SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
---------
FORM 10-Q
Quarterly Report Pursuant to Section 13 or
15(d) of Securities Exchange Act of 1934
For Quarter Ended March 31, 1998
Commission File Number 1-4373
THREE-FIVE SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
Delaware 86-0654102
- ------------------------------- ---------------------
(State or other jurisdiction of I.R.S. Employer
incorporation or organization) Identification Number
1600 North Desert Drive, Tempe, Arizona 85281
- --------------------------------------- -----
(Address of principal executive offices) (Zip Code)
(602)389-8600
--------------------------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES X NO
----- -----
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 March 31, 1998
- ----- --------------------------------
Common 7,907,123
------------------
Par value $.01 per share
<PAGE>
THREE-FIVE SYSTEMS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 1998
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION
Page
ITEM 1. FINANCIAL STATEMENTS:
Consolidated Balance Sheets-
March 31, 1998 and December 31, 1997................1
Consolidated Statements of Income-
Three Months Ended March 31, 1998 and 1997..........2
Consolidated Statements of Cash Flows-
Three Months Ended March 31, 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............................12
SIGNATURES....................................................................13
<PAGE>
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
MARCH 31, DECEMBER 31,
1998 1997
---- ----
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 13,943 $ 16,371
Accounts receivable, net 12,808 12,540
Inventories, net 12,865 8,255
Deferred tax asset 4,311 4,311
Other current assets 1,134 1,228
-------- --------
Total current assets 45,061 42,705
PROPERTY, PLANT AND EQUIPMENT, net 30,444 29,847
OTHER ASSETS 272 283
-------- --------
$ 75,777 $ 72,835
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 10,370 $ 8,513
Accrued liabilities 4,350 5,079
Current maturities of long term debt -- --
Current taxes payable 813 --
-------- --------
Total current liabilities 15,533 13,592
-------- --------
DEFERRED TAX LIABILITY 2,718 2,718
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock -- --
Common stock 79 79
Additional paid-in capital 32,423 32,420
Retained earnings 25,254 24,259
Cumulative translation adjustment 23 20
Less - Treasury Stock at cost (22,500 shares) (253) (253)
-------- --------
Total stockholders' equity 57,526 56,525
-------- --------
$ 75,777 $ 72,835
======== ========
The accompanying notes are an integral part of these consolidated statements.
1
<PAGE>
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
(in thousands, except per share amounts)
THREE MONTHS ENDED
MARCH 31,
-----------------------
1998 1997
-------- --------
NET SALES $ 18,479 $ 16,129
COSTS AND EXPENSES:
Cost of sales 13,687 12,488
Selling, general and administrative 1,619 1,466
Research and development 1,689 1,130
-------- --------
16,995 15,084
-------- --------
Operating Income 1,484 1,045
OTHER INCOME (EXPENSE):
Interest, net 192 157
Other, net (17) (12)
-------- --------
INCOME BEFORE PROVISION FOR INCOME TAXES 1,659 1,190
Provision for income taxes 664 389
-------- --------
NET INCOME $ 995 $ 801
======== ========
EARNINGS PER COMMON SHARE:
Basic $ .13 $ .10
======== ========
Diluted $ .12 $ .10
======== ========
WEIGHTED AVERAGE NUMBER OF COMMON SHARES:
Basic 7,907 7,759
======== ========
Diluted 8,165 8,048
======== ========
The accompanying notes are an integral part of these consolidated statements.
2
<PAGE>
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
--------------------
1998 1997
-------- --------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 995 $ 801
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 1,078 972
Provision for (reduction of) accounts receivable valuation
reserves 9 (4)
(Reduction of) inventory valuation reserves (1,114) (117)
Change in assets and liabilities:
(Increase) in accounts receivable (278) (300)
(Increase) in inventories (3,496) (1,068)
(Increase) decrease in other assets (240) 457
Increase in accounts payable and accrued liabilities 1,128 1,060
Increase (decrease) in taxes payable, net 1,160 (202)
-------- --------
Net cash (used in) provided operating activities (758) 1,599
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, plant and equipment (1,675) (1,395)
-------- --------
Net cash (used in) investing activities (1,675) (1,395)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Stock options exercised 3 30
-------- --------
Net cash provided by financing activities 3 30
-------- --------
Effect of exchange rate changes 2 1
-------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (2,428) 235
CASH AND CASH EQUIVALENTS, beginning of period 16,371 12,580
-------- --------
CASH AND CASH EQUIVALENTS, end of period $ 13,943 $ 12,815
======== ========
</TABLE>
The accompanying notes are an integral part of these consolidated statements.
