##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q

Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934


For Quarter Ended September 30, 2002

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
incorporation or organization) |  | I.R.S. Employer
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   o

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 SEPTEMBER 30, 2002
|                                |  |                                     
|Common
Par value $.01 per share |  | 21,429,439                          





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TABLE OF CONTENTS



|                                                                                              |                                                      |  |  |  |  |  |  | 
|--------------------------------------------------------------------------------------------- | ---------------------------------------------------- |  |  |  |  |  |  | 
|ITEM 1. FINANCIAL STATEMENTS                                                                 
|                                                                                              | CONDENSED CONSOLIDATED BALANCE SHEETS               
|                                                                                              | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS     
|                                                                                              | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                                                                                              | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
|ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK                            
|ITEM 4. CONTROLS AND PROCEDURES                                                              
|PART II. OTHER INFORMATION                                                                   
|ITEM 5. OTHER INFORMATION                                                                    
|ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K                                                     
|SIGNATURES                                                                                   
|CERTIFICATIONS                                                                               
|EXHIBIT INDEX                                                                                
|EX-99.1                                                                                      
|EX-99.2                                                                                      



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##### Table of Contents



THREE-FIVE SYSTEMS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2002
TABLE OF CONTENTS

PART I  FINANCIAL INFORMATION

|       |  |                                                                                       |  |  |    |      |  | 
|------ |  | ------------------------------------------------------------------------------------- |  |  | -- | ---- |  | 
|       |  |                                                                                       |  |  |    | Page
|       |  |                                                                                       |  |  |    |     
|ITEM 1 |  | FINANCIAL STATEMENTS:                                                                 |  |  |    |     
|      
|      
|      
|      
|       |  | Condensed Consolidated Balance Sheets-                                                |  |  |    |     
|      
|      
|      
|      
|       |  | December 31, 2001 and September 30, 2002                                              |  |  | 1  |     
|      
|      
|      
|      
|       |  | Condensed Consolidated Statements of Operations-                                      |  |  |    |     
|      
|      
|      
|      
|       |  | Three Months and Nine Months Ended September 30, 2001 and 2002                        |  |  | 2  |     
|      
|      
|      
|      
|       |  | Condensed Consolidated Statements of Cash Flows-                                      |  |  |    |     
|      
|      
|      
|      
|       |  | Nine Months Ended September 30, 2001 and 2002                                         |  |  | 3  |     
|      
|      
|      
|      
|       |  | Notes to Condensed Consolidated Financial Statements                                  |  |  | 4  |     
|      
|      
|      
|      
|ITEM 2 |  | MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS |  |  | 10 |     
|      
|      
|      
|      
|ITEM 3 |  | QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK                             |  |  | 19 |     
|      
|      
|      
|      
|ITEM 4 |  | CONTROLS AND PROCEDURES                                                               |  |  | 19 |     
|      
|      
|      
|      
|       |  | PART II - OTHER INFORMATION                                                           |  |  |    |     
|      
|      
|      
|      
|ITEM 5 |  | OTHER INFORMATION                                                                     |  |  | 19 |     
|      
|      
|      
|      
|ITEM 6 |  | EXHIBITS AND REPORTS ON FORM 8-K                                                      |  |  | 20 |     
|      
|      
|      
|      
|       |  | SIGNATURES                                                                            |  |  | 20 |     
|      
|      
|      
|      
|       |  | CERTIFICATIONS                                                                        |  |  | 21 |     





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##### Table of Contents









ITEM 1.   FINANCIAL STATEMENTS

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

|                                             |                                      |   |                            |         |              |         |               |         |   |         | 
|-------------------------------------------- | ------------------------------------ | - | -------------------------- | ------- | ------------ | ------- | ------------- | ------- | - | ------- | 
|                                             |                                      |   |                            |         | DECEMBER 31, |         | SEPTEMBER 30,
|                                             |                                      |   |                            |         | 2001         |         | 2002         
|                                             |                                      |   |                            |         |              |         |              
|ASSETS                                       |                                      |   |                            |         |              |         | (unaudited)  
|                                             |                                      |   |                            |         |              |         |               |         |  
|Current Assets:                              |                                      |   |                            |         |              |         |               |        
|                                            
|                                            
|                                            
|                                            
|                                             | Cash and cash equivalents            |   | $                          | 37,003  |              |         | $             | 25,617  |  
|                                            
|                                            
|                                            
|                                            
|                                             | Short-term investments               |   |                            | 110,016 |              |         |               | 96,386  |  
|                                            
|                                            
|                                            
|                                            
|                                             | Accounts receivable, net             |   |                            | 18,102  |              |         |               | 13,258  |  
|                                            
|                                            
|                                            
|                                            
|                                             | Inventories                          |   |                            | 15,629  |              |         |               | 11,642  |  
|                                            
|                                            
|                                            
|                                            
|                                             | Taxes receivable                     |   |                            | 3,960   |              |         |               |        |  
|                                            
|                                            
|                                            
|                                            
|                                             | Deferred tax asset                   |   |                            | 3,930   |              |         |               | 3,829   |  
|                                            
|                                            
|                                            
|                                            
|                                             | Assets held for sale                 |   |                            |        |              |         |               | 1,841   |  
|                                            
|                                            
|                                            
|                                            
|                                             | Other current assets                 |   |                            | 2,104   |              |         |               | 1,564   |  
|                                             |                                      |   |                            |         |              |         |               |         |  
|                                             |                                      |   | Total current assets       |         |              | 190,744 |               |         |   | 154,137 | 
|                                            
|                                            
|                                            
|                                            
|Long-term Investments                        |                                      |   | 9,034                      |         |              |         | 4,421         |        
|                                            
|                                            
|                                            
|                                            
|Property, Plant and Equipment, net           |                                      |   | 38,353                     |         |              |         | 30,866        |        
|                                            
|                                            
|                                            
|                                            
|Intangibles, net                             |                                      |   | 5,886                      |         |              |         | 13,222        |        
|                                            
|                                            
|                                            
|                                            
|Goodwill                                     |                                      |   |                           |         |              |         | 7,631         |        
|                                            
|                                            
|                                            
|                                            
|Deferred Tax Asset, net                      |                                      |   | 219                        |         |              |         | 7,462         |        
|                                            
|                                            
|                                            
|                                            
|Other Assets, net                            |                                      |   | 1,652                      |         |              |         | 6,793         |        
|                                             |                                      |   |                            |         |              |         |               |         |  
|                                             |                                      | $ | 245,888                    |         |              | $       | 224,532       |        
|                                             |                                      |   |                            |         |              |         |               |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY         |                                      |   |                            |         |              |         |               |        
|Current Liabilities:                         |                                      |   |                            |         |              |         |               |        
|                                            
|                                            
|                                            
|                                            
|                                             | Accounts payable                     |   | $                          | 14,785  |              |         | $             | 8,890   |  
|                                            
|                                            
|                                            
|                                            
|                                             | Accrued liabilities                  |   |                            | 4,130   |              |         |               | 3,725   |  
|                                            
|                                            
|                                            
|                                            
|                                             | Income taxes payable                 |   |                            |        |              |         |               | 136     |  
|                                            
|                                            
|                                            
|                                            
|                                             | Term loan                            |   |                            | 2,706   |              |         |               | 2,706   |  
|                                             |                                      |   |                            |         |              |         |               |         |  
|                                             |                                      |   | Total current liabilities  |         |              | 21,621  |               |         |   | 15,457  | 
|                                             |                                      |   |                            |         |              |         |               |         |  
|Minority Interest in Consolidated Subsidiary |                                      |   | 323                        |         |              |         |              |        
|                                             |                                      |   |                            |         |              |         |               |         |  
|Commitments and Contingencies                |                                      |   |                            |         |              |         |               |        
|                                            
|                                            
|                                            
|                                            
|Stockholders Equity:                        |                                      |   |                            |         |              |         |               |        
|                                            
|                                            
|                                            
|                                            
|                                             | Common stock                         |   |                            | 219     |              |         |               | 219     |  
|                                            
|                                            
|                                            
|                                            
|                                             | Additional paid-in capital           |   |                            | 200,395 |              |         |               | 200,710 |  
|                                            
|                                            
|                                            
|                                            
|                                             | Retained earnings                    |   |                            | 30,666  |              |         |               | 16,336  |  
|                                            
|                                            
|                                            
|                                            
|                                             | Stock subscription note receivable   |   |                            | (163    | )            |         |               | (171    | )
|                                            
|                                            
|                                            
|                                            
|                                             | Accumulated other comprehensive loss |   |                            | (21     | )            |         |               | (233    | )
|                                            
|                                            
|                                            
|                                            
|                                             | Less  treasury stock, at cost       |   |                            | (7,152  | )            |         |               | (7,786  | )
|                                             |                                      |   |                            |         |              |         |               |         |  
|                                             |                                      |   | Total stockholders equity |         |              | 223,944 |               |         |   | 209,075 | 
|                                             |                                      |   |                            |         |              |         |               |         |  
|                                             |                                      | $ | 245,888                    |         |              | $       | 224,532       |        
|                                             |                                      |   |                            |         |              |         |               |         |  

The accompanying notes are an integral part of these condensed consolidated balance sheets.

1



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##### Table of Contents






THREE-FIVE SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
(in thousands, except per share data)

