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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
Annual Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 1998
Commission File Number 1-4373
THREE-FIVE SYSTEMS, INC.
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(Exact Name of Registrant as Specified in Its Charter)
Delaware 86-0654102
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(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
1600 North Desert Drive, Tempe, Arizona 85281
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(Address of Principal Executive Offices)
(602) 389-8600
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(Registrant's Telephone Number, Including Area Code)
Securities registered under Section 12(b) of the Exchange Act:
Title of Each Class Name of Each Exchange On Which Registered
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Common Stock, Par Value $.01 Per Share New York Stock Exchange
Securities registered under Section 12(g) of the Exchange Act: None
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12
months (or for such shorter period that the registrant was required to file such
reports) and (2) has been subject to such filing requirements for the past 90
days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
As of March 8, 1999, the aggregate market value of the voting stock held by
non-affiliates of the issuer, computed by reference to the price at which stock
was sold as of such date in the stock market as reported on the New York Stock
Exchange, was $68,080,668. Shares of Common Stock held by each officer and
director and by each person who owns 10% or more of the outstanding Common Stock
have been excluded in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily conclusive and does not
constitute an admission of affiliate status.
As of March 8, 1999, there were 7,012,107 shares of the issuer's Common Stock
outstanding.
Documents incorporated by reference: Portions of the issuer's definitive Proxy
Statement for the 1999 Annual Meeting of Stockholders are incorporated by
reference into Part III hereof.
THREE-FIVE SYSTEMS, INC.
ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 1998
TABLE OF CONTENTS
Page
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PART I
ITEM 1. BUSINESS.......................................................... 1
ITEM 2. PROPERTIES........................................................ 22
ITEM 3 LEGAL PROCEEDINGS................................................. 22
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............... 22
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND
RELATED STOCKHOLDER MATTERS..................................... 23
ITEM 6. SELECTED FINANCIAL DATA........................................... 24
ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS............................. 25
ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK............................................... 34
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA....................... 35
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE............................. 35
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS.................................. 35
ITEM 11. EXECUTIVE COMPENSATION............................................ 35
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT.................................................. 35
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................... 35
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES,
AND REPORTS ON FORM 8-K......................................... 36
SIGNATURES.................................................................. 38
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STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
THE STATEMENTS CONTAINED IN THIS REPORT ON FORM 10-K THAT ARE NOT
PURELY HISTORICAL ARE FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF
APPLICABLE SECURITIES LAWS. FORWARD-LOOKING STATEMENTS INCLUDE STATEMENTS
REGARDING THE COMPANY'S "EXPECTATIONS," "ANTICIPATION," "INTENTIONS," "BELIEFS,"
OR "STRATEGIES" REGARDING THE FUTURE. FORWARD-LOOKING STATEMENTS ALSO INCLUDE
STATEMENTS REGARDING REVENUE, MARGINS, EXPENSES, AND EARNINGS ANALYSIS FOR
FISCAL 1999 AND THEREAFTER; TECHNOLOGICAL INNOVATIONS; FUTURE PRODUCTS OR
PRODUCT DEVELOPMENT; THE COMPANY'S PRODUCT DEVELOPMENT STRATEGIES; POTENTIAL
ACQUISITIONS OR STRATEGIC ALLIANCES; THE SUCCESS OF PARTICULAR PRODUCT OR
MARKETING PROGRAMS; THE AMOUNTS OF REVENUE GENERATED AS A RESULT OF SALES TO
SIGNIFICANT CUSTOMERS; AND LIQUIDITY AND ANTICIPATED CASH NEEDS AND
AVAILABILITY. ALL FORWARD-LOOKING STATEMENTS INCLUDED IN THIS REPORT ARE BASED
ON INFORMATION AVAILABLE TO THE COMPANY AS OF THE FILING DATE OF THIS REPORT,
AND THE COMPANY ASSUMES NO OBLIGATION TO UPDATE ANY SUCH FORWARD-LOOKING
STATEMENTS. THE COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE
FORWARD-LOOKING STATEMENTS. AMONG THE FACTORS THAT COULD CAUSE ACTUAL RESULTS TO
DIFFER MATERIALLY ARE THE FACTORS DISCUSSED IN ITEM 1, "BUSINESS - SPECIAL
CONSIDERATIONS."
PART I
ITEM 1. BUSINESS
INTRODUCTION
The Company designs and manufactures a wide range of display modules
for use in the end products of original equipment manufacturers ("OEMs"). Most
of the Company's sales consist of custom display modules developed in close
collaboration with its customers. Devices designed and manufactured by the
Company find application in cellular telephones and other wireless communication
devices as well as in medical equipment, office automation equipment, industrial
process controls, instrumentation, consumer electronic products, automotive
equipment, and industrial and military control products. The Company currently
specializes in liquid crystal display ("LCD") components and technology in
providing its design and manufacturing services for its customers. The Company
markets its services primarily in North America, Europe, and Asia through direct
technical sales persons and, to a much lesser extent, through an independent
sales and distribution network.
The Company experienced substantial growth from 1993 through 1995 with
net sales increasing from $38.0 million in 1993 to $91.6 million in 1995. The
Company's growth during that period, however, depended primarily upon the
Company's participation in the substantial growth of the wireless communications
market and sales to a single major customer in that industry. In 1996, the
Company's sales declined to $60.7 million, largely as the result of the
phase-out by that major customer of a significant family of programs in early
1996, and the Company reported a loss in 1996 as a result of that phase-out and
the significant inventory reserve taken during the third quarter. The Company's
sales increased to $84.6 million in 1997 and $95.0 million in 1998, primarily as
a result of several new programs, including programs for a telecommunications
customer and an office automation customer. The growth that occurred during the
period from 1993 through 1995 allowed the Company to construct the highest
volume passive matrix LCD glass production facility in North America, which
enables the Company to produce a substantial portion of its LCD glass
requirements, as well as to attract key personnel, expand its research and
development efforts, and build its infrastructure. The Company has undertaken
substantial efforts to broaden its customer base by obtaining new customers and
by increasing its business with those existing customers that historically have
comprised a small percentage of the Company's revenue. The Company has also
undertaken efforts to expand its markets by (1) placing sales personnel in new
geographic locations, (2) setting up a new manufacturing facility in China, (3)
targeting new industrial applications, and (4) developing new kinds of products.
The Company believes that it is positioned to continue the growth that
it experienced in 1997 and 1998 as a result of its efforts in expanding its
customer base and the markets it serves as well as its strength in designing,
prototyping, and producing, on a timely and cost-efficient basis, a wide range
of innovative, distinctive, and high-quality display modules required in the end
products of OEMs. In the past few years, the Company has refocused its research
and development capabilities with the intention of developing display
technologies and manufacturing processes that will be useful for its current and
future customers. The Company's design processes utilize advanced computer-aided
design software to provide custom solutions for customers' products in time
frames and on cost bases that it believes are competitive. The Company utilizes
advanced, flexible manufacturing systems that can accommodate low-volume
production runs or highly sophisticated applications in Arizona and high-volume,
price sensitive runs in Manila, the Philippines and Beijing, China.
The Company maintains its principal executive offices at 1600 North
Desert Drive, Tempe, Arizona 85281, and its telephone number is (602) 389-8600.
Unless the context indicates otherwise, all references to the "Company" refer to
Three-Five Systems, Inc., its subsidiaries and predecessors.
TECHNOLOGY
Since the commercial introduction of the first light emitting diodes
("LEDs") in the 1960s and twisted nematic liquid crystal displays in the 1970s,
the use of LCD and LED indicators has become widespread in industrial and
consumer electronic products. Prior to these innovations, the most common
displays or indicators had substantial limitations as to their use, especially
in terms of size, life, and power consumption. LCD and LED technologies were
developed in order to overcome these limitations.
1
An LCD modifies light that passes through or is reflected by it, rather
than emitting light like an LED. An LCD generally consists of a layer of liquid
crystalline material suspended between two glass plates. The crystals align
themselves in a predictable manner, and this alignment changes when stimulated
electrically. This changed alignment produces a visual representation of the
information desired when used in conjunction with a polarizer and either natural
ambient light or an external light source.
The Company also has undertaken substantial efforts with respect to
liquid crystal on silicon (LCoS(TM)) microdisplays. Liquid crystal on silicon
displays are a form of LCD where, instead of suspending liquid crystalline
material between two glass plates, the material is suspended between a glass
plate and silicon backplate. The silicon backplate is an integrated circuit that
provides drive signals for each element of the display (for instance,
active-matrix drive) and also provides logic functions, such as serial to
parallel conversion and data storage. Because highly developed silicon
integrated circuits form the basis of these displays, the LCoS(TM) technology
provides very high information displays in a small size and at a relatively low
cost. The high information presented by such displays is magnified for view,
generally either in a projector or in a view-finder.
INDUSTRY OVERVIEW
The Company has benefited from the determination by certain OEMs in the
electronics industry to outsource the design and production of certain
components included in the end products of those OEMs. The Company believes that
the following factors have contributed to this growing trend among OEMs:
+ As technology has become increasingly sophisticated and complex, it
has become more difficult for even the leading OEMs to maintain the
necessary technology, expertise, personnel, and equipment to design
and produce internally all of the various components necessary for
their products.
+ Advanced design and manufacturing processes require increasingly
greater investments for research and development, personnel, and
equipment.
+ Competitive market conditions require OEMs to reduce the period of
time from product conception to delivery, to differentiate their
products from those of their competitors, to improve user
friendliness, and to continually enhance product performance and
reduce product cost during the life cycle of the product.
OEMs often design their products to contain display modules as a highly
cost-effective means of differentiating their products from competing products.
OEMs then make the decision of whether to use standard devices, to design and
produce the devices in-house, or to outsource with a third party for design and
production. In making this decision, companies often recognize that their
greatest strengths consist of consumer recognition of brand names, market
research and product development expertise, and highly developed sales and
distribution channels. OEMs also recognize that the desired devices often cannot
be obtained "off-the-shelf" and that time constraints and limitations on
available resources often preclude them from maintaining the specialized
in-house expertise and equipment necessary to design and manufacture the desired
devices. OEMs often conclude that the logical solution is to focus their
resources on those areas (such as marketing and distribution) where they possess
the greatest leverage and to outsource the design and production of devices and
components in which they lack the requisite technology and expertise.
Outsourcing enables OEMs to obtain the following desired benefits:
+ To gain access to specialized design and manufacturing technology and
expertise.
+ To accelerate the design process and to reduce design and
manufacturing costs by utilizing the specialized personnel, equipment,
and facilities of the supplier.
