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 June 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
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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 JUNE 30, 1998
- ----- -------------------------------
Common 7,927,085
Par value $.01 per share
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THREE-FIVE SYSTEMS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 1998
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION
Page
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ITEM 1. FINANCIAL STATEMENTS:
Consolidated Balance Sheets-
June 30, 1998 and December 31, 1997..........................1
Consolidated Statements of Income-
Three Months and Six Months Ended June 30, 1998 and 1997.....2
Consolidated Statements of Cash Flows-
Six Months Ended June 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 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITY HOLDERS............13
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K................................13
SIGNATURES...............................................................14
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ITEM 1.
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
JUNE 30, DECEMBER 31,
1998 1997
---- ----
(Unaudited)
ASSETS
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CURRENT ASSETS:
Cash and cash equivalents $ 7,085 $ 16,371
Accounts receivable, net 14,349 12,540
Inventories, net 22,399 8,255
Deferred tax asset 4,113 4,311
Other current assets 1,058 1,228
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Total current assets 49,004 42,705
PROPERTY, PLANT AND EQUIPMENT, net 32,550 29,847
OTHER ASSETS 2,680 283
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$ 84,234 $ 72,835
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LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
CURRENT LIABILITIES:
Accounts payable $ 17,186 $ 8,513
Accrued liabilities 4,323 5,079
Current taxes payable 1,308 --
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Total current liabilities 22,817 13,592
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DEFERRED TAX LIABILITY 2,718 2,718
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COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock -- --
Common stock 79 79
Additional paid-in capital 32,468 32,420
Retained earnings 26,378 24,259
Cumulative translation adjustment 5 20
Less - Treasury Stock at cost (20,496 shares) (231) (253)
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Total stockholders' equity 58,699 56,525
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$ 84,234 $ 72,835
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The accompanying notes are an integral part of these consolidated balance
sheets.
1
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ITEM 1.
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
(in thousands, except per share amounts)
THREE MONTHS SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
----------------- ---------------
1998 1997 1998 1997
---- ---- ---- ----
NET SALES $ 22,682 $ 18,737 $ 41,161 $ 34,866
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COSTS AND EXPENSES:
Cost of sales 17,095 14,377 30,782 26,865
Selling, general and administrative 1,815 1,479 3,434 2,945
Research and development 1,904 1,315 3,593 2,445
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20,814 17,171 37,809 32,255
-------- -------- -------- --------
Operating income 1,868 1,566 3,352 2,611
OTHER INCOME (EXPENSE):
Interest, net 130 154 322 311
Other, net (6) (7) (23) (19)
-------- -------- -------- --------
INCOME BEFORE PROVISION FOR
INCOME TAXES 1,992 1,713 3,651 2,903
Provision for income taxes 869 685 1,533 1,074
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NET INCOME $ 1,123 $ 1,028 $ 2,118 $ 1,829
======== ======== ======== ========
EARNINGS PER COMMON SHARE
Basic $ 0.14 $ 0.13 $ 0.27 $ 0.23
======== ======== ======== ========
Diluted $ 0.14 $ 0.13 $ 0.26 $ 0.23
======== ======== ======== ========
WEIGHTED AVERAGE NUMBER OF
COMMON SHARES
Basic 7,918 7,855 7,913 7,807
======== ======== ======== ========
Diluted 8,128 8,071 8,141 8,063
======== ======== ======== ========
The accompanying notes are an integral part of these consolidated statements.
2
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ITEM 1.
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
SIX MONTHS ENDED
JUNE 30,
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1998 1997
---- ----
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 2,118 $ 1,829
Adjustments to reconcile net income to net cash
(used in) provided by operating activities:
Depreciation and amortization 2,178 2,034
Reduction of accounts receivable valuation reserves (15) (174)
Reduction of inventory valuation reserves (803) (980)
Loss on disposal of assets -- 3
Change in assets and liabilities:
Increase in accounts receivable (1,794) (2,773)
Increase in inventories (13,341) (2,278)
(Increase) decrease in other assets (153) 712
Increase in accounts payable and accrued liabilities 7,917 2,439
Increase in taxes payable, net 1,851 332
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Net cash provided by (used in) operating activities (2,042) 1,144
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CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property, plant and equipment, net (4,880) (2,100)
Investments (2,420) --
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Net cash used in investing activities (7,300) (2,100)
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CASH FLOWS FROM FINANCING ACTIVITIES:
Issue of treasury stock 22 --
Stock options exercised 48 37
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Net cash provided by financing activities 70 37
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Effect of exchange rate changes on cash and cash equivalents (14) --
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NET (DECREASE) IN CASH AND CASH EQUIVALENTS (9,286) (919)
CASH AND CASH EQUIVALENTS, beginning of period 16,371 12,580
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CASH AND CASH EQUIVALENTS, end of period $ 7,085 $ 11,661
======== ========
The accompanying notes are an integral part of these consolidated statements.
