SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                 ---------------

                                    FORM 10-K
 Annual Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934
                  For the fiscal year ended December 31, 1998

                          Commission File Number 1-4373


                            THREE-FIVE SYSTEMS, INC.
                  ---------------------------------------------
             (Exact Name of Registrant as Specified in Its Charter)

           Delaware                                               86-0654102
-------------------------------                              -------------------
(State or Other Jurisdiction of                               (I.R.S. Employer
 Incorporation or Organization)                              Identification No.)

                  1600 North Desert Drive, Tempe, Arizona 85281
                  ---------------------------------------------
                    (Address of Principal Executive Offices)

                                 (602) 389-8600
              ----------------------------------------------------
              (Registrant's Telephone Number, Including Area Code)

Securities registered under Section 12(b) of the Exchange Act:

         Title of Each Class           Name of Each Exchange On Which Registered
         -------------------           -----------------------------------------

Common Stock, Par Value $.01 Per Share          New York Stock Exchange

Securities registered under Section 12(g) of the Exchange Act:  None

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Exchange  Act during the  preceding 12
months (or for such shorter period that the registrant was required to file such
reports)  and (2) has been subject to such filing  requirements  for the past 90
days. Yes [X]  No [ ]

Indicate by check mark if disclosure of delinquent  filers  pursuant to Item 405
of Regulation  S-K is not contained  herein,  and will not be contained,  to the
best of registrant's  knowledge,  in definitive proxy or information  statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

As of March 8, 1999,  the  aggregate  market  value of the voting  stock held by
non-affiliates of the issuer,  computed by reference to the price at which stock
was sold as of such date in the stock  market as  reported on the New York Stock
Exchange,  was  $68,080,668.  Shares of Common  Stock held by each  officer  and
director and by each person who owns 10% or more of the outstanding Common Stock
have been  excluded in that such  persons may be deemed to be  affiliates.  This
determination  of affiliate  status is not  necessarily  conclusive and does not
constitute an admission of affiliate status.

As of March 8, 1999,  there were 7,012,107  shares of the issuer's  Common Stock
outstanding.

Documents  incorporated by reference:  Portions of the issuer's definitive Proxy
Statement  for the 1999  Annual  Meeting of  Stockholders  are  incorporated  by
reference into Part III hereof.

<PAGE>

                            THREE-FIVE SYSTEMS, INC.

                           ANNUAL REPORT ON FORM 10-K

                      FOR THE YEAR ENDED DECEMBER 31, 1998

                                TABLE OF CONTENTS

                                                                            Page
                                                                            ----
                                     PART I
ITEM 1.   BUSINESS..........................................................  1
ITEM 2.   PROPERTIES........................................................ 22
ITEM 3    LEGAL PROCEEDINGS................................................. 22
ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............... 22

                                PART II

ITEM 5.   MARKET FOR REGISTRANT'S COMMON EQUITY AND
            RELATED STOCKHOLDER MATTERS..................................... 23
ITEM 6.   SELECTED FINANCIAL DATA........................................... 24
ITEM 7    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
            CONDITION AND RESULTS OF OPERATIONS............................. 25
ITEM 7A   QUANTITATIVE AND QUALITATIVE DISCLOSURES
            ABOUT MARKET RISK............................................... 34
ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................... 35
ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
            ACCOUNTING AND FINANCIAL DISCLOSURE............................. 35

                               PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS.................................. 35
ITEM 11.  EXECUTIVE COMPENSATION............................................ 35
ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
            AND MANAGEMENT.................................................. 35
ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................... 35

                                PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES,
            AND REPORTS ON FORM 8-K......................................... 36

SIGNATURES.................................................................. 38

                              --------------------

                 STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

         THE  STATEMENTS  CONTAINED  IN THIS  REPORT  ON FORM  10-K THAT ARE NOT
PURELY  HISTORICAL  ARE   FORWARD-LOOKING   STATEMENTS  WITHIN  THE  MEANING  OF
APPLICABLE  SECURITIES  LAWS.   FORWARD-LOOKING  STATEMENTS  INCLUDE  STATEMENTS
REGARDING THE COMPANY'S "EXPECTATIONS," "ANTICIPATION," "INTENTIONS," "BELIEFS,"
OR "STRATEGIES"  REGARDING THE FUTURE.  FORWARD-LOOKING  STATEMENTS ALSO INCLUDE
STATEMENTS  REGARDING  REVENUE,  MARGINS,  EXPENSES,  AND EARNINGS  ANALYSIS FOR
FISCAL  1999 AND  THEREAFTER;  TECHNOLOGICAL  INNOVATIONS;  FUTURE  PRODUCTS  OR
PRODUCT  DEVELOPMENT;  THE COMPANY'S PRODUCT DEVELOPMENT  STRATEGIES;  POTENTIAL
ACQUISITIONS  OR  STRATEGIC  ALLIANCES;  THE  SUCCESS OF  PARTICULAR  PRODUCT OR
MARKETING  PROGRAMS;  THE AMOUNTS OF REVENUE  GENERATED  AS A RESULT OF SALES TO
SIGNIFICANT   CUSTOMERS;   AND   LIQUIDITY  AND   ANTICIPATED   CASH  NEEDS  AND
AVAILABILITY.  ALL FORWARD-LOOKING  STATEMENTS INCLUDED IN THIS REPORT ARE BASED
ON  INFORMATION  AVAILABLE  TO THE COMPANY AS OF THE FILING DATE OF THIS REPORT,
AND THE  COMPANY  ASSUMES  NO  OBLIGATION  TO  UPDATE  ANY SUCH  FORWARD-LOOKING
STATEMENTS.  THE  COMPANY'S  ACTUAL  RESULTS  COULD DIFFER  MATERIALLY  FROM THE
FORWARD-LOOKING STATEMENTS. AMONG THE FACTORS THAT COULD CAUSE ACTUAL RESULTS TO
DIFFER  MATERIALLY  ARE THE  FACTORS  DISCUSSED  IN ITEM 1,  "BUSINESS - SPECIAL
CONSIDERATIONS."

<PAGE>
                                     PART I

ITEM 1. BUSINESS

INTRODUCTION

         The Company  designs and  manufactures a wide range of display  modules
for use in the end products of original equipment  manufacturers  ("OEMs"). Most
of the Company's  sales  consist of custom  display  modules  developed in close
collaboration  with its  customers.  Devices  designed and  manufactured  by the
Company find application in cellular telephones and other wireless communication
devices as well as in medical equipment, office automation equipment, industrial
process controls,  instrumentation,  consumer  electronic  products,  automotive
equipment,  and industrial and military control products.  The Company currently
specializes  in liquid  crystal  display  ("LCD")  components  and technology in
providing its design and manufacturing  services for its customers.  The Company
markets its services primarily in North America, Europe, and Asia through direct
technical  sales persons and, to a much lesser  extent,  through an  independent
sales and distribution network.

         The Company experienced  substantial growth from 1993 through 1995 with
net sales  increasing  from $38.0 million in 1993 to $91.6 million in 1995.  The
Company's  growth  during that  period,  however,  depended  primarily  upon the
Company's participation in the substantial growth of the wireless communications
market and sales to a single  major  customer  in that  industry.  In 1996,  the
Company's  sales  declined  to  $60.7  million,  largely  as the  result  of the
phase-out by that major  customer of a  significant  family of programs in early
1996, and the Company  reported a loss in 1996 as a result of that phase-out and
the significant  inventory reserve taken during the third quarter. The Company's
sales increased to $84.6 million in 1997 and $95.0 million in 1998, primarily as
a result of several new programs,  including  programs for a  telecommunications
customer and an office automation customer.  The growth that occurred during the
period from 1993  through  1995  allowed the  Company to  construct  the highest
volume passive  matrix LCD glass  production  facility in North  America,  which
enables  the  Company  to  produce  a  substantial  portion  of  its  LCD  glass
requirements,  as well as to attract  key  personnel,  expand its  research  and
development  efforts,  and build its infrastructure.  The Company has undertaken
substantial  efforts to broaden its customer base by obtaining new customers and
by increasing its business with those existing  customers that historically have
comprised a small  percentage  of the  Company's  revenue.  The Company has also
undertaken  efforts to expand its markets by (1) placing sales  personnel in new
geographic locations,  (2) setting up a new manufacturing facility in China, (3)
targeting new industrial applications, and (4) developing new kinds of products.

         The Company  believes that it is positioned to continue the growth that
it  experienced  in 1997 and 1998 as a result of its  efforts in  expanding  its
customer  base and the markets it serves as well as its  strength in  designing,
prototyping,  and producing,  on a timely and cost-efficient basis, a wide range
of innovative, distinctive, and high-quality display modules required in the end
products of OEMs. In the past few years,  the Company has refocused its research
and  development   capabilities   with  the  intention  of  developing   display
technologies and manufacturing processes that will be useful for its current and
future customers. The Company's design processes utilize advanced computer-aided
design  software to provide  custom  solutions for  customers'  products in time
frames and on cost bases that it believes are competitive.  The Company utilizes
advanced,   flexible  manufacturing  systems  that  can  accommodate  low-volume
production runs or highly sophisticated applications in Arizona and high-volume,
price sensitive runs in Manila, the Philippines and Beijing, China.

         The Company  maintains  its principal  executive  offices at 1600 North
Desert Drive, Tempe,  Arizona 85281, and its telephone number is (602) 389-8600.
Unless the context indicates otherwise, all references to the "Company" refer to
Three-Five Systems, Inc., its subsidiaries and predecessors.

TECHNOLOGY

         Since the commercial  introduction  of the first light emitting  diodes
("LEDs") in the 1960s and twisted nematic liquid crystal  displays in the 1970s,
the use of LCD and LED  indicators  has  become  widespread  in  industrial  and
consumer  electronic  products.  Prior to  these  innovations,  the most  common
displays or indicators had substantial  limitations as to their use,  especially
in terms of size, life, and power  consumption.  LCD and LED  technologies  were
developed in order to overcome these limitations.

                                       1
<PAGE>
         An LCD modifies light that passes through or is reflected by it, rather
than emitting light like an LED. An LCD generally  consists of a layer of liquid
crystalline  material  suspended  between two glass plates.  The crystals  align
themselves in a predictable  manner,  and this alignment changes when stimulated
electrically.  This changed  alignment  produces a visual  representation of the
information desired when used in conjunction with a polarizer and either natural
ambient light or an external light source.

         The Company  also has  undertaken  substantial  efforts with respect to
liquid crystal on silicon  (LCoS(TM))  microdisplays.  Liquid crystal on silicon
displays  are a form of LCD where,  instead  of  suspending  liquid  crystalline
material  between two glass  plates,  the material is suspended  between a glass
plate and silicon backplate. The silicon backplate is an integrated circuit that
provides   drive  signals  for  each  element  of  the  display  (for  instance,
active-matrix  drive)  and also  provides  logic  functions,  such as  serial to
parallel   conversion  and  data  storage.   Because  highly  developed  silicon
integrated  circuits form the basis of these displays,  the LCoS(TM)  technology
provides very high information  displays in a small size and at a relatively low
cost.  The high  information  presented by such  displays is magnified for view,
generally either in a projector or in a view-finder.

INDUSTRY OVERVIEW

         The Company has benefited from the determination by certain OEMs in the
electronics   industry  to  outsource  the  design  and  production  of  certain
components included in the end products of those OEMs. The Company believes that
the following factors have contributed to this growing trend among OEMs:

     +    As technology has become  increasingly  sophisticated and complex,  it
          has become more  difficult  for even the leading  OEMs to maintain the
          necessary technology,  expertise,  personnel,  and equipment to design
          and produce  internally  all of the various  components  necessary for
          their products.

     +    Advanced  design  and  manufacturing  processes  require  increasingly
          greater  investments  for research  and  development,  personnel,  and
          equipment.

     +    Competitive  market  conditions  require  OEMs to reduce the period of
          time from product  conception  to  delivery,  to  differentiate  their
          products   from  those  of  their   competitors,   to   improve   user
          friendliness,  and to  continually  enhance  product  performance  and
          reduce product cost during the life cycle of the product.

         OEMs often design their products to contain display modules as a highly
cost-effective means of differentiating  their products from competing products.
OEMs then make the  decision of whether to use standard  devices,  to design and
produce the devices in-house,  or to outsource with a third party for design and
production.  In making  this  decision,  companies  often  recognize  that their
greatest  strengths  consist of  consumer  recognition  of brand  names,  market
research  and product  development  expertise,  and highly  developed  sales and
distribution channels. OEMs also recognize that the desired devices often cannot
be  obtained  "off-the-shelf"  and that  time  constraints  and  limitations  on
available  resources  often  preclude  them  from  maintaining  the  specialized
in-house expertise and equipment necessary to design and manufacture the desired
devices.  OEMs  often  conclude  that the  logical  solution  is to focus  their
resources on those areas (such as marketing and distribution) where they possess
the greatest  leverage and to outsource the design and production of devices and
components in which they lack the requisite technology and expertise.

         Outsourcing enables OEMs to obtain the following desired benefits:

     +    To gain access to specialized design and manufacturing  technology and
          expertise.

     +    To   accelerate   the  design   process  and  to  reduce   design  and
          manufacturing costs by utilizing the specialized personnel, equipment,
          and facilities of the supplier.

     +    To reduce their own investment in personnel, equipment, and facilities
          necessary for specialized design and production capabilities.

     +    To streamline their own operations by concentrating their resources on
          the design, production, and distribution of their core products.

                                       2
<PAGE>
         By eliminating the duplication and overlap of investment and resources,
outsourcing  permits  the Company  and the OEMs to work  together  and grow at a
faster rate than would  otherwise be possible.  Outsourcing  greatly reduces the
Company's need to devote time and resources on market  development  for specific
products and allows the Company to concentrate on the development of its display
technologies and their applications to a multitude of products.

PRODUCTS AND SERVICES

         The Company currently emphasizes  custom-designed  display modules. The
Company  believes  that custom  devices  represent a  significant  source of its
profits and growth potential. For each custom device, the Company works directly
with its customer to develop and produce the original  design and to manufacture
the device in accordance  with the customer's  specifications.  The Company also
designs and produces standard or "off-the-shelf"  devices, which involve designs
that are adaptable to various fixed end uses without modification or with slight
modifications.  In the last few  years,  the  Company's  standard  devices  have
accounted  for less than 10  percent  of its  revenues.  In 1999,  however,  the
Company  is  planning  to  introduce  new  standard  products  using some of the
Company's new display technologies.

         The  Company  pursues a strategy  designed  to enable it to enhance its
position as a major,  worldwide  supplier of  custom-designed  and  manufactured
display modules for products of leading OEMs in various high growth  industries.
The Company attempts to identify  industries that present the greatest long-term
potential for growth at any given time. The Company's  research and  development
activities then focus upon  technological  developments that attempt to meet the
current  and future  requirements  of those  industries.  The  Company  seeks to
establish  strong  and  long-lasting  customer  relationships  by  aligning  its
prospects with those of its customers and by seeking to make its engineering and
advanced  manufacturing  functions seamless extensions of the product design and
production  departments  of its  customers.  The  Company  engages  in a careful
customer  selection  process  because  it  recognizes  that its own  growth  and
development  will be closely  aligned  with the growth  and  development  of the
customers it serves. The Company's strategy currently involves concentrating its
efforts on providing design and production services to leading companies in five
primary industries: cellular telephones and other wireless communications,  data
collection, office automation, medical devices, and industrial process controls.

         More  recently,   with  the   availability   of  the   high-volume  LCD
manufacturing  line in Arizona,  the Company has begun  focusing  its efforts on
creating advanced display technologies. These advanced display technologies will
allow the  Company to provide its  customers  with  differentiating  products or
products  that  provide  higher  information  content.  These  products  may  be
available  for  use in  custom  devices  or in  standard  devices.  The  Company
currently has three announced  technology  initiatives.  First,  the Company has
patented a new type of LCD display that emulates an emissive LED display,  which
the  Company  calls  LCiD(TM)  or  Liquid  Crystal  intense  Display.  This  low
information content device provides a multi-colored  emissive-looking display at
passive  LCD  prices.  The second  initiative  involves  the  creation of a high
information  content display with numerous gray shades but again at the price of
a more typical LCD. This new product is called LCaD(TM) or Liquid Crystal active
Drive(TM). This technology is based, in part, on technology licensed from Motif,
Inc. and additional  proprietary  technology developed by the Company. The third
technology  initiative is liquid crystal on silicon  microdisplays  or LCoS(TM).
LCoS(TM)  microdisplays  provide  high-resolution  (up to one million pixels and
beyond) active matrix displays that are less than 8/10 of an inch in diameter on
the  diagonal.  LCoS(TM)  microdisplays  are  expected  to  serve  the  need for
portable,  high  information  content  displays in  industries  such as wireless
communications, office automation, and industrial process controls. In addition,
the Company expects that LCoS(TM)  microdisplays will open new market industries
for the Company in areas such as business and consumer  electronics,  as well as
provide  a source  for  inexpensive,  high  resolution  displays  in  projection
products such as  rear-projection  monitors,  high-definition  televisions,  and
front projection audio-visual units.

CUSTOM DEVICES

         LCD and LED custom displays  currently account for  approximately  95.3
percent of the  Company's  revenue,  with the majority  consisting of LCD custom
displays.  A manufacturer of a complete  system or product  requiring a specific
type of  visual  display  (such as a  cellular  telephone,  medical  instrument,
business  machine,  or hand-held data  collection  device)  represents a typical
buyer for a custom device.

                                       3
<PAGE>

         The Company has developed a  sophisticated  design  process to meet the
specific needs of its  customers'  applications.  Each design  project  normally
involves a  cross-functional  team of Company  engineers  who are  assigned to a
customer program. The team consults with the customer's engineers throughout the
design phase,  prototype  development,  and manufacturing  process.  The Company
continues to supply  value-added  engineering  support after the design solution
has been developed and integrated into the  manufacturing  process in an ongoing
effort  to  provide   customers  with  product   performance   enhancements  and
cost-reduction opportunities.

STANDARD DEVICES

         Standard devices encompass a wide variety of LCD and LED devices having
varied applications. "Visible" LCD and LED standard devices include

     +    solid state lamps used for indicators, status lights, on-board circuit
          monitors, and instrumentation;

     +    multi-digit  numerical  displays  used  for  calculators,   industrial
          controls,   data   terminals,    instrumentation   timers,   hand-held
          instruments,   event  counters,  test  equipment,  embedded  computing
          equipment, and consumer applications;

     +    integrated  displays (with on-board  integrated  circuit  drivers) and
          alpha  numeric  displays  used  for  hand-held   terminals,   embedded
          computing equipment and telecommunications; and

     +    bar graph displays (with  integrated  circuit drivers) used as linear,
          logarithmic  and  VU  meters  in  stereo  systems,   radios,  magnetic
          recording devices, process control instruments, and volt meters.

         Standard  infrared  devices  include  infrared  emitters used in remote
controllers,  disk drives, tape drives, printers,  encoders, solid state relays,
photoelectric controls, slotted switches, reflective switches, intrusion alarms,
touch  screens,   wireless  data  entry   terminals,   and  positioning   sensor
applications.

         Standard LCiD(TM) display devices will include a 1 line by 10 character
and 2 line by 10 character dot matrix display  available in a variety of colors.
The Company  expects  that  LCiD(TM)  displays  will be used  primarily in lower
information content applications where high contrast, desired color, and ease of
readability  from full  sunlight  to complete  darkness  are  required.  Typical
applications  for LCiD(TM)  display  standard  devices would include  automotive
instrumentation,   appliances,   hand-held   instrumentation   devices,  vending
equipment,  stereo  equipment,  embedded  computing  equipment,  remote  sensing
equipment, outdoor monitor equipment, and industrial controls.

         Standard  LCaD(TM)  display  devices  will include a variety of backlit
quarter VGA (240 rows x 320 columns), 16 gray shade capable display systems. The
standard   LCaD(TM)   display  will  consist  of  a  complete   display   system
incorporating  LCD  panel,  lighting,  memory,  LCD  controller,  and  interface
electronics. Typical applications for the LCaD(TM) display would include medical
and industrial instrumentation, test equipment, point-of-sale terminals, mapping
and hand held global positioning system devices, stereo equipment,  and embedded
computing equipment.

MANUFACTURING SERVICES

         The Company has geographically organized its manufacturing capabilities
in a manner that optimizes the  combination  of technology and human  resources.
This enables the Company to compete  solely on the basis of cost,  if necessary,
with suppliers of similar products and services  throughout the world.  Advanced
manufacturing  techniques  include  surface mount  technologies,  chip-on-board,
chip-on-flex,  flip-chip,  tape automated  bonding,  and  sophisticated  testing
systems throughout the process.

         The Company  seeks to increase its value to its  customers by providing
responsive,  flexible,  total  manufacturing  services.  To date,  manufacturing
services have been  concentrated  toward the manufacture of LCDs and assembly of
Company-designed  display module  assemblies.  The Company will provide extended
manufacturing  services  beyond these core  services,  however,  if the customer
requires them. Extended services may include adding additional components,  such
as a keypad, microphone, card reader, product housing, or non-display electronic
sub-assembly, or the turn-key manufacture of a complete OEM product.

                                       4
<PAGE>
MANUFACTURING FACILITIES

         The  Company  currently  conducts  manufacturing  operations  in Tempe,
Arizona;  Manila,  the  Philippines;  and Beijing,  China.  The Arizona facility
houses a Class 1000 "clean room" and LCD fabrication and prototyping  operation.
The  Company  utilizes  this  facility  primarily  to conduct LCD  research  and
development,  to  produce  prototype  and  pre-production  runs of  devices  for
customer approval, to conduct full production runs of low-volume devices, and to
develop advanced manufacturing  processes that can be applied in the Philippines
and China  during  full-scale  production.  In  addition,  the  facility has the
largest fully  automated LCD glass  production  capacity in North America.  This
highly  automated  line enables the Company to reduce its  dependence on foreign
suppliers of LCD glass.  Facility  personnel  include a team of experts  ranging
from LCD research  scientists  to  specialized  engineers  with  backgrounds  in
electronics,  mechanics,  chemistry,  physics,  and  manufacturing.  The Company
maintains  a wide  variety  of  state-of-the-art  testing  and  quality  control
equipment at the facility.

         High  volume  display  module  manufacturing  is  done in  Manila,  the
Philippines  and  Beijing,  China.  In  Manila,  the  Company  is a party  to an
agreement (the "Sub-Assembly Agreement") with Technology Electronic Assembly and
Management Pacific Corporation ("TEAM"),  pursuant to which TEAM supplies direct
manufacturing  services  at a facility  owned by TEAM  located  in  Manila.  The
Company is also party to a lease  agreement  (the "Lease  Agreement")  with TEAM
pursuant  to which  TEAM  leases  space to the  Company  with  respect  to those
manufacturing  operations  services  performed  by TEAM  under the  Sub-Assembly
Agreement.  TEAM  manufactures,  assembles,  and tests  devices  designed by the
Company in the space leased to the Company and pursuant to procedures  set forth
in the Sub-Assembly Agreement in accordance with specifications  supplied by the
Company.  In  1997,  TEAM  and the  Company  entered  into an  amendment  to the
Sub-Assembly Agreement whereby all indirect  manufacturing  employees (primarily
technicians,  supervisors,  and engineers) became employees of the Company. As a
result, under the Sub-Assembly Agreement TEAM now only supplies the direct labor
and certain incidental  services required to manufacture the Company's products.
The Company owns the manufacturing, assembling, and testing equipment (including
automated die attach and wire bond equipment with automatic pattern  recognition
features for die and wire  placement  for LED die) as well as the  processes and
documentation used by TEAM at the Manila facility. The Company pays TEAM for the
direct  manufacturing  personnel based upon a negotiated  available hourly rate.
The Company employs all professional personnel, including an Operations Manager,
with a support staff  consisting of  manufacturing  supervisors;  manufacturing,
quality,  and process engineers;  and logistics and administrative  personnel at
the Manila facility.

