SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For Quarter Ended March 31, 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 MARCH 31, 1999
- ----- --------------------------------
Common 7,012,107
Par value $.01 per share
<PAGE>
THREE-FIVE SYSTEMS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 1999
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION
Page
----
ITEM 1.FINANCIAL STATEMENTS:
Consolidated Balance Sheets-
March 31, 1999 and December 31, 1998................................ 1
Consolidated Statements of Income-
Three Months Ended March 31, 1999 and 1998.......................... 2
Consolidated Statements of Stockholder's Equity-
March 31, 1999 and December 31, 1998................................ 3
Consolidated Statements of Cash Flows-
Three Months Ended March 31, 1999 and 1998.......................... 4
Notes to Consolidated Financial Statements............................ 5
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.................................. 6
PART II - OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K..................................... 13
SIGNATURES................................................................... 14
<PAGE>
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
MARCH 31, DECEMBER 31,
1999 1998
-------- ------------
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 7,369 $ 4,946
Accounts receivable, net 17,659 18,601
Inventories, net 13,278 12,493
Deferred tax asset 2,680 2,680
Other current assets 2,641 2,313
-------- --------
Total current assets 43,627 41,033
PROPERTY, PLANT AND EQUIPMENT, net 34,773 33,314
OTHER ASSETS 3,546 3,557
-------- --------
$ 81,946 $ 77,904
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 12,414 $ 10,649
Accrued liabilities 4,453 4,673
Current taxes payable 309 235
Notes payable 3,000 --
Current portion of long-term debt 1,056 651
-------- --------
Total current liabilities 21,232 16,208
-------- --------
LONG-TERM DEBT 7,039 7,444
-------- --------
DEFERRED TAX LIABILITY 3,156 3,156
-------- --------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Common stock 80 80
Additional paid-in capital 32,549 32,484
Retained earnings 26,207 26,849
Cumulative translation adjustment 8 8
Less - Treasury stock, at cost (8,325) (8,325)
-------- --------
Total stockholders' equity 50,519 51,096
-------- --------
$ 81,946 $ 77,904
======== ========
The accompanying notes are an integral part of these consolidated statements.
1
<PAGE>
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME (LOSS)
(UNAUDITED)
(in thousands, except per share amounts)
THREE MONTHS ENDED
MARCH 31,
-------------------------
1999 1998
-------- --------
NET SALES $ 23,044 $ 18,479
COSTS AND EXPENSES:
Cost of sales 20,191 13,687
Selling, general and administrative 2,449 1,619
Research and technology 1,821 1,689
-------- --------
24,461 16,995
-------- --------
Operating income (loss) (1,417) 1,484
-------- --------
OTHER INCOME (EXPENSE):
Interest, net (155) 192
Other, net (30) (17)
-------- --------
INCOME (LOSS) BEFORE PROVISION FOR
(BENEFIT FROM) INCOME TAXES: (1,602) 1,659
Provision for (benefit from) income taxes (960) 664
-------- --------
NET INCOME (LOSS) $ (642) $ 995
======== ========
EARNINGS (LOSS) PER COMMON SHARE:
Basic $ (.09) $ .13
======== ========
Diluted $ (.09) $ .12
======== ========
WEIGHTED AVERAGE NUMBER OF COMMON SHARES:
Basic 7,009 7,907
======== ========
Diluted 7,009 8,165
======== ========
The accompanying notes are an integral part of these consolidated statements.
