-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, FtOTjgmIWQnhLz3qxKicr7NHZPUhhtnj3hknECSzQsBxjv+IP/acX/JaX8CLmO3t GbhLKJpL5liMVVSlIEXi+A== 0000950147-98-000189.txt : 19980317 0000950147-98-000189.hdr.sgml : 19980317 ACCESSION NUMBER: 0000950147-98-000189 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 13 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980313 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: THREE FIVE SYSTEMS INC CENTRAL INDEX KEY: 0000032272 STANDARD INDUSTRIAL CLASSIFICATION: SEMICONDUCTORS & RELATED DEVICES [3674] IRS NUMBER: 860654102 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 001-04373 FILM NUMBER: 98565642 BUSINESS ADDRESS: STREET 1: 1600 N DESERT DR CITY: TEMPE STATE: AR ZIP: 85281-1230 BUSINESS PHONE: 6024960035 MAIL ADDRESS: STREET 1: 1600 N DESERT DRIVE CITY: TEMPE STATE: AZ ZIP: 85281-1230 FORMER COMPANY: FORMER CONFORMED NAME: ELECTRONIC RESEARCH ASSOCIATES INC DATE OF NAME CHANGE: 19900507 10-K 1 ANNUAL REPORT SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------- FORM 10-K Annual Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 1997 Commission File Number 1-4373 ------ THREE-FIVE SYSTEMS, INC. (Name of Issuer Specified in Its Charter) Delaware 86-0654102 ------------------------------- ---------------- (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 1600 North Desert Drive, Tempe, Arizona 85281 --------------------------------------------- (Address of Principal Executive Offices) (602) 389-8600 -------------- (Issuer's Telephone Number, Including Area Code) Securities registered under Section 12(b) of the Exchange Act: Title of Each Class Name of Each Exchange on Which Registered Common Stock, Par Value $.01 Per Share New York Stock Exchange - -------------------------------------- ----------------------- Securities registered under Section 12(g) of the Exchange Act: None Check whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes X No __ Check if there is no disclosure of delinquent filers pursuant to Item 405 of Regulation S-K contained in this form, and no disclosure will be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [_____] State issuer's revenues for its most recent fiscal year: $84,642,000 As of March 6, 1998, the aggregate market value of the voting stock held by non-affiliates of the issuer, computed by reference to the price at which stock was sold as of such date in the stock market as reported on the New York Stock Exchange, was $152,309,391. Shares of Common Stock held by each officer and director and by each person who owns 10% or more of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily conclusive and does not constitute an admission of affiliate status. As of March 6, 1998, there were 7,907,123 shares of the issuer's Common Stock outstanding. Documents incorporated by reference: Portions of the issuer's definitive Proxy Statement for the 1998 Annual Meeting of Stockholders are incorporated by reference into Part III hereof. THREE-FIVE SYSTEMS, INC. ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1997 TABLE OF CONTENTS
PART I ITEM 1. DESCRIPTION OF BUSINESS.........................................................................1 ITEM 2. DESCRIPTION OF PROPERTY........................................................................19 ITEM 3. LEGAL PROCEEDINGS..............................................................................19 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............................................19 PART II ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.......................................20 ITEM 6. SELECTED FINANCIAL DATA .......................................................................22 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS............................................................23 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.....................................32 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................................................32 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE............................................................32 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS ..............................................................32 ITEM 11. EXECUTIVE COMPENSATION.........................................................................32 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.....................................................................................32 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................................................32 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K....................................................................................33 SIGNATURES.......................................................................................................35 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS......................................................................F-1
PART I ITEM 1. DESCRIPTION OF BUSINESS Introduction The Company designs and manufactures a wide range of user interface devices for operational control and informational display functions required in the end products of original equipment manufacturers ("OEMs"). Most of the Company's sales consist of custom devices developed in close collaboration with its customers. Devices designed and manufactured by the Company find application in cellular telephones and other wireless communication devices as well as in medical equipment, office automation equipment, industrial process controls, instrumentation, consumer electronic products, automotive equipment, and industrial and military control products. The Company currently specializes in liquid crystal display ("LCD") and light emitting diode ("LED") components and technology in providing its design and manufacturing services for its customers. The Company markets its services primarily in North America, Europe, and Asia through direct technical sales persons and, to a much lesser extent, through an independent sales and distribution network. The Company experienced substantial growth from 1993 through 1995 with net sales increasing from $38.0 million in 1993 to $91.6 million in 1995. The Company's growth during that period, however, depended primarily upon the Company's participation in the substantial growth of the wireless communications market and sales to a single major customer in that industry. In 1996, the Company's sales declined to $60.7 million, largely as the result of the phase-out by that major customer of a significant family of programs in early 1996, and the Company reported a loss in 1996 as a result of that phase-out and the significant inventory reserve taken during the third quarter. In 1997, the Company's sales increased to $84.6 million, primarily as a result of several new programs, including programs for an office automation customer. The growth that occurred during the period from 1993 through 1995 allowed the Company to construct the highest volume passive matrix LCD glass production facility in North America, which enables the Company to produce a substantial portion of its LCD glass requirements, as well as to attract key personnel, expand its research and development efforts, and build its infrastructure. The Company has undertaken substantial efforts to broaden its customer base by obtaining new customers and by increasing its business with those existing customers which have historically comprised a small percentage of the Company's revenue. The Company has also undertaken efforts to expand its markets by (1) placing sales personnel in new geographic locations, (2) targeting new industrial applications, and (3) developing new kinds of products. The Company believes that it is positioned to continue the growth that it experienced in 1997 as a result of its efforts in expanding its customer base and the markets it serves as well as its strength in designing, prototyping, and producing, on a timely and cost-efficient basis, a wide range of innovative, distinctive, and high-quality user interface devices required in the end products of OEMs. In the past few years, the Company has refocused its research and development capabilities with the intention of developing display technologies and manufacturing processes that will be useful for its current and future customers. The Company's design processes utilize advanced computer-aided design software to provide custom solutions for customers' products in time frames and on cost bases that it believes are competitive. The Company utilizes advanced, flexible manufacturing systems that can accommodate low-volume production runs or highly sophisticated applications in Arizona and high-volume, price sensitive runs in Manila, the Philippines. The Company maintains its principal executive offices at 1600 North Desert Drive, Tempe, Arizona 85281, and its telephone number is (602) 389-8600. Unless the context indicates otherwise, all references to the "Company" refer to Three-Five Systems, Inc., its subsidiaries and predecessors. Technology Since the commercial introduction of the first light emitting diodes in the 1960s and twisted nematic liquid crystal displays in the 1970s, the use of LCD and LED indicators has become widespread in industrial and consumer 1 electronic products. Prior to these innovations, the most common displays or indicators had substantial limitations as to their use, especially in terms of size, life, and power consumption. LCD and LED technologies were developed in order to overcome these limitations. An LCD modifies light that passes through or is reflected by it, rather than emitting light like an LED. An LCD generally consists of a layer of liquid crystalline material suspended between two glass plates. The crystals align themselves in a predictable manner, and this alignment changes when stimulated electrically. This changed alignment produces a visual representation of the information desired when used in conjunction with a polarizer and either natural ambient light or an external light source. An LED chip produces light as the result of the application of direct current at a low voltage. Different wavelengths (colors) can be produced in a product depending upon the manufacturing process and the dopant (impurity) added to the basic chip material, usually gallium arsenide or gallium phosphide. These wavelengths can be visible or non-visible. In the visible range, LED chips produce red, yellow, green, and recently, blue and white colors. In the non-visible range (infrared), the Company's devices utilize 880 nanometer wavelength or 940 nanometer wavelength chips. Industry Overview The Company has benefited from the determination by certain OEMs in the electronics industry to outsource the design and production of certain components included in the end products of those OEMs. The Company believes that the following factors have contributed to this growing trend among OEMs: o As technology has become increasingly sophisticated and complex, it has become more difficult for even the leading OEMs to maintain the necessary technology, expertise, personnel, and equipment to design and produce internally all of the various components necessary for their products. o Advanced design and manufacturing processes require increasingly greater investments for research and development, personnel, and equipment. o Competitive market conditions require OEMs to reduce the period of time from product conception to delivery, to differentiate their products from those of their competitors, to improve user friendliness, and to continually enhance product performance and reduce product cost during the life cycle of the product. OEMs often design their products to contain user interface devices (including those relating to operational control and informational display) as a highly cost-effective means of differentiating their products from competing products. OEMs then make the decision of whether to use standard devices, to design and produce the devices in-house, or to outsource with a third party for design and production. In making this decision, companies often recognize that their greatest strengths consist of consumer recognition of brand names, market research and product development expertise, and highly developed sales and distribution channels. OEMs also recognize that the desired devices often cannot be obtained "off-the-shelf" and that time constraints and limitations on available resources often preclude them from maintaining the specialized in-house expertise and equipment necessary to design and manufacture the desired devices. OEMs often conclude that the logical solution is to focus their resources on those areas (such as marketing and distribution) where they possess the greatest leverage and to outsource the design and production of devices and components in which they lack the requisite technology and expertise. Outsourcing enables OEMs to obtain the following desired benefits: o To gain access to specialized design and manufacturing technology and expertise. 2 o To accelerate the design process and to reduce design and manufacturing costs by utilizing the specialized personnel, equipment, and facilities of the supplier. o To reduce their own investment in personnel, equipment, and facilities necessary for specialized design and production capabilities. o To streamline their own operations by concentrating their resources on the design, production, and distribution of their core products. By eliminating the duplication and overlap of investment and resources, outsourcing permits the Company and the OEMs to work together and grow at a faster rate than would otherwise be possible. Outsourcing greatly reduces the Company's need to devote time and resources on market development for specific products and allows the Company to concentrate on the development of its display technologies and their applications to a multitude of products. Products and Services The Company currently emphasizes custom designed user interface devices for operational control and informational display functions. The Company believes that custom devices represent the source of its greatest profits and growth potential. For each custom device, the Company works directly with its customer to develop and produce the original design and to manufacture the device in accordance with the customer's specifications. The Company also designs and produces standard or "off-the-shelf" devices, which involve designs that are adaptable to various fixed end uses without modification. The Company pursues a strategy designed to enable it to enhance its position as a major, worldwide supplier of custom-designed and manufactured user interface devices for products of leading OEMs in various high growth industries. The Company attempts to identify industries that present the greatest long-term potential for growth at any given time. The Company's research and development activities then focus upon technological developments that attempt to meet the current and future requirements of those industries. The Company seeks to establish strong and long-lasting customer relationships by aligning its prospects with those of its customers and by seeking to make its engineering and advanced manufacturing functions seamless extensions of the product design and production departments of its customers. The Company engages in a careful customer selection process because it recognizes that its own growth and development will be closely aligned with the growth and development of the customers it serves. The Company's strategy currently involves concentrating its efforts on providing design and production services to leading companies in five primary industries: cellular telephones and other wireless communications, data collection, office automation, medical devices, and industrial process controls. More recently, with the availability of the high-volume LCD manufacturing line in Arizona, the Company has begun focusing its efforts on creating advanced display techonologies. These advanced display technologies will allow the Company to provide its customers with differentiating products or products that provide higher information content. These products may be available for use in custom devices or in standard devices. The Company currently has three technology initiatives. First, the Company has patented a new type of LCD display that emulates an emissive LED display, which the Company calls LCiD(TM) or Liquid Crystal intense Display. This low information content device is expected to provide a multi-colored emissive-looking display at passive LCD prices. The second initiative involves the creation of a high information content display with numerous gray shades but again at the price of a more typical LCD. This new product is called LCaD(TM) or Liquid Crystal active Drive(TM). This technology is based, in part, on technology licensed from Motif, Inc. and additional proprietary technology developed by the Company. The third technology initiative is liquid crystal on silicon microdisplays or LCoS(TM). LCoS(TM) microdisplays will provide high-resolution (up to one million pixels and beyond) active matrix displays that are less than 8/10 of an inch in diameter on the diagonal. LCoS(TM) microdisplays are expected to serve the need for portable, high information content displays in industries such as wireless communications, office automation, and industrial process controls. In addition, the Company expects that LCoS(TM) microdisplays will open new market industries for the Company in areas such as business and consumer electronics. 3 Custom Devices LCD and LED custom displays currently account for approximately 94.3 percent of the Company's revenue, with the majority consisting of LCD custom displays. A manufacturer of a complete system or product requiring a specific type of visual display (such as a cellular telephone, medical instrument, business machine, or hand-held data collection device) represents a typical buyer for a custom device. The Company has developed a sophisticated design process to meet the specific needs of its customers' applications. Each design project normally involves a cross-functional team of Company engineers who are assigned to a customer program. The team consults with the customer's engineers throughout the design phase, prototype development, and manufacturing process. The Company continues to supply value-added engineering support after the design solution has been developed and integrated into the manufacturing process in an ongoing effort to provide customers with product performance enhancements and cost-reduction opportunities. Standard Devices Standard devices encompass a wide variety of LCD and LED devices having varied applications. "Visible" LCD and LED standard devices include (i) solid state lamps used for indicators, status lights, on-board circuit monitors, and instrumentation; (ii) multi-digit numerical displays used for calculators, industrial controls, data terminals, instrumentation timers, hand-held instruments, event counters, and PCB test equipment; (iii) integrated displays (with on-board integrated circuit drivers) and alpha numeric displays used for hand-held terminals, minicomputers, telecommunications, and instrumentation word processors; (iv) bar graph displays used for power meters in stereo systems, Ham and CB radio meters, VU meters in tape recorders, process control indicators, and replacements for volt meters; and (v) multi-digit numeric displays used for industrial controls, data terminals, test equipment, point of sale, mini-computer readout, and home consumer applications. Standard infrared devices include infrared emitters and silicon detectors used for TV remote controls, disk drives, tape drives, printers, encoders, solid state relays, photoelectric controls, slotted switches, reflective switches, intrusion alarms, touch screens, wireless data entry and positioning sensors. Manufacturing Services The Company has geographically organized its manufacturing capabilities in a manner that optimizes the combination of technology and human resources. This enables the Company to compete solely on the basis of cost, if necessary, with suppliers of similar products and services throughout the world. Advanced manufacturing techniques include surface mount technologies, chip-on-board, chip-on-flex, flip-chip, tape automated bonding, and sophisticated testing systems throughout the process. The Company seeks to increase its value to its customers by providing responsive, flexible, total manufacturing services. To date, manufacturing services have been concentrated toward the manufacture of LCD's and assembly of Company-designed user interface module assemblies. However, the Company has recognized an increased demand for extended manufacturing services beyond these core services. These extended services may include adding additional components, such as a keypad, microphone, card reader, product housing, or non-display electronic sub-assembly, or the turn-key manufacture of a complete OEM product. The Company intends to pursue extended manufacturing opportunities in those instances when the Company believes it will be beneficial to do so. Manufacturing Facilities The Company currently conducts manufacturing operations in Tempe, Arizona and in Manila, the Philippines. The Arizona facility houses a Class 1000 "clean room" and LCD fabrication and prototyping operation. The Company utilizes the facility primarily to conduct LCD research and development, to produce prototype and pre-production runs of devices for customer approval, to conduct full production runs of low-volume devices, and to 4 develop advanced manufacturing processes that can be applied in Manila during full-scale production. In addition, the facility has the largest fully automated LCD glass production capacity in North America. This highly automated line enables the Company to reduce its dependence on foreign suppliers of LCD glass. Facility personnel include a team of experts ranging from LCD research scientists to specialized engineers with backgrounds in electronics, mechanics, chemistry, physics, and manufacturing. The Company maintains a wide variety of state-of-the-art testing and quality control equipment at the facility. High volume LCD module manufacturing is done in Manila, the Philippines. The Company is a party to an agreement (the "Sub-Assembly Agreement") with Technology Electronic Assembly and Management Pacific Corporation ("TEAM"), pursuant to which TEAM supplies direct manufacturing services at a facility owned by TEAM located in Manila. The Company is also party to a lease agreement (the "Lease Agreement") with TEAM pursuant to which TEAM leases space to the Company with respect to those manufacturing operations services performed by TEAM under the Sub-Assembly Agreement. TEAM manufactures, assembles, and tests devices designed by the Company in the space leased to the Company and pursuant to procedures set forth in the Sub-Assembly Agreement in accordance with specifications supplied by the Company. In 1997, TEAM and the Company entered into an amendment to the Sub-Assembly Agreement whereby all indirect manufacturing employees (primarily technicians, supervisors and engineers) became employees of the Company. As a result, under the Sub-Assembly Agreement TEAM now only supplies the direct labor and certain incidental services required to manufacture the Company's products. The Company owns the manufacturing, assembling, and testing equipment (including automated die attach and wire bond equipment with automatic pattern recognition features for die and wire placement for LED die) as well as the processes and documentation used by TEAM at the Manila facility. The Company pays TEAM for the direct manufacturing personnel based upon a negotiated available hourly rate. The Company employs all professional personnel, including an Operations Manager, with a support staff consisting of manufacturing supervisors, manufacturing, quality, and process engineers, and logistics and administrative personnel at the Manila facility. The Sub-Assembly Agreement and Lease Agreement between the Company and TEAM extend through December 31, 1999 and are renewable from year to year thereafter. The Sub-Assembly Agreement requires the Company to maintain minimum production levels. The termination of the Lease Agreement or Sub-Assembly Agreement or the inability of TEAM to fulfill its requirements under the Sub-Assembly Agreement would require the Company to acquire additional manufacturing facilities or to contract for additional manufacturing services. The Philippines has been subject to volcanic eruptions, typhoons, and substantial civil disturbances, including attempted military coups against the government. These circumstances could affect the Company's ability to obtain products pursuant to the Sub-Assembly Agreement, although there has not been any material interruption of operations to date. The termination of or the inability of the Company to obtain products pursuant to the Sub-Assembly Agreement, even for a relatively short period, would have a material adverse effect on the operations and profitability of the Company. The Company plans to construct a manufacturing facility in the People's Republic of China ("China") during 1998. The China facility will be a high-volume LCD module manufacturing facility similar to the Company's current facility in Manila. The Company initially will lease a facility in Beijing on a temporary basis, and the Company expects manufacturing to commence in that temporary facility in the middle of 1998. The Company is planning to construct its own facility in Beijing and expects to move into that new facility at the end of 1998. The Chinese manufacturing facility will be owned and operated by a wholly owned foreign subsidiary of the Company. The cost of equipping and constructing the China facility is expected to be approximately $8.0 million. For further discussions on the proposed China operations, See "Management Discussion and Analysis of Financial Conditions and Results of Operations" contained in Item 7 of this Report and "Description of Business - Special Considerations - Risks of International Operations" contained in Item 1 of this Report. 5 Quality Control The Company has implemented an aggressive quality control program and maintains at each of its facilities quality systems and processes that meet or exceed the demanding standards set by many leading OEMs in targeted industries. The Company's quality control program is based upon Statistical Process Control, which advocates continual quantitative measurements of crucial parameters and uses those measurements in a closed-loop feedback system to control the manufacturing process. The Company performs product life testing to help ensure long-term product reliability. The Company analyzes results of product life tests and takes actions to refine the manufacturing process or enhance the product design. Increased global competition has led to increased customer expectations for price, delivery, and quality. Customers often evaluate price in the quotation process, while delivery and quality are evaluated only after the product is received. Therefore, many customers preview a company's quality by viewing the quality systems employed. In 1997, the Company received ISO 9002 certification of its Manila manufacturing facility. ISO is a quality standard established by the International Organization for Standardization, which attempts to ensure that the processes used in development and production remain consistent. This is accomplished through documentation maintenance, training, and management review of the processes used. Although achievement of ISO 9002 certification is no guarantee of the Company's ability to obtain future business, it is a factor that enables the Company's customers to recognize that the Company's production processes meet this established, global standard of performance. Sales and Marketing The Company markets its services primarily in North America and Europe through direct technical sales persons and, to a much lesser extent, through an independent sales and distribution network. This network includes two franchised distributors in approximately 96 sales offices. A staff of in-house, Arizona-based sales and engineering personnel directs and aids all direct and distribution sales. The Company also has sales personnel in California, Massachusetts, Illinois, and Florida. The Company's sales to customers in Europe represented approximately 13 percent of net sales in 1997. In addition to a direct technical sales force, the Company distributes products in Europe through a network of distributors, augmented in some regions by marketing representatives. This network receives support from the marketing, customer service, and support staff employed by the Company's subsidiary, Three-Five Systems Limited, located in Swindon, England. The European staff and network of distributors provide marketing, consulting, and product design input locally for customers throughout Western Europe. Customers The Company's strategy involves concentrating its efforts on providing design and production services to leading companies in five primary industries: cellular telephones and other wireless communications, data collection, office automation, medical devices, and industrial process controls. As a result, the Company generally derives its revenue from services provided to a limited number of customers. The Company's largest customer is Motorola, Inc. ("Motorola"). The Company currently designs and manufactures user interface devices used in approximately 35 individual product programs for Motorola. Sales to Motorola accounted for 34.6 percent of the Company's revenue during 1997. Devices that are used in cellular telephones accounted for substantially all of the Company's sales to Motorola in 1997. Motorola recently awarded several new design programs to the Company. In addition, during 1997, Motorola instituted a LCD module allocation process in which it designated a few key LCD module vendors, including the Company, and communicated to each vendor the anticipated amount of purchases for 1998. Although the allocation process does not provide a guarantee of business to the Company, it provides an indication that purchases by Motorola could rise to as much as 50 percent of the Company's revenue in 1998. The Company's second largest customer in 1997 was Hewlett-Packard Company ("Hewlett-Packard"). Sales to Hewlett-Packard accounted for 32.0 percent of the Company's revenue during 1997. As the LCD modules manufactured by the 6 Company for Hewlett-Packard move into second generation versions in 1998, the Company expects that the selling price of some of those modules will be greatly reduced. Consequently, the Company believes that in 1998 the percentage of its revenue attributed to Hewlett-Packard will decline. See "Description of Business - - Special Considerations - Substantial Reliance on Certain Customers" contained in Item 1 of this Report. Backlog As of December 31, 1997, the Company had a backlog of orders of approximately $21.8 million, all of which orders are believed to be firm and all of which are expected to be filled during fiscal 1998. The backlog of orders at December 31, 1996 was approximately $17.9 million. The Company's business may be developing some seasonality as the result of the significant amount of retail products into which its products are placed. Design cycles have shortened and many customers finish cycles in the fourth quarter (because of the holiday sales season) and ramp up new products in the second quarter of the calendar year. Consequently, the first quarter of a calendar year may have a disproportionately lower percentage of the year's total sales. Patents and Trademarks The Company relies on a combination of patent, trade secrets and trademark laws, confidentiality procedures, and contractual provisions to protect its intellectual property. Although the Company's core business does not depend on any patent or trademark protection, the Company is manufacturing more advanced display products in which there are patent or trademark issues. The Company recently received a patent on a new display technology, which the Company refers to as LCiD(TM) or Liquid Crystal intense Display. In 1997, the Company also signed a license agreement with Motif, Inc. to license from Motif technology that forms the basis of its LCaD(TM) or Liquid Crystal active Drive. The Company recently applied for a patent on its LCaD(TM) technology. Raw Materials The principal raw materials used in producing the Company's displays consist of gallium arsenide and gallium phosphorous wafers and die, LCD glass, driver die, circuit boards, molded plastic parts, lead frames, wire, chips, and packaging materials. The Company's procurement strategy provides alternative sources of supplies for the majority of these materials. Many of such materials, however, must be obtained from foreign suppliers, which subjects the Company to the risks inherent in obtaining materials from foreign sources, including supply interruptions and currency fluctuations. The Company's suppliers currently are meeting the requirements of the Company, and strategic supplier alliances have further strengthened relations with offshore suppliers. The Company's ability to produce a significant percentage of its requirements of LCD glass in its Arizona facility is expected to reduce the Company's dependence on foreign suppliers. See "Description of Business - Special Considerations - Shortage of Raw Materials and Supplies" contained in Item 1 of this Report. Competition The Company believes that Optrex America, Inc., Seiko-Epson, Samsung, Seiko Instruments, Hyundai, PCI Limited, and Philips Components B.V. constitute the principal competitors for the Company's LCD devices. Hewlett-Packard, Rohm Co., Ltd., LiteOn, Inc., Siemens, Inc., Stanley Electric Company, Ltd., and Quality Technologies Corp. constitute its principal competitors for its LED devices. Most of these competitors are large companies that have greater financial, technical, marketing, manufacturing, and personnel resources than the Company. The revenue, profitability, and success of the Company depend substantially upon its ability to compete with other providers of user interface devices. No assurance can be given that the Company will continue to be able to compete successfully with such organizations. The Company currently competes principally on the basis of the technical innovation and performance of its product solutions, including their ease of use and reliability, as well as on their cost, timely design, and manufacturing and delivery schedules. The Company's competitive position could be adversely affected if one or 7 more of its customers, particularly Motorola or Hewlett-Packard, determine to design and manufacture their user interface devices internally or secure them from other parties. See " Description of Business - Special Considerations - Competition" contained in Item 1 of this Report. Research and Development The Company conducts an active and ongoing research, development, and engineering program that focuses on advancing technology, developing improved design and manufacturing processes, and improving the overall quality of the products and services that the Company provides. Research and development personnel concentrate on LCD technology, especially improving performance of current products and expanding the technology to serve new markets. Research and development also is conducted in manufacturing processes, including those associated with efficient, high-volume production and electronic packaging. More recently, the Company has begun to focus its research and development efforts on new display technologies. See "Description of Business Products and Services" contained in Item 1 of this Report. The Company has undertaken a significant research and development program with respect to the development of LCoS(TM) microdisplays and expects that the majority of available research and development personnel hours will be dedicated to LCoS(TM) microdisplays in 1998. Environmental Regulation The operations of the Company result in the creation of small amounts of hazardous waste, including various epoxies, gases, inks, solvents, and other wastes. The amount of hazardous waste produced by the Company may increase in the future depending on changes in the Company's operations. The general issue of the disposal of hazardous waste has received increasing focus from federal, state, local, and international governments and agencies and has been subject to increasing regulation. See "Description of Business - Special Considerations - Environmental Regulation" contained in Item 1 of this Report. In 1991, the Company received a notice of potential liability at the Barkhamsted-New Hartford Landfill Site in Barkhamsted, Connecticut from the United States Environmental Protection Agency ("EPA"). No further administrative action was taken against the Company and the Company has been verbally advised by a representative of the EPA that the Company will have no liability with respect to this matter. In a separate matter, the Company conducted a clean-up of limited chemical contamination at its former property located in Barkhamsted, Connecticut. The contamination was caused by the previous owner of the property, and not as a result of any of the Company's operations. The Company has contracted with an environmental consulting firm for assistance with the clean-up process and has complied with the requests and recommendations of the Connecticut Environmental Protection Agency throughout the process. The Company believes that the source of the contamination has been removed from the property and that the clean-up has been completed. Four monitoring wells have been installed to permit periodic chemical analysis to be made at the property. The property was sold on June 25, 1995, subject to the Company making its best efforts to obtain from either the Connecticut or Federal Environmental Protection Agency documentation to the effect that the property is clean and that there is no actionable contamination in the vicinity of the property. Employees As of December 31, 1997, the Company employed a total of 459 persons. This number includes 174 full-time and approximately 10 temporary employees at its principal U.S. facility in Tempe, Arizona and U.S. sales offices; 267 employees at its manufacturing facility in Manila, the Philippines; and 8 employees at its Three-Five Systems, Limited subsidiary in Swindon, England. The Company considers its relationship with its employees to be good, and none of its employees currently are represented by a union in collective bargaining with the Company. 8 TEAM provides the personnel engaged in the direct assembly of the Company's devices in Manila pursuant to the Sub-Assembly Agreement between the Company and TEAM. See "Description of Business - Manufacturing Facilities" contained in Item 1 of this Report. As of December 31, 1997, approximately 1,133 persons performed direct labor operations at the Manila facility through the Sub-Assembly Agreement with TEAM. Executive Officers The following table sets forth information concerning each of the Company's executive officers.