|                                                     |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |        |         |  
|---------------------------------------------------- | -------------------------------------- | -------------- | ------ | ------------------- | ------ | ------------------- | ------ | ------ | ------ | ---- | ------- | ------ | ------- | - | ------- | ------ | ------- | -
|                                                     |                                        |                |        | Three Months        |        | Nine Months        
|                                                     |                                        |                |        | Ended September 30, |        | Ended September 30,
|                                                     |                                        |                |        |                     |        |                    
|                                                     |                                        |                |        | 2001                |        | 2002                |        | 2001   |        | 2002
|                                                     |                                        |                |        |                     |        |                     |        |        |        |     
|Net Sales                                            |                                        | $              | 26,594 |                     |        | $                   | 18,584 |        |        | $    | 87,223  |        |         | $ | 65,781  |       
|                                                     |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|Costs and Expenses:                                  |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Cost of sales                          |                |        | 27,453              |        |                     |        | 18,049 |        |      |         | 90,856 |         |   |         | 64,435 |        
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Selling, general, and administrative   |                |        | 2,444               |        |                     |        | 2,665  |        |      |         | 7,857  |         |   |         | 8,602  |        
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Research, development, and engineering |                |        | 4,224               |        |                     |        | 4,359  |        |      |         | 12,680 |         |   |         | 13,973 |        
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Loss on assets held for sale           |                |        |                    |        |                     |        |       |        |      |         |       |         |   |         | 4,545  |        
|                                                     |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|                                                     |                                        |                | 34,121 |                     |        |                     | 25,073 |        |        |      | 111,393 |        |         |   | 91,555  |       
|                                                     |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|                                                     |                                        | Operating loss |        |                     | (7,527 | )                   |        |        | (6,489 | )    |         |        | (24,170 | ) |         |        | (25,774 | )
|                                                     |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|Other Income (Expense):                              |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Interest, net                          |                |        | 1,500               |        |                     |        | 716    |        |      |         | 5,439  |         |   |         | 2,722  |        
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Loss on investment in start-up company |                |        |                    |        |                     |        |       |        |      |         | (3,820 | )       |   |         |       |        
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Other, net                             |                |        | (3                  | )      |                     |        | 39     |        |      |         | (55    | )       |   |         | 125    |        
|                                                     |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|                                                     |                                        |                | 1,497  |                     |        |                     | 755    |        |        |      | 1,564   |        |         |   | 2,847   |       
|                                                     |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|Minority Interest in Loss of
Consolidated Subsidiary |                                        |                | 62     |                     |        |                     |       |        |        |      | 62      |        |         |   | 84      |       
|                                                     |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|Loss before Income Taxes                             |                                        |                | (5,968 | )                   |        |                     | (5,734 | )      |        |      | (22,544 | )      |         |   | (22,843 | )     
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Benefit from income taxes              |                |        | (1,972              | )      |                     |        | (2,354 | )      |      |         | (7,442 | )       |   |         | (8,513 | )      
|                                                     |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|Net Loss                                             |                                        | $              | (3,996 | )                   |        | $                   | (3,380 | )      |        | $    | (15,102 | )      |         | $ | (14,330 | )     
|                                                     |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|Loss per Common Share:                               |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Basic                                  |                | $      | (0.19               | )      |                     | $      | (0.16  | )      |      | $       | (0.70  | )       |   | $       | (0.67  | )      
|                                                     |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|                                                     | Diluted                                |                | $      | (0.19               | )      |                     | $      | (0.16  | )      |      | $       | (0.70  | )       |   | $       | (0.67  | )      
|                                                     |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|Weighted Average Number of Common Shares:            |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Basic                                  |                |        | 21,363              |        |                     |        | 21,330 |        |      |         | 21,427 |         |   |         | 21,425 |        
|                                                     |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       
|                                                     | Diluted                                |                |        | 21,363              |        |                     |        | 21,330 |        |      |         | 21,427 |         |   |         | 21,425 |        
|                                                     |                                        |                |        |                     |        |                     |        |        |        |      |         |        |         |   |         |       

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

2



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##### Table of Contents






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

|                                               |                                                                             |                                                              |                                                      |                                       |          |                   |         |         |         |        |        |  
|---------------------------------------------- | --------------------------------------------------------------------------- | ------------------------------------------------------------ | ---------------------------------------------------- | ------------------------------------- | -------- | ----------------- | ------- | ------- | ------- | ------ | ------ | -
|                                               |                                                                             |                                                              |                                                      |                                       |          | Nine Months Ended
|                                               |                                                                             |                                                              |                                                      |                                       |          | September 30,    
|                                               |                                                                             |                                                              |                                                      |                                       |          |                  
|                                               |                                                                             |                                                              |                                                      |                                       |          | 2001              |         | 2002   
|                                               |                                                                             |                                                              |                                                      |                                       |          |                   |         |        
|Cash Flows from Operating Activities:          |                                                                             |                                                              |                                                      |                                       |          |                   |         |        
|                                              
|                                              
|                                              
|                                              
|                                               | Net loss                                                                    |                                                              | $                                                    | (15,102                               | )        |                   | $       | (14,330 | )      
|                                              
|                                              
|                                              
|                                              
|                                               | Adjustments to reconcile net loss to net cash used in operating activities: |                                                              |                                                      |                                       |          |                   |         |         |        
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             |                                                              | Depreciation and amortization                        |                                       |          | 4,356             |         |         |         | 5,312  |       
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             |                                                              | Stock compensation                                   |                                       |          |                  |         |         |         | 92     |       
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             |                                                              | Minority interest in consolidated subsidiary         |                                       |          | (62               | )       |         |         | (84    | )     
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             |                                                              | Provision for accounts receivable valuation reserves |                                       |          | 191               |         |         |         | 185    |       
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             |                                                              | Loss on disposal of assets                           |                                       |          | 1,289             |         |         |         | 4,545  |       
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             |                                                              | Loss on investment in start-up company               |                                       |          | 3,820             |         |         |         |       |       
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             |                                                              | Benefit from deferred taxes, net                     |                                       |          |                  |         |         |         | (7,039 | )     
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             |                                                              | Interest on stock subscription note receivable       |                                       |          | (22               | )       |         |         | (8     | )     
|                                              
|                                              
|                                              
|                                              
|                                               | Change in assets and liabilities:                                           |                                                              |                                                      |                                       |          |                   |         |         |        
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             |                                                              | Decrease in accounts receivable                      |                                       |          | 3,085             |         |         |         | 6,110  |       
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             |                                                              | Decrease in inventories                              |                                       |          | 2,665             |         |         |         | 4,661  |       
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             |                                                              | Decrease (increase) in other assets                  |                                       |          | (291              | )       |         |         | 621    |       
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             |                                                              | Decrease in accounts payable and accrued liabilities |                                       |          | (2,044            | )       |         |         | (7,331 | )     
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             |                                                              | Decrease (increase) in taxes receivable              |                                       |          | (7,688            | )       |         |         | 4,096  |       
|                                               |                                                                             |                                                              |                                                      |                                       |          |                   |         |         |        
|                                               |                                                                             |                                                              |                                                      | Net cash used in operating activities |          |                   | (9,803  | )       |         |        | (3,170 | )
|                                               |                                                                             |                                                              |                                                      |                                       |          |                   |         |         |        
|Cash Flows from Investing Activities:          |                                                                             |                                                              |                                                      |                                       |          |                   |         |        
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             | Purchase of property, plant, and equipment                   |                                                      |                                       | (6,324   | )                 |         |         | (3,886  | )     
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             | Deposit received for assets held for sale                    |                                                      |                                       |         |                   |         |         | 1,100   |       
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             | Purchase of intangibles                                      |                                                      |                                       | (1,247   | )                 |         |         | (5,656  | )     
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             | Purchase of investments                                      |                                                      |                                       | (181,452 | )                 |         |         | (95,884 | )     
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             | Proceeds from maturities/sales of investments                |                                                      |                                       | 185,724  |                   |         |         | 113,874 |       
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             | Business acquisition                                         |                                                      |                                       |         |                   |         |         | (11,950 | )     
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             | Other investments                                            |                                                      |                                       | (1,000   | )                 |         |         | (5,081  | )     
|                                               |                                                                             |                                                              |                                                      |                                       |          |                   |         |         |        
|                                               |                                                                             |                                                              |                                                      | Net cash used in investing activities |          |                   | (4,299  | )       |         |        | (7,483 | )
|                                               |                                                                             |                                                              |                                                      |                                       |          |                   |         |         |        
|Cash Flows from Financing Activities:          |                                                                             |                                                              |                                                      |                                       |          |                   |         |        
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             | Stock options exercised                                      |                                                      |                                       | 331      |                   |         |         | 202     |       
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             | Receipt from (distribution to) minority interest holder      |                                                      |                                       | 490      |                   |         |         | (239    | )     
|                                              
|                                              
|                                              
|                                              
|                                               |                                                                             | Purchase of treasury stock                                   |                                                      |                                       | (2,526   | )                 |         |         | (634    | )     
|                                               |                                                                             |                                                              |                                                      |                                       |          |                   |         |         |        
|                                               |                                                                             |                                                              |                                                      | Net cash used in financing activities |          |                   | (1,705  | )       |         |        | (671   | )
|                                               |                                                                             |                                                              |                                                      |                                       |          |                   |         |         |        
|                                               |                                                                             | Effect of exchange rate changes on cash and cash equivalents |                                                      |                                       | (18      | )                 |         |         | (62     | )     
|                                               |                                                                             |                                                              |                                                      |                                       |          |                   |         |         |        
|Net decrease in cash and cash equivalents      |                                                                             |                                                              | (15,825                                              | )                                     |          |                   | (11,386 | )      
|                                              
|                                              
|                                              
|                                              
|Cash and cash equivalents, beginning of period |                                                                             |                                                              | 45,645                                               |                                       |          |                   | 37,003  |        
|                                               |                                                                             |                                                              |                                                      |                                       |          |                   |         |         |        
|Cash and cash equivalents, end of period       |                                                                             | $                                                            | 29,820                                               |                                       |          | $                 | 25,617  |        
|                                               |                                                                             |                                                              |                                                      |                                       |          |                   |         |         |        

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

3



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##### Table of Contents






|       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|------ |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|       |  | THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|      
|      
|      
|      
|Note A |  | The accompanying unaudited Condensed Consolidated Financial
Statements have been prepared in accordance with accounting
principles generally accepted in the United States for interim
financial information and the instructions to Form 10-Q.
Accordingly, they do not include all the information and footnotes
required by accounting principles generally accepted in the United
States for complete financial statements. In our opinion, all
adjustments (which include only normal recurring adjustments and to
record a loss on assets held for sale) 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 nine-month periods ended September 30, 2002 are not
necessarily indicative of the operating results that may be
expected for the entire year ending December 31, 2002. These
financial statements should be read in conjunction with our
December 31, 2001 financial statements and accompanying notes
thereto.
|      
|Note B |  | Basic loss per common share is computed by dividing net loss by the
weighted average number of shares of common stock outstanding
during the three- and nine-month periods ended September 30, 2001
and 2002. Diluted loss per common share is determined assuming
that outstanding dilutive options and warrants were exercised at
the beginning of the period or at the time of issuance, if later.
No outstanding options or warrants were assumed to be exercised for
purposes of calculating diluted loss per share for the three- and
nine-month periods ended September 30, 2001 and September 30, 2002,
as their effect was anti-dilutive. Set forth below are the
disclosures for the three- and nine-month periods ended September
30, 2001 and 2002.                                                                                                                                                                                                                                                                                                