3
<PAGE>
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-month period ended
March 31, 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 month period. Diluted earnings per
common share for the three month period are determined assuming
that 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:
March 31, 1998 December 31, 1997
-------------- -----------------
(Unaudited)
(in thousands)
Raw Materials $ 10,404 $ 6,052
Work-in-process 1,353 1,195
Finished Good 1,108 1,008
--------- --------
$ 12,865 $ 8,255
========= ========
Note D Property, plant, and equipment consist of the following at:
March 31, 1998 December 31, 1997
-------------- -----------------
(Unaudited)
(in thousands)
Building and improvements $ 10,431 $ 10,431
Furniture and equipment 33,479 31,804
-------- --------
43,910 42,235
Less - accumulated depreciation (13,466) (12,388)
-------- ---------
$ 30,444 $ 29,847
======== =========
Note E Recently issued accounting standard:
The Financial Accounting Standard Board issued SFAS No. 130,
Reporting Comprehensive Income, which establishes standards for
reporting and display of comprehensive income and its components
in a full set of general purpose financial statements. The new
statement did not have a material impact on the Company's
financial statements.
4
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
Three Months Ended March 31, 1998 Compared with Three Months Ended March 31,
1997.
Net sales were $18.5 million for the quarter ended March 31, 1998, an
increase of 14.9 percent compared with net sales of $16.1 million for the
quarter ended March 31, 1997. The Company believes that it may have some
seasonality to its sales. Many of the Company's products are components in
retail products such as cellular phones and office automation equipment for
which sales in the first calendar quarter are historically slow. In addition,
several new programs, previously expected to begin manufacturing in the first
quarter of 1998, were delayed by customers for a variety of reasons. During the
first quarter of 1998, sales to Motorola were 45.2 percent of the Company's
revenue, sales to Hewlett-Packard were 14.7 percent of the Company's revenue,
and sales to all other customers were 40.1 percent of the Company's revenue.
Cost of sales, as a percentage of net sales, decreased to 74.1 percent
for the quarter ended March 31, 1998 as compared with 77.4 percent for the
quarter ended March 31, 1997. Historically, at these revenue levels, the
Company's gross margin is usually lower than its desired range because of
absorption issues relating to under-utilization of its facilities. In the first
quarter of 1998, however, those unabsorbed costs were more than offset by
inventory management strategies. Specifically, the increased backlog reduced the
need for certain inventory reserves taken in the fourth quarter of 1997 pursuant
to the Company's inventory reserve policies. The gross margin is expected to be
significantly lower in the next few quarters. See "Business Outlook and Risk
Factors" below.
Selling, general, and administrative expense of $1.6 million for the
quarter ended March 31, 1998 was slightly higher than the selling, general, and
administrative expense of $1.5 million for the quarter ended March 31, 1997.
Selling, general, and administrative expenses have increased as the Company has
expanded its infrastructure to accommodate the increasing number of customers
and the expected increase in sales and production throughout the remainder of
the year.
Research and development expense totaled $1.7 million for the quarter
ended March 31, 1998 as compared with $1.1 million for the quarter ended March
31, 1997, for an overall increase of 55%. Research and development expenses
consist principally of salaries and benefits to scientists and other personnel,
related facilities costs, and various expenses for projects. During the current
quarter, expenses relating to process developments on the high volume LCD line
were higher than normal. Research and development expense has increased as the
Company has invested in new technologies, such as LCoS(TM) microdisplays, and
manufacturing processes and has continued with its in-house process development
efforts related to the high-volume manufacturing LCD line located in Tempe,
Arizona. The Company believes that continued investments in research and
development relating to manufacturing processes and new display technologies are
necessary to remain competitive in its marketplace and provide opportunities for
growth.
Interest income (net) for the quarter ended March 31, 1998 was
$192,000, up from $157,000 for the quarter ended March 31, 1997. The increase in
interest income was the result of investing higher average cash balances during
the quarter. Other expense (net) was $17,000 for the quarter ended March 31,
1998 as compared with $12,000 for the quarter ended March 31, 1997. Income
before taxes was $1.7 million for the quarter ended March 31, 1998, an increase
of approximately 42% over the income before taxes of $1.2 million dollars for
the quarter ended March 31, 1997.
