UNITED STATES

FORM 10-Q

For the Quarter Ended March 31, 2005

Commission file number 0-50289

Brillian Corporation

(602) 389-8888

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

YES þ NO o

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

YES o NO þ

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

BRILLIAN CORPORATION
QUARTERLY REPORT ON FORM 10-Q
FOR QUARTER ENDED MARCH 31, 2005
TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

BRILLIAN CORPORATION

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

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BRILLIAN CORPORATION

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

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BRILLIAN CORPORATION

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

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BRILLIAN CORPORATION

Note A	Organization and Basis of Presentation
	We design and develop large-screen, rear-projection, high-definition televisions, or HDTVs, utilizing our proprietary liquid crystal on silicon, or LCoSTM, microdisplay technology. We market our HDTVs for sale under the brand names of retailers, including high-end audio/video manufactures, distributors of high-end consumer electronics, and consumer electronics retailers. We have established a virtual manufacturing model utilizing third-party contract manufacturers to produce our HDTVs, which incorporate the LCoS microdisplays that we manufacture. We also offer a broad line of LCoS microdisplay products and subsystems that original equipment manufacturers, or OEMs, can integrate into proprietary HDTV products, home theater projectors, and near-to-eye applications, such as head-mounted monocular or binocular headsets and viewers, for industrial, medical, military, commercial, and consumer applications.
	Historically, we operated as a division of Three-Five Systems, Inc. (“TFS”). On March 17, 2003, TFS announced that its board of directors had approved a decision to incorporate us as a wholly owned subsidiary of TFS, to transfer our business and assets into this subsidiary, and to distribute the common stock of this subsidiary to its stockholders in a spin-off. We were formed on May 7, 2003 in anticipation of this spin-off. The spin-off was completed on September 15, 2003 as a special dividend to the stockholders of TFS.
	On September 1, 2003, we and TFS entered into a Master Separation and Distribution Agreement under which TFS transferred to us substantially all of the assets of, and we assumed substantially all of the corresponding liabilities of, TFS’ microdisplay business. On September 15, 2003, TFS distributed all outstanding shares of Brillian common stock owned by TFS to TFS stockholders as a dividend (the “spin-off”). Each TFS stockholder of record as of September 4, 2003, received one share of our stock for every four shares of TFS common stock they owned. In addition, we entered into ancillary agreements that govern various ongoing relationships between us and TFS. In connection with the spin-off, TFS received a ruling from the Internal Revenue Service (the “IRS”) that the spin-off would be tax free. In connection with the spin-off, TFS provided initial cash funding in the amount of $20.9 million, net of $1.1 million of spin-off related costs incurred prior to the spin-off.
	The accompanying unaudited Condensed Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and the instructions to Form 10-Q. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In our opinion, all adjustments, which include only normal recurring adjustments necessary to present fairly the financial position, results of operations, and cash flows for all periods presented have been made. The results of operations for the three-month period ended March 31, 2005 are not necessarily indicative of the operating results that may be expected for the entire year ending December 31, 2005. These financial statements should be read in conjunction with our December 31, 2004 financial statements and the accompanying notes thereto.
	The accompanying financial statements have been prepared on a going concern basis which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. We have incurred recurring operating losses and negative cash flows since our inception as a division of TFS. We have never been profitable. Our net loss for the quarter ended March 31, 2005, was $5.3 million, and was $32.9 million, $18.7 million, and $23.2 million for the years ended December 31, 2004, 2003, and 2002, respectively. Net cash used in operating activities was $5.3 million for the quarter ended March 31, 2005, and $18.9 million, $15.9 million, and $20.1 million for the years ended December 31, 2004, 2003, and 2002, respectively. At March 31, 2005, we had $6.9 million of working capital, including cash and cash equivalents of $3.0 million. These factors, among others, may indicate that we will be unable to continue as a going concern for a reasonable period of time.
	The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern. Our continuation as a going concern is dependent upon our ability to

