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SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
   FORM 10-K ANNUAL REPORT PURSUANT
TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934
 For the fiscal year ended December 31, 2004 Commission file number 1- 4373   THREE-FIVE SYSTEMS, INC. 
  Delaware
    
    86 - 0654102(State or Other Jurisdiction
    
    (I.R.S. Employer Identification No.)of Incorporation or Organization)
 1600 North Desert Drive, Tempe, Arizona
    
    85281(Address of Principal Executive Offices)
    
    (Zip Code)
 (602) 389-8600(Registrants telephone number, including area code)
 Securities registered pursuant to Section 12(b) of the Exchange Act: Title of Each Class
    
    Name of Each Exchange on Which RegisteredCommon Stock, par value $.01 per share
    
    New York Stock ExchangePreferred Stock Purchase Rights
    
    New York Stock Exchange
 Indicate by check mark whether the registrant: (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation
S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in
definitive proxy or information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. o Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange
Act Rule 12b-2). Yes þ No o The aggregate market value of Common Stock held by nonaffiliates of the registrant (17,362,905
shares) based on the closing price of the registrants Common Stock as reported on the New York
Stock Exchange on June 30, 2004, which was the last business day of the registrants most recently
completed second fiscal quarter, was $88,550,816. For purposes of this computation, all officers,
directors, and 10% beneficial owners of the registrant are deemed to be affiliates. Such
determination should not be deemed to be an admission that such officers, directors, or 10%
beneficial owners are, in fact, affiliates of the registrant. As of March 28, 2005, there were outstanding 21,767,653 shares of the registrants Common
Stock, par value $.01 per share. Documents Incorporated by Reference Portions of the registrants definitive Proxy Statement for the 2005 Annual Meeting of
Stockholders are incorporated by reference into Part III of this Form 10-K. If for any reason such
statement is not filed within 120 days after the close of the fiscal year ended December 31, 2004,
this annual report will be appropriately amended.




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THREE-FIVE SYSTEMS, INC. ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2004 TABLE OF CONTENTS PART IITEM 1. BUSINESS
    
    
    1ITEM 2. PROPERTIES
    
    
    18ITEM 3. LEGAL PROCEEDINGS
    
    
    19ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
    
    
    19PART IIITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
    
    
    19ITEM 6. SELECTED FINANCIAL DATA
    
    
    19ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
    
    
    20ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
    
    
    38ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
    
    
    39ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
    
    
    39ITEM 9A. CONTROLS AND PROCEDURES
    
    
    39ITEM 9B. OTHER INFORMATION
    
    
    42PART IIIITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
    
    
    42ITEM 11. EXECUTIVE COMPENSATION
    
    
    42ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
    
    
    42ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
    
    
    42ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
    
    
    42PART IVITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
    
    
    43SIGNATURES
    
    
    47INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
    
    
    F-1EX-10.34EX-10.35EX-10.36EX-10.37EX-21EX-23.1EX-31.1EX-31.2EX-32.1EX-32.2
  __________________ Statement Regarding Forward-Looking Statements The statements contained in this report on Form 10-K that are not purely historical are
forward-looking statements within the meaning of applicable securities laws. Forward-looking
statements include statements regarding our expectations, anticipation, intentions,
beliefs, or strategies regarding the future. Forward-looking statements also include
statements regarding revenue, margins, expenses, and earnings analysis for fiscal 2005 and
thereafter; technological innovations; future products or product development; our product
development strategies; potential acquisitions or strategic alliances; the success of particular
product or marketing programs; the amounts of revenue generated as a result of sales to significant
customers; and liquidity and anticipated cash needs and availability. All forward-looking
statements included in this report are based on information available to us as of the filing date
of this report, and we assume no obligation to update any such forward-looking statements. Our
actual results could differ materially from the forward-looking statements. Among the factors that
could cause actual results to differ materially are the factors discussed in Item 1, Business 
Risk Factors. i




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PART I 
 ITEM 1. BUSINESS Overview We are a global provider of electronics manufacturing services, or EMS. We design and/or
manufacture electronic printed circuit board assemblies, radio frequency, or RF, modules, display
modules and systems, and complete systems for customers in the computing, consumer, industrial,
medical, telecommunications and transportation industries. Our services include advanced
engineering support, designed for services, automated printed circuit board assembly, in-circuit
and functional testing, systems level integration and box build, and turn-key supply chain
management services, all of which enable our customers the ability to outsource all stages of
product engineering, design, development, materials procurement and management, manufacturing, and
testing. Our design and manufacturing services include a distinctive competence in display modules
and systems and the integration of display modules and systems into other products. The display
modules and systems we design and manufacture primarily utilize liquid crystal displays, or LCDs.
Those LCDs include small form factor monochrome and color LCDs, including thin film transistor
LCDs, or TFTs, as well as large format flat panel monitors, all of which are TFTs. We refer to the
business involving displays as our Display business. All other business, other than the Display
business, is referred to herein as the EMS business. The products we manufacture for customers are of varying sizes and have varying levels of
integration. The typical design program life cycle of a custom-designed product is three to
fifteen months and includes technical design, prototyping, pilot manufacturing, and high-volume
manufacturing. The cycle is shorter for products in which no display is involved or when the
customer has already completed the design. Our website is located at www.tfsc.com. Through our website, we make available free
of charge our annual report on Form 10-K, our proxy statement, our quarterly reports on Form 10-Q,
our current reports on Form 8-K, any amendments to those reports filed or furnished under the
Securities Exchange Act, and our earnings press releases. These reports and press releases are
available as soon as reasonably practical after we electronically file them with the Securities and
Exchange Commission. We also post on our website the charters of our Audit, Compensation, and
Nominating/Corporate Governance Committees; our Corporate Governance Guidelines, Code of Business
Conduct and Ethics, and Code of Ethics for the CEO and Senior Financial Officers, and any
amendments of or waiver thereto; and any other corporate governance materials contemplated by SEC
and NYSE regulations. These documents are also available in print to any stockholder requesting a
copy from our corporate secretary at our principal executive offices. Industry Overview Historically, original equipment manufacturers, or OEMs, have been fully integrated,
performing the engineering and design, new product introduction, assembly and manufacturing,
testing, procurement, distribution and logistics, and aftermarket support functions for their
products. In recent years, however, OEMs have been under intense pressure to reduce costs, focus
on core competencies, and reduce supply chain investment. In response, OEMs have increasingly
outsourced these functions to EMS companies. By focusing on these functions, we believe that EMS
companies provide OEMs with cost savings, superior technological know-how, and access to more
advanced manufacturing processes. These services enable OEMs to concentrate on their core
competencies, such as product development, marketing, and sales. As a result of this outsourcing
strategy, many OEMs are divesting a significant portion of their manufacturing facilities, and many
newer OEMs are choosing to outsource rather than add additional capital equipment and build
internal manufacturing infrastructures. Today, the EMS industry consists of companies that provide a broad range of services,
including engineering and design, new product introduction, printed circuit board assembly, or
PCBA, box build, testing, distribution and logistics, and aftermarket support services for OEMs in
the electronics industry. The trend toward outsourcing by OEMs has continued in recent years, as
OEMs have been under increased pressure to pursue aggressive cost savings. In addition, OEMs have
continued to move manufacturing programs to lower cost regions and sought EMS providers with global
footprints. Although EMS industry revenue declined in recent years as a result of significant cutbacks in
customer production requirements, industry revenue has slowly begun to increase again over the last
year as inventories have declined and customer production requirements generally have begun to
stabilize. We believe further growth opportunities exist for EMS providers to penetrate the
worldwide electronics markets. We also believe that an EMS




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provider with a global presence will grow faster than the industry average because of the
ability to offer multinational OEMs a comprehensive set of outsourced services through a single
global manufacturing platform. The factors driving OEMs to favor an outsourcing strategy include the following:  
    Reduce Operating Costs and Capital Investment.In the current economic environment,
OEMs are under significant pressure to reduce manufacturing costs and capital
expenditures. EMS companies can provide OEMs with flexible, cost-efficient
manufacturing services. In addition, as OEM products have become more technologically
advanced, the manufacturing and system test processes have become increasingly
automated and complex, requiring significant capital investments. EMS companies enable
OEMs to access technologically advanced manufacturing and test equipment and facilities
without additional capital expenditures.
    Access Global Manufacturing Services.OEMs seek to reduce their manufacturing costs
by having EMS companies manufacture their products in the lowest cost locations that
are appropriate for their products and end customers. OEMs also are increasingly
requiring particular products to be manufactured simultaneously in multiple locations,
often near end users, to bring products to market more quickly, reduce shipping and
logistics costs, and meet local product content requirements. Global EMS companies are
able to satisfy these requirements by capitalizing on their geographically dispersed
manufacturing facilities, including those in lower cost regions.
    Accelerate Time to Market.OEMs face increasingly short product life cycles
resulting from increased competition and rapid technological changes. As a result, OEMs
must reduce the time required to bring their products to market. OEMs can bring a
product to market faster by using EMS companies expertise in new product introduction,
including manufacturing design, engineering support, and prototype production. OEMs
can more quickly achieve volume production of their products by capitalizing on EMS
companies manufacturing expertise and global presence and infrastructure.
    Ability to Focus on Core Competencies. By shifting design, manufacturing, testing,
logistics and distribution, and aftermarket support functions to EMS companies, OEMs
can focus their resources on their core competencies, including product development,
marketing, and sales.
    Access to Engineering and Manufacturing Technologies. OEMs continually seek access
to engineering expertise and manufacturing technologies necessary to build their
increasingly complex products, such as displays, as described below. OEMs are
motivated to work with EMS companies to gain access to their expertise in product
design, assembly, manufacturing, and testing technologies.
    Reduced Supply Chain Investment. Outsourcing to EMS companies allows OEMs to enter
into short-term manufacturing contracts and lower their investment in inventory and
long-term manufacturing assets, enabling them to increase their return on assets. As a
result, OEMs can react more quickly to changing market conditions and allocate capital
to other core activities. As part of our suite of electronics manufacturing services, our expertise in display systems
differentiates us from competitors. Displays are a prevalent feature in many OEM products. OEMs
increasingly believe that a display interface is important because it makes products more useful
and easier to operate. Custom LCDs, including both monochrome and color displays, address
requirements for high performance, increased information content, low power, and low cost. Custom-designed display modules provide OEMs a cost-effective means to differentiate their
products from the products of their competitors. In designing a product, an OEM must determine
whether to use standard off-the-shelf display modules or a custom display module. OEMs recognize
that standard off-the-shelf displays may be more cost-effective, but make it more difficult to
differentiate their products from those of their competitors. Our EMS services include custom display solutions and standard display products. Our focus is
on LCD display technologies. Historically, our emphasis was on small form factor displays, but
since 2002 we have also offered our customers monitors with large-format displays for use in
industrial and governmental applications. Products and Services We provide integrated design, manufacturing, and supply chain solutions that address all
stages of our customers product life cycles, including advanced engineering and design, new
product introduction and prototyping, global supply chain management, printed circuit board
assembly, display module assembly, RF module 2




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assembly, box build, testing, logistics and distribution, and aftermarket services. We also
provide a wide range of aftermarket support, such as repairs, refurbishment, systems upgrades, and
spare part manufacturing. By providing these design, engineering, manufacturing, and logistics
services, we enable our customers to focus on their core competencies and to enhance their
competitiveness by reducing the cost of their products, increasing product performance and
functionality, and shortening the time from product conception to product introduction in the
marketplace. Engineering and Design. We offer engineering, design, and related services for new products
and assist our customers in designing products for optimal manufacturing and testing. Our design
for manufacturability service seeks to achieve defect-free and cost-effective product designs,
reduce product development cycles, create high production yields, and establish superior product
quality. Our design for testability service focuses on achieving the highest level of in-circuit
and functional test coverage prior to product shipment. Our engineering and development activities
also focus on display products intended to meet the requirements of our target markets. We add
value for our customers through our ability to integrate the design and production process, which
reduces the time between product conception and market introduction. Our emphasis on engineering
and manufacturing services has positioned us to develop unique product solutions for our customers
as they seek displays with more information content at lower cost. New Product Introduction and Prototyping. We offer technical services that shorten the time
it takes our customers to introduce their products into the market and that help them to optimize
the commercial manufacturing of their products. Our integrated approach draws on our engineering,
design, supply chain management, prototyping and production manufacturing, quality, and test
engineering experience to enable a fast, cost-effective ramp to volume production. We are able to
assist our customers with component selection, materials strategies, supply chain development,
manufacturing process development, reliability modeling, quality plan development, and test plan
implementation. Supply Chain Management. Our global supply chain services include materials, logistics, and
storage of materials for the manufacturing of custom products and deliveries of those products to
our customers. Our supply chain process starts by selecting suppliers that provide high levels of
quality, flexibility, competitive prices, and value added delivery programs, all on a global basis
to service those needs. We have established with our suppliers various delivery mechanisms from
supplier delivery vehicles to consolidated shipping containers. These methods vary based on cost
and proximity. These suppliers must also meet ongoing reviews for total cost reduction,
flexibility, and quality. Our global supply chain provides value to our customers by increasing
flexibility, reducing risk, improving time-to-market, and lowering cost. Assembly and Manufacturing. We provide turnkey and consigned manufacturing and assembly
services. These services include printed circuit board and subsystems assembly, display modules
and systems, RF modules, box build, system and subsystem integration, downloading software, and
building and configuring the final product. Display Products.Our services include display products incorporating both monochrome and
color LCDs. We utilize inquiries from customers for display products to offer a manufacturing
solution for the customers entire product. We typically deal with customers seeking custom
designed displays that provide unique functionality and differentiation. Our large-format monitor
products offer customized solutions for the industrial, human-machine interface, and kiosk markets
and integrate various levels of system solutions, including innovative features like wireless
interfaces. Platform Display Business.In the custom display business in 2004, we also began to devote
significant effort to TFT color displays. TFT is the acronym for thin-film transistor and is the
type of color LCD display typically used in a laptop computer or monitor. Those displays are now
becoming prevalent in mobile phone handsets, which is our principal market focus. We refer to the
TFT business as Platform business because it is not cost effective to create a custom LCD for
every product. Instead, we create a platform of semi-custom LCDs and then further customize a
module to fit a customers unique handset design. Product Testing. We offer in-circuit testing of printed circuit boards and functional testing
of subsystems and systems, which contributes significantly to our ability to deliver high-quality
products on a consistent basis. We work with our customers to develop product-specific test
strategies. Our test capabilities include design for test and manufacturing defect analysis,
in-circuit development and implementation, and functional tests. We either custom design test
equipment and software ourselves or use test equipment and software provided by our customers. In
addition, we provide environmental stress tests to assure reliability. 3




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Logistics and Distribution. We offer flexible services related to the configuration and
shipment of our customers products. We perform final product packaging, out-of-box audit, and
distribution services for completed products as well as direct order fulfillment. We can deliver
final products directly into our customers distribution channels and to our customers end-users.
We believe that these services compliment our comprehensive manufacturing solutions, enabling our
customers to be more responsive to changing market demands and to get their products to market more
quickly at a lower total cost. Aftermarket Service. We provide a wide range of aftermarket services, including repair,
refurbishment, remanufacturing, system upgrades, and spare part manufacturing. These services are
supported by specific information systems and testing technologies and can be tailored to meet
specific customer requirements. Other Business Factors Sales and Marketing We achieve worldwide sales coverage through a direct sales force and direct sale
representatives that focus on generating new accounts. Program managers are responsible for
managing relationships with existing customers and making follow-on sales. Application engineers
work with their counterparts at customers to ensure all technical details are addressed. In
addition to our sales force, program managers, and application engineers, our executive staff plays
an integral role in our sales efforts. Our sales to customers in North America represented approximately 54.0% of net sales in 2003
and 62.2% of net sales in 2004. Our sales to customers in Asia represented approximately 20.5% of
net sales in 2003 and 18.4% of net sales in 2004. Our sales to customers in Europe represented
approximately 25.5% of net sales in 2003 and 19.4% of net sales in 2004. Our sales to customers in our EMS business represented approximately 50.6% of net sales in
2003 and 66.6% of net sales in 2004. Our sales to customers in our Display business represented
approximately 49.4% of net sales in 2003 and 33.4% of net sales in 2004. Customers Our customers include large multinational and smaller OEMs that have chosen outsourcing as a
core manufacturing strategy. We service a diverse range of industries, including medical,
industrial, telecommunications, transportation, consumer, and computing. We believe we are able to
offer customers an outsourcing solution that involves lower costs than typically would be provided
by their internal operations. We seek to differentiate ourselves from our competitors by providing
advanced methodologies and capabilities and exceptional customer focus by integrating our services
into our customers operations. Additionally, we also offer unique expertise in designing and
manufacturing display systems and RF modules. We believe that providing display modules as part of
our EMS offering provides us with a unique value proposition in our target markets. The printed
circuit board assembly and the display represent a large portion of an OEMs bill of materials,
thus allowing us to offer one-stop shopping. In fiscal 2004, our ten largest customers accounted for approximately 71% of our net sales.
Our largest customer during fiscal 2004 was Avocent, accounting for approximately 38% of net sales.
No other customer accounted for more than 10% of net sales in fiscal 2004. 4




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The following table lists in alphabetical order a representative sample of our largest
customers in fiscal 2004 and the products of those customers for which we provide manufacturing
services: Customer
    
    End ProductsAvocent
    
    KVM (keyboard, video, mouse) server switchesHypercom
    
    POS (point of sale) terminalsIsilon
    
    Data storage for video server marketInverness
    
    Consumer medical (glucometers)Invensys
    
    Industrial controlsMicrotune
    
    RF modulesMotorola
    
    Telematics
 Backlog As of December 31, 2004, we had a backlog of orders of approximately $47.0 million. The
backlog of orders as of December 31, 2003 was approximately $46.7 million. Our backlog consists of
product orders for which confirmed purchase orders or fixed forecasts have been received and which
are scheduled for shipment within 12 months. Orders are typically given with only a six to eight
week lead time. Some of our largest customers provide purchase orders of only one week and fixed
forecasts beyond the one week. Most orders are subject to rescheduling or cancellation by the
customer with limited penalties. Because of the possibility of customer changes in delivery
schedules or cancellations and potential delays in product shipments, our backlog as of a
particular date may not be indicative of net sales for any succeeding period. Components and Raw Materials We purchase raw materials and electronic components from manufacturers and distribution
companies. The key electronic components we purchase include printed circuit boards, specialized
components, such as application-specific integrated circuits, LCD glass, semiconductors,
interconnect products, electronic subassemblies (including memory modules, power supply modules,
and cable and wire harnesses), inductors, resistors, and capacitors. Along with these electronic
components, we also purchase components for use in higher-level assembly and manufacturing. These
components include injection-molded plastics, pressure-formed plastics, vacuum-formed plastics,
sheet metal fabrications, aluminum extrusions, die castings, and various other hardware and
fastener components. These components range from standard to highly customized, and they vary
widely in terms of market volatility and price. From time to time, allocation of components by suppliers becomes an integral part of the
electronics industry, and component shortages can occur with respect to particular components. In
response, we actively manage our business in a way to minimize our exposure to materials and
component shortages. We create strong supplier alliances to ensure, to the extent possible, a
steady flow of components at competitive prices. We have also established and continue to expand
our strategic relationships with international purchasing offices, and we attempt to leverage our
design position with suppliers. Our procurement strategy is to secure alternative supply sources for the majority of these
materials. Many of these materials, however, must be obtained from foreign suppliers, which
subjects us to the risks inherent in obtaining materials from foreign sources, including supply
interruptions and currency fluctuations. Our suppliers generally are meeting our requirements, and
we believe our strategic supplier alliances have further strengthened our relations with offshore
suppliers. We have experienced material shortages in the past. Those shortages prevented us from
meeting customer demand for certain services. Similar shortages in the future could have a
material adverse effect on our business. We attempt to procure components and other raw materials only when a purchase order or
forecast is received from a customer. We experience component shortages and longer lead times for
various components and raw materials from time to time. We generally have been able to reduce the
impact of shortages by working with customers to reschedule deliveries and by working with
suppliers to provide the needed components using just-in-time vendor managed or consigned inventory
programs. 5




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Intellectual Property We own various service marks, including Three-Five Systems, the stylized TFS, and our
logo. Although we own certain patents, they are not currently material to our business. We do not
have any material copyrights. Information Technology We are implementing a multi-year phased roll-out of a new enterprise resource planning, or
ERP, platform for certain of our locations. This ERP platform is intended to augment our management
information systems and includes software from SAP and several other vendors. The ERP platform is
intended to enhance and standardize our ability to translate information globally from production
facilities into operational and financial information and to create a consistent set of core
business applications at our worldwide facilities, although we will not necessarily convert all of
our facilities to the same system. We believe that the related licenses are of a general commercial
character on terms customary for these types of agreements. We have invested approximately $2.1
million as of December 31, 2004 for the new ERP platform. In February, this implementation project
was put on hold as we evaluate our situation regarding the possible sale of our Manila facility and
the move of our corporate headquarters. Our current plan is to restart the implementation in the
second half of 2005. Employees We currently employ approximately 1,800 full-time employees. Given the quick response time
required by our customers, we seek to maintain flexibility to scale our operations as necessary to
maximize efficiency. To do so, we use skilled temporary labor in addition to our full-time
employees. None of our employees are covered by union agreements. We have no history of labor
disputes at any of our facilities. We believe that our employee relationships are good. Competition We believe Benchmark Electronics, Plexus, Pemstar, Suntron, and other smaller, proximity-based
domestic EMS providers constitute our principal competitors. In addition, we believe that AU
Optronics Corp., Philips, Samsung, Seiko-Epson, Hosiden, Optrex, Seiko Instruments, International
Displayworks, Wintek, and Sharp constitute the principal competitors for our EMS services involving
display solutions. We compete primarily on the basis of engineering, design, testing, and
production capabilities; our technological know-how; the responsiveness, quality, flexibility, and
price of our services; and geographic locations. Many of our competitors have substantially
greater manufacturing, financial, and research and development resources than we possess and offer
broader geographic operations and a greater range of services than we do. We also face competition
from the manufacturing operations of current and potential customers, which continually evaluate
the benefits of internal manufacturing versus outsourcing. Acquisitions and Strategic Ventures In September 2002, we purchased the assets and ongoing business of Advanced Video
Technologies, a privately held company, located in Marlborough, Massachusetts that specialized in
the design and integration of complex, high-resolution display systems. As a result, we now design
and provide customized and ruggedized flat panel, touchscreen, and rackmount systems for OEMs in
the industrial and medical markets. We outsource display components from a variety of companies,
including Sony, Sharp, NEC, LG, and Samsung. The purchase price of the acquisition was $12.0
million, which we paid entirely in cash. In December 2002, we purchased the stock of ETMA Corporation, located in Redmond, Washington,
a privately held electronics manufacturer for OEM customers in the computer peripheral, medical
monitoring, and Internet security industries. As a result, we now offer the manufacturing
capabilities of five surface mount manufacturing lines, including one dedicated to new product
introduction and prototyping activity. We also provide engineering support, automated printed
circuit board assembly, in-circuit and functional testing, systems integration and box build,
complete supply chain management, and turnkey packaging and fulfillment services. The purchase
price of the ETMA acquisition was $38.1 million, which we paid entirely in cash. In January 2003, we signed licensing and manufacturing agreements with Data International Co.,
Ltd. of Taiwan. Under those agreements, we became the exclusive channel in the Americas for LCD
products 6




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manufactured by Data International. We also obtained the right to sell those products through our
worldwide channels. In conjunction with the agreement, we established a sales office in Orlando,
Florida, and hired sales and applications engineering personnel from a distributor that had
previously supported Data Internationals products. The cost of the license was $3.9 million, of
which $1.0 million was paid upon signing and $2.9 million was a term loan. In the first quarter of
2004, we paid $1.4 million against the term loan. The remaining $1.5 million was due in January
2005, although it was subject to a reduction if certain margin targets were not met. As a result
of a dispute with Data International, however, that note has not yet been paid. We recently
determined that certain of the specified Data International display products have been
simultaneously available in the United States through a third party and that we had not been
provided exclusive distribution rights to the United States market as required by the license.
Based on that determination, we believe that the license was breached, and we are exercising our
rights of rescission. We notified Data International in February 2005 that we will not make the
final $1.5 million payment to Data International that was due in January 2005. We also asserted
damages of at least $2.5 million, plus interest and other expenses, against Data International. We
also notified Data International that we will off-set our claimed damages against money owed by us
to Data International for product purchases. We recently filed a complaint against Data
International in Arizona requesting a declaratory judgment for breach of contract. In March 2003, we signed an agreement with Microtune, Inc. under which we agreed to
manufacture, assemble, and test Microtunes radio frequency, or RF, tuner modules and wireless
module products in our manufacturing facility in Manila, the Philippines. As part of the agreement,
Microtune sold to us certain of its own equipment and inventory for $8.2 million, of which we paid
$2.7 million with a note payable due in September 2003, and contracted with us to provide 100% of
Microtunes current demand for fully assembled RF subsystems. We also hired approximately 500
Microtune employees in Manila. In October 2003, we paid off approximately $300,000 of the $2.7
million note payable to Microtune and entered into an agreement to cancel the remaining $2.4
million balance on that note in exchange for the return of certain excess inventory to Microtune.
As a result of this transaction, we now provide 100% of the manufacturing outsourcing for
Microtunes RF module products. We recently announced that we are exploring the possible sale of
our Manila facility. If that occurs, it is likely that the Microtune business would be sold along
with the facility. In April 2003, we acquired the business and certain assets of Unico Technology Bhd., a
privately held Malaysian company located in Penang. Unico was an electronics manufacturer for OEM
customers in the computer, computer peripheral, and communications industries. The Unico business
was acquired by TFS Electronics Manufacturing Services Sdn. Bhd., or TFS-Malaysia, a former joint
venture owned 60% by an overseas TFS subsidiary and 40% by Unico Holdings Bhd., the former parent
of Unico. Unico Holdings is the investment arm of the Chinese Chamber of Commerce of Malaysia. Our
share of the initial cost of capitalizing TFS-Malaysia was $3.8 million and Unico Holdings share
was $2.5 million, most of which was used for working capital. TFS-Malaysia purchased $4.1 million
in inventory from Unico, of which $2.7 million was paid at the time of the purchase and $1.4
million was subsequently paid. No advance payment was required for the acquisition of the
property, plant, and equipment of Unico, all of which is leased from the seller. The equipment
lease is accounted for as a capital lease payable by TFS-Malaysia. The principal balance on that
lease was $6.1 million as of December 31, 2004. In the second quarter of 2004, Unico Holdings
exchanged its ownership interest in TFS-Malaysia for approximately 423,000 shares of our common
stock held in treasury in a transaction valued at $2.8 million, compared with Unico Holdings
interest of $2.6 million. As a result of that transaction, we now own 100% of TFS-Malaysia. In February 2004, we entered into a transaction with Integrex, a Seattle-based electronics
manufacturing services company that was liquidating its business. Under that transaction, we
bought the raw materials inventory of Integrex for $1.4 million and hired certain of its employees.
We also obtained the rights to most of its customers and agreed with those customers that we would
manufacture those customers products in our Redmond manufacturing facility. In exchange for those
customer rights, we agreed to pay a license fee for between 15 and 24 months based on revenue
receipts from former Integrex customers. In February 2004 and at a second closing in April 2004, we
paid $1.3 million in non-refundable license fees to Integrex. At the second closing in April, we
also acquired $300,000 of capital equipment. We have since renegotiated the license fees, reducing
the percentage fee on specific customers and, in one instance, extending by three months the time
during which the reduced fee is paid. Government Regulation Our operations are subject to certain federal, state, and local regulatory requirements
relating to environmental, waste management, health, and safety matters. We believe we operate in
substantial compliance 7




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with all applicable requirements. There can be no assurance, however, that material costs and
liabilities will not arise from complying with these requirements or from complying with new,
modified, or more stringent requirements. In addition, our past, current, or future operations may
give rise to claims of exposure by employees or the public or to other claims or liabilities
relating to environmental, waste management, or health and safety concerns. Our operations create a small amount of hazardous waste, including various epoxies, gases,
inks, solvents, and other wastes. The amount of hazardous waste we produce may increase in the
future depending on changes in our 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. Executive Officers The following table sets forth certain information regarding our executive officers: Name
    
    Age
    
    PositionJack L. Saltich
    
    
    61
    
    
    President, Chief Executive Officer, and DirectorJames E. Jurgens
    
    
    56
    
    
    Interim Chief Financial OfficerDavid K. McQuiggan
    
    
    41
    
    
    Senior Vice President  Platform Display ProductsVan H. Potter
    
    
    46
    
    
    Senior Vice President  Electronic Manufacturing ServicesEric W. Haeussler
    
    
    44
    
    
    Corporate Controller and Principal Accounting Officer
 
 Jack L. Saltichhas served as a director and the President and Chief Executive Officer of our
company since July 1999. Mr. Saltich served as Vice President of Advanced Micro Devices from May
1993 until July 1999; as Executive Vice President of Applied Micro Circuits Corp. from January 1991
until March 1993; and as Vice President of VLSI from July 1988 until January 1991. Mr. Saltich
held a variety of executive positions for Motorola from July 1971 until June 1988. These positions
included serving as an Engineering Manager from May 1974 until January 1980, an Operation Manager
from January 1980 until May 1982, a Vice President and Director of the Bipolar Technology Center
from May 1982 until June 1986, and a Vice President and Director of the Advanced Product Research
and Development Laboratory from June 1986 until June 1988. Mr. Saltich serves as the Chairman of
the Board of Brillian Corporation, a public company that designs and sells microdisplay products;
as a member of the board of directors of Immersion Corporation, a public company that develops,
licenses, and markets haptic technology and products; and as a member of the board of directors of
Vitex Systems, Inc., a private company that commercializes transparent ultra-barrier films for use
in flat panel displays. James E. Jurgenshas served as Interim Chief Financial Officer of our company since February,
2005. Mr. Jurgens has been working with our company as a consultant since August 2004. From 2001
to 2003, Mr. Jurgens was an Operations Director for Intel Corporation. From 1999 to 2001, Mr.
Jurgens was Chief Financial Officer and Operations Director of Ziatech Corporation, a privately
held developer of embedded computers for telecom applications. From 1994 to 1999, Mr. Jurgens was
Chief Financial Officer/Prokurist and European Finance Director for Advanced Micro Devices GmbH. David K. McQuigganhas served as Senior Vice President of Platform Display Products of our
company since October 2004. Mr. McQuiggan served as Chief Executive Officer of Densitron
Technologies, PLC from 2002 to 2004; General Management of North American Operations from 2000 to
2002; Vice President of Marketing and Business Development from 1998 to 2000; Regional Sales
Manager from 1991 to 1996; and a Development Engineer from 1989 to 1991. Prior to joining
Densitron Technologies, PLC, Mr. McQuiggan began his career in 1986 with Marconi Avionics. Van H. Potterhas served as Senior Vice President  Electronic Manufacturing Services since
October of 2004. From April through October of 2004, Mr. Potter served as Senior Vice President,
Business Groups. Mr. Potter joined TFS as Vice President, Display Products in February 2003. Mr.
Potter was Market Development Manager and Project Manager for Rogers Corporation, a manufacturer of
specialty polymer composite materials, 8