Name Age Position - ---- --- -------- David R. Buchanan 65 Chairman of the Board, President, and Chief Executive Officer Vincent C. Hren 47 Vice President - Operations Jeffrey D. Buchanan 42 Vice President - Finance, Administration, and Legal; Chief Financial Officer; Secretary; and Treasurer Dan J. Schott 58 Vice President - Research and Development
David R. Buchanan has been Chairman of the Board, President, Chief Executive Officer, and a director of the Company since its formation in February 1990. Mr. Buchanan served as Treasurer of the Company from May 1990 until January 1994 and as Chairman of the Board, Chief Executive Officer, President, and a director of one of the predecessors of the Company from October 1986, February 1987, and November 1985, respectively, until the predecessor's merger into the Company in May 1990. Vincent C. Hren has been Vice President - Operations of the Company since August 1996 and served as Vice President - Manufacturing Operations from January 1996 to August 1996. Mr. Hren served as Vice President - Worldwide Automotive of Graco Inc. from 1994 to 1995. Mr. Hren served as Vice President - Worldwide Operations for Fisher-Rosemount Systems, Inc. from 1993 to 1994, General Manager of Rosemount Analytical, Inc. from 1992 to 1993, and held various management positions with Fisher-Rosemount, Inc. from 1974 to 1992. Jeffrey D. Buchanan has been Vice President - Finance, Administration, and Legal, Chief Financial Officer, and Treasurer of the Company since June 1996 and Vice President - Administration and Legal and Secretary of the Company since May 1996. Mr. Buchanan served as a Senior Partner of O'Connor, Cavanagh, Anderson, Killingsworth & Beshears from June 1986 until May 1996, where he practiced as a business lawyer with an emphasis on mergers and acquisitions, joint ventures, and taxation. Mr. Buchanan was associated with the international law firm of Davis Wright Tremaine from 1984 to 1986, and he was a senior staff person at Deloitte & Touche from 1982 to 1984. Mr. Buchanan is a member of the Arizona and Washington state bars and passed the certified public accounting examination in 1983. Mr. Buchanan is the son of David R. Buchanan. Dan J. Schott has been Vice President - Research and Development of the Company since July 1996. From January 1994 until July 1996 he was Vice President of Technology. From 1988 to January 1994, Mr. Schott was an Associate Director with Honeywell Inc., where his responsibilities included flat panel display research and development. From 1981 until 1987, he held various engineering management and program management positions with Sperry Rand Corp. 9 Special Considerations Certain Factors Affecting Operating Results The Company's operating results are affected by a wide variety of factors which could adversely impact its net sales and profitability. These factors, many of which are beyond the control of the Company, include the Company's ability to identify industries which have significant growth potential and to establish strong and long-lasting relationships with companies in those industries; the Company's ability to provide significant design and manufacturing services for those companies on a timely and cost-effective basis; the Company's success in maintaining customer satisfaction with its design and manufacturing services; market acceptance of products of its customers incorporating devices designed and manufactured by the Company; the level and timing of orders placed by customers which the Company can complete in a quarter; customer order patterns; changes in order mix; the performance and reliability of devices designed and manufactured by the Company; the life cycles of its customers' products; the availability and utilization of manufacturing capacity; fluctuations in manufacturing yield and productivity; the quality, availability, and cost of raw materials, equipment, and supplies; the timing of expenditures in anticipation of orders; the cyclical nature of the industries and the markets served by the Company; technological changes; and competition and competitive pressures on prices. The Company's ability to increase its design and manufacturing capacity to meet customer demand and maintain satisfactory delivery schedules will be an important factor in its long-term prospects. Although the Company's product solutions are incorporated into a wide variety of communications, consumer, medical, office automation, and industrial products, a majority of its sales in 1997 were display modules for cellular products. A slowdown in demand for customer products, particularly cellular and office automation products which utilize the Company's products, as a result of economic or other conditions in the United States or worldwide markets served by the Company or other broadbased factors would adversely affect the Company's operating results. Dependence on New Products and Technologies The Company operates in fast changing industries. Technological advances, the introduction of new products, and new design and manufacturing techniques could adversely affect the Company's operations unless the Company is able to adapt to the resulting changing conditions. As a result, the Company will be required to expend substantial funds for and commit significant resources to continuing research and development activities, the engagement of additional engineering and other technical personnel, the purchase of advanced design, production and test equipment, and the enhancement of design and manufacturing processes and techniques. The Company's future operating results will depend to a significant extent on its ability to continue to provide design and manufacturing services for new products that compare favorably on the basis of time to introduction, cost, and performance with the design and manufacturing capabilities of OEMs and other third-party suppliers. The success of new design and manufacturing services depends on various factors, including proper customer selection, utilization of advances in technology, innovative development of new solutions for customer products, efficient and cost-effective services, timely completion and delivery of new product solutions, and market acceptance of customers' end products. Because of the complexity of the Company's design and manufacturing services, the Company may experience delays from time to time in completing the design and manufacture of new product solutions. In addition, there can be no assurance that any new product solutions will receive or maintain customer or market acceptance. If the Company were unable to design and manufacture solutions for new products of its customers on a timely and cost-effective basis, its future operating results would be adversely affected. See "Description of Business - Products and Services" contained in Item 1 of this Report. Finally, even when a design and manufacturing solution is satisfactorily completed, circumstances outside of the Company's control may result in the loss of expected revenue. For example, a customer may terminate or delay its own program for any number of reasons unrelated to the Company, including problems with other suppliers to the program or lack of market acceptance of the customer's product. In such instances, the future operating results of the Company could be adversely affected. 10 Substantial Reliance on Certain Customers In the past few years, the Company has generated most of its revenue from sales to a few significant customers. The Company's largest customer is Motorola, which accounted for 34.6 percent of the Company's revenue in 1997, 65.1 percent of the Company's revenue in 1996 and 80.5 percent of the Company's revenue in 1995. Devices that are used in cellular telephones accounted for substantially all of the Company's sales to Motorola in 1997. Although the percentage of sales to Motorola declined in 1997, the Company anticipates that this percentage will increase in 1998 to as much as 50 percent of the Company's revenue. The Company's second largest customer is Hewlett-Packard, which accounted for 32.0 percent of the Company's 1997 revenue. See "Description of Business - Customers" contained in Item 1 of this Report. The Company does not have long-term supply contracts with any customers, and customers also generally do not commit to long-term production schedules. In addition, customer orders generally can be cancelled and volume levels changed or delayed. The timely replacement of cancelled, delayed, or reduced orders cannot be assured and, among other things, could result in the Company holding excess and obsolete inventory. The Company's operating results have been materially and adversely affected in the past by the failure of anticipated orders to be realized and by deferrals or cancellations of orders as a result of changes in customer requirements. Cancelled, delayed, or reduced commitments from any of the Company's major customers, particularly Motorola or Hewlett-Packard, would have a material adverse effect on the Company's results of operations. Risks of International Operations General. The Company currently has substantial manufacturing operations located in the Philippines and the United States. The Company also has a sales office and distribution warehouse in Europe. In addition, in 1998 the Company is planning to construct a manufacturing facility in China, where the Company has not previously manufactured products. The geographical distances between Asia, Europe, and North America create a number of logistical and communications challenges. Because of the location of manufacturing facilities in a number of countries, the Company may be affected by economic and political conditions in those countries, including fluctuations in the value of currency, duties, possible employee turnover, labor unrest, lack of developed infrastructure, longer payment cycles, greater difficulty in collecting accounts receivable, the burdens and costs of compliance with a variety of foreign laws and, in certain parts of the world, political instability. Changes in policies by the United States or foreign governments resulting in, among other things, increased duties, higher taxation, currency conversion limitations, restrictions on the transfer of funds, limitations on imports or exports, or the expropriation of private enterprises also could have a material adverse effect on the Company, its results of operations, prospects or debt service ability. The Company also could be adversely affected if the current policies encouraging foreign investment or foreign trade by its host countries were to be reversed. In addition, the attractiveness of the Company's services to its United States customers is affected by United States trade policies, such as "most favored nation" status and trade preferences for certain Asian nations. In particular, the Company's operations and assets are subject to significant political, economic, legal and other uncertainties in the Philippines and China, where the Company is planning to substantially expand its operations. Manufacturing Operations in the Philippines. The Company has maintained its primary manufacturing facility in Manila, the Philippines since 1986. TEAM, a third party subcontractor, owns the facility, which is located on land it leases from the Philippine government. TEAM operates the facility under the Sub-Assembly Agreement and the Lease Agreement utilizing equipment, processes, and documentation owned by the Company and supervisory personnel employed by the Company. TEAM provides direct-level production personnel under the Sub-Assembly Agreement and leases space to the Company under the Lease Agreement. TEAM also utilizes other space in the facility to produce products for other entities unrelated to the Company. The Sub-Assembly Agreement and the Lease Agreement have current terms extending through December 31, 1999 and are renewable from year to year thereafter. Although the Company has made advance payments to TEAM since 1994 to assist it in meeting its working capital needs while it negotiates new financing arrangements, there were no outstanding advances to TEAM at December 31, 1997. The Company expects to make advances to TEAM in 1998 for generators and equipment needed for building improvements. 11 The Company has made cumulative capital investments in the Philippines amounting to approximately $11.1 million through December 31, 1997. The Company's reliance on personnel and facilities in the Philippines and its maintenance of inventories abroad expose the Company to certain economic and political risks, including the business and financial condition of the subcontractor, political instability and expropriation, supply disruption, currency controls, and exchange fluctuations as well as changes in tax laws, tariffs, and freight rates. The Company has not experienced any significant interruptions in its business operations in the Philippines to date despite the fact that the Philippines has been subject to volcanic eruptions, typhoons, and substantial civil disturbances, including attempted military coups against the government. The Company believes that its manufacturing operations in the Philippines constitute one of the Company's most important resources and that it would be difficult for it to replace the low-cost, high-performance facility or the high-quality and hard working production staff if its manufacturing operations in the Philippines were disrupted or terminated. As a result, the Company's operations would be adversely affected if operations in the Philippines or air transportation with the Philippines were disrupted or terminated, even for a relatively short period of time. See "Description of Business - Manufacturing Facilities" contained in Item 1 of this Report. Proposed Manufacturing Operations in China. The Company is planning to begin a manufacturing operation in China in 1998. The Company's operations and assets will be subject to significant political, economic, legal and other uncertainties in China. Under its current leadership, the Chinese government has been pursuing economic reform policies, including the encouragement of foreign trade and investment and greater economic decentralization. No assurance can be given, however, that the Chinese government will continue to pursue such policies, that such policies will be successful if pursued, or that such policies will not be significantly altered from time to time. Despite progress in developing its legal system, China does not have a comprehensive and highly developed system of laws, particularly with respect to foreign investment activities and foreign trade. Enforcement of existing and future laws and contracts is uncertain, and implementation and interpretation thereof may be inconsistent. As the Chinese legal system develops, the promulgation of new laws, changes to existing laws, and the preemption of local regulations by national laws may adversely affect foreign investors. The Company also could be adversely affected by the imposition of austerity measures intended to reduce inflation; the inadequate development or maintenance of infrastructure, including the unavailability of adequate power and water supplies, transportation, raw materials, and parts; or a deterioration of the general political, economic or social environment in China. In addition, China currently enjoys "most favored nation" ("MFN") status granted by the United States government, pursuant to which the United States imposes the lowest applicable tariffs on Chinese exports to the United States. The United States annually reconsiders the renewal of MFN trading status for China. No assurance can be given that the United States will renew China's MFN status in future years. The failure or refusal of the United States government to renew China's MFN status could adversely affect the Company by increasing the cost to United States customers of products manufactured by the Company in China. International Trade and Currency Exchange Approximately 33.8 percent of the Company's net sales in 1997 were international sales. Nearly all of those international sales were from sales in foreign markets, primarily Europe, China, and Hong Kong, to U.S. based OEMs based in the United States. In 1998, the Company expects sales to OEMs in Europe and China to increase and sales to OEMs in Hong Kong to decrease. In 1998, the Company expects to begin manufacturing operations in China and to continue its operations in Manila. The foreign sale and manufacture of products may be adversely affected by political and economic conditions abroad. Protectionist trade legislation in either the United States or foreign countries, such as a change in the current tariff structures, export or import compliance laws, or other trade policies, could adversely affect the Company's ability to manufacture or sell devices in foreign markets and purchase materials or equipment from foreign suppliers. While the Company transacts business predominantly in United States dollars and most of its revenues are collected in U.S. dollars, a portion of the Company's costs, such as payroll, rent, and indirect operation costs, are denominated in other currencies, including Philippine pesos ("PhP"), British pounds sterling, and (in 12 1998) Chinese renminbi ("RMB"). For example, the Company's Sub-Assembly Agreement with TEAM is based on a fixed conversion rate, exposing the Company to exchange rate fluctuations with the Philippine peso. In 1998, the Company may have transactions, including sales, designated in Chinese RMB. Historically, fluctuations in foreign currency exchange rates have not resulted in significant exchange losses to the Company. Changes in the relation of these and other currencies to the United States dollar could affect the Company's cost of goods sold and operating margins and could result in exchange losses. The impact of future exchange rate fluctuations on the Company's results of operations cannot be accurately predicted. In late 1997, the Philippine peso suffered a major devaluation from its historic levels of around $1.00 to PhP 25 down to as much as $1.00 to PhP 49. Over the last five years, the Chinese RMB has experienced significant devaluation against most major currencies. The establishment of the current exchange rate system as of January 1, 1994 produced a significant devaluation of the RMB from $1.00 to RMB 5.7 to approximately $1.00 to RMB 8.7. The rates at which exchanges of RMB into U.S. dollars may take place in the future may vary, and any material increase in the value of the RMB relative to the U.S. dollar would increase the Company's costs and expenses and therefore would have a material adverse effect on the Company. The Company anticipates that from time to time it will make United States dollar-denominated intercompany loans to its wholly owned subsidiary in China. Any decrease in the value of the RMB could adversely affect the Company if there are U.S. dollar-demoninated intercompany loans from the Company to its subsidiary. Hedging RMB is currently difficult because the currency is not freely traded. The Company would suffer a recordable loss as a result of a RMB devaluation if its intercompany loans to its subsidiary in China are not hedged. Manufacturing Yields and Capacity The design and manufacture of user interface devices are highly complex processes that are sensitive to a wide variety of factors, including the level of contaminants in the manufacturing environment, impurities in the materials used, and the performance of the design and production personnel and equipment. As is typical in the industry, the Company from time to time has experienced lower than anticipated manufacturing yields and lengthening of delivery schedules. This may be particularly true as the Company ramps up its high-volume LCD line to greater production levels in 1998, adds more equipment, and begins to manufacture LCoS(TM) microdisplays. See "Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources" contained in Item 7 of this Report. Additionally, as the sophistication of user interface devices increases, so does the level of complexity in the required manufacturing processes. The Company continually reviews its processes in an effort to increase its manufacturing productivity, achieve higher manufacturing yields, and reduce design and manufacturing errors. In addition, the Company reviews ongoing procedures regularly to maintain its ability to meet delivery schedules to satisfy increased business. The Company's operating results would be adversely affected if it were unable to maintain high levels of productivity or satisfactory delivery schedules in either its Manila manufacturing plant or its Arizona high-volume LCD line. Manufacturing yields and delivery schedules also may be affected as the Company ramps up its manufacturing capabilities in China. Other companies in the industry have experienced difficulty in expanding or relocating manufacturing output and capacity, with such difficulty resulting in reduced yields or delays in product deliveries. No assurance can be given that the Company will not experience manufacturing yield or delivery problems in the future. Such problems could materially affect the Company's operating results. See "Description of Business - Manufacturing Facilities" contained in Item 1 of this Report. Variability of Customer Requirements and Operating Results Custom manufacturers for OEMs must provide increasingly rapid product turnaround and respond to ever-shorter lead times. The Company generally does not obtain long-term purchase orders but instead works with its customers to anticipate the volume of future orders. The Company must procure components and determine the levels of business that it will seek and accept, production schedules, personnel needs and other resource requirements, in each case without the benefit of long-term purchase commitments based upon the Company's estimate of anticipated future orders. A variety of conditions, both specific to the individual customer and generally affecting the industry, may cause customers to cancel, reduce or delay orders. Cancellations, reductions 13 or delays by a significant customer or by a group of customers would adversely affect the Company, its results of operations, prospects or debt service ability. On occasion, customers may require rapid increases in production, which can stress the Company's resources and reduce margins. Although the Company has increased its manufacturing capacity, there can be no assurance that the Company will have sufficient capacity at any given time to meet its customers' demands if such demands exceed anticipated levels. In addition to the variability resulting from the short-term nature of its customers' commitments, other factors have contributed, and may contribute in the future, to significant periodic and quarterly fluctuations in the Company's results of operations. These factors include, among other things, the timing of orders; volume of orders relative to the Company's capacity; customers' announcements, introductions and market acceptance of new products or new generations of products; evolution in the life cycles of customers' products; timing of expenditures in anticipation of future orders; effectiveness in managing manufacturing processes; changes in cost and availability of labor and components; product mix; pricing and availability of competitive products and services; and changes or anticipated changes in economic conditions. The Company uses existing design programs to gauge expected future volume of business. Completion of the design is dependent, however, on a variety of factors, including the customer's changing needs, and not every design is successful in meeting those needs. Utilization of Arizona Facility The Company has made substantial expenditures in constructing and equipping its facility in Tempe, Arizona, with a high-volume LCD manufacturing line. The high-volume line was placed in service in 1996, although the Company committed a significant amount of time and resources in 1996 and 1997 to the development of manufacturing processes on the line. The Company utilizes the high-volume line to produce a substantial portion of its own requirements for LCD glass. The successful utilization of the LCD glass line will require the Company (i) to produce LCD glass on a timely and cost-effective basis at quality levels at least equal to the LCD glass available from independent suppliers and (ii) to utilize the LCD glass it produces in devices it designs and manufactures in a manner satisfactory to its customers. The Company experienced some delays in fully implementing its LCD glass manufacturing operations in 1996, and no assurance can be given that the Company will not experience problems or delays in the future in conducting its LCD glass manufacturing operations. Any such problems could result in the lengthening of the Company's delivery schedules, reductions in the quality or performance of the Company's design and manufacturing services, and reduced customer satisfaction. Such problems also could require the Company to purchase its LCD glass requirements from third parties and could delay the Company's ability to recover its investment in the high-volume LCD line. In addition, in 1998 the Company intends to add additional equipment to the LCD glass line to enhance its ability to manufacture LCoS(TM) microdisplays. See "Description of Business-Research and Development" contained in Item 1 of this Report. Manufacturing a LCoS(TM) microdisplay is a significantly different procedure than manufacturing a typical liquid crystal display. The manufacturing of microdisplays will require the Company to overcome challenges, including the use of a new material (silicon), the modification of equipment and processes to accommodate the miniature size of the product, the implementation of new scribing and breaking techniques, the incorporation of new handling procedures, the maintenance of cleaner manufacturing environments, and the ability to master tighter tolerances in the manufacturing process. Utilization of the LCD line for microdisplays also will require higher yields because of the significant cost of the silicon backplane. Management of Growth The Company's revenue expanded substantially during the period from 1993 through 1995, but declined significantly in 1996 as a result of the discontinuation of a few significant programs from its major customer. During 1997, however, the Company increased the number of its manufacturing and design programs and the 14 Company plans to further expand the number and diversity of its programs in the future. At the end of 1997, the Company had 76 manufacturing and design programs versus 69 at the end of 1996. The Company's ability to manage its planned growth effectively will require it to enhance its operational, financial, and management systems, to expand its facilities and equipment, and to successfully hire, train, and motivate additional employees, including the technical personnel necessary to operate its new LCD glass production facility in Arizona. The failure of the Company to manage its growth on an effective basis could have a material adverse effect on the Company's operations. As the Company expands and diversifies its product and customer base, it may have to further increase its selling and administrative expenses. The Company may be required to increase staffing and other expenses as well as its expenditures on capital equipment and leasehold improvements in order to meet the anticipated demand of its customers. Customers, however, generally do not commit to firm production schedules for more than a short time in advance. The Company's profitability would be adversely affected if the Company increases its expenditures in anticipation of future orders that do not materialize. Customers also may require rapid increases in design and production services that place an excessive short-term burden on the Company's resources. Dependence on Key Personnel The Company's development and operations depend substantially on the efforts and abilities of its senior management and technical personnel, including David R. Buchanan, who has served as the Chairman of the Board since 1986 and as President and Chief Executive Officer of the Company since 1987. The competition for qualified management and technical personnel is intense. The loss of services of one or more of its key employees or the inability to add key personnel (including those required for its LCD glass production facility) could have a material adverse effect on the Company. See "Description of Business - Executive Officers" contained in Item 1 of this Report. The Company does not have any fixed-term agreements with, or key person life insurance covering, any officer or employee. The Company, however, maintains noncompetition and nondisclosure agreements with its key personnel. Protection of Intellectual Property The Company relies on a combination of patent, trade secret, and trademark laws, confidentiality procedures, and contractual provisions to protect its intellectual property. The Company seeks to protect certain of its technology under trade secret laws, which afford only limited protection. There can be no assurance that any of the Company's pending patent applications will be issued or that intellectual property laws will protect the Company's intellectual property rights. In addition, there can be no assurance that any patent issued to the Company will not be challenged, invalidated or circumvented or that the rights granted thereunder will provide competitive advantages to the Company. Despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to obtain and use information that the Company regards as proprietary. Furthermore, there can be no assurance that others will not independently develop similar technology or design around any patents issued to the Company. Moreover, effective protection of intellectual property rights may be unavailable or limited in certain foreign countries in which the Company operates. In particular, the Company may be afforded only limited protection of its intellectual property rights in China. The Company may in the future be notified that it is infringing certain patents or other intellectual property rights of others, although there are no such pending lawsuits against the Company or unresolved notices that it is infringing intellectual property rights of others. No assurance can be given that in the event of such infringement, licenses could be obtained on commercially reasonable terms, if at all, or that litigation will not occur. The failure to obtain necessary licenses or other rights or the occurrence of litigation arising out of such claims could materially adversely affect the Company, its results of operations, prospects or debt service ability. Possible Volatility of Stock Price The market price of the Company's Common Stock increased dramatically during the three-year period ended December 31, 1994, but declined significantly during 1995 and 1996. See "Market for Common Equity and 15 Related Stockholder Matters" contained in Item 5 of this Report. The trading price of the Company's Common Stock in the future could continue to be subject to wide fluctuations in response to various factors, including quarterly variations in operating results of the Company, actual or anticipated announcements of technical innovations or new product developments by the Company or its competitors, changes in analysts' estimates of the Company's financial performance, general conditions in the electronics industry, worldwide economic and financial conditions, and other events or factors. In addition, the stock market has experienced extreme price and volume fluctuations which have particularly affected the market prices for many high technology companies and which often have been unrelated to the operating performance of such companies. These broad market fluctuations and other factors may adversely affect the market price of the Company's Common Stock. Competition The industries which the Company serves are intensely competitive and have been characterized by price erosion, rapid technological change, and foreign competition. The Company competes with major domestic and international companies, many of which have greater market recognition and substantially greater financial, technical, marketing, distribution, and other resources than the Company possesses. Emerging companies also may increase their participation in the user interface device market. The ability of the Company to compete successfully depends on a number of factors both within and outside its control, including the quality, performance, reliability, features, ease of use, pricing, and diversity of its product solutions; foreign currency fluctuations, which may cause a foreign competitor's products to be priced significantly lower than the Company's products; the quality of its customer services; its ability to address the needs of its customers; its success in designing and manufacturing new product solutions, including those implementing new technologies; the availability of adequate sources of raw materials and other supplies at acceptable prices; its efficiency of production; the rate at which customers incorporate the Company's user interface devices into their own products; product solution introductions by the Company's competitors; the number, nature, and success of its competitors in a given market; and general market and economic conditions. The Company currently competes principally on the basis of the technical innovation and performance of its user interface devices, including their ease of use and reliability, as well as on cost and timely design, manufacturing, and delivery schedules. The Company's competitive position could be adversely affected if one or more of these customers increase their own capacity and decide to design and manufacture their own user interface devices, to use standard devices, or to outsource with a competitor. There is no assurance that the Company will continue to be able to compete successfully in the future. See "Description of Business - Competition" contained in Item 1 of this Report. Shortage of Raw Materials and Supplies The principal raw materials used in producing the Company's product solutions consist of gallium arsenide and gallium phosphorous wafers and die, LCD glass, driver die, circuit boards, molded plastic parts, lead frames, wire, chips, and packaging materials, most of which are acquired from Asian sources. The Company does not have long-term contracts with its suppliers. The Company believes that there are alternative sources of supplies for most of these materials. Many materials, however, must be obtained from foreign suppliers, which subjects the Company to certain risks, including supply interruptions and currency price fluctuations. Purchasers of these materials, including the Company, experience difficulty from time to time in obtaining such materials. Although some component leadtimes have lengthened, the Company's suppliers currently are adequately meeting the requirements of the Company, and the Company's ability to produce a substantial portion of its own requirements for LCD glass in its Arizona facility has reduced the Company's dependence on foreign suppliers of LCD glass. The Electronics Industry: Cyclicality and Capital Requirements The electronics industry has experienced significant economic downturns at various times, characterized by diminished product demand, accelerated erosion of average selling prices, and production over-capacity. In addition, 16 the electronics industry has been characterized by cyclicality. The Company has sought to reduce its exposure to industry downturns and cyclicality by providing design and production services for leading companies in rapidly expanding segments of the electronics industry. However, the Company may experience substantial period-to-period fluctuations in future operating results because of general industry conditions or events occurring in the general economy. There is no assurance that the Company will continue to experience increased demand. To remain competitive, the Company must continue to make significant investments in research and development, equipment, and facilities. As a result of the increase in fixed costs and operating expenses related to these capital expenditures, the Company's operating results may be adversely affected if its net sales do not increase sufficiently to offset these increased costs. The Company from time to time may seek additional equity or debt financing to provide for the capital expenditures required to maintain or expand the Company's design and production facilities and equipment. The timing and amount of any such capital requirements cannot be predicted at this time. There can be no assurance that any such financing will be available on acceptable terms. If such financing is not available on satisfactory terms, the Company may be unable to expand its business or develop new customers at the rate desired and its operating results may be adversely affected. Debt financing increases expenses and must be repaid regardless of operating results. Equity financing could result in additional dilution to existing stockholders. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" contained in Item 7 of this Report. Environmental Regulation The operations of the Company result in the creation of small amounts of hazardous waste, including various epoxies, gases, inks, solvents, and other wastes. The Company, therefore, is subject to federal, state, and local governmental regulations related to the use, storage, discharge, and disposal of toxic, volatile, or otherwise hazardous chemicals used in its design and manufacturing processes. The amount of hazardous waste produced by the Company may increase in the future depending on changes in the Company's operations. The failure by the Company to comply with present or future environmental regulations could result in fines being imposed on the Company, suspension of production, or a cessation of operations. Compliance with such regulations could require the Company to acquire costly equipment or to incur other significant expenses. Any failure by the Company to control the use of, or adequately restrict the discharge of, hazardous substances could subject it to future liabilities. In January 1991, the Company received a notice of potential liability respecting a landfill site near the Company's former property in Barkhamsted, Connecticut from the United States Environmental Protection Agency. No further administrative action was taken against the Company and the Company was verbally advised by a representative of the EPA that the Company will have no liability with respect to this matter. In a separate matter, the Company has removed contamination and continues to conduct periodic chemical monitoring at the Company's former Connecticut property. There can be no assurance that other environmental problems will not be discovered in the future which could subject the Company to future costs or liabilities. See "Description of Business - Environmental Regulation" contained in Item 1 of this Report. Change in Control Provisions The Company's Restated Certificate of Incorporation (the "Restated Certificate") and the Delaware General Corporation Law (the "Delaware GCL") contain provisions that may have the effect of making more difficult or delaying attempts by others to obtain control of the Company, even when these attempts may be in the best interests of stockholders. The Restated Certificate also authorizes the Board of Directors, without stockholder approval, to issue one or more series of Preferred Stock which could have voting and conversion rights that adversely affect or dilute the voting power of the holders of Common Stock. The Delaware GCL also imposes conditions on certain business combination transactions with "interested stockholders" (as defined therein). 17 Year 2000 Compliance Many currently installed computer systems and software products are coded to accept only two-digit entries to represent years. For example, the year "1997" would be represented by "97". These systems and products will need to be able to accept four-digit entries to distinguish years beginning with 2000 from prior years. As a result, systems and products that do not accept four-digit year entries will need to be upgraded or replaced to comply with such "Year 2000" requirements. Currently, the Company is reviewing its internal systems to determine the impact of the Year 2000 requirements. The Company believes that its internal systems are Year 2000 compliant or will be upgraded or replaced prior to the need to comply with Year 2000 requirements, and the Company does not anticipate any material disruption in its operations as the result of any failure by the Company to be compliant. The Company believes that the overall cost of compliance will not be material and expenses such compliance costs when incurred. It is uncertain whether the Company's customers and suppliers will have Year 2000 issues that may affect the Company, but the Company currently is developing a plan to evaluate the Year 2000 compliance status of its customers and suppliers. Rights to Acquire Shares At December 31, 1997, 22,000 shares of Common Stock were reserved for issuance upon exercise of options previously granted under the Company's 1997 Stock Option Plan; 9,000 shares of Common Stock were reserved for issuance upon exercise of options previously granted under the Company's 1994 Automatic Stock Option Plan; 309,750 shares of Common Stock were reserved for issuance upon exercise of options previously granted under the Company's 1993 Stock Option Plan; and 210,220 shares of Common Stock were reserved for issuance upon exercise of options previously granted under the Company's 1990 Stock Option Plan. The weighted average exercise price of those shares is $11.01 per share. During the terms of such options, the holders thereof will have an opportunity to profit from an increase in the market price of Common Stock with resulting dilution in the interests of holders of Common Stock. The existence of such stock options may adversely affect the terms on which the Company can obtain additional financing, and the holders of such options can be expected to exercise such options at a time when the Company, in all likelihood, would be able to obtain additional capital by offering shares of its Common Stock on terms more favorable to the Company than those provided by the exercise of such options. Repurchase of Common Stock In August 1996, the Board of Directors authorized the repurchase from time to time of up to one million shares of the Company's Common Stock on the open market or in negotiated transactions, depending on market conditions and other factors. The repurchase of shares by the Company would reduce the Company's capital. If the Company obtains financing from other sources for such repurchases, the liabilities of the Company would increase. The reduction in capital or increase in liabilities could adversely affect the Company's ability to expand its business or commit resources to needed expenditures. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" contained in Item 7 of this Report. A significant reduction in the number of shares outstanding on the open market could also increase the volatility of the stock as a result of the reduced supply of available shares on the open market. Shares Eligible for Future Sale; Potential Depressive Effect on Stock Price Currently, Rule 144 under the Securities Act of 1933, as amended (the "Securities Act"), provides that each person who beneficially owns restricted securities with respect to which at least one year has elapsed since the later of the date the shares were acquired from the Company or an affiliate of the Company may, every three months, sell in ordinary brokerage transactions or to market makers an amount of shares equal to the greater of 1 percent of the Company's then-outstanding Common Stock or the average weekly trading volume for the four weeks prior to the proposed sale of such shares. An aggregate of 957,908 shares of Common Stock held by all the executive officers and directors of the Company currently are available for sale under Rule 144. Sales of substantial amounts of Common Stock by the stockholders of the Company, or even the potential for such sales, may have a depressive effect on the market price of the Common Stock and could impair the Company's ability to raise capital through the sale of its equity securities. 18 Dividends The Company has never paid any cash dividends on its Common Stock and does not anticipate that it will pay cash dividends in the near term. Instead, the Company intends to apply any earnings to the expansion and development of its business. See "Market for Common Equity and Related Stockholder Matters" contained in Item 5 of this Report. Cautionary Statement Regarding Forward-Looking Statements Certain statements and information contained in this Report under the headings "Description of Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" concerning future, proposed, and anticipated activities of the Company, certain trends with respect to the Company's revenue, operating results, capital resources, and liquidity or with respect to the markets in which the Company competes or the electronics industry in general, and other statements contained in this Report regarding matters that are not historical facts are forward-looking statements, as such term is defined in the Securities Act. Forward-looking statements, by their very nature, include risks and uncertainties, many of which are beyond the Company's control. Accordingly, actual results may differ, perhaps materially, from those expressed in or implied by such forward-looking statements. Factors that could cause actual results to differ materially include those discussed elsewhere under this Item 1, "Description of Business - Special Considerations" in Item 1 of this Report. ITEM 2. DESCRIPTION OF PROPERTY The Company occupies a 97,000 square foot facility in Tempe, Arizona, which houses its United States based manufacturing operations; its research, development, engineering, design, and corporate functions; and the largest fully automated LCD glass manufacturing operations in North America. The Company entered into a ground lease through December 31, 2069, subject to renewal and purchase options as well as early termination provisions. Costs to construct, furnish, and equip the new facility were approximately $24.0 million. The Company leases approximately 3,500 square feet of office space in Swindon, United Kingdom, where it maintains its European administrative and executive offices. The Company leases approximately 60,000 square feet of manufacturing space in Manila, the Philippines. Approximately 40,000 square feet is subject to a lease which expires on December 31, 1999, and the remaining 20,000 square feet is subject to a lease which expires on March 31, 1999, and is renewable from year to year thereafter. ITEM 3. LEGAL PROCEEDINGS There are no legal proceedings to which the Company is a party or to which any of its properties are subject, other than routine litigation incident to the Company's business which is covered by insurance or an indemnity or which are not expected to have a material adverse effect on the Company. It is possible, however, that the Company could incur claims for which it is not insured or that exceed the amount of its insurance coverage. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable 19 PART II ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock has been listed on the New York Stock Exchange ("NYSE") under the symbol "TFS" since December 29, 1994. The Company's Common Stock was listed on the American Stock Exchange ("AMEX") from January 28, 1993 through December 28, 1994. The Company's Common Stock was listed on the AMEX Emerging Company Marketplace from March 18, 1992 until January 27, 1993, and on the Nasdaq National Market system from May 1, 1990 until March 17, 1992. The following table sets forth the quarterly high and low prices of the Company's Common Stock for the periods indicated, adjusted to reflect the two-for-one split of the Common Stock effected as a stock dividend in May 1994.
