SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d)
of Securities Exchange Act of 1934
For Quarter Ended September 30, 1998
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Commission File Number 1-4373
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THREE-FIVE SYSTEMS, INC.
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(Exact name of registrant as specified in its charter)
Delaware 86-0654102
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(State or other jurisdiction of I.R.S. Employer
incorporation or organization) Identification Number
1600 North Desert Drive, Tempe, Arizona 85281
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(Address of principal executive offices) (Zip Code)
(602) 389-8600
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(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES [X] NO [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, at the latest practical date.
CLASS OUTSTANDING AS OF SEPTEMBER 30, 1998
- ----- ------------------------------------
Common 7,415,807
Par value $.01 per share
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THREE-FIVE SYSTEMS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 1998
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION
PAGE
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ITEM 1. FINANCIAL STATEMENTS:
Consolidated Balance Sheets-
September 30, 1998 and December 31, 1997..........................1
Consolidated Statements of Income (Loss)-
Three Months and Nine Months Ended September 30, 1998 and 1997....2
Consolidated Statements of Cash Flows-
Nine Months Ended September 30, 1998 and 1997.....................3
Notes to Consolidated Financial Statements..........................4
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION...............................5
PART II - OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K...................................14
SIGNATURES..................................................................14
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THREE-FIVE SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
SEPTEMBER 30, DECEMBER 31,
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1998 1997
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(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 6,706 $ 16,371
Accounts receivable, net 16,224 12,540
Inventories, net 13,427 8,255
Deferred tax asset 4,311 4,311
Other current assets 1,377 1,228
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Total current assets 42,045 42,705
PROPERTY, PLANT AND EQUIPMENT, net 32,887 29,847
OTHER ASSETS 2,669 283
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$ 77,601 $ 72,835
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LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 6,866 $ 8,513
Accrued liabilities 4,055 5,079
Current taxes payable 709 --
Notes payable 5,000 --
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Total current liabilities 16,630 13,592
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LONG-TERM DEBT 4,600 --
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DEFERRED TAX LIABILITY 2,718 2,718
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COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock -- --
Common stock 80 79
Additional paid-in capital 32,484 32,420
Retained earnings 25,973 24,259
Cumulative translation adjustment 15 20
Less - Treasury Stock, at cost (559,094 shares) (4,899) (253)
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Total stockholders' equity 53,653 56,525
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$ 77,601 $ 72,835
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The accompanying notes are an integral part of these consolidated balance
sheets.
1
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THREE-FIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME (LOSS)
(UNAUDITED)
(in thousands, except per share amounts)
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------- --------------------
1998 1997 1998 1997
---- ---- ---- ----
NET SALES $ 24,572 $ 24,074 $ 65,733 $ 58,940
-------- -------- -------- --------
COSTS AND EXPENSES:
Cost of sales 22,243 18,511 53,025 45,376
Selling, general and administrative 1,721 1,822 5,155 4,767
Research and development 1,250 1,314 4,843 3,759
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25,214 21,647 63,023 53,902
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Operating income (loss) (642) 2,427 2,710 5,038
OTHER INCOME (EXPENSE):
Interest, net (4) 152 317 463
Other, net (48) (41) (70) (60)
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INCOME (LOSS) BEFORE PROVISION FOR
(BENEFIT FROM) INCOME TAXES (694) 2,538 2,957 5,441
Provision for (benefit from)
income taxes (291) 1,010 1,242 2,084
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NET INCOME (L0SS) $ (403) $ 1,528 $ 1,715 $ 3,357
======== ======== ======== ========
EARNINGS (LOSS) PER COMMON SHARE
Basic $ (0.05) $ 0.19 $ 0.22 $ 0.43
======== ======== ======== ========
Diluted $ (0.05) $ 0.19 $ 0.21 $ 0.41
======== ======== ======== ========
WEIGHTED AVERAGE NUMBER OF
COMMON SHARES
Basic 7,656 7,874 7,826 7,834
======== ======== ======== ========
Diluted 7,656 8,181 8,021 8,111
======== ======== ======== ========
The accompanying notes are an integral part of these consolidated statements.
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THREE-FIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
NINE MONTHS ENDED
SEPTEMBER 30,
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1998 1997
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CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 1,715 $ 3,357
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization 3,347 3,066
Provision for (reduction of) accounts receivable
valuation reserves 22 (108)
Reduction of inventory valuation reserves (748) (1,620)
Loss on disposal of assets -- 3
Changes in assets and liabilities:
Increase in accounts receivable (3,707) (6,854)
Increase in inventories (4,423) (3,922)
(Increase) decrease in other assets (490) 1,114
Increase (decrease) in accounts payable and
accrued liabilities (2,671) 4,032
Increase in taxes payable, net 1,054 954
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Net cash provided by (used in) operating
activities (5,901) 22
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CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, plant and equipment (6,356) (2,498)
Investments (2,420) --
Proceeds from sale of furniture and equipment -- 16
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Net cash used in investing activities (8,776) (2,482)
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CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings on letters of credit to banks 9,600 --
Stock options exercised 64 44
Purchase of treasury stock, net (4,646) --
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Net cash provided by financing activities 5,018 44
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Effect of exchange rate changes on cash and
cash equivalents (6) 34
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NET DECREASE IN CASH AND CASH EQUIVALENTS (9,665) (2,382)
CASH AND CASH EQUIVALENTS, beginning of period 16,371 12,580
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CASH AND CASH EQUIVALENTS, end of period $ 6,706 $ 10,198
======== ========
The accompanying notes are an integral part of these consolidated statements.