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	generate sufficient cash flow to meet our obligations on a timely basis, to obtain additional capital as may be required, and ultimately to attain successful operations.
	The successful introduction of an HDTV product to market and securing volume orders from consumer electronics retailers for HTDVs represent a key ingredient in our success. In the second quarter of 2004, we signed a supply agreement to provide HDTVs to Sears Roebuck and Company. In the third quarter of 2004, we began shipping HDTVs to Sears. Also in the third quarter of 2004, our supplier of light engines, a major sub-assembly of the HDTV, informed us that they were unable to supply us with the volume of light engines necessary to satisfy our requirements. As a result of our not being able to supply the required number of HDTVs, Sears exercised their option to terminate the supply agreement. In the fourth quarter of 2004, our light engine supplier informed us that they would not be able to manufacture the light engine in volume until the second quarter of 2005. In March of 2005, we received authorization from our light engine supplier to have the light engine manufactured on our behalf by a third party manufacturer and granted us a perpetual license to the light engine technology. In April, 2005, we selected Suntron Corporation to manufacture light engines on our behalf. We currently believe that light engine availability will begin to increase in the third quarter of 2005 and that capacity will exceed 1,000 units per month in the fourth quarter of 2005.
	We do not have any definitive agreements with retailers to sell our HDTVs. We are currently manufacturing a limited quantity of light engines in our manufacturing facility in Tempe, Arizona. This will allow us to manufacture a limited number of HDTVs and support low volume customers until we can obtain a high volume supply of light engines. Until we obtain a high volume supply of light engines, we will not be able to manufacture and sell a sufficient number of HDTVs to achieve positive cash flow or profitability. As a result of this situation, we believe that our cash balances on December 31, 2004 will not be sufficient to finance our operations through 2005, and that we will need to obtain debt or additional equity financing. We are actively pursuing additional capital, but we currently have no commitments or understandings regarding any additional funding with any person or firm. We can provide no assurance that we will be able to obtain any necessary financing on satisfactory terms, or at all. We believe that obtaining orders from customers and announcing progress towards obtaining a high volume supply of light engines will increase our ability to raise debt or additional equity financing.
Note B	Inventories consisted of the following (in thousands):

Note C

Property, plant, and equipment consisted of the following (in thousands):

Note D	Loss per Share
	Basic and diluted loss per common share was computed by dividing net loss by the weighted average number of shares of common stock outstanding during the three-month periods ended March 31, 2005, and 2004. For the three-month periods ended March 31, 2005, and 2004, the effect of approximately 1.6 million and 1.4 million stock options were excluded from the calculation of diluted loss per share, as their effect would have been antidilutive and decreased the loss per share.
Note E	Segment Reporting, Sales to Major Customers, and Geographic Information
	SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” establishes standards for the reporting by public business enterprises of information about operating segments, products and services, geographic areas, and major customers.

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	Because the products we sell for use in near-to-eye and projection devices share the same underlying technology and have similar economic characteristics, production processes, and customer types, we operate and report internally as one segment in accordance with SFAS No. 131. All of our assets are located in the United States.
	Projection device sales, which include HDTV sales, for the three months ended March 31, 2005, were $690,000, or 80% of sales, while near-to-eye sales were $168,000, or 20% of sales. During the same period in 2004, projection device sales, which included $138,000 of design and engineering sales, were $298,000, or 62% of sales, and near-to-eye sales were $180,000, or 38% of sales.
	For the three months ended March 31, 2005, sales to SEOS Ltd., BAE Systems Avionics, and I-O Display accounted for 23%, 15%, and 13%, respectively, of our net sales. For the three months ended March 31, 2004, sales to I-O Display, Kodak, and Zehda Technology accounted for approximately 28%, 25%, and 22%, respectively, of our net sales.
	We also track net sales by geographic location. Net sales by geographic area are determined based upon the location of the end customer. The following sets forth net sales (in thousands) for our geographic areas:

Note F	Transactions with TFS
	On the spin-off date, we and TFS entered into a series of agreements to facilitate our separation from TFS. These agreements included certain transitional services, leases, intellectual property transfers, and tax sharing agreements. In the three-month period ended March 31, 2005, we paid TFS $272,000 for rent and $33,000 for engineering and design services related to the development of printed circuit board assemblies and for purchases of these assemblies for our HDTV product. In the three-month period ended March 31, 2004, we paid TFS $234,000 for rent, $32,000 for engineering services and $553,000 engineering and design services related to the development of printed circuit board assemblies and for purchases of these assemblies for our HDTV product.
	Tax Sharing Agreement
	Under the Tax Sharing Agreement, we have agreed to indemnify TFS against any taxes (other than Separation Taxes) that are attributable to us since our formation, even while we were a member of TFS’ federal consolidated tax group. TFS has indemnified us against any taxes (other than Separation Taxes) that are attributable to the businesses retained by TFS. The Tax Sharing Agreement sets forth rules for determining taxes attributable to us and taxes attributable to the businesses retained by TFS.
	We have agreed not to take any action that would cause the spin-off not to qualify under Section 355 of the Internal Revenue Code of 1986, as amended (the “Code”). We have agreed not to take certain actions for two years following the spin-off unless we obtain an IRS ruling or an opinion of counsel to the effect that these actions will not affect the tax-free nature of the spin-off. These actions include certain issuances of our stock, a liquidation or merger of our company, and dispositions of assets outside the ordinary course of our business. If any of these transactions were to occur, the spin-off could be deemed to be a taxable distribution to TFS. This would subject TFS to a substantial tax liability. We have agreed to indemnify TFS and its affiliates to the extent that any action we take or fail to take gives rise to a tax incurred by TFS or any of its affiliates with

