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, 1997

                          Commission File Number 1-4373
                                                 ------

                            THREE-FIVE SYSTEMS, INC.
                    (Name of Issuer 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
                                 --------------
                (Issuer'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

Check  whether  the issuer  (1) has filed all  reports  required  to be filed by
Section 13 or 15(d) of the  Exchange  Act during the past 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 __

Check if there is no  disclosure of  delinquent  filers  pursuant to Item 405 of
Regulation S-K contained in this form, and no disclosure  will 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. [_____]

State issuer's revenues for its most recent fiscal year:  $84,642,000

As of March 6, 1998,  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  $152,309,391.  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 6, 1998,  there were 7,907,123  shares of the issuer's  Common Stock
outstanding.

Documents  incorporated by reference:  Portions of the issuer's definitive Proxy
Statement  for the 1998  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, 1997

                                TABLE OF CONTENTS
<TABLE>
<CAPTION>
                                                       PART I

<S>               <C>                                                                                            <C>
ITEM 1.           DESCRIPTION OF BUSINESS.........................................................................1
ITEM 2.           DESCRIPTION OF PROPERTY........................................................................19
ITEM 3.           LEGAL PROCEEDINGS..............................................................................19
ITEM 4.           SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............................................19

                                                       PART II

ITEM 5.           MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.......................................20
ITEM 6.           SELECTED FINANCIAL DATA .......................................................................22
ITEM 7.           MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
                  CONDITION AND RESULTS OF OPERATIONS............................................................23
ITEM 7A.          QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.....................................32
ITEM 8.           FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................................................32
ITEM 9.           CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
                  ACCOUNTING AND FINANCIAL DISCLOSURE............................................................32

                                                      PART III

ITEM 10.          DIRECTORS AND EXECUTIVE OFFICERS ..............................................................32
ITEM 11.          EXECUTIVE COMPENSATION.........................................................................32
ITEM 12.          SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
                  MANAGEMENT.....................................................................................32
ITEM 13.          CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................................................32

                                                       PART IV

ITEM 14.          EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS
                  ON FORM 8-K....................................................................................33

SIGNATURES.......................................................................................................35

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS......................................................................F-1
</TABLE>
<PAGE>
                                     PART I

ITEM 1.  DESCRIPTION OF BUSINESS

Introduction

         The  Company  designs and  manufactures  a wide range of user interface
devices for operational control and informational  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,
instrumentation,   consumer  electronic  products,   automotive  equipment,  and
industrial and military control 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 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.  In 1997, the
Company's sales increased to $84.6 million, primarily as a result of several new
programs,  including programs for 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  which
have  historically  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)  targeting   new   industrial
applications, and (3) developing new kinds of products.

         The  Company believes that it is positioned to continue the growth that
it experienced in 1997 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  user  interface  devices  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.

         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 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
                                       1
<PAGE>
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.

         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.

         An LED chip produces  light as the result of the  application of direct
current at a low voltage.  Different  wavelengths  (colors) can be produced in a
product depending upon the manufacturing process and the dopant (impurity) added
to the basic chip material, usually gallium arsenide or gallium phosphide. These
wavelengths  can be visible or  non-visible.  In the  visible  range,  LED chips
produce  red,  yellow,  green,  and  recently,  blue and  white  colors.  In the
non-visible  range  (infrared),  the  Company's  devices  utilize 880  nanometer
wavelength or 940 nanometer wavelength chips.

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:

         o        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.

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

         o        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  user  interface  devices
(including those relating to operational control and informational display) 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:

         o        To  gain  access  to  specialized   design  and  manufacturing
                  technology and expertise.
                                       2
<PAGE>
         o        To  accelerate  the design  process  and to reduce  design and
                  manufacturing  costs by utilizing the  specialized  personnel,
                  equipment, and facilities of the supplier.

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

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

         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 user interface devices
for  operational  control  and  informational  display  functions.  The  Company
believes that custom  devices  represent the source of its greatest  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.

         The  Company  pursues a strategy  designed  to enable it to enhance its
position as a major, worldwide supplier of custom-designed and manufactured user
interface   devices  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  techonologies.  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  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 is  expected  to  provide 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 will 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.
                                       3
<PAGE>
Custom Devices

         LCD and LED custom displays  currently account for  approximately  94.3
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.

         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 (i) solid
state lamps used for indicators,  status lights,  on-board circuit monitors, and
instrumentation;  (ii)  multi-digit  numerical  displays  used for  calculators,
industrial  controls,   data  terminals,   instrumentation   timers,   hand-held
instruments,  event counters, and PCB test equipment;  (iii) integrated displays
(with on-board  integrated  circuit drivers) and alpha numeric displays used for
hand-held terminals, minicomputers, telecommunications, and instrumentation word
processors; (iv) bar graph displays used for power meters in stereo systems, Ham
and CB radio meters,  VU meters in tape recorders,  process control  indicators,
and replacements for volt meters; and (v) multi-digit  numeric displays used for
industrial   controls,   data  terminals,   test   equipment,   point  of  sale,
mini-computer readout, and home consumer applications.

         Standard   infrared  devices  include  infrared  emitters  and  silicon
detectors  used for TV remote  controls,  disk drives,  tape  drives,  printers,
encoders,  solid  state  relays,   photoelectric  controls,   slotted  switches,
reflective switches,  intrusion alarms,  touch screens,  wireless data entry and
positioning sensors.

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 LCD's and assembly of
Company-designed  user interface  module  assemblies.  However,  the Company has
recognized an increased demand for extended  manufacturing services beyond these
core services. These 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.
The Company  intends to pursue  extended  manufacturing  opportunities  in those
instances when the Company believes it will be beneficial to do so.

Manufacturing Facilities

         The  Company  currently  conducts  manufacturing  operations  in Tempe,
Arizona and in Manila, the Philippines. The Arizona facility houses a Class 1000
"clean room" and LCD fabrication and prototyping operation. The Company utilizes
the  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
                                       4
<PAGE>
develop  advanced  manufacturing  processes that can be applied in Manila 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  LCD  module   manufacturing   is  done  in  Manila,   the
Philippines.  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.  These  circumstances  could affect the Company's  ability to obtain
products pursuant to the Sub-Assembly Agreement, although there has not been any
material interruption of operations to date. 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.

         The Company plans to construct a manufacturing facility in the People's
Republic  of  China  ("China")  during  1998.  The  China  facility  will  be  a
high-volume LCD module  manufacturing  facility similar to the Company's current
facility in Manila.  The Company initially will lease a facility in Beijing on a
temporary  basis,  and the  Company  expects  manufacturing  to commence in that
temporary  facility in the middle of 1998.  The Company is planning to construct
its own  facility in Beijing  and expects to move into that new  facility at the
end of 1998. The Chinese manufacturing  facility will be owned and operated by a
wholly  owned  foreign  subsidiary  of the Company.  The cost of  equipping  and
constructing  the China facility is expected to be  approximately  $8.0 million.
For further  discussions  on the  proposed  China  operations,  See  "Management
Discussion  and  Analysis of  Financial  Conditions  and Results of  Operations"
contained  in Item 7 of this  Report  and  "Description  of  Business  - Special
Considerations - Risks of International  Operations" contained in Item 1 of this
Report.
                                       5
<PAGE>
Quality Control

         The Company has  implemented 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's quality control program is based 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
for  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.  In 1997, the Company  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 and, to a much lesser extent,  through an
independent sales and distribution network. This network includes two franchised
distributors  in   approximately   96  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, and Florida.

         The Company's sales to customers in Europe represented approximately 13
percent of net sales in 1997. 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.
The European staff and network of distributors  provide  marketing,  consulting,
and product design input locally for customers throughout Western Europe.

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  user  interface  devices  used in
approximately  35 individual  product  programs for Motorola.  Sales to Motorola
accounted for 34.6 percent of the Company's  revenue  during 1997.  Devices that
are used in cellular telephones accounted for substantially all of the Company's
sales to Motorola in 1997. Motorola recently awarded several new design programs
to the Company.  In  addition,  during  1997,  Motorola  instituted a LCD module
allocation  process  in  which  it  designated  a few  key LCD  module  vendors,
including the Company, and communicated to each vendor the anticipated amount of
purchases for 1998. Although the allocation process does not provide a guarantee
of business to the Company, it provides an indication that purchases by Motorola
could  rise to as much as 50  percent  of the  Company's  revenue  in 1998.  The
Company's   second  largest  customer  in  1997  was   Hewlett-Packard   Company
("Hewlett-Packard").  Sales to Hewlett-Packard accounted for 32.0 percent of the
Company's revenue during 1997. As the LCD modules manufactured by the
                                       6
<PAGE>
Company for  Hewlett-Packard  move into second generation  versions in 1998, the
Company  expects that the selling price of some of those modules will be greatly
reduced.  Consequently,  the Company believes that in 1998 the percentage of its
revenue attributed to Hewlett-Packard will decline. See "Description of Business
- Special  Considerations - Substantial Reliance on Certain Customers" contained
in Item 1 of this Report.

Backlog

         As of  December  31,  1997,  the  Company  had a  backlog  of orders of
approximately $21.8 million, all of which orders are believed to be firm and all
of which are expected to be filled during fiscal 1998.  The backlog of orders at
December 31, 1996 was approximately $17.9 million. The Company's business may be
developing 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.

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 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.  The
Company  recently  received  a patent  on a new  display  technology,  which the
Company refers to as LCiD(TM) or Liquid Crystal  intense  Display.  In 1997, the
Company also signed a license  agreement with Motif,  Inc. to license from Motif
technology  that forms the basis of its LCaD(TM) or Liquid Crystal active Drive.
The Company recently applied for a patent on its LCaD(TM) technology.

Raw Materials

         The principal raw  materials  used in producing the Company's  displays
consist of gallium arsenide and gallium  phosphorous  wafers and die, 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 is expected to reduce the Company's  dependence  on foreign  suppliers.
See  "Description  of  Business  -  Special  Considerations  -  Shortage  of Raw
Materials and Supplies" contained in Item 1 of this Report.

Competition

         The Company believes that Optrex America, Inc.,  Seiko-Epson,  Samsung,
Seiko Instruments,  Hyundai, PCI Limited, and Philips Components B.V. constitute
the principal competitors for the Company's LCD devices.  Hewlett-Packard,  Rohm
Co., Ltd., LiteOn,  Inc.,  Siemens,  Inc.,  Stanley Electric Company,  Ltd., and
Quality  Technologies  Corp.  constitute its principal  competitors  for its LED
devices.  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 user interface
devices.  No assurance can be given that the Company will continue to be able to
compete successfully with such organizations.

         The  Company  currently  competes  principally  on  the  basis  of  the
technical  innovation and performance of its product solutions,  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
                                       7
<PAGE>
more of its customers,  particularly  Motorola or Hewlett-Packard,  determine to
design and manufacture  their user interface  devices  internally or secure them
from other  parties.  See " Description of Business - Special  Considerations  -
Competition" contained in Item 1 of this Report.

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  performance of
current products and expanding the technology to serve new markets. Research and
development  also is  conducted  in  manufacturing  processes,  including  those
associated with efficient, high-volume production and electronic packaging.

         More  recently,  the  Company  has  begun to  focus  its  research  and
development  efforts on new display  technologies.  See "Description of Business
Products  and  Services"  contained  in Item 1 of this  Report.  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 1998.

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 "Description of Business - Special Considerations -
Environmental Regulation" contained in Item 1 of this Report.

         In 1991,  the Company  received a notice of potential  liability at the
Barkhamsted-New  Hartford  Landfill Site in  Barkhamsted,  Connecticut  from the
United States Environmental Protection Agency ("EPA"). No further administrative
action was taken against the Company and the Company has been  verbally  advised
by a  representative  of the EPA that the Company  will have no  liability  with
respect to this matter.

