SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Quarterly Report Pursuant To Section 13 or 15(d) of
the Securities Exchange Act Of 1934

For the Quarter Ended June 30, 2004

Commission file number 1-4373

THREE-FIVE SYSTEMS, INC.

1600 North Desert Drive, Tempe, Arizona          85281

(602) 389-8600

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, at the latest practicable date.

THREE-FIVE SYSTEMS, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR QUARTER ENDED JUNE 30, 2004

TABLE OF CONTENTS

ITEM 1. FINANCIAL STATEMENTS

THREE-FIVE SYSTEMS, INC.

The accompanying notes are an integral part of these condensed consolidated financial statements.

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THREE-FIVE SYSTEMS, INC.

The accompanying notes are an integral part of these condensed consolidated financial statements.

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THREE-FIVE SYSTEMS, INC.

The accompanying notes are an integral part of these condensed consolidated financial statements.

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THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS AND FACTORS THAT MAY AFFECT RESULTS

                 The statements contained in this report on Form 10-Q that are not purely historical are forward-looking statements within the meaning of applicable securities laws. Forward-looking statements include statements regarding our “expectations,” “anticipation,” “intentions,” “beliefs,” or “strategies” regarding the future. Forward-looking statements also include statements regarding revenue, margins, expenses, and earnings analysis for fiscal 2004 and thereafter; technological innovations; future products or product development; our 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 us as

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of the filing date of this report, and we assume no obligation to update any such forward-looking statements. Our actual results could differ materially from the forward-looking statements.

Overview

Current Operations

     We are a global provider of electronics manufacturing services, or EMS. We design and manufacture printed circuit board assemblies, radio frequency, or RF, modules, display modules and systems, and complete systems for customers in the transportation, computing, consumer, industrial, medical, and telecommunications industries. Our services include advanced engineering support, “designed for” services, automated printed circuit board assembly, in-circuit and functional testing, systems level integration and box build, turnkey packaging, fulfillment services, and turnkey supply chain management services, all of which enable our customers to outsource all stages of product engineering, design, development, materials procurement and management, manufacturing, and testing. Our design and manufacturing services include a distinctive competence in display modules and systems and the integration of display modules and systems into other products. These display modules and systems we design and manufacture include monochrome and color liquid crystal display, or LCD, components, organic light emitting diodes, or OLEDs, cathode ray tubes, or CRTs, and flat panel monitors.

     The products we manufacture for customers are of varying sizes and have varying levels of integration. The typical design program life cycle of a custom-designed product is three to 15 months and includes technical design, prototyping, pilot manufacturing, and high-volume manufacturing. The cycle is shorter in products where no display is involved and/or where the customer has already completed the design.

     Several factors impact our gross margins, including manufacturing efficiencies, product mix, product differentiation, product uniqueness, inventory management, and volume pricing. We have factories in Washington and Massachusetts in the United States and in the Philippines, Malaysia, and China. In Washington and in Malaysia, we provide engineering support, automated printed circuit board assembly, in-circuit and functional testing, systems integration and box build, complete supply chain management, and turnkey packaging and fulfillment services. In Massachusetts, we provide aftermarket customization of flat panel displays and CRTs. In China, we assemble displays into modules and are adding some of the manufacturing services offered in Washington and Malaysia. In the Philippines, we assemble and test RF modules.

     Selling, general, and administrative expense consists principally of administrative and selling costs; salaries, commissions, and benefits to personnel; and related facility costs. In general, these costs have risen as a result of the acquisitions we have completed in the last two years. We make substantially all of our sales directly to customers through a sales force that consists mainly of direct technical sales persons, but also includes a small representative network. As a result, there is no material cost of distribution in our selling, general, and administrative expense.

     Research, development, and engineering expense consists principally of salaries and benefits to design engineers and other technical personnel, related facility costs, process development costs, and various expenses for projects, including new product development. In general, these costs have declined in the last few years because we no longer do any pure research work. Thus, most of our expense relates to the development engineering costs associated with preproduction design and prototyping of custom products and the conceptual formulation and design of potential standard display products. We also have moved some of our engineering resources to Asia, resulting in lower costs.

     We also incur expenses relating to the amortization of intangibles. Those expenses relate to amortizable intangibles acquired in acquisitions as described below.

Future Operations

     Our long-term goal is to have gross margins of 12 percent to 14 percent and operating costs of between six percent and eight percent of revenue. Our goal is to achieve an interim model within 12 months of 10 percent to 12 percent gross margins with operating costs of between eight percent and 11 percent of revenue. The drivers to achieving our long-term and interim models are improving the utilization of our off-shore factories through

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increased revenue and improving our gross margins by focusing on markets, like gaming and medical, that value our unique combination of global EMS capabilities and display expertise.

Historic Operations

     Prior to 2002, our business strategy was to seek large-volume display programs from major original equipment manufacturers, or OEMs, typically 100,000 units per year or higher, with selling prices of approximately $7 per unit. Although our focus was designing and manufacturing display modules, we often engaged in extended contract manufacturing services for other items related to the display modules, such as printed circuit boards, keyboards, microphones, speakers, plastic housing, and other similar components. We also manufactured liquid crystal display glass cells from 1995 to 2002. From 1998 to 2002, substantially all of our large-volume business was in providing display modules for Motorola handsets. In 2001, new monochrome design wins in that business became unprofitable; thus, we began to refocus our strategy to expand our customer base and our product and service offering. We further modified our strategy in late 2002 to expand our manufacturing services to include products that do not need displays.

