SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the Quarter Ended September 30, 2004

Commission file number 1-4373

THREE-FIVE SYSTEMS, INC.

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES [X] NO [  ]

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

THREE-FIVE SYSTEMS, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR QUARTER ENDED SEPTEMBER 30, 2004

TABLE OF CONTENTS

ITEM 1. FINANCIAL STATEMENTS

THREE-FIVE SYSTEMS, INC.

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

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THREE-FIVE SYSTEMS, INC.

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

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THREE-FIVE SYSTEMS, INC.

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

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THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Note A Three-Five Systems, Inc. (together with its subsidiaries, herein referred to as “we,” “us,” or “the Company”) is a global provider of electronics manufacturing services, or EMS. We design and manufacture electronic printed circuit board assemblies, radio frequency, or RF, modules, display modules and systems, and complete systems for customers in the computing, consumer, industrial, medical, telecommunications and transportation industries. Our services include advanced engineering support, “designed for” services, automated printed circuit board assembly, in-circuit and functional testing, systems level integration and box build, turn-key packaging, fulfillment services, and turn-key supply chain management services, all of which enable our customers the ability to outsource all stages of product engineering, design, development, materials procurement and management, manufacturing, and testing. Our design and manufacturing services include a distinctive competence in display modules and systems and the integration of display modules and systems into other products. The display modules and systems we design and manufacture primarily utilize liquid crystal displays, or LCDs. Those LCDs include small form factor monochrome and color LCDs, including thin film transistor LCDs, or TFTs, as well as large format flat panel monitors, all of which are TFTs. To a smaller extent, we also utilize organic light emitting diodes, or OLEDs.

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

Note B Inventories:

Inventories are stated at the lower of cost (first-in, first-out) or net realizable value and consisted of the following at (in thousands):

Shipping terms with one of our major customers is FOB destination, and many of those products are shipped by sea, taking four to six weeks to reach their destinations. As a result, product in transit that was in our finished goods inventory was $3.4 million as of September 30, 2004 compared with $3.6 million as of December 31, 2003.

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

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

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

During the third quarter of 2004, we wrote off $435,000 of our Redmond inventory due to the pending end-of-life of several long-running programs. The conclusion of the move of the display module operations from Manila to Beijing resulted in inventory write-offs and other charges of $806,000. Lastly, in Manila we wrote off $202,000 of inventory related to our RF programs.

Note C Property, Plant, and Equipment:

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

In April 2004, we purchased our facility in Manila from our lessor and paid $3.8 million. Of the $3.8 million paid, $2.9 million was assigned to the carrying value of the building and $846,000 was applied to accrued rent liabilities. We also paid $614,000 to the RBF Development Corporation, or RBF, for a 50 year land right. Lastly, we executed an agreement with RBF for an option to purchase the leased land for $1 at any time until April 23, 2014. As a result of the building purchase and land right agreement, we will no longer be required to pay the $7.8 million in lease payments due over the next seven years that was remaining on our original ten year lease agreement.

During the third quarter of 2004, our facility in Tempe was reclassified as an asset held for sale back into property, plant, and equipment. This reclassification added $10.4 million to land and building and $757,000 to furniture and equipment and an amount equal to $2.6 million to accumulated amortization.

The remaining capital expenditures during the first nine months of 2004 related primarily to equipment purchased from Integrex, our ongoing ERP implementation, and additions in China related to our TFT clean room.

Note D Asset Held for Sale:

In the fourth quarter of 2003, we formalized plans to sell our Tempe, Arizona corporate facility. Therefore, we reclassified $8.6 million of our building and improvements to assets held for sale. The building was listed and actively marketed for sale at the beginning of October 2003. In the third quarter of 2004, we agreed to sell the Tempe building for approximately $11 million and leaseback the entire facility for a period of five years. The Tempe building, which had been previously classified as an asset held for sale, is now considered to be an asset held for sale and leaseback. Accordingly, depreciation costs in the amount of $362,000, which would otherwise have been recorded during the period the building was held for sale, were recorded in the third quarter. That sale is expected to finalize near the end of 2004.

Note E Intangibles:

In January 2003, we signed licensing and manufacturing agreements with Data International Co., Ltd. of Taiwan. Under those agreements, we became the exclusive channel in the Americas for standard and custom LCD products manufactured by Data International. We also have the right to sell those products through our worldwide channels. The agreements provide us with access to a full suite of standard display products that round out our existing standard product portfolio. The cost of the license was $3.9 million, of which $1.0 million was paid upon signing and we entered into a $2.9 million term loan. In the first quarter

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of 2004, we paid $1.4 million against the term loan. The remaining $1.5 million is due in January 2005 and is subject to reduction if certain margin targets are not met.