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from February 2002 until February 2003. From April 1994 until February 2002, Mr. Potter held a
variety of management, marketing, and new business development positions with Durel Corp., a joint
venture between Rogers Corporation and 3M Corporation. Eric W. Haeusslerhas been Principal Accounting Officer of our company since May 2004 and
Corporate Controller of our company since August 2002. Mr. Haeussler joined our company in October
1990 and served as Cost Accounting Supervisor until September 1996, Cost Accounting Manager from
October 1996 until August 2000, and Director of Finance and Assistant Controller from September
2000 until August 2002. DISCONTINUED OPERATIONS On September 1, 2003, we transferred all of the net assets of our microdisplay division, plus
approximately $20.9 million in cash, to a newly created Delaware corporation called Brillian
Corporation. On September 15, 2003, we spun off Brillian by distributing all of the outstanding
common stock of Brillian to our stockholders on a pro rata basis, with each stockholder receiving
one share of Brillian common stock for every four shares of our common stock. Brillian is now
traded on the Nasdaq National Market under the symbol BRLC. Brillian had $44.1 million of net
assets on the spin-off date. The microdisplay business that we transferred to Brillian is now
reported in our consolidated financial statements as Discontinued Operations. RISK FACTORS You should carefully consider the following factors, in addition to those discussed elsewhere
in this report, in evaluating our company and our business. We may be delisted from the New York Stock Exchange. Our common stock is listed on the New York Stock Exchange. To continue trading on the NYSE,
we must meet the NYSE listing maintenance standards. If we are unable to continue to meet the
NYSEs listing maintenance standards, our common stock could be delisted from the NYSE. If our
common stock were delisted, we likely would seek to list the common stock on the Nasdaq SmallCap
Market, the American Stock Exchange, or on a regional stock exchange. Listing on such other market
or exchange could reduce the liquidity for our common stock. If our common stock were not listed
on the Nasdaq SmallCap Market or an exchange, trading of our common stock would be conducted in the
over-the-counter market on an electronic bulletin board established for unlisted securities or
directly through market makers in our common stock. If our common stock were to trade in the
over-the-counter market, an investor would find it more difficult to dispose of, or to obtain
accurate quotations for the price of, the common stock. We have received an unqualified report on our consolidated financial statements with an explanation
paragraph from our independent registered public accounting firm. The report by the independent registered public accounting firm of our company on our
consolidated financial statements states that the consolidated financial statements have been
prepared assuming that we will continue as a going concern. The report indicates that our
recurring losses from operations and difficulties financing future working capital needs raise
substantial doubt about our ability to continue as a going concern. 9




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The majority of our sales come from a small number of customers, and our sales could decline
significantly if we lose any of these customers. Sales to our ten largest customers have represented a significant percentage of our net sales
in recent periods. Our ten largest customers accounted for approximately 71% and 79% of net sales
in fiscal 2004 and fiscal 2003, respectively. Our largest customer during fiscal 2004 was Avocent,
accounting for approximately 38% of net sales. Our largest customers during fiscal 2003 were
Avocent and Vitelcom, accounting for approximately 23% and 13% of net sales, respectively. No other
customer accounted for more than 10% of net sales in fiscal 2004 or fiscal 2003. Our principal customers have varied from year to year, and our principal customers may not
continue to purchase services from us at current levels, if at all. Significant reductions in sales
to any of these customers, or the loss of major customers, would seriously harm our business. If
we are not able to timely replace expired, canceled, or reduced contracts with new business, our
revenue could be harmed. Our recent history of losses makes financing our working capital and ongoing business needs
difficult. We have had several years of operating losses and reduced working capital resources. As a
result, to fund our operations, we will be required to reduce our expenses significantly or raise
additional funds through an offering of debt or equity securities, borrowings from financial
institutions, or the sale of assets. We can provide no assurance that these efforts will be
successful. We have key suppliers that could limit our credit. Our recent history of losses and liquidity position could result in a lowering or elimination
of our credit with key suppliers. In such instance, this could result in a material adverse effect
to us including an accelerated depletion of our cash and an inability to timely deliver products to
our customers because of our inability to procure raw materials. Our operating results may be adversely affected by excess inventory. We typically purchase components and other materials in anticipation of customer orders based
on customer purchase orders or forecasts. For a variety of reasons, such as decreased OEM customer
or end-user demand, we may not be able to utilize various components or other supplies that we have
purchased in anticipation of customer demand. In such event, we generally attempt to recoup our
materials and manufacturing costs by various means, including returning components to our
suppliers, disposing of excess inventory through other channels, or attempting to require our OEM
customers to purchase or otherwise compensate us for such excess inventory. These efforts,
however, may not be successful. To the extent we are unsuccessful in recouping our materials and
manufacturing costs, our operating results would be adversely affected and excess inventory would
utilize our working capital. Our operating results have been materially and adversely affected in
the past as a result of the write-off of excess or obsolete inventory. In 2004, for example, we had
expenses of $5.2 million relating to scrap, excess or obsolete inventory. We must integrate our acquired businesses. We recently acquired ETMA Corporation, Unico, and Integrex. Among other things, we have been
working through the integration of those businesses. Integration has proved difficult with respect
to ETMA and Integrex. We have experienced losses and unexpected charges as a result of the
difficulties with those integration efforts. We may not yet have remedied all integration issues,
which could result in additional unexpected expenses and charges. In addition to business integration risks, substantially expanding our electronics
manufacturing services has resulted in various other risks, including the following:  
    the information technology challenges relating to the integration of disparate worldwide systems;
    the ability to procure and install necessary additional equipment;
    the ability to hire, train, and manage additional manufacturing personnel; 10




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
    production delays, unfavorable manufacturing yields, and lengthening delivery schedules;
    the ability to service widespread customers in varied industries;
    the need to satisfy increasingly rapid product turnaround time and rapid increases
in production levels;
    the volume of customer orders relative to our capacity;
    the typically short life cycle of our customers products;
    changes in our sales mix to our customers;
    the timing of our expenditures in anticipation of future orders;
    our effectiveness in managing manufacturing processes;
    changes in cost and availability of labor and components;
    changes in economic conditions; and
    local events that affect our production volume. We face intense competition. We serve intensely competitive industries that are characterized by price erosion, rapid
technological change, and competition from major domestic and international companies. We compete
against large EMS companies, which have greater market recognition, larger customer bases, and
substantially greater financial, technical, marketing, distribution, and other resources than we
possess. We compete primarily on the basis of our engineering, design, testing, and production
capabilities; our technological know-how; the responsiveness, quality, flexibility, and price of
our services; and our geographic locations. Certain sectors of the EMS industry are currently
experiencing increased price competition, and a continuation of this increased level of competition
would adversely affect our revenue and gross margin. In some cases, our smaller size may mean that
we are required to accept less than favorable contractual obligations with larger vendors and
customers. We also face competition from the manufacturing operations of current and potential
customers, which continually evaluate the benefits of internal manufacturing versus outsourcing. Prior to the recent current economic downturn, many participants in the EMS industry,
including us, substantially expanded their manufacturing capacity. In the last few years, however,
the overall demand for electronics manufacturing services has decreased, resulting in increased
capacity and substantial pricing pressures, which have harmed our operating results. Our ability to compete successfully depends on a number of factors, both within and outside
our control. These factors include the following:  
    our success in providing design and manufacturing services, and in incorporating new
technologies, processes, and product solutions;
    our ability to address the needs of our customers;
    the quality of our customer services;
    our efficiency of production;
    product or technology introductions by our competitors;
    the pricing, quality, performance, reliability, timeliness, technological
sophistication, geographic location, and efficiency of our design and manufacturing
services; and
    foreign currency devaluations, especially in Asian currencies, such as the Japanese
Yen, the Korean Won, and the Taiwanese Dollar, which may cause foreign competitors
products to be priced significantly lower than our product solutions. 11




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We are subject to lengthy development periods and product acceptance cycles. OEMs make the determination during their product development programs whether to utilize our
services or pursue other alternatives. This requires us to make significant investments of time
and capital well before our customers introduce their products utilizing our services and before we
can be sure that we will generate any significant revenue from our customers or even recover our
investment. During a customers entire product development process, we face the risk that our services
will fail to meet our customers technical, performance, or cost requirements or will be replaced
by an alternative solution. Even if we provide our services in a manner satisfactory to our
customer, the customer may delay or terminate its product development efforts. The occurrence of
any of these events would adversely affect our operating results. The lengthy development period
also means that it is difficult to immediately replace an unexpected loss of existing business. We do not have long-term commitments from our customers. Our customers generally do not provide us with firm, long-term volume commitments. In
addition, worldwide economic conditions have led to substantially shortened lead times on purchase
orders. Although we sometimes enter into manufacturing contracts with our customers, these
contracts clarify order lead times, inventory risk allocation, and similar matters rather than
provide firm, long-term volume commitments. As a result, customers can generally cancel
commitments or reduce or delay orders at any time. The cancellation, delay, or reduction of
customer commitments could result in reduced revenue and in our holding excess and obsolete
inventory or having unabsorbed manufacturing capacity. The large percentage of our revenue from
customers in the electronics industry, which is subject to severe competitive pressures, rapid
technological change, and product obsolescence, increases our inventory and overhead risks. In addition, we make significant decisions, including determining the levels of business that
we will seek or accept, production schedules, component procurement commitments, facility
requirements, personnel needs, and other resource requirements, based on our estimates of customer
requirements. The short-term nature of our customers commitments and the possibility of rapid
changes in demand for their products reduce our ability to estimate accurately the future
requirements of those customers. Because many of our costs and operating expenses are relatively
fixed, a reduction in customer demand can harm our gross margins and operating results. On occasion, customers may require rapid increases in production, which can stress our
resources and reduce operating margins. We may not have sufficient capacity at any given time to
meet all of our customers demands or to meet the requirements of a specific project. Our operating results have been materially and adversely affected in the past as a result of
the failure to obtain anticipated orders and deferrals or cancellations of purchase commitments
because of changes in customer requirements. For example, we have made announcements in the past
that sales would not meet our expectations because of delays in customer programs. We depend on the market acceptance of the products of our customers. In most instances, we do not provide services to end users. As a result, our success depends
almost entirely upon the widespread market acceptance of our customers products. Any significant
slowdown in the demand for our customers products would adversely affect our business. Because our success depends on the widespread market acceptance of our customers products, we
must identify industries that have significant growth potential and establish relationships with
OEMs in those industries. Our failure to identify potential growth opportunities or establish
relationships with OEMs in those industries would adversely affect our business. Our dependence on the success of the products of our customers exposes us to a variety of
risks, including the following:  
    our ability to provide significant design and manufacturing services for customers
on a timely and cost-effective basis;
    our success in maintaining customer satisfaction with our design and manufacturing
services; 12




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
    our ability to match our design and manufacturing capacity with customer demand and
to maintain satisfactory delivery schedules;
    customer order patterns, changes in order mix, and the level and timing of orders
placed by customers that we can complete in a quarter; and
    the cyclical nature of the industries and markets we serve. Our failure to address these risks may cause our sales to decline. Shortages of components and materials may delay or reduce our sales and increase our costs. We rely on a limited number of suppliers for many components used in our manufacturing and
assembly processes. We especially depend on a small number of strategic suppliers for key
components such as LCD glass and drivers. We do not have any long-term supply agreements. At
various times, there have been shortages of some of the key electronic components. Our inability
to obtain sufficient quantities of components and other materials to support our electronics
manufacturing services could result in reduced, delayed, or lost orders, increased inventory, and
underutilized manufacturing capacity. Any reduction, delay, or loss of customer orders could
adversely impact our operating results. In addition, we may not be able to pass on component and
materials price increases to our customers, particularly in the case of turnkey manufacturing
agreements. We obtain many of the materials we use from a limited number of foreign suppliers,
particularly suppliers located in Asia. As a result, we are subject to increased costs, supply
interruptions, and difficulties in obtaining materials. Our customers also may encounter
difficulties or increased costs in obtaining from others the materials necessary to produce their
products into which our product solutions are incorporated. Our revenue and gross margins depend upon our ability to utilize our manufacturing capacity. Our revenue and gross margins depend to a great extent upon our ability to utilize our
manufacturing capacity. We must balance the need to maintain manufacturing capacity to fulfill new
customers orders while maintaining sufficient utilization of our manufacturing capacity to cover
our fixed overhead expenses. Like most EMS companies under current market conditions, we have
underutilized manufacturing capacity. As a result, we are considering the sale of our operations
in Manila. There is no assurance that this sale will resolve our overcapacity issues or that we
will not experience difficulties in satisfying any significant additional customer demand for our
manufacturing services. We must maintain satisfactory manufacturing yields and capacity. Our inability to maintain high levels of productivity or satisfactory delivery schedules at
our manufacturing facilities would adversely affect our operating results. The design and
manufacture of electronic 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 personnel and equipment. These problems could be heightened
by moving the manufacturing of products to different facilities. As is typical in the EMS
industry, at times we have experienced lower than anticipated manufacturing yields and lengthening
of delivery schedules. Any problems with our manufacturing operations could result in the lengthening of our delivery
schedules, reductions in the quality or performance of our design and manufacturing services, and
reduced customer satisfaction. 13




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Products we manufacture may contain design or manufacturing defects, which could result in
reduced demand for our services and liability claims against us. We manufacture products to our customers specifications, which are highly complex and may at
times contain design or manufacturing errors or failures. Any defects in the products we
manufacture, or in the products we purchase, whether caused by a design, manufacturing, or
component failure or error, may result in delayed services to customers or reduced or cancelled
customer orders. If these defects occur in large quantities or too frequently, our business
reputation also may be impaired. In addition, these defects may result in liability claims against
us. Our inability to maintain our technological expertise in design and manufacturing processes would
adversely affect our competitive condition. Our success depends on our ability to develop and provide design and manufacturing services
that meet the changing needs of our customers. This requires us to anticipate and respond to
technological changes in design and manufacturing processes in a cost-effective and timely manner.
To achieve this goal, we continually evaluate the advantages and feasibility of new product design
and manufacturing processes. We cannot assure that we will be successful. We are exposed to intangible asset impairment. In 2004, we recorded charges of $23.1 million for impairment of goodwill and customer lists,
leaving $13.4 million of goodwill and $0.6 million of customer lists assets on our balance sheet at

the end of 2004. These intangible assets are attributable to acquisitions and represent the
difference between the purchase price paid for the acquired businesses and the fair value of net
tangible assets of the acquired businesses. We are required to evaluate goodwill for impairment on
at least an annual basis, and other intangibles whenever changes in circumstances indicate that the
carrying amount may not be recoverable from estimated future cash flows. As a result of our annual
and other periodic evaluations, we may determine that these remaining intangible asset values
should be written down to their fair values, which could result in material charges that could be
adverse to our operating results and financial position. We sublease some facilities and are subject to the credit risk of the subleases. We sold our 97,000 square foot Tempe facility in December 2004 and leased back the entire
facility under a five-year lease. We subleased approximately 56,000 square feet of that Tempe
facility to Brillian Corporation for the same five-year period. Brillian pays to us the same lease
rate that we pay the lessor on the master lease. If Brillian were to default on its obligation to
us, we would still be obligated on the master lease to continue to make payments on the Brillian
space. In December 2004, we moved out of a building in Redmond, Washington, which we refer to as
Building 1, into a new facility, which we refer to as Building 4. The lease on Building 1 expires
in December 2007 and we have subleased that building to Pogo Linux for an amount that is
approximately 70% of the original lease rate. Thus, we will continue to pay the 30% differential
to the building owner. In addition, if Pogo Linux were to default on its lease obligations, we
would still be obligated on the original lease to continue to make payments to the building owner.
In January 2005, we moved out of another building in Redmond, which we refer to as Building 2. We
are looking for a sublessor of that building, which has a lease that expires January 2006. We will
continue to be obligated on that lease through its remaining term. We have risks associated with our real property in China. We own our manufacturing facility in China. That facility is situated on land of which we are
the sole and exclusive holder of the land use rights certificate approved and issued by the Natural
Resources Administration Bureau of the local jurisdiction in which the property is located. The
certificate provides for a land use rights term of 50 years until approximately 2048. After
issuance of that certificate, we subsequently learned that the approval may have not been
consistent with relevant law in China because a higher level land bureau had not approved the
grant. Although the relevant authorities have indicated a likely favorable resolution with regard
to this issue, a risk exists as to the ownership of the land and whether any penalties may be owed
as a result of this issue. 14




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We face risks associated with international operations. Our Asia-based manufacturing operations, and our sales and distribution operations in Europe
and Asia, create a number of logistical and communications challenges. Our international
operations also expose us to various economic, political, and other risks, including the following:  
    management of a multi-national organization;
    compliance with local laws and regulatory requirements as well as changes in those
laws and requirements;
    imposition of restrictions on currency conversion or the transfer of funds;
    the possibility of appropriation of our assets without just compensation;
    transportation delays or interruptions and other effects of less developed infrastructures;
    foreign exchange rate fluctuations;
    limitations on imports and exports;
    difficulties in staffing and managing foreign personnel and diverse cultures;
    employment and severance issues;
    overlap of tax issues;
    tariffs and duties;
    possible employee turnover or labor unrest;
    the burdens and costs of compliance with a variety of foreign laws; and
    political or economic instability in countries in which we conduct business,
including possible terrorist acts. Changes in policies by the United States or foreign governments resulting in, among other
things, increased duties, higher taxation, currency conversion limitations, restrictions on the
transfer or repatriation of funds, limitations on imports or exports, or the expropriation of
private enterprises also could have a material adverse effect on us. Any actions by our host
countries to reverse policies that encourage foreign investment or foreign trade also could
adversely affect our operating results. In addition, U.S. trade policies, such as most favored
nation status and trade preferences for certain Asian nations, could affect the attractiveness of
our services to our U.S. customers. We face risks associated with international trade and currency exchange. Political and economic conditions abroad may adversely affect our foreign manufacturing and
sales operations. 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 our ability to provide design and manufacturing
services in foreign markets or for foreign customers and to purchase materials or equipment from
foreign suppliers. While we transact business predominantly in U.S. Dollars and bill and collect most of our
sales in U.S. Dollars, we collect a portion of our revenue in non-U.S. currencies, such as the
Chinese Renminbi. In the future, customers increasingly may make payments in non-U.S. currencies,
such as the Euro. In addition, we account for a portion of our costs, such as payroll, rent, and
indirect operating costs, in non-U.S. currencies, including Philippine Pesos, British Pounds
Sterling, Malaysian Ringgit, and Chinese Renminbi. Fluctuations in foreign currency exchange rates could affect our cost of goods and operating
margins and could result in exchange losses. In addition, currency devaluation can result in a
loss to us if we hold deposits of that currency. Hedging foreign currencies can be difficult,
especially if the currency is not freely traded. We cannot predict the impact of future exchange
rate fluctuations on our operating results. 15




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The risks described above are particularly important since sales outside North America
represented 37.8% of our net sales in 2004 and 46.0% of our net sales in 2003. Sales in foreign
markets, primarily Europe and Asia, to OEMs based in the United States accounted for almost all of
our international sales in both of these periods. Our operating results have significant fluctuations. In addition to the variability resulting from the short-term nature of our customers
commitments, other factors contribute to significant periodic and seasonal quarterly fluctuations
in our results of operations. These factors include the following:  
    the timing of customer orders;
    the volume of customer orders relative to our capacity;
    changes in economic conditions generally or in our customers markets;
    product introductions and market acceptance of new products or new generations of
products by customers and their competitors;
    evolution in the life cycles of customers products;
    timing of expenditures in anticipation of future customer orders;
    ability to manage inventory and inventory obsolescence;
    effectiveness in managing manufacturing processes and costs;
    changes in cost and availability of labor and components;
    product mix or our customers orders;
    pricing and other competitive pressures; and
    changes or anticipated changes in economic conditions. Accordingly, you should not rely on the results of any past periods as an indication of our
future performance. It is likely that in some future period, our operating results may be below
expectations of public market analysts or investors. If this occurs, our stock price may decline. We depend on key personnel. We depend on the efforts and abilities of our senior management and technical personnel. The
competition for qualified management and technical personnel is intense. The loss of services of
one or more of our key employees or the inability to add key personnel could have a material
adverse effect on us. Although we maintain non-competition and nondisclosure covenants with
certain key personnel, we do not have any fixed-term agreements with, or key person life insurance
covering, any officer or employee. We have announced that we are moving our corporate headquarters
in 2005 from Tempe, Arizona to Redmond, Washington. Most of our finance staff will be replaced in
the move. This change in staff may result in delayed financial reporting and other related issues
during the course of the move. The move may also adversely affect our internal control over
financial reporting. Potential strategic alliances may not achieve their objectives. We have entered into various strategic alliances, and we plan on entering into other similar
types of alliances in the future. Among other matters, we will explore strategic alliances
designed to enhance or complement our technology or to work in conjunction with our technology; to
increase our manufacturing capacity; to provide necessary know-how, components, or supplies; and to
develop, introduce, and distribute products and services utilizing our technology and know-how.
Any strategic alliances may not achieve their strategic objectives, and parties to our strategic
alliances may not perform as contemplated. The market price of our common stock may be volatile. The market price of our common stock has been extremely volatile. Our stock price increased
dramatically during the three-year period ended December 31, 1994, but declined significantly
during 1995 and 1996. Our stock 16




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price increased again during 1997, but declined significantly in 1998. Our stock price again
increased significantly during 1999 and in early 2000, but suffered a major decline in the second
half of 2000 and again in 2001 and 2002. It declined significantly again in the last half of 2004
and to date in 2005. The trading price of our common stock in the future could continue to be subject to wide
fluctuations in response to various factors, including the following:  
    variations in our quarterly operating results;
    announcements about the prospects or financial performance of the industries or
customers we serve;
    changes in analysts estimates of our financial performance;
    failure to meet performance estimates of securities analysts;
    general conditions in the electronics industry; and
    worldwide economic and financial conditions. In addition, the stock market has experienced extreme price and volume fluctuations that have
particularly affected the market prices for many technology-related companies and that often have
been unrelated to the operating performance of these companies. These broad market fluctuations
and other factors may adversely affect the market price of our common stock. Adverse trends in the electronics industry may adversely affect our operating results. The electronics manufacturing services industry is impacted by the state of the electronics
industry, general U.S. and global economic conditions, and worldwide events. A continued slowdown
in the U.S. or global economies or the particular industries served by us may result in customers
reducing orders. Our revenue may be adversely impacted by the slowdown in the worldwide
electronics markets, which have been subject to reduced end-market demand and reduced capital
spending. Our business also depends on the electronics industry in general, which is subject to rapid
technological change, short product life cycles, and margin pressures. In addition, the
electronics industry historically has been cyclical and subject to significant downturns
characterized by diminished product demand, accelerated erosion of average selling prices, and
production over-capacity. We seek to reduce our exposure to industry downturns and cyclicality by
providing design and production services for leading companies in a variety of rapidly expanding
segments of the electronics industry. Despite these efforts, economic conditions affecting the
electronics industry in general or our major customers may adversely affect our operating results. We could be required to expend substantial resources to comply with governmental regulations. Our operations are subject to certain federal, state, and local regulatory requirements
relating to environmental, waste management, health, and safety matters. As a publicly traded
company in the United States, we are also subject to federal and state governance and internal
control requirements as well as to the New York Stock Exchange listing requirements. We believe we
operate in substantial compliance with all applicable requirements. There can be no assurance,
however, that material costs and liabilities will not arise from complying with these or from new,
modified, or more stringent requirements. In addition, our past, current, or future operations,
including any operations we have acquired, may give rise to claims of exposure by employees or the
public or to other claims or liabilities relating to environmental, waste management, or health and
safety concerns. The costs of complying with all regulatory requirements may be material when
compared to our revenue. 17




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Change in control provisions may adversely affect existing stockholders. Our restated certificate of incorporation and the Delaware General Corporation Law contain
provisions that may have the effect of making more difficult or delaying attempts by others to
obtain control of our company, even when these attempts may be in the best interests of
stockholders. Our 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. Delaware
law also imposes conditions on certain business combination transactions with interested
stockholders. We have also adopted a stockholders rights plan intended to encourage anyone seeking to
acquire our company to negotiate with our board of directors prior to attempting a takeover. While
the plan was designed to guard against coercive or unfair tactics to gain control of our company,
the plan may have the effect of making more difficult or delaying any attempts by others to obtain
control of our company. We do not pay cash dividends. We have never paid any cash dividends on our common stock and do not anticipate that we will
pay cash dividends in the foreseeable future. 
 ITEM 2.
    
    PROPERTIES
 Location
    
    Type
    
    Leased or Owned
    
    Square FeetTempe, Arizona, USA
    
    Administrative; sales; design
    
    Leased1
    
    97,0002Redmond, Washington, USA
    
    Manufacturing; sales (4 separate locations)
    
    Leased3
    
    230,0003Marlborough, Massachusetts, USA
    
    Manufacturing; sales
    
    Leased
    
    
    20,000Orlando, Florida, USA
    
    Sales
    
    Leased
    
    26,8006Manila, Philippines
    
    Manufacturing
    
    Owned
    
    71,0004Penang, Malaysia
    
    Manufacturing; design; sales
    
    Leased
    
    
    120,000Beijing, Republic of China
    
    Manufacturing; design; sales
    
    Owned7
    
    
    54,900Swindon, England
    
    Sales
    
    Leased
    
    3,1005
   1
    
    In December 2004, we sold our Tempe, Arizona building for approximately $11.3
million less selling costs of approximately $500,000. At the time of the sale, we entered into an
agreement with the buyer to lease back the entire facility for a period of five years.2
    
    We sublease approximately 56,000 square feet of space to Brillian
Corporation.3
    
    In October 2004 (effective January 1, 2005), we subleased approximately 32,000 square
feet of our facilities to Pogo Linux, Inc. In December 2004, we recognized a charge of
approximately $382,000 for future costs associated with the termination of the original lease and
subsequent sublease of this facility to Pogo Linux, Inc.We also sublease approximately
11,000 square feet of space to Sindhara Super Media Corporation in our new building.In
January 2005, we vacated an additional approximately 30,000 square feet. A charge of approximately
$197,000 is expected to be recorded in the first quarter of 2005 to recognize future costs
associated with the continuing lease obligation for this vacated facility. We have undertaken
efforts to sublease this facility.4
    
    In the second quarter of 2004, we purchased our facility in Manila from our lessor for
a total payment of $3.8 million. We also paid $614,000 to the RBF Development Corporation, or RBF,
for a 50-year land right. Lastly, we executed an agreement with RBF for the option to purchase the
leased land for $1 at any time until April 23, 2014. In January 2005, we announced
that we are exploring opportunities to sell this facility.5
    
    In February 2005, we vacated our space in Swindon and a charge of approximately $15,400
was recorded in February 2005 to recognize future costs associated with continuing lease
obligations for this vacated facility. We have undertaken efforts to sublease this facility. 18




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##### Table of Contents



6
    
    Our lease in Orlando expired in January 2005, and we vacated the facility. We moved
into a new office and leased 570 square feet at that new location. We intend to vacate that
facility by the end of the first quarter of 2005. A charge of approximately $24,000 is expected to
be recorded in the first quarter of 2005 to recognize future lease costs associated with the
continuing obligation for this vacated facility.7
    
    We own our manufacturing facility in China. That facility is situated on land of which
we are the sole and exclusive holder of the land use rights certificate approved and issued by the
local government in which the property is located. The certificate provides for a land use rights
term of 50 years until approximately 2048. 
 ITEM 3.
    
    LEGAL PROCEEDINGS
 We recently filed a complaint against Data International in Arizona requesting a declaratory
judgment for breach of contract. We also filed a complaint against Vitelcom, a customer of ours in
Spain, for unpaid monies due to us for product sales. 
 ITEM 4.
    
    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 Not applicable. 
 PART II 
 ITEM 5.
    
    MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF
EQUITY SECURITIES
 Our common stock has been listed on the New York Stock Exchange under the symbol TFS since
December 29, 1994. The following table sets forth the quarterly high and low sales prices of our
common stock as reported on the New York Stock Exchange for the periods indicated: High
    
    
    Low2003:First Quarter
    
    $
    6.34
    
    
    $
    3.67Second Quarter
    
    
    6.94
    
    
    
    4.89Third Quarter
    
    
    9.76
    
    
    
    5.51Fourth Quarter
    
    
    6.77
    
    
    
    4.642004:First Quarter
    
    $
    6.59
    
    
    $
    4.19Second Quarter
    
    
    7.78
    
    
    
    4.86Third Quarter
    
    
    4.96
    
    
    
    2.74Fourth Quarter
    
    
    2.83
    
    
    
    1.852005:First Quarter (through March 28, 2005)
    
    $
    0.92
    
    
    $
    0.88
 As of March 28, 2005, there were approximately 565 holders of record of our common stock. The
closing sale price of our common stock on the New York Stock Exchange on March 28, 2005 was $0.89
per share. Our policy is to retain earnings to provide funds for the operation and expansion of our
business. We have never paid cash dividends on our common stock and do not anticipate that we will
do so in the foreseeable future. 
 ITEM 6.
    