     As a result of the foregoing, we have substantially changed our business since late in 2002. We have reduced our concentration in Motorola revenue. The selling price of the products we manufacture and sell now range up to $8,000 per unit. We have numerous customers in six principal markets. We have expanded our business both through organic growth and through the acquisitions of AVT, ETMA, and Unico. We have also expanded through the license arrangements with Data International and Integrex and through our manufacturing agreement with Microtune.

     The substantial shift in our business strategy has resulted in increased selling and administrative costs. By previously focusing on one market and one customer, we were able to maintain selling, general and administrative costs at a very low level. By contrast, we now have many more customers requiring more sales interface. In addition, administrative costs have increased as we have increased the number of operating locations in the United States and around the world. In addition, as a result of the Sarbanes-Oxley Act of 2002, we have incurred additional administrative expenses, such as additional auditing fees and the costs related to the establishment of an internal auditing function. In addition, the shift in sales strategy from a high-volume focus to a more value-add focus has resulted in reduced volumes at higher selling prices. The reduced volumes have resulted in excess capacity at our factories overseas.

Acquisitions and Strategic Transactions

     In September 2002, we purchased the assets and ongoing business of AVT, Advanced Video Technologies, located in Marlborough, Massachusetts, a privately held company that specializes in the design and integration of complex, high-resolution display systems. As a result, we now design and provide customized and ruggedized flat panel, touchscreen, and rackmount systems for OEMs in the industrial and medical markets. We outsource display components from a variety of companies, including Sony, Sharp, NEC, LG, and Samsung. The purchase price of the acquisition was $12.0 million, which we paid entirely in cash.

     In December 2002, we purchased the stock of ETMA Corporation, located in Redmond, Washington, a privately held electronic manufacturer for OEM customers in the computer peripheral, medical monitoring, and Internet security industries. As a result, we now offer the manufacturing capabilities of five surface mount manufacturing lines, including one dedicated to new product introduction and prototyping activity. We also provide engineering support, automated printed circuit board assembly, in-circuit and functional testing, systems integration and box build, complete supply chain management, and turnkey packaging and fulfillment services. The purchase price of the ETMA acquisition was $38.1 million, which we paid entirely in cash.

     In January 2003, we signed licensing and manufacturing agreements with Data International Co., Ltd. of Taiwan. Under those agreements, we became the exclusive channel in the Americas for standard and custom LCD products manufactured by Data International. We also have the right to sell those products through our worldwide channels. The agreements provide us with access to a full suite of standard display products that round out our existing standard product portfolio. In conjunction with the agreement, we established a sales office in Orlando, Florida, and hired sales and applications engineering personnel from a distributor that had previously supported Data International’s products. The cost of the license was $3.9 million, of which $1.0 million was paid upon signing and we entered into a $2.9 million term loan. In the first quarter of 2004, we paid $1.4 million against the term loan. The remaining $1.5 million is due in January 2005 and is subject to reduction if certain margin targets are not met.

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     In March 2003, we signed an agreement with Microtune, Inc. in which we agreed to manufacture, assemble, and test Microtune’s radio frequency, or RF, tuner modules and wireless module products in our manufacturing facility in Manila, the Philippines. As part of the agreement, Microtune sold to us certain of its own equipment and inventory for $8.2 million, of which $2.7 million was a note payable due in September 2003, and contracted with us to provide 100% of Microtune’s current demand for fully assembled RF subsystems. We also hired approximately 500 Microtune employees in Manila. In October 2003, we paid off approximately $300,000 of the $2.7 million note payable to Microtune and entered into an agreement to cancel the remaining $2.4 million balance on that note in exchange for the return of certain excess inventory to Microtune. As a result of this transaction, we now provide 100% of the manufacturing outsourcing for Microtune’s RF module products.

     In April 2003, we acquired the business and certain assets of Unico Technology Bhd., a privately held Malaysian company located in Penang. Unico was an electronic manufacturer for OEM customers in the computer, computer peripheral, and communications industries. The Unico business was acquired by TFS Electronics Manufacturing Services Sdn. Bhd., or TFS-Malaysia, a joint venture owned 60% by an overseas TFS subsidiary and 40% by Unico Holdings Bhd., the former parent of Unico. Unico Holdings is the investment arm of the Chinese Chamber of Commerce of Malaysia. Our share of the initial cost of capitalizing TFS-Malaysia was $3.8 million and Unico Holdings’ share was $2.5 million, most of which was used for working capital. TFS-Malaysia purchased $4.1 million in inventory from Unico, of which $2.7 million was paid at the time of the purchase and $1.4 million was subsequently paid. No advance payment was required for the acquisition of the property, plant, and equipment of Unico, all of which is leased from the seller. The equipment lease is accounted for as a capital lease payable by TFS-Malaysia. The principal balance on that lease was $7.1 million as of June 30, 2004. In the second quarter of 2004, Unico Holdings exchanged its ownership interest in TFS-Malaysia for approximately 423,000 shares of our common stock in a transaction valued at $2.8 million, compared to Unico Holdings’ interest of $2.6 million. As a result of that transaction, we now own 100% of TFS-Malaysia.