3
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ITEM 1. (continued)
THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS
Note A The accompanying unaudited Consolidated Financial Statements have been
prepared in accordance with generally accepted accounting principles for
interim financial information and the instructions to Form 10-Q.
Accordingly, they do not include all the information and footnotes
required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments
(which include only normal recurring adjustments) necessary to present
fairly the financial position, results of operations, and cash flows for
all periods presented have been made. The results of operations for the
three and nine-month periods ended September 30, 1998 are not
necessarily indicative of the operating results that may be expected for
the entire year ending December 31, 1998. These financial statements
should be read in conjunction with the Company's December 31, 1997
financial statements and accompanying notes thereto.
Note B Basic earnings per common share are computed by dividing net income by
the weighted average number of shares of common stock outstanding during
the three and nine-month periods. Diluted earnings per common share for
the three months ended September 30, 1998, no common share equivalents
were considered in the calculation of earning (loss) as the effect was
antidilutive. Diluted earnings per share for all other periods presented
are determined assuming that the options were exercised at the beginning
of the period or at the time of issuance, if later.
Note C Inventories consist of the following at:
September 30, 1998 December 31, 1997
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(Unaudited)
(in thousands)
Raw Materials $10,217 $6,052
Work-in-process 1,707 1,195
Finished Good 1,503 1,008
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$13,427 $8,255
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Note D Property, plant, and equipment consist of the following at:
September 30, 1998 December 31, 1997
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(Unaudited)
(in thousands)
Building and improvements $12,631 $10,431
Furniture and equipment 35,961 31,804
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48,592 42,235
Less accumulated depreciation (15,705) (12,388)
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$32,887 $29,847
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED WITH THREE MONTHS ENDED
SEPTEMBER 30, 1997.
Net sales were $24.6 million for the quarter ended September 30, 1998,
an increase of 2.1 percent compared with net sales of $24.1 million for the
quarter ended September 30, 1997. The Company believes that it may have some
seasonality to its sales. Many of the company's components are in retail
products such as cellular telephones and office automation equipment for which
sales in the first calendar quarter are historically slow. During the third
quarter of 1998, sales to Motorola, Inc. ("Motorola") were 69.5 percent of the
Company's revenue. No other customer accounted for greater than 10 percent of
the Company's revenue.
Cost of sales, as a percentage of net sales, increased to 90.5 percent
for the quarter ended September 30, 1998 as compared with 76.9 percent for the
quarter ended September 30, 1997. The corresponding decrease in the gross margin
in the third quarter was the result of a number of factors. First, the Company
incurred approximately $504,000 of incremental expenses in the cost of sales as
the result of starting operations in China. Those incremental China expenses
were reflected as under-absorbed material overhead in cost of sales because
there was no significant manufacturing activity in the China facility during the
first two months of the quarter. Second, as a result of high inventory balances
at the beginning of the quarter, the Company had unusually low inventory
purchases during the third quarter of 1998 which resulted in under-absorption of
the material overhead. Third, the Company started several new programs during
the quarter and encountered some yield start-up issues with some of those
programs. Finally, the Company's standard margin on its products sold in the
quarter ended September 30, 1998 was lower than the standard margin for products
sold in the quarter ended September 30, 1997. This lower standard margin is a
result of pricing pressures in the LCD module industry.
Selling, general, and administrative expense decreased to $1.7 million
for the quarter ended September 30, 1998 from $1.8 million for the quarter ended
September 30, 1997. Selling, general, and administrative expense decreased as a
percentage of net sales to 7.0 percent for the quarter ended September 30, 1998
from 7.6 percent for the quarter ended September 30, 1997.
Research and development expense totaled $1.3 million, or 5.3 percent
of net sales, for the quarter ended September 30, 1998 as compared with $1.3
million, or 5.4 percent of net sales, for the quarter ended September 30, 1997.
Research and development expenses consist principally of salaries and benefits
to scientists and other personnel, related facilities costs, process development
costs, and various expenses for projects, including new product development. The
Company has focused its research and development expenditures on display
products and technologies while continuing with its in-house process development
efforts related to the high-volume manufacturing LCD line located in Tempe,
Arizona. The research and development expense for the quarter ended September
30, 1998 was significantly lower than the research and development expense for
the quarter ended June 30, 1998 primarily because of process developments on its
LCD manufacturing line in the second quarter.
Interest expense (net) for the quarter ended September 30, 1998 was
$4,000, as compared with $152,000 of interest income (net) for the quarter ended
September 30, 1997. This difference was primarily as a result of investing lower
average cash balances during the quarter as well as incurring interest expense
on the Company's line of credit. Other expense (net) was $48,000 for the quarter
ended September 30, 1998, as compared with $41,000 for the quarter ended
September 30, 1997.
There was a benefit for income taxes of $291,000 for the quarter ended
September 30, 1998 as compared with a provision for income taxes of $1.0 million
for the quarter ended September 30, 1997. This difference resulted primarily
from having a loss for the quarter ended September 30, 1998 as compared with net
income for the same period in 1997.
5
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The Company reported a loss of $403,000, or $0.05 per share (diluted),
for the quarter ended September 30, 1998 as compared with net income of $1.5
million, or $0.19 per share (diluted), for the quarter ended September 30, 1997.
Without China-related incremental expenses, the quarter ended September 30, 1998
would have been essentially break-even.
NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED WITH NINE MONTHS ENDED
SEPTEMBER 30, 1997.