3
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ITEM 1.
Three-Five Systems, Inc. and Subsidiaries Notes to Consolidated
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Financial Statements
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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 six-month periods ended June 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 six-month periods. Diluted earnings per common
share for the three and six-months period 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:
June 30, 1998 December 31, 1997
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(Unaudited)
(in thousands)
Raw Materials $ 16,711 $ 6,052
Work-in-process 2,304 1,195
Finished Good 3,384 1,008
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$ 22,399 $ 8,255
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Note D Property, plant, and equipment consist of the following at:
June 30, 1998 December 31, 1997
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(Unaudited)
(in thousands)
Building and improvements $ 10,431 $ 10,431
Furniture and equipment 36,685 31,804
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$ 47,116 $ 42,235
Less accumulated depreciation (14,566) (12,388)
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$ 32,550 $ 29,847
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4
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Three Months Ended June 30, 1998 Compared with Three Months Ended June 30, 1997.
Net sales were $22.7 million for the quarter ended June 30, 1998, an
increase of 21.4 percent compared with net sales of $18.7 million for the
quarter ended June 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. In addition, several
new programs, previously expected to begin manufacture in the first half of
1998, were delayed by customers for a variety of reasons. During the second
quarter of 1998, sales to Motorola were 52.9 percent of the Company's revenue,
sales to Hewlett-Packard were 9.1 percent of the Company's revenue, and sales to
all other customers were 38 percent of the Company's revenue.
Cost of sales, as a percentage of net sales, decreased to 75.4 percent
for the quarter ended June 30, 1998 as compared with 76.7 percent for the
quarter ended June 30, 1997. The corresponding increase in the gross margin in
the second quarter is mainly attributed to positive material overhead absorption
occurring as a result of significantly increased material purchases. Since
inventory balances are now unusually high, purchases of inventory will
significantly slow in the third quarter of 1998, and under-absorption of the
material overhead will likely occur, which will have the impact of reducing
gross margins in that quarter. See "Business Outlook and Risk Factors" below.
The positive material overhead absorption in the second quarter more than offset
the $543,000 of incremental expenses the Company incurred in cost of sales as a
result of starting up operations in China. Those incremental China expenses are
reflected as under-absorbed overhead in costs of sales as a result of no
significant manufacturing activity in the China facility.
Selling, general, and administrative expense of $1.8 million for the
quarter ended June 30, 1998 was higher than the expense of $1.5 million for the
quarter ended June 30, 1997. Selling, general, and administrative expense as a
percentage of net sales was 7.9 percent for the quarter ended June 30, 1998 as
compared with 8.0 percent for the quarter ended June 30, 1997.
Research and development expense totaled $1.9 million, or 8.4 percent
of net sales, for the quarter ended June 30, 1998 as compared with $1.3 million,
or 7.0 percent of net sales, for the quarter ended June 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. Research and
development expense has continued to increase as the Company works to develop
new 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. Most of the increase this quarter related to process
developments on the LCD line.
Interest income (net) for the quarter ended June 30, 1998 was $130,000,
down from $154,000 for the quarter ended June 30, 1997. The decrease in interest
income was the result of investing lower cash balances during the quarter. Other
expense (net) was $6,000 for the quarter ended June 30, 1998 as compared with
$7,000 for the quarter ended June 30, 1997.
The provision for income taxes increased to $869,000 for the quarter
ended June 30, 1998 from $685,000 for the quarter ended June 30, 1997. This
increase resulted primarily from higher pre-tax income in the quarter ended June
30, 1998 as compared with the same period in 1997. In addition, the Company
applied a tax rate of 43.6 percent for this quarter (versus a 40% rate in the
quarter ended June 30, 1997) in order to bring the tax rate for the first six
months up to 42 percent. The Company will have an approximate 42 percent tax
rate in the remainder of 1998 as a result of the losses it is incurring 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 like the United States. In 1999, the Company's overall tax rate should
drop as the Company increases manufacturing operations, in China. The actual
world-wide tax rate at that time will depend upon a variety of factors,
including inter-company transfer pricing, the amount of China sales, the
profitability of China operations, and whether any inter-company dividends are
declared.