         The Sub-Assembly  Agreement and Lease Agreement between the Company and
TEAM  extend  through  December  31,  1999 and are  renewable  from year to year
thereafter.  The Sub-Assembly Agreement requires the Company to maintain minimum
production  levels.  The  termination  of the Lease  Agreement  or  Sub-Assembly
Agreement  or the  inability  of TEAM to  fulfill  its  requirements  under  the
Sub-Assembly   Agreement  would  require  the  Company  to  acquire   additional
manufacturing  facilities or to contract for additional  manufacturing services.
The  Philippines  has  been  subject  to  volcanic  eruptions,   typhoons,   and
substantial civil  disturbances,  including attempted military coups against the
government.  Although there has not been any material interruption of operations
to date,  these  circumstances  could  affect  the  Company's  ability to obtain
products pursuant to the Sub-Assembly Agreement. The termination or inability of
the Company to obtain products pursuant to the Sub-Assembly Agreement,  even for
a  relatively  short  period,  would  have  a  material  adverse  effect  on the
operations and profitability of the Company.

         The Company commenced manufacturing operations in the People's Republic
of China  ("China")  during 1998.  The China  facility is a high-volume  display
module  manufacturing  facility  similar to the  Company's  current  facility in
Manila. The Company initially leased a facility in Beijing on a temporary basis,
and the Company commenced  manufacturing in that temporary facility in the third
quarter of 1998.  The  Company  has begun  construction  of its own  facility in
Beijing  and expects to move into that new  facility in the middle of 1999.  The
Company employs all direct and indirect manufacturing employees at the facility,
including  technicians,  supervisors,  and  engineers.  The Company  expects the
initial  cost  of  equipping  and   constructing   the  China   facility  to  be
approximately $10.0 million. For further discussions on the Company's operations
in  China,  see Item 7,  "Management's  Discussion  and  Analysis  of  Financial
Conditions and Results of Operations" and Item 1, "Special  Considerations - The
Company Faces Risks Associated with International Operations."

                                       5
<PAGE>
QUALITY CONTROL

         The Company has an aggressive  quality control program and maintains at
each of its  facilities  quality  systems and processes  that meet or exceed the
demanding standards set by many leading OEMs in targeted industries. The Company
bases its quality  control  program  upon  Statistical  Process  Control,  which
advocates  continual  quantitative  measurements of crucial  parameters and uses
those measurements in a closed-loop feedback system to control the manufacturing
process.  The Company  performs  product life  testing to help ensure  long-term
product  reliability.  The Company  analyzes  results of product  life tests and
takes actions to refine the manufacturing process or enhance the product design.

         Increased global competition has led to increased customer expectations
with respect to price, delivery, and quality.  Customers often evaluate price in
the quotation  process,  while delivery and quality are evaluated only after the
product is received.  Therefore,  many customers  preview a company's quality by
viewing  the  quality  systems  employed.  The  Company  has  received  ISO 9002
certification of its Manila  manufacturing  facility.  ISO is a quality standard
established  by  the  International  Organization  for  Standardization,   which
attempts to ensure that the processes used in development and production  remain
consistent.  This is accomplished through documentation  maintenance,  training,
and management  review of the processes used.  Although  achievement of ISO 9002
certification  is no  guarantee  of  the  Company's  ability  to  obtain  future
business,  it is a factor that enables the Company's customers to recognize that
the Company's  production  processes meet this  established,  global standard of
performance.

SALES AND MARKETING

         The Company markets its services  primarily in North America and Europe
through  direct  technical  sales  persons.  In 1998,  the Company  added direct
technical  sales  persons in Asia.  To a much lesser  extent,  the Company  also
markets some standard  products  through an independent  sales and  distribution
network.  This network includes two franchised  distributors in approximately 91
sales  offices.  A  staff  of  in-house,  Arizona-based  sales  and  engineering
personnel  directs and aids all direct and distribution  sales. The Company also
has sales personnel in California, Massachusetts,  Illinois, North Carolina, and
Florida.

         The Company's sales to customers in Europe represented approximately 35
percent of net sales in 1998. In addition to a direct technical sales force, the
Company  distributes  products  in Europe  through a  network  of  distributors,
augmented in some regions by marketing  representatives.  This network  receives
support from the marketing,  customer service, and support staff employed by the
Company's subsidiary,  Three-Five Systems Limited, located in Swindon,  England.
In addition,  the Company's  design  engineers in Tempe,  Arizona provide design
input for customers in Europe.

         The Company's sales to customers is Asia represented  approximately 7.0
percent of net sales in 1998.  The Company has added  several  direct  technical
sales  and  marketing  persons  in Asia  and has  also  trained  Chinese  design
engineers to provide design input for customers in Asia.

CUSTOMERS

         The Company's strategy involves  concentrating its efforts on providing
design and production  services to leading companies in five primary industries:
cellular telephones and other wireless communications,  data collection,  office
automation,  medical devices, and industrial process controls.  As a result, the
Company generally derives its revenue from services provided to a limited number
of customers. The Company's largest customer is Motorola, Inc. ("Motorola"). The
Company currently designs and manufactures display modules used in approximately
45 individual  product  programs for Motorola.  Sales to Motorola  accounted for
63.6 percent of the  Company's  revenue  during  1998.  Devices that are used in
cellular  telephones  accounted for  substantially all of the Company's sales to
Motorola  in 1998.  Motorola  continues  to award  new  design  programs  to the
Company.  Motorola has an LCD module  allocation  process in which it designates
three or four key LCD module vendors, including the Company, and communicates to
each vendor the anticipated annual amount of purchases.  Although the allocation
process does not provide a guarantee of business to the Company,  it provides an
indication that purchases by Motorola during 1999 could continue at 1998 levels.
The  Company's  second-largest  customer  in 1998  was  Hewlett-Packard

                                       6
<PAGE>
Company ("Hewlett-Packard").  Sales to Hewlett-Packard accounted for 6.6 percent
of the Company's revenue during 1998. As the display modules manufactured by the
Company for  Hewlett-Packard  moved into second generation versions in 1998, the
selling price of some of those  modules was greatly  reduced.  In addition,  the
number of LCD display  modules  required  by  Hewlett-Packard  was also  greatly
reduced as  Hewlett-Packard  moved to less  expensive  front panel devices in an
extremely  competitive  market.  Consequently,  in 1998  the  percentage  of the
Company's revenue attributed to Hewlett-Packard declined substantially. See Item
1, "Special Considerations - Certain Customers Account for a Significant Portion
of the Company's Sales."

BACKLOG

         As of  December  31,  1998,  the  Company  had a  backlog  of orders of
approximately  $23.3  million,  all of which are  believed to be firm and all of
which are expected to be filled  during  fiscal  1999.  The backlog of orders at
December 31, 1997 was approximately  $21.8 million.  The Company's  business has
some seasonality as the result of the significant amount of retail products into
which its products are placed.  Design cycles have  shortened and many customers
finish  cycles in the fourth  quarter  (because of the holiday sales season) and
ramp up new products in the second quarter of the calendar  year.  Consequently,
the  first  quarter  of a  calendar  year  may have a  disproportionately  lower
percentage of the year's total sales. In both 1997 and 1998, sales in the fourth
quarter were approximately 60 percent greater than sales in the first quarter.

PATENTS AND TRADEMARKS

         The  Company  relies on a  combination  of patent,  trade  secrets  and
trademark  laws,  confidentiality  procedures,  and  contractual  provisions  to
protect its intellectual property. Although the Company's existing core business
does  not  depend  on  any  patent  or  trademark  protection,  the  Company  is
manufacturing  more  advanced  display  products  in which  there are  patent or
trademark issues.  For example,  the Company has patents on its LCiD(TM) display
technology.  The Company  also signed a license  agreement  with Motif,  Inc. to
license the  technology  that forms the basis of its LCaD(TM) or Liquid  Crystal
active  Drive.  The Company has applied for a patent on its LCaD(TM)  technology
and has filed several patents relating to its LCoS(TM) microdisplay  technology.
The Company has also applied for numerous other process and product patents, all
related to display technologies.

RAW MATERIALS

         The principal raw  materials  used in producing the Company's  displays
consist of LCD glass,  driver die,  circuit boards,  molded plastic parts,  lead
frames, wire, chips, and packaging materials. The Company's procurement strategy
provides  alternative  sources of supplies for the majority of these  materials.
Many of such materials,  however, must be obtained from foreign suppliers, which
subjects the Company to the risks  inherent in obtaining  materials from foreign
sources, including supply interruptions and currency fluctuations. The Company's
suppliers  currently are meeting the requirements of the Company,  and strategic
supplier alliances have further strengthened  relations with offshore suppliers.
The Company's ability to produce a significant percentage of its requirements of
LCD glass in its  Arizona  facility  has  reduced the  Company's  dependence  on
foreign LCD glass suppliers.  See Item 1, "Special  Considerations - The Company
May be Subject to Shortages of Raw Materials and Supplies."

COMPETITION

         The  Company  believes  that  Optrex,   Seiko-Epson,   Samsung,   Seiko
Instruments, Sharp, Hosiden, Hyundai, PCI, and Philips Components constitute the
principal  competitors  for the  Company's LCD devices.  Hewlett-Packard,  Rohm,
LiteOn,  Siemens,  Stanley  Electric  Company,  and Quality  Technologies  Corp.
constitute its principal  competitors  for its LED devices and for its LCiD(TM).
Most of these  competitors  are large  companies  that have  greater  financial,
technical, marketing,  manufacturing,  and personnel resources than the Company.
The revenue, profitability, and success of the Company depend substantially upon
its ability to compete  with other  providers  of display  modules.  The Company
cannot  provide   assurance  that  it  will  continue  to  be  able  to  compete
successfully with such organizations.

                                       7
<PAGE>
         The  Company  currently  competes  principally  on  the  basis  of  the
technical  innovation and  performance of its display  modules,  including their
ease of use and  reliability,  as well as on  their  cost,  timely  design,  and
manufacturing and delivery schedules.  The Company's  competitive position could
be adversely  affected if one or more of its customers,  particularly  Motorola,
determines to design and manufacture their display modules  internally or secure
them from other parties. See Item 1, "Special Considerations - The Company Faces
Intense Competition."

RESEARCH AND DEVELOPMENT

         The Company conducts an active and ongoing research,  development,  and
engineering  program that focuses on advancing  technology,  developing improved
design and  manufacturing  processes,  and improving the overall  quality of the
products  and  services  that the Company  provides.  Research  and  development
personnel concentrate on LCD technology, especially improving the performance of
current products and expanding the technology to serve new markets.  The Company
also conducts  research and development in  manufacturing  processes,  including
those   associated  with  efficient,   high-volume   production  and  electronic
packaging.

         More  recently,  the Company has focused its research  and  development
efforts on new  display  technologies.  See Item 1,  "Business  -  Products  and
Services."  The Company has  undertaken a significant  research and  development
program with respect to the  development of LCoS(TM)  microdisplays  and expects
that the majority of available research and development  personnel hours will be
dedicated to LCoS(TM) microdisplays in 1999.

ENVIRONMENTAL REGULATION

         The  operations of the Company  result in the creation of small amounts
of hazardous waste, including various epoxies,  gases, inks, solvents, and other
wastes.  The amount of hazardous  waste  produced by the Company may increase in
the future depending on changes in the Company's  operations.  The general issue
of the disposal of hazardous waste has received  increasing  focus from federal,
state, local, and international governments and agencies and has been subject to
increasing  regulation.  See Item 1,  "Special  Considerations  -  Environmental
Regulation."

         In a separate  matter,  the  Company  conducted  a clean-up  of limited
chemical   contamination   at  its  former  property   located  in  Barkhamsted,
Connecticut. The contamination was caused by the previous owner of the property,
and  not as a  result  of  any of the  Company's  operations.  The  Company  has
contracted  with an  environmental  consulting  firm  for  assistance  with  the
clean-up process and has complied with the requests and  recommendations  of the
Connecticut  Environmental Protection Agency throughout the process. The Company
believes that the source of the contamination has been removed from the property
and that the  clean-up  has been  completed.  Four  monitoring  wells  have been
installed to permit periodic chemical  analysis to be made at the property.  The
property  was sold on June 25,  1995,  subject  to the  Company  making its best
efforts  to  obtain  from  either  the  Connecticut  or  Federal   Environmental
Protection  Agency  documentation  to the effect that the  property is clean and
that there is no actionable contamination in the vicinity of the property.

EMPLOYEES

         As of December 31, 1998,  the Company  employed a total of 867 persons.
This number includes 172 full-time and  approximately 16 temporary  employees at
its  principal  U.S.  facility in Tempe,  Arizona and U.S.  sales  offices;  256
employees  at  its  manufacturing  facility  in  Manila,  the  Philippines;  415
employees at its  manufacturing  facility in Beijing,  China; and 8 employees at
its  Three-Five  Systems,  Ltd.  subsidiary  in  Swindon,  England.  The Company
considers  its  relationship  with its  employees  to be  good,  and none of its
employees currently are represented by a union in collective bargaining with the
Company.

         TEAM  provides  the  personnel  engaged in the direct  assembly  of the
Company's  devices in Manila pursuant to the Sub-Assembly  Agreement between the
Company and TEAM.  See Item 1,  "Business  -  Manufacturing  Facilities."  As of
December 31, 1998, approximately 1,152 persons performed direct labor operations
at the Manila facility through the Sub-Assembly Agreement with TEAM.

                                       8
<PAGE>
EXECUTIVE OFFICERS

         The  following  table sets  forth  information  concerning  each of the
Company's executive officers.


    NAME                       AGE                     POSITION
    ----                       ---                     --------

    David R. Buchanan          66   Chairman of the Board, President, and Chief
                                    Executive Officer

    Lawrence E. Kagemann, Sr.  56   Vice President - Operations

    Radu Andrei                48   Vice President - Marketing and Sales

    Jeffrey D. Buchanan        43   Executive Vice President - Finance,
                                    Administration,  and Legal; Chief Financial
                                    Officer; Secretary; Treasurer; and Director

    Dan J. Schott              59   Vice President - Research and Development

    Robert T. Berube           60   Principal Accounting Officer and Corporate
                                    Controller

         DAVID R.  BUCHANAN has been  Chairman of the Board of the Company since
its formation in February 1990. Mr. Buchanan  served as the Company's  President
and Chief Executive Officer from February 1990 until July 1998. In January 1999,
Mr. Buchanan  reassumed duties as interim  President and Chief Executive Officer
while the Board of  Directors  conducts a search for a new  President  and Chief
Executive Officer. Mr. Buchanan also served as Treasurer of the Company from May
1990 until January 1994 and as Chairman of the Board,  Chief Executive  Officer,
President, and a director of one of the predecessors of the Company from October
1986,  February 1987, and November 1985,  respectively,  until the predecessor's
merger into the Company in May 1990.

         LAWRENCE E.  KAGEMANN,  SR. has been Vice President - Operations of the
Company since August 10, 1998. Mr.  Kagemann  served as Vice President - Quality
and  Manufacturing  Technology for Harman OEM Group  ("Harman")  from 1990 until
December   1996,   where  he  led  quality,   plant,   manufacturing,   advanced
manufacturing,  and supplier  engineering for the U.S. and Wales sites. In 1997,
Mr.  Kagemann was appointed Vice  President - Audio for Computer  Operations and
Quality for Harman,  where he had  responsibility  for  maintaining  quality and
supplier  engineering  for the U.S. and Wales sites.  From August 1997 to August
1998,  Mr.  Kagemann held the position of Vice  President - Quality and Supplier
Engineering for Harman,  where he was assigned the responsibility of quality and
supplier engineering for the group.

         RADU  ANDREI  has been  Vice  President  -  Marketing  and Sales of the
Company since June 1, 1998.  Mr.  Andrei  served a Research  Director for Semico
Research Arizona and Intechno Consulting Director - Basel,  Switzerland/Phoenix,
Arizona from 1996 until June 1998. His  responsibilities  included assessing the
market,  analyzing external market drivers,  correlating the results of business
core competencies,  resources and objectives,  and devising a long-term plan. In
1994 and 1995, Mr. Andrei held the position of Manager,  Strategic Marketing and
Systems Engineering (Director) for Motorola SPS Division in Phoenix, Arizona.

         JEFFREY  D.  BUCHANAN  has  served as a  director  and  Executive  Vice
President - Finance,  Administration,  and Legal of the Company since June 1998;
as Chief Financial  Officer and Treasurer of the Company since June 1996; and as
Secretary of the Company since May 1996. Mr. Buchanan served as Vice President -
Finance, Administration, and Legal of the Company from June 1996 until July 1998
and as Vice President - Legal and Administration of the Company from May 1996 to
June  1996.  Mr.  Buchanan  served  as a Senior  Member of  O'Connor,  Cavanagh,
Anderson,  Killingsworth  &  Beshears  from June 1986  until May 1996,  where he
practiced  as a business  lawyer with an  emphasis on mergers and  acquisitions,
joint ventures, and taxation. Mr. Buchanan was associated with the international
law firm of Davis Wright  Tremaine from 1984 to 1986,  and he was a senior staff
person at Deloitte & Touche from 1982 to 1984.  Mr.  Buchanan is a member of the
Arizona and  Washington  state 

                                       9
<PAGE>
bars and  passed  the  certified  public  accounting  examination  in 1983.  Mr.
Buchanan is the son of David R. Buchanan.

         DAN J. SCHOTT has been Vice President - Research and Development of the
Company  since July  1996.  From  January  1994 until July 1996 he served as the
Company's Vice  President of  Technology.  From 1988 to January 1994, Mr. Schott
was an  Associate  Director  with  Honeywell  Inc.,  where his  responsibilities
included flat panel display research and development.  From 1981 until 1987, Mr.
Schott held various engineering management and program management positions with
Sperry Rand Corp.

         ROBERT T. BERUBE has been the Company's  Principal  Accounting  Officer
since July 1998 and has served as the Company's Corporate  Controller since July
1990.

SPECIAL CONSIDERATIONS

A VARIETY OF FACTORS AFFECT THE COMPANY'S OPERATING RESULTS

         A wide variety of factors  affect the Company's  operating  results and
could adversely impact its net sales and profitability.  These factors,  many of
which are beyond the control of the Company, include the following:

     +    the Company's  ability to identify  industries  that have  significant
          growth   potential   and  to   establish   strong   and   long-lasting
          relationships with companies in those industries;

     +    the Company's ability to provide  significant design and manufacturing
          services for those companies on a timely and cost-effective basis;

     +    the Company's  success in maintaining  customer  satisfaction with its
          design and manufacturing services;

     +    market acceptance of products of its customers  incorporating  devices
          designed and manufactured by the Company;

     +    customer  order  patterns,  changes  in order  mix,  and the level and
          timing of orders placed by customers  that the Company can complete in
          a quarter;

     +    the performance and reliability of devices  designed and  manufactured
          by the Company;

     +    the life cycles of its customers' products;

     +    the availability and utilization of manufacturing capacity;

     +    fluctuations in manufacturing yield and productivity;

     +    the quality, availability,  and cost of raw materials,  equipment, and
          supplies;

     +    the timing of expenditures in anticipation of orders;

     +    the cyclical  nature of the  industries  and the markets served by the
          Company;

     +    technological changes; and

     +    competition and competitive pressures on prices.

         The Company's ability to increase its design and manufacturing capacity
to meet customer demand and maintain  satisfactory  delivery schedules represent
important  factors in its long-term  prospects.  Although the Company's  product
solutions  are  incorporated  into a wide variety of  communications,  consumer,
medical, office automation,  and industrial products, a majority of its sales in
1998 were  display  modules  for  cellular  products.  A slowdown  in demand for
customer  products,  particularly  cellular and office automation  products that
utilize the Company's  products,  as a result of economic or other conditions in
the  United  States  or  worldwide  markets  served  by  the  Company  or  other
broad-based factors would adversely affect the Company's operating results.

                                       10
<PAGE>
CERTAIN CUSTOMERS ACCOUNT FOR A SIGNIFICANT PORTION OF THE COMPANY'S SALES

         In the past few years,  the Company has  generated  most of its revenue
from sales to a few  significant  customers.  Motorola,  the  Company's  largest
customer,  accounted  for 63.6 percent of the  Company's  revenue in 1998,  34.6
percent of revenue in 1997, and 65.1 percent of revenue in 1996. Devices used in
cellular  telephones  accounted for  substantially all of the Company's sales to
Motorola in 1998.  The Company  anticipates  that sales to Motorola in 1999 will
reach or exceed 1998 levels, but believes that the percentage of its net revenue
from sales to Motorola should decrease in 1999 as a result of increased sales to
other customers. The Company's second largest customer is Hewlett-Packard, which
accounted  for 6.6 percent of the  Company's  revenue  during 1998.  This amount
represents a significant  reduction from sales to Hewlett-Packard that accounted
for  32.0  percent  of the  Company's  sales in 1997.  See Item 1,  "Business  -
Customers."

         Although  the  Company  has  begun to  enter  into  more  manufacturing
contracts with its  customers,  the principal  benefit of these  contracts is to
clarify order lead times, inventory risk allocation, and similar matters and not
to provide firm, long-term volume purchase  commitments.  Customers generally do
not provide firm long-term  volume  purchase  commitments to the Company.  Thus,
customers can cancel  purchase  commitments  and change or delay expected volume
levels.  The  Company  may be unable to replace  canceled,  delayed,  or reduced
commitments  in a timely  manner.  The  cancellation,  delay,  or  reduction  of
customer  commitments  could result in the Company  holding  excess and obsolete
inventory  or  having  unfavorable   manufacturing  variances  as  a  result  of
under-absorption.  These risks are enhanced  because of the large  percentage of
sales to  customers  in the  retail  electronics  industry,  which is subject to
severe competitive pressures, rapid technological change, and obsolescence.  The
Company's  operating results have been materially and adversely  affected in the
past as a result of the  non-realization  of anticipated orders and deferrals or
cancellations  of orders as a result of changes in  customer  requirements.  For
example,  in 1998 the Company made two  announcements  that sales would not meet
its expectations because of delays in customer programs.  Cancelled, delayed, or
reduced  commitments  from any of the Company's  major  customers,  particularly
Motorola,  would  have a material  adverse  effect on the  Company's  results of
operations.

         A few  of  the  Company's  customers  have  inquired  about  "inventory
hubbing"  agreements,  under which the Company would maintain stocks of finished
goods  at or near the  customer's  factory.  Although  the  Company  has not yet
entered into such agreements, the use of such type of agreements for significant
customers could result in higher inventory balances and excess inventory.