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	respect to the spin-off. In addition, we have agreed to indemnify TFS for any tax resulting from an acquisition by one or more persons of a 50% or greater interest in our company.
	Intellectual Property Agreement
	We and TFS have entered into an Intellectual Property Agreement under which we granted to TFS a nonexclusive, royalty-free, worldwide, perpetual, fully paid up license in and to all intellectual property that was assigned to us and that is used in all fields other than in the field of microdisplays. This intellectual property includes all patents, copyrights, trademarks, trade names, trade dress, trade secrets, know how, and show how whether or not legal protection has been sought or obtained. In addition, the license granted to TFS is non-assignable and non-licensable to third parties except that TFS may sublicense its rights to the intellectual property to any party or entity in which TFS owns at least a 50% equity interest.
	Real Property Sublease Agreement
	On December 22, 2004, we and TFS amended and restated the Real Property Sublease Agreement under which we lease office and manufacturing space in the TFS headquarters building. The initial term of the sublease now terminates December 16, 2009, with automatic one-year renewal terms thereafter unless either party elects to terminate the sublease upon notice delivered at least six months prior to the expiration of the then applicable sublease term. The agreement also sets forth certain circumstances under which all or a portion of the sublease may be terminated without penalty. We sublease approximately 55,780 square feet of the building from TFS and share certain common areas in the building with TFS. Our monthly rent payable to TFS is $61,592 plus $28,963 for normal and customary services in connection with the operation and maintenance of the building. This amount does not, however, include water or electrical utilities, which we pay separately based on our use of those items. The sublease is not assignable by us without the prior written consent of TFS, which consent may be withheld by TFS in its sole discretion.
Note G	Commitments and Contingencies:
	We made a guarantee in connection with a Small Business Administration loan to VoiceViewer Technology, Inc., a private company developing microdisplay products. VoiceViewer is unable to meet its current obligations under the loan agreement. We and the other guarantors are making payments as they become due. We have determined that it is probable that VoiceViewer will be unable to meet its future obligations under the loan agreement. Therefore, at March 31, 2005, we have accrued $292,000, which represents our maximum remaining obligation under the guarantee. We have a security interest in, and second rights to, the intellectual property of VoiceViewer, while the lending institution has the first rights. However, we do not believe we can realize any significant value from VoiceViewer’s intellectual property.
Note H	Stock Compensation:
	Our 2003 Incentive Compensation Plan was adopted by our board of directors and approved by our stockholder on August 26, 2003. Under the 2003 Incentive Compensation Plan, an aggregate of 1,650,000 shares of common stock were originally available for issuance pursuant to options granted to acquire common stock, the direct granting of restricted common stock and deferred stock, the granting of stock appreciation rights, and the granting of stock equivalents. On the first day of each fiscal year, an additional number of shares equal to 4% of the total number of shares then outstanding is added to the number of shares that may be subject to the granting of awards.
	Prior to the spin-off, certain of our employees were granted options to purchase TFS common stock under TFS’ stock-based compensation plans. In connection with the spin-off, each outstanding TFS option granted prior to the spin-off was converted into both an adjusted TFS option and a substitute Brillian option. The treatment of such TFS options and the substitute Brillian options is identical for those employees who remained employees of TFS immediately after the spin-off and for those employees who became employees of Brillian in connection with the spin-off. These TFS options were converted in a manner that preserved the aggregate exercise price of each option, which was allocated between the adjusted TFS option and the substitute Brillian option, and each preserved the ratio of the exercise price to the fair market value of the