High Low ---- --- 1993: First Quarter.............................................................. $ 3 7/8 $ 1 3/4 Second Quarter............................................................. 8 3 7/16 Third Quarter.............................................................. 12 1/16 6 3/8 Fourth Quarter............................................................. 17 5/8 10 7/8 1994: First Quarter.............................................................. $ 30 7/8 $ 16 9/16 Second Quarter............................................................. 29 15/16 20 Third Quarter.............................................................. 46 1/2 26 1/4 Fourth Quarter............................................................. 50 28 3/4 1995: First Quarter.............................................................. $ 38 3/8 $ 20 5/8 Second Quarter............................................................. 38 7/8 22 3/8 Third Quarter.............................................................. 36 3/4 24 1/4 Fourth Quarter............................................................. 26 1/2 16 1996: First Quarter.............................................................. $ 21 7/8 $ 11 5/8 Second Quarter............................................................. 14 1/8 9 1/8 Third Quarter.............................................................. 13 8 3/4 Fourth Quarter............................................................. 14 10 5/8 1997: First Quarter.............................................................. $ 16 1/4 $ 12 1/4 Second Quarter ............................................................ 16 11 5/8 Third Quarter.............................................................. 26 7/8 14 1/4 Fourth Quarter............................................................. 26 1/2 16 1/2 1998: First Quarter (through March 6, 1998)...................................... $ 23 1/16 $ 17 3/4
As of March 6, 1998, there were approximately 1,160 holders of record of the Company's Common Stock. The closing sale price of the Company's Common Stock on the NYSE on March 6, 1998 was $21.88 per share. 20 The present policy of the Company is to retain earnings to provide funds for the operation and expansion of its business. The Company has not paid dividends on its Common Stock and does not anticipate that it will do so in the near term. Furthermore, the Company's line of credit with Imperial Bank does not permit the payment of dividends without the consent of Imperial Bank. The payment of dividends in the future will depend on the Company's growth, profitability, financial condition, and other factors which the directors may deem relevant. 21 ITEM 6. SLECTED FINANCIAL DATA The following table summarizes certain selected consolidated financial data of the Company and is qualified in its entirety by the more detailed consolidated financial statements and notes thereto appearing elsewhere herein. The data have been derived from the consolidated financial statements of the Company audited by Arthur Andersen LLP, independent public accountants. All share amounts and per share data have been adjusted to reflect the two-for-one split of the Company's Common Stock effected as a stock dividend in May 1994.
1997 1996 1995 1994 1993 ---- ---- ---- ---- ---- Consolidated Statements of Income (Loss): (in thousands, except per share amounts) Net sales.............................................. $84,642 $60,713 $91,585 $85,477 $38,002 ------- ------ ------ ------ ------ Costs and expenses: Cost of sales........................................ 64,760 58,321 70,481 59,409 26,725 Selling, general and administrative.................. 6,557 5,351 5,386 4,867 3,853 Research and development............................. 5,106 4,065 2,396 1,270 857 ------- ------ ------ ------ ------ 76,423 67,737 78,263 65,546 31,435 ------- ------ ------ ------ ------ Operating income (loss)................................ 8,219 (7,024) 13,322 19,931 6,567 ------- ------ ------ ------ ------ Other income (expense) Interest, net........................................ 548 412 765 859 (117) Other, net........................................... (190) (139) (122) (135) (277) ------- ------ ------ ------ ------ 358 273 643 724 (394) ------- ------ ------ ------ ------ Income (loss) before provision for (benefit from) income taxes and cumulative effect of accounting change.................................... 8,577 (6,751) 13,965 20,655 6,173 Provision for (benefit from) income taxes.............. 3,334 (2,920) 5,548 8,109 2,043 ------- ------ ------ ------ ------ Income (loss) before cumulative effect of accounting change.................................... 5,243 (3,831) 8,417 12,546 4,130 Cumulative effect of accounting change................. -- -- -- -- 924 ------- ------ ------ ------ ------ Net income (loss)...................................... $5,243 $ (3,831) $8,417 $12,546 $5,054 ======= ======= ======= ======= ======= Earnings (loss) per common share Basic................................................. $ 0.67 $ (0.49) $ 1.09 $ 1.88 $ 0.77 ======= ======= ======= ======= ======= Diluted............................................... $ 0.65 $ (0.49) $ 1.04 $ 1.59 $ 0.71 ======= ======= ======= ======= ======= Weighted average number of common shares Basic................................................ 7,854 7,768 7,716 6,666 6,578 ======= ======= ======= ======= ======= Diluted.............................................. 8,090 7,768 8,084 7,890 7,083 ======= ======= ======= ======= ======= Consolidated Balance Sheet Data (at end of period): Working capital........................................ $29,113 $21,513 $22,400 $37,638 $ 7,427 Total assets........................................... 72,835 62,569 63,780 56,280 17,470 Notes payable to banks and long-term debt.............. -- -- 3,000 182 223 Stockholders' equity................................... 56,525 51,184 55,224 46,561 10,202
22 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations Annual Table: Percentages of Net Sales The following table sets forth, for the periods indicated, the percentage of net sales of certain items in the Company's Consolidated Financial Statements. The table and the discussion below should be read in conjunction with the Consolidated Financial Statements and Notes thereto.
Year Ended December 31, ----------------------- 1997 1996 1995 ---- ---- ---- Net sales......................................................... 100.0% 100.0% 100.0% ------ ------- ------ Costs and expenses Cost of sales................................................... 76.5 96.1 77.0 Selling, general, and administrative............................ 7.8 8.8 5.9 Research and development........................................ 6.0 6.7 2.6 ------- ------- ------- 90.3 111.6 85.5 Operating income (loss)........................................... 9.7 (11.6) 14.5 Other income ..................................................... 0.4 0.5 0.7 ------- ------- ------- Income (loss) before provision for (benefit from) income taxes.... 10.1 (11.1) 15.2 Provision for (benefit from) income taxes......................... 3.9 (4.8) 6.1 ------- ------- ------- Net income (loss)................................................. 6.2% (6.3)% 9.1% ======== ========= ========
Year Ended December 31, 1997 Compared with Year Ended December 31,1996 Net sales were $84.6 million for 1997, an increase of 39.4 percent compared with net sales of $60.7 million for 1996. The sales increase was as a result of several new programs in 1997 for a variety of customers, including a major office automation customer. In 1997, the Company's largest customer accounted for net sales of $29.2 million compared with net sales of $39.5 million to that customer in 1996, for an overall decrease of 26.1 percent. The Company's major customer accounted for approximately 34.6 percent of net sales for 1997 compared with approximately 65.1 percent for 1996. One other customer accounted for $27.1 million, or 32 percent of the net sales, in 1997. Cost of sales, as a percentage of net sales, decreased to 76.5 percent for 1997 as compared with 96.1 percent for 1996. The corresponding increase in the gross margin was the result of a number of factors, including decreased provisions for excess and obsolete inventory, decreased unfavorable manufacturing variances occurring as a result of increased manufacturing volume, labor utilization, and material purchases, and a more mature product mix with higher margins and better yields. In the third quarter of 1996, the Company took a special one-time provision for excess and obsolete inventory related primarily to end-of-life programs for which the majority of shipments, expected to occur in the latter part of 1996, never materialized. Furthermore, the Company was required to make significant design modifications to a new product, which also resulted in obsolete inventory. Without the provision for excess and obsolete inventory taken in the third quarter of 1996, the cost of sales, as a percentage of net sales, would have been 84.5 percent for 1996. Selling, general, and administrative expense was $6.6 million for 1997, as compared with $5.4 million in 1996. Selling, general and administrative expenses have increased in absolute terms as a result of increased selling expenses and the addition of administrative personnel. As a result of increased revenue in 1997, however, selling, general, and administrative expense declined to 7.8 percent of net sales from 8.8 percent of net sales in 1996. 23 Research and development expense totaled $5.1 million, or 6.0 percent of net sales, for 1997 as compared with $4.1 million, or 6.7 percent of net sales, for 1996. Research and development expense consists principally of salaries and benefits to scientists and other personnel, related facilities costs, including certain expenses associated with the development of new processes on the LCD line in Tempe, Arizona, and various expenses for projects. Research and development expense has increased as the Company has invested in new technologies and manufacturing processes, developed new potential products, and continued its in-house process development efforts related to the high-volume manufacturing LCD line. The Company believes that continued investments in research and development relating to manufacturing processes and new display technology are necessary to remain competitive in the marketplace, as well as to provide opportunities for growth. Interest income (net) for 1997 was $548,000, up from $412,000 for 1996. The increase in interest income was the result of investing higher average cash balances during the year. Other expenses (net) increased to $190,000 for 1997 from $139,000 for 1996. The increase was primarily attributed to foreign exchange losses. The Company recorded a provision for income taxes of $3.3 million for 1997, as compared with a benefit from income taxes of $2.9 million for 1996. This resulted primarily from having a loss in 1996 as compared with reporting net income in 1997. The overall tax rate for the Company for 1997 was 38.9 percent as compared with 43.3 percent for 1996. The Company expects that the tax rate for 1998 will approximate 40.0 percent. For 1997, the Company reported net income of $5.2 million, or $0.65 per share (diluted), as compared with a net loss of $3.8 million, or $0.49 per share (diluted), for 1996. Without the provision for excess and obsolete inventory taken in 1996, the Company would have reported net income of $158,000, or $0.02 per share, in 1996. Year Ended December 31, 1996 Compared with Year Ended December 31,1995 Net sales were $60.7 million for 1996, a decrease of 33.7 percent compared with net sales of $91.6 million for 1995. The sales decrease was primarily a result of lower order rates from the Company's major customer for existing product programs. During the first quarter of 1996, that customer, which is in the wireless communications industry, informed the Company that it had made an unexpected decision to begin phasing out certain of its cellular products that used display modules which comprised the Company's highest volume, longest running programs. Subsequently, the phase-out of those programs occurred even more quickly than the Company had anticipated or its customer had initially indicated. The sudden and unexpected reduction of those programs was the greatest contributor to the reduced revenue in 1996. The long product development time in the custom display business prevented the Company from quickly replacing the phased-out programs. In 1996, the Company's largest customer accounted for net sales of $39.5 million compared with net sales of $73.7 million to that customer for 1995, for an overall decrease of 46.4 percent. The Company's major customer accounted for approximately 65.1 percent of the net sales for 1996 compared with approximately 80.5 percent for 1995. All other customers accounted for net sales of $21.2 million for 1996 compared with net sales of $17.9 million for 1995. Cost of sales, as a percentage of net sales, increased to 96.1 percent for 1996 as compared with 77.0 percent for 1995. The corresponding decline in the gross margin was the result of a number of factors, including increased provisions for excess and obsolete inventory, manufacturing variances occurring as a result of decreased manufacturing volume and material purchases, and sales of low-margin products. In the third quarter of 1996, the Company took a special one-time provision for excess and obsolete inventory related primarily to end-of-life programs for which the majority of shipments, expected to occur in the latter part of 1996, never materialized. Furthermore, the Company was required to make significant design modifications to a new product, which also resulted in obsolete inventory. Without the provision for excess and obsolete inventory taken in the third quarter, the cost of sales, as a percentage of net sales, would have been 84.5 percent for 1996. Selling, general, and administrative expense was $5.4 million for 1996, the same as in 1995. As a result of reduced revenue in 1996, however, selling, general, and administrative expense rose to 8.8 percent of net sales from 5.9 percent of net sales in 1995. 24 Research and development expense totaled $4.1 million, or 6.7 percent of net sales, for 1996 as compared with $2.4 million, or 2.6 percent of net sales, for 1995. Research and development expense consists principally of salaries and benefits to scientists and other personnel, related facilities costs, including certain expenses associated with the start-up and continued operations of the LCD line in Tempe, Arizona, and various expenses for projects. Interest income (net) for 1996 was $412,000, down from $765,000 for 1995. The decrease in interest income was the result of investing lower average cash balances during the year. Other expenses (net) increased to $139,000 for 1996 from $122,000 for 1995. An increase in closed facilities expenses and foreign exchange losses in 1996 was partially offset by decreased net losses on the sale of assets. The Company recorded a benefit from income taxes of $2.9 million for 1996, as compared with a provision for income taxes of $5.5 million for 1995. This resulted primarily from having a loss in 1996 as compared with reporting net income in 1995. The reported tax rate for the Company in the fourth quarter of 1996 was lower than normal because of an adjustment related to the difference between 1995 tax accruals and taxes actually incurred. This adjustment was $371,000 and was reflected in the reduced tax provision in the fourth quarter of 1996. The overall tax rate for the Company for 1996 was 43.3 percent as compared with 39.7 percent for 1995. For 1996, the Company reported a net loss of $3.8 million, or $0.49 per share (diluted), as compared to net income of $8.4 million, or $1.04 per share (diluted), for 1995. Without the provision for excess and obsolete inventory taken in the third quarter, the Company would have reported net income of $158,000, or $0.02 per share (diluted) in 1996. 25 Quarterly Results of Operations The following table presents unaudited consolidated financial results for each of the eight quarters in the period ended December 31, 1997. The Company believes that all necessary adjustments have been included to present fairly the quarterly information when read in conjunction with the Consolidated Financial Statements. The operating results for any quarter are not necessarily indicative of the results for any subsequent quarter.
Quarters Ended ----------------------------------------------------------------------------------------- (in thousands, except per share amounts) 1997 1996 -------------------------------------------- -------------------------------------------- Mar 31 June 30 Sept 30 Dec 31 Mar 31 June 30 Sept 30 Dec 31 ------ ------- ------- ------ ------ ------- ------- ------ Net sales........................ $16,129 $18,737 $24,074 $25,702 $18,082 $14,457 $13,118 $15,056 ------- ------- ------- ------- ------- ------- ------- ------- Costs and expenses: Cost of sales................... 12,488 14,377 18,511 19,384 14,401 11,944 19,798 12,178 Selling, general, and administrative................. 1,466 1,479 1,822 1,790 1,459 1,471 1,316 1,105 Research and development........ 1,130 1,315 1,314 1,347 1,010 820 1,074 1,161 ------- ------- ------- ------- ------- ------- ------- ------- 15,084 17,171 21,647 22,521 16,870 14,235 22,188 14,444 ------- ------- ------- ------- ------- ------- ------- ------- Operating income (loss).......... 1,045 1,566 2,427 3,181 1,212 222 (9,070) 612 Other income (expense): Interest, net................... 157 154 152 85 19 133 90 170 Other, net...................... (12) (7) (41) (130) (27) (72) (17) (23) ------- ------- ------- ------- ------- ------- ------- ------- Income (loss) before provision for (benefit from) income taxes.. 1,190 1,713 2,538 3,136 1,204 283 (8,997) 759 Provision for (benefit from) income taxes................... 389 685 1,010 1,250 482 113 (3,519) 4 ------- ------- ------- ------- ------- ------- ------- ------- Net income (loss)................ $801 $1,028 $1,528 $1,886 $ 722 $ 170 $(5,478) $ 755 ======= ======= ======= ======= ======= ======= ======= ======= Earnings (loss) per common share Basic................... $0.10 $0.13 $0.19 $0.24 $0.09 $0.02 $(0.70) $0.10 ======= ======= ======= ======= ======= ======= ======= ======= Diluted................. $0.10 $0.13 $0.19 $0.23 $0.09 $0.02 $(0.70) $0.09 ======= ======= ======= ======= ======= ======= ======= ======= Weighted average number of common shares Basic............... 7,759 7,855 7,874 7,900 7,737 7,775 7,779 7,780 ======= ======= ======= ======= ======= ======= ======= ======= Diluted............. 8,048 8,071 8,181 8,168 8,040 8,032 7,779 8,049 ======= ======= ======= ======= ======= ======= ======= =======
Liquidity and Capital Resources During 1997, the Company generated $6.8 million in cash flow from operations as compared with $12.2 million during 1996. The decrease in cash flow from operations was primarily due to the increase in accounts receivable (versus the reductions in accounts receivable that occurred in 1996) and the increase in inventory. The increase in inventory and accounts receivable occurred primarily as a result of the increased sales activity in 1997. Depreciation expense in 1997 was $4.1 million versus $3.6 million in 1996. This increase was primarily as a result of an increased number of starts on the LCD manufacturing line in Tempe, Arizona. The high-volume LCD line is depreciated on a units of production method based on units started. The Company anticipates that depreciation will rise in 1998 as a result of additional capital expenditures in 1998, including a new building and equipment for the proposed manufacturing facility in China, the installation of additional equipment in its Manila manufacturing location, and the installation of equipment in Tempe, Arizona to manufacture liquid crystal on silicon (LCoS(TM)) microdisplays. The Company's working capital was $29.1 million at December 31, 1997, up from $21.5 million at December 31, 1996. The Company's current ratio at December 31, 1997 was 3.1-to-1 as compared with a current ratio of 3.2-to-1 at December 31, 1996. Including its cash and loan commitments, the Company had over $31.7 million in readily available funds on December 31, 1997. 26 In May 1997, the Company entered into a new $15.0 million revolving line of credit with Imperial Bank, which matures May 22, 1998. At December 31, 1997, no borrowings were outstanding under this credit facility. Advances under the revolving line may be made as Prime Rate Advances, which accrue interest payable monthly at the bank's prime lending rate, or as LIBOR Rate Advances, which bear interest at 175 basis points in excess of the LIBOR Base Rate. The Company's subsidiary, Three-Five Systems Limited, has established an annually renewable credit facility with a United Kingdom bank, Barclays Bank PLC, in order to fund its working capital requirements. The facility provides $350,000 of borrowing capacity secured by accounts receivable of Three-Five Systems Limited. Advances under the credit facility are based on accounts receivable, as defined, and accrue interest, which is payable quarterly, at the bank's base rate plus 200 basis points. The United Kingdom credit facility matures June 20, 1998. Three-Five Systems Limited had no borrowings outstanding under this line of credit at December 31, 1997. In 1996, the Board of Directors authorized the repurchase from time to time of up to one million shares of the Company's Common Stock on the open market or in negotiated transactions, depending on market conditions and other factors. As of December 31, 1997, 22,500 treasury shares had been purchased by the Company at a total cost of $253,000. Capital expenditures during 1997 were approximately $3.0 million, as compared with $948,000 during 1996. Capital expenditures for 1997 consisted primarily of manufacturing and office equipment for the Company's operations in Manila and Arizona and laboratory equipment for research and development. The Company anticipates that it will increase its capital expenditures during 1998. Those expenditures will primarily relate to advanced manufacturing processes, the high-volume LCD line, and necessary manufacturing equipment. The Company anticipates that it will spend approximately $3.0 million in early 1998 on the capital equipment needed to manufacture LCoS(TM) microdisplays. A major portion of that equipment already is on order. The Company also has decided to expand its overseas manufacturing capabilities in 1998 by opening a manufacturing facility in Beijing, China. The Company anticipates the facilities and capital cost for China in 1998 to be approximately $8.0 million. The Company anticipates that accounts receivable and inventory will rise in 1998 if revenue levels increase as currently anticipated. The Company believes that its existing capital, and anticipated cash flow from operations and credit lines will provide adequate sources to fund operations and planned expenditures throughout 1998. Should the Company encounter additional cash requirements, however, the Company may have to expand its loan commitments or pursue alternate methods of financing or raising capital. Effects of Inflation and Foreign Currency Exchange Fluctuations The results of operations of the Company for the periods discussed have not been significantly affected by inflation or foreign currency fluctuations. The Company generally sells its products and services and negotiates purchase orders with its foreign suppliers in United States dollars. An exception is the Company's Sub-Assembly Agreement in the Philippines, which is based on a fixed conversion rate, exposing the Company to exchange rate fluctuations with the Philippine peso. Although the Company has not incurred any material exchange gains or losses to date, there has been some minor benefit as a result of the recent peso devaluation. If the peso devaluation were to continue, a substantial portion of the benefit to the Company will likely be offset by an increase in the Philippine labor rates and costs. There can be no assurance that fluctuations and currency exchange rates in the future will not have an adverse affect on the Company's operations. The Company is planning to commence operations in China in 1998. Although the Chinese currency currently is stable, there can be no assurance that it will remain so in the future. The Company from time to time may enter into hedging transactions in order to minimize its exposure to currency rate fluctuations. Business Outlook and Risk Factors This Business Outlook section has numerous forward-looking statements. Some of the risk factors associated with those forward-looking statements are set forth in "Risk Factors" below. Other important risk factors are set forth under "Special Considerations" in Item 1 of this Report. 27 The Company offers advanced design and manufacturing services to original equipment manufacturers. The Company specializes in custom displays and front panel displays utilizing liquid crystal display (LCD) and light emitting diode (LED) components and technology. The Company experienced substantial growth from 1993 through 1995 with such growth dependent primarily upon the Company's participation in the substantial growth of the wireless communications market and sales to a single major customer in that industry. In 1996, the Company's sales declined, largely as a result of the phase-out by that major customer of a significant family of programs in early 1996. In 1997, sales returned to pre-1996 levels primarily as a result of several new programs and customers, including a major office automation customer. The Company had substantial growth in its revenues in 1997 with a 39.4 percent rate of growth over 1996. Fourth quarter revenues in 1997 were almost 59.3 percent greater than first quarter revenues in 1997. This growth occurred because several new programs began production in the second and third quarters of 1997 while many existing programs were in the middle of their life cycles. In 1997, more than 80 percent of revenue occurred in the second, third and fourth quarters. In 1998, the Company anticipates that this type of revenue pattern will be repeated. The Company believes that a pattern of seasonality may be developing as OEMs with retail products develop shorter product life cycles and introduce new programs early in the year following holiday sales. Although the Company expects some significant new programs to begin ramping up production in 1998, several existing programs are nearing the completion of their natural life cycles. Previously, the Company expected some of the new programs to begin to ramp up production in the first quarter prior to the completion of the mature programs. As the result of customer design issues, it now appears that those new programs will not begin to ramp up until the second and third quarter in a manner similar to the ramp up that occurred in 1997. As a result, the revenue from those new programs will not be available in the first quarter to offset the loss of revenue occurring from the completion of the older programs. Thus, sales in the first quarter of 1998 will decline over sales in the fourth quarter of 1997. The Company's estimated backlog of manufacturing revenue for programs currently in design is substantially greater than it was at the end of 1996. Therefore, if additional programs currently in development begin to ramp up their production levels in the second and third quarter of 1998 as anticipated, the Company should continue its year over year growth rate in 1998. In the past several quarters, the Company has undertaken substantial efforts to diversify its business, broaden its customer base, and expand its markets, and the Company intends to continue those efforts. The Company's historical major customer, which accounted for approximately 80 percent of the Company's revenue in 1995, accounted for 65 percent of the Company's revenue in 1996 and slightly less than 35 percent of the Company's revenue in 1997. This reduced percentage occurred as a result of the increased sales to other customers and reduced product selling prices and overall revenue from that major customer. Late in 1997, that major customer instituted an allocation process for awarding 1998 LCD module business. Although the allocation does not provide a guarantee of business, the Company anticipates that business with that customer will increase in 1998 at a rate faster than increases in business with other customers. Therefore, the percentage of revenue attributed to that wireless communications customer may increase in 1998, but the current business plan of the Company targets that customer to account for no more than 50 percent of its 1998 revenue. Another customer also accounted for 32 percent of the Company's revenue in 1997, but the Company expects this percentage to decline significantly over the next few quarters as current programs reach the end of their cycles and replacement programs with lower selling prices are introduced. The Company's gross margins are impacted by several factors, including manufacturing efficiencies, product differentiation, product uniqueness, billings for non-recurring engineering services, engineering costs, product mix, and volume pricing. Generally, higher-volume programs using more generic, low-information content LCD displays have lower margins. As the production levels of some of the Company's new high-volume programs increase in early 1998, the gross margins on those programs, which are generally lower, may have more of an impact on the Company's overall margins. In addition, many of the Company's competitors are Asian suppliers, and a strong dollar gives a competitive pricing advantage to those suppliers. Thus, the Company may see competitive margin pressure from Asian suppliers, particularly those in Korea and Japan. It is a goal of the Company, however, for increased manufacturing efficiencies to occur on those high-volume programs in order to maintain its gross margins at existing 28 levels, although those efficiencies should not positively impact the Company's gross margins until after the first quarter of 1998. The Company also expects that more advanced display modules, expected to be introduced later in 1998, will command higher margins and should enable the Company to maintain its overall 1998 gross margins in the same range as the gross margins in 1997. As the Company expands and diversifies its product and customer base, it may have to further increase its selling, general, and administrative expenses. Serving a variety of customers with complex and differing issues requires increased personnel committed to those customers. As a result, the actual dollar amount of the selling, general, and administrative expenses in 1998 should be 20 to 25 percent greater than in 1997, although SG&A expenditures as a percentage of net sales should continue decreasing in 1998. The Company believes that continued investments in research and development relating to new display technology and manufacturing processes are necessary to remain competitive in the marketplace as well as to provide opportunities for growth. In 1997, the Company continued to expand and intensify its internal research and development to focus on proprietary display products rather than emphasizing manufacturing process improvements. Use of the LCD manufacturing line in Tempe, Arizona as a resource for the testing of the new ideas is the key to the development of these products, some of which will be proprietary and not available from other display manufacturers. In addition, the development of the high-volume manufacturing LCD line has helped reduce the Company's dependence on foreign suppliers of LCD glass. The Company also intends to pursue technologies being developed in related fields. The Company operates the highest-volume fully automated LCD manufacturing line in North America. As a result, several companies have approached the Company about potential alliances. The Company believes that a strategic alliance with one or more of those companies could minimize the cost of entry into new markets and new technologies. In August 1997, National Semiconductor Corporation and the Company entered into a strategic supplier alliance agreement for the development and manufacture of LCoS(TM) microdisplays. Under the alliance, the two companies are working together in developing the LCoS(TM) technology with each company focusing on its core competency of silicon and LCDs, respectively. The Company also is considering licensing technologies from other companies that could be optimized on the LCD manufacturing line. This internal and external focus on research and development will continue indefinitely. As a result, the actual dollar amount of such expenditures in 1998 should increase over 1997, although research and development expenditures should decrease as a percentage of net sales in 1998. The Company has decided to establish manufacturing operations in The People's Republic of China. A site was recently selected in Beijing, and an individual with management experience in China was hired to act as the General Manager and Vice President for the China operations. The Company plans to establish Chinese manufacturing operations in 1998 for several reasons. First, based upon its growth expectations for 1998 in the European and United States marketplaces, the Company anticipates a need for manufacturing capacity beyond what is available at its Philippine location. China was selected because of the desire to diversify manufacturing locations and because of the cost benefits that are expected to be achieved in China. The Company also believes that locating a portion of its manufacturing operations in China will create synergistic opportunities for the Company because many of the components used in the Company's products are manufactured in China. Second, many of the Company's existing and potential customers maintain manufacturing operations near the proposed China location. Despite the current Asian situation, those customers continue to require LCD modules and the Company participates very little in that market. Currently, there are few LCD module manufacturers in China. Under current Chinese government rules, however, OEMs in China have a strong motivation to utilize locally manufactured components. The Company expects some start up costs in 1998 associated with its manufacturing operations in China in advance of the first revenues from China, which are expected to occur in the third or fourth quarter of 1998. Other important risk factors are set forth under "Special Considerations" in Item 1 of this Report. 29 Risk Factors Forward-looking statements in this Report include revenue, margin, expense, and earnings analysis for 1998 as well as the Company's expectations relating to operations in China, future technologies, and future design and production orders. The Company's future operating results may be affected by various trends, developments, and factors that the Company must successfully manage in order to achieve its goals. In addition, there are trends, developments, and factors beyond the Company's control that may affect its operations. The cautionary statements and risk factors set forth below and elsewhere in this document, and in the Company's other filings with the Securities and Exchange Commission, identify important trends, factors, and currently known developments that could cause actual results to differ materially from those in any forward-looking statements contained in this Report and in any written or oral statements of the Company. As noted previously, two customers currently are responsible for about two-thirds of the Company's revenue. As a result, the majority of the Company's revenue comes from a core customer base. Any material delay, cancellation, or reduction of orders from one or more of those core customers could have a material adverse effect on the Company's operations. The Company expects the two-thirds concentration levels from those two combined customers in 1997 to continue into 1998. Although the trend of the Company is to enter into more manufacturing contracts with its customers, the principal benefit of these contracts is to clarify order lead times, inventory risk allocation, and similar matters and not to provide firm, long-term volume purchase commitments. The Company has no firm long-term volume purchase commitments from its customers. As a result, customer commitments can be canceled and expected volume levels can be changed or delayed. The timely replacement of canceled, delayed, or reduced commitments cannot be assured and, among other things, could result in the Company holding excess and obsolete inventory or having unfavorable manufacturing variances as a result of under-absorption. These risks are exacerbated because the Company expects that a majority of its sales will be to customers in the retail electronics industry, which is subject to severe competitive pressures, rapid technological change, and obsolescence. Another risk inherent in custom manufacturing is the satisfactory completion of design services and securing of production orders. A significant portion of the Company's anticipated revenue for the future will come from programs currently in the design or pilot production stage. Completion of the design is dependent on a variety of factors, including the customer's changing needs, and not every design is successful in meeting those needs. In addition, some designs test new theories or applications and may not meet the desired results. Failure of a design order to achieve the customer's desired results could result in a material adverse effect on the Company's operations if the expected production order for that product was significant. Even when a design is satisfactorily completed, the customer may terminate or delay the program as a result of marketing or other pressures. Finally, the Company is frequently one of several sources to a customer on a program. Therefore, the Company could satisfactorily complete all phases of the design and still fail to secure significant production orders on that program because of competitive issues. The Company plans to introduce several new products over the next few years. These new products will require significant expenditures, including expenses for custom integrated circuits as well as various capital expenditures for manufacturing capability. For example, the Company estimates that its initial capital expenditures for production of LCoS(TM) microdisplays will require approximately $3.0 million. The failure of the Company to sell one or more of these new technologies, including LCoS(TM) microdisplays, for any reason could have a material adverse impact on the Company. In addition to capital expenditures for new products, the Company is currently spending research and development dollars on several new technologies that it plans to introduce in the future. There is a risk that some or all of those technologies may not successfully make the transition from the research and development lab to cost-effective manufacturing capability, and such failure could have a material adverse effect on the Company. Risks include technology problems, competitive cost issues, and yield problems. In addition, even if a new technology proves to be manufacturable, it may not be accepted by the Company's customer and the customer's marketplace because of price or technology issues or it may compare unfavorably with products previously introduced by others. 