Net sales were $65.7 million for the nine months ended September 30,
1998, an increase of 11.5 percent over net sales of $58.9 million for the nine
months ended September 30, 1997. The sales increase is primarily a result of
several new programs for new and existing customers, which offset decreases in
sales to Hewlett-Packard Company ("Hewlett-Packard"). During the nine month
period ended September 30, 1998, (a) Motorola accounted for net sales of $37.4
million compared with sales of $19.1 million to that customer for the nine
months ended September 30, 1997, and (b) Hewlett-Packard accounted for net sales
of $5.5 million compared with net sales of $19.3 million to that customer for
the nine months ended September 30, 1997.
Cost of sales, as a percentage of net sales, was 80.7 percent for the
nine months ended September 30, 1998 as compared with 77.0 percent for the nine
months ended September 30, 1997. The corresponding decrease in the gross margin
was the result of a number of factors, including China-related incremental
expenses and overall lower margins on LCD modules.
Selling, general, and administrative expense increased to $5.2 million
for the nine months ended September 30, 1998 from $4.8 million for the nine
months ended September 30, 1997, with such increase primarily attributed to
increased selling expenses and additional administrative personnel. Selling,
general, and administrative expense decreased as a percentage of net sales to
7.9 percent for the nine months ended September 30, 1998 from 8.1 percent for
the nine months ended September 30, 1997, primarily as a result of increased
sales.
Research and development expense totaled $4.8 million, or 7.3 percent
of net sales, for the nine months ended September 30, 1998 as compared with $3.8
million, or 6.5 percent of net sales, for the nine months ended September 30,
1997. The increase in research and development expense was a result of the
Company's continued focus on the development of advanced display technologies
and development of its in-house efforts relating to the high-volume
manufacturing LCD line.
Interest income (net) for the nine months ended September 30, 1998 was
$317,000, down from $463,000 for the nine months ended September 30, 1997. The
decrease in interest income was the result of investing lower average cash
balances during the nine months ended September 30, 1998 and as the result of
increased interest expense. Other expense (net) increased to $70,000 for the
nine months ended September 30, 1998 from $60,000 for the nine months ended
September 30, 1997. The increase was due primarily to increased foreign exchange
loss for the nine months ended September 30, 1998.
The provision for income taxes was $1.2 million for the nine months
ended September 30, 1998 as compared with a provision of $2.1 million for the
nine months ended September 30, 1997. This difference resulted primarily from
having lower pre-tax income in the nine months ended September 30, 1998 as
compared with the same period in 1997. The Company will have an approximate 42
percent tax rate in 1998 as a result of the losses it has incurred in China. The
income tax rate structure in China is lower; therefore, losses in China do not
provide as great a tax benefit as losses in a higher tax rate country such as
the United States. In 1999, the Company's overall tax rate should drop as the
Company increases manufacturing operations in China. The actual worldwide tax
rate at that time will depend upon a variety of factors, including inter-company
transfer pricing, the amount of sales in China, the profitability of operations
in China, and whether any inter-company dividends are declared.
Net income was $1.7 million, or $0.21 per share (diluted) for the nine
months ended September 30, 1998, as compared with net income of $3.4 million, or
$0.41 per share (diluted), for the nine months ended September 30, 1997.
6
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LIQUIDITY AND CAPITAL RESOURCES
During the first nine months of 1998, the Company had $5.9 million in
negative cash flow from operations as compared with break-even cash flow from
operations during the first nine months of 1997. The negative cash flow from
operations was primarily due to the increase in inventories and accounts
receivable. The Company purchased inventories in expectation of the start-up of
several new programs in the second and third quarters of 1998. All of those
programs have since commenced and the inventory balance decreased by over $9.0
million during the third quarter. Accounts receivable are higher at the end of
the third quarter because sales were weighted towards the end of the quarter.
The Company's working capital was $25.4 million at September 30, 1998,
down from $29.1 million at December 31, 1997. The Company's current ratio at
September 30, 1998 was 2.5-to-1, as compared with a current ratio of 3.1-to-1 at
December 31, 1997. The reduction in working capital and the current ratio
occurred primarily because of the substantial investments made in fixed assets
and in Siliscape, Inc. In addition, the Company has an outstanding balance of
$5.0 million in its line of credit, which is currently classified as a current
liability. The Company also incurred $4.6 million of debt to purchase stock
under the Company's stock repurchase program (see below). As explained below,
the Company has a new loan commitment, the result of which is that all debt
incurred to purchase stock through the stock repurchase program will become
long-term debt.
In May 1998, the Company entered into a new $15.0 million unsecured
revolving line of credit with Imperial Bank, which matures in May 2000. At
September 30, 1998, $9.6 million of borrowings were outstanding under this
credit facility. Advances under the revolving line may be made as Prime Rate
Advances, which accrue interest payable monthly at the bank's prime lending
rate, or as LIBOR Rate Advances, which bear interest at 175 basis points in
excess of the LIBOR Base Rate. The Company's subsidiary, Three-Five Systems
Limited, has established an annually renewable credit facility with a United
Kingdom bank, Barclays Bank PLC, in order to fund its working capital
requirements. The facility provides $350,000 of borrowing capacity secured by
accounts receivable of Three-Five Systems Limited. Advances are based on
accounts receivable, as defined. Advances under the credit facility accrue
interest, which is payable quarterly, at the bank's base rate plus 200 basis
points. The United Kingdom credit facility matures in June 1999. Three-Five
Systems Limited had no borrowings outstanding under this line of credit at
September 30, 1998.