    SELECTED FINANCIAL DATA
 The selected historical financial data presented below are derived from our consolidated
financial statements. The balance sheet data as of December 31, 2003, and 2004 and statements of
operations data for the fiscal years ended December 31, 2002, 2003, and 2004 were derived from the
consolidated financial statements and notes included elsewhere in this report that have been
audited by Deloitte & Touche LLP, independent registered 19




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public accounting firm. The selected financial data should be read in conjunction with Item
7, Managements Discussion and Analysis of Financial Condition and Results of Operations and the
Consolidated Financial Statements and the Notes thereto included elsewhere in this report. Years Ended December 31,2000
    
    
    2001
    
    
    2002
    
    
    2003
    
    
    2004(Dollars in thousands, except per share data)Consolidated Statements of Operations Data:Net sales
    
    $
    159,329
    
    
    $
    117,200
    
    
    $
    86,587
    
    
    $
    159,018
    
    
    $
    158,947Costs and expenses:Cost of sales
    
    
    124,284
    
    
    
    115,820
    
    
    
    78,718
    
    
    
    155,125
    
    
    
    161,009Selling, general, and administrative
    
    
    8,460
    
    
    
    8,828
    
    
    
    10,382
    
    
    
    17,524
    
    
    
    24,961Research, development, and engineering
    
    
    7,053
    
    
    
    8,623
    
    
    
    4,913
    
    
    
    4,742
    
    
    
    2,912Impairment of goodwill
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    21,350Impairment of intangibles
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,850Loss (gain) on sale of assets
    
    
    63
    
    
    
    1,371
    
    
    
    4,545
    
    
    
    (25
    )
    
    
    (100
    )Amortization of intangibles
    
    
    
    
    
    
    
    
    
    
    256
    
    
    
    2,043
    
    
    
    1,893139,860
    
    
    
    134,642
    
    
    
    98,814
    
    
    
    179,409
    
    
    
    213,875Operating income (loss)
    
    
    19,469
    
    
    
    (17,442
    )
    
    

    (12,227
    )
    
    
    (20,391
    )
    
    
    (54,928
    )Other income (expense), net
    
    
    7,258
    
    
    
    7,270
    
    
    
    3,492
    
    
    
    864
    
    
    
    432Minority interest in loss (income) of
consolidated subsidiary
    
    
    
    
    
    
    167
    
    
    
    84
    
    
    
    (36
    )
    
    
    (22
    )Income (loss) from continuing operations
before income taxes
    
    
    26,727
    
    
    
    (10,005
    )
    
    
    (8,651
    )
    
    
    (19,563
    )
    
    
    (54,518
    )Provision for (benefit from) income taxes
    
    
    7,968
    
    
    
    (4,172
    )
    
    
    (3,921
    )
    
    
    14,338
    
    
    
    (226
    )Income (loss) from continuing operations
    
    
    18,759
    
    
    
    (5,833
    )
    
    
    (4,730
    )
    
    
    (33,901
    )
    
    
    (54,292
    )Loss from discontinued operations, net of taxes
    
    
    (3,925
    )
    
    
    (11,931
    )
    
    
    (12,241
    )
    
    
    (10,552
    )
    
    
    Net income (loss)
    
    $
    14,834
    
    
    $
    (17,764
    )
    
    $
    (16,971
    )
    
    $
    (44,453
    )
    
    $
    (54,292
    )Earnings (loss) per common share:Basic:Net income (loss) from continuing operations
    
    $
    0.92
    
    
    $
    (0.27
    )
    
    $
    (0.22
    )
    
    $
    (1.59
    )
    
    $
    (2.50
    )Net income (loss)
    
    $
    0.73
    
    
    $
    (0.83
    )
    
    $
    (0.79
    )
    
    $
    (2.09
    )
    
    $
    (2.50
    )Diluted:Net income (loss) from continuing operations
    
    $
    0.87
    
    
    $
    (0.27
    )
    
    $
    (0.22
    )
    
    $
    (1.59
    )
    
    $
    (2.50
    )Net income (loss)
    
    $
    0.69
    
    
    $
    (0.83
    )
    
    $
    (0.79
    )
    
    $
    (2.09
    )
    
    $
    (2.50
    )Weighted average number of common shares:Basic
    
    
    20,457
    
    
    
    21,401
    
    
    
    21,465
    
    
    
    21,301
    
    
    
    21,719Diluted
    
    
    21,636
    
    
    
    21,401
    
    
    
    21,465
    
    
    
    21,301
    
    
    
    21,719
 December 31,2000
    
    
    2001
    
    
    2002
    
    
    2003
    
    
    2004(Dollars in thousands)Consolidated Balance Sheet Data:Working capital
    
    $
    194,492
    
    
    $
    169,123
    
    
    $
    107,885
    
    
    $
    59,640
    
    
    $
    26,900Total assets
    
    
    267,843
    
    
    
    245,888
    
    
    
    222,694
    
    
    
    167,237
    
    
    
    111,801Debt and capital leases
    
    
    2,706
    
    
    
    2,706
    
    
    
    2,734
    
    
    
    11,851
    
    
    
    10,720Stockholders equity
    
    
    242,002
    
    
    
    223,944
    
    
    
    205,668
    
    
    
    117,032
    
    
    
    65,837
 
 ITEM 7.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
 Overview Current Operations
 We are a global provider of electronics manufacturing services, or EMS. We design and/or
manufacture electronic printed circuit board assemblies, radio frequency, or RF, modules, display
modules and systems, and complete systems for customers in the computing, consumer, industrial,
medical, telecommunications, and transportation industries. Our services include advanced
engineering support, designed for services, automated printed circuit board assembly, in-circuit
and functional testing, systems level integration and box build, and turn-key supply chain
management services, all of which enable our customers the ability to outsource all stages of 20




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product engineering, design, development, materials procurement and management, manufacturing,
and testing. Our design and manufacturing services include a distinctive competence in display
modules and systems and the integration of display modules and systems into other products. The
display modules and systems we design and manufacture primarily utilize liquid crystal displays, or
LCDs. Those LCDs include small form factor monochrome and color LCDs, including thin film
transistor LCDs, or TFTs, as well as large format flat panel monitors, all of which are TFTs. We
refer to the business involving displays as our Display business. All other business other than
the Display business is referred to herein as the EMS business. The products we manufacture for customers are of varying sizes and have varying levels of
integration. The typical design program life cycle of a custom-designed product is three to
fifteen months and includes technical design, prototyping, pilot manufacturing, and high-volume
manufacturing. The cycle is shorter in products where no display is involved and/or where the
customer has already completed the design. Several factors impact our gross margins, including manufacturing efficiencies, product mix,
product differentiation, product uniqueness, inventory management, and volume pricing. We have
factories in Washington and Massachusetts in the United States and in the Philippines, Malaysia,
and China. In Washington and in Malaysia, we provide engineering support, automated printed
circuit board assembly, in-circuit and functional testing, systems integration and box build,
complete supply chain management, and turnkey packaging and fulfillment services. In Massachusetts,
we provide aftermarket customization of flat panel displays. In China, we primarily assemble
displays into modules. In the Philippines, we assemble and test RF modules. We recently announced
that we are exploring the potential sale of our Philippines facility. Selling, general, and administrative expense consists principally of administrative and
selling costs; salaries, commissions, and benefits to personnel; and related facility costs. In
general, these costs have risen as a result of the acquisitions we have completed in the last two
years and from increased costs related to complying with the Sarbanes-Oxley Act of 2002. We make
substantially all of our sales directly to customers through a sales force that consists mainly of
direct technical sales persons, but also includes a small representative network. As a result,
there is no material cost of distribution in our selling, general, and administrative expense. Research, development, and engineering expense consists principally of salaries and benefits
to design engineers and other technical personnel, related facility costs, process development
costs, and various expenses for projects, including new product development. In general, these
costs have declined in the last few years because we no longer conduct pure research work. Thus,
most of our expense relates to the development engineering costs associated with preproduction
design and prototyping of custom products and the conceptual formulation and design of potential
standard display products. We have moved most of our engineering resources to Asia, resulting in
lower costs. We also incur expenses related to the amortization of intangibles as described below. Historic Operations Prior to 2002, our business strategy was to seek large-volume display programs from major
original equipment manufacturers, or OEMs, typically 100,000 units per year or higher, with selling
prices of approximately $7 per unit. Although our focus was designing and manufacturing display
modules, we often engaged in extended contract manufacturing services for other items related to
the display modules, such as printed circuit boards, keyboards, microphones, speakers, plastic
housings, and other similar components. We also manufactured liquid crystal display glass cells
from 1995 to 2002. In 2001, new monochrome design wins in that business became unprofitable; thus,
we began to refocus our strategy to expand our customer base and our product and service offerings.
We further modified our strategy in late 2002 to expand our manufacturing services to include
products that do not need displays. As a result of the foregoing, we have substantially changed our business since late in 2002.
The selling price of the products we manufacture now ranges from below $10 to as high as $8,000 per
unit. We have numerous customers in six principal markets. We have expanded our capabilities
organically, such as moving into the color display business, and through the acquisitions of AVT,
ETMA, and Unico. We have also expanded our capabilities through the license arrangement with
Integrex and through our manufacturing agreement with Microtune. The substantial shift in our business strategy has resulted in increased selling and
administrative costs. By previously focusing primarily on one market and one customer, we were able
to maintain selling, general, and 21




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administrative costs at a very low level. By contrast, we now have many more customers
requiring more sales interface. In addition, administrative costs have increased as we have
increased the number of operating locations in the United States and around the world. In addition,
as a result of the Sarbanes-Oxley Act of 2002, we have incurred additional administrative expenses,
such as additional auditing fees and the costs related to the establishment of an internal auditing
function. In addition, the shift in sales strategy from a high-volume focus to a more value-add
focus has resulted in reduced volumes at higher selling prices. The reduced volumes have resulted
in excess capacity at our factories overseas. Acquisitions and Strategic Transactions In September 2002, we purchased the assets and ongoing business of Advanced Video
Technologies, a privately held company, located in Marlborough, Massachusetts, that specializes in
the design and integration of complex, high-resolution display systems. As a result, we now design
and provide customized and ruggedized flat panel, touchscreen, and rackmount systems for OEMs in
the industrial and medical markets. We outsource display components from a variety of companies,
including Sony, Sharp, NEC, LG, and Samsung. The purchase price of the acquisition was $12.0
million, which we paid entirely in cash. In December 2002, we purchased the stock of ETMA Corporation, located in Redmond, Washington,
a privately held electronics manufacturer for OEM customers in the computer peripheral, medical
monitoring, and Internet security industries. As a result, we now offer the manufacturing
capabilities of five surface mount manufacturing lines, including one dedicated to new product
introduction and prototyping activity. We also provide engineering support, automated printed
circuit board assembly, in-circuit and functional testing, systems integration and box build,
complete supply chain management, and turnkey packaging and fulfillment services. The purchase
price of the ETMA acquisition was $38.1 million, which we paid entirely in cash. In January 2003, we signed certain agreements, including a technology licensing agreement,
with Data International Co., Ltd. of Taiwan. Under those agreements, we became the exclusive
channel in the Americas for LCD products manufactured by Data International. We also obtained the
right to sell those products through our worldwide channels. In conjunction with the agreement, we
established a sales office in Orlando, Florida, and hired sales and applications engineering
personnel from a distributor that had previously supported Data Internationals products. The
cost of the license was $3.9 million, of which $1.0 million was paid upon signing and $2.9 million
was a term loan. In the first quarter of 2004, we paid $1.4 million against the term loan. The
remaining $1.5 million was due in January 2005, although it was subject to reduction if certain
margin targets were not met. That note has not yet been paid. For a further explanation, please
refer to the Subsequent Eventssection below. In March 2003, we signed an agreement with Microtune, Inc. under which we agreed to
manufacture, assemble, and test Microtunes radio frequency, or RF, tuner modules and wireless
module products in our manufacturing facility in Manila, the Philippines. As part of the agreement,
Microtune sold to us certain of its own equipment and inventory for $8.2 million, for which we paid
$2.7 million with a note payable due in September 2003, and contracted with us to provide 100% of
Microtunes current demand for fully assembled RF subsystems. We also hired approximately 500
Microtune employees in Manila. In October 2003, we paid off approximately $300,000 of the $2.7
million note payable to Microtune and entered into an agreement to cancel the remaining $2.4
million balance on that note in exchange for the return of certain excess inventory to Microtune.
As a result of this transaction, we now manufacture 100% of Microtunes RF module products. We
recently announced that we are exploring the possible sale of our Manila facility. If that occurs,
it is likely that the Microtune business would be sold along with the facility. In April 2003, we acquired the business and certain assets of Unico Technology Bhd., a
privately held Malaysian company located in Penang. Unico was an electronics manufacturer for OEM
customers in the computer, computer peripheral, and communications industries. The Unico business
was acquired by TFS Electronics Manufacturing Services Sdn. Bhd., or TFS-Malaysia, a former joint
venture owned 60% by an overseas TFS subsidiary and 40% by Unico Holdings Bhd., the former parent
of Unico. Unico Holdings is the investment arm of the Chinese Chamber of Commerce of Malaysia. Our
share of the initial cost of capitalizing TFS-Malaysia was $3.8 million and Unico Holdings share
was $2.5 million, most of which was used for working capital. TFS-Malaysia purchased $4.1 million
in inventory from Unico, for which $2.7 million was paid at the time of the purchase and $1.4
million was subsequently paid. No advance payment was required for the acquisition of the
property, plant, and equipment of Unico, all of which is leased from the seller. The equipment
lease is accounted for as a capital lease payable by TFS- 22




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Malaysia. In the second quarter of 2004, Unico Holdings exchanged its ownership interest in
TFS-Malaysia for approximately 423,000 shares of our common stock held in treasury in a transaction
valued at $2.8 million, compared with Unico Holdings interest of $2.6 million. As a result of that
transaction, we now own 100% of TFS-Malaysia. In February 2004, we entered into a transaction with Integrex, a Seattle-based electronics
manufacturing services company that was liquidating its business. Under that transaction, we bought
the raw materials inventory of Integrex for $1.4 million and hired certain of its employees. We
also obtained the rights to most of its customers and agreed with those customers that we would
manufacture those customers products in our Redmond manufacturing facility. In exchange for those
customer rights, we agreed to pay a license fee for between 15 and 24 months based on revenue
receipts from former Integrex customers. In February 2004 and at a second closing in April 2004, we
paid $1.3 million in non-refundable license fees to Integrex. At the second closing in April, we
also acquired $300,000 of capital equipment. We have since renegotiated the license fees, reducing
the percentage fee on specific customers and, in one instance, extending by three months the time
during which the reduced fee is paid. Discontinued Operations On September 1, 2003, we transferred all of the net assets of our microdisplay division, plus
approximately $20.9 million in cash, to a newly created Delaware corporation called Brillian
Corporation. On September 15, 2003, we spun off Brillian by distributing all of the outstanding
common stock of Brillian to our stockholders on a pro rata basis, with each stockholder receiving
one share of Brillian common stock for every four shares of our common stock held. Brillian is now
traded on the Nasdaq National Market under the symbol BRLC. Brillian had $44.1 million of net
assets on the spin-off date. The microdisplay business that we transferred to Brillian is now
reported in our consolidated financial statements as Discontinued Operations. Subsequent Events We recently announced that we signed a definitive agreement to sell the assets of our small
form factor-display business to International DisplayWorks, Inc. and that the closing of the
transaction, which is subject to normal conditions, is expected to
occur in April 2005. Revenues from our small form factor display
business in 2004 were approximately $28 million. The
small form factor display assets to be sold include 100% of the outstanding shares of
Three-Five Systems, Beijing, Inc., our China-based display subsidiary, and display-related
equipment currently housed at our Manila, Philippines factory. The sale will not include the
display monitor business operated out of our Marlborough, Massachusetts facility and our electronic
manufacturing services (EMS) business located in Redmond, Washington, Penang, Malaysia, and Manila,
Philippines. We estimate the total value of the transaction to be in the range of between $11 million and
$21 million, which will come from a variety of components. These components include the following:  
    $8 million in cash to be paid to us at closing;
    Up to an estimated $3 million in additional cash to be paid to us over time, based upon
inventory consumption and accounts receivable collections ; and
    An estimated zero to $9 million in the common stock of International DisplayWorks to be
paid to us in May 2006, based on a percentage of the transferred display business revenue
for the preceding 12-month period if certain minimum revenue targets are met. At closing, International DisplayWorks will assume the obligations of TFS Beijing, including a
$2.4 million line of credit it had established with a bank located in China. We also recently announced that we had retained SG Cowen & Company to review strategic
alternatives aimed at maximizing shareholder value and that we will continue to work with SG Cowen
with regard to our large form factor display, EMS, and RF module manufacturing businesses. We are
exploring a range of possible alternatives, such as acquisitions, strategic alliances, business
combinations, and the sale of a portion or all of the company. We are currently in discussions
with multiple potential buyers of the RF business and have received an 23




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initial offer from a potential buyer of the EMS business. We indicated that there is no assurance
that any business transactions will be effected or what the timing and terms of any such business
transactions could be. In March 2005, we determined to discontinue our distribution of certain display products
that we licensed from Data International. The decision follows the exercise by us of our right to
rescind a technology licensing agreement, or TLA, that was entered into during January 2003 with
Data International Co, Ltd., and discussed above in this Item 7 in Acquisitions and Strategic
Transactions.Revenue from those Data International
products in 2004 were approximately $17
million. The TLA designated us as the exclusive distributor of certain Data International display
products in the Americas in return for deferred payments to Data International of $3.9 million.
Through the end of 2004, we had paid approximately $2.4 million to Data International, and a final
payment of approximately $1.5 million was due in January 2005. We recently determined that certain of the specified Data International display products have
been simultaneously available in the United States through a third party and that we had not been
provided exclusive distribution rights to the United States market as required by the TLA. Based
on that determination, we believe that the TLA was breached, and we are exercising our rights of
rescission. We notified Data International in February 2005 that we will not make the final
$1.5 million payment to Data International that was due in January 2005. We also asserted damages
of at least $2.5 million, plus interest and other expenses, against Data International. We
notified Data International that we will off-set our claimed damages against money owed by us to
Data International for product purchases. We recently filed a complaint against Data International
in Arizona requesting a declaratory judgment for breach of contract. We also announced in January 2005 that we are considering the sale of our RF module
manufacturing business and that we are going to move our corporate headquarters from Tempe, Arizona
to Redmond, Washington. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based
upon our financial statements, which have been prepared in accordance with generally accepted
accounting principles (GAAP) in the United States. During preparation of these financial
statements, we are required to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenue, and expenses, and related disclosure of contingent assets and
liabilities. On an ongoing basis, we evaluate our estimates and judgments, including those related
to sales returns, bad debts, inventories, fixed assets, goodwill, intangible assets, income taxes,
and contingencies. We base our estimates on historical experience and on various other assumptions
that we believe are reasonable under the circumstances. The results form the basis for making
judgments about the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different assumptions or
conditions. We believe the following critical accounting policies affect our more significant judgments
and estimates used in the preparation of our financial statements. We assemble and manufacture products for our customers and recognize revenue when persuasive
evidence of a sale exists; that is, a product is shipped under an agreement with a customer; risk
of loss and title have passed to the customer; the fee is fixed or determinable; and collection of
the resulting receivable is reasonably assured. This means that when a product is shipped from one
of our factories under the terms FOB Factory then the risk of loss passes to the customer when
the product leaves our factory and we recognize revenue at that time. On the other hand, when a
product is shipped under the title transfer terms of FOB Destination then the risk of loss during
transit is maintained by us. Thus, we recognize revenue when the product is accepted by the
customer. Shipping terms with one of our major customers is FOB Destination, and many of those
products are shipped by sea, taking four to six weeks to reach their destination. As a result, we
frequently have a significant amount of product in transit recorded in our finished goods
inventory. At December 31, 2004 and 2003, we had $3.1 million and $3.6 million of product in
transit, respectively. We recognize revenue related to engineering, design and other-related services after the
service has been rendered, which is determined based upon completion of agreed-upon milestones or
deliverables. Service revenues are not significant in any period presented. 24




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##### Table of Contents



We estimate sales allowances based upon historical experience of sales returns. To establish
our allowance for doubtful accounts, we perform credit evaluations of our customers financial
condition, along with analyzing past experience, and make provisions for doubtful accounts based on
the outcome of our credit valuations and analysis. We evaluate the collectability of our accounts
receivable based on specific customer circumstances, current economic trends, historical experience
with collections, and the age of past due receivables. We believe the allowances that we have
established are adequate under the circumstances; however, a change in the economic environment or
a customers financial condition could cause our estimates of allowances, and consequently the
provision for doubtful accounts, to change. During 2004, we entered into a series of agreements with Vitelcom, a former European customer,
with regard to their payment of an outstanding balance due us. The first agreement was entered into
in June 2004 with regard to $5.9 million due to us and provided for the amount due to be paid to us
in a series of installments through October 2004. In September 2004, we agreed to a revised payment
schedule with installments due through the end of 2004. At the end of the year, $1.4 million
remained unpaid under that revised payment schedule. We have not taken a reserve for doubtful
accounts for this amount because, in our estimation, this amount will be paid. In the first
quarter of 2005 we filed a lawsuit against Vitelcom in Spain for the unpaid amount. We scrap inventory when materials are determined to be defective, damaged or no longer
required. We also write down our inventory for estimated obsolescence or unmarketable inventory
based upon assumptions and estimates about future demand and market conditions. If actual market
conditions are less favorable than those projected by us, additional inventory write-downs may be
required. As noted below, we have had a significant history of inventory charges and write-offs,
with over $5 million of expenses in 2004:  
    In the fourth quarter of 2003, we learned from a customer that a product shipped by
us to them contained potentially defective parts. Those potentially defective parts
were printed circuit boards supplied to us by a vendor specified by our customer. At
year-end 2003, we believed the parts could be repaired or that the component supplier
would reimburse us for the damages. We determined in the first quarter of 2004 that the
latent defect in the materials purchased was not repairable and that it was possible
that the component supplier would not reimburse us for damages beyond the cost of those
boards. As a result, we established a reserve for the value of that inventory, which
included other component parts that had already been included on those boards less the
$158,000 value of the boards for which we believe the supplier is obligated to repay at
a minimum. The amount reserved was approximately $1.0 million.
    At year-end 2003, we held $778,000 of inventory relating to a program cancelled by a
customer. At that time, we believed we would recover the carrying value of this
inventory and did not establish a reserve. After further discussions and negotiations
with this customer during the first quarter of 2004, we wrote off $332,000 of this
inventory while receiving settlement against the remainder of the inventory.
    In the second quarter of 2004, a telecommunications customer declared bankruptcy. As
a result of that event, we wrote off $127,000 in accounts receivable and recorded a
$567,000 reserve against inventory relating to specific programs for that customer.
    In the third quarter of 2004, we wrote off $1.4 million as follows: (a) $435,000 of
Redmond inventory due to the pending end-of-life of several long-running programs; (b)
$806,000 for inventory write-offs and other charges relating to the shut-down of
various programs as a result of the move of the display module operations from Manila
to Beijing; and (c) $202,000 of inventory in Manila related to Microtune.
    In the fourth quarter of 2004, we wrote off $1.8 million of inventory as follows:
(a) $284,000 of Redmond inventory relating to termination of customer programs; (b)
$284,000 of Penang inventory for quality issues related to a new customer start-up; (c)
$469,000 of Manila inventory for excess and obsolete inventory relating to Microtune;
and (d) $774,000 display platform related inventory charges, most of which were due to
excess and obsolete issues. 25




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Despite these write-offs, the inventory balances at the end of 2004 still exceeded the
inventory amounts needed to satisfy all open orders. This is a typical situation in the
manufacturing industry, however, and we have estimated that all unreserved inventory will be
utilized. Pursuant to Financial Accounting Standards Board (FASB) Statement of Financial Accounting
Standards (SFAS) No. 109, Accounting for Income Taxes, income taxes are recorded based on
current year amounts payable or refundable, as well as the consequences of events that give rise to
deferred tax assets and liabilities. We base our estimate of current and deferred taxes on the tax
laws and rates that are currently in effect in the appropriate jurisdiction. Changes in tax laws
or rates may affect the current amounts payable or refundable as well as the amount of deferred tax
assets or liabilities. At the end of the second quarter of 2003, we had $19.8 million of net deferred tax assets,
resulting primarily from net operating loss and tax credit carryforwards. SFAS No. 109 requires
that a valuation allowance be established when it is more likely than not that all or a portion of
a deferred tax asset will not be realized. In determining whether a valuation allowance is
required, we are required to take into account all positive and negative evidence with regard to
the utilization of a deferred tax asset, including our past earnings history, market conditions,
management forecasts of future profitability, the character and jurisdiction of such earnings,
unsettled circumstances that, if unfavorably resolved, would adversely affect utilization of a
deferred tax asset, carryback and carryforward periods, and tax strategies that could potentially
enhance the likelihood of realization of a deferred tax asset. SFAS No. 109 further states that it
is difficult to conclude that a valuation allowance is not needed when there is negative evidence
such as cumulative losses in recent years. Therefore, despite the fact that a major portion of the
losses came from our spun-off microdisplay division, the expectation in the third quarter of 2003
was that we would have three years of cumulative losses. Those cumulative losses weighed heavily in
the overall required assessment and outweighed our forecasted future profitability and expectation
that we will be able to utilize all of our net operating loss carryforwards. As a result, in the
third quarter of 2003, we recorded a charge to establish a full valuation allowance against our
deferred tax asset. We expect to continue to record a full valuation allowance on future tax
benefits until we return to sustained profitability. Long-term assets, such as property, plant, and equipment, intangibles, goodwill, and other
investments, are originally recorded at cost. On an ongoing basis, we assess these assets to
determine if their current recorded value is impaired. When assessing these assets, we consider
projected future cash flows to determine if impairment is applicable. Assets may also be evaluated
by identifying independent market values of assets that we believe to be comparable. If we believe
that an assets value is impaired, we write down the carrying value of the identified asset and
charge the impairment as an expense in the period in which the determination is made. In the third quarter of 2004, we determined that the $27.1 million goodwill balance associated
with the EMS reporting unit was impaired. Because of the ongoing performance issues experienced by
the Redmond location, including the integration issues experienced in Redmond in the second and
third quarters of 2004, and because of the reduction in market comparables, we engaged a
professional valuation firm to assist us in determining the fair value of the EMS goodwill. The
valuation included a market comparable study and a present value valuation based on our best
estimates of the future cash flows. The amount of the impairment loss was $21.3 million, and was
determined in accordance with the provisions of SFAS No. 142. As a result of the valuation
analysis, a goodwill balance of $5.7 million remains associated with the EMS reporting unit. The
valuation analysis involves significant management judgment regarding future operations. If actual
performance is less than forecasted, additional impairments could be required. We also conducted an analysis of the goodwill relating to the AVT acquisition, and that
analysis indicated no impairment of the AVT goodwill asset. In the third quarter of 2004, we wrote off the remaining $1.8 million of the customer list
associated with the AVT acquisition. This write-off occurred as a result of numerous changes in
the AVT business, including notification during the quarter that a customer was not renewing a
program. That notification, along with the other cumulative changes that have occurred since the
acquisition, resulted in a complete turnover in the customer base. Most of these changes were
driven mainly by the fact that the original business when acquired by us was selling CRT displays
and now is exclusively selling flat panel displays. 26




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##### Table of Contents



Under GAAP, we are required to amortize cash lease incentives that we receive up-front
relating to a lease over the term of the respective lease. In addition, when we sublease property
for an amount of consideration that is less than the lease amount we pay, we are required to report
as an expense the amount by which the total amount of lease consideration due under the original
lease exceeds the total amount of sublease income due under the sublease. In the fourth quarter of
2004, we moved into a new facility in Redmond and signed a seven year lease, under which the lessor
paid to us $900,000 upon moving into that new facility, in part to offset the costs of the move. We
have the option to renew the lease for an incremental five year term. We will offset our lease
expense on that new facility by the $900,000 ratably over the term of that lease. In addition, in
connection with that move, we moved out of an older, leased facility that had 36 months remaining
on the lease. We subleased that building for a monthly amount that was approximately 30% less than
the original lease amount due. As a result, we expensed in the fourth quarter the cumulative loss
on that sublease of $382,000. In January of 2005, we moved out of another older facility in
Redmond, Washington that had 12 months remaining on the lease. A charge of approximately $197,000
is expected to be recorded in the first quarter of 2005 to recognize future costs associated with
the continuing lease obligation of this facility. In the fourth quarter of 2004, we sold our Tempe building for $11.3 million, less selling
costs of approximately $500,000. Under the terms of the sale, we received net cash (after expenses)
of $8.8 million and a promissory note of $2 million payable in five years, resulting in a $2.7
million gain on the sale of that building. Because we leased back the Tempe facility for five
years, we will recognize the gain ratably over the life of the lease. At the end of 2004, we began to review our business performance using two segments, Display
and EMS. Within the Display business, our design and manufacturing services include a distinctive
competence in display modules and systems and the integration of display modules and systems into
other products. The display modules and systems we design and manufacture primarily utilize liquid
crystal displays, or LCDs. Those LCDs include small form factor monochrome and color LCDs,
including thin film transistor LCDs, or TFTs, as well as large format flat panel monitors. Within
the EMS business, we design and/or manufacture electronic printed circuit board assemblies, radio
frequency, or RF, modules, display modules and systems, and complete systems for customers in the
computing, consumer, industrial, medical, telecommunications, and transportation industries.
Corporate costs not allocated to operating segments include administrative costs for the chief
executive officer, chief financial officer and investor relations as well as accounting and human
resource costs in Tempe, Arizona. Corporate costs in 2002 and 2003 also include costs related to
Microdisplays that could not be classified as discontinued operations. Results of Operations The following table sets forth, for the periods indicated, the percentage of net sales of
certain items in our Consolidated Financial Statements. 27




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##### Table of Contents



Years Ended December 31,2002
    
    
    2003
    
    
    2004Net sales
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Costs and expenses:Cost of sales
    
    
    90.9
    
    
    
    97.6
    
    
    
    101.3Selling, general, and administrative
    
    
    12.0
    
    
    
    11.0
    
    
    
    15.7Research, development, and engineering
    
    
    5.7
    
    
    
    3.0
    
    
    
    1.8Impairment of goodwill
    
    
    
    
    
    
    
    
    
    
    13.4Impairment of intangibles
    
    
    
    
    
    
    
    
    
    
    1.2Loss (gain) on sale of assets
    
    
    5.2
    
    
    
    
    
    
    
    Amortization of intangibles
    
    
    0.3
    
    
    
    1.3
    
    
    
    1.2114.1
    
    
    
    112.9
    
    
    
    134.6Operating loss
    
    
    (14.1
    )
    
    
    (12.9
    )
    
    
    (34.6
    )Other income, net
    
    
    4.0
    
    
    
    0.6
    
    
    
    0.3Minority interest in loss (income) of
consolidated subsidiary
    
    
    0.1
    
    
    
    
    
    
    
    Loss from continuing operations
before income taxes
    
    
    (10.0
    )
    
    
    (12.3
    )
    
    
    (34.3
    )Provision for (benefit from) incomes taxes
    
    
    (4.5
    )
    
    
    9.0
    
    
    
    (.1
    )Loss from continuing operations
    
    
    (5.5
    )
    
    
    (21.3
    )
    
    
    (34.2
    )Loss from discontinued operations, net of taxes
    
    
    (14.1
    )
    
    
    (6.7
    )
    
    
    Net loss
    
    
    (19.6
    )%
    
    
    (28.0
    )%
    
    
    (34.2
    )%
 Year ended December 31, 2004 compared to year ended December 31, 2003 Overview of 2004.We continued our transition from being mainly a display company to becoming
a full service electronic manufacturing services, or EMS, company. Our revenue was flat in 2004
over 2003. Our display sales were down, primarily because we are in a transition period with our
display business as we move from manufacturing only passive display modules to focusing on
manufacturing color TFT products. Our EMS sales were up, primarily because we had a full year of
sales in 2004 in our Penang operations and only a partial year of operations in 2003. We also
completed a transaction in early 2004 with Integrex, which provided us with several new EMS
customers in our Redmond operation. We reported losses throughout 2004 for several reasons. We
continue to have excess capacity in our factories. We had integration problems with Integrex in the
second and third quarters. We also reported substantial write-offs of excess, scrap, and obsolete
inventory in each quarter in 2004 as a result of several factors, including changes in customer
demand, lost customers, and defective materials. We consolidated our display module operations in
Beijing and closed the display module operations in Manila, which resulted in expenses associated
with layoffs and excess inventory. We had impairment charges of some of our intangible assets
associated with past acquisitions. We also made several changes in our ownership and leasing of our
factories in 2004. In mid 2004, we purchased our Manila factory. In late 2004, we sold our Tempe
building and leased it back for 5 years. We also moved into a new facility in Redmond with the plan
to sublease some or all of our other facilities in Redmond. Finally, in early 2005 we announced
that we are considering the sale of Manila, moving our corporate headquarters to Redmond, and
closing down our line of display products provided by Data International. Net Sales.Net sales were $158.9 million in 2004 and $159.0 million in 2003. In 2004, our
sales were distributed over six major markets: computing, consumer, industrial, medical,
telecommunications, and transportation. In 2003, we primarily sold to the same six major markets.
In 2004, we experienced a decline in our sales to the telecommunications industry. Our net sales
distributed by industry were as follows: 28




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##### Table of Contents



Industry
    
    2003
    
    
    2004Computing
    
    
    38
    %
    
    
    53
    %Consumer
    
    
    6
    %
    
    
    11
    %Industrial
    
    
    10
    %
    
    
    13
    %Medical
    
    
    13
    %
    
    
    10
    %Telecommunications
    
    
    28
    %
    
    
    8
    %Transportation
    
    
    5
    %
    
    
    5
    %
 Geographically, in 2004, 62.2% of our sales were in the United States; 18.4% of our sales were
in Asia; and 19.4% of our sales were in Europe. Sales in our two segments, in millions, were as follows: 2003
    
    
    2004Display
    
    $
    78.5
    
    
    $
    53.1EMS
    
    
    80.5
    
    
    
    105.8$
    159.0
    
    
    $
    158.9
 Sales in the display business declined as a result of our decision to transition our products
from monochrome and passive color to the more advanced thin film transistor (TFT) color. That
transition resulted in reduced passive display sales before the TFT ramp up, which is now expected
in mid 2005. Sales in the EMS business increased primarily as a result of the acquisition of Unico
in April 2003 and Integrex in February 2004. Cost of Sales.Cost of sales increased to 101.3% of net sales in 2004 from 97.6% in 2003.
Our gross margin is equal to the difference between our revenue and our cost of sales.
Consequently, our company-wide gross margin in 2004 was a negative $2.1 million. The gross margin
dollars in our two segments, in millions, were as follows: 2003
    
    
    2004Display
    
    $
    (1.4
    )
    
    $
    (0.9
    )EMS
    
    
    5.5
    
    
    
    (1.2
    )Corporate costs
    
    
    (0.2
    )
    
    
    $
    3.9
    
    
    $
    (2.1
    )
 The negative gross margins in 2004 were caused by several factors, including excess capacity
in the manufacturing facilities, integration problems with the new Integrex customers, and
operational issues resulting in write-downs of excess inventory. Specifically, nearly $5.2 million
of charges relate to inventory write-offs for excess, scrap, and obsolete inventory, of which $2.7
related to the EMS business and $2.5 related to the Display business. Also included in the Display
gross margins was the cost of consolidating the display module business in Beijing, estimated at
approximately $1.0 in 2004. That business was previously operating in both Beijing and Manila. Not
including that consolidation cost, the Display business gross margins improved in 2004 because
issues in 2003 relating to the initial ramp of passive color display modules were remedied at the
end of 2003. Selling, General, and Administrative Expense.Selling, general, and administrative expense
increased 42% to $24.9 million in 2004 from $17.5 million in 2003. As a percentage of net sales,
SG&A expense increased from 11.0% of net sales in 2003 to 15.7% of net sales in 2004. This increase
in SG&A expense occurred primarily as a result of additional finance and administrative expenses of
$1.9 million associated with our increased infrastructure, costs of approximately $1.2 million
associated with our compliance with the Sarbanes-Oxley Act of 2002, $1.0 million associated with
incurring Brillian related facility costs under SG&A (all of which are paid for by Brillian under
their sub-lease, which we report in other income), and additional selling expenses of $3.3 million
associated with personnel added from acquisitions and expansion of our market focus. The SG&A expense in our two segments and for unallocated corporate costs for the last two
years, in millions, were as follows: 29