     In February 2004, we entered into a transaction with Integrex, a Seattle-based electronics manufacturing services company liquidating its business. Under that transaction, we bought the raw materials inventory of Integrex for $1.4 million and hired certain of its employees. We also obtained the rights to most of its customers and agreed with those customers that we would manufacture those customers’ products in our Redmond manufacturing facility. In exchange for those customer rights, we agreed to pay a license fee for between 15 and 24 months based on revenue receipts from former Integrex customers. In February 2004 and at a second closing in April 2004, we paid $1.3 million in non-refundable license fees to Integrex. At the second closing in April, we also acquired $300,000 of capital equipment.

Discontinued Operations

     On September 1, 2003, we transferred all of the net assets of our microdisplay division, plus approximately $20.9 million in cash, into a newly created Delaware corporation called Brillian Corporation. On September 15, 2003, we spun off Brillian by distributing all of the outstanding common stock of Brillian to our stockholders on a pro rata basis, with each of our stockholders receiving one share of Brillian common stock for every four shares of our common stock. Brillian is now traded on the Nasdaq National Market under the symbol “BRLC.” Brillian had $44.1 million of net assets on the spin-off date. For more information on the reasons for the spin-off, as well as the description of business and risks associated with the spin-off, please refer to the Form 10 and other filings by Brillian with the Securities and Exchange Commission. The microdisplay business that we transferred to Brillian is now reported in our consolidated financial statements as Discontinued Operations.

Critical Accounting Policies and Estimates

     Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with generally accepted accounting principles (GAAP) in the United States. During preparation of these financial statements, we are required to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates and judgments, including those related to sales returns, bad debts, inventories, fixed assets, intangible assets, income taxes, and contingencies. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. The results form the basis for making judgments about the carrying values of assets and liabilities

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that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

     We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements.

     We recognize revenue from product sales when persuasive evidence of a sale exists; that is, a product is shipped under an agreement with a customer; risk of loss and title has passed to the customer; the fee is fixed or determinable; and collection of the resulting receivable is reasonably assured. This means that when a product is shipped from one of our factories under the terms “FOB Factory” then the risk of loss passes to the customer when the product leaves our factory and we recognize revenue at that time. On the other hand, when a product is shipped “FOB Destination” then the risk of loss during transit is maintained by us. Thus, we recognize revenue when the product is accepted by the customer. Shipping terms with one of our major customers is FOB Destination, and many of those products are shipped by sea, taking four to six weeks to reach their destination. As a result, we frequently have a significant amount of product in transit at the end of each quarter and in our finished goods inventory.

     We recognize revenue related to engineering and tooling services after service has been rendered, which is determined based upon completion of agreed-upon milestones or deliverables.

     Sales allowances are estimated based upon historical experience of sales returns. To establish our allowance for doubtful accounts, we perform credit evaluations of our customers’ financial condition, along with analyzing past experience, and make provisions for doubtful accounts based on the outcome of our credit valuations and analysis. We evaluate the collectability of our accounts receivable based on specific customer circumstances, current economic trends, historical experience with collections, and the age of past due receivables. We believe the allowances that we have established are adequate under the circumstances; however, a change in the economic environment or a customer’s financial condition could cause our estimates of allowances, and consequently the provision for doubtful accounts, to change.

     We write down our inventory for estimated obsolescence or unmarketable inventory. We write down our inventory to estimated market value based upon assumptions and estimates about future demand and market conditions. If actual market conditions are less favorable than those projected by us, additional inventory write-downs may be required.

     During the fourth quarter of 2003, we learned from a customer that a product shipped by us to them contained potentially defective parts. Those potentially defective parts were printed circuit boards supplied to us by a vendor specified by our customer. At year-end 2003, we believed the parts could be repaired or that the component supplier would reimburse us for the damages. We determined in the first quarter of 2004 that the latent defect in the materials purchased was not repairable. As a result, we established a reserve for the value of that inventory, which included other component parts that had already been included on those boards less the $158,000 value of the boards for which the supplier is obligated to repay at a minimum. The amount reserved was just over $1.0 million.

     At year-end 2003, we held $778,000 of inventory relating to a program cancelled by a customer. At that time, we believed we would recover the carrying value of this inventory and did not establish a reserve. After further discussions and negotiations with this customer during the first quarter of 2004, we wrote off $332,000 of this inventory while receiving settlement against the remainder of the inventory.

     During the second quarter of 2004, a telecommunications customer declared bankruptcy. As a result of that event, we had to write off $127,000 in accounts receivable and take a $567,000 reserve against inventory relating to specific programs for that customer.