|                        |                                                   |                          |        |                                       |       |                   |        |        |       |      |         |        |       |   |         |        |       |  
|----------------------- | ------------------------------------------------- | ------------------------ | ------ | ------------------------------------- | ----- | ----------------- | ------ | ------ | ----- | ---- | ------- | ------ | ----- | - | ------- | ------ | ----- | -
|                        |                                                   |                          |        | Three Months Ended                    |       | Nine Months Ended
|                        |                                                   |                          |        | September 30,                         |       | September 30,    
|                        |                                                   |                          |        |                                       |       |                  
|                        |                                                   |                          |        | 2001                                  |       | 2002              |        | 2001   |       | 2002
|                        |                                                   |                          |        |                                       |       |                   |        |        |       |     
|                        |                                                   |                          |        | (in thousands, except per share data)
|Basic loss per share:   |                                                   |                          |        |                                       |       |                   |        |        |       |      |         |        |       |   |         |       
|                       
|                       
|                       
|                       
|Net loss                |                                                   | $                        | (3,996 | )                                     |       | $                 | (3,380 | )      |       | $    | (15,102 | )      |       | $ | (14,330 | )     
|                        |                                                   |                          |        |                                       |       |                   |        |        |       |      |         |        |       |   |         |       
|                        | Weighted average common shares                    |                          |        | 21,363                                |       |                   |        | 21,330 |       |      |         | 21,427 |       |   |         | 21,425 |      
|                        |                                                   |                          |        |                                       |       |                   |        |        |       |      |         |        |       |   |         |       
|                        |                                                   | Basic per share amount   |        | $                                     | (0.19 | )                 |        | $      | (0.16 | )    |         |        | (0.70 | ) |         | $      | (0.67 | )
|                        |                                                   |                          |        |                                       |       |                   |        |        |       |      |         |        |       |   |         |       
|Diluted loss per share: |                                                   |                          |        |                                       |       |                   |        |        |       |      |         |        |       |   |         |       
|                       
|                       
|                       
|                       
|Net loss                |                                                   | $                        | (3,996 | )                                     |       | $                 | (3,380 | )      |       | $    | (15,102 | )      |       | $ | (14,330 | )     
|                        |                                                   |                          |        |                                       |       |                   |        |        |       |      |         |        |       |   |         |       
|                        | Weighted average common shares                    |                          |        | 21,363                                |       |                   |        | 21,330 |       |      |         | 21,427 |       |   |         | 21,425 |      
|                       
|                       
|                       
|                       
|                        | Options and warrants assumed exercised            |                          |        |                                      |       |                   |        |       |       |      |         |       |       |   |         |       |      
|                        |                                                   |                          |        |                                       |       |                   |        |        |       |      |         |        |       |   |         |       
|                        | Total common shares plus common
Stock equivalents |                          |        | 21,363                                |       |                   |        | 21,330 |       |      |         | 21,427 |       |   |         | 21,425 |      
|                        |                                                   |                          |        |                                       |       |                   |        |        |       |      |         |        |       |   |         |       
|                        |                                                   | Diluted per share amount |        | $                                     | (0.19 | )                 |        | $      | (0.16 | )    |         | $      | (0.70 | ) |         | $      | (0.67 | )
|                        |                                                   |                          |        |                                       |       |                   |        |        |       |      |         |        |       |   |         |       

|       |  |                                      
|------ |  | -------------------------------------
|Note C |  | Inventories consist of the following:

|                |  |                   |        |                    |  |   |        | 
|--------------- |  | ----------------- | ------ | ------------------ |  | - | ------ | 
|                |  | December 31, 2001 |        | September 30, 2002
|                |  |                   |        |                   
|                |  | (in thousands)   
|Raw materials   |  | $                 | 11,535 |                    |  | $ | 8,985  | 
|               
|               
|               
|               
|Work-in-process |  |                   | 964    |                    |  |   | 833    | 
|               
|               
|               
|               
|Finished goods  |  |                   | 3,130  |                    |  |   | 1,824  | 
|                |  |                   |        |                    |  |   |        | 
|                |  | $                 | 15,629 |                    |  | $ | 11,642 | 
|                |  |                   |        |                    |  |   |        | 

4



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##### Table of Contents



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

|                              |  |                   |         |                    |  |   |         |  
|----------------------------- |  | ----------------- | ------- | ------------------ |  | - | ------- | -
|                              |  | December 31, 2001 |         | September 30, 2002
|                              |  |                   |         |                   
|                              |  | (in thousands)   
|Building and improvements     |  | $                 | 16,476  |                    |  | $ | 16,476  |  
|                             
|                             
|                             
|                             
|Furniture and equipment       |  |                   | 53,728  |                    |  |   | 45,681  |  
|                              |  |                   |         |                    |  |   |         |  
|                              |  |                   | 70,204  |                    |  |   | 62,157  |  
|                             
|                             
|                             
|                             
|Less accumulated depreciation |  |                   | (31,851 | )                  |  |   | (31,291 | )
|                              |  |                   |         |                    |  |   |         |  
|                              |  | $                 | 38,353  |                    |  | $ | 30,866  |  
|                              |  |                   |         |                    |  |   |         |  

|       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|------ |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|       |  | See Note O for the $4.5 million loss on assets held for sale during 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|      
|      
|      
|      
|       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|      
|      
|      
|      
|Note E |  | Intangibles:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|      
|      
|      
|      
|       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|      
|      
|      
|      
|       |  | Intangibles consist of mask works, patents, licenses, customer lists and
other intangible assets. Intangibles are recorded at cost and amortized
using the straight-line method over the estimated useful lives of the
respective assets, which range from two to five years. Our policy is to
commence amortization of intangibles when their related benefits begin to
be realized. In January 2002, we purchased the intellectual property of
Zight Corporation, a private company focused on microdisplays for
personal display system applications, for $2.0 million. In April 2002,
we purchased the intellectual property of Inviso, Inc. for $750,000. In
each case, the intellectual property purchased consisted of patents,
patents pending, and patent disclosures. In September 2002, $3.0 million
was allocated to customer lists through the acquisition of AVT Advanced
Video Technologies, or AVT, as described in Note Q.
|      
|      
|      
|      
|       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|      
|      
|      
|      
|       |  | Intangible assets consist of the following:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

|                              |                                     |                |                   |       |                    |   |        |       | 
|----------------------------- | ----------------------------------- | -------------- | ----------------- | ----- | ------------------ | - | ------ | ----- | 
|                              |                                     |                | December 31, 2001 |       | September 30, 2002
|                              |                                     |                |                   |       |                   
|Amortized Intangible Assets:  |                                     | (in thousands)
|                              | Mask works                          |                | $                 | 3,481 |                    |   | $      | 5,981 | 
|                             
|                             
|                             
|                             
|                              | Patents and other intangible assets |                |                   | 200   |                    |   |        | 3,356 | 
|                             
|                             
|                             
|                             
|                              | Customer lists                      |                |                   |      |                    |   |        | 3,000 | 
|                             
|                             
|                             
|                             
|                              | Licenses                            |                |                   | 2,954 |                    |   |        | 2,954 | 
|                              |                                     |                |                   |       |                    |   |        |       | 
|                              |                                     |                | 6,635             |       |                    |   | 15,291 |      
|                             
|                             
|                             
|                             
|Less accumulated amortization |                                     |                | (749              | )     |                    |   | (2,069 | )    
|                              |                                     |                |                   |       |                    |   |        |       | 
|                              |                                     | $              | 5,886             |       |                    | $ | 13,222 |      
|                              |                                     |                |                   |       |                    |   |        |       | 

| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Intangible asset amortization expense for the three month period ended
September 30, 2001 was $276,000 as compared to $473,000 for the three
month period ended September 30, 2002. Intangible asset amortization
expense for the nine month period ended September 30, 2001 was $276,000
as compared to $1.3 million for the nine month period ended September 30,
2002. Estimated annual amortization expense through 2006 related to
intangible assets reported as of September 30, 2002 is as follows (in
thousands):

|            |  |        |       | 
|----------- |  | ------ | ----- | 
|Fiscal Year |  | Amount
|            |  |       
|2002        |  | $      | 1,894 | 
|           
|           
|           
|           
|2003        |  |        | 3,064 | 
|           
|           
|           
|           
|2004        |  |        | 3,045 | 
|           
|           
|           
|           
|2005        |  |        | 3,120 | 
|           
|           
|           
|           
|2006        |  |        | 2,197 | 

|       |  |                                                                                                 
|------ |  | ------------------------------------------------------------------------------------------------
|Note F |  | Goodwill:                                                                                       
|      
|      
|      
|      
|       |  | Our goodwill of $7.6 million consists entirely of goodwill generated during the purchase of AVT.

5



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##### Table of Contents



|       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|------ |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|      
|      
|      
|      
|Note G |  | Segment information:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|      
|      
|      
|      
|       |  | We monitor and evaluate the financial performance of our operations by
our two product lines (operating segments): LCD and Microdisplay. The LCD
operating segment consists of products that employ an LCD (Liquid Crystal
Display) or CRT to present information to the user. The Microdisplay
operating segment consists of products that employ a Liquid Crystal on
Silicon (LCoS) display to present information to the user. The
accounting policies related to the operating segments are the same as
those described in Note 2, Summary of Significant Accounting Policies, in
our financial statements included in our Report on Form 10-K for the
fiscal year ended December 31, 2001. Non-specific operating segment
expenses were allocated based upon estimated usage. Interest income was
split equally between the LCD and Microdisplay operating segments. The
worldwide average tax rate was used for both segments. The following
includes financial information, for our two operating segments (in
thousands, except share data):

|                                       |  |     |        |              |  |       |         |   |  |   |         |  
|-------------------------------------- |  | --- | ------ | ------------ |  | ----- | ------- | - |  | - | ------- | -
|Three Months Ended Sept. 30, 2001      |  | LCD |        | Microdisplay |  | Total
|                                       |  |     |        |              |  |       |         |   |  |   |         |  
|Net sales                              |  | $   | 25,963 |              |  | $     | 631     |   |  | $ | 26,594  |  
|                                      
|                                      
|                                      
|                                      
|Other income                           |  |     | 748    |              |  |       | 749     |   |  |   | 1,497   |  
|                                      
|                                      
|                                      
|                                      
|Benefit from income taxes              |  |     | (570   | )            |  |       | (1,402  | ) |  |   | (1,972  | )
|                                      
|                                      
|                                      
|                                      
|Net loss                               |  |     | (1,149 | )            |  |       | (2,847  | ) |  |   | (3,996  | )
|                                      
|                                      
|                                      
|                                      
|Loss per share                         |  |     | (0.05  | )            |  |       | (0.14   | ) |  |   | (0.19   | )
|                                      
|                                      
|                                      
|                                      
|                                       |  |     |        |              |  |       |         |   |  |   |         |  
|                                      
|                                      
|                                      
|                                      
|Three Months Ended Sept. 30, 2002      |  | LCD |        | Microdisplay |  | Total
|                                       |  |     |        |              |  |       |         |   |  |   |         |  
|Net sales                              |  | $   | 18,241 |              |  | $     | 343     |   |  | $ | 18,584  |  
|                                      
|                                      
|                                      
|                                      
|Other income                           |  |     | 378    |              |  |       | 377     |   |  |   | 755     |  
|                                      
|                                      
|                                      
|                                      
|Benefit from income taxes              |  |     | (406   | )            |  |       | (1,948  | ) |  |   | (2,354  | )
|                                      
|                                      
|                                      
|                                      
|Net loss                               |  |     | (498   | )            |  |       | (2,882  | ) |  |   | (3,380  | )
|                                      
|                                      
|                                      
|                                      
|Loss per share                         |  |     | (0.02  | )            |  |       | (0.14   | ) |  |   | (0.16   | )
|                                      
|                                      
|                                      
|                                      
|                                       |  |     |        |              |  |       |         |   |  |   |         |  
|                                      
|                                      
|                                      
|                                      
|Nine Months Ended Sept. 30, 2001       |  | LCD |        | Microdisplay |  | Total
|                                       |  |     |        |              |  |       |         |   |  |   |         |  
|Net sales                              |  | $   | 85,265 |              |  | $     | 1,958   |   |  | $ | 87,223  |  
|                                      
|                                      
|                                      
|                                      
|Other income (loss)                    |  |     | 2,692  |              |  |       | (1,128  | ) |  |   | 1,564   |  
|                                      
|                                      
|                                      
|                                      
|Benefit from income taxes income
taxes |  |     | (2,985 | )            |  |       | (4,457  | ) |  |   | (7,442  | )
|                                      
|                                      
|                                      
|                                      
|Net loss                               |  |     | (6,052 | )            |  |       | (9,050  | ) |  |   | (15,102 | )
|                                      
|                                      
|                                      
|                                      
|Loss per share                         |  |     | (0.28  | )            |  |       | (0.42   | ) |  |   | (0.70   | )
|                                      
|                                      
|                                      
|                                      
|                                       |  |     |        |              |  |       |         |   |  |   |         |  
|                                      
|                                      
|                                      
|                                      
|Nine Months Ended Sept. 30, 2002       |  | LCD |        | Microdisplay |  | Total
|                                       |  |     |        |              |  |       |         |   |  |   |         |  
|Net sales                              |  | $   | 64,987 |              |  | $     | 794     |   |  | $ | 65,781  |  
|                                      
|                                      
|                                      
|                                      
|Other income                           |  |     | 1,423  |              |  |       | 1,424   |   |  |   | 2,847   |  
|                                      
|                                      
|                                      
|                                      
|Benefit from income taxes              |  |     | (2,377 | )            |  |       | (6,136  | ) |  |   | (8,513  | )
|                                      
|                                      
|                                      
|                                      
|Net loss                               |  |     | (4,003 | )            |  |       | (10,327 | ) |  |   | (14,330 | )
|                                      
|                                      
|                                      
|                                      
|Loss per share                         |  |     | (0.19  | )            |  |       | (0.48   | ) |  |   | (0.67   | )

