<PAGE> 1
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 September 30, 1999
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 SEPTEMBER 30, 1999
Common 9,051,466
Par value $.01 per share
<PAGE> 2
THREE-FIVE SYSTEMS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 1999
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PART I - FINANCIAL INFORMATION
Page
ITEM 1. FINANCIAL STATEMENTS:
<S> <C> <C>
Consolidated Balance Sheets -
September 30, 1999 and December 31, 1998........................................... 1
Consolidated Statements of Income (Loss) -
Three Months and Nine Months Ended September 30, 1999 and 1998..................... 2
Consolidated Statements of Cash Flows -
Nine Months Ended September 30, 1999 and 1998...................................... 3
Notes to Consolidated Financial Statements.................................................. 4
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS............................................... 6
</TABLE>
<TABLE>
<CAPTION>
PART II - OTHER INFORMATION
<S> <C> <C>
ITEM 5. OTHER INFORMATION........................................................................... 13
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K............................................................ 13
SIGNATURES.................................................................................................... 14
</TABLE>
<PAGE> 3
ITEM 1. FINANCIAL STATEMENTS
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1998
---- ----
(unaudited)
ASSETS
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents $ 7,474 $ 4,946
Accounts receivable, net 25,752 18,601
Receivable from equity offering 36,592 -
Inventories, net 15,265 12,493
Deferred tax asset 2,649 2,680
Other current assets 1,692 2,313
------------- ------------
Total current assets 89,424 41,033
PROPERTY, PLANT AND EQUIPMENT, net 39,919 33,314
OTHER ASSETS 3,525 3,557
------------- ------------
$ 132,868 $ 77,904
============= ============
</TABLE>
<TABLE>
<CAPTION>
LIABILITIES AND STOCKHOLDERS' EQUITY
<S> <C> <C>
CURRENT LIABILITIES:
Accounts payable $ 16,336 $ 10,649
Accrued liabilities 5,364 4,673
Current taxes payable 580 235
Notes payable 9,000 -
Current portion of long-term debt 1,866 651
------------- ------------
Total current liabilities 33,146 16,208
------------- ------------
LONG-TERM DEBT 6,229 7,444
------------- ------------
DEFERRED TAX LIABILITY 3,104 3,156
------------- ------------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Common stock 91 80
Additional paid-in capital 61,008 32,484
Retained earnings 29,284 26,849
Cumulative translation adjustment 6 8
Less - Treasury stock, at cost - (8,325)
------------- ------------
Total stockholders' equity 90,389 51,096
------------- ------------
$ 132,868 $ 77,904
============= ============
</TABLE>
The accompanying notes are an integral part of these consolidated statements.
1
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THREE-FIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME (LOSS)
(UNAUDITED)
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
------------------------------------ ------------------------------------
1999 1998 1999 1998
----------------- ---------------- ----------------- -----------------
<S> <C> <C> <C> <C>
NET SALES $ 42,723 $ 24,572 $ 97,367 $ 65,733
--------------- -------------- -------------- ---------------
COSTS AND EXPENSES:
Cost of sales 33,882 22,243 79,176 53,025
Selling, general and administrative 2,741 1,721 7,683 5,155
Research and technology 2,427 1,250 6,256 4,843
--------------- -------------- -------------- ---------------
39,050 25,214 93,115 63,023
--------------- -------------- -------------- ---------------
Operating income (loss) 3,673 (642) 4,252 2,710
OTHER INCOME (EXPENSE):
Interest, net (152) (4) (518) 317
Other, net (8) (48) (41) (70)
--------------- -------------- -------------- ---------------
INCOME (LOSS) BEFORE PROVISION FOR
(BENEFIT FROM) INCOME TAXES 3,513 (694) 3,693 2,957
Provision for (benefit from) income taxes 1,476 (291) 1,258 1,242
--------------- -------------- -------------- ---------------
NET INCOME (LOSS) $ 2,037 $ (403) $ 2,435 $ 1,715
=============== ============== ============== ===============
EARNINGS (LOSS) PER COMMON SHARE
Basic $ 0.29 $ (0.05) $ 0.35 $ 0.22
=============== ============== ============== ===============
Diluted $ 0.28 $ (0.05) $ 0.34 $ 0.21
=============== ============== ============== ===============
WEIGHTED AVERAGE NUMBER OF
COMMON SHARES
Basic 7,110 7,656 7,035 7,826
=============== ============== ============== ===============
Diluted 7,321 7,656 7,165 8,021
=============== ============== ============== ===============
</TABLE>
The accompanying notes are an integral part of these consolidated statements.
2
<PAGE> 5
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------------------------------
1999 1998
------------- -------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 2,435 $ 1,715
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization 4,330 3,347
Provision for accounts receivable valuation reserves 174 22
Provision for (reduction of) inventory valuation reserves 2,208 (748)
Changes in assets and liabilities:
(Increase) in accounts receivable (7,324) (3,707)
(Increase) in inventories (4,980) (4,423)
(Increase) decrease in other assets 626 (490)
Increase (decrease) in accounts payable and accrued liabilities 6,378 (2,671)
Increase in taxes payable, net 323 1,054
------------- -------------
Net cash provided by (used in) operating activities 4,170 (5,901)
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, plant and equipment (10,907) (6,356)
Investments - (2,420)
------------- -------------
Net cash used in investing activities (10,907) (8,776)
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from notes payable to banks 9,000 9,600
Stock options exercised 76 64
Expenses paid in connection with equity offering (363) -
Warrants issued 555 -
Purchase of treasury stock, net - (4,646)
------------- -------------
Net cash provided by financing activities 9,268 5,018
------------- -------------
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH
EQUIVALENTS (3) (6)
------------- -------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 2,528 (9,665)
CASH AND CASH EQUIVALENTS, beginning of period 4,946 16,371
------------- -------------
CASH AND CASH EQUIVALENTS, end of period $ 7,474 $ 6,706
============= =============
</TABLE>
The accompanying notes are an integral part of these consolidated statements.