+ To reduce their own investment in personnel, equipment, and facilities
necessary for specialized design and production capabilities.
+ To streamline their own operations by concentrating their resources on
the design, production, and distribution of their core products.
2
By eliminating the duplication and overlap of investment and resources,
outsourcing permits the Company and the OEMs to work together and grow at a
faster rate than would otherwise be possible. Outsourcing greatly reduces the
Company's need to devote time and resources on market development for specific
products and allows the Company to concentrate on the development of its display
technologies and their applications to a multitude of products.
PRODUCTS AND SERVICES
The Company currently emphasizes custom-designed display modules. The
Company believes that custom devices represent a significant source of its
profits and growth potential. For each custom device, the Company works directly
with its customer to develop and produce the original design and to manufacture
the device in accordance with the customer's specifications. The Company also
designs and produces standard or "off-the-shelf" devices, which involve designs
that are adaptable to various fixed end uses without modification or with slight
modifications. In the last few years, the Company's standard devices have
accounted for less than 10 percent of its revenues. In 1999, however, the
Company is planning to introduce new standard products using some of the
Company's new display technologies.
The Company pursues a strategy designed to enable it to enhance its
position as a major, worldwide supplier of custom-designed and manufactured
display modules for products of leading OEMs in various high growth industries.
The Company attempts to identify industries that present the greatest long-term
potential for growth at any given time. The Company's research and development
activities then focus upon technological developments that attempt to meet the
current and future requirements of those industries. The Company seeks to
establish strong and long-lasting customer relationships by aligning its
prospects with those of its customers and by seeking to make its engineering and
advanced manufacturing functions seamless extensions of the product design and
production departments of its customers. The Company engages in a careful
customer selection process because it recognizes that its own growth and
development will be closely aligned with the growth and development of the
customers it serves. The Company's strategy currently involves concentrating its
efforts on providing design and production services to leading companies in five
primary industries: cellular telephones and other wireless communications, data
collection, office automation, medical devices, and industrial process controls.
More recently, with the availability of the high-volume LCD
manufacturing line in Arizona, the Company has begun focusing its efforts on
creating advanced display technologies. These advanced display technologies will
allow the Company to provide its customers with differentiating products or
products that provide higher information content. These products may be
available for use in custom devices or in standard devices. The Company
currently has three announced technology initiatives. First, the Company has
patented a new type of LCD display that emulates an emissive LED display, which
the Company calls LCiD(TM) or Liquid Crystal intense Display. This low
information content device provides a multi-colored emissive-looking display at
passive LCD prices. The second initiative involves the creation of a high
information content display with numerous gray shades but again at the price of
a more typical LCD. This new product is called LCaD(TM) or Liquid Crystal active
Drive(TM). This technology is based, in part, on technology licensed from Motif,
Inc. and additional proprietary technology developed by the Company. The third
technology initiative is liquid crystal on silicon microdisplays or LCoS(TM).
LCoS(TM) microdisplays provide high-resolution (up to one million pixels and
beyond) active matrix displays that are less than 8/10 of an inch in diameter on
the diagonal. LCoS(TM) microdisplays are expected to serve the need for
portable, high information content displays in industries such as wireless
communications, office automation, and industrial process controls. In addition,
the Company expects that LCoS(TM) microdisplays will open new market industries
for the Company in areas such as business and consumer electronics, as well as
provide a source for inexpensive, high resolution displays in projection
products such as rear-projection monitors, high-definition televisions, and
front projection audio-visual units.
CUSTOM DEVICES
LCD and LED custom displays currently account for approximately 95.3
percent of the Company's revenue, with the majority consisting of LCD custom
displays. A manufacturer of a complete system or product requiring a specific
type of visual display (such as a cellular telephone, medical instrument,
business machine, or hand-held data collection device) represents a typical
buyer for a custom device.
3
The Company has developed a sophisticated design process to meet the
specific needs of its customers' applications. Each design project normally
involves a cross-functional team of Company engineers who are assigned to a
customer program. The team consults with the customer's engineers throughout the
design phase, prototype development, and manufacturing process. The Company
continues to supply value-added engineering support after the design solution
has been developed and integrated into the manufacturing process in an ongoing
effort to provide customers with product performance enhancements and
cost-reduction opportunities.
STANDARD DEVICES
Standard devices encompass a wide variety of LCD and LED devices having
varied applications. "Visible" LCD and LED standard devices include
+ solid state lamps used for indicators, status lights, on-board circuit
monitors, and instrumentation;
+ multi-digit numerical displays used for calculators, industrial
controls, data terminals, instrumentation timers, hand-held
instruments, event counters, test equipment, embedded computing
equipment, and consumer applications;
+ integrated displays (with on-board integrated circuit drivers) and
alpha numeric displays used for hand-held terminals, embedded
computing equipment and telecommunications; and
+ bar graph displays (with integrated circuit drivers) used as linear,
logarithmic and VU meters in stereo systems, radios, magnetic
recording devices, process control instruments, and volt meters.
Standard infrared devices include infrared emitters used in remote
controllers, disk drives, tape drives, printers, encoders, solid state relays,
photoelectric controls, slotted switches, reflective switches, intrusion alarms,
touch screens, wireless data entry terminals, and positioning sensor
applications.
Standard LCiD(TM) display devices will include a 1 line by 10 character
and 2 line by 10 character dot matrix display available in a variety of colors.
The Company expects that LCiD(TM) displays will be used primarily in lower
information content applications where high contrast, desired color, and ease of
readability from full sunlight to complete darkness are required. Typical
applications for LCiD(TM) display standard devices would include automotive
instrumentation, appliances, hand-held instrumentation devices, vending
equipment, stereo equipment, embedded computing equipment, remote sensing
equipment, outdoor monitor equipment, and industrial controls.
Standard LCaD(TM) display devices will include a variety of backlit
quarter VGA (240 rows x 320 columns), 16 gray shade capable display systems. The
standard LCaD(TM) display will consist of a complete display system
incorporating LCD panel, lighting, memory, LCD controller, and interface
electronics. Typical applications for the LCaD(TM) display would include medical
and industrial instrumentation, test equipment, point-of-sale terminals, mapping
and hand held global positioning system devices, stereo equipment, and embedded
computing equipment.
MANUFACTURING SERVICES
The Company has geographically organized its manufacturing capabilities
in a manner that optimizes the combination of technology and human resources.
This enables the Company to compete solely on the basis of cost, if necessary,
with suppliers of similar products and services throughout the world. Advanced
manufacturing techniques include surface mount technologies, chip-on-board,
chip-on-flex, flip-chip, tape automated bonding, and sophisticated testing
systems throughout the process.
The Company seeks to increase its value to its customers by providing
responsive, flexible, total manufacturing services. To date, manufacturing
services have been concentrated toward the manufacture of LCDs and assembly of
Company-designed display module assemblies. The Company will provide extended
manufacturing services beyond these core services, however, if the customer
requires them. Extended services may include adding additional components, such
as a keypad, microphone, card reader, product housing, or non-display electronic
sub-assembly, or the turn-key manufacture of a complete OEM product.
4
MANUFACTURING FACILITIES
The Company currently conducts manufacturing operations in Tempe,
Arizona; Manila, the Philippines; and Beijing, China. The Arizona facility
houses a Class 1000 "clean room" and LCD fabrication and prototyping operation.
The Company utilizes this facility primarily to conduct LCD research and
development, to produce prototype and pre-production runs of devices for
customer approval, to conduct full production runs of low-volume devices, and to
develop advanced manufacturing processes that can be applied in the Philippines
and China during full-scale production. In addition, the facility has the
largest fully automated LCD glass production capacity in North America. This
highly automated line enables the Company to reduce its dependence on foreign
suppliers of LCD glass. Facility personnel include a team of experts ranging
from LCD research scientists to specialized engineers with backgrounds in
electronics, mechanics, chemistry, physics, and manufacturing. The Company
maintains a wide variety of state-of-the-art testing and quality control
equipment at the facility.
High volume display module manufacturing is done in Manila, the
Philippines and Beijing, China. In Manila, the Company is a party to an
agreement (the "Sub-Assembly Agreement") with Technology Electronic Assembly and
Management Pacific Corporation ("TEAM"), pursuant to which TEAM supplies direct
manufacturing services at a facility owned by TEAM located in Manila. The
Company is also party to a lease agreement (the "Lease Agreement") with TEAM
pursuant to which TEAM leases space to the Company with respect to those
manufacturing operations services performed by TEAM under the Sub-Assembly
Agreement. TEAM manufactures, assembles, and tests devices designed by the
Company in the space leased to the Company and pursuant to procedures set forth
in the Sub-Assembly Agreement in accordance with specifications supplied by the
Company. In 1997, TEAM and the Company entered into an amendment to the
Sub-Assembly Agreement whereby all indirect manufacturing employees (primarily
technicians, supervisors, and engineers) became employees of the Company. As a
result, under the Sub-Assembly Agreement TEAM now only supplies the direct labor
and certain incidental services required to manufacture the Company's products.
The Company owns the manufacturing, assembling, and testing equipment (including
automated die attach and wire bond equipment with automatic pattern recognition
features for die and wire placement for LED die) as well as the processes and
documentation used by TEAM at the Manila facility. The Company pays TEAM for the
direct manufacturing personnel based upon a negotiated available hourly rate.
The Company employs all professional personnel, including an Operations Manager,
with a support staff consisting of manufacturing supervisors; manufacturing,
quality, and process engineers; and logistics and administrative personnel at
the Manila facility.
The Sub-Assembly Agreement and Lease Agreement between the Company and
TEAM extend through December 31, 1999 and are renewable from year to year
thereafter. The Sub-Assembly Agreement requires the Company to maintain minimum
production levels. The termination of the Lease Agreement or Sub-Assembly
Agreement or the inability of TEAM to fulfill its requirements under the
Sub-Assembly Agreement would require the Company to acquire additional
manufacturing facilities or to contract for additional manufacturing services.
The Philippines has been subject to volcanic eruptions, typhoons, and
substantial civil disturbances, including attempted military coups against the
government. Although there has not been any material interruption of operations
to date, these circumstances could affect the Company's ability to obtain
products pursuant to the Sub-Assembly Agreement. The termination or inability of
the Company to obtain products pursuant to the Sub-Assembly Agreement, even for
a relatively short period, would have a material adverse effect on the
operations and profitability of the Company.