30 The Company designs and manufactures products based on firm quotes. As a result, the Company bears the risk of component price increases, which could adversely affect the Company's gross margins. In addition, the Company depends on certain suppliers, and the unavailability or shortage of materials could cause delays or lost orders. Recently, several material components of some of the Company's major programs have been subject to allocation because of shortages by vendors and continued or increased shortages could have a material adverse effect on the Company in the future. In addition, although most of the components purchased by the Company are purchased from vendors in Asian countries unaffected by the current currency crisis, a significant portion of the silicon drivers purchased by the Company are manufactured in Korea and Japan. The instability in certain Asian countries could cause supply problems with respect to these components. The Company's primary competitors are located in Asia, including, Japan, Korea, and Hong Kong, and most of the Company's customers are U.S.-based. The recent currency devaluation of several Asian countries could have an impact on the gross margins of the Company as the competitors' products become cheaper to purchase with a stronger dollar. Many currently installed computer systems and software products are coded to accept only two-digit entries to represent years. For example, the year "1997" would be represented by "97". These systems and products will need to be able to accept four-digit entries to distinguish years beginning with 2000 from prior years. As a result, systems and products that do not accept four-digit year entries will need to be upgraded or replaced to comply with such "Year 2000" requirements. Currently, the Company is reviewing its internal systems to determine the impact of the Year 2000 requirements. The Company believes that its internal systems are Year 2000 compliant or will be upgraded or replaced prior to the need to comply with Year 2000 requirements, and the Company does not anticipate any material disruption in its operations as the result of any failure by the Company to be compliant. The Company believes that the overall cost of compliance will not be material and expenses such compliance costs when incurred. It is uncertain whether the Company's customers and suppliers will have year 2000 issues that may affect the Company, but the Company currently is developing a plan to evaluate the year 2000 compliance status of its customers and suppliers. Finally, the Company's success, especially in penetrating new markets and increasing its OEM customer base, depends to a large extent upon the efforts and abilities of key managerial and technical employees. The loss of services of certain key personnel could have a material adverse effect on the Company. The Company's business also depends upon its ability to continue to attract and retain senior managers and skilled employees. Failure to do so could adversely affect the Company's operations. As a result of the foregoing and other factors, the Company's stock price may be subject to significant volatility, particularly on a quarterly basis. Any shortfall in revenue or earnings from levels expected by investors, analysts, and brokers could have an immediate and significant adverse effect on the trading price of the Company's Common Stock in any given period. Additionally, the Company may not learn of such shortfalls until late in a fiscal quarter, which could result in an even more immediate and adverse effect on the trading price of the Company's Common Stock. Finally, other factors, which generally affect the market for stocks of high technology companies, could cause the price of the Company's Common Stock to fluctuate substantially over short periods for reasons unrelated to the Company's performance. 31 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the financial statements, the report thereon, the notes thereto and the supplementary data commencing at page F-1 of this Report, which financial statements, report, notes and data are incorporated herein by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS The information required by this Item relating to directors of the Company is incorporated by reference to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for the Company's 1998 Annual Meeting of Stockholders. The information required by this Item relating to executive officers of the Company is included in "Description of Business - Executive Officers" contained in Item 1 of this Report. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is incorporated herein by reference to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for the Company's 1998 Annual Meeting of Stockholders. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is incorporated herein by reference to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for the Company's 1998 Annual Meeting of Stockholders. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable. 32 PART IV ITEM 14. EXHIBITS, FINANICAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Financial Statements and Financial Statement Schedule (1) Financial Statements are listed in the Index to Financial Statements on page F-1 of this Report. (2) Financial Statement Schedule: Schedule II Valuation and Qualifying Accounts and Reserves is set forth on page S-1 of this Report. Other schedules are omitted because they are not applicable, not required or because required information is included in the consolidated financial statements or notes thereto. (b) Reports on Form 8-K Not applicable. (c) Exhibits
Exhibit Number Exhibits - ------ -------- 2 Amended and Restated Agreement and Plan of Reorganization(1) 3(a) Restated Certificate of Incorporation of the Company(2) 3(b) Bylaws of the Company(1) 10(a) 1990 Incentive Stock Option Plan(1) 10(c) Line of Credit Agreement between Three-Five Systems Limited and Barclays Bank, PLC(1) 10(d) Sub-Assembly Agreement between Three-Five Systems, Inc. and TEAM Pacific Corporation dated February 22, 1995(3) 10(g) Form of Three-Five Systems, Inc. Distributor Franchise Agreement(4) 10(j) 1993 Stock Option Plan(4) 10(k) 1994 Automatic Stock Option Plan(5) 10(l) Lease Agreement between Technology Electronic Assembly and Management (T.E.A.M.) Pacific Corporation and Three-Five Systems Pacific, Inc.(6) 10(m) Lease Agreement between Regent Apparel Corporation and Three-Five Systems Pacific, Inc.(6) 10(o) Lease dated April 1, 1994, between Papago Park Center, Inc. and Three-Five Systems, Inc.(7) 10(t) Credit Agreement dated May 23, 1997 between Three-Five Systems, Inc. and Imperial Bank, together with form of Revolving Promissory Note 10(u) Addendum No. 1 to Sub-Assembly Agreement between Three-Five Systems, Inc. and TEAM Pacific Corporation dated March 12, 1997 10(v) 1997 Employee Stock Option Agreement 10(w) 1998 Stock Option Agreement 10(x) 1998 Director's Stock Plan 10(y) Addendum No. 2 to Sub-Assembly Agreement between Three-Five Systems, Inc. and TEAM Pacific Corporation dated January 1, 1998 21 List of Subsidiaries 23 Consent of Arthur Andersen LLP 27.1 Financial Data Schedule 27.2 Amended and Restated Financial Data Schedule 27.3 Amended and Restated Financial Data Schedules 27.4 Restated Financial Data Schedule - ----------------------------------------
(1) Incorporated by reference to the Registration Statement on Form S-4 of TF Consolidation, Inc. (Registration No. 33-33944) as filed March 27, 1990 and declared effective March 27, 1990. 33 (2) Incorporated by reference to the Registrant's Form 10-QSB for the quarter ended March 31, 1994, as filed with the Commission on or about May 12, 1994. (3) Incorporated by reference to the Registrant's Form 10-KSB for the fiscal year ended December 31, 1994 filed with the Commission on March 22, 1995, as amended by Form 10-KSB/A as filed with the Commission on April 28, 1995. (4) Incorporated by reference to the Registration Statement on Form S-1 (Registration No. 33-74788) as filed on February 3, 1994, and declared effective March 15, 1994. (5) Incorporated by reference to the Registration Statement on Form S-8 (Registration No. 33-88706) as filed on January 24, 1995. (6) Incorporated by reference to the Registrant's Form 10-K for the fiscal year ended December 31, 1995, as filed with the Commission on March 13, 1996. (7) Incorporated by reference to the Registrant's Form 10-K for the fiscal year ended December 31, 1996, as filed with the Commission on March 14, 1997. 34 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 6, 1998 THREE-FIVE SYSTEMS, INC. By /s/ David R. Buchanan -------------------------------------- David R. Buchanan, Chairman of the Board, President, and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Name Title Date ---- ----- ---- /s/ David R. Buchanan Chairman of the Board, President, March 6, 1998 - ------------------------------------ And Chief Executive Officer David R. Buchanan (Principal Executive Officer) /s/ Jeffrey D. Buchanan Vice President - Finance, Administration, and March 6, 1998 - ------------------------------------ Legal; Chief Financial Officer; Secretary; Jeffrey D. Buchanan and Treasurer (Principal Financial and Accounting Officer) /s/ David C. Malmberg Director March 6, 1998 - ------------------------------------ David C. Malmberg /s/ Burton E. McGillivray Director March 6, 1998 - ------------------------------------ Burton E. McGillivray /s/ Gary R. Long Director March 6, 1998 - ------------------------------------ Gary R. Long /s/ Kenneth M. Julien Director March 6, 1998 - ------------------------------------ Kenneth M. Julien
35 THREE-FIVE SYSTEMS, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Report of Independent Public Accountants ....................................F-2 Consolidated Balance Sheets as of December 31, 1997 and 1996 ................F-3 Consolidated Statements of Income (Loss) for the years ended December 31, 1997, 1996 and 1995 .........................................F-4 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1997, 1996 and 1995 .............................F-5 Consolidated Statements of Cash Flows for the years ended December 31, 1997, 1996 and 1995 .........................................F-6 Notes to Consolidated Financial Statements ..................................F-7 F-1 ARTHUR ANDERSEN LLP REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Three-Five Systems, Inc.: We have audited the accompanying consolidated balance sheets of THREE-FIVE SYSTEMS, INC. (a Delaware corporation) and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income (loss), stockholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Three-Five Systems, Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. ARTHUR ANDERSEN LLP Phoenix, Arizona, January 20, 1998. F-2 THREE-FIVE SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS (in thousands, except share amounts) ASSETS December 31, -------------------- 1997 1996 -------- -------- CURRENT ASSETS: Cash and cash equivalents (Note 2) $ 16,371 $ 12,580 Accounts receivable, net 12,540 6,830 Inventories, net (Note 2) 8,255 4,606 Deferred tax asset (Note 6) 4,311 5,930 Other current assets 1,228 1,384 -------- -------- Total current assets 42,705 31,330 PROPERTY, PLANT AND EQUIPMENT, net (Note 2) 29,847 30,913 OTHER ASSETS 283 326 -------- -------- $ 72,835 $ 62,569 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 8,513 $ 4,289 Accrued liabilities (Note 2) 5,079 4,524 Current taxes payable (Note 6) -- 1,004 -------- -------- Total current liabilities 13,592 9,817 -------- -------- DEFERRED TAX LIABILITY (Note 6) 2,718 1,568 COMMITMENTS AND CONTINGENCIES (Note 7) STOCKHOLDERS' EQUITY (Note 4): Preferred stock, $.01 par value; 1,000,000 shares authorized -- -- Common stock, $.01 par value; 15,000,000 shares authorized, 7,928,023 shares issued, 7,905,523 shares outstanding at December 31, 1997; 7,779,829 shares issued, 7,757,329 shares outstanding at December 31, 1996 79 78 Additional paid-in capital 32,420 32,329 Retained earnings 24,259 19,016 Cumulative translation adjustment (Note 2) 20 14 Less- Treasury stock, at cost (22,500 shares) (253) (253) -------- -------- Total stockholders' equity 56,525 51,184 -------- -------- $ 72,835 $ 62,569 ======== ======== The accompanying notes are an integral part of these consolidated balance sheets. F-3 THREE-FIVE SYSTEMS, INC. CONSOLIDATED STATEMENTS OF INCOME (LOSS) (in thousands, except share amounts)
Years Ended December 31, ----------------------------------------- 1997 1996 1995 ----------- ----------- ----------- NET SALES (Notes 5 and 8) $ 84,642 $ 60,713 $ 91,585 ----------- ----------- ----------- COSTS AND EXPENSES: Cost of sales 64,760 58,321 70,481 Selling, general and administrative 6,557 5,351 5,386 Research and development 5,106 4,065 2,396 ----------- ----------- ----------- 76,423 67,737 78,263 ----------- ----------- ----------- Operating income (loss) 8,219 (7,024) 13,322 ----------- ----------- ----------- OTHER INCOME (EXPENSE): Interest, net 548 412 765 Other, net (190) (139) (122) ----------- ----------- ----------- 358 273 643 ----------- ----------- ----------- INCOME (LOSS) BEFORE PROVISION FOR (BENEFIT FROM) INCOME TAXES 8,577 (6,751) 13,965 Provision for (benefit from) income taxes (Note 6) 3,334 (2,920) 5,548 ----------- ----------- ----------- NET INCOME (LOSS) $ 5,243 $ (3,831) $ 8,417 =========== =========== =========== EARNINGS (LOSS) PER COMMON SHARE (Note 2): Basic $ 0.67 $ (0.49) $ 1.09 =========== =========== =========== Diluted $ 0.65 $ (0.49) $ 1.04 =========== =========== =========== WEIGHTED AVERAGE NUMBER OF COMMON SHARES: Basic 7,854,053 7,767,744 7,715,996 =========== =========== =========== Diluted 8,089,975 7,767,744 8,083,551 =========== =========== ===========
The accompanying notes are an integral part of these consolidated statements. F-4 THREE-FIVE SYSTEMS, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995 (in thousands, except share amounts)
Common Stock --------------------- Additional Cumulative Shares Paid-in Retained Translation Treasury Issued Amount Capital Earnings Adjustment Stock Total --------- --------- --------- --------- ---------- --------- --------- BALANCE, December 31, 1994 7,691,524 $ 77 $ 32,052 $ 14,430 $ 2 $ -- $ 46,561 Stock options exercised 44,221 -- 32 -- -- -- 32 Tax benefit from early disposition of incentive stock options (Note 6) -- -- 202 -- -- -- 202 Net income -- -- -- 8,417 -- -- 8,417 Translation adjustment -- -- -- -- 12 -- 12 --------- --------- --------- --------- --------- --------- --------- BALANCE, December 31, 1995 7,735,745 77 32,286 22,847 14 -- 55,224 Stock options exercised 44,084 1 11 -- -- -- 12 Tax benefit from early disposition of incentive stock options (Note 6) -- -- 32 -- -- -- 32 Net loss -- -- -- (3,831) -- -- (3,831) Purchase of treasury stock -- -- -- -- -- (253) (253) --------- --------- --------- --------- --------- --------- --------- BALANCE, December 31, 1996 7,779,829 78 32,329 19,016 14 (253) 51,184 Stock options exercised 148,194 1 50 -- -- -- 51 Tax benefit from early disposition of incentive stock options (Note 6) -- -- 41 -- -- -- 41 Net income -- -- -- 5,243 -- -- 5,243 Translation adjustment -- -- -- -- 6 -- 6 --------- --------- --------- --------- --------- --------- --------- BALANCE, December 31, 1997 7,928,023 $ 79 $ 32,420 $ 24,259 $ 20 $ (253) $ 56,525 ========= ========= ========= ========= ========= ========= =========
The accompanying notes are an integral part of these consolidated statements F-5 THREE-FIVE SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
Years Ended December 31, --------------------------------- 1997 1996 1995 --------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) $ 5,243 $(3,831) $ 8,417 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization 4,135 3,551 2,278 Provision for (reduction of) accounts receivable valuation reserves (69) 47 (1) Provision for (reduction of) inventory valuation reserves (2,473) 4,015 1,218 Loss on disposal of assets 2 12 24 Changes in assets and liabilities: (Increase) decrease in accounts receivable (5,641) 2,469 (624) (Increase) decrease in inventories (1,176) 5,082 (5,264) (Increase) decrease in other assets 505 (1,070) (32) Increase (decrease) in accounts payable and accrued liabilities 4,778 4,296 (3,170) Increase (decrease) in taxes payable, net 1,461 (2,358) (1,568) --------- --------- ------- Net cash provided by operating activities 6,765 12,213 1,278 --------- --------- ------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property, plant and equipment (3,049) (948) (27,051) Proceeds from sale of property, plant and equipment 19 5 326 --------- --------- ------- Net cash used for investing activities (3,030) (943) (26,725) --------- --------- ------- CASH FLOWS FROM FINANCING ACTIVITIES: Net proceeds from (payments on) notes payable to banks - (3,000) 3,000 Principal payments on and retirement of long-term debt - - (182) Stock options exercised 52 12 32 Purchase of treasury stock - (253) - --------- --------- ------ Net cash provided by (used for) financing activities 52 (3,241) 2,850 --------- --------- ------- Effect of exchange rate changes on cash 4 - 12 --------- --------- ------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 3,791 8,029 (22,585) CASH AND CASH EQUIVALENTS, beginning of year 12,580 4,551 27,136 --------- --------- ------- CASH AND CASH EQUIVALENTS, end of year $ 16,371 $ 12,580 $ 4,551 ========= ========= ======= SUPPLEMENTAL CASH FLOW INFORMATION: Interest paid $ 4 $ 60 $ 12 ========= ========= ======= Income taxes paid $ 1,973 $ 1,832 $ 7,296 ========= ========= =======
The accompanying notes are an integral part of these consolidated statements. F-6 THREE-FIVE SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1997, 1996 AND 1995 (1) ORGANIZATION AND OPERATIONS: The Company designs and manufactures a wide range of user interface devices for operational control and informational display functions required in the end products of original equipment manufacturers ("OEMs"). Most of the Company's sales consist of custom devices developed in close collaboration with its customers. Devices designed and manufactured by the Company find application in cellular telephones and other wireless communication devices as well as in medical equipment, office automation equipment, industrial process controls, instrumentation, consumer electronic products, automotive equipment, and industrial and military control products. The Company currently specializes in liquid crystal display ("LCD") and light emitting diode ("LED") components and technology in providing its design and manufacturing services for its customers. The Company markets its services primarily in North America, Europe, and Asia through direct technical sales persons and, to a much lesser extent, through an independent sales and distribution network. The Company maintains its primary manufacturing facility in Manila, the Philippines. A third-party subcontractor operates the facility under a sub-assembly agreement with the Company utilizing equipment, processes, and documentation owned by the Company. The sub-assembly agreement has a current term extending through December 31, 1999, and from year to year thereafter, but may be terminated by either party upon 180 days written notice. The termination of or the inability of the Company to obtain products pursuant to the sub-assembly agreement, even for a relatively short period, would have a material adverse effect on the operations and profitability of the Company. Since December 1994, the Company has made advances totaling approximately $1.7 million to the subcontractor to help the subcontractor in meeting its working capital needs, all of which have been paid in full in 1997. The Company plans on incorporating a wholly-owned subsidiary during 1998 which will be engaged in the manufacturing and sale of the Company's products in China. Management expects that capital expenditures to acquire the property, plant, and equipment for this expansion will total approximately $8.0 million in 1998. During 1995, the Company formed a wholly-owned subsidiary, Three-Five Systems Pacific, Inc. (Pacific). Pacific, a Philippines corporation, procures supplies primarily from Philippine vendors, as well as manages and assists production personnel of a third party subcontractor the Company employs. Three-Five Systems Limited (Limited), a wholly-owned subsidiary of the Company, is incorporated in the United Kingdom. Limited sells and distributes the Company's products to customers on the European continent. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation and Preparation of Financial Statements The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All material intercompany transactions have been eliminated. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. F-7 Fair Value of Financial Instruments The estimated fair value of financial instruments has been determined by the Company using available market information and valuation methodologies. Considerable judgment is required in estimating fair values. Accordingly, the estimates may not be indicative of amounts that would be realized in a current market exchange. The carrying values of cash, accounts receivable and accounts payable approximate fair value due to the short maturities of these instruments. Cash and Cash Equivalents For purposes of the statements of cash flows, all highly liquid investments with a maturity of three months or less at the time of purchase are considered to be cash equivalents. Cash equivalents consist of investments in commercial paper, marketable debt securities, money market mutual funds, and United States government agencies' obligations and are classified as held-to-maturity in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. Cash equivalents were $12,886,000 and $11,243,000 at December 31, 1997 and December 31, 1996, respectively. Inventories Inventories are stated at the lower of cost (first-in, first-out) or net realizable value. Reserves are established against Company-owned inventories for excess, slow-moving, and obsolete items and for items where the net realizable value is less than cost. The reserve for obsolete inventory totaled $4,309,000 and $6,782,000 at December 31, 1997 and December 31, 1996, respectively. Inventories at December 31 consist of the following: 1997 1996 --------- ---------- (in thousands) Raw materials $ 6,052 $ 3,147 Work-in-process 1,195 780 Finished goods 1,008 679 --------- ---------- $ 8,255 $ 4,606 ========= ========== Property, Plant and Equipment Property, plant and equipment is recorded at cost and generally is depreciated using the straight-line method over the estimated useful lives of the respective assets, which range from 3 to 39 years. During 1996, the Company placed into service a high-volume LCD glass manufacturing line in its Tempe, Arizona manufacturing facility. The Company is depreciating the LCD glass line using the units of production method. Depreciation expense recorded using this method may be subject to significant fluctuation from year to year resulting from changes in actual production levels and ongoing analysis of the capacity of the equipment. Property, plant and equipment at December 31 consist of the following: 1997 1996 ---------- ----------- (in thousands) Building and improvements $ 10,431 $ 10,431 Furniture and equipment 31,804 28,776 ---------- ----------- 42,235 39,207 Less- accumulated depreciation (12,388) (8,294) ---------- ----------- $ 29,847 $ 30,913 ========== =========== F-8 The Company intends to utilize a significant portion of the high-volume LCD glass manufacturing line facility to produce a substantial portion of its own requirements for LCD glass. The successful utilization of the manufacturing facility will require the Company (i) to produce LCD glass on a timely and cost-effective basis at quality levels at least equal to the LCD glass available from independent suppliers and (ii) to utilize the LCD glass it produces in devices it designs and manufactures in a manner satisfactory to its customers. Although management believes that the manufacturing facility will be successfully utilized, no assurance can be given that the Company will not experience problems or delays in the future in conducting its LCD glass manufacturing operations. Such problems could require the Company to continue to purchase its LCD glass requirements from third parties and result in the inability of the Company to recover its investment in the manufacturing facility. During 1996, the Company entered into a transaction in which it conveyed its Tempe, Arizona facility and certain improvements to the City of Tempe as consideration for a rent-free 75-year lease. The Company has the option to repurchase the facility for $1,000 after ten years; therefore, the lease is accounted for as a capital lease. Accrued Liabilities Accrued liabilities include accrued compensation of approximately $1,675,000 and $988,000 at December 31, 1997 and 1996, respectively. Foreign Currency Translation Financial information relating to the Company's foreign subsidiaries is reported in accordance with SFAS No. 52, Foreign Currency Translation. The gain or loss resulting from the translation of the subsidiaries' financial statements has been included as a separate component of stockholders' equity. The net foreign currency transaction loss in 1997, 1996 and 1995 was $183,000, $46,000, and $32,000, respectively, and has been included in other expenses in the accompanying statements of income (loss). Revenue Recognition The Company recognizes revenue upon shipment. The Company's distributor agreements provide for stock (inventory) rotation and price protection. Reserves are provided for each of these programs based on past return experience. These reserves are established at the time of shipment and reduce gross sales to arrive at net sales as presented in the accompanying consolidated statements of income (loss). These reserves are reflected as a reserve against accounts receivable from sales to distributors and totaled $125,000 and $89,000 at December 31, 1997 and 1996, respectively. The Company's distributors generally offset any returns and allowances against payments on accounts receivable. The Company also provides reserves for uncollectible accounts receivable. These reserves totaled $455,000 and $560,000 at December 31, 1997 and 1996, respectively. The Company performs ongoing credit evaluations of all of its customers and considers various factors in establishing its allowance for doubtful accounts. Research and Development Research and development costs are expensed as incurred. The Company currently is spending research and development dollars on several new technologies that it plans to introduce in the future. There is a risk that some or all of those technologies may not successfully make the transition from the research and development lab to cost-effective manufacturable products. Earnings (Loss) Per Share During 1997, the Company adopted SFAS No. 128, Earnings per Share. Pursuant to SFAS No. 128, basic earnings per common share are computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the year. Diluted earnings (loss) per common share for the years ended December 31, 1997, 1996 and 1995 are determined assuming that options were exercised at the beginning of each F-9 year or at the time of issuance, if later. No outstanding options were assumed to be exercised for purposes of calculating diluted earnings per share for the year ended December 31, 1996 as their effect was anti-dilutive. Below are the disclosures required pursuant to SFAS No. 128 for the years ended December 31, 1997, 1996 and 1995 (in thousands, except per share data): For the Years Ended December 31, ---------------------------- 1997 1996 1995 ------- ------- ------- Basic earnings (loss) per share: Income available to common shareholders $ 5,243 $(3,831) $ 8,417 Weighted average common shares 7,854 7,768 7,716 ------- ------- ------- Basic per share amount $ 0.67 $ (0.49) $ 1.09 ======= ======= ======= Diluted earnings (loss) per share: Income available to common shareholders $ 5,243 $(3,831) $ 8,417 Weighted average common shares 7,854 7,768 7,716 Options assumed converted 236 -- 368 ------- ------- ------- Total common shares plus assumed conversions 8,090 7,768 8,084 ------- ------- ------- Diluted per share amount $ 0.65 $ (0.49) $ 1.04 ======= ======= ======= (3) LONG-TERM DEBT: In May 1997, the Company entered into a new $15.0 million unsecured revolving line of credit which matures May 22, 1998. This line of credit bears interest at the bank's prime rate (8.50% at December 31, 1997) or at the LIBOR base rate (5.7% to 6.0% at December 31, 1997) plus 1.75%, and is payable monthly. There was no balance outstanding at December 31, 1997 or 1996. In addition, the Company has a $350,000 United Kingdom credit facility with interest due quarterly at the bank's base rate (7.75% at December 31, 1997) plus 2%. Any unpaid balance is due June 20, 1998, and is secured by United Kingdom accounts receivable. Management intends to renew the United Kingdom credit facility and does not anticipate any material changes to the existing terms. The lines of credit contain certain restrictive covenants which include, among other things, restrictions on the declaration or payment of dividends and the amount of capital expenditures. The lines also require the Company to maintain a specified net worth, as defined, to maintain a required debt to equity ratio and to maintain certain other financial ratios. (4) BENEFIT PLANS: The Company has four stock option plans: the 1997 Stock Option Plan (1997 Plan), the 1994 Non-Employee Directors Stock Option Plan (1994 Plan), the 1993 Stock Option Plan (1993 Plan), and the 1990 Stock Option Plan (1990 Plan). 1997 Stock Option Plan The 1997 Plan provides for the granting of nonqualified options to purchase up to 100,000 shares of the Company's common stock. Under the 1997 Plan, options may be issued to key personnel and others providing valuable services to the Company and its subsidiaries. The options issued will be nonqualified stock options and shall not be "incentive stock options" as defined in Section 422 of the Internal Revenue Code of 1986 (the Code). Any option that expires or terminates without having been exercised in full will again be available for grant pursuant to the 1997 Plan. There were options outstanding to acquire 22,000 shares of the Company's common stock under the 1997 Plan at December 31, 1997. F-10 The expiration date, maximum number of shares purchasable and the other provisions of the options will be established at the time of grant. Options may be granted for terms of up to ten years and become exercisable in whole or in one or more installments at such time as may be determined by the plan administrator upon grant of the options. The exercise prices of the options will be determined by the plan administrator, but may not be less than 100 percent of the fair market value of the common stock at the time of the grant. The 1997 Plan will remain in force until May 12, 2007. 1994 Non-Employee Directors Stock Option Plan The 1994 Plan provides for the automatic grant of stock options to non-employee directors to purchase up to 100,000 shares of the Company's common stock. Under the 1994 Plan, options to acquire 500 shares of common stock will be automatically granted to each non-employee director at the meeting of the Board of Directors held immediately after each annual meeting of stockholders, with such options to vest in a series of 12 equal and successive monthly installments commencing one month after the annual automatic grant date. In addition, each non-employee director serving on the Board of Directors on the date the 1994 Plan was approved by the Company's stockholders received an automatic grant of options to acquire 1,000 shares of common stock and each subsequent newly elected non-employee member of the Board of Directors will receive an automatic grant of options to acquire 1,000 shares of common stock on the date of their first appointment or election to the Board of Directors. Those options become exercisable and vest in a series of three equal and successive annual installments, with the first such installment becoming exercisable 13 months after the automatic grant date. A non-employee member of the Board of Directors is not eligible to receive the 500 share automatic option grant if that option grant date is within 30 days of such non-employee member receiving the 1,000 share automatic option grant. The exercise price per share of common stock subject to options granted under the 1994 Plan will be equal to 100 percent of the fair market value of the Company's common stock on the date such options are granted. There were outstanding options to acquire 9,000 shares of the Company's common stock under the 1994 Plan at December 31, 1997. 1993 Stock Option Plan The 1993 Plan provides for the granting of options to purchase up to 385,454 shares of the Company's common stock (which includes 85,454 shares previously reserved for issuance under the Company's 1990 Stock Option Plan), the direct granting of common stock (stock awards), the granting of stock appreciation rights (SARs) and the granting of other cash awards (cash awards; stock awards, SARs and cash awards are collectively referred to herein as Awards). Under the 1993 Plan, options and Awards may be issued to key personnel and others providing valuable services to the Company and its subsidiaries. The options issued may be incentive stock options or nonqualified stock options. If any option or SAR terminates or expires without having been exercised in full, stock not issued under such option or SAR will again be available for grant pursuant to the 1993 Plan. There were options outstanding to acquire 309,750 shares of the Company's common stock under the 1993 Plan at December 31, 1997. To the extent that granted options are incentive stock options, the terms and conditions of those options must be consistent with the qualification requirement set forth in the Code. The expiration date, maximum number of shares purchasable and the other provisions of the options will be established at the time of grant. Options may be granted for terms of up to ten years and become exercisable in whole or in one or more installments at such time as may be determined by the plan administrator upon grant of the options. The exercise prices of options will be determined by the plan administrator, but may not be less than 100 percent (110 percent if the option is granted to a stockholder who at the time the option is granted owns stock representing more than ten percent of the total combined voting power of all classes of stock of the Company) of the fair market value of the common stock at the time of the grant. The 1993 Plan will remain in force until February 24, 2003. 1990 Stock Option Plan Under the 1990 Plan, there are 210,220 options issued but unexercised as of December 31, 1997. In conjunction with stockholder approval of the 1993 Plan, the Board terminated the 1990 Plan with respect to unissued options F-11 to purchase 85,454 shares of common stock which remained and were unissued as of the date the 1993 Plan was adopted. The 1990 Plan will remain in force through May 1, 2000. The expiration date, maximum number of shares purchasable, and the other provisions of the options granted under the 1990 Plan were established at the time of grant. Options were granted for terms of up to ten years and become exercisable in whole or in one or more installments at such times as were determined by the Board of Directors upon grant of the options. Tax benefits from early disposition of common stock by optionees under the 1993 and 1990 Plans and from the exercise of nonqualified options are credited to additional paid-in capital. Pursuant to the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, the Company accounts for transactions with its employees pursuant to Accounting Principles Board Opinion No. 25, Accounting for Stock-Issued to Employees, under which no compensation cost has been recognized. Had compensation cost for these plans been determined consistent with SFAS No. 123, the Company's net income (loss) and earnings (loss) per share would have been as follows (in thousands, except per share data):
