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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, 1998
Commission File Number 1-4373
THREE-FIVE SYSTEMS, INC.
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(Exact Name of Registrant as Specified in Its Charter)
Delaware 86-0654102
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(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
1600 North Desert Drive, Tempe, Arizona 85281
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(Address of Principal Executive Offices)
(602) 389-8600
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(Registrant'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
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Common Stock, Par Value $.01 Per Share New York Stock Exchange
Securities registered under Section 12(g) of the Exchange Act: None
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12
months (or for such shorter period that the registrant was required to file such
reports) and (2) has been subject to such filing requirements for the past 90
days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not 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. [ ]
As of March 8, 1999, 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 $68,080,668. 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 8, 1999, there were 7,012,107 shares of the issuer's Common Stock
outstanding.
Documents incorporated by reference: Portions of the issuer's definitive Proxy
Statement for the 1999 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, 1998
TABLE OF CONTENTS
Page
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PART I
ITEM 1. BUSINESS.......................................................... 1
ITEM 2. PROPERTIES........................................................ 22
ITEM 3 LEGAL PROCEEDINGS................................................. 22
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............... 22
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND
RELATED STOCKHOLDER MATTERS..................................... 23
ITEM 6. SELECTED FINANCIAL DATA........................................... 24
ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS............................. 25
ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK............................................... 34
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................... 35
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE............................. 35
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS.................................. 35
ITEM 11. EXECUTIVE COMPENSATION............................................ 35
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT.................................................. 35
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................... 35
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES,
AND REPORTS ON FORM 8-K......................................... 36
SIGNATURES.................................................................. 38
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STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
THE STATEMENTS CONTAINED IN THIS REPORT ON FORM 10-K THAT ARE NOT
PURELY HISTORICAL ARE FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF
APPLICABLE SECURITIES LAWS. FORWARD-LOOKING STATEMENTS INCLUDE STATEMENTS
REGARDING THE COMPANY'S "EXPECTATIONS," "ANTICIPATION," "INTENTIONS," "BELIEFS,"
OR "STRATEGIES" REGARDING THE FUTURE. FORWARD-LOOKING STATEMENTS ALSO INCLUDE
STATEMENTS REGARDING REVENUE, MARGINS, EXPENSES, AND EARNINGS ANALYSIS FOR
FISCAL 1999 AND THEREAFTER; TECHNOLOGICAL INNOVATIONS; FUTURE PRODUCTS OR
PRODUCT DEVELOPMENT; THE COMPANY'S PRODUCT DEVELOPMENT STRATEGIES; POTENTIAL
ACQUISITIONS OR STRATEGIC ALLIANCES; THE SUCCESS OF PARTICULAR PRODUCT OR
MARKETING PROGRAMS; THE AMOUNTS OF REVENUE GENERATED AS A RESULT OF SALES TO
SIGNIFICANT CUSTOMERS; AND LIQUIDITY AND ANTICIPATED CASH NEEDS AND
AVAILABILITY. ALL FORWARD-LOOKING STATEMENTS INCLUDED IN THIS REPORT ARE BASED
ON INFORMATION AVAILABLE TO THE COMPANY AS OF THE FILING DATE OF THIS REPORT,
AND THE COMPANY ASSUMES NO OBLIGATION TO UPDATE ANY SUCH FORWARD-LOOKING
STATEMENTS. THE COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE
FORWARD-LOOKING STATEMENTS. AMONG THE FACTORS THAT COULD CAUSE ACTUAL RESULTS TO
DIFFER MATERIALLY ARE THE FACTORS DISCUSSED IN ITEM 1, "BUSINESS - SPECIAL
CONSIDERATIONS."
PART I
ITEM 1. BUSINESS
INTRODUCTION
The Company designs and manufactures a wide range of display modules
for use in the end products of original equipment manufacturers ("OEMs"). Most
of the Company's sales consist of custom display modules 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") 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. The Company's
sales increased to $84.6 million in 1997 and $95.0 million in 1998, primarily as
a result of several new programs, including programs for a telecommunications
customer and 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 that historically have
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) setting up a new manufacturing facility in China, (3)
targeting new industrial applications, and (4) developing new kinds of products.
The Company believes that it is positioned to continue the growth that
it experienced in 1997 and 1998 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 display modules 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 and Beijing, China.
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
("LEDs") 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 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.
1
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.
The Company also has undertaken substantial efforts with respect to
liquid crystal on silicon (LCoS(TM)) microdisplays. Liquid crystal on silicon
displays are a form of LCD where, instead of suspending liquid crystalline
material between two glass plates, the material is suspended between a glass
plate and silicon backplate. The silicon backplate is an integrated circuit that
provides drive signals for each element of the display (for instance,
active-matrix drive) and also provides logic functions, such as serial to
parallel conversion and data storage. Because highly developed silicon
integrated circuits form the basis of these displays, the LCoS(TM) technology
provides very high information displays in a small size and at a relatively low
cost. The high information presented by such displays is magnified for view,
generally either in a projector or in a view-finder.
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:
+ 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.
+ Advanced design and manufacturing processes require increasingly
greater investments for research and development, personnel, and
equipment.
+ 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 display modules 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:
+ To gain access to specialized design and manufacturing technology and
expertise.
+ To accelerate the design process and to reduce design and
manufacturing costs by utilizing the specialized personnel, equipment,
and facilities of the supplier.
+ To reduce their own investment in personnel, equipment, and facilities
necessary for specialized design and production capabilities.
+ To streamline their own operations by concentrating their resources on
the design, production, and distribution of their core products.
2
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 display modules. The
Company believes that custom devices represent a significant source of its
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 or with slight
modifications. In the last few years, the Company's standard devices have
accounted for less than 10 percent of its revenues. In 1999, however, the
Company is planning to introduce new standard products using some of the
Company's new display technologies.
The Company pursues a strategy designed to enable it to enhance its
position as a major, worldwide supplier of custom-designed and manufactured
display modules 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 technologies. 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 announced 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 provides 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 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, as well as
provide a source for inexpensive, high resolution displays in projection
products such as rear-projection monitors, high-definition televisions, and
front projection audio-visual units.
CUSTOM DEVICES
LCD and LED custom displays currently account for approximately 95.3
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.
3
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
+ solid state lamps used for indicators, status lights, on-board circuit
monitors, and instrumentation;
+ multi-digit numerical displays used for calculators, industrial
controls, data terminals, instrumentation timers, hand-held
instruments, event counters, test equipment, embedded computing
equipment, and consumer applications;
+ integrated displays (with on-board integrated circuit drivers) and
alpha numeric displays used for hand-held terminals, embedded
computing equipment and telecommunications; and
+ bar graph displays (with integrated circuit drivers) used as linear,
logarithmic and VU meters in stereo systems, radios, magnetic
recording devices, process control instruments, and volt meters.
Standard infrared devices include infrared emitters used in remote
controllers, disk drives, tape drives, printers, encoders, solid state relays,
photoelectric controls, slotted switches, reflective switches, intrusion alarms,
touch screens, wireless data entry terminals, and positioning sensor
applications.
Standard LCiD(TM) display devices will include a 1 line by 10 character
and 2 line by 10 character dot matrix display available in a variety of colors.
The Company expects that LCiD(TM) displays will be used primarily in lower
information content applications where high contrast, desired color, and ease of
readability from full sunlight to complete darkness are required. Typical
applications for LCiD(TM) display standard devices would include automotive
instrumentation, appliances, hand-held instrumentation devices, vending
equipment, stereo equipment, embedded computing equipment, remote sensing
equipment, outdoor monitor equipment, and industrial controls.
Standard LCaD(TM) display devices will include a variety of backlit
quarter VGA (240 rows x 320 columns), 16 gray shade capable display systems. The
standard LCaD(TM) display will consist of a complete display system
incorporating LCD panel, lighting, memory, LCD controller, and interface
electronics. Typical applications for the LCaD(TM) display would include medical
and industrial instrumentation, test equipment, point-of-sale terminals, mapping
and hand held global positioning system devices, stereo equipment, and embedded
computing equipment.
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 LCDs and assembly of
Company-designed display module assemblies. The Company will provide extended
manufacturing services beyond these core services, however, if the customer
requires them. 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.
4
MANUFACTURING FACILITIES
The Company currently conducts manufacturing operations in Tempe,
Arizona; Manila, the Philippines; and Beijing, China. The Arizona facility
houses a Class 1000 "clean room" and LCD fabrication and prototyping operation.
The Company utilizes this 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
develop advanced manufacturing processes that can be applied in the Philippines
and China 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 display module manufacturing is done in Manila, the
Philippines and Beijing, China. In Manila, 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. Although there has not been any material interruption of operations
to date, these circumstances could affect the Company's ability to obtain
products pursuant to the Sub-Assembly Agreement. The termination or 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 commenced manufacturing operations in the People's Republic
of China ("China") during 1998. The China facility is a high-volume display
module manufacturing facility similar to the Company's current facility in
Manila. The Company initially leased a facility in Beijing on a temporary basis,
and the Company commenced manufacturing in that temporary facility in the third
quarter of 1998. The Company has begun construction of its own facility in
Beijing and expects to move into that new facility in the middle of 1999. The
Company employs all direct and indirect manufacturing employees at the facility,
including technicians, supervisors, and engineers. The Company expects the
initial cost of equipping and constructing the China facility to be
approximately $10.0 million. For further discussions on the Company's operations
in China, see Item 7, "Management's Discussion and Analysis of Financial
Conditions and Results of Operations" and Item 1, "Special Considerations - The
Company Faces Risks Associated with International Operations."
5
QUALITY CONTROL
The Company has 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
bases its quality control program 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
with respect to 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. The Company has 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. In 1998, the Company added direct
technical sales persons in Asia. To a much lesser extent, the Company also
markets some standard products through an independent sales and distribution
network. This network includes two franchised distributors in approximately 91
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, North Carolina, and
Florida.
The Company's sales to customers in Europe represented approximately 35
percent of net sales in 1998. 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.
In addition, the Company's design engineers in Tempe, Arizona provide design
input for customers in Europe.
The Company's sales to customers is Asia represented approximately 7.0
percent of net sales in 1998. The Company has added several direct technical
sales and marketing persons in Asia and has also trained Chinese design
engineers to provide design input for customers in Asia.
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 display modules used in approximately
45 individual product programs for Motorola. Sales to Motorola accounted for
63.6 percent of the Company's revenue during 1998. Devices that are used in
cellular telephones accounted for substantially all of the Company's sales to
Motorola in 1998. Motorola continues to award new design programs to the
Company. Motorola has an LCD module allocation process in which it designates
three or four key LCD module vendors, including the Company, and communicates to
each vendor the anticipated annual amount of purchases. Although the allocation
process does not provide a guarantee of business to the Company, it provides an
indication that purchases by Motorola during 1999 could continue at 1998 levels.
The Company's second-largest customer in 1998 was Hewlett-Packard
6
Company ("Hewlett-Packard"). Sales to Hewlett-Packard accounted for 6.6 percent
of the Company's revenue during 1998. As the display modules manufactured by the
Company for Hewlett-Packard moved into second generation versions in 1998, the
selling price of some of those modules was greatly reduced. In addition, the
number of LCD display modules required by Hewlett-Packard was also greatly
reduced as Hewlett-Packard moved to less expensive front panel devices in an
extremely competitive market. Consequently, in 1998 the percentage of the
Company's revenue attributed to Hewlett-Packard declined substantially. See Item
1, "Special Considerations - Certain Customers Account for a Significant Portion
of the Company's Sales."
BACKLOG
As of December 31, 1998, the Company had a backlog of orders of
approximately $23.3 million, all of which are believed to be firm and all of
which are expected to be filled during fiscal 1999. The backlog of orders at
December 31, 1997 was approximately $21.8 million. The Company's business has
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. In both 1997 and 1998, sales in the fourth
quarter were approximately 60 percent greater than sales in the first quarter.
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 existing 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. For example, the Company has patents on its LCiD(TM) display
technology. The Company also signed a license agreement with Motif, Inc. to
license the technology that forms the basis of its LCaD(TM) or Liquid Crystal
active Drive. The Company has applied for a patent on its LCaD(TM) technology
and has filed several patents relating to its LCoS(TM) microdisplay technology.
The Company has also applied for numerous other process and product patents, all
related to display technologies.
RAW MATERIALS
The principal raw materials used in producing the Company's displays
consist of 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 has reduced the Company's dependence on
foreign LCD glass suppliers. See Item 1, "Special Considerations - The Company
May be Subject to Shortages of Raw Materials and Supplies."
COMPETITION
The Company believes that Optrex, Seiko-Epson, Samsung, Seiko
Instruments, Sharp, Hosiden, Hyundai, PCI, and Philips Components constitute the
principal competitors for the Company's LCD devices. Hewlett-Packard, Rohm,
LiteOn, Siemens, Stanley Electric Company, and Quality Technologies Corp.
constitute its principal competitors for its LED devices and for its LCiD(TM).
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 display modules. The Company
cannot provide assurance that it will continue to be able to compete
successfully with such organizations.