The provision for income taxes increased to $664,000 for the quarter
ended March 31, 1998 from $389,000 for the quarter ended March 31, 1997. The tax
rate for the first quarter was 40% as compared with 32.7% for the first quarter
of 1997. The tax rate was lower in the first quarter of 1997 due to certain
accrual adjustments. The Company expects that the overall tax rate for 1998 will
approximate its historical rate of 40%. This rate eventually may drop a few
percentage points as the Company increases manufacturing operations in the
People's Republic of China, where the Company's tax rate will initially be
substantially less than 40%. The actual world-wide tax rate at that time will
depend on a variety of factors including intercompany transfer pricing, the
amount of China sales, the profitability of China operations, and whether any
intercompany dividends are declared.
5
<PAGE>
Net income increased to $995,000, or $0.12 per share, for the quarter
ended March 31, 1998 from $801,000, or $0.10 per share, for the quarter ended
March 31, 1997 for an overall increase of 24.2%.
Liquidity and Capital Resources
During the first three months of 1998, the Company had $758,000 in
negative cash flow from operations as compared with $1.6 million in positive
cash flow during the first three months of 1997. The negative cash flow from
operations was primarily due to a significant increase in inventories, which
occurred primarily as a result of the increase in the Company's overdue backlog.
Overall, the Company's depreciation expense has risen approximately 11 percent
since the first quarter of 1997. The high-volume LCD line is depreciated on a
units-of-production method based on units started. It is anticipated that
depreciation will sharply rise in 1998 as a result of additional capital
expenditures and an expected higher number of starts for the high-volume LCD
manufacturing line in 1998 versus 1997. Capital expenditures expected in 1998
include a new building and equipment for the proposed manufacturing facility in
China and the installation of additional equipment in its Tempe, Arizona and
Manila manufacturing locations, including equipment to manufacture liquid
crystal on silicon (LCoS(TM)) microdisplays. The Company's working capital was
$29.5 million at March 31, 1998, up from $29.1 million at December 31, 1997. The
Company's current ratio at March 31, 1998 was 2.9 -to-1 as compared with a
current ratio of 3.1-to-1 at December 31, 1997. Including its cash and loan
commitments, the Company had over $29 million in readily available funds on
March 31, 1998.
In May 1997, the Company entered into a new $15 million revolving line
of credit with Imperial Bank, which matures May 22, 1998. At maturity, the
Company expects to renew that line for another year upon similar terms. At March
31, 1998, no borrowings were outstanding under this credit facility. Advances
under the revolving line may be made as Prime Rate Advances, which accrue
interest payable monthly at the bank's prime lending rate, or as LIBOR Rate
Advances, which bear interest at 175 basis points in excess of the LIBOR Base
Rate. The Company's subsidiary, Three-Five Systems Limited, has established an
annually renewable credit facility with a United Kingdom bank, Barclays Bank
PLC, in order to fund its working capital requirements. The facility provides
$350,000 of borrowing capacity secured by accounts receivable of Three-Five
Systems Limited. Advances 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 June 20, 1998. Three-Five Systems Limited had no borrowings outstanding
under this line of credit at March 31, 1998.
Capital expenditures during the first quarter of 1998 were
approximately $1.7 million, as compared with $1.4 million during the first
quarter of 1997. Capital expenditures for the first quarter of 1998 consisted
primarily of manufacturing and office equipment for the Company's operations in
Manila and Arizona, including over $1 million of equipment necessary to
manufacture LCoS(TM) microdisplays, and laboratory equipment for research and
development. The Company anticipates that it will have substantial capital
expenditures during 1998. Those expenditures will primarily relate to advanced
manufacturing processes, the high-volume LCD line, and necessary manufacturing
equipment. In the near term, the Company anticipates spending approximately
another $1 to $2 million on the capital equipment needed to manufacture LCoS(TM)
microdisplays. The Company has also decided to expand it oversees manufacturing
capabilities in 1998 by opening a manufacturing facility in Beijing, China. The
Company anticipates the initial facilities and capital cost for its operations
in China in 1998 to be approximately $8 million. The China operations will also
need approximately $4 million of working capital. Additional capital costs will
be incurred as additional manufacturing lines are added. Although the Company
initially will operate out of a leased facility, the Company is purchasing land
and will be constructing its own building in the Beijing area, which is expected
to be ready late in 1998. The Company also expects to expend $3 to $5 million in
Manila and Tempe on capital for general manufacturing and research and
development needs.