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	stock subject to the option. For employees who remained employees of TFS after the spin-off, employment with TFS will be taken into account in determining when each substitute Brillian option becomes exercisable and when it terminates, and in all other respects the terms of the substitute option is substantially the same as the original TFS option. Under this arrangement, on September 15, 2003, we issued options to purchase 750,275 shares of Brillian common stock. Of these options, 600,410 were issued to employees who remained employees of TFS after the spin-off. Options granted under TFS’ plans generally vest over a four-year period and are exercisable for a term of 10 years.
	In addition to the Brillian substitute options granted under the terms of the Master Separation and Distribution Agreement, on September 4, 2003, we granted options to our employees to purchase approximately 526,000 shares of our common stock. Options with respect to approximately 300,000 shares have a vesting period of 32 months, and the remaining options have vesting periods of 50 months. Additionally, on September 4, 2003, we granted approximately 56,000 shares of restricted common stock to employees with a vesting period of one year. As of March 31, 2005, all shares of this restricted common stock had vested and been issued. On September 4, 2003, the spin-off had not been completed and, therefore, no market had developed for our common stock. For purposes of setting the exercise price of the options granted on that date, fair market value was estimated by our board of directors. Based on the initial trading prices of our common stock, we recorded deferred compensation of approximately $1.5 million related to the stock option and restricted stock grants of September 4, 2003. The total amount of deferred compensation will be expensed over the vesting terms of the options and shares of restricted stock. During the quarter ended March 31, 2005, we recorded non-cash compensation expense of $85,000 related to option grants.
	On January 26, 2005, our Board of Directors approved the immediate vesting of certain unvested stock options previously awarded to employees (the “Accelerated Options”), and re-priced certain stock options previously awarded to employees (the “Re-priced Options”). The Board did not accelerate vesting or re-price any stock options previously awarded to officers and directors. The Accelerated Options and Re-priced Options were issued under our 2003 Incentive Compensation Plan. The Board considered the need to retain employees in light of recent stock price declines and that there were no merit increases, nor cash bonuses, paid to employees in 2004. The Board also recognized that the exercise of any Accelerated Options would bring cash into the Company. The closing market price per share of our common stock on January 26, 2005 was $2.42 and the exercise prices of the approximately 183,000 Accelerated Options on that date ranged from $3.27 to $67.60. The original exercise prices of the 268,950 Re-priced Options ranged from $3.90 to $12.06 and were re-priced to $2.42. The original vesting schedules and all other terms of the Re-priced Options, except the exercise prices, were not modified. Until the Re-priced Options are exercised, forfeited, or expire unexercised, future compensation expense may result due to variable accounting rules.
	Employees will benefit from the accelerated vesting of their stock options in the event they terminate their employment with or service to the Company prior to the completion of the original vesting terms, as they would have the ability to exercise certain options that would have otherwise been forfeited. For those employees who do benefit from the accelerated vesting, we are required to record additional stock-based compensation expense equal to the intrinsic value of the option on the date of modification.
	On February 28, 2005, 100,000 Restricted Stock Units were issued to certain officers of the Company. The Restricted Stock Units expire on February 28, 2010 and may be exchanged for our common stock on a one-for-one basis providing certain cash flow objectives are attained. At March 31, 2005, the Company had not recognized any compensation related to these awards.
	Pursuant to the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, we account for options granted to our employees pursuant to Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees. We have computed compensation cost, for pro forma disclosure purposes, based on the fair value of all options awarded on the date of grant, utilizing the Black-Scholes option pricing method with the following weighted assumptions: risk-free interest rates of 3.81% and 2.99% for the options granted during periods ended March 31, 2005, and 2004; expected dividend yields of zero for all scenarios; expected lives of 5.0 years for all scenarios; and expected volatility (a measure of the

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amount by which a price has fluctuated or is expected to fluctuate during a period) of 123% and 74% for options granted during the periods ended March 31, 2005, and 2004. Had compensation cost for these plans been determined consistent with SFAS No. 123, our net loss and loss per share for the three-months ended March 31, 2005, and 2004 would have been as follows (in thousands, except per share data):

Note I	Recently Issued Accounting Standards:
	On December 16, 2004, the FASB issued Statement No. 123 (revised 2004), “Share-Based Payment” that will require compensation costs related to share-based payment transactions with employees to be recognized in our financial statements. With limited exceptions, the amount of compensation cost will be measured based on the grant date fair value of the equity or liability instruments issued. In addition, liability awards will be re-measured each reporting period. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. Statement 123 (revised 2004) replaces FASB Statement No. 123, “Accounting for Stock-Based Compensation”, and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” and is effective as of the first annual reporting period that begins after June 15, 2005. We have not completed the process of evaluating the impact that the adoption of Statement 123 (revised 2004) will have on our financial position or results of operations.
	On November 24, 2004, the FASB issued Statement No. 151, “Inventory Costs, an Amendment of ARB No. 43, Chapter 4”, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. This Statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We have not completed the process of evaluating the impact that the adoption of Statement 151 will have on our financial position or results of operations.
Note J	Subsequent Event:
	On April 20, 2005, we issued $2.5 million of 7% Convertible Debentures and $2.0 million of 9% Senior Secured Debentures, both maturing on April 20, 2008, to institutional investors. The 7% Convertible Debentures are convertible into shares of our common stock at a conversion price of $1.57 per share. Subject to shareholder approval, interest on the 7% Convertible Debentures is payable, at our option, in either stock or cash. The 9% Senior Secured Debentures are secured by a first lien on our assets. The purchasers of both issues have also received five-year options to purchase, for an exercise price of $1.57 per share, approximately 1.75 million shares of our common stock beginning 181 days from closing.