The Company commenced manufacturing operations in the People's Republic
of China ("China") during 1998. The China facility is a high-volume display
module manufacturing facility similar to the Company's current facility in
Manila. The Company initially leased a facility in Beijing on a temporary basis,
and the Company commenced manufacturing in that temporary facility in the third
quarter of 1998. The Company has begun construction of its own facility in
Beijing and expects to move into that new facility in the middle of 1999. The
Company employs all direct and indirect manufacturing employees at the facility,
including technicians, supervisors, and engineers. The Company expects the
initial cost of equipping and constructing the China facility to be
approximately $10.0 million. For further discussions on the Company's operations
in China, see Item 7, "Management's Discussion and Analysis of Financial
Conditions and Results of Operations" and Item 1, "Special Considerations - The
Company Faces Risks Associated with International Operations."
5
QUALITY CONTROL
The Company has an aggressive quality control program and maintains at
each of its facilities quality systems and processes that meet or exceed the
demanding standards set by many leading OEMs in targeted industries. The Company
bases its quality control program upon Statistical Process Control, which
advocates continual quantitative measurements of crucial parameters and uses
those measurements in a closed-loop feedback system to control the manufacturing
process. The Company performs product life testing to help ensure long-term
product reliability. The Company analyzes results of product life tests and
takes actions to refine the manufacturing process or enhance the product design.
Increased global competition has led to increased customer expectations
with respect to price, delivery, and quality. Customers often evaluate price in
the quotation process, while delivery and quality are evaluated only after the
product is received. Therefore, many customers preview a company's quality by
viewing the quality systems employed. The Company has received ISO 9002
certification of its Manila manufacturing facility. ISO is a quality standard
established by the International Organization for Standardization, which
attempts to ensure that the processes used in development and production remain
consistent. This is accomplished through documentation maintenance, training,
and management review of the processes used. Although achievement of ISO 9002
certification is no guarantee of the Company's ability to obtain future
business, it is a factor that enables the Company's customers to recognize that
the Company's production processes meet this established, global standard of
performance.
SALES AND MARKETING
The Company markets its services primarily in North America and Europe
through direct technical sales persons. In 1998, the Company added direct
technical sales persons in Asia. To a much lesser extent, the Company also
markets some standard products through an independent sales and distribution
network. This network includes two franchised distributors in approximately 91
sales offices. A staff of in-house, Arizona-based sales and engineering
personnel directs and aids all direct and distribution sales. The Company also
has sales personnel in California, Massachusetts, Illinois, North Carolina, and
Florida.
The Company's sales to customers in Europe represented approximately 35
percent of net sales in 1998. In addition to a direct technical sales force, the
Company distributes products in Europe through a network of distributors,
augmented in some regions by marketing representatives. This network receives
support from the marketing, customer service, and support staff employed by the
Company's subsidiary, Three-Five Systems Limited, located in Swindon, England.
In addition, the Company's design engineers in Tempe, Arizona provide design
input for customers in Europe.
The Company's sales to customers is Asia represented approximately 7.0
percent of net sales in 1998. The Company has added several direct technical
sales and marketing persons in Asia and has also trained Chinese design
engineers to provide design input for customers in Asia.
CUSTOMERS
The Company's strategy involves concentrating its efforts on providing
design and production services to leading companies in five primary industries:
cellular telephones and other wireless communications, data collection, office
automation, medical devices, and industrial process controls. As a result, the
Company generally derives its revenue from services provided to a limited number
of customers. The Company's largest customer is Motorola, Inc. ("Motorola"). The
Company currently designs and manufactures display modules used in approximately
45 individual product programs for Motorola. Sales to Motorola accounted for
63.6 percent of the Company's revenue during 1998. Devices that are used in
cellular telephones accounted for substantially all of the Company's sales to
Motorola in 1998. Motorola continues to award new design programs to the
Company. Motorola has an LCD module allocation process in which it designates
three or four key LCD module vendors, including the Company, and communicates to
each vendor the anticipated annual amount of purchases. Although the allocation
process does not provide a guarantee of business to the Company, it provides an
indication that purchases by Motorola during 1999 could continue at 1998 levels.
The Company's second-largest customer in 1998 was Hewlett-Packard
6
Company ("Hewlett-Packard"). Sales to Hewlett-Packard accounted for 6.6 percent
of the Company's revenue during 1998. As the display modules manufactured by the
Company for Hewlett-Packard moved into second generation versions in 1998, the
selling price of some of those modules was greatly reduced. In addition, the
number of LCD display modules required by Hewlett-Packard was also greatly
reduced as Hewlett-Packard moved to less expensive front panel devices in an
extremely competitive market. Consequently, in 1998 the percentage of the
Company's revenue attributed to Hewlett-Packard declined substantially. See Item
1, "Special Considerations - Certain Customers Account for a Significant Portion
of the Company's Sales."
BACKLOG
As of December 31, 1998, the Company had a backlog of orders of
approximately $23.3 million, all of which are believed to be firm and all of
which are expected to be filled during fiscal 1999. The backlog of orders at
December 31, 1997 was approximately $21.8 million. The Company's business has
some seasonality as the result of the significant amount of retail products into
which its products are placed. Design cycles have shortened and many customers
finish cycles in the fourth quarter (because of the holiday sales season) and
ramp up new products in the second quarter of the calendar year. Consequently,
the first quarter of a calendar year may have a disproportionately lower
percentage of the year's total sales. In both 1997 and 1998, sales in the fourth
quarter were approximately 60 percent greater than sales in the first quarter.
PATENTS AND TRADEMARKS
The Company relies on a combination of patent, trade secrets and
trademark laws, confidentiality procedures, and contractual provisions to
protect its intellectual property. Although the Company's existing core business
does not depend on any patent or trademark protection, the Company is
manufacturing more advanced display products in which there are patent or
trademark issues. For example, the Company has patents on its LCiD(TM) display
technology. The Company also signed a license agreement with Motif, Inc. to
license the technology that forms the basis of its LCaD(TM) or Liquid Crystal
active Drive. The Company has applied for a patent on its LCaD(TM) technology
and has filed several patents relating to its LCoS(TM) microdisplay technology.
The Company has also applied for numerous other process and product patents, all
related to display technologies.
RAW MATERIALS
The principal raw materials used in producing the Company's displays
consist of LCD glass, driver die, circuit boards, molded plastic parts, lead
frames, wire, chips, and packaging materials. The Company's procurement strategy
provides alternative sources of supplies for the majority of these materials.
Many of such materials, however, must be obtained from foreign suppliers, which
subjects the Company to the risks inherent in obtaining materials from foreign
sources, including supply interruptions and currency fluctuations. The Company's
suppliers currently are meeting the requirements of the Company, and strategic
supplier alliances have further strengthened relations with offshore suppliers.
The Company's ability to produce a significant percentage of its requirements of
LCD glass in its Arizona facility has reduced the Company's dependence on
foreign LCD glass suppliers. See Item 1, "Special Considerations - The Company
May be Subject to Shortages of Raw Materials and Supplies."
COMPETITION
The Company believes that Optrex, Seiko-Epson, Samsung, Seiko
Instruments, Sharp, Hosiden, Hyundai, PCI, and Philips Components constitute the
principal competitors for the Company's LCD devices. Hewlett-Packard, Rohm,
LiteOn, Siemens, Stanley Electric Company, and Quality Technologies Corp.
constitute its principal competitors for its LED devices and for its LCiD(TM).
Most of these competitors are large companies that have greater financial,
technical, marketing, manufacturing, and personnel resources than the Company.
The revenue, profitability, and success of the Company depend substantially upon
its ability to compete with other providers of display modules. The Company
cannot provide assurance that it will continue to be able to compete
successfully with such organizations.
7
The Company currently competes principally on the basis of the
technical innovation and performance of its display modules, including their
ease of use and reliability, as well as on their cost, timely design, and
manufacturing and delivery schedules. The Company's competitive position could
be adversely affected if one or more of its customers, particularly Motorola,
determines to design and manufacture their display modules internally or secure
them from other parties. See Item 1, "Special Considerations - The Company Faces
Intense Competition."
RESEARCH AND DEVELOPMENT
The Company conducts an active and ongoing research, development, and
engineering program that focuses on advancing technology, developing improved
design and manufacturing processes, and improving the overall quality of the
products and services that the Company provides. Research and development
personnel concentrate on LCD technology, especially improving the performance of
current products and expanding the technology to serve new markets. The Company
also conducts research and development in manufacturing processes, including
those associated with efficient, high-volume production and electronic
packaging.
More recently, the Company has focused its research and development
efforts on new display technologies. See Item 1, "Business - Products and
Services." The Company has undertaken a significant research and development
program with respect to the development of LCoS(TM) microdisplays and expects
that the majority of available research and development personnel hours will be
dedicated to LCoS(TM) microdisplays in 1999.
ENVIRONMENTAL REGULATION
The operations of the Company result in the creation of small amounts
of hazardous waste, including various epoxies, gases, inks, solvents, and other
wastes. The amount of hazardous waste produced by the Company may increase in
the future depending on changes in the Company's operations. The general issue
of the disposal of hazardous waste has received increasing focus from federal,
state, local, and international governments and agencies and has been subject to
increasing regulation. See Item 1, "Special Considerations - Environmental
Regulation."
In a separate matter, the Company conducted a clean-up of limited
chemical contamination at its former property located in Barkhamsted,
Connecticut. The contamination was caused by the previous owner of the property,
and not as a result of any of the Company's operations. The Company has
contracted with an environmental consulting firm for assistance with the
clean-up process and has complied with the requests and recommendations of the
Connecticut Environmental Protection Agency throughout the process. The Company
believes that the source of the contamination has been removed from the property
and that the clean-up has been completed. Four monitoring wells have been
installed to permit periodic chemical analysis to be made at the property. The
property was sold on June 25, 1995, subject to the Company making its best
efforts to obtain from either the Connecticut or Federal Environmental
Protection Agency documentation to the effect that the property is clean and
that there is no actionable contamination in the vicinity of the property.
EMPLOYEES
As of December 31, 1998, the Company employed a total of 867 persons.
This number includes 172 full-time and approximately 16 temporary employees at
its principal U.S. facility in Tempe, Arizona and U.S. sales offices; 256
employees at its manufacturing facility in Manila, the Philippines; 415
employees at its manufacturing facility in Beijing, China; and 8 employees at
its Three-Five Systems, Ltd. subsidiary in Swindon, England. The Company
considers its relationship with its employees to be good, and none of its
employees currently are represented by a union in collective bargaining with the
Company.
TEAM provides the personnel engaged in the direct assembly of the
Company's devices in Manila pursuant to the Sub-Assembly Agreement between the
Company and TEAM. See Item 1, "Business - Manufacturing Facilities." As of
December 31, 1998, approximately 1,152 persons performed direct labor operations
at the Manila facility through the Sub-Assembly Agreement with TEAM.