7
The Company currently competes principally on the basis of the
technical innovation and performance of its display modules, 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 more of its customers, particularly Motorola,
determines to design and manufacture their display modules internally or secure
them from other parties. See Item 1, "Special Considerations - The Company Faces
Intense Competition."
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 the performance of
current products and expanding the technology to serve new markets. The Company
also conducts research and development in manufacturing processes, including
those associated with efficient, high-volume production and electronic
packaging.
More recently, the Company has focused its research and development
efforts on new display technologies. See Item 1, "Business - Products and
Services." 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 1999.
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 Item 1, "Special Considerations - Environmental
Regulation."
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, 1998, the Company employed a total of 867 persons.
This number includes 172 full-time and approximately 16 temporary employees at
its principal U.S. facility in Tempe, Arizona and U.S. sales offices; 256
employees at its manufacturing facility in Manila, the Philippines; 415
employees at its manufacturing facility in Beijing, China; and 8 employees at
its Three-Five Systems, Ltd. 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.
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 Item 1, "Business - Manufacturing Facilities." As of
December 31, 1998, approximately 1,152 persons performed direct labor operations
at the Manila facility through the Sub-Assembly Agreement with TEAM.
8
EXECUTIVE OFFICERS
The following table sets forth information concerning each of the
Company's executive officers.
NAME AGE POSITION
---- --- --------
David R. Buchanan 66 Chairman of the Board, President, and Chief
Executive Officer
Lawrence E. Kagemann, Sr. 56 Vice President - Operations
Radu Andrei 48 Vice President - Marketing and Sales
Jeffrey D. Buchanan 43 Executive Vice President - Finance,
Administration, and Legal; Chief Financial
Officer; Secretary; Treasurer; and Director
Dan J. Schott 59 Vice President - Research and Development
Robert T. Berube 60 Principal Accounting Officer and Corporate
Controller
DAVID R. BUCHANAN has been Chairman of the Board of the Company since
its formation in February 1990. Mr. Buchanan served as the Company's President
and Chief Executive Officer from February 1990 until July 1998. In January 1999,
Mr. Buchanan reassumed duties as interim President and Chief Executive Officer
while the Board of Directors conducts a search for a new President and Chief
Executive Officer. Mr. Buchanan also 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.
LAWRENCE E. KAGEMANN, SR. has been Vice President - Operations of the
Company since August 10, 1998. Mr. Kagemann served as Vice President - Quality
and Manufacturing Technology for Harman OEM Group ("Harman") from 1990 until
December 1996, where he led quality, plant, manufacturing, advanced
manufacturing, and supplier engineering for the U.S. and Wales sites. In 1997,
Mr. Kagemann was appointed Vice President - Audio for Computer Operations and
Quality for Harman, where he had responsibility for maintaining quality and
supplier engineering for the U.S. and Wales sites. From August 1997 to August
1998, Mr. Kagemann held the position of Vice President - Quality and Supplier
Engineering for Harman, where he was assigned the responsibility of quality and
supplier engineering for the group.
RADU ANDREI has been Vice President - Marketing and Sales of the
Company since June 1, 1998. Mr. Andrei served a Research Director for Semico
Research Arizona and Intechno Consulting Director - Basel, Switzerland/Phoenix,
Arizona from 1996 until June 1998. His responsibilities included assessing the
market, analyzing external market drivers, correlating the results of business
core competencies, resources and objectives, and devising a long-term plan. In
1994 and 1995, Mr. Andrei held the position of Manager, Strategic Marketing and
Systems Engineering (Director) for Motorola SPS Division in Phoenix, Arizona.
JEFFREY D. BUCHANAN has served as a director and Executive Vice
President - Finance, Administration, and Legal of the Company since June 1998;
as Chief Financial Officer and Treasurer of the Company since June 1996; and as
Secretary of the Company since May 1996. Mr. Buchanan served as Vice President -
Finance, Administration, and Legal of the Company from June 1996 until July 1998
and as Vice President - Legal and Administration of the Company from May 1996 to
June 1996. Mr. Buchanan served as a Senior Member 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
9
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 served as the
Company's 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, Mr.
Schott held various engineering management and program management positions with
Sperry Rand Corp.
ROBERT T. BERUBE has been the Company's Principal Accounting Officer
since July 1998 and has served as the Company's Corporate Controller since July
1990.
SPECIAL CONSIDERATIONS
A VARIETY OF FACTORS AFFECT THE COMPANY'S OPERATING RESULTS
A wide variety of factors affect the Company's operating results and
could adversely impact its net sales and profitability. These factors, many of
which are beyond the control of the Company, include the following:
+ the Company's ability to identify industries that 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;
+ customer order patterns, changes in order mix, and the level and
timing of orders placed by customers that the Company can complete in
a quarter;
+ 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 represent
important factors 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
1998 were display modules for cellular products. A slowdown in demand for
customer products, particularly cellular and office automation products that
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
broad-based factors would adversely affect the Company's operating results.
10
CERTAIN CUSTOMERS ACCOUNT FOR A SIGNIFICANT PORTION OF THE COMPANY'S SALES
In the past few years, the Company has generated most of its revenue
from sales to a few significant customers. Motorola, the Company's largest
customer, accounted for 63.6 percent of the Company's revenue in 1998, 34.6
percent of revenue in 1997, and 65.1 percent of revenue in 1996. Devices used in
cellular telephones accounted for substantially all of the Company's sales to
Motorola in 1998. The Company anticipates that sales to Motorola in 1999 will
reach or exceed 1998 levels, but believes that the percentage of its net revenue
from sales to Motorola should decrease in 1999 as a result of increased sales to
other customers. The Company's second largest customer is Hewlett-Packard, which
accounted for 6.6 percent of the Company's revenue during 1998. This amount
represents a significant reduction from sales to Hewlett-Packard that accounted
for 32.0 percent of the Company's sales in 1997. See Item 1, "Business -
Customers."
Although the Company has begun to enter into more manufacturing
contracts with its customers, the principal benefit of these contracts is to
clarify order lead times, inventory risk allocation, and similar matters and not
to provide firm, long-term volume purchase commitments. Customers generally do
not provide firm long-term volume purchase commitments to the Company. Thus,
customers can cancel purchase commitments and change or delay expected volume
levels. The Company may be unable to replace canceled, delayed, or reduced
commitments in a timely manner. The cancellation, delay, or reduction of
customer commitments could result in the Company holding excess and obsolete
inventory or having unfavorable manufacturing variances as a result of
under-absorption. These risks are enhanced because of the large percentage of
sales to customers in the retail electronics industry, which is subject to
severe competitive pressures, rapid technological change, and obsolescence. The
Company's operating results have been materially and adversely affected in the
past as a result of the non-realization of anticipated orders and deferrals or
cancellations of orders as a result of changes in customer requirements. For
example, in 1998 the Company made two announcements that sales would not meet
its expectations because of delays in customer programs. Cancelled, delayed, or
reduced commitments from any of the Company's major customers, particularly
Motorola, would have a material adverse effect on the Company's results of
operations.
A few of the Company's customers have inquired about "inventory
hubbing" agreements, under which the Company would maintain stocks of finished
goods at or near the customer's factory. Although the Company has not yet
entered into such agreements, the use of such type of agreements for significant
customers could result in higher inventory balances and excess inventory.
THE COMPANY FACES INTENSE COMPETITION
The Company serves intensely competitive industries that are
characterized by price erosion, rapid technological change, and foreign
competition. The Company competes with major domestic and international
companies. Most of the Company's competitors are located in Asia, and many have
greater market recognition and substantially greater financial, technical,
marketing, distribution, and other resources than the Company possesses. See
Item 1, "Business - Competition." Emerging companies also may increase their
participation in the display module market. The Company currently competes
principally on the basis of the technical innovation and performance of its
display modules, including their ease of use and reliability, as well as on
pricing and timely design, manufacturing, and delivery schedules. The Company's
ability to compete successfully depends on a number of factors, both within and
outside its control. These factors include the following:
+ 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;
11
+ 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 display modules
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's competitive position could be adversely affected if one
or more of its customers increase their own capacity and decide to design and
manufacture their own display modules, to use standard devices, or to outsource
with a competitor. The Company cannot provide assurance that it will continue to
be able to compete successfully in the future.
THE COMPANY'S BUSINESS DEPENDS 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 it 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;
+ engaging additional engineering and other technical personnel;
+ purchasing advanced design, production, and test equipment; and
+ enhancing 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 the following:
+ 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 from time to time may experience delays in completing the design and
manufacture of new product solutions. In addition, certain new product solutions
may not receive or maintain customer or market acceptance. The Company's
inability to design and manufacture solutions for its customers' new products on
a timely and cost-effective basis would adversely affect its future operating
results. See Item 1, "Business - Products and Services."
Finally, circumstances outside of the Company's control may cause the
loss of expected revenue even when the Company satisfactorily completes a design
and manufacturing solution. 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.
12
THE COMPANY FACES RISKS ASSOCIATED WITH RESEARCH AND DEVELOPMENT EFFORTS
The Company currently is investing in research and development of
several new technologies that it plans to introduce in the future. Some or all
of those technologies may not successfully make the transition from the research
and development lab to cost-effective manufacturability as a result of
technology problems, competitive cost issues, yield problems, and other factors.
An investment of significant amounts of resources in one or more technologies
that fail to achieve manufacturability could have a material adverse effect on
the Company. In addition, even if a new technology proves to be manufacturable,
the Company's customers and the customers' marketplaces may not accept the
technology because of price or technology issues or because of unfavorable
comparisons with products introduced by others. The Company will be required to
make significant expenditures, including development expenses and various
capital expenditures and investments, for these new technologies. For example,
the Company estimates that its initial capital expenditures for LCoS(TM)
microdisplays will be approximately $3.0 million to $4.0 million. The Company
also made an equity investment of $3.3 million in Siliscape, Inc. during 1998
for the purposes of further developing the LCoS(TM) microdisplay product.
Significant investments in one or more of the new technologies, especially
LCoS(TM) microdisplays, that ultimately prove to be unsuccessful for any reason
could have a material adverse impact on the Company. In addition, if Siliscape
were to encounter technological or financial difficulties, the value of the
Company's investment in that company could decline, in which case the Company
would have to write down all or a portion of its investment and report a loss
equal to such write-down.
THE COMPANY FACES RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS
GENERAL. The Company currently has substantial manufacturing operations
located in the Philippines, China, and the United States. The Company also
maintains a sales office and distribution warehouse in Europe. 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 the following:
+ management of a multi-national organization;
+ compliance with local laws and regulatory requirements as well as
changes in such laws and requirements;
+ employment and severance issues;
+ overlap of tax issues;
+ fluctuations in the value of currency;
+ tariffs and duties;
+ possible employee turnover or 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
+ political or economic instability in certain parts of the world.
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 or repatriation 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, and ability to service debt. The Company's operating results also
could be adversely affected if its host countries were to reverse the current
policies encouraging foreign investment or foreign trade. In addition, U.S.
trade policies, such as "most favored nation" status and trade preferences for
certain Asian nations, affect the attractiveness of the Company's services to
its U.S. customers. In particular, the
13
Company's operations and assets are subject to significant political, economic,
legal, and other uncertainties in the Philippines and China.
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 additional 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. The Company has made advance payments to TEAM since
1994 for a variety of reasons, including to assist it in meeting its working
capital needs while it negotiates new financing arrangements for generators and
equipment needed for building improvements. The outstanding advances to TEAM at
December 31, 1998 totaled approximately $205,000.
The Company has made cumulative capital investments in the Philippines
amounting to approximately $12.0 million through December 31, 1998. 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 following:
+ the business and financial condition of the subcontractor;
+ political instability and expropriation;
+ supply disruption;
+ currency controls and exchange fluctuations; and
+ 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 to
replace the low-cost, high-performance facility or the high-quality,
hard-working production staff if its manufacturing operations in the Philippines
were disrupted or terminated. As a result, any disruption or termination of
operations in the Philippines or air transportation with the Philippines even
for a relatively short period of time, would adversely effect the Company's
operations. See Item 1, "Business - Manufacturing Facilities."
MANUFACTURING OPERATIONS IN CHINA. The Company commenced manufacturing
operations in China during 1998. The China facility is a high-volume LCD module
manufacturing facility similar to the Company's facility in Manila. The Company
initially leased a facility in Beijing on a temporary basis and commenced
manufacturing in that temporary facility in the third quarter of 1998. The
Company has begun construction of its own facility in Beijing and expects to
move into that new facility in mid-1999. The Company expects that the initial
cost of equipping and constructing the permanent China facility will be
approximately $10.0 million. The Company's lease of its temporary facility
expires in 1999. Therefore, any significant delay in the construction of the
permanent facility could result in the temporary suspension of the China
manufacturing operations. Construction delays for a variety of reasons are not
unusual in China. Any such suspension could adversely affect the Company's
operations. For further discussions on the Company's operations in China, see
Item 7, "Management's Discussion and Analysis of Financial Conditions and
Results of Operations" and Item 1, "Business - Manufacturing Facilities."