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##### Table of Contents



2003
    
    
    2004Display
    
    $
    4.3
    
    
    $
    7.5EMS
    
    
    4.6
    
    
    
    7.4Corporate costs
    
    
    8.6
    
    
    
    10.0$
    17.5
    
    
    $
    24.9
 The increase in the EMS costs were the result of several factors, including having a full year
of costs associated with our Penang operations in 2004, but only a partial year of expenses in 2003
because that business was acquired in April 2003. The EMS business also had $561,000 of moving
expenses relating to the move of Redmonds manufacturing operation in the fourth quarter to a new
building. Most of the moving expense was reimbursed by the new landlord, but that reimbursement
will be amortized against the new lease expense ratably over the life of the new lease. The increase in the Display costs were primarily the result of moving engineering personnel
that were formerly reported in RD&E, into the sales function. Other cost increases relate to
increased sales and administrative personnel. Corporate costs include all unallocated finance, IT,, and administrative costs. Those costs
increased primarily because of the increase in costs associated with compliance with Sarbanes-Oxley
requirements, including the establishment of an internal auditing function and the increased
external auditing costs associated with the Section 404 assessment. Research, Development, and Engineering Expense.Research, development, and engineering
expense decreased to $2.9 million in 2004 from $4.7 million in 2003. Research, development, and
engineering expense was 1.8% of net sales in 2004 compared with 3.0% of net sales in 2003. The
RD&E expense in our two segments and for unallocated corporate costs for the last two years, in
millions, was as follows: 2003
    
    
    2004Display
    
    $
    3.3
    
    
    $
    2.6EMS
    
    
    0.1
    
    
    
    0.3Corporate costs
    
    
    1.3
    
    
    
    $
    4.7
    
    
    $
    2.9
 The large drop in Display RD&E expense was due to moving engineering personnel into the sales
function, as well as moving engineering operations offshore. The drop in Corporate was the result
of the reduction of RD&E expenses associated with the Brillian spin off. Impairment of Goodwill.During 2004, in our EMS segment, we reduced the goodwill on our
balance sheet relating to our ETMA acquisition. The write-off of goodwill was $21.3 million and
was due to the ongoing performance issues experienced by our Redmond manufacturing facility,
including the integration issues and the reduction in market comparables. We engaged a
professional valuation firm to assist us in determining the fair market value of that goodwill. Impairment of Intangibles.During 2004, in our Display segment, we wrote off $1.8 million for
customer lists associated with the AVT acquisition. These write-offs occurred as a result of
numerous changes in the AVT business, including notification during the third quarter of 2004 that
a customer was not renewing a program. That notification and other cumulative changes that have
occurred since the acquisition resulted in a complete turnover in the customer base. Most of the
changes were driven primarily by the fact that the original business when acquired by us was
selling CRT displays and is now exclusively selling flat panel displays. Loss (Gain) on Sale of Assets.In 2004, we realized a gain of $100,000 compared with a gain
of $25,000 in 2003 for the sale of certain assets. The gain in 2004 was primarily due to the sale
of module production equipment no longer required in Manila. Amortization of Intangibles.The amortization of customer lists was $1.9 million in 2004 and
$2.0 million in 2003. The amortization in 2003 and 2004 relates to the acquisitions of AVT and ETMA
and to the license agreement with Data International, all described above in Overview. Going
forward, the amortization of intangibles will relate solely to the ETMA customer list, as we wrote
off the intangible related to AVTs customer list in 2004 and we rescinded the license agreement
with Data International in 2005. The original balance of the 30




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##### Table of Contents



amortizable asset associated with ETMA was $2.0 million and is being amortized over three
years starting in 2002. The original amortizable asset associated with Data International was $3.9
million and is being amortized over five years starting in 2003. The original amortizable asset
associated with AVT was $3.0 million and was being amortized over five years starting in 2002.
This asset was written off during the third quarter of 2004. Other Income (Expense), Net.Other income in 2004 was $432,000 compared with $864,000 in
2003. The composition and differences of the items that make up other income were as follows (in
thousands): 2003
    
    
    2004Interest Income
    
    $
    872
    
    
    $
    227Interest Expense
    
    
    (1,051
    )
    
    
    (1,156
    )Rental and Service Income from Brillian
    
    
    384
    
    
    
    1,302Foreign Exchange and Other Gain (Loss)
    
    
    659
    
    
    
    59Other Income (Loss)
    
    $
    864
    
    
    $
    432
 The primary difference was an increase of $918,000 in rental and service income received from
Brillian Corporation. Our interest income decreased $645,000 because of decreased cash and
investments balances. Interest expense increased $105,000 and was primarily associated with the
capital leases for our equipment acquired in Malaysia and Redmond in the Unico and ETMA
acquisitions described above in Overview. In 2003, we reached a settlement of our legal claim
against J.D. Edwards and recorded the settlement as other income of approximately $700,000. Minority Interest.During the second quarter of 2004 we agreed with Unico Holdings to
exchange its ownership interest in TFS Electronic Manufacturing Services Sdn. Bhd. (TFS 
Malaysia) for approximately 423,000 shares of TFS common stock held in treasury in a transaction
valued at $2.8 million. As a result of that transaction, we now own 100% of TFS  Malaysia and no
longer have a minority interest adjustment. During 2003 we controlled and owned only 60% of the
business in Malaysia. During 2003 that business had losses and we recorded a benefit of $36,000 to
account for the losses allocated to the minority interest holder. Provision for (Benefit from) Income Taxes.We recorded a benefit for income taxes of $226,000
in 2004 compared to a provision for income taxes of $14.3 million for 2003. The benefit in 2004
was for tax refunds. The charge recorded in 2003 was to establish a valuation allowance against
our deferred tax asset, which consists primarily of net operating loss carryforwards, or NOLs. A
further description of that allowance is described above in Critical Accounting Policies and
Estimates. As a result, we generally no longer record a tax benefit for losses, except as
previously described. Net Loss.We had a net loss of $54.3 million, or $2.50 per diluted share, in 2004 compared
with a net loss of $44.5 million, or $2.09 per diluted share, in 2003. As noted above, the net loss
in 2004 included $23.1 million associated with the write-off of the goodwill of ETMA and the
customer list of AVT. The net loss in 2003 included $10.6 million from discontinued operations
relating to our former microdisplay business and $14.3 million for the tax valuation allowance. Year ended December 31, 2003 compared to year ended December 31, 2002 Overview of 2003.This was a year of transition for us. Prior to late 2002, we were a
monochrome custom LCD module supplier servicing primarily Motorola in the handset market. Beginning
in the second half of 2002, we expanded our capabilities to include standard, color and
large-format display products. More importantly, as a result of several acquisitions, we became a
broad-based electronics manufacturing services company offering services such as advanced printed
circuit board assembly, RF module assembly, and box build. In addition, we made the decision in
2003 to spin off our research-intensive microdisplay business to Brillian. Finally, we ceased
manufacturing display modules for Motorolas handset business in the second half of 2003. This
rapid change resulted in several issues during the year, including integration issues with the RF
module business, excess capacity at the display module factories, and negative margins on new color
display products. In the fourth quarter of 2003, we remedied the initial negative margin issues on
the color display products. We also made improvements in the manufacturing issues we had with the
RF modules. 31




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##### Table of Contents



Net Sales.Net sales increased 83.6% to $159.0 million in 2003 from $86.6 million in 2002.
Sales in our two segments, in millions, were as follows: 2002
    
    
    2003Display
    
    $
    82.8
    
    
    $
    78.5EMS
    
    
    3.8
    
    
    
    80.5$
    86.6
    
    
    $
    159.0
 We first acquired a business that could be characterized as electronics manufacturing
services, or EMS, in December 2002. Therefore, the EMS business conducted in 2002 was very small,
constituting only $3.8 million. In 2003, revenue in the EMS business had grown to $80.5 million,
and the revenue in the Display business was $78.5 million, which was slightly down from $82.8
million in 2002. The increase in the EMS revenue was primarily a result of the acquired business in Redmond and
Malaysia of $66.4 million, and growth in our EMS business through the addition of the RF module
business of $10.3 million. The decrease in the Display business was as a result of a decline in
sales to Motorola of $54.2 million. That decline was offset by the addition of our display
products from Data International of $15.9 million and sales of color display modules of $24.7
million. Our sales to Motorola declined because we did not win any display module business in
handsets after 2001 because of pricing issues. Motorola accounted for less than 10% of our total net sales in 2003 compared to 78% in 2002.
We had two customers that each exceeded more than 10% of our net sales in 2003. Avocent, which is
in the computer peripherals business and an EMS business customer, accounted for 23% of our net
sales, and Vitelcom, a European telecom company and a Display business customer, accounted for 13%
of our net sales. In 2003, our sales were distributed over six major markets: transportation, computing,
consumer, industrial, medical/instrumentation, and telecommunications. By contrast, in 2002, we
were highly concentrated, with 82.0% of our sales coming from a single market, telecommunications.
Our net sales distributed by industry were as follows: Industry
    
    2002
    
    
    2003Computing
    
    
    7
    %
    
    
    38
    %Consumer
    
    
    1
    %
    
    
    6
    %Industrial
    
    
    5
    %
    
    
    10
    %Medical
    
    
    4
    %
    
    
    13
    %Telecommunication
    
    
    82
    %
    
    
    28
    %Transportation
    
    
    1
    %
    
    
    5
    %
 Geographically, in 2003, 54.0% of our sales were in the United States; 20.5% of our sales were
in Asia; and 25.5% of our sales were in Europe. Our recent trend has shown increased sales in the
United States and Europe. Our increased sales in the United States were primarily a result of
several recently acquired businesses and because of increased display-oriented manufacturing
business. Our increased sales in Europe were primarily a result of the increased sales of color LCD
modules to a European handset manufacturing company. Asia sales declined because of the reduced
sales to Motorola, most of which were in China. Not including Motorola, however, the trend has been
that our sales in Asia are increasing. Most of our Asian sales in 2003 were to U.S.-based,
multinational companies with factories located in Asia. Cost of Sales.Cost of sales increased to 97.6% of net sales in 2003 from 90.9% in 2002. Our
gross margin is equal to the difference between our revenue and our cost of sales. Consequently,
our company-wide gross margin in 2003 was $3.9 million or 2.4% of net sales, as compared to $7.9
million, or 9.1% of net sales in 2002. The gross margin dollars in our two segments, in millions,
were as follows: 2002
    
    
    2003Display
    
    $
    7.6
    
    
    $
    (1.4
    )EMS
    
    
    0.5
    
    
    
    5.5Corporate costs
    
    
    (0.2
    )
    
    
    (0.2
    )$
    7.9
    
    
    $
    3.9
 32




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The gross margin in the Display segment was impacted in 2003 because of the reduced sales to
Motorola and because the replacement sales to other display customers had lower volumes but higher
selling prices. These reduced manufacturing volumes resulted in under-absorption of our fixed
manufacturing costs. Also, in Manila, the gross margins on our color display products were
negative because of introductory pricing on new products and because we had not obtained expected
pricing reductions from vendors of color panels. The gross margin in the EMS segment was impacted
in 2003 because we were still in the process of ramping up our RF module manufacturing in Manila
and moving those processes from Microtunes factory to ours. As a result, those products sold at
below breakeven during the ramp-up phase. Selling, General, and Administrative Expense.Selling, general, and administrative expense
increased 68.3% to $17.5 million in 2003 from $10.4 million in 2002. As a percentage of net sales,
however, SG&A expense decreased from 12.0% of net sales in 2002 to 11.0% of net sales in 2003. The
SG&A expense in our two segments and for unallocated corporate costs for the two comparative years,
in millions, were as follows: 2002
    
    
    2003Display
    
    $
    3.2
    
    
    $
    4.3EMS
    
    
    0.2
    
    
    
    4.6Corporate costs
    
    
    7.0
    
    
    
    8.6$
    10.4
    
    
    $
    17.5
 This overall change in SG&A expense occurred primarily because of four factors: (1) the
additional SG&A costs in the EMS segment associated with the acquired EMS business in Redmond of
$2.9 million and the acquired EMS business in Penang of $1.5 million, (2) increased sales expenses
of $1.3 million in the Display segment as a result of increased sales, and (3) increased expenses
in corporate, including the recording of expenses of approximately $1.2 million associated with an
arbitration claim we pursued against J.D. Edwards, which was settled. Research, Development, and Engineering Expense.Research, development, and engineering
expense decreased slightly to $4.7 million in 2003 from $4.9 million in 2002. Research,
development, and engineering expense decreased as a percentage of net sales, declining to 3.0% of
net sales in 2003 from 5.7% of net sales in 2002. Corporate costs are related to our prior
microdisplay business. The RD&E expense in our two segments and for unallocated corporate costs
for the two comparative years, in millions, was as follows: 2002
    
    
    2003Display
    
    $
    3.1
    
    
    $
    3.3EMS
    
    
    
    
    
    
    0.1Corporate costs
    
    
    1.8
    
    
    
    1.3$
    4.9
    
    
    $
    4.7
 Loss (Gain) on Sale of Assets.In 2003, we realized a gain of $25,000 from the sale of
certain assets compared to a loss of $4.5 million in 2002. The loss in 2002 related to the sale of
our front-end manufacturing LCD equipment for $3 million. Amortization of Intangibles.During 2003, we had $2.0 million of amortization relating to
customer lists and distribution rights compared to $256,000 of amortization expense during 2002.
The amortization in 2003 relates to the acquisitions of AVT and ETMA and to the license agreement
with Data International, all described above in Overview. The amortizable asset associated with
ETMA was $2.0 million and was being amortized over three years. The amortizable asset associated
with Data International was $3.9 million and was being amortized over five years. The amortizable
asset associated with AVT was $3.0 million and was being amortized over five years starting in
2002. This asset was written off during the third quarter of 2004. Other Income (Expense), Net.Other income in 2003 was $864,000 compared to $3.5 million in
2002. The primary difference was that interest income decreased $2.6 million because of decreased
cash and investments balances and because the interest rate earned on investments was lower in 2003
than 2002. The interest expense increased $886,000 and was primarily associated with the capital
leases for our equipment acquired in Malaysia and 33




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Redmond in the Unico and ETMA acquisitions described above in Overview. In 2003, we reached
a settlement of our legal claim against J.D. Edwards and recorded the settlement as other income of
approximately $700,000. Minority Interest.Prior to 2004, we owned only 60% of the business in Malaysia. Since that
business had losses in 2003, we recorded a benefit of $36,000 to account for the losses allocated
to the minority interest holder compared to a charge of $84,000 in 2002 relating to the winding-up
of another investment with a different minority partner. Provision for (Benefit from) Income Taxes.We recorded a provision for income taxes of $14.3
million in 2003 compared to a benefit from income taxes of $3.9 million for 2002. We recorded a
charge in 2003 to establish a valuation allowance against our deferred tax asset, which consists
primarily of net operating loss carryforwards, or NOLs. A further description of that allowance is
described above in Critical Accounting Policies and Estimates. The loss from discontinued
operations was net of a tax benefit of $6.7 million for the year ended December 31, 2002. There was
no tax benefit in 2003 for discontinued operations. Net Loss.We had a net loss of $44.5 million, or $2.09 per diluted share, in 2003 compared
with a net loss of $17.0 million, or $0.79 per diluted share, in 2002. The net loss in 2003
included $10.6 million, or $0.50 per share, from discontinued operations relating to our former
microdisplay business. As described above in Discontinued Operations, our microdisplay division
was spun off as a separate public company as of September 15, 2003, as Brillian Corporation. The
net loss for the Brillian discontinued operations in 2002 was $12.3 million, or $0.57 per share. Liquidity and Capital Resources At December 31, 2004, we had cash, cash equivalents, and short-term investments of $16.2
million compared with $33.1 million at December 31, 2003, which was a reduction, or cash outflow of
$16.9 million. The primary components of the reduction can be summarized for 2004, in millions, as
follows: Operating Cash Flow
    
    $
    (14.7
    )Capital Expenditures, Acquisitions, net of proceeds from Sales of
Assets
    
    $
    (1.3
    )Debt and Capital Lease Repayments
    
    $
    (3.6
    )Borrowings on Line of Credit
    
    $
    2.4
 In reviewing our consolidated statement of cash flows, we had $14.7 million in net cash
outflow from operations in 2004 compared with $2.0 million in net cash outflow from operations in
2003. Our inventory turns were 6.8 and day sales outstanding, or DSOs, were 52 days in 2004

compared with 7.2 inventory turns and 51 DSOs in 2003. Our depreciation and amortization expense
was $8.6 million in 2004 and $7.6 million in 2003. The increased operating loss was the primary
reason for increased net cash outflow from operations. We had purchases of property, plant and equipment of approximately $8.1 million, which
included our ongoing ERP implementation and additions in China related to our TFT clean room. Also
included in those expenditures was the purchase of our facility in Manila from our lessor for a
total payment of $3.8 million, of which $3.2 million was assigned to the carrying value of the
building and $585,000 was applied to accrued rent liabilities. We also paid $614,000 to the RBF
Development Corporation for a 50-year land right. Lastly, we executed an agreement with RBF for an
option to purchase the leased land for $1 at any time until April 23, 2014. As a result of the
building purchase and land right agreement, we were released from the obligation to pay $7.8
million in lease payments that were due over the next seven years that were remaining on our
original ten- year lease agreement. In 2004, we realized net proceeds from the sale of assets of $9.6 million. Those proceeds were
generated from the sale of various pieces of unused manufacturing equipment as well as from the
sale of our facility in Tempe, Arizona, which generated $8.8 million in cash. On the sale of the
Tempe facility, we also received a $2.0 million note receivable from the buyer, which bears simple
interest at 6% per year. Interest is payable monthly beginning on February 1, 2005. The principal
is due in a lump sum payment on December 30, 2009. At the time of the Tempe sale, we entered into
a lease agreement with the buyer for a period of five years. Under the terms of the lease, if we
default on the rental payments during the five-year period, the buyer is relieved of its obligation
to pay the $2.0 million note. 34




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During 2004, we also completed further acquisitions and strategic investments of $2.7 million
all of which related to the Integrex transaction, which included license fees. The Integrex
transaction is described above in Overview  Acquisitions and Strategic Investments in this Item. During 2004, we had payments on our capital leases of $2.2 million. Most of those payments
related to our capital leases for our manufacturing equipment in Penang. Our working capital was $26.9 million at December 31, 2004, down from $59.6 million at
December 31, 2003. Our current ratio at December 31, 2004 was 1.7-to-1 compared with 2.5-to-1 at
December 31, 2003. The decrease in working capital was primarily because of reduced cash,
short-term investments, and accounts receivable balances. While we transact business predominantly in U.S. dollars and invoice and collect most of our
sales in U.S. dollars, we collect a portion of our revenue in non-U.S. currencies, such as the
Chinese Renminbi. In the future, customers increasingly may make payments in non-U.S. currencies,
such as the Euro. In addition, we account for a portion of our costs, such as payroll, rent, and
indirect operating costs, in non-U.S. currencies, including Philippine Pesos, British Pounds
Sterling, Malaysian Ringgit, and Chinese Renminbi. Thus, fluctuations in foreign currency exchange
rates could affect our cost of goods and operating margins and could result in exchange losses. In
addition, currency devaluation can result in a loss to us if we hold deposits of that currency.
Hedging foreign currencies can be difficult, especially if the currency is not freely traded. We
cannot predict the impact of future exchange rate fluctuations on our operating results. These
currency risks are particularly important since sales outside North America represented 37.8% of
our net sales in 2004 and 46.0% of our net sales in 2003. Sales in foreign markets, primarily
Europe and Asia, to OEMs based in the United States accounted for almost all of our international
sales in both of these periods. In the first quarter of 2004, we entered into a credit facility with the First National Bank
under which we borrowed $5.0 million secured by restricted cash deposits. In the second quarter of
2004, we repaid and terminated that credit facility. In the second quarter of 2004, we entered into a $10.0 million secured revolving line of
credit with Silicon Valley Bank, or SVB, which matures on June 25, 2005. Initially, that line of
credit bore interest at the banks prime rate plus 75 basis points, subject to a minimum rate of
4.75%. The SVB line also contained restrictive covenants that included, among other things,
restrictions on the declaration of payments of dividends, restrictions on the sale or transfer of
assets, and maintenance of specified net worth and quick ratio. We owed $5.0 million under that
line of credit as of September 30, 2004. As of September 30, 2004, we did not meet some of the
required covenants, although SVB did not call a default on the SVB line. During the fourth
quarter, we signed an amendment to the original SVB line that substantially revised its terms and
conditions. Under those new terms, the first $2.5 million of borrowings under that line of credit
accrue interest at the banks prime rate plus 125 basis points subject to a minimum rate of 4.75%
and borrowings above $2.5 million are subject to a factoring arrangement, bearing an initial
discount fee and interest of prime plus 450 basis points on the factored receivables. The credit
limit remained at $10 million, but there were fewer receivables that qualified as factorable as
compared to the original borrowing base, resulting in a potentially lower borrowing base. Many of
the restrictive covenants previously contained in the SVB line documents were removed, although
covenants did remain relating to cash earnings, revenue, and the Tempe building sale. We reduced
our line of credit balance with SVB from $5 million to zero during the fourth quarter. Although
there were no borrowings under the SVB line as of December 31, 2004, we were in violation of our
covenants relating to cash earnings and revenue. SVB did not declare a default on the line, but we
are currently under discussion with SVB with regard to a re-negotiation of the terms of the line.
During this re-negotiation period, SVB has issued a forbearance letter under which we are precluded
access to the line. In addition, SVB required us to make a cash deposit in the first quarter of
2005 to secure a $600,000 letter of credit, which SVB had issued to the lessor of our building in
Redmond. In the second quarter of 2004, our Beijing subsidiary secured a $2.4 million line of credit
with Hua Xia Bank secured principally by our building in Beijing. We had borrowed $2.4 million
under that facility at December 31, 2004, which accrues simple, annual interest at 5.31%. 35




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The
following tables list our contractual obligations and commercial
commitments as of December 31, 2004: Payments due by PeriodContractual Obligations
    
    Total
    
    
    Less
    
    
    
    
    
    
    
    
    
    
    6 Years(Dollars in thousands)
    
    Obligations
    
    
    than 1 Year
    
    
    1-3 Years
    
    
    4-5 Years
    
    
    and OverNotes Payable
    
    
    1,547
    
    
    
    1,547
    
    
    
    
    
    
    
    
    
    
    
    Lines of Credit
    
    
    2,416
    
    
    
    2,416
    
    
    
    
    
    
    
    
    
    
    
    Operating Leases
    
    
    25,333
    
    
    
    4,908
    
    
    
    6,621
    
    
    
    5,267
    
    
    
    8,537Capital Leases
    
    
    7,770
    
    
    
    3,430
    
    
    
    4,310
    
    
    
    30
    
    
    
    Other Contractual Obligations
    
    
    1,080
    
    
    
    871
    
    
    
    209
    
    
    
    
    
    
    
    Total
    
    $
    38,146
    
    
    $
    13,172
    
    
    $
    11,140
    
    
    $
    5,297
    
    
    $
    8,537
 Amount of Commitment Expiration Per PeriodOther Commercial Commitments
    
    Total
    
    
    Less
    
    
    
    
    
    
    
    
    
    
    6 Years(Dollars in thousands)
    
    Commitments
    
    
    than 1 Year
    
    
    1-3 Years
    
    
    4-5 Years
    
    
    and OverGuarantee
    
    $
    327
    
    
    $
    
    
    
    $
    327
    
    
    $
    
    
    
    
    
 The operating leases include leases for our factories in Penang, Washington,
Massachusetts, our lease in Arizona, and our sales offices in Florida and in the United Kingdom.
In the second quarter of 2004, we purchased our leased building in Manila. As a result of the
building purchase, we will no longer be required to pay the $7.8 million over the next seven years
that was remaining on our original ten year operating lease agreement. These leases are described
in detail in Item 2 of this report. The capital leases are for our equipment in Malaysia and
Washington. One of the capital leases includes certain financial covenants that we were not in
compliance with at December 31, 2004. The lessor has advised us they are accelerating the payments
due on the lease obligations. The guarantee relates to our guarantee in connection with a Small
Business Administration loan to VoiceViewer Technology, Inc., a privately held company developing
microdisplay products. Brillian assumed this guarantee in the spin-off. If Brillian Corporation
were unable to satisfy its obligation as primary guarantor, then we would be required to pay the
guaranteed amount. We have no other long-term debt, capital lease obligations, unconditional purchase
obligations, or other long-term obligations, and we do not have any other commercial commitments or
other off-balance sheet arrangements. Our cash balance as of December 31, 2004 was $16.2 million. We expect to have continued
operating losses in 2005, primarily in our EMS segment. Therefore, we have taken numerous steps to
provide adequate liquidity to operate through the end of 2005. We recently signed a definitive agreement to sell the assets of our small form factor display
business to International DisplayWorks, Inc. That sale would not include the display monitor
business operated out of our Marlborough, Massachusetts facility. Closing of the sale to
International DisplayWorks, Inc. is expected to occur in April 2005. TFS estimates the total value of
that transaction will range between $11 million and $21 million and will include an $8 million cash
payment at closing. The sale of the small form factor display operations to International
DisplayWorks, Inc. will not only generate cash proceeds to us but eliminate the need for additional
sources of funds for the sold operations. In January 2005 we began to explore the sale of our Manila factory, and we currently are
reviewing indications of interest made with respect to that facility. In the second quarter, we
expect either to sell that operation intact or terminate the operations at that facility and sell
the liquidated assets, including the equipment, inventory, and real property. Additional potential sources of capital in 2005 will be bank financings. We are pursuing a
loan in Malaysia, and we expect to finalize the documentation of that loan in the second quarter.
It also is possible that the sale of display operations could enable us to re-establish loan
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or banks. We cannot provide assurance on potential loans or that the terms of such loan
commitments or debt financing would be on terms acceptable to us. Based upon our cash balances, our expected use of cash in 2005, and the definitive agreement
with International DisplayWorks, Inc., we believe that we have adequate sources to fund our
remaining operations and planned expenditures through 2005, as well as to meet our contractual
obligations. The expected use of funds through the rest of 2005, however, is based on our
judgments and forecasts. Actual results could prove materially different and, in such instances,
may require additional funds. We cannot provide assurance that additional asset sales, such as the
sale of the Manila operations, loan commitments, or other methods of financing will be available
for any such unexpected additional requirements or, if available, that they will be on terms
acceptable to us. Impact of Recently Issued Standards. In November 2004, the FASB issued SFAS No. 151, Inventory Costs  An Amendment of ARB No. 43,
Chapter 4. SFAS No. 151 amends the guidance in Accounting Research Bulletin (ARB) No. 43, Chapter
4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material (spoilage). Among other provisions, the new rule
requires that items such as idle facility expense, excessive spoilage, double freight, and
rehandling costs be recognized as current-period charges regardless of whether they meet the
criterion of so abnormal as stated in ARB No. 43. Additionally, SFAS No. 151 requires that the
allocation of fixed production overheads to the costs of conversion be based on the normal capacity
of the production facilities. SFAS No. 151 is effective for fiscal years beginning after June 15,
2005, and is required to be adopted by the Company effective January 1, 2006. The Company is
currently evaluating the impact SFAS No. 151 will have on its consolidated results of operations or
financial condition. In December 2004, the FASB issued Statement 123 (R), Share-Based Payment which replaces FASB
Statement No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25,
Accounting for Stock Issued to Employees. FASB Statement 123 (R) will require compensation costs
related to share-based payment transactions to be recognized in the financial statements. With
limited exceptions, the amount of compensation cost will be measured based on the grant-date fair
value of the equity instruments issued. Compensation cost will be recognized over the period that
an employee provides service in exchange for the award. FASB Statement 123 (R) becomes effective
for interim or annual periods beginning after June 15, 2005. At this time the company is in the
process of evaluating the impact this will have on its financial statements. We adopted the provisions of FASB Interpretation No. 46 (Revised), Consolidation of Variable
Interest Entities (Interpretation No. 46 (Revised)) in our interim period ending March 31, 2004.
Interpretation No. 46 (Revised) clarifies the application of existing consolidation requirements to entities where
a controlling financial interest is achieved through arrangements that do not involve voting
interests. The
application of Interpretation No. 46 (Revised) did not have an impact on our financial statements. Rule 10b5-1 Trading Plans Our Insider Trading Policy permits our directors, officers, and other key personnel to
establish purchase and sale programs in accordance with Rule 10b5-1 adopted by the Securities and
Exchange Commission. The rule permits employees to adopt written plans at a time before becoming
aware of material nonpublic information and to sell shares according to a plan on a regular basis
(for example, weekly or monthly), regardless of any subsequent nonpublic information they receive.
In our view, Rule 10b5-1 plans are beneficial because systematic, pre-planned sales that take place
over an extended period should have a less disruptive influence on the price of our stock. We also
believe plans of this type are beneficial because they inform the marketplace about the nature of
the trading activities of our directors and officers. In the absence of such information, the
market could mistakenly attribute transactions as reflecting a lack of confidence in our company or
an indication of an impending event involving our company. We recognize that our directors and
officers may have reasons totally apart from the company in determining to effect transactions in
our common stock. These reasons could include the purchase of a home, tax and estate planning, the
payment of college tuition, the establishment of a trust, the balancing of assets, or other
personal reasons. The establishment of any trading plan involving our company requires the
pre-clearance by our Chief Executive Officer or Chief Financial Officer. An individual adopting a
trading plan must comply with all requirements of Rule 10b5-1, including the requirement that the
individual not possess any material nonpublic 37




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information regarding our company at the time of the establishment of the plan. In addition, sales
under a trading plan may be made no earlier than 30 days after the plan establishment date. No officers currently maintain trading plans. 
 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity
Instruments At December 31, 2004, we did not participate in any derivative financial instruments, or other
financial and commodity instruments for which fair value disclosure would be required under
Statement of Financial Accounting Standards No. 107. We hold no investment securities that would
require disclosure of market risk. We have certain receivables denominated in Chinese Renminbi and certain payables denominated
in Japanese Yen. To eliminate our exposure to changes in the U.S. Dollar exchange rate with
Chinese Renminbi and Japanese Yen, we may enter into forward contracts to protect future cash
flows. We have designated the forward contracts as cash flow hedges. Accordingly, we account for
changes in the fair value of our forward contracts, based on changes in the forward exchange rate,
with all changes in fair value reported in other comprehensive income. Amounts in other
comprehensive income will be reclassified into earnings upon settlement of the forward contract.
As of December 31, 2004, we had no forward contracts outstanding. Primary Market Risk Exposures Our primary market risk exposures are in the areas of interest rate risk and foreign currency
exchange rate risk. We currently have no outstanding borrowing under our credit facility in the
United States. We generally sell our products and services and negotiate purchase orders with our foreign
suppliers in U.S. Dollars. However, we have certain foreign currency exchange exposure as a result
of our manufacturing operations in the Philippines, Malaysia, and China and our sales and
distribution facility in the United Kingdom. We have not incurred any material exchange gains or
losses to date. Some of the expenses of these foreign operations are denominated in the Philippine
Peso, Malaysian Ringgit, Chinese Renminbi, and British Pound Sterling, respectively. These
expenses include local salaries and wages, utilities, and some operating supplies. As a result of
these sales and expenses, we do have accounts receivable and cash deposits in local currencies. We
believe, however, that the operating expenses currently incurred in foreign currencies other than
the Chinese Renminbi are immaterial, and therefore any associated market risk is unlikely to have a
material adverse effect on our business, results of operations, or financial condition. Although
the Chinese currency currently is stable, its value in relation to the U.S. Dollar is determined by
the Chinese government. There is general speculation that China may devalue its currency.
Devaluation of the Chinese currency could result in translation adjustments to our balance sheet as
well as reportable losses depending on our monetary balances and outstanding indebtedness at the
time of devaluation. The government of China historically has made it difficult to convert its
local currency into foreign currencies. Although we from time to time may enter into hedging
transactions in order to minimize our exposure to currency rate fluctuations, the Chinese currency
is not freely traded and thus is difficult to hedge. In addition, the government of China has
imposed restrictions on Chinese currency loans to foreign-operated entities in China. Based on the
foregoing, we cannot provide assurance that fluctuations and currency exchange rates in the future
will not have an adverse effect on our operations. We are exposed to risks from fluctuations in foreign currency exchange rates, primarily U.S.
Dollar/Japanese Yen, U.S. Dollar/Philippine Peso, U.S. Dollar/Malaysian Ringgit, and U.S.
Dollar/Chinese Renminbi. At December 31, 2004, one U.S. Dollar was worth 102.47 Japanese Yen. For the year ended
December 31, 2004, the U.S. Dollar/Japanese Yen exchange rate fluctuated between 1:102.47 and
1:114.43. If there were a 10% change in the U.S. Dollar/Japanese Yen exchange rate, the foreign
currency gain/loss would be immaterial. At December 31, 2004, one U.S. Dollar was worth 56.13 Philippine Pesos. For the year ended
December 31, 2004, the U.S. Dollar/Philippine Pesos exchange rate fluctuated between 1:55.13 and
1:56.46. If there were a 10% change in the U.S. Dollar/Philippine Pesos exchange rate, the foreign
currency gain/loss would be immaterial. 38