8
EXECUTIVE OFFICERS
The following table sets forth information concerning each of the
Company's executive officers.
NAME AGE POSITION
---- --- --------
David R. Buchanan 66 Chairman of the Board, President, and Chief
Executive Officer
Lawrence E. Kagemann, Sr. 56 Vice President - Operations
Radu Andrei 48 Vice President - Marketing and Sales
Jeffrey D. Buchanan 43 Executive Vice President - Finance,
Administration, and Legal; Chief Financial
Officer; Secretary; Treasurer; and Director
Dan J. Schott 59 Vice President - Research and Development
Robert T. Berube 60 Principal Accounting Officer and Corporate
Controller
DAVID R. BUCHANAN has been Chairman of the Board of the Company since
its formation in February 1990. Mr. Buchanan served as the Company's President
and Chief Executive Officer from February 1990 until July 1998. In January 1999,
Mr. Buchanan reassumed duties as interim President and Chief Executive Officer
while the Board of Directors conducts a search for a new President and Chief
Executive Officer. Mr. Buchanan also served as Treasurer of the Company from May
1990 until January 1994 and as Chairman of the Board, Chief Executive Officer,
President, and a director of one of the predecessors of the Company from October
1986, February 1987, and November 1985, respectively, until the predecessor's
merger into the Company in May 1990.
LAWRENCE E. KAGEMANN, SR. has been Vice President - Operations of the
Company since August 10, 1998. Mr. Kagemann served as Vice President - Quality
and Manufacturing Technology for Harman OEM Group ("Harman") from 1990 until
December 1996, where he led quality, plant, manufacturing, advanced
manufacturing, and supplier engineering for the U.S. and Wales sites. In 1997,
Mr. Kagemann was appointed Vice President - Audio for Computer Operations and
Quality for Harman, where he had responsibility for maintaining quality and
supplier engineering for the U.S. and Wales sites. From August 1997 to August
1998, Mr. Kagemann held the position of Vice President - Quality and Supplier
Engineering for Harman, where he was assigned the responsibility of quality and
supplier engineering for the group.
RADU ANDREI has been Vice President - Marketing and Sales of the
Company since June 1, 1998. Mr. Andrei served a Research Director for Semico
Research Arizona and Intechno Consulting Director - Basel, Switzerland/Phoenix,
Arizona from 1996 until June 1998. His responsibilities included assessing the
market, analyzing external market drivers, correlating the results of business
core competencies, resources and objectives, and devising a long-term plan. In
1994 and 1995, Mr. Andrei held the position of Manager, Strategic Marketing and
Systems Engineering (Director) for Motorola SPS Division in Phoenix, Arizona.
JEFFREY D. BUCHANAN has served as a director and Executive Vice
President - Finance, Administration, and Legal of the Company since June 1998;
as Chief Financial Officer and Treasurer of the Company since June 1996; and as
Secretary of the Company since May 1996. Mr. Buchanan served as Vice President -
Finance, Administration, and Legal of the Company from June 1996 until July 1998
and as Vice President - Legal and Administration of the Company from May 1996 to
June 1996. Mr. Buchanan served as a Senior Member of O'Connor, Cavanagh,
Anderson, Killingsworth & Beshears from June 1986 until May 1996, where he
practiced as a business lawyer with an emphasis on mergers and acquisitions,
joint ventures, and taxation. Mr. Buchanan was associated with the international
law firm of Davis Wright Tremaine from 1984 to 1986, and he was a senior staff
person at Deloitte & Touche from 1982 to 1984. Mr. Buchanan is a member of the
Arizona and Washington state
9
bars and passed the certified public accounting examination in 1983. Mr.
Buchanan is the son of David R. Buchanan.
DAN J. SCHOTT has been Vice President - Research and Development of the
Company since July 1996. From January 1994 until July 1996 he served as the
Company's Vice President of Technology. From 1988 to January 1994, Mr. Schott
was an Associate Director with Honeywell Inc., where his responsibilities
included flat panel display research and development. From 1981 until 1987, Mr.
Schott held various engineering management and program management positions with
Sperry Rand Corp.
ROBERT T. BERUBE has been the Company's Principal Accounting Officer
since July 1998 and has served as the Company's Corporate Controller since July
1990.
SPECIAL CONSIDERATIONS
A VARIETY OF FACTORS AFFECT THE COMPANY'S OPERATING RESULTS
A wide variety of factors affect the Company's operating results and
could adversely impact its net sales and profitability. These factors, many of
which are beyond the control of the Company, include the following:
+ the Company's ability to identify industries that have significant
growth potential and to establish strong and long-lasting
relationships with companies in those industries;
+ the Company's ability to provide significant design and manufacturing
services for those companies on a timely and cost-effective basis;
+ the Company's success in maintaining customer satisfaction with its
design and manufacturing services;
+ market acceptance of products of its customers incorporating devices
designed and manufactured by the Company;
+ customer order patterns, changes in order mix, and the level and
timing of orders placed by customers that the Company can complete in
a quarter;
+ the performance and reliability of devices designed and manufactured
by the Company;
+ the life cycles of its customers' products;
+ the availability and utilization of manufacturing capacity;
+ fluctuations in manufacturing yield and productivity;
+ the quality, availability, and cost of raw materials, equipment, and
supplies;
+ the timing of expenditures in anticipation of orders;
+ the cyclical nature of the industries and the markets served by the
Company;
+ technological changes; and
+ competition and competitive pressures on prices.
The Company's ability to increase its design and manufacturing capacity
to meet customer demand and maintain satisfactory delivery schedules represent
important factors in its long-term prospects. Although the Company's product
solutions are incorporated into a wide variety of communications, consumer,
medical, office automation, and industrial products, a majority of its sales in
1998 were display modules for cellular products. A slowdown in demand for
customer products, particularly cellular and office automation products that
utilize the Company's products, as a result of economic or other conditions in
the United States or worldwide markets served by the Company or other
broad-based factors would adversely affect the Company's operating results.
10
CERTAIN CUSTOMERS ACCOUNT FOR A SIGNIFICANT PORTION OF THE COMPANY'S SALES
In the past few years, the Company has generated most of its revenue
from sales to a few significant customers. Motorola, the Company's largest
customer, accounted for 63.6 percent of the Company's revenue in 1998, 34.6
percent of revenue in 1997, and 65.1 percent of revenue in 1996. Devices used in
cellular telephones accounted for substantially all of the Company's sales to
Motorola in 1998. The Company anticipates that sales to Motorola in 1999 will
reach or exceed 1998 levels, but believes that the percentage of its net revenue
from sales to Motorola should decrease in 1999 as a result of increased sales to
other customers. The Company's second largest customer is Hewlett-Packard, which
accounted for 6.6 percent of the Company's revenue during 1998. This amount
represents a significant reduction from sales to Hewlett-Packard that accounted
for 32.0 percent of the Company's sales in 1997. See Item 1, "Business -
Customers."
Although the Company has begun to enter into more manufacturing
contracts with its customers, the principal benefit of these contracts is to
clarify order lead times, inventory risk allocation, and similar matters and not
to provide firm, long-term volume purchase commitments. Customers generally do
not provide firm long-term volume purchase commitments to the Company. Thus,
customers can cancel purchase commitments and change or delay expected volume
levels. The Company may be unable to replace canceled, delayed, or reduced
commitments in a timely manner. The cancellation, delay, or reduction of
customer commitments could result in the Company holding excess and obsolete
inventory or having unfavorable manufacturing variances as a result of
under-absorption. These risks are enhanced because of the large percentage of
sales to customers in the retail electronics industry, which is subject to
severe competitive pressures, rapid technological change, and obsolescence. The
Company's operating results have been materially and adversely affected in the
past as a result of the non-realization of anticipated orders and deferrals or
cancellations of orders as a result of changes in customer requirements. For
example, in 1998 the Company made two announcements that sales would not meet
its expectations because of delays in customer programs. Cancelled, delayed, or
reduced commitments from any of the Company's major customers, particularly
Motorola, would have a material adverse effect on the Company's results of
operations.
A few of the Company's customers have inquired about "inventory
hubbing" agreements, under which the Company would maintain stocks of finished
goods at or near the customer's factory. Although the Company has not yet
entered into such agreements, the use of such type of agreements for significant
customers could result in higher inventory balances and excess inventory.
THE COMPANY FACES INTENSE COMPETITION
The Company serves intensely competitive industries that are
characterized by price erosion, rapid technological change, and foreign
competition. The Company competes with major domestic and international
companies. Most of the Company's competitors are located in Asia, and many have
greater market recognition and substantially greater financial, technical,
marketing, distribution, and other resources than the Company possesses. See
Item 1, "Business - Competition." Emerging companies also may increase their
participation in the display module market. The Company currently competes
principally on the basis of the technical innovation and performance of its
display modules, including their ease of use and reliability, as well as on
pricing and timely design, manufacturing, and delivery schedules. The Company's
ability to compete successfully depends on a number of factors, both within and
outside its control. These factors include the following:
+ the quality, performance, reliability, features, ease of use, pricing,
and diversity of its product solutions;
+ foreign currency fluctuations, which may cause a foreign competitor's
products to be priced significantly lower than the Company's products;
+ the quality of its customer services;
+ its ability to address the needs of its customers;
+ its success in designing and manufacturing new product solutions,
including those implementing new technologies;
11
+ the availability of adequate sources of raw materials and other
supplies at acceptable prices;
+ its efficiency of production;
+ the rate at which customers incorporate the Company's display modules
into their own products;
+ product solution introductions by the Company's competitors;
+ the number, nature, and success of its competitors in a given market;
and
+ general market and economic conditions.
The Company's competitive position could be adversely affected if one
or more of its customers increase their own capacity and decide to design and
manufacture their own display modules, to use standard devices, or to outsource
with a competitor. The Company cannot provide assurance that it will continue to
be able to compete successfully in the future.
THE COMPANY'S BUSINESS DEPENDS ON NEW PRODUCTS AND TECHNOLOGIES
The Company operates in fast changing industries. Technological
advances, the introduction of new products, and new design and manufacturing
techniques could adversely affect the Company's operations unless it is able to
adapt to the resulting changing conditions. As a result, the Company will be
required to expend substantial funds for and commit significant resources to
+ continuing research and development activities;
+ engaging additional engineering and other technical personnel;
+ purchasing advanced design, production, and test equipment; and
+ enhancing design and manufacturing processes and techniques.