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. The
14
Chinese government may not continue to pursue such policies. In addition, such
policies may not be successful if pursued or the Chinese government may
significantly alter the policies 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 of such laws 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 a number of other factors, including the following:
+ the imposition of austerity measures intended to reduce inflation;
+ 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 U.S. 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. The Company cannot provide assurance that the United States will renew
China's MFN status in future years. The failure or refusal of the U.S.
government to renew China's MFN status could adversely affect the Company by
increasing the cost to U.S. customers of products manufactured by the Company in
China.
THE COMPANY FACES RISKS ASSOCIATED WITH INTERNATIONAL TRADE AND CURRENCY
EXCHANGE
International sales represented approximately 42 percent of the
Company's net sales in 1998. Sales in foreign markets, primarily Europe and
China, to OEMs based in the United States accounted for almost all of the
Company's international sales in 1998. In 1999, the Company expects sales to
OEMs based in Europe and China to increase. Political and economic conditions
abroad may adversely affect the foreign manufacture and sale of products.
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 to purchase
materials or equipment from foreign suppliers.
While the Company transacts business predominantly in U.S. dollars and
bills and collects most of its sales in U.S. dollars, the Company collects a
portion of its revenue in non-U.S. currencies, such as the Chinese renminbi
("RMB"). In the future, customers increasingly may make payments in non-U.S.
currencies, such as the newly created Euro. In addition, the Company accounts
for a portion of its costs, such as payroll, rent, and indirect operating costs,
in non-U.S. currencies, including Philippine pesos ("PhP"), British pounds
sterling, and Chinese RMB. For example, the Company's Sub-Assembly Agreement
with TEAM is based on a fixed conversion rate, which exposes the Company to
exchange rate fluctuations with the Philippine peso.
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 U.S. dollar, however, could affect the
Company's cost of goods sold and operating margins and could result in exchange
losses. In addition, currency devaluation can result in a reportable loss to the
Company if the Company holds deposits of that currency. The Company cannot
predict the impact of future exchange rate fluctuations on its results of
operations. 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. In addition, any decrease in the value
of the RMB may adversely affect the Company's operations if there are U.S.
dollar-denominated
15
intercompany loans from the Company to its subsidiary or if the Company has
substantial RMB deposits or receivables. Hedging RMB is difficult because the
currency is not freely traded.
In January 1999, a new currency called the "Euro" was introduced in
certain Economic and Monetary Union ("EMU") countries in Europe. All EMU
countries are expected to be operating with the Euro as their single currency by
2002. Although a significant amount of uncertainty exists as to the effect the
Euro currency will have on the marketplace generally, the Company currently does
not believe that introduction of the Euro will create a material adverse effect
on the Company's business or operating results. The Company intends to monitor
the impact, if any, of the introduction of the Euro currency on the Company's
internal systems and the sale of its products and will take appropriate actions
to address those issues if required. The Company cannot predict the impact, if
any, of the introduction of the Euro on its business, financial condition, or
results of operations.
THE COMPANY MUST MAINTAIN SATISFACTORY MANUFACTURING YIELDS AND CAPACITY
The design and manufacture of LCDs and display modules 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 continues to
ramp up its high-volume LCD line to greater production levels in 1999 and begins
to manufacture LCoS(TM) microdisplays. See Item 7, "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Liquidity and
Capital Resources." Additionally, as the sophistication of display modules
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 inability to maintain high levels
of productivity or satisfactory delivery schedules in its manufacturing plants
in the Philippines or China, or at its Arizona high-volume LCD line would
adversely affect the Company's operating results.
Manufacturing yields and delivery schedules also may be affected as the
Company ramps up its manufacturing capabilities in China and moves into its new
facility in 1999. Other companies in the industry have experienced difficulty in
expanding or relocating manufacturing output and capacity, resulting in reduced
yields or delays in product deliveries. The Company could experience similar
manufacturing yield or delivery problems. Any such problems could adversely
affect the Company's operating results. See Item 1, "Business - Manufacturing
Facilities."
VARIABILITY OF CUSTOMER REQUIREMENTS MAY AFFECT 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. Based upon its estimates of anticipated
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. 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, or delays by a significant
customer or by a group of customers could adversely affect the Company, its
results of operations, prospects, and ability to service its debt. On occasion,
customers may require rapid increases in production, which can strain the
Company's resources and reduce margins. Although the Company has increased its
manufacturing capacity, the Company may lack 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
following:
16
+ the timing of orders;
+ the volume of orders relative to the Company's capacity;
+ customers' announcements, product 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 the expected future
volume of business. Completion of a particular design, however, depends on a
variety of factors, including the customer's changing needs, and not every
design is successful in meeting those needs.
The Company designs and manufactures products based on firm quotes.
Thus, the Company bears the risk of component price increases, which could
adversely affect the Company's gross margins. In addition, the Company depends
on certain suppliers, and the unavailability or shortage of materials could
cause delays or lost orders. Material components of some of the Company's major
programs from time to time have been subject to allocation because of shortages
by vendors and continued or increased shortages could have a material adverse
effect on the Company in the future. In addition, the Company purchases many
product components from vendors in Asian countries. Economic instability in
certain Asian countries could cause supply problems with respect to these
components.
THE COMPANY MUST EFFECTIVELY UTILIZE ITS ARIZONA FACILITY
The Company has made substantial expenditures in constructing its
facility in Tempe, Arizona, and equipping the facility with a high-volume LCD
manufacturing line. The Company placed the high-volume line in service in 1996,
although the Company continued to commit 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 requires the Company
to (i) 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)
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. The Company
could 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, the Company added additional equipment to the LCD glass
line in 1998 to enhance its ability to manufacture LCoS(TM) microdisplays. See
Item 1, "Business - Research and Development." 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 following:
+ the use of a new material (silicon);
+ the modification of equipment and processes to accommodate the
miniature size of the product;
17
+ 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. The Company could
experience significant problems in starting up volume production of LCoS(TM)
microdisplays. Any such problems could result in the delay of the full
implementation of high-volume LCoS(TM) microdisplay production. In addition,
lower-than-expected yields could significantly and adversely effect the Company
because of the relative high cost of the silicon backplane.
THE COMPANY MUST EFFECTIVELY MANAGE ITS GROWTH
The failure of the Company to manage its growth effectively could
adversely affect its operations. The Company's revenue increased substantially
during the period from 1993 through 1995, but declined significantly in 1996 as
a result of the discontinuation of a few significant programs by its major
customer. During 1997 and 1998, the Company increased the number of its
manufacturing and design programs and plans to further expand the number and
diversity of its programs in the future. The Company's ability to manage its
planned growth effectively will require it to
+ enhance its operational, financial, and management systems;
+ expand its facilities and equipment; and
+ successfully hire, train, and motivate additional employees, including
the technical personnel necessary to operate its new production
facility in China.
As the Company expands and diversifies its product and customer base,
it may be required to further increase its overhead and selling expenses. The
Company also 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.
Any increase in expenditures in anticipation of future orders that do not
materialize would adversely affect the Company's profitability. For example, the
Company substantially increased its manufacturing capacity in 1998 by starting
up manufacturing operations in Beijing, China. Customers also may require rapid
increases in design and production services that place an excessive short-term
burden on the Company's resources.
THE COMPANY DEPENDS 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 served as President and Chief Executive Officer ("CEO") of the Company
from 1987 to mid-1998. When Mr. Buchanan's successor resigned in January 1999,
Mr. Buchanan reassumed his duties as President and CEO on an interim basis until
the Company retains a replacement CEO. Mr. Buchanan has announced his intention
to retire from the Board of Directors upon the hiring of a new President and
CEO.
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
Item 1, "Business - Executive Officers." The Company does not have any
fixed-term agreements with, or key person life insurance covering, any officer
or employee. The Company, however, maintains non-competition and nondisclosure
agreements with its key personnel.
18
THE COMPANY MUST PROTECT ITS 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. The
Company faces risks associated with its intellectual property, including the
following:
+ pending patent applications may not be issued;
+ intellectual property laws may not protect the Company's intellectual
property rights;
+ third parties may challenge, invalidate, or circumvent any patent
issued to the Company;
+ rights granted under patents issued to the Company may not 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;
+ others may independently develop similar technology or design around
any patents issued to the Company; and
+ effective protection of intellectual property rights may be limited or
unavailable in certain foreign countries in which the Company
operates, such as China.
Third parties in the future may claim that the Company is infringing
certain patents or other intellectual property rights, although there are no
such pending lawsuits against the Company or unresolved notices that it is
infringing intellectual property rights of others. In the event that a third
party alleges that the Company is infringing its rights, the Company may not be
able to obtain licenses on commercially reasonable terms from the third party,
if at all, or the third party may commence litigation against the Company. The
failure to obtain necessary licenses or other rights or the occurrence of
litigation arising out of such claims could materially and adversely affect the
Company, its results of operations, prospects, or ability to service its debt.
THE MARKET PRICE OF THE COMPANY'S COMMON STOCK MAY BE VOLATILE
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. The stock price increased again during 1997, but declined
significantly in 1998. See Item 5, "Market for Registrant's Common Equity and
Related Stockholder Matters." 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 the following:
+ 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; and
+ worldwide economic and financial conditions.
In addition, the stock market has experienced extreme price and volume
fluctuations that have particularly affected the market prices for many high
technology companies and that 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.
19
THE COMPANY MAY BE SUBJECT TO SHORTAGES OF RAW MATERIALS AND SUPPLIES
The principal raw materials used in producing the Company's product
solutions consist of LCD glass, driver die, circuit boards, molded plastic
parts, lead frames, wire, chips, and packaging materials. The Company purchases
most of these materials from Asian sources. The Company does not have long-term
contracts with its suppliers. During 1998, the Company occasionally was required
to delay sales because it was unable to complete timely deliveries of certain
products as a result of the unavailability of certain raw materials, including
LCD polarizers and drivers.
Because the Company obtains many materials from foreign suppliers, the
Company may be subject to certain risks, including supply interruptions and
currency fluctuations. Purchasers of these materials, including the Company,
from time to time experience difficulty in obtaining such materials.
THE ELECTRONICS INDUSTRY IS CYCLICAL
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,
the electronics industry is cyclical in nature. 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.
THE COMPANY MUST FINANCE THE GROWTH OF ITS BUSINESS AND THE DEVELOPMENT OF NEW
PRODUCTS
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 failure of the Company to sufficiently increase its net sales
to offset these increased costs will adversely affect the Company's operating
results.
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 Company cannot
predict the timing and amount of any such capital requirements at this time. If
such financing is not available on satisfactory terms, the Company may be unable
to expand its business or to 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 Item 7,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Capital Resources."
THE COMPANY IS SUBJECT TO ENVIRONMENTAL REGULATIONS
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 of the Company to comply with present or future environmental
regulations could result in the imposition of fines, 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, or adequately restrict the discharge,
of hazardous substances could subject it to future liabilities. For example, the
Company has removed contamination from and continues to conduct periodic
chemical monitoring at the Company's former Connecticut property. Other
environmental problems may be discovered in the future, which could subject the
Company to future costs or liabilities.
20
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).
YEAR 2000 COMPLIANCE
Many existing computer programs and databases use only two digits to
identify a year in the date field (I.E., 99 would represent 1999). These
programs and databases were designed and developed without considering the
impact of the upcoming millennium. Consequently, date sensitive computer
programs may interpret the date "00" as 1900 rather than 2000. If not corrected,
many computer systems could fail or create erroneous results in 2000. Failure in
the Company's systems, or in the systems of its vendors or customers, could
cause significant adverse effects to the Company. For a full discussion of those
potential effects, see Item 7, "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Year 2000 Compliance
Disclosure."
RIGHTS TO ACQUIRE SHARES
At December 31, 1998, an aggregate of 695,800 shares of common stock
were reserved for issuance upon exercise of options previously granted under the
Company's stock option plans. The weighted average exercise price of those
options is $12.14 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.
REPURCHASES OF COMMON STOCK
In August 1996, the Board of Directors authorized the repurchase from
time to time of up to 1,000,000 shares of the Company's Common Stock on the open
market or in negotiated transactions, depending on market conditions and other
factors. In October 1998, the Board of Directors further extended and revised
the repurchase program to authorize the repurchase of up to $10 million of the
Company's stock. As of December 31, 1998, the Company had purchased 969,794
shares of the Company's Common Stock at a total purchase price of $8.3 million.
The repurchase of shares by the Company significantly reduced the Company's
capital. In addition, the Company has obtained long-term financing for such
repurchases, which increases the liabilities of the Company. 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 Item 7,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Capital Resources." A significant reduction in the
number of shares outstanding on the open market also could 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 laws 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 one 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 960,492 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
21
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.
THE COMPANY DOES NOT PAY CASH 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 Item 5, "Market for Registrant's Common Equity and Related
Stockholder Matters."
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
Certain statements and information contained in this Report 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 under applicable securities laws. 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, "Business - Special
Considerations."
ITEM 2. PROPERTIES
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 that expires on December 31, 1999, and the remaining 20,000 square feet
is subject to a lease that expires on March 31, 1999, and is renewable from year
to year thereafter.
The Company currently leases approximately 27,000 square feet of
manufacturing space in Beijing, China, which includes 4,200 square feet of
office space. The lease will expire on July 25, 1999. The Company is
constructing a permanent manufacturing facility in Beijing, China near the
existing leased facility. The permanent facility will occupy 46,000 square feet,
of which 29,000 square feet will be manufacturing space, and is being
constructed on property that the Company has purchased on a long-term land use
contract. The Company expects the cost to construct the facility will be
approximately $5.3 million. The Company currently anticipates the facility will
be completed in mid-1999.