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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 which 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 2005 and thereafter; the amounts, prices, timing, or terms under which we sell HDTVs to our customers; 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 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

     We design and develop large-screen, rear-projection, high-definition televisions, or HDTVs, utilizing our proprietary liquid crystal on silicon, or LCoS™, microdisplay technology. We market our HDTVs for sale under the brand names of retailers, including high-end audio/video manufacturers, distributors of high-end consumer electronics products, and consumer electronics retailers. We have established a virtual manufacturing model utilizing third-party contract manufacturers to produce our HDTVs, which incorporate the LCoS microdisplays that we manufacture. We also offer a broad line of LCoS microdisplay products and subsystems that original equipment manufacturers, or OEMs, can integrate into proprietary HDTV products, home theater projectors, and near-to-eye applications, such as head-mounted monocular or binocular headsets and viewers, for industrial, medical, military, commercial, and consumer applications.

     We derive revenue from the sale of our microdisplay products and from providing design and engineering services. During 2004, we recorded revenue from product sales of $2.3 million, or 84% of net sales, and revenue from design and engineering services of $426,000, or 16% of net sales. We have never been profitable. Our net loss for the quarter ended March 31, 2005, was $5.3 million, and was $32.9 million, $18.7 million, and $23.2 million for the years ended December 31, 2004, 2003, and 2002, respectively.

     We started the development of LCoS microdisplays in 1997 as a division of Three-Five Systems, Inc., or TFS, under which we operated until our spin-off in September 2003. In anticipation of our spin-off to the stockholders of TFS, TFS organized us as a wholly owned subsidiary. In connection with the spin-off, TFS transferred to us its LCoS microdisplay business, including the related manufacturing and business assets, personnel, and intellectual property. TFS also provided initial cash funding to us in the amount of $20.9 million. The spin-off was completed on September 15, 2003 as a special dividend to the stockholders of TFS.

     We share occupancy with TFS in a building in Tempe, Arizona. We manufacture all of our LCoS microdisplays on our high-volume liquid crystal on silicon manufacturing line in that Tempe facility, where we also maintain our corporate headquarters. In addition, we conduct all testing and assembly of LCoS modules and conduct research and development activities in Tempe. We also operate a facility in Boulder, Colorado. In Boulder, we conduct sales and marketing activities and research and development activities.

     Net Sales. Our sales result from both design and engineering services and product sales. Until early 2002, substantially all of our sales were for use in projection-based applications. After the purchase of certain assets in early 2002, however, we became equally focused on the near-to-eye market. In the fourth quarter of 2003, we announced our intention to design, develop, and sell a complete HDTV product based on our Gen II LCoS microdisplay. Since this announcement, most of our efforts have been focused on the design of this product and the

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establishment of a supply chain to source the components that we do not manufacture. We currently anticipate that sales of our HDTVs will comprise the majority of our total sales in future periods.

     In addition to designing, developing, and selling our own HDTVs, we will continue to seek selective OEM customers for our projection displays. We typically sell three displays and associated electronics for products in the projection market. In the near-to-eye market, we sell either one or two displays and associated electronics. The displays and electronics are sold together as a kit. We also sell optical modules in the near-to-eye market.

     Cost of Sales. Our gross margins are influenced by various factors, including manufacturing efficiencies, yields, and absorption issues, product mix, product differentiation, product uniqueness, inventory management, and volume pricing. The manufacturing-related issues have the most significant impact on our gross margins. To date, our manufacturing capacity has exceeded our manufacturing volume, resulting in the inability to fully absorb the cost of our manufacturing infrastructure. As a result, we expect it will be difficult to attain significant improvements in gross margin until we can operate at higher production volumes.

     Selling, General, and Administrative Expense. Selling, general, and administrative expense consists principally of administrative and selling costs; salaries, commissions, and benefits to personnel; and related facilities costs. We make substantially all of our sales directly to OEMs through a very small sales force that consists primarily of direct technical sales persons. Therefore, there is no material cost of distribution in our selling, general, and administrative expense.

     Research and Development Expense. Research and development expense consists principally of salaries and benefits to scientists, engineers, and other technical personnel; related facilities costs; process development costs; and various expenses for projects, including new product development. Research and development expense continues to be very high as we continue to develop our LCoS technology and manufacturing processes, and refine our HDTV products.

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 accounting principles generally accepted 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 ongoing basis, we evaluate our estimates and judgments, including those related to bad debts, inventories, investments, 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 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 have passed to the customer; the fee is fixed and determinable; and collection of the resulting receivable is reasonably assured. Sales allowances are estimated based upon historical experience of sales returns.