The Company's future operating results will depend to a significant
extent on its ability to continue to provide design and manufacturing services
for new products that compare favorably on the basis of time to introduction,
cost, and performance with the design and manufacturing capabilities of OEMs and
other third-party suppliers. The success of new design and manufacturing
services depends on various factors, including the following:
+ proper customer selection;
+ utilization of advances in technology;
+ innovative development of new solutions for customer products;
+ efficient and cost-effective services;
+ timely completion and delivery of new product solutions; and
+ market acceptance of customers' end products.
Because of the complexity of the Company's design and manufacturing services,
the Company from time to time may experience delays in completing the design and
manufacture of new product solutions. In addition, certain new product solutions
may not receive or maintain customer or market acceptance. The Company's
inability to design and manufacture solutions for its customers' new products on
a timely and cost-effective basis would adversely affect its future operating
results. See Item 1, "Business - Products and Services."
Finally, circumstances outside of the Company's control may cause the
loss of expected revenue even when the Company satisfactorily completes a design
and manufacturing solution. For example, a customer may terminate or delay its
own program for any number of reasons unrelated to the Company, including
problems with other suppliers to the program or lack of market acceptance of the
customer's product.
12
THE COMPANY FACES RISKS ASSOCIATED WITH RESEARCH AND DEVELOPMENT EFFORTS
The Company currently is investing in research and development of
several new technologies that it plans to introduce in the future. Some or all
of those technologies may not successfully make the transition from the research
and development lab to cost-effective manufacturability as a result of
technology problems, competitive cost issues, yield problems, and other factors.
An investment of significant amounts of resources in one or more technologies
that fail to achieve manufacturability could have a material adverse effect on
the Company. In addition, even if a new technology proves to be manufacturable,
the Company's customers and the customers' marketplaces may not accept the
technology because of price or technology issues or because of unfavorable
comparisons with products introduced by others. The Company will be required to
make significant expenditures, including development expenses and various
capital expenditures and investments, for these new technologies. For example,
the Company estimates that its initial capital expenditures for LCoS(TM)
microdisplays will be approximately $3.0 million to $4.0 million. The Company
also made an equity investment of $3.3 million in Siliscape, Inc. during 1998
for the purposes of further developing the LCoS(TM) microdisplay product.
Significant investments in one or more of the new technologies, especially
LCoS(TM) microdisplays, that ultimately prove to be unsuccessful for any reason
could have a material adverse impact on the Company. In addition, if Siliscape
were to encounter technological or financial difficulties, the value of the
Company's investment in that company could decline, in which case the Company
would have to write down all or a portion of its investment and report a loss
equal to such write-down.
THE COMPANY FACES RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS
GENERAL. The Company currently has substantial manufacturing operations
located in the Philippines, China, and the United States. The Company also
maintains a sales office and distribution warehouse in Europe. The geographical
distances between Asia, Europe, and North America create a number of logistical
and communications challenges. Because of the location of manufacturing
facilities in a number of countries, the Company may be affected by economic and
political conditions in those countries, including the following:
+ management of a multi-national organization;
+ compliance with local laws and regulatory requirements as well as
changes in such laws and requirements;
+ employment and severance issues;
+ overlap of tax issues;
+ fluctuations in the value of currency;
+ tariffs and duties;
+ possible employee turnover or labor unrest;
+ lack of developed infrastructure;
+ longer payment cycles;
+ greater difficulty in collecting accounts receivable;
+ the burdens and costs of compliance with a variety of foreign laws;
and
+ political or economic instability in certain parts of the world.
Changes in policies by the United States or foreign governments resulting in,
among other things, increased duties, higher taxation, currency conversion
limitations, restrictions on the transfer or repatriation of funds, limitations
on imports or exports, or the expropriation of private enterprises also could
have a material adverse effect on the Company, its results of operations,
prospects, and ability to service debt. The Company's operating results also
could be adversely affected if its host countries were to reverse the current
policies encouraging foreign investment or foreign trade. In addition, U.S.
trade policies, such as "most favored nation" status and trade preferences for
certain Asian nations, affect the attractiveness of the Company's services to
its U.S. customers. In particular, the
13
Company's operations and assets are subject to significant political, economic,
legal, and other uncertainties in the Philippines and China.
MANUFACTURING OPERATIONS IN THE PHILIPPINES. The Company has maintained
its primary manufacturing facility in Manila, the Philippines since 1986. TEAM,
a third-party subcontractor, owns the facility, which is located on land it
leases from the Philippine government. TEAM operates the facility under the
Sub-Assembly Agreement and the Lease Agreement, utilizing equipment, processes,
and documentation owned by the Company and supervisory personnel employed by the
Company. TEAM provides direct-level production personnel under the Sub-Assembly
Agreement and leases space to the Company under the Lease Agreement. TEAM also
utilizes additional space in the facility to produce products for other entities
unrelated to the Company. The Sub-Assembly Agreement and the Lease Agreement
have current terms extending through December 31, 1999 and are renewable from
year to year thereafter. The Company has made advance payments to TEAM since
1994 for a variety of reasons, including to assist it in meeting its working
capital needs while it negotiates new financing arrangements for generators and
equipment needed for building improvements. The outstanding advances to TEAM at
December 31, 1998 totaled approximately $205,000.
The Company has made cumulative capital investments in the Philippines
amounting to approximately $12.0 million through December 31, 1998. The
Company's reliance on personnel and facilities in the Philippines and its
maintenance of inventories abroad expose the Company to certain economic and
political risks, including the following:
+ the business and financial condition of the subcontractor;
+ political instability and expropriation;
+ supply disruption;
+ currency controls and exchange fluctuations; and
+ changes in tax laws, tariffs, and freight rates.
The Company has not experienced any significant interruptions in its business
operations in the Philippines to date despite the fact that the Philippines has
been subject to volcanic eruptions, typhoons, and substantial civil
disturbances, including attempted military coups against the government. The
Company believes that its manufacturing operations in the Philippines constitute
one of the Company's most important resources, and that it would be difficult to
replace the low-cost, high-performance facility or the high-quality,
hard-working production staff if its manufacturing operations in the Philippines
were disrupted or terminated. As a result, any disruption or termination of
operations in the Philippines or air transportation with the Philippines even
for a relatively short period of time, would adversely effect the Company's
operations. See Item 1, "Business - Manufacturing Facilities."
MANUFACTURING OPERATIONS IN CHINA. The Company commenced manufacturing
operations in China during 1998. The China facility is a high-volume LCD module
manufacturing facility similar to the Company's facility in Manila. The Company
initially leased a facility in Beijing on a temporary basis and commenced
manufacturing in that temporary facility in the third quarter of 1998. The
Company has begun construction of its own facility in Beijing and expects to
move into that new facility in mid-1999. The Company expects that the initial
cost of equipping and constructing the permanent China facility will be
approximately $10.0 million. The Company's lease of its temporary facility
expires in 1999. Therefore, any significant delay in the construction of the
permanent facility could result in the temporary suspension of the China
manufacturing operations. Construction delays for a variety of reasons are not
unusual in China. Any such suspension could adversely affect the Company's
operations. For further discussions on the Company's operations in China, see
Item 7, "Management's Discussion and Analysis of Financial Conditions and
Results of Operations" and Item 1, "Business - Manufacturing Facilities."
The Company's operations and assets will be subject to significant
political, economic, legal and other uncertainties in China. Under its current
leadership, the Chinese government has been pursuing economic reform policies,
including the encouragement of foreign trade and investment and greater economic
decentralization. The
14
Chinese government may not continue to pursue such policies. In addition, such
policies may not be successful if pursued or the Chinese government may
significantly alter the policies from time to time. Despite progress in
developing its legal system, China does not have a comprehensive and highly
developed system of laws, particularly with respect to foreign investment
activities and foreign trade. Enforcement of existing and future laws and
contracts is uncertain, and implementation and interpretation of such laws may
be inconsistent. As the Chinese legal system develops, the promulgation of new
laws, changes to existing laws, and the preemption of local regulations by
national laws may adversely affect foreign investors. The Company also could be
adversely affected by a number of other factors, including the following:
+ the imposition of austerity measures intended to reduce inflation;
+ inadequate development or maintenance of infrastructure, including the
unavailability of adequate power and water supplies, transportation,
raw materials, and parts; or
+ a deterioration of the general political, economic or social
environment in China.
In addition, China currently enjoys "most favored nation" ("MFN")
status granted by the U.S. government, pursuant to which the United States
imposes the lowest applicable tariffs on Chinese exports to the United States.
The United States annually reconsiders the renewal of MFN trading status for
China. The Company cannot provide assurance that the United States will renew
China's MFN status in future years. The failure or refusal of the U.S.
government to renew China's MFN status could adversely affect the Company by
increasing the cost to U.S. customers of products manufactured by the Company in
China.
THE COMPANY FACES RISKS ASSOCIATED WITH INTERNATIONAL TRADE AND CURRENCY
EXCHANGE
International sales represented approximately 42 percent of the
Company's net sales in 1998. Sales in foreign markets, primarily Europe and
China, to OEMs based in the United States accounted for almost all of the
Company's international sales in 1998. In 1999, the Company expects sales to
OEMs based in Europe and China to increase. Political and economic conditions
abroad may adversely affect the foreign manufacture and sale of products.
Protectionist trade legislation in either the United States or foreign
countries, such as a change in the current tariff structures, export or import
compliance laws, or other trade policies, could adversely affect the Company's
ability to manufacture or sell devices in foreign markets and to purchase
materials or equipment from foreign suppliers.
While the Company transacts business predominantly in U.S. dollars and
bills and collects most of its sales in U.S. dollars, the Company collects a
portion of its revenue in non-U.S. currencies, such as the Chinese renminbi
("RMB"). In the future, customers increasingly may make payments in non-U.S.
currencies, such as the newly created Euro. In addition, the Company accounts
for a portion of its costs, such as payroll, rent, and indirect operating costs,
in non-U.S. currencies, including Philippine pesos ("PhP"), British pounds
sterling, and Chinese RMB. For example, the Company's Sub-Assembly Agreement
with TEAM is based on a fixed conversion rate, which exposes the Company to
exchange rate fluctuations with the Philippine peso.