3
<PAGE> 6
THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS
Note A The accompanying unaudited Consolidated Financial Statements of
Three-Five Systems, Inc. and Subsidiaries (the "Company") have been
prepared in accordance with generally accepted accounting principles
for interim financial information and the instructions to Form 10-Q.
Accordingly, they do not include all the information and footnotes
required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments
(which include only normal recurring adjustments) necessary to present
fairly the financial position, results of operations, and cash flows
for all periods presented have been made. The results of operations for
the three and nine-month periods ended September 30, 1999 are not
necessarily indicative of the operating results that may be expected
for the entire year ending December 31, 1999. These financial
statements should be read in conjunction with the December 31, 1998
financial statements and accompanying notes thereto.
Note B Basic earnings per common share are computed by dividing net income
by the weighted average number of shares of common stock outstanding
during the three and nine-month periods. In computing diluted earnings
per common share for the three months ended September 30, 1998, no
common share equivalents were considered in the calculation as the
effect was antidilutive. Diluted earnings per share for all other
periods presented are determined assuming that the options were
exercised at the beginning of the period or at the time of issuance, if
later.
Note C Inventories consist of the following at:
<TABLE>
<CAPTION>
September 30, 1999 December 31, 1998
------------------ -----------------
(unaudited)
(in thousands)
<S> <C> <C>
Raw Materials $10,805 $ 9,367
Work-in-process 2,510 1,459
Finished Good 1,950 1,667
------- -------
$15,265 $12,493
======= =======
</TABLE>
Note D Property, plant, and equipment consist of the following at:
<TABLE>
<CAPTION>
September 30, 1999 December 31, 1998
------------------ -----------------
(unaudited)
(in thousands)
<S> <C> <C>
Building and improvements $16,230 $13,031
Furniture and equipment 45,031 37,324
------ -------
61,261 50,355
Less accumulated depreciation (21,342) (17,041)
------ ------
$39,919 $33,314
====== ======
</TABLE>
Note E Segment information:
Management monitors and evaluates the financial performance of the
Company's operations by its four operating segments located in various
parts of the world. These segments consist of three manufacturing
operations, located in the United States, China, and the Philippines,
and a sales and distribution operation in the United Kingdom.
The following operating segment information includes financial
information (in thousands) for all four of the Company's operating
segments.
4
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<TABLE>
<CAPTION>
Three Months Ended United United
September 30, 1999 States Kingdom China Philippines Eliminations Total
------------------ ------ ------- ----- ----------- ------------ -----
(unaudited)
<S> <C> <C> <C> <C> <C> <C>
Net sales $ 17,073 $ 21,267 $ 4,383 $ - $ - $ 42,723
Intersegment sales 22,598 - 5,599 767 (28,964) -
Income before provision for
income taxes 1,916 1,050 515 16 16 3,513
</TABLE>
<TABLE>
<CAPTION>
Three Months Ended United United
September 30, 1998 States Kingdom China Philippines Eliminations Total
------------------ ------ ------- ----- ----------- ------------ -----
(unaudited)
<S> <C> <C> <C> <C> <C> <C>
Net sales $ 13,566 $ 10,473 $ 533 $ - $ - $ 24,572
Intersegment sales 10,307 - - 685 (10,992) -
Income (loss) before
provision for (benefit
from) income taxes (906) 458 (328) 2 80 (694)
</TABLE>
<TABLE>
<CAPTION>
Nine Months Ended United United
September 30, 1999 States Kingdom China Philippines Eliminations Total
------------------ ------ ------- ----- ----------- ------------ -----
(unaudited)
<S> <C> <C> <C> <C> <C> <C>
Net sales $ 34,556 $ 45,843 $ 16,968 $ - $ - $ 97,367
Intersegment sales 56,116 - 9,438 2,362 (67,916) -
Income before provision for
income taxes 1,307 1,432 864 47 43 3,693
</TABLE>
<TABLE>
<CAPTION>
Nine Months Ended United United
September 30, 1998 States Kingdom China Philippines Eliminations Total
------------------ ------ ------- ----- ----------- ------------ -----
(unaudited)
<S> <C> <C> <C> <C> <C> <C>
Net sales $ 43,636 $ 21,564 $ 533 $ - $ - $ 65,733
Intersegment sales 21,519 - - 2,010 (23,529) -
Income (loss) before
provision for (benefit
from) income taxes 2,730 855 (710) 39 43 2,957
</TABLE>
Note F Comprehensive income (in thousands) during:
1999 1998
---- ----
Three months ended September 30 $2,032 $(395)
Nine months ended September 30 2,432 1,709
Note G Equity Offering
The Company sold approximately 2.0 million shares of its common
stock in a secondary offering on September 27, 1999. Since it did
not receive the $36.6 million in proceeds from that offering until
October 1, 1999, those proceeds were reflected as "Receivable from
Equity Offering" in the September 30, 1999 balance sheet. Taking
into account expenses, the net proceeds from the equity offering
were $36.2 million.