     We recognize revenue related to design and engineering services depending on the relevant contractual terms. Under fixed-price contracts that contain project milestones, revenue is recognized as milestones are met. Under contracts where revenue is recognized based on milestones, the fair value of milestones completed equals the fair value of work performed. Under a fixed price contract whereby we were paid based on performance of tasks, we recognized revenue based on the estimated percentage of completion of the entire project as measured by the costs for man hours and materials incurred to date compared to the total estimated costs for man hours and materials. Any anticipated losses on fixed price contracts are recorded in the period they are determinable. All major design

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and engineering services projects for customers were complete at December 31, 2004, and such work is expected to be minimal in the future.

     We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We determine the adequacy of this allowance by regularly evaluating individual customer receivables and considering a customer’s financial condition, credit history, and current economic conditions. If the financial condition of our customers were to deteriorate, additional allowances could be required.

     We write down our inventory for obsolete inventory. We write down our inventory to estimated market value based upon assumptions 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.

     Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes”, requires 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. Changes in valuation allowances from period to period are included in our tax provision in the period of change. In determining whether a valuation allowance is required, we take into account all evidence with regard to the utilization of a deferred tax asset, including our past earnings history, expected future earnings, 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. Deferred tax assets resulting from net operating losses and tax credits generated by our pre-spin-off operations were retained by TFS in accordance with applicable tax law. We do not expect to record a tax benefit on any losses that we incur until we have a history of profitability.

     Long-term assets, such as property, plant, and equipment, intangibles, and other investments, are originally recorded at cost. On an ongoing 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. We may also identify and consider independent market values of assets that we believe are comparable. If we were to 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. During the fourth quarter of 2004, we recorded an impairment charge of $10.2 million related to long-lived assets in accordance with this policy.

     Because our business serves new and developing markets, is based on a relatively new technology, and is expected to be significantly influenced by the introduction of new HDTV products, accurately forecasting revenue for a particular future period is difficult. To date, the majority of our product sales to customers have been for their use in designing their end products or for improving their production processes as opposed to volume production lots. Therefore, the amount of revenue recorded in any given period may fluctuate significantly, and predictable revenue trends have not yet developed. While we anticipate that our revenue will increase, there can be no assurances that this will occur or when it will occur. Because a significant amount of our expenses are fixed in nature and we still experience low manufacturing volumes, we anticipate that the amount of revenue recognized during the first half of 2005 will not result in a material change to our cash consumption rate. We do anticipate, however, that as we continue the move into volume production, we will continue to improve our manufacturing yields and more fully absorb our fixed costs, which will result in improved gross margins and results of operations. However, as we continue to increase our revenue and shift our product mix predominantly to HDTVs, we will use cash to finance increases in working capital.

Results of Operations

Three months ended March 31, 2005 compared to three months ended March 31, 2004

     Net Sales. Net sales increased 79% to $858,000 in the first quarter of 2005 from $478,000 in the first quarter of 2004. Product sales increased to $858,000 in the first quarter of 2005 from $340,000 in the first quarter of

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2004. There were no design and engineering services revenues recorded in the first quarter of 2005, compared with $138,000 recorded in the first quarter of 2004.

     Projection device sales, which include HDTV sales, for the three months ended March 31, 2005, were $690,000, or 80% of net sales, while near-to-eye sales were $168,000, or 20% of net sales. During the same period in 2004, projection device sales were $298,000, or 62% of net sales, and near-to-eye sales were $180,000, or 38% of net sales.

     Net sales in North America totaled $326,000, or 38% of total net sales, in the first quarter of 2005 compared with $314,000, or 66% of total net sales, in the first quarter of 2004. Net sales in Asia totaled $14,000, or 2% of total net sales, in the first quarter of 2005 compared with $107,000, or 22% of total net sales, in the first quarter of 2004. Net sales in Europe totaled $518,000, or 60% of total net sales, the first quarter of 2005 compared with $57,000, or 12% of total net sales, in the first quarter of 2004.

     Cost of Sales. Cost of sales was $3.2 million, or 367% of net sales, in the first quarter of 2005 compared with $2.4 million, or 499% of net sales, in the first quarter of 2004. The large negative gross margin in each period resulted primarily from the low volume of shipments and low manufacturing yields in the shipped products. To date, our manufacturing capacity has exceeded our manufacturing volume, resulting in the inability to fully absorb the cost of our manufacturing infrastructure.

     As is typical in most segments of the high-technology industry, we anticipate downward pressure on the prices of our products. A significant portion of our manufacturing costs are fixed in nature and consist of items such as utilities, depreciation, and amortization. The amounts of these costs do not vary period to period based on the number of units produced nor can the amounts of these costs be adjusted in the short term. Therefore, in periods of lower production volume, these fixed costs are absorbed by a lower number of units, thus increasing the cost per unit. As a result, we expect it will be difficult to attain significant improvements in gross margins until we can operate at higher production volumes.