Historically, fluctuations in foreign currency exchange rates have not
resulted in significant exchange losses to the Company. Changes in the relation
of these and other currencies to the U.S. dollar, however, could affect the
Company's cost of goods sold and operating margins and could result in exchange
losses. In addition, currency devaluation can result in a reportable loss to the
Company if the Company holds deposits of that currency. The Company cannot
predict the impact of future exchange rate fluctuations on its results of
operations. In late 1997, the Philippine peso suffered a major devaluation from
its historic levels of around $1.00 to PhP 25 down to as much as $1.00 to PhP
49. Over the last five years, the Chinese RMB has experienced significant
devaluation against most major currencies. The establishment of the current
exchange rate system as of January 1, 1994 produced a significant devaluation of
the RMB from $1.00 to RMB 5.7 to approximately $1.00 to RMB 8.7. The rates at
which exchanges of RMB into U.S. dollars may take place in the future may vary,
and any material increase in the value of the RMB relative to the U.S. dollar
would increase the Company's costs and expenses and therefore would have a
material adverse effect on the Company. In addition, any decrease in the value
of the RMB may adversely affect the Company's operations if there are U.S.
dollar-denominated
15
intercompany loans from the Company to its subsidiary or if the Company has
substantial RMB deposits or receivables. Hedging RMB is difficult because the
currency is not freely traded.
In January 1999, a new currency called the "Euro" was introduced in
certain Economic and Monetary Union ("EMU") countries in Europe. All EMU
countries are expected to be operating with the Euro as their single currency by
2002. Although a significant amount of uncertainty exists as to the effect the
Euro currency will have on the marketplace generally, the Company currently does
not believe that introduction of the Euro will create a material adverse effect
on the Company's business or operating results. The Company intends to monitor
the impact, if any, of the introduction of the Euro currency on the Company's
internal systems and the sale of its products and will take appropriate actions
to address those issues if required. The Company cannot predict the impact, if
any, of the introduction of the Euro on its business, financial condition, or
results of operations.
THE COMPANY MUST MAINTAIN SATISFACTORY MANUFACTURING YIELDS AND CAPACITY
The design and manufacture of LCDs and display modules are highly
complex processes that are sensitive to a wide variety of factors, including the
level of contaminants in the manufacturing environment, impurities in the
materials used, and the performance of the design and production personnel and
equipment. As is typical in the industry, the Company from time to time has
experienced lower than anticipated manufacturing yields and lengthening of
delivery schedules. This may be particularly true as the Company continues to
ramp up its high-volume LCD line to greater production levels in 1999 and begins
to manufacture LCoS(TM) microdisplays. See Item 7, "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Liquidity and
Capital Resources." Additionally, as the sophistication of display modules
increases, so does the level of complexity in the required manufacturing
processes. The Company continually reviews its processes in an effort to
increase its manufacturing productivity, achieve higher manufacturing yields,
and reduce design and manufacturing errors. In addition, the Company reviews
ongoing procedures regularly to maintain its ability to meet delivery schedules
to satisfy increased business. The Company's inability to maintain high levels
of productivity or satisfactory delivery schedules in its manufacturing plants
in the Philippines or China, or at its Arizona high-volume LCD line would
adversely affect the Company's operating results.
Manufacturing yields and delivery schedules also may be affected as the
Company ramps up its manufacturing capabilities in China and moves into its new
facility in 1999. Other companies in the industry have experienced difficulty in
expanding or relocating manufacturing output and capacity, resulting in reduced
yields or delays in product deliveries. The Company could experience similar
manufacturing yield or delivery problems. Any such problems could adversely
affect the Company's operating results. See Item 1, "Business - Manufacturing
Facilities."
VARIABILITY OF CUSTOMER REQUIREMENTS MAY AFFECT OPERATING RESULTS
Custom manufacturers for OEMs must provide increasingly rapid product
turnaround and respond to ever-shorter lead times. The Company generally does
not obtain long-term purchase orders, but instead works with its customers to
anticipate the volume of future orders. Based upon its estimates of anticipated
future orders, the Company must procure components and determine the levels of
business that it will seek and accept, production schedules, personnel needs,
and other resource requirements, in each case without the benefit of long-term
purchase commitments. A variety of conditions, both specific to the individual
customer and generally affecting the industry, may cause customers to cancel,
reduce, or delay orders. Cancellations, reductions, or delays by a significant
customer or by a group of customers could adversely affect the Company, its
results of operations, prospects, and ability to service its debt. On occasion,
customers may require rapid increases in production, which can strain the
Company's resources and reduce margins. Although the Company has increased its
manufacturing capacity, the Company may lack sufficient capacity at any given
time to meet its customers' demands if such demands exceed anticipated levels.
In addition to the variability resulting from the short-term nature of
its customers' commitments, other factors have contributed, and may contribute
in the future, to significant periodic and quarterly fluctuations in the
Company's results of operations. These factors include, among other things, the
following:
16
+ the timing of orders;
+ the volume of orders relative to the Company's capacity;
+ customers' announcements, product introductions, and market acceptance
of new products or new generations of products;
+ evolution in the life cycles of customers' products;
+ timing of expenditures in anticipation of future orders;
+ effectiveness in managing manufacturing processes;
+ changes in cost and availability of labor and components;
+ product mix;
+ pricing and availability of competitive products and services; and
+ changes or anticipated changes in economic conditions.
The Company uses existing design programs to gauge the expected future
volume of business. Completion of a particular design, however, depends on a
variety of factors, including the customer's changing needs, and not every
design is successful in meeting those needs.
The Company designs and manufactures products based on firm quotes.
Thus, the Company bears the risk of component price increases, which could
adversely affect the Company's gross margins. In addition, the Company depends
on certain suppliers, and the unavailability or shortage of materials could
cause delays or lost orders. Material components of some of the Company's major
programs from time to time have been subject to allocation because of shortages
by vendors and continued or increased shortages could have a material adverse
effect on the Company in the future. In addition, the Company purchases many
product components from vendors in Asian countries. Economic instability in
certain Asian countries could cause supply problems with respect to these
components.
THE COMPANY MUST EFFECTIVELY UTILIZE ITS ARIZONA FACILITY
The Company has made substantial expenditures in constructing its
facility in Tempe, Arizona, and equipping the facility with a high-volume LCD
manufacturing line. The Company placed the high-volume line in service in 1996,
although the Company continued to commit a significant amount of time and
resources in 1996 and 1997 to the development of manufacturing processes on the
line. The Company utilizes the high-volume line to produce a substantial portion
of its own requirements for LCD glass.
The successful utilization of the LCD glass line requires the Company
to (i) produce LCD glass on a timely and cost-effective basis at quality levels
at least equal to the LCD glass available from independent suppliers and (ii)
utilize the LCD glass it produces in devices it designs and manufactures in a
manner satisfactory to its customers. The Company experienced some delays in
fully implementing its LCD glass manufacturing operations in 1996. The Company
could experience problems or delays in the future in conducting its LCD glass
manufacturing operations. Any such problems could result in the lengthening of
the Company's delivery schedules, reductions in the quality or performance of
the Company's design and manufacturing services, and reduced customer
satisfaction. Such problems also could require the Company to purchase its LCD
glass requirements from third parties and could delay the Company's ability to
recover its investment in the high-volume LCD line.
In addition, the Company added additional equipment to the LCD glass
line in 1998 to enhance its ability to manufacture LCoS(TM) microdisplays. See
Item 1, "Business - Research and Development." Manufacturing a LCoS(TM)
microdisplay is a significantly different procedure than manufacturing a typical
liquid crystal display. The manufacturing of microdisplays will require the
Company to overcome challenges, including the following:
+ the use of a new material (silicon);
+ the modification of equipment and processes to accommodate the
miniature size of the product;
17
+ the implementation of new scribing and breaking techniques;
+ the incorporation of new handling procedures;
+ the maintenance of cleaner manufacturing environments; and
+ the ability to master tighter tolerances in the manufacturing process.
Utilization of the LCD line for microdisplays also will require higher yields
because of the significant cost of the silicon backplane. The Company could
experience significant problems in starting up volume production of LCoS(TM)
microdisplays. Any such problems could result in the delay of the full
implementation of high-volume LCoS(TM) microdisplay production. In addition,
lower-than-expected yields could significantly and adversely effect the Company
because of the relative high cost of the silicon backplane.
THE COMPANY MUST EFFECTIVELY MANAGE ITS GROWTH
The failure of the Company to manage its growth effectively could
adversely affect its operations. The Company's revenue increased substantially
during the period from 1993 through 1995, but declined significantly in 1996 as
a result of the discontinuation of a few significant programs by its major
customer. During 1997 and 1998, the Company increased the number of its
manufacturing and design programs and plans to further expand the number and
diversity of its programs in the future. The Company's ability to manage its
planned growth effectively will require it to
+ enhance its operational, financial, and management systems;
+ expand its facilities and equipment; and
+ successfully hire, train, and motivate additional employees, including
the technical personnel necessary to operate its new production
facility in China.
As the Company expands and diversifies its product and customer base,
it may be required to further increase its overhead and selling expenses. The
Company also may be required to increase staffing and other expenses as well as
its expenditures on capital equipment and leasehold improvements in order to
meet the anticipated demand of its customers. Customers, however, generally do
not commit to firm production schedules for more than a short time in advance.
Any increase in expenditures in anticipation of future orders that do not
materialize would adversely affect the Company's profitability. For example, the
Company substantially increased its manufacturing capacity in 1998 by starting
up manufacturing operations in Beijing, China. Customers also may require rapid
increases in design and production services that place an excessive short-term
burden on the Company's resources.
THE COMPANY DEPENDS ON KEY PERSONNEL
The Company's development and operations depend substantially on the
efforts and abilities of its senior management and technical personnel,
including David R. Buchanan, who has served as the Chairman of the Board since
1986 and served as President and Chief Executive Officer ("CEO") of the Company
from 1987 to mid-1998. When Mr. Buchanan's successor resigned in January 1999,
Mr. Buchanan reassumed his duties as President and CEO on an interim basis until
the Company retains a replacement CEO. Mr. Buchanan has announced his intention
to retire from the Board of Directors upon the hiring of a new President and
CEO.
The competition for qualified management and technical personnel is
intense. The loss of services of one or more of its key employees or the
inability to add key personnel (including those required for its LCD glass
production facility) could have a material adverse effect on the Company. See
Item 1, "Business - Executive Officers." The Company does not have any
fixed-term agreements with, or key person life insurance covering, any officer
or employee. The Company, however, maintains non-competition and nondisclosure
agreements with its key personnel.
18
THE COMPANY MUST PROTECT ITS INTELLECTUAL PROPERTY
The Company relies on a combination of patent, trade secret, and
trademark laws, confidentiality procedures, and contractual provisions to
protect its intellectual property. The Company seeks to protect certain of its
technology under trade secret laws, which afford only limited protection. The
Company faces risks associated with its intellectual property, including the
following:
+ pending patent applications may not be issued;
+ intellectual property laws may not protect the Company's intellectual
property rights;
+ third parties may challenge, invalidate, or circumvent any patent
issued to the Company;
+ rights granted under patents issued to the Company may not provide
competitive advantages to the Company;
+ despite the Company's efforts to protect its proprietary rights,
unauthorized parties may attempt to obtain and use information that
the Company regards as proprietary;
+ others may independently develop similar technology or design around
any patents issued to the Company; and
+ effective protection of intellectual property rights may be limited or
unavailable in certain foreign countries in which the Company
operates, such as China.