         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, 1997,  the Company  employed a total of 459 persons.
This number includes 174 full-time and  approximately 10 temporary  employees at
its  principal  U.S.  facility in Tempe,  Arizona and U.S.  sales  offices;  267
employees  at its  manufacturing  facility  in Manila,  the  Philippines;  and 8
employees at its Three-Five Systems, Limited 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.
                                       8
<PAGE>
         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  "Description  of Business -  Manufacturing  Facilities"
contained in Item 1 of this Report. As of December 31, 1997, approximately 1,133
persons  performed  direct labor  operations at the Manila facility  through the
Sub-Assembly Agreement with TEAM.

Executive Officers

The  following  table sets forth  information  concerning  each of the Company's
executive officers.
<TABLE>
<CAPTION>
Name                               Age                                 Position
----                               ---                                 --------

<S>                                <C>     <C>
David R. Buchanan                  65      Chairman of the Board, President, and Chief Executive Officer

Vincent C. Hren                    47      Vice President - Operations

Jeffrey D. Buchanan                42      Vice President - Finance, Administration, and Legal;
                                           Chief Financial Officer; Secretary; and Treasurer

Dan J. Schott                      58      Vice President - Research and Development
</TABLE>

         David R.  Buchanan  has been  Chairman of the Board,  President,  Chief
Executive Officer, and a director of the Company since its formation in February
1990.  Mr.  Buchanan  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.

         Vincent C. Hren has been Vice  President  -  Operations  of the Company
since August 1996 and served as Vice President -  Manufacturing  Operations from
January  1996 to August  1996.  Mr.  Hren  served as Vice  President - Worldwide
Automotive of Graco Inc. from 1994 to 1995.  Mr. Hren served as Vice President -
Worldwide  Operations  for  Fisher-Rosemount  Systems,  Inc.  from 1993 to 1994,
General  Manager  of  Rosemount  Analytical,  Inc.  from 1992 to 1993,  and held
various management positions with Fisher-Rosemount, Inc. from 1974 to 1992.

         Jeffrey D. Buchanan has been Vice President - Finance,  Administration,
and Legal, Chief Financial Officer, and Treasurer of the Company since June 1996
and Vice President - Administration and Legal and Secretary of the Company since
May  1996.  Mr.  Buchanan  served as a Senior  Partner  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 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 was 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,  he held  various  engineering
management and program management positions with Sperry Rand Corp.
                                       9
<PAGE>
Special Considerations

Certain Factors Affecting Operating Results

         The  Company's  operating  results are  affected  by a wide  variety of
factors  which could  adversely  impact its net sales and  profitability.  These
factors,  many of which are  beyond  the  control of the  Company,  include  the
Company's ability to identify industries which 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;  the level and
timing of orders  placed  by  customers  which the  Company  can  complete  in a
quarter;  customer order  patterns;  changes in order mix; 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 will be an
important  factor 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
1997 were  display  modules  for  cellular  products.  A slowdown  in demand for
customer products,  particularly  cellular and office automation  products which
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 broadbased
factors would adversely affect the Company's operating results.

Dependence 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 the Company 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,  the engagement of
additional  engineering and other technical personnel,  the purchase of advanced
design,  production  and test  equipment,  and the  enhancement  of  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  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 may experience delays from time to time in completing the
design and manufacture of new product  solutions.  In addition,  there can be no
assurance that any new product  solutions  will receive or maintain  customer or
market  acceptance.  If the  Company  were  unable  to  design  and  manufacture
solutions  for new  products  of its  customers  on a timely and  cost-effective
basis,  its  future  operating   results  would  be  adversely   affected.   See
"Description  of Business - Products and  Services"  contained in Item 1 of this
Report.

         Finally,   even   when  a  design   and   manufacturing   solution   is
satisfactorily  completed,  circumstances  outside of the Company's  control may
result in the loss of expected revenue. 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.  In such instances,  the future operating
results of the Company could be adversely affected.
                                       10
<PAGE>
Substantial Reliance on Certain Customers

         In the past few years,  the Company has  generated  most of its revenue
from sales to a few significant  customers.  The Company's  largest  customer is
Motorola,  which  accounted for 34.6 percent of the  Company's  revenue in 1997,
65.1 percent of the Company's  revenue in 1996 and 80.5 percent of the Company's
revenue in 1995.  Devices  that are used in cellular  telephones  accounted  for
substantially  all of the  Company's  sales to  Motorola in 1997.  Although  the
percentage of sales to Motorola  declined in 1997, the Company  anticipates that
this  percentage will increase in 1998 to as much as 50 percent of the Company's
revenue.  The  Company's  second  largest  customer  is  Hewlett-Packard,  which
accounted for 32.0 percent of the Company's 1997 revenue.  See  "Description  of
Business - Customers" contained in Item 1 of this Report.

         The  Company  does  not  have  long-term   supply  contracts  with  any
customers,  and customers also  generally do not commit to long-term  production
schedules.  In addition,  customer orders  generally can be cancelled and volume
levels  changed or delayed.  The timely  replacement of cancelled,  delayed,  or
reduced  orders cannot be assured and,  among other things,  could result in the
Company holding excess and obsolete  inventory.  The Company's operating results
have been  materially  and  adversely  affected  in the past by the  failure  of
anticipated orders to be realized and by deferrals or cancellations of orders as
a result of changes in customer  requirements.  Cancelled,  delayed,  or reduced
commitments from any of the Company's major customers,  particularly Motorola or
Hewlett-Packard,  would have a material adverse effect on the Company's  results
of operations.

Risks of International Operations

         General. The Company currently has substantial manufacturing operations
located in the Philippines  and the United States.  The Company also has a sales
office and distribution warehouse in Europe. In addition, in 1998 the Company is
planning to construct a manufacturing  facility in China,  where the Company has
not previously  manufactured  products. 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  fluctuations  in the  value of  currency,  duties,
possible  employee  turnover,  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, in certain
parts of the world,  political  instability.  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 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 or debt service ability.  The Company also
could  be  adversely  affected  if  the  current  policies  encouraging  foreign
investment  or  foreign  trade by its host  countries  were to be  reversed.  In
addition,  the  attractiveness  of the  Company's  services to its United States
customers is affected by United  States trade  policies,  such as "most  favored
nation" status and trade  preferences for certain Asian nations.  In particular,
the  Company's  operations  and assets are  subject  to  significant  political,
economic,  legal and other uncertainties in the Philippines and China, where the
Company is planning to substantially expand its operations.

         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  other 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.  Although the Company has made advance payments to TEAM
since 1994 to assist it in meeting its working capital needs while it negotiates
new  financing  arrangements,  there  were no  outstanding  advances  to TEAM at
December  31,  1997.  The Company  expects to make  advances to TEAM in 1998 for
generators and equipment needed for building improvements.
                                       11
<PAGE>
         The Company has made cumulative capital  investments in the Philippines
amounting  to  approximately  $11.1  million  through  December  31,  1997.  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  business  and  financial  condition  of  the
subcontractor,  political  instability  and  expropriation,  supply  disruption,
currency  controls,  and exchange  fluctuations  as well as 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 for it to replace the low-cost,  high-performance facility or
the  high-quality  and  hard  working  production  staff  if  its  manufacturing
operations in the  Philippines  were disrupted or terminated.  As a result,  the
Company's   operations  would  be  adversely   affected  if  operations  in  the
Philippines  or air  transportation  with  the  Philippines  were  disrupted  or
terminated,  even for a relatively  short period of time.  See  "Description  of
Business - Manufacturing Facilities" contained in Item 1 of this Report.

         Proposed Manufacturing  Operations in China. The Company is planning to
begin a manufacturing  operation in China in 1998. The Company's  operations and
assets  will be  subject to  significant  political,  economic,  legal and other
uncertainties in China. 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.  No assurance can be
given,  however,  that the  Chinese  government  will  continue  to pursue  such
policies,  that  such  policies  will be  successful  if  pursued,  or that such
policies will not be significantly  altered 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  thereof 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 the imposition of austerity  measures  intended to reduce
inflation;   the  inadequate   development  or  maintenance  of  infrastructure,
including   the   unavailability   of   adequate   power  and  water   supplies,
transportation,  raw materials,  and parts;  or a  deterioration  of the general
political, economic or social environment in China.

         In addition,  China  currently  enjoys "most  favored  nation"  ("MFN")
status  granted by the United  States  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.  No assurance  can be given that the United States will renew China's
MFN  status in future  years.  The  failure  or  refusal  of the  United  States
government  to renew  China's MFN status could  adversely  affect the Company by
increasing the cost to United States  customers of products  manufactured by the
Company in China.

International Trade and Currency Exchange

         Approximately  33.8  percent  of the  Company's  net sales in 1997 were
international  sales. Nearly all of those international sales were from sales in
foreign  markets,  primarily  Europe,  China,  and Hong Kong, to U.S. based OEMs
based in the United States. In 1998, the Company expects sales to OEMs in Europe
and China to increase and sales to OEMs in Hong Kong to decrease.  In 1998,  the
Company expects to begin  manufacturing  operations in China and to continue its
operations  in Manila.  The foreign  sale and  manufacture  of  products  may be
adversely affected by political and economic  conditions  abroad.  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  purchase  materials  or
equipment from foreign suppliers.

         While the Company  transacts  business  predominantly  in United States
dollars and most of its revenues are collected in U.S. dollars, a portion of the
Company's  costs,  such as payroll,  rent,  and indirect  operation  costs,  are
denominated in other  currencies,  including  Philippine pesos ("PhP"),  British
pounds sterling, and (in
                                       12
<PAGE>
1998)  Chinese  renminbi  ("RMB").  For  example,  the  Company's   Sub-Assembly
Agreement with TEAM is based on a fixed conversion rate, exposing the Company to
exchange rate  fluctuations  with the Philippine  peso. In 1998, the Company may
have  transactions,  including sales,  designated in Chinese RMB.  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 United States dollar could affect the Company's  cost of goods
sold and operating  margins and could result in exchange  losses.  The impact of
future exchange rate  fluctuations on the Company's results of operations cannot
be accurately  predicted.  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.  The Company  anticipates
that  from  time  to  time  it  will  make  United   States   dollar-denominated
intercompany  loans to its wholly owned subsidiary in China. Any decrease in the
value  of the  RMB  could  adversely  affect  the  Company  if  there  are  U.S.
dollar-demoninated  intercompany  loans  from  the  Company  to its  subsidiary.
Hedging RMB is currently  difficult  because the currency is not freely  traded.
The Company would suffer a recordable  loss as a result of a RMB  devaluation if
its intercompany loans to its subsidiary in China are not hedged.

Manufacturing Yields and Capacity

         The design and manufacture of user interface devices 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 ramps up its high-volume
LCD line to greater  production levels in 1998, adds more equipment,  and begins
to manufacture LCoS(TM) microdisplays. See "Management's Discussion and Analysis
of  Financial  Condition  and  Results  of  Operations   Liquidity  and  Capital
Resources"   contained  in  Item  7  of  this  Report.   Additionally,   as  the
sophistication  of user  interface  devices  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
operating results would be adversely affected if it were unable to maintain high
levels of productivity or satisfactory  delivery  schedules in either its Manila
manufacturing plant or its Arizona high-volume LCD line.

         Manufacturing yields and delivery schedules also may be affected as the
Company ramps up its manufacturing capabilities in China. Other companies in the
industry have  experienced  difficulty in expanding or relocating  manufacturing
output and capacity,  with such difficulty resulting in reduced yields or delays
in product  deliveries.  No  assurance  can be given that the  Company  will not
experience manufacturing yield or delivery problems in the future. Such problems
could materially  affect the Company's  operating  results.  See "Description of
Business - Manufacturing Facilities" contained in Item 1 of this Report.