1997 1996 1995 --------- ---------- --------- Net income (loss): As reported $ 5,243 $ (3,831) $ 8,417 Pro forma 4,785 (4,076) 8,327 Basic earnings (loss) per share: As reported $ 0.67 $ (0.49) $ 1.09 Pro forma 0.61 (0.52) 1.08 Diluted earnings (loss) per share: As reported $ 0.65 $ (0.49) $ 1.04 Pro forma 0.59 (0.52) 1.03
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions for grants in 1997, 1996 and 1995, respectively: risk-free interest rates of 5.45%, 6.31% and 6.31%; expected dividend yields of zero; expected lives of 6.4, 6.1 and 5.7 years; and expected volatility (a measure of the amount by which a price has fluctuated or is expected to fluctuate during a period) of 60.0%, 61.9% and 58.7%. Because the SFAS No. 123 method of accounting has not been applied to options granted prior to January 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years. The weighted average fair value of shares sold in 1997 was $14.98. F-12 A summary of the status of the Company's four stock option plans at December 31, 1997, 1996 and 1995 and changes during the three years then ended is presented in the table and narrative below:
1997 1996 1995 ------------------------ ----------------------------- -------------------------- Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price --------- --------- --------- -------- ---------- -------- Outstanding at beginning of year 551,776 $ 6.92 539,576 $ 8.06 465,326 $ 4.68 Granted 200,500 14.63 250,100 11.89 178,000 22.15 Exercised (162,306) 1.34 (44,900) 0.49 (44,250) 0.75 Expired (39,000) 12.23 (193,000) 18.04 (59,500) 29.24 --------- --------- ---------- Outstanding at end of year 550,970 $ 11.01 551,776 $ 6.92 539,576 $ 8.06 ========= ========= ========== Exercisable at end of year 165,110 294,982 308,940 ========= ========= ========== Weighted average fair value of options granted $ 9.19 $ 7.57 $ 13.19 ======== ====== ========
The following table summarizes information about stock options outstanding at December 31, 1997:
Options Outstanding Options Exercisable ----------------------------------------------------------- -------------------------- Weighted Number Average Weighted Number Weighted Range of Outstanding at Remaining Average Exercisable at Average Exercise December 31, Contractual Exercise December 31, Exercise Prices 1997 Life Price 1997 Price -------------- -------------- ------------ ----------- --------------- -------- $ 0.25 - $9.00 108,720 5.7 years $ 0.77 108,720 $ 0.77 9.01 - 20.00 422,250 8.0 years 13.06 51,390 13.52 20.01 - 34.38 20,000 8.9 years 23.23 5,000 26.93 --------- --------- -------- --------- ------ 550,970 7.6 years $ 11.01 165,110 $ 5.53 ========= ========= ======== ========= ======
401(k) Profit Sharing Plan Effective September 1, 1990, the Company adopted a profit sharing plan (401(k) Plan) pursuant to Section 401(k) of the Code. The 401(k) Plan covers substantially all full-time employees who meet the eligibility requirements and provides for a discretionary profit sharing contribution by the Company and an employee elective contribution with a discretionary Company matching provision. The Company expensed discretionary contributions pursuant to the 401(k) Plan in the amount of $71,000, $65,000, and $0 for the years ended December 31, 1997, 1996, and 1995, respectively. F-13 (5) MAJOR CUSTOMERS: The Company's strategy involves concentrating its efforts on providing design and production services to leading companies in a limited number of fast growing industries. Beginning in 1996, the Company has been undertaking substantial efforts to diversify its business, broaden its customer base, and expand its markets. The Company's historical major customer, who accounted for approximately 65 percent and 81 percent of the Company's revenue in 1996 and 1995, respectively, accounted for approximately 35 percent of the Company's revenue during 1997. This reduced percentage occurred as a result of the increased sales to other customers and reduced product selling prices and revenues from that major customer. The Company's other significant customer accounted for 32 percent of the Company's revenue during 1997. Sales to this customer were less than 10 percent of the Company's revenue during 1996 and 1995. The significant amount of sales to a few customers results in certain concentrations of credit risk for the Company. The Company's accounts receivable balance, including the accounts receivable of the Company's largest customers, is comprised of a large number of customers, primarily in the cellular phone, computer hardware and other electronic products industries. These customers are located primarily in the United States and Europe. (6) INCOME TAXES: SFAS No. 109, Accounting for Income Taxes, requires the use of an asset and liability approach in accounting for income taxes. Deferred tax assets and liabilities are recorded based on the differences between the financial statement and tax bases of assets and liabilities and the tax rates in effect when these differences are expected to reverse. The provision for income taxes for the years ended December 31 consists of the following:
1997 1996 1995 ---------- ---------- -------- (in thousands) Current, net of operating loss carryforwards and tax credits utilized Federal, net of tax benefit from early termination of incentive stock options $ 356 $ 556 $ 2,775 State 97 58 790 Foreign 71 9 1,681 ---------- ---------- -------- 524 623 5,246 Deferred provision (benefit) 2,769 (3,575) 100 Tax benefit from early termination of incentive stock options, reflected in stockholders' equity 41 32 202 ---------- ---------- -------- Provision (benefit) for income taxes $ 3,334 $ (2,920) $ 5,548 ========== ========== ========
In accordance with SFAS No. 109, a tax benefit for net operating losses of approximately $35,000, $102,000, and $67,000 and tax credits of approximately $0, $938,000, and $1,478,000 utilized in 1997, 1996, and 1995, respectively, are included as a reduction of the provision for income taxes in the consolidated statements of income (loss). F-14 The components of deferred taxes at December 31 are as follows:
1997 1996 --------- -------- (in thousands) Net long-term deferred tax liabilities: Accelerated tax depreciation $ 2,685 $ 1,535 Other 33 33 --------- -------- $ 2,718 $ 1,568 ========= ======== Net short-term deferred tax assets: Inventory reserve $ 1,721 $ 2,675 Uniform capitalization 1,251 1,868 Accrued liabilities not currently deductible 1,080 1,080 Allowance for doubtful accounts 156 196 Tax effect of regular U.S. net operating loss carry forward 166 189 Other 91 76 --------- -------- 4,465 6,084 Valuation allowance (154) (154) --------- -------- $ 4,311 $ 5,930 ========= ========
SFAS No. 109 requires the reduction of deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. As a result of certain limitations on the use of net operating loss carryforwards acquired in the ERA acquisition, a valuation allowance has been established for those net operating losses not likely to be realized. A reconciliation of the U.S. federal statutory rate to the Company's effective tax rate is as follows: 1997 1996 1995 ------ ------ ------ Statutory federal rate 34% 34% 34% Effect of state taxes 5 6 6 Other - 3 - ------ ------ ------ 39% 43% 40% ====== ====== ====== Net operating loss carryforwards for federal tax purposes totaled approximately $490,000 at December 31, 1997. The use of these carryforwards is limited to $67,000 per year and they expire through 2003. (7) COMMITMENTS AND CONTINGENCIES: In March 1995, the Company entered into a non-cancelable operating lease for its primary manufacturing facility in Manila, the Philippines. The lease expires December 31, 1999. In April 1995, the Company entered into a non-cancelable operating lease for an additional manufacturing facility in Manila, the Philippines. In February 1997, the Company exercised its option to renew the lease for two years. The lease expires March 31, 1999. Rent expense was approximately $793,000, $477,000 and $683,000 for the years ended December 31, 1997, 1996, and 1995, respectively. In April 1994, the Company entered into a ground lease (with purchase options) on a 5.7 acre site in Tempe, Arizona. Annual lease payments under the ground lease, which will expire on March 31, 2069, subject to renewal and purchase options as well as termination provisions, will average approximately $100,000 over the term of the lease subject to certain escalation provisions. A new design, manufacturing, and corporate headquarters facility containing approximately 97,000 square feet was completed on the land in 1995 at a cost of approximately $10.4 million. F-15 The Company's future lease commitments under the non-cancelable operating leases as of December 31, 1997, are as follows (in thousands): 1998 $ 419 1999 372 2000 100 2001 100 2002 100 Thereafter 6,625 -------- $ 7,716 ======== The Company is involved in certain administrative proceedings arising in the normal course of business. In the opinion of management, the Company's potential exposure under the pending administrative proceedings is adequately provided for in the accompanying financial statements. (8) GEOGRAPHIC SEGMENTS: Sales by geographic area and identifiable assets for the years ended December 31, 1997, 1996, and 1995 were as follows:
North America Europe Pacific Rim Eliminations Consolidated --------- --------- ----------- ------------ ------------ (in thousands) December 31, 1997: Net sales $ 73,887 $ 10,755 $ - $ - $ 84,642 Transfers to Europe 9,136 - - (9,136) - Transfers to North America - - 3,107 (3,107) - --------- --------- --------- ---------- -------- Total revenue $ 83,023 $ 10,755 $ 3,107 $ (12,243) $ 84,642 ========= ========= ========= ========== ========= Net income $ 4,728 $ 404 $ 65 $ 46 $ 5,243 ========= ========= ========= ========== ========= Identifiable assets $ 61,307 $ 4,896 $ 7,431 $ (799) $ 72,835 ========= ========= ========= ========== ========= December 31, 1996: Net sales $ 32,899 $ 27,814 $ - $ - $ 60,713 Transfers to Europe 25,810 - - (25,810) - Transfers to North America - - 1,494 (1,494) - --------- --------- --------- ---------- -------- Total revenue $ 58,709 $ 27,814 $ 1,494 $ (27,304) $ 60,713 ========= ========= ========= ========== ========= Net income (loss) $ (4,005) $ 19 $ 12 $ 143 $ (3,831) ========= ========= ========= ========== ========= Identifiable assets $ 52,951 $ 3,824 $ 6,164 $ (370) $ 62,569 ========= ========= ========= ========== ========= December 31, 1995: Net sales $ 24,235 $ 67,350 $ - $ - $ 91,585 Transfers to Europe 60,361 - - (60,361) - Transfers to North America - - 1,437 (1,437) - --------- --------- --------- ---------- -------- Total revenue $ 84,596 $ 67,350 $ 1,437 $ (61,798) $ 91,585 ========= ========= ========= ========== ========= Net income (loss) $ 5,093 $ 3,353 $ (46) $ 17 $ 8,417 ========= ========= ========= ========== ========= Identifiable assets $ 50,779 $ 8,491 $ 7,789 $ (3,279) $ 63,780 ========= ========= ========= ========== =========
F-16 THREE-FIVE SYSTEMS, INC. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995
Balance at Charged to Charged to Balance at Beginning Costs and Other End of of Period Expenses Accounts Other Period --------- -------- -------- ----- ------ (in thousands) Allowance for doubtful accounts and sales returns and allowances: - ----------------------- Year ended December 31, 1997 $ 649 (105) 36(1) -- $ 580 Year ended December 31, 1996 $ 603 14 32(1) -- $ 649 Year ended December 31, 1995 $ 604 (36) 35(1) -- $ 603 Inventory Reserve: - ------------------ Year ended December 31, 1997 $6,782 1,114 (3,587)(2) $4,309 Year ended December 31, 1996 $2,767 5,939 142(2) (2,066)(2) $6,782 Year ended December 31, 1995 $1,548 1,563 391(3) (735)(2) $2,767
(1) Actual return activity (2) Obsolete inventory written off (3) Inventory adjustments S-1 EX-10.T 2 CREDIT AGREEMENT ================================================================================ CREDIT AGREEMENT by and between THREE-FIVE SYSTEMS, INC. and IMPERIAL BANK Dated as of May 23, 1997 ================================================================================ TABLE OF CONTENTS
Page ARTICLE 1 RECITALS........................................................................................1 ARTICLE 2 DEFINITION OF TERMS.............................................................................2 Section 2.1 Definitions.................................................................................2 Section 2.2 Accounting Terms............................................................................6 ARTICLE 3 RLC.............................................................................................8 Section 3.1 RLC Commitment Amount.......................................................................8 Section 3.2 RLC Note....................................................................................8 Section 3.3 RLC Advances................................................................................8 Section 3.4 Conversion of Advances......................................................................9 Section 3.5 RLC Payments................................................................................9 Section 3.6 Prepayments................................................................................10 Section 3.7 RLC Service Fee............................................................................11 Section 3.8 Additional Provisions for LIBOR Rate Advances..............................................11 Section 3.9 Method of Payment..........................................................................12 Section 3.10 Conditions................................................................................12 Section 3.11 [Intentionally left blank.]...............................................................13 Section 3.12 Assignment................................................................................13 ARTICLE 4 CONDITIONS PRECEDENT...........................................................................14 Section 4.1 Conditions Precedent.......................................................................14 Section 4.2 Conditions Precedent to All Future Advances................................................15 ARTICLE 5 GENERAL REPRESENTATIONS AND WARRANTIES.........................................................16 Section 5.1 Recitals...................................................................................16 Section 5.2 Organization and Good Standing.............................................................16 Section 5.3 Business...................................................................................16 Section 5.4 Authorization and Power....................................................................16 Section 5.5 Enforceability.............................................................................16 Section 5.6 No Conflicts...............................................................................16 Section 5.7 No Litigation..............................................................................16 Section 5.8 Financial Condition........................................................................16 Section 5.9 Taxes......................................................................................17
-i- Section 5.10 No Stock Purchase.........................................................................17 Section 5.11 Advances..................................................................................17 Section 5.12 Solvency..................................................................................17 Section 5.13 ERISA.....................................................................................17 ARTICLE 6 AFFIRMATIVE COVENANTS..........................................................................18 Section 6.1 Maintenance of Existence...................................................................18 Section 6.2 Maintain Business..........................................................................18 Section 6.3 Insurance..................................................................................18 Section 6.4 Compliance with Credit Documents...........................................................18 Section 6.5 Financial Statements and Reports...........................................................18 Section 6.6 Books and Records; Access..................................................................19 Section 6.7 Payment of Taxes and Other Indebtedness....................................................19 Section 6.8 Notice of Default..........................................................................20 Section 6.9 Other Notices..............................................................................20 Section 6.10 ERISA Compliance..........................................................................20 Section 6.11 Further Assurances........................................................................20 ARTICLE 7 NEGATIVE COVENANTS.............................................................................21 Section 7.1 Indebtedness...............................................................................21 Section 7.2 Liens......................................................................................21 Section 7.3 Loans......................................................................................21 Section 7.4 Dividends..................................................................................21 Section 7.5 Existence..................................................................................21 Section 7.6 Fiscal Year................................................................................22 Section 7.7 Margin Stock...............................................................................22 Section 7.8 Tangible Net Worth.........................................................................22 Section 7.9 Leverage Ratio.............................................................................22 Section 7.10 Debt Coverage Ratio.......................................................................22 Section 7.11 Current Ratio.............................................................................23 ARTICLE 8 DEFAULT AND REMEDIES...........................................................................24 Section 8.1 Event of Default...........................................................................24 Section 8.2 Remedies...................................................................................25 Section 8.3 Delay or Omission by Lender................................................................26 ARTICLE 9 ACTION UPON AGREEMENT..........................................................................27 Section 9.1 Third Party................................................................................27 Section 9.2 Entire Agreement...........................................................................27
-ii- Section 9.3 Writing Required...........................................................................27 Section 9.4 No Partnership.............................................................................27 ARTICLE 10 GENERAL........................................................................................28 Section 10.1 Survival..................................................................................28 Section 10.2 Context...................................................................................28 Section 10.3 Time......................................................................................28 Section 10.4 Notices...................................................................................28 Section 10.5 Costs.....................................................................................29 Section 10.6 Successors................................................................................29 Section 10.7 Headings..................................................................................29 Section 10.8 Governing Law; Jurisdiction, Venue; Waiver of Jury Trial..................................29 Section 10.9 Arbitration Provision.....................................................................29 Section 10.10 Confidentiality...........................................................................29
EXHIBITS A Form of Advance Notice B Covenant Certificate -iii- CREDIT AGREEMENT BY THIS CREDIT AGREEMENT (the "Agreement"), made and entered into as of this 23rd day of May, 1997, IMPERIAL BANK, a California banking corporation (hereinafter called "Lender"), and THREE-FIVE SYSTEMS, INC., a Delaware corporation (hereinafter called "Borrower"), in consideration of the mutual covenants herein contained and other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, hereby confirm and agree as follows: ARTICLE 1 RECITALS -------- Section 1.1 Borrower has requested that Lender establish a revolving line of credit (the "RLC") with Borrower in the principal amount of $15,000,000.00, under which revolving line of credit advances shall be made to Borrower for the purposes of providing Borrower with financing for general corporate purposes. Section 1.2 Lender has agreed to do so upon the terms, conditions and provisions set forth herein. Section 1.3 Notwithstanding anything herein to the contrary, Borrower and Lender acknowledge that: (a) the RLC has been approved by Lender at its principal office in California; (b) all RLC Advances are to be made by Lender from its principal office in California; (c) all payments hereunder are to be sent by Borrower to the principal office of Lender in California; and (d) the election of Arizona law as the governing law hereunder has been agreed to by Lender as an accommodation to Borrower. -1- ARTICLE 2 DEFINITION OF TERMS ------------------- Section 2.1 Definitions. For the purposes of this Agreement, unless the context otherwise requires, the following terms shall have the respective meanings assigned to therein in this Article 2 of in the Section hereof referred to below: "Advance" means an RLC Advance. "Agreement" means this Credit Agreement, as amended, modified or restated from time to time. "Applicable Interest Rate" with respect to any given Advance shall mean either the Variable Rate or the LIBOR Rate, as applicable under the provisions of this Agreement. "Authorized Officer" means the chief executive officer or chief financial officer of Borrower, or such other individual who is from time to time designated to Lender in writing by said officer as authorized to act for Borrower with respect to the Loan. "Banking Day" means a day of the year on which banks are not required or authorized to close in Inglewood California, and, with respect to a LIBOR Rate Advance, a day on which dealings are carried on in the London interbank market. "Borrower": See the Preamble hereto. "Cash Flow": See Section 7.10. "Closing Date" means May 23, 1997. "Code" means the Internal Revenue Code of 1986, as amended. "Controlled Group" means, severally and collectively, the members of the group controlling, controlled by and/or in common control of Borrower, within the meaning of Section 4001(b) of ERISA. "Convert," "Conversion," and "Converted" each refers to a conversion of Advances of one Type into Advances of another Type pursuant to Section 3.4. "Credit Documents" means this Agreement, the Note (including any renewals, extensions and refundings thereof), and any written agreements, certificates or documents (and with respect to this Agreement and such other written agreements and documents, any amendments or -2- supplements thereto or modifications thereof) executed or delivered pursuant to the terms of this Agreement. "Current Assets": See Section 7.11. "Current Liabilities": See Section 7.11. "Debt service requirement": See Section 7.10. "Default Rate" means at any time five percent (5%) over the Variable Rate, which Default Rate shall change when and as the Variable Rate changes. "Dollars" and the sign "$" mean lawful currency of the United States of America. "ERISA" means the Employee Retirement Income Security Act of 1974, as amended, together with all final and permanent regulations issued pursuant thereto. References herein to sections and subsections of ERISA are deemed to refer to any successor or substitute provisions therefor. "Event of Default": See Section 8.1. "Financial Covenants" means those financial covenants specified in Sections 7.8 through 7.11. "Intangible Assets": See Section 7.8. "Lender": See the Preamble. "LIBOR" means the London Interbank Offered Rate, determined as provided herein, for the applicable LIBOR Interest Period to be specified by the Borrower as provided in Section 3.3(b) of this Agreement. For each Advance under the LIBOR option, the LIBOR rate will remain in effect through the end of the LIBOR Interest Period. If prior to the due date for a LIBOR Rate Advance Borrower requests a continuation of said LIBOR Rate Advance, Borrower's request shall comply with the request procedure specified below and the LIBOR rate for the LIBOR Rate Advance shall be re-determined for the next LIBOR Interest Period as provided below. LIBOR shall mean with respect to any LIBOR Interest Period the rate equal to the arithmetic mean (rounded upwards, if necessary, to the nearest one-sixteenth (1/16th) of one percent (1%)) of: (a) the offered rates per annum for deposits in U.S. Dollars for a period equal to such LIBOR Interest Period which appears at 11:00 a.m., London time, on the Reuters Screen LIBOR Page on the Banking Day that is two (2) -3- Banking Days before the first day of such LIBOR Interest Period, in each case if at least four (4) such offered rates appear on such page, or (b) if clause (a) is not available, (x) the offered rate per annum for deposits in U.S. Dollars for a period equal to such LIBOR Interest Period for a LIBOR Rate Advance hereunder which appears as of 11:00 a.m., London time on the Telerate Monitor on Telerate Screen 3750 on the Banking Day which is two (2) Banking Days before the first day of such LIBOR Interest Period; or (y) if clause (x) above is not available, the arithmetic mean (rounded upwards, if necessary, to the nearest one-sixteenth (1/16th) of one percent (1%)) of the interest rates per annum offered by at least three (3) prime banks selected by Lender at approximately 11:00 a.m., London time, on the Banking Day which is two (2) Banking Days before such date for deposits in U.S. Dollars to prime banks in the London interbank market, in each case for a period equal to such LIBOR Interest Period for a LIBOR Rate Advance hereunder in an amount equal to the amount to which the LIBOR applies. "Reuters Screen LIBOR Page" as used herein means the display designated as page LIBOR on the Reuters Monitor Money Rates Service or such other page as may replace the LIBOR page on that service for the purpose of displaying London interbank offered rates of major banks. "LIBOR Interest Period" means, for each LIBOR Rate Advance, the period commencing on the date of such LIBOR Rate Advance and ending on the last day of the period selected by Borrower pursuant to the provisions herein and, thereafter, each subsequent period commencing on the last day of the immediately preceding LIBOR Interest Period and ending on the last day of the period selected by Borrower pursuant to the provisions herein. The duration of each LIBOR Interest Period shall be 30, 60, 90 or 180 days, as selected by Borrower (A), for a new Advance, in the request for a LIBOR Rate Advance or (B), for an outstanding Advance, in the request for a LIBOR Rate Advance to continue bearing interest at the LIBOR Rate or (C), for an outstanding Variable Rate Advance, in the request to convert to a LIBOR Rate Advance, provided, however, that: (i) LIBOR Interest Periods commencing on the same date shall be of the same duration; (ii) Whenever the last day of any LIBOR Interest Period would otherwise occur on a day other than a Banking Day, the last day of such LIBOR Interest Period shall be extended to occur on the next succeeding Banking Day, provided that if such extension would cause the last day of such LIBOR Interest Period to occur in the next following calendar month, the last day of such LIBOR Interest Period shall occur on the next preceding Banking Day; and (iii) No LIBOR Interest Period with respect to any RLC Advance shall extend beyond the RLC Maturity Date. -4- "LIBOR Rate" means the rate per annum equal to the sum of (i) LIBOR, and (ii) 1.75%. "LIBOR Rate Advance" means an Advance that bears or that is requested to bear interest at the applicable LIBOR Rate. "LIBOR Rate RLC Advance" means an RLC Advance that bears or that is requested to bear interest at the applicable LIBOR Rate. "Loan" means the RLC. "Material Adverse Event" means any circumstance or event which materially and adversely impairs the ability of Borrower taken as a whole to fulfill its obligations under this Agreement. "Note" means the RLC Note. "Notice of RLC Advance": See Section 3.3(b). "PBGC" means the Pension Benefit Guaranty Corporation, and any successor to all or substantially all of the Pension Benefit Guaranty Corporation's functions under ERISA. "Payment Date" means: (a) As to each Variable Rate Advance, the first day of each month. (b) As to each LIBOR Rate Advance, the earlier of the last day of the LIBOR Interest Period or the ninetieth (90th) day after the beginning of the LIBOR Interest Period. "Plan" means an employee defined benefit plan or other plan maintained by Borrower for employees of Borrower and covered by Title IV of ERISA, or subject to the minimum funding standards under Section 412 of the Code. "Prime Rate" means the interest rate per annum publicly announced by Lender, or its successors, as its "prime rate" as in effect from time to time. Borrower acknowledges that the Prime Rate is not necessarily the best or lowest rate offered by Lender and Lender may lend to its customers at rates that are at, above or below its Prime Rate. "Quarterly End Date" means the last day of March, June, September and December. "Regulatory Change" means any change effective after the date of this Agreement in United States federal, state, or foreign law or regulations or the adoption or making after such date of any interpretation, directive, or request applying to a class of banks including Lender, of or under any United States federal, state, or foreign law or regulations (whether or not having the -5- force of law) by any court or governmental or monetary authority charged with the interpretation or administration thereof. "Reportable Event" means any "reportable event" as described in Section 4043(b) of ERISA with respect to which the thirty (30) day notice requirement has not been waived by the PBGC. "RLC": See Section 1.1. "RLC Advance" means an advance by Lender to the Borrower under the RLC pursuant to Section 3 and includes a Variable Rate RLC Advance or a LIBOR Rate RLC Advance (each of which shall be a "Type" of RLC Advance). "RLC Commitment Amount" means $15,000,000.00. "RLC Maturity Date" means May 22, 1998. "RLC Note" means that Revolving Promissory Note of even date herewith in the face amount equal to the RLC Commitment Amount made by Borrower payable to the order of Lender, evidencing the RLC, and extensions, modifications and renewals thereof. "RLC Service Fee": See Section 3.7. "SEC" means the United States Securities and Exchange Commission. "Subsidiaries" means all business associations directly or indirectly controlled by Borrower. "Tangible Net Worth": See Section 7.8. "Variable Rate" means the Prime Rate. "Variable Rate Advance" means an Advance that bears interest at the Variable Rate. "Variable Rate RLC Advance" means on RLC Advance that bears interest at the Variable Rate. Section 2.2 Accounting Terms. All accounting terms used herein without definition shall be interpreted in accordance with generally accepted accounting principles and, except as otherwise expressly provided herein, all determinations required herein shall be made in accordance with generally accepted accounting principles. -6- Section 2.3 References. Capitalized terms shall be equally applicable to both the singular and the plural forms of the terms therein defined. References to "Agreement," "this Agreement," "herein," "hereof," "hereunder," or other like words mean this Agreement as amended, supplemented, restated or otherwise modified and in effect from time to time. -7- ARTICLE 3 RLC --- Section 3.1 RLC Commitment Amount. Subject to the conditions set forth herein, Lender, from time to time, shall make such RLC Advances as Borrower may request provided that the aggregate amount of RLC Advances at any one time outstanding shall not exceed the RLC Commitment Amount. The RLC shall be a revolving credit, against which RLC Advances may be made to Borrower, repaid by Borrower, and readvances made to Borrower, provided that (i) Borrower is not in default under any provision of this Agreement or under the RLC Note, (ii) no RLC Advance shall be made that would cause the outstanding principal balance of the RLC to exceed the RLC Commitment Amount, and (iii) no RLC Advance shall be made on or after the RLC Maturity Date. Section 3.2 RLC Note. The RLC shall be evidenced by the RLC Note in the form approved by Lender, payable to the order of Lender upon the terms and conditions therein contained, and executed and delivered simultaneously with the execution of this Agreement. Section 3.3 RLC Advances. (a) Lender may from time to time make RLC Advances upon written notice in substantially the form attached hereto as "Exhibit A" from an Authorized Officer. Each such RLC Advance shall be in the minimum amount of $500,000.00. (b) Each request for an RLC Advance shall, in addition to complying with the other requirements in this Agreement, (i) specify the date and amount of the requested RLC Advance, (ii) specify whether the RLC Advance shall be an RLC Advance that bears interest at the Variable Rate or the LIBOR Rate, and (iii), if the RLC Advance is to bear interest at the LIBOR Rate, (A) specify the LIBOR Interest Period, (B) be delivered to Lender at least two (2) Banking Days prior to the date of the requested RLC Advance, and (C) be in a minimum amount of $500,000.00 with integral multiples of $1,000.00 in excess thereof. Any request for an RLC Advance not complying with the foregoing requirements for an RLC Advance bearing interest at the LIBOR Rate shall bear interest at the Variable Rate; provided that in the event such non-compliance is due to Borrower's failure to specify the required information, Lender agrees to notify Borrower of such failure and to provide Borrower the opportunity to provide such information prior to directing that the RLC Advance bear interest at the Variable Rate. (c) If Borrower desires that a LIBOR Rate RLC Advance continue to bear interest at the LIBOR Rate after the end of an existing LIBOR Interest Period, -8- Borrower shall deliver to Lender at least two (2) Banking Days prior to the end of such LIBOR Interest Period, a notice making such election and specifying the new LIBOR Interest Period. If Borrower does not deliver such notice within such time, then after the existing LIBOR Interest Period the LIBOR Rate RLC Advance shall become a Variable Rate RLC Advance and shall bear interest at the Variable Rate. (d) Notwithstanding any provision of the Credit Documents to the contrary, Lender shall be entitled to fund and maintain its funding of all or any part of any Advance in any manner it sees fit, provided, however, that all determinations hereunder shall be made as if Lender had actually funded and maintained each LIBOR Rate Advance during the LIBOR Interest Period therefor through the purchase of deposits having a maturity corresponding to the last day of the LIBOR Interest Period and bearing an interest rate equal to the LIBOR Rate for such LIBOR Interest Period. Section 3.4 Conversion of Advances. (a) Borrower may on any Banking Day, upon written notice to and received by Lender not later than 12:00 p.m. (Inglewood, California local time) (i) on the second Banking Day, in the case of any conversion of a Variable Rate Advance into a LIBOR Rate Advance and (ii) on the first Banking Day in the case of any conversion of a LIBOR Rate Advance into a Variable Rate Advance, prior to the date of the proposed conversion, converts any Advance of one type into an Advance of the other type, provided, however, that any conversion of a LIBOR Rate Advance (A) shall only be made on the last day of the applicable LIBOR Interest Period, and (B) shall be made only as to an Advance in a minimum amount of $500,000.00 with integral multiples of $1,000.00 in excess thereof. Each such notice of a conversion shall specify the date of such conversion and the Advance to be converted. Section 3.5 RLC Payments. (a) Interest on the RLC shall accrue on the unpaid principal of each RLC Advance: (i) At the Variable Rate if it is a Variable Rate RLC Advance. (ii) At the applicable LIBOR Rate if it is a LIBOR Rate RLC Advance. (b) All accrued interest on an RLC Advance shall be due and payable on the Payment Date. -9- (c) The entire outstanding principal balance of the RLC Note, all accrued and unpaid interest and all other sums which may have become payable