THE COMPANY FACES INTENSE COMPETITION

         The  Company  serves   intensely   competitive   industries   that  are
characterized  by  price  erosion,   rapid  technological  change,  and  foreign
competition.   The  Company  competes  with  major  domestic  and  international
companies.  Most of the Company's competitors are located in Asia, and many have
greater market  recognition  and  substantially  greater  financial,  technical,
marketing,  distribution,  and other resources than the Company  possesses.  See
Item 1,  "Business -  Competition."  Emerging  companies also may increase their
participation  in the display  module  market.  The Company  currently  competes
principally  on the basis of the technical  innovation  and  performance  of its
display  modules,  including  their ease of use and  reliability,  as well as on
pricing and timely design, manufacturing,  and delivery schedules. The Company's
ability to compete successfully depends on a number of factors,  both within and
outside its control. These factors include the following:

     +    the quality, performance, reliability, features, ease of use, pricing,
          and diversity of its product solutions;

     +    foreign currency fluctuations,  which may cause a foreign competitor's
          products to be priced significantly lower than the Company's products;

     +    the quality of its customer services;

     +    its ability to address the needs of its customers;

     +    its success in  designing  and  manufacturing  new product  solutions,
          including those implementing new technologies;

                                       11
<PAGE>
     +    the  availability  of  adequate  sources  of raw  materials  and other
          supplies at acceptable prices;

     +    its efficiency of production;

     +    the rate at which customers  incorporate the Company's display modules
          into their own products;

     +    product solution introductions by the Company's competitors;

     +    the number,  nature, and success of its competitors in a given market;
          and

     +    general market and economic conditions.

         The Company's  competitive  position could be adversely affected if one
or more of its  customers  increase  their own capacity and decide to design and
manufacture their own display modules,  to use standard devices, or to outsource
with a competitor. The Company cannot provide assurance that it will continue to
be able to compete successfully in the future.

THE COMPANY'S BUSINESS DEPENDS ON NEW PRODUCTS AND TECHNOLOGIES

         The  Company  operates  in  fast  changing  industries.   Technological
advances,  the  introduction of new products,  and new design and  manufacturing
techniques could adversely affect the Company's  operations unless it is able to
adapt to the resulting  changing  conditions.  As a result,  the Company will be
required to expend substantial funds for and commit significant resources to

     +    continuing research and development activities;

     +    engaging additional engineering and other technical personnel;

     +    purchasing advanced design, production, and test equipment; and

     +    enhancing design and manufacturing processes and techniques.

         The  Company's  future  operating  results will depend to a significant
extent on its ability to continue to provide design and  manufacturing  services
for new products  that compare  favorably on the basis of time to  introduction,
cost, and performance with the design and manufacturing capabilities of OEMs and
other  third-party  suppliers.  The  success  of new  design  and  manufacturing
services depends on various factors, including the following:

     +    proper customer selection;

     +    utilization of advances in technology;

     +    innovative development of new solutions for customer products;

     +    efficient and cost-effective services;

     +    timely completion and delivery of new product solutions; and

     +    market acceptance of customers' end products.

Because of the complexity of the Company's  design and  manufacturing  services,
the Company from time to time may experience delays in completing the design and
manufacture of new product solutions. In addition, certain new product solutions
may not  receive  or  maintain  customer  or market  acceptance.  The  Company's
inability to design and manufacture solutions for its customers' new products on
a timely and  cost-effective  basis would adversely  affect its future operating
results. See Item 1, "Business - Products and Services."

         Finally,  circumstances  outside of the Company's control may cause the
loss of expected revenue even when the Company satisfactorily completes a design
and manufacturing  solution.  For example, a customer may terminate or delay its
own  program  for any  number of reasons  unrelated  to the  Company,  including
problems with other suppliers to the program or lack of market acceptance of the
customer's product.

                                       12
<PAGE>
THE COMPANY FACES RISKS ASSOCIATED WITH RESEARCH AND DEVELOPMENT EFFORTS

         The Company  currently  is investing  in research  and  development  of
several new technologies  that it plans to introduce in the future.  Some or all
of those technologies may not successfully make the transition from the research
and  development  lab  to  cost-effective   manufacturability  as  a  result  of
technology problems, competitive cost issues, yield problems, and other factors.
An investment of  significant  amounts of resources in one or more  technologies
that fail to achieve  manufacturability  could have a material adverse effect on
the Company. In addition,  even if a new technology proves to be manufacturable,
the  Company's  customers  and the  customers'  marketplaces  may not accept the
technology  because of price or  technology  issues or  because  of  unfavorable
comparisons with products  introduced by others. The Company will be required to
make  significant  expenditures,  including  development  expenses  and  various
capital expenditures and investments,  for these new technologies.  For example,
the  Company  estimates  that its  initial  capital  expenditures  for  LCoS(TM)
microdisplays  will be approximately  $3.0 million to $4.0 million.  The Company
also made an equity  investment of $3.3 million in Siliscape,  Inc.  during 1998
for the  purposes  of further  developing  the  LCoS(TM)  microdisplay  product.
Significant  investments  in one or  more of the  new  technologies,  especially
LCoS(TM) microdisplays,  that ultimately prove to be unsuccessful for any reason
could have a material adverse impact on the Company.  In addition,  if Siliscape
were to  encounter  technological  or financial  difficulties,  the value of the
Company's  investment in that company could  decline,  in which case the Company
would have to write down all or a portion  of its  investment  and report a loss
equal to such write-down.

THE COMPANY FACES RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS

         GENERAL. The Company currently has substantial manufacturing operations
located in the  Philippines,  China,  and the United  States.  The Company  also
maintains a sales office and distribution  warehouse in Europe. The geographical
distances between Asia,  Europe, and North America create a number of logistical
and  communications  challenges.   Because  of  the  location  of  manufacturing
facilities in a number of countries, the Company may be affected by economic and
political conditions in those countries, including the following:

     +    management of a multi-national organization;

     +    compliance  with local  laws and  regulatory  requirements  as well as
          changes in such laws and requirements;

     +    employment and severance issues;

     +    overlap of tax issues;

     +    fluctuations in the value of currency;

     +    tariffs and duties;

     +    possible employee turnover or labor unrest;

     +    lack of developed infrastructure;

     +    longer payment cycles;

     +    greater difficulty in collecting accounts receivable;

     +    the burdens and costs of  compliance  with a variety of foreign  laws;
          and

     +    political or economic instability in certain parts of the world.

Changes in policies by the United  States or foreign  governments  resulting in,
among other things,  increased  duties,  higher  taxation,  currency  conversion
limitations,  restrictions on the transfer or repatriation of funds, limitations
on imports or exports,  or the  expropriation of private  enterprises also could
have a material  adverse  effect on the  Company,  its  results  of  operations,
prospects,  and ability to service debt.  The Company's  operating  results also
could be adversely  affected if its host  countries  were to reverse the current
policies  encouraging  foreign  investment or foreign trade.  In addition,  U.S.
trade policies,  such as "most favored nation" status and trade  preferences for
certain Asian nations,  affect the  attractiveness of the Company's  services to
its U.S.  customers.  In  particular,  the 

                                       13
<PAGE>
Company's operations and assets are subject to significant political,  economic,
legal, and other uncertainties in the Philippines and China.

         MANUFACTURING OPERATIONS IN THE PHILIPPINES. The Company has maintained
its primary manufacturing  facility in Manila, the Philippines since 1986. TEAM,
a  third-party  subcontractor,  owns the  facility,  which is located on land it
leases from the  Philippine  government.  TEAM  operates the facility  under the
Sub-Assembly Agreement and the Lease Agreement, utilizing equipment,  processes,
and documentation owned by the Company and supervisory personnel employed by the
Company. TEAM provides direct-level  production personnel under the Sub-Assembly
Agreement and leases space to the Company under the Lease  Agreement.  TEAM also
utilizes additional space in the facility to produce products for other entities
unrelated to the Company.  The  Sub-Assembly  Agreement and the Lease  Agreement
have current terms  extending  through  December 31, 1999 and are renewable from
year to year  thereafter.  The Company has made  advance  payments to TEAM since
1994 for a variety of  reasons,  including  to assist it in meeting  its working
capital needs while it negotiates new financing  arrangements for generators and
equipment needed for building improvements.  The outstanding advances to TEAM at
December 31, 1998 totaled approximately $205,000.

         The Company has made cumulative capital  investments in the Philippines
amounting  to  approximately  $12.0  million  through  December  31,  1998.  The
Company's  reliance on  personnel  and  facilities  in the  Philippines  and its
maintenance  of  inventories  abroad expose the Company to certain  economic and
political risks, including the following:

     +    the business and financial condition of the subcontractor;

     +    political instability and expropriation;

     +    supply disruption;

     +    currency controls and exchange fluctuations; and

     +    changes in tax laws, tariffs, and freight rates.

The Company has not experienced any  significant  interruptions  in its business
operations in the  Philippines to date despite the fact that the Philippines has
been  subject  to  volcanic   eruptions,   typhoons,   and   substantial   civil
disturbances,  including  attempted  military coups against the government.  The
Company believes that its manufacturing operations in the Philippines constitute
one of the Company's most important resources, and that it would be difficult to
replace  the   low-cost,   high-performance   facility   or  the   high-quality,
hard-working production staff if its manufacturing operations in the Philippines
were  disrupted or  terminated.  As a result,  any  disruption or termination of
operations in the Philippines or air  transportation  with the Philippines  even
for a relatively  short period of time,  would  adversely  effect the  Company's
operations. See Item 1, "Business - Manufacturing Facilities."

         MANUFACTURING  OPERATIONS IN CHINA. The Company commenced manufacturing
operations in China during 1998. The China facility is a high-volume  LCD module
manufacturing  facility similar to the Company's facility in Manila. The Company
initially  leased a  facility  in  Beijing on a  temporary  basis and  commenced
manufacturing  in that  temporary  facility  in the third  quarter of 1998.  The
Company  has begun  construction  of its own  facility in Beijing and expects to
move into that new  facility in mid-1999.  The Company  expects that the initial
cost  of  equipping  and  constructing  the  permanent  China  facility  will be
approximately  $10.0  million.  The Company's  lease of its  temporary  facility
expires in 1999.  Therefore,  any significant  delay in the  construction of the
permanent  facility  could  result  in the  temporary  suspension  of the  China
manufacturing  operations.  Construction delays for a variety of reasons are not
unusual in China.  Any such  suspension  could  adversely  affect the  Company's
operations.  For further  discussions on the Company's  operations in China, see
Item 7,  "Management's  Discussion  and  Analysis of  Financial  Conditions  and
Results of Operations" and Item 1, "Business - Manufacturing Facilities."

         The  Company's  operations  and assets  will be subject to  significant
political,  economic,  legal and other uncertainties in China. Under its current
leadership,  the Chinese  government has been pursuing economic reform policies,
including the encouragement of foreign trade and investment and greater economic
decentralization.  The  

                                       14
<PAGE>
Chinese government may not continue to pursue such policies.  In addition,  such
policies  may  not be  successful  if  pursued  or the  Chinese  government  may
significantly  alter  the  policies  from  time to  time.  Despite  progress  in
developing  its legal  system,  China does not have a  comprehensive  and highly
developed  system of laws,  particularly  with  respect  to  foreign  investment
activities  and  foreign  trade.  Enforcement  of  existing  and future laws and
contracts is uncertain,  and  implementation and interpretation of such laws may
be inconsistent.  As the Chinese legal system develops,  the promulgation of new
laws,  changes to existing  laws,  and the  preemption of local  regulations  by
national laws may adversely affect foreign investors.  The Company also could be
adversely affected by a number of other factors, including the following:

     +    the imposition of austerity measures intended to reduce inflation;

     +    inadequate development or maintenance of infrastructure, including the
          unavailability  of adequate power and water supplies,  transportation,
          raw materials, and parts; or

     +    a  deterioration  of  the  general   political,   economic  or  social
          environment in China.

         In addition,  China  currently  enjoys "most  favored  nation"  ("MFN")
status  granted by the U.S.  government,  pursuant  to which the  United  States
imposes the lowest  applicable  tariffs on Chinese exports to the United States.
The United States  annually  reconsiders  the renewal of MFN trading  status for
China.  The Company cannot  provide  assurance that the United States will renew
China's  MFN  status  in  future  years.  The  failure  or  refusal  of the U.S.
government  to renew  China's MFN status could  adversely  affect the Company by
increasing the cost to U.S. customers of products manufactured by the Company in
China.

THE COMPANY FACES RISKS ASSOCIATED WITH INTERNATIONAL TRADE AND CURRENCY
EXCHANGE

         International  sales  represented   approximately  42  percent  of  the
Company's  net sales in 1998.  Sales in foreign  markets,  primarily  Europe and
China,  to OEMs  based in the  United  States  accounted  for  almost all of the
Company's  international  sales in 1998. In 1999,  the Company  expects sales to
OEMs based in Europe and China to increase.  Political  and economic  conditions
abroad  may  adversely  affect the  foreign  manufacture  and sale of  products.
Protectionist   trade  legislation  in  either  the  United  States  or  foreign
countries,  such as a change in the current tariff structures,  export or import
compliance  laws, or other trade policies,  could adversely affect the Company's
ability  to  manufacture  or sell  devices in foreign  markets  and to  purchase
materials or equipment from foreign suppliers.

         While the Company transacts business  predominantly in U.S. dollars and
bills and collects  most of its sales in U.S.  dollars,  the Company  collects a
portion of its revenue in  non-U.S.  currencies,  such as the  Chinese  renminbi
("RMB").  In the future,  customers  increasingly  may make payments in non-U.S.
currencies,  such as the newly created Euro. In addition,  the Company  accounts
for a portion of its costs, such as payroll, rent, and indirect operating costs,
in non-U.S.  currencies,  including  Philippine  pesos  ("PhP"),  British pounds
sterling,  and Chinese RMB. For example,  the Company's  Sub-Assembly  Agreement
with TEAM is based on a fixed  conversion  rate,  which  exposes  the Company to
exchange rate fluctuations with the Philippine peso.

         Historically,  fluctuations in foreign currency exchange rates have not
resulted in significant exchange losses to the Company.  Changes in the relation
of these and other  currencies  to the U.S.  dollar,  however,  could affect the
Company's cost of goods sold and operating  margins and could result in exchange
losses. In addition, currency devaluation can result in a reportable loss to the
Company if the Company  holds  deposits  of that  currency.  The Company  cannot
predict  the  impact of future  exchange  rate  fluctuations  on its  results of
operations.  In late 1997, the Philippine peso suffered a major devaluation from
its  historic  levels of around  $1.00 to PhP 25 down to as much as $1.00 to PhP
49.  Over the last five  years,  the  Chinese  RMB has  experienced  significant
devaluation  against most major  currencies.  The  establishment  of the current
exchange rate system as of January 1, 1994 produced a significant devaluation of
the RMB from $1.00 to RMB 5.7 to  approximately  $1.00 to RMB 8.7.  The rates at
which exchanges of RMB into U.S.  dollars may take place in the future may vary,
and any material  increase in the value of the RMB  relative to the U.S.  dollar
would  increase the  Company's  costs and expenses  and  therefore  would have a
material adverse effect on the Company.  In addition,  any decrease in the value
of the RMB may  adversely  affect  the  Company's  operations  if there are U.S.
dollar-denominated  

                                       15
<PAGE>
intercompany  loans from the  Company to its  subsidiary  or if the  Company has
substantial  RMB deposits or receivables.  Hedging RMB is difficult  because the
currency is not freely traded.

         In January  1999, a new currency  called the "Euro" was  introduced  in
certain  Economic  and  Monetary  Union  ("EMU")  countries  in Europe.  All EMU
countries are expected to be operating with the Euro as their single currency by
2002.  Although a significant  amount of uncertainty exists as to the effect the
Euro currency will have on the marketplace generally, the Company currently does
not believe that  introduction of the Euro will create a material adverse effect
on the Company's business or operating  results.  The Company intends to monitor
the impact,  if any, of the  introduction  of the Euro currency on the Company's
internal systems and the sale of its products and will take appropriate  actions
to address those issues if required.  The Company cannot predict the impact,  if
any, of the introduction of the Euro on its business,  financial  condition,  or
results of operations.

THE COMPANY MUST MAINTAIN SATISFACTORY MANUFACTURING YIELDS AND CAPACITY

         The design  and  manufacture  of LCDs and  display  modules  are highly
complex processes that are sensitive to a wide variety of factors, including the
level  of  contaminants  in the  manufacturing  environment,  impurities  in the
materials used, and the  performance of the design and production  personnel and
equipment.  As is typical in the  industry,  the  Company  from time to time has
experienced  lower than  anticipated  manufacturing  yields and  lengthening  of
delivery  schedules.  This may be particularly  true as the Company continues to
ramp up its high-volume LCD line to greater production levels in 1999 and begins
to manufacture LCoS(TM) microdisplays.  See Item 7, "Management's Discussion and
Analysis of  Financial  Condition  and  Results of  Operations  - Liquidity  and
Capital  Resources."  Additionally,  as the  sophistication  of display  modules
increases,  so does  the  level  of  complexity  in the  required  manufacturing
processes.  The  Company  continually  reviews  its  processes  in an  effort to
increase its manufacturing  productivity,  achieve higher manufacturing  yields,
and reduce design and  manufacturing  errors.  In addition,  the Company reviews
ongoing procedures  regularly to maintain its ability to meet delivery schedules
to satisfy increased  business.  The Company's inability to maintain high levels
of productivity or satisfactory  delivery schedules in its manufacturing  plants
in the  Philippines  or China,  or at its  Arizona  high-volume  LCD line  would
adversely affect the Company's operating results.

         Manufacturing yields and delivery schedules also may be affected as the
Company ramps up its manufacturing  capabilities in China and moves into its new
facility in 1999. Other companies in the industry have experienced difficulty in
expanding or relocating manufacturing output and capacity,  resulting in reduced
yields or delays in product  deliveries.  The Company could  experience  similar
manufacturing  yield or delivery  problems.  Any such problems  could  adversely
affect the Company's  operating  results.  See Item 1, "Business - Manufacturing
Facilities."

VARIABILITY OF CUSTOMER REQUIREMENTS MAY AFFECT OPERATING RESULTS

         Custom  manufacturers for OEMs must provide  increasingly rapid product
turnaround and respond to ever-shorter  lead times.  The Company  generally does
not obtain long-term  purchase  orders,  but instead works with its customers to
anticipate the volume of future orders.  Based upon its estimates of anticipated
future orders,  the Company must procure  components and determine the levels of
business that it will seek and accept,  production  schedules,  personnel needs,
and other resource  requirements,  in each case without the benefit of long-term
purchase commitments.  A variety of conditions,  both specific to the individual
customer and generally  affecting the industry,  may cause  customers to cancel,
reduce, or delay orders.  Cancellations,  reductions, or delays by a significant
customer or by a group of customers  could  adversely  affect the  Company,  its
results of operations,  prospects, and ability to service its debt. On occasion,
customers  may  require  rapid  increases  in  production,  which can strain the
Company's  resources and reduce margins.  Although the Company has increased its
manufacturing  capacity,  the Company may lack sufficient  capacity at any given
time to meet its customers' demands if such demands exceed anticipated levels.

         In addition to the variability  resulting from the short-term nature of
its customers' commitments,  other factors have contributed,  and may contribute
in the  future,  to  significant  periodic  and  quarterly  fluctuations  in the
Company's results of operations.  These factors include, among other things, the
following:

                                       16
<PAGE>
     +    the timing of orders;

     +    the volume of orders relative to the Company's capacity;

     +    customers' announcements, product introductions, and market acceptance
          of new products or new generations of products;

     +    evolution in the life cycles of customers' products;

     +    timing of expenditures in anticipation of future orders;

     +    effectiveness in managing manufacturing processes;

     +    changes in cost and availability of labor and components;

     +    product mix;

     +    pricing and availability of competitive products and services; and

     +    changes or anticipated changes in economic conditions.

         The Company uses existing  design programs to gauge the expected future
volume of business.  Completion of a particular  design,  however,  depends on a
variety of factors,  including  the  customer's  changing  needs,  and not every
design is successful in meeting those needs.

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

THE COMPANY MUST EFFECTIVELY UTILIZE ITS ARIZONA FACILITY

         The Company  has made  substantial  expenditures  in  constructing  its
facility in Tempe,  Arizona,  and equipping the facility with a high-volume  LCD
manufacturing  line. The Company placed the high-volume line in service in 1996,
although  the  Company  continued  to  commit a  significant  amount of time and
resources in 1996 and 1997 to the development of manufacturing  processes on the
line. The Company utilizes the high-volume line to produce a substantial portion
of its own requirements for LCD glass.

         The  successful  utilization of the LCD glass line requires the Company
to (i) produce LCD glass on a timely and cost-effective  basis at quality levels
at least equal to the LCD glass  available from  independent  suppliers and (ii)
utilize the LCD glass it produces  in devices it designs and  manufactures  in a
manner  satisfactory to its customers.  The Company  experienced  some delays in
fully implementing its LCD glass  manufacturing  operations in 1996. The Company
could  experience  problems or delays in the future in conducting  its LCD glass
manufacturing  operations.  Any such problems could result in the lengthening of
the Company's  delivery  schedules,  reductions in the quality or performance of
the  Company's  design  and   manufacturing   services,   and  reduced  customer
satisfaction.  Such  problems also could require the Company to purchase its LCD
glass  requirements  from third parties and could delay the Company's ability to
recover its investment in the high-volume LCD line.

         In addition,  the Company added  additional  equipment to the LCD glass
line in 1998 to enhance its ability to manufacture LCoS(TM)  microdisplays.  See
Item  1,  "Business  -  Research  and  Development."  Manufacturing  a  LCoS(TM)
microdisplay is a significantly different procedure than manufacturing a typical
liquid crystal display.  The  manufacturing  of  microdisplays  will require the
Company to overcome challenges, including the following:

     +    the use of a new material (silicon);

     +    the  modification  of  equipment  and  processes  to  accommodate  the
          miniature size of the product;

                                       17
<PAGE>
     +    the implementation of new scribing and breaking techniques;

     +    the incorporation of new handling procedures;

     +    the maintenance of cleaner manufacturing environments; and

     +    the ability to master tighter tolerances in the manufacturing process.

Utilization  of the LCD line for  microdisplays  also will require higher yields
because of the  significant  cost of the silicon  backplane.  The Company  could
experience  significant  problems in starting up volume  production  of LCoS(TM)
microdisplays.  Any  such  problems  could  result  in the  delay  of  the  full
implementation of high-volume  LCoS(TM)  microdisplay  production.  In addition,
lower-than-expected  yields could significantly and adversely effect the Company
because of the relative high cost of the silicon backplane.

THE COMPANY MUST EFFECTIVELY MANAGE ITS GROWTH

         The  failure of the  Company to manage  its  growth  effectively  could
adversely affect its operations.  The Company's revenue increased  substantially
during the period from 1993 through 1995, but declined  significantly in 1996 as
a result  of the  discontinuation  of a few  significant  programs  by its major
customer.  During  1997 and  1998,  the  Company  increased  the  number  of its
manufacturing  and design  programs  and plans to further  expand the number and
diversity of its  programs in the future.  The  Company's  ability to manage its
planned growth effectively will require it to

     +    enhance its operational, financial, and management systems;

     +    expand its facilities and equipment; and

     +    successfully hire, train, and motivate additional employees, including
          the  technical  personnel  necessary  to  operate  its new  production
          facility in China.