5
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Net income increased to $1.1 million, or $0.14 per share (diluted), for
the quarter ended June 30, 1998 from $1.0 million, or $0.13 per share (diluted),
for the quarter ended June 30, 1997. Without China-related incremental expenses
in the costs of sales, net income for the quarter ended June 30, 1998 would have
been approximately $1.4 million or $0.18 per share (diluted).
Six Months Ended June 30, 1998 Compared with Six Months Ended June 30, 1997.
Net sales were $41.2 million for the six months ended June 30, 1998, an
increase of 18.1 percent compared with net sales of $34.9 million for the six
months ended June 30, 1997. The sales increase was primarily a result of the
increased production of several new programs for new and existing customers. In
the six-month period ended June 30, 1998, (a) Motorola accounted for net sales
of $20.3 million compared with net sales of $12.2 million to that customer for
the six months ended June 30, 1997, (b) Hewlett-Packard accounted for net sales
of $4.8 million compared with net sales of $9.0 million to that customer for the
six months ended June 30, 1997, and (c) other customers accounted for net sales
of $16.1 million, compared with the net sales of $13.7 million to those other
customers for the six months ended June 30, 1997.
Cost of sales, as a percentage of net sales, decreased to 74.8 percent
for the six months ended June 30, 1998 as compared with 77.1 percent for the six
months ended June 30, 1997. The corresponding increase in the gross margin was
primarily due to positive material overhead absorption as the result of the
significantly increased inventory purchases.
Selling, general, and administrative expense of $3.4 million for the
six months ended June 30, 1998 was greater than the expense of $2.9 million for
the six months ended June 30, 1997. Selling, general, and administrative expense
as a percentage of net sales was 8.3 percent for the six months ended June 30,
1998, which was the same percentage for the six months ended June 30, 1997.
Research and development expense totaled $3.6 million, or 8.7 percent
of net sales, for the six months ended June 30, 1998 as compared with $2.4
million, or 6.9 percent of net sales, for the six months ended June 30, 1997.
The increase in research and development expense was as a result of the
Company's continued focus on the development of advanced display technologies
and development of its in-house efforts relative to the high-volume
manufacturing LCD line.
Interest income (net) for the six months ended June 30, 1998 was
$322,000, up from $311,000 for the six months ended June 30, 1997. The increase
in interest income was the result of investing higher average cash balances
during the six months. Other expense (net) increased to $23,000 for the six
months ended June 30, 1998 from $19,000 for the six months ended June 30, 1997.
The provisions for income taxes increased to $1.5 million for the six
months ended June 30, 1998 from $1.1 million for the six months ended June 30,
1997. This resulted primarily from higher pre-tax income in the six months ended
June 30, 1998 as compared with the same period in 1997. In addition, the Company
used a tax rate of 42 percent for the first six months versus a 37% rate for the
six month period ending June 30, 1998.
Net income increased to $2.1 million, or $0.26 per share (diluted), for
the six months ended June 30, 1998 from $1.8 million, or $0.23 per share
(diluted), for the six months ended June 30, 1997. Without China-related
incremental expenses in the cost of sales, net income for the six months ended
June 30, 1998 would have been approximately $2.6 million, or $0.32 per share
(diluted).
Liquidity and Capital Resources
During the first six months of 1998, the Company had $2.0 million in
negative cash flow from operations as compared with $1.1 million in positive
cash flow during the first six months of 1997. The negative cash flow from
operations was primarily due to the significant increase in inventories. The
Company purchased inventories in expectation of the start-up of several new
programs in the second and third quarters of 1998. A delay in the start-up of
those programs resulted in a substantial inventory balance on June 30, 1998. The
6
<PAGE>
Company believes that it will receive orders for the new programs sufficient to
utilize the unreserved inventory because most of the unreserved inventory
balance is for programs which are at the beginning of the production cycle. If
some or all of those programs are cancelled, however, the Company may end up
holding excess inventory. See "Business Outlook and Risk Factors" below.