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Both the U.S. Dollar/Malaysian Ringgit and U.S. Dollar/Chinese Renminbi exchange rates have
been pegged by the respective governments, and remained so throughout the year ended December 31,
2004. However, there is the possibility that the respective governments may decide to revalue their
exchange rate against the U.S. Dollar. If there were a 10% change in the U.S. Dollar/Malaysian
Ringgit and U.S. Dollar/Chinese Renminbi exchange rates, the foreign currency gain/loss would be
immaterial. 
 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the financial statements, the reports thereon, the notes thereto, and the
supplementary data commencing at page F-1 of this report, which financial statements, reports,
notes, and data are incorporated herein by reference. 
 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE Not applicable. 
 ITEM 9A. CONTROLS AND PROCEDURES We have evaluated, with the participation of our Chief Executive Officer and Chief Financial
Officer, the effectiveness of our disclosure controls and procedures as of December 31, 2004.
Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have each
concluded that our disclosure controls and procedures are effective to ensure that we record,
process, summarize, and report information required to be disclosed by us in our reports filed
under the Securities Exchange Act within the time periods specified by the Securities and Exchange
Commissions rules and forms. During the fiscal year covered by this report, there have not been
any changes in our internal controls over financial reporting that have materially affected, or is
reasonably likely to materially affect, our internal control over financial reporting. Subsequent to the date of their evaluation, there have not been any significant changes in our
internal controls or in other facts that could significantly affect these controls, including any
corrective action with regard to significant deficiencies and material weaknesses. Managements Report on Internal Control over Financial Reporting To the Board of Directors and Stockholders of
Three-Five Systems, Inc.
Tempe, Arizona Management of Three-Five Systems, Inc., also referred to in this report as the Company, is
responsible for establishing and maintaining adequate internal control over financial reporting.
The Companys internal control framework and processes were designed to provide reasonable
assurance to management and the Board of Directors regarding the reliability of financial reporting
and the preparation of the Companys consolidated financial statements for external purposes in
accordance with accounting principles generally accepted in the United States of America. The Companys internal control over financial reporting includes those policies and procedures
that:  
    pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the Company;
    provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting
principles, and that receipts and expenditures of the Company are being made only in
accordance with authorizations of management and Directors of the Company; and 39




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##### Table of Contents




    provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use, or disposition of the Companys assets that could have a
material effect on the consolidated financial statements. Because of its inherent limitations, a system of internal control over financial reporting may
not prevent or detect misstatements. Further, because of changing conditions, effectiveness of
internal control over financial reporting may vary over time. Thus, projections of any evaluation
of effectiveness to future periods are subject to the risks that controls may become inadequate
because of changes in conditions and that the degree of compliance with the policies or procedures
may deteriorate. Management assessed the effectiveness of the Companys internal control over financial
reporting as of December 31, 2004. In making this assessment, management used the criteria set
forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal
Control  Integrated Framework. Management reviewed the results of its assessment with the Audit
Committee and the Board of Directors of the Company. Based upon its assessment and those criteria set forth in COSO, management believes that the
Company maintained effective internal control over financial reporting as of December 31, 2004. The Companys independent registered public accounting firm, Deloitte & Touche LLP, has issued
an attestation report on managements assessment of the Companys internal control over financial
reporting and their report has been included herein. Their report on the Companys consolidated
financial statements appears in Form 10K, Part II, Item 8, Financial Statements and Supplementary
Data. 40




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##### Table of Contents



Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders of
Three-Five Systems, Inc.
Tempe, Arizona We have audited managements assessment, included in the accompanying Managements Report on
Internal Control Over Financial Reporting, that Three-Five Systems, Inc. and subsidiaries (the
Company) maintained effective internal control over financial reporting as of December 31, 2004,
based on criteria established in Internal ControlIntegrated Frameworkissued by the Committee of
Sponsoring Organizations of the Treadway Commission. The Companys management is responsible for
maintaining effective internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility is to express an
opinion on managements assessment and an opinion on the effectiveness of the Companys internal
control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether effective internal control over financial reporting was
maintained in all material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating managements assessment, testing and evaluating the
design and operating effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audit provides a reasonable basis
for our opinions. A companys internal control over financial reporting is a process designed by, or under the
supervision of, the companys principal executive and principal financial officers, or persons
performing similar functions, and effected by the companys board of directors, management, and
other personnel to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance with generally
accepted accounting principles. A companys internal control over financial reporting includes
those policies and procedures that (1) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of the assets of the
company; (2) provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting principles,
and that receipts and expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and (3) provide reasonable assurance
regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the
companys assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including
the possibility of collusion or improper management override of controls, material misstatements
due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any
evaluation of the effectiveness of the internal control over financial reporting to future periods
are subject to the risk that the controls may become inadequate because of changes in conditions,
or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, managements assessment that the Company maintained effective internal control
over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based
on the criteria established in Internal ControlIntegrated Frameworkissued by the Committee of
Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained,
in all material respects, effective internal control over financial reporting as of December 31,
2004, based on the criteria established in Internal ControlIntegrated Frameworkissued by the
Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated financial statements and financial statement
schedule as of and for the year ended December 31, 2004 of the Company and our report dated March
30, 2005 expressed an unqualified opinion on those financial statements and financial statement
schedule and included an explanatory paragraph regarding the Companys ability to continue as a
going concern at December 31, 2004. Phoenix, Arizona
March 30, 2005 41




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##### Table of Contents



ITEM 9B. OTHER INFORMATION On March 30, 2005, we signed a definitive agreement to sell the assets of our small form
factor display business to International DisplayWorks, Inc. That sale would not include the
display monitor business operated out of our Marlborough, Massachusetts facility. Closing of the
sale to International DisplayWorks, Inc. is expected to occur in April. TFS estimates the total
value of that transaction will range between $11 million and $21 million and will include an $8
million cash payment at closing. A copy of the purchase agreement is filed herewith. 
 PART III 
 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item relating to our directors is incorporated herein by
reference to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange
Act for our 2005 Annual Meeting of Stockholders. If for any reason such statement is not filed
within 120 days after the close of the fiscal year ended December 31, 2004, this annual report will
be appropriately amended. The information required by this Item relating to our executive officers
is included in Item 1, Business  Executive Officers 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 our 2005 Annual
Meeting of Stockholders. If for any reason such statement is not filed within 120 days after the
close of the fiscal year ended December 31, 2004, this annual report will be appropriately amended. 
  ITEM 12.
    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS 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 our 2005 Annual
Meeting of Stockholders. If for any reason such statement is not filed within 120 days after the
close of the fiscal year ended December 31, 2004, this annual report will be appropriately amended. 
 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 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 our 2005 Annual
Meeting of Stockholders. If for any reason such statement is not filed within 120 days after the
close of the fiscal year ended December 31, 2004, this annual report will be appropriately amended. 
 ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES 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 our 2005 Annual
Meeting of Stockholders. If for any reason such statement is not filed within 120 days after the
close of the fiscal year ended December 31, 2004, this annual report will be appropriately amended. 42




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##### Table of Contents



PART IV 
 ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES  (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 the
required information is included in the consolidated financial statements or notes thereto. 43




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##### Table of Contents



(b)
    Exhibits Exhibit Number
    
    Exhibits2
    
    Amended and Restated Agreement and Plan of Reorganization(1)2.2
    
    Master Separation and Distribution
Agreement between the Registrant and Brillian Corporation(18)3(i)(a)
    
    Amended and Restated Certificate of Incorporation of the Company(2)3(i)(b)
    
    Certificate of Amendment of Restated Certificate of Incorporation(3)3(i)(c)
    
    Certificate of Designation of Series A Junior Participating Preferred Stock(4)3(ii)
    
    Amended and Restated Bylaws of the Company(5)4.1
    
    Form of Certificate of Common Stock(16)4.2
    
    Rights Agreement, dated as of April 26, 2001, between Three-Five Systems, Inc. and
Bank of New York, as Rights Agent(6)10.2
    
    Ground Sublease dated April 1, 1994, between Papago Park Center, Inc. and
Three-Five Systems, Inc.(8)10.3
    
    Amended and Restated 1990 Incentive Stock Option Plan (as Amended and Restated
through March 7, 2003)(16)10.3
    
    2004 Incentive Compensation Plan(19)10.4
    
    Amended and Restated 1993 Stock Option Plan (as Amended and Restated through March
7, 2003)(16)10.5
    
    Amended and Restated 1994 Stock Option Plan for Non-Employee Directors (as Amended
and Restated through February 12, 2001)(9)10.6
    
    Amended and Restated 1997 Employee Stock Option Plan (as Amended and Restated
through November 27, 2002) (as corrected)(17)10.7
    
    Form of Notice and Acceptance of Stock Option Grant for Amended and Restated 1997
Employee Stock Option Plan(10)10.8
    
    Amended and Restated 1998 Stock Option Plan (as Amended and Restated through
February 8, 2002)(16)10.9
    
    Amended and Restated Directors Stock Plan (amended as of January 27, 2000)(11)10.10
    
    401(k) Profit Sharing Plan(12)10.15
    
    Technology License Agreement between Data International, Ltd. and TFS-DI dated
January 13, 2003(16)10.16
    
    Supply Agreement between Data International, Ltd. and TFS-DI dated January 13,
2003(16)10.17
    
    Term Promissory Note dated January 13, 2003 executed by TFS-DI in favor of Data
International, Ltd.(16)10.18
    
    Assignment and Assumption Agreement between the Registrant and Brillian
Corporation(18)10.19
    
    Intellectual Property Agreement between the Registrant and Brillian Corporation(18)10.20
    
    Tax Sharing Agreement between the Registrant and Brillian Corporation(18)10.21
    
    First Amended and Restated Real Property Sublease Agreement between the Registrant
and Brillian Corporation, dated as of June 1, 2004(21)10.22
    
    Manufacturing Agreement between the Registrant and Microtune, Inc., dated March
27, 2003(20)10.23
    
    Joint Venture Agreement regarding the establishment and operation of TFS
Electronic Manufacturing Services Sdn Bhd, dated April 1, 2003(20)10.24
    
    Equipment Lease Agreement between Unico Technology Berhad and Mattline Industries
Sdn Bhd, dated April 1, 2003(20)10.25
    
    Tenancy Agreement between Fortune Century Sdn Bhd, Jantron Sdn Bhd, and Mattline
Industries Sdn Bhd, dated April 1, 2003(20)10.26
    
    Tenancy Agreement between Geok Hong Sdn Bhd and Mattline Industries Sdn Bhd, dated
April 1, 2003(20)10.27
    
    License Agreement between the Registrant and Integrex, Inc., dated February 19,
2004(20)10.28
    
    Lease Agreement between SFERS Real Estate Corp. V and ETMA Corporation, dated July
21, 1999(20)10.29
    
    Lease Agreement between Therriault-Cogan, L.L.C. and ETMA Corporation, dated
January 17, 2001(20)
 44




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##### Table of Contents



Exhibit Number
    
    Exhibits10.30
    
    Lease Agreement between Rapp/Rise L.L.C. and ETMA Corporation, dated December 13,
2002(20)10.31
    
    Loan and Security Agreement among the Registrant, TFS Electronics Manufacturing
Services, Inc. and Silicon Valley Bank, dated June 25, 2004 (21)10.32
    
    Amendment No.1 to the First Amended and Restated Real Property Sublease Agreement
between Registrant and Brillian Corporation, dated June 1, 2004 (22)10.33
    
    Severance Agreement and General Release between the Registrant and Jeffrey D.
Buchanan, dated January 26, 2005(23)10.34
    
    Net Lease Agreement among L & A Kessler Family Partners, L.P., Marilyn Dreyfuss,
Phillip Francis and Curtis Burr, as Trustees of the Edward S. Ageno 1992 Revocable
Trust, Kay Enterprises, and TFS Electronic Manufacturing Services, Inc., dated
November 19, 2004 *10.35
    
    Second Amended and Restated Real Property Sublease Agreement by and between the
Registrant and Brillian Corporation, dated December 22, 2004 *10.36
    
    Lease by and between Papago Paragon Partners, LLC and the Registrant, dated
December 30, 2004 *10.37
    
    Purchase Agreement by and among International DisplayWorks, Inc., International
DisplayWorks (Hong Kong) Limited, the Registrant, TFS International, Ltd., and
Three-Five Systems (Beijing) Co., Ltd., dated March 30, 2005 *21
    
    List of Subsidiaries*23.1
    
    Consent of Deloitte & Touche LLP*23.2
    
    Notice Regarding Consent of Arthur Andersen LLP(16)31.1
    
    Certification of Chief Executive Officer of the Registrant pursuant to Rule
13a-14(a) and Rule 15d-14(a) promulgated under the Securities Exchange Act of
1934, as amended.*31.2
    
    Certification of Chief Financial Officer of the Registrant pursuant to Rule
13a-14(a) and Rule 15d-14(a) promulgated under the Securities Exchange Act of
1934, as amended.*32.1
    
    Certification of the Chief Executive Officer of the Registrant pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.*32.2
    
    Certification of the Chief Financial Officer of the Registrant, pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.*
   *
    
    Filed herein. 45




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##### Table of Contents



(1)
    
    Incorporated by reference to Exhibit 2 to the Registration Statement on Form S-4 of TF
Consolidation, Inc. (Registration No. 33-33944) as filed on March 27, 1990.(2)
    
    Incorporated by reference to Exhibit 3(a) to the Registrants Form 10-QSB for the quarter
ended March 31, 1994, as filed on or about May 12, 1994.(3)
    
    Incorporated by reference to Exhibit 3(b) to the Registration Statement on Form S-3
(Registration No. 333-35788) as filed on April 27, 2000, as amended by Form S-3/A as filed on
May 5, 2000.(4)
    
    Incorporated by reference to Exhibit 3(d) to the Registrants Form 8-A as filed on May 10,
2001.(5)
    
    Incorporated by reference to Exhibit 3(b) to the Registration Statement on Form S-3
(Registration No. 333-84083) as filed on July 30, 1999, as amended by Form S-3/A as filed on
August 26, 1999.(6)
    
    Incorporated by reference to Exhibit 4(b) to the Registrants Form 8-A as filed on May 10,
2001.(7)
    
    Incorporated by reference to Exhibit 10(c) to the Registration Statement on Form S-4 of TF
Consolidation, Inc. (Registration No. 33-33944) as filed on March 27, 1990.(8)
    
    Incorporated by reference to Exhibit 10(o) to the Registrants Form 10-K for the fiscal year
ended December 31, 1996, as filed on March 14, 1997.(9)
    
    Incorporated by reference to Exhibit 10(x) to the Registrants Form 10-Q for the quarter
ended June 30, 2001, as filed on July 27, 2001.(10)
    
    Incorporated by reference to Exhibit 10.5(b) to the Registration Statement on Form S-8
(Registration No. 333-59234) as filed on April 19, 2001.(11)
    
    Incorporated by reference to Exhibit 10(y) to the Registration Statement on Form S-8
(Registration No. 333-50689) as filed on November 3, 2000.(12)
    
    Incorporated by reference to Exhibit 10(z) to the Registration Statement on Form S-8
(Registration No. 333-57933) as filed on June 26, 1998.(13)
    
    Incorporated by reference to Exhibit 10(aa) to the Registrants Form 10-Q for the quarter
ended June 30, 2000, as filed on July 27, 2000.(14)
    
    Incorporated by reference to Exhibit 10(cc) to the Registrants Form 10-K for the fiscal year
ended December 31, 2000, as filed on March 13, 2001.(15)
    
    Incorporated by reference to Exhibit 10(cc) to the Registrants Form 10-Q for the quarter
ended March 31, 2002, as filed on April 19, 2002.(16)
    
    Incorporated by reference to the Registrants Form 10-K for the fiscal year ended December
31, 2002, as filed on March 28, 2003.(17)
    
    Incorporated by reference to the Registrants Form 10-Q for the quarter ended June 30, 2003,
as filed on July 31, 2003.(18)
    
    Incorporated by reference to the Registrants Form 10/A (Amendment No. 4) (Registration No.
000-50289) as filed with the SEC by Brillian Corporation on September 3, 2003.(19)
    
    Incorporated by reference to the Registration Statement on Form S-8 (Registration No.
333-115314) as filed on May 7, 2004.(20)
    
    Incorporated by reference to the Registrants Form 10-K for the fiscal year ended December
31, 2003, as filed on March 15, 2004.(21)
    
    Incorporated by reference to the Registrants Form 10-Q for the quarter ended June 30, 2004,
as filed on August 9, 2004.(22)
    
    Incorporated by reference to the Registrants Form 10-Q for the quarter ended September 30,
2004, as filed on November 9, 2004.(23)
    
    Incorporated by reference to the Registrants Current Report on Form 8-K, as filed on January
28, 2005. 46




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized. THREE-FIVE SYSTEMS, INC.Date: April 1, 2005
    
    By:
    
    /s/ Jack L. SaltichJack L. Saltich
President and Chief Executive Officer
 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the capacities and on the
dates indicated. Name
    
    Title
    
    Date/s/ Jack L. Saltich
    
    President, Chief Executive Officer (Principal
    
    April 1, 2005Jack L. Saltich
    
    Executive Officer), and Director/s/ James E. Jurgens
    
    Interim Chief Financial Officer (Principal
    
    April 1, 2005James E. Jurgens
    
    Financial Officer)/s/ Eric W. Haeussler
    
    Corporate Controller (Principal Accounting Officer)
    
    April 1, 2005Eric W. Haeussler/s/ David C. Malmberg
    
    Chairman of the Board of Directors
    
    April 1, 2005David C. Malmberg/s/ David P. Chavoustie
    
    Director
    
    April 1, 2005David P. Chavoustie/s/ Murray A. Goldman
    
    Director
    
    April 1, 2005Murray A. Goldman/s/ Henry L. Hirvela
    
    Director
    
    April 1, 2005Henry L. Hirvela/s/ Thomas H. Werner
    
    Director
    
    April 1, 2005Thomas H. Werner
 47




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THREE-FIVE SYSTEMS, INC.
AND SUBSIDIARIES 
 INDEX TO CONSOLIDATED
FINANCIAL STATEMENTS
 PageReport of Independent Registered Public Accounting Firm
    
    
    F-2Consolidated Balance Sheets as of December 31, 2003 and 2004
    
    
    F-3Consolidated Statements of Operations for the years ended December 31, 2002, 2003 and 2004
    
    
    F-4Consolidated Statements of Stockholders Equity for the years ended December 31, 2002, 2003 and 2004
    
    
    F-5Consolidated Statements of Comprehensive Loss for the years ended December 31, 2002, 2003 and 2004
    
    
    F-6Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2003 and 2004
    
    
    F-7Notes to Consolidated Financial Statements
    
    
    F-8Schedule II  Valuation and Qualifying Accounts and Reserves for the years ended December 31, 2002, 2003 and 2004
    
    
    S-1
 F-1




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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of
Three-Five Systems, Inc. We have audited the accompanying consolidated balance sheets of Three-Five Systems, Inc. and
subsidiaries (the Company) as of December 31, 2004 and 2003, and the related consolidated
statements of operations, stockholders equity, comprehensive loss, and cash flows for each of the
three years in the period ended December 31, 2004. Our audits also included the financial
statement schedule listed in the Index at Item 15. These financial statements and the financial
statement schedule are the responsibility of the Companys management. Our responsibility is to
express an opinion on the financial statements and the financial statement schedule based on our
audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit 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, such consolidated financial statements present fairly, in all material respects,
the financial position of Three-Five Systems, Inc. and subsidiaries as of December 31, 2004 and
2003, and the results of their operations and their cash flows for each of the three years in the
period ended December 31, 2004, in conformity with accounting principles generally accepted in the
United States of America. Also, in our opinion, the financial statement schedule, when considered
in relation to the basic consolidated financial statements taken as a whole, presents fairly, in
all material respects, the information set forth therein. The accompanying financial statements for the year ended December 31, 2004 have been prepared
assuming that the Company will continue as a going concern. As discussed in Note 1 to the
financial statements, the Companys recurring losses from operations and difficulties financing
future working capital needs raise substantial doubt about its ability to continue as a going
concern. Managements plans concerning these matters are also described in Note 1. The financial
statements do not include any adjustments that might result from the outcome of this uncertainty. We have also audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the effectiveness of the Companys internal control over financial reporting
as of December 31, 2004, based on the criteria established in Internal ControlIntegrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated
March 30, 2005 expressed an unqualified opinion on managements assessment of the effectiveness of
the Companys internal control over financial reporting and an unqualified opinion on the
effectiveness of the Companys internal control over financial reporting. Phoenix, Arizona
March 30, 2005 F-2




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THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS
 (Dollars in thousands, except share data)
 December 31,2003
    
    
    2004ASSETSCurrent Assets:Cash and cash equivalents
    
    $
    27,976
    
    
    $
    16,198Short-term investments
    
    
    5,130
    
    
    
    Accounts receivable, net
    
    
    28,133
    
    
    
    22,050Inventories
    
    
    25,854
    
    
    
    23,445Income taxes receivable
    
    
    678
    
    
    
    181Deferred tax asset
    
    
    130
    
    
    
    122Assets held for sale
    
    
    8,615
    
    
    
    10Other current assets
    
    
    2,782
    
    
    
    3,675Total current assets
    
    
    99,298
    
    
    
    65,681Property, Plant and Equipment, net
    
    
    25,323
    
    
    
    26,713Intangibles, net
    
    
    7,574
    
    
    
    3,704Goodwill
    
    
    34,606
    
    
    
    13,444Other Assets
    
    
    436
    
    
    
    2,259Total Assets
    
    $
    167,237
    
    
    $
    111,801LIABILITIES AND STOCKHOLDERS EQUITYCurrent Liabilities:Accounts payable
    
    $
    30,826
    
    
    $
    23,638Accrued liabilities
    
    
    4,529
    
    
    
    4,721Customer deposits
    
    
    388
    
    
    
    3,043Deferred revenue
    
    
    48
    
    
    
    69Deferred sale leaseback gain, short-term portion
    
    
    
    
    
    
    545Income taxes payable
    
    
    
    
    
    
    40Current portion of long-term debt
    
    
    1,515
    
    
    
    1,547Current portion of capital leases
    
    
    2,352
    
    
    
    2,762Lines of credit
    
    
    
    
    
    
    2,416Total Current Liabilities
    
    
    39,658
    
    
    
    38,781Long-term Debt
    
    
    1,441
    
    
    
    Deferred sale leaseback gain, long-term portion
    
    
    
    
    
    
    2,178Capital Leases
    
    
    6,543
    
    
    
    3,995Other Long-term Liabilities
    
    
    
    
    
    
    1,010Total Long-term Liabilities
    
    
    7,984
    
    
    
    7,183Commitments and Contingencies (Note 9)Minority Interest in Consolidated Subsidiary
    
    
    2,563
    
    
    
    Preferred stock, $.01 par value; 1,000,000 shares authorized,
No shares issued or outstanding
    
    
    
    
    
    
    Common stock, $.01 par value; 60,000,000 shares authorized,
21,972,020 and 21,995,804 shares issued at December 31, 2003
and 2004, respectively
    
    
    220
    
    
    
    220Additional paid-in capital
    
    
    200,930
    
    
    
    201,065Accumulated deficit
    
    
    (74,915
    )
    
    
    (133,730
    )Stock subscription note receivable
    
    
    (185
    )
    
    
    Accumulated other comprehensive loss
    
    
    (515
    )
    
    
    (547
    )Less  Treasury stock, at cost, 651,317 shares at December 31, 2003
and 228,151 shares at December 31, 2004
    
    
    (8,503
    )
    
    
    (1,171
    )Total stockholders equity
    
    
    117,032
    
    
    
    65,837$
    167,237
    
    
    $
    111,801
 The accompanying notes are an integral part of these consolidated financial statements F-3




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THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 (Dollars in thousands, except per share data)
 Years EndedDecember 31,2002
    
    
    2003
    
    
    2004Net Sales
    
    $
    86,587
    
    
    $
    159,018
    
    
    $
    158,947Costs and Expenses:Cost of sales
    
    
    78,718
    
    
    
    155,125
    
    
    
    161,009Selling, general and administrative
    
    
    10,382
    
    
    
    17,524
    
    
    
    24,961Research, development and engineering
    
    
    4,913
    
    
    
    4,742
    
    
    
    2,912Impairment of goodwill
    
    
    
    
    
    
    
    
    
    
    21,350Impairment of intangibles
    
    
    
    
    
    
    
    
    
    
    1,850Loss (gain) on sale of assets
    
    
    4,545
    
    
    
    (25
    )
    
    
    (100
    )Amortization of intangibles
    
    
    256
    
    
    
    2,043
    
    
    
    1,89398,814
    
    
    
    179,409
    
    
    
    213,875Operating loss
    
    
    (12,227
    )
    
    
    (20,391
    )
    
    
    (54,928
    )Other Income (Expense):Interest, net
    
    
    3,328
    
    
    
    (179
    )
    
    
    (929
    )Other, net
    
    
    164
    
    
    
    1,043
    
    
    
    1,3613,492
    
    
    
    864
    
    
    
    432Minority Interest in Loss (Income) of Consolidated Subsidiary
    
    
    84
    
    
    
    (36
    )
    
    
    (22
    )Loss from Continuing Operations before Income Taxes
    
    
    (8,651
    )
    
    
    (19,563
    )
    
    
    (54,518
    )Provision for (benefit from) income taxes
    
    
    (3,921
    )
    
    
    14,338
    
    
    
    (226
    )Loss from Continuing Operations
    
    
    (4,730
    )
    
    
    (33,901
    )
    
    
    (54,292
    )Loss from Discontinued Operation, net of taxes
    
    
    (12,241
    )
    
    
    (10,552)
    )
    
    
    Net Loss
    
    $
    (16,971
    )
    
    $
    (44,453
    )
    
    $
    (54,292
    )Loss Per Common Share  Basic and Diluted:Loss from Continuing Operations
    
    $
    (0.22
    )
    
    $
    (1.59
    )
    
    $
    (2.50
    )Loss from Discontinued Operation
    
    
    (0.57
    )
    
    
    (0.50
    )
    
    
    Net Loss
    
    $
    (0.79
    )
    
    $
    (2.09
    )
    
    $
    (2.50
    )Weighted Average Number of Common Shares:Basic and Diluted
    
    
    21,465
    
    
    
    21,301
    
    
    
    21,719
 The accompanying notes are an integral part of these consolidated financial statements F-4




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##### Table of Contents



THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
 For the Years Ended December 31, 2002, 2003 and 2004
 (Dollars in thousands, except share data)
 Stock
    
    
    AccumulatedAdditional
    
    
    
    
    
    
    Subscription
    
    
    Other
    
    
    
    
    
    
    TotalCommon Stock
    
    
    Paid-in
    
    
    Retained
    
    
    Note
    
    
    Comprehensive
    
    
    Treasury
    
    
    StockholdersShares Issued
    
    
    Amount
    
    
    Capital
    
    
    Earnings
    
    
    Receivable
    
    
    Income (Loss)
    
    
    Stock
    
    
    EquityBalance, December 31, 2001
    
    
    21,894,628
    
    
    $
    219
    
    
    $
    200,395
    
    
    $
    30,666
    
    
    $
    (163
    )
    
    $
    (21
    )
    
    $
    (7,152
    )
    
    $
    223,944Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (16,971
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (16,971
    )Unrealized losses on investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (197
    )
    
    
    
    
    
    
    (197
    )Foreign currency translation
adjustments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (114
    )
    
    
    
    
    
    
    (114
    )Stock subscription note receivable
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (11
    )
    
    
    
    
    
    
    
    
    
    
    (11
    )Stock options exercised and other
    
    
    42,728
    
    
    
    
    
    
    
    323
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    323Tax benefit on stock option
exercises
    
    
    
    
    
    
    
    
    
    
    45
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    45Purchase of treasury stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,351
    )
    
    
    (1,351
    )Balance, December 31, 2002
    
    
    21,937,356
    
    
    
    219
    
    
    
    200,763
    
    
    
    13,695
    
    
    
    (174
    )
    
    
    (332
    )
    
    
    (8,503
    )
    
    
    205,668Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (44,453
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (44,453
    )Unrealized losses on investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (65
    )
    
    
    
    
    
    
    (65
    )Foreign currency translation
adjustments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (118
    )
    
    
    
    
    
    
    (118
    )Stock subscription note receivable
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (11
    )
    
    
    
    
    
    
    
    
    
    
    (11
    )Stock options exercised and other
    
    
    34,664
    
    
    
    1
    
    
    
    167
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    168Distribution related to
discontinued operation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (44,157
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (44,157
    )Balance, December 31, 2003
    
    
    21,972,020
    
    
    
    220
    
    
    
    200,930
    
    
    
    (74,915
    )
    
    
    (185
    )
    
    
    (515
    )
    
    
    (8,503
    )
    
    
    117,032Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (54,292
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (54,292
    )Unrealized losses on investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2
    
    
    
    
    
    
    
    2Foreign currency translation
adjustments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (34
    )
    
    
    
    
    
    
    (34
    )Stock subscription note receivable
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    185
    
    
    
    
    
    
    
    
    
    
    
    185Stock options exercised and stock
compensation
    
    
    23,784
    
    
    
    
    
    
    
    135
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    135Issuance of treasury stock for
acquisition of minority interest
in TFS Malaysia
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,523
    )
    
    
    
    
    
    
    
    
    
    
    7,332
    
    
    
    2,809Balance, December 31, 2004
    
    
    21,995,804
    
    
    $
    220
    
    
    $
    201,065
    
    
    $
    (133,730
    )
    
    $
    
    
    
    $
    (547
    )
    
    $
    (1,171
    )
    
    $
    65,837
 The accompanying notes are an integral part of these consolidated financial statements. F-5




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##### Table of Contents



CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS For the Years Ended December 31, 2002, 2003 and 2004
 (Dollars in thousands)
 Years Ended December 31,2002
    
    
    2003
    
    
    2004Net Loss
    
    $
    (16,971
    )
    
    $
    (44,453
    )
    
    $
    (54,292
    )Other Comprehensive Loss, net of taxes:Unrealized gains (losses), net of tax expense
(benefit) of ($96) for the year ended 2002
    
    
    (197
    )
    
    
    (65
    )
    
    
    2Foreign currency translation adjustment
    
    
    (114
    )
    
    
    (118
    )
    
    
    (34
    )Comprehensive loss
    
    $
    (17,282
    )
    
    $
    (44,636
    )
    
    $
    (54,324
    )
 The accompanying notes are an integral part of these consolidated financial statements F-6




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##### Table of Contents



THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (Dollars in thousands)
 Years Ended December 31,2002
    
    
    2003
    
    
    2004CASH FLOWS FROM OPERATING ACTIVITIES:Net loss
    
    $
    (16,971
    )
    
    $
    (44,453
    )
    
