pro forma net loss
    
    $
    (6,239
    )
    
    $
    (8,495
    )Basic and diluted net loss per share:As reported
    
    $
    (0.26
    )
    
    $
    (0.31
    )Pro forma
    
    
    (0.29
    )
    
    
    (0.40
    )
 7




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Note I
    
    Earnings Per Share:Basic net loss per common share is computed by dividing net loss by
the weighted average number of common shares outstanding during the
year before giving effect to stock options and warrants considered
to be dilutive common stock equivalents. Diluted net loss per
common share is computed by dividing net loss by the weighted
average number of common shares outstanding during the year after
giving effect to stock options and warrants considered to be
dilutive common stock equivalents. Set forth below (in thousands)
are the disclosures required pursuant to SFAS No. 128  Earnings
per Share:
 Three Months EndedMarch 31,2003
    
    2004Basic and diluted loss per share:Net loss
    
    
    (5,475
    )
    
    
    (6,644
    )Weighted average common shares
    
    
    21,286
    
    
    
    21,321Basic and diluted loss per share amount
    
    $
    (0.26
    )
    
    $
    (0.31
    )
 For the three months ended March 31, 2003 and 2004, the effect of 8,638
and 224,004 shares, respectively, were excluded from the calculation of
loss per share as their effect would have been antidilutive and decreased
the loss per share.Note J
    
    Debt:In the first quarter of 2004, we entered into a credit facility with
First National Bank. That $5.0 million credit facility, which matures in
June 2004, is secured by a restricted cash deposit. We borrowed the full
amount of $5.0 under that credit facility in the first quarter of 2004.
Advances under the facility are made as prime rate advances, which accrue
interest payable monthly at the banks prime lending rate. After the end
of the first quarter of 2004, that loan was repaid in its entirety.In January 2003, we signed a term loan of $2.9 million to Data
International. In the first quarter of 2004, we paid $1.4 million against
the term loan. The unpaid $1.5 million is due in January 2005 and is
subject to reduction if certain margin targets are not met.Note K
    
    Commitments and Contingencies:In February 2002, we guaranteed up to $500,000 of the debt of a private
start-up company, VoiceViewer Technology, Inc., which is developing
microdisplay products. This guarantee was assumed by Brillian Corporation
in the spin-off. As we have not yet been released from our obligation on
the guarantee, if Brillian becomes required to pay on the guarantee and
is unable to satisfy its obligation, we would be secondarily liable and
would be required to pay this guarantee to the lender. As of March 31,
2004, the outstanding balance on the debt was $398,000. This loan
guarantee has a five-year term and matures in January 2007.We are also included in certain legal and administrative proceedings
arising in the normal course of business. In our opinion, the ultimate
settlement of these legal and administrative proceedings will not
materially impact our financial position or results of operations.Note L
    
    Recently Issued Accounting Standards:In November 2002, the FASB issued FASB Interpretation No. 46 (FIN
46), Consolidation of Variable Interest Entities, which
clarifies the application of Accounting Research Bulletin No. 51,
Consolidated Financial Statements, relating to consolidation of
certain entities. This interpretation was subsequently revised by
FIN 46 (Revised 2003) in December 2003. This interpretation states
that consolidation of variable interest entities will be required
by the primary beneficiary if the entities do not effectively
disperse risk among the parties involved. The requirements are
effective for fiscal years ending after
 8




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December 15, 2003. We have no variable interest entities and do not
believe that FIN No. 46 (R) will impact our future financial results.Note
M Subsequent Events:In the second quarter of 2004, we agreed with Unico Holdings to exchange
its ownership interest in TFS Electronic Manufacturing Services Sdn. Bhd.
(TFS-Malaysia) for approximately 423,000 shares of our common stock in
a transaction valued at approximately $2.5 million, which is an amount
equal to Unico Holdings original purchase price for TFS-Malaysia. As a
result of that transaction, we will own 100% of TFS-Malaysia.In April, 2004, we purchased our facility in Manila from our lessor and
paid $3.8 million. Of the $3.8 million paid, $3.0 million will be
assigned to the carrying value of the building and $788,000 will be
applied to accrued rent liabilities. We also paid $614,000 to the RBF
Development Corporation (RBF) for a 50 year land right. The 50 year
land right is still awaiting formal approval by the Philippine Department
of Trade and Industry. If not approved, the land right agreement will be
changed to a 25 year lease agreement with RBF. Lastly, we also executed
an agreement with RBF for the option to purchase the leased land for $1
at any time until April 23, 2014. As a result of the building purchase
and land right agreement, we will no longer be required to pay the $7.8
million over the next 7 years that was remaining on our original ten year
lease agreement.
 
 ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 FORWARD-LOOKING STATEMENTS AND FACTORS THAT MAY AFFECT RESULTS The statements contained in this report on Form 10-Q that are not purely
historical are forward-looking statements within the meaning of applicable
securities laws. Forward-looking statements include statements regarding our
expectations, anticipation, intentions, beliefs, or strategies
regarding the future. Forward-looking statements also include statements
regarding revenue, margins, expenses, and earnings analysis for fiscal 2003 and
thereafter; technological innovations; future products or product development;
our product development strategies; potential acquisitions or strategic
alliances; the success of particular product or marketing programs; the amounts
of revenue generated as a result of sales to significant customers; and
liquidity and anticipated cash needs and availability. All forward-looking
statements included in this report are based on information available to us as
of the filing date of this report, and we assume no obligation to update any
such forward-looking statements. Our actual results could differ materially
from the forward-looking statements. Overview Current Operations We are a global provider of electronics manufacturing services, or EMS. We
design and manufacture printed circuit board assemblies, radio frequency, or
RF, modules, display modules and systems, and complete systems for customers in
the transportation, computing, consumer, industrial, medical, and
telecommunications industries. Our services include advanced engineering
support, designed for services, automated printed circuit board assembly,
in-circuit and functional testing, systems level integration and box build,
turnkey packaging, fulfillment services, and turnkey supply chain management
services, all of which enable our customers the ability to outsource all stages
of product engineering, design, development, materials procurement and
management, manufacturing, and testing. Our design and manufacturing services
include a distinctive competence in display modules and systems and the
integration of display modules and systems into other products. These display
modules and systems we design and manufacture include monochrome and color
liquid crystal display, or LCD, components, organic light emitting diodes, or
OLEDs, cathode ray tubes, or CRTs, and flat panel monitors. The products we manufacture for customers are of varying sizes and have
varying levels of integration. The typical design program life cycle of a
custom-designed product is three to 15 months and includes technical 9