| |  |                                                                                                                                                                                                                                    
| |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We also track net sales data by geographic location. Net sales by
geographic area are determined based upon the location of the end
customer. The following includes financial information for our
geographic areas (in thousands):

|                                  |  |         |       |       |  |         |        |       |  |   |        |  |  |   |        | 
|--------------------------------- |  | ------- | ----- | ----- |  | ------- | ------ | ----- |  | - | ------ |  |  | - | ------ | 
|                                  |  | North   |       |       |  |         |        | Other |  |   |        | 
|                                 
|                                 
|                                 
|                                 
|Three Months Ended Sept. 30, 2001 |  | America |       | China |  | Foreign |        | Total
|                                  |  |         |       |       |  |         |        |       |  |   |        |  |  |   |        | 
|Net sales                         |  | $       | 4,186 |       |  | $       | 11,802 |       |  | $ | 10,606 |  |  | $ | 26,594 | 
|                                 
|                                 
|                                 
|                                 
|                                  |  |         |       |       |  |         |        |       |  |   |        |  |  |   |        | 
|                                 
|                                 
|                                 
|                                 
|                                  |  | North   |       |       |  |         |        | Other |  |   |        | 
|                                 
|                                 
|                                 
|                                 
|Three Months Ended Sept. 30, 2002 |  | America |       | China |  | Foreign |        | Total
|                                  |  |         |       |       |  |         |        |       |  |   |        |  |  |   |        | 
|Net sales                         |  | $       | 1,645 |       |  | $       | 5,856  |       |  | $ | 11,083 |  |  | $ | 18,584 | 

6



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##### Table of Contents



|                                 |  |         |        |       |  |         |        |       |  |   |        |  |  |   |        | 
|-------------------------------- |  | ------- | ------ | ----- |  | ------- | ------ | ----- |  | - | ------ |  |  | - | ------ | 
|                                
|                                
|                                
|                                
|                                 |  | North   |        |       |  |         |        | Other |  |   |        | 
|                                
|                                
|                                
|                                
|Nine Months Ended Sept. 30, 2001 |  | America |        | China |  | Foreign |        | Total
|                                 |  |         |        |       |  |         |        |       |  |   |        |  |  |   |        | 
|Net sales                        |  | $       | 16,873 |       |  | $       | 35,088 |       |  | $ | 35,262 |  |  | $ | 87,223 | 
|                                
|                                
|                                
|                                
|                                 |  |         |        |       |  |         |        |       |  |   |        |  |  |   |        | 
|                                
|                                
|                                
|                                
|                                 |  | North   |        |       |  |         |        | Other |  |   |        | 
|                                
|                                
|                                
|                                
|Nine Months Ended Sept. 30, 2002 |  | America |        | China |  | Foreign |        | Total
|                                 |  |         |        |       |  |         |        |       |  |   |        |  |  |   |        | 
|Net sales                        |  | $       | 5,834  |       |  | $       | 29,231 |       |  | $ | 30,716 |  |  | $ | 65,781 | 

|       |  |                                                   
|------ |  | --------------------------------------------------
|Note H |  | Comprehensive loss for the periods was as follows:

|                                   |                                                    |   |                    |     |                   |   |                |      |      |   |         |     |   |   |         |      |  
|---------------------------------- | -------------------------------------------------- | - | ------------------ | --- | ----------------- | - | -------------- | ---- | ---- | - | ------- | --- | - | - | ------- | ---- | -
|                                   |                                                    |   | Three Months Ended |     | Nine Months Ended
|                                   |                                                    |   | September 30,      |     | September 30,    
|                                   |                                                    |   |                    |     |                  
|                                   |                                                    |   | 2001               |     | 2002              |   | 2001           |      | 2002
|                                   |                                                    |   |                    |     |                   |   |                |      |     
|                                   |                                                    |   |                    |     |                   |   | (in thousands) |      |      |   |        
|Net loss                           |                                                    | $ | (3,996             | )   |                   | $ | (3,380         | )    |      | $ | (15,102 | )   |   | $ | (14,330 | )   
|                                  
|                                  
|                                  
|                                  
|Other comprehensive income (loss): |                                                    |   |                    |     |                   |   |                |      |      |   |         |     |   |   |         |     
|                                  
|                                  
|                                  
|                                  
|                                   | Cumulative foreign currency
translation adjustment |   |                    | 67  |                   |   |                | (114 | )    |   |         | (18 | ) |   |         | (62  | )
|                                  
|                                  
|                                  
|                                  
|                                   | Unrealized gain (loss) on
securities, net of tax   |   |                    | 199 |                   |   |                | 58   |      |   |         | 451 |   |   |         | (150 | )
|                                   |                                                    |   |                    |     |                   |   |                |      |      |   |         |     |   |   |         |     
|Comprehensive loss                 |                                                    | $ | (3,730             | )   |                   | $ | (3,436         | )    |      | $ | (14,669 | )   |   | $ | (14,542 | )   
|                                   |                                                    |   |                    |     |                   |   |                |      |      |   |         |     |   |   |         |     

|       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note I |  | Debt:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|      
|      
|      
|      
|       |  | In February 2002, we renewed our credit facility with Comerica Bank.
That credit facility is a $15.0 million unsecured revolving line of
credit that matures in January 2003. No borrowings were outstanding under
that credit facility on September 30, 2002. Advances under the facility
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 150 basis points in excess of the LIBOR base rate. In May
2002, our Beijing subsidiary renewed its credit facility with the Bank of
China. As of September 30, 2002, our Beijing subsidiary had an
outstanding $2.7 million term loan due April 30, 2003 to the Bank of
China, which was secured by a $3.0 million stand-by letter of credit
issued by Comerica Bank.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|      
|      
|      
|      
|Note J |  | Commitments and Contingencies:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|      
|      
|      
|      
|       |  | In 1991, we received a notice of potential liability at the
Barkhamsted-New Hartford Landfill Site (the Landfill) in Barkhamsted,
Connecticut from the U.S. Environmental Protection Agency (EPA).
Fifty-seven other entities received similar letters. The Landfill is a
semi-active waste disposal area consisting of 97.84 acres located in
Barkhamsted and New Hartford, Connecticut. The Landfill is owned and
operated by the Administrative Board of Regional Refuse Disposal and
began operating as a landfill in 1974. Industrial wastes were received
by the Landfill until 1993, and the Landfill was closed in 1995. In
January 1992, we received a 104(e) questionnaire from the EPA, which was
completed and submitted during 1992. We later received verbal
notification that we had no further liability in the matter. According
to the EPA, groundwater contamination at the site, which includes
volatile and semi-volatile organic compounds and low concentrations of
metals, constitutes a low-level threat. As a result of previous actions
at the site, groundwater is the only medium requiring additional cleanup.
All source material and principal threats have been addressed through
the landfill capping and related activity completed in 1999. On February
28, 2002, we received notification from the EPA that the EPA believes we
are an involved party and indicated that the EPA was seeking to negotiate
an agreement with the involved parties to fund the EPAs chosen remedy of
monitored natural attenuation of the groundwater. We then received
notification that we had become a member of the Potential Responsible
Party (PRP) group noticed by the EPA. The EPA has conducted a Remedial
Investigation/Feasibility Study and issued a
Proposed Plan to clean up the site. In

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|       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|      
|      
|      
|      
|       |  | September 2002, we proposed and
recognized a settlement with the EPA of $65,000. Our settlement would
remove us from future liabilities associated with the Landfill.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|      
|      
|      
|      
|       |  | We have guaranteed up to $450,000 of the debt of a start-up company,
VoiceViewer Technology, Inc., a private company developing microdisplay
products. We will be required to pay this guarantee to the lender if the
start-up company defaults on its debt obligations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|      
|      
|      
|      
|       |  | We are also involved in certain administrative proceedings arising in the
normal course of business. In our opinion, the ultimate settlement of
these administrative proceedings will not materially impact our financial
position or results of operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|      
|Note K |  | Recently Issued Accounting Standards:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|      
|      
|      
|      
|       |  | In September 2001, the FASB issued SFAS No. 141, Business Combinations,
and SFAS No. 142, Goodwill and Other Intangible Assets.  SFAS No. 141
requires companies to apply the purchase method of accounting for all
business combinations initiated after September 30, 2001 and prohibits
the use of the pooling-of-interest method. SFAS No. 142 changes the
method by which companies may recognize intangible assets in purchase
business combinations and generally requires identifiable intangible
assets to be recognized separately from goodwill. In addition, it
eliminates the amortization of all existing and newly acquired goodwill
on a prospective basis and requires companies to assess goodwill for
impairment, at least annually, based on the fair value of the reporting
unit. We adopted SFAS Nos. 141 and 142 on January 1, 2002, and there was
no material impact on our financial position or results of operations.
|      
|      
|      
|      
|       |  | In August 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supersedes
SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of, and the accounting and reporting
provisions of APB Opinion No. 30, Reporting the Results of Operations 
Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and
Transactions. SFAS No. 144 modifies the method in which companies
account for certain asset impairment losses. We adopted SFAS No. 144 on
January 1, 2002, and there was no material impact on our financial
position or results of operations.                                                                                                                                                                                                   
|      
|      
|      
|      
|       |  | In July 2001, the FASB issued SFAS No. 146, Accounting for Costs
Associated with Exit or Disposal Activities. SFAS No. 146 requires
companies to recognize costs associated with exit or disposal activities
when they are incurred rather than at the date of a commitment to an exit
or disposal plan. SFAS No. 146 replaces EITF Issue No. 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other Costs to
Exit an Activity (including Certain Costs Incurred in a Restructuring),
and will apply to exit or disposal activities initiated after December
31, 2002. We have reviewed the requirements of SFAS No. 146 and believe
the adoption of this statement will not have a material impact on our
financial statements.                                                                                                                                                                                       
|      
|Note L |  | Reclassifications:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|      
|      
|      
|      
|       |  | Certain amounts in the statements of cash flows for the nine-month period
ended September 30, 2001 have been reclassified to conform with the 2002
presentation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|      
|Note M |  | Benefit Plans:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|      
|      
|      
|      
|       |  | On May 3, 2002, the stockholders approved an amendment to increase
the number of our shares of common stock available for issuance
under the 1998 Stock Option Plan from 1,100,000 to 1,600,000
shares. In August 2002, the Board of Directors approved an
amendment to increase the number of our shares of common stock
available for issuance under the 1997 Employee Option Plan from
1,150,000 to 1,350,000 shares.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