         As the Company  expands and  diversifies its product and customer base,
it may be required to further  increase its overhead and selling  expenses.  The
Company also may be required to increase  staffing and other expenses as well as
its  expenditures  on capital  equipment and leasehold  improvements in order to
meet the anticipated demand of its customers.  Customers,  however, generally do
not commit to firm  production  schedules for more than a short time in advance.
Any  increase  in  expenditures  in  anticipation  of future  orders that do not
materialize would adversely affect the Company's profitability. For example, the
Company substantially  increased its manufacturing  capacity in 1998 by starting
up manufacturing  operations in Beijing, China. Customers also may require rapid
increases in design and production  services that place an excessive  short-term
burden on the Company's resources.

THE COMPANY DEPENDS ON KEY PERSONNEL

         The Company's  development and operations  depend  substantially on the
efforts  and  abilities  of  its  senior  management  and  technical  personnel,
including  David R. Buchanan,  who has served as the Chairman of the Board since
1986 and served as President and Chief Executive  Officer ("CEO") of the Company
from 1987 to mid-1998.  When Mr. Buchanan's  successor resigned in January 1999,
Mr. Buchanan reassumed his duties as President and CEO on an interim basis until
the Company retains a replacement  CEO. Mr. Buchanan has announced his intention
to retire from the Board of  Directors  upon the hiring of a new  President  and
CEO.

         The  competition  for qualified  management and technical  personnel is
intense.  The  loss of  services  of one or more  of its  key  employees  or the
inability  to add key  personnel  (including  those  required  for its LCD glass
production  facility) could have a material  adverse effect on the Company.  See
Item 1,  "Business  -  Executive  Officers."  The  Company  does  not  have  any
fixed-term  agreements with, or key person life insurance covering,  any officer
or employee. The Company,  however,  maintains non-competition and nondisclosure
agreements with its key personnel.

                                       18
<PAGE>
THE COMPANY MUST PROTECT ITS INTELLECTUAL PROPERTY

         The  Company  relies on a  combination  of patent,  trade  secret,  and
trademark  laws,  confidentiality  procedures,  and  contractual  provisions  to
protect its intellectual  property.  The Company seeks to protect certain of its
technology  under trade secret laws, which afford only limited  protection.  The
Company faces risks  associated with its  intellectual  property,  including the
following:

     +    pending patent applications may not be issued;

     +    intellectual property laws may not protect the Company's  intellectual
          property rights;

     +    third parties may  challenge,  invalidate,  or  circumvent  any patent
          issued to the Company;

     +    rights  granted  under  patents  issued to the Company may not provide
          competitive advantages to the Company;

     +    despite  the  Company's  efforts to protect  its  proprietary  rights,
          unauthorized  parties may attempt to obtain and use  information  that
          the Company regards as proprietary;

     +    others may independently  develop similar  technology or design around
          any patents issued to the Company; and

     +    effective protection of intellectual property rights may be limited or
          unavailable  in  certain  foreign   countries  in  which  the  Company
          operates, such as China.

         Third  parties in the future may claim that the  Company is  infringing
certain patents or other  intellectual  property  rights,  although there are no
such  pending  lawsuits  against the Company or  unresolved  notices  that it is
infringing  intellectual  property  rights of others.  In the event that a third
party alleges that the Company is infringing its rights,  the Company may not be
able to obtain licenses on commercially  reasonable  terms from the third party,
if at all, or the third party may commence  litigation against the Company.  The
failure  to obtain  necessary  licenses  or other  rights or the  occurrence  of
litigation  arising out of such claims could materially and adversely affect the
Company, its results of operations, prospects, or ability to service its debt.

THE MARKET PRICE OF THE COMPANY'S COMMON STOCK MAY BE VOLATILE

         The market price of the Company's  Common Stock increased  dramatically
during the three-year period ended December 31, 1994, but declined significantly
during 1995 and 1996. The stock price  increased again during 1997, but declined
significantly  in 1998. See Item 5, "Market for  Registrant's  Common Equity and
Related Stockholder Matters." The trading price of the Company's Common Stock in
the future  could  continue  to be subject to wide  fluctuations  in response to
various factors, including the following:

     +    quarterly variations in operating results of the Company;

     +    actual or anticipated  announcements  of technical  innovations or new
          product developments by the Company or its competitors;

     +    changes in analysts' estimates of the Company's financial performance;

     +    general conditions in the electronics industry; and

     +    worldwide economic and financial conditions.

In  addition,  the  stock  market  has  experienced  extreme  price  and  volume
fluctuations  that have  particularly  affected the market  prices for many high
technology  companies  and that  often  have  been  unrelated  to the  operating
performance of such companies. These broad market fluctuations and other factors
may adversely affect the market price of the Company's Common Stock.

                                       19
<PAGE>
THE COMPANY MAY BE SUBJECT TO SHORTAGES OF RAW MATERIALS AND SUPPLIES

         The  principal raw  materials  used in producing the Company's  product
solutions  consist of LCD glass,  driver die,  circuit  boards,  molded  plastic
parts, lead frames, wire, chips, and packaging materials.  The Company purchases
most of these materials from Asian sources.  The Company does not have long-term
contracts with its suppliers. During 1998, the Company occasionally was required
to delay sales  because it was unable to complete  timely  deliveries of certain
products as a result of the  unavailability of certain raw materials,  including
LCD polarizers and drivers.

         Because the Company obtains many materials from foreign suppliers,  the
Company may be subject to certain  risks,  including  supply  interruptions  and
currency  fluctuations.  Purchasers of these  materials,  including the Company,
from time to time experience difficulty in obtaining such materials.

THE ELECTRONICS INDUSTRY IS CYCLICAL

         The electronics industry has experienced significant economic downturns
at various  times,  characterized  by  diminished  product  demand,  accelerated
erosion of average selling prices,  and production  over-capacity.  In addition,
the electronics industry is cyclical in nature. The Company has sought to reduce
its exposure to industry  downturns  and  cyclicality  by  providing  design and
production  services for leading companies in rapidly expanding  segments of the
electronics   industry.   However,   the  Company  may  experience   substantial
period-to-period  fluctuations  in future  operating  results because of general
industry conditions or events occurring in the general economy.

THE COMPANY MUST FINANCE THE GROWTH OF ITS BUSINESS AND THE DEVELOPMENT OF NEW
PRODUCTS

         To remain  competitive,  the Company must continue to make  significant
investments in research and development,  equipment, and facilities. As a result
of the increase in fixed costs and operating  expenses  related to these capital
expenditures,  the failure of the Company to sufficiently increase its net sales
to offset these  increased costs will adversely  affect the Company's  operating
results.

         The  Company  from  time to time may  seek  additional  equity  or debt
financing to provide for the capital expenditures required to maintain or expand
the Company's design and production facilities and equipment. The Company cannot
predict the timing and amount of any such capital  requirements at this time. If
such financing is not available on satisfactory terms, the Company may be unable
to expand its  business or to develop new  customers at the rate desired and its
operating results may be adversely  affected.  Debt financing increases expenses
and must be repaid  regardless  of operating  results.  Equity  financing  could
result  in   additional   dilution  to  existing   stockholders.   See  Item  7,
"Management's  Discussion  and  Analysis of Financial  Condition  and Results of
Operations - Liquidity and Capital Resources."

THE COMPANY IS SUBJECT TO ENVIRONMENTAL REGULATIONS

         The  operations of the Company  result in the creation of small amounts
of hazardous waste, including various epoxies,  gases, inks, solvents, and other
wastes.  The  Company,  therefore,  is  subject  to  federal,  state,  and local
governmental regulations related to the use, storage, discharge, and disposal of
toxic,  volatile,  or  otherwise  hazardous  chemicals  used in its  design  and
manufacturing  processes.  The amount of hazardous waste produced by the Company
may increase in the future depending on changes in the Company's operations. The
failure  of  the  Company  to  comply  with  present  or  future   environmental
regulations  could result in the imposition of fines,  suspension of production,
or a cessation of operations. Compliance with such regulations could require the
Company to acquire costly equipment or to incur other significant expenses.  Any
failure by the Company to control the use, or adequately restrict the discharge,
of hazardous substances could subject it to future liabilities. For example, the
Company  has  removed  contamination  from and  continues  to  conduct  periodic
chemical  monitoring  at  the  Company's  former  Connecticut  property.   Other
environmental  problems may be discovered in the future, which could subject the
Company to future costs or liabilities.

                                       20
<PAGE>
CHANGE IN CONTROL PROVISIONS

         The Company's  Restated  Certificate  of  Incorporation  (the "Restated
Certificate")  and the Delaware  General  Corporation  Law (the "Delaware  GCL")
contain provisions that may have the effect of making more difficult or delaying
attempts by others to obtain  control of the Company,  even when these  attempts
may be in the best  interests of  stockholders.  The Restated  Certificate  also
authorizes the Board of Directors, without stockholder approval, to issue one or
more series of Preferred  Stock,  which could have voting and conversion  rights
that adversely affect or dilute the voting power of the holders of Common Stock.
The  Delaware  GCL also  imposes  conditions  on  certain  business  combination
transactions with "interested stockholders" (as defined therein).

YEAR 2000 COMPLIANCE

         Many  existing  computer  programs and databases use only two digits to
identify  a year in the date  field  (I.E.,  99  would  represent  1999).  These
programs and  databases  were  designed and developed  without  considering  the
impact  of  the  upcoming  millennium.  Consequently,  date  sensitive  computer
programs may interpret the date "00" as 1900 rather than 2000. If not corrected,
many computer systems could fail or create erroneous results in 2000. Failure in
the  Company's  systems,  or in the systems of its vendors or  customers,  could
cause significant adverse effects to the Company. For a full discussion of those
potential  effects,  see  Item  7,  "Management's  Discussion  and  Analysis  of
Financial   Condition  and  Results  of   Operations  -  Year  2000   Compliance
Disclosure."

RIGHTS TO ACQUIRE SHARES

         At December  31, 1998,  an aggregate of 695,800  shares of common stock
were reserved for issuance upon exercise of options previously granted under the
Company's  stock option  plans.  The weighted  average  exercise  price of those
options is $12.14  per share.  During  the terms of such  options,  the  holders
thereof will have an  opportunity to profit from an increase in the market price
of Common Stock with  resulting  dilution in the  interests of holders of Common
Stock.  The existence of such stock  options may  adversely  affect the terms on
which the  Company  can obtain  additional  financing,  and the  holders of such
options can be expected to exercise such options at a time when the Company,  in
all likelihood, would be able to obtain additional capital by offering shares of
its Common Stock on terms more  favorable to the Company than those  provided by
the exercise of such options.

REPURCHASES OF COMMON STOCK

         In August 1996, the Board of Directors  authorized the repurchase  from
time to time of up to 1,000,000 shares of the Company's Common Stock on the open
market or in negotiated  transactions,  depending on market conditions and other
factors.  In October 1998, the Board of Directors  further  extended and revised
the  repurchase  program to authorize the repurchase of up to $10 million of the
Company's  stock.  As of December 31, 1998,  the Company had  purchased  969,794
shares of the Company's  Common Stock at a total purchase price of $8.3 million.
The  repurchase  of shares by the Company  significantly  reduced the  Company's
capital.  In addition,  the Company has obtained  long-term  financing  for such
repurchases,  which increases the  liabilities of the Company.  The reduction in
capital or increase in liabilities  could adversely affect the Company's ability
to expand its business or commit resources to needed  expenditures.  See Item 7,
"Management's  Discussion  and  Analysis of Financial  Condition  and Results of
Operations - Liquidity and Capital  Resources."  A significant  reduction in the
number  of  shares  outstanding  on the open  market  also  could  increase  the
volatility of the stock as a result of the reduced supply of available shares on
the open market.

SHARES ELIGIBLE FOR FUTURE SALE; POTENTIAL DEPRESSIVE EFFECT ON STOCK PRICE

         Currently, Rule 144 under the securities laws provides that each person
who beneficially  owns restricted  securities with respect to which at least one
year has elapsed  since the later of the date the shares were  acquired from the
Company or an affiliate of the Company may, every three months, sell in ordinary
brokerage  transactions  or to market  makers  an amount of shares  equal to the
greater of one percent of the  Company's  then-outstanding  Common  Stock or the
average  weekly  trading volume for the four weeks prior to the proposed sale of
such  shares.  An  aggregate  of 960,492  shares of Common Stock held by all the
executive officers and directors of the Company currently are available for sale
under Rule 144. Sales of substantial amounts of Common Stock by the stockholders

                                       21
<PAGE>
of the  Company,  or even the  potential  for such sales,  may have a depressive
effect on the market price of the Common  Stock and could  impair the  Company's
ability to raise capital through the sale of its equity securities.

THE COMPANY DOES NOT PAY CASH DIVIDENDS

         The Company has never paid any cash  dividends  on its Common Stock and
does not anticipate  that it will pay cash dividends in the near term.  Instead,
the Company  intends to apply any earnings to the expansion and  development  of
its  business.  See Item 5, "Market for  Registrant's  Common Equity and Related
Stockholder Matters."

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

         Certain statements and information  contained in this Report concerning
future, proposed, and anticipated activities of the Company; certain trends with
respect to the Company's  revenue,  operating results,  capital  resources,  and
liquidity  or with  respect to the markets in which the Company  competes or the
electronics  industry in general;  and other statements contained in this Report
regarding matters that are not historical facts are forward-looking  statements,
as such  term is  defined  under  applicable  securities  laws.  Forward-looking
statements, by their very nature, include risks and uncertainties, many of which
are beyond the  Company's  control.  Accordingly,  actual  results  may  differ,
perhaps materially,  from those expressed in or implied by such  forward-looking
statements. Factors that could cause actual results to differ materially include
those   discussed   elsewhere   under   this   Item  1,   "Business   -  Special
Considerations."

ITEM 2. PROPERTIES

         The Company  occupies a 97,000 square foot facility in Tempe,  Arizona,
which houses its United  States-based  manufacturing  operations;  its research,
development, engineering, design, and corporate functions; and the largest fully
automated  LCD glass  manufacturing  operations  in North  America.  The Company
entered into a ground lease  through  December 31, 2069,  subject to renewal and
purchase options as well as early  termination  provisions.  Costs to construct,
furnish, and equip the new facility were approximately $24.0 million.

         The Company leases  approximately  3,500 square feet of office space in
Swindon,  United  Kingdom,  where it maintains its European  administrative  and
executive offices.

         The Company leases  approximately  60,000 square feet of  manufacturing
space in Manila, the Philippines. Approximately 40,000 square feet is subject to
a lease that expires on December 31, 1999, and the remaining  20,000 square feet
is subject to a lease that expires on March 31, 1999, and is renewable from year
to year thereafter.

         The  Company  currently  leases  approximately  27,000  square  feet of
manufacturing  space in Beijing,  China,  which  includes  4,200  square feet of
office  space.  The  lease  will  expire  on  July  25,  1999.  The  Company  is
constructing  a permanent  manufacturing  facility  in  Beijing,  China near the
existing leased facility. The permanent facility will occupy 46,000 square feet,
of  which  29,000  square  feet  will  be  manufacturing  space,  and  is  being
constructed  on property that the Company has purchased on a long-term  land use
contract.  The  Company  expects  the cost to  construct  the  facility  will be
approximately $5.3 million. The Company currently  anticipates the facility will
be completed in mid-1999.

ITEM 3. LEGAL PROCEEDINGS

         There are no legal  proceedings  to which the  Company is a party or to
which any of its properties are subject,  other than routine litigation incident
to the  Company's  business that is covered by insurance or an indemnity or that
are not  expected  to have a  material  adverse  effect  on the  Company.  It is
possible,  however,  that the  Company  could  incur  claims for which it is not
insured or that exceed the amount of its insurance coverage.

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

         Not applicable.

                                       22
<PAGE>
                                     PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

         The  Company's  Common  Stock  has been  listed  on the New York  Stock
Exchange  ("NYSE") under the symbol "TFS" since December 29, 1994. The Company's
Common Stock was listed on the American Stock Exchange ("AMEX") from January 28,
1993 through  December 28, 1994.  The  Company's  Common Stock was listed on the
AMEX Emerging  Company  Marketplace  from March 18, 1992 until January 27, 1993,
and on the Nasdaq  National Market system from May 1, 1990 until March 17, 1992.
The  following  table  sets  forth  the  quarterly  high and low  prices  of the
Company's Common Stock for the periods indicated.

                                                             High         Low
                                                             ----         ---
1996:
First Quarter............................................   $21 7/8     $11 5/8
Second Quarter...........................................    14 1/8       9 1/8
Third Quarter............................................    13           8 3/4
Fourth Quarter...........................................    14          10 5/8

1997:
First Quarter............................................   $16 1/4     $12 1/4
Second Quarter...........................................    16          11 5/8
Third Quarter............................................    26 7/8      14 1/4
Fourth Quarter...........................................    26 1/2      16 1/4

1998:
First Quarter............................................   $23 1/16    $17 3/4
Second Quarter...........................................    20 3/8      14 7/8
Third Quarter............................................    18 3/16      7 1/16
Fourth Quarter...........................................    13 7/8       6 1/2

1999:
First Quarter (through March 8, 1999)....................   $16         $11 1/8

         As of March 8, 1999, there were  approximately  1,100 holders of record
and  approximately  6,000  beneficial  owners of the Company's Common Stock. The
closing  sale price of the  Company's  Common Stock on the NYSE on March 8, 1999
was $11.25 per share.

         The  present  policy of the  Company is to retain  earnings  to provide
funds for the operation and expansion of its business.  The Company has not paid
dividends on its Common Stock and does not anticipate  that it will do so in the
near term. Furthermore,  the Company's line of credit with Imperial Bank Arizona
("Imperial  Bank") does not permit the payment of dividends  without the consent
of  Imperial  Bank.  The payment of  dividends  in the future will depend on the
Company's growth, profitability, financial condition, and other factors that the
directors may deem relevant.

                                       23
<PAGE>

ITEM 6.           SELECTED FINANCIAL DATA

         The following table summarizes certain selected consolidated  financial
data of the  Company  and is  qualified  in its  entirety  by the more  detailed
consolidated  financial statements and notes thereto appearing elsewhere herein.
The data have been derived from the  consolidated  financial  statements  of the
Company  audited by Arthur Andersen LLP,  independent  public  accountants.  All
share amounts and per share data have been  adjusted to reflect the  two-for-one
split of the Company's Common Stock effected as a stock dividend in May 1994.
<TABLE>
<CAPTION>
                                              1998        1997        1996        1995        1994
                                            --------    --------    --------    --------    --------
                                                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                         <C>         <C>         <C>         <C>         <C>
Net sales ................................  $ 95,047    $ 84,642    $ 60,713    $ 91,585    $ 85,477
                                            --------    --------    --------    --------    --------
Costs and expenses:
  Cost of sales ..........................    76,149      64,760      58,321      70,481      59,409
  Selling, general, and administrative ...     7,334       6,557       5,351       5,386       4,867
  Research and development ...............     7,159       5,106       4,065       2,396       1,270
                                            --------    --------    --------    --------    --------
                                              90,642      76,423      67,737      78,263      65,546
                                            --------    --------    --------    --------    --------
Operating income (loss) ..................     4,405       8,219      (7,024)     13,322      19,931
                                            --------    --------    --------    --------    --------
Other income (expense):
  Interest, net ..........................        75         548         412         765         859
  Other, net .............................      (117)       (190)       (139)       (122)       (135)
                                            --------    --------    --------    --------    --------
                                                 (42)        358         273         643         724
                                            --------    --------    --------    --------    --------
Income (loss) before provision for
  (benefit from) income taxes ............     4,363       8,577      (6,751)     13,965      20,655
Provision for (benefit from) income taxes      1,773       3,334      (2,920)      5,548       8,109
                                            --------    --------    --------    --------    --------
Net income (loss) ........................  $  2,590    $  5,243    $ (3,831)   $  8,417    $ 12,546
                                            ========    ========    ========    ========    ========
Earnings (loss) per common share:
  Basic ..................................  $   0.34    $   0.67    $  (0.49)   $   1.09    $   1.88
                                            ========    ========    ========    ========    ========
  Diluted ................................  $   0.33    $   0.65    $  (0.49)   $   1.04    $   1.59
                                            ========    ========    ========    ========    ========
Weighted average number of common shares:
  Basic ..................................     7,639       7,854       7,768       7,716       6,666
                                            ========    ========    ========    ========    ========
  Diluted ................................     7,802       8,090       7,768       8,084       7,890
                                            ========    ========    ========    ========    ========
CONSOLIDATED BALANCE SHEET DATA
  (AT END OF PERIOD):

Working capital ..........................  $ 24,825    $ 29,113    $ 21,513    $ 22,400    $ 37,638
Total assets .............................    77,904      72,835      62,569      63,780      56,280
Notes payable to banks and long-term debt      8,095          --          --       3,000         182
Stockholders' equity .....................    51,096      56,525      51,184      55,224      46,561
</TABLE>
                                       24
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
        AND RESULTS OF OPERATIONS

RESULTS OF OPERATIONS

ANNUAL TABLE: PERCENTAGES OF NET SALES

The following table sets forth, for the periods indicated, the percentage of net
sales of certain items in the Company's Consolidated  Financial Statements.  The
table  and  the  discussion  below  should  be  read  in  conjunction  with  the
Consolidated Financial Statements and Notes thereto.

                                                       YEARS ENDED DECEMBER 31,
                                                       -----------------------
                                                        1998     1997     1996
                                                       -----    -----    -----

Net sales ..........................................   100.0%   100.0%   100.0%
                                                       -----    -----    -----
Costs and expenses:
  Cost of sales ....................................    80.1     76.5     96.1
  Selling, general, and administrative .............     7.7      7.8      8.8
  Research and development .........................     7.6      6.0      6.7
                                                       -----    -----    -----
                                                        95.4     90.3    111.6
Operating income (loss) ............................     4.6      9.7    (11.6)
Other income .......................................      --      0.4      0.5
                                                       -----    -----    -----
Income (loss) before provision for
  (benefit from) income taxes ......................     4.6     10.1    (11.1)
Provision for (benefit from) income taxes ..........     1.9      3.9     (4.8)
                                                       -----    -----    -----
Net income (loss) ..................................     2.7%     6.2%    (6.3)%
                                                       =====    =====    =====

YEAR ENDED DECEMBER 31, 1998 COMPARED WITH YEAR ENDED DECEMBER 31,1997

         Net sales were $95.0  million for 1998,  an  increase  of 12.3  percent
compared with net sales of $84.6 million for 1997.  The sales  increase was as a
result of several new programs in 1998 for a variety of  customers,  including a
major communications customer. In 1998, the Company's largest customer accounted
for net sales of $60.5 million  compared with net sales of $29.2 million to that
customer in 1997, for an overall increase of 107.2 percent.  The Company's major
customer accounted for approximately 63.6 percent of net sales for 1998 compared
with  approximately  34.6  percent for 1997.  No other  customer  accounted  for
greater than 10 percent of sales in 1998.

         Cost of sales, as a percentage of net sales,  increased to 80.1 percent
for 1998 as compared with 76.5 percent for 1997. The  corresponding  decrease in
the gross margin was the result of a number of factors,  including manufacturing
variances  occurring  as a  result  of the  start-up  of the  new  manufacturing
facility  in Beijing,  some  unfavorable  yields  occurring  on the  start-up of
several  new  programs,  and  increased  pricing  pressure  from  customers  and
competitors, partially as a result of the Asian economic crisis.