The Company has received a new commitment from Imperial Bank and the
National Bank of Canada for a $25.0 million credit facility. That new credit
facility will have two tranches: a $15.0 million revolving line of credit, which
is similar to the existing credit facility and which will be available for
general corporate purposes, and a $10.0 million term loan, which will provide
available funds to repurchase the Company's stock. Including cash and
pre-existing loan commitments, the Company had $12.4 million in readily
available funds at September 30, 1998. The new credit facility would add an
additional $10.0 million in available funds to that amount.
In August 1996, the Board of Directors authorized the repurchase from
time to time of up to one million shares of the Company's common stock on the
open market or negotiated transactions depending on market conditions and other
factors. During the quarter ended September 30, 1998, the Company purchased
approximately 539,000 shares under the repurchase program at a total cost of
$4.6 million. Taking into account previous purchases, as of September 30, 1998,
a total of approximately 561,000 shares have been purchased by the Company under
the repurchase program at a cost of $4.9 million.
Capital expenditures during the nine months ended September 30, 1998
were approximately $6.4 million, as compared with $2.5 million during the same
period of 1997. Capital expenditures for the first nine months of 1998 consisted
primarily of manufacturing and office equipment for the Company's operations in
Beijing, Manila and Tempe, including laboratory equipment for research and
development and nearly $2.0 million of equipment necessary to manufacture
LCoS(TM) microdisplays. The Company anticipates that it will have substantial
additional capital expenditures during the remainder of 1998 and during 1999.
Those expenditures will primarily relate to advanced manufacturing processes,
the high-volume LCD line, and necessary manufacturing equipment for its new
manufacturing facility in Beijing, China. The Company anticipates the initial
facilities and capital cost for its operations in China in 1998 and 1999 to be
approximately $10.0 million. The China operations will also require
7
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approximately $4.0 million of working capital. Additional capital costs will be
incurred as additional manufacturing lines are added. Thus far, the Company has
expended approximately $3.8 million in China for manufacturing equipment,
building materials and land costs. Although the Company is operating out of a
leased facility in the Beijing area, the Company has purchased land-use rights
nearby upon which it is expected to complete construction of its own building in
1999.
In April 1998, the Company invested approximately $2.4 million in a
minority equity interest in Siliscape, Inc. ("Siliscape"), a start-up company
involved in developing various technologies for microdisplays. Under the terms
of the investment, the Company is obligated to purchase an additional equity
interest in Siliscape for $900,000 in the fourth quarter of 1998. The Company's
ownership interest in Siliscape is accounted for under the cost method of
accounting.
The Company anticipates that cash flow from operations in the fourth
quarter of 1998 will allow the Company to retire the portion of its line of
credit that is unrelated to the stock repurchase program. The Company believes
that its existing capital, anticipated cash flows from operations, and available
and anticipated credit lines will provide adequate sources to fund operations
and planned expenditures through 1999. The Company may have to pursue alternate
methods of financing or raise capital, however, should the Company encounter
additional cash requirements. For example, the Company has considered entering
into alliances with regard to the strategic development of various new
technologies, especially LCoS(TM) miscrodisplays. Some of these alliances may
result in a capital investment by the Company in other companies, such as
Siliscape. The Company also has considered acquisitions of other businesses.
Such investments and/or acquisitions would likely require the Company to pursue
additional financing mechanisms, such as debt or equity placements.
EFFECTS OF INFLATION AND FOREIGN CURRENCY EXCHANGE FLUCTUATIONS
The results of operations of the Company for the periods discussed have
not been significantly affected by inflation or foreign currency fluctuations.
The Company generally sells its products and services and negotiates purchase
orders with its foreign suppliers in United States dollars. An exception is the
Company's sub-assembly agreement in the Philippines, which is based on a fixed
conversion rate, exposing the Company to exchange rate fluctuations with the
Philippine peso. The Company has not incurred any material exchange gains or
losses to date and there has been some minor benefit as a result of last year's
peso devaluation, although the Company is now required to pay approximately
one-third of any peso devaluation gain to its lessor and direct labor
subcontractor in Manila.
The Company commenced operations in China in 1998. Although the Chinese
currency is currently stable, its value in relation to the U.S. dollar is
determined by the Chinese government. There is general speculation that China
may devalue its currency in response to the current Asian economic situation.
Devaluation of the Chinese currency could result in translation adjustments to
the Company's balance sheet as well as reportable losses depending on monetary
balances and loans of the Company at the time of devaluation. Although the
Company from time to time may enter into hedging transactions in order to
minimize its exposure to currency rate fluctuations, the Chinese currency is not
freely traded and thus is difficult to hedge. In addition, the government of
China has recently imposed restrictions on Chinese currency loans to
foreign-operated entities in China. Based on the foregoing, there can be no
assurance that fluctuations and currency exchange rates in the future will not
have an adverse affect on the Company's operations.
BUSINESS OUTLOOK AND RISK FACTORS
BUSINESS OUTLOOK
This Business Outlook section has numerous forward-looking statements.
Some of the risk factors associated with those forward-looking statements are
set forth in "Risk Factors" below. Other important risk factors are set forth in
the Company's other filings with the Securities and Exchange Commission.
8
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The Company offers advanced design and manufacturing services to
original equipment manufacturers. The Company specializes in custom displays and
front panel displays utilizing liquid crystal display (LCD) technology. The
Company experienced substantial growth from 1993 through 1995 with such growth
dependent primarily upon the Company's participation in the substantial growth
of the wireless communications market and sales to a single major customer in
that industry. In 1996, the Company's sales declined, largely as a result of the
early 1996 phase-out by that major customer of a significant family of programs.