Variability of Customer Requirements and 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.  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 based upon the Company's estimate
of  anticipated  future orders.  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
                                       13
<PAGE>
or delays by a significant  customer or by a group of customers  would adversely
affect  the  Company,  its  results of  operations,  prospects  or debt  service
ability. On occasion, customers may require rapid increases in production, which
can stress the Company's resources and reduce margins.  Although the Company has
increased its manufacturing capacity, there can be no assurance that the Company
will have 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
timing  of  orders;  volume  of  orders  relative  to  the  Company's  capacity;
customers' announcements, 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  expected  future
volume of business. Completion of the design is dependent, however, on a variety
of factors,  including the customer's  changing  needs,  and not every design is
successful in meeting those needs.

Utilization of Arizona Facility

         The Company  has made  substantial  expenditures  in  constructing  and
equipping its facility in Tempe,  Arizona,  with a high-volume LCD manufacturing
line. The high-volume  line was placed in service in 1996,  although the Company
committed 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 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.  The Company experienced some delays
in fully  implementing  its LCD glass  manufacturing  operations in 1996, and no
assurance can be given that the Company will not  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, in 1998 the Company intends to add additional equipment to
the LCD glass line to enhance its ability to manufacture LCoS(TM) microdisplays.
See "Description of  Business-Research  and Development"  contained in Item 1 of
this Report.  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
use of a new material (silicon),  the modification of equipment and processes to
accommodate  the  miniature  size  of the  product,  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.

Management of Growth

         The Company's  revenue  expanded  substantially  during the period from
1993  through  1995,  but  declined  significantly  in 1996 as a  result  of the
discontinuation  of a few significant  programs from its major customer.  During
1997, however,  the Company increased the number of its manufacturing and design
programs and the
                                       14
<PAGE>
Company plans to further  expand the number and diversity of its programs in the
future. At the end of 1997, the Company had 76 manufacturing and design programs
versus 69 at the end of 1996. The Company's ability to manage its planned growth
effectively  will  require  it  to  enhance  its  operational,   financial,  and
management systems, to expand its facilities and equipment,  and to successfully
hire,  train,  and  motivate  additional  employees,   including  the  technical
personnel necessary to operate its new LCD glass production facility in Arizona.
The failure of the Company to manage its growth on an effective basis could have
a material adverse effect on the Company's operations.

         As the Company  expands and  diversifies its product and customer base,
it may have to further  increase its selling and  administrative  expenses.  The
Company 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.  The
Company's profitability would be adversely affected if the Company increases its
expenditures in anticipation of future orders that do not materialize. Customers
also may require rapid increases in design and production services that place an
excessive short-term burden on the Company's resources.

Dependence 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 as President and Chief Executive Officer of the Company since 1987. 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  "Description of Business -
Executive  Officers"  contained in Item 1 of this  Report.  The Company does not
have any fixed-term agreements with, or key person life insurance covering,  any
officer  or  employee.  The  Company,  however,   maintains  noncompetition  and
nondisclosure agreements with its key personnel.

Protection of 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.  There
can be no assurance that any of the Company's  pending patent  applications will
be  issued  or that  intellectual  property  laws  will  protect  the  Company's
intellectual  property rights.  In addition,  there can be no assurance that any
patent issued to the Company will not be challenged, invalidated or circumvented
or that the rights granted thereunder will 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.  Furthermore, there can be no assurance that others will
not independently develop similar technology or design around any patents issued
to the Company.  Moreover,  effective protection of intellectual property rights
may be unavailable or limited in certain foreign  countries in which the Company
operates. In particular,  the Company may be afforded only limited protection of
its intellectual property rights in China.

         The Company may in the future be notified that it is infringing certain
patents or other intellectual  property rights of others,  although there are no
such  pending  lawsuits  against the Company or  unresolved  notices  that it is
infringing  intellectual  property  rights of others.  No assurance can be given
that  in  the  event  of  such  infringement,  licenses  could  be  obtained  on
commercially reasonable terms, if at all, or that litigation will not occur. The
failure  to obtain  necessary  licenses  or other  rights or the  occurrence  of
litigation  arising out of such claims  could  materially  adversely  affect the
Company, its results of operations, prospects or debt service ability.

Possible Volatility of Stock Price

         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. See "Market for Common Equity and
                                       15
<PAGE>
Related  Stockholder  Matters"  contained in Item 5 of this Report.  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  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, worldwide
economic and financial conditions, and other events or factors. In addition, the
stock market has experienced  extreme price and volume  fluctuations  which have
particularly  affected the market prices for many high technology  companies and
which 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.

Competition

         The industries  which the Company serves are intensely  competitive and
have been  characterized  by price  erosion,  rapid  technological  change,  and
foreign competition.  The Company competes with major domestic and international
companies,  many of which have  greater  market  recognition  and  substantially
greater financial, technical, marketing,  distribution, and other resources than
the Company possesses.  Emerging companies also may increase their participation
in the user  interface  device  market.  The  ability of the  Company to compete
successfully depends on a number of factors both within and outside its control,
including 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;   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  user  interface  devices  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 currently competes principally on the basis of
the  technical  innovation  and  performance  of  its  user  interface  devices,
including  their  ease of use and  reliability,  as well as on cost  and  timely
design, manufacturing, and delivery schedules.

         The Company's  competitive  position could be adversely affected if one
or more of these customers  increase their own capacity and decide to design and
manufacture their own user interface  devices,  to use standard  devices,  or to
outsource  with a  competitor.  There  is no  assurance  that the  Company  will
continue to be able to compete  successfully in the future.  See "Description of
Business - Competition" contained in Item 1 of this Report.

Shortage of Raw Materials and Supplies

         The  principal raw  materials  used in producing the Company's  product
solutions  consist of gallium arsenide and gallium  phosphorous  wafers and die,
LCD glass, driver die, circuit boards,  molded plastic parts, lead frames, wire,
chips, and packaging  materials,  most of which are acquired from Asian sources.
The Company does not have long-term contracts with its suppliers.

         The Company believes that there are alternative sources of supplies for
most of these materials. Many materials,  however, must be obtained from foreign
suppliers,  which  subjects  the  Company to  certain  risks,  including  supply
interruptions  and currency price  fluctuations.  Purchasers of these materials,
including the Company, experience difficulty from time to time in obtaining such
materials.  Although some  component  leadtimes have  lengthened,  the Company's
suppliers currently are adequately meeting the requirements of the Company,  and
the Company's  ability to produce a substantial  portion of its own requirements
for LCD glass in its Arizona  facility has reduced the  Company's  dependence on
foreign suppliers of LCD glass.

The Electronics Industry: Cyclicality and Capital Requirements

         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,
                                       16
<PAGE>
the electronics industry has been characterized by cyclicality.  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. There is
no assurance that the Company will continue to experience increased demand.

         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 Company's  operating results may be adversely affected if its
net sales do not increase sufficiently to offset these increased costs.

         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 timing and
amount of any such capital  requirements cannot be predicted at this time. There
can be no assurance  that any such  financing  will be  available on  acceptable
terms. If such financing is not available on satisfactory terms, the Company may
be unable to expand its  business or 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 "Management's
Discussion  and  Analysis of  Financial  Condition  and Results of  Operations -
Liquidity and Capital Resources" contained in Item 7 of this Report.

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  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  by  the  Company  to  comply  with  present  or  future   environmental
regulations  could result in fines being  imposed on the Company,  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 of, or  adequately
restrict the  discharge  of,  hazardous  substances  could  subject it to future
liabilities.

         In January 1991, the Company  received a notice of potential  liability
respecting a landfill site near the Company's  former  property in  Barkhamsted,
Connecticut from the United States  Environmental  Protection Agency. No further
administrative action was taken against the Company and the Company was verbally
advised by a  representative  of the EPA that the Company will have no liability
with  respect to this  matter.  In a separate  matter,  the  Company has removed
contamination  and  continues to conduct  periodic  chemical  monitoring  at the
Company's  former  Connecticut  property.  There can be no assurance  that other
environmental  problems will not be discovered in the future which could subject
the  Company to future  costs or  liabilities.  See  "Description  of Business -
Environmental Regulation" contained in Item 1 of this Report.

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).
                                       17
<PAGE>
Year 2000 Compliance

         Many currently  installed  computer  systems and software  products are
coded to accept only two-digit entries to represent years. For example, the year
"1997" would be represented by "97".  These systems and products will need to be
able to accept four-digit  entries to distinguish years beginning with 2000 from
prior years.  As a result,  systems and products  that do not accept  four-digit
year  entries  will need to be  upgraded  or  replaced to comply with such "Year
2000" requirements.  Currently, the Company is reviewing its internal systems to
determine the impact of the Year 2000  requirements.  The Company  believes that
its  internal  systems are Year 2000  compliant  or will be upgraded or replaced
prior to the need to comply with Year 2000  requirements,  and the Company  does
not  anticipate  any material  disruption in its operations as the result of any
failure by the Company to be  compliant.  The Company  believes that the overall
cost of compliance will not be material and expenses such compliance  costs when
incurred.  It is uncertain  whether the Company's  customers and suppliers  will
have Year 2000 issues that may affect the Company,  but the Company currently is
developing a plan to evaluate the Year 2000  compliance  status of its customers
and suppliers.

Rights to Acquire Shares

         At December 31, 1997,  22,000  shares of Common Stock were reserved for
issuance upon exercise of options  previously  granted under the Company's  1997
Stock Option Plan;  9,000 shares of Common Stock were reserved for issuance upon
exercise of options  previously granted under the Company's 1994 Automatic Stock
Option  Plan;  309,750  shares of Common Stock were  reserved for issuance  upon
exercise of options  previously  granted under the  Company's  1993 Stock Option
Plan;  and  210,220  shares of Common  Stock were  reserved  for  issuance  upon
exercise of options  previously  granted under the  Company's  1990 Stock Option
Plan. The weighted  average  exercise price of those shares is $11.01 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.

Repurchase of Common Stock

         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 on market  conditions and
other  factors.  The  repurchase  of  shares by the  Company  would  reduce  the
Company's capital.  If the Company obtains financing from other sources for such
repurchases,  the  liabilities of the Company would  increase.  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
"Management's  Discussion  and  Analysis of Financial  Condition  and Results of
Operations  -  Liquidity  and  Capital  Resources"  contained  in Item 7 of this
Report. A significant  reduction in the number of shares outstanding on the open
market  could  also  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 Act of 1933, as amended (the
"Securities  Act"),  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 1 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
957,908 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 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.
                                       18
<PAGE>
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 "Market for Common Equity and Related  Stockholder  Matters"
contained in Item 5 of this Report.

Cautionary Statement Regarding Forward-Looking Statements

         Certain  statements and information  contained in this Report under the
headings "Description of Business" and "Management's  Discussion and Analysis of
Financial Condition and Results of Operations" 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
in the Securities Act. 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,  "Description  of Business - Special  Considerations"  in Item 1 of this
Report.

ITEM 2.  DESCRIPTION OF PROPERTY

         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 which expires on December 31, 1999, and the remaining 20,000 square feet
is subject to a lease which  expires on March 31, 1999,  and is  renewable  from
year to year thereafter.