In April 1998, after the end of the first quarter, the Company invested
approximately $2.4 million in a minority equity interest in Siliscape, Inc., 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 anticipates that accounts receivable and inventory will
rise in 1998 if revenue levels increase as currently anticipated. The Company
believes that its existing capital, anticipated cash flow from operations, and
available and anticipated credit lines will provide adequate sources to fund
operations and planned expenditures throughout 1998. Should the Company
encounter additional cash requirements, however, the Company may have to
6
<PAGE>
expand its loan commitments or pursue alternate methods of financing or raising
capital. For example, the Company has considered entering into various 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. Although the Company has not incurred any material exchange
gains or losses to date, there has been some minor benefit as a result of the
recent Peso devaluation. If the peso devaluation were to continue, a substantial
portion of the benefit to the Company will likely be offset by an increase in
the Philippine labor rates and costs. In addition, the Company is now required
to pay approximately one-third of any peso devaluation gain to its lessor and
direct labor subcontractor in Manila. There can be no assurance that
fluctuations and currency exchange rates in the future will not have an adverse
affect on the Company's operations. The Company is planning to commence
operations in China in 1998. Although the Chinese currency is currently stable,
there is no assurance that it will remain so in the future. The Company's
Chinese subsidiary will be capitalized with approximately one-half equity and
one-half debt. If the Company lends funds to the subsidiary, such U.S. dollar
loans could result in a loss on the consolidated income statement if the Chinese
currency was devalued. 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. Thus, unless the Company can obtain loans in the Chinese currency, there
is a substantial risk of recording a loss upon a Chinese currency devaluation.
Business Outlook and Risk Factors
This Business Outlook section has numerous forward-looking statements.
Some of the risk factors associated with those forward-looking statements are
set forth in "Risk Factors" below. Other important risk factors are set forth in
the Company's other filings with the Securities and Exchange Commission.
The Company offers advanced design and manufacturing services to
original equipment manufacturers. The Company specializes in custom displays and
front panel displays utilizing liquid crystal display (LCD) and light emitting
diode (LED) components and technology. The Company experienced substantial
growth from 1993 through 1995 with such growth dependent primarily upon the
Company's participation in the substantial growth of the wireless communications
market and sales to a single major customer in that industry. In 1996, the
Company's sales declined, largely as a result of the phase-out by that major
customer of a significant family of programs in early 1996. In 1997, sales
returned to pre-1996 levels primarily as a result of several new programs and
customers, including a major office automation customer.
The Company had substantial growth in its revenues in 1997 with a 39.4
percent rate of growth over 1996. This growth occurred because several strong
new programs began production in the second and third quarters of 1997 while
many existing programs were in the middle of their life cycles. In 1997, over 80
percent of revenue occurred in the second, third, and fourth quarters. In 1998,
this type of revenue pattern is expected to be repeated, likely with an even
greater percentage of the overall 1998 revenue occurring in the second, third,
and fourth quarters. A pattern of seasonality may be developing as OEMs with
retail products develop shorter product life cycles and introduce new programs
early in the year after the winter holiday season. In addition, some new
programs, previously expected to begin to ramp up production in the first
quarter of 1998, are now not expected to begin to ramp up until after the first
quarter. As a result, the revenue from those new programs was not available in
the first quarter to offset the loss of revenue occurring from the completion of
certain older programs. Thus, although sales in the first quarter of 1998 were
14.9 percent higher than sales in the first quarter of 1997, sales in the first
quarter of 1998 declined over sales in the fourth quarter of 1997.
7
<PAGE>
The Company's actual backlog at the end of March 31, 1998 of $39.2
million is substantially higher than the $17.8 million that existed at March 31,
1997. In addition, at the beginning of 1998, the Company's estimated 1998
backlog of manufacturing revenue for programs currently in design was
substantially greater than the estimated 1997 backlog was at the beginning of
1997. Therefore, if additional programs moving out of development begin to ramp
their production levels up in 1998 as anticipated, the Company should continue
its year-over-year growth rate in 1998.
In the past several quarters, the Company has undertaken substantial
efforts to diversify its business, broaden its customer base, and expand its
markets, and the Company intends to continue those efforts. The Company's
historical major customer, 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. Late in 1997, Motorola instituted an allocation process for
awarding 1998 LCD module business. Although the allocation does not provide a
guarantee of business, the Company anticipates that its business with Motorola
will increase in 1998 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 approximately one-half of its 1998 revenue.