5
<PAGE> 8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS AND FACTORS THAT MAY AFFECT RESULTS
Except for the historical information contained herein, this Report
contains forward-looking statements, including those relating to margins,
pricing pressures, quarterly fluctuations, the impact of our China facility,
material shortages, research and technology expenses that involve risks and
uncertainties that could cause actual results to differ materially.
We caution that these statements are qualified by various factors that
may affect future results, including the following: changes in the market for
our products and the success of our customers' products, the failure of key
technologies to deliver commercially acceptable performance, our dependence on
one large customer, the absence of long-term purchase commitments, and our
lengthy development periods and product acceptance cycles. This Report should be
read in conjunction with our Report on Form 10-K for the fiscal year ended
December 31, 1998 and our Report on Form S-3 (Registration No. 333-84083) as
declared effective by the Securities and Exchange Commission on September 27,
1999.
OVERVIEW
We offer advanced design and manufacturing services to original
equipment manufacturers, commonly referred to as OEMs. We specialize in custom
display modules utilizing liquid crystal display, or LCD, components and
technology. Our LCD modules have varying levels of integration. At a minimum,
each module includes an LCD, a custom LCD driver, and a flexible connector. We
also provide value-added services, which usually increase our profit margins, by
assembling additional components onto the module based upon the specific needs
of the customer. These additional components include such items as key pads,
plastics, speakers, light guides, and optics.
We currently sell substantially all of our LCD modules to major OEMs.
When we win a design program, our customer typically pays most or all of our
nonrecurring engineering expenses to defray the costs of custom design, as well
as the costs of nonrecurring tooling for custom components. The typical program
life cycle of a custom-designed LCD module is three to twelve months and
includes technical design, prototyping, pilot manufacturing, and high-volume
manufacturing. We typically seek large volume programs from major OEMs. The
minimum production quantity for an LCD module typically approximates 100,000
units per year, although the production rate for some programs has been as high
as 100,000 units per week. The selling price of our LCD modules usually ranges
between $5 and $20 per unit. We recognize revenue upon product shipment.
We experienced substantial growth from 1993 through 1995, primarily as
a result of sales to OEMs in the wireless communications industry, which grew
substantially during that period. During that period, our primary customer was
Motorola. In 1996, our net sales declined, primarily as a result of the
phase-out by Motorola of a significant family of programs. In 1997, our net
sales returned to pre-1996 levels primarily as a result of several new programs
and customers, including Hewlett-Packard. Motorola accounted for 65.1% of our
net sales in 1996, 34.6% in 1997, and 63.6% in 1998. Since mid-1998, we
increased our penetration at Motorola by being involved in more programs and
selling to more geographical regions. As a result, in the first nine months of
1999, net sales to Motorola increased at a faster rate than net sales to our
other customers and represented 84.3% of our net sales. Hewlett-Packard
accounted for 32.0% of our net sales in 1997 and less than 10.0% in 1998 and the
first nine months of 1999. This percentage decrease occurred as several older
Hewlett-Packard programs matured. In addition, new programs launched by
Hewlett-Packard in 1998 either did not require our LCD modules or required less
complex, lower cost modules.
During the past several years, we have experienced seasonal quarterly
fluctuations in our net sales as our OEM customers developed retail products
with shorter product life cycles and phased out older programs early in the year
following holiday sales. As a result, sales usually peak in the fourth quarter
of a calendar year and are lower in the following quarter.
Several factors impact our gross margins, including manufacturing
efficiencies, product differentiation, product uniqueness, inventory management,
product mix, and volume pricing. Currently, significant pricing pressure exists
in the LCD module market, especially in higher volume programs in the wireless
communications industry. Accordingly, as the
6
<PAGE> 9
production levels of some of our new higher volume programs have increased, the
lower standard gross margins on those programs have impacted our overall
margins.
We vertically integrate our manufacturing facilities. In Arizona, we
own and operate the largest high-volume LCD production line in North America. We
generally use the Arizona facility for the manufacture of more technologically
complex and custom high-volume LCDs. We also purchase LCDs from Asian sources to
provide us an alternate source and to ensure available capacity. In order to
take advantage of lower labor costs, we ship our LCDs to our facilities in
Manila, the Philippines, or Beijing, China, for assembly into modules.
Historically, we have conducted most of our manufacturing operations at
our facility in Manila. At that facility, we assemble LCDs into modules and
perform certain back-end LCD processing operations. We conduct our operations in
Manila under an agreement with a third-party subcontract manufacturer. Under
this agreement, the subcontractor supplies direct labor and incidental services
required to manufacture our products. We also lease our manufacturing facility
from the subcontractor. All indirect manufacturing employees, primarily
technicians, supervisors, and engineers, are our employees.
In early 1998, we decided to open a similar display module
manufacturing facility in Beijing. Within six months, we located a temporary
manufacturing facility, equipped the facility, trained our personnel, qualified
the facility for customers, and qualified products manufactured at the facility.
As we began manufacturing operations in Beijing in the second and third quarters
of 1998, however, we incurred costs in advance of the receipt of significant
sales. These incremental Beijing-based expenses were reflected in our cost of
sales. We began manufacturing in volume in Beijing in our temporary facility in
the fourth quarter of 1998. We commenced construction of our permanent Beijing
facility in late 1998. This facility was substantially completed in early July
1999, and in September 1999 all of our product in China was manufactured in the
permanent facility.
Selling, general, and administrative expense consists principally of
administrative and selling costs, salaries, commissions, and benefits to
personnel and related facility costs. We make substantially all of our sales
directly to OEMs, and our sales force consists of a small number of direct
technical sales persons. As a result, there is no material cost of distribution
in our selling, general, and administrative expense. Selling, general, and
administrative expense has increased as we have expanded our business and
increased our diversification efforts. In addition, we have recently incurred
substantial marketing and administrative expenses in connection with our
LCoS(TM) microdisplay business.