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 that is covered by insurance or an indemnity or that
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.
22
PART II
ITEM 5. MARKET FOR REGISTRANT'S 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.
High Low
---- ---
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 1/4
1998:
First Quarter............................................ $23 1/16 $17 3/4
Second Quarter........................................... 20 3/8 14 7/8
Third Quarter............................................ 18 3/16 7 1/16
Fourth Quarter........................................... 13 7/8 6 1/2
1999:
First Quarter (through March 8, 1999).................... $16 $11 1/8
As of March 8, 1999, there were approximately 1,100 holders of record
and approximately 6,000 beneficial owners of the Company's Common Stock. The
closing sale price of the Company's Common Stock on the NYSE on March 8, 1999
was $11.25 per share.
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 Arizona
("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 that the
directors may deem relevant.
23
ITEM 6. SELECTED 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.
1998 1997 1996 1995 1994
-------- -------- -------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Net sales ................................ $ 95,047 $ 84,642 $ 60,713 $ 91,585 $ 85,477
-------- -------- -------- -------- --------
Costs and expenses:
Cost of sales .......................... 76,149 64,760 58,321 70,481 59,409
Selling, general, and administrative ... 7,334 6,557 5,351 5,386 4,867
Research and development ............... 7,159 5,106 4,065 2,396 1,270
-------- -------- -------- -------- --------
90,642 76,423 67,737 78,263 65,546
-------- -------- -------- -------- --------
Operating income (loss) .................. 4,405 8,219 (7,024) 13,322 19,931
-------- -------- -------- -------- --------
Other income (expense):
Interest, net .......................... 75 548 412 765 859
Other, net ............................. (117) (190) (139) (122) (135)
-------- -------- -------- -------- --------
(42) 358 273 643 724
-------- -------- -------- -------- --------
Income (loss) before provision for
(benefit from) income taxes ............ 4,363 8,577 (6,751) 13,965 20,655
Provision for (benefit from) income taxes 1,773 3,334 (2,920) 5,548 8,109
-------- -------- -------- -------- --------
Net income (loss) ........................ $ 2,590 $ 5,243 $ (3,831) $ 8,417 $ 12,546
======== ======== ======== ======== ========
Earnings (loss) per common share:
Basic .................................. $ 0.34 $ 0.67 $ (0.49) $ 1.09 $ 1.88
======== ======== ======== ======== ========
Diluted ................................ $ 0.33 $ 0.65 $ (0.49) $ 1.04 $ 1.59
======== ======== ======== ======== ========
Weighted average number of common shares:
Basic .................................. 7,639 7,854 7,768 7,716 6,666
======== ======== ======== ======== ========
Diluted ................................ 7,802 8,090 7,768 8,084 7,890
======== ======== ======== ======== ========
CONSOLIDATED BALANCE SHEET DATA
(AT END OF PERIOD):
Working capital .......................... $ 24,825 $ 29,113 $ 21,513 $ 22,400 $ 37,638
Total assets ............................. 77,904 72,835 62,569 63,780 56,280
Notes payable to banks and long-term debt 8,095 -- -- 3,000 182
Stockholders' equity ..................... 51,096 56,525 51,184 55,224 46,561
24
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.
YEARS ENDED DECEMBER 31,
-----------------------
1998 1997 1996
----- ----- -----
Net sales .......................................... 100.0% 100.0% 100.0%
----- ----- -----
Costs and expenses:
Cost of sales .................................... 80.1 76.5 96.1
Selling, general, and administrative ............. 7.7 7.8 8.8
Research and development ......................... 7.6 6.0 6.7
----- ----- -----
95.4 90.3 111.6
Operating income (loss) ............................ 4.6 9.7 (11.6)
Other income ....................................... -- 0.4 0.5
----- ----- -----
Income (loss) before provision for
(benefit from) income taxes ...................... 4.6 10.1 (11.1)
Provision for (benefit from) income taxes .......... 1.9 3.9 (4.8)
----- ----- -----
Net income (loss) .................................. 2.7% 6.2% (6.3)%
===== ===== =====
YEAR ENDED DECEMBER 31, 1998 COMPARED WITH YEAR ENDED DECEMBER 31,1997
Net sales were $95.0 million for 1998, an increase of 12.3 percent
compared with net sales of $84.6 million for 1997. The sales increase was as a
result of several new programs in 1998 for a variety of customers, including a
major communications customer. In 1998, the Company's largest customer accounted
for net sales of $60.5 million compared with net sales of $29.2 million to that
customer in 1997, for an overall increase of 107.2 percent. The Company's major
customer accounted for approximately 63.6 percent of net sales for 1998 compared
with approximately 34.6 percent for 1997. No other customer accounted for
greater than 10 percent of sales in 1998.
Cost of sales, as a percentage of net sales, increased to 80.1 percent
for 1998 as compared with 76.5 percent for 1997. The corresponding decrease in
the gross margin was the result of a number of factors, including manufacturing
variances occurring as a result of the start-up of the new manufacturing
facility in Beijing, some unfavorable yields occurring on the start-up of
several new programs, and increased pricing pressure from customers and
competitors, partially as a result of the Asian economic crisis.
Selling, general, and administrative expense was $7.3 million for 1998,
as compared with $6.6 million in 1997. Selling, general, and administrative
expense increased in absolute terms as a result of increased selling expenses
and the addition of administrative personnel. As a result of increased revenue
in 1998, however, selling, general, and administrative expense declined to 7.7
percent of net sales from 7.8 percent of net sales in 1997.
Research and development expense totaled $7.2 million, or 7.6 percent
of net sales for 1998, as compared with $5.1 million, or 6.0 percent of net
sales, for 1997. 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,
continued its in-house process development efforts related to the high-volume
manufacturing LCD line, and developed application specific integrated circuits
("ASICs") for its new display technologies. The Company believes that continued
investments in research and development
25
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 1998 was $75,000, down from $548,000 for
1997. The decrease in interest income was the result of investing lower average
cash balances during the year as well as increased interest expense as a result
of increased debt. Other expenses (net) decreased to $117,000 for 1998 from
$190,000 for 1997. The decrease was primarily attributed to reduced foreign
exchange losses.
The Company recorded a provision for income taxes of $1.8 million for
1998, as compared with a provision for income taxes of $3.3 million for 1997.
The overall tax rate for the Company for 1998 was 40.6 percent as compared with
38.9 percent for 1997. The increased tax rate is primarily as a result of the
Company having incurred losses in China, which is a low tax rate jurisdiction.
In such instance, the Company does not obtain a tax benefit for the losses equal
to its tax rate elsewhere in the world. The Company expects that the tax rate
for 1999 will approximate 40.0 percent.
For 1998, the Company reported net income of $2.6 million, or $0.33 per
share (diluted), as compared with net income of $5.2 million, or $0.65 per share
(diluted), for 1997.
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 32.0 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 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.
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 increased in 1997 as the Company 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.
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.
26
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.
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.
QUARTERLY RESULTS OF OPERATIONS
The following table presents unaudited consolidated financial results
for each of the eight quarters in the period ended December 31, 1998. 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)
1998 1997
---------------------------------- ----------------------------------
MAR 31 JUN 30 SEP 30 DEC 31 MAR 31 JUN 30 SEP 30 DEC 31
------- ------- ------- ------- ------- ------- ------- -------
Net sales .................... $18,479 $22,682 $24,572 $29,314 $16,129 $18,737 $24,074 $25,702
Cost and expenses:
Cost of sales .............. 13,687 17,095 22,243 23,124 12,488 14,377 18,511 19,384
Selling, general, and
administrative ............. 1,619 1,815 1,721 2,179 1,466 1,479 1,822 1,790
Research and development ... 1,689 1,904 1,250 2,316 1,130 1,315 1,314 1,347
------- ------- ------- ------- ------- ------- ------- -------
16,995 20,814 25,214 27,619 15,084 17,171 21,647 22,521
------- ------- ------- ------- ------- ------- ------- -------
Operating income (loss) ...... 1,484 1,868 (642) 1,695 1,045 1,566 2,427 3,181
Other income (expense):
Interest, net .............. 192 130 (4) (243) 157 154 152 85
Other, net ................. (17) (6) (48) (46) (12) (7) (41) (130)
------- ------- ------- ------- ------- ------- ------- -------
Income (loss) before provision
for (benefit from) income
taxes ...................... 1,659 1,992 (694) 1,406 1,190 1,713 2,538 3,136
Provision for (benefit from)
income taxes ............... 664 869 (291) 531 389 685 1,010 1,250
------- ------- ------- ------- ------- ------- ------- -------
Net income (loss) ............ $ 995 $ 1,123 $ (403) $ 875 $ 801 $ 1,028 $ 1,528 $ 1,886
======= ======= ======= ======= ======= ======= ======= =======
Earnings (loss) per common
share:
Basic .................... $ 0.13 $ 0.14 $ (0.05) $ 0.12 $ 0.10 $ 0.13 $ 0.19 $ 0.24
------- ------- ------- ------- ------- ------- ------- -------
Diluted .................. $ 0.12 $ 0.14 $ (0.05) $ 0.12 $ 0.10 $ 0.13 $ 0.19 $ 0.23
------- ------- ------- ------- ------- ------- ------- -------
Weighted average number of
common shares:
Basic .................... 7,907 7,918 7,656 7,081 7,759 7,855 7,874 7,900
======= ======= ======= ======= ======= ======= ======= =======
Diluted .................. 8,165 8,128 7,656 7,146 8,048 8,071 8,181 8,168
======= ======= ======= ======= ======= ======= ======= =======
LIQUIDITY AND CAPITAL RESOURCES
During 1998, the Company had net cash outflow from operations of
$62,000, as compared with positive cash inflow of $6.8 million during 1997. The
decrease in cash flow from operations was primarily due to the increase in
accounts receivable, the increase in inventory, and the decreased provision for
inventory valuation reserves. The increase in accounts receivable occurred
primarily as a result of the increased sales activity in 1998
27
and the increase in inventory occurred primarily as a result of a build-up for
anticipated sales in the first quarter of 1999. Depreciation expense in 1998 was
$4.7 million versus $4.1 million in 1997. 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 continue
to rise in 1999 as a result of additional capital expenditures in 1999,
including the new building and equipment for the manufacturing facility in
China, the installation of additional equipment in its Manila manufacturing
location, and the installation of additional equipment in Tempe, Arizona to
manufacture LCoS(TM) microdisplays.
The Company's working capital was $24.8 million at December 31, 1998,
down from $29.1 million at December 31, 1997. The Company's current ratio at
December 31, 1998 was 2.5-to-1 as compared with a current ratio of 3.1-to-1 at
December 31, 1997. Including its cash and loan commitments, the Company had
nearly $22.0 million in readily available funds on December 31, 1998.
In November 1998, the Company entered into a new $25.0 million secured
revolving line of credit with Imperial Bank and the National Bank of Canada. The
new credit facility matures in May 2000 and consists of a $15.0 million
revolving line of credit, which will be available for general corporate purposes
(the "General Facility"), and a $10.0 million long-term loan, which will provide
available funds to repurchase the Company's stock (the "Repurchase Facility").
At December 31, 1998, $8.1 million of borrowings were outstanding under the
Repurchase Facility. Advances under the loans may be made as Prime Rate
Advances, which accrue interest payable monthly at the bank's prime lending
rate, or as LIBOR Rate Advances, which bear interest at 175 basis points in
excess of the LIBOR Base Rate for the General Facility and 225 basis points in
excess of the LIBOR Base Rate for the Repurchase Facility.
The Company's subsidiary, Three-Five Systems Limited, has established
an annually renewable credit facility with a United Kingdom bank, Barclays Bank
PLC, in order to fund its working capital requirements. The facility provides
$350,000 of borrowing capacity secured by accounts receivable of Three-Five
Systems Limited. Advances are based on accounts receivable, as defined. Advances
under the credit facility accrue interest, which is payable quarterly, at the
bank's base rate plus 200 basis points. The United Kingdom credit facility
matures in July 1999. Three-Five Systems Limited had no borrowings outstanding
under this line of credit at December 31, 1998.
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 upon market conditions and
other factors. In October 1998, the Board of Directors further extended and
revised the repurchase program to authorize repurchases of up to $10.0 million
of Common Stock. During the quarter ended December 31, 1998, the Company
purchased approximately 410,700 shares under the repurchase program at a total
cost of $3.4 million. Taking into account previous purchases, as of December 31,
1998, the Company had purchased a total of approximately 971,798 shares under
the repurchase program at a cost of $8.3 million.
Capital expenditures during 1998 were approximately $8.1 million, as
compared with $3.0 million during 1997. Capital expenditures for 1998 consisted
primarily of manufacturing and office equipment for the Company's operations in
Manila, Arizona, and China and laboratory equipment for research and
development. The Company anticipates that it will increase its capital
expenditures during 1999. Those expenditures will primarily relate to advanced
manufacturing processes, the high-volume LCD line, and necessary manufacturing
equipment. In 1998, the Company spent $5.3 million for equipment and
construction related to its Beijing, China operations. The Company anticipates
the facilities and capital cost for China in 1999 to be approximately $4.7
million.