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 which is covered by insurance or an indemnity or which
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
                                       19
<PAGE>
                                     PART II

ITEM 5.  MARKET FOR 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,  adjusted  to reflect  the
two-for-one split of the Common Stock effected as a stock dividend in May 1994.
<TABLE>
<CAPTION>
                                                                                     High              Low
                                                                                     ----              ---
<S>                                                                             <C>              <C>
1993:
First Quarter..............................................................     $   3  7/8       $   1  3/4
Second Quarter.............................................................         8                3  7/16
Third Quarter..............................................................        12  1/16          6  3/8
Fourth Quarter.............................................................        17  5/8          10  7/8

1994:
First Quarter..............................................................     $  30  7/8       $  16  9/16
Second Quarter.............................................................        29  15/16        20
Third Quarter..............................................................        46  1/2          26  1/4
Fourth Quarter.............................................................        50               28  3/4

1995:
First Quarter..............................................................     $  38  3/8       $  20  5/8
Second Quarter.............................................................        38  7/8          22  3/8
Third Quarter..............................................................        36  3/4          24  1/4
Fourth Quarter.............................................................        26  1/2          16

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  1/2

1998:
First Quarter (through March 6, 1998)......................................     $  23  1/16      $  17  3/4
</TABLE>

         As of March 6, 1998, there were  approximately  1,160 holders of record
of the Company's  Common Stock.  The closing sale price of the Company's  Common
Stock on the NYSE on March 6, 1998 was $21.88 per share.
                                       20
<PAGE>
         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 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 which the directors may
deem relevant.
                                       21
<PAGE>
ITEM 6.  SLECTED 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>
                                                             1997          1996          1995         1994          1993
                                                             ----          ----          ----         ----          ----
Consolidated Statements of Income (Loss):                      (in thousands, except per share amounts)
<S>                                                        <C>           <C>           <C>           <C>           <C>    
Net sales..............................................    $84,642       $60,713       $91,585       $85,477       $38,002
                                                           -------        ------        ------        ------        ------
Costs and expenses:
  Cost of sales........................................     64,760        58,321        70,481        59,409        26,725
  Selling, general and administrative..................      6,557         5,351         5,386         4,867         3,853
  Research and development.............................      5,106         4,065         2,396         1,270           857
                                                           -------        ------        ------        ------        ------
                                                            76,423        67,737        78,263        65,546        31,435
                                                           -------        ------        ------        ------        ------
Operating income (loss)................................      8,219        (7,024)       13,322        19,931         6,567
                                                           -------        ------        ------        ------        ------
Other income (expense)
  Interest, net........................................        548           412           765           859         (117)
  Other, net...........................................       (190)         (139)         (122)         (135)        (277)
                                                           -------        ------        ------        ------        ------
                                                               358           273           643           724         (394)
                                                           -------        ------        ------        ------        ------
Income (loss) before provision for (benefit from)
  income taxes and cumulative effect of
  accounting change....................................      8,577        (6,751)       13,965        20,655         6,173
Provision for (benefit from) income taxes..............      3,334        (2,920)        5,548         8,109         2,043
                                                           -------        ------        ------        ------        ------
Income (loss) before cumulative effect of
  accounting change....................................      5,243        (3,831)        8,417        12,546         4,130
Cumulative effect of accounting change.................         --            --            --            --           924
                                                           -------        ------        ------        ------        ------
Net income (loss)......................................     $5,243     $  (3,831)       $8,417       $12,546        $5,054
                                                           =======       =======       =======       =======       =======
Earnings (loss) per common share
 Basic.................................................    $  0.67     $   (0.49)       $ 1.09        $ 1.88        $ 0.77
                                                           =======       =======       =======       =======       =======
 Diluted...............................................    $  0.65     $   (0.49)       $ 1.04        $ 1.59        $ 0.71
                                                           =======       =======       =======       =======       =======
Weighted average number of common shares
  Basic................................................      7,854         7,768         7,716         6,666         6,578
                                                           =======       =======       =======       =======       =======
  Diluted..............................................      8,090         7,768         8,084         7,890         7,083
                                                           =======       =======       =======       =======       =======


Consolidated Balance Sheet Data (at end of period):

Working capital........................................    $29,113      $21,513        $22,400       $37,638      $ 7,427
Total assets...........................................     72,835       62,569         63,780        56,280       17,470
Notes payable to banks and long-term debt..............         --           --          3,000           182          223
Stockholders' equity...................................     56,525       51,184         55,224        46,561       10,202
</TABLE>
                                       22
<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.
<TABLE>
<CAPTION>
                                                                          Year Ended December 31,
                                                                          -----------------------
                                                                       1997        1996        1995
                                                                       ----        ----        ----
<S>                                                                   <C>         <C>         <C>   
Net sales.........................................................    100.0%      100.0%      100.0%
                                                                      ------      -------     ------
Costs and expenses
  Cost of sales...................................................     76.5        96.1        77.0
  Selling, general, and administrative............................      7.8         8.8         5.9
  Research and development........................................      6.0         6.7         2.6
                                                                    -------     -------     -------
                                                                       90.3       111.6        85.5
Operating income (loss)...........................................      9.7       (11.6)       14.5
Other income .....................................................      0.4         0.5         0.7
                                                                    -------     -------     -------
Income (loss) before provision for (benefit from) income taxes....     10.1       (11.1)       15.2
Provision for (benefit from) income taxes.........................      3.9        (4.8)        6.1
                                                                    -------     -------     -------
Net income (loss).................................................      6.2%       (6.3)%       9.1%
                                                                    ========    =========   ========
</TABLE>

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 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  have  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.
                                       23
<PAGE>
         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 has  increased as the Company has 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.  The  Company  believes  that  continued
investments in research and development 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 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.

         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. The Company expects that the tax
rate for 1998 will approximate 40.0 percent.

         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.

Year Ended December 31, 1996 Compared with Year Ended December 31,1995

         Net sales were $60.7  million  for 1996,  a  decrease  of 33.7  percent
compared  with net sales of $91.6  million  for 1995.  The  sales  decrease  was
primarily a result of lower order rates from the  Company's  major  customer for
existing  product  programs.  During the first quarter of 1996,  that  customer,
which is in the wireless communications  industry,  informed the Company that it
had made an  unexpected  decision to begin  phasing out certain of its  cellular
products that used display modules which comprised the Company's highest volume,
longest running programs. Subsequently, the phase-out of those programs occurred
even more quickly than the Company had anticipated or its customer had initially
indicated.  The  sudden  and  unexpected  reduction  of those  programs  was the
greatest   contributor  to  the  reduced  revenue  in  1996.  The  long  product
development  time in the custom  display  business  prevented  the Company  from
quickly  replacing the  phased-out  programs.  In 1996,  the  Company's  largest
customer  accounted  for net sales of $39.5  million  compared with net sales of
$73.7  million  to that  customer  for 1995,  for an  overall  decrease  of 46.4
percent.  The Company's major customer  accounted for approximately 65.1 percent
of the net sales for 1996 compared with approximately 80.5 percent for 1995. All
other customers  accounted for net sales of $21.2 million for 1996 compared with
net sales of $17.9 million for 1995.

         Cost of sales, as a percentage of net sales,  increased to 96.1 percent
for 1996 as compared with 77.0 percent for 1995.  The  corresponding  decline in
the gross  margin was the  result of a number of  factors,  including  increased
provisions for excess and obsolete inventory,  manufacturing variances occurring
as a result of decreased manufacturing volume and material purchases,  and sales
of low-margin products. 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,  the cost of sales, as a percentage of net
sales, would have been 84.5 percent for 1996.

         Selling, general, and administrative expense was $5.4 million for 1996,
the same as in 1995. As a result of reduced revenue in 1996,  however,  selling,
general,  and  administrative  expense rose to 8.8 percent of net sales from 5.9
percent of net sales in 1995.
                                       24
<PAGE>
         Research and development  expense totaled $4.1 million,  or 6.7 percent
of net sales,  for 1996 as  compared  with $2.4  million,  or 2.6 percent of net
sales,  for 1995.  Research and  development  expense  consists  principally  of
salaries and benefits to  scientists  and other  personnel,  related  facilities
costs,  including  certain  expenses  associated with the start-up and continued
operations of the LCD line in Tempe, Arizona, and various expenses for projects.

         Interest  income (net) for 1996 was  $412,000,  down from  $765,000 for
1995. The decrease in interest  income was the result of investing lower average
cash balances  during the year.  Other expenses (net)  increased to $139,000 for
1996 from  $122,000  for 1995.  An increase in closed  facilities  expenses  and
foreign  exchange losses in 1996 was partially offset by decreased net losses on
the sale of assets.

         The Company  recorded a benefit  from income  taxes of $2.9 million for
1996,  as compared  with a provision  for income taxes of $5.5 million for 1995.
This resulted  primarily  from having a loss in 1996 as compared with  reporting
net income in 1995.  The reported tax rate for the Company in the fourth quarter
of 1996 was lower than normal because of an adjustment related to the difference
between 1995 tax accruals  and taxes  actually  incurred.  This  adjustment  was
$371,000 and was reflected in the reduced tax provision in the fourth quarter of
1996. The overall tax rate for the Company for 1996 was 43.3 percent as compared
with 39.7 percent for 1995.

         For 1996, the Company reported a net loss of $3.8 million, or $0.49 per
share (diluted),  as compared to net income of $8.4 million,  or $1.04 per share
(diluted),  for 1995.  Without the provision  for excess and obsolete  inventory
taken in the third  quarter,  the  Company  would  have  reported  net income of
$158,000, or $0.02 per share (diluted) in 1996.
                                       25
<PAGE>
Quarterly Results of Operations

         The following table presents unaudited  consolidated  financial results
for each of the eight  quarters  in the period  ended  December  31,  1997.  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)

                                                      1997                                         1996
                                   -------------------------------------------- --------------------------------------------

                                     Mar 31     June 30    Sept 30     Dec 31     Mar 31     June 30    Sept 30     Dec 31
                                     ------     -------    -------     ------     ------     -------    -------     ------
<S>                                  <C>        <C>        <C>         <C>        <C>        <C>         <C>        <C>    
Net sales........................    $16,129    $18,737    $24,074     $25,702    $18,082    $14,457     $13,118    $15,056
                                     -------    -------    -------     -------    -------    -------     -------    -------
Costs and expenses:
 Cost of sales...................     12,488     14,377     18,511      19,384     14,401     11,944      19,798     12,178
 Selling, general, and
  administrative.................      1,466      1,479      1,822       1,790      1,459      1,471       1,316      1,105
 Research and development........      1,130      1,315      1,314       1,347      1,010        820       1,074      1,161
                                     -------    -------    -------     -------    -------    -------     -------    -------
                                      15,084     17,171     21,647      22,521     16,870     14,235      22,188     14,444
                                     -------    -------    -------     -------    -------    -------     -------    -------
Operating income (loss)..........      1,045      1,566      2,427       3,181      1,212        222      (9,070)       612
Other income (expense):
 Interest, net...................        157        154        152          85         19        133          90        170
 Other, net......................        (12)        (7)       (41)       (130)       (27)       (72)        (17)       (23)
                                     -------    -------    -------     -------    -------    -------     -------    -------
Income (loss) before provision
for (benefit from) income taxes..      1,190      1,713      2,538       3,136      1,204        283      (8,997)       759
   
Provision for (benefit from)
  income taxes...................        389        685      1,010       1,250        482        113      (3,519)         4
                                     -------    -------    -------     -------    -------    -------     -------    -------
Net income (loss)................       $801     $1,028     $1,528      $1,886      $ 722      $ 170     $(5,478)    $  755
                                     =======    =======    =======     =======    =======    =======     =======    =======
Earnings (loss) per common share
         Basic...................      $0.10      $0.13      $0.19       $0.24      $0.09      $0.02     $(0.70)      $0.10
                                     =======    =======    =======     =======    =======    =======     =======    =======
         Diluted.................      $0.10      $0.13      $0.19       $0.23      $0.09      $0.02     $(0.70)      $0.09
                                     =======    =======    =======     =======    =======    =======     =======    =======
Weighted average number of
   common shares
             Basic...............      7,759      7,855      7,874       7,900      7,737      7,775       7,779      7,780
                                     =======    =======    =======     =======    =======    =======     =======    =======
             Diluted.............      8,048      8,071      8,181       8,168      8,040      8,032       7,779      8,049
                                     =======    =======    =======     =======    =======    =======     =======    =======
</TABLE>