    $
    (54,292
    )Less loss  discontinued operations
    
    
    (12,241
    )
    
    
    (10,552
    )
    
    
    Loss  continuing operations
    
    
    (4,730
    )
    
    
    (33,901
    )
    
    
    (54,292
    )Adjustments to reconcile net loss to net cash (used in) provided by operating
activities:Depreciation and amortization
    
    
    3,950
    
    
    
    7,588
    
    
    
    8,650Stock compensation
    
    
    104
    
    
    
    50
    
    
    
    62Minority interest in consolidated subsidiary
    
    
    (84
    )
    
    
    36
    
    
    
    22Deferred revenue
    
    
    23
    
    
    
    25
    
    
    
    21Provision for accounts receivable valuation reserves
    
    
    323
    
    
    
    271
    
    
    
    212Loss on impairment of intangibles and goodwill
    
    
    
    
    
    
    
    
    
    
    23,200Loss (gain) on disposal of assets
    
    
    4,545
    
    
    
    (25
    )
    
    
    (100
    )Tax benefit on stock options exercised
    
    
    45
    
    
    
    
    
    
    
    Provision for (benefit from) deferred taxes, net
    
    
    (2,289
    )
    
    
    14,164
    
    
    
    8Foreign currency translation adjustments
    
    
    (114
    )
    
    
    (118
    )
    
    
    (34
    )Interest on notes payable
    
    
    
    
    
    
    74
    
    
    
    41Interest on employee loan
    
    
    (11
    )
    
    
    (11
    )CHANGES IN OPERATING ASSETS AND LIABILITIES:(Increase) decrease in accounts receivable
    
    
    6,961
    
    
    
    (12,077
    )
    
    
    5,871(Increase) decrease in inventories
    
    
    7,010
    
    
    
    (593
    )
    
    
    3,755(Increase) decrease in other assets
    
    
    452
    
    
    
    (360
    )
    
    
    720Increase (decrease) in accounts payable and accrued liabilities
    
    
    (13,959
    )
    
    
    23,000
    
    
    
    (3,331
    )Increase (decrease) in taxes payable/receivable
    
    
    3,399
    
    
    
    (117
    )
    
    
    537Net cash (used in) provided by operating activities
    
    
    5,625
    
    
    
    (1,994
    )
    
    
    (14,658
    )CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of property, plant, and equipment
    
    
    (1,211
    )
    
    
    (2,644
    )
    
    
    (8,121
    )Proceeds from sale of assets
    
    
    2,100
    
    
    
    1,030
    
    
    
    9,642Purchase of intangibles
    
    
    (547
    )
    
    
    (1,444
    )
    
    
    (97
    )Purchase of investments
    
    
    (102,591
    )
    
    
    (13,262
    )
    
    
    Proceeds from maturities/sales of short-term investments
    
    
    159,233
    
    
    
    70,245
    
    
    
    5,132Acquisitions and strategic investments
    
    
    (50,089
    )
    
    
    (10,441
    )
    
    
    (2,746
    )Net cash provided by investing activities
    
    
    6,895
    
    
    
    43,484
    
    
    
    3,810CASH FLOWS FROM FINANCING ACTIVITIES:Borrowings from lines of credit
    
    
    2,706
    
    
    
    
    
    
    
    2,416Payments on debt
    
    
    (2,706
    )
    
    
    (2,734
    )
    
    
    (1,450
    )Stock options exercised
    
    
    210
    
    
    
    118
    
    
    
    73Payments on capital leases
    
    
    
    
    
    
    (1,722
    )
    
    
    (2,154
    )Payments on stock subscription note receivable
    
    
    
    
    
    
    
    
    
    
    185(Distribution to) receipt from minority interest
    
    
    (239
    )
    
    
    2,527
    
    
    
    Purchase of treasury stock
    
    
    (1,351
    )
    
    
    
    
    
    
    Net cash used in financing activities
    
    
    (1,380
    )
    
    
    (1,811
    )
    
    
    (930
    )NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 
CONTINUING OPERATIONS
    
    
    11,140
    
    
    
    39,679
    
    
    
    (11,778
    )NET CASH USED IN AND CONTRIBUTED TO DISCONTINUED
OPERATIONS
    
    
    (29,754
    )
    
    
    (30,092
    )
    
    
    NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    
    
    (18,614
    )
    
    
    9,587
    
    
    
    (11,778
    )CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR
    
    
    37,003
    
    
    
    18,389
    
    
    
    27,976CASH AND CASH EQUIVALENTS, END OF YEAR
    
    $
    18,389
    
    
    $
    27,976
    
    
    
    16,198SUPPLEMENTAL INFORMATION AND NONCASH INVESTING AND FINANCING ACTIVITIES:Interest paid
    
    $
    178
    
    
    $
    1,007
    
    
    $
    1,195Treasury stock issued for purchase of minority interest in TFS Malaysia
    
    
    
    
    
    
    
    
    
    
    2,809Income taxes paid (refunded)
    
    
    (5,088
    )
    
    
    387
    
    
    
    278Note payable due on purchase of distribution rights license
    
    
    
    
    
    
    2,956
    
    
    
    Capital leases due on purchase of equipment
    
    
    
    
    
    
    8,895
    
    
    
    
 The accompanying notes are an integral part of these consolidated financial statements F-7




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THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2002, 2003 and 2004
 (1) Organization and Operations: Three-Five Systems, Inc. (together with its subsidiaries, herein referred to as we, us, or
the Company) is a global provider of electronics manufacturing services, or EMS. We design and
manufacture electronic printed circuit board assemblies, radio frequency, or RF, modules, display
modules and systems, and complete systems for customers in the computing, consumer, industrial,
medical, telecommunications and transportation industries. Our design and manufacturing services
include a distinctive competence in display modules and systems and the integration of display
modules and systems into other products. The accompanying financial statements have been prepared on a going concern basis, which
contemplates the realization of assets and the satisfaction of liabilities in the normal course of
business. However, we have incurred recurring operating losses and used $14.7 million of cash in
our operating activities during 2004. These factors, among others, have led our auditors to
believe that we may be unable to continue as a going concern for a reasonable period of time. The
financial statements do not include any adjustments relating to the recoverability and
classification of recorded asset amounts or the amounts and classifications of liabilities that
might be necessary should we be unable to continue as a going concern. Our continuation as a going
concern is dependent upon a combination of our ability to generate sufficient cash flows from
operations, to obtain additional debt or equity financing, or to sell additional assets to meet our
obligations on a timely basis, and ultimately to attain successful operations. Our cash balance as of December 31, 2004 was $16.2 million. We expect to have continued
operating losses in 2005, primarily in our EMS segment. Therefore, we have taken numerous steps to
provide adequate liquidity to operate through the end of 2005. We recently signed a definitive agreement to sell the assets of our small form factor display
business to International DisplayWorks, Inc. That sale would not include the display monitor
business operated out of our Marlborough, Massachusetts facility. Closing of the sale to
International DisplayWorks, Inc. is expected to occur in April 2005.
Revenues from our small form factor display business in 2004 were
approximately $28 million. TFS estimates the total value of
that transaction will range between $11 million and $21 million and will include an $8 million cash
payment at closing. The sale of the small form factor display operations to International
DisplayWorks, Inc. will not only generate cash proceeds to us but eliminate the need for additional
sources of funds for the sold operations. In March 2005, we determined to discontinue our display
product offerings from Data International which is included in our
Display segment. Revenues from
those products in 2004 were approximately $17 million. In January 2005 we began to explore the sale of our Manila factory, and we currently are
reviewing indications of interest made with respect to that facility. In the second quarter, we
expect either to sell that operation intact or terminate the operations at that facility and sell
the liquidated assets, including the equipment, inventory, and real property. Additional potential sources of capital in 2005 will be bank financings. We are pursuing a
loan in Malaysia, and we expect to finalize the documentation of that loan in the second quarter.
It also is possible that the sale of display operations could enable us to re-establish loan
commitments or debt financing with a domestic bank or banks. We cannot provide assurance on
potential loans or that the terms of such loan commitments or debt financing would be on terms
acceptable to us. Based upon our cash balances, our expected use of cash in 2005, and the definitive agreement
with International DisplayWorks, Inc., we believe that we have adequate sources to fund our
remaining operations and planned expenditures through 2005, as well as to meet our contractual
obligations. The expected use of funds F-8




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through the rest of 2005, however, is based on our judgments and forecasts. Actual results could
prove materially different and, in such instances, may require additional funds. We cannot provide
assurance that additional asset sales, such as the sale of the Manila operations, loan commitments,
or other methods of financing will be available for any such unexpected additional requirements or,
if available, that they will be on terms acceptable to us. On September 1, 2003, we transferred all of the net assets of our microdisplay division, plus
approximately $20.9 million in cash, into a newly created Delaware corporation called Brillian
Corporation. On September 15, 2003, we spun off Brillian by distributing all of the outstanding
common stock of Brillian to our stockholders on a pro rata basis, with each stockholder of
Three-Five Systems, Inc., or TFS, receiving one share of Brillian common stock for every four
shares of our common stock. Brillian is now traded on the NASDAQ National Market under the symbol
BRLC. Brillian had $44.1 million of net assets on the spin-off date. The microdisplay business
that we transferred to Brillian is now reported in these consolidated financial statements as
Discontinued Operations. Net loss from discontinued operation before income taxes was $19.0 million and $10.6 million
in 2002 and 2003, respectively. We had no discontinued operations in 2004. The income tax benefit
for discontinued operation was $6.7 million in 2002. There was no tax benefit in 2003 for the
discontinued operation. Net loss from discontinued operations was $12.3 million and $10.6 million
in 2002 and 2003, respectively. Sales from discontinued operations were $1.4 million and $1.6
million in 2002 and 2003, respectively. There were no sales from discontinued operations in 2004.
The major classes of discontinued assets and liabilities included in the Consolidated Balance Sheet
as of the day of spin-off were as follows: September 15,(Dollars in thousands)
    
    2003Assets:Cash
    
    $
    20,453Accounts receivable
    
    
    473Inventories
    
    
    2,937Other current assets
    
    
    961Property, plant and equipment, net
    
    
    6,884Intangibles, net
    
    
    8,894Other long-term assets
    
    
    4,730Total assets from discontinued operations
    
    $
    45,332Liabilities:Accounts payable and accrued liabilities
    
    $
    1,063Deferred revenue
    
    
    112Total liabilities from discontinued operations
    
    $
    1,175
 (2) Summary of Significant Accounting Policies: Principles of Consolidation and Preparation of Financial Statements The consolidated financial statements include the accounts of Three-Five Systems, Inc. and its
wholly owned subsidiaries. All material intercompany transactions and balances have been
eliminated. The accompanying financial statements have been prepared to reflect our historical financial
position and results of operations and cash flows as adjusted for the reclassification of our
microdisplay division as a discontinued operation. Historical results of operations of the
microdisplay division are reported as a discontinued operation in the accompanying consolidated
financial statements. Use of Accounting Estimates The preparation of financial statements in conformity with accounting principles generally
accepted in the United States requires us 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. On an on-going basis, we evaluate our estimates and judgments, F-9




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including those related to sales returns, bad debts, inventories, fixed assets, intangible assets,
income taxes, and contingencies. We base our estimates on historical experience and on various
other assumptions that we believe are reasonable under the circumstances. The results form the
basis for making judgments about the carrying values of assets and liabilities that are not readily
apparent from other sources. Actual results could differ from those estimates. Customer Concentration Product sales for our historical major customer, Motorola, accounted for approximately 78% of
sales in 2002 and less than 10% of our net sales in 2003 and 2004, respectively. In 2003, two
customers each accounted for more than 10% of our net sales, Avocent and Vitelcom, accounting for
23% and 13% of our net sales, respectively. In 2004, one customer, Avocent, accounted for more
than 10% of our net sales, accounting for 38% of our net sales. Fair Value of Financial Instruments We have determined the estimated fair value of financial instruments using available market
information and valuation methodologies. Estimating fair values requires considerable judgment.
Accordingly, the estimates may not be indicative of amounts that would be realized in a current
market exchange. The carrying values of cash, short-term investments, accounts receivable, and
accounts payable approximate fair value due to the short maturities of these instruments. In
addition, at December 31, 2003 and 2004, the carrying amount of the term loan payable and capital
lease obligations is estimated to approximate fair value as the actual interest rate is consistent
with rates estimated to be currently available for debt with similar terms and remaining
maturities. Cash and Cash Equivalents For purposes of the statements of cash flows, all highly liquid investments with an original
maturity of three months or less are considered to be cash equivalents. Cash equivalents consist of
investments in money market mutual funds. A portion of our funds held in money market mutual funds
are invested in repurchase agreements. These repurchase agreements are collateralized by U.S.
Treasury and Government obligations. Cash and cash equivalents at December 31 consisted of the
following: December 31,(Dollars in thousands)
    
    2003
    
    
    2004Cash and cash equivalents:Cash
    
    $
    19,568
    
    
    $
    16,198Money market
    
    
    8,408
    
    
    
    $
    27,976
    
    
    $
    16,198
 Investments Short-term investments have original maturities greater than three months and remaining
maturities of less than one year. All investments are classified as available for sale and are
presented at market value using the specific identification method based on quoted market prices.
Unrealized gains and losses are reflected in other comprehensive income. Realized gains and losses
are included in results of operations. Short-term investments of $5.1 million as of December 31,
2003 consisted of corporate notes and bonds. There were no short-term investments as of December
31, 2004. Accounts Receivable, net We estimate sales allowances based upon historical experience of sales returns. To establish
our allowance for doubtful accounts, we perform credit evaluations of our customers financial
condition, along with analyzing past experience, and make provisions for doubtful accounts based on
the outcome of our credit valuations and analysis. We evaluate the collectability of our accounts
receivable based on specific customer circumstances, current economic trends, historical experience
with collections, and the age of past due receivables. We believe the allowances that we have
established are adequate under the circumstances; however, a change in the economic environment or
a customers financial condition could cause our estimates of allowances and, consequently, the F-10




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provision for doubtful accounts, to change. Allowance for doubtful accounts was $509,000 and
$651,000 as of December 31, 2003 and 2004, respectively. Allowance for sales returns was $227,000
and $292,000 as of December 31, 2003 and 2004, respectively. During 2004, we entered into a series of agreements with Vitelcom, a former European customer,
with regard to its payment of an outstanding balance due us. The first agreement was entered into
in June 2004 with regard to $5.9 million due to us and provided for the amount due to be paid to us
in a series of installments through October 2004. In September 2004, we agreed to a revised payment
schedule with installments due through the end of 2004. At the end of the year $1.4 million
remained unpaid under that revised payment schedule. We have not taken a reserve for doubtful
accounts for this amount because we believe this amount will be paid. In the first quarter of 2005
we filed a lawsuit against Vitelcom in Spain for the unpaid amount. Inventories Inventories are stated at the lower of cost (first-in, first-out) or net realizable value and
consisted of the following at: December 31,(Dollars in thousands)
    
    2003
    
    
    2004Raw materials
    
    $
    14,188
    
    
    $
    15,128Work-in-process
    
    
    5,321
    
    
    
    2,444Finished goods
    
    
    6,345
    
    
    
    5,873$
    25,854
    
    
    $
    23,445
 Shipping terms with one of our major customers is FOB destination, and many of those products
are shipped by sea, taking four to six weeks to reach their destinations. As a result, product in
transit that was in our finished goods inventory was $3.1 million as of December 31, 2004 compared
with $3.6 million as of December 31, 2003. We scrap inventory when materials are determined to be defective, damaged or no longer
required. We also write down our inventory for estimated obsolescence or unmarketable inventory
based upon assumptions and estimates about future demand and market conditions. If actual market
conditions are less favorable than those projected by us, additional inventory write-downs may be
required. As noted below, we have had a significant history of inventory charges and write-offs
with over $5 million of expenses written off in 2004:  
    In the fourth quarter of 2003, we learned from a customer that a product shipped by us
to the customer contained potentially defective parts. Those potentially defective parts
were printed circuit boards supplied to us by a vendor specified by our customer. At
year-end 2003, we believed the parts could be repaired or that the component supplier would
reimburse us for the damages. We determined in the first quarter of 2004 that the latent
defect in the materials purchased was not repairable and that it was possible that the
component supplier would not reimburse us for damages beyond the cost of those boards. As
a result, we established a reserve for the value of that inventory, which included other
component parts that had already been included on those boards less the $158,000 value of
the boards for which we believe the supplier is obligated to repay at a minimum. The amount
reserved was approximately $1.0 million.
    At year-end 2003, we held $778,000 of inventory relating to a program cancelled by a
customer. At that time, we believed we would recover the carrying value of this inventory
and did not establish a reserve. After further discussions and negotiations with this
customer during the first quarter of 2004, we wrote off $332,000 of this inventory while
receiving settlement against the remainder of the inventory.
    In the second quarter of 2004, a telecommunications customer declared bankruptcy. As a
result of that event, we wrote off $127,000 in accounts receivable and recorded a $567,000
reserve against inventory relating to specific programs for that customer.
    In the third quarter of 2004, we wrote off $1.4 million as follows: (a) $435,000 of
Redmond inventory due to the pending end-of-life of several long-running programs; (b)
$806,000 for inventory write-offs and F-11




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other charges relating to the shut-down of various programs as a result of the move of our
display module operations from Manila to Beijing; and (c) $202,000 of inventory in Manila
related to Microtune.
    In the fourth quarter of 2004, we wrote off $1.8 million of inventory as follows: (a)
$284,000 of Redmond inventory relating to termination of customer programs; (b) $284,000 of
Penang inventory for quality issue related to a new customer start-up; (c) $469,000 of
Manila inventory for excess and obsolete inventory relating to Microtune; and (d) $774,000
display platform related inventory charges, most of which were due to excess and obsolete
issues. Of the total write-offs and charges in 2004, $4.1 million was charged as excess inventory.
Excess inventory charges in 2003 and 2002 were $1.6 million and $1.9 million, respectively. Property, Plant, and Equipment Property, plant, and equipment is recorded at cost and is depreciated using the straight-line
method over the estimated useful lives of the respective assets. Lives for the major asset
categories are as follows: LivesBuildings
    
    35  39 yearsBuilding Improvements
    
    10  35 yearsEquipment
    
    3  7 yearsFurniture
    
    3  10 years
 Major additions and betterments are capitalized, while replacements, maintenance, and repairs
that do not extend the useful lives of the assets are charged to expense as incurred. Depreciation
expense totaled $3.7 million, $5.5 million, and $6.5 million for the years ended December 31, 2002,
2003, and 2004, respectively. Property, plant, and equipment consisted of the following at the
dates indicated: December 31,(Dollars in thousands)
    
    2003
    
    
    2004Land and building
    
    $
    6,122
    
    
    $
    10,494Furniture and equipment
    
    
    40,907
    
    
    
    39,59947,029
    
    
    
    50,093Less accumulated depreciation
    
    
    (21,706
    )
    
    
    (23,380
    )$
    25,323
    
    
    $
    26,713
 In 1994, we conveyed our Tempe, Arizona facility and certain improvements to the city of Tempe
as consideration for a rent-free 75-year lease. We had the option to repurchase the facility for
$1,000 after ten years; therefore, the building lease was accounted for as a capital lease. We
exercised that right in mid-2004 and took ownership of the facility. In April 2004, we purchased our facility in Manila from our lessor for $3.8 million. Of the
$3.8 million paid, $3.2 million was assigned to the carrying value of the building and $585,000 was
applied to accrued rent liabilities. We also paid $614,000 to the RBF Development Corporation, or
RBF, for a 50 year land right. Lastly, we executed an agreement with RBF for an option to purchase
the leased land for $1 at any time until April 23, 2014. In January 2005, we issued a press release
in which we stated that we are exploring opportunities to sell this facility. In December 2004, we sold our Tempe Arizona building for approximately $11.3 million, less
selling costs of approximately $500,000. As part of this transaction, we received a $2.0 million
note receivable due in five years. At the time of the sale, we entered into an agreement with the
buyer to leaseback the entire facility for a period of five years. The remaining capital expenditures for 2004 related primarily to equipment purchased from
Integrex, our ongoing ERP implementation, and additions in China related to our TFT clean room. We
have invested $2.1 million in our ERP implementation. F-12




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Evaluation of Long-Lived Assets with Definite Lives In accordance with Financial Accounting Standards Board (FASB) Statement of Financial
Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets, we evaluate the recoverability of property, plant, equipment, and intangibles with
definite lives not held for sale. Whenever events or changes in circumstances indicate that the
carrying amounts of the assets may not be recoverable, we evaluate recoverability by comparing the
carrying amount of the asset or group of assets against the estimated undiscounted future cash
flows expected to result from the use of the asset or group of assets and their eventual
disposition. If the undiscounted cash flows are less than the carrying value of the asset or group
of assets being evaluated, an impairment loss is recorded. These cash flows are evaluated for
objectivity by using weighted probability techniques and also comparisons of past performance
against projections. Assets may also be evaluated by identifying independent market values. The
loss is measured as the difference between the fair value and carrying value of the asset or group
of assets being evaluated. Assets held for sale are reported at the lower of the carrying amount
or the fair value less cost to sell. The estimated fair value is based on the best information
available under the circumstances, including prices for similar assets or the results of valuation
techniques, including the present value of expected future cash flows using a discount rate
commensurate with the risks involved. Intangibles Intangibles consist of mask works, trademarks, customer lists, and licensing/distribution
rights. SFAS 142, Goodwill and Other Intangible Assets, requires purchased intangible assets with
finite lives to be amortized over their useful lives. Purchased intangibles are recorded at cost
and amortized using the straight-line method over the estimated useful lives of the respective
assets, which range from two to five years. Our policy is to commence amortization of intangibles
when their related benefits begin to be realized. In January 2003, we signed licensing and manufacturing agreements with Data International Co.,
Ltd. of Taiwan. Under those agreements, we agreed to pay $3.9 million to become the exclusive
channel in the Americas for LCD products manufactured by Data International. The remaining $1.5
million cost of the license was due in January 2005. We have not paid the $1.5 million due to an
ongoing dispute with Data International. See footnote 12, Subsequent Events for additional
information. In the third quarter of 2004, we wrote off the remaining $1.8 million of the customer list
associated with the AVT acquisition. The acquisition value of the customer lists acquired from our
AVT acquisition was $3.0 million and the accumulated amortization was $1.2 million. This write-off
occurred as a result of numerous changes in the AVT business, including notification during the
quarter that a customer was not renewing a program. That notification, along with the other
cumulative changes that have occurred since the acquisition, have now resulted in a complete
turnover in the customer base. Most of these changes were driven by the fact that the original
business when acquired by us was selling CRT displays and now is exclusively selling LCD flat panel
displays. Intangible assets consisted of the following: Acquisition
    
    
    Accumulated
    
    
    Book
    
    
    Weighted(Dollars in thousands)
    
    Value
    
    
    Amortization
    
    
    Value
    
    
    Avg LifeDecember 31, 2003Amortized Intangible Assets:Mask works
    
    $
    991
    
    
    $
    
    
    
    $
    991
    
    
    
    3.0Customer lists
    
    
    5,000
    
    
    
    (1,523
    )
    
    
    3,477
    
    
    
    4.2License
    
    
    3,882
    
    
    
    (776
    )
    
    
    3,106
    
    
    

    5.0$
    9,873
    
    
    $
    (2,299
    )
    
    $
    7,574
    
    
    
    4.4
 F-13




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Acquisition
    
    
    Accumulated
    
    
    Book
    
    
    Weighted(Dollars in thousands)
    
    Value
    
    
    Amortization
    
    
    Value
    
    
    Avg LifeDecember 31, 2004Amortized Intangible Assets:Mask works
    
    $
    988
    
    
    $
    (225
    )
    
    $
    763
    
    
    
    2.4Customer lists
    
    
    2,000
    
    
    
    (1,389
    )
    
    
    611
    
    
    
    3.0License
    
    
    3,882
    
    
    
    (1,552
    )
    
    
    2,330
    
    
    
    5.0$
    6,870
    
    
    $
    (3,166
    )
    
    $
    3,704
    
    
    
    4.0
 Intangible asset amortization expense for the years ended December 31, 2002, 2003 and 2004 was
$256,000, $2.0 million and $2.1 million, respectfully. During 2004, approximately $225,000 of
amortization expense was included in cost of sales. Estimated annual amortization expense through 2009 and thereafter related to intangible assets
reported as of December 31, 2004 was as follows: Fiscal Year
    
    (Dollars in thousands)2005
    
    $
    1,8152006
    
    
    1,0572007
    
    
    8322008
    
    
    2009
    
    
    Thereafter
    
    
    $
    3,704
 Goodwill In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, goodwill is analyzed
for impairment, on at least an annual basis, or more frequently under certain circumstances, and
written down when impaired rather than being amortized. Changes in goodwill from December 31, 2003 to December 31, 2004 were as follows: (Dollars in thousands)
    
    TotalBalance at December 31, 2002
    
    $
    34,901Purchase of
Unico Technology, Bhd.
    
    
    315Reduction of ETMA Corporation purchase price
    
    
    (610
    )Balance at December 31, 2003
    
    $
    34,606Purchase of
minority interest in TFS Malaysia
    
    
    232Other adjustments
    
    
    (44
    )Goodwill impairment
    
    
    (21,350
    )Balance at December 31, 2004
    
    $
    13,444
 Other Assets Other assets consist primarily of the $2.0 million note receivable that we received in
connection with the sale and leaseback of the Tempe building. Accrued Liabilities Accrued liabilities included, among other things, accrued compensation of approximately $1.9
million and $1.5 million at December 31, 2003 and 2004, respectively. Customer Deposits Customer deposits include approximately $2.9 million of invoices issued in the fourth quarter
of 2004 to a specific customer in accordance with the terms and conditions of that customers
purchase order. The invoices are to F-14




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cover costs associated with the establishment of the supply chain and the long lead times required
for materials used in the manufacturing process. Deferred Sale Leaseback Gain In December 2004, we sold our Tempe building for approximately $11.3 million less selling
costs of approximately $500,000. Under the terms of the sale, we received net cash (after expenses)
of $8.8 million and a promissory note of $2 million payable in five years, resulting in a $2.7
million gain on the sale of that building. The $2.7 million deferred gain on the sale and
leaseback of our Tempe, Arizona corporate facility will be amortized over the five year term of the
lease. Estimated annual amortization through 2009 and thereafter related to the deferred gain on the
sale of fixed assets reported as of December 31, 2004 was as follows: Fiscal Year
    
    (Dollars in thousands)2005
    
    $
    5452006
    
    
    5442007
    
    
    5452008
    
    
    5442009
    
    
    545Thereafter
    
    
    $
    2,723
 Line of Credit In the second quarter of 2004, our Beijing subsidiary obtained a $2.4 million line of credit
with Hua Xia Bank secured principally by our building in Beijing. We have borrowed $2.4 million
under that facility at December 31, 2004, which accrues simple, annual interest at 5.31%. Income Taxes Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (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. Foreign Currency Translation For foreign subsidiaries that use currency other than the U.S. dollar as their functional
currency, assets and liabilities are translated at exchange rates in effect at the balance sheet
date, and revenue and expenses are translated at the weighted average exchange rate for the period.
The effects of these translation adjustments are reported in other comprehensive income and as a
separate component of stockholders equity. Derivatives On January 1, 2001, we adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities, which establishes accounting and reporting standards requiring us to recognize
derivatives as either assets or liabilities on the balance sheet and to measure those instruments
at fair value. The adoption of SFAS No. 133 did not have a material impact on our financial
position or results of operation. We may use derivatives to manage exposures to foreign currency fluctuations. The only type of
derivative we use is foreign currency forward contracts. Our objectives for holding these forward
contracts are to decrease the potential volatility of earnings and cash flows associated with
changes in foreign currency exchange rates (see Note 9). F-15




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Revenue Recognition We assemble and manufacture products for our customers and recognize revenue when persuasive
evidence of a sale exists; that is, a product is shipped under an agreement with a customer, risk
of loss and title have passed to the customer, the fee is fixed or determinable, and collection of
the resulting receivable is reasonably assured. This means that when a product is shipped from one
of our factories under the terms of FOB Factory, then the risk of loss passes to the customer
when the product leaves our factory and we recognize revenue at that time. On the other hand, when
a product is shipped FOB Destination, then risk of loss during transit is maintained by us.
Thus, we recognize revenue when the product is accepted by the customer. Shipping terms with one
of our major customers is FOB Destination, and many of those products are shipped by sea, taking
four to six weeks to reach their destination. As a result, we frequently have a significant amount
of product in transit recorded in our finished goods inventory balance. We recognize revenue related to engineering, design, and other related services after the
service has been rendered, which is determined based upon completion of agreed upon milestones or
deliverables. Service revenues are not significant in any period presented. Research, Development, and Engineering Research, development, and engineering costs are expensed as incurred. Stock Compensation. Pursuant to the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, we
account for options granted to our employees pursuant to Accounting Principles Board Opinion (APB)
No. 25, Accounting for Stock Issued to Employees, under which no compensation cost has been
recognized. However, we have computed compensation cost, for pro forma disclosure purposes, based
on the fair value of all options awarded on the date of grant, utilizing the Black-Scholes option
pricing method with the following weighted assumptions: risk-free interest rates of 2.74%, 3.25%
and 3.63% for 2002, 2003, and 2004; expected dividend yields of zero for all scenarios; expected
lives of 6.1 years for 2002, 5.7 years for 2003, and 4.1 years for 2004; and expected volatility (a
measure of the amount by which a price has fluctuated or is expected to fluctuate during a period)
of 74.4%, 79.6%, and 77.81% for 2002, 2003, and 2004, respectively. The compensation costs for
2002 are tax-effected and the compensation costs for 2003 and 2004 are not tax-effected. Had
compensation cost for these plans been determined consistent with SFAS No. 123, our net loss and
loss per share would have been as follows: Years Ended December 31,(In thousands, except per share data)
    
    2002
    
    
    2003
    
    
    2004Net loss:As reported
    
    $
    (16,971
    )
    
    $
    (44,453
    )
    
    $
    (54,292
    )Total stock-based compensation
expenses determined under fair value
based method for all awards, net of
related tax effects
    
    
    (4,378
    )
    
    
    (5,035
    )
    
    
    (3,556
    )Pro forma net loss
    
    $
    (21,349
    )
    
    $
    (49,488
    )
    
    $
    (57,848
    )Basic and diluted net loss per share:As reported
    
    $
    (0.79
    )
    
    $
    (2.09
    )
    
    $
    (2.50
    )Pro forma
    
    
    (0.99
    )
    
    
    (2.32
    )
    
    
    (2.66
    )
 Earnings Per Share Basic net income (loss) per common share is computed by dividing net income (loss) by the
weighted average number of common shares outstanding during the year before giving effect to stock
options considered to be dilutive common stock equivalents. Diluted net income (loss) per common
share is computed by dividing net income (loss) by the weighted average number of common shares
outstanding during the year after giving effect to stock options considered to be dilutive common
stock equivalents. Set forth below are the disclosures required pursuant to SFAS No. 128 
Earnings per Share: F-16




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Years Ended December 31,(In thousands, except per share data)
    
    2002
    
    
    2003
    
    
    2004Basic earnings (loss) per share:Net income (loss)
    
    $
    (16,971
    )
    
    $
    (44,453
    )
    
    $
    (54,292
    )Weighted average common shares
    
    
    21,465
    
    
    
    21,301
    
    
    
    21,719Basic earnings (loss) per share amount
    
    $
    (0.79
    )
    
    $
    (2.09
    )
    
    $
    (2.50
    )Diluted earnings (loss) per share:Net income (loss)
    
    $
    (16,971
    )
    
    $
    (44,453
    )
    
    $
    (54,292
    )Weighted average common shares
    
    
    21,465
    
    
    
    21,301
    
    
    
    21,719Dilutive stock options
    
    
    
    
    
    
    
    
    
    
    Total common shares plus common stock equivalents
    
    
    21,465
    
    
    
    21,301
    
    
    
    21,719Diluted earnings (loss) per share amount
    
    $
    (0.79
    )
    
    $
    (2.09
    )
    