The Company anticipates that accounts receivable and inventory will
rise in 1999 if revenue levels increase as currently anticipated. The Company
believes that its existing capital and anticipated cash flow from operations and
credit lines will provide adequate sources to fund operations and planned
expenditures throughout 1999. Should the Company encounter additional cash
requirements, however, the Company may have to expand its loan commitments or
pursue alternate methods of financing or raising capital. The Company cannot
provide assurance, however, that adequate additional financing will be available
or, if available, that such financing will be on terms acceptable to the
Company.
28
EFFECTS OF INFLATION AND FOREIGN CURRENCY EXCHANGE FLUCTUATIONS
The results of operations of the Company for the periods discussed have
not been significantly affected by inflation or foreign currency fluctuations.
The Company generally sells its products and services and negotiates purchase
orders with its foreign suppliers in United States dollars. An exception is the
Sub-Assembly Agreement in the Philippines, which is based on a fixed conversion
rate, exposing the Company to exchange rate fluctuations with the Philippine
peso. The Company has not incurred any material exchange gains or losses to date
and there has been some minor benefit as a result of the peso devaluation,
although the Company is now required to pay approximately one-third of any peso
devaluation gain to its lessor and direct labor subcontractor in Manila.
The Company commenced operations in China in 1998. Although the Chinese
currency currently is stable, its value in relation to the U.S. dollar is
determined by the Chinese government. There is general speculation that China
may devalue its currency in response to the current Asian economic situation.
Devaluation of the Chinese currency could result in translation adjustments to
the Company's balance sheet as well as reportable losses depending on monetary
balances and loans of the Company at the time of devaluation. Recently, the
government in China has made it difficult to convert its local currency into
foreign currencies. Although the Company from time to time may enter into
hedging transactions in order to minimize its exposure to currency rate
fluctuations, the Chinese currency is not freely traded and thus is difficult to
hedge. In addition, the government of China has recently imposed restrictions on
Chinese currency loans to foreign-operated entities in China. Based on the
foregoing, there can be no assurance that fluctuations and currency exchange
rates in the future will not have an adverse affect on the Company's operations.
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.
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. In 1998, sales to that
office automation customer were greatly reduced, but that reduction was more
than offset by increased sales to the Company's largest telecommunications
customer. Sales in 1998 increased by about 12.3 percent over 1997, but net
profit declined as the Company increased R&D expenses significantly, incurred
start-up expenses for China, and experienced pricing pressures from its Asian
competitors, partially as a result of the Asian economic situation.
In 1998, the Company recorded almost 57 percent of its revenue in the
third and fourth quarters. Fourth quarter revenue in 1998 was almost 60 percent
greater than first quarter revenues in 1998. In 1999, the Company anticipates
that this type of revenue pattern will be repeated. The Company believes that it
has a pattern of seasonality to its sales as OEMs with retail products develop
shorter product life cycles and phase out old programs early in the year
following holiday sales.
The Company has undertaken efforts to diversify its business, broaden
its customer base, and expand its markets. The Company's historical major
customer, which accounted for approximately 80 percent of the Company's revenue
in 1995, accounted for 65 percent of the Company's revenue in 1996 and slightly
less than 35 percent of the Company's revenue in 1997. These reduced percentages
occurred as a result of the increased sales to other customers and reduced
product selling prices and revenues from that major customer. In 1998, however,
the Company's business with that customer has increased at a rate faster than
business with other customers. Therefore, the percentage of revenue attributed
to that customer substantially increased in 1998. In 1999, the Company expects
its business with that customer to remain at approximately the same dollar
amount. In addition, the Company plans
29
to increase sales to other customers, which would result in declining customer
concentration. One other customer accounted for 32.0 percent of the Company's
revenue in 1997, but this percentage declined in 1998 to below 10 percent of the
Company's revenue as older programs have matured. Some replacement programs did
not have the type of LCD modules supplied by the Company and those that did had
significantly lower selling prices. The Company expects to do continued business
with this customer, but does not expect it to constitute more than 10 percent of
its revenue in 1999.
Several factors impact the Company's gross margins, including
manufacturing efficiencies, product differentiation, product uniqueness,
billings for non-recurring engineering services, inventory management,
engineering costs, product mix, and volume pricing. There is significant pricing
pressure in higher volume programs in the telecommunications and office
automation industries. As the production levels of some of the Company's new
high-volume programs increase, the lower standard gross margins on those
programs have had an impact on the Company's overall margins. In addition, in an
effort to secure sales to certain strategic customers, the Company may
aggressively price its products. Depending on the size of the programs achieved,
such pricing strategies also could have an effect on overall margins.
The Company's gross margins on its products are also typically lower at
the start of a program as a result of yield and other start-up issues. In the
third quarter of 1998, the Company started several new programs and incurred
substantial start-up costs. The Company expects to start up several new programs
throughout 1999.
The Company started operations in China in 1998, and the Company's
gross margins have been adversely affected by the start-up of those China
manufacturing operations. As the Company ramped up its manufacturing operations
in China, it incurred costs in advance of the receipt of significant revenues.
Generally, the incremental China-based expenses were in the total cost of sales.
Those incremental expenses arose mainly from under-absorption of the costs of
operating the China facility and are included in the cost of sales, thus
reducing overall gross margins. In the fourth quarter of 1998, the Company had a
slight profit in China because significant increases in manufacturing volumes
resulted in absorption of the existing costs. In the next few quarters,
profitability in China will be volume-dependent. In the long run, however, the
Company expects the China operations to positively impact gross margins because
of certain competitive cost advantages provided by maintaining operations in
China.
The Company anticipates that weakened Asian currencies will have a
continued impact on the Company's gross margins. Many of the Company's
competitors are Asian suppliers, and a strong U.S. dollar gives a competitive
pricing advantage to those suppliers. Thus, the Company may continue to see
competitive margin pressure from Asian suppliers, particularly those in Korea
and Japan.
Serving a variety of customers with complex and differing issues
requires increased personnel committed to those customers. As the Company
expands and diversifies its product and customer base, the Company has had to
increase its selling, general, and administrative expenses. The volume and
complexity of the Company's business is expected to continue to grow. As a
result, the Company anticipates that it will continue to increase its selling
and administrative expenses on a quarter-by-quarter basis.
The Company believes that continued investments in research and
development relating to new display technology and manufacturing processes are
necessary to remain competitive in the marketplace and to provide opportunities
for growth. The Company continues to expand and intensify its internal research
and development to focus on proprietary display products as well as continue LCD
manufacturing process improvements. Use of the LCD manufacturing line in Tempe,
Arizona as a resource for testing new ideas is key to development of these
products, some of which will be proprietary and not available from other display
manufacturers. Further, the development of the high-volume manufacturing LCD
line has helped reduce the Company's dependence on foreign suppliers of LCD
glass. Some of the Company's new display technologies also require the
development of application specific integrated circuits ("ASICs") to
electronically drive the displays. Development of custom ASICs is a lengthy and
expensive process.
The Company also intends to pursue technologies being developed in
related fields. The Company operates the highest volume fully automated LCD
manufacturing line in North America. As a result, several companies have
30
approached the Company about potential alliances. The Company believes that a
strategic alliance with one or more of those companies could minimize the cost
of entry into new markets and new technologies. For example, in 1997 National
Semiconductor Corporation and the Company entered into a strategic supplier
alliance agreement for the development and manufacture of LCoS(TM)
microdisplays. In April 1998, the Company acquired approximately a 19 percent
interest in Siliscape, Inc., a start-up company with numerous patents and
proprietary technology relating to microdisplays. The Company and Siliscape,
Inc. also entered into a strategic agreement under which they will focus on the
development of microdisplay products, with the Company providing certain
proprietary manufacturing capabilities and Siliscape, Inc. providing certain
patented and proprietary technologies and components.
The Company also is considering licensing from other companies
technologies that could be optimized on the LCD manufacturing line, as well as
entering into further alliances. The Company intends to continue this internal
and external focus on research and development indefinitely. As a result, the
actual dollar amount of such research and development expenditures in 1999 will
substantially increase over 1998.
As previously described, the Company has established manufacturing
operations in China. Three-Five Systems (Beijing) Co., Ltd. was incorporated in
China during the first quarter of 1998 and business license approval was
received from the governmental authorities. During the first quarter of 1998, a
temporary leased site was selected in Beijing, as was the permanent site. In the
second quarter of 1998, the Company moved into the temporary site and set up
manufacturing lines. In the third quarter of 1998, the factory was qualified by
customers and began making initial shipments. In the fourth quarter of 1998, the
Company shipped over $5.7 million in products.
The Company has established a China-based manufacturing operation for
several reasons. First, based upon growth expectations in the European and
United States marketplaces, the Company anticipated a need for manufacturing
capacity beyond what is available at its Philippine manufacturing facility.
China was selected because of the desire to diversify manufacturing locations
and because of the cost benefits that are expected to be achieved in China.
China also is expected to be a synergistic business location for the Company
because many of the components used by the Company are manufactured in China.
Second, many of the Company's existing and potential customers maintain
manufacturing operations near the Company's operations in China. Despite the
current Asian economic situation, those customers continue to require LCD
modules and the Company has limited participation in that market. There
currently are very few LCD module manufacturers in China. Under current Chinese
government rules, however, OEMs in China have a strong motivation to utilize
locally manufactured components.
RISK FACTORS
Forward-looking statements in this report include revenue, margin,
expense, and earnings analysis for 1999 as well as the Company's expectations
relating to operations in China; future technologies; and future designs,
inventory balances, and production orders. The Company's future operating
results may be affected by various trends, developments, and factors that the
Company must successfully manage in order to achieve its goals. In addition,
there are trends, developments, and factors beyond the Company's control that
may affect its operations. The cautionary statements and risk factors set forth
below and elsewhere in this Report, and in the Company's other filings with the
Securities and Exchange Commission, identify important trends, factors, and
currently known developments that could cause actual results to differ
materially from those in any forward-looking statements contained in this Report
and in any written or oral statements of the Company.
A few core customers currently are responsible for a majority of the
Company's revenue, and the Company expects the high concentration levels with
its core customers to continue through 1999. Thus, any material delay,
cancellation, or reduction of orders from one or more of those core customers
could have a material adverse effect on the Company's operations.
Although the trend of the Company is to enter into more manufacturing
contracts with its customers, the principal benefit of these contracts is to
clarify order lead times, inventory risk allocation, and similar matters and not
to provide firm, long-term volume purchase commitments. Customers generally do
not provide firm long-term volume purchase commitments to the Company. Thus,
customers can cancel purchase commitments and change or
31
delay expected volume levels. The Company cannot provide assurance that it will
be able to replace canceled, delayed, or reduced commitments in a timely manner.
If customers cancel, delay, or reduce commitments, the Company could be left
holding excess and obsolete inventory or having unfavorable manufacturing
variances as a result of under-absorption. These risks are exacerbated because
the Company expects that a majority of its sales will be to customers in the
retail electronics industry, which is subject to severe competitive pressures,
rapid technological change, and obsolescence. A few of the Company's customers
have inquired about inventory hubbing agreements, pursuant to which the Company
will maintain stocks of finished goods at or near the customer's factory.
Although the Company has not yet entered into such agreements with any of its
customers, the use of such type of agreements could result in higher inventory
balances for the Company and/or excess inventory.
Another risk inherent in custom manufacturing is the satisfactory
completion of design services and securing of production orders. The Company
anticipates that a significant portion of its revenue for the future will come
from programs currently in the design or pilot production stage. Completion of
the design depends on a variety of factors, including the customer's changing
needs, and not every design is successful in meeting those needs. In addition,
some designs test new theories or applications and may not meet the desired
results. Failure of a design order to achieve the customer's desired results
could result in a material adverse effect on the Company's operations if the
expected production order for that product was significant. Finally, even when a
design is satisfactorily completed, the customer may terminate or delay the
program as a result of marketing or other pressures.
The Company currently is investing in research and development of
several new technologies that it plans to introduce in the future. The Company
faces the risk that some or all of those technologies may not successfully make
the transition from the research and development lab to cost-effective
manufacturability as a result of technology problems, competitive cost issues,
yield problems, and other factors. In addition, even if a new technology proves
to be manufacturable, the Company's customers and the customers' marketplaces
may not accept it because of price or technology issues or because it compares
unfavorably with products introduced by others. The Company will be required to
make significant expenditures, including development expenses and various
capital expenditures and investments, for these new technologies. For example,
the Company estimates that its initial capital expenditures for LCoS(TM)
microdisplays will be approximately $3.0 million to $4.0 million. The Company
also made an equity investment of $3.3 million in Siliscape during 1998 for the
purposes of further developing the LCoS(TM) microdisplay product. Significant
investments in one or more of the new technologies, especially LCoS(TM)
microdisplays, that ultimately prove to be unsuccessful for any reason could
have a material adverse impact on the Company. In addition, if Siliscape were to
encounter technological or financial difficulties, the value of the Company's
investment could decline, in which case the Company would have to write down all
or a portion of its investment and report a loss equal to such write-down.