2
<PAGE>
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE PERIOD ENDED DECEMBER 31, 1998 AND MARCH 31, 1999
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
Common Stock
----------------- Additional
Shares Paid-in Retained
Issued Amount Capital Earnings
------ ------ ------- --------
<S> <C> <C> <C> <C>
BALANCE, December 31, 1998 7,974,901 $ 80 $32,484 $ 26,849
Net Loss -- -- -- (642)
Other comprehensive income--
Foreign currency translation
adjustments -- -- -- --
Comprehensive income -- -- -- --
Stock options exercised 7,000 -- 65 --
--------- ---- ------- --------
BALANCE, March 31, 1999 (unaudited) 7,981,901 $ 80 $32,549 $ 26,207
========= ==== ======= ========
Cumulative Total
Treasury Translation Stockholders' Comprehensive
Stock Adjustment Equity Income
----- ---------- ------ ------
BALANCE, December 31, 1998 ($8,325) $ 8 $ 51,096
Net Loss -- -- (642) ($642)
Other comprehensive income--
Foreign currency translation
adjustments -- -- -- --
-----
Comprehensive income -- -- -- ($642)
=====
Stock options exercised -- -- 65
------- ---- --------
BALANCE, March 31, 1999 (unaudited) ($8,325) $ 8 $ 50,519
======= ==== ========
</TABLE>
The accompanying notes are an integral part of these consolidated statements.
3
<PAGE>
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
THREE MONTHS ENDED
MARCH 31,
---------------------
1999 1998
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ (642) $ 995
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Depreciation and amortization 1,279 1,078
Provision for accounts receivable valuation reserves 45 9
Provision for (reduction of) inventory
valuation reserves 61 (1,114)
Changes in assets and liabilities:
(Increase) decrease in accounts receivable 898 (278)
(Increase) decrease in inventories (845) (3,496)
(Increase) decrease in other assets (328) (240)
Increase (decrease) in accounts payable and
accrued liabilities 1,544 1,128
Increase (decrease) in taxes payable, net 73 1,160
-------- --------
Net cash provided by (used in) operating
activities 2,085 (758)
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, plant and equipment (2,727) (1,675)
-------- --------
Net cash used in investing activities (2,727) (1,675)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from (payments on) notes payable
to banks 3,000 --
Stock options exercised 65 3
-------- --------
Net cash provided by financing activities 3,065 3
-------- --------
Effect of exchange rate changes on cash -- 2
-------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 2,423 (2,428)
CASH AND CASH EQUIVALENTS, beginning of period 4,946 16,371
-------- --------
CASH AND CASH EQUIVALENTS, end of period $ 7,369 $ 13,943
======== ========
The accompanying notes are an integral part of these consolidated statements.
4
<PAGE>
ITEM 1. (continued)
THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS
Note A The accompanying unaudited Consolidated Financial Statements have
been prepared in accordance with generally accepted accounting
principles for interim financial information and the instructions to
Form 10-Q. Accordingly, they do not include all the information and
footnotes required by generally accepted accounting principles for
complete financial statements. In the opinion of management, all
adjustments (which include only normal recurring adjustments)
necessary to present fairly the financial position, results of
operations, stockholders' equity and cash flows for all periods
presented have been made. The results of operations for the
three-month period ended March 31, 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 Company's December 31, 1998 financial statements
and accompanying notes thereto.
Note B Basic earnings per common share are computed by dividing net income
(loss) by the weighted average number of shares of common stock
outstanding during the three-month period. Diluted earnings (loss) per
common share for the three month period ended March 31, 1998 are
determined assuming that options were exercised at the beginning of
the period or at the time of issuance, if later. No outstanding
options were assumed to be exercised for purposes of calculating
diluted earnings per share for the three months ended March 31, 1999,
as their effect was anti-dilutive.
Note C Inventories consist of the following at:
March 31, 1999 December 31, 1998
-------------- -----------------
(Unaudited)
(in thousands)
Raw materials $ 9,354 $ 9,367
Work-in-process 1,456 1,459
Finished goods 2,468 1,667
------- -------
$13,278 $12,493
======= =======
Note D Property, plant, and equipment consist of the following at:
March 31, 1999 December 31, 1998
-------------- -----------------
(Unaudited)
(in thousands)
Building and improvements $ 14,670 $ 13,031
Furniture and equipment 38,413 37,324
-------- --------
53,083 50,355
Less - accumulated depreciation (18,310) (17,041)
-------- --------
$ 34,773 $ 33,314
======== ========
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.