Liquidity and Capital Resources

         During  1997,  the  Company  generated  $6.8  million in cash flow from
operations as compared with $12.2 million during 1996. The decrease in cash flow
from operations was primarily due to the increase in accounts receivable (versus
the reductions in accounts receivable that occurred in 1996) and the increase in
inventory.  The increase in inventory and accounts receivable occurred primarily
as a result of the increased  sales  activity in 1997.  Depreciation  expense in
1997 was $4.1 million  versus $3.6 million in 1996.  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
rise in 1998 as a result of additional capital expenditures in 1998, including a
new building and equipment for the proposed manufacturing facility in China, the
installation of additional equipment in its Manila manufacturing  location,  and
the installation of equipment in Tempe, Arizona to manufacture liquid crystal on
silicon  (LCoS(TM))  microdisplays.  The  Company's  working  capital  was $29.1
million at December 31, 1997,  up from $21.5  million at December 31, 1996.  The
Company's  current  ratio at December 31, 1997 was  3.1-to-1 as compared  with a
current  ratio of 3.2-to-1 at December  31,  1996.  Including  its cash and loan
commitments,  the Company had over $31.7 million in readily  available  funds on
December 31, 1997.
                                       26
<PAGE>
         In May 1997,  the Company  entered into a new $15.0  million  revolving
line of credit with Imperial  Bank,  which matures May 22, 1998. At December 31,
1997, no borrowings were outstanding under this credit facility.  Advances under
the revolving  line may be made as Prime Rate  Advances,  which accrue  interest
payable  monthly at the bank's prime lending  rate,  or as LIBOR Rate  Advances,
which bear  interest at 175 basis  points in excess of the LIBOR Base Rate.  The
Company's  subsidiary,  Three-Five Systems Limited,  has established an annually
renewable  credit  facility with a United  Kingdom  bank,  Barclays Bank PLC, in
order to fund its working capital  requirements.  The facility provides $350,000
of borrowing  capacity  secured by accounts  receivable  of  Three-Five  Systems
Limited. Advances under the credit facility are based on accounts receivable, as
defined,  and accrue interest,  which is payable  quarterly,  at the bank's base
rate plus 200 basis points.  The United Kingdom credit facility matures June 20,
1998.  Three-Five Systems Limited had no borrowings  outstanding under this line
of credit at December 31, 1997.

         In 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 on market conditions and other
factors.  As of December 31, 1997,  22,500 treasury shares had been purchased by
the Company at a total cost of $253,000.

         Capital  expenditures  during 1997 were approximately $3.0 million,  as
compared with $948,000  during 1996.  Capital  expenditures  for 1997  consisted
primarily of manufacturing and office equipment for the Company's  operations in
Manila and Arizona and laboratory  equipment for research and  development.  The
Company anticipates that it will increase its capital  expenditures during 1998.
Those  expenditures will primarily relate to advanced  manufacturing  processes,
the high-volume  LCD line, and necessary  manufacturing  equipment.  The Company
anticipates that it will spend  approximately  $3.0 million in early 1998 on the
capital equipment needed to manufacture LCoS(TM) microdisplays.  A major portion
of that  equipment  already is on order.  The Company also has decided to expand
its  overseas  manufacturing  capabilities  in 1998 by  opening a  manufacturing
facility in Beijing,  China. The Company  anticipates the facilities and capital
cost for China in 1998 to be approximately $8.0 million.

         The Company  anticipates  that accounts  receivable  and inventory will
rise in 1998 if revenue levels  increase as currently  anticipated.  The Company
believes that its existing  capital,  and anticipated  cash flow from operations
and credit lines will provide  adequate  sources to fund  operations and planned
expenditures  throughout  1998.  Should the Company  encounter  additional  cash
requirements,  however,  the Company may have to expand its loan  commitments or
pursue alternate methods of financing or raising capital.

Effects of Inflation and Foreign Currency Exchange Fluctuations

         The results of operations of the Company for the periods discussed have
not been significantly  affected by inflation or foreign currency  fluctuations.
The Company  generally  sells its products and services and negotiates  purchase
orders with its foreign suppliers in United States dollars.  An exception is the
Company's Sub-Assembly  Agreement in the Philippines,  which is based on a fixed
conversion  rate,  exposing the Company to exchange rate  fluctuations  with the
Philippine  peso.  Although the Company has not  incurred any material  exchange
gains or losses to date,  there has been some  minor  benefit as a result of the
recent peso devaluation. If the peso devaluation were to continue, a substantial
portion of the  benefit to the  Company  will likely be offset by an increase in
the  Philippine  labor  rates  and  costs.   There  can  be  no  assurance  that
fluctuations and currency  exchange rates in the future will not have an adverse
affect  on the  Company's  operations.  The  Company  is  planning  to  commence
operations in China in 1998.  Although the Chinese currency currently is stable,
there can be no assurance that it will remain so in the future. The Company from
time to time may  enter  into  hedging  transactions  in order to  minimize  its
exposure to currency rate fluctuations.

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.
                                       27
<PAGE>
         The  Company  offers  advanced  design and  manufacturing  services  to
original equipment manufacturers. The Company specializes in custom displays and
front panel displays  utilizing  liquid crystal display (LCD) and light emitting
diode (LED)  components  and  technology.  The Company  experienced  substantial
growth from 1993  through  1995 with such growth  dependent  primarily  upon the
Company's participation in the substantial growth of the wireless communications
market and sales to a single  major  customer  in that  industry.  In 1996,  the
Company's  sales  declined,  largely as a result of the  phase-out by that major
customer of a  significant  family of programs  in early  1996.  In 1997,  sales
returned to pre-1996  levels  primarily  as a result of several new programs and
customers, including a major office automation customer.

         The Company had substantial  growth in its revenues in 1997 with a 39.4
percent rate of growth over 1996.  Fourth  quarter  revenues in 1997 were almost
59.3 percent  greater than first quarter  revenues in 1997. This growth occurred
because  several new programs began  production in the second and third quarters
of 1997 while many existing programs were in the middle of their life cycles. In
1997, more than 80 percent of revenue  occurred in the second,  third and fourth
quarters.  In 1998, the Company  anticipates  that this type of revenue  pattern
will be repeated.  The Company  believes  that a pattern of  seasonality  may be
developing as OEMs with retail products  develop shorter product life cycles and
introduce new programs early in the year following  holiday sales.  Although the
Company expects some  significant new programs to begin ramping up production in
1998, several existing programs are nearing the completion of their natural life
cycles.  Previously,  the Company  expected some of the new programs to begin to
ramp up production  in the first  quarter prior to the  completion of the mature
programs. As the result of customer design issues, it now appears that those new
programs  will not begin to ramp up until the  second  and  third  quarter  in a
manner  similar to the ramp up that occurred in 1997.  As a result,  the revenue
from those new programs will not be available in the first quarter to offset the
loss of revenue occurring from the completion of the older programs. Thus, sales
in the first  quarter of 1998 will decline  over sales in the fourth  quarter of
1997.

         The Company's  estimated backlog of manufacturing  revenue for programs
currently  in design is  substantially  greater  than it was at the end of 1996.
Therefore,  if additional  programs  currently in  development  begin to ramp up
their production  levels in the second and third quarter of 1998 as anticipated,
the Company should continue its year over year growth rate in 1998.

         In the past several  quarters,  the Company has undertaken  substantial
efforts to diversify its  business,  broaden its customer  base,  and expand its
markets,  and the  Company  intends to continue  those  efforts.  The  Company's
historical major customer,  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.  This
reduced  percentage  occurred  as a  result  of the  increased  sales  to  other
customers and reduced product selling prices and overall revenue from that major
customer. Late in 1997, that major customer instituted an allocation process for
awarding 1998 LCD module  business.  Although the allocation  does not provide a
guarantee of business,  the Company anticipates that business with that customer
will  increase in 1998 at a rate faster than  increases  in business  with other
customers.  Therefore,  the  percentage  of revenue  attributed to that wireless
communications  customer may increase in 1998, but the current  business plan of
the Company  targets that customer to account for no more than 50 percent of its
1998 revenue.  Another  customer also  accounted for 32 percent of the Company's
revenue  in  1997,   but  the  Company   expects  this   percentage  to  decline
significantly  over the next few quarters as current  programs  reach the end of
their cycles and replacement programs with lower selling prices are introduced.

         The Company's gross margins are impacted by several factors,  including
manufacturing   efficiencies,   product  differentiation,   product  uniqueness,
billings for non-recurring engineering services, engineering costs, product mix,
and volume  pricing.  Generally,  higher-volume  programs  using  more  generic,
low-information  content LCD  displays  have lower  margins.  As the  production
levels of some of the Company's new high-volume programs increase in early 1998,
the gross margins on those programs, which are generally lower, may have more of
an impact on the Company's overall margins.  In addition,  many of the Company's
competitors are Asian suppliers, and a strong dollar gives a competitive pricing
advantage  to those  suppliers.  Thus,  the Company may see  competitive  margin
pressure from Asian  suppliers,  particularly  those in Korea and Japan. It is a
goal of the Company, however, for increased manufacturing  efficiencies to occur
on those high-volume programs in order to maintain its gross margins at existing
                                       28
<PAGE>
levels,  although those efficiencies  should not positively impact the Company's
gross margins  until after the first  quarter of 1998.  The Company also expects
that more advanced  display  modules,  expected to be introduced  later in 1998,
will  command  higher  margins and should  enable the  Company to  maintain  its
overall 1998 gross margins in the same range as the gross margins in 1997.

         As the Company  expands and  diversifies its product and customer base,
it may  have to  further  increase  its  selling,  general,  and  administrative
expenses.  Serving a variety of  customers  with  complex and  differing  issues
requires  increased  personnel  committed to those customers.  As a result,  the
actual dollar amount of the selling,  general,  and  administrative  expenses in
1998 should be 20 to 25 percent greater than in 1997, although SG&A expenditures
as a percentage of net sales should continue decreasing in 1998.

         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  as well  as to  provide
opportunities for growth. In 1997, the Company continued to expand and intensify
its internal  research and development to focus on proprietary  display products
rather  than  emphasizing  manufacturing  process  improvements.  Use of the LCD
manufacturing  line in Tempe,  Arizona as a resource  for the testing of the new
ideas is the key to the  development  of these  products,  some of which will be
proprietary and not available from other display manufacturers. In addition, the
development  of the  high-volume  manufacturing  LCD line has helped  reduce the
Company's dependence on foreign suppliers of LCD glass.

         The Company  also  intends to pursue  technologies  being  developed in
related  fields.  The Company  operates the  highest-volume  fully automated LCD
manufacturing  line in  North  America.  As a  result,  several  companies  have
approached the Company about potential  alliances.  The Company  believes that a
strategic  alliance with one or more of those  companies could minimize the cost
of entry  into new  markets  and new  technologies.  In  August  1997,  National
Semiconductor  Corporation  and the Company  entered  into a strategic  supplier
alliance   agreement   for  the   development   and   manufacture   of  LCoS(TM)
microdisplays.  Under the alliance,  the two  companies are working  together in
developing  the  LCoS(TM)  technology  with each  company  focusing  on its core
competency of silicon and LCDs, respectively.

         The  Company  also is  considering  licensing  technologies  from other
companies that could be optimized on the LCD  manufacturing  line. This internal
and external focus on research and development will continue indefinitely.  As a
result,  the actual dollar amount of such  expenditures  in 1998 should increase
over 1997,  although research and development  expenditures should decrease as a
percentage of net sales in 1998.