    $
    (2.50
    )
 For the years ended December 31, 2002, 2003 and 2004, the effect of 314,569, 348,030 and
73,352 shares, respectively, were excluded from the calculation of loss per share as their effect
would have been antidilutive and decreased the loss per share. Recently Issued Accounting Standards In November 2004, the FASB issued SFAS No. 151, Inventory Costs  An Amendment of ARB No. 43,
Chapter 4. SFAS No. 151 amends the guidance in Accounting Research Bulletin (ARB) No. 43, Chapter
4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material (spoilage). Among other provisions, the new rule
requires that items such as idle facility expense, excessive spoilage, double freight, and
rehandling costs be recognized as current-period charges regardless of whether they meet the
criterion of so abnormal as stated in ARB No. 43. Additionally, SFAS No. 151 requires that the
allocation of fixed production overheads to the costs of conversion be based on the normal capacity
of the production facilities. SFAS No. 151 is effective for fiscal years beginning after June 15,
2005 and is required to be adopted by us effective January 1, 2006. We are currently evaluating the
impact SFAS No. 151 will have on our consolidated results of operations and financial condition... In
December 2004, the FASB issued Statement 123 (R), Share-Based Payment, which replaces
FASB Statement No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25,
Accounting for Stock Issued to Employees. FASB Statement 123 ® will require compensation costs
related to share-based payment transactions to be recognized in the financial statements. With
limited exceptions, the amount of compensation cost will be measured based on the grant-date fair
value of the equity instruments issued. Compensation cost will be recognized over the period that
an employee provides service in exchange for the award. FASB Statement 123 ® becomes effective
for interim or annual periods beginning after June 15, 2005. At this time, we are in the process
of evaluating the impact this will have on our financial statements. We adopted the provisions of FASB Interpretation No. 46 (Revised), Consolidation of Variable
Interest Entities (Interpretation No. 46 (Revised)) in our interim period ending March 31, 2004.
Interpretation No. 46 (Revised) clarifies the application of existing consolidation requirements to entities where
a controlling financial interest is achieved through arrangements that do not involve voting
interests. The application of Interpretation No. 46 (Revised) did not have an impact on our financial statements. Assets Held For Sale and Loss (Gain) on Sale of Assets During 2002, we signed a Cooperative Agreement with a Chinese company under which we agreed to
sell the equipment used in our front-end LCD equipment and establish a supply agreement. Under the
terms of the Cooperative Agreement, in exchange for our front-end LCD line, we received a total of
$3.0 million in cash during 2002 and 2003. In the second quarter of 2002, as a result of signing
the Cooperative Agreement, we realized a charge of $4.5 million for the write-down on the LCD
equipment sold to the Chinese company. This charge was reported as a separate line item in
operating expense. In connection with the Cooperative Agreement, we received $2.1 million in 2002,
all of which was applied against the $3.0 million sales price and recorded as a reduction in the
carrying value of the LCD equipment held for sale. The sale of the equipment is now complete, and
we received $900,000 in 2003. F-17




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During the fourth quarter of 2003, we formalized plans to sell our Tempe, Arizona corporate
facility; therefore, in accordance with Financial Accounting Standards Board (FASB) Statement of
Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets, we reclassified $8.6 million of our building and improvements to assets held
for sale. The building was listed and actively marketed for sale at the beginning of October 2003;
therefore, no depreciation expense was recorded during the subsequent 12-month period. However,
in the third quarter of 2004, we agreed to sell and leaseback the Tempe building. Accordingly,
depreciation expense of $362,000, which would otherwise have been recorded during the period the
building was held for sale, was recorded in the third quarter. In December 2004, we sold our
Tempe, Arizona building for approximately $11.3 million less selling costs of approximately
$500,000. Under the terms of the sale, we received net cash (after expenses) of $8.8 million and a
promissory note of $2.0 million payable in five years, resulting in a $2.7 million gain on the sale
of that building. Because we leased back the Tempe facility for five years, we will recognize the
gain ratably over the life of the lease. (3) Acquisitions and Strategic Transactions: In February 2004, we entered into a transaction with Integrex, a Seattle-based electronics
manufacturing services company that was liquidating its business. Under that transaction, we bought
the raw materials inventory of Integrex for $1.4 million and hired certain of its employees. We
also obtained the rights to most of its customers and agreed with those customers that we would
manufacture those customers products in our Redmond manufacturing facility. In exchange for those
customer rights, we agreed to pay a license fee for between 15 and 24 months based on revenue
receipts from former Integrex customers. In February 2004 and at a second closing in April 2004, we
paid $1.3 million in non-refundable license fees to Integrex. At the second closing in April, we
also acquired $300,000 of capital equipment. In April 2003, we acquired the business and certain assets of Unico Technology Bhd., a
privately held Malaysian company located in Penang. Unico was an electronics manufacturer for OEM
customers in the computer, computer peripheral, and communications industries. The Unico business
was acquired by TFS Electronics Manufacturing Services Sdn. Bhd., or TFS-Malaysia, a former joint
venture owned 60% by an overseas TFS subsidiary and 40% by Unico Holdings Bhd., the former parent
of Unico. Unico Holdings is the investment arm of the Chinese Chamber of Commerce of Malaysia. Our
share of the initial cost of capitalizing TFS-Malaysia was $3.8 million and Unico Holdings share
was $2.5 million, most of which was used for working capital. TFS-Malaysia purchased $4.1 million
in inventory from Unico, of which $2.7 million was paid at the time of the purchase and $1.4
million was subsequently paid. No advance payment was required for the acquisition of the property,
plant, and equipment of Unico, all of which is leased from the seller. The equipment lease is
accounted for as a capital lease payable by TFS-Malaysia. The principal balance on that lease was
$6.1 million as of December 31, 2004. In the second quarter of 2004, Unico Holdings exchanged its
ownership interest in TFS-Malaysia for approximately 423,000 shares of our common stock held in
treasury in a transaction valued at $2.8 million, compared with Unico Holdings interest of $2.6
million. As a result of that transaction, we recorded approximately $232,000 in additional goodwill
and we now own 100% of TFS-Malaysia. In March 2003, we signed an agreement with Microtune, Inc. under which we agreed to
manufacture, assemble, and test Microtunes radio frequency, or RF, tuner modules and wireless
module products in our manufacturing facility in Manila, the Philippines. As part of the agreement,
Microtune sold to us certain of its own equipment and inventory for $8.2 million, of which $2.7
million was a note payable due in September 2003, and contracted with us to provide 100% of
Microtunes current demand for fully assembled RF subsystems. We also hired approximately 500
Microtune employees in Manila. In October 2003, we paid off approximately $300,000 of the $2.7
million note payable to Microtune and entered into an agreement to cancel the remaining $2.4
million balance on that note payable in exchange for the return of inventory to Microtune. In
January 2005, we announced that we are exploring the possible sale of our Manila manufacturing
facility. In January 2003, we signed licensing and manufacturing agreements with Data International Co.,
Ltd. of Taiwan. Under those agreements, we became the exclusive channel in the Americas for LCD
products manufactured by Data International. We obtained the right to sell those products through
our worldwide channels. The cost of the license was $3.9 million, of which $1.0 million was paid
upon signing and $2.9 million was a term loan. In the first quarter of 2004, we paid $1.4 million
against the term loan. The remaining $1.5 million was due in F-18




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##### Table of Contents



January 2005 and is subject to reduction if certain margin targets are not met. We have not paid
the remaining amount due as a result of an ongoing dispute with Data International. See footnote
12, Subsequent Events for additional information regarding the dispute. In September 2002, we purchased the assets and ongoing business of AVT, a privately held
company located in Marlborough, Massachusetts that specialized in the design and integration of
complex, high-resolution display systems. AVT designs and provides customized and ruggedized flat
panel, touchscreen and rackmount systems for original equipment manufacturers. The purchase price
of the acquisition was $12.0 million, which we paid entirely in cash. The purchase price was allocated as follows: (Dollars in thousands)Current assets
    
    $
    2,115Property, plant and equipment
    
    
    105Customer list intangibles
    
    
    3,000Goodwill
    
    
    7,774Other long-term assets
    
    
    40Current liabilities
    
    
    (1,045
    )Net Acquisition price
    
    $
    11,989
 In December 2002, we purchased the stock of ETMA Corporation, located in Redmond, Washington,
a privately held electronics services manufacturer for OEM customers in the automotive,
computer/server, medical monitoring, and Internet security industries. ETMA offers the
manufacturing capabilities of five surface mount manufacturing lines, including one dedicated to
new product introduction and prototyping activity. ETMA provides engineering support, automated
printed circuit board assembly, in-circuit and functional testing, systems integration and box
build, complete supply chain management, and turnkey packaging and fulfillment services. The
purchase price of the acquisition was $38.1 million, which we paid entirely in cash. The purchase price was allocated as follows: (Dollars in thousands)Current assets
    
    $
    17,389Property, plant and equipment
    
    
    1,454Customer list intangibles
    
    
    2,000Goodwill
    
    
    27,127Current liabilities
    
    
    (9,842
    )Long-term liabilities
    
    
    (28
    )Net Acquisition price
    
    $
    38,100
 In the third quarter of 2004, we determined that the $27.1 million goodwill balance associated
with the EMS reporting unit was impaired. Because of the ongoing performance issues experienced by
the Redmond location, including the integration issues experienced in Redmond in the second and
third quarters of 2004, and because of the reduction in market comparables, we engaged a
professional valuation firm to assist us in determining the fair value of the EMS goodwill. The
valuation included a market comparable study and a present value valuation based on managements
best estimates of the future cash flows. The amount of the impairment loss was $21.3 million, and
was determined in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible
Assets. Total intangible assets from the acquisition of ETMA related to customer lists of $2.0 million
will be amortized over their weighted averaged useful lives of approximately three years. The results of operations of AVT and ETMA have been included in the accompanying financial
statements since their respective acquisition dates. The acquisition of AVT was considered
immaterial and pro forma results are therefore not presented. Unaudited pro forma Consolidated
Statements of Operations for 2002, presented as if ETMA had been acquired at the beginning of each
year, are as: F-19




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##### Table of Contents



Years Ended December 31,2002(Dollars in thousands, except per share data)
    
    (unaudited)Net sales
    
    $
    150,108Net loss
    
    
    (17,065
    )Loss per share (basic and diluted)
    
    
    (0.80
    )
 The pro forma amounts include a reduction in interest income related to the presumption that
the acquisition occurred as of January 1, 2002 and investments were therefore reduced by $38.1
million. (4) Long-Term Debt: Long-term balances were as follows at: December 31,(Dollars in thousands)
    
    2003
    
    
    2004Term loan due to Data International,
interest rate of 2.6% due January 2005
    
    $
    2,956
    
    
    $
    1,547Less current portion
    
    
    1,515
    
    
    
    1,547Long-term portion
    
    $
    1,441
    
    
    $
    0
 In the first quarter of 2004 we entered into a temporary credit facility with First National
Bank in which we borrowed $5 million secured by restricted cash deposits. In the second quarter of
2004, we repaid and terminated that credit facility. In the second quarter of 2004, we entered into a $10.0 million secured revolving line of
credit with Silicon Valley Bank, or SVB, which matures on June 25, 2005. Initially, that line of
credit bore interest at the banks prime rate plus 75 basis points, subject to a minimum rate of
4.75%. The SVB line also contained restrictive covenants that included, among other things,
restrictions on the declaration of payments of dividends, restrictions on the sale or transfer of
assets, and maintenance of specified net worth and quick ratio. We owed $5.0 million under that
line of credit as of September 30, 2004. As of September 30, 2004, we did not meet some of the
required covenants, although SVB did not call a default on the SVB line. During Q4 we signed an
amendment to the original SVB line that substantially revises its terms and conditions. Under those
new terms, the first $2.5 million of borrowings under that line of credit bears interest at the
banks prime rate plus 125 basis points subject to a minimum rate of 4.75%, and borrowings above
$2.5 million are subject to a factoring arrangement, bearing an initial discount fee and interest
of prime plus 450 basis points on the factored receivables. The credit limit remains at $10
million, but there are fewer receivables that qualify as factorable as compared to the original
borrowing base, resulting in a potentially lower borrowing base. Many of the restrictive covenants
previously contained in the SVB line documents have been removed, although covenants do remain
relating to cash earnings, revenue, and the Tempe building sale. Although there were no borrowings
under the SVB line as of December 31, 2004, we were in violation of our covenants relating to cash
earnings and revenue. SVB did not declare a default on the line, but we are currently under
discussion with the SVB with regard to a re-negotiation of the terms of the line. During this
re-negotiation period, SVB has issued a forbearance letter under which we are precluded access to
the line. In addition, SVB required us to make a cash deposit in 2005 to secure a $600,000 letter
of credit, which SVB had issued to the lessor of our building in Redmond. In January 2003, we signed a term loan of $2.9 million with Data International. In the first
quarter of 2004, we paid $1.4 million against the term loan. The remaining $1.5 million was due in
January 2005 and is subject to reduction if certain margin targets are not met. We have not paid
the remaining amount due as a result of an ongoing dispute with Data International. See footnote
12, Subsequent Events for additional information. Interest expense related to debt was $186,000, $204,000, and $144,000, respectively, for 2002,
2003, and 2004. F-20




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##### Table of Contents



Other Long-Term Liabilities In the fourth quarter of 2004, we moved into a new facility in Redmond and signed a seven year
lease with a five year renewal option. Prior to moving into that building, which we refer to as
Building 4, we leased three other buildings in the Redmond area. In the fourth quarter of 2004 we
vacated Building 1 and subleased that building. All of the activities in Building 1 are now
conducted in our new Building 4. As a part of that transaction, we received $900,000 from the
landlord of building 4 as an inducement to enter into the new lease and to cover costs associated
with the move. We are required to amortize the $900,000 against rent expense over the term of the
lease. Therefore, at December 31, 2004, the long-term portion of the amount to be amortized was
approximately $763,000. At the time we vacated Building 1, we recognized a charge of $382,000, which is equal to the
difference between the amount of rent, property taxes and local improvement districts assessments
that we would be required to pay during the remaining three years of the original five year lease
less the amount of rent we will receive from the sublease of that facility, which commenced on
January 1, 2005. Therefore, at December 31, 2004, the long-term portion attributable to the charge
was approximately $247,000. (5) Capital Leases: Capital leases were as follows at: December 31,(Dollars in thousands)
    
    2003
    
    
    2004Capital
lease due on purchase of Unico equipment, interest rate 13.3%, payable through April 2007
    
    $
    8,135
    
    
    $
    6,058Other capital leases with interest rate ranges from 1.9% to 14.2%,
payable through December 2003 and July 2007
    
    
    760
    
    
    
    6998,895
    
    
    
    6,757Less current portion
    
    
    2,352
    
    
    
    2,762Long-term portion
    
    $
    6,543
    
    
    $
    3,995
 The capital leases are for our equipment in Malaysia and Washington. One of the capital
leases includes certain financial covenants that we were not in compliance with at December 31,
2004. The lessor has informed us that as a result of covenant violations, they are accelerating
the payments due on the lease obligations. Interest expense related to capital leases was $868,000 and $1,012,000, respectfully, in 2003
and 2004. The following table lists our payments to be made on our capital leases reported as of
December 31, 2004: Fiscal Year
    
    (Dollars in thousands)2005
    
    $
    3,4302006
    
    
    3,2362007
    
    
    1,0742008
    
    
    30Total lease payments
    
    
    7,770Less interest portion
    
    
    (1,013
    )Capital lease obligations
    
    $
    6,757
 (6) Stockholders Equity: On December 7, 2000, the Board of Directors authorized a stock repurchase program whereby our
company, at the discretion of management, could buy back up to $30.0 million of our common stock in
the open market. During the year ended December 31, 2002, we purchased 260,600 shares at a cost of
$1,351,000. There were no stock repurchases in 2003 and 2004. This program was rescinded in May
2003. F-21




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##### Table of Contents



In the second quarter of 2004, we agreed with Unico Holdings to exchange its ownership
interest in TFS-Malaysia for approximately 423,000 shares of our common stock held in treasury in a
transaction valued at $2.8 million, compared with Unico Holdings interest of $2.6 million. During the second quarter of 2001, the Board of Directors adopted a stockholder rights plan
(the Rights Plan). Under the Rights Plan, we issued a dividend of one Preferred Share Purchase
Right (the Right) for each share of common stock of our company held by stockholders of record as
of the close of business on May 14, 2001. Each Right entitles stockholders to buy one
one-thousandth (1/1000th) of a share of Series A Junior Participating Preferred Stock of
our company at an exercise price of $120.00 (subject to adjustment). The Rights Plan was not
adopted in response to any specific takeover threat. The Rights Plan, however, was designed to
assure that all of our stockholders receive fair and equal treatment in the event of any proposed
takeover of our company, and to guard against coercive or unfair tactics to gain control of our
company without paying all stockholders a premium for that control. (7) Benefit Plans: We have six different stock option plans covering our employees, officers, directors, and
consultants and a Directors Stock Plan covering our directors; The 1990 Stock Option Plan (1990
Plan), the 1993 Stock Option Plan (1993 Plan), the 1994 Non-Employee Directors Stock Option Plan
(1994 Plan), the 1997 Stock Option Plan (1997 Plan), 1998 Stock Option Plan (1998 Plan) and the
2004 Incentive Compensation Plan. 1990 Stock Option Plan Under the 1990 Plan, there were options issued but unexercised to purchase 71,016 shares of
our companys common stock as of December 31, 2004. The 1990 Plan expired on May 1, 2001, at which
time all unissued options expired. 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 became 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. 1993 Stock Option Plan Under the 1993 Plan, there were options outstanding to acquire 260,367 shares of our companys
common stock under the 1993 Plan at December 31, 2004. The 1993 Plan expired on February 24, 2003,
at which time all unissued options expired. 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 our common stock. On April 26, 2001, our stockholders approved a
proposal to amend our 1994 Automatic Stock Option Plan for Non-Employee Directors (the 1994
Plan). Now, under the 1994 Plan, options to acquire 2,000 shares of common stock will be
automatically granted to each non-employee director at the meeting of our 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 our Board of Directors on the date the
1994 Plan was approved by our stockholders received an automatic grant of options to acquire 5,000
shares of common stock and each subsequent newly elected non-employee member of our Board of
Directors receives an automatic grant of options to acquire 5,000 shares of common stock on the
date of their first appointment or election to our Board of Directors. Those options become
exercisable and vest in a series of three equal and successive annual installments, with the first
such installment becoming exercisable immediately after the directors second successive election
to our Board of Directors (the First Vesting Date), the second installment becoming exercisable 10
months after the first vesting date, and the third installment becoming exercisable 22 months after
the first vesting date (provided that the director has not ceased serving as a director prior to a
vesting date). A non-employee member of our Board of Directors is not eligible to receive the 2,000
share automatic option grant if that option grant date is within 30 days F-22




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##### Table of Contents



of such non-employee member receiving the 5,000 share automatic option grant. The exercise price
per share of common stock subject to options granted under the 1994 Plan will be equal to 100% of
the fair market value of our common stock on the date such options are granted. There were
outstanding options to acquire 51,092 shares of our common stock under the 1994 Plan at December
31, 2004. The plan expired on April 12, 2004, at which time all unissued options expired. 1997 Stock Option Plan The 1997 Plan provides for the granting of nonqualified options to purchase up to 2,100,000
shares of our common stock. Under the 1997 Plan, options may be issued to key personnel and others
providing valuable services to our company. 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 1,442,593 shares of our common stock under the 1997 Plan at December
31, 2004. The expiration date, maximum number of shares purchasable, and the other provisions of the
options will be established at the time of grant. Options may be granted for terms of up to ten
years and become exercisable in whole or in one or more installments at such time as may be
determined by the plan administrator upon grant of the options. The exercise prices of the options
are determined by the plan administrator, but may not be less than 100% of the fair market value of
the common stock at the time of the grant. The 1997 Plan will remain in force until May 12, 2007. 1998 Stock Option Plan The 1998 Plan provides for the granting of incentive stock options and nonqualified options to
purchase up to 1,600,000 shares of our common stock. Under the 1998 Plan, options may be issued to
key personnel and others providing valuable services to our company. The options issued will be
incentive stock options or nonqualified stock options as defined in Section 422 of the Code. Any
option that expires or terminates without having been exercised in full will again be available for
grant pursuant to the 1998 Plan. There were options outstanding to acquire 1,528,461 shares of our
common stock under the 1998 Plan at December 31, 2004. The expiration date, maximum number of shares purchasable, and the other provisions of the
options will be established at the time of grant. Options may be granted for terms of up to ten
years and become exercisable in whole or in one or more installments at such time as may be
determined by the plan administrator upon grant of the options. The exercise prices of the options
are determined by the plan administrator, but may not be less than 100% of the fair market value of
the common stock at the time of the grant (110% if the option is an incentive stock option granted
to a stockholder who at the time the option is granted owns stock representing more than 10% of the
total combined voting power of all classes of stock of our company). The 1998 Plan will remain in
force until January 28, 2008. 2004 Incentive Compensation Plan On February 13, 2004, the Board of Directors adopted the 2004 Incentive Compensation Plan, or
Incentive Plan. As of March 24, 2004, there were outstanding options for 3,544,657 shares in the
five option plans that existed at December 31, 2003. The Incentive Plan was approved by our
stockholders at our annual meeting of stockholders on May 7, 2004. No new shares are being added
under the Incentive Plan. Instead, the aggregate number of shares of common stock to be issued
under the Incentive Plan equals the aggregate number of shares of common stock under all of the
five other stock option plans and Directors Stock Plan that are being consolidated into the
Incentive Plan as of February 13, 2004. The Incentive Plan provides for an aggregate of 4,079,299 shares of common stock to be issued
pursuant to options previously granted or to be granted to acquire common stock, the direct
granting of restricted common stock and deferred stock, the granting of stock appreciation rights,
and the granting of dividend equivalents. All options previously issued pursuant to the five
original plans remain outstanding. The Incentive Plan consolidates only the un-issued options of
the five original plans into one consolidated plan. F-23




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##### Table of Contents



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 committee or the Board of Directors upon grant of the options. The exercise price
per share of stock purchasable under an Option shall not be less than 100% of the fair market value
of the stock on the date of grant of the Option. If an employee owns or is deemed to own (by reason
of the attribution rules applicable under Section 424(d) of the Code) more than 10% of the combined
voting power of all classes of stock of our company or a subsidiary of our company and an incentive
stock option is granted to such employee, the option price of such incentive stock option (to the
extent required by the Code at the time of grant) shall be no less than 110% of the fair market
value of the stock on the date such incentive option is granted. During the term of the Plan, we will make automatic grants of options (Automatic Options) to
each director who is not employed by our company. Each year on the annual grant date, an Automatic
Option to acquire 2,000 shares of stock will be granted to each director for as long as shares of
stock are available. The Annual Grant Date will be the date of our annual stockholders meeting
commencing as of the first annual meeting occurring after the effective date. On the initial grant
date, every new member of the board that has not previously received an Automatic Option under this
plan will be granted an Automatic Option to acquire 5,000 shares of stock for as long as shares of
stock are available under this plan. The Initial Grant Date will be the date that a director is
first appointed or elected to the board. The exercise price per share of stock subject to each
Automatic Option granted will be equal to 100 percent of the fair market value per share of the
stock on the date such Automatic Option was granted. Each Automatic Option (2,000 shares) granted
will vest and become exercisable 12 months after the date of grant. Each Initial Automatic Option
(5,000 options) granted will vest and become exercisable in a series of three equal and successive
installments with the first installment vested on the date of grant and the next two installments
12 months and 24 months after the date of grant. Each Automatic Option will vest and become
exercisable only if the option holder has not ceased serving as a board member as of such vesting
date. Each Automatic Option will expire on the tenth anniversary (the Expiration Date) of the
date on which such Automatic Option was granted. There were options outstanding to acquire 375,300 shares of our common stock under the 2004
Incentive Compensation Plan at December 31, 2004. Tax benefits from option exercises are credited to additional paid-in capital. The following table and narrative summarizes the status of our six stock option plans at
December 31, 2002, 2003, and 2004 and changes during the years then ended: F-24




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##### Table of Contents



2002
    
    
    2003
    
    
    2004Weighted
    
    
    
    
    
    
    Weighted
    
    
    
    
    
    
    WeightedAverage
    
    
    
    
    
    
    Average
    
    
    
    
    
    
    AverageExercise
    
    
    
    
    
    
    Exercise
    
    
    
    
    
    
    ExerciseOptions
    
    
    Price
    
    
    Options
    
    
    Price
    
    
    Options
    
    
    PriceOutstanding at beginning
of year
    
    
    2,086,969
    
    
    $
    14.97
    
    
    
    2,890,728
    
    
    $
    12.59
    
    
    
    3,033,474
    
    
    $
    8.87Granted
    
    
    1,153,699
    
    
    
    9.21
    
    
    
    497,402
    
    
    
    4.65
    
    
    
    926,650
    
    
    
    4.17Exercised
    
    
    (39,183
    )
    
    
    5.35
    
    
    
    (24,684
    )
    
    
    4.79
    
    
    
    (13,904
    )
    
    
    4.86Expired or canceled
    
    
    (310,757
    )
    
    
    16.94
    
    
    
    (329,972
    )
    
    
    35.40
    
    
    
    (217,391
    )
    
    
    6.74Outstanding at end of year
    
    
    2,890,728
    
    
    
    12.59
    
    
    
    3,033,474
    
    
    
    8.87
    
    
    
    3,728,829
    
    
    
    7.84Exercisable at end of year
    
    
    1,042,169
    
    
    $
    11.48
    
    
    
    1,648,170
    
    
    $
    9.57
    
    
    
    2,154,898
    
    
    $
    9.44Weighted average fair value of
options granted
    
    
    
    
    
    $
    7.29
    
    
    
    
    
    
    $
    5.05
    
    
    
    
    
    
    $
    2.79
 The following table summarizes information about stock options outstanding at December
31, 2004: Options Outstanding
    
    
    Options ExercisableNumber
    
    
    Weighted
    
    
    
    
    
    NumberOutstanding
    
    
    Average
    
    Weighted
    
    
    Exercisable
    
    
    WeightedRange of
    
    at
    
    
    Remaining
    
    Average
    
    
    at
    
    
    AverageExercise
    
    December 31,
    
    
    Contractual
    
    Exercise
    
    
    December 31,
    
    
    ExercisePrices
    
    2004
    
    
    Life
    
    Price
    
    
    2004
    
    
    Price0.00  2.00
    
    
    6,500
    
    
    9.9
    
    
    1.97
    
    
    
    
    
    
    
    2.01  4.00
    
    
    686,935
    
    
    5.9
    
    
    3.48
    
    
    
    230,434
    
    
    
    3.704.01  6.00
    
    
    1,351,927
    
    
    6.0
    
    
    4.73
    
    
    
    539,978
    
    
    
    4.856.01  8.00
    
    
    515,086
    
    
    4.5
    
    
    6.50
    
    
    
    506,428
    
    
    
    6.508.01  10.00
    
    
    414,786
    
    
    4.8
    
    
    9.48
    
    
    
    307,423
    
    
    
    9.4910.01  15.00
    
    
    167,181
    
    
    5.8
    
    
    11.27
    
    
    
    89,816
    
    
    
    11.5115.01  17.50
    
    
    314,589
    
    
    4.9
    
    
    15.48
    
    
    
    209,869
    
    
    
    15.3717.51  20.00
    
    
    42,450
    
    
    4.4
    
    
    18.80
    
    
    
    41,575
    
    
    
    18.8020.01  30.00
    
    
    204,625
    
    
    2.6
    
    
    22.39
    
    
    
    204,625
    
    
    
    22.3930.01  100.00
    
    
    24,750
    
    
    5.0
    
    
    41.70
    
    
    
    24,750
    
    
    
    41.703,728,829
    
    
    5.4
    
    
    7.84
    
    
    
    2,154,898
    
    
    
    9.44
 In connection with the spin-off, each outstanding TFS option granted prior to the
spin-off was converted into both an adjusted TFS option and a substitute Brillian option. The
treatment of such TFS options and the substitute Brillian options is identical for those employees
who remained employees of TFS immediately after the spin-off and for those employees who became
employees of Brillian in connection with the spin-off. These TFS options were converted in a
manner that preserved the aggregate exercise price of each option, which was allocated between the
adjusted TFS option and the substitute Brillian options, and each preserved the ratio of the
exercise price to the fair market value of the stock subject to the option. 401(k)Profit Sharing Plan We have adopted a profit sharing plan (401(k) Plan). The 401(k) Plan covers substantially all
full-time employees who meet the eligibility requirements and provides for a discretionary profit
sharing contribution by us and an employee elective contribution with a discretionary matching
provision by our company. We expensed discretionary contributions pursuant to the 401(k) Plan in
the amount of $200,000, $187,000, and $427,000 for the years ended December 31, 2002, 2003, and
2004, respectively. (7) Income Taxes: The following table presents the U.S. and international components of income (loss) from
continuing operations before income taxes for the years ended December 31 (in thousands): F-25




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##### Table of Contents



Operations Before Income Tax December 31,2002
    
    
    2003
    
    
    2004United States
    
    $
    (12,116
    )
    
    $
    (18,866
    )
    
    $
    (52,472
    )International
    
    
    3,465
    
    
    
    (697
    )
    
    
    (2,046
    )Total Pretax Loss from Continuing Operations
    
    $
    (8,651
    )
    
    $
    (19,563
    )
    
    $
    (54,518
    )
 The provision (benefit) for income taxes for the years ended December 31 consists of the following
(in thousands): 2002
    
    
    2003
    
    
    2004Current provision (benefit), net of tax credits utilized:Federal
    
    $
    (2,118
    )
    
    $
    15
    
    
    $
    (127
    )States
    
    
    0
    
    
    
    0
    
    
    
    1Foreign
    
    
    486
    
    
    
    159
    
    
    
    (108
    )(1,632
    )
    
    
    174
    
    
    
    (234
    )Deferred provision (benefit)
    
    
    (2,289
    )
    
    
    14,164
    
    
    
    8Provision for (benefit from) income taxes
    
    $
    (3,921
    )
    
    $
    14,338
    
    
    $
    (226
    )
 The components of deferred taxes at December 31 are as follows (in thousands): 2003
    
    
    2004Net current deferred tax assets:Uniform
capitalization
    
    $
    261
    
    
    $
    702Accrued liabilities and
reserves not currently
deductible
    
    
    952
    
    
    
    522Allowance for doubtful
accounts
    
    
    77
    
    
    
    205Valuation
allowance
    
    
    (1,294
    )
    
    
    (1,433
    )Other
    
    
    134
    
    
    
    126$
    130
    
    
    $
    122
 2003
    
    
    2004Net long-term deferred tax (liabilities)/assets:Accelerated tax depreciation
    
    $
    1,332
    
    
    $
    436Goodwill and Intangibles
    
    
    (535
    )
    
    
    9,333Net operation loss and tax credit
carryforward
    
    
    23,303
    
    
    
    31,820Capital loss carryforward
    
    
    1,288
    
    
    
    1,288Valuation allowance
    
    
    (25,064
    )
    
    
    (44,183
    )Other
    
    
    (324
    )
    
    
    1,306$
    0
    
    
    $
    0
 We currently have $122,000 of short-term deferred tax assets resulting from operations in
foreign jurisdictions. SFAS No. 109 requires that a valuation allowance be established when it is
more likely than not that all or a portion of a deferred tax asset will not be realized. In
determining whether a valuation allowance is required, we must take into account all positive and
negative evidence with regard to the utilization of a deferred tax asset, including our past
earnings, unsettled circumstances that, if unfavorably resolved, would adversely affect utilization
of a deferred tax asset, carryback and carryforward periods, and tax strategies that could
potentially enhance the likelihood of realization of a deferred tax asset. SFAS No. 109 further
states that it is difficult to conclude that a valuation allowance is not needed when there is
negative evidence such as cumulative losses in recent years. Cumulative losses weigh heavily in the overall assessment and outweigh our forecasted future
profitability and expectation that we will be able to utilize all of our net operating loss
carryforwards. As a result, in the third quarter of 2003, we recorded a charge to establish a full
valuation allowance against our deferred tax asset and in 2004 we increased our valuation allowance
by $19.3 million because we believe it is more likely than not that we will be unable to utilize
our U.S. deferred tax assets. We expect to continue to record a full valuation allowance on future
tax benefits until we return to profitability. During 2003, our tax expense was $14.3 million as a
result of recording a full valuation allowance. F-26