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design, prototyping, pilot manufacturing, and high-volume manufacturing.
The cycle is shorter in products where no display is involved and/or where the
customer has already completed the design. Several factors impact our gross margins, including manufacturing
efficiencies, product mix, product differentiation, product uniqueness,
inventory management, and volume pricing. We have factories in Washington and
Massachusetts in the United States and in the Philippines, Malaysia, and China.
In Washington and in Malaysia, we provide engineering support, automated
printed circuit board assembly, in-circuit and functional testing, systems
integration and box build, complete supply chain management, and turnkey
packaging and fulfillment services. In Massachusetts, we provide aftermarket
customization of flat panel displays and CRTs. In the Philippines and China, we
assemble displays into modules and are adding some of the manufacturing
services offered in Washington and Malaysia. We also assemble RF modules in the
Philippines. In the first quarter of 2004, we announced that we are
consolidating our overseas LCD module operations in China. Once that
consolidation has occurred, the Philippines facility will focus exclusively on
RF modules. Selling, general, and administrative expense consists principally of
administrative and selling costs; salaries, commissions, and benefits to
personnel; and related facility costs. In general, these costs have risen as a
result of the acquisitions we have completed in the last 15 months. We make
substantially all of our sales directly to customers through a sales force that
consists mainly of direct technical sales persons, but also includes a small
representative network. As a result, there is no material cost of distribution
in our selling, general, and administrative expense. Research, development, and engineering expense consists principally of
salaries and benefits to design engineers and other technical personnel,
related facility costs, process development costs, and various expenses for
projects, including new product development. In general, these costs have
declined in the last few years because we no longer do any pure research work.
Thus, most of our expense relates to the development engineering costs
associated with preproduction design and prototyping of custom products and the
conceptual formulation and design of potential standard display products. We
also have moved some of our engineering resources to Asia, resulting in lower
costs. We also incur expenses relating to the amortization of intangibles. Those
expenses relate to amortizable intangibles acquired in acquisitions as
described below. Future Operations Our long-term model is to have gross margins of 12 percent to 14 percent
and operating costs of between six percent and eight percent of revenue. Our
goal is to achieve an interim model within 15 months of 10 percent to 12
percent gross margins with operating costs of between eight percent and 11
percent of revenue. The drivers to achieving our long-term and interim models
are improving the utilization of our off-shore factories through increased
revenue and improving our gross margins by focusing on markets, like gaming and
medical, that value our unique combination of global EMS capabilities and
display expertise. Historic Operations Prior to 2002, our business strategy was to seek large-volume display
programs from major original equipment manufacturers, or OEMs, typically
100,000 units per year or higher, with selling prices of approximately $7 per
unit. Although our focus was designing and manufacturing display modules, we
often engaged in extended contract manufacturing services for other items
related to the display modules, such as printed circuit boards, keyboards,
microphones, speakers, plastic housing, and other similar components. We also
manufactured liquid crystal displays glass cells from 1995 to 2002. From 1998
to 2002, substantially all of our large volume business was in providing
display modules for Motorola handsets. In 2001, new monochrome design wins in
that business became unprofitable; thus, we began to refocus our strategy to
expand our customer base and our product and service offering. We further
modified our strategy in late 2002 to expand our manufacturing services to
include products that do not need displays. As a result of the foregoing, we have substantially changed our business
since late in 2002. We have reduced our concentration in Motorola revenue. The
selling price of the products we manufacture and sell now range 10