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|       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note N |  | Joint Venture:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|       |  | In the second quarter of 2002, we agreed with DuPont Displays to
liquidate our joint venture, Three-D OLED L.L.C., and enter into a
non-equity based Strategic Manufacturing and Supply Agreement.
Under that agreement, the parties will continue to work together
in a fashion similar to the venture, but the relationship will be
nonexclusive. Thus, we will have the right to purchase the glass
panel output of a planned high-volume manufacturing plant located
in Taiwan, announced by DuPont and RiTdisplay Technology
Corporation. In addition, we will utilize other OLED glass panel
sources. Upon the request of DuPont Displays, we will also
manufacture OLED display modules for them at our display module
assembly facilities in Beijing and Manila.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|Note O |  | Loss on Sale of Assets:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|       |  | During the second quarter of 2001, we announced our strategic
decision to move our front-end manufacturing LCD line from Arizona
to Asia. The front-end LCD line was operated in Arizona through
the third quarter of 2001 and was then shut down. We now purchase
all of our LCDs from third parties, although we sometimes purchase
partially completed LCDs and complete the back-end operations on
those LCDs in Manila. During the second quarter of 2002, we signed
a Cooperative Agreement with a Chinese company in which we agreed
to sell our front-end LCD line and establish a supply agreement.
The sale of the front-end LCD line will likely occur in the fourth
quarter of 2002. Under the terms of the Cooperative Agreement, in
exchange for our front-end LCD line, we will receive $3 million in
cash, favorable LCD glass pricing, and flexible yet assured
manufacturing capacity from this strategic partner. In the second
quarter of 2002, as a result of signing the Cooperative Agreement,
we realized a one-time charge of $4.5 million for the loss on
assets held for sale. This charge was reported as a separate line
item in operating expense. We received $600,000 of the sales price
in June 2002 and $500,000 of the sales price in September 2002,
both of which were recorded as a reduction in the carrying value
of the assets held for sale.
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|Note P |  | Investments:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|       |  | In July 2002, we invested $5.0 million in Series B Preferred Stock
of ColorLink, Inc. which is convertible at anytime to common stock
of ColorLink at a conversion price of $10 per share. ColorLink has
a leading position worldwide in the development and manufacture of
color management technologies for LCoS microdisplays. ColorLinks
products consist of color management components and system
architectures that are critical for digital projection systems
that use high-resolution microdisplays. Those projection systems
include color monitors, high-definition televisions and
multi-media projectors. This investment furthers our efforts to
accelerate as much as possible the establishment of the necessary
infrastructure for LCoS microdisplays. Our investment in ColorLink
is accounted for under the cost method as our ownership is less
than 20% and we do not exert significant influence. An additional
$81,000 was recorded as investment in ColorLink during the third
quarter of 2002 for legal and due diligence expenses.                                                                                                                                                                                                                                                                                                                        
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|Note Q |  | Business Acquisitions:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|      
|       |  | In September 2002, we purchased the assets and ongoing business of
AVT, a privately held company that specializes in the design and
integration of complex, high-resolution display systems. AVT
designs and provides customized and ruggedized flat panel,
touchscreen and rackmount systems for original equipment
manufacturers including General Electric, Westinghouse, Gillette
and the U.S. military. AVT sources its display components from a
variety of companies including Sony, Sharp, NEC, LG and Samsung.
The purchase price of the acquisition was $12 million, which we
paid entirely in cash. The purchase agreement also calls for a
residual purchase payment of $2 million should the AVT division
achieve certain revenue and profit objectives for 2002 and 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

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| |  | The purchase price was allocated as follows in thousands:
| |  | ---------------------------------------------------------

|                              |                       |   |        |        | 
|----------------------------- | --------------------- | - | ------ | ------ | 
|Current Assets                |                       | $ | 2,206  |       
|                             
|                             
|                             
|                             
|Property, plant and equipment |                       |   | 105    |       
|                             
|                             
|                             
|                             
|Intangibles                   |                       |   | 3,000  |       
|                             
|                             
|                             
|                             
|Goodwill                      |                       |   | 7,631  |       
|                             
|                             
|                             
|                             
|Other long-term assets        |                       |   | 40     |       
|                             
|                             
|                             
|                             
|Current liabilities           |                       |   | (1,032 | )     
|                              |                       |   |        |       
|                              | Net Acquisition price |   | $      | 11,950 | 
|                              |                       |   |        |       




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

FORWARD-LOOKING STATEMENTS AND FACTORS THAT MAY AFFECT RESULTS

In addition to the historical information contained herein, this Report
contains forward-looking statements, including those relating to revenue,
earnings margins, pricing pressures, quarterly fluctuations, the impact of
moving our Arizona LCD line, material shortages, research, development, and
engineering expense, selling, general, and administrative expense, and
liquidity and anticipated cash needs that involve risks and uncertainties that
could cause actual results to differ materially.

We caution that these statements are qualified by various factors that may
affect future results, including the Special Considerations in Item 1 of our
Report on Form 10-K for the fiscal year ended December 31, 2001. Therefore,
this Report should be read in conjunction with that Form 10-K.

Overview

We offer advanced design and manufacturing services to original equipment
manufacturers, commonly referred to as OEMs. We have two business segments.
In one segment, referred to as the LCD business, we specialize in custom
display modules utilizing liquid crystal display, or LCD, components and
technology. Our LCD modules have varying levels of integration. At a minimum,
each module includes an LCD, a custom LCD driver, and a flexible connector. We
also provide value-added services, which increase our competitiveness, by
assembling additional components onto the module based upon the specific needs
of the customer. These additional components may include such items as
keypads, microphones, speakers, light guides, and optics. In addition, as
described below, we purchased the net assets of AVT Advanced Video
Technologies, or AVT, in September 2002, and all of its business will be
included in the LCD business segment. In our second business segment, referred
to as the Microdisplay business, we are pursuing the commercialization of
liquid crystal on silicon (LCoS)microdisplays following several years of
extensive research and development activities. We believe that the initial
markets for our LCoSmicrodisplay products will be in front projectors, large
screen television sets, and personal display system applications. We plan to
offer a range of LCoSproduct solutions with different levels of integration
from individual imagers to optical light engines for sale to OEMs that
manufacture monitors and televisions.

Substantially all of our sales are in our LCD business segment. We
currently sell substantially all of our LCD modules to major OEMs. We derived
more than 80% of our net sales in 1999, 2000, 2001, and the first nine months
of 2002 from the mobile handset market. When we win a design program, our
customers sometimes pay all or a portion of our nonrecurring engineering
expenses to defray the costs of custom design, as well as all or a portion of
the costs of nonrecurring tooling for custom components. The typical design
program life cycle of a custom-designed LCD module is three to 15 months and
includes technical design, prototyping, pilot manufacturing, and high-volume
manufacturing. Until 2001, our strategy was to seek large-volume programs from
major OEMs. In that situation, the minimum production quantity for an LCD
module typically approximates 100,000 units per year, although the production
rate for some programs has been higher than 100,000 units per week. Recently,
we have re-focused our strategy on lower-volume programs with potentially
higher gross margins. We have re-focused our strategy because some OEMs with
high-volume programs have begun to expect to

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purchase LCD modules for less than
industry costs. The selling price of our LCD modules usually ranges between $3
and $50 per unit. We
recognize revenue when persuasive evidence of an arrangement exists,
delivery has occurred, the fee is fixed or determinable, and collectability is
probable. These conditions are met at the time we ship products to customers.

We experienced substantial growth from 1993 through 1995, primarily as a
result of sales to OEMs in the wireless communications industry, which grew
substantially during that period. During that period, our primary customer in
the wireless communications industry was Motorola. In 1996, our net sales
declined, primarily as a result of the phase-out by Motorola of a significant
family of programs. In 1997, our net sales returned to pre-1996 levels,
primarily as a result of several new programs and customers. We experienced
substantial growth again in 1999 and 2000, but our sales substantially declined
in 2001 as a result of the world-wide economic slowdown. Motorola and its
subcontractors accounted for 34.6% of our net sales in 1997, 63.6% in 1998,
86.1% in 1999, 86.9% in 2000, and 85.4% in 2001. In the first nine months of
2002, Motorola and its subcontractors accounted for 84.5% of our net sales. As
a result of our change in strategy, discussed above, none of our design wins in
2001 and 2002 thus far have been with the handset group at Motorola.
Consequently, we expect total Motorola business to decline sharply over the
next several quarters as older programs end. In the third quarter of 2002,
Motorola business declined 32% over the second quarter of 2002. By the end of
2003, we expect Motorola to account for less than 10% of our revenue.

During the past several years, we have experienced seasonal quarterly
fluctuations in our net sales as our OEM customers developed retail products
with shorter product life cycles and phased out older programs early in the
year following holiday sales. Therefore, as compared with the fourth quarter
of a calendar year, sales are usually lower in the following quarter.

Several factors impact our gross margins, including manufacturing
efficiencies, product mix, product differentiation, product uniqueness,
inventory management, and volume pricing. In addition, significant pricing
pressure exists in the LCD module market. Accordingly, those factors have
impacted, and can be expected to continue to impact, our overall margins.

In the past, we used our own front-end LCD production line in Tempe,
Arizona for the manufacture of more technologically complex and custom
high-volume LCDs. We also purchased LCDs from third parties to provide us an
alternate source and to ensure available capacity. In order to take advantage
of lower labor costs, we traditionally shipped LCDs to our facilities in
Manila, the Philippines, or Beijing, China, for assembly into modules.

During the second quarter of 2001, we announced our strategic decision to
move our front-end manufacturing LCD line from Arizona to Asia. The front-end
LCD line was operated in Arizona through the third quarter of 2001 and was then
shut down. We now purchase all of our LCDs from third parties, although we
sometimes purchase partially completed LCDs and complete the back-end
operations on those LCDs in Manila, as described below. During the second
quarter of 2002, we signed a Cooperative Agreement with a Chinese company in
which we agreed to sell our front-end LCD line and establish a supply
agreement. The sale of the front-end LCD line will likely occur in the fourth
quarter of 2002. Under the terms of the Cooperative Agreement, in exchange for
our front-end LCD line, we will receive $3 million in cash, favorable LCD glass
pricing, and flexible yet assured manufacturing capacity from this strategic
partner. In the second quarter of 2002, as a result of signing the Cooperative
Agreement, we realized a one-time charge of $4.5 million for the loss on assets
held for sale. This charge was reported as a separate line item in operating
expense. We received $600,000 of the sales price in June 2002 and $500,000 of
the sales price in September 2002, both of which were recorded as a reduction
in the carrying value of the assets held for sale.