The Company designs and manufactures products based on firm quotes.
Thus, the Company bears the risk of component price increases, which could
adversely affect the Company's gross margins. In addition, the Company depends
on certain suppliers, and the unavailability or shortage of materials could
cause delays or lost orders. Material components of some of the Company's major
programs from time to time have been subject to allocation because of shortages
by vendors and continued or increased shortages could have a material adverse
effect on the Company in the future. In addition, the Company purchases many
product components from vendors in Asian countries. Economic instability in
certain Asian countries could cause supply problems with respect to these
components.
The Company's primary competitors are located in Asia, including,
Japan, Korea, and Hong Kong, and most of the Company's customers are U.S.-based.
The recent currency devaluation of several Asian countries has had, and could
continue to have, a negative impact on the gross margins of the Company as the
competitors' products become less expensive to purchase with a stronger dollar.
The Company has established a manufacturing operation in China. The
Company's operations and assets will be subject to significant political,
economic, legal and other uncertainties in China. The Company's operations in
China also could be adversely affected by the imposition of austerity measures
intended to reduce inflation; the inadequate development or maintenance of
infrastructure, including the unavailability of adequate
32
power and water supplies, transportation, raw materials, and parts; or a
deterioration of the general political, economic or social environment in China.
The Company has set up manufacturing operations in Beijing in an
interim leased facility. If there are delays in the completion of the permanent
facility, the Company may run into capacity issues in the interim facility
because of space constraints and/or power requirements. In addition, the Company
has a short-term lease on the interim facility and could be required to move out
if there are delays in the completion of the permanent facility, which would
severely interrupt the Company's manufacturing operations in China.
One of the reasons the Company is starting up operations in China is
because the Company believes that its Manila manufacturing facility may have
occasional capacity issues within the next year. Failure to begin operations in
the permanent China facility on a timely basis could result in capacity
restraints and late or canceled customer deliveries. Manufacturing yields and
delivery schedules also may be affected as the Company ramps up its
manufacturing capabilities in China. Other companies in the industry have
experienced difficulty in expanding or relocating manufacturing output and
capacity, with such difficulty resulting in reduced yields or delays in product
deliveries. The Company cannot provide assurance that it will not experience
manufacturing yield or delivery problems in the future. Such problems could
materially affect the Company's operating results.
Finally, the Company's success, especially in penetrating new markets
and increasing its OEM customer base, depends to a large extent upon the efforts
and abilities of key managerial and technical employees. The loss of services of
certain key personnel could have a material adverse effect on the Company. The
Company's business also depends upon its ability to continue to attract and
retain senior managers and skilled employees. Failure to do so could adversely
affect the Company's operations.
As a result of the foregoing and other factors, the Company's stock
price may be subject to significant volatility, particularly on a quarterly
basis. Any shortfall in revenue or earnings from levels expected by investors,
analysts, and brokers could have an immediate and significant adverse effect on
the trading price of the Company's Common Stock in any given period.
Additionally, the Company may not learn of such shortfalls until late in a
fiscal quarter, which could result in an even more immediate and adverse effect
on the trading price of the Company's Common Stock. Finally, other factors,
which generally affect the market for stocks of high technology companies, could
cause the price of the Company's Common Stock to fluctuate substantially over
short periods for reasons unrelated to the Company's performance.
YEAR 2000 COMPLIANCE DISCLOSURE
Many existing computer programs and databases use only two digits to
identify a year in the date field (I.E., 99 would represent 1999). These
programs and databases were designed and developed without considering the
impact of the upcoming millennium. Consequently, date sensitive computer
programs may interpret the date "00" as 1900 rather than 2000. If not corrected,
many computer systems could fail or create erroneous results in 2000. The
following disclosure is as required by SEC Release No. 33-7558.
COMPANY'S STATE OF READINESS
The Company has completed an assessment of all of its internal and
external systems and processes with respect to the "Year 2000" issue. In
response to this assessment, the Company has created a multi-functional Year
2000 task force to resolve any non-compliant Year 2000 systems or processes. To
date, this group is on schedule to complete this task during 1999. The Company
plans to continuously test all of its internal and external systems and
processes, including the associated Year 2000 "fixes," for Year 2000 compliance
during 1999. As part of this process, the Company has assessed the potential
impact of Year 2000 failures from vendors and outside parties upon its business
and currently is taking steps to minimize that risk. Based on the Company's
current state of readiness and the steps currently being taken (I.E., installing
backup processes and systems), the Company does not believe that the Year 2000
problem will have a material adverse effect on the Company's financial position,
liquidity, or operations.
33
COMPANY'S COSTS OF YEAR 2000 COMPLIANCE
The Company estimates that its total cost of Year 2000 compliance will
be less than $100,000. Those costs include updating of computer software and
hardware manufacturing equipment, as well as employment and other out-of-pocket
costs.
COMPANY'S RISKS OF YEAR 2000 ISSUES
The Company procures a significant amount of raw materials used in its
manufacturing processes from foreign vendors. As a result, the Company may be at
risk from foreign companies and countries that are not taking adequate measures
to ensure Year 2000 compliance or that may not be at the same level of
preparedness as the United States. For example, economic problems in Asia may
affect or divert resources with respect to the Year 2000 issue. Failure of those
foreign countries and companies to be Year 2000 compliant may cause new material
shortages that would adversely impact the Company's manufacturing operations. In
addition, the Company currently has significant manufacturing operations in
Manila, the Philippines and Beijing, China. As a result, the Company may be at
risk with respect to suppliers of necessary resources (such as power or water)
that may not be Year 2000 compliant. For example, brownouts or blackouts may
occur due to lack of Year 2000 compliance. In addition, the Company's customers
may have catastrophic Year 2000 failures, including prolonged interruptions in
factory productions, in which case they may have a reduced demand for the
Company's products.
COMPANY'S CONTINGENCY PLANS
The Company is developing contingency plans with respect to significant
Year 2000 issues within its control. For example, the Company is in the process
of assessing and verifying the Year 2000 compliance of its international and
domestic raw material vendors. Verification will be accomplished through the use
of written certifications and audits. The Company intends to replace any vendors
found not to be Year 2000 compliant with vendors that are Year 2000 compliant.
In the construction of its new Beijing facility, the Company will procure
material, processes, and equipment that are Year 2000 compliant. The Company
also is investigating the use of stand-by generators for its plants in the event
of a local power failure. The Company is investigating transferring all
manufacturing processes to alternate manufacturing facilities if external
factors beyond its control relative to the Year 2000 issue occur and the Company
cannot conduct manufacturing operations at any particular facility.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
DERIVATIVE FINANCIAL INSTRUMENTS, OTHER FINANCIAL INSTRUMENTS, AND DERIVATIVE
COMMODITY INSTRUMENTS.
At December 31, 1998 the Company did not participate in any derivative
financial instruments or other financial and commodity instruments for which
fair value disclosure would be required under Statement of Financial Accounting
Standards No. 107. The Company holds no investment securities that would require
disclosure of market risk.
PRIMARY MARKET RISK EXPOSURES.
The Company's primary market risk exposures are in the areas of interest
rate risk and foreign currency exchange rate risk. The Company incurs interest
on loans made under a revolving line of credit at interest rates under a
variable interest rate of the bank's prime rate (7.75% at December 31, 1998)
plus 2.375%, the principal of which is due 2004. At December 31, 1998, the
Company's outstanding borrowings on the line of credit was approximately $8.1
million. Substantially all of the Company's business outside the United States
is conducted in U.S. dollar denominated transactions. The Company operates
high-volume manufacturing facilities in Manilla, the Philippines and Beijing,
China, and a sales and distribution facility in the United Kingdom. Some of the
expenses of these foreign operations are denominated in the Philippine peso,
Chinese renminbi, and British pound sterling, respectively. These expenses
include local salaries and wages, utilities and some operating supplies.
However, the Company believes that the operating expenses currently incurred in
foreign currencies are immaterial, and therefore any associated market risk is
unlikely to have a material adverse effect on the Company's business, results of
operations or financial condition.
34
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 filed
pursuant to Regulation 14A of the Exchange Act for the Company's 1999 Annual
Meeting of Stockholders. The information required by this Item relating to
executive officers of the Company is included in "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 filed pursuant to Regulation 14A of
the Exchange Act for the Company's 1999 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 filed pursuant to Regulation 14A of
the Exchange Act for the Company's 1999 Annual Meeting of Stockholders.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Not applicable.
35
PART IV
ITEM 14. EXHIBITS 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(8)
10(u) Addendum No. 1 to Sub-Assembly Agreement between Three-Five Systems,
Inc. and TEAM Pacific Corporation dated March 12, 1997(8)
10(v) 1997 Employee Stock Option Agreement(8)
10(w) 1998 Stock Option Agreement(8)
10(x) 1998 Director's Stock Plan(8)
10(y) Addendum No. 2 to Sub-Assembly Agreement between Three-Five Systems,
Inc. and TEAM Pacific Corporation dated January 1, 1998(8)
10(z) 401(k) Profit Sharing Plan(9)
10(aa) Credit Agreement dated November 5, 1998, by and among Three-Five
Systems, Inc., its subsidiaries, the Banks named therein, and Imperial
Bank Arizona, as Agent.
10(bb) Security Agreement dated November 5, 1998, by Three-Five Systems, Inc.
in favor of Imperial Bank Arizona, as Agent.
21 List of Subsidiaries
23 Consent of Arthur Andersen LLP
27 Financial Data Schedule
36
(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.
(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.
(8) Incorporated by reference to the Registrant's Form 10-K for the fiscal year
ended December 31, 1997, as filed with the Commission on March 13, 1998,
and as amended by Form 10-K/A filed with the Commission on March 23, 1998.
(9) Incorporated by reference to the Registration Statement on Form S-8
(Registration No. 333-57933) as filed on June 26, 1998.
37
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.
THREE-FIVE SYSTEMS, INC.
Date: March 9, 1999 By: /s/ David R. Buchanan
-------------------------------------
David R. Buchanan
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 President, Chief Executive Officer March 9, 1999
- -------------------------- (Principal Executive Officer),
David R. Buchanan and Director
/s/ Jeffrey D. Buchanan Executive Vice President March 9, 1999
- -------------------------- - Finance, Administration, and Legal;
Jeffrey D. Buchanan Chief Financial Officer; Secretary;
Treasurer (Principal Financial
Officer), and Director
/s/ Robert T. Berube Corporate Controller March 9, 1999
- -------------------------- (Principal Accounting Officer)
Robert T. Berube
/s/ David C. Malmberg Director March 9, 1999
- --------------------------
David C. Malmberg
/s/ Burton E. McGillivray Director March 9, 1999
- --------------------------
Burton E. McGillivray
/s/ Gary R. Long Director March 9, 1999
- --------------------------
Gary R. Long
/s/ Kenneth M. Julien Director March 9, 1999
- --------------------------
Kenneth M. Julien
/s/ Thomas A. Werner Director March 9, 1999
- --------------------------
Thomas A. Werner
38
THREE-FIVE SYSTEMS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Report of Independent Public Accountants ................................... F-2
Consolidated Balance Sheets as of December 31, 1998 and 1997 ............... F-3
Consolidated Statements of Income (Loss) for the years ended
December 31, 1998, 1997 and 1996 ........................................ F-4
Consolidated Statements of Stockholders' Equity for the
years ended December 31, 1998, 1997 and 1996 ............................ F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 1998, 1997 and 1996 ........................................ 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, 1998
and 1997, 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, 1998. 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, 1998 and 1997, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1998, in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedules listed in the index of
financial statements are presented for purposes of complying with the Securities
and Exchange Commission's rules and are not part of the basic financial
statements. These schedules have been subjected to the auditing procedures
applied in the audits of the basic financial statements and, in our opinion,
fairly state in all material respects the financial data required to be set
forth therein in relation to the basic financial statements taken as a whole.
/s/ Arthur Andersen LLP
Phoenix, Arizona,
January 22, 1999.