Research and technology expense consists principally of salaries and
benefits to scientists, design engineers, and other technical personnel, related
facility costs, process development costs, and various expenses for projects,
including new product development. Research and technology expense continues to
increase as we develop new display products and technologies, especially LCoS
microdisplays, while we continue with our in-house process development efforts
related to the high-volume LCD manufacturing line located in Arizona.
Since 1997, we have been working on the development of LCoS
microdisplays. In 1997, we entered into a strategic alliance with National
Semiconductor Corporation for the development of LCoS microdisplay products.
Under that alliance, National focused on the silicon technologies needed for
microdisplays, and we focused on the liquid crystal technologies. In early 1999,
National decided to close its microdisplay business unit, and in connection with
that closing, in July 1999, we purchased certain assets and licensed silicon
technologies from National relating to LCoS microdisplays for approximately $3.0
million in cash and warrants to purchase 70,000 shares of our common stock in a
transaction valued at approximately $3.6 million. No additional payments are
required under the licenses. We also hired several key technical employees of
National to assist in the implementation of the acquired technologies.
In April 1998, we entered into a strategic relationship with inViso,
Inc., formerly Siliscape, Inc., a privately held company with numerous patents
and proprietary technology related to microdisplay development. We acquired a
minority equity interest in inViso for approximately $3.3 million. As part of
this strategic relationship, we provide proprietary manufacturing capabilities
and liquid crystal expertise, and inViso provides patented and proprietary
technologies and components for the joint development of microdisplay products.
In August 1999, we licensed the microdisplay technology of S-Vision
Corporation, a former microdisplay competitor that recently ceased operations.
This license is an irrevocable, royalty free, fully paid-up, worldwide license
to manufacture and package certain microdisplay products and patented optical
engines.
7
<PAGE> 10
In October 1999, we entered into a strategic sourcing alliance with
Tecdis, S.p.A., an Italian passive matrix display company. Under the terms of
that alliance, among other things, we will contribute funds to start up a
semiconductor design company. The purpose of that start-up company will be to
design application specific integrated circuits used to drive LCDs.
These acquisitions, investments, and licenses will result in increased
research and technology expenses as we expand our LCoS microdisplay development
efforts in preparation for the commercial introduction of LCoS microdisplay
products. We are also considering licensing other technologies from other
companies that could be optimized on our LCD manufacturing line as well as
entering into further alliances. We expect to continue to devote substantial
resources to research and technology, focusing, especially in the near term, on
our LCoS microdisplay technology and related products. As a result, the actual
dollar amount of our research and technology expenses will continue to increase.
THREE MONTHS ENDED SEPTEMBER 30, 1999 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 1998
NET SALES. Net sales increased 73.6% to $42.7 million in the three
months ended September 30, 1999 from $24.6 million in the three months ended
September 30, 1998. This increase was the result of several new programs,
primarily for Motorola.
COST OF SALES. Cost of sales decreased to 79.3% of net sales in the
three months ended September 30, 1999 from 90.5% in the three months ended
September 30, 1998. Our cost of sales in the three months ended September 30,
1998 was adversely impacted by delayed program start-ups, yield issues related
to new programs, and start-up expenses for our Beijing factory. None of those
factors were relevant in the third quarter of 1999. As a result of significant
competitive pricing pressures in the LCD module market, we expect the cost of
sales to remain in this range for the next several quarters.
SELLING, GENERAL, AND ADMINISTRATIVE EXPENSE. Selling, general, and
administrative expense increased 58.8% to $2.7 million in the three months ended
September 30, 1999 from $1.7 million in the three months ended September 30,
1998. The increase in selling, general, and administrative expense mostly
relates to the continued expansion of our LCoS microdisplay business. In
particular, in the third quarter of 1999, we incurred approximately $600,000 of
marketing and administrative expenditures relating to our LCoS microdisplay
business compared to approximately $80,000 in the third quarter of 1998. As a
percentage of net sales, selling, general, and administrative expense decreased
to 6.4% in the three months ended September 30, 1999 compared to 7.0% in the
three months ended September 30, 1998. This was as a result of increased sales.
RESEARCH AND TECHNOLOGY EXPENSE. Research and technology expense
increased 84.6% to $2.4 million in the three months ended September 30, 1999
from $1.3 million in the three months ended September 30, 1998. Research and
technology expense was 5.7% of net sales in the three months ended September 30,
1999 compared to 5.1% in the three months ended September 30, 1998. Research and
technology expense overall increased as the result of the development of new
display products and technologies, primarily LCoS microdisplays. LCoS
microdisplays accounted for approximately $1.2 million of research and
technology expense in the three months ended September 30, 1999 compared to
approximately $500,000 in the three months ended September 30, 1998.
OTHER INCOME (EXPENSE), NET. Other expense in the three months ended
September 30, 1999 was $160,000 compared to other expense of $52,000 in the
three months ended September 30, 1998. The difference was a result of increased
interest expense and reduced interest income. The increase in interest expense
was primarily a result of additional borrowing incurred in connection with our
stock repurchase program and increased borrowings on our working capital line of
credit. Reduced interest income was a result of lower cash balances.
PROVISION FOR INCOME TAXES. We had a provision for income taxes of $1.5
million in the three months ended September 30, 1999 compared to a benefit from
income taxes of $291,000 for the quarter ended September 30, 1998. This change
resulted from having income in the three months ended September 30, 1999
compared to a net loss in the same period in 1998.