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up to $4,000 per unit. We have numerous customers in six principal
markets. We have expanded our business both through organic growth and through
the acquisitions of AVT, ETMA, Unico, and Integrex. We have also expanded
through the license arrangement with Data International and through our
manufacturing agreement with Microtune. The substantial shift in our business strategy has resulted in increased
selling and administrative costs. By previously focusing on one market and one
customer, we were able to maintain selling, general and administrative at a
very low level. By contrast, we now have many more customers requiring more
sales interface. In addition, administrative costs have increased as we have
increased the number of operating locations in the United States and around the
world. In addition, as a result of the Sarbanes-Oxley Act of 2002, we have
incurred additional administrative expenses, such as additional auditing fees
and the costs related to the establishment of an internal auditing function.
In addition, the shift in sales strategy from a high-volume focus to a more
value-add focus has resulted in reduced volumes at higher selling prices. The
reduced volumes have resulted in some excess capacity at our factories
overseas. Acquisitions and Strategic Transactions In September 2002, we purchased the assets and ongoing business of AVT,
located in Marlborough, Massachusetts, a privately held company that
specializes in the design and integration of complex, high-resolution display
systems. As a result, we now design and provide customized and ruggedized flat
panel, touchscreen, and rackmount systems for OEMs in the industrial and
medical markets. We outsource display components from a variety of companies,
including Sony, Sharp, NEC, LG, and Samsung. The purchase price of the
acquisition was $12.0 million, which we paid entirely in cash. In December 2002, we purchased the stock of ETMA Corporation, located in
Redmond, Washington, a privately held electronic manufacturer for OEM customers
in the computer peripheral, medical monitoring, and Internet security
industries. As a result, we now offer the manufacturing capabilities of five
surface mount manufacturing lines, including one dedicated to new product
introduction and prototyping activity. We also provide engineering support,
automated printed circuit board assembly, in-circuit and functional testing,
systems integration and box build, complete supply chain management, and
turnkey packaging and fulfillment services. The purchase price of the ETMA
acquisition was $38.1 million, which we paid entirely in cash. In January 2003, we signed licensing and manufacturing agreements with
Data International Co., Ltd. of Taiwan. Under those agreements, we became the
exclusive channel in the Americas for standard and custom LCD products
manufactured by Data International. We also have the right to sell those
products through our worldwide channels. The agreements provide us with access
to a full suite of standard display products that round out our existing
standard product portfolio. In conjunction with the agreement, we established a
sales office in Orlando, Florida, and hired sales and applications engineering
personnel from a distributor that had previously supported Data Internationals
products. The cost of the license was $3.9 million, of which $1.0 million was
paid upon signing and we entered into a $2.9 million term loan. In the first
quarter of 2004, we paid $1.4 million against the term loan. The remaining $1.5
million is due in January 2005 and is subject to reduction if certain margin
targets are not met. In March 2003, we signed an agreement with Microtune, Inc. in which we
agreed to manufacture, assemble, and test Microtunes radio frequency, or RF,
tuner modules and wireless module products in our manufacturing facility in
Manila, the Philippines. As part of the agreement, Microtune sold to us certain
of its own equipment and inventory for $8.2 million, of which $2.7 million was
a note payable due in September 2003, and contracted with us to provide 100% of
Microtunes current demand for fully assembled RF subsystems. We also hired
approximately 500 Microtune employees in Manila. In October 2003, we paid off
approximately $300,000 of the $2.7 million note payable to Microtune and
entered into an agreement to cancel the remaining $2.4 million balance on that
note in exchange for the return of certain excess inventory to Microtune. As a
result of this transaction, we now provide 100% of the manufacturing
outsourcing for Microtunes RF module products. In April 2003, we acquired the business and certain assets of Unico
Technology Bhd., a privately held Malaysian company located in Penang. Unico
was an electronic manufacturer for OEM customers in the computer, computer
peripheral, and communications industries. The Unico business was acquired by
TFS Electronics Manufacturing Services Sdn. Bhd., or TFS-Malaysia, a joint
venture owned 60% by an overseas TFS subsidiary and 40% by Unico Holdings Bhd.,
the former parent of Unico. Unico Holdings is the investment arm of the Chinese 11




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Chamber of Commerce of Malaysia. Our share of the initial cost of capitalizing
TFS-Malaysia was $3.8 million and Unico Holdings share was $2.5 million, most
of which was used for working capital. TFS-Malaysia purchased $4.1 million in
inventory from Unico, of which $2.7 million was paid at the time of the
purchase and $1.4 million was subsequently paid. No advance payment was
required for the acquisition of the property, plant, and equipment of Unico,
all of which is leased from the seller. The equipment lease is accounted for as
a capital lease payable by TFS-Malaysia. The principal balance on that lease
was $7.6 million as of March 31, 2004. In the second quarter of 2004, we agreed
with Unico Holdings to exchange its ownership interest in TFS-Malaysia for
approximately 423,000 shares of our common stock in a transaction valued at
approximately $2.5 million, which is an amount equal to Unico Holdings
original purchase price for TFS-Malaysia. As a result of that transaction, we
will own 100% of TFS-Malaysia. In February 2004, we entered into a transaction with Integrex, a
Seattle-based electronics manufacturing services company liquidating its
business. Under that transaction, we bought the raw materials inventory of
Integrex for $1.4 million and hired certain of its employees. We also obtained
the rights to most of its customers and agreed with those customers that we
would manufacture those customers products in our Redmond manufacturing
facility. In exchange for those customer rights, we agreed to pay a license
fee for between 15 and 24 months based on revenue receipts from former Integrex
customers. In February of 2004 and at a second closing in April 2004, we paid
non-refundable license fees to Integrex. The nonrefundable license fees total
$1.3 million. At the second closing in April, we also acquired $300,000 of
capital equipment. Discontinued Operations On September 1, 2003, we transferred all of the net assets of our
microdisplay division, plus approximately $20.9 million in cash, into a newly
created Delaware corporation called Brillian Corporation. On September 15,
2003, we spun off Brillian by distributing all of the outstanding common stock
of Brillian to our stockholders on a pro rata basis, with each of our
stockholders receiving one share of Brillian common stock for every four shares
of our common stock. Brillian is now traded on the Nasdaq National Market under
the symbol BRLC. Brillian had $44.1 million of net assets on the spin-off
date. For more information on the reasons for the spin-off, as well as the
description of business and risks associated with the spin-off, please refer to
the Form 10 and other filings by Brillian with the Securities and Exchange
Commission. The microdisplay business that we transferred to Brillian is now
reported in our consolidated financial statements as Discontinued Operations. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of
operations are based upon our financial statements, which have been prepared in
accordance with generally accepted accounting principles (GAAP) in the United
States. During preparation of these financial statements, we are required to
make estimates and judgments that affect the reported amounts of assets,
liabilities, revenue, and expenses and related disclosure of contingent assets
and liabilities. On an on-going basis, we evaluate our estimates and judgments,
including those related to sales returns, bad debts, inventories, fixed assets,
intangible assets, income taxes, and contingencies. We base our estimates on
historical experience and on various other assumptions that we believe are
reasonable under the circumstances. The results form the basis for making
judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our financial
statements. We recognize revenue from product sales when persuasive evidence of a sale
exists; that is, a product is shipped under an agreement with a customer; risk
of loss and title has passed to the customer; the fee is fixed or determinable;
and collection of the resulting receivable is reasonably assured. This means
that when a product is shipped from one of our factories under the terms FOB
Factory then the risk of loss passes to the customer when the product leaves
our factory and we recognize revenue at that time. On the other hand, when a
product is shipped FOB Destination then the risk of loss during transit is
maintained by us. Thus, we recognize revenue when the product is accepted by
the customer. Shipping terms with one of our major customers is FOB
Destination, and many 12