5
<PAGE>
<TABLE>
<CAPTION>
United United
March 31, 1999 States Kingdom China Philippines Eliminations Total
- -------------- ------ ------- ----- ----------- ------------ -----
<S> <C> <C> <C> <C> <C> <C>
Net sales $ 6,948 $ 10,351 $5,745 $ -- $ -- $ 23,044
Intersegment sales 15,091 -- 1,145 791 (17,027) --
Operating income (loss) (1,954) 137 57 15 143 (1,602)
United United
March 31, 1998 States Kingdom China Philippines Eliminations Total
- -------------- ------ ------- ----- ----------- ------------ -----
Net sales $ 13,999 $ 4,480 $ -- $ -- $ -- $ 18,479
Intersegment sales 4,114 -- -- 598 (4,712) --
Operating income (loss) 1,644 (26) -- 13 28 1,659
</TABLE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
THREE MONTHS ENDED MARCH 31, 1999 COMPARED WITH THREE MONTHS ENDED
MARCH 31, 1998.
Net sales were $23.0 million for the quarter ended March 31, 1999, an
increase of 24.3 percent compared with net sales of $18.5 million for the
quarter ended March 31, 1998. This increase was attributed primarily to new
business in Asia for the Company's key customer. The Company believes that it
may have some seasonality to its sales. Many of the Company's products are
components in retail products, such as telecommunication products, for which
sales in the first calendar quarter are historically slow. During the first
quarter of 1999, sales to Motorola, Inc. represented 75 percent of the Company's
revenue.
Cost of sales, as a percentage of net sales, increased to 87.6 percent
for the quarter ended March 31, 1999 as compared with 74.1 percent for the
quarter ended March 31, 1998. Gross margin was lower than the desired range for
three principal reasons: under-absorption of fixed overhead, yield issues, and
product mix. With regard to the first issue, the Company's facility in Manila
was somewhat under-utilized during the quarter and therefore did not fully
absorb all of the fixed overhead. Part of the reason for the under-utilization
was that the Company's new facility in China produced approximately 30 percent
of the Company's volume during the quarter. The Company expects to level the
manufacturing output from China this year and use the Manila facility to handle
quarterly fluctuations. The Company expects that it will more fully utilize the
Manila facility as the year progresses.
With regard to the yield issues, in late 1998 and early 1999 the
Company moved the labor-intensive portion of the LCD line and certain
chip-on-glass equipment to Manila. The yields have been lower in Manila due to
learning curve issues, but it the Company expects that in the second quarter
Manila will achieve comparable yields to those achieved in Tempe.
The third reason for the lower-than-desired gross margin was the
Company's product mix in the first quarter of 1999. As a result of a variety of
issues, including material shortages, customer demand, and engineering delays,
the Company's product mix for this quarter had an unusually low margin. In
addition, the competition from Asian-based suppliers has intensified in the last
few months, keeping pressure on margins in the Company's core business. The
Company expects that its margins will improve, however, from these levels
throughout the remainder of 1999.
The China facility reported a small profit in the first quarter on
sales of $6.9 million. All expenses relating to the China operations are
included in the overall cost of sales. Therefore, even though China was
profitable, the small net margin in China adversely affects the Company's
overall gross margins. The Company expects that net margins in China will
increase as it adds more manufacturing lines in China and improves manufacturing
yields.
Selling, general, and administrative expense of $2.4 million for the
quarter ended March 31, 1999 was higher than the selling, general, and
administrative expense of $1.6 million for the quarter ended March 31, 1998.
6
<PAGE>
Selling, general, and administrative expenses have increased as the Company has
expanded its infrastructure to accommodate the international focus in sales and
marketing, the increasing number of customers, and the expected increase in
sales and production throughout the remainder of the year. In addition, the
Company had significant executive recruiting expenses in the quarter as a result
of the CEO and CTO searches.
Research and technology ("R&T") expense totaled $1.8 million for the
quarter ended March 31, 1999 as compared with $1.7 million for the quarter ended
March 31, 1998. R&T expenses consist principally of salaries and benefits to
design engineers, research scientists and other personnel, related facilities
costs, and various expenses for custom designed programs and new technology
development projects. The Company generally expects that a significant portion
of R&T will relate to third-party project expenses, and the Company did not have
as much of those expenses in the first quarter of 1999 as originally
anticipated. During the next several quarters, R&T expenditures may fluctuate as
the Company funds various technology projects. R&T expense has increased as the
Company has invested in new technologies, such as LCoS(TM) microdisplays, and
manufacturing processes, and has continued with its in-house process development
efforts related to the high-volume manufacturing LCD line located in Tempe,
Arizona. The Company believes that continued investments in research and
development relating to manufacturing processes and new display technologies
will be necessary to remain competitive in its marketplace and to provide
opportunities for growth.
Interest expense (net) for the quarter ended March 31, 1999 was
$155,000, as compared with interest income of $192,000 for the quarter ended
March 31, 1998. The Company's interest expense was primarily a result of its
stock repurchase program re-introduced in the middle of 1998, which the Company
financed with debt. Other expense (net) was $30,000 for the quarter ended March
31, 1999 as compared with $17,000 for the quarter ended March 31, 1998.
The Company reported a loss before taxes of $1.6 million for the
quarter ended March 31, 1999, as compared with income before taxes of $1.7
million dollars for the quarter ended March 31, 1998. As a result of the
reported loss, the Company recognized a benefit from taxes of $960,000 for the
quarter ended March 31, 1999, as compared with a provision for taxes of $664,000
for the quarter ended March 31, 1998. Included in the benefit from income taxes
was a one-time benefit of $295,000 related to an expected tax refund for
previous years. The Company expects that the overall tax rate for 1999 will
approximate its historical rate of 40 percent. This rate eventually may drop a
few percentage points as the Company increases the profitability of its
manufacturing operations in the People's Republic of China, where the corporate
tax rate is lower. The actual worldwide tax rate, however, will depend on a
variety of factors, including intercompany transfer pricing, the amount of sales
in China, the profitability of China operations, and whether any intercompany
dividends are declared.
The Company reported a net loss of $642,000, or $0.09 per share
(diluted), for the quarter ended March 31, 1999, as compared with net income of
$995,000, or $0.12 per share (diluted), for the quarter ended March 31, 1998.
LIQUIDITY AND CAPITAL RESOURCES
During the first three months of 1999, the Company had $2.1 million in
positive cash flow from operations as compared with $758,000 in negative cash
flow during the first three months of 1998. The positive cash flow from
operations was primarily due to the increase in accounts payable and
depreciation and decrease in accounts receivable. Overall, the Company's
depreciation expense has risen approximately 18.6 percent since the first
quarter of 1998. The high-volume LCD line is depreciated on a
units-of-production method based on units started. The Company anticipates that
depreciation will continue to increase throughout 1999 as a result of additional
capital expenditures, including the start-up of the new building in China and an
expected higher number of starts for the high-volume LCD manufacturing line in
1999 versus 1998. Capital expenditures expected in 1999 include the completion
of the new building and equipment for the permanent manufacturing facility in
China and the installation of additional equipment in the Arizona and Manila
manufacturing locations.
The Company's working capital was $22.4 million at March 31, 1999, a
decrease from $24.8 million at December 31, 1998. The Company's current ratio at
March 31, 1999 was 2.1-to-1 as compared with a current ratio of 2.5-to-1 at
December 31, 1998. Including its cash and loan commitments, the Company had over
$21.6 million in readily available funds on March 31, 1999.
7
<PAGE>
In November 1998, the Company entered into a $25.0 million secured
revolving line of credit with Imperial Bank and the National Bank of Canada. The
credit facility matures in May 2000 and consists of a $15.0 million revolving
line of credit, which will be available for general corporate purposes (the
"General Facility"), and a $10.0 million long-term loan, which will provide
available funds to repurchase the Company's stock (the "Repurchase Facility").
At March 31, 1999, $8.1 million of borrowings were outstanding under the
Repurchase Facility. Advances under the loans 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 for the General Facility and 225 basis points in
excess of the LIBOR Base Rate for the Repurchase Facility.
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 July 1999. Three-Five Systems Limited had no borrowings outstanding
under this line of credit at March 31, 1999.
Capital expenditures during the first quarter of 1999 were
approximately $2.7 million, as compared with $1.7 million during the first
quarter of 1998. Capital expenditures for the first quarter of 1999 consisted of
$1.8 million for the new China manufacturing facility and $900,000 for
improvements in Arizona. The Company anticipates that its capital expenditures
during 1999 will primarily relate to its China facility, advanced manufacturing
processes, the high-volume LCD line, and necessary manufacturing equipment. The
Company anticipates remaining capital expenditures in 1999 to be approximately
$8.0 to $9.0 million.
The Company anticipates that accounts receivable and inventory may rise
in 1999 if revenue levels increase as currently anticipated. The Company
believes that its existing capital and anticipated cash flow from operations and
credit lines will provide adequate sources to fund operations and planned
expenditures throughout 1999. Should the Company encounter additional cash
requirements, however, the Company may have to expand its loan commitments or
pursue alternate methods of financing or raising capital. The Company cannot
provide assurance, however, that adequate additional financing will be available
or, if available, that such financing will be on terms acceptable to the
Company.
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
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 the peso devaluation,
although the Company is now required to pay approximately one-third of any peso
devaluation gain to its lessor and direct labor subcontractor in Manila.
The Company has manufacturing operations in the People's Republic of
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 in response to the current Asian
economic situation. Devaluation of the Chinese currency could result in
translation adjustments to the Company's balance sheet as well as reportable
losses depending on accounts receivable, monetary balances, and loans of the
Company based on Chinese currency at the time of devaluation. Recently, the
government in China has made it difficult to convert its local currency into
foreign currencies. Although the Company from time to time may enter into
hedging transactions in order to minimize its exposure to currency rate
fluctuations, the Chinese currency is not freely traded and thus is difficult to
hedge. In addition, the government of China has recently imposed restrictions on
Chinese currency loans to foreign-operated entities in China. Based on the
foregoing, there can be no assurance that fluctuations and currency exchange
rates in the future will not have an adverse affect on the Company's operations.
8
<PAGE>
BUSINESS OUTLOOK AND RISK FACTORS
This Business Outlook section has numerous forward-looking statements.
Some of the risk factors associated with those forward-looking statements are
set forth in "Risk Factors" below.
The Company offers advanced design and manufacturing services to
original equipment manufacturers. The Company specializes in custom displays and
front panel displays primarily utilizing liquid crystal display (LCD)
technology. Sales in 1998 increased by about 12.3 percent over 1997, but net
profit declined as the Company increased R&T expenses significantly, incurred
start-up expenses for China, and experienced pricing pressures from its Asian
competitors, partially as a result of the Asian economic situation.
In 1998, the Company recorded almost 57 percent of its revenue in the
third and fourth quarters. Fourth quarter revenue in 1998 was almost 60 percent
greater than first quarter revenues in 1998. In 1999, the Company anticipates
that this type of revenue pattern will be repeated. The Company believes that it
has a pattern of seasonality to its sales as OEMs with retail products develop
shorter product life cycles and phase out old programs early in the year
following holiday sales.
The Company has undertaken efforts to diversify its business, broaden
its customer base, and expand its markets. The Company's historical major
customer, 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. Recently, however,
the Company's business with that customer has increased at a rate faster than
business with other customers. As a result, sales to that customer represented
64 percent of the Company's revenue in 1998 and 75 percent of the of the
Company's revenue in the first quarter of 1999. For the full year 1999, the
Company expects its business with that customer to remain in that range during
the entire year. The Company also expects to increase sales to other customers
during the second half of 1999 and in 2000. Currently, no other customer
accounts for more than 10 percent of the Company's revenue.