         Selling, general, and administrative expense was $7.3 million for 1998,
as compared  with $6.6 million in 1997.  Selling,  general,  and  administrative
expense  increased in absolute terms as a result of increased  selling  expenses
and the addition of administrative  personnel.  As a result of increased revenue
in 1998, however,  selling,  general, and administrative expense declined to 7.7
percent of net sales from 7.8 percent of net sales in 1997.

         Research and development  expense totaled $7.2 million,  or 7.6 percent
of net sales for 1998,  as  compared  with $5.1  million,  or 6.0 percent of net
sales,  for 1997.  Research and  development  expense  consists  principally  of
salaries and benefits to  scientists  and other  personnel;  related  facilities
costs,  including  certain  expenses  associated  with  the  development  of new
processes on the LCD line in Tempe,  Arizona; and various expenses for projects.
Research and  development  expense has  increased as the Company has invested in
new technologies and manufacturing processes,  developed new potential products,
continued its in-house  process  development  efforts related to the high-volume
manufacturing LCD line, and developed  application  specific integrated circuits
("ASICs") for its new display technologies.  The Company believes that continued
investments in research and development

                                       25
<PAGE>
relating to manufacturing  processes and new display technology are necessary to
remain competitive in the marketplace,  as well as to provide  opportunities for
growth.

         Interest  income  (net) for 1998 was  $75,000,  down from  $548,000 for
1997. The decrease in interest  income was the result of investing lower average
cash balances during the year as well as increased  interest expense as a result
of increased  debt.  Other  expenses  (net)  decreased to $117,000 for 1998 from
$190,000 for 1997.  The decrease was  primarily  attributed  to reduced  foreign
exchange losses.

         The Company  recorded a provision  for income taxes of $1.8 million for
1998,  as compared  with a provision  for income taxes of $3.3 million for 1997.
The overall tax rate for the Company for 1998 was 40.6 percent as compared  with
38.9 percent for 1997.  The  increased  tax rate is primarily as a result of the
Company having incurred losses in China,  which is a low tax rate  jurisdiction.
In such instance, the Company does not obtain a tax benefit for the losses equal
to its tax rate  elsewhere in the world.  The Company  expects that the tax rate
for 1999 will approximate 40.0 percent.

         For 1998, the Company reported net income of $2.6 million, or $0.33 per
share (diluted), as compared with net income of $5.2 million, or $0.65 per share
(diluted), for 1997.

YEAR ENDED DECEMBER 31, 1997 COMPARED WITH YEAR ENDED DECEMBER 31,1996

         Net sales were $84.6  million for 1997,  an  increase  of 39.4  percent
compared with net sales of $60.7 million for 1996.  The sales  increase was as a
result of several new programs in 1997 for a variety of  customers,  including a
major office  automation  customer.  In 1997,  the  Company's  largest  customer
accounted  for net  sales  of $29.2  million  compared  with net  sales of $39.5
million to that customer in 1996, for an overall  decrease of 26.1 percent.  The
Company's major customer  accounted for approximately  34.6 percent of net sales
for 1997 compared with  approximately  65.1 percent for 1996. One other customer
accounted for $27.1 million, or 32.0 percent of the net sales, in 1997.

         Cost of sales, as a percentage of net sales,  decreased to 76.5 percent
for 1997 as compared with 96.1 percent for 1996. The  corresponding  increase in
the gross  margin was the  result of a number of  factors,  including  decreased
provisions   for   excess  and   obsolete   inventory,   decreased   unfavorable
manufacturing variances occurring as a result of increased manufacturing volume,
labor utilization,  and material  purchases,  and a more mature product mix with
higher margins and better yields. In the third quarter of 1996, the Company took
a special one-time provision for excess and obsolete inventory related primarily
to end-of-life  programs for which the majority of shipments,  expected to occur
in the latter part of 1996,  never  materialized.  Furthermore,  the Company was
required to make significant design  modifications to a new product,  which also
resulted in obsolete  inventory.  Without the  provision for excess and obsolete
inventory taken in the third quarter of 1996, the cost of sales, as a percentage
of net sales, would have been 84.5 percent for 1996.

         Selling, general, and administrative expense was $6.6 million for 1997,
as compared  with $5.4  million in 1996.  Selling,  general  and  administrative
expenses  increased in absolute terms as a result of increased  selling expenses
and the addition of administrative  personnel.  As a result of increased revenue
in 1997, however,  selling,  general, and administrative expense declined to 7.8
percent of net sales from 8.8 percent of net sales in 1996.

         Research and development  expense totaled $5.1 million,  or 6.0 percent
of net sales,  for 1997 as  compared  with $4.1  million,  or 6.7 percent of net
sales,  for 1996.  Research and  development  expense  consists  principally  of
salaries and benefits to  scientists  and other  personnel,  related  facilities
costs,  including  certain  expenses  associated  with  the  development  of new
processes on the LCD line in Tempe,  Arizona, and various expenses for projects.
Research and development  expense  increased in 1997 as the Company  invested in
new technologies and manufacturing processes,  developed new potential products,
and  continued  its  in-house  process   development   efforts  related  to  the
high-volume manufacturing LCD line.

         Interest income (net) for 1997 was $548,000, up from $412,000 for 1996.
The increase in interest income was the result of investing  higher average cash
balances  during the year.  Other expenses (net)  increased to $190,000 for 1997
from  $139,000  for 1996.  The  increase  was  primarily  attributed  to foreign
exchange losses.

                                       26
<PAGE>
         The Company  recorded a provision  for income taxes of $3.3 million for
1997,  as compared  with a benefit  from income  taxes of $2.9 million for 1996.
This resulted  primarily  from having a loss in 1996 as compared with  reporting
net  income in 1997.  The  overall  tax rate for the  Company  for 1997 was 38.9
percent as compared with 43.3 percent for 1996.

         For 1997, the Company reported net income of $5.2 million, or $0.65 per
share (diluted), as compared with a net loss of $3.8 million, or $0.49 per share
(diluted),  for 1996.  Without the provision  for excess and obsolete  inventory
taken in 1996, the Company would have reported net income of $158,000,  or $0.02
per share, in 1996.

QUARTERLY RESULTS OF OPERATIONS

         The following table presents unaudited  consolidated  financial results
for each of the eight  quarters  in the period  ended  December  31,  1998.  The
Company  believes that all necessary  adjustments  have been included to present
fairly the quarterly  information when read in conjunction with the Consolidated
Financial Statements.  The operating results for any quarter are not necessarily
indicative of the results for any subsequent quarter.
<TABLE>
<CAPTION>
                                                            QUARTERS ENDED
                                -----------------------------------------------------------------------
                                                (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                               1998                                  1997
                                ----------------------------------   ----------------------------------
                                 MAR 31   JUN 30   SEP 30   DEC 31    MAR 31   JUN 30   SEP 30   DEC 31
                                -------  -------  -------  -------   -------  -------  -------  -------
<S>                             <C>      <C>      <C>      <C>       <C>      <C>      <C>      <C>    
Net sales ....................  $18,479  $22,682  $24,572  $29,314   $16,129  $18,737  $24,074  $25,702
Cost and expenses:
  Cost of sales ..............   13,687   17,095   22,243   23,124    12,488   14,377   18,511   19,384
  Selling, general, and
  administrative .............    1,619    1,815    1,721    2,179     1,466    1,479    1,822    1,790
  Research and development ...    1,689    1,904    1,250    2,316     1,130    1,315    1,314    1,347
                                -------  -------  -------  -------   -------  -------  -------  -------
                                 16,995   20,814   25,214   27,619    15,084   17,171   21,647   22,521
                                -------  -------  -------  -------   -------  -------  -------  -------
Operating income (loss) ......    1,484    1,868     (642)   1,695     1,045    1,566    2,427    3,181
Other income (expense):
  Interest, net ..............      192      130       (4)    (243)      157      154      152       85
  Other, net .................      (17)      (6)     (48)     (46)      (12)      (7)     (41)    (130)
                                -------  -------  -------  -------   -------  -------  -------  -------
Income (loss) before provision
  for (benefit from) income
  taxes ......................    1,659    1,992     (694)   1,406     1,190    1,713    2,538    3,136
Provision for (benefit from)
  income taxes ...............      664      869     (291)     531       389      685    1,010    1,250
                                -------  -------  -------  -------   -------  -------  -------  -------
Net income (loss) ............  $   995  $ 1,123  $  (403) $   875   $   801  $ 1,028  $ 1,528  $ 1,886
                                =======  =======  =======  =======   =======  =======  =======  =======
Earnings (loss) per common
  share:
    Basic ....................  $  0.13  $  0.14  $ (0.05) $  0.12   $  0.10  $  0.13  $  0.19  $  0.24
                                -------  -------  -------  -------   -------  -------  -------  -------
    Diluted ..................  $  0.12  $  0.14  $ (0.05) $  0.12   $  0.10  $  0.13  $  0.19  $  0.23
                                -------  -------  -------  -------   -------  -------  -------  -------
Weighted average number of
  common shares:
    Basic ....................    7,907    7,918    7,656    7,081     7,759    7,855    7,874    7,900
                                =======  =======  =======  =======   =======  =======  =======  =======
    Diluted ..................    8,165    8,128    7,656    7,146     8,048    8,071    8,181    8,168
                                =======  =======  =======  =======   =======  =======  =======  =======
</TABLE>

LIQUIDITY AND CAPITAL RESOURCES

         During  1998,  the  Company had net cash  outflow  from  operations  of
$62,000,  as compared with positive cash inflow of $6.8 million during 1997. The
decrease  in cash flow from  operations  was  primarily  due to the  increase in
accounts receivable,  the increase in inventory, and the decreased provision for
inventory  valuation  reserves.  The  increase in accounts  receivable  occurred
primarily as a result of the increased  sales  activity in 1998 

                                       27
<PAGE>
and the increase in inventory  occurred  primarily as a result of a build-up for
anticipated sales in the first quarter of 1999. Depreciation expense in 1998 was
$4.7 million  versus $4.1  million in 1997.  This  increase  was  primarily as a
result of an increased number of starts on the LCD manufacturing  line in Tempe,
Arizona. The high-volume LCD line is depreciated on a units of production method
based on units started.  The Company anticipates that depreciation will continue
to  rise in 1999  as a  result  of  additional  capital  expenditures  in  1999,
including  the new  building and  equipment  for the  manufacturing  facility in
China,  the  installation  of additional  equipment in its Manila  manufacturing
location,  and the  installation  of additional  equipment in Tempe,  Arizona to
manufacture LCoS(TM) microdisplays.

         The Company's  working  capital was $24.8 million at December 31, 1998,
down from $29.1  million at December 31, 1997.  The  Company's  current ratio at
December 31, 1998 was 2.5-to-1 as compared  with a current  ratio of 3.1-to-1 at
December  31, 1997.  Including  its cash and loan  commitments,  the Company had
nearly $22.0 million in readily available funds on December 31, 1998.

         In November 1998, the Company  entered into a new $25.0 million secured
revolving line of credit with Imperial Bank and the National Bank of Canada. The
new  credit  facility  matures  in May  2000  and  consists  of a $15.0  million
revolving line of credit, which will be available for general corporate purposes
(the "General Facility"), and a $10.0 million long-term loan, which will provide
available funds to repurchase the Company's stock (the  "Repurchase  Facility").
At December 31, 1998,  $8.1 million of  borrowings  were  outstanding  under the
Repurchase  Facility.  Advances  under  the  loans  may be  made as  Prime  Rate
Advances,  which accrue  interest  payable  monthly at the bank's prime  lending
rate,  or as LIBOR Rate  Advances,  which bear  interest at 175 basis  points in
excess of the LIBOR Base Rate for the General  Facility  and 225 basis points in
excess of the LIBOR Base Rate for the Repurchase Facility.

         The Company's  subsidiary,  Three-Five Systems Limited, has established
an annually renewable credit facility with a United Kingdom bank,  Barclays Bank
PLC, in order to fund its working capital  requirements.  The facility  provides
$350,000 of borrowing  capacity  secured by accounts  receivable  of  Three-Five
Systems Limited. Advances are based on accounts receivable, as defined. Advances
under the credit facility accrue interest,  which is payable  quarterly,  at the
bank's  base rate plus 200 basis  points.  The United  Kingdom  credit  facility
matures in July 1999.  Three-Five Systems Limited had no borrowings  outstanding
under this line of credit at December 31, 1998.

         In August 1996, the Board of Directors  authorized the repurchase  from
time to time of up to one million  shares of the  Company's  Common Stock on the
open market or in negotiated transactions,  depending upon market conditions and
other  factors.  In October 1998,  the Board of Directors  further  extended and
revised the repurchase  program to authorize  repurchases of up to $10.0 million
of Common  Stock.  During the  quarter  ended  December  31,  1998,  the Company
purchased  approximately  410,700 shares under the repurchase program at a total
cost of $3.4 million. Taking into account previous purchases, as of December 31,
1998,  the Company had purchased a total of  approximately  971,798 shares under
the repurchase program at a cost of $8.3 million.

         Capital  expenditures  during 1998 were approximately $8.1 million,  as
compared with $3.0 million during 1997. Capital  expenditures for 1998 consisted
primarily of manufacturing and office equipment for the Company's  operations in
Manila,   Arizona,   and  China  and  laboratory   equipment  for  research  and
development.   The  Company  anticipates  that  it  will  increase  its  capital
expenditures  during 1999. Those  expenditures will primarily relate to advanced
manufacturing  processes,  the high-volume LCD line, and necessary manufacturing
equipment.   In  1998,   the  Company  spent  $5.3  million  for  equipment  and
construction related to its Beijing,  China operations.  The Company anticipates
the  facilities  and  capital  cost for China in 1999 to be  approximately  $4.7
million.

         The Company  anticipates  that accounts  receivable  and inventory will
rise in 1999 if revenue levels  increase as currently  anticipated.  The Company
believes that its existing capital and anticipated cash flow from operations and
credit  lines will  provide  adequate  sources to fund  operations  and  planned
expenditures  throughout  1999.  Should the Company  encounter  additional  cash
requirements,  however,  the Company may have to expand its loan  commitments or
pursue  alternate  methods of financing or raising  capital.  The Company cannot
provide assurance, however, that adequate additional financing will be available
or,  if  available,  that  such  financing  will be on terms  acceptable  to the
Company.
                                       28
<PAGE>
EFFECTS OF INFLATION AND FOREIGN CURRENCY EXCHANGE FLUCTUATIONS

         The results of operations of the Company for the periods discussed have
not been significantly  affected by inflation or foreign currency  fluctuations.
The Company  generally  sells its products and services and negotiates  purchase
orders with its foreign suppliers in United States dollars.  An exception is the
Sub-Assembly Agreement in the Philippines,  which is based on a fixed conversion
rate,  exposing the Company to exchange rate  fluctuations  with the  Philippine
peso. The Company has not incurred any material exchange gains or losses to date
and there  has been  some  minor  benefit  as a result of the peso  devaluation,
although the Company is now required to pay approximately  one-third of any peso
devaluation gain to its lessor and direct labor subcontractor in Manila.

         The Company commenced operations in China in 1998. Although the Chinese
currency  currently  is  stable,  its value in  relation  to the U.S.  dollar is
determined by the Chinese  government.  There is general  speculation that China
may devalue its currency in response to the current  Asian  economic  situation.
Devaluation of the Chinese  currency could result in translation  adjustments to
the Company's  balance sheet as well as reportable  losses depending on monetary
balances  and loans of the  Company at the time of  devaluation.  Recently,  the
government  in China has made it  difficult to convert its local  currency  into
foreign  currencies.  Although  the  Company  from time to time may  enter  into
hedging  transactions  in  order to  minimize  its  exposure  to  currency  rate
fluctuations, the Chinese currency is not freely traded and thus is difficult to
hedge. In addition, the government of China has recently imposed restrictions on
Chinese  currency  loans to  foreign-operated  entities  in China.  Based on the
foregoing,  there can be no assurance that  fluctuations  and currency  exchange
rates in the future will not have an adverse affect on the Company's operations.

BUSINESS OUTLOOK AND RISK FACTORS

         This Business Outlook section has numerous forward-looking  statements.
Some of the risk factors  associated with those  forward-looking  statements are
set forth in "Risk Factors"  below.  Other  important risk factors are set forth
under "Special Considerations" in Item 1 of this Report.

         The  Company  offers  advanced  design and  manufacturing  services  to
original equipment manufacturers. The Company specializes in custom displays and
front panel displays  utilizing  liquid crystal display (LCD) and light emitting
diode (LED)  components  and  technology.  The Company  experienced  substantial
growth from 1993  through  1995 with such growth  dependent  primarily  upon the
Company's participation in the substantial growth of the wireless communications
market and sales to a single  major  customer  in that  industry.  In 1996,  the
Company's  sales  declined,  largely as a result of the  phase-out by that major
customer of a  significant  family of programs  in early  1996.  In 1997,  sales
returned to pre-1996  levels  primarily  as a result of several new programs and
customers,  including a major office automation customer. In 1998, sales to that
office  automation  customer were greatly  reduced,  but that reduction was more
than  offset by  increased  sales to the  Company's  largest  telecommunications
customer.  Sales in 1998  increased  by about 12.3  percent  over 1997,  but net
profit declined as the Company  increased R&D expenses  significantly,  incurred
start-up  expenses for China, and experienced  pricing  pressures from its Asian
competitors, partially as a result of the Asian economic situation.

         In 1998, the Company  recorded  almost 57 percent of its revenue in the
third and fourth quarters.  Fourth quarter revenue in 1998 was almost 60 percent
greater than first quarter  revenues in 1998. In 1999,  the Company  anticipates
that this type of revenue pattern will be repeated. The Company believes that it
has a pattern of seasonality to its sales as OEMs with retail  products  develop
shorter  product  life  cycles  and  phase  out old  programs  early in the year
following holiday sales.

         The Company has undertaken  efforts to diversify its business,  broaden
its  customer  base,  and expand its markets.  The  Company's  historical  major
customer,  which accounted for approximately 80 percent of the Company's revenue
in 1995,  accounted for 65 percent of the Company's revenue in 1996 and slightly
less than 35 percent of the Company's revenue in 1997. These reduced percentages
occurred  as a result of the  increased  sales to other  customers  and  reduced
product selling prices and revenues from that major customer.  In 1998, however,
the  Company's  business  with that customer has increased at a rate faster than
business with other customers.  Therefore,  the percentage of revenue attributed
to that customer  substantially  increased in 1998. In 1999, the Company expects
its  business  with that  customer  to remain at  approximately  the same dollar
amount.  In addition,  the Company plans 

                                       29
<PAGE>
to increase sales to other customers,  which would result in declining  customer
concentration.  One other  customer  accounted for 32.0 percent of the Company's
revenue in 1997, but this percentage declined in 1998 to below 10 percent of the
Company's revenue as older programs have matured.  Some replacement programs did
not have the type of LCD modules  supplied by the Company and those that did had
significantly lower selling prices. The Company expects to do continued business
with this customer, but does not expect it to constitute more than 10 percent of
its revenue in 1999.

         Several   factors  impact  the  Company's   gross  margins,   including
manufacturing   efficiencies,   product  differentiation,   product  uniqueness,
billings  for  non-recurring   engineering   services,   inventory   management,
engineering costs, product mix, and volume pricing. There is significant pricing
pressure  in  higher  volume  programs  in  the  telecommunications  and  office
automation  industries.  As the  production  levels of some of the Company's new
high-volume  programs  increase,  the  lower  standard  gross  margins  on those
programs have had an impact on the Company's overall margins. In addition, in an
effort  to  secure  sales  to  certain  strategic  customers,  the  Company  may
aggressively price its products. Depending on the size of the programs achieved,
such pricing strategies also could have an effect on overall margins.

         The Company's gross margins on its products are also typically lower at
the start of a program as a result of yield and other  start-up  issues.  In the
third  quarter of 1998,  the Company  started  several new programs and incurred
substantial start-up costs. The Company expects to start up several new programs
throughout 1999.

         The Company  started  operations  in China in 1998,  and the  Company's
gross  margins  have been  adversely  affected  by the  start-up  of those China
manufacturing  operations. As the Company ramped up its manufacturing operations
in China,  it incurred costs in advance of the receipt of significant  revenues.
Generally, the incremental China-based expenses were in the total cost of sales.
Those incremental  expenses arose mainly from  under-absorption  of the costs of
operating  the  China  facility  and are  included  in the cost of  sales,  thus
reducing overall gross margins. In the fourth quarter of 1998, the Company had a
slight profit in China because  significant  increases in manufacturing  volumes
resulted  in  absorption  of the  existing  costs.  In the  next  few  quarters,
profitability in China will be  volume-dependent.  In the long run, however, the
Company expects the China operations to positively  impact gross margins because
of certain  competitive  cost advantages  provided by maintaining  operations in
China.

         The Company  anticipates  that weakened  Asian  currencies  will have a
continued  impact  on  the  Company's  gross  margins.  Many  of  the  Company's
competitors  are Asian  suppliers,  and a strong U.S. dollar gives a competitive
pricing  advantage  to those  suppliers.  Thus,  the Company may continue to see
competitive  margin pressure from Asian suppliers,  particularly  those in Korea
and Japan.

         Serving a variety  of  customers  with  complex  and  differing  issues
requires  increased  personnel  committed  to those  customers.  As the  Company
expands and  diversifies  its product and customer  base, the Company has had to
increase its  selling,  general,  and  administrative  expenses.  The volume and
complexity  of the  Company's  business is  expected  to continue to grow.  As a
result,  the Company  anticipates  that it will continue to increase its selling
and administrative expenses on a quarter-by-quarter basis.

         The  Company  believes  that  continued  investments  in  research  and
development  relating to new display technology and manufacturing  processes are
necessary to remain competitive in the marketplace and to provide  opportunities
for growth.  The Company continues to expand and intensify its internal research
and development to focus on proprietary display products as well as continue LCD
manufacturing process improvements.  Use of the LCD manufacturing line in Tempe,
Arizona as a  resource  for  testing  new ideas is key to  development  of these
products, some of which will be proprietary and not available from other display
manufacturers.  Further,  the development of the high-volume  manufacturing  LCD
line has helped  reduce the  Company's  dependence  on foreign  suppliers of LCD
glass.  Some  of  the  Company's  new  display  technologies  also  require  the
development   of  application   specific   integrated   circuits   ("ASICs")  to
electronically drive the displays.  Development of custom ASICs is a lengthy and
expensive process.

         The Company  also  intends to pursue  technologies  being  developed in
related  fields.  The Company  operates the highest  volume fully  automated LCD
manufacturing  line in  North  America.  As a  result,  several  companies  have

                                       30
<PAGE>
approached the Company about potential  alliances.  The Company  believes that a
strategic  alliance with one or more of those  companies could minimize the cost
of entry into new markets and new  technologies.  For example,  in 1997 National
Semiconductor  Corporation  and the Company  entered  into a strategic  supplier
alliance   agreement   for  the   development   and   manufacture   of  LCoS(TM)
microdisplays.  In April 1998, the Company  acquired  approximately a 19 percent
interest in  Siliscape,  Inc.,  a start-up  company  with  numerous  patents and
proprietary  technology  relating to  microdisplays.  The Company and Siliscape,
Inc. also entered into a strategic  agreement under which they will focus on the
development  of  microdisplay  products,  with  the  Company  providing  certain
proprietary  manufacturing  capabilities and Siliscape,  Inc.  providing certain
patented and proprietary technologies and components.