Intangibles consist of mask works, trademarks, customer lists, and distribution rights. SFAS No. 142, Goodwill and Other Intangible Assets, requires purchased intangible assets with finite lives to be amortized over their useful lives. Purchased intangibles are recorded at cost and amortized using the straight-line method over the estimated useful lives of the respective assets, which range from two to five years. Our policy is to commence amortization of intangibles when their related benefits begin to be realized.

In the third quarter of 2004, we wrote off the remaining $1.8 million of the customer list associated with the AVT acquisition. This write-off occurred as a result of numerous changes in the AVT business, including notification during the quarter that a customer was not renewing a program. That notification, along with the other cumulative changes that have occurred since the acquisition, have now resulted in a complete turnover in the customer base. Most of these changes were driven mainly by the fact that the original business when acquired by us was selling CRT displays and now is exclusively selling LCD flat panel displays. Going forward, the amortization of intangibles will relate solely to the ETMA customer lists, the mask sets and to the license agreement with Data International, as described above.

Intangible assets consisted of the following (in thousands):

The acquisition value of the customer lists acquired from our AVT acquisition was $3.0 million and the accumulated amortization was $1.2 million.

Estimated annual amortization expense through 2008 and thereafter, including actual amortization for the first nine months of 2004, related to intangible assets reported as of September 30, 2004 is as follows (in thousands):

Note F Goodwill:

In the second quarter of 2004, we agreed with Unico Holdings to exchange its ownership interest in TFS-Malaysia for approximately 423,000 shares of our common stock in a transaction valued at $2.8 million, compared with Unico Holdings’ interest of $2.6 million. As a result of that transaction, we now own 100% of TFS-Malaysia.

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In the third quarter of 2004, we determined that the $27 million goodwill balance associated with the acquisitions of ETMA, located in Redmond, Washington, and TFS-Malaysia was impaired. Because of the ongoing performance issues experienced by the Redmond location, including the integration issues experienced in Redmond in the second and third quarters of 2004, and because of the reduction in market comparables, we engaged a professional valuation firm to assist us in determining the fair value of the ETMA and TFS-Malaysia goodwill. The valuation included a market comparable study and a present value valuation based on management’s best estimates of the future cash flows. The amount of the impairment loss was $21.3 million, and was determined in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets.

We also conducted an analysis of the goodwill relating to the AVT acquisition, and that analysis indicated no impairment to the AVT goodwill asset.

Changes in goodwill from December 31, 2003 to September 30, 2004 (in thousands) were as follows:

Note G Segment Information:

We offer advanced design and manufacturing services with an emphasis on displays. Historically, we focused on display-oriented products, although we have always performed extended manufacturing in conjunction with the display module. In the past two years, we expanded the value-added manufacturing services we provide through several acquisitions. As a result, we now provide printed circuit board assembly, or PCBA, radio frequency, or RF, module assembly, new product introduction, or NPI, box build, and order fulfillment, even in products that do not include displays. In products that do include displays, we specialize in custom and standard display solutions utilizing various display technologies, including liquid crystal displays, or LCDs and organic light emitting diodes, or OLEDs. The products we manufacture for customers are of varying sizes and have varying levels of integration.

As a result of the spin-off of our microdisplay division into Brillian, we now report only one operating segment, although we also track net sales and certain property, plant, equipment, and intangibles by geographic location. Net sales by geographic area are determined based upon the location of the end customer, while long-lived assets are based upon physical location of the assets. The following includes net sales (in thousands) for our designated geographic areas:

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     In the third quarter of 2004, our sales were distributed over six major markets: computing, consumer, industrial, medical, telecommunications, and transportation. During October 2004, we reclassified the 2004 sales to one of our customers from the consumer market segment to the industrial market segment as compared to previously reported results. This reclassified 2004 first quarter market segment sales by $16,000, second quarter market segment sales by $34,000, third quarter market segment sales by $169,000 and year-to-date market segment sales by $219,000. On a 2004 percentage basis for the consumer and industrial markets, there was no change in the first quarter percentage, a 0.1% change in the second quarter percentage, a 0.4% change in the third quarter percentage and a 0.1% change in the year-to-date percentage. Our net sales distributed by market were as follows: