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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
Annual Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 1997
Commission File Number 1-4373
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THREE-FIVE SYSTEMS, INC.
(Name of Issuer Specified in Its Charter)
Delaware 86-0654102
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(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
1600 North Desert Drive, Tempe, Arizona 85281
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(Address of Principal Executive Offices)
(602) 389-8600
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(Issuer's Telephone Number, Including Area Code)
Securities registered under Section 12(b) of the Exchange Act:
Title of Each Class Name of Each Exchange on Which Registered
Common Stock, Par Value $.01 Per Share New York Stock Exchange
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Securities registered under Section 12(g) of the Exchange Act: None
Check whether the issuer (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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 __
Check if there is no disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K contained in this form, and no disclosure will be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_____]
State issuer's revenues for its most recent fiscal year: $84,642,000
As of March 6, 1998, the aggregate market value of the voting stock held by
non-affiliates of the issuer, computed by reference to the price at which stock
was sold as of such date in the stock market as reported on the New York Stock
Exchange, was $152,309,391. Shares of Common Stock held by each officer and
director and by each person who owns 10% or more of the outstanding Common Stock
have been excluded in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily conclusive and does not
constitute an admission of affiliate status.
As of March 6, 1998, there were 7,907,123 shares of the issuer's Common Stock
outstanding.
Documents incorporated by reference: Portions of the issuer's definitive Proxy
Statement for the 1998 Annual Meeting of Stockholders are incorporated by
reference into Part III hereof.
THREE-FIVE SYSTEMS, INC.
ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 1997
TABLE OF CONTENTS
PART I
ITEM 1. DESCRIPTION OF BUSINESS.........................................................................1
ITEM 2. DESCRIPTION OF PROPERTY........................................................................19
ITEM 3. LEGAL PROCEEDINGS..............................................................................19
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............................................19
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.......................................20
ITEM 6. SELECTED FINANCIAL DATA .......................................................................22
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS............................................................23
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.....................................32
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................................................32
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE............................................................32
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS ..............................................................32
ITEM 11. EXECUTIVE COMPENSATION.........................................................................32
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT.....................................................................................32
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................................................32
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS
ON FORM 8-K....................................................................................33
SIGNATURES.......................................................................................................35
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS......................................................................F-1
PART I
ITEM 1. DESCRIPTION OF BUSINESS
Introduction
The Company designs and manufactures a wide range of user interface
devices for operational control and informational display functions required in
the end products of original equipment manufacturers ("OEMs"). Most of the
Company's sales consist of custom devices developed in close collaboration with
its customers. Devices designed and manufactured by the Company find application
in cellular telephones and other wireless communication devices as well as in
medical equipment, office automation equipment, industrial process controls,
instrumentation, consumer electronic products, automotive equipment, and
industrial and military control products. The Company currently specializes in
liquid crystal display ("LCD") and light emitting diode ("LED") components and
technology in providing its design and manufacturing services for its customers.
The Company markets its services primarily in North America, Europe, and Asia
through direct technical sales persons and, to a much lesser extent, through an
independent sales and distribution network.
The Company experienced substantial growth from 1993 through 1995 with
net sales increasing from $38.0 million in 1993 to $91.6 million in 1995. The
Company's growth during that period, however, depended primarily upon the
Company's participation in the substantial growth of the wireless communications
market and sales to a single major customer in that industry. In 1996, the
Company's sales declined to $60.7 million, largely as the result of the
phase-out by that major customer of a significant family of programs in early
1996, and the Company reported a loss in 1996 as a result of that phase-out and
the significant inventory reserve taken during the third quarter. In 1997, the
Company's sales increased to $84.6 million, primarily as a result of several new
programs, including programs for an office automation customer. The growth that
occurred during the period from 1993 through 1995 allowed the Company to
construct the highest volume passive matrix LCD glass production facility in
North America, which enables the Company to produce a substantial portion of its
LCD glass requirements, as well as to attract key personnel, expand its research
and development efforts, and build its infrastructure. The Company has
undertaken substantial efforts to broaden its customer base by obtaining new
customers and by increasing its business with those existing customers which
have historically comprised a small percentage of the Company's revenue. The
Company has also undertaken efforts to expand its markets by (1) placing sales
personnel in new geographic locations, (2) targeting new industrial
applications, and (3) developing new kinds of products.
The Company believes that it is positioned to continue the growth that
it experienced in 1997 as a result of its efforts in expanding its customer base
and the markets it serves as well as its strength in designing, prototyping, and
producing, on a timely and cost-efficient basis, a wide range of innovative,
distinctive, and high-quality user interface devices required in the end
products of OEMs. In the past few years, the Company has refocused its research
and development capabilities with the intention of developing display
technologies and manufacturing processes that will be useful for its current and
future customers. The Company's design processes utilize advanced computer-aided
design software to provide custom solutions for customers' products in time
frames and on cost bases that it believes are competitive. The Company utilizes
advanced, flexible manufacturing systems that can accommodate low-volume
production runs or highly sophisticated applications in Arizona and high-volume,
price sensitive runs in Manila, the Philippines.
The Company maintains its principal executive offices at 1600 North
Desert Drive, Tempe, Arizona 85281, and its telephone number is (602) 389-8600.
Unless the context indicates otherwise, all references to the "Company" refer to
Three-Five Systems, Inc., its subsidiaries and predecessors.
Technology
Since the commercial introduction of the first light emitting diodes in
the 1960s and twisted nematic liquid crystal displays in the 1970s, the use of
LCD and LED indicators has become widespread in industrial and consumer
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electronic products. Prior to these innovations, the most common displays or
indicators had substantial limitations as to their use, especially in terms of
size, life, and power consumption. LCD and LED technologies were developed in
order to overcome these limitations.
An LCD modifies light that passes through or is reflected by it, rather
than emitting light like an LED. An LCD generally consists of a layer of liquid
crystalline material suspended between two glass plates. The crystals align
themselves in a predictable manner, and this alignment changes when stimulated
electrically. This changed alignment produces a visual representation of the
information desired when used in conjunction with a polarizer and either natural
ambient light or an external light source.
An LED chip produces light as the result of the application of direct
current at a low voltage. Different wavelengths (colors) can be produced in a
product depending upon the manufacturing process and the dopant (impurity) added
to the basic chip material, usually gallium arsenide or gallium phosphide. These
wavelengths can be visible or non-visible. In the visible range, LED chips
produce red, yellow, green, and recently, blue and white colors. In the
non-visible range (infrared), the Company's devices utilize 880 nanometer
wavelength or 940 nanometer wavelength chips.
Industry Overview
The Company has benefited from the determination by certain OEMs in the
electronics industry to outsource the design and production of certain
components included in the end products of those OEMs. The Company believes that
the following factors have contributed to this growing trend among OEMs:
o As technology has become increasingly sophisticated and
complex, it has become more difficult for even the leading
OEMs to maintain the necessary technology, expertise,
personnel, and equipment to design and produce internally all
of the various components necessary for their products.
o Advanced design and manufacturing processes require
increasingly greater investments for research and development,
personnel, and equipment.
o Competitive market conditions require OEMs to reduce the
period of time from product conception to delivery, to
differentiate their products from those of their competitors,
to improve user friendliness, and to continually enhance
product performance and reduce product cost during the life
cycle of the product.
OEMs often design their products to contain user interface devices
(including those relating to operational control and informational display) as a
highly cost-effective means of differentiating their products from competing
products. OEMs then make the decision of whether to use standard devices, to
design and produce the devices in-house, or to outsource with a third party for
design and production. In making this decision, companies often recognize that
their greatest strengths consist of consumer recognition of brand names, market
research and product development expertise, and highly developed sales and
distribution channels. OEMs also recognize that the desired devices often cannot
be obtained "off-the-shelf" and that time constraints and limitations on
available resources often preclude them from maintaining the specialized
in-house expertise and equipment necessary to design and manufacture the desired
devices. OEMs often conclude that the logical solution is to focus their
resources on those areas (such as marketing and distribution) where they possess
the greatest leverage and to outsource the design and production of devices and
components in which they lack the requisite technology and expertise.
Outsourcing enables OEMs to obtain the following desired benefits:
o To gain access to specialized design and manufacturing
technology and expertise.
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o To accelerate the design process and to reduce design and
manufacturing costs by utilizing the specialized personnel,
equipment, and facilities of the supplier.
o To reduce their own investment in personnel, equipment, and
facilities necessary for specialized design and production
capabilities.
o To streamline their own operations by concentrating their
resources on the design, production, and distribution of their
core products.
By eliminating the duplication and overlap of investment and resources,
outsourcing permits the Company and the OEMs to work together and grow at a
faster rate than would otherwise be possible. Outsourcing greatly reduces the
Company's need to devote time and resources on market development for specific
products and allows the Company to concentrate on the development of its display
technologies and their applications to a multitude of products.
Products and Services
The Company currently emphasizes custom designed user interface devices
for operational control and informational display functions. The Company
believes that custom devices represent the source of its greatest profits and
growth potential. For each custom device, the Company works directly with its
customer to develop and produce the original design and to manufacture the
device in accordance with the customer's specifications. The Company also
designs and produces standard or "off-the-shelf" devices, which involve designs
that are adaptable to various fixed end uses without modification.
The Company pursues a strategy designed to enable it to enhance its
position as a major, worldwide supplier of custom-designed and manufactured user
interface devices for products of leading OEMs in various high growth
industries. The Company attempts to identify industries that present the
greatest long-term potential for growth at any given time. The Company's
research and development activities then focus upon technological developments
that attempt to meet the current and future requirements of those industries.
The Company seeks to establish strong and long-lasting customer relationships by
aligning its prospects with those of its customers and by seeking to make its
engineering and advanced manufacturing functions seamless extensions of the
product design and production departments of its customers. The Company engages
in a careful customer selection process because it recognizes that its own
growth and development will be closely aligned with the growth and development
of the customers it serves. The Company's strategy currently involves
concentrating its efforts on providing design and production services to leading
companies in five primary industries: cellular telephones and other wireless
communications, data collection, office automation, medical devices, and
industrial process controls.
More recently, with the availability of the high-volume LCD
manufacturing line in Arizona, the Company has begun focusing its efforts on
creating advanced display techonologies. These advanced display technologies
will allow the Company to provide its customers with differentiating products or
products that provide higher information content. These products may be
available for use in custom devices or in standard devices. The Company
currently has three technology initiatives. First, the Company has patented a
new type of LCD display that emulates an emissive LED display, which the Company
calls LCiD(TM) or Liquid Crystal intense Display. This low information content
device is expected to provide a multi-colored emissive-looking display at
passive LCD prices. The second initiative involves the creation of a high
information content display with numerous gray shades but again at the price of
a more typical LCD. This new product is called LCaD(TM) or Liquid Crystal active
Drive(TM). This technology is based, in part, on technology licensed from Motif,
Inc. and additional proprietary technology developed by the Company. The third
technology initiative is liquid crystal on silicon microdisplays or LCoS(TM).
LCoS(TM) microdisplays will provide high-resolution (up to one million pixels
and beyond) active matrix displays that are less than 8/10 of an inch in
diameter on the diagonal. LCoS(TM) microdisplays are expected to serve the need
for portable, high information content displays in industries such as wireless
communications, office automation, and industrial process controls. In addition,
the Company expects that LCoS(TM) microdisplays will open new market industries
for the Company in areas such as business and consumer electronics.
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Custom Devices
LCD and LED custom displays currently account for approximately 94.3
percent of the Company's revenue, with the majority consisting of LCD custom
displays. A manufacturer of a complete system or product requiring a specific
type of visual display (such as a cellular telephone, medical instrument,
business machine, or hand-held data collection device) represents a typical
buyer for a custom device.
The Company has developed a sophisticated design process to meet the
specific needs of its customers' applications. Each design project normally
involves a cross-functional team of Company engineers who are assigned to a
customer program. The team consults with the customer's engineers throughout the
design phase, prototype development, and manufacturing process. The Company
continues to supply value-added engineering support after the design solution
has been developed and integrated into the manufacturing process in an ongoing
effort to provide customers with product performance enhancements and
cost-reduction opportunities.
Standard Devices
Standard devices encompass a wide variety of LCD and LED devices having
varied applications. "Visible" LCD and LED standard devices include (i) solid
state lamps used for indicators, status lights, on-board circuit monitors, and
instrumentation; (ii) multi-digit numerical displays used for calculators,
industrial controls, data terminals, instrumentation timers, hand-held
instruments, event counters, and PCB test equipment; (iii) integrated displays
(with on-board integrated circuit drivers) and alpha numeric displays used for
hand-held terminals, minicomputers, telecommunications, and instrumentation word
processors; (iv) bar graph displays used for power meters in stereo systems, Ham
and CB radio meters, VU meters in tape recorders, process control indicators,
and replacements for volt meters; and (v) multi-digit numeric displays used for
industrial controls, data terminals, test equipment, point of sale,
mini-computer readout, and home consumer applications.
Standard infrared devices include infrared emitters and silicon
detectors used for TV remote controls, disk drives, tape drives, printers,
encoders, solid state relays, photoelectric controls, slotted switches,
reflective switches, intrusion alarms, touch screens, wireless data entry and
positioning sensors.
Manufacturing Services
The Company has geographically organized its manufacturing capabilities
in a manner that optimizes the combination of technology and human resources.
This enables the Company to compete solely on the basis of cost, if necessary,
with suppliers of similar products and services throughout the world. Advanced
manufacturing techniques include surface mount technologies, chip-on-board,
chip-on-flex, flip-chip, tape automated bonding, and sophisticated testing
systems throughout the process.
The Company seeks to increase its value to its customers by providing
responsive, flexible, total manufacturing services. To date, manufacturing
services have been concentrated toward the manufacture of LCD's and assembly of
Company-designed user interface module assemblies. However, the Company has
recognized an increased demand for extended manufacturing services beyond these
core services. These extended services may include adding additional components,
such as a keypad, microphone, card reader, product housing, or non-display
electronic sub-assembly, or the turn-key manufacture of a complete OEM product.
The Company intends to pursue extended manufacturing opportunities in those
instances when the Company believes it will be beneficial to do so.
Manufacturing Facilities
The Company currently conducts manufacturing operations in Tempe,
Arizona and in Manila, the Philippines. The Arizona facility houses a Class 1000
"clean room" and LCD fabrication and prototyping operation. The Company utilizes
the facility primarily to conduct LCD research and development, to produce
prototype and pre-production runs of devices for customer approval, to conduct
full production runs of low-volume devices, and to
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develop advanced manufacturing processes that can be applied in Manila during
full-scale production. In addition, the facility has the largest fully automated
LCD glass production capacity in North America. This highly automated line
enables the Company to reduce its dependence on foreign suppliers of LCD glass.
Facility personnel include a team of experts ranging from LCD research
scientists to specialized engineers with backgrounds in electronics, mechanics,
chemistry, physics, and manufacturing. The Company maintains a wide variety of
state-of-the-art testing and quality control equipment at the facility.
High volume LCD module manufacturing is done in Manila, the
Philippines. The Company is a party to an agreement (the "Sub-Assembly
Agreement") with Technology Electronic Assembly and Management Pacific
Corporation ("TEAM"), pursuant to which TEAM supplies direct manufacturing
services at a facility owned by TEAM located in Manila. The Company is also
party to a lease agreement (the "Lease Agreement") with TEAM pursuant to which
TEAM leases space to the Company with respect to those manufacturing operations
services performed by TEAM under the Sub-Assembly Agreement. TEAM manufactures,
assembles, and tests devices designed by the Company in the space leased to the
Company and pursuant to procedures set forth in the Sub-Assembly Agreement in
accordance with specifications supplied by the Company. In 1997, TEAM and the
Company entered into an amendment to the Sub-Assembly Agreement whereby all
indirect manufacturing employees (primarily technicians, supervisors and
engineers) became employees of the Company. As a result, under the Sub-Assembly
Agreement TEAM now only supplies the direct labor and certain incidental
services required to manufacture the Company's products. The Company owns the
manufacturing, assembling, and testing equipment (including automated die attach
and wire bond equipment with automatic pattern recognition features for die and
wire placement for LED die) as well as the processes and documentation used by
TEAM at the Manila facility. The Company pays TEAM for the direct manufacturing
personnel based upon a negotiated available hourly rate. The Company employs all
professional personnel, including an Operations Manager, with a support staff
consisting of manufacturing supervisors, manufacturing, quality, and process
engineers, and logistics and administrative personnel at the Manila facility.
The Sub-Assembly Agreement and Lease Agreement between the Company and
TEAM extend through December 31, 1999 and are renewable from year to year
thereafter. The Sub-Assembly Agreement requires the Company to maintain minimum
production levels. The termination of the Lease Agreement or Sub-Assembly
Agreement or the inability of TEAM to fulfill its requirements under the
Sub-Assembly Agreement would require the Company to acquire additional
manufacturing facilities or to contract for additional manufacturing services.
The Philippines has been subject to volcanic eruptions, typhoons, and
substantial civil disturbances, including attempted military coups against the
government. These circumstances could affect the Company's ability to obtain
products pursuant to the Sub-Assembly Agreement, although there has not been any
material interruption of operations to date. The termination of or the inability
of the Company to obtain products pursuant to the Sub-Assembly Agreement, even
for a relatively short period, would have a material adverse effect on the
operations and profitability of the Company.
The Company plans to construct a manufacturing facility in the People's
Republic of China ("China") during 1998. The China facility will be a
high-volume LCD module manufacturing facility similar to the Company's current
facility in Manila. The Company initially will lease a facility in Beijing on a
temporary basis, and the Company expects manufacturing to commence in that
temporary facility in the middle of 1998. The Company is planning to construct
its own facility in Beijing and expects to move into that new facility at the
end of 1998. The Chinese manufacturing facility will be owned and operated by a
wholly owned foreign subsidiary of the Company. The cost of equipping and
constructing the China facility is expected to be approximately $8.0 million.
For further discussions on the proposed China operations, See "Management
Discussion and Analysis of Financial Conditions and Results of Operations"
contained in Item 7 of this Report and "Description of Business - Special
Considerations - Risks of International Operations" contained in Item 1 of this
Report.
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Quality Control
The Company has implemented an aggressive quality control program and
maintains at each of its facilities quality systems and processes that meet or
exceed the demanding standards set by many leading OEMs in targeted industries.
The Company's quality control program is based upon Statistical Process Control,
which advocates continual quantitative measurements of crucial parameters and
uses those measurements in a closed-loop feedback system to control the
manufacturing process. The Company performs product life testing to help ensure
long-term product reliability. The Company analyzes results of product life
tests and takes actions to refine the manufacturing process or enhance the
product design.
Increased global competition has led to increased customer expectations
for price, delivery, and quality. Customers often evaluate price in the
quotation process, while delivery and quality are evaluated only after the
product is received. Therefore, many customers preview a company's quality by
viewing the quality systems employed. In 1997, the Company received ISO 9002
certification of its Manila manufacturing facility. ISO is a quality standard
established by the International Organization for Standardization, which
attempts to ensure that the processes used in development and production remain
consistent. This is accomplished through documentation maintenance, training,
and management review of the processes used. Although achievement of ISO 9002
certification is no guarantee of the Company's ability to obtain future
business, it is a factor that enables the Company's customers to recognize that
the Company's production processes meet this established, global standard of
performance.
Sales and Marketing
The Company markets its services primarily in North America and Europe
through direct technical sales persons and, to a much lesser extent, through an
independent sales and distribution network. This network includes two franchised
distributors in approximately 96 sales offices. A staff of in-house,
Arizona-based sales and engineering personnel directs and aids all direct and
distribution sales. The Company also has sales personnel in California,
Massachusetts, Illinois, and Florida.
The Company's sales to customers in Europe represented approximately 13
percent of net sales in 1997. In addition to a direct technical sales force, the
Company distributes products in Europe through a network of distributors,
augmented in some regions by marketing representatives. This network receives
support from the marketing, customer service, and support staff employed by the
Company's subsidiary, Three-Five Systems Limited, located in Swindon, England.
The European staff and network of distributors provide marketing, consulting,
and product design input locally for customers throughout Western Europe.
Customers
The Company's strategy involves concentrating its efforts on providing
design and production services to leading companies in five primary industries:
cellular telephones and other wireless communications, data collection, office
automation, medical devices, and industrial process controls. As a result, the
Company generally derives its revenue from services provided to a limited number
of customers. The Company's largest customer is Motorola, Inc. ("Motorola"). The
Company currently designs and manufactures user interface devices used in
approximately 35 individual product programs for Motorola. Sales to Motorola
accounted for 34.6 percent of the Company's revenue during 1997. Devices that
are used in cellular telephones accounted for substantially all of the Company's
sales to Motorola in 1997. Motorola recently awarded several new design programs
to the Company. In addition, during 1997, Motorola instituted a LCD module
allocation process in which it designated a few key LCD module vendors,
including the Company, and communicated to each vendor the anticipated amount of
purchases for 1998. Although the allocation process does not provide a guarantee
of business to the Company, it provides an indication that purchases by Motorola
could rise to as much as 50 percent of the Company's revenue in 1998. The
Company's second largest customer in 1997 was Hewlett-Packard Company
("Hewlett-Packard"). Sales to Hewlett-Packard accounted for 32.0 percent of the
Company's revenue during 1997. As the LCD modules manufactured by the
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Company for Hewlett-Packard move into second generation versions in 1998, the
Company expects that the selling price of some of those modules will be greatly
reduced. Consequently, the Company believes that in 1998 the percentage of its
revenue attributed to Hewlett-Packard will decline. See "Description of Business
- - Special Considerations - Substantial Reliance on Certain Customers" contained
in Item 1 of this Report.
Backlog
As of December 31, 1997, the Company had a backlog of orders of
approximately $21.8 million, all of which orders are believed to be firm and all
of which are expected to be filled during fiscal 1998. The backlog of orders at
December 31, 1996 was approximately $17.9 million. The Company's business may be
developing some seasonality as the result of the significant amount of retail
products into which its products are placed. Design cycles have shortened and
many customers finish cycles in the fourth quarter (because of the holiday sales
season) and ramp up new products in the second quarter of the calendar year.
Consequently, the first quarter of a calendar year may have a disproportionately
lower percentage of the year's total sales.
Patents and Trademarks
The Company relies on a combination of patent, trade secrets and
trademark laws, confidentiality procedures, and contractual provisions to
protect its intellectual property. Although the Company's core business does not
depend on any patent or trademark protection, the Company is manufacturing more
advanced display products in which there are patent or trademark issues. The
Company recently received a patent on a new display technology, which the
Company refers to as LCiD(TM) or Liquid Crystal intense Display. In 1997, the
Company also signed a license agreement with Motif, Inc. to license from Motif
technology that forms the basis of its LCaD(TM) or Liquid Crystal active Drive.
The Company recently applied for a patent on its LCaD(TM) technology.
Raw Materials
The principal raw materials used in producing the Company's displays
consist of gallium arsenide and gallium phosphorous wafers and die, LCD glass,
driver die, circuit boards, molded plastic parts, lead frames, wire, chips, and
packaging materials. The Company's procurement strategy provides alternative
sources of supplies for the majority of these materials. Many of such materials,
however, must be obtained from foreign suppliers, which subjects the Company to
the risks inherent in obtaining materials from foreign sources, including supply
interruptions and currency fluctuations. The Company's suppliers currently are
meeting the requirements of the Company, and strategic supplier alliances have
further strengthened relations with offshore suppliers. The Company's ability to
produce a significant percentage of its requirements of LCD glass in its Arizona
facility is expected to reduce the Company's dependence on foreign suppliers.
See "Description of Business - Special Considerations - Shortage of Raw
Materials and Supplies" contained in Item 1 of this Report.
Competition
The Company believes that Optrex America, Inc., Seiko-Epson, Samsung,
Seiko Instruments, Hyundai, PCI Limited, and Philips Components B.V. constitute
the principal competitors for the Company's LCD devices. Hewlett-Packard, Rohm
Co., Ltd., LiteOn, Inc., Siemens, Inc., Stanley Electric Company, Ltd., and
Quality Technologies Corp. constitute its principal competitors for its LED
devices. Most of these competitors are large companies that have greater
financial, technical, marketing, manufacturing, and personnel resources than the
Company. The revenue, profitability, and success of the Company depend
substantially upon its ability to compete with other providers of user interface
devices. No assurance can be given that the Company will continue to be able to
compete successfully with such organizations.
The Company currently competes principally on the basis of the
technical innovation and performance of its product solutions, including their
ease of use and reliability, as well as on their cost, timely design, and
manufacturing and delivery schedules. The Company's competitive position could
be adversely affected if one or
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more of its customers, particularly Motorola or Hewlett-Packard, determine to
design and manufacture their user interface devices internally or secure them
from other parties. See " Description of Business - Special Considerations -
Competition" contained in Item 1 of this Report.
Research and Development
The Company conducts an active and ongoing research, development, and
engineering program that focuses on advancing technology, developing improved
design and manufacturing processes, and improving the overall quality of the
products and services that the Company provides. Research and development
personnel concentrate on LCD technology, especially improving performance of
current products and expanding the technology to serve new markets. Research and
development also is conducted in manufacturing processes, including those
associated with efficient, high-volume production and electronic packaging.
More recently, the Company has begun to focus its research and
development efforts on new display technologies. See "Description of Business
Products and Services" contained in Item 1 of this Report. The Company has
undertaken a significant research and development program with respect to the
development of LCoS(TM) microdisplays and expects that the majority of available
research and development personnel hours will be dedicated to LCoS(TM)
microdisplays in 1998.
Environmental Regulation
The operations of the Company result in the creation of small amounts
of hazardous waste, including various epoxies, gases, inks, solvents, and other
wastes. The amount of hazardous waste produced by the Company may increase in
the future depending on changes in the Company's operations. The general issue
of the disposal of hazardous waste has received increasing focus from federal,
state, local, and international governments and agencies and has been subject to
increasing regulation. See "Description of Business - Special Considerations -
Environmental Regulation" contained in Item 1 of this Report.
In 1991, the Company received a notice of potential liability at the
Barkhamsted-New Hartford Landfill Site in Barkhamsted, Connecticut from the
United States Environmental Protection Agency ("EPA"). No further administrative
action was taken against the Company and the Company has been verbally advised
by a representative of the EPA that the Company will have no liability with
respect to this matter.
In a separate matter, the Company conducted a clean-up of limited
chemical contamination at its former property located in Barkhamsted,
Connecticut. The contamination was caused by the previous owner of the property,
and not as a result of any of the Company's operations. The Company has
contracted with an environmental consulting firm for assistance with the
clean-up process and has complied with the requests and recommendations of the
Connecticut Environmental Protection Agency throughout the process. The Company
believes that the source of the contamination has been removed from the property
and that the clean-up has been completed. Four monitoring wells have been
installed to permit periodic chemical analysis to be made at the property. The
property was sold on June 25, 1995, subject to the Company making its best
efforts to obtain from either the Connecticut or Federal Environmental
Protection Agency documentation to the effect that the property is clean and
that there is no actionable contamination in the vicinity of the property.
Employees
As of December 31, 1997, the Company employed a total of 459 persons.
This number includes 174 full-time and approximately 10 temporary employees at
its principal U.S. facility in Tempe, Arizona and U.S. sales offices; 267
employees at its manufacturing facility in Manila, the Philippines; and 8
employees at its Three-Five Systems, Limited subsidiary in Swindon, England. The
Company considers its relationship with its employees to be good, and none of
its employees currently are represented by a union in collective bargaining with
the Company.
8
TEAM provides the personnel engaged in the direct assembly of the
Company's devices in Manila pursuant to the Sub-Assembly Agreement between the
Company and TEAM. See "Description of Business - Manufacturing Facilities"
contained in Item 1 of this Report. As of December 31, 1997, approximately 1,133
persons performed direct labor operations at the Manila facility through the
Sub-Assembly Agreement with TEAM.
Executive Officers
The following table sets forth information concerning each of the Company's
executive officers.
Name Age Position
- ---- --- --------
David R. Buchanan 65 Chairman of the Board, President, and Chief Executive Officer
Vincent C. Hren 47 Vice President - Operations
Jeffrey D. Buchanan 42 Vice President - Finance, Administration, and Legal;
Chief Financial Officer; Secretary; and Treasurer
Dan J. Schott 58 Vice President - Research and Development
David R. Buchanan has been Chairman of the Board, President, Chief
Executive Officer, and a director of the Company since its formation in February
1990. Mr. Buchanan served as Treasurer of the Company from May 1990 until
January 1994 and as Chairman of the Board, Chief Executive Officer, President,
and a director of one of the predecessors of the Company from October 1986,
February 1987, and November 1985, respectively, until the predecessor's merger
into the Company in May 1990.
Vincent C. Hren has been Vice President - Operations of the Company
since August 1996 and served as Vice President - Manufacturing Operations from
January 1996 to August 1996. Mr. Hren served as Vice President - Worldwide
Automotive of Graco Inc. from 1994 to 1995. Mr. Hren served as Vice President -
Worldwide Operations for Fisher-Rosemount Systems, Inc. from 1993 to 1994,
General Manager of Rosemount Analytical, Inc. from 1992 to 1993, and held
various management positions with Fisher-Rosemount, Inc. from 1974 to 1992.
Jeffrey D. Buchanan has been Vice President - Finance, Administration,
and Legal, Chief Financial Officer, and Treasurer of the Company since June 1996
and Vice President - Administration and Legal and Secretary of the Company since
May 1996. Mr. Buchanan served as a Senior Partner of O'Connor, Cavanagh,
Anderson, Killingsworth & Beshears from June 1986 until May 1996, where he
practiced as a business lawyer with an emphasis on mergers and acquisitions,
joint ventures, and taxation. Mr. Buchanan was associated with the international
law firm of Davis Wright Tremaine from 1984 to 1986, and he was a senior staff
person at Deloitte & Touche from 1982 to 1984. Mr. Buchanan is a member of the
Arizona and Washington state bars and passed the certified public accounting
examination in 1983. Mr. Buchanan is the son of David R. Buchanan.
Dan J. Schott has been Vice President - Research and Development of the
Company since July 1996. From January 1994 until July 1996 he was Vice President
of Technology. From 1988 to January 1994, Mr. Schott was an Associate Director
with Honeywell Inc., where his responsibilities included flat panel display
research and development. From 1981 until 1987, he held various engineering
management and program management positions with Sperry Rand Corp.
9
Special Considerations
Certain Factors Affecting Operating Results
The Company's operating results are affected by a wide variety of
factors which could adversely impact its net sales and profitability. These
factors, many of which are beyond the control of the Company, include the
Company's ability to identify industries which have significant growth potential
and to establish strong and long-lasting relationships with companies in those
industries; the Company's ability to provide significant design and
manufacturing services for those companies on a timely and cost-effective basis;
the Company's success in maintaining customer satisfaction with its design and
manufacturing services; market acceptance of products of its customers
incorporating devices designed and manufactured by the Company; the level and
timing of orders placed by customers which the Company can complete in a
quarter; customer order patterns; changes in order mix; the performance and
reliability of devices designed and manufactured by the Company; the life cycles
of its customers' products; the availability and utilization of manufacturing
capacity; fluctuations in manufacturing yield and productivity; the quality,
availability, and cost of raw materials, equipment, and supplies; the timing of
expenditures in anticipation of orders; the cyclical nature of the industries
and the markets served by the Company; technological changes; and competition
and competitive pressures on prices.
The Company's ability to increase its design and manufacturing capacity
to meet customer demand and maintain satisfactory delivery schedules will be an
important factor in its long-term prospects. Although the Company's product
solutions are incorporated into a wide variety of communications, consumer,
medical, office automation, and industrial products, a majority of its sales in
1997 were display modules for cellular products. A slowdown in demand for
customer products, particularly cellular and office automation products which
utilize the Company's products, as a result of economic or other conditions in
the United States or worldwide markets served by the Company or other broadbased
factors would adversely affect the Company's operating results.
Dependence on New Products and Technologies
The Company operates in fast changing industries. Technological
advances, the introduction of new products, and new design and manufacturing
techniques could adversely affect the Company's operations unless the Company is
able to adapt to the resulting changing conditions. As a result, the Company
will be required to expend substantial funds for and commit significant
resources to continuing research and development activities, the engagement of
additional engineering and other technical personnel, the purchase of advanced
design, production and test equipment, and the enhancement of design and
manufacturing processes and techniques.
The Company's future operating results will depend to a significant
extent on its ability to continue to provide design and manufacturing services
for new products that compare favorably on the basis of time to introduction,
cost, and performance with the design and manufacturing capabilities of OEMs and
other third-party suppliers. The success of new design and manufacturing
services depends on various factors, including proper customer selection,
utilization of advances in technology, innovative development of new solutions
for customer products, efficient and cost-effective services, timely completion
and delivery of new product solutions, and market acceptance of customers' end
products. Because of the complexity of the Company's design and manufacturing
services, the Company may experience delays from time to time in completing the
design and manufacture of new product solutions. In addition, there can be no
assurance that any new product solutions will receive or maintain customer or
market acceptance. If the Company were unable to design and manufacture
solutions for new products of its customers on a timely and cost-effective
basis, its future operating results would be adversely affected. See
"Description of Business - Products and Services" contained in Item 1 of this
Report.
Finally, even when a design and manufacturing solution is
satisfactorily completed, circumstances outside of the Company's control may
result in the loss of expected revenue. For example, a customer may terminate or
delay its own program for any number of reasons unrelated to the Company,
including problems with other suppliers to the program or lack of market
acceptance of the customer's product. In such instances, the future operating
results of the Company could be adversely affected.
10
Substantial Reliance on Certain Customers
In the past few years, the Company has generated most of its revenue
from sales to a few significant customers. The Company's largest customer is
Motorola, which accounted for 34.6 percent of the Company's revenue in 1997,
65.1 percent of the Company's revenue in 1996 and 80.5 percent of the Company's
revenue in 1995. Devices that are used in cellular telephones accounted for
substantially all of the Company's sales to Motorola in 1997. Although the
percentage of sales to Motorola declined in 1997, the Company anticipates that
this percentage will increase in 1998 to as much as 50 percent of the Company's
revenue. The Company's second largest customer is Hewlett-Packard, which
accounted for 32.0 percent of the Company's 1997 revenue. See "Description of
Business - Customers" contained in Item 1 of this Report.
The Company does not have long-term supply contracts with any
customers, and customers also generally do not commit to long-term production
schedules. In addition, customer orders generally can be cancelled and volume
levels changed or delayed. The timely replacement of cancelled, delayed, or
reduced orders cannot be assured and, among other things, could result in the
Company holding excess and obsolete inventory. The Company's operating results
have been materially and adversely affected in the past by the failure of
anticipated orders to be realized and by deferrals or cancellations of orders as
a result of changes in customer requirements. Cancelled, delayed, or reduced
commitments from any of the Company's major customers, particularly Motorola or
Hewlett-Packard, would have a material adverse effect on the Company's results
of operations.
Risks of International Operations
General. The Company currently has substantial manufacturing operations
located in the Philippines and the United States. The Company also has a sales
office and distribution warehouse in Europe. In addition, in 1998 the Company is
planning to construct a manufacturing facility in China, where the Company has
not previously manufactured products. The geographical distances between Asia,
Europe, and North America create a number of logistical and communications
challenges. Because of the location of manufacturing facilities in a number of
countries, the Company may be affected by economic and political conditions in
those countries, including fluctuations in the value of currency, duties,
possible employee turnover, labor unrest, lack of developed infrastructure,
longer payment cycles, greater difficulty in collecting accounts receivable, the
burdens and costs of compliance with a variety of foreign laws and, in certain
parts of the world, political instability. Changes in policies by the United
States or foreign governments resulting in, among other things, increased
duties, higher taxation, currency conversion limitations, restrictions on the
transfer of funds, limitations on imports or exports, or the expropriation of
private enterprises also could have a material adverse effect on the Company,
its results of operations, prospects or debt service ability. The Company also
could be adversely affected if the current policies encouraging foreign
investment or foreign trade by its host countries were to be reversed. In
addition, the attractiveness of the Company's services to its United States
customers is affected by United States trade policies, such as "most favored
nation" status and trade preferences for certain Asian nations. In particular,
the Company's operations and assets are subject to significant political,
economic, legal and other uncertainties in the Philippines and China, where the
Company is planning to substantially expand its operations.
Manufacturing Operations in the Philippines. The Company has maintained
its primary manufacturing facility in Manila, the Philippines since 1986. TEAM,
a third party subcontractor, owns the facility, which is located on land it
leases from the Philippine government. TEAM operates the facility under the
Sub-Assembly Agreement and the Lease Agreement utilizing equipment, processes,
and documentation owned by the Company and supervisory personnel employed by the
Company. TEAM provides direct-level production personnel under the Sub-Assembly
Agreement and leases space to the Company under the Lease Agreement. TEAM also
utilizes other space in the facility to produce products for other entities
unrelated to the Company. The Sub-Assembly Agreement and the Lease Agreement
have current terms extending through December 31, 1999 and are renewable from
year to year thereafter. Although the Company has made advance payments to TEAM
since 1994 to assist it in meeting its working capital needs while it negotiates
new financing arrangements, there were no outstanding advances to TEAM at
December 31, 1997. The Company expects to make advances to TEAM in 1998 for
generators and equipment needed for building improvements.
11
The Company has made cumulative capital investments in the Philippines
amounting to approximately $11.1 million through December 31, 1997. The
Company's reliance on personnel and facilities in the Philippines and its
maintenance of inventories abroad expose the Company to certain economic and
political risks, including the business and financial condition of the
subcontractor, political instability and expropriation, supply disruption,
currency controls, and exchange fluctuations as well as changes in tax laws,
tariffs, and freight rates. The Company has not experienced any significant
interruptions in its business operations in the Philippines to date despite the
fact that the Philippines has been subject to volcanic eruptions, typhoons, and
substantial civil disturbances, including attempted military coups against the
government. The Company believes that its manufacturing operations in the
Philippines constitute one of the Company's most important resources and that it
would be difficult for it to replace the low-cost, high-performance facility or
the high-quality and hard working production staff if its manufacturing
operations in the Philippines were disrupted or terminated. As a result, the
Company's operations would be adversely affected if operations in the
Philippines or air transportation with the Philippines were disrupted or
terminated, even for a relatively short period of time. See "Description of
Business - Manufacturing Facilities" contained in Item 1 of this Report.
Proposed Manufacturing Operations in China. The Company is planning to
begin a manufacturing operation in China in 1998. The Company's operations and
assets will be subject to significant political, economic, legal and other
uncertainties in China. Under its current leadership, the Chinese government has
been pursuing economic reform policies, including the encouragement of foreign
trade and investment and greater economic decentralization. No assurance can be
given, however, that the Chinese government will continue to pursue such
policies, that such policies will be successful if pursued, or that such
policies will not be significantly altered from time to time. Despite progress
in developing its legal system, China does not have a comprehensive and highly
developed system of laws, particularly with respect to foreign investment
activities and foreign trade. Enforcement of existing and future laws and
contracts is uncertain, and implementation and interpretation thereof may be
inconsistent. As the Chinese legal system develops, the promulgation of new
laws, changes to existing laws, and the preemption of local regulations by
national laws may adversely affect foreign investors. The Company also could be
adversely affected by the imposition of austerity measures intended to reduce
inflation; the inadequate development or maintenance of infrastructure,
including the unavailability of adequate power and water supplies,
transportation, raw materials, and parts; or a deterioration of the general
political, economic or social environment in China.
In addition, China currently enjoys "most favored nation" ("MFN")
status granted by the United States government, pursuant to which the United
States imposes the lowest applicable tariffs on Chinese exports to the United
States. The United States annually reconsiders the renewal of MFN trading status
for China. No assurance can be given that the United States will renew China's
MFN status in future years. The failure or refusal of the United States
government to renew China's MFN status could adversely affect the Company by
increasing the cost to United States customers of products manufactured by the
Company in China.
International Trade and Currency Exchange
Approximately 33.8 percent of the Company's net sales in 1997 were
international sales. Nearly all of those international sales were from sales in
foreign markets, primarily Europe, China, and Hong Kong, to U.S. based OEMs
based in the United States. In 1998, the Company expects sales to OEMs in Europe
and China to increase and sales to OEMs in Hong Kong to decrease. In 1998, the
Company expects to begin manufacturing operations in China and to continue its
operations in Manila. The foreign sale and manufacture of products may be
adversely affected by political and economic conditions abroad. Protectionist
trade legislation in either the United States or foreign countries, such as a
change in the current tariff structures, export or import compliance laws, or
other trade policies, could adversely affect the Company's ability to
manufacture or sell devices in foreign markets and purchase materials or
equipment from foreign suppliers.
While the Company transacts business predominantly in United States
dollars and most of its revenues are collected in U.S. dollars, a portion of the
Company's costs, such as payroll, rent, and indirect operation costs, are
denominated in other currencies, including Philippine pesos ("PhP"), British
pounds sterling, and (in
12
1998) Chinese renminbi ("RMB"). For example, the Company's Sub-Assembly
Agreement with TEAM is based on a fixed conversion rate, exposing the Company to
exchange rate fluctuations with the Philippine peso. In 1998, the Company may
have transactions, including sales, designated in Chinese RMB. Historically,
fluctuations in foreign currency exchange rates have not resulted in significant
exchange losses to the Company. Changes in the relation of these and other
currencies to the United States dollar could affect the Company's cost of goods
sold and operating margins and could result in exchange losses. The impact of
future exchange rate fluctuations on the Company's results of operations cannot
be accurately predicted. In late 1997, the Philippine peso suffered a major
devaluation from its historic levels of around $1.00 to PhP 25 down to as much
as $1.00 to PhP 49. Over the last five years, the Chinese RMB has experienced
significant devaluation against most major currencies. The establishment of the
current exchange rate system as of January 1, 1994 produced a significant
devaluation of the RMB from $1.00 to RMB 5.7 to approximately $1.00 to RMB 8.7.
The rates at which exchanges of RMB into U.S. dollars may take place in the
future may vary, and any material increase in the value of the RMB relative to
the U.S. dollar would increase the Company's costs and expenses and therefore
would have a material adverse effect on the Company. The Company anticipates
that from time to time it will make United States dollar-denominated
intercompany loans to its wholly owned subsidiary in China. Any decrease in the
value of the RMB could adversely affect the Company if there are U.S.
dollar-demoninated intercompany loans from the Company to its subsidiary.
Hedging RMB is currently difficult because the currency is not freely traded.
The Company would suffer a recordable loss as a result of a RMB devaluation if
its intercompany loans to its subsidiary in China are not hedged.
Manufacturing Yields and Capacity
The design and manufacture of user interface devices are highly complex
processes that are sensitive to a wide variety of factors, including the level
of contaminants in the manufacturing environment, impurities in the materials
used, and the performance of the design and production personnel and equipment.
As is typical in the industry, the Company from time to time has experienced
lower than anticipated manufacturing yields and lengthening of delivery
schedules. This may be particularly true as the Company ramps up its high-volume
LCD line to greater production levels in 1998, adds more equipment, and begins
to manufacture LCoS(TM) microdisplays. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations Liquidity and Capital
Resources" contained in Item 7 of this Report. Additionally, as the
sophistication of user interface devices increases, so does the level of
complexity in the required manufacturing processes. The Company continually
reviews its processes in an effort to increase its manufacturing productivity,
achieve higher manufacturing yields, and reduce design and manufacturing errors.
In addition, the Company reviews ongoing procedures regularly to maintain its
ability to meet delivery schedules to satisfy increased business. The Company's
operating results would be adversely affected if it were unable to maintain high
levels of productivity or satisfactory delivery schedules in either its Manila
manufacturing plant or its Arizona high-volume LCD line.
Manufacturing yields and delivery schedules also may be affected as the
Company ramps up its manufacturing capabilities in China. Other companies in the
industry have experienced difficulty in expanding or relocating manufacturing
output and capacity, with such difficulty resulting in reduced yields or delays
in product deliveries. No assurance can be given that the Company will not
experience manufacturing yield or delivery problems in the future. Such problems
could materially affect the Company's operating results. See "Description of
Business - Manufacturing Facilities" contained in Item 1 of this Report.
Variability of Customer Requirements and Operating Results
Custom manufacturers for OEMs must provide increasingly rapid product
turnaround and respond to ever-shorter lead times. The Company generally does
not obtain long-term purchase orders but instead works with its customers to
anticipate the volume of future orders. The Company must procure components and
determine the levels of business that it will seek and accept, production
schedules, personnel needs and other resource requirements, in each case without
the benefit of long-term purchase commitments based upon the Company's estimate
of anticipated future orders. A variety of conditions, both specific to the
individual customer and generally affecting the industry, may cause customers to
cancel, reduce or delay orders. Cancellations, reductions
13
or delays by a significant customer or by a group of customers would adversely
affect the Company, its results of operations, prospects or debt service
ability. On occasion, customers may require rapid increases in production, which
can stress the Company's resources and reduce margins. Although the Company has
increased its manufacturing capacity, there can be no assurance that the Company
will have sufficient capacity at any given time to meet its customers' demands
if such demands exceed anticipated levels.
In addition to the variability resulting from the short-term nature of
its customers' commitments, other factors have contributed, and may contribute
in the future, to significant periodic and quarterly fluctuations in the
Company's results of operations. These factors include, among other things, the
timing of orders; volume of orders relative to the Company's capacity;
customers' announcements, introductions and market acceptance of new products or
new generations of products; evolution in the life cycles of customers'
products; timing of expenditures in anticipation of future orders; effectiveness
in managing manufacturing processes; changes in cost and availability of labor
and components; product mix; pricing and availability of competitive products
and services; and changes or anticipated changes in economic conditions.
The Company uses existing design programs to gauge expected future
volume of business. Completion of the design is dependent, however, on a variety
of factors, including the customer's changing needs, and not every design is
successful in meeting those needs.
Utilization of Arizona Facility
The Company has made substantial expenditures in constructing and
equipping its facility in Tempe, Arizona, with a high-volume LCD manufacturing
line. The high-volume line was placed in service in 1996, although the Company
committed a significant amount of time and resources in 1996 and 1997 to the
development of manufacturing processes on the line. The Company utilizes the
high-volume line to produce a substantial portion of its own requirements for
LCD glass.
The successful utilization of the LCD glass line will require the
Company (i) to produce LCD glass on a timely and cost-effective basis at quality
levels at least equal to the LCD glass available from independent suppliers and
(ii) to utilize the LCD glass it produces in devices it designs and manufactures
in a manner satisfactory to its customers. The Company experienced some delays
in fully implementing its LCD glass manufacturing operations in 1996, and no
assurance can be given that the Company will not experience problems or delays
in the future in conducting its LCD glass manufacturing operations. Any such
problems could result in the lengthening of the Company's delivery schedules,
reductions in the quality or performance of the Company's design and
manufacturing services, and reduced customer satisfaction. Such problems also
could require the Company to purchase its LCD glass requirements from third
parties and could delay the Company's ability to recover its investment in the
high-volume LCD line.
In addition, in 1998 the Company intends to add additional equipment to
the LCD glass line to enhance its ability to manufacture LCoS(TM) microdisplays.
See "Description of Business-Research and Development" contained in Item 1 of
this Report. Manufacturing a LCoS(TM) microdisplay is a significantly different
procedure than manufacturing a typical liquid crystal display. The manufacturing
of microdisplays will require the Company to overcome challenges, including the
use of a new material (silicon), the modification of equipment and processes to
accommodate the miniature size of the product, the implementation of new
scribing and breaking techniques, the incorporation of new handling procedures,
the maintenance of cleaner manufacturing environments, and the ability to master
tighter tolerances in the manufacturing process. Utilization of the LCD line for
microdisplays also will require higher yields because of the significant cost of
the silicon backplane.
Management of Growth
The Company's revenue expanded substantially during the period from
1993 through 1995, but declined significantly in 1996 as a result of the
discontinuation of a few significant programs from its major customer. During
1997, however, the Company increased the number of its manufacturing and design
programs and the
14
Company plans to further expand the number and diversity of its programs in the
future. At the end of 1997, the Company had 76 manufacturing and design programs
versus 69 at the end of 1996. The Company's ability to manage its planned growth
effectively will require it to enhance its operational, financial, and
management systems, to expand its facilities and equipment, and to successfully
hire, train, and motivate additional employees, including the technical
personnel necessary to operate its new LCD glass production facility in Arizona.
The failure of the Company to manage its growth on an effective basis could have
a material adverse effect on the Company's operations.
As the Company expands and diversifies its product and customer base,
it may have to further increase its selling and administrative expenses. The
Company may be required to increase staffing and other expenses as well as its
expenditures on capital equipment and leasehold improvements in order to meet
the anticipated demand of its customers. Customers, however, generally do not
commit to firm production schedules for more than a short time in advance. The
Company's profitability would be adversely affected if the Company increases its
expenditures in anticipation of future orders that do not materialize. Customers
also may require rapid increases in design and production services that place an
excessive short-term burden on the Company's resources.
Dependence on Key Personnel
The Company's development and operations depend substantially on the
efforts and abilities of its senior management and technical personnel,
including David R. Buchanan, who has served as the Chairman of the Board since
1986 and as President and Chief Executive Officer of the Company since 1987. The
competition for qualified management and technical personnel is intense. The
loss of services of one or more of its key employees or the inability to add key
personnel (including those required for its LCD glass production facility) could
have a material adverse effect on the Company. See "Description of Business -
Executive Officers" contained in Item 1 of this Report. The Company does not
have any fixed-term agreements with, or key person life insurance covering, any
officer or employee. The Company, however, maintains noncompetition and
nondisclosure agreements with its key personnel.
Protection of Intellectual Property
The Company relies on a combination of patent, trade secret, and
trademark laws, confidentiality procedures, and contractual provisions to
protect its intellectual property. The Company seeks to protect certain of its
technology under trade secret laws, which afford only limited protection. There
can be no assurance that any of the Company's pending patent applications will
be issued or that intellectual property laws will protect the Company's
intellectual property rights. In addition, there can be no assurance that any
patent issued to the Company will not be challenged, invalidated or circumvented
or that the rights granted thereunder will provide competitive advantages to the
Company. Despite the Company's efforts to protect its proprietary rights,
unauthorized parties may attempt to obtain and use information that the Company
regards as proprietary. Furthermore, there can be no assurance that others will
not independently develop similar technology or design around any patents issued
to the Company. Moreover, effective protection of intellectual property rights
may be unavailable or limited in certain foreign countries in which the Company
operates. In particular, the Company may be afforded only limited protection of
its intellectual property rights in China.
The Company may in the future be notified that it is infringing certain
patents or other intellectual property rights of others, although there are no
such pending lawsuits against the Company or unresolved notices that it is
infringing intellectual property rights of others. No assurance can be given
that in the event of such infringement, licenses could be obtained on
commercially reasonable terms, if at all, or that litigation will not occur. The
failure to obtain necessary licenses or other rights or the occurrence of
litigation arising out of such claims could materially adversely affect the
Company, its results of operations, prospects or debt service ability.
Possible Volatility of Stock Price
The market price of the Company's Common Stock increased dramatically
during the three-year period ended December 31, 1994, but declined significantly
during 1995 and 1996. See "Market for Common Equity and
15
Related Stockholder Matters" contained in Item 5 of this Report. The trading
price of the Company's Common Stock in the future could continue to be subject
to wide fluctuations in response to various factors, including quarterly
variations in operating results of the Company, actual or anticipated
announcements of technical innovations or new product developments by the
Company or its competitors, changes in analysts' estimates of the Company's
financial performance, general conditions in the electronics industry, worldwide
economic and financial conditions, and other events or factors. In addition, the
stock market has experienced extreme price and volume fluctuations which have
particularly affected the market prices for many high technology companies and
which often have been unrelated to the operating performance of such companies.
These broad market fluctuations and other factors may adversely affect the
market price of the Company's Common Stock.
Competition
The industries which the Company serves are intensely competitive and
have been characterized by price erosion, rapid technological change, and
foreign competition. The Company competes with major domestic and international
companies, many of which have greater market recognition and substantially
greater financial, technical, marketing, distribution, and other resources than
the Company possesses. Emerging companies also may increase their participation
in the user interface device market. The ability of the Company to compete
successfully depends on a number of factors both within and outside its control,
including the quality, performance, reliability, features, ease of use, pricing,
and diversity of its product solutions; foreign currency fluctuations, which may
cause a foreign competitor's products to be priced significantly lower than the
Company's products; the quality of its customer services; its ability to address
the needs of its customers; its success in designing and manufacturing new
product solutions, including those implementing new technologies; the
availability of adequate sources of raw materials and other supplies at
acceptable prices; its efficiency of production; the rate at which customers
incorporate the Company's user interface devices into their own products;
product solution introductions by the Company's competitors; the number, nature,
and success of its competitors in a given market; and general market and
economic conditions. The Company currently competes principally on the basis of
the technical innovation and performance of its user interface devices,
including their ease of use and reliability, as well as on cost and timely
design, manufacturing, and delivery schedules.
The Company's competitive position could be adversely affected if one
or more of these customers increase their own capacity and decide to design and
manufacture their own user interface devices, to use standard devices, or to
outsource with a competitor. There is no assurance that the Company will
continue to be able to compete successfully in the future. See "Description of
Business - Competition" contained in Item 1 of this Report.
Shortage of Raw Materials and Supplies
The principal raw materials used in producing the Company's product
solutions consist of gallium arsenide and gallium phosphorous wafers and die,
LCD glass, driver die, circuit boards, molded plastic parts, lead frames, wire,
chips, and packaging materials, most of which are acquired from Asian sources.
The Company does not have long-term contracts with its suppliers.
The Company believes that there are alternative sources of supplies for
most of these materials. Many materials, however, must be obtained from foreign
suppliers, which subjects the Company to certain risks, including supply
interruptions and currency price fluctuations. Purchasers of these materials,
including the Company, experience difficulty from time to time in obtaining such
materials. Although some component leadtimes have lengthened, the Company's
suppliers currently are adequately meeting the requirements of the Company, and
the Company's ability to produce a substantial portion of its own requirements
for LCD glass in its Arizona facility has reduced the Company's dependence on
foreign suppliers of LCD glass.
The Electronics Industry: Cyclicality and Capital Requirements
The electronics industry has experienced significant economic downturns
at various times, characterized by diminished product demand, accelerated
erosion of average selling prices, and production over-capacity. In addition,
16
the electronics industry has been characterized by cyclicality. The Company has
sought to reduce its exposure to industry downturns and cyclicality by providing
design and production services for leading companies in rapidly expanding
segments of the electronics industry. However, the Company may experience
substantial period-to-period fluctuations in future operating results because of
general industry conditions or events occurring in the general economy. There is
no assurance that the Company will continue to experience increased demand.
To remain competitive, the Company must continue to make significant
investments in research and development, equipment, and facilities. As a result
of the increase in fixed costs and operating expenses related to these capital
expenditures, the Company's operating results may be adversely affected if its
net sales do not increase sufficiently to offset these increased costs.
The Company from time to time may seek additional equity or debt
financing to provide for the capital expenditures required to maintain or expand
the Company's design and production facilities and equipment. The timing and
amount of any such capital requirements cannot be predicted at this time. There
can be no assurance that any such financing will be available on acceptable
terms. If such financing is not available on satisfactory terms, the Company may
be unable to expand its business or develop new customers at the rate desired
and its operating results may be adversely affected. Debt financing increases
expenses and must be repaid regardless of operating results. Equity financing
could result in additional dilution to existing stockholders. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Liquidity and Capital Resources" contained in Item 7 of this Report.
Environmental Regulation
The operations of the Company result in the creation of small amounts
of hazardous waste, including various epoxies, gases, inks, solvents, and other
wastes. The Company, therefore, is subject to federal, state, and local
governmental regulations related to the use, storage, discharge, and disposal of
toxic, volatile, or otherwise hazardous chemicals used in its design and
manufacturing processes. The amount of hazardous waste produced by the Company
may increase in the future depending on changes in the Company's operations. The
failure by the Company to comply with present or future environmental
regulations could result in fines being imposed on the Company, suspension of
production, or a cessation of operations. Compliance with such regulations could
require the Company to acquire costly equipment or to incur other significant
expenses. Any failure by the Company to control the use of, or adequately
restrict the discharge of, hazardous substances could subject it to future
liabilities.
In January 1991, the Company received a notice of potential liability
respecting a landfill site near the Company's former property in Barkhamsted,
Connecticut from the United States Environmental Protection Agency. No further
administrative action was taken against the Company and the Company was verbally
advised by a representative of the EPA that the Company will have no liability
with respect to this matter. In a separate matter, the Company has removed
contamination and continues to conduct periodic chemical monitoring at the
Company's former Connecticut property. There can be no assurance that other
environmental problems will not be discovered in the future which could subject
the Company to future costs or liabilities. See "Description of Business -
Environmental Regulation" contained in Item 1 of this Report.
Change in Control Provisions
The Company's Restated Certificate of Incorporation (the "Restated
Certificate") and the Delaware General Corporation Law (the "Delaware GCL")
contain provisions that may have the effect of making more difficult or delaying
attempts by others to obtain control of the Company, even when these attempts
may be in the best interests of stockholders. The Restated Certificate also
authorizes the Board of Directors, without stockholder approval, to issue one or
more series of Preferred Stock which could have voting and conversion rights
that adversely affect or dilute the voting power of the holders of Common Stock.
The Delaware GCL also imposes conditions on certain business combination
transactions with "interested stockholders" (as defined therein).
17
Year 2000 Compliance
Many currently installed computer systems and software products are
coded to accept only two-digit entries to represent years. For example, the year
"1997" would be represented by "97". These systems and products will need to be
able to accept four-digit entries to distinguish years beginning with 2000 from
prior years. As a result, systems and products that do not accept four-digit
year entries will need to be upgraded or replaced to comply with such "Year
2000" requirements. Currently, the Company is reviewing its internal systems to
determine the impact of the Year 2000 requirements. The Company believes that
its internal systems are Year 2000 compliant or will be upgraded or replaced
prior to the need to comply with Year 2000 requirements, and the Company does
not anticipate any material disruption in its operations as the result of any
failure by the Company to be compliant. The Company believes that the overall
cost of compliance will not be material and expenses such compliance costs when
incurred. It is uncertain whether the Company's customers and suppliers will
have Year 2000 issues that may affect the Company, but the Company currently is
developing a plan to evaluate the Year 2000 compliance status of its customers
and suppliers.
Rights to Acquire Shares
At December 31, 1997, 22,000 shares of Common Stock were reserved for
issuance upon exercise of options previously granted under the Company's 1997
Stock Option Plan; 9,000 shares of Common Stock were reserved for issuance upon
exercise of options previously granted under the Company's 1994 Automatic Stock
Option Plan; 309,750 shares of Common Stock were reserved for issuance upon
exercise of options previously granted under the Company's 1993 Stock Option
Plan; and 210,220 shares of Common Stock were reserved for issuance upon
exercise of options previously granted under the Company's 1990 Stock Option
Plan. The weighted average exercise price of those shares is $11.01 per share.
During the terms of such options, the holders thereof will have an opportunity
to profit from an increase in the market price of Common Stock with resulting
dilution in the interests of holders of Common Stock. The existence of such
stock options may adversely affect the terms on which the Company can obtain
additional financing, and the holders of such options can be expected to
exercise such options at a time when the Company, in all likelihood, would be
able to obtain additional capital by offering shares of its Common Stock on
terms more favorable to the Company than those provided by the exercise of such
options.
Repurchase of Common Stock
In August 1996, the Board of Directors authorized the repurchase from
time to time of up to one million shares of the Company's Common Stock on the
open market or in negotiated transactions, depending on market conditions and
other factors. The repurchase of shares by the Company would reduce the
Company's capital. If the Company obtains financing from other sources for such
repurchases, the liabilities of the Company would increase. The reduction in
capital or increase in liabilities could adversely affect the Company's ability
to expand its business or commit resources to needed expenditures. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Capital Resources" contained in Item 7 of this
Report. A significant reduction in the number of shares outstanding on the open
market could also increase the volatility of the stock as a result of the
reduced supply of available shares on the open market.
Shares Eligible for Future Sale; Potential Depressive Effect on Stock Price
Currently, Rule 144 under the Securities Act of 1933, as amended (the
"Securities Act"), provides that each person who beneficially owns restricted
securities with respect to which at least one year has elapsed since the later
of the date the shares were acquired from the Company or an affiliate of the
Company may, every three months, sell in ordinary brokerage transactions or to
market makers an amount of shares equal to the greater of 1 percent of the
Company's then-outstanding Common Stock or the average weekly trading volume for
the four weeks prior to the proposed sale of such shares. An aggregate of
957,908 shares of Common Stock held by all the executive officers and directors
of the Company currently are available for sale under Rule 144. Sales of
substantial amounts of Common Stock by the stockholders of the Company, or even
the potential for such sales, may have a depressive effect on the market price
of the Common Stock and could impair the Company's ability to raise capital
through the sale of its equity securities.
18
Dividends
The Company has never paid any cash dividends on its Common Stock and
does not anticipate that it will pay cash dividends in the near term. Instead,
the Company intends to apply any earnings to the expansion and development of
its business. See "Market for Common Equity and Related Stockholder Matters"
contained in Item 5 of this Report.
Cautionary Statement Regarding Forward-Looking Statements
Certain statements and information contained in this Report under the
headings "Description of Business" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations" concerning future, proposed, and
anticipated activities of the Company, certain trends with respect to the
Company's revenue, operating results, capital resources, and liquidity or with
respect to the markets in which the Company competes or the electronics industry
in general, and other statements contained in this Report regarding matters that
are not historical facts are forward-looking statements, as such term is defined
in the Securities Act. Forward-looking statements, by their very nature, include
risks and uncertainties, many of which are beyond the Company's control.
Accordingly, actual results may differ, perhaps materially, from those expressed
in or implied by such forward-looking statements. Factors that could cause
actual results to differ materially include those discussed elsewhere under this
Item 1, "Description of Business - Special Considerations" in Item 1 of this
Report.
ITEM 2. DESCRIPTION OF PROPERTY
The Company occupies a 97,000 square foot facility in Tempe, Arizona,
which houses its United States based manufacturing operations; its research,
development, engineering, design, and corporate functions; and the largest fully
automated LCD glass manufacturing operations in North America. The Company
entered into a ground lease through December 31, 2069, subject to renewal and
purchase options as well as early termination provisions. Costs to construct,
furnish, and equip the new facility were approximately $24.0 million.
The Company leases approximately 3,500 square feet of office space in
Swindon, United Kingdom, where it maintains its European administrative and
executive offices.
The Company leases approximately 60,000 square feet of manufacturing
space in Manila, the Philippines. Approximately 40,000 square feet is subject to
a lease which expires on December 31, 1999, and the remaining 20,000 square feet
is subject to a lease which expires on March 31, 1999, and is renewable from
year to year thereafter.
ITEM 3. LEGAL PROCEEDINGS
There are no legal proceedings to which the Company is a party or to
which any of its properties are subject, other than routine litigation incident
to the Company's business which is covered by insurance or an indemnity or which
are not expected to have a material adverse effect on the Company. It is
possible, however, that the Company could incur claims for which it is not
insured or that exceed the amount of its insurance coverage.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable
19
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock has been listed on the New York Stock
Exchange ("NYSE") under the symbol "TFS" since December 29, 1994. The Company's
Common Stock was listed on the American Stock Exchange ("AMEX") from January 28,
1993 through December 28, 1994. The Company's Common Stock was listed on the
AMEX Emerging Company Marketplace from March 18, 1992 until January 27, 1993,
and on the Nasdaq National Market system from May 1, 1990 until March 17, 1992.
The following table sets forth the quarterly high and low prices of the
Company's Common Stock for the periods indicated, adjusted to reflect the
two-for-one split of the Common Stock effected as a stock dividend in May 1994.
High Low
---- ---
1993:
First Quarter.............................................................. $ 3 7/8 $ 1 3/4
Second Quarter............................................................. 8 3 7/16
Third Quarter.............................................................. 12 1/16 6 3/8
Fourth Quarter............................................................. 17 5/8 10 7/8
1994:
First Quarter.............................................................. $ 30 7/8 $ 16 9/16
Second Quarter............................................................. 29 15/16 20
Third Quarter.............................................................. 46 1/2 26 1/4
Fourth Quarter............................................................. 50 28 3/4
1995:
First Quarter.............................................................. $ 38 3/8 $ 20 5/8
Second Quarter............................................................. 38 7/8 22 3/8
Third Quarter.............................................................. 36 3/4 24 1/4
Fourth Quarter............................................................. 26 1/2 16
1996:
First Quarter.............................................................. $ 21 7/8 $ 11 5/8
Second Quarter............................................................. 14 1/8 9 1/8
Third Quarter.............................................................. 13 8 3/4
Fourth Quarter............................................................. 14 10 5/8
1997:
First Quarter.............................................................. $ 16 1/4 $ 12 1/4
Second Quarter ............................................................ 16 11 5/8
Third Quarter.............................................................. 26 7/8 14 1/4
Fourth Quarter............................................................. 26 1/2 16 1/2
1998:
First Quarter (through March 6, 1998)...................................... $ 23 1/16 $ 17 3/4
As of March 6, 1998, there were approximately 1,160 holders of record
of the Company's Common Stock. The closing sale price of the Company's Common
Stock on the NYSE on March 6, 1998 was $21.88 per share.
20
The present policy of the Company is to retain earnings to provide
funds for the operation and expansion of its business. The Company has not paid
dividends on its Common Stock and does not anticipate that it will do so in the
near term. Furthermore, the Company's line of credit with Imperial Bank does not
permit the payment of dividends without the consent of Imperial Bank. The
payment of dividends in the future will depend on the Company's growth,
profitability, financial condition, and other factors which the directors may
deem relevant.
21
ITEM 6. SLECTED FINANCIAL DATA
The following table summarizes certain selected consolidated financial
data of the Company and is qualified in its entirety by the more detailed
consolidated financial statements and notes thereto appearing elsewhere herein.
The data have been derived from the consolidated financial statements of the
Company audited by Arthur Andersen LLP, independent public accountants. All
share amounts and per share data have been adjusted to reflect the two-for-one
split of the Company's Common Stock effected as a stock dividend in May 1994.
1997 1996 1995 1994 1993
---- ---- ---- ---- ----
Consolidated Statements of Income (Loss): (in thousands, except per share amounts)
Net sales.............................................. $84,642 $60,713 $91,585 $85,477 $38,002
------- ------ ------ ------ ------
Costs and expenses:
Cost of sales........................................ 64,760 58,321 70,481 59,409 26,725
Selling, general and administrative.................. 6,557 5,351 5,386 4,867 3,853
Research and development............................. 5,106 4,065 2,396 1,270 857
------- ------ ------ ------ ------
76,423 67,737 78,263 65,546 31,435
------- ------ ------ ------ ------
Operating income (loss)................................ 8,219 (7,024) 13,322 19,931 6,567
------- ------ ------ ------ ------
Other income (expense)
Interest, net........................................ 548 412 765 859 (117)
Other, net........................................... (190) (139) (122) (135) (277)
------- ------ ------ ------ ------
358 273 643 724 (394)
------- ------ ------ ------ ------
Income (loss) before provision for (benefit from)
income taxes and cumulative effect of
accounting change.................................... 8,577 (6,751) 13,965 20,655 6,173
Provision for (benefit from) income taxes.............. 3,334 (2,920) 5,548 8,109 2,043
------- ------ ------ ------ ------
Income (loss) before cumulative effect of
accounting change.................................... 5,243 (3,831) 8,417 12,546 4,130
Cumulative effect of accounting change................. -- -- -- -- 924
------- ------ ------ ------ ------
Net income (loss)...................................... $5,243 $ (3,831) $8,417 $12,546 $5,054
======= ======= ======= ======= =======
Earnings (loss) per common share
Basic................................................. $ 0.67 $ (0.49) $ 1.09 $ 1.88 $ 0.77
======= ======= ======= ======= =======
Diluted............................................... $ 0.65 $ (0.49) $ 1.04 $ 1.59 $ 0.71
======= ======= ======= ======= =======
Weighted average number of common shares
Basic................................................ 7,854 7,768 7,716 6,666 6,578
======= ======= ======= ======= =======
Diluted.............................................. 8,090 7,768 8,084 7,890 7,083
======= ======= ======= ======= =======
Consolidated Balance Sheet Data (at end of period):
Working capital........................................ $29,113 $21,513 $22,400 $37,638 $ 7,427
Total assets........................................... 72,835 62,569 63,780 56,280 17,470
Notes payable to banks and long-term debt.............. -- -- 3,000 182 223
Stockholders' equity................................... 56,525 51,184 55,224 46,561 10,202
22
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Results of Operations
Annual Table: Percentages of Net Sales
The following table sets forth, for the periods indicated, the
percentage of net sales of certain items in the Company's Consolidated Financial
Statements. The table and the discussion below should be read in conjunction
with the Consolidated Financial Statements and Notes thereto.
Year Ended December 31,
-----------------------
1997 1996 1995
---- ---- ----
Net sales......................................................... 100.0% 100.0% 100.0%
------ ------- ------
Costs and expenses
Cost of sales................................................... 76.5 96.1 77.0
Selling, general, and administrative............................ 7.8 8.8 5.9
Research and development........................................ 6.0 6.7 2.6
------- ------- -------
90.3 111.6 85.5
Operating income (loss)........................................... 9.7 (11.6) 14.5
Other income ..................................................... 0.4 0.5 0.7
------- ------- -------
Income (loss) before provision for (benefit from) income taxes.... 10.1 (11.1) 15.2
Provision for (benefit from) income taxes......................... 3.9 (4.8) 6.1
------- ------- -------
Net income (loss)................................................. 6.2% (6.3)% 9.1%
======== ========= ========
Year Ended December 31, 1997 Compared with Year Ended December 31,1996
Net sales were $84.6 million for 1997, an increase of 39.4 percent
compared with net sales of $60.7 million for 1996. The sales increase was as a
result of several new programs in 1997 for a variety of customers, including a
major office automation customer. In 1997, the Company's largest customer
accounted for net sales of $29.2 million compared with net sales of $39.5
million to that customer in 1996, for an overall decrease of 26.1 percent. The
Company's major customer accounted for approximately 34.6 percent of net sales
for 1997 compared with approximately 65.1 percent for 1996. One other customer
accounted for $27.1 million, or 32 percent of the net sales, in 1997.
Cost of sales, as a percentage of net sales, decreased to 76.5 percent
for 1997 as compared with 96.1 percent for 1996. The corresponding increase in
the gross margin was the result of a number of factors, including decreased
provisions for excess and obsolete inventory, decreased unfavorable
manufacturing variances occurring as a result of increased manufacturing volume,
labor utilization, and material purchases, and a more mature product mix with
higher margins and better yields. In the third quarter of 1996, the Company took
a special one-time provision for excess and obsolete inventory related primarily
to end-of-life programs for which the majority of shipments, expected to occur
in the latter part of 1996, never materialized. Furthermore, the Company was
required to make significant design modifications to a new product, which also
resulted in obsolete inventory. Without the provision for excess and obsolete
inventory taken in the third quarter of 1996, the cost of sales, as a percentage
of net sales, would have been 84.5 percent for 1996.
Selling, general, and administrative expense was $6.6 million for 1997,
as compared with $5.4 million in 1996. Selling, general and administrative
expenses have increased in absolute terms as a result of increased selling
expenses and the addition of administrative personnel. As a result of increased
revenue in 1997, however, selling, general, and administrative expense declined
to 7.8 percent of net sales from 8.8 percent of net sales in 1996.
23
Research and development expense totaled $5.1 million, or 6.0 percent
of net sales, for 1997 as compared with $4.1 million, or 6.7 percent of net
sales, for 1996. Research and development expense consists principally of
salaries and benefits to scientists and other personnel, related facilities
costs, including certain expenses associated with the development of new
processes on the LCD line in Tempe, Arizona, and various expenses for projects.
Research and development expense has increased as the Company has invested in
new technologies and manufacturing processes, developed new potential products,
and continued its in-house process development efforts related to the
high-volume manufacturing LCD line. The Company believes that continued
investments in research and development relating to manufacturing processes and
new display technology are necessary to remain competitive in the marketplace,
as well as to provide opportunities for growth.
Interest income (net) for 1997 was $548,000, up from $412,000 for 1996.
The increase in interest income was the result of investing higher average cash
balances during the year. Other expenses (net) increased to $190,000 for 1997
from $139,000 for 1996. The increase was primarily attributed to foreign
exchange losses.
The Company recorded a provision for income taxes of $3.3 million for
1997, as compared with a benefit from income taxes of $2.9 million for 1996.
This resulted primarily from having a loss in 1996 as compared with reporting
net income in 1997. The overall tax rate for the Company for 1997 was 38.9
percent as compared with 43.3 percent for 1996. The Company expects that the tax
rate for 1998 will approximate 40.0 percent.
For 1997, the Company reported net income of $5.2 million, or $0.65 per
share (diluted), as compared with a net loss of $3.8 million, or $0.49 per share
(diluted), for 1996. Without the provision for excess and obsolete inventory
taken in 1996, the Company would have reported net income of $158,000, or $0.02
per share, in 1996.
Year Ended December 31, 1996 Compared with Year Ended December 31,1995
Net sales were $60.7 million for 1996, a decrease of 33.7 percent
compared with net sales of $91.6 million for 1995. The sales decrease was
primarily a result of lower order rates from the Company's major customer for
existing product programs. During the first quarter of 1996, that customer,
which is in the wireless communications industry, informed the Company that it
had made an unexpected decision to begin phasing out certain of its cellular
products that used display modules which comprised the Company's highest volume,
longest running programs. Subsequently, the phase-out of those programs occurred
even more quickly than the Company had anticipated or its customer had initially
indicated. The sudden and unexpected reduction of those programs was the
greatest contributor to the reduced revenue in 1996. The long product
development time in the custom display business prevented the Company from
quickly replacing the phased-out programs. In 1996, the Company's largest
customer accounted for net sales of $39.5 million compared with net sales of
$73.7 million to that customer for 1995, for an overall decrease of 46.4
percent. The Company's major customer accounted for approximately 65.1 percent
of the net sales for 1996 compared with approximately 80.5 percent for 1995. All
other customers accounted for net sales of $21.2 million for 1996 compared with
net sales of $17.9 million for 1995.
Cost of sales, as a percentage of net sales, increased to 96.1 percent
for 1996 as compared with 77.0 percent for 1995. The corresponding decline in
the gross margin was the result of a number of factors, including increased
provisions for excess and obsolete inventory, manufacturing variances occurring
as a result of decreased manufacturing volume and material purchases, and sales
of low-margin products. In the third quarter of 1996, the Company took a special
one-time provision for excess and obsolete inventory related primarily to
end-of-life programs for which the majority of shipments, expected to occur in
the latter part of 1996, never materialized. Furthermore, the Company was
required to make significant design modifications to a new product, which also
resulted in obsolete inventory. Without the provision for excess and obsolete
inventory taken in the third quarter, the cost of sales, as a percentage of net
sales, would have been 84.5 percent for 1996.
Selling, general, and administrative expense was $5.4 million for 1996,
the same as in 1995. As a result of reduced revenue in 1996, however, selling,
general, and administrative expense rose to 8.8 percent of net sales from 5.9
percent of net sales in 1995.
24
Research and development expense totaled $4.1 million, or 6.7 percent
of net sales, for 1996 as compared with $2.4 million, or 2.6 percent of net
sales, for 1995. Research and development expense consists principally of
salaries and benefits to scientists and other personnel, related facilities
costs, including certain expenses associated with the start-up and continued
operations of the LCD line in Tempe, Arizona, and various expenses for projects.
Interest income (net) for 1996 was $412,000, down from $765,000 for
1995. The decrease in interest income was the result of investing lower average
cash balances during the year. Other expenses (net) increased to $139,000 for
1996 from $122,000 for 1995. An increase in closed facilities expenses and
foreign exchange losses in 1996 was partially offset by decreased net losses on
the sale of assets.
The Company recorded a benefit from income taxes of $2.9 million for
1996, as compared with a provision for income taxes of $5.5 million for 1995.
This resulted primarily from having a loss in 1996 as compared with reporting
net income in 1995. The reported tax rate for the Company in the fourth quarter
of 1996 was lower than normal because of an adjustment related to the difference
between 1995 tax accruals and taxes actually incurred. This adjustment was
$371,000 and was reflected in the reduced tax provision in the fourth quarter of
1996. The overall tax rate for the Company for 1996 was 43.3 percent as compared
with 39.7 percent for 1995.
For 1996, the Company reported a net loss of $3.8 million, or $0.49 per
share (diluted), as compared to net income of $8.4 million, or $1.04 per share
(diluted), for 1995. Without the provision for excess and obsolete inventory
taken in the third quarter, the Company would have reported net income of
$158,000, or $0.02 per share (diluted) in 1996.
25
Quarterly Results of Operations
The following table presents unaudited consolidated financial results
for each of the eight quarters in the period ended December 31, 1997. The
Company believes 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.
Quarters Ended
-----------------------------------------------------------------------------------------
(in thousands, except per share amounts)
1997 1996
-------------------------------------------- --------------------------------------------
Mar 31 June 30 Sept 30 Dec 31 Mar 31 June 30 Sept 30 Dec 31
------ ------- ------- ------ ------ ------- ------- ------
Net sales........................ $16,129 $18,737 $24,074 $25,702 $18,082 $14,457 $13,118 $15,056
------- ------- ------- ------- ------- ------- ------- -------
Costs and expenses:
Cost of sales................... 12,488 14,377 18,511 19,384 14,401 11,944 19,798 12,178
Selling, general, and
administrative................. 1,466 1,479 1,822 1,790 1,459 1,471 1,316 1,105
Research and development........ 1,130 1,315 1,314 1,347 1,010 820 1,074 1,161
------- ------- ------- ------- ------- ------- ------- -------
15,084 17,171 21,647 22,521 16,870 14,235 22,188 14,444
------- ------- ------- ------- ------- ------- ------- -------
Operating income (loss).......... 1,045 1,566 2,427 3,181 1,212 222 (9,070) 612
Other income (expense):
Interest, net................... 157 154 152 85 19 133 90 170
Other, net...................... (12) (7) (41) (130) (27) (72) (17) (23)
------- ------- ------- ------- ------- ------- ------- -------
Income (loss) before provision
for (benefit from) income taxes.. 1,190 1,713 2,538 3,136 1,204 283 (8,997) 759
Provision for (benefit from)
income taxes................... 389 685 1,010 1,250 482 113 (3,519) 4
------- ------- ------- ------- ------- ------- ------- -------
Net income (loss)................ $801 $1,028 $1,528 $1,886 $ 722 $ 170 $(5,478) $ 755
======= ======= ======= ======= ======= ======= ======= =======
Earnings (loss) per common share
Basic................... $0.10 $0.13 $0.19 $0.24 $0.09 $0.02 $(0.70) $0.10
======= ======= ======= ======= ======= ======= ======= =======
Diluted................. $0.10 $0.13 $0.19 $0.23 $0.09 $0.02 $(0.70) $0.09
======= ======= ======= ======= ======= ======= ======= =======
Weighted average number of
common shares
Basic............... 7,759 7,855 7,874 7,900 7,737 7,775 7,779 7,780
======= ======= ======= ======= ======= ======= ======= =======
Diluted............. 8,048 8,071 8,181 8,168 8,040 8,032 7,779 8,049
======= ======= ======= ======= ======= ======= ======= =======
Liquidity and Capital Resources
During 1997, the Company generated $6.8 million in cash flow from
operations as compared with $12.2 million during 1996. The decrease in cash flow
from operations was primarily due to the increase in accounts receivable (versus
the reductions in accounts receivable that occurred in 1996) and the increase in
inventory. The increase in inventory and accounts receivable occurred primarily
as a result of the increased sales activity in 1997. Depreciation expense in
1997 was $4.1 million versus $3.6 million in 1996. This increase was primarily
as a result of an increased number of starts on the LCD manufacturing line in
Tempe, Arizona. The high-volume LCD line is depreciated on a units of production
method based on units started. The Company anticipates that depreciation will
rise in 1998 as a result of additional capital expenditures in 1998, including a
new building and equipment for the proposed manufacturing facility in China, the
installation of additional equipment in its Manila manufacturing location, and
the installation of equipment in Tempe, Arizona to manufacture liquid crystal on
silicon (LCoS(TM)) microdisplays. The Company's working capital was $29.1
million at December 31, 1997, up from $21.5 million at December 31, 1996. The
Company's current ratio at December 31, 1997 was 3.1-to-1 as compared with a
current ratio of 3.2-to-1 at December 31, 1996. Including its cash and loan
commitments, the Company had over $31.7 million in readily available funds on
December 31, 1997.
26
In May 1997, the Company entered into a new $15.0 million revolving
line of credit with Imperial Bank, which matures May 22, 1998. At December 31,
1997, no borrowings were outstanding under this credit facility. Advances under
the revolving line may be made as Prime Rate Advances, which accrue interest
payable monthly at the bank's prime lending rate, or as LIBOR Rate Advances,
which bear interest at 175 basis points in excess of the LIBOR Base Rate. The
Company's subsidiary, Three-Five Systems Limited, has established an annually
renewable credit facility with a United Kingdom bank, Barclays Bank PLC, in
order to fund its working capital requirements. The facility provides $350,000
of borrowing capacity secured by accounts receivable of Three-Five Systems
Limited. Advances under the credit facility are based on accounts receivable, as
defined, and accrue interest, which is payable quarterly, at the bank's base
rate plus 200 basis points. The United Kingdom credit facility matures June 20,
1998. Three-Five Systems Limited had no borrowings outstanding under this line
of credit at December 31, 1997.
In 1996, the Board of Directors authorized the repurchase from time to
time of up to one million shares of the Company's Common Stock on the open
market or in negotiated transactions, depending on market conditions and other
factors. As of December 31, 1997, 22,500 treasury shares had been purchased by
the Company at a total cost of $253,000.
Capital expenditures during 1997 were approximately $3.0 million, as
compared with $948,000 during 1996. Capital expenditures for 1997 consisted
primarily of manufacturing and office equipment for the Company's operations in
Manila and Arizona and laboratory equipment for research and development. The
Company anticipates that it will increase its capital expenditures during 1998.
Those expenditures will primarily relate to advanced manufacturing processes,
the high-volume LCD line, and necessary manufacturing equipment. The Company
anticipates that it will spend approximately $3.0 million in early 1998 on the
capital equipment needed to manufacture LCoS(TM) microdisplays. A major portion
of that equipment already is on order. The Company also has decided to expand
its overseas manufacturing capabilities in 1998 by opening a manufacturing
facility in Beijing, China. The Company anticipates the facilities and capital
cost for China in 1998 to be approximately $8.0 million.
The Company anticipates that accounts receivable and inventory will
rise in 1998 if revenue levels increase as currently anticipated. The Company
believes that its existing capital, and anticipated cash flow from operations
and credit lines will provide adequate sources to fund operations and planned
expenditures throughout 1998. Should the Company encounter additional cash
requirements, however, the Company may have to expand its loan commitments or
pursue alternate methods of financing or raising capital.
Effects of Inflation and Foreign Currency Exchange Fluctuations
The results of operations of the Company for the periods discussed have
not been significantly affected by inflation or foreign currency fluctuations.
The Company generally sells its products and services and negotiates purchase
orders with its foreign suppliers in United States dollars. An exception is the
Company's Sub-Assembly Agreement in the Philippines, which is based on a fixed
conversion rate, exposing the Company to exchange rate fluctuations with the
Philippine peso. Although the Company has not incurred any material exchange
gains or losses to date, there has been some minor benefit as a result of the
recent peso devaluation. If the peso devaluation were to continue, a substantial
portion of the benefit to the Company will likely be offset by an increase in
the Philippine labor rates and costs. There can be no assurance that
fluctuations and currency exchange rates in the future will not have an adverse
affect on the Company's operations. The Company is planning to commence
operations in China in 1998. Although the Chinese currency currently is stable,
there can be no assurance that it will remain so in the future. The Company from
time to time may enter into hedging transactions in order to minimize its
exposure to currency rate fluctuations.
Business Outlook and Risk Factors
This Business Outlook section has numerous forward-looking statements.
Some of the risk factors associated with those forward-looking statements are
set forth in "Risk Factors" below. Other important risk factors are set forth
under "Special Considerations" in Item 1 of this Report.
27
The Company offers advanced design and manufacturing services to
original equipment manufacturers. The Company specializes in custom displays and
front panel displays utilizing liquid crystal display (LCD) and light emitting
diode (LED) components and technology. The Company experienced substantial
growth from 1993 through 1995 with such growth dependent primarily upon the
Company's participation in the substantial growth of the wireless communications
market and sales to a single major customer in that industry. In 1996, the
Company's sales declined, largely as a result of the phase-out by that major
customer of a significant family of programs in early 1996. In 1997, sales
returned to pre-1996 levels primarily as a result of several new programs and
customers, including a major office automation customer.
The Company had substantial growth in its revenues in 1997 with a 39.4
percent rate of growth over 1996. Fourth quarter revenues in 1997 were almost
59.3 percent greater than first quarter revenues in 1997. This growth occurred
because several new programs began production in the second and third quarters
of 1997 while many existing programs were in the middle of their life cycles. In
1997, more than 80 percent of revenue occurred in the second, third and fourth
quarters. In 1998, the Company anticipates that this type of revenue pattern
will be repeated. The Company believes that a pattern of seasonality may be
developing as OEMs with retail products develop shorter product life cycles and
introduce new programs early in the year following holiday sales. Although the
Company expects some significant new programs to begin ramping up production in
1998, several existing programs are nearing the completion of their natural life
cycles. Previously, the Company expected some of the new programs to begin to
ramp up production in the first quarter prior to the completion of the mature
programs. As the result of customer design issues, it now appears that those new
programs will not begin to ramp up until the second and third quarter in a
manner similar to the ramp up that occurred in 1997. As a result, the revenue
from those new programs will not be available in the first quarter to offset the
loss of revenue occurring from the completion of the older programs. Thus, sales
in the first quarter of 1998 will decline over sales in the fourth quarter of
1997.
The Company's estimated backlog of manufacturing revenue for programs
currently in design is substantially greater than it was at the end of 1996.
Therefore, if additional programs currently in development begin to ramp up
their production levels in the second and third quarter of 1998 as anticipated,
the Company should continue its year over year growth rate in 1998.
In the past several quarters, the Company has undertaken substantial
efforts to diversify its business, broaden its customer base, and expand its
markets, and the Company intends to continue those efforts. The Company's
historical major customer, 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. This
reduced percentage occurred as a result of the increased sales to other
customers and reduced product selling prices and overall revenue from that major
customer. Late in 1997, that major customer instituted an allocation process for
awarding 1998 LCD module business. Although the allocation does not provide a
guarantee of business, the Company anticipates that business with that customer
will increase in 1998 at a rate faster than increases in business with other
customers. Therefore, the percentage of revenue attributed to that wireless
communications customer may increase in 1998, but the current business plan of
the Company targets that customer to account for no more than 50 percent of its
1998 revenue. Another customer also accounted for 32 percent of the Company's
revenue in 1997, but the Company expects this percentage to decline
significantly over the next few quarters as current programs reach the end of
their cycles and replacement programs with lower selling prices are introduced.
The Company's gross margins are impacted by several factors, including
manufacturing efficiencies, product differentiation, product uniqueness,
billings for non-recurring engineering services, engineering costs, product mix,
and volume pricing. Generally, higher-volume programs using more generic,
low-information content LCD displays have lower margins. As the production
levels of some of the Company's new high-volume programs increase in early 1998,
the gross margins on those programs, which are generally lower, may have more of
an impact on the Company's overall margins. In addition, many of the Company's
competitors are Asian suppliers, and a strong dollar gives a competitive pricing
advantage to those suppliers. Thus, the Company may see competitive margin
pressure from Asian suppliers, particularly those in Korea and Japan. It is a
goal of the Company, however, for increased manufacturing efficiencies to occur
on those high-volume programs in order to maintain its gross margins at existing
28
levels, although those efficiencies should not positively impact the Company's
gross margins until after the first quarter of 1998. The Company also expects
that more advanced display modules, expected to be introduced later in 1998,
will command higher margins and should enable the Company to maintain its
overall 1998 gross margins in the same range as the gross margins in 1997.
As the Company expands and diversifies its product and customer base,
it may have to further increase its selling, general, and administrative
expenses. Serving a variety of customers with complex and differing issues
requires increased personnel committed to those customers. As a result, the
actual dollar amount of the selling, general, and administrative expenses in
1998 should be 20 to 25 percent greater than in 1997, although SG&A expenditures
as a percentage of net sales should continue decreasing in 1998.
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 as well as to provide
opportunities for growth. In 1997, the Company continued to expand and intensify
its internal research and development to focus on proprietary display products
rather than emphasizing manufacturing process improvements. Use of the LCD
manufacturing line in Tempe, Arizona as a resource for the testing of the new
ideas is the key to the development of these products, some of which will be
proprietary and not available from other display manufacturers. In addition, the
development of the high-volume manufacturing LCD line has helped reduce the
Company's dependence on foreign suppliers of LCD glass.
The Company also intends to pursue technologies being developed in
related fields. The Company operates the highest-volume fully automated LCD
manufacturing line in North America. As a result, several companies have
approached the Company about potential alliances. The Company believes that a
strategic alliance with one or more of those companies could minimize the cost
of entry into new markets and new technologies. In August 1997, National
Semiconductor Corporation and the Company entered into a strategic supplier
alliance agreement for the development and manufacture of LCoS(TM)
microdisplays. Under the alliance, the two companies are working together in
developing the LCoS(TM) technology with each company focusing on its core
competency of silicon and LCDs, respectively.
The Company also is considering licensing technologies from other
companies that could be optimized on the LCD manufacturing line. This internal
and external focus on research and development will continue indefinitely. As a
result, the actual dollar amount of such expenditures in 1998 should increase
over 1997, although research and development expenditures should decrease as a
percentage of net sales in 1998.
The Company has decided to establish manufacturing operations in The
People's Republic of China. A site was recently selected in Beijing, and an
individual with management experience in China was hired to act as the General
Manager and Vice President for the China operations. The Company plans to
establish Chinese manufacturing operations in 1998 for several reasons. First,
based upon its growth expectations for 1998 in the European and United States
marketplaces, the Company anticipates a need for manufacturing capacity beyond
what is available at its Philippine location. China was selected because of the
desire to diversify manufacturing locations and because of the cost benefits
that are expected to be achieved in China. The Company also believes that
locating a portion of its manufacturing operations in China will create
synergistic opportunities for the Company because many of the components used in
the Company's products are manufactured in China. Second, many of the Company's
existing and potential customers maintain manufacturing operations near the
proposed China location. Despite the current Asian situation, those customers
continue to require LCD modules and the Company participates very little in that
market. Currently, there are few LCD module manufacturers in China. Under
current Chinese government rules, however, OEMs in China have a strong
motivation to utilize locally manufactured components. The Company expects some
start up costs in 1998 associated with its manufacturing operations in China in
advance of the first revenues from China, which are expected to occur in the
third or fourth quarter of 1998. Other important risk factors are set forth
under "Special Considerations" in Item 1 of this Report.
29
Risk Factors
Forward-looking statements in this Report include revenue, margin,
expense, and earnings analysis for 1998 as well as the Company's expectations
relating to operations in China, future technologies, and future design and
production orders. The Company's future operating results may be affected by
various trends, developments, and factors that the Company must successfully
manage in order to achieve its goals. In addition, there are trends,
developments, and factors beyond the Company's control that may affect its
operations. The cautionary statements and risk factors set forth below and
elsewhere in this document, and in the Company's other filings with the
Securities and Exchange Commission, identify important trends, factors, and
currently known developments that could cause actual results to differ
materially from those in any forward-looking statements contained in this Report
and in any written or oral statements of the Company.
As noted previously, two customers currently are responsible for about
two-thirds of the Company's revenue. As a result, the majority of the Company's
revenue comes from a core customer base. Any material delay, cancellation, or
reduction of orders from one or more of those core customers could have a
material adverse effect on the Company's operations. The Company expects the
two-thirds concentration levels from those two combined customers in 1997 to
continue into 1998.
Although the trend of the Company is to enter into more manufacturing
contracts with its customers, the principal benefit of these contracts is to
clarify order lead times, inventory risk allocation, and similar matters and not
to provide firm, long-term volume purchase commitments. The Company has no firm
long-term volume purchase commitments from its customers. As a result, customer
commitments can be canceled and expected volume levels can be changed or
delayed. The timely replacement of canceled, delayed, or reduced commitments
cannot be assured and, among other things, could result in the Company holding
excess and obsolete inventory or having unfavorable manufacturing variances as a
result of under-absorption. These risks are exacerbated because the Company
expects that a majority of its sales will be to customers in the retail
electronics industry, which is subject to severe competitive pressures, rapid
technological change, and obsolescence.
Another risk inherent in custom manufacturing is the satisfactory
completion of design services and securing of production orders. A significant
portion of the Company's anticipated revenue for the future will come from
programs currently in the design or pilot production stage. Completion of the
design is dependent on a variety of factors, including the customer's changing
needs, and not every design is successful in meeting those needs. In addition,
some designs test new theories or applications and may not meet the desired
results. Failure of a design order to achieve the customer's desired results
could result in a material adverse effect on the Company's operations if the
expected production order for that product was significant. Even when a design
is satisfactorily completed, the customer may terminate or delay the program as
a result of marketing or other pressures. Finally, the Company is frequently one
of several sources to a customer on a program. Therefore, the Company could
satisfactorily complete all phases of the design and still fail to secure
significant production orders on that program because of competitive issues.
The Company plans to introduce several new products over the next few
years. These new products will require significant expenditures, including
expenses for custom integrated circuits as well as various capital expenditures
for manufacturing capability. For example, the Company estimates that its
initial capital expenditures for production of LCoS(TM) microdisplays will
require approximately $3.0 million. The failure of the Company to sell one or
more of these new technologies, including LCoS(TM) microdisplays, for any reason
could have a material adverse impact on the Company.
In addition to capital expenditures for new products, the Company is
currently spending research and development dollars on several new technologies
that it plans to introduce in the future. There is a risk that some or all of
those technologies may not successfully make the transition from the research
and development lab to cost-effective manufacturing capability, and such failure
could have a material adverse effect on the Company. Risks include technology
problems, competitive cost issues, and yield problems. In addition, even if a
new technology proves to be manufacturable, it may not be accepted by the
Company's customer and the customer's marketplace because of price or technology
issues or it may compare unfavorably with products previously introduced by
others.
30
The Company designs and manufactures products based on firm quotes. As
a result, 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. Recently, several material components of some of
the Company's major programs have been subject to allocation because of
shortages by vendors and continued or increased shortages could have a material
adverse effect on the Company in the future. In addition, although most of the
components purchased by the Company are purchased from vendors in Asian
countries unaffected by the current currency crisis, a significant portion of
the silicon drivers purchased by the Company are manufactured in Korea and
Japan. The instability in certain Asian countries could cause supply problems
with respect to these components.
The Company's primary competitors are located in Asia, including,
Japan, Korea, and Hong Kong, and most of the Company's customers are U.S.-based.
The recent currency devaluation of several Asian countries could have an impact
on the gross margins of the Company as the competitors' products become cheaper
to purchase with a stronger dollar.
Many currently installed computer systems and software products are
coded to accept only two-digit entries to represent years. For example, the year
"1997" would be represented by "97". These systems and products will need to be
able to accept four-digit entries to distinguish years beginning with 2000 from
prior years. As a result, systems and products that do not accept four-digit
year entries will need to be upgraded or replaced to comply with such "Year
2000" requirements. Currently, the Company is reviewing its internal systems to
determine the impact of the Year 2000 requirements. The Company believes that
its internal systems are Year 2000 compliant or will be upgraded or replaced
prior to the need to comply with Year 2000 requirements, and the Company does
not anticipate any material disruption in its operations as the result of any
failure by the Company to be compliant. The Company believes that the overall
cost of compliance will not be material and expenses such compliance costs when
incurred. It is uncertain whether the Company's customers and suppliers will
have year 2000 issues that may affect the Company, but the Company currently is
developing a plan to evaluate the year 2000 compliance status of its customers
and suppliers.
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.
31
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to the financial statements, the report thereon, the
notes thereto and the supplementary data commencing at page F-1 of this Report,
which financial statements, report, notes and data are incorporated herein by
reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
The information required by this Item relating to directors of the
Company is incorporated by reference to the definitive Proxy Statement to be
filed pursuant to Regulation 14A of the Exchange Act for the Company's 1998
Annual Meeting of Stockholders. The information required by this Item relating
to executive officers of the Company is included in "Description of Business -
Executive Officers" contained in Item 1 of this Report.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated herein by
reference to the definitive Proxy Statement to be filed pursuant to Regulation
14A of the Exchange Act for the Company's 1998 Annual Meeting of Stockholders.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is incorporated herein by
reference to the definitive Proxy Statement to be filed pursuant to Regulation
14A of the Exchange Act for the Company's 1998 Annual Meeting of Stockholders.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Not applicable.
32
PART IV
ITEM 14. EXHIBITS, FINANICAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Financial Statements and Financial Statement Schedule
(1) Financial Statements are listed in the Index to Financial
Statements on page F-1 of this Report.
(2) Financial Statement Schedule:
Schedule II Valuation and Qualifying Accounts and Reserves is
set forth on page S-1 of this Report.
Other schedules are omitted because they are not applicable, not
required or because required information is included in the consolidated
financial statements or notes thereto.
(b) Reports on Form 8-K
Not applicable.
(c) Exhibits
Exhibit
Number Exhibits
- ------ --------
2 Amended and Restated Agreement and Plan of Reorganization(1)
3(a) Restated Certificate of Incorporation of the Company(2)
3(b) Bylaws of the Company(1)
10(a) 1990 Incentive Stock Option Plan(1)
10(c) Line of Credit Agreement between Three-Five Systems Limited and Barclays Bank, PLC(1)
10(d) Sub-Assembly Agreement between Three-Five Systems, Inc. and TEAM Pacific Corporation dated
February 22, 1995(3)
10(g) Form of Three-Five Systems, Inc. Distributor Franchise Agreement(4)
10(j) 1993 Stock Option Plan(4)
10(k) 1994 Automatic Stock Option Plan(5)
10(l) Lease Agreement between Technology Electronic Assembly and Management (T.E.A.M.) Pacific
Corporation and Three-Five Systems Pacific, Inc.(6)
10(m) Lease Agreement between Regent Apparel Corporation and Three-Five Systems Pacific, Inc.(6)
10(o) Lease dated April 1, 1994, between Papago Park Center, Inc. and Three-Five Systems, Inc.(7)
10(t) Credit Agreement dated May 23, 1997 between Three-Five Systems, Inc. and Imperial Bank,
together with form of Revolving Promissory Note
10(u) Addendum No. 1 to Sub-Assembly Agreement between Three-Five Systems, Inc. and TEAM
Pacific Corporation dated March 12, 1997
10(v) 1997 Employee Stock Option Agreement
10(w) 1998 Stock Option Agreement
10(x) 1998 Director's Stock Plan
10(y) Addendum No. 2 to Sub-Assembly Agreement between Three-Five Systems, Inc. and TEAM
Pacific Corporation dated January 1, 1998
21 List of Subsidiaries
23 Consent of Arthur Andersen LLP
27.1 Financial Data Schedule
27.2 Amended and Restated Financial Data Schedule
27.3 Amended and Restated Financial Data Schedules
27.4 Restated Financial Data Schedule
- ----------------------------------------
(1) Incorporated by reference to the Registration Statement on Form S-4 of
TF Consolidation, Inc. (Registration No. 33-33944) as filed March 27,
1990 and declared effective March 27, 1990.
33
(2) Incorporated by reference to the Registrant's Form 10-QSB for the
quarter ended March 31, 1994, as filed with the Commission on or about
May 12, 1994.
(3) Incorporated by reference to the Registrant's Form 10-KSB for the
fiscal year ended December 31, 1994 filed with the Commission on March
22, 1995, as amended by Form 10-KSB/A as filed with the Commission on
April 28, 1995.
(4) Incorporated by reference to the Registration Statement on Form S-1
(Registration No. 33-74788) as filed on February 3, 1994, and declared
effective March 15, 1994.
(5) Incorporated by reference to the Registration Statement on Form S-8
(Registration No. 33-88706) as filed on January 24, 1995.
(6) Incorporated by reference to the Registrant's Form 10-K for the fiscal
year ended December 31, 1995, as filed with the Commission on March 13,
1996.
(7) Incorporated by reference to the Registrant's Form 10-K for the fiscal
year ended December 31, 1996, as filed with the Commission on March 14,
1997.
34
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Date: March 6, 1998 THREE-FIVE SYSTEMS, INC.
By /s/ David R. Buchanan
--------------------------------------
David R. Buchanan, Chairman of the Board,
President, and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
Name Title Date
---- ----- ----
/s/ David R. Buchanan Chairman of the Board, President, March 6, 1998
- ------------------------------------ And Chief Executive Officer
David R. Buchanan (Principal Executive Officer)
/s/ Jeffrey D. Buchanan Vice President - Finance, Administration, and March 6, 1998
- ------------------------------------ Legal; Chief Financial Officer; Secretary;
Jeffrey D. Buchanan and Treasurer (Principal Financial and
Accounting Officer)
/s/ David C. Malmberg Director March 6, 1998
- ------------------------------------
David C. Malmberg
/s/ Burton E. McGillivray Director March 6, 1998
- ------------------------------------
Burton E. McGillivray
/s/ Gary R. Long Director March 6, 1998
- ------------------------------------
Gary R. Long
/s/ Kenneth M. Julien Director March 6, 1998
- ------------------------------------
Kenneth M. Julien
35
THREE-FIVE SYSTEMS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Public Accountants ....................................F-2
Consolidated Balance Sheets as of December 31, 1997 and 1996 ................F-3
Consolidated Statements of Income (Loss) for the years ended
December 31, 1997, 1996 and 1995 .........................................F-4
Consolidated Statements of Stockholders' Equity for the
years ended December 31, 1997, 1996 and 1995 .............................F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 1997, 1996 and 1995 .........................................F-6
Notes to Consolidated Financial Statements ..................................F-7
F-1
ARTHUR ANDERSEN LLP
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Three-Five Systems, Inc.:
We have audited the accompanying consolidated balance sheets of THREE-FIVE
SYSTEMS, INC. (a Delaware corporation) and subsidiaries as of December 31, 1997
and 1996, and the related consolidated statements of income (loss),
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 1997. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Three-Five Systems, Inc. and
subsidiaries as of December 31, 1997 and 1996, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1997, in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Phoenix, Arizona,
January 20, 1998.
F-2
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)
ASSETS
December 31,
--------------------
1997 1996
-------- --------
CURRENT ASSETS:
Cash and cash equivalents (Note 2) $ 16,371 $ 12,580
Accounts receivable, net 12,540 6,830
Inventories, net (Note 2) 8,255 4,606
Deferred tax asset (Note 6) 4,311 5,930
Other current assets 1,228 1,384
-------- --------
Total current assets 42,705 31,330
PROPERTY, PLANT AND EQUIPMENT, net (Note 2) 29,847 30,913
OTHER ASSETS 283 326
-------- --------
$ 72,835 $ 62,569
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 8,513 $ 4,289
Accrued liabilities (Note 2) 5,079 4,524
Current taxes payable (Note 6) -- 1,004
-------- --------
Total current liabilities 13,592 9,817
-------- --------
DEFERRED TAX LIABILITY (Note 6) 2,718 1,568
COMMITMENTS AND CONTINGENCIES (Note 7)
STOCKHOLDERS' EQUITY (Note 4):
Preferred stock, $.01 par value; 1,000,000 shares
authorized -- --
Common stock, $.01 par value; 15,000,000 shares
authorized, 7,928,023 shares issued, 7,905,523 shares
outstanding at December 31, 1997; 7,779,829 shares
issued, 7,757,329 shares outstanding at
December 31, 1996 79 78
Additional paid-in capital 32,420 32,329
Retained earnings 24,259 19,016
Cumulative translation adjustment (Note 2) 20 14
Less- Treasury stock, at cost (22,500 shares) (253) (253)
-------- --------
Total stockholders' equity 56,525 51,184
-------- --------
$ 72,835 $ 62,569
======== ========
The accompanying notes are an integral part
of these consolidated balance sheets.
F-3
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME (LOSS)
(in thousands, except share amounts)
Years Ended December 31,
-----------------------------------------
1997 1996 1995
----------- ----------- -----------
NET SALES (Notes 5 and 8) $ 84,642 $ 60,713 $ 91,585
----------- ----------- -----------
COSTS AND EXPENSES:
Cost of sales 64,760 58,321 70,481
Selling, general and administrative 6,557 5,351 5,386
Research and development 5,106 4,065 2,396
----------- ----------- -----------
76,423 67,737 78,263
----------- ----------- -----------
Operating income (loss) 8,219 (7,024) 13,322
----------- ----------- -----------
OTHER INCOME (EXPENSE):
Interest, net 548 412 765
Other, net (190) (139) (122)
----------- ----------- -----------
358 273 643
----------- ----------- -----------
INCOME (LOSS) BEFORE PROVISION FOR
(BENEFIT FROM) INCOME TAXES 8,577 (6,751) 13,965
Provision for (benefit from) income taxes (Note 6) 3,334 (2,920) 5,548
----------- ----------- -----------
NET INCOME (LOSS) $ 5,243 $ (3,831) $ 8,417
=========== =========== ===========
EARNINGS (LOSS) PER COMMON SHARE (Note 2):
Basic $ 0.67 $ (0.49) $ 1.09
=========== =========== ===========
Diluted $ 0.65 $ (0.49) $ 1.04
=========== =========== ===========
WEIGHTED AVERAGE NUMBER OF COMMON SHARES:
Basic 7,854,053 7,767,744 7,715,996
=========== =========== ===========
Diluted 8,089,975 7,767,744 8,083,551
=========== =========== ===========
The accompanying notes are an integral part
of these consolidated statements.
F-4
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(in thousands, except share amounts)
Common Stock
--------------------- Additional Cumulative
Shares Paid-in Retained Translation Treasury
Issued Amount Capital Earnings Adjustment Stock Total
--------- --------- --------- --------- ---------- --------- ---------
BALANCE, December 31, 1994 7,691,524 $ 77 $ 32,052 $ 14,430 $ 2 $ -- $ 46,561
Stock options exercised 44,221 -- 32 -- -- -- 32
Tax benefit from early disposition
of incentive stock options (Note 6) -- -- 202 -- -- -- 202
Net income -- -- -- 8,417 -- -- 8,417
Translation adjustment -- -- -- -- 12 -- 12
--------- --------- --------- --------- --------- --------- ---------
BALANCE, December 31, 1995 7,735,745 77 32,286 22,847 14 -- 55,224
Stock options exercised 44,084 1 11 -- -- -- 12
Tax benefit from early disposition
of incentive stock options (Note 6) -- -- 32 -- -- -- 32
Net loss -- -- -- (3,831) -- -- (3,831)
Purchase of treasury stock -- -- -- -- -- (253) (253)
--------- --------- --------- --------- --------- --------- ---------
BALANCE, December 31, 1996 7,779,829 78 32,329 19,016 14 (253) 51,184
Stock options exercised 148,194 1 50 -- -- -- 51
Tax benefit from early disposition
of incentive stock options (Note 6) -- -- 41 -- -- -- 41
Net income -- -- -- 5,243 -- -- 5,243
Translation adjustment -- -- -- -- 6 -- 6
--------- --------- --------- --------- --------- --------- ---------
BALANCE, December 31, 1997 7,928,023 $ 79 $ 32,420 $ 24,259 $ 20 $ (253) $ 56,525
========= ========= ========= ========= ========= ========= =========
The accompanying notes are an integral part of these consolidated statements
F-5
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Years Ended December 31,
---------------------------------
1997 1996 1995
---------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 5,243 $(3,831) $ 8,417
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization 4,135 3,551 2,278
Provision for (reduction of) accounts receivable
valuation reserves (69) 47 (1)
Provision for (reduction of) inventory valuation reserves (2,473) 4,015 1,218
Loss on disposal of assets 2 12 24
Changes in assets and liabilities:
(Increase) decrease in accounts receivable (5,641) 2,469 (624)
(Increase) decrease in inventories (1,176) 5,082 (5,264)
(Increase) decrease in other assets 505 (1,070) (32)
Increase (decrease) in accounts payable and accrued liabilities 4,778 4,296 (3,170)
Increase (decrease) in taxes payable, net 1,461 (2,358) (1,568)
--------- --------- -------
Net cash provided by operating activities 6,765 12,213 1,278
--------- --------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property, plant and equipment (3,049) (948) (27,051)
Proceeds from sale of property, plant and equipment 19 5 326
--------- --------- -------
Net cash used for investing activities (3,030) (943) (26,725)
--------- --------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from (payments on) notes payable to banks - (3,000) 3,000
Principal payments on and retirement of long-term debt - - (182)
Stock options exercised 52 12 32
Purchase of treasury stock - (253) -
--------- --------- ------
Net cash provided by (used for) financing activities 52 (3,241) 2,850
--------- --------- -------
Effect of exchange rate changes on cash 4 - 12
--------- --------- -------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 3,791 8,029 (22,585)
CASH AND CASH EQUIVALENTS, beginning of year 12,580 4,551 27,136
--------- --------- -------
CASH AND CASH EQUIVALENTS, end of year $ 16,371 $ 12,580 $ 4,551
========= ========= =======
SUPPLEMENTAL CASH FLOW INFORMATION:
Interest paid $ 4 $ 60 $ 12
========= ========= =======
Income taxes paid $ 1,973 $ 1,832 $ 7,296
========= ========= =======
The accompanying notes are an integral part of these consolidated statements.
F-6
THREE-FIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1997, 1996 AND 1995
(1) ORGANIZATION AND OPERATIONS:
The Company designs and manufactures a wide range of user interface devices for
operational control and informational display functions required in the end
products of original equipment manufacturers ("OEMs"). Most of the Company's
sales consist of custom devices developed in close collaboration with its
customers. Devices designed and manufactured by the Company find application in
cellular telephones and other wireless communication devices as well as in
medical equipment, office automation equipment, industrial process controls,
instrumentation, consumer electronic products, automotive equipment, and
industrial and military control products. The Company currently specializes in
liquid crystal display ("LCD") and light emitting diode ("LED") components and
technology in providing its design and manufacturing services for its customers.
The Company markets its services primarily in North America, Europe, and Asia
through direct technical sales persons and, to a much lesser extent, through an
independent sales and distribution network.
The Company maintains its primary manufacturing facility in Manila, the
Philippines. A third-party subcontractor operates the facility under a
sub-assembly agreement with the Company utilizing equipment, processes, and
documentation owned by the Company. The sub-assembly agreement has a current
term extending through December 31, 1999, and from year to year thereafter, but
may be terminated by either party upon 180 days written notice. The termination
of or the inability of the Company to obtain products pursuant to the
sub-assembly agreement, even for a relatively short period, would have a
material adverse effect on the operations and profitability of the Company.
Since December 1994, the Company has made advances totaling approximately $1.7
million to the subcontractor to help the subcontractor in meeting its working
capital needs, all of which have been paid in full in 1997. The Company plans on
incorporating a wholly-owned subsidiary during 1998 which will be engaged in the
manufacturing and sale of the Company's products in China. Management expects
that capital expenditures to acquire the property, plant, and equipment for this
expansion will total approximately $8.0 million in 1998.
During 1995, the Company formed a wholly-owned subsidiary, Three-Five Systems
Pacific, Inc. (Pacific). Pacific, a Philippines corporation, procures supplies
primarily from Philippine vendors, as well as manages and assists production
personnel of a third party subcontractor the Company employs. Three-Five Systems
Limited (Limited), a wholly-owned subsidiary of the Company, is incorporated in
the United Kingdom. Limited sells and distributes the Company's products to
customers on the European continent.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Principles of Consolidation and Preparation of Financial Statements
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries. All material intercompany transactions have been
eliminated.
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
F-7
Fair Value of Financial Instruments
The estimated fair value of financial instruments has been determined by the
Company using available market information and valuation methodologies.
Considerable judgment is required in estimating fair values. Accordingly, the
estimates may not be indicative of amounts that would be realized in a current
market exchange. The carrying values of cash, accounts receivable and accounts
payable approximate fair value due to the short maturities of these instruments.
Cash and Cash Equivalents
For purposes of the statements of cash flows, all highly liquid investments with
a maturity of three months or less at the time of purchase are considered to be
cash equivalents. Cash equivalents consist of investments in commercial paper,
marketable debt securities, money market mutual funds, and United States
government agencies' obligations and are classified as held-to-maturity in
accordance with Statement of Financial Accounting Standards (SFAS) No. 115,
Accounting for Certain Investments in Debt and Equity Securities. Cash
equivalents were $12,886,000 and $11,243,000 at December 31, 1997 and December
31, 1996, respectively.
Inventories
Inventories are stated at the lower of cost (first-in, first-out) or net
realizable value. Reserves are established against Company-owned inventories for
excess, slow-moving, and obsolete items and for items where the net realizable
value is less than cost. The reserve for obsolete inventory totaled $4,309,000
and $6,782,000 at December 31, 1997 and December 31, 1996, respectively.
Inventories at December 31 consist of the following:
1997 1996
--------- ----------
(in thousands)
Raw materials $ 6,052 $ 3,147
Work-in-process 1,195 780
Finished goods 1,008 679
--------- ----------
$ 8,255 $ 4,606
========= ==========
Property, Plant and Equipment
Property, plant and equipment is recorded at cost and generally is depreciated
using the straight-line method over the estimated useful lives of the respective
assets, which range from 3 to 39 years. During 1996, the Company placed into
service a high-volume LCD glass manufacturing line in its Tempe, Arizona
manufacturing facility. The Company is depreciating the LCD glass line using the
units of production method. Depreciation expense recorded using this method may
be subject to significant fluctuation from year to year resulting from changes
in actual production levels and ongoing analysis of the capacity of the
equipment. Property, plant and equipment at December 31 consist of the
following:
1997 1996
---------- -----------
(in thousands)
Building and improvements $ 10,431 $ 10,431
Furniture and equipment 31,804 28,776
---------- -----------
42,235 39,207
Less- accumulated depreciation (12,388) (8,294)
---------- -----------
$ 29,847 $ 30,913
========== ===========
F-8
The Company intends to utilize a significant portion of the high-volume LCD
glass manufacturing line facility to produce a substantial portion of its own
requirements for LCD glass. The successful utilization of the manufacturing
facility will require the Company (i) to produce LCD glass on a timely and
cost-effective basis at quality levels at least equal to the LCD glass available
from independent suppliers and (ii) to utilize the LCD glass it produces in
devices it designs and manufactures in a manner satisfactory to its customers.
Although management believes that the manufacturing facility will be
successfully utilized, no assurance can be given that the Company will not
experience problems or delays in the future in conducting its LCD glass
manufacturing operations. Such problems could require the Company to continue to
purchase its LCD glass requirements from third parties and result in the
inability of the Company to recover its investment in the manufacturing
facility.
During 1996, the Company entered into a transaction in which it conveyed its
Tempe, Arizona facility and certain improvements to the City of Tempe as
consideration for a rent-free 75-year lease. The Company has the option to
repurchase the facility for $1,000 after ten years; therefore, the lease is
accounted for as a capital lease.
Accrued Liabilities
Accrued liabilities include accrued compensation of approximately $1,675,000 and
$988,000 at December 31, 1997 and 1996, respectively.
Foreign Currency Translation
Financial information relating to the Company's foreign subsidiaries is reported
in accordance with SFAS No. 52, Foreign Currency Translation. The gain or loss
resulting from the translation of the subsidiaries' financial statements has
been included as a separate component of stockholders' equity. The net foreign
currency transaction loss in 1997, 1996 and 1995 was $183,000, $46,000, and
$32,000, respectively, and has been included in other expenses in the
accompanying statements of income (loss).
Revenue Recognition
The Company recognizes revenue upon shipment. The Company's distributor
agreements provide for stock (inventory) rotation and price protection. Reserves
are provided for each of these programs based on past return experience. These
reserves are established at the time of shipment and reduce gross sales to
arrive at net sales as presented in the accompanying consolidated statements of
income (loss). These reserves are reflected as a reserve against accounts
receivable from sales to distributors and totaled $125,000 and $89,000 at
December 31, 1997 and 1996, respectively. The Company's distributors generally
offset any returns and allowances against payments on accounts receivable. The
Company also provides reserves for uncollectible accounts receivable. These
reserves totaled $455,000 and $560,000 at December 31, 1997 and 1996,
respectively. The Company performs ongoing credit evaluations of all of its
customers and considers various factors in establishing its allowance for
doubtful accounts.
Research and Development
Research and development costs are expensed as incurred. The Company currently
is spending research and development dollars on several new technologies that it
plans to introduce in the future. There is a risk that some or all of those
technologies may not successfully make the transition from the research and
development lab to cost-effective manufacturable products.
Earnings (Loss) Per Share
During 1997, the Company adopted SFAS No. 128, Earnings per Share. Pursuant to
SFAS No. 128, 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 year. Diluted earnings (loss) per common share for the
years ended December 31, 1997, 1996 and 1995 are determined assuming that
options were exercised at the beginning of each
F-9
year 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
year ended December 31, 1996 as their effect was anti-dilutive. Below are the
disclosures required pursuant to SFAS No. 128 for the years ended December 31,
1997, 1996 and 1995 (in thousands, except per share data):
For the Years
Ended December 31,
----------------------------
1997 1996 1995
------- ------- -------
Basic earnings (loss) per share:
Income available to common shareholders $ 5,243 $(3,831) $ 8,417
Weighted average common shares 7,854 7,768 7,716
------- ------- -------
Basic per share amount $ 0.67 $ (0.49) $ 1.09
======= ======= =======
Diluted earnings (loss) per share:
Income available to common shareholders $ 5,243 $(3,831) $ 8,417
Weighted average common shares 7,854 7,768 7,716
Options assumed converted 236 -- 368
------- ------- -------
Total common shares plus assumed
conversions 8,090 7,768 8,084
------- ------- -------
Diluted per share amount $ 0.65 $ (0.49) $ 1.04
======= ======= =======
(3) LONG-TERM DEBT:
In May 1997, the Company entered into a new $15.0 million unsecured revolving
line of credit which matures May 22, 1998. This line of credit bears interest at
the bank's prime rate (8.50% at December 31, 1997) or at the LIBOR base rate
(5.7% to 6.0% at December 31, 1997) plus 1.75%, and is payable monthly. There
was no balance outstanding at December 31, 1997 or 1996. In addition, the
Company has a $350,000 United Kingdom credit facility with interest due
quarterly at the bank's base rate (7.75% at December 31, 1997) plus 2%. Any
unpaid balance is due June 20, 1998, and is secured by United Kingdom accounts
receivable. Management intends to renew the United Kingdom credit facility and
does not anticipate any material changes to the existing terms.
The lines of credit contain certain restrictive covenants which include, among
other things, restrictions on the declaration or payment of dividends and the
amount of capital expenditures. The lines also require the Company to maintain a
specified net worth, as defined, to maintain a required debt to equity ratio and
to maintain certain other financial ratios.
(4) BENEFIT PLANS:
The Company has four stock option plans: the 1997 Stock Option Plan (1997 Plan),
the 1994 Non-Employee Directors Stock Option Plan (1994 Plan), the 1993 Stock
Option Plan (1993 Plan), and the 1990 Stock Option Plan (1990 Plan).
1997 Stock Option Plan
The 1997 Plan provides for the granting of nonqualified options to purchase up
to 100,000 shares of the Company's common stock. Under the 1997 Plan, options
may be issued to key personnel and others providing valuable services to the
Company and its subsidiaries. The options issued will be nonqualified stock
options and shall not be "incentive stock options" as defined in Section 422 of
the Internal Revenue Code of 1986 (the Code). Any option that expires or
terminates without having been exercised in full will again be available for
grant pursuant to the 1997 Plan. There were options outstanding to acquire
22,000 shares of the Company's common stock under the 1997 Plan at December 31,
1997.
F-10
The expiration date, maximum number of shares purchasable and the other
provisions of the options will be established at the time of grant. Options may
be granted for terms of up to ten years and become exercisable in whole or in
one or more installments at such time as may be determined by the plan
administrator upon grant of the options. The exercise prices of the options will
be determined by the plan administrator, but may not be less than 100 percent of
the fair market value of the common stock at the time of the grant. The 1997
Plan will remain in force until May 12, 2007.
1994 Non-Employee Directors Stock Option Plan
The 1994 Plan provides for the automatic grant of stock options to non-employee
directors to purchase up to 100,000 shares of the Company's common stock. Under
the 1994 Plan, options to acquire 500 shares of common stock will be
automatically granted to each non-employee director at the meeting of the Board
of Directors held immediately after each annual meeting of stockholders, with
such options to vest in a series of 12 equal and successive monthly installments
commencing one month after the annual automatic grant date. In addition, each
non-employee director serving on the Board of Directors on the date the 1994
Plan was approved by the Company's stockholders received an automatic grant of
options to acquire 1,000 shares of common stock and each subsequent newly
elected non-employee member of the Board of Directors will receive an automatic
grant of options to acquire 1,000 shares of common stock on the date of their
first appointment or election to the Board of Directors. Those options become
exercisable and vest in a series of three equal and successive annual
installments, with the first such installment becoming exercisable 13 months
after the automatic grant date. A non-employee member of the Board of Directors
is not eligible to receive the 500 share automatic option grant if that option
grant date is within 30 days of such non-employee member receiving the 1,000
share automatic option grant. The exercise price per share of common stock
subject to options granted under the 1994 Plan will be equal to 100 percent of
the fair market value of the Company's common stock on the date such options are
granted. There were outstanding options to acquire 9,000 shares of the Company's
common stock under the 1994 Plan at December 31, 1997.
1993 Stock Option Plan
The 1993 Plan provides for the granting of options to purchase up to 385,454
shares of the Company's common stock (which includes 85,454 shares previously
reserved for issuance under the Company's 1990 Stock Option Plan), the direct
granting of common stock (stock awards), the granting of stock appreciation
rights (SARs) and the granting of other cash awards (cash awards; stock awards,
SARs and cash awards are collectively referred to herein as Awards). Under the
1993 Plan, options and Awards may be issued to key personnel and others
providing valuable services to the Company and its subsidiaries. The options
issued may be incentive stock options or nonqualified stock options. If any
option or SAR terminates or expires without having been exercised in full, stock
not issued under such option or SAR will again be available for grant pursuant
to the 1993 Plan. There were options outstanding to acquire 309,750 shares of
the Company's common stock under the 1993 Plan at December 31, 1997.
To the extent that granted options are incentive stock options, the terms and
conditions of those options must be consistent with the qualification
requirement set forth in the Code. The expiration date, maximum number of shares
purchasable and the other provisions of the options will be established at the
time of grant. Options may be granted for terms of up to ten years and become
exercisable in whole or in one or more installments at such time as may be
determined by the plan administrator upon grant of the options. The exercise
prices of options will be determined by the plan administrator, but may not be
less than 100 percent (110 percent if the option is granted to a stockholder who
at the time the option is granted owns stock representing more than ten percent
of the total combined voting power of all classes of stock of the Company) of
the fair market value of the common stock at the time of the grant. The 1993
Plan will remain in force until February 24, 2003.
1990 Stock Option Plan
Under the 1990 Plan, there are 210,220 options issued but unexercised as of
December 31, 1997. In conjunction with stockholder approval of the 1993 Plan,
the Board terminated the 1990 Plan with respect to unissued options
F-11
to purchase 85,454 shares of common stock which remained and were unissued as of
the date the 1993 Plan was adopted. The 1990 Plan will remain in force through
May 1, 2000.
The expiration date, maximum number of shares purchasable, and the other
provisions of the options granted under the 1990 Plan were established at the
time of grant. Options were granted for terms of up to ten years and become
exercisable in whole or in one or more installments at such times as were
determined by the Board of Directors upon grant of the options.
Tax benefits from early disposition of common stock by optionees under the 1993
and 1990 Plans and from the exercise of nonqualified options are credited to
additional paid-in capital.
Pursuant to the provisions of SFAS No. 123, Accounting for Stock-Based
Compensation, the Company accounts for transactions with its employees pursuant
to Accounting Principles Board Opinion No. 25, Accounting for Stock-Issued to
Employees, under which no compensation cost has been recognized. Had
compensation cost for these plans been determined consistent with SFAS No. 123,
the Company's net income (loss) and earnings (loss) per share would have been as
follows (in thousands, except per share data):
1997 1996 1995
--------- ---------- ---------
Net income (loss): As reported $ 5,243 $ (3,831) $ 8,417
Pro forma 4,785 (4,076) 8,327
Basic earnings (loss)
per share: As reported $ 0.67 $ (0.49) $ 1.09
Pro forma 0.61 (0.52) 1.08
Diluted earnings (loss)
per share: As reported $ 0.65 $ (0.49) $ 1.04
Pro forma 0.59 (0.52) 1.03
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted-average
assumptions for grants in 1997, 1996 and 1995, respectively: risk-free interest
rates of 5.45%, 6.31% and 6.31%; expected dividend yields of zero; expected
lives of 6.4, 6.1 and 5.7 years; and expected volatility (a measure of the
amount by which a price has fluctuated or is expected to fluctuate during a
period) of 60.0%, 61.9% and 58.7%.
Because the SFAS No. 123 method of accounting has not been applied to options
granted prior to January 1, 1995, the resulting pro forma compensation cost may
not be representative of that to be expected in future years. The weighted
average fair value of shares sold in 1997 was $14.98.
F-12
A summary of the status of the Company's four stock option plans at December 31,
1997, 1996 and 1995 and changes during the three years then ended is presented
in the table and narrative below:
1997 1996 1995
------------------------ ----------------------------- --------------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
--------- --------- --------- -------- ---------- --------
Outstanding at
beginning of year 551,776 $ 6.92 539,576 $ 8.06 465,326 $ 4.68
Granted 200,500 14.63 250,100 11.89 178,000 22.15
Exercised (162,306) 1.34 (44,900) 0.49 (44,250) 0.75
Expired (39,000) 12.23 (193,000) 18.04 (59,500) 29.24
--------- --------- ----------
Outstanding at
end of year 550,970 $ 11.01 551,776 $ 6.92 539,576 $ 8.06
========= ========= ==========
Exercisable at end of
year 165,110 294,982 308,940
========= ========= ==========
Weighted average fair
value of options
granted $ 9.19 $ 7.57 $ 13.19
======== ====== ========
The following table summarizes information about stock options outstanding at
December 31, 1997:
Options Outstanding Options Exercisable
----------------------------------------------------------- --------------------------
Weighted
Number Average Weighted Number Weighted
Range of Outstanding at Remaining Average Exercisable at Average
Exercise December 31, Contractual Exercise December 31, Exercise
Prices 1997 Life Price 1997 Price
-------------- -------------- ------------ ----------- --------------- --------
$ 0.25 - $9.00 108,720 5.7 years $ 0.77 108,720 $ 0.77
9.01 - 20.00 422,250 8.0 years 13.06 51,390 13.52
20.01 - 34.38 20,000 8.9 years 23.23 5,000 26.93
--------- --------- -------- --------- ------
550,970 7.6 years $ 11.01 165,110 $ 5.53
========= ========= ======== ========= ======
401(k) Profit Sharing Plan
Effective September 1, 1990, the Company adopted a profit sharing plan (401(k)
Plan) pursuant to Section 401(k) of the Code. The 401(k) Plan covers
substantially all full-time employees who meet the eligibility requirements and
provides for a discretionary profit sharing contribution by the Company and an
employee elective contribution with a discretionary Company matching provision.
The Company expensed discretionary contributions pursuant to the 401(k) Plan in
the amount of $71,000, $65,000, and $0 for the years ended December 31, 1997,
1996, and 1995, respectively.
F-13
(5) MAJOR CUSTOMERS:
The Company's strategy involves concentrating its efforts on providing design
and production services to leading companies in a limited number of fast growing
industries. Beginning in 1996, the Company has been undertaking substantial
efforts to diversify its business, broaden its customer base, and expand its
markets. The Company's historical major customer, who accounted for
approximately 65 percent and 81 percent of the Company's revenue in 1996 and
1995, respectively, accounted for approximately 35 percent of the Company's
revenue during 1997. This reduced percentage occurred as a result of the
increased sales to other customers and reduced product selling prices and
revenues from that major customer. The Company's other significant customer
accounted for 32 percent of the Company's revenue during 1997. Sales to this
customer were less than 10 percent of the Company's revenue during 1996 and
1995.
The significant amount of sales to a few customers results in certain
concentrations of credit risk for the Company. The Company's accounts receivable
balance, including the accounts receivable of the Company's largest customers,
is comprised of a large number of customers, primarily in the cellular phone,
computer hardware and other electronic products industries. These customers are
located primarily in the United States and Europe.
(6) INCOME TAXES:
SFAS No. 109, Accounting for Income Taxes, requires the use of an asset and
liability approach in accounting for income taxes. Deferred tax assets and
liabilities are recorded based on the differences between the financial
statement and tax bases of assets and liabilities and the tax rates in effect
when these differences are expected to reverse.
The provision for income taxes for the years ended December 31 consists of the
following:
1997 1996 1995
---------- ---------- --------
(in thousands)
Current, net of operating loss carryforwards
and tax credits utilized
Federal, net of tax benefit from early
termination of incentive stock options $ 356 $ 556 $ 2,775
State 97 58 790
Foreign 71 9 1,681
---------- ---------- --------
524 623 5,246
Deferred provision (benefit) 2,769 (3,575) 100
Tax benefit from early termination of incentive
stock options, reflected in stockholders' equity 41 32 202
---------- ---------- --------
Provision (benefit) for income taxes $ 3,334 $ (2,920) $ 5,548
========== ========== ========
In accordance with SFAS No. 109, a tax benefit for net operating losses of
approximately $35,000, $102,000, and $67,000 and tax credits of approximately
$0, $938,000, and $1,478,000 utilized in 1997, 1996, and 1995, respectively, are
included as a reduction of the provision for income taxes in the consolidated
statements of income (loss).
F-14
The components of deferred taxes at December 31 are as follows:
1997 1996
--------- --------
(in thousands)
Net long-term deferred tax liabilities:
Accelerated tax depreciation $ 2,685 $ 1,535
Other 33 33
--------- --------
$ 2,718 $ 1,568
========= ========
Net short-term deferred tax assets:
Inventory reserve $ 1,721 $ 2,675
Uniform capitalization 1,251 1,868
Accrued liabilities not currently deductible 1,080 1,080
Allowance for doubtful accounts 156 196
Tax effect of regular U.S. net operating loss carry forward 166 189
Other 91 76
--------- --------
4,465 6,084
Valuation allowance (154) (154)
--------- --------
$ 4,311 $ 5,930
========= ========
SFAS No. 109 requires the reduction of deferred tax assets by a valuation
allowance if, based on the weight of available evidence, it is more likely than
not that some or all of the deferred tax assets will not be realized. As a
result of certain limitations on the use of net operating loss carryforwards
acquired in the ERA acquisition, a valuation allowance has been established for
those net operating losses not likely to be realized.
A reconciliation of the U.S. federal statutory rate to the Company's effective
tax rate is as follows:
1997 1996 1995
------ ------ ------
Statutory federal rate 34% 34% 34%
Effect of state taxes 5 6 6
Other - 3 -
------ ------ ------
39% 43% 40%
====== ====== ======
Net operating loss carryforwards for federal tax purposes totaled approximately
$490,000 at December 31, 1997. The use of these carryforwards is limited to
$67,000 per year and they expire through 2003.
(7) COMMITMENTS AND CONTINGENCIES:
In March 1995, the Company entered into a non-cancelable operating lease for its
primary manufacturing facility in Manila, the Philippines. The lease expires
December 31, 1999. In April 1995, the Company entered into a non-cancelable
operating lease for an additional manufacturing facility in Manila, the
Philippines. In February 1997, the Company exercised its option to renew the
lease for two years. The lease expires March 31, 1999.
Rent expense was approximately $793,000, $477,000 and $683,000 for the years
ended December 31, 1997, 1996, and 1995, respectively.
In April 1994, the Company entered into a ground lease (with purchase options)
on a 5.7 acre site in Tempe, Arizona. Annual lease payments under the ground
lease, which will expire on March 31, 2069, subject to renewal and purchase
options as well as termination provisions, will average approximately $100,000
over the term of the lease subject to certain escalation provisions. A new
design, manufacturing, and corporate headquarters facility containing
approximately 97,000 square feet was completed on the land in 1995 at a cost of
approximately $10.4 million.
F-15
The Company's future lease commitments under the non-cancelable operating leases
as of December 31, 1997, are as follows (in thousands):
1998 $ 419
1999 372
2000 100
2001 100
2002 100
Thereafter 6,625
--------
$ 7,716
========
The Company is involved in certain administrative proceedings arising in the
normal course of business. In the opinion of management, the Company's potential
exposure under the pending administrative proceedings is adequately provided for
in the accompanying financial statements.
(8) GEOGRAPHIC SEGMENTS:
Sales by geographic area and identifiable assets for the years ended December
31, 1997, 1996, and 1995 were as follows:
North
America Europe Pacific Rim Eliminations Consolidated
--------- --------- ----------- ------------ ------------
(in thousands)
December 31, 1997:
Net sales $ 73,887 $ 10,755 $ - $ - $ 84,642
Transfers to Europe 9,136 - - (9,136) -
Transfers to North America - - 3,107 (3,107) -
--------- --------- --------- ---------- --------
Total revenue $ 83,023 $ 10,755 $ 3,107 $ (12,243) $ 84,642
========= ========= ========= ========== =========
Net income $ 4,728 $ 404 $ 65 $ 46 $ 5,243
========= ========= ========= ========== =========
Identifiable assets $ 61,307 $ 4,896 $ 7,431 $ (799) $ 72,835
========= ========= ========= ========== =========
December 31, 1996:
Net sales $ 32,899 $ 27,814 $ - $ - $ 60,713
Transfers to Europe 25,810 - - (25,810) -
Transfers to North America - - 1,494 (1,494) -
--------- --------- --------- ---------- --------
Total revenue $ 58,709 $ 27,814 $ 1,494 $ (27,304) $ 60,713
========= ========= ========= ========== =========
Net income (loss) $ (4,005) $ 19 $ 12 $ 143 $ (3,831)
========= ========= ========= ========== =========
Identifiable assets $ 52,951 $ 3,824 $ 6,164 $ (370) $ 62,569
========= ========= ========= ========== =========
December 31, 1995:
Net sales $ 24,235 $ 67,350 $ - $ - $ 91,585
Transfers to Europe 60,361 - - (60,361) -
Transfers to North America - - 1,437 (1,437) -
--------- --------- --------- ---------- --------
Total revenue $ 84,596 $ 67,350 $ 1,437 $ (61,798) $ 91,585
========= ========= ========= ========== =========
Net income (loss) $ 5,093 $ 3,353 $ (46) $ 17 $ 8,417
========= ========= ========= ========== =========
Identifiable assets $ 50,779 $ 8,491 $ 7,789 $ (3,279) $ 63,780
========= ========= ========= ========== =========
F-16
THREE-FIVE SYSTEMS, INC.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995
Balance at Charged to Charged to Balance at
Beginning Costs and Other End of
of Period Expenses Accounts Other Period
--------- -------- -------- ----- ------
(in thousands)
Allowance for doubtful
accounts and sales
returns and allowances:
- -----------------------
Year ended
December 31, 1997 $ 649 (105) 36(1) -- $ 580
Year ended
December 31, 1996 $ 603 14 32(1) -- $ 649
Year ended
December 31, 1995 $ 604 (36) 35(1) -- $ 603
Inventory Reserve:
- ------------------
Year ended
December 31, 1997 $6,782 1,114 (3,587)(2) $4,309
Year ended
December 31, 1996 $2,767 5,939 142(2) (2,066)(2) $6,782
Year ended
December 31, 1995 $1,548 1,563 391(3) (735)(2) $2,767
(1) Actual return activity
(2) Obsolete inventory written off
(3) Inventory adjustments
S-1