Hewlett-Packard accounted for 32 percent of the Company's revenue in 1997, but
this percentage is expected to decline significantly in 1998 as current programs
mature and replacement programs with lower selling prices are introduced.
The Company's gross margins are impacted by several factors, including
manufacturing efficiencies, product differentiation, product uniqueness,
billings for non-recurring engineering services, inventory management,
engineering costs, product mix, and volume pricing. Generally, higher-volume
programs using more generic, low-information content LCD displays have lower
margins. Gross margins generally increase, however, as a program matures because
yields rise and component costs generally fall. As the production levels of some
of the Company's new high-volume programs increase in 1998, the lower standard
gross margins on those programs will have an impact on the Company's overall
margins. In addition, in an effort to penetrate certain strategic customers, the
Company may aggressively price its products. Depending on the size of the
programs won, such pricing strategies could also have an effect on overall
margins.
The Company has accelerated the start-up of the China operations, and
over the next several quarters the Company's gross margins will also be
adversely affected by the start-up of those China manufacturing operations. As
the Company begins ramping up its China manufacturing operations in the second
quarter, it will incur costs in advance of the receipt of significant revenues.
The Company expects that it could have as much as $1 million of incremental
China expenses in the second quarter. Those expenses, arising mainly from
under-absorption of the China facility and yield issues, will be included in the
cost of sales and thus will reduce overall gross margins. In the third quarter,
the Company's plan is for China to be at a break-even point at the gross margin
level, which means that the Company's overall margins would still be impacted by
those break-even margins. The Company expects the China facility will begin to
operate profitably after moving into the permanent facility, which is planned to
occur in the fourth quarter, although gross margins will initially still be
lower than U.S. gross margins. In the long run, however, the Company expects the
China operations to positively impact gross margins because of certain
competitive cost advantages provided by China.
Another potential impact on the Company's gross margins could occur as
a result of the Asian currency situation. 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 see competitive margin pressure from
Asian suppliers, particularly those in Korea and Japan.
Despite the various factors potentially impacting gross margins, it is
the goal of the Company for increased manufacturing efficiencies to occur on the
high-volume programs to help maintain its gross margins in the mid-twenty
percent range, although those gross margin levels should not occur until after
the China facility is fully operational. The Company also expects that more
advanced display modules commanding higher margins should enable the Company to
eventually maintain its gross margins in the desired mid-twenty percent range.
As the Company expands and diversifies its product and customer base,
the Company has had to increase its selling, general, and administrative
expenses. Although those expenses in the first quarter of 1998 decreased over
the
8
<PAGE>
fourth quarter of 1997, the decrease was mainly due to an adjustment of certain
accruals. Generally, those expenses are somewhat inelastic; accordingly,
selling, general, and administrative expenses have increased as a percentage of
sales in the first quarter of 1998 as a result of the reduced revenue from the
fourth quarter of last year. The volume and complexity of the Company's business
is expected to continue to grow throughout the remainder of 1998. Therefore, the
Company anticipates that it will increase its selling and administrative
expenses over those incurred in 1997. Serving a myriad of customers with complex
and differing issues requires increased personnel committed to those customers.
The actual dollar amount of the selling, general, and administrative expenses in
1998 could be 20 to 25 percent greater than in 1997, although SG&A expenditures
as a percentage of net sales should decrease in 1998 over the 1997 levels.
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 rather than emphasize
manufacturing process improvements. Use of the LCD manufacturing line in Tempe,
Arizona as a resource for testing of 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 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 invested $2.4 million 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 hand-held products using
microdisplays 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 expenditures in 1998 may increase by 10 to 20 percent over 1997,
although R&D expenditures as a percentage of net sales should decrease in 1998.
As mentioned previously, the Company has decided to establish
manufacturing operations in The People's Republic of China. A very experienced
individual was hired in early 1998 to act as the General Manager and Vice
President for the China operations. 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. A temporary leased site
was recently selected in Beijing, as was the permanent site. The Company plans
to establish Chinese manufacturing operations in 1998 for several reasons.
First, based upon growth expectations for 1998 in the European and United States
marketplaces, the Company anticipates a need for manufacturing capacity beyond
what is available at its Philippine location. China was selected because of the
desire to diversify manufacturing locations and because of the cost benefits
that are expected to be achieved in China. China is also expected to be
synergistic for the Company because many of its components are manufactured in
China.