         The Company has decided to establish  manufacturing  operations  in The
People's  Republic of China.  A site was  recently  selected in Beijing,  and an
individual with  management  experience in China was hired to act as the General
Manager  and Vice  President  for the China  operations.  The  Company  plans to
establish Chinese manufacturing  operations in 1998 for several reasons.  First,
based upon its growth  expectations  for 1998 in the European and United  States
marketplaces,  the Company anticipates a need for manufacturing  capacity beyond
what is available at its Philippine location.  China was selected because of the
desire to diversify  manufacturing  locations  and because of the cost  benefits
that are  expected to be  achieved in China.  The  Company  also  believes  that
locating  a  portion  of its  manufacturing  operations  in  China  will  create
synergistic opportunities for the Company because many of the components used in
the Company's products are manufactured in China.  Second, many of the Company's
existing and potential  customers  maintain  manufacturing  operations  near the
proposed China location.  Despite the current Asian  situation,  those customers
continue to require LCD modules and the Company participates very little in that
market.  Currently,  there are few LCD  module  manufacturers  in  China.  Under
current  Chinese  government  rules,  however,  OEMs  in  China  have  a  strong
motivation to utilize locally manufactured components.  The Company expects some
start up costs in 1998 associated with its manufacturing  operations in China in
advance of the first  revenues  from China,  which are  expected to occur in the
third or fourth  quarter of 1998.  Other  important  risk  factors are set forth
under "Special Considerations" in Item 1 of this Report.
                                       29
<PAGE>
Risk Factors

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

         As noted previously,  two customers currently are responsible for about
two-thirds of the Company's revenue.  As a result, the majority of the Company's
revenue comes from a core customer base. Any material  delay,  cancellation,  or
reduction  of  orders  from one or more of those  core  customers  could  have a
material  adverse effect on the Company's  operations.  The Company  expects the
two-thirds  concentration  levels from those two  combined  customers in 1997 to
continue into 1998.

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

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

         The Company  plans to introduce  several new products over the next few
years.  These new products  will  require  significant  expenditures,  including
expenses for custom integrated circuits as well as various capital  expenditures
for  manufacturing  capability.  For  example,  the Company  estimates  that its
initial  capital  expenditures  for  production of LCoS(TM)  microdisplays  will
require  approximately  $3.0 million.  The failure of the Company to sell one or
more of these new technologies, including LCoS(TM) microdisplays, for any reason
could have a material adverse impact on the Company.

         In addition to capital  expenditures  for new products,  the Company is
currently spending research and development  dollars on several new technologies
that it plans to  introduce  in the future.  There is a risk that some or all of
those  technologies may not  successfully  make the transition from the research
and development lab to cost-effective manufacturing capability, and such failure
could have a material  adverse effect on the Company.  Risks include  technology
problems,  competitive cost issues, and yield problems.  In addition,  even if a
new  technology  proves  to be  manufacturable,  it may not be  accepted  by the
Company's customer and the customer's marketplace because of price or technology
issues or it may compare  unfavorably  with  products  previously  introduced by
others.
                                       30
<PAGE>
         The Company designs and manufactures  products based on firm quotes. As
a result,  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.  Recently,  several material  components of some of
the  Company's  major  programs  have been  subject  to  allocation  because  of
shortages by vendors and continued or increased  shortages could have a material
adverse effect on the Company in the future.  In addition,  although most of the
components  purchased  by the  Company  are  purchased  from  vendors  in  Asian
countries  unaffected by the current currency  crisis, a significant  portion of
the silicon  drivers  purchased  by the Company  are  manufactured  in Korea and
Japan.  The  instability in certain Asian  countries could cause supply problems
with respect to these components.

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

         Many currently  installed  computer  systems and software  products are
coded to accept only two-digit entries to represent years. For example, the year
"1997" would be represented by "97".  These systems and products will need to be
able to accept four-digit  entries to distinguish years beginning with 2000 from
prior years.  As a result,  systems and products  that do not accept  four-digit
year  entries  will need to be  upgraded  or  replaced to comply with such "Year
2000" requirements.  Currently, the Company is reviewing its internal systems to
determine the impact of the Year 2000  requirements.  The Company  believes that
its  internal  systems are Year 2000  compliant  or will be upgraded or replaced
prior to the need to comply with Year 2000  requirements,  and the Company  does
not  anticipate  any material  disruption in its operations as the result of any
failure by the Company to be  compliant.  The Company  believes that the overall
cost of compliance will not be material and expenses such compliance  costs when
incurred.  It is uncertain  whether the Company's  customers and suppliers  will
have year 2000 issues that may affect the Company,  but the Company currently is
developing a plan to evaluate the year 2000  compliance  status of its customers
and suppliers.

         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.
                                       31
<PAGE>
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

         Not applicable.

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 to be
filed  pursuant to  Regulation  14A of the Exchange Act for the  Company's  1998
Annual Meeting of Stockholders.  The information  required by this Item relating
to executive  officers of the Company is included in  "Description of 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 to be filed pursuant to Regulation
14A of the Exchange Act for the Company's 1998 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 to be filed pursuant to Regulation
14A of the Exchange Act for the Company's 1998 Annual Meeting of Stockholders.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         Not applicable.
                                       32
<PAGE>
                                     PART IV

ITEM 14. EXHIBITS, FINANICAL STATEMENT SCHEDULES, 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
<TABLE>
<CAPTION>
Exhibit
Number                                Exhibits
------                                --------
<S>               <C>
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,
                  together with form of Revolving Promissory Note
10(u)             Addendum No. 1 to Sub-Assembly Agreement between Three-Five Systems, Inc. and TEAM
                  Pacific Corporation dated March 12, 1997
10(v)             1997 Employee Stock Option Agreement
10(w)             1998 Stock Option Agreement
10(x)             1998 Director's Stock Plan
10(y)             Addendum No. 2 to Sub-Assembly Agreement between Three-Five Systems, Inc. and TEAM
                  Pacific Corporation dated January 1, 1998
21                List of Subsidiaries
23                Consent of Arthur Andersen LLP
27.1              Financial Data Schedule
27.2              Amended and Restated Financial Data Schedule
27.3              Amended and Restated Financial Data Schedules
27.4              Restated Financial Data Schedule

----------------------------------------
</TABLE>
(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.
                                       33
<PAGE>
(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.
                                       34
<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.

Date: March 6, 1998                    THREE-FIVE SYSTEMS, INC.



                                       By /s/ David R. Buchanan
                                          --------------------------------------
                                       David R. Buchanan, Chairman of the Board,
                                       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.
<TABLE>
<CAPTION>
        Name                                           Title                                        Date
        ----                                           -----                                        ----
<S>                                      <C>                                                   <C>
/s/ David R. Buchanan                    Chairman of the Board, President,                     March 6, 1998
------------------------------------     And Chief Executive Officer  
David R. Buchanan                        (Principal Executive Officer)
                                         
/s/ Jeffrey D. Buchanan                  Vice President - Finance, Administration, and         March 6, 1998
------------------------------------     Legal; Chief Financial Officer; Secretary;
Jeffrey D. Buchanan                      and Treasurer (Principal Financial and    
                                         Accounting Officer)                       

/s/ David C. Malmberg                    Director                                              March 6, 1998
------------------------------------
David C. Malmberg

/s/ Burton E. McGillivray                Director                                              March 6, 1998
------------------------------------
Burton E. McGillivray

/s/ Gary R. Long                         Director                                              March 6, 1998
------------------------------------
Gary R. Long

/s/ Kenneth M. Julien                    Director                                              March 6, 1998
------------------------------------
Kenneth M. Julien
</TABLE>
                                       35
<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, 1997 and 1996 ................F-3

Consolidated Statements of Income (Loss) for the years ended
   December 31, 1997, 1996 and 1995 .........................................F-4

Consolidated Statements of Stockholders' Equity for the
   years ended December 31, 1997, 1996 and 1995 .............................F-5

Consolidated Statements of Cash Flows for the years ended
   December 31, 1997, 1996 and 1995 .........................................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, 1997
and  1996,   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, 1997. 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,  1997  and  1996,  and the  results  of their
operations  and their cash flows for each of the three years in the period ended
December 31, 1997, in conformity with generally accepted accounting principles.

                                        ARTHUR ANDERSEN LLP

Phoenix, Arizona,
January 20, 1998.
                                      F-2
<PAGE>
                            THREE-FIVE SYSTEMS, INC.

                           CONSOLIDATED BALANCE SHEETS
                      (in thousands, except share amounts)

                                     ASSETS
                                                               December 31,
                                                           --------------------
                                                             1997        1996
                                                           --------    --------
CURRENT ASSETS:
   Cash and cash equivalents (Note 2)                      $ 16,371    $ 12,580
   Accounts receivable, net                                  12,540       6,830
   Inventories, net (Note 2)                                  8,255       4,606
   Deferred tax asset (Note 6)                                4,311       5,930
   Other current assets                                       1,228       1,384
                                                           --------    --------
      Total current assets                                   42,705      31,330

PROPERTY, PLANT AND EQUIPMENT, net (Note 2)                  29,847      30,913

OTHER ASSETS                                                    283         326
                                                           --------    --------
                                                           $ 72,835    $ 62,569
                                                           ========    ========

                      LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
   Accounts payable                                        $  8,513    $  4,289
   Accrued liabilities (Note 2)                               5,079       4,524
   Current taxes payable (Note 6)                                --       1,004
                                                           --------    --------
      Total current liabilities                              13,592       9,817
                                                           --------    --------

DEFERRED TAX LIABILITY (Note 6)                               2,718       1,568

COMMITMENTS AND CONTINGENCIES (Note 7)

STOCKHOLDERS' EQUITY (Note 4):
   Preferred stock, $.01 par value; 1,000,000 shares            
      authorized                                                 --          --
   Common stock, $.01 par value; 15,000,000 shares
      authorized, 7,928,023 shares issued, 7,905,523 shares
      outstanding at December 31, 1997; 7,779,829 shares 
      issued, 7,757,329 shares outstanding at 
      December 31, 1996                                          79          78
   Additional paid-in capital                                32,420      32,329
   Retained earnings                                         24,259      19,016
   Cumulative translation adjustment (Note 2)                    20          14
   Less- Treasury stock, at cost (22,500 shares)               (253)       (253)
                                                           --------    --------
      Total stockholders' equity                             56,525      51,184
                                                           --------    --------
                                                           $ 72,835    $ 62,569
                                                           ========    ========



                  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)
<TABLE>
<CAPTION>
                                                                   Years Ended December 31,
                                                          -----------------------------------------
                                                              1997           1996           1995
                                                          -----------    -----------    -----------
<S>                                                       <C>            <C>            <C>        
NET SALES (Notes 5 and 8)                                 $    84,642    $    60,713    $    91,585
                                                          -----------    -----------    -----------

COSTS AND EXPENSES:
   Cost of sales                                               64,760         58,321         70,481
   Selling, general and administrative                          6,557          5,351          5,386
   Research and development                                     5,106          4,065          2,396
                                                          -----------    -----------    -----------
                                                               76,423         67,737         78,263
                                                          -----------    -----------    -----------
   Operating income (loss)                                      8,219         (7,024)        13,322
                                                          -----------    -----------    -----------

OTHER INCOME (EXPENSE):
   Interest, net                                                  548            412            765
   Other, net                                                    (190)          (139)          (122)
                                                          -----------    -----------    -----------
                                                                  358            273            643
                                                          -----------    -----------    -----------

INCOME (LOSS) BEFORE PROVISION FOR
   (BENEFIT FROM) INCOME TAXES                                  8,577         (6,751)        13,965

   Provision for (benefit from) income taxes (Note 6)           3,334         (2,920)         5,548
                                                          -----------    -----------    -----------
NET INCOME (LOSS)                                         $     5,243    $    (3,831)   $     8,417
                                                          ===========    ===========    ===========