In Tempe, Arizona, we continue to manufacture all of our LCoS
microdisplays on our high-volume liquid crystal on silicon manufacturing line.
In addition, all testing and assembly into LCoSmodules is done in Tempe.

In Manila, we assemble LCDs into modules and perform certain back-end LCD
processing operations. We now conduct all of our operations in Manila at our
own factory, where we employ our own employees and do not employ the services
of a third-party subcontractor. Until April 2002, our back-end LCD processing
operations were

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conducted in Manila through a third-party subcontract
manufacturer. Since that date, however, the Manila back-end LCD processing has
been performed in our own facility.

In Beijing, we also assemble LCDs into modules. We conduct our LCD
module operations in Beijing through a wholly owned foreign subsidiary at a
facility we own. We also employ all of our own employees in Beijing.

Selling, general, and administrative expense consists principally of
administrative and selling costs, salaries, commissions, and benefits to
personnel and related facility costs. We make substantially all of our sales
directly to OEMs, and our sales force consists of a small number of direct
technical sales persons. As a result, there is no material cost of
distribution in our selling, general, and administrative expense. In addition,
we have recently incurred substantial marketing and administrative expenses in
connection with our LCoSmicrodisplay business.

Research, development, and engineering expense consists principally of
salaries and benefits to scientists, design engineers, and other technical
personnel, related facility costs, process development costs, and various
expenses for projects, including new product development. Research,
development, and engineering expense continues to increase as we develop new
display products and technologies, especially LCoSmicrodisplays.

Since 1997, we have been working on the development of LCoSmicrodisplays.
In 1997, we entered into a strategic alliance with National Semiconductor
Corporation for the development of LCoSmicrodisplay products. Under that
alliance, National Semiconductor focused on the silicon technologies needed for
microdisplays, and we focused on the liquid crystal technologies. In 1999,
National Semiconductor decided to close its microdisplay business unit. In
connection with that closing, in July 1999, we purchased certain assets and
licensed silicon technologies from National Semiconductor relating to LCoS
microdisplays. We paid approximately $3.0 million in cash and issued warrants
to purchase 140,000 shares of our common stock in the transaction, which valued
the transaction at approximately $3.6 million. No additional payments are
required under the licenses. We also hired several key technical employees of
National Semiconductor to assist in the implementation of the acquired
technologies.

In April 1998, we entered into a strategic relationship with Inviso, Inc.,
a privately held company with numerous patents and proprietary technology
related to microdisplay development. We acquired a minority equity interest in
Inviso for approximately $3.3 million. In March 2000, we acquired an
additional interest in Inviso for $500,000, raising our total minority equity
interest to $3.8 million. As part of this strategic relationship, we provided
proprietary manufacturing capabilities and liquid crystal expertise, and Inviso
provided patented and proprietary technologies and components for the joint
development of microdisplay products. In the second quarter of 2001, we wrote
off our investment of $3.8 million in Inviso because we determined that our
investment was impaired, as that term is defined under generally accepted
accounting principles. Subsequent to our write-off, Inviso was unable to raise
funds to operate its business and has since ceased operations. In the second
quarter of 2002, we purchased all of the intellectual property of Inviso for
$750,000.

In August 2000, our wholly owned subsidiary, Three-Five Systems (Beijing)
Co., Ltd., entered into a strategic agreement with Heibei Jiya Electronics,
Co., Ltd. (Jiya), a Chinese-based manufacturer of LCD glass. Under the terms
of the agreement, Jiya agreed to provide LCD glass to us and reserve a
significant amount of LCD glass manufacturing capacity for us. In exchange, we
agreed to assist Jiya in further developing its LCD glass manufacturing
processes. At the end of the agreement term in February 2002, we had the
option to extend the agreement or to acquire a majority interest in Jiya. We
elected not to extend the agreement or acquire a majority interest.

In 2001, we invested $1.25 million in Silicon Bandwidth, Inc., a privately
held company providing unique semiconductor and optoelectronic interconnect
solutions based upon multiple, patented, proprietary technologies. We are
working closely with Silicon Bandwidth to design unique, cost-effective,
reconfigurable packaging platforms for LCoSmicrodisplays.

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During the second quarter of 2001, we formed a new company, Three-D OLED
L.L.C., with DuPont Displays, a business unit of DuPont Corporation. We owned
51% of this new venture, and DuPont Displays owned 49%. The companies pledged
$3.0 million to the venture. Our share of that obligation was slightly over
$1.5 million. This venture was formed to design, assemble, and market OLED
(Organic Light Emitting Diode) display modules to OEMs worldwide with the focus
on glass substrate, passive matrix OLED displays. In the second quarter
of 2002, we agreed with DuPont Displays to liquidate our joint venture
with Three-D OLED L.L.C. and enter into a non-equity based Strategic
Manufacturing and Supply Agreement. Under that agreement, the parties will
continue to work together in a fashion similar to the venture, but the
relationship will be nonexclusive. Thus, we will have the right, but are not
required, to purchase the glass panel output of a planned high-volume
manufacturing plant located in Taiwan, announced by DuPont and RiTdisplay
Technology Corporation. In addition, we will utilize other OLED glass panel
sources. Upon the request of DuPont Displays, we will also manufacture OLED
display modules for them at our display module assembly facilities in Beijing
and Manila.

In January 2002, we purchased the intellectual property of Zight
Corporation, a private company focused on microdisplays for personal display
system applications. In addition, we purchased certain key assets of Zight at
a creditors auction and we hired seven key technical persons formerly employed
by Zight. The total cost of the acquisition was approximately $2.6 million.

In July 2002, we invested $5.0 million in ColorLink, Inc. ColorLink has a
leading position worldwide in the development and manufacture of color
management technologies for LCoS microdisplays. ColorLinks products consist
of color management components and system architectures that are critical for
digital projection systems that use high-resolution microdisplays. Those
projection systems include color monitors, high-definition televisions and
multi-media projectors. This investment furthers our efforts to accelerate as
much as possible the establishment of the necessary infrastructure for LCoS
microdisplays. An additional $81,000 was recorded as investment in ColorLink
during the third quarter of 2002 for legal and due diligence expenses.

In September 2002, we purchased the assets and ongoing business of AVT, a
privately held company that specializes in the design and integration of
complex, high-resolution display systems. AVT designs and provides customized
and ruggedized flat panel, touchscreen and rackmount systems for original
equipment manufacturers including General Electric, Westinghouse, Gillette and
the U.S. military. AVT sources its display components from a variety of
companies including Sony, Sharp, NEC, LG and Samsung. The purchase price of the
acquisition was $12 million, which we paid entirely in cash. The purchase
agreement also calls for a residual purchase payment of $2 million should the
AVT division achieve certain revenue and profit objectives for 2002 and 2003.

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 judgements 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, bad debts, inventories, investments, fixed
assets, intangible assets, income taxes, pensions and other post-retirement
benefits, contingencies, and litigation. 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 judgements 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 judgements and estimates used in the preparation of our financial
statements.

We recognize 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
have passed to the customer, the fee is fixed or determinable, and collection
of the resulting receivable is reasonably assured. Sales allowances are
created when any of the foregoing

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conditions are not met. Non-recurring
engineering and non-recurring tooling revenues are recognized as costs are
incurred.

We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. We
determine the adequacy of this allowance by regularly evaluating individual
customer receivables and considering a customers financial condition, credit
history, and current
economic conditions. If the financial condition of our customers were to
deteriorate, additional allowances may be required.

We write down our inventory for estimated obsolescence or unmarketable
inventory equal to the difference between the cost of inventory and the
estimated market value based upon assumptions 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.

We estimate our actual current tax exposure together with the temporary
differences that have resulted from the differing treatment of items dictated
by GAAP versus U.S. and foreign tax laws. These temporary differences result in
deferred tax assets and liabilities. Net operating loss carry forwards and
other credit carry forwards also result in deferred tax assets. On an on-going
basis, we then assess the likelihood that our deferred tax assets will be
recovered from future taxable income. If we were to believe that the recovery
were not more likely than not, we would establish a valuation allowance against
the deferred tax asset and charge the amount as an income tax expense in the
period in which such a determination was made.

Long-term assets, such as Long-term Investments, Property, Plant and
Equipment, Intangibles, Goodwill and Other Assets, are originally recorded at
cost. On an on-going basis, we assess these assets to determine if their
current recorded value is impaired. If we were to 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 September 30, 2002 compared to three months ended September 30, 2001.

Net Sales.Our net sales decreased 30.1% to $18.6 million in the three
months ended September 30, 2002 from $26.6 million in the three months ended
September 30, 2001. This decline was due entirely to the expected reduction in
shipments to our largest historic customer and a slower than expected ramp-up
in shipments to new customers. Sales to our largest historic customer were
36.7% lower in the third quarter of 2002 compared to the third quarter of 2001.
We derived more than 80% of our net sales from the mobile handset market.
Since the second half of 2000, weak and uncertain demand in the mobile handset
industry and continued issues with handset inventories have led to
cancellations, delays and push-outs for existing and new customers programs.
In addition, pricing pressures in the LCD module industry have led to a
reduction in average selling prices.

Cost of Sales.Cost of sales decreased to 97.1% of net sales in the three
months ended September 30, 2002 from 103.4% in the three months ended September
30, 2001. The higher percentage in 2001 was a result of sudden, intense
pricing pressure and operating inefficiencies caused by a rapid reduction in
production volumes. Since the second quarter of 2001, we have focused on
continued cost reductions to increase our operating efficiencies and lower our
breakeven levels.

Selling, General, and Administrative Expense.Selling, general, and
administrative expense, or SG&A, was $2.7 million in the three months ended
September 30, 2002, as compared to $2.4 million in the three months ended
September 30, 2001. The slight increase was due to increases in administrative
and legal expenses.

Research, Development, and Engineering Expense.Research, development,
and engineering expense , or RD&E, was $4.4 million in the three months ended
September 30, 2002, as compared to $4.2 million in the three months ended
September 30, 2001. The slight increase was due to the new efforts by us
focusing on near-to-eye

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microdisplay applications. Approximately 80% of the
RD&E expense related to the effort to develop LCoSmicrodisplays.

Other Income, Net.Other income in the three months ended September 30,
2002 was $755,000 compared to other income of $1.5 million in the three months
ended September 30, 2001. The interest income earned in the third quarter of
2002 was $716,000 compared to $1.5 million in the third quarter of 2001. The
primary reason for the
reduced interest income was a substantial reduction in the market interest
rate combined with a reduction in our average cash balances and liquid
investments.