Second, many of the Company's existing and potential customers maintain
manufacturing operations near the proposed China location. Despite the current
Asian economic situation, those customers continue to require LCD modules and
the Company participates very little 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
9
<PAGE>
to utilize locally manufactured components. As mentioned above, the Company
expects start up costs associated with China to occur in advance of the first
significant revenues from China, which are expected to occur in the third
quarter of 1998.
Risk Factors
Forward-looking statements in this report include revenue, margin,
expense, and earnings analysis for 1998 as well as the Company's expectations
relating to operations in China, future technologies and future design, and
production orders. The Company's future operating results may be affected by
various trends, developments, and factors that the Company must successfully
manage in order to achieve its goals. In addition, there are trends,
developments, and factors beyond the Company's control that may affect its
operations. The cautionary statements and risk factors set forth below and
elsewhere in this document, and in the Company's other filings with the
Securities and Exchange Commission, identify important trends, factors, and
currently known developments that could cause actual results to differ
materially from those in any forward-looking statements contained in this report
and in any written or oral statements of the Company.
A few core customers are currently responsible for a majority of the
Company's revenue. 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. The Company expects the current
concentration levels from those core customers to continue through 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.
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
design is satisfactorily completed, the customer may terminate or delay the
program as a result of marketing or other pressures.
The Company is expected to introduce several new products over the next
few years. These new products 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
to $3 million of capital expenditures, and the Company has committed to a $3.3
million investment in Siliscape for the purposes of further developing the
LCoS(TM) microdisplay product. There could be a materially adverse impact on the
Company if one or more of the new technologies were unsuccessful for any reason,
especially LCoS(TM) microdisplays.
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 previously introduced by others.
10
<PAGE>
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. On occasions, several material components of some
of the Company's major programs have been subject to allocation because of
shortages by vendors and continued or increased shortages could have a material
adverse effect on the Company in the future. In addition, although most of the
components purchased by the Company are purchased from vendors in Asian
countries unaffected by the current currency crisis, a significant portion of
the silicon drivers purchased by the Company are manufactured in Korea and
Japan. 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 impact
on the gross margins of the Company as the competitors' products become less
expensive to purchase with a stronger dollar.
The Company is planning to begin a manufacturing operation in China in
1998. The Company's operations and assets will be subject to significant
political, economic, legal and other uncertainties in China. The Company also
could be adversely affected by the imposition of austerity measures intended to
reduce inflation; the inadequate development or maintenance of infrastructure,
including the unavailability of adequate power and water supplies,
transportation, raw materials, and parts; or a deterioration of the general
political, economic or social environment in China.
The Company is starting up China operations because the Company
believes that its Manila manufacturing facility may have occasional capacity
issues as early as the fourth quarter of 1998. 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.
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.
11
<PAGE>
PART II. OTHER INFORMATION
ITEM 6. Exhibits and Reports on Form 8-K
--------------------------------
(a) EXHIBIT 27: Financial Data Schedule
(b) Reports on Form 8-K: None
12
<PAGE>
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: May 01, 1998 By: /s/ Jeffrey D. Buchanan
----------------- -----------------------------------
Jeffrey D. Buchanan
Its: Vice President Finance,
Administration and Legal; Chief
Financial Officer
13
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED BALANCE SHEET AT MARCH 31, 1998 AND THE RELATED CONSOLIDATED
STATEMENTS OF INCOME AND OF CASH FLOWS FOR THE THREE MONTHS ENDED MARCH 31, 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>
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLARS
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> MAR-31-1998
<EXCHANGE-RATE> 1
<CASH> 13,943
<SECURITIES> 0
<RECEIVABLES> 13,398
<ALLOWANCES> 590
<INVENTORY> 12,865
<CURRENT-ASSETS> 45,061
<PP&E> 43,910
<DEPRECIATION> 13,466
<TOTAL-ASSETS> 75,777
<CURRENT-LIABILITIES> 15,533
<BONDS> 0
0
0
<COMMON> 79
<OTHER-SE> 0
<TOTAL-LIABILITY-AND-EQUITY> 75,777
<SALES> 18,479
<TOTAL-REVENUES> 18,479
<CGS> 13,687
<TOTAL-COSTS> 16,995
<OTHER-EXPENSES> 17
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 1,659
<INCOME-TAX> 664
<INCOME-CONTINUING> 995
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 995
<EPS-PRIMARY> 0.13
<EPS-DILUTED> 0.12
</TABLE>