Several factors impact the Company's gross margins, including
manufacturing efficiencies, product differentiation, product uniqueness,
billings for non-recurring engineering services, inventory management,
engineering costs, product mix, and volume pricing. Significant pricing pressure
exists in higher volume programs in the telecommunications industries. As the
production levels of some of the Company's new high-volume programs increase,
the lower standard gross margins on those programs continue to impact the
Company's overall margins. In addition, in an effort to secure sales to certain
strategic customers, the Company has in the past, and may in the future,
aggressively price its products. Depending on the size of the programs achieved,
such pricing strategies will have an effect on overall margins.
The Company's gross margins on its products also are typically lower at
the start of a program as a result of yield and other start-up issues. The
Company expects to start up several new programs throughout 1999.
The Company started operations in China in 1998, and the Company's
gross margins have been adversely affected by the start-up of those China
manufacturing operations. As the Company ramped up its manufacturing operations
in China, it incurred costs in advance of the receipt of significant revenues.
All expenses related to the operations in China are included in the overall cost
of sales. In the fourth quarter of 1998 and in the first quarter of 1999, the
Company had a small profit in China because significant increases in
manufacturing volumes resulted in absorption of the existing costs. Although
profitable, the low net margin adversely affects the Company's overall gross
margins. In the next few quarters, profitability in China will be
volume-dependent. In the long run, however, the Company expects the operations
in China to positively impact gross margins because of certain competitive cost
advantages provided by maintaining operations in China.
The Company anticipates that weakened Asian currencies will have a
continued impact on the Company's gross margins. Many of the Company's
competitors are Asian suppliers, and a strong U.S. dollar gives a competitive
pricing advantage to those suppliers. Thus, the Company expects to see continued
competitive margin pressure from Asian suppliers.
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 Company expects
that the volume and complexity of its business will continue to grow. In
addition, the Company has expanded its marketing function as it has expanded the
technologies its offers. As a result, the Company anticipates that its selling
and administrative expenses for 1999 will increase significantly over 1998.
9
<PAGE>
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 to 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. Some of the Company's new display technologies also require the
development of application specific integrated circuits ("ASICs") to
electronically drive the displays. Development of custom ASICs is a lengthy and
expensive process.
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. For example, in 1997 National
Semiconductor Corporation and the Company entered into a strategic supplier
alliance agreement for the development and manufacture of LCoS(TM)
microdisplays. In April 1998, the Company acquired a minority interest in
inViso, Inc. (formerly known as Siliscape, Inc.), a start-up company with
numerous patents and proprietary technology relating to microdisplays. The
Company and inViso also entered into a strategic agreement under which they will
focus on the development of microdisplay products, with the Company providing
certain proprietary manufacturing capabilities and inViso 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. The Company intends to continue this internal
and external focus on research and development indefinitely. As a result, the
actual dollar amount of such research and development expenditures in 1999
should increase over 1998.
In the second quarter of 1998, the Company established manufacturing
operations at a temporary leased site in Beijing, China. From that temporary
factory, the Company shipped over $5.7 million in products in the fourth quarter
of 1998 and $6.9 million in products in the first quarter of 1999. The Company
is currently constructing a permanent factory, which the Company expects to
occupy by late summer 1999.
The Company has established a China-based manufacturing operation for
several reasons. First, based upon growth expectations in the European and
United States marketplaces, the Company anticipated 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 also is expected to be a synergistic business location for the Company
because many of the components used by the Company are manufactured in China.
Further, many of the Company's existing and potential customers maintain
manufacturing operations near the Company's operations in China. Under current
Chinese government rules, OEMs in China have a strong motivation to utilize
locally manufactured components.
RISK FACTORS
Forward-looking statements in this Report include revenue, margin,
expense, and earnings analysis for 1999 as well as the Company's expectations
relating to operations in China; future technologies; and future designs,
inventory balances, and production orders. The Company's future operating
results may be affected by various trends, developments, and factors that the
Company must successfully manage in order to achieve its goals. In addition,
there are trends, developments, and factors beyond the Company's control that
may affect its operations. The cautionary statements and risk factors set forth
below and elsewhere in this Report, and in the Company's other filings with the
Securities and Exchange Commission, identify important trends, factors, and
currently known developments that could cause actual results to differ
materially from those in any forward-looking statements contained in this Report
and in any written or oral statements of the Company.