thereunder shall be due and payable in full on the RLC Maturity Date. (d) If any payment of interest and/or principal is not received by Lender when such payment is due, then in addition to the remedies conferred upon the Lender under the Credit Documents, a late charge of five percent (5%) of the amount of the installment due and unpaid will be added to the delinquent amount to compensate the Lender for the expense of handling the delinquency for any payment past due in excess of five (5) days, regardless of any notice and cure period. (e) Upon the occurrence of an Event of Default and after maturity, including maturity upon acceleration, the unpaid principal balance, all accrued and unpaid interest and all other amounts payable hereunder shall bear interest at the Default Rate. Section 3.6 Prepayments. (a) Borrower shall have the option to prepay the Loan, in full or in part, at any time, subject to payment of all amounts specified hereinbelow with respect to any LIBOR Rate Advance. (b) If for any reason (including voluntary prepayment, voluntary conversion of a LIBOR Rate Advance into a Variable Rate Advance, or acceleration, but excluding any mandatory prepayment or mandatory conversion such as pursuant to Section 3.8(b)), the Lender receives all or part of the principal amount of a LIBOR Rate Advance prior to the last day of the LIBOR Interest Period for such Advance, the Borrower shall immediately notify the Borrower's account officer at the Lender and, on demand by the Lender, pay the "LIBOR Breakage Fees," defined as the amount (if any) by which (i) the additional interest which would have been payable on the amount so received had it not been received until the last day of such LIBOR Interest Period exceeds (ii) the interest which would have been recoverable by Lender (without regard to whether Lender actually so invests said funds) by placing the amount so received on deposit in the certificate of deposit markets or the offshore currency interbank markets or United States Treasury investment products, as the case may be for a period starting on the date on which it was so received and ending on the last day of such LIBOR Interest Period at the interest rate determined by Lender in its reasonable discretion. Lender's determination as to such amount shall be conclusive and final, absent manifest error. -10- (c) The Borrower shall pay to Lender, upon the demand of Lender, such other amount or amounts as shall be sufficient to compensate it for any loss, costs or expense ("LIBOR Prepayment Charges") incurred by it as a result of any prepayment by the Borrower (including voluntary prepayment, voluntary conversion of a LIBOR Rate Advance into a Variable Rate Advance, or prepayment due to acceleration, but excluding any mandatory prepayment or mandatory conversion such as pursuant to Section 3.8(b)) of all or part of the principal amount of a LIBOR Rate Advance prior to the last day of the LIBOR Interest Period for such Advance (including without limitation, any failure by the Borrower to borrow a LIBOR Rate Advance on the loan date for such borrowing specified in the relevant notice of borrowing hereunder). Such LIBOR Prepayment Charges shall include, without limitation, any interest or fees payable by Lender to lenders of funds obtained by it in order to make or maintain its loans based on the London interbank eurodollar market. Lender's determination as to such LIBOR Prepayment Charges shall be conclusive and final, absent manifest error. (d) Lender agrees that it shall make a best effort to minimize any such LIBOR Breakage Fees or any such LIBOR Prepayment Charges. Section 3.7 RLC Service Fee. Borrower agrees to pay to Lender, commencing with the execution of this Agreement and continuing until the RLC Maturity Date (such period being hereinafter referred to as the "RLC Disbursement Period"), a commitment fee (the "RLC Service Fee") equal to one-fourth of one percent (1/4%) per annum of the average daily undrawn balance of the RLC, which shall be payable quarterly in arrears, within three (3) days after Lender gives Borrower a notice showing the amount due with respect to the prior three-month period, the first such payment to be due on June 30, 1997, and thereafter on each Quarterly End Date. Section 3.8 Additional Provisions for LIBOR Rate Advances. (a) If, due to any Regulatory Change, there shall be any increase in the cost to Lender of agreeing to make or making, funding, or maintaining LIBOR Rate Advances (including, without limitation, any increase in any applicable reserve requirement), then Borrower shall from time to time, upon demand by Lender, pay to Lender such amounts as Lender may reasonably determine to be necessary to compensate Lender for any additional costs that Lender reasonably determines are attributable to such Regulatory Change and Lender will notify the Borrower of any Regulatory Change that will entitle Lender to compensation pursuant to this paragraph as promptly as practicable. Lender will furnish to Borrower a certificate setting forth in reasonable detail the basis for the amount of each request by Lender for compensation under this paragraph. Determinations by Lender of the amounts required to compensate Lender shall be conclusive, absent manifest error. Lender shall be entitled to compensation in connection with any Regulatory Change only for costs actually incurred by Lender. -11- (b) Notwithstanding any provision of the Credit Documents, if Lender shall notify Borrower that as a result of a Regulatory Change it is unlawful for Lender to make Advances at the LIBOR Rate, or to fund or maintain LIBOR Rate Advances, (i) the obligations of Lender to make Advances at the LIBOR Rate and to convert Advances to the LIBOR Rate shall be suspended until Lender shall notify Borrower that the circumstances causing such suspension no longer exist, and (ii) in the event such Regulatory Change makes the maintenance of Advances at the LIBOR Rate unlawful, Borrower shall forthwith prepay in full all LIBOR Rate Advances then outstanding, together with interest accrued thereon and all amounts in connection with such prepayment specified in the Note, unless Borrower, within five (5) Banking Days of notice from Lender, converts all LIBOR Rate Advances then outstanding into Variable Rate Advances pursuant to the conversion procedures herein and pays all amounts in connection with such prepayments or conversions specified herein. (c) Notwithstanding any other provision of the Credit Documents, if prior to the commencement of any LIBOR Interest Period, Lender shall determine (i) that United States dollar deposits in the amount of any LIBOR Rate Advance to be outstanding during such LIBOR Interest Period are not readily available to Lender in the London interbank market, or (ii) by reason of circumstances affecting the London interbank market, adequate and reasonable means do not exist for ascertaining the LIBOR Rate for such LIBOR Interest Period in the manner prescribed in the definition of "LIBOR Rate", then Lender shall promptly give notice thereof to Borrower and the obligation of Lender to create, continue, or effect by conversion any LIBOR Rate Advance in such amount and for such LIBOR Interest Period shall terminate until United States dollar deposits in such amount and for the LIBOR Interest Period shall again be readily available in the London interbank market and adequate and reasonable means exist for ascertaining the LIBOR Rate. Section 3.9 Method of Payment. All payments of principal of, and interest on, the Note shall be made to Lender before 2:00 p.m. (Inglewood, California local time), in immediately available funds. All payments made on the Note shall be credited, to the extent of the amount thereof, in the following manner: (i) first, to the payment of costs, fees or other charges incurred in connection with the Loan; (ii) second, to the payment of accrued interest on the Loan; and (iii) third, to the reduction of the principal balance of the Loan, in the inverse order of maturity. Section 3.10 Conditions. Lender shall have no obligation to make any Advance unless and until all of the conditions and requirements of this Agreement are fully satisfied. However, Lender in its sole and absolute discretion may elect to make one or more Advances prior to full satisfaction of one or more such conditions and/or requirements. Notwithstanding that such an Advance or Advances are made, such unsatisfied conditions and/or requirements shall not be waived or released thereby. Borrower shall be and continue to be obligated to fully satisfy such -12- conditions and requirements, and Lender, at any time, in Lender's sole and absolute discretion, may stop making Advances until all conditions and requirements are fully satisfied. Section 3.11 [Intentionally left blank.] Section 3.12 Assignment. Borrower shall have no right to any Advance other than to have the same disbursed by Lender in accordance with the disbursement provisions contained in this Agreement. Any assignment or transfer, voluntary or involuntary, of this Agreement or any right hereunder shall not be binding upon or in any way affect Lender without its written consent; Lender may make Advances under the disbursement provisions herein, notwithstanding any such assignment or transfer. -13- ARTICLE 4 CONDITIONS PRECEDENT -------------------- Section 4.1 Conditions Precedent. The obligation of Lender to fund the Loan is subject to the fulfillment of the following conditions: (a) Borrower shall have executed (or obtained the execution or issuing of) and delivered to Lender the following documents or information, all in form satisfactory to Lender: (i) This Agreement. (ii) The RLC Note. (iii) A corporate resolution of Borrower authorizing (i) the Loan, and (ii) the execution and delivery by an Authorized Officer of all documents to be executed by Borrower, and the performance by Borrower of all acts and things to be performed by Borrower, pursuant to this Agreement. (iv) A copy of the current Certificate of Incorporation and Bylaws, so certified by the Secretary of the corporation, together with a copy of a current Certificate of Good Standing in the State of incorporation for Borrower; and such other documents as Lender may reasonably require relating to the existence and good standing of Borrower and the authority of any person acting or executing documents on behalf of Borrower. (v) Evidence satisfactory to Lender that Borrower shall have terminated all other lines of credit excluding its line of credit with Barclays Bank PLC (U.K.), but including without limitation any revolving lines of credit and its $5 million ($5,000,000.00) line of credit for use in connection with its purchase of treasury stocks. (vi) Such other documents and information as may reasonably be required by Lender or Lender's counsel. (b) All representations and warranties by Borrower contained in this Agreement shall remain true and correct and the Borrower shall have performed or complied with all agreements of Borrower made in this Agreement that Borrower is to have performed or complied with by the date of the first Advance. -14- (c) No Event of Default shall exist and no event or condition shall exist that after notice or lapse of time, or both would constitute an Event of Default. Section 4.2 Conditions Precedent to All Future Advances. The obligation of the Lender to make any Advances to the Borrower following the initial Advance under Section 4.1 hereof shall be subject to the condition precedent that, on the date of each such Advance, no Event of Default shall exist and no event or condition shall exist that after notice or lapse of time or both, would constitute an Event of Default. -15- ARTICLE 5 GENERAL REPRESENTATIONS AND WARRANTIES -------------------------------------- Borrower hereby represents and warrants to Lender as follows: Section 5.1 Recitals. The recitals and statements of intent appearing in this Agreement are true and correct. Section 5.2 Organization and Good Standing. Borrower is duly organized, validly existing and in good standing under the laws of the state of its organization. Borrower is qualified to do business and is in good standing in the State of Arizona and in each state in which it is required by law to do so. Section 5.3 Business. Borrower has full corporate power and authority to own its properties and assets and to carry on its business as presently being conducted. Section 5.4 Authorization and Power. Borrower is fully authorized and permitted to enter into this Agreement, to execute any and all documentation required herein, to borrow the amounts contemplated herein upon the terms set forth herein and to perform the terms of this Agreement, none of which conflicts with any provision of law or regulation applicable to Borrower. Section 5.5 Enforceability. This Agreement and the other Credit Documents are the valid and binding legal obligations of the Borrower and are enforceable in accordance with their terms. Section 5.6 No Conflicts. The execution, delivery and performance by Borrower of this Agreement, the Note and all other documents and instruments relating to the Loan are not in conflict with any provision of law applicable to Borrower or with the Certificate of Incorporation or Bylaws of Borrower and will not result in any breach of the terms or conditions or constitute a default under any agreement or instrument under which Borrower is a party or is obligated. Borrower is not in default in the performance or observance of any material obligations, covenants or conditions of any such agreement or instrument. Section 5.7 No Litigation. There are no actions, suits or proceedings pending or threatened against Borrower which materially affect the repayment of the Loan, the performance by Borrower under this Agreement or the financial condition, business or operations of Borrower. Section 5.8 Financial Condition. All financial statements and profit and loss statements, all statements as to ownership and all other statements or reports previously or hereafter given to Lender by Borrower are and shall be true and correct as of the date thereof. There has been no material adverse change in the business, properties or condition (financial or otherwise) of Borrower since the date of the latest financial statements given to Lender. -16- Section 5.9 Taxes. Borrower has filed all federal, state and local tax returns by the due date as extended and has paid all federal, state and local taxes shown due thereon by such extended due date and all other payments required under federal, state or local law, except such assessments or taxes, if any, which are being contested in good faith by appropriate proceedings. Section 5.10 No Stock Purchase. No part of the proceeds of any financial accommodation made by Lender in connection with this Agreement will be used to purchase or carry "margin stock," as that term is defined in Regulation U of the Board of Governors of the Federal Reserve System, or to extend credit to others for the purpose of purchasing or carrying such margin stock. Section 5.11 Advances. Each request by Borrower for an Advance hereunder shall constitute an affirmation on the part of the Borrower that the representations and warranties of Section 5.8 are true and correct with respect to any financial statements submitted by Borrower to Lender between the date of this Agreement and the date of such request, that the representations and warranties of Sections 5.1, 5.5, 5.6, 5.7, 5.8 and 5.9 hereof are true and correct as of the time of such request and that the condition precedents set forth in Article 4 hereof are fully satisfied. All representations and warranties made herein shall survive the execution of this Agreement, any and all Advances or proceeds of the Loan and the execution and delivery of all other documents and instruments in connection with the Loan, so long as Lender has any commitment to lend to Borrower hereunder and until the Loan and all indebtedness hereunder have been paid in full and all of Borrower's obligations hereunder have been fully discharged. Section 5.12 Solvency. Borrower (both before and after giving effect to the transactions contemplated hereby) is solvent, has assets having a fair value in excess of the amount required to pay its probable liabilities on its existing debts as they become absolute and matured, and has, and will have, access to adequate capital for the conduct of its business and the ability to pay its debts from time to time incurred in connection therewith as such debts mature. Section 5.13 ERISA. (a) No Reportable Event has occurred and is continuing with respect to any Plan; (b) PBGC has not instituted proceedings to terminate any Plan; (c) neither the Borrower, any member of the Controlled Group, nor any duly-appointed administrator of a Plan (i) has incurred any liability to PBGC with respect to any Plan other than for premiums not yet due or payable or (ii) has instituted or intends to institute proceedings to terminate any Plan under Section 4041 or 4041A of ERISA; and (d) each Plan of Borrower has been maintained and funded in all material respects in accordance with its terms and in all material respects in accordance with all provisions of ERISA applicable thereto. Neither the Borrower nor any of its Subsidiaries participates in, or is required to make contributions to, any Multi-employer Plan (as that term is defined in Section 3(37) of ERISA). -17- ARTICLE 6 AFFIRMATIVE COVENANTS --------------------- Borrower hereby covenants and agrees that so long as Lender has any commitment to lend to Borrower hereunder and until the Loan and all other indebtedness hereunder have been paid in full and all of Borrower's obligations hereunder have been fully discharged: Section 6.1 Maintenance of Existence. Borrower shall maintain its existence with no material amendments or changes in its organizational documents without the prior written approval of the Lender. Section 6.2 Maintain Business. Borrower shall maintain in full force and effect all agreements, rights, trademarks, patents and licenses necessary to carry out its business in its reasonable business judgment, shall keep all of its properties in good condition and repair, and shall make all needed and proper repairs and improvements to its properties in order to properly conduct its business in its reasonable business judgment. Section 6.3 Insurance. To the extent Borrower is not self-insured, Borrower shall maintain in full force and effect at all times policies of fire, flood and extended coverage insurance and policies of public liability property damage, workman's compensation insurance and product recall insurance in scope and amount not less than, and not less extensive than, the scope and amount of insurance coverages customary for companies of comparable size and financial strength in the trades or businesses in which Borrower is from time to time engaged. Upon request by Lender, Borrower shall deliver to Lender certificates of, and copies of the originals of, all such policies of insurance in effect from time to time, to be retained by Lender so long as Lender shall have any commitment to lend to Borrower and/or any portion of the Loan shall be outstanding or unsatisfied. Section 6.4 Compliance with Credit Documents. Borrower shall make all payments of interest and principal on the Loan as and when the same become due and payable and shall keep and comply with all covenants, terms and provisions of the Note. Section 6.5 Financial Statements and Reports. Borrower shall maintain a standard system of accounting in accordance with good business practices, that reflects the application of generally accepted accounting principles, consistently applied, and Borrower shall furnish to Lender, in a level of detail acceptable to Lender, the following: (a) Within forty-five (45) days after the end of the first three (3) fiscal quarterly periods of each fiscal year of Borrower, quarterly and year-to-date financial and operating statements for Borrower as of the end of the preceding quarter and profit and loss statements covering that period, certified by Borrower -18- to be a true and accurate representation of its operations and financial condition during that period and at its end. (b) Within ninety (90) days after the end of each fiscal year of Borrower, financial statements which accurately and completely reflect Borrower's assets, liabilities and net worth, as of the end of the fiscal year, together with profit and loss statements for the fiscal year, all prepared in accordance with generally accepted accounting principles together with an opinion thereon of independent certified public accountants of national standing selected by Borrower to the effect that such financial statements have been prepared in accordance with generally accepted accounting principles consistently maintained and applied (except for changes in which such accountants concur) and that their examination of such accounts in connection with such financial statements has been made in accordance with generally accepted auditing standards and, accordingly, included such tests of the accounting records and such other auditing procedures as were considered necessary under the circumstances. (c) Within forty-five (45) days of each fiscal quarter of Borrower, a certificate signed by an Authorized Officer, in the form of Exhibit "B" attached hereto. (d) Promptly after transmission or occurrence (but in any event within fifteen days), other reports, including any communications with shareholders or the financial community, filed by Borrower or its officers and directors with any security exchange or the SEC. (e) Promptly, from time to time, such other information regarding the operations, business affairs and financial condition of the Borrower as Lender may reasonably request. Section 6.6 Books and Records; Access. Borrower shall maintain, in a safe place, proper and accurate books, ledgers, correspondence and other records relating to its operations and business affairs. Lender shall have the right from time to time, upon reasonable notice to Borrower, to examine and audit (within a reasonable scope of audit) at Borrower's expense (such expense not to exceed $5,000.00 per annum) and to make abstracts from and photocopies of Borrower's books, ledgers, correspondence and other records. Section 6.7 Payment of Taxes and Other Indebtedness. Borrower shall pay all of its current obligations before they become delinquent under applicable agreements or normal trade practices, including all accounts payable and all federal, state and local taxes, assessments, levies and governmental charges and all other payments required under any federal state or local law. Borrower may, however, contest in good faith the validity or amount of any such taxes, assessments, levies or other such governmental charges provided that Lender may require -19- Borrower to provide security with respect thereto in the form of a bond, insurance, security deposit, cash reserve or other evidence satisfactory to Lender of Borrower's ability to pay and discharge such matter in the event such contest is unsuccessful where the failure to provide such security would result in the occurrence of a Material Adverse Event. Section 6.8 Notice of Default. Borrower will furnish to Lender immediately upon becoming actually aware of the existence of any event or condition that constitutes an Event of Default, a written notice specifying the nature and period of existence thereof and the action which it is taking or proposes to take with respect thereto. Section 6.9 Other Notices. Borrower will promptly notify Lender of (a) any Material Adverse Event, (b) any claim not covered by insurance against Borrower or any of Borrower's properties that would result in the occurrence of a Material Adverse Event, and (c) the commencement of, and any material determination in, any litigation with any third party or any proceeding before any governmental authority affecting it, except litigation or proceedings which, if adversely determined, would not result in the occurrence of a Material Adverse Event. Section 6.10 ERISA Compliance. With respect to its Plans, Borrower shall (a) at all times comply with the minimum funding standards set forth in Section 302 of ERISA and Section 412 of the Code or shall have duly obtained a formal waiver of such compliance from the proper authority; (b) at Lender's request, within thirty (30) days after the filing thereof, furnish to Lender copies of each annual report/return (Form 5500 Series), as well as all schedules and attachments required to be filed with the Department of Labor and/or the Internal Revenue Service pursuant to ERISA, in connection with each of its Plans for each year of the plan; (c) notify Lender within a reasonable time of any fact, including, but not limited to, any Reportable Event arising in connection with any of its Plans, which constitutes grounds for termination thereof by the PBGC or for the appointment by the appropriate United States District Court of a trustee to administer such Plan, together with a statement, if requested by Lender, as to the reason therefor and the action, if any, proposed to be taken with respect thereto; and (d) furnish to Lender within a reasonable time, upon Lender's request, such additional information concerning any of its Plans as may be reasonably requested. Section 6.11 Further Assurances. Borrower will make, execute or endorse, and acknowledge and deliver or file or cause the same to be done, all such notices, certifications and additional agreements, undertakings or other assurances, and take any and all such other action, as Lender may, from time to time, deem reasonably necessary or proper to fully evidence the Loan. -20- ARTICLE 7 NEGATIVE COVENANTS ------------------ Borrower covenants and agrees that so long as Lender has any commitment to lend to Borrower hereunder and until the Loan and all other indebtedness hereunder have been paid in full and all of the Borrower's obligations hereunder have been fully discharged, Borrower shall not without receiving the prior written consent of Lender: Section 7.1 Indebtedness. Become or remain obligated either directly or as a guarantor or surety for any indebtedness for borrowed money, or for any indebtedness incurred in connection with the acquisition (which shall not include bona fide leases) of any property, real or personal, tangible or intangible including, but not limited to, lease purchase agreements, except: (a) Indebtedness to Lender hereunder. (b) Unsecured trade, utility or accounts payable arising in the ordinary course of its business. (c) Lease purchase agreements and purchase money security interests not exceeding the sum of $3,000,000.00 in payments during any fiscal year. (d) Borrower's line of credit up to $2,000,000 with Barclays Bank PLC (U.K.) secured by U.K. receivables and inventory. (e) Indebtedness secured by liens permitted under Section 7.2 hereof. Section 7.2 Liens. Create or suffer to be created or to exist any mortgages, pledges, security interests, encumbrances or other liens (i) on its real property that aggregate more than $5,000,000.00 or (ii) on its accounts receivable or its inventory. Section 7.3 Loans. Make any loan, advance, or direct extension of credit in excess of $1,000,000.00, or any investment (consisting of equity or debt convertible into equity) in excess of $5,000,000.00, in aggregate on an annual basis to any person(s) or entities other than in the ordinary course of business. Section 7.4 Dividends. Declare or pay any cash dividend. Section 7.5 Existence. Dissolve or liquidate, or merge or consolidate with or into any corporation or entity, or turn over the management or operation of its property, assets or businesses to any other person, firm or corporation, or make any material change in its ownership. -21- Section 7.6 Fiscal Year. Change the times of commencement or termination of its fiscal year or other accounting periods; or change its methods of accounting other than to conform to generally accepted accounting principles applied on a consistent basis. Section 7.7 Margin Stock. Use any proceeds of the Loan, or any proceeds of any other or future financial accommodation from Lender to Borrower, directly or indirectly, for the purpose, whether immediate, incidental or ultimate, of purchasing or carrying any "margin stock" as that term is defined in Regulation U of the Board of Governors of the Federal Reserve System, and will not use such proceeds in a manner that would involve Borrower in a violation of Regulation T, U or X of such Board, nor use such proceeds for any purpose not permitted by Section 7 of the Securities Exchange Act of 1934, as amended, or any of the rules or regulations respecting the extensions of credit promulgated thereunder. Section 7.8 Tangible Net Worth. Permit its Tangible Net Worth to be as of each Quarterly End Date to be less than the Minimum Tangible Net Worth, where "Minimum Tangible Net Worth" means the greater of (i) $45,000,000.00, or (b) $48,000,000.00 less the amount of its treasury stock acquired by Borrower since the Closing Date. For purposes of this Agreement, "Tangible Net Worth" means, at any given date, the total shareholder's equity (including capital stock, additional paid in capital and retained earnings after deducting treasury stock) which would appear on a balance sheet of Borrower prepared as of such date in accordance with generally accepted accounting principles consistently applied, less the aggregate book value of "Intangible Assets" (as defined below) shown on such balance sheet. "Intangible Assets" means those assets that are (i) deferred assets, other than prepaid taxes; (ii) patents, copyrights, trademarks, tradenames, franchises, goodwill, experimental expenses and other similar assets which would be classified as intangible assets on a balance sheet prepared in accordance with generally accepted accounting principles consistently applied; and (iii) unamortized debt discount and expense. Section 7.9 Leverage Ratio. Permit its total liabilities-to-Tangible Net Worth ratio as of each Quarterly End Date to exceed 0.5 to 1. Section 7.10 Debt Coverage Ratio. Permit its debt coverage ratio, calculated on a rolling four (4) quarter basis, to be less than 1.50 to 1 as of each Quarterly End Date, where debt coverage ratio is defined as the ratio of "cash flow" to "debt service requirement." In the ratio, the numerator "cash flow" is defined as the sum for the relevant period of Borrower's net income, tax expense, depreciation expense, amortization of intangibles expense, interest expense and off- balance sheet lease expense, all to the extent deducted in the calculation of net income; and the denominator "debt service requirement" is defined as the sum of the following that are due within the relevant period: all current maturities of long-term debt (excluding the RLC), capital lease obligations, interest expense and off-balance sheet lease expense. Notwithstanding anything herein to the contrary, for purposes of the calculation of "cash flow", the inventory reserve taken in the -22- third fiscal quarter of 1996 shall not be considered in the calculation of net income for the relevant period. Section 7.11 Current Ratio. Permit the ratio of Borrower's Current Assets to its Current Liabilities as of each Quarterly End Date to be less than 1.5 to 1 with both Current Assets and Current Liabilities determined in accordance with generally accepted accounting principles. -23- ARTICLE 8 DEFAULT AND REMEDIES -------------------- Section 8.1 Event of Default. The occurrence of any of the following events or conditions shall constitute an "Event of Default" under this Agreement: (a) Failure to pay any installment of principal or interest under the Loan within five (5) Banking Days of when the same become due and payable, or the failure to pay any other sum due under the Loan or this Agreement when the same shall become due and payable and such failure continues for five (5) Banking Days after notice thereof to Borrower; (b) Any failure or neglect to perform or observe any of the material terms, provisions, or covenants of this Agreement (other than a failure or neglect described in one or more of the other provisions of this Section 8.1) and such failure or neglect either (i) cannot be remedied, (ii) can be remedied within fifteen (15) days by prompt and diligent action, but it continues unremedied for a period of fifteen (15) days after notice thereof to Borrower, or (iii) can be remedied, although not within fifteen (15) days even by prompt and diligent action, but such remedy is not commenced within fifteen (15) days after notice thereof to Borrower or is not diligently prosecuted to completion within a total of forty-five (45) days from the date of such notice; (c) Any warranty, representation or statement contained in this Agreement, or made or furnished to the Lender by or on behalf of the Borrower, that shall be or shall prove to have been false in any material respect when made or furnished; (d) The filing by Borrower (or against Borrower in which any Borrower acquiesces or which is not dismissed within sixty (60) days of the filing thereof) of any proceeding under the federal bankruptcy laws now or hereafter existing or any other similar statute now or hereafter in effect; the entry of an order for relief under such laws with respect to Borrower; or the appointment of a receiver, trustee, custodian or conservator of all or any part of the assets of Borrower; (e) The insolvency of Borrower; or the execution by Borrower of an assignment for the benefit of creditors; or the convening by Borrower of a meeting of its creditors, or any class thereof, for purposes of effecting a moratorium upon or extension or composition of its debts; or if Borrower is generally not paying its debts as they mature; -24- (f) The admission in writing by Borrower that it is unable to pay its debts as they mature or that it is generally not paying its debts as they mature; (g) The failure of Borrower to comply with any Financial Covenant at the end of any fiscal quarter; (h) The occurrence of any default under the Note or any document or instrument given by Borrower in connection with any other indebtedness of Borrower to Lender and the expiration of any grace period provided therein; (i) The liquidation, termination or dissolution of Borrower; (j) Either (i) proceedings shall have been instituted to terminate, or a notice of termination shall have been filed with respect to, any Plans (other than a Multi-Employer Pension Plan as that term is defined in Section 4001(a)(3) of ERISA) by Borrower, any member of the Controlled Group, PBGC or any representative of any thereof, or any such Plan shall be terminated, in each case under Section 4041 or 4042 of ERISA, and such termination shall give rise to a liability of the Borrower or the Controlled Group to the PBGC or the Plan under ERISA having an effect in excess of $500,000.00 or (ii) a Reportable Event, the occurrence of which would cause the imposition of a lien in excess of $500,000.00 under Section 4062 of ERISA, shall have occurred with respect to any Plan (other than a Multi-Employer Pension Plan as that term is defined in Section 4001(a)(3) of ERISA) and be continuing for a period of sixty (60) days; (k) Any of the following events shall occur with respect to any Multi- Employer Pension Plan (as that term is defined in Section 4001(a)(3) of ERISA) to which Borrower contributes or contributed on behalf of its employees and Lender determines in good faith that the aggregate liability likely to be incurred by Borrower, as a result of any of the events specified in Subsections (i), (ii) and (iii) below, will have an effect in excess of $500,000.00; (i) Borrower incurs a withdrawal liability under Section 4201 of ERISA; (ii) any such plan is "in reorganization" as that term is defined in Section 4241 of ERISA; or (iii) any such Plan is terminated under Section 4041A of ERISA; or (l) The occurrence of a Material Adverse Event if Lender in good faith shall believe that the prospect of payment or performance of the Loan is impaired. Section 8.2 Remedies. Upon the occurrence of any Event of Default and at any time thereafter while such Event of Default is continuing, Lender may do one or more of the following: -25- (a) Cease making Advances or extensions of financial accommodations in any form to or for the benefit of Borrower and declare the entire Loan immediately due and payable, without notice or demand; (b) Proceed to protect and enforce its rights and remedies under this Agreement and the Note; and (c) Avail itself of any other relief to which Lender may be legally or equitably entitled. Section 8.3 Delay or Omission by Lender. No delay or omission by Lender in exercising any right, power or remedy hereunder, and no indulgence given to Borrower, with respect to any condition set forth herein, shall impair any right, power or remedy of Lender under the Note, and/or this Agreement, or be construed as a waiver by Lender of, or acquiescence in, any Event of Default. Likewise, no such delay, omission or indulgence by Lender shall be construed as a variation or waiver of any of the terms or provisions of this Agreement. Any actual waiver by Lender of any Event of Default shall not be a waiver of any other prior or subsequent Event of Default or of the same Event of Default after notice to demanding strict performance. -26- ARTICLE 9 ACTION UPON AGREEMENT --------------------- Section 9.1 Third Party. This Agreement is made for the sole protection and benefit of the parties hereto, their successors and assigns, and no other person or organization shall have any right of action hereon. No representation of any kind is made to third parties by the execution hereof, by the existence or form