The Company's working capital was $26.2 million at June 30, 1998, down
from $29.1 million at December 31, 1997. The Company's current ratio at June 30,
1998 was 2.1-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. (see below). Including its cash and loan commitments, the Company had over
$21 million in readily available funds on June 30, 1998.
In May 1998, the Company entered into a new $15 million unsecured,
revolving line of credit with Imperial Bank, which matures in May 2000. At June
30, 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 in June 1999. Three-Five Systems Limited had no borrowings outstanding
under this line of credit at June 30, 1998.
Capital expenditures during the first half of 1998 were approximately
$4.9 million, as compared with $2.1 million during the first half of 1997.
Capital expenditures for the first half 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 over $1 million of equipment necessary to manufacture LCoS(TM)
microdisplays. The Company anticipates that it will have substantial additional
capital expenditures during 1998. 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 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. Thus far,
the Company has expended approximately $3 million in Beijing for manufacturing,
equipment 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
and has begun construction of its own building, which is expected to be ready
early in 1999. 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, 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's ownership
interest in Siliscape will be accounted for on the cost method of accounting.
The Company anticipates that accounts receivable will increase during
1998 if revenue levels increase. 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
throughout 1998. The Company may have to expand its loan commitments or pursue
alternate methods of financing or raising 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.
7
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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. 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 commenced 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 in total 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 is
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. At
this time, the Company has an intercompany loan balance with its Chinese
subsidiary of approximately $2 million, and that balance will likely increase
over the next few months. The Company believes, however, that it will eventually
obtain loans in Chinese currency to replace the inter-company loans. Until the
Company can obtain loans in the Chinese currency, however, a Chinese currency
devaluation would result in the Company recording a reportable loss.
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.
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
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.
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, nearly
59 percent of revenue occurred in the third and fourth quarters. In 1998, this
type of revenue pattern is expected to be repeated, possibly with an even
greater percentage of the overall 1998 revenue occurring in the 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 and second
quarters of 1998 are now not expected to begin to ramp up until the second half
of 1998.
The Company's backlog at June 30, 1998 was $25.9 million as compared
with $39.2 million at March 31, 1998. This reduction in backlog occurred
primarily because several significant new programs were delayed by a customer.
As a result, the net additions to the backlog (after being reduced by the sales
in the second quarter) were lower than normal while these programs were on hold.
If these programs are released and begin to ramp up their production levels in
1998 as anticipated, the backlog would increase.
8
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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 did 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 just over 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 later
in this year. For the first half of 1998, Motorola accounted for 49.4 percent of
revenue and Hewlett-Packard accounted for 11.6 percent of revenue.
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 the second half of 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 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 has begun the start-up of its China-based 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 continues ramping up its manufacturing operations in China, it will
incur costs in advance of the receipt of significant revenues. In the second
quarter of 1998, the Company incurred $543,000 of incremental China-based
expenses in the total cost of sales. Those incremental expenses, which were
somewhat lower than expected, arise mainly from under-absorption of the China
facility and are included in the cost of sales, thus reducing overall gross
margins. The Company's expectation is that there will also be incremental
China-based expenses in the third quarter but that the China facility will begin
to operate profitably in the fourth quarter, although gross margins will
initially 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 maintaining operations in
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.
The large inventory balance as of June 30, 1998 means that the Company
will have lower than normal inventory purchases during the third quarter. As a
result, under-absorption of material overhead costs will likely occur,
increasing the costs of goods sold and reducing margins.
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 throughout
the remainder of 1998. Therefore, the Company anticipates that it will increase
its selling and administrative expenses over those incurred in 1997.
9
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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 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 research and development expenditures in 1998 will increase over
1997 by at least 30 percent.
As mentioned previously, the Company has decided to establish
manufacturing operations in The People's Republic of China. An 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. During the first
quarter of 1998, a temporary leased site was selected in Beijing, as was the
permanent site. The Company has moved into the temporary site and set up two
manufacturing lines.
The Company has established a China-based manufacturing operation in
1998 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.
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 China location. 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. As mentioned above, the Company start-up costs associated with its
China-based operations will 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,
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
10
<PAGE>
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 are currently responsible for a majority of the
Company's revenue, and the Company expects the high concentration levels with
its core customers to continue through 1998. 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. In May 1998,
the Company announced that delays in certain digital cellular programs by
Motorola would contribute to lower than expected sales in the second quarter of
1998. Some of those programs are still delayed, and it is generally acknowledged
that Motorola has lost market share in the digital cellular market.