Benefit from Income Taxes.We had a benefit from income taxes of $2.3
million in the three months ended September 30, 2002 compared to a benefit from
income taxes of $2.0 million in the three months ended September 30, 2001. The
tax benefit rate was 41.1% in the three months ended September 30, 2002
compared to 33.0% in the three months ended September 30, 2001. The increased
tax benefit rate was the result of a higher estimated annual loss in higher tax
rate jurisdictions and because of the allocation of our loss between various
countries. During the three months ended September 30, 2002, we established
valuation allowances for certain foreign tax credits. We also released prior
provisions for taxes related to estimates that were resolved during the three
months ended September 30, 2002.

Net Loss.Our net loss was $3.4 million, or $0.16 per diluted share, in
the three months ended September 30, 2002 compared to a net loss of $4.0
million, or $0.19 per diluted share, in the three months ended September 30,
2001.

For the Microdisplay business segment, we reported a net loss of
approximately $2.9 million, or $0.14 per share, in the third quarter of 2002,
which was equivalent to the net loss of approximately $2.9 million, or $0.14
per share, in the third quarter of 2001. For the LCD business segment, we
reported a net loss of approximately $498,000, or $0.02 per share, in the third
quarter of 2002 compared to a net loss of approximately $1.1 million, or $0.05
per share, in the third quarter of 2001.

Nine months ended September 30, 2002 compared to nine months ended September 30, 2001.

Net Sales.Net sales decreased 24.5% to $65.8 million in the nine months
ended September 30, 2002 from $87.2 million in the nine months ended September
30, 2001. This decrease was primarily a result of the downturn of the economy
in general as well as a downturn in the mobile handset market. The decline was
also due in part to the expected reduction in shipments to our largest historic
customer and a slower than expected ramp-up in shipments to new customers.
Sales to our largest historic customer were 24.9% lower in the first nine
months of 2002 compared to the first nine months of 2001. We derived more than
80% of our net sales from the mobile handset market. The number of LCD module
units shipped in the first nine months of 2002 was 12.3% less than the number
of units shipped in the first nine months of 2001. In addition, pricing
pressures in the LCD module industry have led to a reduction in average selling
prices.

Cost of Sales.Cost of sales decreased to 98.0% of net sales in the nine
months ended September 30, 2002 from 104.2% in the nine months ended September
30, 2001. The higher percentage in 2001 was a result of sudden, intense pricing
pressure and operating inefficiencies caused by a rapid reduction in production
volumes. In addition, in the second quarter of 2001, we had a $2.4 million
charge relating to the write-off of our inventory. The inventory write-off
occurred because of cancellations by customers of various end-of-life programs.
Since the second quarter of 2001, we have focused on continued cost reductions
to increase our operating efficiencies and lower our breakeven levels.

Selling, General, and Administrative Expense.Selling, general, and
administrative expense increased 8.9% to $8.6 million in the nine months ended
September 30, 2002 from $7.9 million in the nine months ended September 30,
2001. The increase in SG&A expense was a result of a variety of factors,
including legal fees, marketing and selling costs.

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Research, Development, and Engineering Expense.Research, development,
and engineering expense increased 10.2% to $14.0 million in the nine months
ended September 30, 2002 from $12.7 million in the nine months ended September
30, 2001. RD&E expense overall increased exclusively as a result of the
efforts to bring LCoSmicrodisplays into production. Part of the increase in
microdisplay RD&E was the result of adding a new group focused on near-to-eye
microdisplay applications.

Loss on Assets Held for Sale.During the second quarter of 2002, we
signed a Cooperative Agreement with a Chinese company in which we agreed to
sell our front-end manufacturing LCD line and establish a supply
agreement. The sale of the front-end LCD line will likely occur in the
fourth quarter of 2002. Under the terms of the Cooperative Agreement, in
exchange for our front-end LCD line, we will receive $3 million in cash,
favorable LCD glass pricing, and flexible yet assured manufacturing capacity
from this strategic partner. In the second quarter of 2002, as a result of
signing the Cooperative Agreement, we realized a one-time charge of $4.5
million for the loss on assets held for sale. This charge was reported as a
separate line item in operating expense.

Other Income, Net.Other income in the nine months ended September 30,
2002 was $2.9 million compared to other income of $1.6 million in the nine
months ended September 30, 2001. The principal reason for the difference was
the write-off of our investment in Inviso, Inc. of $3.8 million in the second
quarter of 2001. In addition, the interest income earned in the first nine
months of 2001 was $5.4 million as compared to $2.7 million in the first nine
months of 2002. The primary reason for the reduced interest income was a
substantial reduction in the market interest rate combined with a reduction in
our average cash balances and liquid investments.

Benefit from Income Taxes.We had a benefit from income taxes of $8.5
million for the nine months ended September 30, 2002 compared to a benefit from
income taxes of $7.4 million for the nine months ended September 30, 2001. The
tax benefit rate was 37.3% in the nine months ended September 30, 2002 compared
to a tax benefit rate of 33.0% in the nine months ended September 30, 2001.
The increased tax benefit rate was the result of a higher estimated annual loss
in higher tax rate jurisdictions and because of the allocation of our loss
between various countries. During the nine months ended September 30, 2002, we
established valuation allowances for certain foreign tax credits. We also
released prior provisions for taxes related to estimates that were resolved
during the nine months ended September 30, 2002.

Net Loss.Our net loss was $14.3 million, or $0.67 per diluted share, in
the nine months ended September 30, 2002 compared to a net loss of $15.1
million, or $0.70 per diluted share, in the nine months ended September 30,
2001.

For the Microdisplay business segment, we reported a net loss of
approximately $10.3 million, or $0.48 per share, in the nine months ended
September 30, 2002, compared to a net loss of approximately $9.1 million, or
$0.42 per share, in the nine months ended September 30, 2001. For the LCD
business segment, we reported a net loss of $4.0 million, or $0.19 per share,
in the nine months ended September 30, 2002 compared to a net loss of $6.0
million, or $0.28 per share, in the nine months ended September 30, 2001.

Quarterly Results of Operations

The following table presents unaudited consolidated statement of
operations data for each of the five quarters in the period ended September 30,
2002. We believe that all necessary adjustments have been included to present
fairly the quarterly information when read in conjunction with the Condensed
Consolidated Financial Statements. The operating results for any quarter are
not necessarily indicative of the results for any subsequent quarter.

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|                                                              |                                        |   |                |        |         |   |         |        |         |   |         |        |  |   |         |        |  |   |        |        | 
|------------------------------------------------------------- | -------------------------------------- | - | -------------- | ------ | ------- | - | ------- | ------ | ------- | - | ------- | ------ |  | - | ------- | ------ |  | - | ------ | ------ | 
|                                                              |                                        |   | Quarters Ended
|                                                              |                                        |   |               
|                                                              |                                        |   | (in thousands)
|                                                              |                                        |   | Sep 30,        |        | Dec 31, |   | Mar 31, |        | Jun 30, |   | Sep 30,
|                                                              |                                        |   |                |        |         |   |         |        |         |   |        
|                                                              |                                        |   | 2001           |        | 2002   
|                                                              |                                        |   |                |        |        
|Net sales                                                     |                                        | $ | 26,594         |        |         | $ | 31,913  |        |         | $ | 23,110  |        |  | $ | 24,087  |        |  | $ | 18,584 |       
|                                                              |                                        |   |                |        |         |   |         |        |         |   |         |        |  |   |         |        |  |   |        |       
|Costs and expenses:                                           |                                        |   |                |        |         |   |         |        |         |   |         |        |  |   |         |        |  |   |        |       
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | Cost of sales                          |   |                | 27,453 |         |   |         | 30,658 |         |   |         | 22,902 |  |   |         | 23,484 |  |   |        | 18,049 | 
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | Selling, general, and administrative   |   |                | 2,444  |         |   |         | 2,273  |         |   |         | 3,125  |  |   |         | 2,812  |  |   |        | 2,665  | 
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | Research, development, and engineering |   |                | 4,224  |         |   |         | 4,938  |         |   |         | 4,818  |  |   |         | 4,796  |  |   |        | 4,359  | 
|                                                             
|                                                             
|                                                             
|                                                             
|                                                              | Loss on sale of assets                 |   |                |       |         |   |         |       |         |   |         |       |  |   |         | 4,545  |  |   |        |       | 
|                                                              |                                        |   |                |        |         |   |         |        |         |   |         |        |  |   |         |        |  |   |        |       
|                                                              |                                        |   | 34,121         |        |         |   | 37,869  |        |         |   | 30,845  |        |  |   | 35,637  |        |  |   | 25,073 |       
|                                                              |                                        |   |                |        |         |   |         |        |         |   |         |        |  |   |         |        |  |   |        |       
|Operating loss                                                |                                        |   | (7,527         | )      |         |   | (5,956  | )      |         |   | (7,735  | )      |  |   | (11,550 | )      |  |   | (6,489 | )     
|                                                             
|                                                             
|                                                             
|                                                             
|Other income, net                                             |                                        |   | 1,497          |        |         |   | 1,886   |        |         |   | 1,198   |        |  |   | 894     |        |  |   | 755    |       
|                                                             
|                                                             
|                                                             
|                                                             
|Minority interest in loss (income) of
consolidated subsidiary |                                        |   | 62             |        |         |   | 105     |        |         |   | 105     |        |  |   | (21     | )      |  |   |       |       
|                                                              |                                        |   |                |        |         |   |         |        |         |   |         |        |  |   |         |        |  |   |        |       
|Loss before income taxes                                      |                                        |   | (5,968         | )      |         |   | (3,965  | )      |         |   | (6,432  | )      |  |   | (10,677 | )      |  |   | (5,734 | )     
|                                                             
|                                                             
|                                                             
|                                                             
|Benefit from income taxes                                     |                                        |   | (1,972         | )      |         |   | (1,303  | )      |         |   | (2,122  | )      |  |   | (4,037  | )      |  |   | (2,354 | )     
|                                                              |                                        |   |                |        |         |   |         |        |         |   |         |        |  |   |         |        |  |   |        |       
|Net loss                                                      |                                        | $ | (3,996         | )      |         | $ | (2,662  | )      |         | $ | (4,310  | )      |  | $ | (6,640  | )      |  | $ | (3,380 | )     
|                                                              |                                        |   |                |        |         |   |         |        |         |   |         |        |  |   |         |        |  |   |        |       

Liquidity and Capital Resources

At September 30, 2002, we had cash, cash equivalents, and liquid
investments of $126.4 million compared to $156.1 million at December 31, 2001.
This decrease was due primarily from our operating cash outflow, the purchase
of AVT, the investment in ColorLink, the acquisition of the intellectual
property and certain other assets of Zight Corporation, the acquisition of the
intellectual property of Inviso, Inc., and the purchase of tooling, production,
and test upgrades to our microdisplay equipment in Tempe.

In the quarter ended September 30, 2002, we had approximately $4.9 million
in net cash flow from operations compared to $1.9 million in net cash outflow
from operations in the quarter ended September 30, 2001. The net cash flow was
primarily related to the $6.2 million in tax refunds received during the
quarter.