of the indebtedness treated herein, or by any performance, or failure or waiver thereof, by any party of the terms hereof. Specifically, without limitation of the foregoing, the Lender makes no representation to any third party as to the solvency of the Borrower or of the commercial practicability of any business enterprise to which or for which the RLC is made. Section 9.2 Entire Agreement. This Agreement embodies the entire Agreement of the parties with regard to the subject matter hereof. There are no representations, promises, warranties, understandings or agreements express or implied, oral or otherwise, in relation thereto, except those expressly referred to or set forth herein. Borrower acknowledges that the execution and the delivery of this Agreement is its free and voluntary act and deed, and that said execution and delivery have not been induced by, nor done in reliance upon, any representations, promises, warranties, understandings or agreements made by Lender, its agents, officers, employees or representatives. Section 9.3 Writing Required. No promise, representation, warranty or agreement made subsequent to the execution and delivery hereof by either party hereto, and no revocation, partial or otherwise, or change, amendment, addition, alteration or modification of this Agreement shall be valid unless the same shall be in writing signed by all parties hereto. Section 9.4 No Partnership. Lender and Borrower each have separate and independent rights and obligations under this Agreement. Nothing contained herein shall be construed as creating, forming or constituting any partnership, joint venture, merger or consolidation of Borrower and Lender for any purpose or in any respect. -27- ARTICLE 10 GENERAL ------- Section 10.1 Survival. This Agreement shall survive the making of the Loan and shall continue so long as any part of the Loan, or any extension or renewal thereof, remains outstanding. Section 10.2 Context. This Agreement shall apply to the parties hereto according to the context hereof, and without regard to the number or gender of words or expressions used herein. Section 10.3 Time. Time is expressly made of the essence of this Agreement. Section 10.4 Notices. All notices required or permitted to be given hereunder shall be in writing and may be given in person or by United States mail, by delivery service or by electronic transmission. Any notice directed to a party to this Agreement shall become effective upon the earliest of the following: (i) actual receipt by that party; (ii) delivery to the designated address of that party, addressed to that party; or (iii) if given by certified or registered United States mail, forty-eight (48) hours after deposit with the United States Postal Service, postage prepaid, addressed as shown below, or to such other address as such party may from time to time designate in writing: Borrower: Three-Five Systems, Inc. 1600 North Desert Drive Tempe, Arizona 85281-1212 Attention: Vice President - Administration Telecopier: (602) 389-8836 Lender: Imperial Bank 9920 South La Cienega Boulevard Suite 636 Inglewood, California 90301 Attention: General Counsel Telecopier: (310) 417-5695 With a copy to: Imperial Bank One Arizona Center 400 East Van Buren Suite 900 Phoenix, Arizona 85004 Attention: Kevin Halloran Telecopier: (602) 952-8643 -28- Section 10.5 Costs. Borrower shall pay all out of pocket costs and expenses arising from the preparation of this Agreement, the Note, the closing of the Loan, the making of Advances, and the enforcement of Lender's rights hereunder, including but not limited to, accounting fees, appraisal fees, attorneys' fees, UCC search fees and any charges that may be imposed on Lender as a result of this transaction. At the option of Lender and with the agreement of the Borrower, Advances may be made and disbursed from time to time by Lender directly in payment of such costs and expenses. Section 10.6 Successors. This Agreement shall, except as herein otherwise provided, be binding upon and inure to the benefit of the successors and assigns of the parties, hereto. Section 10.7 Headings. The headings or captions of sections in this Agreement are for convenience and reference only, and in no way define, limit or describe the scope or intent of this Agreement or the provisions of such sections. Section 10.8 Governing Law; Jurisdiction, Venue; Waiver of Jury Trial. The Credit Documents shall be governed by and construed in accordance with the substantive laws (other than conflict of law rules) of the State of Arizona, except to the extent Lender has greater rights or remedies under Federal law, whether as a national bank or otherwise, in which case such choice of Arizona law shall not be deemed to deprive Lender of any such rights and remedies as may be available under Federal law. Subject to the provisions of Section 10.9 hereof, each party consents to the personal jurisdiction and venue of the state courts located in Phoenix, State of Arizona in connection with any controversy related to this Agreement, waives any argument that venue in any such forum is not convenient and agrees that any litigation initiated by any of them in connection with this Agreement shall be venued in the Superior Court of Maricopa County, Arizona. The parties waive any right to trial by jury in any action or proceeding based on or pertaining to this Agreement. Section 10.9 Arbitration Provision. All claims or controversies of any type regarding matters occurring at any time arising under or relating to this Agreement (including, but not limited to, claims under contract, law or statute), except the parties rights to seek injunctive relief between Borrower and Lender (including claims against any shareholders or affiliated entities of Lender in claims against any directors, officers, employees or agents of Lender or their affiliated entities), shall be settled and finally determined by one arbitrator in Maricopa County, Arizona, in accordance with the arbitration rules of JAMS/Endispute and judgment by the arbitrator may be entered into any court having jurisdiction thereof. This Agreement to arbitrate includes all claims of breach of contract and all other claims of any type to the maximum extent permissible. The prevailing party in any such arbitration shall be awarded its reasonable costs and attorneys' fees as determined by the arbitrator. Section 10.10 Confidentiality. Lender agrees to keep confidential (and to cause its respective officers, directors, employees, agents and representatives to keep confidential) the Information (as defined below), except that Lender shall be permitted to disclose Information (i) -29- to such of its officers, directors, employees, agents and representatives (including outside counsel) as need to know such Information; (ii) to the extent required by applicable laws and regulations or by any subpoena or similar legal process, or requested by any bank regulatory authority (provided that Lender shall, except for Information requested by any such bank regulatory authority, promptly notify Borrower (to the extent practicable and lawful, notice shall be given to the Borrower before such disclosure is made so as to permit Borrower to seek a protective order) of the circumstances and content of each such disclosure and shall request confidential treatment of any Information so disclosed); (iii) to the extent such Information (A) becomes publicly available other than as a result of a breach of this Agreement, (B) becomes available to Lender on a nonconfidential basis from a source other than the Borrower or (C) was available to Lender on a nonconfidential basis prior to its disclosure to Lender by the Borrower; or (iv) to the extent the Borrower shall have consented to such disclosure in writing. As used in this Section 10.10, "Information" shall mean any financial statements, materials, documents and other information that the Borrower may have furnished or may hereafter furnish to Lender in connection with this Agreement or any other materials prepared from any of the foregoing. IN WITNESS WHEREOF, these presents have been executed, as of the day and year first set forth above. THREE-FIVE SYSTEMS, INC., a Delaware corporation By: ------------------------------------- Name: ----------------------------------- Its: ------------------------------------ BORROWER IMPERIAL BANK, a California banking corporation By ------------------------------------- Its ---------------------------- LENDER -30- REVOLVING PROMISSORY NOTE $15,000,000.00 Phoenix, Arizona May 23, 1997 FOR VALUE RECEIVED, the undersigned THREE-FIVE SYSTEMS, INC. (hereinafter called "Maker"), promises to pay to the order of IMPERIAL BANK, a California banking corporation (the "Payee"; Payee and each subsequent transferee and/or owner of this Note, whether taking by endorsement or otherwise, are herein successively called "Holder"), at 9920 South La Cienega Boulevard, Lending Services, Inglewood, California 90301, or at such other place as Holder may from time to time designate in writing, the principal sum of FIFTEEN MILLION AND NO/100 DOLLARS ($15,000,000.00) or so much thereof as Holder may advance to or for the benefit of Maker plus interest calculated on a daily basis (based on a 360-day year) from the date hereof on the principal balance from time to time outstanding as hereinafter provided, principal, interest and all other sums payable hereunder to be paid in lawful money of the United States of America at the rates of interest per annum and at the times specified in that Credit Agreement of even date herewith between the Maker and Payee (the "Credit Agreement"). Maker agrees to an effective rate of interest that is the rate stated above plus any additional rate of interest resulting from any other charges in the nature of interest paid or to be paid by or on behalf of Maker, or any benefit received or to be received by Holder, in connection with this Note. This Note is issued pursuant to the Credit Agreement. Time is of the essence of this Note. Maker shall pay all costs and expenses, including reasonable attorneys' fees and court costs, incurred in the collection or enforcement of all or any part of this Note. Failure of Holder to exercise any option hereunder shall not constitute a waiver of the right to exercise the same in the event of any subsequent default or in the event of continuance of any existing default after demand for strict performance hereof. Maker and all sureties, guarantors and/or endorsers hereof (or of any obligation hereunder) and accommodation parties hereon (severally each hereinafter called a "Surety") each: (a) agree that the liability under this Note of all parties hereto is joint and several; and (b) severally waive any and all formalities in connection with this Note to the maximum extent allowed by law, including (but not limited to) demand, diligence, presentment for payment, protest and demand, and notice of extension, dishonor, protest, demand and nonpayment of this Note. In addition, each Surety, other than Maker, consent that Holder may extend the time of payment or otherwise modify the terms of payment of any part or the whole of the debt evidenced by this Note, at the request of any other person liable hereon, and such consent shall not alter nor diminish the liability of any person hereon. This Note shall be binding upon Maker and its successors and assigns and shall inure to the benefit of Payee, and any subsequent holders of this Note, and their successors and assigns. All notices required or permitted in connection with this Note shall be given at the place and in the manner provided in the Credit Agreement for the giving of notices. If any payment of interest and/or principal is not received by the Holder hereof when such payment is due, then in addition to the remedies conferred upon the Holder hereof and the other loan documents, a late charge of five percent (5%) of the amount of the installment due and unpaid will be added to the delinquent amount to compensate the Holder hereof for the expense of handling the delinquency for any payment past due in excess of five (5) days, regardless of any notice and cure period. In any action brought under or arising out of this Note, each obligor, including successor(s) or assign(s), hereby consents to the application of Arizona law, with the exception of provisions on conflicts of laws, to the jurisdiction of any competent court within the State of Arizona, and to service of process by any means authorized by Arizona law. IN WITNESS WHEREOF, these presents are executed as of the date first written above. THREE-FIVE SYSTEMS, INC. By: ------------------------------------- Name: ----------------------------------- Its: ------------------------------------ MAKER -2- EX-10.U 3 ADDENDUM NO. 1 TO AGREEMENT ADDENDUM NO. 1 TO AGREEMENT FOR THE ASSEMBLY OF OPTOELECTRONIC AND OTHER RELATED PRODUCTS THIS ADDENDUM NO. 1 TO AGREEMENT FOR THE ASSEMBLY OF OPTOELECTRONIC AND OTHER RELATED PRODUCTS ("Addendum") is entered into as of the _____ day of March, 1997, by and between TECHNOLOGY ELECTRONIC ASSEMBLY AND MANAGEMENT (T.E.A.M.) PACIFIC CORPORATION, a Philippine corporation, with principal offices located at FTI Complex, Taguig, Metro Manila, Philippines (hereinafter referred to as "TEAM") and THREE-FIVE SYSTEMS, lNC., a Delaware, U.S.A. corporation, with its principal place of business located at 1600 North Desert Drive, Tempe, Arizona 85281 (hereinafter referred to as "TFS"). A. On February 22, 1995, TEAM and TFS entered into an agreement (the "Original Agreement") for the assembly of optoelectronic and other related products. B. TEAM and TFS now wish to add an addendum to the Original Agreement. In consideration of the foregoing recitals and mutual covenants hereinafter set forth, the parties hereto hereby agree as follows: Section 1 Definitions. 1.1 Direct Labor. Subject to the terms and conditions contained in this Addendum and in the Original Agreement, TEAM shall provide direct labor resources and other services needed by TFS for the assembly and testing of optoelectronic products and other such products as TFS shall designate from time to time pursuant to the procedures set forth in the Original Agreement. TFS will have the responsibility of providing, and will employ, all others, including its own indirect work force. For purposes of the foregoing, a person in the "direct" work force shall mean those nonsupervisory personnel directly engaged in the manufacturing of TFS products and whose hours worked are associated with labor standards. Direct labor shall include operators, material handlers, and line QA's. TFS will offer to hire the existing indirect work force of TEAM currently working on TFS' projects. The terms and conditions of this Addendum shall become fully applicable on the day that TFS hires the indirect labor force. 1.2 Available Hours. Notwithstanding the Original Agreement, and subject to Section 4 below, TFS shall pay TEAM for the Actual Work Hours ("AWH") of each direct labor employee of TEAM requested by TFS and provided by TEAM. For purposes of defining AWH, (a) the hours spent in training and work stoppages initiated by TFS are included in AWH and (b) maternity leave ("ML"), bereavement leave ("BL"), vacation leave ("VL"), and all other leaves are not included in AWH. Section 2 Data Reference. 2.1 Procedures. TFS and TEAM agree to follow the Labor Available Hours Billing Proposal set forth on Exhibit A. 2.1.1 The Timetrack system of TEAM shall validated by TFS with an attendance register. When discrepancies arise, TEAM and TFS shall reconcile data using the attendance records. 2.1.2 The authorization and approval of overtime, change of shift, VL, SL, BL, and all other leaves will be the responsibility of the TEAM representative upon the request of the appropriate TFS supervisor. 2.1.3 With respect to the direct labor force provided to TFS by TEAM, TFS will have the operational control of the direct labor but TEAM will be the employer and have the duty to provide administrative and other related services relating to the direct labor force such as payroll, hiring and cafeteria services. 2.2 Weekly Invoicing. TEAM shall invoice TFS weekly for AWH. 2.3 Standard Hours. The daily standard AWH for a direct labor person, except as otherwise provided in Section 4 below, shall be based on the work rendered or performed for 8 hours in a day including training and work stoppages initiated by TFS. 2.4 Overtime Hours. The amount of overtime hours included in the AWH for a direct labor person shall be (a) the work actually performed or rendered in excess of 8 hours in any day that is not a Sunday or holiday and (b) all work actually performed or rendered on any day that is a Sunday or holiday. The specified holidays shall be as set forth in the current TEAM guidelines and policies. Any change to TEAM's guidelines and policies which would affect the calculation of overtime hours shall require the approval of TFS. Section 3 Calculation Method. 3.1 Billing Separated. Billing by TEAM to TFS for AWH shall be separated into two categories: (a) Standard rate charge and (b) Overtime premium charge. 3.2 Standard Rate Charge. The standard rate charge shall be equal to the sum of all regular hours and overtime hours multiplied by the Standard Hourly Rate set forth on the attached Exhibit B. 3.3 Overtime Premium Charge. The overtime rate charge for each direct labor person shall be equal to the number of overtime hours multiplied by the Actual Basic Rate multiplied by the Premium Percentage set forth on the attached Exhibit B. For purposes of the foregoing, the Actual Basic Rate for each direct labor person is the actual hourly wage of that person paid by TEAM. 2 Section 4 TFS Initiated Work Stoppages. 4.1 Unannounced Stoppages. In the case of TFS initiated work stoppages which are unannounced in advance and require direct labor persons to be sent home, the AWH for such sent home persons shall as follows: (a) four hours if a person is sent home after working four or less hours in a day; (b) six hours if such person is sent home after working more than four hours but less than six; and (c) eight hours if such person is sent home after working more than six hours. 4.2 Announced Stoppages for Material Shortages. If there is an announced stoppage for material shortages or other similar TFS initiated reasons, TFS shall specify by the end of each working day (a) the actual number of persons that TEAM shall make available for the next succeeding working day ("Available Directs") and (b) an good faith estimate of the actual number of persons that TFS will require for the next three working days after that (the "Estimated Directs"). For each direct labor person that is directed not to show up (but remains as direct labor available headcount) on a regular working day ("On-Leave Directs"), TFS shall be billed by TEAM at the rate of 37% of the Actual Basic Rate (as defined in Section 3.3 above) of each On-Leave Direct. Section 5 Miscellaneous 5.1. TEAM agrees that it will work closely with TFS in TFS' development of weekly labor utilization and labor capacity schedules. This effort shall include but not be limited to TEAM providing dedicated personnel to serve on joint committees with TFS personnel and a commitment from TEAM's human resources and accounting departments to ensure that the TFS labor plan schedule is successful. 5.2 Section II.B in the Original Agreement shall no longer be applicable. TFS will guarantee to pay a minimum of 150,000 AWH per calendar quarter. 5.3 To the extent that this Addendum conflicts with the Original Agreement, this Addendum shall control. Otherwise, the Original Agreement and this Addendum shall be considered as one document. IN WITNESS WHEREOF, the parties hereto have executed this Addendum as of the day and year first above written. THREE-FIVE SYSTEMS, INC. TECHNOLOGY ELECTRONIC ASSEMBLY AND MANAGEMENT (T.E.A.M.) PACIFIC CORPORATION By: By: ------------------------------ ------------------------------ Name: Name: ------------------------------ ------------------------------ Its: Its: ------------------------------ ------------------------------ 3 EX-10.V 4 1997 EMPLOYEE STOCK OPTION PLAN THREE-FIVE SYSTEMS, INC. 1997 EMPLOYEE STOCK OPTION PLAN Section 1. Purpose of Plan; Term (a) General Purpose. The purpose of the Plan is to further the interests of Three-Five Systems, Inc., a Delaware corporation (the "Company"), and its stockholders by encouraging employees associated with the Company (or parent or subsidiary corporations of the Company) to acquire shares of the Company's common stock, thereby acquiring a proprietary interest in its business and an increased personal interest in its continued success and progress. Such purpose shall be accomplished by providing for the granting of options to acquire the Company's common stock ("Options"). A "parent corporation" for purposes of this Plan is any corporation in the unbroken chain of corporations ending with the employer corporation, where, at each link of the chain, the corporation and the link above owns at least 50 percent of the combined total voting power of all classes of the stock in the corporation in the link below. A "subsidiary corporation" for purposes of this Plan is any corporation in the unbroken chain of corporations starting with the employer corporation, where, at each link of the chain, the corporation and the link above owns at least 50 percent of the combined voting power of all classes of stock in the corporation below. (b) Options. All Options granted under this Plan will be nonqualified options and shall not be "incentive stock options" as defined in section 422 of the Code. (c) Duration of Plan. The term of the Plan is 10 years commencing on the date of adoption of the Plan by the Board. No Option shall be granted under the Plan unless granted within 10 years of the adoption of the Plan by the Board, but Options outstanding on that date shall not be terminated or otherwise affected by virtue of the Plan's expiration. Section 2. Stock and Maximum Number of Shares Subject to Plan (a) Description of Stock and Maximum Shares Allocated. The stock subject to the provisions of the Plan and issuable upon the grant of Options granted under the Plan is shares of the Company's common stock, $.01 par value per share (the "Stock"), which may be either unissued or treasury shares, as the Board may from time to time determine. Subject to adjustment as provided in Section 7 hereof, the aggregate number of shares of Stock covered by the Plan and issuable thereunder shall be 100,000 shares of Stock. (b) Calculation of Available Shares. For purposes of calculating the maximum number of shares of Stock that may be issued under the Plan, the shares issued (including the shares, if any, withheld for tax withholding requirements) upon exercise of an Option shall be counted. (c) Restoration of Unpurchased Shares. If an Option expires or terminates for any reason prior to its exercise in full and before the term of the Plan expires, the shares of Stock subject to, but not issued under, such Option shall, without further action or by or on behalf of the Company, again be available under the Plan. If shares of Stock are used to pay for the exercise price, those shares shall be added to the shares available under the Plan. Section 3. Administration; Approval; Amendments (a) General Administration. The power to administer the Plan with respect to Eligible Persons shall be vested exclusively with the Board. (b) Plan Administrator. The Board shall be referred to herein as the "Plan Administrator." The Board may, at any time, appoint a committee of one or more persons who are members of the Board and delegate to that committee the power to administer the Plan. Members of such committee shall serve for such period of time as the Board may determine and shall be subject to removal by the Board at any time. The Board may, at any time, terminate the functions of any such committee and reassume all powers and authority previously delegated to that committee. The Plan Administrator shall have the authority and discretion to select which Eligible Persons shall participate in the Plan, to grant Options under the Plan, to establish such rules and regulations as they may deem appropriate with the proper administration of the Plan and to make such determinations under, and issue such interpretations of, the Plan and any outstanding Option as they may deem necessary or advisable. Decisions of the Plan Administrator shall be final and binding on all parties who have an interest in the Plan or any outstanding Option. (c) Approval of Plan. This Plan shall not require the approval of the stockholders of the Company and shall be effective as of the date adopted by the Board. (d) Amendments to Plan. The Board may, without action on the part of the Company's stockholders, make such amendments to, changes in and additions to the Plan as it may, from time to time, deem necessary or appropriate and in the best interests of the Company; provided, the Board may not, without the consent of the Optionholder, take any action which adversely affects or impairs the rights of the Optionholder of any Option outstanding under the Plan. Section 4. Participants (a) Eligibility and Participation. Options may be granted only to persons ("Eligible Persons") who at the time of grant are employees of or consultants to the Company or parent or subsidiaries of the Company; provided, however, that any person that is an Affiliate shall not be an Eligible Person under this Plan. The Plan Administrator shall have full authority to determine which Eligible Persons in its administered group are to receive Option grants under the Plan, the number of shares to be covered by each such grant, the time or times at which each such Option is to become exercisable, and the maximum term for which the Option is to be outstanding. (b) Guidelines for Participation. In designating and selecting Eligible Persons for participation in the Plan, the Plan Administrator shall consult with and give consideration to the recommendations and criticisms submitted by appropriate managerial and executive officers of the Company. The Plan Administrator also shall take into account the duties and responsibilities of the Eligible Persons, their past, present and potential contributions to the success of the Company and such other factors as the Plan Administrator shall deem relevant in connection with accomplishing the purpose of the Plan. Section 5. Terms and Conditions of Options (a) Allotment of Shares. The Plan Administrator shall determine the number of shares of Stock to be optioned from time to time and the number of shares to be optioned to any Eligible Person (the "Optioned Shares"). The grant of an Option to a person shall neither entitle such person to, nor disqualify such person from, participation in any other grant of Options under this Plan or any other stock option plan of the Company. 2 (b) Exercise Price. Upon the grant of any Option, the Plan Administrator shall specify the option price per share. In no event may the option price per share specified by the Plan Administrator be less than 100 percent of the fair market value per share of the Stock on the date the Option is granted. (c) Calculation of Fair Market Value of Stock. The fair market value of a share of Stock on any relevant date shall be the closing selling price per share of Stock on the date in question on the stock exchange determined by the Board to be the primary market for the Stock, as such price is officially quoted in the composite tape of transactions on such exchange. If there is no reported sale of Stock on such exchange on the date in question, then the fair market value shall be the closing selling price on the exchange on the last preceding date for which such quotation exists. (d) Individual Stock Option Agreements. Options granted under the Plan shall be evidenced by option agreements in such form and content as the Plan Administrator from time to time approves, which agreements shall substantially comply with and be subject to the terms of the Plan, including the terms and conditions of this Section 5. As determined by a Plan Administrator, each option agreement shall state (i) the total number of shares to which it pertains, (ii) the exercise price for the shares covered by the Option, (iii) the time at which the Options vest and become exercisable and (iv) the Option's scheduled expiration date. The option agreements may contain such other provisions or conditions as the Plan Administrator deems necessary or appropriate to effectuate the sense and purpose of the Plan, including covenants by the Optionholder not-to-compete and remedies to the Company in the event of the breach of any such covenant. (e) Option Period. No Option granted under the Plan shall be exercisable for a period in excess of 10 years from the date of its grant subject to earlier termination in the event of termination of employment, retirement or death of the Optionholder. An Option may be exercised in full or in part at any time or from time to time during the term of the Option or provide for its exercise in stated installments at stated times during the Option's term. (f) Vesting; Limitations. The time at which the Optioned Shares vest with respect to a participant shall be in the discretion of the Plan Administrator. (g) No Fractional Shares. Options shall be exercisable only for whole shares; no fractional shares will be issuable upon exercise of any Option granted under the Plan. (h) Method of Exercising Options; Full Payment. Options shall be exercised by written notice to the Company, addressed to the Company at its principal place of business. Such notice shall state the election to exercise the Option and the number of shares with respect to which it is being exercised, and shall be signed by the person exercising the Option. Such notice shall be accompanied by payment in full of the exercise price for the number of shares being purchased. Payment may be made in cash or by check as prescribed by the applicable Plan Administrator or by tendering duly endorsed certificates representing shares of Stock then owned by the Optionholder and held for the requisite period necessary to avoid a charge to the Company's earnings and valued at fair market value on the date of exercise (as determined in accordance with Section 5(c) hereof). Upon the exercise of any Option, the Company shall deliver, or cause to be delivered, to the Optionholder a certificate or certificates representing the shares of Stock purchased upon such exercise as soon as practicable after payment for those shares has been received by the Company. If an Option is exercised pursuant to Section 5(j) hereof by any person other than the Optionholder, such notice shall be accompanied by appropriate proof of the right of such person to exercise the Option. All shares that are purchased and paid for in full upon the exercise of an Option shall be fully paid and non-assessable. 3 (i) Rights of a Stockholder. An Optionholder shall have no rights as a stockholder with respect to shares covered by his Option until such Optionholder shall have exercised the Option and paid the full exercise price for the Optioned Shares. No adjustment will be made for dividends or other rights with respect to any Optioned Shares for which the record date is prior to the date on which the Optionholder exercises the Option for such shares. (j) Exercise of Options After Cessation of Service; Termination of Employment. If any Optionholder ceases to be in Service to the Company for a reason other than death, such Optionholder may, within one month after the date of termination of such Service, but in no event after the Option's stated expiration date, exercise some or all of the Options that the Optionholder was entitled to exercise on the date the Optionholder's Service terminated; provided, that (i) if the Optionholder's Service is terminated by the Company in its good faith judgment, for (A) commission of a crime by the Optionholder or for reasons involving moral turpitude; (B) an act by the Optionholder which tends to bring the Company into disrepute; or (C) negligent, fraudulent or willful misconduct by the Optionholder, or (ii) if after the Service of the Optionholder is terminated, the Optionholder commits acts detrimental to the Company's interests, then the Option shall thereafter be void for all purposes. Notwithstanding the foregoing, if any Optionholder who is an employee of the Company ceases to be in Service to the Company by reason of permanent disability within the meaning of section 22(e)(3) of the Internal Revenue Code (as determined by the applicable Plan Administrator), the Optionholder shall have 12 months after the date of termination of Service, but in no event after Optionholder's Option's stated expiration date, to exercise Options that the Optionholder was entitled to exercise on the date the Optionholder's Service terminated as a result of disability. (k) Death of Optionholder. If an Optionholder dies while in the Company's Service, the Optionholder's vested Options on the date of death shall be exercisable within three months of such death or until the stated expiration date of the Optionholder's Option, whichever occurs first, by the person or persons ("successors") to whom the Optionholder's rights pass under a will or by the laws of descent and distribution. An Option may be exercised and payment of the option price made in full by the successors only after written notice to the Company specifying the number of shares to be purchased. Such notice shall state that the Option price is being paid in full in the manner specified in Section 5(h) hereof. As soon as practicable after receipt by the Company of such notice and of payment in full of the Option price, a certificate or certificates representing such shares shall be registered in the name or names specified by the successors in the written notice of exercise and shall be delivered to the successors. (l) Other Plan Provisions Still Applicable. If an Option is exercised upon the termination of Service or death of an Optionholder under this Section 5, the other provisions of the Plan shall still be applicable to such exercise. (m) Definition of "Service." For purposes of this Plan, unless it is evidenced otherwise in the option agreement with the Optionholder, the Optionholder shall be deemed to be in "Service" to the Company so long as such individual renders services on a periodic basis to the Company (or to any parent or subsidiary corporation) in the capacity of an employee or a consultant or independent contractor. The Optionholder shall be considered to be an employee for so long as such individual remains in the employ of the Company or one or more of its parent or subsidiary corporations. (n) Nonassignability. Except as specifically allowed by the Plan Administrator at the time of grant and as set forth in the documents evidencing an Option, no Option granted under the Plan or any of the rights and privileges conferred thereby shall be assignable or transferable by an Optionholder 4 other than by will or the laws of descent and distribution, and such Option shall be exercisable during the Optionholder's lifetime only by the Optionholder. Section 6. Certain Adjustments. (a) Capital Adjustments. The aggregate number of shares of Stock subject to the Plan (and the number of shares covered by outstanding Options and the price per share stated in such Options) shall be proportionately adjusted for any increase or decrease in the number of outstanding shares of Stock of the Company resulting from a subdivision or consolidation of shares or any other capital adjustment or the payment of a stock dividend or any other increase or decrease in the number of such shares effected without the Company's receipt of consideration therefor in money, services or property. (b) Mergers, Etc. If the Company is the surviving corporation in any merger or consolidation, any Option granted under the Plan shall pertain to and apply to the securities to which a holder of the number of shares of Stock subject to the Option would have been entitled prior to the merger or consolidation. A dissolution or liquidation of the Company shall cause every Option outstanding hereunder to terminate. A merger or consolidation in which the Company is not the surviving corporation shall also cause every Option outstanding hereunder to terminate. (c) Change in Control. With respect to any Change in Control, the Plan Administrator shall have the discretion and authority, exercisable at any time, whether before or after the Change in Control, to provide for the automatic acceleration of one or more outstanding Options granted by it under the Plan upon the occurrence of such Change in Control. The Plan Administrator may also impose limitations upon the automatic acceleration of such Options to the extent it deems appropriate. Any Options accelerated upon a Change in Control will remain fully exercisable until the expiration or sooner termination of the Option term. Section 7. Miscellaneous (a) Use of Proceeds. The proceeds received by the Company from the sale of Stock pursuant to the exercise of Options hereunder, if any, shall be used for general corporate purposes. (b) Cancellation of Options. The Plan Administrator shall have the authority to effect, at any time and from time to time, with the consent of the affected Optionholders, the cancellation of any or all outstanding Options granted under the Plan by the Plan Administrator and to grant in substitution therefore new Options under the Plan covering the same or different numbers of shares of Stock as long as such new Options have an exercise price per share of Stock no less than the minimum exercise price as set forth in Section 5(b) hereof on