Third parties in the future may claim that the Company is infringing
certain patents or other intellectual property rights, although there are no
such pending lawsuits against the Company or unresolved notices that it is
infringing intellectual property rights of others. In the event that a third
party alleges that the Company is infringing its rights, the Company may not be
able to obtain licenses on commercially reasonable terms from the third party,
if at all, or the third party may commence litigation against the Company. The
failure to obtain necessary licenses or other rights or the occurrence of
litigation arising out of such claims could materially and adversely affect the
Company, its results of operations, prospects, or ability to service its debt.
THE MARKET PRICE OF THE COMPANY'S COMMON STOCK MAY BE VOLATILE
The market price of the Company's Common Stock increased dramatically
during the three-year period ended December 31, 1994, but declined significantly
during 1995 and 1996. The stock price increased again during 1997, but declined
significantly in 1998. See Item 5, "Market for Registrant's Common Equity and
Related Stockholder Matters." The trading price of the Company's Common Stock in
the future could continue to be subject to wide fluctuations in response to
various factors, including the following:
+ quarterly variations in operating results of the Company;
+ actual or anticipated announcements of technical innovations or new
product developments by the Company or its competitors;
+ changes in analysts' estimates of the Company's financial performance;
+ general conditions in the electronics industry; and
+ worldwide economic and financial conditions.
In addition, the stock market has experienced extreme price and volume
fluctuations that have particularly affected the market prices for many high
technology companies and that often have been unrelated to the operating
performance of such companies. These broad market fluctuations and other factors
may adversely affect the market price of the Company's Common Stock.
19
THE COMPANY MAY BE SUBJECT TO SHORTAGES OF RAW MATERIALS AND SUPPLIES
The principal raw materials used in producing the Company's product
solutions consist of LCD glass, driver die, circuit boards, molded plastic
parts, lead frames, wire, chips, and packaging materials. The Company purchases
most of these materials from Asian sources. The Company does not have long-term
contracts with its suppliers. During 1998, the Company occasionally was required
to delay sales because it was unable to complete timely deliveries of certain
products as a result of the unavailability of certain raw materials, including
LCD polarizers and drivers.
Because the Company obtains many materials from foreign suppliers, the
Company may be subject to certain risks, including supply interruptions and
currency fluctuations. Purchasers of these materials, including the Company,
from time to time experience difficulty in obtaining such materials.
THE ELECTRONICS INDUSTRY IS CYCLICAL
The electronics industry has experienced significant economic downturns
at various times, characterized by diminished product demand, accelerated
erosion of average selling prices, and production over-capacity. In addition,
the electronics industry is cyclical in nature. The Company has sought to reduce
its exposure to industry downturns and cyclicality by providing design and
production services for leading companies in rapidly expanding segments of the
electronics industry. However, the Company may experience substantial
period-to-period fluctuations in future operating results because of general
industry conditions or events occurring in the general economy.
THE COMPANY MUST FINANCE THE GROWTH OF ITS BUSINESS AND THE DEVELOPMENT OF NEW
PRODUCTS
To remain competitive, the Company must continue to make significant
investments in research and development, equipment, and facilities. As a result
of the increase in fixed costs and operating expenses related to these capital
expenditures, the failure of the Company to sufficiently increase its net sales
to offset these increased costs will adversely affect the Company's operating
results.
The Company from time to time may seek additional equity or debt
financing to provide for the capital expenditures required to maintain or expand
the Company's design and production facilities and equipment. The Company cannot
predict the timing and amount of any such capital requirements at this time. If
such financing is not available on satisfactory terms, the Company may be unable
to expand its business or to develop new customers at the rate desired and its
operating results may be adversely affected. Debt financing increases expenses
and must be repaid regardless of operating results. Equity financing could
result in additional dilution to existing stockholders. See Item 7,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Capital Resources."
THE COMPANY IS SUBJECT TO ENVIRONMENTAL REGULATIONS
The operations of the Company result in the creation of small amounts
of hazardous waste, including various epoxies, gases, inks, solvents, and other
wastes. The Company, therefore, is subject to federal, state, and local
governmental regulations related to the use, storage, discharge, and disposal of
toxic, volatile, or otherwise hazardous chemicals used in its design and
manufacturing processes. The amount of hazardous waste produced by the Company
may increase in the future depending on changes in the Company's operations. The
failure of the Company to comply with present or future environmental
regulations could result in the imposition of fines, suspension of production,
or a cessation of operations. Compliance with such regulations could require the
Company to acquire costly equipment or to incur other significant expenses. Any
failure by the Company to control the use, or adequately restrict the discharge,
of hazardous substances could subject it to future liabilities. For example, the
Company has removed contamination from and continues to conduct periodic
chemical monitoring at the Company's former Connecticut property. Other
environmental problems may be discovered in the future, which could subject the
Company to future costs or liabilities.
20
CHANGE IN CONTROL PROVISIONS
The Company's Restated Certificate of Incorporation (the "Restated
Certificate") and the Delaware General Corporation Law (the "Delaware GCL")
contain provisions that may have the effect of making more difficult or delaying
attempts by others to obtain control of the Company, even when these attempts
may be in the best interests of stockholders. The Restated Certificate also
authorizes the Board of Directors, without stockholder approval, to issue one or
more series of Preferred Stock, which could have voting and conversion rights
that adversely affect or dilute the voting power of the holders of Common Stock.
The Delaware GCL also imposes conditions on certain business combination
transactions with "interested stockholders" (as defined therein).
YEAR 2000 COMPLIANCE
Many existing computer programs and databases use only two digits to
identify a year in the date field (I.E., 99 would represent 1999). These
programs and databases were designed and developed without considering the
impact of the upcoming millennium. Consequently, date sensitive computer
programs may interpret the date "00" as 1900 rather than 2000. If not corrected,
many computer systems could fail or create erroneous results in 2000. Failure in
the Company's systems, or in the systems of its vendors or customers, could
cause significant adverse effects to the Company. For a full discussion of those
potential effects, see Item 7, "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Year 2000 Compliance
Disclosure."
RIGHTS TO ACQUIRE SHARES
At December 31, 1998, an aggregate of 695,800 shares of common stock
were reserved for issuance upon exercise of options previously granted under the
Company's stock option plans. The weighted average exercise price of those
options is $12.14 per share. During the terms of such options, the holders
thereof will have an opportunity to profit from an increase in the market price
of Common Stock with resulting dilution in the interests of holders of Common
Stock. The existence of such stock options may adversely affect the terms on
which the Company can obtain additional financing, and the holders of such
options can be expected to exercise such options at a time when the Company, in
all likelihood, would be able to obtain additional capital by offering shares of
its Common Stock on terms more favorable to the Company than those provided by
the exercise of such options.
REPURCHASES OF COMMON STOCK
In August 1996, the Board of Directors authorized the repurchase from
time to time of up to 1,000,000 shares of the Company's Common Stock on the open
market or in negotiated transactions, depending on market conditions and other
factors. In October 1998, the Board of Directors further extended and revised
the repurchase program to authorize the repurchase of up to $10 million of the
Company's stock. As of December 31, 1998, the Company had purchased 969,794
shares of the Company's Common Stock at a total purchase price of $8.3 million.
The repurchase of shares by the Company significantly reduced the Company's
capital. In addition, the Company has obtained long-term financing for such
repurchases, which increases the liabilities of the Company. The reduction in
capital or increase in liabilities could adversely affect the Company's ability
to expand its business or commit resources to needed expenditures. See Item 7,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Capital Resources." A significant reduction in the
number of shares outstanding on the open market also could increase the
volatility of the stock as a result of the reduced supply of available shares on
the open market.
SHARES ELIGIBLE FOR FUTURE SALE; POTENTIAL DEPRESSIVE EFFECT ON STOCK PRICE
Currently, Rule 144 under the securities laws provides that each person
who beneficially owns restricted securities with respect to which at least one
year has elapsed since the later of the date the shares were acquired from the
Company or an affiliate of the Company may, every three months, sell in ordinary
brokerage transactions or to market makers an amount of shares equal to the
greater of one percent of the Company's then-outstanding Common Stock or the
average weekly trading volume for the four weeks prior to the proposed sale of
such shares. An aggregate of 960,492 shares of Common Stock held by all the
executive officers and directors of the Company currently are available for sale
under Rule 144. Sales of substantial amounts of Common Stock by the stockholders
21
of the Company, or even the potential for such sales, may have a depressive
effect on the market price of the Common Stock and could impair the Company's
ability to raise capital through the sale of its equity securities.
THE COMPANY DOES NOT PAY CASH DIVIDENDS
The Company has never paid any cash dividends on its Common Stock and
does not anticipate that it will pay cash dividends in the near term. Instead,
the Company intends to apply any earnings to the expansion and development of
its business. See Item 5, "Market for Registrant's Common Equity and Related
Stockholder Matters."
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
Certain statements and information contained in this Report concerning
future, proposed, and anticipated activities of the Company; certain trends with
respect to the Company's revenue, operating results, capital resources, and
liquidity or with respect to the markets in which the Company competes or the
electronics industry in general; and other statements contained in this Report
regarding matters that are not historical facts are forward-looking statements,
as such term is defined under applicable securities laws. Forward-looking
statements, by their very nature, include risks and uncertainties, many of which
are beyond the Company's control. Accordingly, actual results may differ,
perhaps materially, from those expressed in or implied by such forward-looking
statements. Factors that could cause actual results to differ materially include
those discussed elsewhere under this Item 1, "Business - Special
Considerations."
ITEM 2. PROPERTIES
The Company occupies a 97,000 square foot facility in Tempe, Arizona,
which houses its United States-based manufacturing operations; its research,
development, engineering, design, and corporate functions; and the largest fully
automated LCD glass manufacturing operations in North America. The Company
entered into a ground lease through December 31, 2069, subject to renewal and
purchase options as well as early termination provisions. Costs to construct,
furnish, and equip the new facility were approximately $24.0 million.
The Company leases approximately 3,500 square feet of office space in
Swindon, United Kingdom, where it maintains its European administrative and
executive offices.