     Pursuant to Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes”, income taxes are recorded based on current year amounts payable or refundable, as well as the consequences of events that give rise to deferred tax assets and liabilities. We base our estimate of current and deferred taxes on the tax laws and rates that are currently in effect in the appropriate jurisdiction. Changes in tax laws or rates may affect the current amounts payable or refundable as well as the amount of deferred tax assets or liabilities. At the end of the second quarter of 2003, we had $19.8 million of net deferred tax assets, resulting primarily from net operating loss and tax credit carryforwards. SFAS No. 109 requires

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that a valuation allowance be established when it is more likely than not that all or a portion of a deferred tax asset will not be realized. In determining whether a valuation allowance is required, we are required to take into account all positive and negative evidence with regard to the utilization of a deferred tax asset, including our past earnings history, market conditions, management forecasts of future profitability, the character and jurisdiction of such earnings, unsettled circumstances that, if unfavorably resolved, would adversely affect utilization of a deferred tax asset, carryback and carryforward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset. SFAS No. 109 further states that it is difficult to conclude that a valuation allowance is not needed when there is negative evidence such as cumulative losses in recent years. Therefore, despite the fact that a major portion of the losses came from our spun-off microdisplay division, the expectation in the third quarter of 2003 was that we would have three years of cumulative losses. Those cumulative losses weighed heavily in the overall required assessment and outweighed our forecasted future profitability and expectation that we will be able to utilize all of our net operating loss carryforwards. As a result, in the third quarter of 2003, we recorded a charge to establish a full valuation allowance against our deferred tax asset. We expect to continue to record a full valuation allowance on future tax benefits until we return to sustained profitability.

     Long-term assets, such as property, plant, and equipment, intangibles, goodwill, and other investments, are originally recorded at cost. On an on-going basis, we assess these assets to determine if their current recorded value is impaired. When assessing these assets, we consider projected future cash flows to determine if impairment is applicable. These cash flows are evaluated for objectivity by using weighted probability techniques and also comparisons of past performance against projections. Assets may also be evaluated by identifying independent market values of assets that we believe to be comparable. If we believe that an asset’s value was impaired, we would write down the carrying value of the identified asset and charge the impairment as an expense in the period in which the determination was made.

Results of Operations

  Three months ended June 30, 2004 compared to three months ended June 30, 2003

     Net Sales. Net sales decreased 18% to $37.6 million in the second quarter of 2004 from $46.0 million in the second quarter of 2003. The decrease was primarily a result of reduced sales of our monochrome display modules, a substantial portion of which were sold to Motorola in 2003. In fact, Motorola accounted for 3% of our net sales in the second quarter of 2004 compared to 13% in the second quarter of 2003. We had two customers that accounted for more than 10% of our net sales in the second quarter of 2004. One of these customers is in the computer peripherals business and the other is in the RF business, and those two customers accounted for 35% and 12% of our net sales, respectively. The sales in our six markets (in thousands) are broken down as follows:

     Gross Margin. Our gross margin in the second quarter of 2004 was a negative $133,000 compared to a positive $1.9 million in the second quarter of 2003. The gross margin in the second quarter of 2004 was lower than we originally expected, primarily due to product pricing and mix issues at our Redmond, Washington facility and the integration of Integrex, whose customers we recently acquired. The integration issues of Integrex primarily related to handling the unexpected volume of new programs that transferred over from Integrex. In addition, many of those programs had quality issues left over from Integrex that required a longer and more extensive new product introduction and qualification schedule than expected. These two items contributed to the negative gross margin dollars in the Redmond facility of $1.0 million in the three months ended June 30, 2004 compared to positive gross margin dollars of $854,000 in the three months ended June 30, 2003. We also wrote off inventory valued at $567,000 relating to the sudden bankruptcy and dissolution of one of our telecommunications customers. Offsetting some of those costs, we made significant strides in our RF module business, generating gross margin dollars in the second quarter that were almost $500,000 greater than in the first quarter. Our gross margin continues to be

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negatively impacted by our excess capacity offshore. Currently, we are at approximately 60% factory utilization in Manila, 45% in Penang, and 27% in Beijing.

     Selling, General, and Administrative Expense. Selling, general, and administrative expense increased to $5.7 million in the second quarter of 2004 from $4.1 million in the second quarter of 2003. SG&A expense was 15% of net sales in the second quarter of 2004 compared to 9% in the second quarter of 2003. This increase in SG&A expense occurred primarily for the following reasons. First, we had additional finance and administrative expenses of $706,000 as a result of increased infrastructure and with increased costs associated with our compliance with the Sarbanes-Oxley Act of 2002. We also had additional selling costs of $891,000 as a result of personnel added from acquisitions and expanding our market focus.

     Research, Development, and Engineering Expense. Research, development, and engineering expense decreased to $685,000 in the second quarter of 2004 from $1.4 million in the second quarter of 2003. Research, development, and engineering expense was 2% of net sales in the second quarter of 2004 compared to 3% in the second quarter of 2003. The decrease in the second quarter of 2004 was due to two reasons. First, we have significantly reduced our pure research efforts in displays as we have spun off our microdisplay business and become more of a manufacturing services company versus a product company. Second, we have continued to move our engineering efforts to Asia, resulting in lower overall costs.

     Amortization of Intangibles. The amortization of customer lists of $511,000 was identical for the second quarter of 2004 and 2003. The amortization relates to the acquisitions of AVT and ETMA and to the license agreement with Data International, all described above in “Overview.” The amortizable asset associated with AVT is $3.0 million and is being amortized over five years. The amortizable asset associated with ETMA is $2.0 million and is being amortized over three years. The amortizable asset associated with Data International is $3.9 million and is being amortized over five years.