         The  Company  also  is  considering   licensing  from  other  companies
technologies that could be optimized on the LCD  manufacturing  line, as well as
entering into further  alliances.  The Company intends to continue this internal
and external focus on research and development  indefinitely.  As a result,  the
actual dollar amount of such research and development  expenditures in 1999 will
substantially increase over 1998.

         As  previously  described,  the Company has  established  manufacturing
operations in China.  Three-Five Systems (Beijing) Co., Ltd. was incorporated in
China  during  the first  quarter  of 1998 and  business  license  approval  was
received from the governmental authorities.  During the first quarter of 1998, a
temporary leased site was selected in Beijing, as was the permanent site. In the
second  quarter of 1998,  the Company moved into the  temporary  site and set up
manufacturing  lines. In the third quarter of 1998, the factory was qualified by
customers and began making initial shipments. In the fourth quarter of 1998, the
Company shipped over $5.7 million in products.

         The Company has established a China-based  manufacturing  operation for
several  reasons.  First,  based upon growth  expectations  in the  European and
United States  marketplaces,  the Company  anticipated a need for  manufacturing
capacity  beyond what is available  at its  Philippine  manufacturing  facility.
China was selected  because of the desire to diversify  manufacturing  locations
and  because of the cost  benefits  that are  expected  to be achieved in China.
China also is expected to be a  synergistic  business  location  for the Company
because many of the components  used by the Company are  manufactured  in China.
Second,  many  of  the  Company's  existing  and  potential  customers  maintain
manufacturing  operations  near the Company's  operations in China.  Despite the
current  Asian  economic  situation,  those  customers  continue  to require LCD
modules  and  the  Company  has  limited  participation  in that  market.  There
currently are very few LCD module  manufacturers in China. Under current Chinese
government  rules,  however,  OEMs in China have a strong  motivation to utilize
locally manufactured components.

RISK FACTORS

         Forward-looking  statements  in this report  include  revenue,  margin,
expense,  and earnings  analysis for 1999 as well as the Company's  expectations
relating  to  operations  in China;  future  technologies;  and future  designs,
inventory  balances,  and  production  orders.  The Company's  future  operating
results may be affected by various  trends,  developments,  and factors that the
Company  must  successfully  manage in order to achieve its goals.  In addition,
there are trends,  developments,  and factors beyond the Company's  control that
may affect its operations.  The cautionary statements and risk factors set forth
below and elsewhere in this Report,  and in the Company's other filings with the
Securities and Exchange  Commission,  identify  important trends,  factors,  and
currently  known   developments  that  could  cause  actual  results  to  differ
materially from those in any forward-looking statements contained in this Report
and in any written or oral statements of the Company.

         A few core customers  currently are  responsible  for a majority of the
Company's revenue,  and the Company expects the high  concentration  levels with
its  core  customers  to  continue  through  1999.  Thus,  any  material  delay,
cancellation,  or reduction  of orders from one or more of those core  customers
could have a material adverse effect on the Company's operations.

         Although  the trend of the Company is to enter into more  manufacturing
contracts with its  customers,  the principal  benefit of these  contracts is to
clarify order lead times, inventory risk allocation, and similar matters and not
to provide firm, long-term volume purchase  commitments.  Customers generally do
not provide firm long-term  volume  purchase  commitments to the Company.  Thus,
customers can cancel  purchase  commitments  and change or 

                                       31
<PAGE>
delay expected volume levels.  The Company cannot provide assurance that it will
be able to replace canceled, delayed, or reduced commitments in a timely manner.
If customers  cancel,  delay, or reduce  commitments,  the Company could be left
holding  excess  and  obsolete  inventory  or having  unfavorable  manufacturing
variances as a result of  under-absorption.  These risks are exacerbated because
the Company  expects  that a majority of its sales will be to  customers  in the
retail electronics industry,  which is subject to severe competitive  pressures,
rapid technological  change, and obsolescence.  A few of the Company's customers
have inquired about inventory hubbing agreements,  pursuant to which the Company
will  maintain  stocks  of  finished  goods at or near the  customer's  factory.
Although  the Company has not yet entered into such  agreements  with any of its
customers,  the use of such type of agreements  could result in higher inventory
balances for the Company and/or excess inventory.

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

         The Company  currently  is investing  in research  and  development  of
several new technologies  that it plans to introduce in the future.  The Company
faces the risk that some or all of those  technologies may not successfully make
the  transition  from  the  research  and  development  lab  to   cost-effective
manufacturability as a result of technology  problems,  competitive cost issues,
yield problems, and other factors. In addition,  even if a new technology proves
to be manufacturable,  the Company's  customers and the customers'  marketplaces
may not accept it because of price or  technology  issues or because it compares
unfavorably with products  introduced by others. The Company will be required to
make  significant  expenditures,  including  development  expenses  and  various
capital expenditures and investments,  for these new technologies.  For example,
the  Company  estimates  that its  initial  capital  expenditures  for  LCoS(TM)
microdisplays  will be approximately  $3.0 million to $4.0 million.  The Company
also made an equity  investment of $3.3 million in Siliscape during 1998 for the
purposes of further developing the LCoS(TM)  microdisplay  product.  Significant
investments  in one  or  more  of  the  new  technologies,  especially  LCoS(TM)
microdisplays,  that ultimately  prove to be  unsuccessful  for any reason could
have a material adverse impact on the Company. In addition, if Siliscape were to
encounter  technological or financial  difficulties,  the value of the Company's
investment could decline, in which case the Company would have to write down all
or a portion of its investment and report a loss equal to such write-down.

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

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

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

                                       32
<PAGE>
power and  water  supplies,  transportation,  raw  materials,  and  parts;  or a
deterioration of the general political, economic or social environment in China.

         The  Company  has set up  manufacturing  operations  in  Beijing  in an
interim leased facility.  If there are delays in the completion of the permanent
facility,  the Company  may run into  capacity  issues in the  interim  facility
because of space constraints and/or power requirements. In addition, the Company
has a short-term lease on the interim facility and could be required to move out
if there are delays in the  completion  of the permanent  facility,  which would
severely interrupt the Company's manufacturing operations in China.

         One of the reasons the  Company is starting up  operations  in China is
because the Company  believes  that its Manila  manufacturing  facility may have
occasional  capacity issues within the next year. Failure to begin operations in
the  permanent  China  facility  on a timely  basis  could  result  in  capacity
restraints and late or canceled customer  deliveries.  Manufacturing  yields and
delivery   schedules   also  may  be  affected  as  the  Company  ramps  up  its
manufacturing  capabilities  in China.  Other  companies  in the  industry  have
experienced  difficulty  in expanding  or  relocating  manufacturing  output and
capacity,  with such difficulty resulting in reduced yields or delays in product
deliveries.  The Company  cannot  provide  assurance that it will not experience
manufacturing  yield or delivery  problems in the future.  Such  problems  could
materially affect the Company's operating results.

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

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

YEAR 2000 COMPLIANCE DISCLOSURE

         Many  existing  computer  programs and databases use only two digits to
identify  a year in the date  field  (I.E.,  99  would  represent  1999).  These
programs and  databases  were  designed and developed  without  considering  the
impact  of  the  upcoming  millennium.  Consequently,  date  sensitive  computer
programs may interpret the date "00" as 1900 rather than 2000. If not corrected,
many  computer  systems  could fail or create  erroneous  results  in 2000.  The
following disclosure is as required by SEC Release No. 33-7558.

COMPANY'S STATE OF READINESS

         The Company has  completed  an  assessment  of all of its  internal and
external  systems  and  processes  with  respect to the "Year  2000"  issue.  In
response to this  assessment,  the Company has created a  multi-functional  Year
2000 task force to resolve any non-compliant Year 2000 systems or processes.  To
date,  this group is on schedule to complete this task during 1999.  The Company
plans  to  continuously  test  all of its  internal  and  external  systems  and
processes,  including the associated Year 2000 "fixes," for Year 2000 compliance
during 1999.  As part of this  process,  the Company has assessed the  potential
impact of Year 2000 failures from vendors and outside  parties upon its business
and  currently is taking  steps to minimize  that risk.  Based on the  Company's
current state of readiness and the steps currently being taken (I.E., installing
backup  processes and systems),  the Company does not believe that the Year 2000
problem will have a material adverse effect on the Company's financial position,
liquidity, or operations.

                                       33
<PAGE>
COMPANY'S COSTS OF YEAR 2000 COMPLIANCE

         The Company  estimates that its total cost of Year 2000 compliance will
be less than  $100,000.  Those costs include  updating of computer  software and
hardware manufacturing  equipment, as well as employment and other out-of-pocket
costs.

COMPANY'S RISKS OF YEAR 2000 ISSUES

         The Company procures a significant  amount of raw materials used in its
manufacturing processes from foreign vendors. As a result, the Company may be at
risk from foreign  companies and countries that are not taking adequate measures
to  ensure  Year  2000  compliance  or that  may  not be at the  same  level  of
preparedness as the United States.  For example,  economic  problems in Asia may
affect or divert resources with respect to the Year 2000 issue. Failure of those
foreign countries and companies to be Year 2000 compliant may cause new material
shortages that would adversely impact the Company's manufacturing operations. In
addition,  the Company  currently has  significant  manufacturing  operations in
Manila,  the Philippines and Beijing,  China. As a result, the Company may be at
risk with respect to suppliers of necessary  resources  (such as power or water)
that may not be Year 2000  compliant.  For example,  brownouts or blackouts  may
occur due to lack of Year 2000 compliance.  In addition, the Company's customers
may have catastrophic Year 2000 failures,  including prolonged  interruptions in
factory  productions,  in which  case  they may have a  reduced  demand  for the
Company's products.

COMPANY'S CONTINGENCY PLANS

         The Company is developing contingency plans with respect to significant
Year 2000 issues within its control.  For example, the Company is in the process
of assessing  and verifying the Year 2000  compliance of its  international  and
domestic raw material vendors. Verification will be accomplished through the use
of written certifications and audits. The Company intends to replace any vendors
found not to be Year 2000 compliant  with vendors that are Year 2000  compliant.
In the  construction  of its new  Beijing  facility,  the Company  will  procure
material,  processes,  and equipment that are Year 2000  compliant.  The Company
also is investigating the use of stand-by generators for its plants in the event
of a  local  power  failure.  The  Company  is  investigating  transferring  all
manufacturing  processes  to  alternate  manufacturing  facilities  if  external
factors beyond its control relative to the Year 2000 issue occur and the Company
cannot conduct manufacturing operations at any particular facility.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

DERIVATIVE FINANCIAL INSTRUMENTS, OTHER FINANCIAL INSTRUMENTS, AND DERIVATIVE  
COMMODITY  INSTRUMENTS.  

     At December  31, 1998 the Company  did not  participate  in any  derivative
financial  instruments or other  financial and commodity  instruments  for which
fair value disclosure would be required under Statement of Financial  Accounting
Standards No. 107. The Company holds no investment securities that would require
disclosure of market risk.

PRIMARY MARKET RISK EXPOSURES.  

     The Company's  primary  market risk  exposures are in the areas of interest
rate risk and foreign  currency  exchange rate risk. The Company incurs interest
on loans  made  under a  revolving  line of credit  at  interest  rates  under a
variable  interest  rate of the bank's  prime rate (7.75% at December  31, 1998)
plus  2.375%,  the  principal of which is due 2004.  At December  31, 1998,  the
Company's  outstanding  borrowings on the line of credit was approximately  $8.1
million.  Substantially all of the Company's  business outside the United States
is conducted  in U.S.  dollar  denominated  transactions.  The Company  operates
high-volume  manufacturing  facilities in Manilla,  the Philippines and Beijing,
China, and a sales and distribution  facility in the United Kingdom. Some of the
expenses of these foreign  operations are  denominated  in the Philippine  peso,
Chinese  renminbi,  and British pound  sterling,  respectively.  These  expenses
include  local  salaries  and  wages,  utilities  and some  operating  supplies.
However,  the Company believes that the operating expenses currently incurred in
foreign  currencies are immaterial,  and therefore any associated market risk is
unlikely to have a material adverse effect on the Company's business, results of
operations or financial condition.

                                       34
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

         Reference is made to the financial statements,  the report thereon, the
notes thereto, and the supplementary data commencing at page F-1 of this Report,
which financial  statements,  report,  notes and data are incorporated herein by
reference.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
        AND FINANCIAL DISCLOSURE

         Not applicable.

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS

         The  information  required by this Item  relating to  directors  of the
Company is  incorporated  by reference to the definitive  Proxy  Statement filed
pursuant to  Regulation  14A of the Exchange Act for the  Company's  1999 Annual
Meeting of  Stockholders.  The  information  required  by this Item  relating to
executive officers of the Company is included in "Business - Executive Officers"
contained in Item 1 of this Report.

ITEM 11. EXECUTIVE COMPENSATION

         The  information  required  by this  Item  is  incorporated  herein  by
reference to the definitive  Proxy Statement filed pursuant to Regulation 14A of
the Exchange Act for the Company's 1999 Annual Meeting of Stockholders.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The  information  required  by this  Item  is  incorporated  herein  by
reference to the definitive  Proxy Statement filed pursuant to Regulation 14A of
the Exchange Act for the Company's 1999 Annual Meeting of Stockholders.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         Not applicable.

                                       35
<PAGE>
                                     PART IV

ITEM 14. EXHIBITS AND REPORTS ON FORM 8-K

     (a)  FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE

          (1)  Financial  Statements  are  listed  in  the  Index  to  Financial
               Statements on page F-1 of this Report.

          (2)  Financial Statement Schedule:

               Schedule II Valuation and Qualifying Accounts and Reserves is set
               forth on page S-1 of this Report.

         Other  schedules  are  omitted  because  they are not  applicable,  not
required  or  because  required  information  is  included  in the  consolidated
financial statements or notes thereto.

     (b)  REPORTS ON FORM 8-K

          Not applicable.

     (c)  EXHIBITS

EXHIBIT
NUMBER              EXHIBITS
------              --------
2       Amended and Restated Agreement and Plan of Reorganization(1)
3(a)    Restated Certificate of Incorporation of the Company(2)
3(b)    Bylaws of the Company(1)
10(a)   1990 Incentive Stock Option Plan(1)
10(c)   Line of Credit Agreement between Three-Five Systems Limited and Barclays
        Bank, PLC(1)
10(d)   Sub-Assembly Agreement between Three-Five Systems, Inc. and TEAM Pacific
        Corporation dated February 22, 1995(3)
10(g)   Form of Three-Five Systems, Inc. Distributor Franchise Agreement(4)
10(j)   1993 Stock Option Plan(4)
10(k)   1994 Automatic Stock Option Plan(5)
10(l)   Lease Agreement between  Technology  Electronic  Assembly and Management
        (T.E.A.M.) Pacific Corporation and Three-Five Systems Pacific, Inc.(6)
10(m)   Lease  Agreement  between  Regent  Apparel  Corporation  and  Three-Five
        Systems Pacific, Inc.(6)
10(o)   Lease  dated  April 1,  1994,  between  Papago  Park  Center,  Inc.  and
        Three-Five Systems, Inc. (7)
10(t)   Credit Agreement dated May 23, 1997 between Three-Five Systems, Inc. and
        Imperial Bank(8)
10(u)   Addendum No. 1 to Sub-Assembly  Agreement  between  Three-Five  Systems,
        Inc. and TEAM Pacific Corporation dated March 12, 1997(8)
10(v)   1997 Employee Stock Option Agreement(8)
10(w)   1998 Stock Option Agreement(8)
10(x)   1998 Director's Stock Plan(8)
10(y)   Addendum No. 2 to Sub-Assembly  Agreement  between  Three-Five  Systems,
        Inc. and TEAM Pacific Corporation dated January 1, 1998(8)
10(z)   401(k) Profit Sharing Plan(9)
10(aa)  Credit  Agreement  dated  November  5,  1998,  by and  among  Three-Five
        Systems,  Inc., its subsidiaries,  the Banks named therein, and Imperial
        Bank Arizona, as Agent.
10(bb)  Security Agreement dated November 5, 1998, by Three-Five  Systems,  Inc.
        in favor of Imperial Bank Arizona, as Agent.
21      List of Subsidiaries
23      Consent of Arthur Andersen LLP
27      Financial Data Schedule

                                       36
<PAGE>

(1)  Incorporated by reference to the  Registration  Statement on Form S-4 of TF
     Consolidation, Inc. (Registration No. 33-33944) as filed March 27, 1990 and
     declared effective March 27, 1990.
(2)  Incorporated by reference to the  Registrant's  Form 10-QSB for the quarter
     ended  March 31,  1994,  as filed with the  Commission  on or about May 12,
     1994.
(3)  Incorporated  by reference to the  Registrant's  Form 10-KSB for the fiscal
     year ended  December 31, 1994 filed with the  Commission on March 22, 1995,
     as amended by Form 10-KSB/A as filed with the Commission on April 28, 1995.
(4)  Incorporated  by  reference  to the  Registration  Statement  on  Form  S-1
     (Registration  No.  33-74788)  as filed on February 3, 1994,  and  declared
     effective March 15, 1994.
(5)  Incorporated  by  reference  to the  Registration  Statement  on  Form  S-8
     (Registration No. 33-88706) as filed on January 24, 1995.
(6)  Incorporated by reference to the Registrant's Form 10-K for the fiscal year
     ended December 31, 1995, as filed with the Commission on March 13, 1996.
(7)  Incorporated by reference to the Registrant's Form 10-K for the fiscal year
     ended December 31, 1996, as filed with the Commission on March 14, 1997.
(8)  Incorporated by reference to the Registrant's Form 10-K for the fiscal year
     ended  December 31, 1997,  as filed with the  Commission on March 13, 1998,
     and as amended by Form 10-K/A filed with the Commission on March 23, 1998.
(9)  Incorporated  by  reference  to the  Registration  Statement  on  Form  S-8
     (Registration No. 333-57933) as filed on June 26, 1998.

                                       37
<PAGE>
                                   SIGNATURES

         Pursuant to the  requirements  of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

                                       THREE-FIVE SYSTEMS, INC.

Date: March 9, 1999                    By: /s/ David R. Buchanan
                                           -------------------------------------
                                           David R. Buchanan
                                           President and Chief Executive Officer

         Pursuant to the  requirements  of the Securities  Exchange Act of 1934,
this  Report has been  signed  below by the  following  persons on behalf of the
Registrant and in the capacities and on the dates indicated.

         NAME                        TITLE                             DATE
         ----                        -----                             ----

/s/ David R. Buchanan       President, Chief Executive Officer     March 9, 1999
--------------------------  (Principal Executive Officer),
David R. Buchanan           and Director


/s/ Jeffrey D. Buchanan     Executive Vice President               March 9, 1999
--------------------------  - Finance, Administration, and Legal;
Jeffrey D. Buchanan         Chief Financial Officer; Secretary;
                            Treasurer (Principal Financial
                            Officer), and Director

/s/ Robert T. Berube        Corporate Controller                   March 9, 1999
--------------------------  (Principal Accounting Officer)
Robert T. Berube


/s/ David C. Malmberg       Director                               March 9, 1999
--------------------------
David C. Malmberg


/s/ Burton E. McGillivray   Director                               March 9, 1999
--------------------------
Burton E. McGillivray


/s/ Gary R. Long            Director                               March 9, 1999
--------------------------
Gary R. Long


/s/ Kenneth M. Julien       Director                               March 9, 1999
--------------------------
Kenneth M. Julien


/s/ Thomas A. Werner        Director                               March 9, 1999
--------------------------
Thomas A. Werner

                                       38
<PAGE>
                            THREE-FIVE SYSTEMS, INC.

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

                                                                            Page
                                                                            ----

Report of Independent Public Accountants ................................... F-2

Consolidated Balance Sheets as of December 31, 1998 and 1997 ............... F-3

Consolidated Statements of Income (Loss) for the years ended
   December 31, 1998, 1997 and 1996 ........................................ F-4

Consolidated Statements of Stockholders' Equity for the
   years ended December 31, 1998, 1997 and 1996 ............................ F-5

Consolidated Statements of Cash Flows for the years ended
   December 31, 1998, 1997 and 1996 ........................................ F-6

Notes to Consolidated Financial Statements ................................. F-7

                                       F-1
<PAGE>
                              ARTHUR ANDERSEN LLP

                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


To Three-Five Systems, Inc.:

We have  audited the  accompanying  consolidated  balance  sheets of  THREE-FIVE
SYSTEMS,  INC. (a Delaware corporation) and subsidiaries as of December 31, 1998
and  1997,   and  the  related   consolidated   statements  of  income   (loss),
stockholders'  equity and cash  flows for each of the three  years in the period
ended December 31, 1998. These financial  statements are the  responsibility  of
the Company's  management.  Our responsibility is to express an opinion on these
financial statements based on our audits.

We  conducted  our  audits  in  accordance  with  generally   accepted  auditing
standards. Those standards require that we plan and perform the audits to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the  accounting  principles  used and  significant  estimates  made by
management,  as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion,  the financial  statements  referred to above present fairly, in
all material respects,  the financial position of Three-Five  Systems,  Inc. and
subsidiaries  as of  December  31,  1998  and  1997,  and the  results  of their
operations  and their cash flows for each of the three years in the period ended
December 31, 1998, in conformity with generally accepted accounting principles.

Our  audits  were  made for the  purpose  of  forming  an  opinion  on the basic
financial  statements  taken as a whole.  The  schedules  listed in the index of
financial statements are presented for purposes of complying with the Securities
and  Exchange  Commission's  rules  and are  not  part  of the  basic  financial
statements.  These  schedules  have been  subjected to the  auditing  procedures
applied in the audits of the basic  financial  statements  and, in our  opinion,
fairly state in all  material  respects the  financial  data  required to be set
forth therein in relation to the basic financial statements taken as a whole.
                                          
                                                    /s/ Arthur Andersen LLP


Phoenix, Arizona,
  January 22, 1999.

                                      F-2
<PAGE>
                            THREE-FIVE SYSTEMS, INC.
                           CONSOLIDATED BALANCE SHEETS
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)

                                     ASSETS
                                                               December 31,
                                                           --------------------
                                                             1998        1997
                                                           --------    --------
CURRENT ASSETS:
   Cash and cash equivalents (Note 2)                      $  4,946    $ 16,371
   Accounts receivable, net                                  18,601      12,540
   Inventories, net (Note 2)                                 12,493       8,255
   Deferred tax asset (Note 5)                                2,680       4,311
   Other current assets                                       2,313       1,228
                                                           --------    --------

        Total current assets                                 41,033      42,705

PROPERTY, PLANT AND EQUIPMENT, net (Note 2)                  33,314      29,847

OTHER ASSETS                                                  3,557         283
                                                           --------    --------

                                                           $ 77,904    $ 72,835
                                                           ========    ========

                      LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
   Accounts payable                                        $ 10,649    $  8,513
   Accrued liabilities (Note 2)                               4,673       5,079
   Current taxes payable (Note 5)                               235          --
   Current portion of long-term debt (Note 3)                   651          --
                                                           --------    --------

        Total current liabilities                            16,208      13,592
                                                           --------    --------

LONG-TERM DEBT (Note 3)                                       7,444          --
                                                           --------    --------

DEFERRED TAX LIABILITY (Note 5)                               3,156       2,718
                                                           --------    --------
COMMITMENTS AND CONTINGENCIES (Note 6)

STOCKHOLDERS' EQUITY (Note 4):
   Preferred stock, $.01 par value; 1,000,000
     shares authorized                                           --          --
   Common stock, $.01 par value; 15,000,000 shares
     authorized, 7,974,901 shares issued, 7,005,107
     shares outstanding at December 31, 1998;
     7,928,023 shares issued, 7,905,523 shares
     outstanding at December 31, 1997                            80          79
   Additional paid-in capital                                32,484      32,420
   Retained earnings                                         26,849      24,259
   Cumulative translation adjustment (Note 2)                     8          20
   Less - Treasury stock, at cost (969,794 shares)           (8,325)       (253)
                                                           --------    --------

        Total stockholders' equity                           51,096      56,525
                                                           --------    --------

                                                           $ 77,904    $ 72,835
                                                           ========    ========

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

                                       F-3
<PAGE>
                            THREE-FIVE SYSTEMS, INC.