F-2
THREE-FIVE SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
ASSETS
December 31,
--------------------
1998 1997
-------- --------
CURRENT ASSETS:
Cash and cash equivalents (Note 2) $ 4,946 $ 16,371
Accounts receivable, net 18,601 12,540
Inventories, net (Note 2) 12,493 8,255
Deferred tax asset (Note 5) 2,680 4,311
Other current assets 2,313 1,228
-------- --------
Total current assets 41,033 42,705
PROPERTY, PLANT AND EQUIPMENT, net (Note 2) 33,314 29,847
OTHER ASSETS 3,557 283
-------- --------
$ 77,904 $ 72,835
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 10,649 $ 8,513
Accrued liabilities (Note 2) 4,673 5,079
Current taxes payable (Note 5) 235 --
Current portion of long-term debt (Note 3) 651 --
-------- --------
Total current liabilities 16,208 13,592
-------- --------
LONG-TERM DEBT (Note 3) 7,444 --
-------- --------
DEFERRED TAX LIABILITY (Note 5) 3,156 2,718
-------- --------
COMMITMENTS AND CONTINGENCIES (Note 6)
STOCKHOLDERS' EQUITY (Note 4):
Preferred stock, $.01 par value; 1,000,000
shares authorized -- --
Common stock, $.01 par value; 15,000,000 shares
authorized, 7,974,901 shares issued, 7,005,107
shares outstanding at December 31, 1998;
7,928,023 shares issued, 7,905,523 shares
outstanding at December 31, 1997 80 79
Additional paid-in capital 32,484 32,420
Retained earnings 26,849 24,259
Cumulative translation adjustment (Note 2) 8 20
Less - Treasury stock, at cost (969,794 shares) (8,325) (253)
-------- --------
Total stockholders' equity 51,096 56,525
-------- --------
$ 77,904 $ 72,835
======== ========
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,
------------------------------------
1998 1997 1996
---------- ---------- ----------
NET SALES (Note 7) $ 95,047 $ 84,642 $ 60,713
---------- ---------- ----------
COSTS AND EXPENSES:
Cost of sales 76,149 64,760 58,321
Selling, general and administrative 7,334 6,557 5,351
Research and development 7,159 5,106 4,065
---------- ---------- ----------
90,642 76,423 67,737
---------- ---------- ----------
Operating income (loss) 4,405 8,219 (7,024)
---------- ---------- ----------
OTHER INCOME (EXPENSE):
Interest, net 75 548 412
Other, net (117) (190) (139)
---------- ---------- ----------
(42) 358 273
---------- ---------- ----------
INCOME (LOSS) BEFORE PROVISION FOR
(BENEFIT FROM) INCOME TAXES: 4,363 8,577 (6,751)
Provision for (benefit from)
income taxes (Note 5) 1,773 3,334 (2,920)
---------- ---------- ----------
NET INCOME (LOSS) $ 2,590 $ 5,243 $ (3,831)
========== ========== ==========
EARNINGS (LOSS) PER COMMON SHARE (Note 2):
Basic $ 0.34 $ 0.67 $ (0.49)
========== ========== ==========
Diluted $ 0.33 $ 0.65 $ (0.49)
========== ========== ==========
WEIGHTED AVERAGE NUMBER OF COMMON
SHARES:
Basic 7,638,631 7,854,053 7,767,744
========== ========== ==========
Diluted 7,802,041 8,089,975 7,767,744
========== ========== ==========
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, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
Common Stock
---------------------- Additional
Shares Paid-in Retained
Issued Amount Capital Earnings
--------- --------- --------- ---------
BALANCE, December 31, 1995 7,735,745 $ 77 $ 32,286 $ 22,847
Net loss -- -- -- (3,831)
Other comprehensive income-
Foreign currency translation
adjustments -- -- -- --
Comprehensive income -- -- -- --
Stock options exercised 44,084 1 11 --
Tax benefit from early disposition
of incentive stock options -- -- 32 --
Purchase of treasury stock -- -- -- --
--------- --------- --------- ---------
BALANCE, December 31, 1996 7,779,829 78 32,329 19,016
Net income -- -- -- 5,243
Other comprehensive income-
Foreign currency translation
adjustments -- -- -- --
Comprehensive income -- -- -- --
Stock options exercised 148,194 1 50 --
Tax benefit from early disposition
of incentive stock options -- -- 41 --
--------- --------- --------- ---------
BALANCE, December 31, 1997 7,928,023 79 32,420 24,259
Net income -- -- -- 2,590
Other comprehensive income-
Foreign currency translation
adjustments -- -- -- --
Comprehensive income -- -- -- --
Stock options exercised 46,878 1 64 --
Purchase of treasury stock -- -- -- --
--------- --------- --------- ---------
BALANCE, December 31, 1998 7,974,901 $ 80 $ 32,484 $ 26,849
========= ========= ========= =========
Cumulative Total
Treasury Translation Stockholders' Comprehensive
Stock Adjustment Equity Income
-------- ---------- ---------- ----------
BALANCE, December 31, 1995 $ -- $ 14 $55,224
Net loss -- -- (3,831) $(3,831)
Other comprehensive income-
Foreign currency translation
adjustments -- -- -- --
Comprehensive income -------
Stock options exercised -- -- -- $(3,831)
Tax benefit from early disposition =======
of incentive stock options -- -- 12
Purchase of treasury stock -- -- 32
(253) -- (253)
------- ------ -------
BALANCE, December 31, 1996 (253) 14 51,184
Net income -- -- 5,243 $ 5,243
Other comprehensive income-
Foreign currency translation
adjustments -- 6 6 6
Comprehensive income -- -- -- -------
Stock options exercised -- -- 51 $ 5,249
Tax benefit from early disposition =======
of incentive stock options -- -- 41
------- ------ -------
BALANCE, December 31, 1997 (253) 20 56,525
Net income -- -- 2,590 $ 2,590
Other comprehensive income-
Foreign currency translation
adjustments -- (12) (12) (12)
Comprehensive income -- -- -- -------
Stock options exercised -- -- 65 $ 2,578
Purchase of treasury stock (8,072) -- (8,072) =======
------- ------ -------
BALANCE, December 31, 1998 $(8,325) $ 8 $51,096
======= ====== =======
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,
----------------------------
1998 1997 1996
-------- ------- -------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 2,590 $ 5,243 $(3,831)
Adjustments to reconcile net income (loss)
to net cash (used in) provided by
operating activities-
Depreciation and amortization 4,693 4,135 3,551
Provision for (reduction of) accounts
receivable valuation reserves (64) (69) 47
Provision for (reduction of) inventory
valuation reserves (3,184) (2,473) 4,015
Loss on disposal of assets -- 2 12
Changes in assets and liabilities:
(Increase) decrease in accounts receivable (5,997) (5,641) 2,469
(Increase) decrease in inventories (1,054) (1,176) 5,082
(Increase) decrease in other assets (1,425) 505 (1,070)
Increase in accounts payable and accrued
liabilities 1,730 4,778 4,296
Increase (decrease) in taxes payable, net 2,649 1,461 (2,358)
-------- ------- -------
Net cash (used in) provided by operating
activities (62) 6,765 12,213
-------- ------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property, plant and equipment (8,119) (3,050) (948)
Proceeds from sale of property, plant and
equipment -- 19 5
Investment in Siliscape, Inc. (3,320) -- --
-------- ------- -------
Net cash used in investing activities (11,439) (3,031) (943)
-------- ------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from (payments on) notes
payable to banks 8,095 -- (3,000)
Stock options exercised 65 51 12
Purchase of treasury stock (8,072) -- (253)
-------- ------- -------
Net cash provided by (used in) financing
activities 88 51 (3,241)
-------- ------- -------
Effect of exchange rate changes on cash (12) 6 --
-------- ------- -------
NET (DECREASE) INCREASE IN CASH AND CASH
EQUIVALENTS (11,425) 3,791 8,029
CASH AND CASH EQUIVALENTS, beginning of year 16,371 12,580 4,551
-------- ------- -------
CASH AND CASH EQUIVALENTS, end of year $ 4,946 $16,371 $12,580
======== ======= =======
SUPPLEMENTAL CASH FLOW INFORMATION:
Interest paid $ 364 $ 4 $ 60
======== ======= =======
Income taxes paid $ 992 $ 1,973 $ 1,832
======== ======= =======
The accompanying notes are an integral part of these consolidated statements.
F-6
THREE-FIVE SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998, 1997 AND 1996
(1) ORGANIZATION AND OPERATIONS:
Three-Five Systems, Inc. (the Company) designs and manufactures a wide range of
user interface devices for operational control and information 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, consumer electronic products, and data collection 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 currently conducts manufacturing operations in Tempe, Arizona;
Manila, the Philippines; and Beijing, China. The Company believes that the
Arizona facility has the largest fully automated LCD glass production capacity
outside of Asia. High-volume LCD module manufacturing is done in Manila, the
Philippines and Beijing, China. In Manila, 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 $2.2 million to the subcontractor to help the subcontractor meet
its working capital needs. As of December 31, 1998, the subcontractor has repaid
$2.0 million of these advances. The amounts payable to the subcontractor more
than exceeded the $205,000 advances outstanding at December 31, 1998. These
advances are secured by future payments for subcontracting services to be
provided to the Company. The Company commenced manufacturing operations in China
during 1998. The China facility is a high-volume LCD module manufacturing
facility similar to the Company's facility in Manila. The Company initially
leased a facility in Beijing on a temporary basis, which expires in mid-1999,
and the Company commenced manufacturing operations in that temporary facility in
the second quarter of 1998. The Company has begun construction of its own
facility in Beijing and expects to move into the new facility in the middle of
1999. Any significant delay in the construction of the permanent facility could
result in the temporary shutdown of the China manufacturing operations.
(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.
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.
Three-Five Systems Pacific, Inc. (Pacific), a Philippines corporation, procures
supplies primarily from Philippine vendors. Pacific also manages and assists
production personnel of the third-party subcontractor that operates the facility
in the Philippines.
F-7
During the first quarter of 1998, the Company formed a wholly-owned subsidiary
in China, Three-Five Systems (Beijing) Co., Ltd. (Beijing). Beijing manufactures
and sells the Company's products to customers primarily located in Asia.
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.
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.
In addition, the carrying amount on the outstanding line of credit is estimated
to approximate fair value as the actual interest rate is consistent with rates
estimated to be currently available for debt with similar terms and remaining
maturities.
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 $1,992,000 and $12,886,000 at December 31, 1998 and December
31, 1997, 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 $1,125,000
and $4,309,000 at December 31, 1998 and December 31, 1997, respectively.
Inventories at December 31 consist of the following:
1998 1997
--------- ---------
(in thousands)
Raw materials $ 9,367 $ 6,052
Work-in-process 1,459 1,195
Finished goods 1,667 1,008
--------- ---------
$ 12,493 $ 8,255
========= =========
F-8
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:
1998 1997
-------- --------
(in thousands)
Building and improvements $ 13,031 $ 10,431
Furniture and equipment 37,324 31,804
-------- --------
50,355 42,235
Less - accumulated depreciation (17,041) (12,388)
-------- --------
$ 33,314 $ 29,847
======== ========
The Company utilizes 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 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 $975,000 and
$1,675,000 at December 31, 1998 and 1997, 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 functional
currency of each of Pacific and Limited is the same as the local currency. The
gain or loss resulting from the translation of these two subsidiaries' financial
statements has been included as a separate component of stockholders' equity.
The functional currency of Beijing is the U.S. dollar. Beijing, however,
maintains its books and records in the Renminbi. Therefore, the Company utilizes
the remeasurement method of foreign currency translation when Beijing is
consolidated. Any resulting remeasurement gain or loss is reported in the
Company's consolidated statements of operations.
The net foreign currency transaction loss in 1998, 1997, and 1996 was $177,000,
$183,000, and $46,000, respectively, and has been included in other expenses in
the accompanying statements of income (loss).
F-9
REVENUE RECOGNITION
The Company recognizes revenue upon shipment. The Company provides reserves for
uncollectible accounts receivable. These reserves totaled $431,000 and $455,000
at December 31, 1998 and 1997, 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, 1998 and 1997 are determined assuming that outstanding
options were exercised at the beginning of each 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. Set forth below are the disclosures required
pursuant to SFAS No. 128 for the years ended December 31, 1998, 1997, and 1996:
Years Ended December 31,
------------------------------
1998 1997 1996
------- ------- --------
(in thousands, except per share data)
Basic earnings (loss) per share:
Income (loss) available to common
shareholders $ 2,590 $ 5,243 $ (3,831)
------- ------- --------
Weighted average common shares 7,639 7,854 7,768
------- ------- --------
Basic per share amount $ 0.34 $ 0.67 $ (0.49)
======= ======= ========
Diluted earnings (loss) per share:
Income (loss) available to common
shareholders $ 2,590 $ 5,243 $ (3,831)
------- ------- --------
Weighted average common shares 7,639 7,854 7,768
Options assumed exercised 163 236 -
------- ------- --------
Total common shares plus assumed
exercises 7,802 8,090 7,768
------- ------- --------
Diluted per share amount $ 0.33 $ 0.65 $ (0.49)
======= ======= ========
RECENTLY ADOPTED ACCOUNTING STANDARDS
In 1998, the Company adopted Statement of Financial Accounting Standards No.
130, REPORTING COMPREHENSIVE INCOME, which requires companies to report all
changes in equity during a period, except those resulting from investment by
owners and distribution to owners, in a financial statement for the period in
which they are recognized. The Company has chosen to disclose Comprehensive
Income, which encompasses net income and foreign currency translation
adjustments, in the Consolidated Statement of Shareholder's Equity. Prior years
have been restated to conform to the SFAS No. 130 requirements.
F-10
In 1998, the Company also adopted Statement of Financial Accounting Standards
No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION.
The new rules establish revised standards for public companies relating to the
reporting of financial and descriptive information about their operating
segments in financial statements. The Company adopted SFAS No. 131 and all of
the required disclosures (Note 7).