     Selling, General, and Administrative Expense. Selling, general, and administrative expense decreased 8% to $996,000 in the first quarter of 2005 from $1.1 million in the first quarter of 2004, primarily because of lower compensation costs. A savings of $160,000, resulting from not awarding bonuses in 2005, was partially offset by an $80,000 increase in 2005 salaries due to increased staffing.

     Research and Development Expense. Research and development expense decreased 19% to $2.0 million in the first quarter of 2005 from $2.5 million in the first quarter of 2004. A current period $679,000 reduction in non-recurring engineering (NRE) costs was partially offset by a $100,000 increase in salaries and benefits. NRE in the prior year was especially high because of development of our first HDTV. Salaries increased in the current period because of increased staffing.

     Net Loss. Net loss was $5.3 million in the first quarter of 2005 compared with a net loss of $5.4 million in the first quarter of 2004.

Liquidity and Capital Resources

     At March 31, 2005, we had cash and cash equivalents of $3.0 million, compared with $8.2 million at December 31, 2004.

     In the first quarter of 2005, we had $5.3 million in net cash outflow from operating activities compared to $3.0 million in the first quarter of 2004. Most of the cash outflow in each period related to our losses. Our depreciation and amortization expense was $628,000 in the first quarter of 2005 and $865,000 in the first quarter of 2004.

     In the first quarter of 2005, investing activities used $85,000; proceeds from the sale of investments provided $13,000, and purchases of property and equipment used $98,000. During the first quarter of 2004, investing activities provided $2.5 million; we received proceeds from the sale of short-term investments of $4.0

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million, while purchases of property and equipment totaled $1.3 million and purchases of intangibles totaled $176,000.

     We have incurred recurring operating losses and negative cash flows since our inception as a division of TFS. Our net losses were $32.9 million, $18.7 million, and $23.2 million in 2004, 2003, and 2002, respectively. At March 31, 2005, we had $6.9 million of working capital, including cash and cash equivalents of $3.0 million.

     The successful introduction of an HDTV product to market and securing volume orders from consumer electronics retailers for HTDVs represent a key ingredient in our success. In the second quarter of 2004, we signed a supply agreement to provide HDTVs to Sears Roebuck and Company. In the third quarter of 2004, we began shipping HDTVs to Sears. Also in the third quarter of 2004, our supplier of light engines, a major sub-assembly of the HDTV, informed us that they were unable to supply us with the volume of light engines necessary to satisfy our requirements and granted us a temporary license to build light engines. As a result of our not being able to supply the required number of HDTVs, Sears exercised their option to terminate the supply agreement. In the fourth quarter of 2004, our light engine supplier informed us that they would not be able to manufacture the light engine in volume until the second quarter of 2005, and granted us a temporary license to build light engines. In March 2005, we received authorization from our light engine supplier to have the light engine manufactured on our behalf by a third party manufacturer and granted us a perpetual license to the light engine technology. In April, 2005, we selected Suntron Corporation to manufacture light engines on our behalf. We currently believe that light engine availability will begin to increase in the third quarter of 2005 and that capacity will exceed 1,000 units per month in the fourth quarter of 2005.

     We are currently manufacturing a limited quantity of light engines in our manufacturing facility in Tempe, Arizona. This will allow us to manufacture a limited number of HDTVs and support low volume customers until we can obtain a high volume supply of light engines. Until we obtain a high volume supply of light engines, we will not be able to manufacture and sell a sufficient number of HDTVs to achieve positive cash flow or profitability. As a result of this situation, we believe that our cash balances on March 31, 2005 will not be sufficient to finance our operations through 2005, and that we will need to obtain debt or additional equity financing. On April 20, 2005, we issued $2.5 million of convertible debentures and $2.0 million of senior secured debentures. However, we will still require additional debt or equity financing to finance our operations through 2005. We are actively pursuing additional capital, but we currently have no commitments or understandings regarding any additional funding with any person or firm. We can provide no assurance that we will be able to obtain any necessary financing on satisfactory terms, or at all. We believe that obtaining orders from customers and announcing progress towards obtaining a high volume supply of light engines will increase our ability to raise additional debt or equity financing.

Aggregate Contractual Obligations:

     The following table lists our commercial commitments:

     We have contractual commitments for property leases for our Tempe headquarters and for our development center in Boulder, Colorado. In addition, we have contractual commitments related to the development and production of our HDTV products and have issued purchase orders to vendors for materials totaling approximately $3.4 million.

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     We made a guarantee in connection with a Small Business Administration loan to VoiceViewer Technology, Inc., a private company developing microdisplay products. VoiceViewer is unable to meet its current obligations under the loan agreement. We and the other guarantors are making payments as they become due. We have determined that it is probable that VoiceViewer will be unable to meet its future obligations under the loan agreement. Therefore, at March 31, 2005, we have accrued $292,000, which represents our maximum remaining obligation under the guarantee. We have a security interest in, and second rights to, the intellectual property of VoiceViewer, while the lending institution has the first rights. However, we do not believe we can realize any significant value from VoiceViewer’s intellectual property.

     We believe that the contribution by TFS of the assets related to our business and the assumption by us of the related liabilities in exchange for our common stock, which was part of the spin-off, should be treated as a reorganization within the meaning of Section 368(a)(1)(D) of the Code, and the distribution should qualify as a tax-free distribution under Section 355 of the Code. It should be noted that the application of Section 355 of the Code to the distribution is complex and may be subject to differing interpretation. If the distribution does not qualify as a tax-free distribution under Section 355 of the Code, then (i) TFS would recognize capital gains but not losses equal to the difference between the fair market value of our common stock on the date of the distribution and TFS’ tax basis in such stock; and (ii) the distribution may be taxable to individual stockholders, depending on their individual tax basis. In addition, we have indemnified TFS in the event the distribution is not tax-free to TFS because of actions taken by us or because of failure to take various actions. Certain of the events that could trigger this obligation may be beyond our control. In particular, the transaction may be taxable if the distribution is deemed to be part of a plan in which one or more persons acquire directly or indirectly stock representing a 50% or greater interest in either TFS or our company.

     At March 31, 2005, we had no debt. However, on April 20, 2005, we issued $2.5 million of 7% Convertible Debentures and $2.0 million of 9% Senior Secured Debentures, both maturing on April 20, 2008, to institutional investors. The 7% Convertible Debentures are convertible into shares of our common stock at a conversion price of $1.57 per share. Subject to shareholder approval, interest on the 7% Convertible Debentures is payable, at our option, in either stock or cash. The 9% Senior Secured Debentures are secured by a first lien on our assets. The purchasers of both issues also received five-year warrants to purchase, for an exercise price of $1.57 per share, approximately 1.75 million shares of our common stock beginning 181 days from closing.

     We have no capital lease obligations, unconditional purchase obligations, other long-term obligations, or any other commercial commitments except as noted above.

Off-Balance Sheet Arrangements

     We do not have any off-balance sheet arrangements.

Impact of Recently Issued Standards

On December 16, 2004, the FASB issued Statement No. 123 (revised 2004), Share-Based Payment that will require compensation costs related to share-based payment transactions with employees to be recognized in our financial statements. With limited exceptions, the amount of compensation cost will be measured based on the grant date fair value of the equity or liability instruments issued. In addition, liability awards will be re-measured each reporting period. Compensation cost will be recognized over the period that an employee provides service in exchange for the award. Statement 123 (revised 2004) replaces FASB Statement No. 123, “Accounting for Stock-Based Compensation”, and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” and is effective as of the first annual reporting period that begins after June 15, 2005. We have not completed the process of evaluating the impact that the adoption of Statement 123 (revised 2004) will have on our financial position or results of operations.

On November 24, 2004, the FASB issued Statement No. 151, “Inventory Costs, an Amendment of ARB No. 43, Chapter 4”, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. This Statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We have not completed the process of evaluating the impact that the adoption of Statement 151 will have on our financial position or results of operations.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments

     At March 31, 2005, we did not participate in any derivative financial instruments, or other financial or commodity instruments for which fair value disclosure would be required under Statement of Financial Accounting Standards No. 107. We hold no investment securities that would require disclosure of market risk.

     Primary Market Risk Exposures

     Our primary market risk exposures are in the areas of foreign currency exchange rate risk. Foreign currency devaluations, especially in Asian currencies, such as the Japanese yen, the Korean won, and the Taiwanese dollar, may cause a foreign competitor’s products to be priced significantly lower than our products.

     Fluctuations in foreign currency exchange rates could affect our cost of goods and operating margins. 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 have not attempted to hedge or otherwise mitigate this risk because our exposure to any given currency is nominal. A change in the currency exchange rate of 10% in any given currency would not have a material impact on our results of operations. If, in the future, our exposure to a given currency increases, we would contemplate hedging at that time. Based on the foregoing, we cannot provide assurance that fluctuations in currency exchange rates in the future will not have an adverse effect on our operations.

ITEM 4. CONTROLS AND PROCEDURES

     As of the end of the period covered by this report, our Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the effectiveness of our disclosure controls and procedures, which included inquiries made to certain other of our employees. Based on their evaluation, our Chief Executive Officer and Chief Financial Officer have each concluded that our disclosure controls and procedures are effective and sufficient to ensure that we record, process, summarize, and report information required to be disclosed by us in our periodic reports filed under the Securities Exchange Act within the time periods specified by the Securities and Exchange Commission’s rules and forms. During the quarterly period covered by this report, there have not been any changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

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

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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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