                    CONSOLIDATED STATEMENTS OF INCOME (LOSS)
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)


                                                  Years Ended December 31,
                                           ------------------------------------
                                              1998         1997         1996
                                           ----------   ----------   ----------
NET SALES (Note 7)                         $   95,047   $   84,642   $   60,713
                                           ----------   ----------   ----------
COSTS AND EXPENSES:
 Cost of sales                                 76,149       64,760       58,321
 Selling, general and administrative            7,334        6,557        5,351
 Research and development                       7,159        5,106        4,065
                                           ----------   ----------   ----------

                                               90,642       76,423       67,737
                                           ----------   ----------   ----------

 Operating income (loss)                        4,405        8,219       (7,024)
                                           ----------   ----------   ----------
OTHER INCOME (EXPENSE):
 Interest, net                                     75          548          412
 Other, net                                      (117)        (190)        (139)
                                           ----------   ----------   ----------

                                                  (42)         358          273
                                           ----------   ----------   ----------
INCOME (LOSS) BEFORE PROVISION FOR
 (BENEFIT FROM) INCOME TAXES:                   4,363        8,577       (6,751)
 Provision for (benefit from)
  income taxes (Note 5)                         1,773        3,334       (2,920)
                                           ----------   ----------   ----------

NET INCOME (LOSS)                          $    2,590   $    5,243   $   (3,831)
                                           ==========   ==========   ==========
EARNINGS (LOSS) PER COMMON SHARE (Note 2):
 Basic                                     $     0.34   $     0.67   $    (0.49)
                                           ==========   ==========   ==========

 Diluted                                   $     0.33   $     0.65   $    (0.49)
                                           ==========   ==========   ==========
WEIGHTED AVERAGE NUMBER OF COMMON
 SHARES:
 Basic                                      7,638,631    7,854,053    7,767,744
                                           ==========   ==========   ==========

 Diluted                                    7,802,041    8,089,975    7,767,744
                                           ==========   ==========   ==========

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

                                      F-4
<PAGE>

                            THREE-FIVE SYSTEMS, INC.

                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
                                            Common Stock
                                       ----------------------    Additional
                                        Shares                    Paid-in      Retained
                                        Issued       Amount       Capital      Earnings
                                       ---------    ---------    ---------    ---------
<S>                                  <C>          <C>          <C>          <C>
BALANCE, December 31, 1995             7,735,745    $      77    $  32,286    $  22,847
 Net loss                                     --           --           --       (3,831)
 Other comprehensive income-
   Foreign currency translation
     adjustments                              --           --           --           --
   Comprehensive income                       --           --           --           --
 Stock options exercised                  44,084            1           11           --
 Tax benefit from early disposition
   of incentive stock options                 --           --           32           --
 Purchase of treasury stock                   --           --           --           --
                                       ---------    ---------    ---------    ---------

BALANCE, December 31, 1996             7,779,829           78       32,329       19,016
 Net income                                   --           --           --        5,243
 Other comprehensive income-
   Foreign currency translation
     adjustments                              --           --           --           --
   Comprehensive income                       --           --           --           --
 Stock options exercised                 148,194            1           50           --
 Tax benefit from early disposition
   of incentive stock options                 --           --           41           --
                                       ---------    ---------    ---------    ---------

BALANCE, December 31, 1997             7,928,023           79       32,420       24,259
 Net income                                   --           --           --        2,590
 Other comprehensive income-
   Foreign currency translation
     adjustments                              --           --           --           --
   Comprehensive income                       --           --           --           --
 Stock options exercised                  46,878            1           64           --
 Purchase of treasury stock                   --           --           --           --
                                       ---------    ---------    ---------    ---------

BALANCE, December 31, 1998             7,974,901    $      80    $  32,484    $  26,849
                                       =========    =========    =========    =========

                                                 Cumulative       Total
                                     Treasury    Translation   Stockholders'   Comprehensive
                                       Stock     Adjustment       Equity           Income
                                     --------    ----------     ----------       ----------
BALANCE, December 31, 1995           $    --      $   14          $55,224
 Net loss                                 --          --           (3,831)        $(3,831)
 Other comprehensive income-
   Foreign currency translation
     adjustments                          --          --               --              --
   Comprehensive income                                                           -------
 Stock options exercised                  --          --               --         $(3,831)
 Tax benefit from early disposition                                               =======
   of incentive stock options             --          --               12
 Purchase of treasury stock               --          --               32
                                        (253)         --             (253)
                                     -------      ------          -------

BALANCE, December 31, 1996              (253)         14           51,184
 Net income                               --          --            5,243         $ 5,243
 Other comprehensive income-
   Foreign currency translation
     adjustments                          --           6                6               6
   Comprehensive income                   --          --               --         -------
 Stock options exercised                  --          --               51         $ 5,249
 Tax benefit from early disposition                                               =======
   of incentive stock options             --          --               41
                                     -------      ------          -------
BALANCE, December 31, 1997              (253)         20           56,525
 Net income                               --          --            2,590         $ 2,590
 Other comprehensive income-
   Foreign currency translation
     adjustments                          --         (12)             (12)            (12)
   Comprehensive income                   --          --               --         -------
 Stock options exercised                  --          --               65         $ 2,578
 Purchase of treasury stock           (8,072)         --           (8,072)        =======
                                     -------      ------          -------

BALANCE, December 31, 1998           $(8,325)     $    8          $51,096
                                     =======      ======          =======
</TABLE>
  The accompanying notes are an integral part of these consolidated statements.

                                      F-5
<PAGE>
                            THREE-FIVE SYSTEMS, INC.

                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

                                                      Years Ended December 31,
                                                   ----------------------------
                                                     1998       1997      1996
                                                   --------   -------   -------
CASH FLOWS FROM OPERATING ACTIVITIES:
 Net income (loss)                                 $  2,590   $ 5,243   $(3,831)
 Adjustments to reconcile net income (loss)
  to net cash (used in) provided by
  operating activities-
    Depreciation and amortization                     4,693     4,135     3,551
    Provision for (reduction of) accounts
     receivable valuation reserves                      (64)      (69)       47
    Provision for (reduction of) inventory
     valuation reserves                              (3,184)   (2,473)    4,015
    Loss on disposal of assets                           --         2        12
    Changes in assets and liabilities:
      (Increase) decrease in accounts receivable     (5,997)   (5,641)    2,469
      (Increase) decrease in inventories             (1,054)   (1,176)    5,082
      (Increase) decrease in other assets            (1,425)      505    (1,070)
      Increase in accounts payable and accrued
       liabilities                                    1,730     4,778     4,296
      Increase (decrease) in taxes payable, net       2,649     1,461    (2,358)
                                                   --------   -------   -------
        Net cash (used in) provided by operating
         activities                                     (62)    6,765    12,213
                                                   --------   -------   -------
CASH FLOWS FROM INVESTING ACTIVITIES:
 Purchase of property, plant and equipment           (8,119)   (3,050)     (948)
 Proceeds from sale of property, plant and
  equipment                                              --        19         5
 Investment in Siliscape, Inc.                       (3,320)       --        --
                                                   --------   -------   -------

         Net cash used in investing activities      (11,439)   (3,031)     (943)
                                                   --------   -------   -------
CASH FLOWS FROM FINANCING ACTIVITIES:
 Net proceeds from (payments on) notes
  payable to banks                                    8,095        --    (3,000)
 Stock options exercised                                 65        51        12
 Purchase of treasury stock                          (8,072)       --      (253)
                                                   --------   -------   -------
         Net cash provided by (used in) financing
          activities                                     88        51    (3,241)
                                                   --------   -------   -------

 Effect of exchange rate changes on cash                (12)        6        --
                                                   --------   -------   -------
NET (DECREASE) INCREASE IN CASH AND CASH
 EQUIVALENTS                                        (11,425)    3,791     8,029

CASH AND CASH EQUIVALENTS, beginning of year         16,371    12,580     4,551
                                                   --------   -------   -------

CASH AND CASH EQUIVALENTS, end of year             $  4,946   $16,371   $12,580
                                                   ========   =======   =======
SUPPLEMENTAL CASH FLOW INFORMATION:
 Interest paid                                     $    364   $     4   $    60
                                                   ========   =======   =======

 Income taxes paid                                 $    992   $ 1,973   $ 1,832
                                                   ========   =======   =======

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

                                      F-6
<PAGE>
                            THREE-FIVE SYSTEMS, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                        DECEMBER 31, 1998, 1997 AND 1996

(1) ORGANIZATION AND OPERATIONS:

Three-Five Systems,  Inc. (the Company) designs and manufactures a wide range of
user interface devices for operational control and information display functions
required in the end products of original equipment manufacturers (OEMs). Most of
the Company's sales consist of custom devices  developed in close  collaboration
with its  customers.  Devices  designed  and  manufactured  by the Company  find
application in cellular telephones and other wireless  communication  devices as
well as in medical equipment,  office automation  equipment,  industrial process
controls,  consumer  electronic  products,  and data  collection  products.  The
Company currently specializes in liquid crystal display (LCD) and light emitting
diode (LED) components and technology in providing its design and  manufacturing
services for its customers.  The Company markets its services primarily in North
America,  Europe, and Asia through direct technical sales persons and, to a much
lesser extent, through an independent sales and distribution network.

The Company  currently  conducts  manufacturing  operations  in Tempe,  Arizona;
Manila,  the  Philippines;  and Beijing,  China.  The Company  believes that the
Arizona facility has the largest fully automated LCD glass  production  capacity
outside of Asia.  High-volume LCD module  manufacturing  is done in Manila,  the
Philippines and Beijing, China. In Manila, a third-party  subcontractor operates
the  facility  under  a  sub-assembly   agreement  with  the  Company  utilizing
equipment,  processes,  and documentation owned by the Company. The sub-assembly
agreement has a current term extending  through December 31, 1999, and from year
to year thereafter,  but may be terminated by either party upon 180 days written
notice.  The  termination of or the inability of the Company to obtain  products
pursuant to the  sub-assembly  agreement,  even for a relatively  short  period,
would have a material adverse effect on the operations and  profitability of the
Company.   Since  December   1994,  the  Company  has  made  advances   totaling
approximately  $2.2 million to the subcontractor to help the subcontractor  meet
its working capital needs. As of December 31, 1998, the subcontractor has repaid
$2.0 million of these advances.  The amounts payable to the  subcontractor  more
than  exceeded the $205,000  advances  outstanding  at December 31, 1998.  These
advances  are  secured by future  payments  for  subcontracting  services  to be
provided to the Company. The Company commenced manufacturing operations in China
during  1998.  The China  facility  is a  high-volume  LCD module  manufacturing
facility  similar to the  Company's  facility in Manila.  The Company  initially
leased a facility in Beijing on a temporary  basis,  which  expires in mid-1999,
and the Company commenced manufacturing operations in that temporary facility in
the second  quarter  of 1998.  The  Company  has begun  construction  of its own
facility in Beijing  and expects to move into the new  facility in the middle of
1999. Any significant delay in the construction of the permanent  facility could
result in the temporary shutdown of the China manufacturing operations.

(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

     PRINCIPLES OF CONSOLIDATION AND PREPARATION OF FINANCIAL STATEMENTS

The consolidated  financial  statements  include the accounts of the Company and
its wholly-owned subsidiaries.  All material intercompany transactions have been
eliminated.

Three-Five Systems Limited (Limited), a wholly-owned  subsidiary of the Company,
is  incorporated  in the  United  Kingdom.  Limited  sells and  distributes  the
Company's products to customers on the European continent.

Three-Five Systems Pacific, Inc. (Pacific), a Philippines corporation,  procures
supplies  primarily from  Philippine  vendors.  Pacific also manages and assists
production personnel of the third-party subcontractor that operates the facility
in the Philippines.

                                      F-7
<PAGE>
During the first quarter of 1998, the Company  formed a wholly-owned  subsidiary
in China, Three-Five Systems (Beijing) Co., Ltd. (Beijing). Beijing manufactures
and sells the Company's products to customers primarily located in Asia.

The preparation of financial  statements in conformity  with generally  accepted
accounting principles requires management to make estimates and assumptions that
affect  the  reported  amounts  of assets  and  liabilities  and  disclosure  of
contingent  assets and  liabilities at the date of the financial  statements and
the  reported  amounts of revenues  and expenses  during the  reporting  period.
Actual results could differ from those estimates.

     FAIR VALUE OF FINANCIAL INSTRUMENTS

The estimated  fair value of financial  instruments  has been  determined by the
Company  using  available  market   information  and  valuation   methodologies.
Considerable  judgment is required in estimating fair values.  Accordingly,  the
estimates  may not be  indicative of amounts that would be realized in a current
market exchange. The carrying values of cash, accounts receivable,  and accounts
payable approximate fair value due to the short maturities of these instruments.
In addition,  the carrying amount on the outstanding line of credit is estimated
to approximate  fair value as the actual  interest rate is consistent with rates
estimated to be currently  available  for debt with similar  terms and remaining
maturities.

     CASH AND CASH EQUIVALENTS

For purposes of the statements of cash flows, all highly liquid investments with
a maturity of three months or less at the time of purchase are  considered to be
cash equivalents.  Cash equivalents  consist of investments in commercial paper,
marketable  debt  securities,  money  market  mutual  funds,  and United  States
government  agencies'  obligations  and are  classified as  held-to-maturity  in
accordance  with  Statement of Financial  Accounting  Standards  (SFAS) No. 115,
ACCOUNTING  FOR  CERTAIN  INVESTMENTS  IN  DEBT  AND  EQUITY  SECURITIES.   Cash
equivalents  were  $1,992,000 and  $12,886,000 at December 31, 1998 and December
31, 1997, respectively.

     INVENTORIES

Inventories  are  stated  at the  lower  of cost  (first-in,  first-out)  or net
realizable value. Reserves are established against Company-owned inventories for
excess,  slow-moving,  and obsolete items and for items where the net realizable
value is less than cost. The reserve for obsolete  inventory totaled  $1,125,000
and $4,309,000 at December 31, 1998 and December 31, 1997, respectively.

Inventories at December 31 consist of the following:

                                             1998           1997
                                          ---------      ---------
                                               (in thousands)
     Raw materials                        $   9,367      $   6,052
     Work-in-process                          1,459          1,195
     Finished goods                           1,667          1,008
                                          ---------      ---------
                                          $  12,493      $   8,255
                                          =========      =========

                                      F-8
<PAGE>
     PROPERTY, PLANT AND EQUIPMENT

Property,  plant and equipment is recorded at cost and generally is  depreciated
using the straight-line method over the estimated useful lives of the respective
assets,  which range from 3 to 39 years.  During 1996,  the Company  placed into
service  a  high-volume  LCD  glass  manufacturing  line in its  Tempe,  Arizona
manufacturing facility. The Company is depreciating the LCD glass line using the
units of production method.  Depreciation expense recorded using this method may
be subject to significant  fluctuation  from year to year resulting from changes
in  actual  production  levels  and  ongoing  analysis  of the  capacity  of the
equipment.  Property,  plant  and  equipment  at  December  31  consist  of  the
following:

                                                1998         1997
                                              --------     --------
                                                   (in thousands)
      Building and improvements               $ 13,031     $ 10,431
      Furniture and equipment                   37,324       31,804
                                              --------     --------
                                                50,355       42,235
      Less - accumulated depreciation          (17,041)     (12,388)
                                              --------     --------
                                              $ 33,314     $ 29,847
                                              ========     ========

The  Company  utilizes  a  significant  portion  of the  high-volume  LCD  glass
manufacturing  line  facility  to  produce  a  substantial  portion  of its  own
requirements  for LCD glass.  The successful  utilization  of the  manufacturing
facility  will  require  the  Company  (i) to produce  LCD glass on a timely and
cost-effective basis at quality levels at least equal to the LCD glass available
from  independent  suppliers  and (ii) to utilize  the LCD glass it  produces in
devices it designs and  manufactures in a manner  satisfactory to its customers.
Although   management   believes  that  the   manufacturing   facility  will  be
successfully  utilized,  no  assurance  can be given that the  Company  will not
experience  problems  or  delays  in  conducting  its  LCD  glass  manufacturing
operations.  Such problems could require the Company to continue to purchase its
LCD glass  requirements  from third  parties and result in the  inability of the
Company to recover its investment in the manufacturing facility.

During 1996, the Company  entered into a  transaction,  in which it conveyed its
Tempe,  Arizona  facility  and  certain  improvements  to the  City of  Tempe as
consideration  for a  rent-free  75-year  lease.  The  Company has the option to
repurchase  the  facility for $1,000  after ten years;  therefore,  the lease is
accounted for as a capital lease.

     ACCRUED LIABILITIES

Accrued liabilities include accrued  compensation of approximately  $975,000 and
$1,675,000 at December 31, 1998 and 1997, respectively.

     FOREIGN CURRENCY TRANSLATION

Financial information relating to the Company's foreign subsidiaries is reported
in accordance  with SFAS No. 52, FOREIGN  CURRENCY  TRANSLATION.  The functional
currency of each of Pacific and Limited is the same as the local  currency.  The
gain or loss resulting from the translation of these two subsidiaries' financial
statements has been included as a separate component of stockholders' equity.

The  functional  currency  of  Beijing  is the U.S.  dollar.  Beijing,  however,
maintains its books and records in the Renminbi. Therefore, the Company utilizes
the  remeasurement  method of  foreign  currency  translation  when  Beijing  is
consolidated.  Any  resulting  remeasurement  gain or loss  is  reported  in the
Company's consolidated statements of operations.

The net foreign currency  transaction loss in 1998, 1997, and 1996 was $177,000,
$183,000, and $46,000,  respectively, and has been included in other expenses in
the accompanying statements of income (loss).

                                      F-9
<PAGE>
     REVENUE RECOGNITION

The Company recognizes revenue upon shipment.  The Company provides reserves for
uncollectible accounts receivable.  These reserves totaled $431,000 and $455,000
at December 31, 1998 and 1997, respectively. The Company performs ongoing credit
evaluations  of  all  of  its  customers  and  considers   various   factors  in
establishing its allowance for doubtful accounts.

         RESEARCH AND DEVELOPMENT

Research and development  costs are expensed as incurred.  The Company currently
is spending research and development dollars on several new technologies that it
plans to  introduce  in the  future.  There is a risk  that some or all of those
technologies  may not  successfully  make the  transition  from the research and
development lab to cost-effective manufacturable products.

         EARNINGS (LOSS) PER SHARE

During 1997, the Company adopted SFAS No. 128,  EARNINGS PER SHARE.  Pursuant to
SFAS No. 128,  basic  earnings  per common  share are  computed by dividing  net
income  (loss)  by the  weighted  average  number  of  shares  of  common  stock
outstanding  during the year.  Diluted  earnings (loss) per common share for the
years ended December 31, 1998 and 1997 are determined  assuming that outstanding
options were exercised at the beginning of each year or at the time of issuance,
if later.  No  outstanding  options were assumed to be exercised for purposes of
calculating  diluted  earnings per share for the year ended December 31, 1996 as
their effect was  anti-dilutive.  Set forth below are the  disclosures  required
pursuant to SFAS No. 128 for the years ended December 31, 1998, 1997, and 1996:

                                                 Years Ended December 31,
                                             ------------------------------
                                               1998       1997       1996
                                             -------    -------    --------
                                          (in thousands, except per share data)
Basic earnings (loss) per share:
  Income (loss) available to common
   shareholders                              $ 2,590    $ 5,243    $ (3,831)
                                             -------    -------    --------

  Weighted average common shares               7,639      7,854       7,768
                                             -------    -------    --------

             Basic per share amount          $  0.34    $  0.67    $  (0.49)
                                             =======    =======    ========
Diluted earnings (loss) per share:
  Income (loss) available to common
   shareholders                              $ 2,590    $ 5,243    $ (3,831)
                                             -------    -------    --------

  Weighted average common shares               7,639      7,854       7,768
  Options assumed exercised                      163        236          -
                                             -------    -------    --------
  Total common shares plus assumed
    exercises                                  7,802      8,090       7,768
                                             -------    -------    --------

             Diluted per share amount        $  0.33    $  0.65    $  (0.49)
                                             =======    =======    ========

     RECENTLY ADOPTED ACCOUNTING STANDARDS

In 1998, the Company  adopted  Statement of Financial  Accounting  Standards No.
130,  REPORTING  COMPREHENSIVE  INCOME,  which requires  companies to report all
changes in equity during a period,  except those  resulting  from  investment by
owners and  distribution to owners,  in a financial  statement for the period in
which they are  recognized.  The Company  has chosen to  disclose  Comprehensive
Income,   which   encompasses  net  income  and  foreign  currency   translation
adjustments,  in the Consolidated Statement of Shareholder's Equity. Prior years
have been restated to conform to the SFAS No. 130 requirements.

                                      F-10
<PAGE>
In 1998, the Company also adopted  Statement of Financial  Accounting  Standards
No. 131,  DISCLOSURES  ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED  INFORMATION.
The new rules establish revised  standards for public companies  relating to the
reporting  of  financial  and  descriptive  information  about  their  operating
segments in financial  statements.  The Company  adopted SFAS No. 131 and all of
the required disclosures (Note 7).

(3)   LONG-TERM DEBT:

Long-term debt at December 31 consists of the following:

                                                              1998        1997
                                                            -------     -------
                                                               (in thousands)
     $15.0 million  revolving line of credit,  interest
     due  monthly  at the bank's  prime rate  (7.75% at
     December  31,  1998)  or at the  LIBOR  base  rate
     (5.064% at December 31,  1998) plus 1.75%,  unpaid
     balance  due May 22,  2000,  secured by all assets
     other than real property.                              $    --     $    --

     $10.0 million  revolving line of credit/term loan,
     interest  due monthly at the bank's  prime rate or
     at the LIBOR base rate plus 2.375%, unpaid balance
     due  August 5, 2004,  secured by all assets  other
     than real property.                                      8,095          --

     $350,000 United Kingdom credit facility,  interest
     due  quarterly  at the  bank's  base rate plus 2%,
     unpaid  balance  due July  15,  1999,  secured  by
     United Kingdom accounts receivable.                         --          --
                                                            -------     -------
                                                              8,095
     Less - current maturities                                 (651)         --
                                                            -------     -------
                                                            $ 7,444     $    --
                                                            =======     =======

In November 1998, the Company  entered into a new commitment  from Imperial Bank
and the National Bank of Canada for a $25.0 million  credit  facility.  This new
credit  facility  consists of (i) a $15.0  million  revolving  line of credit is
available for general corporate needs, and (ii) a $10.0 million term loan, which
provides  available funds to repurchase a portion of the Company's common stock.
The amount of the term loan is  available  for  advances  until  August 5, 1999,
followed by a five-year amortization period in which principal and interest will
be payable quarterly in equal installments. Advances under the term loan will be
made as either Prime Rate Advances,  which accrue interest payable  monthly,  at
the bank's prime lending rate, or as LIBOR Rate Advances  which bear interest at
237.5  basis  points in excess of the LIBOR Base Rate.  The credit  facility  is
secured by all of the Company's  assets other than the Company's  real property.
The Company must apply all proceeds  from the sale of any treasury  stock to the
outstanding principal balance of the term loan.