     Other Income, Net. Other income was $159,000 in the second quarter of 2004 compared to $152,000 in the second quarter of 2003. The composition and differences of the items that make up other income are as follows (in thousands):

Interest income decreased as a result of lower cash and short-term investment balances. Interest expense increased as a result of the capital leases. The rental and service income from Brillian increased as a result of the spin-off of our microdisplay business to Brillian Corporation, which is renting part of our existing building and paying for some information technology services. Also included in other income is approximately $150,000 from a legal settlement.

     Minority Interest. In April 2004, we agreed with Unico Holdings to exchange its ownership interest in TFS Electronic Manufacturing Services Sdn. Bhd. (“TFS - Malaysia”) for approximately 423,000 shares of our common stock in a transaction valued at $2.8 million. As a result of that transaction, we now own 100% of TFS - Malaysia. In the second quarter of 2004, we recorded a benefit of $58,000 to account for the losses allocated to the minority interest holder during the period of time preceding the stock exchange. In the second quarter of 2003, we controlled and owned 60% of the business in TFS - Malaysia and we recorded an expense of $43,000 to account for the profits allocated to the minority interest holder.

     Benefit from Income Taxes. We recorded a benefit from income taxes of $16,000 in the second quarter of 2004 compared to a benefit from income taxes of $1.5 million for the second quarter of 2003. The benefit in the second quarter of 2004 related to tax refunds received. The $1.5 million benefit from taxes in 2003 added to our deferred tax asset that we later wrote off during the third quarter of 2003. We recorded a charge in the third quarter of 2003 to establish a valuation allowance against our deferred tax asset, which consists primarily of net operating loss carryforwards, or NOLs. A further description of that allowance is described above in “Critical Accounting Policies and Estimates.” As a result, we generally no longer record a tax benefit for losses.

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     Net Loss. Our net loss was $6.7 million, or $0.31 per diluted share, in the second quarter of 2004 compared to a net loss of $4.9 million, or $0.23 per diluted share, in the second quarter of 2003. The net loss in the second quarter of 2003 included $2.3 million, or $0.11 per share, from discontinued operations relating to our former microdisplay business. As described above in “Discontinued Operations,” our microdisplay division was spun off as a separate public company, as of September 15, 2003.

Results of Operations

  Six months ended June 30, 2004 compared to six months ended June 30, 2003

     Net Sales. Net sales increased 7% to $76.1 million in the first six months of 2004 from $71.3 million in the first six months of 2003. The increase in year over year revenue was primarily a result of growth in (1) our box build/PCBA business in the computing market and (2) our RF module business in the transportation and consumer markets. We had only one customer that accounted for more than 10% of our net sales in the first six months of 2004, and that customer, which is in the computer peripherals business, accounted for 35% of our net sales. The sales (in thousands) in our six markets on a comparative year over year basis are broken down as follows:

     Gross Margin. Our gross margin in the first six months of 2004 was a negative $354,000 compared to a positive $2.1 million in the first six months of 2003. The reasons for the differences are as follows: first, we sold more products at a lower gross margin at our Redmond, Washington facility due primarily to a change in customer and product mix. Second, we brought over a substantial number of new programs from Integrex and the new product introduction process for each of those programs was extensive and costly. Third, we incurred an unplanned inventory write-off of just over $1.0 million at our Redmond facility relating to a supplier’s defective component. These three items contributed to the negative gross margin dollars in the Redmond facility of $1.9 in the first half of 2004 compared to positive gross margin dollars of $1.9 million in the first half of 2003. Fourth, in the first half of 2004, we consolidated our display module operations in China by moving the display module operations from Manila to China. This resulted in a one-time expense of approximately $1.0 million in the first half of 2004. Finally, in the first half of 2004 we wrote off inventory valued at approximately $899,000 million for various reasons, including end-of-life programs and the bankruptcy of a customer. If all of these one-time items are not considered, then gross margins actually improved in the first six months of 2004 compared to the first six months of 2003. Overall gross margins continue to be negatively impacted, however, by our excess capacity offshore. Currently, we are at approximately 60% factory utilization in Manila, 45% in Penang, and 27% in Beijing. These currently reduced manufacturing volumes result in under-absorption of our fixed manufacturing costs. As we begin to ramp new product builds overseas, we expect gross margins to steadily improve.

     Selling, General, and Administrative Expense. Selling, general, and administrative expense increased to $11.3 million in the first six months of 2004 from $7.8 million in the first six months of 2003. SG&A expense was 15% of net sales in the first six months of 2004 and 11% in the first six months of 2003. This increase in SG&A expense occurred primarily because of additional finance and administrative expenses of $1.7 million associated with our increased infrastructure and additional selling costs of $1.8 million associated with personnel added from acquisitions and as we expand our market focus along with increased costs associated with our compliance with the Sarbanes-Oxley Act of 2002.

     Research, Development, and Engineering Expense. Research, development, and engineering expense decreased to $1.4 million in the first six months of 2004 from $2.7 million in the first six months of 2003. Research, development, and engineering expense was 2% of net sales in the first six months of 2004 compared to 4% in the first six months of 2003. The decrease in the first six months of 2004 was due to two reasons. First, we have significantly reduced our pure research efforts in displays as we have spun off our microdisplay business and

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become more of a manufacturing services company versus a product company. Second, we have continued to move our engineering efforts to Asia, resulting in lower overall costs.