A few core customers currently are responsible for a majority of the
Company's revenue, and the Company expects the high concentration levels with
its core customers to continue through 2000. 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.
10
<PAGE>
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. Customers generally do
not provide firm long-term volume purchase commitments to the Company. Thus,
customers can cancel purchase commitments and change or delay expected volume
levels. The Company cannot provide assurance that it will be able to replace
canceled, delayed, or reduced commitments in a timely manner. If customers
cancel, delay, or reduce commitments, the Company could be left holding excess
and obsolete inventory or having unfavorable manufacturing variances as a result
of under-absorption. These risks are exacerbated because the Company expects
that a majority of its sales will be to customers in the retail electronics
industry, which is subject to severe competitive pressures, rapid technological
change, and obsolescence. A few of the Company's customers have inquired about
inventory hubbing agreements, pursuant to which the Company will maintain stocks
of finished goods at or near the customer's factory. Although the Company has
not yet entered into such agreements with any of its customers, the use of such
type of agreements could result in higher inventory balances for the Company
and/or excess inventory.
Another risk inherent in custom manufacturing is the satisfactory
completion of design services and securing of production orders. The Company
anticipates that a significant portion of its revenue for the future will come
from programs currently in the design or pilot production stage. Completion of
the design depends 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 currently is investing in research and development of
several new technologies that it plans to introduce in the future. The Company
faces the risk that some or all of those technologies may not successfully make
the transition from the research and development lab to cost-effective
manufacturability as a result of technology problems, competitive cost issues,
yield problems, and other factors. In addition, even if a new technology proves
to be manufacturable, the Company's customers and the customers' marketplaces
may not accept it because of price or technology issues or because it compares
unfavorably with products introduced by others. The Company will be required to
make significant expenditures, including development expenses and various
capital expenditures and investments, for these new technologies. For example,
the Company estimates that its capital expenditures for LCoS(TM) microdisplays
will be approximately $3.0 million to $4.0 million. The Company also made an
equity investment of $3.3 million in inViso during 1998 for the purposes of
further developing the LCoS(TM) microdisplay product. Significant investments in
one or more of the new technologies, especially LCoS(TM) microdisplays, that
ultimately prove to be unsuccessful for any reason could have a material adverse
impact on the Company. In addition, if inViso were to encounter technological or
financial difficulties, the value of the Company's investment could become
permanently impaired, in which case the Company would have to write down all or
a portion of its investment and report a loss equal to such write-down.
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 from time to time have been subject to allocation because of shortages
by vendors and continued or increased shortages could have a material adverse
effect on the Company in the future. In fact, the Company could have shipped at
least $3.0 million in additional product in the first quarter of 1999 if
integrated circuit ("IC") shortages had not existed. The Company expects the IC
shortage to continue in the next few quarters. In addition, the Company
purchases many product components from vendors in Asian countries. 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
currency devaluation of several Asian countries has had, and could continue to
have, a negative impact on the Company's gross margins as the competitors'
products become less expensive to purchase with a stronger dollar. Pricing
competition intensified in the first quarter of 1999 and is expected to
continue.
11
<PAGE>
The Company has set up manufacturing operations in Beijing in an
interim leased facility while construction is completed on a permanent facility.
If there are delays in the completion of the permanent facility, the Company may
run into capacity issues in the interim facility because of space constraints
and/or power requirements. In addition, the Company has a short-term lease on
the interim facility and could be required to move out if there are delays in
the completion of the permanent facility, which would severely interrupt the
Company's manufacturing operations in China. Further, moving from the temporary
factory to the permanent factory could also interrupt the Company's Chinese
manufacturing operations. Over the long term, 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 started up operations in China is
because the Company believed that its Manila manufacturing facility would begin
to have capacity issues in 1999. Failure to begin operations in the permanent
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. The Company cannot provide
assurance that it 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.