In 1997, sales returned to pre-1996 levels primarily as a result of several new
programs and customers.
The Company had substantial growth in its revenues in 1997 with a 39.4
percent rate of growth over 1996. In 1998, the Company is experiencing strong
growth over 1997, with an expected 40 to 50 percent increase in unit volumes.
Revenue growth has not kept up with unit growth in 1998, however, because of
pricing pressures from customers and competition in the LCD module industry.
Thus, the Company expects its yearly revenue growth from 1997 to 1998 to be
approximately 8 to 12 percent. As customers attempt to increase market share
through pricing, those customers expect their vendors to offer more
competitively priced products. In addition, weakened Asian currencies have
contributed to pricing pressures in the LCD module industry because most vendors
are Asian companies. The Company also is experiencing some effects from the
Asian economic situation as sales in the Company's medical instrumentation and
office automation areas have slowed down and been pushed out.
The Company has undertaken efforts to diversify its business, broaden
its customer base, and expand its markets. The Company's historical major
customer, Motorola, which accounted for approximately 80 percent of the
Company's revenue in 1995, accounted for 65 percent of the Company's revenue in
1996 and slightly less than 35 percent of the Company's revenue in 1997. These
reduced percentages occurred as a result of the increased sales to other
customers and reduced product selling prices and revenues from that major
customer. In 1998, the Company's business with Motorola has increased at a rate
faster than business with other customers is increasing. Therefore, the
percentage of revenue attributed to Motorola is expected to increase in 1998,
and the current business plan of the Company targets that customer to account
for just over 60 percent of its 1998 revenue. Hewlett-Packard accounted for 32
percent of the Company's revenue in 1997, but this percentage has declined
significantly in 1998 as current programs have matured. Replacement programs may
not have the type of LCD modules supplied by the Company and those that do often
have significantly lower selling prices.
The Company's gross margins are impacted by several factors, including
manufacturing efficiencies, product differentiation, product uniqueness,
billings for non-recurring engineering services, inventory management,
engineering costs, product mix, and volume pricing. As mentioned earlier, there
is significant pricing pressure in higher volume programs in the
telecommunications and office automation industries. As the production levels of
some of the Company's new high-volume programs increase, the lower standard
gross margins on those programs will have an impact on the Company's overall
margins. In addition, in an effort to secure sales to certain strategic
customers, the Company may aggressively price its products. Depending on the
size of the programs achieved, such pricing strategies could also have an effect
on overall margins.
The Company's gross margins on its products are also typically lower at
the start of a program as a result of yield and other start-up issues. In the
third quarter of 1998, the Company started several new programs and incurred
substantial start-up costs.
The Company started operations in China in 1998, and the Company's
gross margins have been adversely affected by the start-up of those China
manufacturing operations. As the Company ramped up its manufacturing operations
in China, it incurred costs in advance of the receipt of significant revenues.
In the third quarter of 1998, the Company incurred incremental China-based
expenses in the total cost of sales. Those incremental expenses arise mainly
from under-absorption of the costs of operating the China facility and are
included in the cost of sales, thus reducing overall gross margins. The
Company's expectation is that the incremental China-based expenses in the fourth
quarter will be significantly reduced as a result of yield and absorption
issues. In the long run, the Company expects the China operations to positively
impact gross margins because of certain competitive cost advantages provided by
maintaining operations in China.
9
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The Company anticipates that the Asian currency situation will have a
continued impact on gross margins. Many of the Company's competitors are Asian
suppliers, and a strong U.S. dollar gives a competitive pricing advantage to
those suppliers. Thus, the Company may continue to see competitive margin
pressure from Asian suppliers, particularly those in Korea and Japan.
Serving a variety of customers with complex and differing issues
requires increased personnel committed to those customers. As the Company
expands and diversifies its product and customer base, the Company has had to
increase its selling, general, and administrative expenses. The volume and
complexity of the Company's business is expected to continue to grow. Therefore,
the Company anticipates that it will continue to increase its selling and
administrative expenses on a quarter-by-quarter basis.
The Company believes that continued investments in research and
development relating to new display technology and manufacturing processes are
necessary to remain competitive in the marketplace and provide opportunities for
growth. The Company continues to expand and intensify its internal research and
development to focus on proprietary display products as well as continue LCD
manufacturing process improvements. Use of the LCD manufacturing line in Tempe,
Arizona as a resource for testing new ideas is key to development of these
products, some of which will be proprietary and not available from other display
manufacturers. Further, the development of the high-volume manufacturing LCD
line has helped reduce the Company's dependence on foreign suppliers of LCD
glass.
The Company also intends to pursue technologies being developed in
related fields. The Company operates the highest volume fully automated LCD
manufacturing line in North America. As a result, several companies have
approached the Company about potential alliances. The Company believes that a
strategic alliance with one or more of those companies could minimize the cost
of entry into new markets and new technologies.
In August 1997, National Semiconductor Corporation ("National") and the
Company entered into a strategic supplier alliance agreement for the development
and manufacture of LCoS(TM) microdisplays. Under the alliance, the two companies
are working together in developing the LCoS(TM) technology, with each company
focusing on its core competency of silicon and LCDs, respectively. Once
manufacturing begins, the companies will act as suppliers to one another, with
National supplying the silicon and the Company supplying the LCD manufacturing.