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##### Table of Contents



Our capital loss carryforward expires in 2006. We have $82 million of federal net operating
loss carryforwards that begin to expire in 2022, and $8.7 million of state net operating loss
carryforwards that begin to expire in 2006. We have other general business credit carryforwards
that begin to expire in 2017. In connection with the formation and spin-off of Brillian, Brillian assumed a net deferred tax
liability of approximately $1.1 million. This net deferred tax liability is the result of
differences between book and tax basis of assets transferred to Brillian. We retained the net
operating losses that were generated by Brillian operations before the spin-off. A reconciliation of the U.S. federal statutory rate to our effective tax rate is as follows: 2002
    
    
    2003
    
    
    2004Statutory federal rate
    
    
    (34
    )%
    
    
    (34
    )%
    
    
    (34
    )%Effect of state taxes
    
    
    0
    
    
    
    0
    
    
    
    0Foreign earnings taxed at different rate
    
    
    (16
    )
    
    
    2
    
    
    
    1Other, net
    
    
    (4
    )
    
    
    0
    
    
    
    0Valuation Allowance
    
    
    9
    
    
    
    105
    
    
    
    33(45
    )%
    
    
    73
    %
    
    
    0
    %
 A deferred U.S. tax liability has not been provided on the undistributed earnings of certain
foreign subsidiaries because it is our intent to permanently reinvest such earnings. Undistributed
earnings of foreign subsidiaries, which have been, or are intended to be permanently invested in
accordance with APB No. 23, Accounting for Income Taxes  Special Areas, aggregated approximately
$6.1 million at December 31, 2004. Currently, the Company is under a tax holiday in Penang,
Malaysia. On October 22, 2004, the American Jobs Creation Act (the AJCA) was signed into law. The AJCA
includes a deduction of 85% of certain foreign earnings that are repatriated, as defined in the
AJCA. We may elect to apply this provision to qualifying earnings repatriations in either the
balance of 2005 or in 2006. We have started an evaluation of the effects of the repatriation
provision and are currently unable to estimate the potential earnings and related potential impact
of any repatriation. We expect to complete our evaluation of the effects of the repatriation
provision within a reasonable period of time. On March 30, 2005, we announced the sale of our small form factor display business, including
100% of the outstanding shares of Three-Five Systems (Beijing) Co., Ltd. Such sale could result in
U.S. taxable income, which would be offset by our net operating loss carryforwards. (8) Commitments and Contingencies: Rent and Lease In April 2001, Three-Five Systems Pacific, Inc. began its lease of a build-to-suit factory in
Manila. The term of the lease was 125 months. In April 2004, we purchased our facility in Manila
from our lessor and paid $3.8 million. We also paid $614,000 to the RBF Development Corporation, or
RBF, for a 50-year land right. We executed an agreement with RBF for an option to purchase the
leased land for $1 at any time until April 23, 2014. In January 2005, we issued a press release in
which we stated that we are exploring opportunities to sell this facility. In the fourth quarter of 2004, we moved into a new facility in Redmond and signed a seven-year
lease, under which the lessor paid to us $900,000 upon moving into that new facility, in part to
offset the costs of the move. We have the option to renew the lease for an incremental five year
term. We will offset our lease expense on that new facility by the $900,000 ratably over the term
of that lease. In addition, in connection with that move, we moved out of an older, leased facility
that had 36 months remaining on the lease. We subleased that building for a monthly amount that
was approximately 30% less than the original lease amounts due. As a result, we expensed in the
fourth quarter the cumulative loss on that sublease of $382,000. In January of 2005, we moved out
of another older facility that had 12 months remaining on the lease. A charge of approximately
$197,000 is expected to be recorded in the first quarter of 2005 to recognize future costs
associated with the continuing lease obligations of this facility. F-27




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##### Table of Contents



In December 2004, we sold our Tempe, Arizona building for approximately $11.3 million, less
selling costs of approximately $500,000. At the time of the sale, we entered into an agreement
with the buyer to leaseback the entire facility for a period of five years, which extends through
December 2009. This facility houses our U.S.-based manufacturing operations and our research,
development, engineering, design, and corporate functions. We subleased approximately 56,000
square feet of that Tempe facility to Brillian Corp. for the same five-year period. Brillian pays
to us the same lease rate that we pay the lessor on the master lease. If Brillian were to default
on its obligation to us, we would still be obligated on the master lease to continue to make
payments on the Brillian space. Our future lease commitments under all non-cancelable operating leases and expected future
rental income for the sublease of facilities as of December 31, 2004 are as follows: Lease commitments
    
    (Dollars in thousands)
    
    
    Future Rental Income
    
    (Dollars in thousands)2005
    
    $
    4,908
    
    
    2005
    
    $
    1,0022006
    
    
    3,623
    
    
    2006
    
    
    1,0012007
    
    
    2,998
    
    
    2007
    
    
    1,0062008
    
    
    2,624
    
    
    2008
    
    
    7392009
    
    
    2,643
    
    
    2009
    
    
    739Thereafter
    
    
    8,537
    
    
    Thereafter
    
    
    $
    25,333
    
    
    
    
    $
    $4,487
 Rent expense was approximately $1,783,000, $3,806,000, and $3,047,000 for the years ended
December 31, 2002, 2003, and 2004, respectively. We lease part of our Tempe facility to Brillian
and received $68,000 for 2003 and $188,000 for 2004, respectively. Letter of Credit In accordance with the terms of the lease for one of our facilities in Redmond, Washington, we
have issued an unconditional, sight draft letter of credit in the amount of $600,000 to the
landlord. The landlord letter of credit is security for the companys performance of all of its
covenants and obligations under the lease. Guarantee In February 2002, we guaranteed up to $500,000 of the debt of a private start-up company,
VoiceViewer Technology, Inc., which is developing microdisplay products. This guarantee was
assumed by Brillian Corporation in the spin-off. We have not yet been released from our obligation
on the guarantee, so if Brillian is unable to satisfy its obligation, then we are secondarily
liable and will be required to pay this guarantee to the lender. As of December 31, 2004, our
maximum liability under this guarantee was $327,000. This loan guarantee has a five-year term and
matures in January 2007. Legal Proceedings During the fourth quarter of 2003, we reached a settlement of our legal claim against J.D.
Edwards for $700,000, which has been recorded as other income. We recently filed a complaint against Data International in Arizona requesting a declaratory
judgment for breach of contract. Please refer to Note 12, Subsequent Events. We also filed a
complaint against Vitelcom, a customer of ours in Spain, for unpaid monies due to us for product
sales. We are also involved in certain administrative proceedings arising in the normal course of
business. In our opinion, the ultimate settlement of these administrative proceedings will not
materially impact our financial position or results of operations. F-28




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##### Table of Contents



Derivative Instruments We have certain receivables denominated in Chinese Renminibi and certain payable denominations
in Japanese Yen. To eliminate our exposure to changes in the U.S. Dollar exchange rate with
Chinese Renminibi and Japanese Yen, we may enter into forward contracts to protect our future cash
flows. Our forward contracts generally range from one to six months in original maturity. In accordance with SFAS No. 133, we designate such forward contracts as cash flow hedges. We
account for changes in the fair value of our forward contracts based on changes in the forward
exchange rate, with all such changes in fair value reported in other comprehensive income. Amounts
in other comprehensive income are reclassified into earnings upon settlement of the forward
contract at an amount that will offset the related transaction gain or loss arising from the
re-measurement and adjust earnings for the cost of the forward contracts. During 2004, there were
no significant gains or losses recognized in earnings for hedge ineffectiveness and we did not
discontinue any hedges because it was probable that the original forecasted transaction would not
occur. As of December 31, 2004 and 2003, there were no forward contracts outstanding. (10) Segment Information: We offer advanced design and manufacturing services and display products to OEMs.
Historically, we focused on display-oriented products, although we have always performed extended
manufacturing in conjunction with the display module. In the past two years, we expanded the
value-added manufacturing services we provide through several acquisitions. As a result, we now
provide printed circuit board assembly, or PCBA, radio frequency, or RF, module assembly, new
product introduction, or NPI, box build, and order fulfillment, even in products that do not need
displays. In products that do include displays, we specialize in custom and standard display
solutions utilizing various display technologies, including liquid crystal displays, or LCDs,
organic light emitting diodes, or OLEDs, and cathode ray tubes, or CRTs. The products we
manufacture for OEMs are of varying sizes and have varying levels of integration. At the end of 2004, we began to review our business performance using two segments, Display
and EMS. Within the Display business, our design and manufacturing services include a distinctive
competence in display modules and systems and the integration of display modules and systems into
other products. The display modules and systems we design and manufacture primarily utilize liquid
crystal displays, or LCDs. Those LCDs include small form factor monochrome and color LCDs,
including thin film transistor LCDs, or TFTs, as well as large format flat panel monitors. Within
the EMS business, we design and/or manufacture electronic printed circuit board assemblies, radio
frequency, or RF, modules, display modules and systems, and complete systems for customers in the
computing, consumer, industrial, medical, telecommunications, and transportation industries.
Corporate costs not allocated to operating segments include administrative costs for the chief
executive officer, chief financial officer and investor relations as well as accounting, legal and
human resource costs in Tempe, Arizona. Corporate costs in 2002 and 2003 also include costs
related to Microdisplays that could not be classified as discontinued operations. The segment
information presented below for 2002 and 2003 has been restated to reflect our current business
segments presentation. The following results are for our Display and EMS segments and unallocated
corporate costs: F-29




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##### Table of Contents



(Dollars in thousands)Display
    
    
    EMS
    
    
    Corporate
    
    
    TotalDecember 31, 2002Net Sales
    
    $
    82,813
    
    
    $
    3,774
    
    
    $
    
    
    
    $
    86,587Gross margin (loss)
    
    
    7,645
    
    
    
    474
    
    
    
    (250
    )
    
    
    7,869Operating income (loss)
    
    
    (3,387
    )
    
    
    246
    
    
    
    (9,086
    )
    
    
    (12,227
    )Amortization expense
    
    
    200
    
    
    
    56
    
    
    
    
    
    
    
    256Goodwill
    
    
    7,775
    
    
    
    27,126
    
    
    
    
    
    
    
    34,901December 31, 2003Net Sales
    
    $
    78,526
    
    
    $
    80,492
    
    
    $
    
    
    
    $
    159,018Gross margin (loss)
    
    
    (1,394
    )
    
    
    5,482
    
    
    
    (195
    )
    
    
    3,893Operating income (loss)
    
    
    (10,281
    )
    
    
    (34
    )
    
    
    (10,076
    )
    
    
    (20,391
    )Amortization expense
    
    
    1,375
    
    
    
    668
    
    
    
    
    
    
    
    2,043Goodwill
    
    
    7,773
    
    
    
    26,833
    
    
    
    
    
    
    
    34,606December 31, 2004Net Sales
    
    $
    53,106
    
    
    $
    105,841
    
    
    $
    
    
    
    $
    158,947Gross margin (loss)
    
    
    (928
    )
    
    
    (1,134
    )
    
    
    
    
    
    
    (2,062
    )Operating income (loss)
    
    
    (13,826
    )
    
    
    (31,061
    )
    
    
    (10,041
    )
    
    
    (54,928
    )Amortization expense
    
    
    1,449
    
    
    
    669
    
    
    
    
    
    
    
    2,118Goodwill
    
    
    7,729
    
    
    
    5,715
    
    
    
    
    
    
    
    13,444
 In 2002, the Display segment incurred a loss on sale of assets of $4.5 million related to the
sale of the LCD line. In 2004, the EMS segment incurred an impairment on goodwill of $21.3 million
for the write-off of goodwill associated with the acquisition of ETMA. In 2004, the Display
segment incurred an impairment on intangibles of $1.8 million associated with the customer lists
acquired during the AVT acquisition. We have not disclosed assets, liabilities, cost of property, plant and equipment acquired, and
depreciation expense by segment as this information is not reviewed by the chief operating decision
maker, is not produced internally and is not practical to prepare. We do however track net sales and certain property, plant, equipment, and intangibles by
geographic location. Net sales by geographic area are determined based upon the location of the end
customer, while long-lived assets are based upon physical location of the assets. The following
includes net sales, property, plant and equipment for our designated geographic areas: (Dollars in thousands)NorthAmerica
    
    
    Asia
    
    
    Europe
    
    
    TotalDecember 31, 2002Net sales
    
    $
    12,128
    
    
    $
    50,591
    
    
    $
    23,868
    
    
    $
    86,587Property, plant and equipment
    
    
    11,641
    
    
    
    11,697
    
    
    
    7
    
    
    
    23,345December 31, 2003Net sales
    
    $
    85,813
    
    
    $
    32,632
    
    
    $
    40,573
    
    
    $
    159,018Property, plant and equipment
    
    
    3,477
    
    
    
    21,842
    
    
    
    4
    
    
    
    25,323December 31, 2004Net sales
    
    $
    98,841
    
    
    $
    29,310
    
    
    $
    30,796
    
    
    $
    158,947Property, plant and equipment
    
    
    5,224
    
    
    
    21,489
    
    
    
    
    
    
    
    26,713
 F-30




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##### Table of Contents



In 2002, 2003 and 2004, our sales were distributed over six major markets: computing,
consumer, industrial, medical, telecommunications and transportation. In 2004, 53% of our sales
were into the computing market. In 2003, 38% of our sales came from the computing market and 28%
came from telecommunications. Our net sales distributed by market was as follows: Markets
    
    2002
    
    
    2003
    
    
    2004Computing
    
    
    7
    %
    
    
    38
    %
    
    
    53
    %Consumer
    
    
    1
    %
    
    
    6
    %
    
    
    11
    %Industrial
    
    
    5
    %
    
    
    10
    %
    
    
    13
    %Medical
    
    
    4
    %
    
    
    13
    %
    
    
    10
    %Telecommunications
    
    
    82
    %
    
    
    28
    %
    
    
    8
    %Transportation
    
    
    1
    %
    
    
    5
    %
    
    
    5
    %
 (11) Selected Quarterly Financial Data (Unaudited) The following table summarizes the unaudited consolidated quarterly results of operations as
reported for 2003 and 2004: (Dollars in thousands, except per share amounts)Quarters Ended2003
    
    
    2004Mar 31
    
    
    Jun 30
    
    
    Sep 30
    
    
    Dec 31
    
    
    Mar 31
    
    
    Jun 30
    
    
    Sep 30
    
    
    Dec 31Net sales
    
    $
    25,324
    
    
    $
    45,992
    
    
    $
    41,778
    
    
    $
    45,924
    
    
    $
    38,444
    
    
    $
    37,632
    
    
    $
    42,356
    
    
    $
    40,515Gross profit (loss)
    
    
    175
    
    
    
    1,894
    
    
    
    (272
    )
    
    
    2,096
    
    
    
    (221
    )
    
    
    (133
    )
    
    
    (146
    )
    
    
    (1,562
    )Loss from
continuing
operations
    
    
    (3,197
    )
    
    
    (2,533
    )
    
    
    (24,949
    )
    
    
    (3,222
    )
    
    
    (6,644
    )
    
    
    (6,721
    )
    
    
    (30,750
    )
    
    
    (10,177
    )Loss from
discontinued
operations
    
    
    (2,278
    )
    
    
    (2,343
    )
    
    
    (5,931
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    
    (5,475
    )
    
    
    (4,876
    )
    
    
    (30,880
    )
    
    
    (3,222
    )
    
    
    (6,644
    )
    
    
    (6,721
    )
    
    
    (30,750
    )
    
    
    (10,177
    )Earnings (loss) per
common share
basic and
diluted:Net loss from
continuing
operations
    
    $
    (0.15
    )
    
    $
    (0.12
    )
    
    $
    (1.17
    )
    
    $
    (0.15
    )
    
    $
    (0.31
    )
    
    $
    (0.31
    )
    
    $
    (1.41
    )
    
    $
    (0.47
    )Net loss from
discontinued
operations
    
    $
    (0.11
    )
    
    $
    (0.11
    )
    
    $
    (0.28
    )
    
    $
    0.00
    
    
    $
    0.00
    
    
    $
    0.00
    
    
    $
    0.00
    
    
    $
    0.00Net loss
    
    $
    (0.26
    )
    
    $
    (0.23
    )
    
    $
    (1.45
    )
    
    $
    (0.15
    )
    
    $
    (0.31
    )
    
    $
    (0.31
    )
    
    $
    (1.41
    )
    
    $
    (0.47
    )
 The quarter ended September 30, 2003 included a $17.6 million charge to record a tax
valuation allowance. The quarter ended December 31, 2003, included $700,000 in other income
relating to the J.D. Edwards settlement. The quarter ended September 30, 2004, included a $23.2
million charge related to the impairment of Goodwill and Intangibles. (12)Subsequent Events We recently announced that we signed a definitive agreement to sell the assets of our small
form factor-display business to International DisplayWorks, Inc. and that the closing of the
transaction, which is subject to normal conditions, is expected to
occur in April 2005. Revenues from our small form factor display
business in 2004 were approximately $28 million. The
small form factor display assets to be sold include 100% of the outstanding shares of
Three-Five Systems, Beijing, Inc., our China-based display subsidiary, and display-related
equipment currently housed at our Manila, Philippines factory. The sale will not include the
display monitor business operated out of our F-31




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Marlborough, Massachusetts facility and our electronic manufacturing services (EMS) business
located in Redmond, Washington, Penang, Malaysia, and Manila, Philippines. We estimate the total value of the transaction to be in the range of between $11 million and
$21 million, which will come from a variety of components. These components include the following:  
    $8 million in cash to be paid to us at closing;
    Up to an estimated $3 million in additional cash to be paid to us over time, based upon
inventory consumption and accounts receivable collections ; and
    An estimated zero to $9 million in the common stock of International DisplayWorks to be
paid to us in May 2006, based on a percentage of the transferred display business revenue
for the preceding 12-month period if certain minimum revenue targets are met. At closing, International DisplayWorks will assume the obligations of TFS Beijing, including a
$2.4 million line of credit it had established with a bank located in China. We also recently announced that we had retained SG Cowen & Company to review strategic
alternatives aimed at maximizing shareholder value and that we will continue to work with SG Cowen
with regard to our large form factor display, EMS, and RF module manufacturing businesses. We are
exploring a range of possible alternatives, such as acquisitions, strategic alliances, business
combinations, and the sale of a portion or all of the company. We are currently in discussions
with multiple potential buyers of the RF business and have received an initial offer from a
potential buyer of the EMS business. We indicated that there is no assurance that any business
transactions will be effected or what the timing and terms of any such business transactions could
be. We announced in January 2005 that we are considering selling our Manila manufacturing
facility. In March 2005, we determined to discontinue our product offerings from Data International
which is included in our Display segment. The decision follows the exercise by us of our right to
rescind a technology licensing agreement, or TLA, that was entered into during January 2003 with
Data International Co, Ltd. Revenues from those products in 2004 were approximately $17 million.
The TLA designated us as the exclusive distributor of certain Data International display products
in the Americas in return for deferred payments to Data International of $3.9 million. Through the
end of 2004, we had paid approximately $2.4 million to Data International, and a final payment of
approximately $1.5 million was due in January 2005. We recently determined that certain of the
specified Data International display products have been simultaneously available in the United
States through a third party and that we had not been provided exclusive distribution rights to the
United States market as required by the TLA. Based on that determination, we believe that the TLA
was breached, and we are exercising our rights of rescission. We notified Data International in
February 2005 that we will not make the final $1.5 million payment to Data International that was
due in January 2005. We also asserted damages of at least $2.5 million, plus interest and other
expenses, against Data International. We notified Data International that we will off-set our
claimed damages against money owed by us to Data International for product purchases. We recently
filed a complaint against Data International in Arizona requesting a declaratory judgment for
breach of contract. In January 2005, we vacated approximately 30,020 square feet in a facility we refer to as
Building 2 in Redmond, Washington. We moved all of the operations in that building to our new
Building 4. We had 12 months remaining on our lease on Building 2 at the end of January 2005. A
charge of approximately $197,000 is expected to be recorded in the first quarter of 2005 to
recognize future costs associated with the continuing lease obligation for this vacated facility
(Building 2). We have undertaken efforts to sublease this facility. In February of 2005, we vacated our office space in Swindon, England. A charge of
approximately $15,400 was recorded in February 2005 to recognize future costs associated with the
continuing lease obligation for this vacated facility. We have undertaken efforts to sublease this
facility. F-32




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In January of 2005, we announced that we are moving our corporate headquarters to Redmond,
Washington. This move will result in additional expenses in severance costs and moving costs.
Although we incurred some severance costs in the first quarter as a result of that announcement,
not all of the costs have been identified yet. We also had layoffs in the first quarter as part of
moving part of our engineering operations to Beijing. In the second quarter of 2004, we entered into a $10.0 million secured revolving line of
credit with Silicon Valley Bank, or SVB, which matures on June 25, 2005. Although there are no
borrowings under the SVB line as of December 31, 2004, we were in violation of our covenants
relating to cash earnings and revenue at the end of 2004. SVB did not declare a default on the
line, but we are currently under discussion with the SVB with regard to a re-negotiation of the
terms of the line. During this re-negotiation period, SVB has issued a forbearance letter under
which we are precluded access to the line at this time. In addition, SVB required us to make a
cash deposit in the first quarter of 2005 to secure a $600,000 letter of credit, which SVB had
issued to the lessor of our building in Redmond. F-33




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##### Table of Contents



THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES 
 SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
For the Years Ended December 31, 2002, 2003 and 2004
(Dollars in thousands) Increases(Reductions)Balance at
    
    
    Charged to Costs
    
    
    
    
    
    
    Balance at End ofbeginning of Period
    
    
    and Expenses
    
    
    Write-offs
    
    
    PeriodAllowance for doubtful accounts
and sales returns :Year ended 12/31/2002
    
    $
    228
    
    
    $
    323
    
    
    $
    (64
    )
    
    $
    487Year ended 12/31/2003
    
    $
    487
    
    
    $
    271
    
    
    $
    (22
    )
    
    $
    736Year ended 12/31/2004
    
    $
    736
    
    
    $
    212
    
    
    $
    (5
    )
    
    $
    943Valuation allowance for
deferred taxes :Year ended 12/31/2002
    
    $
    1,299
    
    
    $
    765
    
    
    $
    
    
    
    $
    2,064Year ended 12/31/2003
    
    $
    2,064
    
    
    $
    24,294
    
    
    $
    
    
    
    $
    26,358Year ended 12/31/2004
    
    $
    26,358
    
    
    $
    19,258
    
    
    $
    
    
    
    $
    45,616
 S-1




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##### Table of Contents



Exhibit List Exhibit Number
    
    Exhibits2
    
    Amended and Restated Agreement and Plan of Reorganization(1)2.2
    
    Master Separation and Distribution Agreement between the Registrant and Brillian
Corporation(18)3(i)(a)
    
    Amended and Restated Certificate of Incorporation of the Company(2)3(i)(b)
    
    Certificate of Amendment of Restated Certificate of Incorporation(3)3(i)(c)
    
    Certificate of Designation of Series A Junior Participating Preferred Stock(4)3(ii)
    
    Amended and Restated Bylaws of the Company(5)4.1
    
    Form of Certificate of Common Stock(16)4.2
    
    Rights Agreement, dated as of April 26, 2001, between Three-Five Systems, Inc. and
Bank of New York, as Rights Agent(6)10.2
    
    Ground Sublease dated April 1, 1994, between Papago Park Center, Inc. and
Three-Five Systems, Inc.(8)10.3
    
    Amended and Restated 1990 Incentive Stock Option Plan (as Amended and Restated
through March 7, 2003)(16)10.3
    
    2004 Incentive Compensation Plan(19)10.4
    
    Amended and Restated 1993 Stock Option Plan (as Amended and Restated through March
7, 2003)(16)10.5
    
    Amended and Restated 1994 Stock Option Plan for Non-Employee Directors (as Amended
and Restated through February 12, 2001)(9)10.6
    
    Amended and Restated 1997 Employee Stock Option Plan (as Amended and Restated
through November 27, 2002) (as corrected)(17)10.7
    
    Form of Notice and Acceptance of Stock Option Grant for Amended and Restated 1997
Employee Stock Option Plan(10)10.8
    
    Amended and Restated 1998 Stock Option Plan (as Amended and Restated through
February 8, 2002)(16)10.9
    
    Amended and Restated Directors Stock Plan (amended as of January 27, 2000)(11)10.10
    
    401(k) Profit Sharing Plan(12)10.15
    
    Technology License Agreement between Data International, Ltd. and TFS-DI dated
January 13, 2003(16)10.16
    
    Supply Agreement between Data International, Ltd. and TFS-DI dated January 13,
2003(16)10.17
    
    Term Promissory Note dated January 13, 2003 executed by TFS-DI in favor of Data
International, Ltd.(16)10.18
    
    Assignment and Assumption Agreement between the Registrant and Brillian
Corporation(18)10.19
    
    Intellectual Property Agreement between the Registrant and Brillian Corporation(18)10.20
    
    Tax Sharing Agreement between the Registrant and Brillian Corporation(18)10.21
    
    First Amended and Restated Real Property Sublease Agreement between the Registrant
and Brillian Corporation, dated as of June 1, 2004(21)10.22
    
    Manufacturing Agreement between the Registrant and Microtune, Inc., dated March
27, 2003(20)10.23
    
    Joint Venture Agreement regarding the establishment and operation of TFS
Electronic Manufacturing Services Sdn Bhd, dated April 1, 2003(20)10.24
    
    Equipment Lease Agreement between Unico Technology Berhad and Mattline Industries
Sdn Bhd, dated April 1, 2003(20)10.25
    
    Tenancy Agreement between Fortune Century Sdn Bhd, Jantron Sdn Bhd, and Mattline
Industries Sdn Bhd, dated April 1, 2003(20)10.26
    
    Tenancy Agreement between Geok Hong Sdn Bhd and Mattline Industries Sdn Bhd, dated
April 1, 2003(20)10.27
    
    License Agreement between the Registrant and Integrex, Inc., dated February 19,
2004(20)10.28
    
    Lease Agreement between SFERS Real Estate Corp. V and ETMA Corporation, dated July
21, 1999(20)10.29
    
    Lease Agreement between Therriault-Cogan, L.L.C. and ETMA Corporation, dated
January 17, 2001(20)




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##### Table of Contents



Exhibit Number
    
    Exhibits10.30
    
    Lease Agreement between Rapp/Rise L.L.C. and ETMA Corporation, dated December 13,
2002(20)10.31
    
    Loan and Security Agreement among the Registrant, TFS Electronics Manufacturing
Services, Inc. and Silicon Valley Bank, dated June 25, 2004 (21)10.32
    
    Amendment No.1 to the First Amended and Restated Real Property Sublease Agreement
between Registrant and Brillian Corporation, dated June 1, 2004 (22)10.33
    
    Severance Agreement and General Release between the Registrant and Jeffrey D.
Buchanan, dated January 26, 2005(23)10.34
    
    Net Lease Agreement among L & A Kessler Family Partners, L.P., Marilyn Dreyfuss,
Phillip Francis and Curtis Burr, as Trustees of the Edward S. Ageno 1992 Revocable
Trust, Kay Enterprises, and TFS Electronic Manufacturing Services, Inc., dated
November 19, 2004 *10.35
    
    Second Amended and Restated Real Property Sublease Agreement by and between the
Registrant and Brillian Corporation, dated December 22, 2004 *10.36
    
    Lease by and between Papago Paragon Partners, LLC and the Registrant, dated
December 30, 2004 *10.37
    
    Purchase Agreement by and among International DisplayWorks, Inc., International
DisplayWorks (Hong Kong) Limited, the Registrant, TFS International, Ltd., and
Three-Five Systems (Beijing) Co., Ltd., dated March 30, 2005 *21
    
    List of Subsidiaries*23.1
    
    Consent of Deloitte & Touche LLP*23.2
    
    Notice Regarding Consent of Arthur Andersen LLP(16)31.1
    
    Certification of Chief Executive Officer of the Registrant pursuant to Rule
13a-14(a) and Rule 15d-14(a) promulgated under the Securities Exchange Act of
1934, as amended.*31.2
    
    Certification of Chief Financial Officer of the Registrant pursuant to Rule
13a-14(a) and Rule 15d-14(a) promulgated under the Securities Exchange Act of
1934, as amended.*32.1
    
    Certification of the Chief Executive Officer of the Registrant pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.*32.2
    
    Certification of the Chief Financial Officer of the Registrant, pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.*
   *
    
    Filed herein.




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##### Table of Contents



(1)
    
    Incorporated by reference to Exhibit 2 to the Registration Statement on Form S-4 of TF
Consolidation, Inc. (Registration No. 33-33944) as filed on March 27, 1990.(2)
    
    Incorporated by reference to Exhibit 3(a) to the Registrants Form 10-QSB for the quarter
ended March 31, 1994, as filed on or about May 12, 1994.(3)
    
    Incorporated by reference to Exhibit 3(b) to the Registration Statement on Form S-3
(Registration No. 333-35788) as filed on April 27, 2000, as amended by Form S-3/A as filed on
May 5, 2000.(4)
    
    Incorporated by reference to Exhibit 3(d) to the Registrants Form 8-A as filed on May 10,
2001.(5)
    
    Incorporated by reference to Exhibit 3(b) to the Registration Statement on Form S-3
(Registration No. 333-84083) as filed on July 30, 1999, as amended by Form S-3/A as filed on
August 26, 1999.(6)
    
    Incorporated by reference to Exhibit 4(b) to the Registrants Form 8-A as filed on May 10,
2001.(7)
    
    Incorporated by reference to Exhibit 10(c) to the Registration Statement on Form S-4 of TF
Consolidation, Inc. (Registration No. 33-33944) as filed on March 27, 1990.(8)
    
    Incorporated by reference to Exhibit 10(o) to the Registrants Form 10-K for the fiscal year
ended December 31, 1996, as filed on March 14, 1997.(9)
    
    Incorporated by reference to Exhibit 10(x) to the Registrants Form 10-Q for the quarter
ended June 30, 2001, as filed on July 27, 2001.(10)
    
    Incorporated by reference to Exhibit 10.5(b) to the Registration Statement on Form S-8
(Registration No. 333-59234) as filed on April 19, 2001.(11)
    
    Incorporated by reference to Exhibit 10(y) to the Registration Statement on Form S-8
(Registration No. 333-50689) as filed on November 3, 2000.(12)
    
    Incorporated by reference to Exhibit 10(z) to the Registration Statement on Form S-8
(Registration No. 333-57933) as filed on June 26, 1998.(13)
    
    Incorporated by reference to Exhibit 10(aa) to the Registrants Form 10-Q for the quarter
ended June 30, 2000, as filed on July 27, 2000.(14)
    
    Incorporated by reference to Exhibit 10(cc) to the Registrants Form 10-K for the fiscal year
ended December 31, 2000, as filed on March 13, 2001.(15)
    
    Incorporated by reference to Exhibit 10(cc) to the Registrants Form 10-Q for the quarter
ended March 31, 2002, as filed on April 19, 2002.(16)
    
    Incorporated by reference to the Registrants Form 10-K for the fiscal year ended December
31, 2002, as filed on March 28, 2003.(17)
    
    Incorporated by reference to the Registrants Form 10-Q for the quarter ended June 30, 2003,
as filed on July 31, 2003.(18)
    
    Incorporated by reference to the Registrants Form 10/A (Amendment No. 4) (Registration No.
000-50289) as filed with the SEC by Brillian Corporation on September 3, 2003.(19)
    
    Incorporated by reference to the Registration Statement on Form S-8 (Registration No.
333-115314) as filed on May 7, 2004.(20)
    
    Incorporated by reference to the Registrants Form 10-K for the fiscal year ended December
31, 2003, as filed on March 15, 2004.(21)
    
    Incorporated by reference to the Registrants Form 10-Q for the quarter ended June 30, 2004,
as filed on August 9, 2004.(22)
    
    Incorporated by reference to the Registrants Form 10-Q for the quarter ended September 30,
2004, as filed on November 9, 2004.(23)
    
    Incorporated by reference to the Registrants Current Report on Form 8-K, as filed on January
28, 2005.