     Amortization of Intangibles. The amortization of customer lists of $1.0 million was identical for the first six months of 2004 and 2003. The amortization relates to the acquisitions of AVT and ETMA and to the license agreement with Data International, all described above in “Overview.” The amortizable asset associated with AVT is $3.0 million and is being amortized over five years. The amortizable asset associated with ETMA is $2.0 million and is being amortized over three years. The amortizable asset associated with Data International is $3.9 million and is being amortized over five years.

     Other Income, Net. Other income was $320,000 in the first six months of 2004 compared to $457,000 in the first six months of 2003. The composition and differences of the items that make up other income are as follows (in thousands):

Interest income decreased as a result of lower cash and short-term investment balances. Interest expense increased as a result of the capital leases. The rental and service income from Brillian increased as a result of the spin-off of our microdisplay business to Brillian Corporation, which is renting part of our existing building and paying for some information technology services. Also included in other income is approximately $150,000 from a legal settlement which occurred in the second quarter of 2004.

     Minority Interest. In April 2004, we agreed with Unico Holdings to exchange its ownership interest in TFS - Malaysia for approximately 423,000 shares of our common stock in a transaction valued at $2.8 million. As a result of that transaction, we now own 100% of TFS -Malaysia. In the first six month of 2004 we recorded an expense of $22,000 to account for the profits allocated to the minority interest holder during the period of time preceding the stock exchange. In the first six months of 2003, we controlled and owned 60% of the business in TFS - Malaysia and we recorded an expense of $43,000 to account for the profits allocated to the minority interest holder.

     Benefit from Income Taxes. We recorded a benefit from income taxes of $128,000 in the first six months of 2004 compared to a benefit from income taxes of $3.3 million for the first six months of 2003. The benefit in the first six months of 2004 related to tax refunds received. The $3.3 million benefit from taxes in 2003 added to our deferred tax asset that we later wrote off during the third quarter of 2003. We recorded a charge in the third quarter of 2003 to establish a valuation allowance against our deferred tax asset, which consists primarily of net operating loss carryforwards, or NOLs. A further description of that allowance is described above in “Critical Accounting Policies and Estimates.” As a result, we generally no longer record a tax benefit for losses.

     Net Loss. Our net loss was $13.4 million, or $0.62 per diluted share, in the first six months of 2004 compared to a net loss of $10.4 million, or $0.49 per diluted share, in the first six months of 2003. The net loss in the first six months of 2003 included $4.6 million, or $0.22 per share, from discontinued operations relating to our former microdisplay business. As described above in “Discontinued Operations,” our microdisplay division was spun off as a separate public company, as of September 15, 2003.

Liquidity and Capital Resources

     At June 30, 2004, we had cash of $18.7 million compared to cash and short-term investments of $33.1 million at December 31, 2003. The reductions to these balances over the last six months can be summarized as follows:

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(a)

Includes the following line items from the Condensed Consolidated Statements of Cash Flows appearing on page 3 of this Form 10-Q: purchases of property, plant, and equipment; proceeds from sale of assets; purchase of intangibles; acquisitions and strategic investments.

     In the second quarter of 2004, we had $5.4 million in net cash outflow from operations compared to $6.7 million in net cash outflow from operations in the second quarter of 2003. The principal difference is greater working capital requirements in the second quarter of 2003.

     Our inventory turns were 5.4 and day sales outstanding, or DSOs, were 59 days in the second quarter of 2004 compared with 6.2 inventory turns and 44 DSOs in the second quarter of 2003. Our inventory turns were negatively affected in the second quarter of 2004 because we purchased buffer stock to insure a smooth transition of our module operations from Manila to Beijing and because we had more finished goods inventory as a result of shipping terms. DSO’s were within our historic range, but increased in the second quarter of 2004 because of a chronically late-paying European customer. Our depreciation and amortization expense was $1.8 million in the second quarter of 2004 compared with $2.0 million in the second quarter of 2003.

     During the second quarter of 2004, we incurred capital and intangible additions of $5.2 million. This was principally related to the purchase of our previously leased Manila facility for $3.5 million. The remaining capital expenditures related primarily to equipment purchased from Integrex and our ongoing ERP implementation. In the first six months of 2004, we made a $1.4 million payment to Data International on the term loan that related to the license to resell certain standard products. A final estimated $1.5 million payment on that note is due to Data International in January 2005. During the first six months of 2004, we also consummated the Integrex transaction, described above, for an initial cash outlay of $2.3 million for inventory and prepaid license fees. In the second quarter of 2004, we paid an additional $713,000 to Integrex for license fees and equipment.

     In the second quarter of 2004, we purchased our facility in Manila from our lessor for a total payment of $3.8 million, of which $2.9 million was assigned to the carrying value of the building and $846,000 was applied to accrued rent liabilities. We also paid $614,000 to the RBF Development Corporation (“RBF”) for a 50 year land right. The 50 year land right is still awaiting formal approval by the Philippine Department of Trade and Industry. If not approved, the land right agreement will be changed to a 25 year lease agreement with the RBF. Lastly, we also executed an agreement with the RBF for the option to purchase the leased land for $1 at any time until April 23, 2014. As a result of the building purchase and land right agreement, we will no longer be required to pay the $7.8 million in the lease payments due over the next 7 years that was remaining on our original ten year lease agreement.