8
<PAGE> 11
NET INCOME. Net income was $2.0 million, or $0.28 per diluted share, in
the three months ended September 30, 1999 as compared with a net loss of
$403,000, or $0.05 per diluted share, in the three months ended September 30,
1998. Excluding LCoS microdisplay related expenses, our net income for our core
passive display business for the three months ended September 30, 1999 was
approximately $3.1 million, or $0.42 per diluted share.
NINE MONTHS ENDED SEPTEMBER 30, 1999 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
1998
NET SALES. Net sales increased 48.2% to $97.4 million in the nine
months ended September 30, 1999 from $65.7 million in the nine months ended
September 30, 1998. This increase was the result of several new programs,
primarily for Motorola.
COST OF SALES. Cost of sales increased to 81.3% of net sales in the
nine months ended September 30, 1999 from 80.7% in the nine months ended
September 30, 1998. This percentage increase resulted primarily from significant
competitive price pressure in the LCD module market, especially affecting higher
volume programs in the wireless communications industry. In addition, in late
1998 and early 1999, we moved the labor-intensive portion of our Arizona LCD
line and certain chip-on-glass equipment to Manila. Inefficiencies related to
the start-up of the new lines adversely affected manufacturing yields in Manila
during the first quarter of 1999. However, yields improved as the facility
became fully operational in the second quarter of 1999.
SELLING, GENERAL, AND ADMINISTRATIVE EXPENSE. Selling, general, and
administrative expense increased 48.1% to $7.7 million in the nine months ended
September 30, 1999 from $5.2 million in the nine months ended September 30,
1998. Selling, general, and administrative expense was 7.9% of net sales in the
nine months ended September 30, 1999 compared to 7.8% in the nine months ended
September 30, 1998. Although we have leveraged our selling, general, and
administrative costs in our core passive matrix display business, we have
increased the selling, general, and administrative costs that relate to our LCoS
microdisplay business. In the first nine months of 1999, we incurred
approximately $1.4 million of marketing and administrative expenditures relating
to our LCoS microdisplay business compared to approximately $170,000 in the
first nine months of 1998.
RESEARCH AND TECHNOLOGY EXPENSE. Research and technology expense
increased 31.3% to $6.3 million in the nine months ended September 30, 1999 from
$4.8 million in the nine months ended September 30, 1998. Research and
technology expense was 6.4% of net sales in the nine months ended September 30,
1999 compared to 7.4% in the nine months ended September 30, 1998. Although
research and technology expense associated with in-process developments on the
LCD line decreased in the nine months ended September 30, 1999, research and
technology expense overall increased as the result of the development of new
display products and technologies. For example, LCoS microdisplays accounted for
approximately $3.0 million of research and technology expense in the nine months
ended September 30, 1999 compared to approximately $1.5 million in the nine
months ended September 30, 1998.
OTHER INCOME (EXPENSE), NET. Other expense in the nine months ended
September 30, 1999 was $559,000 compared to other income of $247,000 in the nine
months ended September 30, 1998. The difference was a result of increased
interest expense and reduced interest income. The increase in interest expense
was primarily a result of additional borrowing incurred in connection with our
stock repurchase program and increased borrowings on our working capital line of
credit. Reduced interest income was a result of lower cash balances.
PROVISION FOR INCOME TAXES. We had a provision for income taxes of $1.3
million in the nine months ended September 30, 1999 compared to a provision for
income taxes of $1.2 million in the nine months ended September 30, 1998.
Although we had higher pre-tax income in the nine months ended September 30,
1999 compared to the same period in 1998, we recorded a one-time tax benefit in
the first quarter of 1999 relating to a state income tax refund. Excluding this
one-time item, however, our tax rate has generally been between 38% and 42% in
the last two years. We expect the rate to be approximately 40% in 2000.
NET INCOME. Net income increased 41% to $2.4 million, or $0.34 per
diluted share, in the nine months ended September 30, 1999 from $1.7 million, or
$0.21 per diluted share, in the nine months ended September 30, 1998. Excluding
LCoS microdisplay related expenses, our net income for our core passive display
business for the nine months ended September 30, 1999 was approximately $4.9
million, or $0.69 per diluted share.
9
<PAGE> 12
QUARTERLY RESULTS OF OPERATIONS
The following table presents unaudited consolidated statement of
operations data for each of the seven quarters in the period ended September 30,
1999, as well as such data expressed as a percentage of net sales. We believe
that all necessary adjustments have been included to present fairly the
quarterly information when read in conjunction with the Consolidated Financial
Statements. The operating results for any quarter are not necessarily indicative
of the results for any subsequent quarter.