EARNINGS (LOSS) PER COMMON SHARE (Note 2):
   Basic                                                  $      0.67    $     (0.49)   $      1.09
                                                          ===========    ===========    ===========
   Diluted                                                $      0.65    $     (0.49)   $      1.04
                                                          ===========    ===========    ===========

WEIGHTED AVERAGE NUMBER OF COMMON SHARES:
   Basic                                                    7,854,053      7,767,744      7,715,996
                                                          ===========    ===========    ===========
   Diluted                                                  8,089,975      7,767,744      8,083,551
                                                          ===========    ===========    ===========
</TABLE>
                   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, 1997, 1996 AND 1995
                      (in thousands, except share amounts)
<TABLE>
<CAPTION>
                                                  Common Stock
                                             ---------------------   Additional              Cumulative
                                              Shares                  Paid-in    Retained    Translation  Treasury
                                              Issued      Amount      Capital    Earnings    Adjustment     Stock        Total
                                             ---------   ---------   ---------   ---------   ----------   ---------    ---------
<S>                                          <C>         <C>         <C>         <C>          <C>         <C>          <C>      
BALANCE, December 31, 1994                   7,691,524   $      77   $  32,052   $  14,430    $       2   $    --      $  46,561

     Stock options exercised                    44,221        --            32        --           --          --             32
     Tax benefit from early disposition
       of incentive stock options (Note 6)        --          --           202        --           --          --            202
     Net income                                   --          --          --         8,417         --          --          8,417
     Translation adjustment                       --          --          --          --             12        --             12
                                             ---------   ---------   ---------   ---------    ---------   ---------    ---------

BALANCE, December 31, 1995                   7,735,745          77      32,286      22,847           14        --         55,224

     Stock options exercised                    44,084           1          11        --           --          --             12
     Tax benefit from early disposition
       of incentive stock options (Note 6)        --          --            32        --           --          --             32
     Net loss                                     --          --          --        (3,831)        --          --         (3,831)
     Purchase of treasury stock                   --          --          --          --           --          (253)        (253)
                                             ---------   ---------   ---------   ---------    ---------   ---------    ---------

BALANCE, December 31, 1996                   7,779,829          78      32,329      19,016           14        (253)      51,184

     Stock options exercised                   148,194           1          50        --           --          --             51
     Tax benefit from early disposition
       of incentive stock options (Note 6)        --          --            41        --           --          --             41
     Net income                                   --          --          --         5,243         --          --          5,243
     Translation adjustment                       --          --          --          --              6        --              6
                                             ---------   ---------   ---------   ---------    ---------   ---------    ---------

BALANCE, December 31, 1997                   7,928,023   $      79   $  32,420   $  24,259    $      20   $    (253)   $  56,525
                                             =========   =========   =========   =========    =========   =========    =========
</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)
<TABLE>
<CAPTION>
                                                                              Years Ended December 31,
                                                                         ---------------------------------
                                                                           1997         1996         1995
                                                                         ---------------------------------
<S>                                                                      <C>            <C>        <C>     
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net income (loss)                                                     $   5,243      $(3,831)   $  8,417
   Adjustments to reconcile net income (loss) to net cash
      provided by operating activities:
       Depreciation and amortization                                         4,135        3,551      2,278
       Provision for (reduction of) accounts receivable
         valuation reserves                                                    (69)          47         (1)
       Provision for (reduction of) inventory valuation reserves            (2,473)       4,015      1,218
       Loss on disposal of assets                                                2           12         24

   Changes in assets and liabilities:
       (Increase) decrease in accounts receivable                           (5,641)       2,469       (624)
       (Increase) decrease in inventories                                   (1,176)       5,082     (5,264)
       (Increase) decrease in other assets                                     505       (1,070)       (32)
       Increase (decrease) in accounts payable and accrued liabilities       4,778        4,296     (3,170)
       Increase (decrease) in taxes payable, net                             1,461       (2,358)    (1,568)
                                                                         ---------    ---------    -------
            Net cash provided by operating activities                        6,765       12,213      1,278
                                                                         ---------    ---------    -------

CASH FLOWS FROM INVESTING ACTIVITIES:
   Purchase of property, plant and equipment                                (3,049)        (948)   (27,051)
   Proceeds from sale of property, plant and equipment                          19            5        326
                                                                         ---------    ---------    -------
            Net cash used for investing activities                          (3,030)        (943)   (26,725)
                                                                         ---------    ---------    -------

CASH FLOWS FROM FINANCING ACTIVITIES:
   Net proceeds from (payments on) notes payable to banks                       -        (3,000)     3,000
   Principal payments on and retirement of long-term debt                       -            -        (182)
   Stock options exercised                                                      52           12         32
   Purchase of treasury stock                                                   -          (253)        -
                                                                         ---------    ---------    ------
            Net cash provided by (used for) financing activities                52       (3,241)     2,850
                                                                         ---------    ---------    -------
   Effect of exchange rate changes on cash                                       4           -          12
                                                                         ---------    ---------    -------

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                         3,791        8,029    (22,585)
CASH AND CASH EQUIVALENTS, beginning of year                                12,580        4,551     27,136
                                                                         ---------    ---------    -------
CASH AND CASH EQUIVALENTS, end of year                                   $  16,371    $  12,580    $ 4,551
                                                                         =========    =========    =======

SUPPLEMENTAL CASH FLOW INFORMATION:
   Interest paid                                                         $       4    $      60    $    12
                                                                         =========    =========    =======
   Income taxes paid                                                     $   1,973    $   1,832    $ 7,296
                                                                         =========    =========    =======
</TABLE>
  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, 1997, 1996 AND 1995




(1)   ORGANIZATION AND OPERATIONS:

The Company designs and manufactures a wide range of user interface  devices for
operational  control and  informational  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,
instrumentation,   consumer  electronic  products,   automotive  equipment,  and
industrial and military control 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  maintains  its  primary  manufacturing  facility  in  Manila,  the
Philippines.   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  $1.7
million to the  subcontractor  to help the  subcontractor in meeting its working
capital needs, all of which have been paid in full in 1997. The Company plans on
incorporating a wholly-owned subsidiary during 1998 which will be engaged in the
manufacturing and sale of the Company's  products in China.  Management  expects
that capital expenditures to acquire the property, plant, and equipment for this
expansion will total approximately $8.0 million in 1998.

During 1995, the Company formed a wholly-owned  subsidiary,  Three-Five  Systems
Pacific, Inc. (Pacific).  Pacific, a Philippines corporation,  procures supplies
primarily from  Philippine  vendors,  as well as manages and assists  production
personnel of a third party subcontractor the Company employs. 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.

(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.

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.
                                      F-7
<PAGE>
         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.

         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  $12,886,000 and $11,243,000 at December 31, 1997 and December
31, 1996, 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  $4,309,000
and $6,782,000 at December 31, 1997 and December 31, 1996, respectively.

Inventories at December 31 consist of the following:

                                                     1997           1996
                                                  ---------      ----------
                                                      (in thousands)

                  Raw materials                   $   6,052      $    3,147
                  Work-in-process                     1,195             780
                  Finished goods                      1,008             679
                                                  ---------      ----------
                                                  $   8,255      $    4,606
                                                  =========      ==========

         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:

                                                     1997           1996
                                                  ----------     -----------
                                                        (in thousands)

                  Building and improvements       $   10,431     $    10,431
                  Furniture and equipment             31,804          28,776
                                                  ----------     -----------
                                                      42,235          39,207
                  Less- accumulated depreciation     (12,388)         (8,294)
                                                  ----------     -----------
                                                  $   29,847     $    30,913
                                                  ==========     ===========
                                      F-8
<PAGE>
The Company  intends to utilize 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 the  future  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 $1,675,000 and
$988,000 at December 31, 1997 and 1996, 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 gain or loss
resulting from the  translation of the  subsidiaries'  financial  statements has
been included as a separate  component of stockholders'  equity. The net foreign
currency  transaction  loss in 1997,  1996 and 1995 was $183,000,  $46,000,  and
$32,000,   respectively,  and  has  been  included  in  other  expenses  in  the
accompanying statements of income (loss).

         Revenue Recognition

The  Company  recognizes  revenue  upon  shipment.   The  Company's  distributor
agreements provide for stock (inventory) rotation and price protection. Reserves
are provided for each of these programs based on past return  experience.  These
reserves  are  established  at the time of  shipment  and reduce  gross sales to
arrive at net sales as presented in the accompanying  consolidated statements of
income  (loss).  These  reserves  are  reflected as a reserve  against  accounts
receivable  from sales to  distributors  and  totaled  $125,000  and  $89,000 at
December 31, 1997 and 1996,  respectively.  The Company's distributors generally
offset any returns and allowances against payments on accounts  receivable.  The
Company also provides  reserves for  uncollectible  accounts  receivable.  These
reserves   totaled  $455,000  and  $560,000  at  December  31,  1997  and  1996,
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,  1997,  1996 and 1995 are  determined  assuming  that
options were exercised at the beginning of each
                                      F-9
<PAGE>
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.  Below are the
disclosures  required  pursuant to SFAS No. 128 for the years ended December 31,
1997, 1996 and 1995 (in thousands, except per share data):

                                                      For the Years
                                                    Ended December 31,
                                                ----------------------------
                                                 1997      1996       1995
                                                -------   -------    -------
    Basic earnings (loss) per share:
      Income available to common shareholders   $ 5,243   $(3,831)   $ 8,417

      Weighted average common shares              7,854     7,768      7,716
                                                -------   -------    -------

                 Basic per share amount         $  0.67   $ (0.49)   $  1.09
                                                =======   =======    =======

    Diluted earnings (loss) per share:
      Income available to common shareholders   $ 5,243   $(3,831)   $ 8,417

      Weighted average common shares              7,854     7,768      7,716
      Options assumed converted                     236      --          368
                                                -------   -------    -------
      Total common shares plus assumed
        conversions                               8,090     7,768      8,084
                                                -------   -------    -------

                 Diluted per share amount       $  0.65   $ (0.49)   $  1.04
                                                =======   =======    =======

(3)   LONG-TERM DEBT:

In May 1997, the Company  entered into a new $15.0 million  unsecured  revolving
line of credit which matures May 22, 1998. This line of credit bears interest at
the bank's  prime rate  (8.50% at December  31,  1997) or at the LIBOR base rate
(5.7% to 6.0% at December 31, 1997) plus 1.75%,  and is payable  monthly.  There
was no balance  outstanding  at December  31,  1997 or 1996.  In  addition,  the
Company  has a  $350,000  United  Kingdom  credit  facility  with  interest  due
quarterly  at the bank's  base rate (7.75% at  December  31,  1997) plus 2%. Any
unpaid balance is due June 20, 1998,  and is secured by United Kingdom  accounts
receivable.  Management  intends to renew the United Kingdom credit facility and
does not anticipate any material changes to the existing terms.

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

(4)   BENEFIT PLANS:

The Company has four stock option plans: 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).

         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  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 1997 Plan.  There were  options  outstanding  to acquire
22,000 shares of the Company's  common stock under the 1997 Plan at December 31,
1997.
                                      F-10
<PAGE>
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 will
be determined by the plan administrator, but may not be less than 100 percent 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 will receive 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 13 months
after the automatic grant 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 percent of
the fair market value of the Company's common stock on the date such options are
granted. There were outstanding options to acquire 9,000 shares of the Company's
common stock under the 1994 Plan at December 31, 1997.

         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  309,750 shares of
the Company's common stock under the 1993 Plan at December 31, 1997.