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of those products are shipped by sea, taking four to six weeks to reach
their destination. As a result, we frequently have a significant amount of
product in transit at the end of each quarter and in our finished goods
inventory. We recognize revenue related to engineering and tooling services after
service has been rendered, which is determined based upon completion of
agreed-upon milestones or deliverables. Sales allowances are estimated based upon historical experience of sales
returns. To establish our allowance for doubtful accounts, we perform credit
evaluations of our customers financial condition, along with analyzing past
experience, and make provisions for doubtful accounts based on the outcome of
our credit valuations and analysis. We evaluate the collectability of our
accounts receivable based on specific customer circumstances, current economic
trends, historical experience with collections, and the age of past due
receivables. We believe the allowances that we have established are adequate
under the circumstances; however, a change in the economic environment or a
customers financial condition could cause our estimates of allowances, and
consequently the provision for doubtful accounts, to change. We write down our inventory for estimated obsolescence or unmarketable
inventory. We write down our inventory to estimated market value based upon
assumptions and estimates about future demand and market conditions. If actual
market conditions are less favorable than those projected by us, additional
inventory write-downs may be required. During the fourth quarter of 2003, we learned from a customer that a
product shipped by us to them contained potentially defective printed circuit
boards. Those potentially defective parts were supplied to us by a vendor
specified by our customer. At year-end 2003, we believed the parts could be
repaired or that the component supplier would reimburse us for the damages. We
determined in the first quarter of 2004 that the latent defect in the materials
purchased is not repairable. As a result, we established a reserve for the
value of that inventory, which included other component parts that had already
been included in those boards less the $158,000 value of the components for
which the supplier is obligated to repay at a minimum. The amount reserved was
just over $1.0 million. It is our belief that that the liability for such
inventory lies with the vendor of the defective printed circuit board;
therefore, we will pursue recovery for such liability. Such recovery is still
uncertain, so, we have not taken into account any potential recovery when
establishing the reserve amount. At year-end 2003, we held $778,000 of inventory relating to a program
cancelled by a customer. At that time, we believed we had no liability for this
inventory and did not establish a reserve. After further discussions and
negotiations with that customer during the first quarter of 2004, we wrote off
$332,000 of this inventory while receiving settlement against the remainder of
the inventory. Pursuant to Financial Accounting Standards Board (FASB) Statement of
Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes,
income taxes are recorded based on current year amounts payable or refundable,
as well as the consequences of events that give rise to deferred tax assets and
liabilities. We base our estimate of current and deferred taxes on the tax
laws and rates that are currently in effect in the appropriate jurisdiction.
Changes in tax laws or rates may affect the current amounts payable or
refundable as well as the amount of deferred tax assets or liabilities. At the
end of the second quarter of 2003, we had $19.8 million of net deferred tax
assets, resulting primarily from net operating loss and tax credit
carryforwards. SFAS No. 109 requires that a valuation allowance be established
when it is more likely than not that all or a portion of a deferred tax asset
will not be realized. In determining whether a valuation allowance is
required, we are required to take into account all positive and negative
evidence with regard to the utilization of a deferred tax asset, including our
past earnings history, market conditions, management forecasts of future
profitability, the character and jurisdiction of such earnings, unsettled
circumstances that, if unfavorably resolved, would adversely affect utilization
of a deferred tax asset, carryback and carryforward periods, and tax strategies
that could potentially enhance the likelihood of realization of a deferred tax
asset. SFAS No. 109 further states that it is difficult to conclude that a
valuation allowance is not needed when there is negative evidence such as
cumulative losses in recent years. Therefore, despite the fact that a major
portion of the losses came from our spun-off microdisplay division, the
expectation in the third quarter of 2003 was that we would have three years of
cumulative losses. Those cumulative losses weighed heavily in the overall
required assessment and outweighed our forecasted future profitability and
expectation that we will be able to utilize all of our net operating loss
carryforwards. As a result, in the third quarter of 2003, we recorded a charge
to establish a full valuation allowance against our deferred tax asset. We
expect to continue to 13