Depreciation and amortization expense was $1.9 million for the third
quarter of 2002 compared to $1.5 million for the third quarter of 2001. This
increase was the result of increased amortization of intangibles and
depreciation on equipment related to our LCoS efforts. Inventory turns were
6.5 in the third quarter of 2002 compared to 6.6 in the third quarter of 2001.
Accounts receivable DSOs (Day Sales Outstanding) were 63 days in the third
quarter of 2002 compared to 72 days in the third quarter of 2001.

In the first nine months of 2002, we had $3.2 million in net cash outflow
from operations compared to $9.8 million in net cash outflow from operations
during the same period in 2001.

Our working capital was $138.7 million at September 30, 2002 compared with
$169.1 million at December 31, 2001. Our current ratio increased to 10.0-to-1
at September 30, 2002 from 8.8-to-1 at December 31, 2001. Our working capital
decreased as a result of our cash outflow. Our current ratio increased as a
result of the decrease in our current liabilities.

In February 2002, we renewed our credit facility with Comerica Bank. That
credit facility is a $15.0 million unsecured revolving line of credit that
matures in January 2003. No borrowings were outstanding under that credit
facility on September 30, 2002. Advances under the facility 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 150 basis
points in excess of the LIBOR base rate. In May 2002, our Beijing subsidiary
renewed its credit facility with the Bank of China. As of September 30, 2002,
our Beijing subsidiary had an outstanding $2.7 million term loan due April 30,
2003 to the Bank of China, which was secured by a $3.0 million standby letter
of credit issued by Comerica Bank.

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Purchases of intangibles and property, plant, and equipment during the
third quarter of 2002 were approximately $2.3 million. Another $3.0 million
was allocated to intangibles through the acquisition of AVTs customer lists.

The following tables list our contractual obligations and commercial
commitments:

|                                   |  |               |        |             |  |                        |       |           |  |                  |       |  |  |   |       |  |  |   |       | 
|---------------------------------- |  | ------------- | ------ | ----------- |  | ---------------------- | ----- | --------- |  | ---------------- | ----- |  |  | - | ----- |  |  | - | ----- | 
|                                   |  |               |        |             |  | Payments due by Period
|                                   |  |               |        |             |  |                       
|Contractual Obligations            |  | Total Amounts |        | Less        |  |                        |       |           |  |                  |       |  |  |   |       | 
|(in thousands)                     |  | Committed     |        | than 1 Year |  | 1-3 Years              |       | 4-5 Years |  | 6 Years and Over
|                                   |  |               |        |             |  |                        |       |           |  |                 
|Term Loan                          |  | $             | 2,706  |             |  | $                      | 2,706 |           |  | $                |      |  |  | $ |      |  |  | $ |      | 
|                                  
|                                  
|                                  
|                                  
|Operating Leases                   |  |               | 15,057 |             |  |                        | 964   |           |  |                  | 2,057 |  |  |   | 2,221 |  |  |   | 9,815 | 
|                                   |  |               |        |             |  |                        |       |           |  |                  |       |  |  |   |       |  |  |   |       | 
|Total Contractual Cash Obligations |  | $             | 17,763 |             |  | $                      | 3,670 |           |  | $                | 2,057 |  |  | $ | 2,221 |  |  | $ | 9,815 | 
|                                   |  |               |        |             |  |                        |       |           |  |                  |       |  |  |   |       |  |  |   |       | 

|                             |  |               |     |             |  |                                            |    |           |  |                  |     |  |  |   |     |  |  |  |   | 
|---------------------------- |  | ------------- | --- | ----------- |  | ------------------------------------------ | -- | --------- |  | ---------------- | --- |  |  | - | --- |  |  |  | - | 
|                             |  |               |     |             |  | Amount of Commitment Expiration Per Period
|                             |  |               |     |             |  |                                           
|Other Commercial Commitments |  | Total Amounts |     | Less        |  |                                            |    |           |  |                  |     |  |  |   |     | 
|(in thousands)               |  | Committed     |     | than 1 Year |  | 1-3 Years                                  |    | 4-5 Years |  | 6 Years and Over
|                             |  |               |     |             |  |                                            |    |           |  |                 
|Guarantee                    |  | $             | 450 |             |  | $                                          | 90 |           |  | $                | 200 |  |  | $ | 160 |  |  |  |  | 

The operating leases include a lease for our factory in Manila and our
ground lease in Tempe, Arizona. These leases are described in detail in Note 7
of the Notes to our Consolidated Financial Statements for 2001 included in our
Form 10-K. The guarantee relates to our guarantee in connection with a Small
Business Administration loan to VoiceViewer Technology, Inc., a private company
developing microdisplay products. The $3.0 million standby letter of credit
issued by Comerica has not been included in the Other Commercial Commitments
table because it only exists to secure the term loan obligation of $2.7
million, which is already included in the table for Contractual Obligations. 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. We have no off-balance sheet arrangements.

We believe that our existing balances of cash, cash equivalents, and
investments will provide adequate sources to fund our operations and planned
expenditures through 2002 and 2003, as well as to meet our contractual
obligations. Specifically, we have $126.4 million in cash, cash equivalents,
and short- and long-term investments. Our capital expenditures for the
remainder of 2002 are expected to be less than $1.0 million, and we expect
operating cash outflow to be minimal relative to our cash reserves. We continue
to seek other alliances or acquisitions and additional relationships with
regard to the strategic development of both business segments. We have hired
an investment banking firm in that regard. New acquisitions or alliances may
result in our needing to expand our loan commitments or pursue alternate
methods of financing or raise capital. We cannot provide assurance that
adequate additional loan commitments or alternative methods of financing will
be available or, if available, that they will be on terms acceptable to us.

Impact of Recently Issued Standards.

In September 2001, the FASB issued SFAS No. 141, Business Combinations,
and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141
requires companies to apply the purchase method of accounting for all business
combinations initiated after September 30, 2001 and prohibits the use of the
pooling-of-interest method. SFAS No. 142 changes the method by which companies
may recognize intangible assets in purchase business combinations and generally
requires identifiable intangible assets to be recognized separately from
goodwill. In addition, it eliminates the amortization of all existing and
newly acquired goodwill on a prospective basis and requires companies to assess
goodwill for impairment, at least annually, based on the fair value of the
reporting unit.

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We adopted SFAS Nos. 141 and 142 on January 1, 2002, and there
was no material impact on our financial position or results of operations.

In August 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supersedes SFAS No.
121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of, and the accounting and reporting provisions of APB
Opinion No. 30, Reporting the Results of Operations  Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions. SFAS No. 144 modifies the
method in which companies account for certain asset impairment losses. We
adopted SFAS No. 144 on January 1, 2002 and there was no material impact on our
financial position or results of operations.

In July 2001, the FASB issued SFAS No. 146, Accounting for Costs
Associated with Exit or Disposal Activities. SFAS No. 146 requires companies
to recognize costs associated with exit or disposal activities when they are
incurred rather than at the date of a commitment to an exit or disposal plan.
SFAS No. 146 replaces EITF Issue No. 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring), and will apply to exit or disposal
activities initiated after December 31, 2002. We have reviewed the requirements
of SFAS No. 146 and believe the adoption of this statement will not have a
material impact on our financial statements.




ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURE 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, 2001.




ITEM 4. CONTROLS AND PROCEDURES

As of a date within 90 days prior to the date of the filing of this
report, our Chief Executive Officer and Chief Financial Officer have reviewed
and evaluated the effectiveness of our disclosure controls and procedures,
which included inquiries made to certain other of our employees. Based on
their evaluation, our Chief Executive Officer and Chief Financial Officer have
each concluded that our disclosure controls and procedures are effective and
sufficient to ensure that we record, process, summarize and report information
required to be disclosed by us in our periodic reports filed under the
Securities Exchange Act within the time periods specified by the Securities and
Exchange Commissions rules and forms. Subsequent to the date of their
evaluation, there have not been any significant changes in our internal
controls or in other factors that could significantly affect these controls,
including any corrective action with regard to significant deficiencies and
material weaknesses.




PART II. OTHER INFORMATION




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

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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.

Currently, no officers have adopted trading plans.




ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

|    |  |                                                                                                                                                                   
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) |  | Exhibits:
Exhibit 99.1  Certification of President/CEO, pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
|   
|   
|   
|   
|   
|   
|   
|   
|   
|   
|   
|   
|    |  | Exhibit 99.2  Certification of Chief Financial Officer, 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 August 5, 2002, furnishing an
Item 9 FD disclosure.                                                             




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: October 28, 2002 |  | /s/ Jeffrey D. Buchanan                                                                        
|                       
|                       
|                       
|                       
|                        |  | Name:   Jeffrey D. Buchanan                                                                    
|                       
|                       
|                       
|                       
|                        |  | Its:        Executive Vice President; Chief Financial
                                  Officer

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CERTIFICATIONS

I, Jack L. Saltich, certify that:

1.     I have reviewed this quarterly report on Form 10-Q of Three-Five
Systems, Inc.;

2.     Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
quarterly report;

3.     Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations, and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;

4.     The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:



| |                                                                                                                                                                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
|
| | b) evaluated the effectiveness of the registrants disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the Evaluation Date); and                                                                                                  
|
| | c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;                                                                                                                        

5.     The registrants other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrants auditors and the audit
committee of the registrants board of directors (or persons performing the
equivalent functions):



| |                                                                                                                                                                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrants ability
to record, process, summarize, and report financial data and have
identified for the registrants auditors any material weaknesses in
internal controls; and
|
| | b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrants internal
controls; and                                                                                                                                         

6.     The registrants other certifying officers and I have indicated in this
quarterly report whether there were significant changes in internal controls or
in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions
with regard to significant deficiencies and material weaknesses.

Date: October 28, 2002

| |  |                        
| |  | -----------------------
| |  | /s/ Jack L. Saltich    
|
|
|
|
| |  | Jack L. Saltich        
|
|
|
|
| |  | Chief Executive Officer

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##### Table of Contents



I, Jeffrey D. Buchanan, certify that:

1.     I have reviewed this quarterly report on Form 10-Q of Three-Five
Systems, Inc.;

2.     Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
quarterly report;

3.     Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations, and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;

4.     The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:



| |                                                                                                                                                                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
|
| | b) evaluated the effectiveness of the registrants disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the Evaluation Date); and                                                                                                  
|
| | c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;                                                                                                                        

5.     The registrants other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrants auditors and the audit
committee of the registrants board of directors (or persons performing the
equivalent functions):



| |                                                                                                                                                                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrants ability
to record, process, summarize, and report financial data and have
identified for the registrants auditors any material weaknesses in
internal controls; and
|
| | b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrants internal
controls; and                                                                                                                                         

6.     The registrants other certifying officers and I have indicated in this
quarterly report whether there were significant changes in internal controls or
in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions
with regard to significant deficiencies and material weaknesses.

Date: October 28, 2002

| |  |                        
| |  | -----------------------
| |  | /s/ Jeffrey D. Buchanan
|
|
|
|
| |  | Jeffrey D. Buchanan    
|
|
|
|
| |  | Chief Financial Officer

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EXHIBIT INDEX



| |  | Exhibit 99.1  Certification of President/CEO, pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.          
| |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  | Exhibit 99.2  Certification of Chief Financial Officer, pursuant to
18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.

23