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.
The Company currently holds a very large inventory balance as a result
of delays in certain programs by customers announced during the second quarter
of 1998. The Company has analyzed the inventory balance and believes that the
inventory will be utilized because most of the unreserved inventory relates to
new 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
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
11
<PAGE>
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.
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.
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.
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.
12
<PAGE>
PART II. OTHER INFORMATION
ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company's Annual Meeting of Stockholders was held on April 23,
1998. All of the nominees were elected to the Company's Board of Directors as
set forth in the Proxy Statement as follows:
Nominees Votes in Favor Against
-------- -------------- -------
David R. Buchanan 6,787,632 284,566
David C. Malmberg 6,787,112 285,086
Burton E. McGillivray 6,791,712 280,486
Kenneth M. Julien 6,738,837 332,361
Gary R. Long 6,747,552 324,646
There were 55,075 exceptions (abstentions) in total on the Board of Director's
nominee voting.
The following items were also voted upon and approved by the
Stockholders:
(a) To approve the Company's new 1998 Stock Option Plan (the "1998
Plan").
Votes in Favor Opposed Abstain
-------------- ------- -------
6,571,622 398,811 101,765
(b) To ratify the appoint of Arthur Andersen LLP as the independent
auditors of the Company for the fiscal year ending December 31, 1998.
Votes in Favor Opposed Abstain
-------------- ------- -------
6,972,951 67,409 31,838
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
13
<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: July 17, 1998 By: /s/ Jeffrey D. Buchanan
------------- ----------------------------
Name: Jeffrey D. Buchanan
Its: Executive Vice President;
Chief Financial Officer
14
THREE-FIVE SYSTEMS, INC.
STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS
EXHIBIT 11
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------- ---------------------
1998 1997 1998 1997
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Common shares outstanding beginning
of period 7,907,123 7,762,129 7,905,523 7,757,329
Effect of Weighting Shares:
Employee stock options exercised 8,487 92,856 5,580 50,018
Issue of treasury stock 2,004 -- 2,004 --
---------- ---------- ---------- ----------
Basic 7,917,614 7,854,985 7,913,107 7,807,347
========== ========== ========== ==========
Common shares outstanding beginning
of period 7,907,123 7,762,129 7,905,523 7,757,329
Effect of Weighting Shares:
Employee stock options exercised 8,487 92,856 5,580 50,018
Employee stock options outstanding 210,369 215,623 228,200 255,915
Issue of treasury stock 2,004 -- 2,004 --
---------- ---------- ---------- ----------
Diluted 8,127,983 8,070,608 8,141,307 8,063,262
========== ========== ========== ==========
Net income $1,123,000 $1,028,000 $2,118,000 $1,829,000
========== ========== ========== ==========
NET INCOME PER COMMON SHARE:
Basic $ 0.14 $ 0.13 $ 0.27 $ 0.23
========== ========== ========== ==========
Diluted $ 0.14 $ 0.13 $ 0.26 $ 0.23
========== ========== ========== ==========
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
UNAUDITED CONSOLIDATED BALANCE SHEET AT JUNE 30, 1998 AND THE RELATED
CONSOLIDATED STATEMENTS OF INCOME FOR THE UNAUDITED SIX MONTHS ENDED JUNE 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>
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLARS
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<EXCHANGE-RATE> 1
<CASH> 7,085
<SECURITIES> 0
<RECEIVABLES> 14,914
<ALLOWANCES> 565
<INVENTORY> 22,399
<CURRENT-ASSETS> 49,004
<PP&E> 47,116
<DEPRECIATION> 14,566
<TOTAL-ASSETS> 84,234
<CURRENT-LIABILITIES> 22,817
<BONDS> 0
0
0
<COMMON> 79
<OTHER-SE> 0
<TOTAL-LIABILITY-AND-EQUITY> 84,234
<SALES> 41,161
<TOTAL-REVENUES> 41,161
<CGS> 30,782
<TOTAL-COSTS> 37,809
<OTHER-EXPENSES> 23
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 3,651
<INCOME-TAX> 1,533
<INCOME-CONTINUING> 2,118
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 2,118
<EPS-PRIMARY> 0.27
<EPS-DILUTED> 0.26
</TABLE>