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record a full valuation allowance on future tax benefits until we return
to sustained profitability. During 2003, our income tax expense was $14.3
million as a result of our full valuation allowance. Long-term assets, such as property, plant, and equipment, intangibles,
goodwill, and other investments, are originally recorded at cost. On an
on-going basis, we assess these assets to determine if their current recorded
value is impaired. When assessing these assets, we consider projected future
cash flows to determine if impairment is applicable. These cash flows are
evaluated for objectivity by using weighted probability techniques and also
comparisons of past performance against projections. Assets may also be
evaluated by identifying independent market values of assets that we believe to
be comparable. If we believe that an assets value was impaired, we would write
down the carrying value of the identified asset and charge the impairment as an
expense in the period in which the determination was made. Results of Operations Three months ended March 31, 2004 compared to three months ended March 31,
2003 Net Sales.Net sales increased 52% to $38.4 million in the first quarter
of 2004 from $25.3 million in the first quarter of 2003. The increase in year
over year quarterly revenue was primarily a result of growth in our box
build/PCBA business in computing including the addition of TFS-Malaysia. We
also added our RF module business, which increased sales in the transportation
and consumer markets. Although we increased our sales of color display modules
to the telecom market, our monochrome display module sales, a substantial
portion of which were to Motorola in 2003, declined. In fact, Motorola
accounted for less than 10% of our net sales in the first quarter of 2004
compared to 22% in the first quarter of 2003. We had only one customer that
accounted for more than 10% of our net sales in the first quarter of 2004, and
that customer, which is in the computer peripherals business, accounted for 36%
of our net sales. The sales in our top six markets (in thousands) on a
comparative quarterly basis are broken down as follows: Three Months Ended March 31,2003
    
    2004Computing
    
    $
    10,864
    
    
    $
    18,338Telecom
    
    
    6,812
    
    
    
    6,459Industrial
    
    
    2,583
    
    
    
    4,344Medical
    
    
    4,356
    
    
    
    3,691Consumer
    
    
    583
    
    
    
    3,268Transportation
    
    
    126
    
    
    
    2,344TOTAL
    
    
    25,324
    
    
    $
    38,444
 Gross Margin.Our gross margin in the first quarter of 2004 was a
negative $221,000 compared to a positive $175,000 in the first quarter of 2003.
In the first quarter of 2004, we incurred two one-time expense items in our
gross margin totaling $1.8 million, or $0.08 per share. First, as previously
announced, we are consolidating our display module operations in China in order
to streamline our factories and improve our capacity utilization. This
consolidation resulted in approximately $800,000 of planned one-time expenses
in the first quarter relating to employee termination issues in Manila. Second,
we incurred an unplanned inventory write-off of just over $1.0 million,
relating to a suppliers defective component. It is possible that some or that
entire amount will be reimbursed to us by the supplier in the next several
months, although we have no set date for resolution of that issue. Without
these one-time items, our gross margins would have been in the 4% range, which
is comparable with the fourth quarter of 2003. We believe that all of the
product pricing issues, such as color display and RF products, are behind us
now, and the principal impact for the remainder of the year on our gross
margins will be excess factory capacity overseas. Currently, we are about 40%
utilized overseas, but we expect that to rise to over 60% by the end of the
year. These currently reduced manufacturing volumes result in under-absorption
of our fixed manufacturing costs. As we begin to ramp new product builds
overseas in the second half of the year, gross margins should steadily improve. Selling, General, and Administrative Expense.Selling, general, and
administrative expense increased to $5.6 million in the first quarter of 2004
from $3.7 million in the first quarter of 2003. SG&A expense was 15% of 14




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net sales in the first quarter of 2004 and 2003. This increase in SG&A
expense occurred primarily because of additional finance and administrative
expenses of $946,000 associated with our increased infrastructure and
additional selling costs of $926,000 associated with personnel added from
acquisitions and as we expand our market focus. Research, Development, and Engineering Expense.Research, development,
and engineering expense decreased to $673,000 in the first quarter of 2004 from
$1.3 million in the first quarter of 2003. Research, development, and
engineering expense was 2% of net sales in the first quarter of 2004 compared
to 5% in the first quarter of 2003. The decrease in the first quarter of 2004
was due to two reasons. First, we have significantly reduced our pure research
efforts in displays as we have spun off our microdisplay business and become
more of a manufacturing services company versus a product company. Second, we
have continued to move our engineering efforts to Asia, resulting in lower
overall costs. Amortization of Intangibles.The amortization of customer lists of
$511,000 was identical for the first quarters of 2004 and 2003. The
amortization relates to the acquisitions of AVT and ETMA and to the license
agreement with Data International, all described above in Overview. The
amortizable asset associated with AVT is $3.0 million and is being amortized
over five years. The amortizable asset associated with ETMA is $2.0 million and
is being amortized over three years. The amortizable asset associated with Data
International is $3.9 million and is being amortized over five years. Other Income, Net.Other income was $161,000 in the first quarter of 2004
compared to $305,000 in the first quarter of 2003. The composition and
differences of the items that make up other income are as follows (in
thousands): Three Months Ended March 31,2003
    
    2004Interest Income
    
    $
    356
    
    
    $
    108Interest Expense
    
    
    (60
    )
    
    
    (285
    )Rental and Service Income from Brillian
    
    
    
    
    
    
    306Foreign Exchange and Other Gain (Loss)
    
    
    9
    
    
    
    32Other Income, net
    
    
    305
    
    
    
    161
 Interest income decreased as a result of lower cash and short-term investment
balances. Interest expense increased as a result of the capital leases. The
rental and service income from Brillian increased as a result of the spin-off
of our microdisplay business to Brillian Corporation, which is renting part of
our existing building and paying for some information technology services. Minority Interest.We control and own 60% of the business in
TFS-Malaysia. Since that business had a profit in the first quarter of 2004, we
recorded an expense of $80,000 to account for the profits allocated to the
minority interest holder. We had no minority interest partners in the first
quarter of 2003. After the end of the first quarter of 2004, we signed an
agreement to acquire the remaining 40% of TFS-Malaysia and thus we will no
longer have a minority interest line item. Benefit from Income Taxes.We recorded a benefit from income taxes of
$112,000 in the first quarter of 2004 compared to a benefit from income taxes
of $1.8 million for the first quarter of 2003. The benefit in the first quarter
of 2004 related to a tax refunds received. The $1.8 million benefit from taxes
in 2003 added to our deferred tax asset that we later wrote off during the
third quarter of 2003. We recorded a charge in the third quarter 2003 to
establish a valuation allowance against our deferred tax asset, which consists
primarily of net operating loss carryforwards, or NOLs. A further description
of that allowance is described above in Critical Accounting Policies and
Estimates. As a result, we generally no longer record a tax benefit for
losses. Net Loss.Our net loss was $6.6 million, or $0.31 per diluted share, in
the first quarter of 2004 compared to a net loss of $5.5 million, or $0.26 per
diluted share, in the first quarter of 2003. The net loss in the first quarter
of 2003 included $2.3 million, or $0.11 per share, from discontinued operations
relating to our former microdisplay 15