<TABLE>
<CAPTION>
QUARTERS ENDED
---------------------------------------------------------------------------------
(IN THOUSANDS)
1998 1999
------------------------------------------ ----------------------------------
MAR 31 JUN 30 SEPT 30 DEC 31 MAR 31 JUN 30 SEPT 30
------ ------ ------- ------ ------ ------ -------
<S> <C> <C> <C> <C> <C> <C> <C>
Net sales $ 18,479 $ 22,682 $ 24,572 $ 29,314 $ 23,044 $ 31,600 $ 42,723
-------- -------- --------- -------- --------- --------- ---------
Cost and expenses:
Cost of sales 13,687 17,095 22,243 23,124 20,191 25,103 33,882
Selling, general, and administrative 1,619 1,815 1,721 2,179 2,449 2,493 2,741
Research and technology 1,689 1,904 1,250 2,316 1,821 2,008 2,427
-------- -------- --------- -------- --------- --------- ---------
16,995 20,814 25,214 27,619 24,461 29,604 39,050
-------- -------- --------- -------- --------- --------- ---------
Operating income (loss) 1,484 1,868 (642) 1,695 (1,417) 1,996 3,673
Other income (expense), net 175 124 (52) (289) (185) (214) (160)
-------- -------- --------- -------- --------- --------- --------
Income (loss) before provision for (benefit
from) income taxes 1,659 1,992 (694) 1,406 (1,602) 1,782 3,513
Provision for (benefit from) income taxes 664 869 (291) 531 (960) 742 1,476
-------- -------- --------- -------- --------- --------- ---------
Net income (loss) $ 995 $ 1,123 $ (403) $ 875 $ (642) $ 1,040 $ 2,037
======== ======== ========= ======== ========= ========= =========
</TABLE>
<TABLE>
<CAPTION>
PERCENTAGE OF NET SALES
QUARTERS ENDED
---------------------------------------------------------------------------------
1998 1999
------------------------------------------ ----------------------------------
MAR 31 JUN 30 SEPT 30 DEC 31 MAR 31 JUN 30 SEPT 30
------ ------ ------- ------ ------ ------ -------
<S> <C> <C> <C> <C> <C> <C> <C>
Net sales 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
------ ------ ------ ------ ------ ------ -----
Cost and expenses:
Cost of sales 74.1 75.4 90.5 78.9 87.6 79.4 79.3
Selling, general, and administrative 8.8 8.0 7.0 7.4 10.6 7.9 6.4
Research and technology 9.1 8.4 5.1 7.9 7.9 6.4 5.7
------- ------- ------- ------- ------ ------ -------
92.0 91.8 102.6 94.2 106.1 93.7 91.4
------- ------- ------- ------- ------ ------ -------
Operating income (loss) 8.0 8.2 (2.6) 5.8 (6.1) 6.3 8.6
Other income (expense), net 1.0 0.6 (0.2) (1.0) (0.9) (0.7) (0.4)
------- ------- ------- ------- ------ ------ -------
Income (loss) before provision for (benefit
from) income taxes 9.0 8.8 (2.8) 4.8 (7.0) 5.6 8.2
Provision for (benefit from) income taxes 3.6 3.8 (1.2) 1.8 (4.2) 2.3 3.4
------- ------- ------- ------- ------ ------ -------
Net income (loss) 5.4% 5.0% (1.6)% 3.0% (2.8)% 3.3% 4.8%
======= ======= ======== ======= ======= ====== =======
</TABLE>
Historically, we have experienced seasonal fluctuations in our net
sales. OEM customers that purchase our products for incorporation into retail
products typically increase their purchases during the year-end holiday period
and phase out old programs early in the year following holiday sales. As a
result, net sales typically peak in the fourth quarter and reach a seasonal low
point in the first quarter.
There is significant pricing pressure in higher volume programs in the
wireless communications and office automation industries. In addition,
high-volume programs that generally have lower gross margins began to represent
a larger percentage of net sales in the second half of 1998, thereby increasing
the cost of sales. In the third quarter of 1998, we also started several new
programs and incurred substantial start-up costs on those new programs. In the
first quarter of 1999, we
10
<PAGE> 13
had an unfavorable product mix, shipping principally lower margin products.
In addition, reduced manufacturing yields and under-absorption of fixed overhead
contributed to an increased cost of sales.
We started new manufacturing operations in Beijing in 1998. Our cost of
sales in the second and third quarters of 1998 were adversely affected by
start-up costs associated with these operations, which were incurred in advance
of the receipt of significant sales.
In 1998, we continued to expand and intensify our research and
technology efforts on proprietary display products, such as LCoS microdisplays,
as well as ongoing LCD manufacturing process improvements, including increased
use of the LCD manufacturing line at our Arizona facility. Research and
technology expense declined in the third quarter of 1998 as process developments
on the LCD line subsided and third-party expenditures were postponed. Other
expense increased in the last half of 1998 as our cash balances declined and we
increased our borrowings.
LIQUIDITY AND CAPITAL RESOURCES
At September 30, 1999, we had cash and cash equivalents of $7.5 million
compared to cash and cash equivalents of $4.9 million at December 31, 1998. We
sold approximately 2.0 million shares of our common stock in a secondary
offering on September 27, 1999. Since we did not receive the $36.6 million in
proceeds from that offering until October 1, 1999, those proceeds were reflected
as "Receivable from Equity Offering" in the September 30, 1999 balance sheet.
Taking into account expenses, the net proceeds from the equity offering were
$36.2 million.
During the first nine months of 1999, we had $4.2 million net cash flow
from operations compared to $5.9 million in net cash outflow from operations
during the first nine months of 1998. Cash flow from operations improved
primarily as a result of increased income, depreciation and inventory turns
during the nine months ended September 30, 1999 as compared with the same period
in 1998.
Our working capital was $56.3 million at September 30, 1999, up from
$24.8 million at December 31, 1998. Our current ratio at September 30, 1999 was
2.7-to-1 compared to 2.5-to-1 at December 31, 1998. The increase in our working
capital and current ratio occurred primarily because of the completion of our
secondary offering of approximately 2.0 million shares. Including our cash, cash
equivalents, and available credit facilities, we had approximately $15.4 million
in readily available funds at September 30, 1999 compared to $21.9 million at
December 31, 1998. In addition, we had a Receivable from Equity Offering of
$36.6 million, the proceeds of which were received on October 1, 1999.