In April 1998, the Company acquired an approximate 19 percent interest
in Siliscape, a start-up company with numerous patents and proprietary
technology relating to microdisplays. The Company and Siliscape also entered
into a strategic agreement under which they will focus on the development of
microdisplay products, with the Company providing certain proprietary
manufacturing capabilities and Siliscape providing certain patented and
proprietary technologies and components.
The Company also is considering licensing technologies from other
companies that could be optimized on the LCD manufacturing line as well as
entering into further alliances. This internal and external focus on research
and development will continue indefinitely. As a result, the actual dollar
amount of such research and development expenditures in 1998 will increase over
1997.
As previously described, the Company has established manufacturing
operations in The People's Republic of China. Three-Five Systems (Beijing) Co.,
Ltd. was incorporated in China during the first quarter of 1998 and business
license approval was received from the governmental authorities. During the
first quarter of 1998, a temporary leased site was selected in Beijing, as was
the permanent site. The Company has now moved into the temporary site and set up
manufacturing lines.
The Company has established a China-based manufacturing operation for
several reasons. First, based upon growth expectations in the European and
United States marketplaces, the Company anticipates a need for manufacturing
capacity beyond what is available at its Philippine manufacturing facility.
10
<PAGE>
China was selected because of the desire to diversify manufacturing locations
and because of the cost benefits that are expected to be achieved in China.
China is also expected to be a synergistic business location for the Company
because many of the components used by the Company are manufactured in China.
Second, many of the Company's existing and potential customers maintain
manufacturing operations near the Company's operations in China. Despite the
current Asian economic situation, those customers continue to require LCD
modules and the Company has limited participation in that market. There
currently are very few LCD module manufacturers in China. Under current Chinese
government rules, however, OEMs in China have a strong motivation to utilize
locally manufactured components.
RISK FACTORS
Forward-looking statements in this report include revenue, margin,
expense, and earnings analysis for 1998 as well as the Company's expectations
relating to operations in China; future technologies; and future designs,
inventory balances, and production orders. The Company's future operating
results may be affected by various trends, developments, and factors that the
Company must successfully manage in order to achieve its goals. In addition,
there are trends, developments, and factors beyond the Company's control that
may affect its operations. The cautionary statements and risk factors set forth
below and elsewhere in this document, and in the Company's other filings with
the Securities and Exchange Commission, especially Form 10-K, identify important
trends, factors, and currently known developments that could cause actual
results to differ materially from those in any forward-looking statements
contained in this report and in any written or oral statements of the Company.
A few core customers currently are responsible for a majority of the
Company's revenue, and the Company expects the high concentration levels with
its core customers to continue through 1999. Thus, any material delay,
cancellation, or reduction of orders from one or more of those core customers
could have a material adverse effect on the Company's operations. For example,
previously announced delays in certain Motorola programs have contributed to
lower than expected sales for the Company in 1998.
Although the trend of the Company is to enter into more manufacturing
contracts with its customers, the principal benefit of these contracts is to
clarify order lead times, inventory risk allocation, and similar matters and not
to provide firm, long-term volume purchase commitments. The Company has no firm
long-term volume purchase commitments from its customers. Thus, customer
commitments can be canceled, and expected volume levels can be changed or
delayed. The timely replacement of canceled, delayed, or reduced commitments
cannot be assured and, among other things, could result in the Company holding
excess and obsolete inventory or having unfavorable manufacturing variances as a
result of under-absorption. These risks are exacerbated because the Company
expects that a majority of its sales will be to customers in the retail
electronics industry, which is subject to severe competitive pressures, rapid
technological change, and obsolescence. A few of the Company's customers have
inquired about inventory hubbing agreements pursuant to which the Company will
maintain stocks of finished goods on or near the customer's factory. Although
such agreements have not yet been implemented, the use of such type of
agreements could result in higher inventory balances for the Company and/or
excess inventory.
The Company held a large inventory balance as of June 30, 1998 as a
result of delays in certain programs announced by customers during the second
quarter of 1998. That balance has been substantially reduced as of September 30,
1998. The Company has analyzed the remaining inventory balance and believes that
the inventory will be utilized because all of the unreserved inventory relates
to ongoing programs. There is a risk that if some or all of those new programs
are canceled, however, the Company could be left with excess inventory.
Another risk inherent in custom manufacturing is the satisfactory
completion of design services and securing of production orders. A significant
portion of the Company's anticipated revenue for the future will come from
programs currently in the design or pilot production stage. Completion of the
design is dependent on a variety of factors, including the customer's changing
needs, and not every design is successful in meeting those needs. In addition,
some designs test new theories or applications and may not meet the desired
results. Failure of a design order to achieve the customer's desired results
could result in a material adverse effect on the Company's operations if the
expected production order for that product was significant. Finally, even when a
11
<PAGE>
design is satisfactorily completed, the customer may terminate or delay the
program as a result of marketing or other pressures.
The Company is currently spending research and development dollars on
several new technologies that it plans to introduce in the future. There is a
risk that some or all of those technologies may not successfully make the
transition from the research and development lab to cost-effective
manufacturability, and such failure could have a material adverse effect on the
Company. Risks include technology problems, competitive cost issues, and yield
problems. In addition, even if a new technology proves to be manufacturable, it
may not be accepted by the Company's customers and the customers' marketplaces
because of price or technology issues or it may compare unfavorably with
products introduced by others. These new technologies will require significant
expenditures, including development expenses, such as those for custom
integrated circuits, as well as various capital expenditures and investments.