The credit facility  contains  restrictive  covenants that include,  among other
things,  restrictions  on the declaration or payment of dividends and the amount
of capital  expenditures.  The credit  facility  also  requires  the  Company to
maintain a specified net worth, as defined,  to maintain required debt to equity
ratio, and to maintain certain other financial ratios.

Any unpaid balance of the United  Kingdom credit  facility is due July 15, 1999,
and is secured by United Kingdom accounts receivable.

                                      F-11
<PAGE>
(4)   BENEFIT PLANS:

The Company has five stock option plans, the 1998 Stock Option Plan (1998 Plan),
the 1997 Stock Option Plan (1997 Plan),  the 1994  Non-Employee  Directors Stock
Option Plan (1994 Plan),  the 1993 Stock  Option Plan (1993 Plan),  and the 1990
Stock Option Plan (1990 Plan).

     1998 STOCK OPTION PLAN

The 1998 Plan  provides  for the  granting of  incentive  stock  options  and/or
nonqualified  options to purchase up to 300,000  shares of the Company's  common
stock.  Under the 1998 Plan,  options may be issued to key  personnel and others
providing  valuable  services to the Company and its  subsidiaries.  The options
issued will be incentive stock options or nonqualified  stock options as defined
in Section 422 of the Internal  Revenue Code of 1986 (the Code). Any option that
expires  or  terminates  without  having  been  exercised  in full will again be
available for grant pursuant to the 1998 Plan. There were options outstanding to
acquire  122,500  shares of the  Company's  common  stock under the 1998 Plan at
December 31, 1998.

The  expiration  date,  maximum  number  of  shares  purchasable,  and the other
provisions of the options will be established at the time of grant.  Options may
be granted  for terms of up to ten years and become  exercisable  in whole or in
one  or  more  installments  at  such  time  as may be  determined  by the  plan
administrator upon grant of the options.  The exercise prices of the options are
determined by the plan administrator,  but may not be less than 100% of the fair
market value of the common stock at the time of the grant (110% if the option is
an incentive stock option granted to a stockholder who at the time the option is
granted owns stock representing more than 10% of the total combined voting power
of all  classes  of stock of the  Company).  The 1998 Plan will  remain in force
until January 28, 2008.

     1997 STOCK OPTION PLAN

The 1997 Plan provides for the granting of  nonqualified  options to purchase up
to 100,000 shares of the Company's  common stock.  Under the 1997 Plan,  options
may be issued to key personnel  and others  providing  valuable  services to the
Company and its  subsidiaries.  The options  issued will be  nonqualified  stock
options and shall not be  incentive  stock  options as defined in Section 422 of
the Code. Any option that expires or terminates without having been exercised in
full will again be  available  for grant  pursuant to the 1997 Plan.  There were
options outstanding to acquire 38,300 shares of the Company's common stock under
the 1997 Plan at December 31, 1998.

The  expiration  date,  maximum  number  of  shares  purchasable,  and the other
provisions of the options will be established at the time of grant.  Options may
be granted  for terms of up to ten years and become  exercisable  in whole or in
one  or  more  installments  at  such  time  as may be  determined  by the  plan
administrator upon grant of the options.  The exercise prices of the options are
determined by the plan administrator,  but may not be less than 100% of the fair
market  value of the common  stock at the time of the grant.  The 1997 Plan will
remain in force until May 12, 2007.

     1994 NON-EMPLOYEE DIRECTORS STOCK OPTION PLAN

The 1994 Plan provides for the automatic  grant of stock options to non-employee
directors to purchase up to 100,000 shares of the Company's common stock.  Under
the  1994  Plan,  options  to  acquire  500  shares  of  common  stock  will  be
automatically  granted to each non-employee director at the meeting of the Board
of Directors held immediately  after each annual meeting of  stockholders,  with
such options to vest in a series of 12 equal and successive monthly installments
commencing one month after the annual  automatic  grant date. In addition,  each
non-employee  director  serving on the Board of  Directors  on the date the 1994
Plan was approved by the Company's  stockholders  received an automatic grant of
options  to  acquire  1,000  shares of common  stock and each  subsequent  newly
elected  non-employee  member of the Board of  Directors  receives an  automatic
grant of options to acquire  1,000  shares of common  stock on the date of their
first  appointment  or election to the Board of Directors.  Those options become
exercisable  and  vest  in  a  series  of  three  equal  and  successive  annual
installments,  with the first such installment becoming exercisable  immediately
after the director's second  successive  election to the Board of Directors (the
First Vesting Date), the second installment becoming exercisable 10 months after
the First Vesting 

                                      F-12
<PAGE>
Date, and the third installment  becoming  exercisable 22 months after the First
Vesting Date  (provided  that the director has not ceased  serving as a director
prior to a vesting date). A non-employee member of the Board of Directors is not
eligible to receive the 500 share  automatic  option  grant if that option grant
date is within 30 days of such  non-employee  member  receiving  the 1,000 share
automatic  option grant. The exercise price per share of common stock subject to
options  granted  under the 1994  Plan will be equal to 100% of the fair  market
value of the Company's common stock on the date such options are granted.  There
were outstanding  options to acquire 11,000 shares of the Company's common stock
under the 1994 Plan at December 31, 1998.

     1993 STOCK OPTION PLAN

The 1993 Plan  provides  for the  granting  of options to purchase up to 385,454
shares of the Company's  common stock (which includes  85,454 shares  previously
reserved for issuance  under the Company's  1990 Stock Option Plan),  the direct
granting of common stock  (stock  awards),  the  granting of stock  appreciation
rights (SARs) and the granting of other cash awards (cash awards;  stock awards,
SARs, and cash awards are collectively referred to herein as Awards).  Under the
1993  Plan,  options  and  Awards  may be issued  to key  personnel  and  others
providing  valuable  services to the Company and its  subsidiaries.  The options
issued may be incentive  stock options or  nonqualified  stock  options.  If any
option or SAR terminates or expires without having been exercised in full, stock
not issued under such option or SAR will again be available  for grant  pursuant
to the 1993 Plan.  There were options  outstanding to acquire  360,900 shares of
the Company's common stock under the 1993 Plan at December 31, 1998.

To the extent that granted  options are incentive  stock options,  the terms and
conditions  of  those  options  must  be  consistent   with  the   qualification
requirement set forth in the Code. The expiration date, maximum number of shares
purchasable,  and the other provisions of the options will be established at the
time of grant.  Options  may be granted  for terms of up to ten years and become
exercisable  in  whole  or in one or more  installments  at such  time as may be
determined  by the plan  administrator  upon grant of the options.  The exercise
prices of options are determined by the plan administrator,  but may not be less
than  100%  (110% if the  option  is an  incentive  stock  option  granted  to a
stockholder who at the time the option is granted owns stock  representing  more
than 10% of the  total  combined  voting  power of all  classes  of stock of the
Company) of the fair market  value of the common stock at the time of the grant.
The 1993 Plan will remain in force until February 24, 2003.

     1990 STOCK OPTION PLAN

Under the 1990 Plan,  there are 163,100  options  issued but  unexercised  as of
December 31, 1998. In conjunction  with  stockholder  approval of the 1993 Plan,
the Board  terminated the 1990 Plan with respect to unissued options to purchase
85,454  shares of common stock which  remained and were  unissued as of the date
the 1993 Plan was adopted.  The exercise prices of options are determined by the
plan administrator, but may not be less than 100% (110% if the option is granted
to a stockholder  who at the time the option is granted owns stock  representing
more than 10% of the total combined  voting power of all classes of stock of the
Company). The 1990 Plan will remain in force through May 1, 2000.

The  expiration  date,  maximum  number  of  shares  purchasable,  and the other
provisions of the options  granted under the 1990 Plan were  established  at the
time of grant.  Options  were  granted  for terms of up to ten years and  become
exercisable  in  whole  or in one or more  installments  at such  times  as were
determined by the Board of Directors upon grant of the options.

Tax benefits from early  disposition of common stock by optionees under the 1993
Plan and 1990 Plan and from the exercise of nonqualified options are credited to
additional paid-in capital.

Pursuant  to  the  provisions  of  SFAS  No.  123,  ACCOUNTING  FOR  STOCK-BASED
COMPENSATION,  the Company accounts for transactions with its employees pursuant
to Accounting  Principles  Board Opinion No. 25,  ACCOUNTING FOR STOCK ISSUED TO
EMPLOYEES,   under  which  no  compensation   cost  has  been  recognized.   Had
compensation cost for these plans been determined  consistent with SFAS No. 123,
the Company's net income (loss) and earnings (loss) per share would have been as
follows:

                                      F-13
<PAGE>
                                            Years Ended December 31,
                                         ------------------------------
                                           1998       1997        1996
                                         -------    -------     -------
                                      (in thousands, except per share data)

Net income (loss):        As reported    $ 2,590    $ 5,243     $(3,831)
                          Pro forma        1,998      4,785      (4,076)
Basic earnings (loss)
  per share:              As reported    $  0.34    $  0.67     $ (0.49)
                          Pro forma         0.26       0.61       (0.52)
Diluted earnings (loss)
  per share:              As reported    $  0.33    $  0.65     $ (0.49)
                          Pro forma         0.26       0.59       (0.52)

The fair value of each option  grant is estimated on the date of grant using the
Black-Scholes   option   pricing  model  with  the  following   weighted-average
assumptions for grants in 1998, 1997, and 1996, respectively: risk-free interest
rates of 4.52%,  5.45%, and 6.31%;  expected  dividend yields of zero;  expected
lives of 6.6,  6.4,  and 6.1 years;  and expected  volatility  (a measure of the
amount by which a price has  fluctuated  or is  expected to  fluctuate  during a
period) of 61.4%, 60.0%, and 61.9%.

Because the SFAS No. 123 method of  accounting  has not been  applied to options
granted prior to January 1, 1995, the resulting pro forma  compensation cost may
not be  representative  of that to be expected  in future  years.  The  weighted
average fair value of shares exercised in 1998 was $14.03.

A summary of the status of the Company's five stock option plans at December 31,
1998,  1997, and 1996 and changes during the years then ended,  are presented in
the table and narrative below:

                             1998                1997                1996
                      ------------------  ------------------  ------------------
                                Weighted            Weighted            Weighted
                                Average             Average             Average
                                Exercise            Exercise            Exercise
                        Shares   Price      Shares   Price      Shares   Price
                       -------  --------   -------  --------   -------  --------
Outstanding at
  beginning of year    550,970   $11.01    551,776   $ 6.92    539,576   $ 8.06
Granted                334,800    13.87    200,500    14.63    250,100    11.89
Exercised              (47,020)    1.08   (162,306)    1.34    (44,900)    0.49
Expired                142,950)   15.45    (39,000)   12.23   (193,000)   18.04
                       -------            --------            --------

    Outstanding at
      end of year      695,800   $12.14    550,970   $11.01    551,776   $ 6.92
                       =======            ========            ========

Exercisable at end of
  year                 226,731             165,110             294,982
                       =======            ========            ========

Weighted average fair
  value of options
  granted                        $10.25              $ 9.19              $ 7.57
                                 ======              ======              ======

                                      F-14
<PAGE>

The following table summarizes  information  about stock options  outstanding at
December 31, 1998:

                Options Outstanding                       Options Exercisable
-----------------------------------------------------  -------------------------
                                Weighted
                   Number        Average     Weighted      Number      Weighted
   Range of    Outstanding at   Remaining    Average   Exercisable at  Average
   Exercise     December 31,   Contractual   Exercise   December 31,   Exercise
    Prices          1998           Life       Price         1998         Price
-------------  --------------  -----------  ---------  -------------- ----------
$0.25 - $9.00      85,100       4.1 years   $    2.46      63,600     $    0.81
 9.01 - 20.00     588,700       7.9 years       13.14     153,799         12.85
20.01 - 34.38      22,000       8.1 years       22.97       9,332         24.41
                  -------                   ---------     -------     ---------

                  695,800       7.5 years   $   12.14     226,731     $    9.95
                  =======                   =========     =======     =========

     401(K) PROFIT SHARING PLAN

Effective  September 1, 1990, the Company  adopted a profit sharing plan (401(k)
Plan)   pursuant  to  Section  401(k)  of  the  Code.  The  401(k)  Plan  covers
substantially all full-time employees who meet the eligibility  requirements and
provides for a discretionary  profit sharing  contribution by the Company and an
employee elective  contribution with a discretionary Company matching provision.
The Company expensed discretionary  contributions pursuant to the 401(k) Plan in
the amount of $100,000,  $71,000,  and $65,000 for the years ended  December 31,
1998, 1997, and 1996, respectively.

(5) INCOME TAXES:

SFAS No. 109,  ACCOUNTING  FOR INCOME  TAXES,  requires  the use of an asset and
liability  approach in  accounting  for income  taxes.  Deferred  tax assets and
liabilities  are  recorded  based  on  the  differences  between  the  financial
statement  and tax bases of assets and  liabilities  and the tax rates in effect
when these differences are expected to reverse.

The  provision  (benefit)  for  income  taxes for the years  ended  December  31
consists of the following:

                                                     1998       1997      1996
                                                   -------    -------   -------
                                                          (in thousands)
Current, net of operating loss carryforwards
  and tax credits utilized
     Federal, net of tax benefit from early
       termination of incentive stock options      $  (509)   $   356   $   556
     State                                             (24)        97        58
     Foreign                                           237         71         9
                                                   -------    -------   -------
                                                      (296)       524       623

Deferred provision (benefit)                         2,069      2,769    (3,575)
Tax benefit from early termination of incentive
  stock options, reflected in stockholders' equity      --         41        32
                                                   -------    -------   -------

         Provision (benefit) for income taxes      $ 1,773    $ 3,334   $(2,920)
                                                   =======    =======   =======

In  accordance  with SFAS No.  109, a tax benefit  for net  operating  losses of
approximately $-0-, $35,000, and $102,000 and tax credits of approximately $-0-,
$-0-, and $938,000 utilized in 1998, 1997, and 1996, respectively,  are included
as a reduction of the current  provision  for income  taxes in the  consolidated
statements of income (loss).

                                      F-15
<PAGE>
The components of deferred taxes at December 31 are as follows:

                                                             1998       1997
                                                           -------    -------
                                                             (in thousands)
  Net long-term deferred tax liabilities:
    Accelerated tax depreciation                           $ 3,156    $ 2,685
    Other                                                       --         33
                                                           -------    -------

                                                           $ 3,156    $ 2,718
                                                           =======    =======
  Net short-term deferred tax assets:
    Inventory reserve                                      $   436    $ 1,721
    Uniform capitalization                                   1,076      1,251
    Accrued liabilities not currently deductible             1,022      1,080
    Allowance for doubtful accounts                            156        156
    Tax effect of regular U.S. net operating
      loss carryforward                                         --         12
    Other                                                      (10)        91
                                                           -------    -------

                                                           $ 2,680    $ 4,311
                                                           =======    =======

A reconciliation of the U.S. federal  statutory rate to the Company's  effective
tax rate is as follows:

                                              1998      1997       1996
                                             ------    ------     ------

  Statutory federal rate                         34%       34%       (34)%
  Effect of state taxes                           3         5         (6)
  Other                                           4        --         (3)
                                             ------    ------     ------

                                                 41%       39%       (43)%
                                             ======    ======     ======

(6) COMMITMENTS AND CONTINGENCIES:

In March 1995, the Company entered into a non-cancelable operating lease for its
primary  manufacturing  facility in Manila,  the Philippines.  The lease expires
December  31, 1999.  In April 1995,  the Company  entered into a  non-cancelable
operating  lease  for  an  additional  manufacturing  facility  in  Manila,  the
Philippines.  The lease  expires  March 31,  1999.  The Company has an option to
extend the lease for an additional year at  substantially  the same rates as the
current lease.

Rent expense was approximately  $917,000,  $793,000,  and $477,000 for the years
ended December 31, 1998, 1997, and 1996, respectively.

In April 1994, the Company  entered into a ground lease (with purchase  options)
on a 5.7 acre site in Tempe,  Arizona.  Annual lease  payments  under the ground
lease,  which will expire on March 31,  2069,  subject to renewal  and  purchase
options as well as termination  provisions,  will average approximately $100,000
over the term of the lease subject to certain escalation  provisions.  A design,
manufacturing,  and corporate  headquarters  facility  containing  approximately
97,000 square feet was completed on the land in 1995 at a cost of  approximately
$10.4 million.

                                      F-16
<PAGE>
The Company's future lease commitments under the non-cancelable operating leases
as of December 31, are as follows (in thousands):

          1999                            $  373
          2000                               100
          2001                               100
          2002                               100
          2003                               100
          Thereafter                       6,525
                                          ------
                                          $7,298
                                          ======

The  Company is involved in certain  administrative  proceedings  arising in the
normal course of business. In the opinion of management, the Company's potential
exposure under the pending administrative proceedings is adequately provided for
in the accompanying financial statements.

(7) SEGMENT INFORMATION:

The Company designs and manufactures a wide range of user interface  devices for
operational  control  and  information  display  functions  required  in the end
products  of  OEMs.  The  Company's  products  are  specialized  in LCD  and LED
components and technology. The majority of the Company's sales are attributed to
the LCD product line.  The Company's  products are included in end-user  devices
for the following  product  categories:  cellular  telephones and other wireless
communication   devices,   medical  equipment,   office  automation   equipment,
industrial process controls,  consumer electronic products,  and data collection
products.

Management  monitors and evaluates the  financial  performance  of the Company's
operations by its four operating  segments located  throughout the world.  These
segments  consist  of three  manufacturing  operations,  located  in the  United
States,  China, and the Philippines,  and a sales and distribution  operation in
the United Kingdom.

The following operating segment information  includes financial  information (in
thousands)  for  all  four  of  the  Company's  operating  segments.   Financial
information for the China  operation is presented  beginning from the date those
operations commenced, June 1998.
<TABLE>
<CAPTION>
                         United   United
December 31, 1998        States   Kingdom     China   Philippines  Eliminations    Total
-----------------       -------- --------   --------  -----------  ------------  --------
<S>                     <C>       <C>      <C>        <C>          <C>           <C>
Net sales               $92,251   $33,438   $ 7,205      $3,010      $(40,857)    $95,047
Operating income (loss)   4,643       676      (947)         (2)           (7)      4,363
Provision for
income taxes              1,537       209        --          27            --       1,773
Depreciation              4,408        36       168          41            --       4,653
Total assets             60,514     9,195    12,301         642        (4,748)     77,904
Capital expenditures      2,809        10     5,298           2            --       8,119
</TABLE>

                                    F-17
<PAGE>
<TABLE>
<CAPTION>
                        United   United
December 31, 1997       States   Kingdom     China   Philippines  Eliminations    Total
-----------------      -------- --------   --------  -----------  ------------  --------
<S>                    <C>       <C>      <C>        <C>          <C>           <C>
Net sales              $83,023  $10,755      $  --     $3,107      $(12,243)     $84,642
Operating income         7,990      436         --        104            47        8,577
Provision for
   income taxes          3,263       32         --         39            --        3,334
Depreciation             4,058       27         --          9            --        4,094
Total assets            68,039    4,896         --        354          (454)      72,835
Capital expenditures     3,036       14         --         --            --        3,050

                        United   United
December 31, 1996       States   Kingdom     China   Philippines  Eliminations    Total
-----------------      -------- --------   --------  -----------  ------------  --------
Net sales              $58,709  $27,814      $  --     $1,494      $(27,304)     $60,713
Operating income (loss) (6,935)      28         --         12           144       (6,751)
Provision for (benefit
 from) income taxes     (2,929)       9         --         --            --       (2,920)
Depreciation             3,375        8         --         57            --        3,440
Total assets            58,828    3,824         --        288          (371)      62,569
Capital expenditures       856       42         --         50            --          948
</TABLE>

Revenues  are  generated  from  the  sale of LCD or LED  user  interface  device
components,  which are  applied in several  different  end-use  products.  Total
revenues by these product categories are as follows:

                                                For the Years Ended December 31,
                                                --------------------------------
                                                         (in thousands)
                                                  1998        1997        1996
                                                -------     -------     -------
Cellular telephones and other wireless
   communication devices                        $62,073     $31,415     $40,360
Office automation equipment                      12,658      33,528       5,979
Other                                            20,316      19,699      14,374
                                                -------     -------     -------
                  Total                         $95,047     $84,642     $60,713
                                                =======     =======     =======

The Company's  strategy  involves  concentrating its efforts on providing design
and production services to leading companies in a limited number of fast-growing
industries.  The Company has been undertaking  substantial  efforts to diversify
its business,  broaden its customer base, and expand its markets.  The Company's
historical major customer,  that accounted for  approximately 35% and 65% of the
Company's  revenue in 1997 and 1996,  respectively,  accounted for approximately
64% of the Company's revenue during 1998. This increased  percentage occurred as
a result of increased sales to that customer as well as decreased sales to other
customers.  The Company's other significant customer accounted for less than 10%
of the  Company's  revenue  during 1998.  Sales to this customer were 32% of the
Company's  revenue during 1997 and less than 10% of the Company's revenue during
1996.

The  significant  amount  of  sales  to  a  few  customers  results  in  certain
concentrations of credit risk for the Company. The Company's accounts receivable
balance,  including the accounts  receivable of the Company's largest customers,
is  comprised  of a  large  number  of  customers,  primarily  in  the  cellular
telephone,  computer hardware,  and other electronic products industries.  These
customers are located primarily in the United States and Europe.

                                      F-18
<PAGE>
                            THREE-FIVE SYSTEMS, INC.
                                   SCHEDULE II
                 VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
<TABLE>
<CAPTION>
                                  Balance at   Charged to   Charged to              Balance at
                                  Beginning    Costs and      Other                   End of
                                  of Period    Expenses      Accounts     Other       Period
                                  ---------    --------      --------     -----       ------
                                                    (in thousands)
<S>                                <C>          <C>           <C>       <C>          <C>
Allowance for doubtful accounts
and sales returns and allowances:
    Year ended 12/31/98            $   580         (24)       (40)(1)       --       $  516
    Year ended 12/31/97                649        (105)        36(1)        --          580
    Year ended 12/31/96                602          14         33(1)        --          649

Inventory Reserve:
    Year ended 12/31/98            $ 4,309      (1,660)          --     (1,524)(2)   $1,125
    Year ended 12/31/97              6,782       1,114           --     (3,587)(2)   $4,309
    Year ended 12/31/96              2,767       5,939        142(3)    (2,066)(2)    6,782
</TABLE>

--------
(1) Actual return activity
(2) Obsolete inventory written off
(3) Inventory adjustments

                                      S-1