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business. As described above in Discontinued Operations, our microdisplay

division was spun off as a separate public company, as of September 15, 2003. Liquidity and Capital Resources At March 31, 2004, we had cash and restricted cash of $26.5 million
compared to cash and short-term investments of $33.1 million at December 31,
2003. The reductions to these balances over the last three months can be
summarized as follows: Operating Cash Outflows
    
    $
    (7,360
    )Capital Expenditures, Acquisitions and Strategic Investments (a)
    
    $
    (2,517
    )Cash from Borrowings, Net of Debt and Capital Lease Repayments
    
    $
    3,068
 (a) Includes the following line items from page 3 of the Condensed
Consolidated Statements of Cash Flows: purchases of property, plant, and
equipment, proceeds from sale of assets, purchase of intangibles,
acquisitions, and strategic investments. In the first quarter of 2004, we had $7.4 million in net cash outflow from
operations compared to $1.7 million in net cash inflow from operations in the
first quarter of 2003. Our inventory turns were 5.7 and day sales outstanding,
or DSOs, were 62 days in the first quarter of 2004 compared with 5.4 inventory
turns and 60 DSOs in the first quarter of 2003. Our inventory turns were
negatively affected in the first quarter of 2004 because we purchased buffer
stock to insure a smooth move of our module operations from Manila to Beijing.
The calculation of inventory turns for 2003 excluded the inventory purchased
from Microtune at the end of the quarter. DSOs were within our historic
range, but increased in the first quarter of 2004 because of a chronically
late-paying European customer. Our depreciation and amortization expense was
$2.1 million in the first quarter of 2004 compared with $1.5 million in the
first quarter of 2003. During the first quarter of 2004, we incurred capital and intangible
additions of $712,000. This was principally related to our implementation of an
enterprise resource planning, or ERP, platform. In addition, we had proceeds
from the sale of unused equipment equal to $579,000. Thus, we had net capital
additions of $133,000. We also made a $1.4 million payment to Data
International on the term loan that related to the licenses to resell certain
standard products. A final $1.5 million payment on that note is due to Data
International in January 2005. During the first quarter of 2004, we also
consummated the Integrex transaction, described above, for an initial cash
outlay of $2.3 million for inventory and prepaid license fees. In April 2004,
we paid an additional $713,000 to Integrex for license fees and equipment. In April, 2004, we purchased our facility in Manila from our lessor and
paid $3.8 million. Of the $3.8 million paid, $3.0 million will be assigned to
the carrying value of the building and $788,000 will be applied to accrued rent
liabilities. We also paid $614,000 to the RBF Development Corporation (RBF)
for a 50 year land right. The 50 year land right is still awaiting formal
approval by the Philippine Department of Trade and Industry. If not approved,
the land right agreement will be changed to a 25 year lease agreement with the
RBF. Lastly, we also executed an agreement with the RBF for the option to
purchase the leased land for $1 at any time until April 23, 2014. As a result
of the building purchase and land right agreement, we will no longer be
required to pay the $7.8 million over the next 7 years that was remaining on
our original ten year lease agreement. Our working capital was $53.0 million and our current ratio was 2.4-to-1
at March 31, 2004, down from working capital of $59.6 million and a current
ratio of 2.5-to-1 at December 31, 2003. These decreases are primarily because
of reduced cash balances. While we transact business predominantly in U.S. dollars and bill and
collect most of our sales in U.S. dollars, we collect a portion of our revenue
in non-U.S. currencies, such as the Chinese Renminbi. In the future, customers
increasingly may make payments in non-U.S. currencies, such as the Euro. In
addition, we account for a portion of our costs, such as payroll, rent, and
indirect operating costs, in non-U.S. currencies, including Philippine Pesos,
British Pounds Sterling, Malaysian Ringgit, and Chinese Renminbi. Thus,
fluctuations in foreign currency exchange rates could affect our cost of goods
and operating margins and could result in exchange losses. In addition,
currency devaluation can result in a loss to us if we hold deposits of that
currency. Hedging foreign 16




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currencies can be difficult, especially if the currency is not freely
traded. We cannot predict the impact of future exchange rate fluctuations on
our operating results. These currency risks are particularly important since
sales outside North America represented 44% of our net sales in the first
quarter of 2004 and 46% of our net sales in 2003. Sales in foreign markets,
primarily Europe and Asia, to OEMs based in the United States accounted for
almost all of our international sales in each of these periods. We entered into a temporary arrangement with First National Bank in the
first quarter of 2004 under which we borrowed $5.0 million secured by
restricted cash deposits. We used most of those proceeds to purchase our
facility in Manila as described above. After the end of the first quarter of
2004, that loan was repaid in its entirety. We expect to sign one or more
permanent facilities in the second quarter of 2004 secured by various assets
including accounts receivable, inventory and our Tempe building. The following
tables list our contractual obligations and commercial commitments as of March
31, 2004: Payments due by PeriodContractual Obligations
    