For example, the Company anticipates that LCoS(TM) microdisplays will initially
require approximately $2.0 to $3.0 million of capital expenditures, and the
Company has also invested in Siliscape for the purposes of further developing
the LCoS(TM) microdisplay product. There could be material adverse impact on the
Company if one or more of the new technologies, especially LCoS(TM)
microdisplays, were unsuccessful for any reason.
The Company designs and manufactures products based on firm quotes.
Thus, the Company bears the risk of component price increases, which could
adversely affect the Company's gross margins. In addition, the Company depends
on certain suppliers, and the unavailability or shortage of materials could
cause delays or lost orders. Material components of some of the Company's major
programs have from time to time been subject to allocation because of shortages
by vendors and continued or increased shortages could have a material adverse
effect on the Company in the future. In addition, although most of the
components purchased by the Company are purchased from vendors in Asian
countries unaffected by the current currency crisis, a significant portion of
the silicon drivers purchased by the Company are manufactured in Korea and
Japan. Economic instability in certain Asian countries could cause supply
problems with respect to these components.
The Company's primary competitors are located in Asia, including,
Japan, Korea, and Hong Kong, and most of the Company's customers are U.S.-based.
The recent currency devaluation of several Asian countries could have an
negative impact on the gross margins of the Company as the competitors' products
become less expensive to purchase with a stronger dollar.
The Company has established a manufacturing operation in China. The
Company's operations and assets will be subject to significant political,
economic, legal and other uncertainties in China. The Company's operations in
China also could be adversely affected by the imposition of austerity measures
intended to reduce inflation; the inadequate development or maintenance of
infrastructure, including the unavailability of adequate power and water
supplies, transportation, raw materials, and parts; or a deterioration of the
general political, economic or social environment in China.
The Company has set up manufacturing operations in Beijing in an
interim leased facility. If there are delays in the completion of the permanent
facility, the Company may run into capacity issues in the interim facility
because of space constraints and/or power requirements. In addition, the Company
has a short-term lease on the interim facility and could be required to move out
if there are delays in the completion of the permanent facility, severely
interrupting the Company's manufacturing operations in China.
One of the reasons the Company is starting up operations in China is
because the Company believes that its Manila manufacturing facility may have
occasional capacity issues within the next year. Failure to begin operations in
the China facility on a timely basis could result in capacity restraints and
late or canceled customer deliveries. Manufacturing yields and delivery
schedules also may be affected as the Company ramps up its manufacturing
capabilities in China. Other companies in the industry have experienced
difficulty in expanding or relocating manufacturing output and capacity, with
such difficulty resulting in reduced yields or delays in product deliveries. No
assurance can be given that the Company will not experience manufacturing yield
or delivery problems in the future. Such problems could materially affect the
Company's operating results.
12
<PAGE>
Finally, the Company's success, especially in penetrating new markets
and increasing its OEM customer base, depends to a large extent upon the efforts
and abilities of key managerial and technical employees. The loss of services of
certain key personnel could have a material adverse effect on the Company. The
Company's business also depends upon its ability to continue to attract and
retain senior managers and skilled employees. Failure to do so could adversely
affect the Company's operations.
As a result of the foregoing and other factors, the Company's stock
price may be subject to significant volatility, particularly on a quarterly
basis. Any shortfall in revenue or earnings from levels expected by investors,
analysts, and brokers could have an immediate and significant adverse effect on
the trading price of the Company's common stock in any given period.
Additionally, the Company may not learn of such shortfalls until late in a
fiscal quarter, which could result in an even more immediate and adverse effect
on the trading price of the Company's common stock. Finally, other factors,
which generally affect the market for stocks of high technology companies, could
cause the price of the Company's common stock to fluctuate substantially over
short periods for reasons unrelated to the Company's performance.
YEAR 2000 COMPLIANCE DISCLOSURE.
Many existing computer programs and databases use only two digits to
identify a year in the date field (I.E., 99 would represent 1999). These
programs and databases were designed and developed without considering the
impact of the upcoming millennium. Consequently, date sensitive computer
programs may interpret the date "00" as 1900 rather than 2000. If not corrected,
many computer systems could fail or create erroneous results in 2000.
The following disclosure is as required by SEC Release No. 33-7558.
COMPANY'S STATE OF READINESS
The Company has completed an assessment of all of its internal and
external systems and processes with respect to the "Year 2000" issue. In
response to this assessment, the Company has created a multi-functional Year
2000 task force to resolve any non-compliant Year 2000 systems or processes. To
date, this group is on schedule to complete this task prior to January 1, 1999.
The Company plans to continuously test all of its internal and external systems
and processes (and the associated Year 2000 "fixes") for Year 2000 compliance
during 1999. As part of this process, the Company has assessed the potential
impact of Year 2000 failures from vendors and outside parties upon its business
and is currently taking steps to minimize that risk. Based on the Company's
current state of readiness and the steps currently being taken (I.E., installing
backup processes and systems), the Company does not believe that the Year 2000
problem will have a material adverse effect on the Company's financial position,
liquidity, or operations.
COMPANY'S COSTS OF YEAR 2000 COMPLIANCE
The Company estimates that its total cost of Year 2000 compliance will
be less than $100,000. Those costs include updating of computer software and
hardware manufacturing equipment, as well as employment and other out-of-pocket
costs.