     Our working capital was $42.5 million and our current ratio was 2.0-to-1 at June 30, 2004, down from working capital of $59.6 million and a current ratio of 2.5-to-1 at December 31, 2003. These decreases are primarily because of reduced cash balances and borrowing on our new lines of credit.

     While we transact business predominantly in U.S. dollars and bill and collect most of our sales in U.S. dollars, we collect a portion of our revenue in non-U.S. currencies, such as the Chinese Renminbi. In the future, customers increasingly may make payments in non-U.S. currencies, such as the Euro. In addition, we account for a portion of our costs, such as payroll, rent, and indirect operating costs, in non-U.S. currencies, including Philippine Pesos, British Pounds Sterling, Malaysian Ringgit, and Chinese Renminbi. Thus, fluctuations in foreign currency exchange rates could affect our cost of goods and operating margins and could result in exchange losses. In addition, currency devaluation can result in a loss to us if we hold deposits of that currency. Hedging foreign currencies can be difficult, especially if the currency is not freely traded. We cannot predict the impact of future exchange rate fluctuations on our operating results. These currency risks are particularly important since sales outside North America represented 38% of our net sales in the first six months of 2004 and 44% of our net sales in 2003. Sales in foreign markets, primarily Europe and Asia, to OEMs based in the United States accounted for almost all of our international sales in each of these periods.

     We entered into a temporary credit facility with First National Bank in the first quarter of 2004 under which we borrowed $5.0 million secured by restricted cash deposits. In the second quarter 2004, we repaid and terminated that credit facility. In the second quarter of 2004, we entered into a $10.0 million secured revolving line of credit with Silicon Valley Bank, which matures on June 25, 2005. The line of credit bears interest at the bank’s prime rate plus 0.75%, subject to a minimum of 4.75%. Currently, the bank’s prime rate is 4.0%. We borrowed $6.0 million under the facility as of June 30, 2004. In addition, as of the second quarter of 2004, our Beijing

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subsidiary also has secured a $2.4 million line of credit with Hua Xia Bank secured principally by our building in Beijing. We have borrowed $2.4 million under that facility, which accrues simple, annual interest at 5.31%.

     The following tables list our contractual obligations and commercial commitments as of June 30, 2004:

     The operating leases listed above include leases for our factories in Penang, Washington, and Massachusetts, our ground lease in Arizona, and our sales office in Florida. In the second quarter of 2004, we purchased our leased building in Manila. As a result of the building purchase, we will no longer be required to pay the $7.8 million over the next 7 years that was remaining on our original ten year operating lease agreement. The capital leases listed above are for our manufacturing equipment in Malaysia and Washington. The guarantee relates to our guarantee in connection with a Small Business Administration loan to VoiceViewer Technology, Inc., a privately held company developing microdisplay products. Brillian assumed this guarantee in the spin-off. If the lending institution were to declare VoiceViewer to be in default under the loan, however, and if Brillian Corporation were unable to satisfy its obligation as primary guarantor, then we would be required to pay the guaranteed amount.

     We have no other long-term debt, capital lease obligations, unconditional purchase obligations, or other long-term obligations, and we do not have any other commercial commitments or other off-balance sheet arrangements.

     Our cash balance was $18.7 million as of June 30, 2004. We expect operating cash outflow to consume only a small portion of our cash reserves for the remainder of 2004, but based on our revenue forecast, we will need substantial working capital in the second half of 2004. We believe that our existing cash balances plus our expected loan commitments will provide adequate sources to fund our operations and planned expenditures through 2004, as well as to meet our contractual obligations. Our currently planned remaining cash outflows for 2004 include capital expenditures of less than $2.0 million.

     It is possible that stronger second half sales would require additional funding for working capital. In addition, we expect to continue our acquisition strategy. As a result, we have an effective Form S-3 registration statement for six million shares of our common stock for possible sale. There is no assurance there will be a market for our shares or that any such equity offering of shares will raise sufficient amounts to fund all of our requirements. As a result, we may be required to pursue alternative methods of financing or raising capital. We cannot provide assurance that adequate additional loan commitments or alternative methods of financing will be available or, if available, that they will be on terms acceptable to us.

Impact of Recently Issued Standards

     In November 2002, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” which clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” relating to consolidation of certain entities. This interpretation was subsequently revised by FIN 46 (Revised 2003) (“FIN 46®”) in December 2003. This interpretation states that consolidation of variable interest entities will be required by the primary beneficiary if the entities do not effectively disperse risk among the parties

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involved. The requirements are effective for fiscal years ending after December 15, 2003. We have no variable interest entities and do not believe that FIN. 46(R) will impact our future financial results.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     There are no material changes in reported market risks since our most recent filing on Form 10-K for the year ended December 31, 2003.

ITEM 4. CONTROLS AND PROCEDURES

Controls Evaluation and Related CEO and CFO Certifications

     We conducted an evaluation of the effectiveness of the design and operation of our “disclosure controls and procedures” (Disclosure Controls) as of the end of the period covered by this Quarterly Report. The controls evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO). Attached as exhibits to this Quarterly Report are certifications of the CEO and the CFO, which are required in accordance with Rule 13a-14 of the Exchange Act. This “Controls and Procedures” section includes the information concerning the controls evaluation referred to in the certifications and it should be read in conjunction with the certifications for a more complete understanding of the topics presented.