    Total
    
    Less
    
    
    
    
    
    
    
    
    
    6 Years(in thousands)
    
    Obligations
    
    than 1 Year
    
    1-3 Years
    
    4-5 Years
    
    and OverNotes Payable
    
    
    1,518
    
    
    
    1,518
    
    
    
    
    
    
    
    
    
    
    
    Operating Leases
    
    
    19,901
    
    
    
    3,775
    
    
    
    6,300
    
    
    
    2,493
    
    
    
    7,333Capital Leases
    
    
    8,413
    
    
    
    2,409
    
    
    
    5,983
    
    
    
    21
    
    
    
    Total Contractual Cash Obligations
    
    $
    29,832
    
    
    $
    7,702
    
    
    $
    12,283
    
    
    $
    2,514
    
    
    $
    7,333
 Amount of Commitment Expiration Per PeriodOther Commercial Commitments
    
    Total
    
    Less
    
    
    
    
    
    
    
    
    
    6 Years(in thousands)
    
    Commitments
    
    than 1 Year
    
    1-3 Years
    
    4-5 Years
    
    and OverGuarantee
    
    $
    398
    
    
    $
    107
    
    
    $
    291
    
    
    $
    
    
    
    $
    
 The operating leases include leases for our factories in Penang,
Washington, Massachusetts, our ground lease in Arizona, a building lease in
Manila, and our sales office in Florida. In the second quarter of 2004, we
purchased our building facility in Manila. As a result of the building
purchase, we will no longer be required to pay the $7.8 million over the next 7
years that was remaining on our original ten year lease agreement. The capital
leases are for our equipment in Malaysia and Washington. The guarantee relates
to our guarantee in connection with a Small Business Administration loan to
VoiceViewer Technology, Inc., a privately held company developing microdisplay
products. Brillian assumed this guarantee in the spin-off. If the lending
institution were to declare VoiceViewer to be in default under the loan,
however, and if Brillian Corporation were unable to satisfy its obligation as
primary guarantor, then we would be required to pay the guaranteed amount. We have no other long-term debt, capital lease obligations, unconditional
purchase obligations, or other long-term obligations, and we do not have any
other commercial commitments or other off-balance sheet arrangements. Our cash balance, not including our restricted cash deposit held by First
National Bank as collateral for its $5.0 million loan, is $21.5 million. We
expect operating cash outflow to consume only a small portion of our cash
reserves for the remaining of 2004, but based on our revenue forecast, we will
need substantial working capital in the second half of 2004. We believe that
our existing cash balances plus our expected loan commitments will provide
adequate sources to fund our operations and planned expenditures through 2004,
as well as to meet our contractual obligations. Our currently planned
remaining cash outflows for 2004 include capital expenditures of less than $2.5
million. It is possible that stronger second half sales would require additional
funding for working capital. In addition, we expect to continue our acquisition
strategy. As a result, we have recently filed a Form S-3 registration statement
to register 6,000,000 shares of our common stock for possible sale. There is no
assurance there will be a market for our shares or that any such equity
offering of shares will raise sufficient amounts to fund all of our
requirements. As a result, we may be required to pursue alternative methods of
financing or raising capital. We 17




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cannot provide assurance that adequate additional loan commitments or
alternative methods of financing will be available or, if available, that they
will be on terms acceptable to us. Impact of Recently Issued Standards In November 2002, the FASB issued FASB Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities, which clarifies the application
of Accounting Research Bulletin No. 51, Consolidated Financial Statements,
relating to consolidation of certain entities. This interpretation was
subsequently revised by FIN 46 (Revised 2003) in December 2003. This
interpretation states that consolidation of variable interest entities will be
required by the primary beneficiary if the entities do not effectively disperse
risk among the parties involved. The requirements are effective for fiscal
years ending after December 15, 2003. We have no variable interest entities
and do not believe that FIN No. 46 (R) will impact our future financial results. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There are no material changes in reported market risks since our most
recent filing on Form 10-K for the year ended December 31, 2003. 
 ITEM 4. CONTROLS AND PROCEDURES Controls Evaluation and Related CEO and CFO Certifications We conducted an evaluation of the effectiveness of the design and
operation of our disclosure controls and procedures (Disclosure Controls) as
of the end of the period covered by this Quarterly Report. The controls
evaluation was done under the supervision and with the participation of
management, including our Chief Executive Officer (CEO) and Chief Financial
Officer (CFO). Attached as exhibits to this Quarterly Report are certifications
of the CEO and the CFO, which are required in accordance with Rule 13a-14 of
the Exchange Act. This Controls and Procedures section includes the
information concerning the controls evaluation referred to in the
certifications and it should be read in conjunction with the certifications for
a more complete understanding of the topics presented. Definition of Disclosure Controls Disclosure Controls are controls and procedures designed to reasonably
assure that information required to be disclosed in our reports filed under the
Exchange Act, such as this Quarterly Report, is recorded, processed, summarized
and reported within the time periods specified in the Securities and Exchange
Commissions rules and forms. Disclosure Controls are also designed to
reasonably assure that such information is accumulated and communicated to our
management, including the CEO and CFO, as appropriate to allow timely decisions
regarding required disclosure. Limitations on the Effectiveness of Controls Our management, including the CEO and CFO, can not assure that our
Disclosure Controls will prevent all error. A control system, no matter how
well designed and operated, can provide only reasonable, not absolute,
assurance that the control systems objectives will be met. Further, the design
of a control system must reflect the fact that there are resource constraints,
and the benefits of controls must be considered relative to their costs.
Because of the inherent limitations in all control systems, no evaluation of
controls can provide absolute assurance that all control issues within the
company have been detected. These inherent limitations include the realities
that judgments in decision-making can be faulty and that breakdowns can occur
because of simple error or mistake. Controls can also be circumvented by the
individual acts of some persons, by collusion of two or more people, or by
management override of the controls. The design of any system of controls is
based in part on certain assumptions about the likelihood of future events, and
there can be no assurance that any design will succeed in achieving its stated
goals under all potential future conditions. Over time, controls may become
inadequate because of changes in 18




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conditions or deterioration in the degree of compliance with policies or
procedures. Because of the inherent limitations in a cost-effective control
system, misstatements due to error may occur and not be detected. Scope of the Controls Evaluation The evaluation of our Disclosure Controls included a review of the
controls objectives and design, the companys implementation of the controls
and the effect of the controls on the information generated for use in this
Quarterly Report. In the course of the controls evaluation, we sought to
identify issues and confirm that appropriate corrective action, including
process improvements, were being undertaken. Many of the components of our
Disclosure Controls are also evaluated on an ongoing basis by our independent
auditors, who evaluate them in connection with determining their auditing
procedures related to their report on our annual financial statements and not
to provide assurance on our controls. The overall goals of these various
evaluation activities are to monitor our Disclosure Controls, and to modify
them as necessary. Among other matters, we also considered whether our evaluation identified
any significant deficiencies or material weaknesses in our internal control
over financial reporting, and whether the company had identified any acts of
fraud involving personnel with a significant role in our internal control over
financial reporting. This information was important both for the controls
evaluation generally, and because item 5 in the certifications of the CEO and
CFO requires that the CEO and CFO disclose that information to our Boards
Audit Committee and to our independent auditors. In the professional auditing
literature, significant deficiencies are referred to as reportable
conditions, which are deficiencies in the design or operation of controls that
could adversely affect our ability to record, process, summarize, and report
financial data in the financial statements. Auditing literature defines
material weakness as a particularly serious reportable condition in which the
internal control does not reduce to a relatively low level the risk that
misstatements caused by error or fraud may occur in amounts that would be
material in relation to the financial statements and the risk that such
misstatements would not be detected within a timely period by employees in the
normal course of performing their assigned functions. We also sought to address
other controls matters in the controls evaluation, and in each case if a
problem was identified, we considered what revision, improvement and/or
correction to make in accordance with our ongoing procedures. Conclusions Based upon the controls evaluation, our CEO and CFO have concluded that,
subject to the limitations noted above, as of the end of the period covered by
this Quarterly Report, our Disclosure Controls were effective to provide
reasonable assurance that material information relating to us and our
consolidated subsidiaries is accumulated and communicated to management,
including the CEO and CFO, as appropriate to allow timely decisions regarding
financial disclosure. 19




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PART II 
 ITEM 5. OTHER INFORMATION Our Insider Trading Policy permits our directors, officers, and other key
personnel to establish purchase and sale programs in accordance with Rule
10b5-1 adopted by the Securities and Exchange Commission. The rule permits
employees to adopt written plans at a time before becoming aware of material
nonpublic information and to sell shares according to a plan on a regular basis
(for example, weekly or monthly), regardless of any subsequent nonpublic
information they receive. In our view, Rule 10b5-1 plans are beneficial
because systematic, pre-planned sales that take place over an extended period
should have a less disruptive influence on the price of our stock. We also
believe plans of this type are beneficial because they inform the marketplace
about the nature of the trading activities of our directors and officers. In
the absence of such information, the market could mistakenly attribute
transactions as reflecting a lack of confidence in our company or an indication
of an impending event involving our company. We recognize that our directors
and officers may have reasons totally apart from the company in determining to
effect transactions in our common stock. These reasons could include the
purchase of a home, tax and estate planning, the payment of college tuition,
the establishment of a trust, the balancing of assets, or other personal
reasons. The establishment of any trading plan involving our company requires
the pre-clearance by our Chief Executive Officer or Chief Financial Officer.
An individual adopting a trading plan must comply with all requirements of Rule
10b5-1, including the requirement that the individual not possess any material
nonpublic information regarding our company at the time of the establishment of
the plan. In addition, sales under a trading plan may be made no earlier than
30 days after the plan establishment date. No officers currently maintain trading plans. 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K  (a)
    
    Exhibits 31.1 Certification of Chief Executive Officer of the Registrant pursuant
to Rule 13a-14(a) and Rule 15d-14(a) promulgated under the Securities
Exchange Act of 1934, as amended. 31.2 Certification of Chief Financial Officer of the Registrant pursuant
to Rule 13a-14(a) and Rule 15d-14(a) promulgated under the Securities
Exchange Act of 1934, as amended. 32.1 Certification of the Chief Executive Officer of the Registrant
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002. 32.2 Certification of the Chief Financial Officer of the Registrant,
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.  (b)
    
    Reports on Form 8-K  1)
    
    Report on Form 8-K dated January 7, 2004, furnishing Item 9
Regulation FD disclosure.2)
    
    Report on Form 8-K dated February 5, 2004, furnishing Item 12
Results of Operations and Financial Condition disclosure.3)
    
    Report on Form 8-K dated February 18, 2004, furnishing Item 9
Regulation FD disclosure.4)
    
    Report on Form 8-K dated February 26, 2004, furnishing Item 9
Regulation FD disclosure. 20




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. THREE-FIVE SYSTEMS, INC.Date: May 7, 2004
    By:
    /s/ Jeffrey D.
BuchananJeffrey D. BuchananChief Financial Officer, Secretary, and
Treasurer 21