the new grant date. (c) Regulatory Approvals. The implementation of the Plan, the granting of any Option hereunder, and the issuance of Stock upon the exercise of any such Option shall be subject to the procurement by the Company of all approvals and permits required by regulatory authorities having jurisdiction over the Plan, the Options granted under it and the Stock issued pursuant to it. (d) Indemnification. In addition to such other rights of indemnification as they may have, the members of the Plan Administrator shall be indemnified and held harmless by the Company, to the extent permitted under applicable law, for, from and against all costs and expenses reasonably incurred by them in connection with any action, legal proceeding to which any member thereof may be a party by reason of any action taken, failure to act under or in connection with the Plan or any rights granted thereunder and 5 against all amounts paid by them in settlement thereof or paid by them in satisfaction of a judgment of any such action, suit or proceeding, except a judgment based upon a finding of bad faith. (e) Plan Not Exclusive. This Plan is not intended to be the exclusive means by which the Company may issue options or warrants to acquire its Stock, stock awards or any other type of award. To the extent permitted by applicable law, any such other option, warrants or awards may be issued by the Company other than pursuant to this Plan without stockholder approval. (f) Governing Law. The Plan shall be governed by, and all questions arising hereunder shall be determined in accordance with, the laws of the State of Arizona. (g) Withholding Taxes. Whenever the Company issues Stock under the Plan pursuant to an Option, the Company shall have the right to require the grantee to remit to the Company an amount sufficient to satisfy any federal, state and/or local withholding or employment tax requirements prior to the delivery of any certificate or certificates for such shares. Alternatively, the Company may issue or transfer such shares of Stock net of the number of shares sufficient to satisfy the withholding or employment tax requirements. For such purposes, the shares of Stock shall be valued on the date the withholding or employment tax obligation is incurred. Section 8. Securities Restrictions (a) Legend on Certificates. All certificates representing shares of Stock issued upon exercise of Options granted under the Plan shall be endorsed with a legend reading as follows: The shares of Common Stock evidenced by this certificate have been issued to the registered owner in reliance upon written representations that these shares have been purchased solely for investment. These shares may not be sold, transferred or assigned unless in the opinion of the Company and its legal counsel such sale, transfer or assignment will not be in violation of the Securities Act of 1933, as amended, and the rules and regulations thereunder. (b) Private Offering for Investment Only. The Options are, and shall be, made available only to a limited number of present and future employees of the Company, and their permitted transferees, who have knowledge of the Company's financial condition, management and its affairs. The Plan is not intended to provide additional capital for the Company, but to encourage ownership of Stock among the Company's employees. By the act of accepting an Option, each grantee or such permitted transferee agrees (i) that, any shares of Stock acquired will be solely for investment and not with any intention to resell or redistribute those shares and (ii) such intention will be confirmed by an appropriate certificate at the time the Stock is acquired if requested by the Company. The neglect or failure to execute such a certificate, however, shall not limit or negate the foregoing agreement. (c) Registration Statement. If a Registration Statement covering the shares of Stock issuable upon exercise of options granted under the Plan is filed under the Securities Exchange Act of 1933, as amended, and is declared effective by the Securities Exchange Commission, the provisions of Sections 8(a) and (b) shall terminate during the period of time that such Registration Statement, as periodically amended, remains effective. Section 9. Definitions 6 The following capitalized terms used in this Plan shall have the meaning described below: "Affiliates" shall mean all "executive officers" (as that term is defined in Rule 16a-1(f) promulgated under the Securities Exchange Act of 1934) and directors of the Company and all persons who own 10 percent or more of the Company's issued and outstanding Stock. "Board" shall mean the Board of Directors of the Company. "Change in Control" shall mean (i) a person or related group of persons, other than the Company or a person that directly or indirectly controls, is controlled by, or under common control with the Company, acquires ownership of 40 percent or more of the Company's outstanding common stock pursuant to a tender or exchange offer which the Board of Directors recommends that the Company's stockholders not accept, or (ii) the change in the composition of the Board occurs such that those individuals who were elected to the Board at the last stockholders' meeting at which there was not a contested election for Board membership subsequently ceased to comprise a majority of the Board by reason of a contested election. "Code" shall mean the Internal Revenue Code of 1986, as amended. "Company" shall mean Three-Five Systems, Inc., a Delaware corporation. "Eligible Persons" shall mean those persons who, at the time that the Option is granted, are employees of the Company, who provide valuable services to the Company or parent or subsidiaries of the Company. "Optionholder" shall mean an Eligible Person to whom Options have been granted. "Optioned Shares" shall be those shares of Stock to be optioned from time to time to any Eligible Person. "Options" shall mean options to acquire Stock granted under the Plan. "Plan" shall mean this stock option plan for Three-Five Systems, Inc. "Plan Administrator" shall mean the Board of Directors or a committee thereof. "Service" shall have the meaning set forth in Section 5(m) hereof. "Stock" shall mean shares of the Company's common stock, $.01 par value per share, which may be unissued or treasury shares, as the Board may from time to time determine. 7 This Plan is hereby executed this ________ day of _________________, 1997. THREE-FIVE SYSTEMS, INC. By: ---------------------------------- Name: David R. Buchanan Its: President and Chairman ATTESTED BY: - ----------------------------------- Secretary 8 EX-10.W 5 THREE-FIVE SYSTEMS, INC. 1998 STOCK OPTION PLAN THREE-FIVE SYSTEMS, INC. 1998 STOCK OPTION PLAN 1. Purpose. The purpose of this 1998 Stock Option Plan (the "Plan") is to attract, retain and motivate employees, independent contractors and non-employee board members by providing them with the opportunity to acquire a proprietary interest in THREE-FIVE SYSTEMS, INC. (the "Company") and to link their interests and efforts to the long-term interests of the Company's shareholders. 2. Plan Administration 2.1 In General. The Plan shall be administered by the Company's Board of Directors (the "Board"). Except for the power to amend the Plan as provided in Section 11, the Board, in its sole discretion, may delegate its authority and duties under the Plan to one or more committees appointed by the Board, under such conditions and limitations as the Board may from time to time establish. The Board and/or any committee that has been delegated the authority to administer the Plan shall be referred to as the "Plan Administrator". Except as otherwise explicitly set forth in the Plan, the Plan Administrator shall have the authority, in its discretion, to determine all matters relating to options granted under the Plan, including selection of the individuals to be granted options, the type of options granted, the number of shares of the Company's Common Stock ("Common Stock") subject to an option, vesting conditions, and any and all other terms, conditions, restrictions and limitations, if any, of an option. Notwithstanding the foregoing, no options granted under the Plan shall have a vesting period of less than one year from the date of grant. All decisions made by the Plan Administrator pursuant to the Plan and related orders and resolutions shall be final and conclusive. 2.2 Rule 16b-3 and Code Section 162(m). Notwithstanding any provision of this Plan to the contrary, only the Board or a committee composed of two or more or Non-Employee Directors may make determinations regarding grants of options to officers, directors and 10% shareholders of the Company ("Affiliates"). (The term "Non-Employee Directors shall satisfy the meaning set forth in Rule 16b-3 promulgated under the Securities Exchange Act of 1934, as amended). The Plan Administrator shall have the authority and discretion to determine the extent to which option grants will conform to the requirements of Section 162(m) Internal Revenue Code of 1986, as amended (the "Code"), and to take such action, establish such procedures, and impose such restrictions as the Plan Administrator determines to be necessary or appropriate to conform to such requirements. 3. Eligibility. Any employee of the Company (the term "employee" shall include a person who has signed an agreement to become an employee) shall be eligible to receive Incentive Stock Options and/or Nonqualified Stock Options (as such terms are defined in Section 5.1). An independent contractor or non-employee board member shall be eligible to receive only Nonqualified Stock Options. For purposes of this Section 3, "Company" includes any parent or subsidiary of the Company as defined in Section 424 of the Code. 4. Shares Subject to the Plan 4.1 Number and Source. The stock offered under the Plan shall be shares of Common Stock and may be unissued shares or shares now held or subsequently acquired by the Company as treasury shares, as the Plan Administrator may from time to time determine. Any shares subject to an option granted under the Plan that is forfeited, terminated or canceled shall again be available for the granting of options under the Plan. Subject to adjustment as provided in Section 4.2, the aggregate number of shares of Common Stock that may be issued under the Plan shall not exceed 300,000. The aggregate number of shares of Common Stock that may be covered by options granted to any one individual in any year shall not exceed 150,000. 4.2 Capital Adjustments. The aggregate numbers and type of shares available for options under the Plan, the maximum number and type of shares that may be subject to options to any individual under the Plan, the number and kind of shares covered by each outstanding option, and the exercise price per share (but not the total price) for stock options outstanding under the Plan shall all be proportionately adjusted for any increase or decrease in the number of issued shares of Common Stock resulting from any split-up, combination or exchange of shares, consolidation, spin-off or recapitalization of shares or any like capital adjustment or the payment of any stock dividend. 4.3 Mergers, Etc. If the Company is the surviving corporation in any merger or consolidation, any option granted under the Plan shall pertain to and apply to the securities to which a holder of the number of shares of Common Stock subject to the option would have been entitled prior to the merger or consolidation. A dissolution or liquidation of the Company shall cause every option outstanding under this Plan to terminate. A merger or consolidation in which the Company is not the surviving corporation shall also cause every option outstanding under this Plan to terminate, but each optionholder shall have the right, immediately prior to such merger or consolidation in which the Company is not a surviving corporation, to exercise vested options in whole or in part, subject to the other provisions of this Plan and the applicable option agreement. 5. Stock Options 5.1 Grant. The Plan Administrator may grant stock options, designated as either "Incentive Stock Options" which comply with the provisions of Section 422 of the Code or any successor statutory provision, or "Nonqualified Stock Options" The price at which shares may be purchased upon exercise of a particular option shall be determined by the Plan Administrator; however, the exercise price of any stock option shall not be less than 100% of the Fair Market Value of such shares on the date such option is granted (110% if options are intended to be Incentive Stock Options and are granted to a stockholder who at the time the option is granted owns or is deemed to own stock possessing more than 10% of the total combined voting power of all classes of stock of the Company). For purposes of the Plan, "Fair Market Value" as to a particular day equals the closing price for the Common Stock on the New York Stock Exchange as reported in the Wall Street Journal or in such other source as 2 the Plan Administrator deems reliable. If there is no reported sale of Common Stock on the New York Stock Exchange on the date in question, then Fair Market Value shall be the closing selling price on the New York Stock Exhange on the last preceding date for which an actual reported sale exists. The Plan Administrator shall set the term of each stock option, but no stock option shall be exercisable more than 10 years after the date such option is granted and, to the extent the aggregate Fair Market Value (determined as of the date the option is granted) of Common Stock with respect to which Incentive Stock Options granted to a particular individual become exercisable for the first time during any calendar year (under the Plan and all other stock option Plans of the Company) exceeds $100,000 (or such corresponding amount as may be set by the Code) such options shall be treated as Nonqualified Stock Options. An optionholder and the Plan Administrator can agree at any time to convert an Incentive Stock Option to a Nonqualified Stock Option. 5.2 No Repricing Without Shareholder Approval. No Stock Options granted to Affiliates may be repriced without the approval of the stockholders of the Company ("Repricing") within 12 months of such repricing. Stockholder approval shall be evidenced by the affirmative vote of the holders of the majority of the shares of the Company's Common Stock present and person by proxy and voting at the meeting. For purposes of this Agreement, "Repricing" shall mean that situation in which new options are issued to an optionholder in place of cancelled options and which would be reportable in the repricing table of the annual proxy. 5.3 Individual Stock Option Agreements. Options granted under the Plan shall be evidenced by option agreements in such form and content as the Plan Administrator from time to time approves, which agreements shall substantially comply with and be subject to the terms of the Plan. The option agreements may contain other provisions or conditions as the Plan Administrator deems necessary or appropriate to effectuate the sense and purpose of the Plan and may be amended from time to time in accordance with the terms thereof. 6. Option Exercise 6.1 Precondition to Stock Issuance. No shares shall be delivered pursuant to the exercise of any stock option, in whole or in part, until qualified for delivery under such securities laws and regulations as may be deemed by the Plan Administrator to be applicable thereto and until, in the case of the exercise of an option, payment in full of the option price thereof (in cash or stock as provided in Section 6.2) is received by the Company. No holder of an option, or any legal representative, legatee or distributee shall be or be deemed to be a holder of any shares subject to such option or right unless and until such shares are issued. No option may at any time be exercised with respect to a fractional share. 6.2 Form of Payment An optionholder may exercise a stock option using as the form of payment (a) cash or cash equivalent, (b) stock-for-stock payment (as described below) (c) any combination of the above, or (d) such other means as the Plan Administrator may approve. Any optionholder who owns Common Stock may use such shares, the value of which shall be as the Fair Market Value on the date the stock option is exercised, as a form of 3 payment to exercise stock options under the Plan. The Plan Administrator, in its discretion, may restrict or rescind the right to use stock-for-stock payment. A stock option may be exercised in such manner only by tendering (actually or by attestation) to the Company whole shares of Common Stock having a Fair Market Value equal to or less than the aggregate exercise price. The Plan Administrator may permit an optionholder to elect to pay the exercise price of a stock option by authorizing a third party to sell shares of Common Stock (or a sufficient portion of the shares) acquired upon exercise of the stock option and remit to the Company a sufficient portion of the sale proceeds to pay the entire exercise price plus any tax withholding resulting from such exercise. If an option is exercised by surrender of stock having a Fair Market Value less than the aggregate exercise price, the optionholder must pay the difference in cash. 7. Transferability. Any Incentive Stock Option granted under the Plan shall, during the recipient's lifetime, be exercisable only by such recipient and shall not be assignable or transferable by such recipient other than by will or the laws of descent and distribution. Except as specifically allowed by the Plan Administrator, a Nonqualified Stock Option granted under the Plan or any of the rights and privileges conferred thereby shall not be assignable or transferable by the optionholder other than by will or the laws of descent and distribution and such option shall be exercisable during the optionholder's lifetime only by the optionholder. 8. Withholding Taxes; Other Deductions. The Company shall have the right to deduct from any settlement of an option granted under the Plan, including the delivery or vesting of shares, (a) an amount sufficient to cover withholding as required by law for any federal, state or local taxes, and (b) any amounts due from the recipient of such option to the Company or to any subsidiary of the Company or to take such other action as may be necessary to satisfy any such withholding or other obligations, including withholding from any other cash amounts due or to become due from the Company to such recipient an amount equal to such taxes or obligations. 9. Termination of Services. The terms and conditions under which an option may be exercised following termination of an optionholder's employment or independent contractor relationship with the company shall be determined by the Plan Administrator; provided, however, that Incentive Stock Options shall not be exercisable at any time after the earliest of the date that is (a) three months after termination of employment, unless due to death or Disability (as defined in Section 22(e)(3) of the Code); (b) one year after termination of employment due to death or Disability. 10. Term of the Plan. The Plan shall become effective as of January 29, 1998, and shall remain in full force and effect through January 28, 2008, unless sooner terminated by the Board. After the Plan is terminated, no future options may be granted, but options previously granted shall remain outstanding in accordance with their applicable terms and conditions and the Plan's terms and conditions. 4 11. Plan Amendment. The Board may amend, suspend or terminate the Plan at any time; provided that no such amendment shall be made without the approval of the Company's stockholders if such approval is: (a) required to comply with Section 422 of the Code with respect to Incentive Stock options; (b) required for purposes of Section 162(m) of the Code; (c) required to comply with New York Stock Exchange rules and regulations; (d) required to comply with SEC or state rules and regulations; (e) to increase the number of shares available for issuance under the Plan; (f) to reduce the minimum exercise price of an option below Fair Market Value on the date of grant; or (g) to allow Repricings without shareholder approval. This Plan was unanimously adapted by the Board of Directors on January 29, 1997. 12. Approval by stockholders. The Plan shall be submitted to the stockholders of the Company for their approval at a regular meeting to be held within 12 months after the adoption of the Plan by the Board. Stockholder approval shall be evidenced by the affirmative vote of the holder of a majority of the shares of the Company's Common Stock present in person or by proxy and voting in the meeting. THREE-FIVE SYSTEMS, INC. By: ------------------------ Its: Secretary 5 EX-10.X 6 DIRECTORS' STOCK PLAN THREE FIVE SYSTEMS, INC. DIRECTORS' STOCK PLAN SECTION 1. Purpose The purpose of the Three Five Systems, Inc. Directors' Stock Plan (the "Plan") is to further strengthen the alignment of interests between members of the Board of Directors (the "Board") of Three Five Systems, Inc. (the "Company") and the Company's stockholders through the increased ownership by non-employee members of the Board ("Participants") of shares of the Company's common stock ("Common Stock"). This will be accomplished by requiring Participants to receive a portion of their fees for services as a Director in shares of Common Stock. SECTION 2. Administration The Plan shall be administered by the Board. Subject to the provisions of the Plan, the Board shall have sole and complete authority to construe and interpret the Plan; to establish, amend and rescind appropriate rules and regulations relating to the Plan; to administer the Plan; and to take all such steps and make all such determinations in connection with the Plan as it may deem necessary or advisable to carry out the provisions and intent of the Plan. All determinations of the Board shall be by a majority of its members, and its determinations shall be final and conclusive for all purposes and upon all persons, including, but without limitation, the Company, the Participants and their respective successors in interest. SECTION 3. Eligibility and Participation Participation in the Plan shall be limited to Participants. On the date specified in Section 5, each Participant shall receive shares of Common Stock equal in value (the "Specified Stock Value") to two-thirds of that Participant's annual retainer fees. The Common Stock received pursuant to this Plan shall be received in lieu of the equivalent value of annual retainer fees paid in cash. SECTION 4. Common Stock Subject to the Plan The total number of shares of Common Stock initially reserved and available for distribution under the Plan shall be 20,000, subject to adjustment as herein provided ("Total Available Shares"). If the number of treasury shares is less than the Total Available Shares, the Total Available Shares shall be reduced to the number of treasury shares. All shares distributed under the Plan (a) shall reduce the Total Available Shares and (b) must be shares previously held by the Company as treasury shares. 1 of 3 In the event of any merger, reorganization, consolidation, recapitalization, Common Stock dividend, Common Stock split or other change in corporate structure affecting the Common Stock, the Board, in its sole discretion, shall make such modifications, substitutions or adjustments as it deems necessary to reflect such change so as to prevent the dilution or enlargement of rights, including, but not limited to, modifications, substitutions or adjustments in the aggregate number of shares reserved for issuance under the Plan. SECTION 5. Issuance of Shares Shares of Common Stock shall be issued annually under the Plan on the date of the annual meeting of the shareholders of the Company. The number of shares of Common Stock to be received by a Participant under the Plan shall be equal to the Specified Stock Value divided by the closing price of the Common Stock as reported in the Wall Street Journal (or in such other source as the Board deems reliable) for the last market trading day prior to the annual meeting of the Shareholders of the Company. All shares issued under the Plan, including fractional shares, shall be held in a book-entry account with the Company's transfer agent unless the Board designates another person to act in that capacity. Participants may in the alternative elect to receive a stock certificate representing the number of whole shares acquired by notifying the Corporate Secretary of the Company in writing. The Company will make a cash payment to the Participants for any fractional share in lieu of issuing a stock certificate. Common Stock acquired under this Plan shall be subject to such other conditions and restrictions, if any, as the Board may determine. SECTION 6. Additional Provisions The Board may, at any time, amend, alter or discontinue the Plan, but no amendment, alteration or discontinuance shall be made which would impair the rights of a Participant with respect to shares of Common Stock previously, distributed to such Participant under the Plan, without the Participant consent, or which, would cause the Plan not to comply with Rule 16b-3. With respect to persons subject to Section 16 of the Act, transactions under this Plan are intended to comply with all applicable conditions of Rule 16b-3 regardless of whether such conditions are set forth in the Plan. To the extent any provision of the Plan or action by the Board fails to so comply, it shall be deemed null and void, to the extent permitted by law and deemed advisable by the Board. Every recipient of shares pursuant to this Plan shall be bound by the terms and provisions of this Plan, and the acceptance of any transfer of shares pursuant to this Plan shall constitute a binding agreement between the recipient and the Company. 2 of 3 SECTION 7. Duration of the Plan The Plan was approved unanimously by the Board on January 29, 1998 and shall become effective immediately. THREE-FIVE SYSTEMS, INC. --------------------------------- Jeffrey D. Buchanan Secretary 3 of 3 EX-10.Y 7 ADDENDUM NO. 2 TO AGREEMENT FOR THE ASSEMBLY ADDENDUM NO. 2 TO TECHNOLOGY ELECTRONIC ASSEMBLY AND MANAGEMENT (T.E.A.M) PACIFIC CORPORATION AND THREE-FIVE SYSTEMS, INC. AGREEMENT FOR THE ASSEMBLY OF OPTOELECTRIC AND OTHER RELATED PRODUCTS THIS ADDENDUM NO. 2 TO THE AGREEMENT FOR THE ASSEMBLY OF OPTOELECTRIC AND OTHER RELATED PRODUCTS ("Addendum No. 2") is entered into as of the 1st day of January, 1998, by and between TECHNOLOGY ELECTRONIC ASSEMBLY and MANAGEMENT (T.E.A.M.) PACIFIC CORPORATION, a Philippine Corporation, with principle offices located at FTI Complex, Taguig Metro Manila, Philippines (hereinafter referred to as "TEAM") and THREE-FIVE SYSTEMS, INC., a Delaware, U.S.A. corporation, with its principle place of business located at 1600 North Desert Drive, Tempe, Arizona 85281 (hereinafter referred to as "TFS"). RECITALS A. On February 1995, TEAM and TFS entered into an agreement ("the "Original Agreement") for the manufacture of optoelectric and other related products( hereinafter referred to as "Products"). On March 12, 1997, the Original Agreement was amended (the "Addendum No. 1"). B. TEAM and TFS now wish to add a second addendum to the Original Agreement. In consideration of the foregoing recitals and mutual covenants hereinafter set forth, the parties hereto hereby agree as follows: AGREEMENT Section 1 Definitions. The following terms are used in this Addendum No. 2: 1.1 Contract Exchange Rate: Shall be defined as the exchange rate identified in Section V of the Original Agreement (US$1.00 = 27.00 Philippine Pesos). 1.2 Spot Exchange Rate: Shall be defined as the actual exchange rate reported in the Western Edition of the Wall Street Journal on date prior to invoice payment date. 1.3 Contract Amount: Shall be in accordance with Section V (B) calculations of the Original Agreement as modified by Addendum No. 1. 1.4 Contract Period: Shall commence as of February 22, 1995 and run through any applicable payment date. 1.5 Lease Amount: Shall be the US$21,384 amount that TFS pays to Team monthly for rent pursuant to the Lease Agreement between the parties. 1.6 Contract Amount Gain: Shall be defined as the excess (or deficit, as the case may be) amount of money accrued by TFS on the payment of the Contract Amount as the result of the payment of such Contract Amount being fixed in Pesos at the Contract Exchange Rate and the Spot Exchange Rate of Pesos to US dollars being higher or lower than the Contract Exchange Rate. To illustrate this situation, shown below is a sample computation assuming that the invoiced amount is US$500,000 and that the Spot Exchange Rate at the time of invoicing was US$1.00 = 30.00 Philippine Pesos. Invoice amount US $ 500,000.00 Multiply by Contract Exchange Rate X 27.00 ----------------------- Invoice Amount in Pesos PHP 13,500,000.00 Divide by Spot Exchange Rate / 30.00 ----------------------- Contract Amount to be paid in USD US $ 450,000.00 Contract Amount Gain US $ 50,000.00 ======================= 1.7 Lease Amount Gain (Loss): Shall be defined as the excess (or deficit, as the case may be) amount of money accrued by Team on the receipt of the Lease Amount as the result of the payment of such Lease Amount being fixed in dollars and the Spot Exchange Rate of Pesos to US dollars being higher or lower than the Contract Exchange Rate. To illustrate this situation, shown below is a sample computation assuming that the Spot Exchange Rate at the time of invoicing was US$1.00 = 30.00 Philippine Pesos as compared with the Contract Exchange Rate of US$1.00 = 27.00: Lease Amount US $ 21,384.00 Multiply by Contract Exchange Rate X 27.00 -------------------- Lease Amount in Peso PHP 577,368.00 Divided By Spot Exchange Rate / 30.00 -------------------- Lease Amount In Dollars US $ 19,241.00 Lease Amount Gain US $ 2,138.00 ==================== 1.8 Net Exchange Rate Gain (Loss): Shall be defined as the sum of the Contract Amount Gain (Loss) and the Lease Amount Gain (Loss). Section 2 Responsibility and Payment for Net Exchange Rate Gain and Loss 2.1 Contract Amount Gain. TFS will retain 100% of all Contract Amount Gains up to the date until all prior Contract Amount Losses incurred by TFS have been offset against all such Contract Amount Gains. Upon the occurrence of this offset event, TFS will thereafter pay TEAM an amount equal to (a) 30% of the Net Exchange Rate Gain existing for any given invoicing period less (b) the Lease Amount Gain for that same period. As of the date of this Agreement, the offset date occurred as described in Attachment A. 2.2 Net Exchange Rate Loss. From and after the date of this Agreement, upon the occurrence of a Contract Amount Loss, TEAM will pay to TFS an amount equal to (a) 30 percent of the Net Exchange Rate Loss existing for any given invoicing period less (b) the Lease Amount Loss for the same period. Team will only be required to make payments under this Section 2.2 until the amounts paid by TEAM pursuant to this Section 2.2 equal the amounts received by TEAM pursuant to Section 2.1. Thereafter, TFS will bear 100 percent of the Contract Amount Loss. 2.3 Catch Up. The calculation of the payments due under this Agreement as of February 4, 1998 is set forth on Attachment A of this Addendum No. 2 and shall be paid immediately upon the signing of this Addendum No. 2. 2 Section 3 Integration To the extent that this Addendum No. 2 conflicts with the Original Agreement or Addendum No. 1, this Addendum No. 2 shall control. Otherwise, the Original Agreement, Addendum No. 1 and this Addendum No. 2 will be considered as one document. The parties hereto have executed this Addendum as of the day and year first above written. THREE-FIVE SYSTEMS, INC TEAM PACIFIC CORPORATION By: By: -------------------- -------------------- Name: Name: -------------------- -------------------- Its: Its: -------------------- -------------------- 3 EX-21 8 LIST OF SUBSIDIARIES Exhibit 21 List of Subsidiaries Name Place of Incorporation - -------------------------------- ---------------------- Three-Five Systems, Limited United Kingdom Three-Five Systems Pacific, Inc. Philippines EX-23 9 CONSENT ARTHUR ANDERSEN LLP ARTHUR ANDERSEN LLP CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our report included in this Form 10-K, into the Company's previously filed Registration Statement File No's. 333-77600, 333-76090, 33-36968, 33-88706, and 333-32795. /s/ ARTHUR ANDERSEN LLP Phoenix, Arizona, March 4, 1998. EX-27.1 10 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED BALANCE SHEET AT DECEMBER 31, 1997 AND THE RELATED CONSOLIDATED STATEMENTS OF INCOME AND OF CASH FLOWS FOR THE TWELVE MONTHS ENDED DECEMBER 31, 1997 OF THREE-FIVE SYSTEMS, INC. AND ITS SUBSIDIARIES AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. THIS EXHIBIT SHALL NOT BE DEEMED FILED FOR THE PURPOSE OF SECTION 11 OF THE SECURITIES ACT OF 1933 AND SECTION 18 OF THE SECURITIES EXCHANGE ACT OF 1934, OR OTHERWISE SUBJECT TO THE LIABILITY OF SUCH SECTIONS, NOR SHALL IT BE DEEMED A PART OF ANY OTHER FILING WHICH INCORPORATES THIS REPORT BY REFERENCE, UNLESS SUCH OTHER FILING EXPRESSLY INCORPORATES THIS EXHIBIT BY REFERENCE. 1,000 U.S. Dollars YEAR DEC-31-1997 JAN-01-1997 DEC-31-1997 1 16,371 0 13,120 580 8,255 42,705 42,235 12,388 72,835 13,592 0 0 0 79 0 72,835 84,642 84,642 64,760 76,423 193 0 0 8,577 3,334 5,243 0 0 0 5,243 .67 .65
EX-27.2 11 AMENDED AND RESTATED FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED BALANCE SHEET AT DECEMBER 31, 1995 AND THE RELATED CONSOLIDATED STATEMENTS OF INCOME AND OF CASH FLOWS FOR THE TWELVE MONTHS ENDED DECEMBER 31, 1995 OF THREE-FIVE SYSTEMS, INC. AND ITS SUBSIDIARIES, IN ADDITION, CERTAIN ENTRIES HAVE BEEN AMENDED FROM THE PREVIOUS FINANCIAL DATA SCHEDULE FILED FOR THIS PERIOD. THIS SCHEDULE IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. THIS EXHIBIT SHALL NOT BE DEEMED FILED FOR THE PURPOSE OF SECTION 11 OF THE SECURITIES ACT OF 1933 AND SECTION 18 OF THE SECURITIES EXCHANGE ACT OF 1934, OR OTHERWISE SUBJECT TO THE LIABILITY OF SUCH SECTIONS, NOR SHALL IT BE DEEMED A PART OF ANY OTHER FILING WHICH INCORPORATES THIS REPORT BY REFERENCE, UNLESS SUCH OTHER FILING EXPRESSLY INCORPORATES THIS EXHIBIT BY REFERENCE. 1,000 U.S. Dollars 12-MOS DEC-31-1995 JAN-01-1995 DEC-31-1995 1 4,551 0 9,949 603 13,703 29,917 38,346 4,853 63,780 7,517 0 0 0 77 0 63,780 91,585 91,585 70,481 78,263 122 0 0 13,965 5,548 8,417 0 0 0 8,417 1.09 1.04
EX-27.3 12 AMENDED AND RESTATED FINANCIAL DATA SCHEDULES
5 THESE SCHEDULES CONTAIN SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED BALANCE SHEETS AT MARCH 31, 1996, JUNE 30, 1996, AND SEPTEMBER 30, 1996 AND THE RELATED CONSOLIDATED STATEMENTS OF INCOME AND OF CASH FLOWS FOR THE PERIODS ENDED MARCH 31, 1996, JUNE 30, 1996, AND SEPTEMBER 30, 1996 OF THREE-FIVE SYSTEMS, INC. AND ITS SUBSIDIARIES (THE "COMPANY"). THESE SCHEDULES ARE QUALIFIED IN THEIR ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. THE INFORMATION PROVIDED FOR THE SIX MONTHS ENDED JUNE 30, 1996 HAS BEEN RESTATED PURSUANT TO STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 128, EARNINGS PER SHARE ("SFAS NO. 128"). NO OTHER QUARTERLY FINANCIAL STATEMENTS FOR THE COMPANY'S FISCAL YEAR ENDED DECEMBER 31, 1996 WERE RESTATED AS A RESULT OF SFAS NO. 128. IN ADDITION, CERTAIN ENTRIES ON EACH OF THESE SCCHEDULES HAVE BEEN AMENDED FROM THE PREVIOUS FINANCIAL DATA SCHEDULE FILED FOR EACH OF THE PERIODS INDICATED. THIS EXHIBIT SHALL NOT BE DEEMED FILED FOR THE PURPOSE OF SECTION 11 OF THE SECURITIES ACT OF 1933 AND SECTION 18 OF THE SECURITIES EXCHANGE ACT OF 1934, OR OTHERWISE SUBJECT TO THE LIABILITY OF SUCH SECTIONS, NOR SHALL IT BE DEEMED A PART OF ANY OTHER FILING WHICH INCORPORATES THIS REPORT BY REFERENCE, UNLESS SUCH OTHER FILING EXPRESSLY INCORPORATES THIS EXHIBIT BY REFERENCE. 1,000 U.S. Dollars 3-MOS 6-MOS 9-MOS DEC-31-1996 DEC-31-1996 DEC-31-1996 JAN-01-1996 JAN-01-1996 JAN-01-1996 MAR-31-1996 JUN-30-1996 SEP-30-1996 1 1 1 6,295 8,461 9,878 0 0 0 6,325 4,777 5,334 639 651 648 15,801 15,243 6,215 29,679 30,115 29,851 38,593 38,676 38,731 5,676 6,538 7,397 62,955 62,622 61,522 5,965 5,456 8,343 0 0 0 0 78 0 0 0 0 77 0 78 0 0 0 62,955 62,622 61,522 18,082 32,539 45,657 18,082 32,539 45,657 14,401 26,345 46,143 16,870 31,105 53,293 27 99 116 0 0 0 0 0 0 1,204 1,487 (7,510) 482 595 (2,924) 722 892 (4,586) 0 0 0 0 0 0 0 0 0 722 892 (4,586) 0.09 0.12 (0.59) 0.09 0.11 (0.59)
EX-27.4 13 RESTATED FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED BALANCE SHEET AT SEPTEMBER 30, 1997 AND THE RELATED CONSOLIDATED STATEMENTS OF INCOME AND OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 OF THREE-FIVE SYSTEMS, INC. AND ITS SUBSIDIARIES (THE "COMPANY"), AS RESTATED PURSUANT TO STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 128, EARNINGS PER SHARE ("SFAS NO. 128"). THIS SCHEDULE IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. NO OTHER QUARTERLY FINANCIAL STATEMENTS FOR THE COMPANY'S FISCAL YEAR ENDED DECEMBER 31, 1997 WERE RESTATED AS A RESULT OF SFAS NO. 128. THIS EXHIBIT SHALL NOT BE DEEMED FILED FOR THE PURPOSE OF SECTION 11 OF THE SECURITIES ACT OF 1933 AND SECTION 18 OF THE SECURITIES EXCHANGE ACT OF 1934, OR OTHERWISE SUBJECT TO THE LIABILITY OF SUCH SECTIONS, NOR SHALL IT BE DEEMED A PART OF ANY OTHER FILING WHICH INCORPORATES THIS REPORT BY REFERENCE, UNLESS SUCH OTHER FILING EXPRESSLY INCORPORATES THIS EXHIBIT BY REFERENCE. 1,000 U.S. Dollars 9-MOS DEC-31-1997 JAN-01-1997 SEP-30-1997 1 10,198 0 14,207 415 10,148 39,274 41,705 11,350 69,922 13,736 0 0 0 79 0 69,922 58,940 58,940 45,376 53,902 60 0 0 5,441 2,084 3,357 0 0 0 3,357 0.43 0.41
-----END PRIVACY-ENHANCED MESSAGE-----