YEAR 2000 COMPLIANCE DISCLOSURE
Many existing computer programs and databases use only two digits to
identify a year in the date field (I.E., 99 would represent 1999). These
programs and databases were designed and developed without considering the
impact of the upcoming millennium. Consequently, date sensitive computer
programs may interpret the date "00" as 1900 rather than 2000. If not corrected,
many computer systems could fail or create erroneous results in 2000.
The following disclosure is as required by SEC Release No. 33-7558.
COMPANY'S STATE OF READINESS
The Company has completed an assessment of all of its internal and
external systems and processes with respect to the "Year 2000" issue. In
response to this assessment, the Company has created a multi-functional Year
2000 task force to resolve any non-compliant Year 2000 systems or processes. To
date, this group is on schedule to complete this task during 1999. The Company
plans to continuously test all of its internal and external systems and
processes, including the associated Year 2000 "fixes," for Year 2000 compliance
during 1999. As part of this process, the Company has assessed the potential
impact of Year 2000 failures from vendors and outside parties upon its business
and currently is taking steps to minimize that risk. Based on the Company's
current state of readiness and the steps currently being taken (I.E., installing
backup processes and systems), the Company does not believe that the Year 2000
problem will have a material adverse effect on the Company's financial position,
liquidity, or operations.
12
<PAGE>
COMPANY'S COSTS OF YEAR 2000 COMPLIANCE
The Company estimates that its total cost of Year 2000 compliance will
be less than $100,000. Those costs include updating of computer software and
hardware manufacturing equipment, as well as employment and other out-of-pocket
costs.
COMPANY'S RISKS OF YEAR 2000 ISSUES
The Company procures a significant amount of raw materials used in its
manufacturing processes from foreign vendors. As a result, the Company may be at
risk from foreign companies and countries that are not taking adequate measures
to ensure Year 2000 compliance or that may not be at the same level of
preparedness as the United States. For example, economic problems in Asia may
affect or divert resources with respect to the Year 2000 issue. Failure of those
foreign countries and companies to be Year 2000 compliant may cause new material
shortages that would adversely impact the Company's manufacturing operations. In
addition, the Company currently has significant manufacturing operations in
Manila, the Philippines and Beijing, China. As a result, the Company may be at
risk with respect to suppliers of necessary resources (such as power or water)
that may not be Year 2000 compliant. For example, brownouts or blackouts may
occur due to lack of Year 2000 compliance. In addition, the Company's customers
may have catastrophic Year 2000 failures, including prolonged interruptions in
factory productions, in which case they may have a reduced demand for the
Company's products.
COMPANY'S CONTINGENCY PLANS
The Company is developing contingency plans with respect to significant
Year 2000 issues within its control. For example, the Company is in the process
of assessing and verifying the Year 2000 compliance of its international and
domestic raw material vendors. Verification will be accomplished through the use
of written certifications and audits. The Company intends to replace any vendors
found not to be Year 2000 compliant with vendors that are Year 2000 compliant.
In the construction of its new Beijing facility, the Company will procure
material, processes, and equipment that are Year 2000 compliant. The Company
also is investigating the use of stand-by generators for its plants in the event
of a local power failure. The Company is investigating transferring all
manufacturing processes to alternate manufacturing facilities if external
factors beyond its control relative to the Year 2000 issue occur and the Company
cannot conduct manufacturing operations at any particular facility.
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBIT 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: April 28, 1999 By: /s/ Jeffrey D. Buchanan
-----------------------------------------
Jeffrey D. Buchanan
Its: Executive Vice President Finance,
Administration and Legal; Chief Financial
Officer
14
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED BALANCE SHEET AT MARCH 31, 1999 AND THE RELATED CONSOLIDATED
STATEMENTS OF INCOME FOR THE THREE MONTHS ENDED MARCH 31, 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>
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