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 will be determined by the plan  administrator,  but may not be
less than 100 percent (110 percent if the option is granted to a stockholder who
at the time the option is granted owns stock  representing more than ten percent
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 210,220  options  issued but  unexercised  as of
December 31, 1997. In conjunction  with  stockholder  approval of the 1993 Plan,
the Board terminated the 1990 Plan with respect to unissued options
                                      F-11
<PAGE>
to purchase 85,454 shares of common stock which remained and were unissued as of
the date the 1993 Plan was adopted.  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
and 1990 Plans 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 (in thousands, except per share data):
<TABLE>
<CAPTION>
                                                                           1997          1996        1995
                                                                         ---------    ----------   ---------

         <S>                                <C>                          <C>          <C>          <C>
         Net income (loss):                 As reported                  $   5,243    $  (3,831)   $   8,417
                                            Pro forma                        4,785       (4,076)       8,327
         Basic earnings (loss)
           per share:                       As reported                  $   0.67     $   (0.49)   $    1.09
                                            Pro forma                        0.61         (0.52)        1.08
         Diluted earnings (loss)
           per share:                       As reported                  $    0.65    $   (0.49)   $    1.04
                                            Pro forma                         0.59        (0.52)        1.03
</TABLE>

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 1997, 1996 and 1995, respectively:  risk-free interest
rates of 5.45%,  6.31% and 6.31%;  expected  dividend  yields of zero;  expected
lives of 6.4,  6.1 and 5.7  years;  and  expected  volatility  (a measure of the
amount by which a price has  fluctuated  or is  expected to  fluctuate  during a
period) of 60.0%, 61.9% and 58.7%.

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 sold in 1997 was $14.98.
                                      F-12
<PAGE>
A summary of the status of the Company's four stock option plans at December 31,
1997,  1996 and 1995 and changes  during the three years then ended is presented
in the table and narrative below:
<TABLE>
<CAPTION>
                                     1997                        1996                           1995
                           ------------------------  -----------------------------  --------------------------
                                         Weighted                      Weighted                       Weighted
                                          Average                       Average                        Average
                                         Exercise                      Exercise                       Exercise
                             Shares        Price         Shares          Price         Shares           Price
                             ---------   ---------     ---------       --------       ----------      --------
<S>                            <C>        <C>            <C>            <C>              <C>           <C>   
   Outstanding at
     beginning of year         551,776    $   6.92       539,576        $ 8.06           465,326       $ 4.68
   Granted                     200,500       14.63       250,100         11.89           178,000        22.15
   Exercised                  (162,306)       1.34       (44,900)         0.49           (44,250)        0.75
   Expired                     (39,000)      12.23      (193,000)        18.04           (59,500)       29.24
                             ---------                 ---------                      ----------

   Outstanding at
         end of year           550,970    $  11.01       551,776        $ 6.92           539,576       $ 8.06
                             =========                 =========                      ==========

   Exercisable at end of
     year                      165,110                   294,982                         308,940
                             =========                 =========                      ==========
   Weighted average fair
     value of options
     granted                              $   9.19                     $ 7.57                        $  13.19
                                          ========                     ======                        ========
</TABLE>
The following table summarizes  information  about stock options  outstanding at
December 31, 1997:
<TABLE>
<CAPTION>
                                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           1997           Life           Price           1997          Price
              --------------  --------------   ------------   -----------  ---------------   --------

              <S>               <C>              <C>            <C>            <C>             <C>
              $ 0.25 - $9.00      108,720        5.7 years      $   0.77        108,720        $ 0.77
                9.01 - 20.00      422,250        8.0 years         13.06         51,390         13.52
               20.01 - 34.38       20,000        8.9 years         23.23          5,000         26.93
                                ---------        ---------      --------      ---------        ------
                                  550,970        7.6 years      $  11.01        165,110        $ 5.53
                                =========        =========      ========      =========        ======
</TABLE>
         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 $71,000,  $65,000,  and $0 for the years ended  December 31, 1997,
1996, and 1995, respectively.
                                      F-13
<PAGE>
(5)   MAJOR CUSTOMERS:

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.  Beginning  in 1996,  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,   who  accounted  for
approximately  65 percent  and 81 percent of the  Company's  revenue in 1996 and
1995,  respectively,  accounted  for  approximately  35 percent of the Company's
revenue  during  1997.  This  reduced  percentage  occurred  as a result  of the
increased  sales to other  customers  and  reduced  product  selling  prices and
revenues from that major  customer.  The Company's  other  significant  customer
accounted for 32 percent of the  Company's  revenue  during 1997.  Sales to this
customer  were less than 10 percent of the  Company's  revenue  during  1996 and
1995.

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  phone,
computer hardware and other electronic products industries.  These customers are
located primarily in the United States and Europe.

(6)   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  for income taxes for the years ended  December 31 consists of the
following:
<TABLE>
<CAPTION>
                                                                             1997          1996         1995
                                                                          ----------    ----------      --------
                                                                                      (in thousands)
         <S>                                                              <C>           <C>             <C>     
         Current, net of operating loss carryforwards
           and tax credits utilized
                Federal, net of tax benefit from early
                  termination of incentive stock options                  $      356    $      556      $  2,775
                State                                                             97            58           790
                Foreign                                                           71             9         1,681
                                                                          ----------    ----------      --------
                                                                                 524           623         5,246
         Deferred provision (benefit)                                          2,769        (3,575)          100
         Tax benefit from early termination of incentive
           stock options, reflected in stockholders' equity                       41            32           202
                                                                          ----------    ----------      --------
                Provision (benefit) for income taxes                      $    3,334    $   (2,920)     $  5,548
                                                                          ==========    ==========      ========
</TABLE>

In  accordance  with SFAS No.  109, a tax benefit  for net  operating  losses of
approximately  $35,000,  $102,000,  and $67,000 and tax credits of approximately
$0, $938,000, and $1,478,000 utilized in 1997, 1996, and 1995, respectively, are
included as a reduction of the  provision  for income taxes in the  consolidated
statements of income (loss).
                                      F-14
<PAGE>
The components of deferred taxes at December 31 are as follows:
<TABLE>
<CAPTION>
                                                                                           1997           1996
                                                                                        ---------       --------
                                                                                              (in thousands)
         <S>                                                                            <C>             <C>     
         Net long-term deferred tax liabilities:
           Accelerated tax depreciation                                                 $   2,685       $  1,535
           Other                                                                               33             33
                                                                                        ---------       --------

                                                                                        $   2,718       $  1,568
                                                                                        =========       ========
         Net short-term deferred tax assets:
           Inventory reserve                                                            $   1,721       $  2,675
           Uniform capitalization                                                           1,251          1,868
           Accrued liabilities not currently deductible                                     1,080          1,080
           Allowance for doubtful accounts                                                    156            196
           Tax effect of regular U.S. net operating loss carry forward                        166            189
           Other                                                                               91             76
                                                                                        ---------       --------
                                                                                            4,465          6,084
           Valuation allowance                                                               (154)          (154)
                                                                                        ---------       --------
                                                                                        $   4,311       $  5,930
                                                                                        =========       ========
</TABLE>

SFAS No. 109  requires  the  reduction  of  deferred  tax assets by a  valuation
allowance if, based on the weight of available evidence,  it is more likely than
not that some or all of the  deferred  tax  assets  will not be  realized.  As a
result of certain  limitations  on the use of net operating  loss  carryforwards
acquired in the ERA acquisition,  a valuation allowance has been established for
those net operating losses not likely to be realized.

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

                                              1997         1996          1995
                                             ------       ------        ------

         Statutory federal rate                  34%          34%           34%
         Effect of state taxes                    5            6             6
         Other                                   -             3            -
                                             ------       ------        ------
                                                 39%          43%          40%
                                             ======       ======        ======

Net operating loss carryforwards for federal tax purposes totaled  approximately
$490,000 at December  31,  1997.  The use of these  carryforwards  is limited to
$67,000 per year and they expire through 2003.

(7)   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.  In February  1997,  the Company  exercised its option to renew the
lease for two years. The lease expires March 31, 1999.

Rent  expense was  approximately  $793,000,  $477,000 and $683,000 for the years
ended December 31, 1997, 1996, and 1995, 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 new
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-15
<PAGE>
The Company's future lease commitments under the non-cancelable operating leases
as of December 31, 1997, are as follows (in thousands):

                  1998                             $    419
                  1999                                  372
                  2000                                  100
                  2001                                  100
                  2002                                  100
                  Thereafter                          6,625
                                                   --------
                                                   $  7,716
                                                   ========

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.

(8)   GEOGRAPHIC SEGMENTS:

Sales by geographic  area and  identifiable  assets for the years ended December
31, 1997, 1996, and 1995 were as follows:
<TABLE>
<CAPTION>
                                                   North
                                                  America      Europe      Pacific Rim  Eliminations    Consolidated
                                                 ---------    ---------    -----------  ------------    ------------
                                                                            (in thousands)
<S>                                              <C>          <C>          <C>           <C>              <C>      
December 31, 1997:
   Net sales                                     $  73,887    $  10,755    $      -      $       -        $  84,642
   Transfers to Europe                               9,136           -            -          (9,136)             -
   Transfers to North America                           -            -         3,107         (3,107)             -
                                                 ---------    ---------    ---------     ----------       --------

           Total revenue                         $  83,023    $  10,755    $   3,107     $  (12,243)      $  84,642
                                                 =========    =========    =========     ==========       =========
   Net income                                    $   4,728    $     404    $      65     $       46       $   5,243
                                                 =========    =========    =========     ==========       =========
   Identifiable assets                           $  61,307    $   4,896    $   7,431     $     (799)      $  72,835
                                                 =========    =========    =========     ==========       =========

December 31, 1996:
   Net sales                                     $  32,899    $  27,814    $      -      $       -        $  60,713
   Transfers to Europe                              25,810           -            -         (25,810)             -
   Transfers to North America                           -            -         1,494         (1,494)             -
                                                 ---------    ---------    ---------     ----------       --------

           Total revenue                         $  58,709    $  27,814    $   1,494     $  (27,304)      $  60,713
                                                 =========    =========    =========     ==========       =========
   Net income (loss)                             $  (4,005)   $      19    $      12     $      143       $  (3,831)
                                                 =========    =========    =========     ==========       =========
   Identifiable assets                           $  52,951    $   3,824    $   6,164     $     (370)      $  62,569
                                                 =========    =========    =========     ==========       =========

December 31, 1995:
   Net sales                                     $  24,235    $  67,350    $      -      $       -        $  91,585
   Transfers to Europe                              60,361           -            -         (60,361)             -
   Transfers to North America                           -            -         1,437         (1,437)             -
                                                 ---------    ---------    ---------     ----------       --------

           Total revenue                         $  84,596    $  67,350    $   1,437     $  (61,798)      $  91,585
                                                 =========    =========    =========     ==========       =========

   Net income (loss)                             $   5,093    $   3,353    $     (46)    $       17       $   8,417
                                                 =========    =========    =========     ==========       =========
   Identifiable assets                           $  50,779    $   8,491    $   7,789     $   (3,279)      $  63,780
                                                 =========    =========    =========     ==========       =========
</TABLE>
                                      F-16
<PAGE>
                            THREE-FIVE SYSTEMS, INC.
          SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
             FOR THE YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995
<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
December 31, 1997             $  649         (105)           36(1)         --             $  580

Year ended
December 31, 1996             $  603           14            32(1)         --             $  649

Year ended
December 31, 1995             $  604          (36)           35(1)         --             $  603


Inventory Reserve:
------------------


Year ended
December 31, 1997             $6,782        1,114                        (3,587)(2)       $4,309

Year ended
December 31, 1996             $2,767        5,939           142(2)       (2,066)(2)       $6,782

Year ended
December 31, 1995             $1,548        1,563           391(3)         (735)(2)       $2,767
</TABLE>

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