The Company leases approximately 60,000 square feet of manufacturing
space in Manila, the Philippines. Approximately 40,000 square feet is subject to
a lease that expires on December 31, 1999, and the remaining 20,000 square feet
is subject to a lease that expires on March 31, 1999, and is renewable from year
to year thereafter.
The Company currently leases approximately 27,000 square feet of
manufacturing space in Beijing, China, which includes 4,200 square feet of
office space. The lease will expire on July 25, 1999. The Company is
constructing a permanent manufacturing facility in Beijing, China near the
existing leased facility. The permanent facility will occupy 46,000 square feet,
of which 29,000 square feet will be manufacturing space, and is being
constructed on property that the Company has purchased on a long-term land use
contract. The Company expects the cost to construct the facility will be
approximately $5.3 million. The Company currently anticipates the facility will
be completed in mid-1999.
ITEM 3. LEGAL PROCEEDINGS
There are no legal proceedings to which the Company is a party or to
which any of its properties are subject, other than routine litigation incident
to the Company's business that is covered by insurance or an indemnity or that
are not expected to have a material adverse effect on the Company. It is
possible, however, that the Company could incur claims for which it is not
insured or that exceed the amount of its insurance coverage.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
22
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock has been listed on the New York Stock
Exchange ("NYSE") under the symbol "TFS" since December 29, 1994. The Company's
Common Stock was listed on the American Stock Exchange ("AMEX") from January 28,
1993 through December 28, 1994. The Company's Common Stock was listed on the
AMEX Emerging Company Marketplace from March 18, 1992 until January 27, 1993,
and on the Nasdaq National Market system from May 1, 1990 until March 17, 1992.
The following table sets forth the quarterly high and low prices of the
Company's Common Stock for the periods indicated.
High Low
---- ---
1996:
First Quarter............................................ $21 7/8 $11 5/8
Second Quarter........................................... 14 1/8 9 1/8
Third Quarter............................................ 13 8 3/4
Fourth Quarter........................................... 14 10 5/8
1997:
First Quarter............................................ $16 1/4 $12 1/4
Second Quarter........................................... 16 11 5/8
Third Quarter............................................ 26 7/8 14 1/4
Fourth Quarter........................................... 26 1/2 16 1/4
1998:
First Quarter............................................ $23 1/16 $17 3/4
Second Quarter........................................... 20 3/8 14 7/8
Third Quarter............................................ 18 3/16 7 1/16
Fourth Quarter........................................... 13 7/8 6 1/2
1999:
First Quarter (through March 8, 1999).................... $16 $11 1/8
As of March 8, 1999, there were approximately 1,100 holders of record
and approximately 6,000 beneficial owners of the Company's Common Stock. The
closing sale price of the Company's Common Stock on the NYSE on March 8, 1999
was $11.25 per share.
The present policy of the Company is to retain earnings to provide
funds for the operation and expansion of its business. The Company has not paid
dividends on its Common Stock and does not anticipate that it will do so in the
near term. Furthermore, the Company's line of credit with Imperial Bank Arizona
("Imperial Bank") does not permit the payment of dividends without the consent
of Imperial Bank. The payment of dividends in the future will depend on the
Company's growth, profitability, financial condition, and other factors that the
directors may deem relevant.
23
ITEM 6. SELECTED FINANCIAL DATA
The following table summarizes certain selected consolidated financial
data of the Company and is qualified in its entirety by the more detailed
consolidated financial statements and notes thereto appearing elsewhere herein.
The data have been derived from the consolidated financial statements of the
Company audited by Arthur Andersen LLP, independent public accountants. All
share amounts and per share data have been adjusted to reflect the two-for-one
split of the Company's Common Stock effected as a stock dividend in May 1994.
1998 1997 1996 1995 1994
-------- -------- -------- -------- --------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Net sales ................................ $ 95,047 $ 84,642 $ 60,713 $ 91,585 $ 85,477
-------- -------- -------- -------- --------
Costs and expenses:
Cost of sales .......................... 76,149 64,760 58,321 70,481 59,409
Selling, general, and administrative ... 7,334 6,557 5,351 5,386 4,867
Research and development ............... 7,159 5,106 4,065 2,396 1,270
-------- -------- -------- -------- --------
90,642 76,423 67,737 78,263 65,546
-------- -------- -------- -------- --------
Operating income (loss) .................. 4,405 8,219 (7,024) 13,322 19,931
-------- -------- -------- -------- --------
Other income (expense):
Interest, net .......................... 75 548 412 765 859
Other, net ............................. (117) (190) (139) (122) (135)
-------- -------- -------- -------- --------
(42) 358 273 643 724
-------- -------- -------- -------- --------
Income (loss) before provision for
(benefit from) income taxes ............ 4,363 8,577 (6,751) 13,965 20,655
Provision for (benefit from) income taxes 1,773 3,334 (2,920) 5,548 8,109
-------- -------- -------- -------- --------
Net income (loss) ........................ $ 2,590 $ 5,243 $ (3,831) $ 8,417 $ 12,546
======== ======== ======== ======== ========
Earnings (loss) per common share:
Basic .................................. $ 0.34 $ 0.67 $ (0.49) $ 1.09 $ 1.88
======== ======== ======== ======== ========
Diluted ................................ $ 0.33 $ 0.65 $ (0.49) $ 1.04 $ 1.59
======== ======== ======== ======== ========
Weighted average number of common shares:
Basic .................................. 7,639 7,854 7,768 7,716 6,666
======== ======== ======== ======== ========
Diluted ................................ 7,802 8,090 7,768 8,084 7,890
======== ======== ======== ======== ========
CONSOLIDATED BALANCE SHEET DATA
(AT END OF PERIOD):
Working capital .......................... $ 24,825 $ 29,113 $ 21,513 $ 22,400 $ 37,638
Total assets ............................. 77,904 72,835 62,569 63,780 56,280
Notes payable to banks and long-term debt 8,095 -- -- 3,000 182
Stockholders' equity ..................... 51,096 56,525 51,184 55,224 46,561
24
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
ANNUAL TABLE: PERCENTAGES OF NET SALES
The following table sets forth, for the periods indicated, the percentage of net
sales of certain items in the Company's Consolidated Financial Statements. The
table and the discussion below should be read in conjunction with the
Consolidated Financial Statements and Notes thereto.
YEARS ENDED DECEMBER 31,
-----------------------
1998 1997 1996
----- ----- -----
Net sales .......................................... 100.0% 100.0% 100.0%
----- ----- -----
Costs and expenses:
Cost of sales .................................... 80.1 76.5 96.1
Selling, general, and administrative ............. 7.7 7.8 8.8
Research and development ......................... 7.6 6.0 6.7
----- ----- -----
95.4 90.3 111.6
Operating income (loss) ............................ 4.6 9.7 (11.6)
Other income ....................................... -- 0.4 0.5
----- ----- -----
Income (loss) before provision for
(benefit from) income taxes ...................... 4.6 10.1 (11.1)
Provision for (benefit from) income taxes .......... 1.9 3.9 (4.8)
----- ----- -----
Net income (loss) .................................. 2.7% 6.2% (6.3)%
===== ===== =====
YEAR ENDED DECEMBER 31, 1998 COMPARED WITH YEAR ENDED DECEMBER 31,1997
Net sales were $95.0 million for 1998, an increase of 12.3 percent
compared with net sales of $84.6 million for 1997. The sales increase was as a
result of several new programs in 1998 for a variety of customers, including a
major communications customer. In 1998, the Company's largest customer accounted
for net sales of $60.5 million compared with net sales of $29.2 million to that
customer in 1997, for an overall increase of 107.2 percent. The Company's major
customer accounted for approximately 63.6 percent of net sales for 1998 compared
with approximately 34.6 percent for 1997. No other customer accounted for
greater than 10 percent of sales in 1998.
Cost of sales, as a percentage of net sales, increased to 80.1 percent
for 1998 as compared with 76.5 percent for 1997. The corresponding decrease in
the gross margin was the result of a number of factors, including manufacturing
variances occurring as a result of the start-up of the new manufacturing
facility in Beijing, some unfavorable yields occurring on the start-up of
several new programs, and increased pricing pressure from customers and
competitors, partially as a result of the Asian economic crisis.
Selling, general, and administrative expense was $7.3 million for 1998,
as compared with $6.6 million in 1997. Selling, general, and administrative
expense increased in absolute terms as a result of increased selling expenses
and the addition of administrative personnel. As a result of increased revenue
in 1998, however, selling, general, and administrative expense declined to 7.7
percent of net sales from 7.8 percent of net sales in 1997.
Research and development expense totaled $7.2 million, or 7.6 percent
of net sales for 1998, as compared with $5.1 million, or 6.0 percent of net
sales, for 1997. Research and development expense consists principally of
salaries and benefits to scientists and other personnel; related facilities
costs, including certain expenses associated with the development of new
processes on the LCD line in Tempe, Arizona; and various expenses for projects.
Research and development expense has increased as the Company has invested in
new technologies and manufacturing processes, developed new potential products,
continued its in-house process development efforts related to the high-volume
manufacturing LCD line, and developed application specific integrated circuits
("ASICs") for its new display technologies. The Company believes that continued
investments in research and development
25
relating to manufacturing processes and new display technology are necessary to
remain competitive in the marketplace, as well as to provide opportunities for
growth.
Interest income (net) for 1998 was $75,000, down from $548,000 for
1997. The decrease in interest income was the result of investing lower average
cash balances during the year as well as increased interest expense as a result
of increased debt. Other expenses (net) decreased to $117,000 for 1998 from
$190,000 for 1997. The decrease was primarily attributed to reduced foreign
exchange losses.
The Company recorded a provision for income taxes of $1.8 million for
1998, as compared with a provision for income taxes of $3.3 million for 1997.
The overall tax rate for the Company for 1998 was 40.6 percent as compared with
38.9 percent for 1997. The increased tax rate is primarily as a result of the
Company having incurred losses in China, which is a low tax rate jurisdiction.
In such instance, the Company does not obtain a tax benefit for the losses equal
to its tax rate elsewhere in the world. The Company expects that the tax rate
for 1999 will approximate 40.0 percent.
For 1998, the Company reported net income of $2.6 million, or $0.33 per
share (diluted), as compared with net income of $5.2 million, or $0.65 per share
(diluted), for 1997.
YEAR ENDED DECEMBER 31, 1997 COMPARED WITH YEAR ENDED DECEMBER 31,1996
Net sales were $84.6 million for 1997, an increase of 39.4 percent
compared with net sales of $60.7 million for 1996. The sales increase was as a
result of several new programs in 1997 for a variety of customers, including a
major office automation customer. In 1997, the Company