COMPANY'S RISKS OF YEAR 2000 ISSUES
The Company procures a significant amount of raw materials used in its
manufacturing processes from foreign vendors. As a result, the Company may be at
risk from foreign companies and countries that are not taking adequate measures
to insure Year 2000 compliance or that may not be at the same level of
preparedness as the United States. For example, economic problems in Asia may
affect or divert resources with respect to the Year 2000 issue. Failure of those
foreign countries and companies to be Year 2000 compliant may cause new material
shortages that would adversely impact the Company's manufacturing operations. In
addition, the Company currently has significant manufacturing operations in
Manila, the Philippines and Beijing, China. As a result, the Company may be at
risk with respect to suppliers of necessary resources (such as power or water)
that may not be Year 2000 compliant. For example, brownouts or blackouts may
13
<PAGE>
occur due to lack of Year 2000 compliance. In addition, the Company's customers
may have catastrophic Year 2000 failures, including prolonged interruptions in
factory productions, in which case they may have a reduced demand for the
Company's products.
COMPANY'S CONTINGENCY PLANS
The Company is developing contingency plans with respect to significant
Year 2000 issues within its control. For example, the Company is in the process
of assessing and verifying the Year 2000 compliance of its international and
domestic raw material vendors. Verification will be accomplished through the use
of written certifications and audits. Any vendors found not to be Year 2000
compliant will be replaced with vendors that are Year 2000 compliant. In the
construction of its new Beijing facility, the Company will procure material,
processes and equipment that are Year 2000 compliant. The Company also plans to
have stand-by generators for its plants in the event of a local power failure.
The Company is investigating transferring all manufacturing processes to
alternate manufacturing facilities if external factors beyond its control
relative to the Year 2000 issue occur and the Company cannot conduct
manufacturing operations at any particular facility.
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBIT 11: Statement Re: Computation of Per Share Earnings.
EXHIBIT 27: Financial Data Schedule
(b) Reports on Form 8-K: None
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of
1934, the Registrant has duly caused this report to be signed on its behalf by
the undersigned thereunto duly authorized.
THREE-FIVE SYSTEMS, INC.
------------------------
(Registrant)
Dated: October 29, 1998 By: /s/ Jeffrey D. Buchanan
------------------------------------
Name: Jeffrey D. Buchanan
Its: Executive Vice President Finance,
Administration and Legal;
Chief Financial Officer
14
THREE-FIVE SYSTEMS, INC.
STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS
EXHIBIT 11
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- ---------------------
1998 1997 1998 1997
---- ---- ---- ----
<S> <C> <C> <C> <C>
Common shares outstanding
beginning of period 7,927,085 7,854,985 7,905,523 7,757,329
Effect of Weighting Shares:
Employee stock options exercised 14,446 19,443 15,203 76,348
Purchase of treasury stock (285,680) -- (96,273) --
Issue of treasury stock -- -- 2,004 --
---------- ---------- ---------- ----------
Basic 7,655,851 7,874,428 7,826,457 7,833,677
========== ========== ========== ==========
Common shares outstanding
beginning of period 7,927,085 7,854,985 7,905,523 7,757,329
Effect of Weighting Shares:
Employee stock options exercised 14,446 19,443 15,203 76,349
Employee stock options outstanding -- 306,983 194,815 277,462
Purchase of treasury stock (285,680) -- (96,273) --
Issue of treasury stock -- -- 2,004 --
---------- ---------- ---------- ----------
Diluted 7,655,851 8,181,411 8,021,272 8,111,140
========== ========== ========== ==========
Net income (loss) $ (403,000) $1,528,000 $1,715,000 $3,357,000
========== ========== ========== ==========
NET INCOME (LOSS) PER COMMON
SHARES:
Net income (loss) per share
Basic $ (0.05) $ 0.19 $ 0.22 $ 0.43
========== ========== ========== ==========
Diluted $ (0.05) $ 0.19 $ 0.21 $ 0.41
========== ========== ========== ==========
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED BALANCE SHEET AT SEPTEMBER 30, 1998 AND THE RELATED CONSOLIDATED
STATEMENTS OF INCOME AND OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30,
1998 OF THREE-FIVE SYSTEMS, INC. AND ITS SUBSIDIARIES AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. THIS EXHIBIT SHALL NOT BE
DEEMED FILED FOR PURPOSES OF SECTION 11 OF THE SECURITIES ACT OF 1933 AND
SECTION 18 OF THE SECURITIES EXCHANGE ACT OF 1934, OR OTHERWISE SUBJECT TO THE
LIABILITY OF SUCH SECTIONS, NOR SHALL IT BE DEEMED A PART OF ANY OTHER FILING
WHICH INCORPORATES THIS REPORT BY REFERENCE, UNLESS SUCH OTHER FILING EXPRESSLY
INCORPORATES THIS EXHIBIT BY REFERENCE.
</LEGEND>
<CURRENCY> U.S DOLLARS
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<EXCHANGE-RATE> 1
<CASH> 6,706
<SECURITIES> 0
<RECEIVABLES> 16,838
<ALLOWANCES> 614
<INVENTORY> 13,427
<CURRENT-ASSETS> 42,045
<PP&E> 48,592
<DEPRECIATION> 15,705
<TOTAL-ASSETS> 77,601
<CURRENT-LIABILITIES> 16,630
<BONDS> 4,600
0
0
<COMMON> 80
<OTHER-SE> 0
<TOTAL-LIABILITY-AND-EQUITY> 77,601
<SALES> 65,733
<TOTAL-REVENUES> 65,733
<CGS> 53,025
<TOTAL-COSTS> 63,023
<OTHER-EXPENSES> 70
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 2,957
<INCOME-TAX> 1,242
<INCOME-CONTINUING> 1,715
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,715
<EPS-PRIMARY> 0.22
<EPS-DILUTED> 0.21
</TABLE>