Definition of Disclosure Controls

     Disclosure Controls are controls and procedures designed to reasonably assure that information required to be disclosed in our reports filed under the Exchange Act, such as this Quarterly Report, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure Controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

Limitations on the Effectiveness of Controls

     Our management, including the CEO and CFO, cannot assure that our Disclosure Controls will prevent all errors. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error may occur and not be detected.

Scope of the Controls Evaluation

     The evaluation of our Disclosure Controls included a review of the controls’ objectives and design, the company’s implementation of the controls, and the effect of the controls on the information generated for use in this Quarterly Report. In the course of the controls evaluation, we sought to identify issues and confirm that appropriate corrective action, including process improvements, were being undertaken. Many of the components of our Disclosure Controls are also evaluated on an ongoing basis by our independent auditors, who evaluate them in connection with determining their auditing procedures related to their report on our annual financial statements and not to provide assurance on our controls. The overall goals of these various evaluation activities are to monitor our Disclosure Controls, and to modify them as necessary.

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     Among other matters, we also considered whether our evaluation identified any “significant deficiencies” or “material weaknesses” in our internal control over financial reporting, and whether the company had identified any acts of fraud involving personnel with a significant role in our internal control over financial reporting. This information was important both for the controls evaluation generally, and because item 5 in the certifications of the CEO and CFO requires that the CEO and CFO disclose that information to our Board’s Audit Committee and to our independent auditors. In the professional auditing literature, “significant deficiencies” are a single deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a misstatement of the annual or interim financial statements that is more than inconsequential will not be prevented or detected. Auditing literature defines “material weakness” as a significant control deficiency, or combination of significant control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. We also sought to address other controls matters in the controls evaluation, and in each case if a problem was identified, we considered what revision, improvement and/or correction to make in accordance with our ongoing procedures.

Conclusions

     Based upon the controls evaluation, our CEO and CFO have concluded that, subject to the limitations noted above, as of the end of the period covered by this Quarterly Report, our Disclosure Controls were effective to provide reasonable assurance that material information relating to us and our consolidated subsidiaries is accumulated and communicated to management, including the CEO and CFO, as appropriate to allow timely decisions regarding financial disclosure.

PART II

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     Our Annual Meeting of Stockholders was held on May 7, 2004. All of the nominees were elected to our Board of Directors as set forth in the Proxy Statement as follows:

     The following items were also voted upon and approved by our stockholders:

     (a) Approval of our 2004 Incentive Compensation Plan.

     (b) Ratification of the appointment of Deloitte & Touche LLP as our independent auditors for the fiscal year ending December 31, 2004.

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ITEM 5. OTHER INFORMATION

     Our Insider Trading Policy permits our directors, officers, and other key personnel to establish purchase and sale programs in accordance with Rule 10b5-1 adopted by the Securities and Exchange Commission. The rule permits employees to adopt written plans at a time before becoming aware of material nonpublic information and to sell shares according to a plan on a regular basis (for example, weekly or monthly), regardless of any subsequent nonpublic information they receive. In our view, Rule 10b5-1 plans are beneficial because systematic, pre-planned sales that take place over an extended period should have a less disruptive influence on the price of our stock. We also believe plans of this type are beneficial because they inform the marketplace about the nature of the trading activities of our directors and officers. In the absence of such information, the market could mistakenly attribute transactions as reflecting a lack of confidence in our company or an indication of an impending event involving our company. We recognize that our directors and officers may have reasons totally apart from the company in determining to effect transactions in our common stock. These reasons could include the purchase of a home, tax and estate planning, the payment of college tuition, the establishment of a trust, the balancing of assets, or other personal reasons. The establishment of any trading plan involving our company requires the pre-clearance by our Chief Executive Officer or Chief Financial Officer. An individual adopting a trading plan must comply with all requirements of Rule 10b5-1, including the requirement that the individual not possess any material nonpublic information regarding our company at the time of the establishment of the plan. In addition, sales under a trading plan may be made no earlier than 30 days after the plan establishment date.

     No officers currently maintain trading plans.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a)

Exhibits

10.21		First Amended and Restated Real Property Sublease Agreement between the Registrant and Brillian Corporation.
10.31		Loan and Security Agreement between the Registrant and Silicon Valley Bank.
31.1		Certification of Chief Executive Officer of the Registrant pursuant to Rule 13a-14(a) and Rule 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended.
31.2		Certification of Chief Financial Officer of the Registrant pursuant to Rule 13a-14(a) and Rule 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended.
32.1		Certification of the Chief Executive Officer of the Registrant pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification of the Chief Financial Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b)

Reports on Form 8-K

1)		Report on Form 8-K dated April 27, 2004, furnishing Item 12 Results of Operations and Financial Condition disclosure.
2)		Report on Form 8-K dated May 7, 2004, furnishing Item 9 Regulation FD disclosure.
3)		Report on Form 8-K dated May 7, 2004, furnishing Item 9 Regulation FD disclosure, as amended by report on Form 8K/A dated May 7, 2004, furnishing Item 9 Regulation FD disclosure.
4)		Report on Form 8-K dated May 18, 2004, furnishing Item 9 Regulation FD disclosure.

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SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

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Exhibit Index