In November 1998, we entered into a $25.0 million secured credit
facility with Imperial Bank and the National Bank of Canada. The credit facility
consists of a $15.0 million revolving line of credit that matures in 2000, which
is available for general corporate purposes, and a $10.0 million term loan
facility that matures in 2004, which provides available funds to repurchase our
common stock. At September 30, 1999, $8.1 million of borrowings were outstanding
under the term loan facility as a result of our purchase of almost one million
shares of our own common stock. In addition, we had a $9.0 million outstanding
balance on the revolving line of credit facility. Both loans were paid off in
full on October 1, 1999 with the cash proceeds received from the equity
offering. As a result of that payoff, the term loan facility has been closed and
only the $15.0 million revolving line of credit facility remains available.
Advances under that facility 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.
In July 1999, we purchased certain assets and licensed silicon
technologies from National Semiconductor relating to LCoS microdisplays for
approximately $3.0 million in cash and warrants to purchase 70,000 shares of our
common stock. Substantially all of the purchase price was allocated to
depreciable assets, tooling and mask rights, and amortizable licenses.
Capital expenditures during the first nine months of 1999 were
approximately $10.9 million compared to $6.4 million during the first nine
months of 1998. Capital expenditures for the first nine months of 1999 consisted
primarily of $5.1 million for equipment and construction costs relating to our
manufacturing facility in Beijing and $4.3 million for microdisplays, mostly
related to the acquisition of the assets of National Semiconductor's
microdisplay business. We anticipated the initial facilities and capital cost
for our operations in Beijing to be approximately $10.0 to $12.0 million. We
expect to incur additional capital costs as we add additional manufacturing
lines in Beijing. To date, we have expended approximately $10.5 million in
Beijing for manufacturing, equipment, building construction, and land costs.
11
<PAGE> 14
We believe that our existing balances of cash and cash equivalents,
anticipated cash flows from operations, the proceeds of the equity offering, and
available and anticipated credit lines will provide adequate sources to fund our
operations and planned expenditures through 2000. Should we encounter additional
cash requirements, however, we may have to expand our loan commitments or pursue
alternate methods of financing or raising capital. For example, accounts
receivable and inventory could rise faster than anticipated if revenue levels
increase more than currently anticipated. In addition, we will continue to seek
other alliances or acquisitions and additional relationships with regard to the
strategic development of various new technologies, especially LCoS
microdisplays, that may also require us to make additional capital investments.
We cannot provide assurance that adequate additional loan commitments or
alternative methods of financing will be available or, if available, that they
will be on terms acceptable to us.
EFFECTS OF INFLATION AND FOREIGN CURRENCY EXCHANGE FLUCTUATIONS
The results of our operations for the periods discussed have not been
significantly affected by inflation or foreign currency fluctuations. We
generally sell our products and services and negotiate purchase orders with our
foreign suppliers in U.S. dollars. The sub-assembly agreement relating to our
operations in Manila, however, is based on a fixed conversion rate, exposing us
to exchange rate fluctuations with the Philippine peso. We have not incurred any
material exchange gains or losses to date. There has been some minor benefit as
a result of the peso devaluation, although we are now required to pay
approximately one-third of any peso devaluation gain to our lessor and direct
labor subcontractor in Manila.
We also have manufacturing operations in Beijing, China. Although the
Chinese currency currently is stable, its value in relation to the U.S. dollar
is determined by the Chinese government. There is general speculation that China
may devalue its currency. Devaluation of the Chinese currency could result in
translation adjustments to our balance sheet as well as reportable losses
depending on our monetary balances and outstanding indebtedness at the time of
devaluation. The government of China historically has made it difficult to
convert its local currency into foreign currencies. Although we from time to
time we have entered into hedging transactions in order to minimize our exposure
to currency rate fluctuations, the Chinese currency is not freely traded and
thus is difficult to hedge. In addition, the government of China has recently
imposed restrictions on Chinese currency loans to foreign-operated entities in
China. Based on the foregoing, there can be no assurance that fluctuations and
currency exchange rates in the future will not have an adverse effect on our
operations.
YEAR 2000 COMPLIANCE DISCLOSURE
Many existing computer programs and databases use only two digits to
identify a year in the date field. For example, "99" would represent 1999. These
programs and databases were designed and developed without considering the
impact of the upcoming millennium. Consequently, date sensitive computer
programs may interpret the date "00" as 1900 rather than 2000. If not corrected,
many computer systems could fail or create erroneous results in 2000.
OUR STATE OF READINESS
We have completed an assessment of all of our internal and external
systems and processes with respect to the year 2000 issue. In response to this
assessment, we have created a multi-functional year 2000 task force to resolve
any non-compliant year 2000 systems or processes. This group has substantially
completed the task. All remaining issues will be completed by mid-November 1999.
We plan to continuously test all of our internal and external systems and
processes, including the associated year 2000 fixes, for year 2000 compliance
during the remainder of 1999. As part of this process, we have assessed the
potential impact of year 2000 failures from vendors and other companies upon our
business and currently are taking steps to minimize that risk. Based on our
current state of readiness and the actions we are currently taking, including
installing backup processes and systems, we do not believe that the year 2000
problem will have a material adverse effect on our financial position,
liquidity, or operations.
OUR COSTS OF YEAR 2000 COMPLIANCE
We estimate that our total costs of year 2000 compliance will be less
than $300,000. These costs include updating of computer software and hardware
manufacturing equipment, as well as employment and other out-of-pocket costs. To
date we have spent $224,000 for the upgrade and testing of our systems.