(3) LONG-TERM DEBT:
Long-term debt at December 31 consists of the following:
1998 1997
------- -------
(in thousands)
$15.0 million revolving line of credit, interest
due monthly at the bank's prime rate (7.75% at
December 31, 1998) or at the LIBOR base rate
(5.064% at December 31, 1998) plus 1.75%, unpaid
balance due May 22, 2000, secured by all assets
other than real property. $ -- $ --
$10.0 million revolving line of credit/term loan,
interest due monthly at the bank's prime rate or
at the LIBOR base rate plus 2.375%, unpaid balance
due August 5, 2004, secured by all assets other
than real property. 8,095 --
$350,000 United Kingdom credit facility, interest
due quarterly at the bank's base rate plus 2%,
unpaid balance due July 15, 1999, secured by
United Kingdom accounts receivable. -- --
------- -------
8,095
Less - current maturities (651) --
------- -------
$ 7,444 $ --
======= =======
In November 1998, the Company entered into a new commitment from Imperial Bank
and the National Bank of Canada for a $25.0 million credit facility. This new
credit facility consists of (i) a $15.0 million revolving line of credit is
available for general corporate needs, and (ii) a $10.0 million term loan, which
provides available funds to repurchase a portion of the Company's common stock.
The amount of the term loan is available for advances until August 5, 1999,
followed by a five-year amortization period in which principal and interest will
be payable quarterly in equal installments. Advances under the term loan will be
made as either Prime Rate Advances, which accrue interest payable monthly, at
the bank's prime lending rate, or as LIBOR Rate Advances which bear interest at
237.5 basis points in excess of the LIBOR Base Rate. The credit facility is
secured by all of the Company's assets other than the Company's real property.
The Company must apply all proceeds from the sale of any treasury stock to the
outstanding principal balance of the term loan.
The credit facility contains restrictive covenants that include, among other
things, restrictions on the declaration or payment of dividends and the amount
of capital expenditures. The credit facility also requires the Company to
maintain a specified net worth, as defined, to maintain required debt to equity
ratio, and to maintain certain other financial ratios.
Any unpaid balance of the United Kingdom credit facility is due July 15, 1999,
and is secured by United Kingdom accounts receivable.
F-11
(4) BENEFIT PLANS:
The Company has five stock option plans, the 1998 Stock Option Plan (1998 Plan),
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).
1998 STOCK OPTION PLAN
The 1998 Plan provides for the granting of incentive stock options and/or
nonqualified options to purchase up to 300,000 shares of the Company's common
stock. Under the 1998 Plan, options may be issued to key personnel and others
providing valuable services to the Company and its subsidiaries. The options
issued will be incentive stock options or nonqualified 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 1998 Plan. There were options outstanding to
acquire 122,500 shares of the Company's common stock under the 1998 Plan at
December 31, 1998.
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 are
determined by the plan administrator, but may not be less than 100% of the fair
market value of the common stock at the time of the grant (110% if the option is
an incentive stock option granted to a stockholder who at the time the option is
granted owns stock representing more than 10% of the total combined voting power
of all classes of stock of the Company). The 1998 Plan will remain in force
until January 28, 2008.
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 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 38,300 shares of the Company's common stock under
the 1997 Plan at December 31, 1998.
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 are
determined by the plan administrator, but may not be less than 100% 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 receives 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 immediately
after the director's second successive election to the Board of Directors (the
First Vesting Date), the second installment becoming exercisable 10 months after
the First Vesting
F-12
Date, and the third installment becoming exercisable 22 months after the First
Vesting Date (provided that the director has not ceased serving as a director
prior to a vesting 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% of the fair market
value of the Company's common stock on the date such options are granted. There
were outstanding options to acquire 11,000 shares of the Company's common stock
under the 1994 Plan at December 31, 1998.
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 360,900 shares of
the Company's common stock under the 1993 Plan at December 31, 1998.
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 are determined by the plan administrator, but may not be less
than 100% (110% if the option is an incentive stock option granted to a
stockholder who at the time the option is granted owns stock representing more
than 10% 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 163,100 options issued but unexercised as of
December 31, 1998. In conjunction with stockholder approval of the 1993 Plan,
the Board terminated the 1990 Plan with respect to unissued options to purchase
85,454 shares of common stock which remained and were unissued as of the date
the 1993 Plan was adopted. The exercise prices of options are determined by the
plan administrator, but may not be less than 100% (110% if the option is granted
to a stockholder who at the time the option is granted owns stock representing
more than 10% of the total combined voting power of all classes of stock of the
Company). 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
Plan and 1990 Plan 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:
F-13
Years Ended December 31,
------------------------------
1998 1997 1996
------- ------- -------
(in thousands, except per share data)
Net income (loss): As reported $ 2,590 $ 5,243 $(3,831)
Pro forma 1,998 4,785 (4,076)
Basic earnings (loss)
per share: As reported $ 0.34 $ 0.67 $ (0.49)
Pro forma 0.26 0.61 (0.52)
Diluted earnings (loss)
per share: As reported $ 0.33 $ 0.65 $ (0.49)
Pro forma 0.26 0.59 (0.52)
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 1998, 1997, and 1996, respectively: risk-free interest
rates of 4.52%, 5.45%, and 6.31%; expected dividend yields of zero; expected
lives of 6.6, 6.4, and 6.1 years; and expected volatility (a measure of the
amount by which a price has fluctuated or is expected to fluctuate during a
period) of 61.4%, 60.0%, and 61.9%.
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 exercised in 1998 was $14.03.
A summary of the status of the Company's five stock option plans at December 31,
1998, 1997, and 1996 and changes during the years then ended, are presented in
the table and narrative below:
1998 1997 1996
------------------ ------------------ ------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
------- -------- ------- -------- ------- --------
Outstanding at
beginning of year 550,970 $11.01 551,776 $ 6.92 539,576 $ 8.06
Granted 334,800 13.87 200,500 14.63 250,100 11.89
Exercised (47,020) 1.08 (162,306) 1.34 (44,900) 0.49
Expired 142,950) 15.45 (39,000) 12.23 (193,000) 18.04
------- -------- --------
Outstanding at
end of year 695,800 $12.14 550,970 $11.01 551,776 $ 6.92
======= ======== ========
Exercisable at end of
year 226,731 165,110 294,982
======= ======== ========
Weighted average fair
value of options
granted $10.25 $ 9.19 $ 7.57
====== ====== ======
F-14
The following table summarizes information about stock options outstanding at
December 31, 1998:
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 1998 Life Price 1998 Price
- ------------- -------------- ----------- --------- -------------- ----------
$0.25 - $9.00 85,100 4.1 years $ 2.46 63,600 $ 0.81
9.01 - 20.00 588,700 7.9 years 13.14 153,799 12.85
20.01 - 34.38 22,000 8.1 years 22.97 9,332 24.41
------- --------- ------- ---------
695,800 7.5 years $ 12.14 226,731 $ 9.95
======= ========= ======= =========
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 $100,000, $71,000, and $65,000 for the years ended December 31,
1998, 1997, and 1996, respectively.
(5) 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 (benefit) for income taxes for the years ended December 31
consists of the following:
1998 1997 1996
------- ------- -------
(in thousands)
Current, net of operating loss carryforwards
and tax credits utilized
Federal, net of tax benefit from early
termination of incentive stock options $ (509) $ 356 $ 556
State (24) 97 58
Foreign 237 71 9
------- ------- -------
(296) 524 623
Deferred provision (benefit) 2,069 2,769 (3,575)
Tax benefit from early termination of incentive
stock options, reflected in stockholders' equity -- 41 32
------- ------- -------
Provision (benefit) for income taxes $ 1,773 $ 3,334 $(2,920)
======= ======= =======
In accordance with SFAS No. 109, a tax benefit for net operating losses of
approximately $-0-, $35,000, and $102,000 and tax credits of approximately $-0-,
$-0-, and $938,000 utilized in 1998, 1997, and 1996, respectively, are included
as a reduction of the current provision for income taxes in the consolidated
statements of income (loss).
F-15
The components of deferred taxes at December 31 are as follows:
1998 1997
------- -------
(in thousands)
Net long-term deferred tax liabilities:
Accelerated tax depreciation $ 3,156 $ 2,685
Other -- 33
------- -------
$ 3,156 $ 2,718
======= =======
Net short-term deferred tax assets:
Inventory reserve $ 436 $ 1,721
Uniform capitalization 1,076 1,251
Accrued liabilities not currently deductible 1,022 1,080
Allowance for doubtful accounts 156 156
Tax effect of regular U.S. net operating
loss carryforward -- 12
Other (10) 91
------- -------
$ 2,680 $ 4,311
======= =======
A reconciliation of the U.S. federal statutory rate to the Company's effective
tax rate is as follows:
1998 1997 1996
------ ------ ------
Statutory federal rate 34% 34% (34)%
Effect of state taxes 3 5 (6)
Other 4 -- (3)
------ ------ ------
41% 39% (43)%
====== ====== ======
(6) 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. The lease expires March 31, 1999. The Company has an option to
extend the lease for an additional year at substantially the same rates as the
current lease.
Rent expense was approximately $917,000, $793,000, and $477,000 for the years
ended December 31, 1998, 1997, and 1996, 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 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-16
The Company's future lease commitments under the non-cancelable operating leases
as of December 31, are as follows (in thousands):
1999 $ 373
2000 100
2001 100
2002 100
2003 100
Thereafter 6,525
------
$7,298
======
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.
(7) SEGMENT INFORMATION:
The Company designs and manufactures a wide range of user interface devices for
operational control and information display functions required in the end
products of OEMs. The Company's products are specialized in LCD and LED
components and technology. The majority of the Company's sales are attributed to
the LCD product line. The Company's products are included in end-user devices
for the following product categories: cellular telephones and other wireless
communication devices, medical equipment, office automation equipment,
industrial process controls, consumer electronic products, and data collection
products.
Management monitors and evaluates the financial performance of the Company's
operations by its four operating segments located throughout the world. These
segments consist of three manufacturing operations, located in the United
States, China, and the Philippines, and a sales and distribution operation in
the United Kingdom.
The following operating segment information includes financial information (in
thousands) for all four of the Company's operating segments. Financial
information for the China operation is presented beginning from the date those
operations commenced, June 1998.
United United
December 31, 1998 States Kingdom China Philippines Eliminations Total
- ----------------- -------- -------- -------- ----------- ------------ --------
Net sales $92,251 $33,438 $ 7,205 $3,010 $(40,857) $95,047
Operating income (loss) 4,643 676 (947) (2) (7) 4,363
Provision for
income taxes 1,537 209 -- 27 -- 1,773
Depreciation 4,408 36 168 41 -- 4,653
Total assets 60,514 9,195 12,301 642 (4,748) 77,904
Capital expenditures 2,809 10 5,298 2 -- 8,119
F-17
United United
December 31, 1997 States Kingdom China Philippines Eliminations Total
- ----------------- -------- -------- -------- ----------- ------------ --------
Net sales $83,023 $10,755 $ -- $3,107 $(12,243) $84,642
Operating income 7,990 436 -- 104 47 8,577
Provision for
income taxes 3,263 32 -- 39 -- 3,334
Depreciation 4,058 27 -- 9 -- 4,094
Total assets 68,039 4,896 -- 354 (454) 72,835
Capital expenditures 3,036 14 -- -- -- 3,050
United United
December 31, 1996 States Kingdom China Philippines Eliminations Total
- ----------------- -------- -------- -------- ----------- ------------ --------
Net sales $58,709 $27,814 $ -- $1,494 $(27,304) $60,713
Operating income (loss) (6,935) 28 -- 12 144 (6,751)
Provision for (benefit
from) income taxes (2,929) 9 -- -- -- (2,920)
Depreciation 3,375 8 -- 57 -- 3,440
Total assets 58,828 3,824 -- 288 (371) 62,569
Capital expenditures 856 42 -- 50 -- 948
Revenues are generated from the sale of LCD or LED user interface device
components, which are applied in several different end-use products. Total
revenues by these product categories are as follows:
For the Years Ended December 31,
--------------------------------
(in thousands)
1998 1997 1996
------- ------- -------
Cellular telephones and other wireless
communication devices $62,073 $31,415 $40,360
Office automation equipment 12,658 33,528 5,979
Other 20,316 19,699 14,374
------- ------- -------
Total $95,047 $84,642 $60,713
======= ======= =======
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. 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, that accounted for approximately 35% and 65% of the
Company's revenue in 1997 and 1996, respectively, accounted for approximately
64% of the Company's revenue during 1998. This increased percentage occurred as
a result of increased sales to that customer as well as decreased sales to other
customers. The Company's other significant customer accounted for less than 10%
of the Company's revenue during 1998. Sales to this customer were 32% of the
Company's revenue during 1997 and less than 10% of the Company's revenue during
1996.
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
telephone, computer hardware, and other electronic products industries. These
customers are located primarily in the United States and Europe.
F-18
THREE-FIVE SYSTEMS, INC.
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
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 12/31/98 $ 580 (24) (40)(1) -- $ 516
Year ended 12/31/97 649 (105) 36(1) -- 580
Year ended 12/31/96 602 14 33(1) -- 649
Inventory Reserve:
Year ended 12/31/98 $ 4,309 (1,660) -- (1,524)(2) $1,125
Year ended 12/31/97 6,782 1,114 -- (3,587)(2) $4,309
Year ended 12/31/96 2,767 5,939 142(3) (2,066)(2) 6,782
- --------
(1) Actual return activity
(2) Obsolete inventory written off
(3) Inventory adjustments
S-1