12
<PAGE> 15
RISKS OF YEAR 2000 ISSUES
We procure a significant amount of raw materials used in our
manufacturing processes from foreign vendors. As a result, we may be at risk
from foreign companies and countries that are not taking adequate measures to
ensure year 2000 compliance or that may not be at the same level of preparedness
as companies in the United States. For example, economic problems in Asia may
affect or divert resources with respect to the year 2000 issue. Failure of those
foreign countries and companies to be year 2000 compliant may cause material
shortages that could adversely impact our manufacturing operations. In addition,
we currently have significant manufacturing operations in Manila and Beijing. As
a result, we may be at risk with respect to suppliers of necessary resources,
such as power or water, that may not be year 2000 compliant. For example,
brownouts or blackouts may occur due to lack of year 2000 compliance. In
addition, some of our customers may experience catastrophic year 2000 failures,
including prolonged interruptions in factory production, in which case they may
have a reduced demand for our products.
OUR CONTINGENCY PLANS
We are developing contingency plans with respect to significant year
2000 issues that are within our control. For example, we are in the process of
assessing and verifying the year 2000 compliance of our international and
domestic raw material vendors. Verification will be accomplished through the use
of written inquiries to suppliers, certifications, audits, and information
provided by suppliers on their web sites. We intend to replace any vendors found
not to be year 2000 compliant with vendors that are year 2000 compliant. In the
construction of our new Beijing facility, we procured material, processes, and
equipment that are year 2000 compliant. We also are investigating the use of
stand-by generators for our plants in the event of local power failures. We are
investigating transferring our manufacturing processes to alternate
manufacturing facilities if external factors beyond our control relative to the
year 2000 issue occur and we cannot conduct manufacturing operations at any
particular facility.
PART II. OTHER INFORMATION
ITEM 5. OTHER INFORMATION
Effective October 11, 1999, we named Dr. Robert L. Melcher Chief
Technology Officer and entered into an employment agreement with Dr. Melcher on
that date. Dr. Melcher began his career in 1970 at IBM Research, and has been at
IBM since that time. Immediately prior to joining us, Dr. Melcher served as
Program Leader for Projection Displays at IBM Research. He was granted stock
options to purchase 60,000 shares of our Common Stock under the 1998 Stock
Option Plan. The options vest over a four-year period and are exercisable at
fair market value as of the date of grant.
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> 16
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
THREE-FIVE SYSTEMS, INC.
-----------------------------
(Registrant)
Dated: October 21, 1999 By: /s/ Jeffrey D. Buchanan
------------------------------------------------
Name: Jeffrey D. Buchanan
Its: Executive Vice President Finance,
Administration and Legal; Chief Financial
Officer
14
<PAGE> 17
EXHIBIT INDEX
EXHIBIT 11: Statement Re: Computation of Per Share Earnings.
EXHIBIT 27: Financial Data Schedule
<PAGE> 1
THREE-FIVE SYSTEMS, INC.
STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS
EXHIBIT 11
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------------- ----------------------------------
1999 1998 1999 1998
-------------- -------------- --------------- ---------------
<S> <C> <C> <C> <C>
Common shares outstanding beginning of period 7,017,836 7,927,085 7,005,107 7,905,523
Effect of Weighting Shares:
Employee stock options exercised 26,541 14,446 16,081 15,203
Issue (purchase) of treasury stock 31,492 (285,680) 2,536 (94,269)
Issue of common stock 33,729 - 11,366 -
-------------- -------------- --------------- ---------------
Basic 7,109,598 7,655,851 7,035,090 7,826,457
============== ============== =============== ===============
Common shares outstanding beginning of period 7,017,836 7,927,085 7,005,107 7,905,523
Effect of Weighting Shares:
Employee stock options exercised 26,541 14,446 16,081 15,203
Employee stock options and warrants
outstanding 211,722 - 129,603 194,815
Issue (purchase) of treasury stock 31,492 (285,680) 2,536 (94,269)
Issue of common stock 33,729 - 11,366 -
-------------- -------------- --------------- ---------------
Diluted 7,321,320 7,655,851 7,164,693 8,021,272
============== ============== =============== ===============
Net income (loss) $ 2,037,000 $ (403,000) $ 2,435,000 $ 1,715,000
============== ============== =============== ===============
Net income (loss) per common share
Basic $ 0.29 $ (0.05) $ 0.35 $ 0.22
============== ============== =============== ===============
Diluted $ 0.28 $ (0.05) $ 0.34 $ 0.21
============== ============== =============== ===============
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED BALANCE SHEET AT SEPTEMBER 30, 1999 AND THE RELATED CONSOLIDATED
STATEMENTS OF INCOME AND OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30,
1999 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> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> SEP-30-1999
<EXCHANGE-RATE> 1
<CASH> 7,474
<SECURITIES> 0
<RECEIVABLES> 63,034
<ALLOWANCES> 690
<INVENTORY> 15,265
<CURRENT-ASSETS> 89,424
<PP&E> 61,261
<DEPRECIATION> 21,342
<TOTAL-ASSETS> 132,868
<CURRENT-LIABILITIES> 16,336
<BONDS> 17,095
0
0
<COMMON> 91
<OTHER-SE> 0
<TOTAL-LIABILITY-AND-EQUITY> 132,868
<SALES> 97,367
<TOTAL-REVENUES> 97,367
<CGS> 79,176
<TOTAL-COSTS> 93,115
<OTHER-EXPENSES> 559
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 3,693
<INCOME-TAX> 1,258
<INCOME-CONTINUING> 2,435
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 2,435
<EPS-BASIC> 0.35
<EPS-DILUTED> 0.34
</TABLE>
