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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549
___________________

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 1999

Commission file number 1-4373
____________________

      Securities registered pursuant to Section 12(b) of the Exchange Act:

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

      Indicate by check mark 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. [ ]

      The aggregate market value of Common Stock held by nonaffiliates of the registrant (11,812,823 shares) based on the closing price of the registrant’s Common Stock as reported on the New York Stock Exchange on March 10, 2000, was $722,058,806. For purposes of this computation, all officers, directors, and 10% beneficial owners of the registrant are deemed to be affiliates. Such determination should not be deemed to be an admission that such officers, directors, or 10% beneficial owners are, in fact, affiliates of the registrant.

      As of March 10, 2000, there were outstanding 12,638,971 shares of the registrant’s Common Stock, par value $.01 per share.

Documents Incorporated by Reference

      Portions of the registrant’s definitive Proxy Statement for the 2000 Annual Meeting of Shareholders are incorporated by reference into Part III of this Form 10-K.

THREE-FIVE SYSTEMS, INC.

ANNUAL REPORT ON FORM 10-K

FOR THE YEAR ENDED DECEMBER 31, 1999

THREE-FIVE SYSTEMS, INC.

ANNUAL REPORT ON FORM 10-K

FOR THE YEAR ENDED DECEMBER 31, 1999

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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 our “expectations,” “anticipation,” “intentions,” “beliefs,” or “strategies” regarding the future. Forward-looking statements also include statements regarding revenue, margins, expenses, and earnings analysis for fiscal 2000 and thereafter; technological innovations; future products or product development; our product development strategies; potential acquisitions or strategic alliances; the success of particular product or marketing programs; the amounts of revenue generated as a result of sales to significant customers; and liquidity and anticipated cash needs and availability. All forward-looking statements included in this Report are based on information available to us as of the filing date of this Report, and we assume no obligation to update any such forward-looking statements. Our actual results could differ materially from the forward-looking statements. Among the factors that could cause actual results to differ materially are the factors discussed in Item 1, “Business - Special Considerations.”

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PART I

ITEM 1. BUSINESS

Introduction

      We design and manufacture display modules for use in the end products of original equipment manufacturers, or OEMs. We currently specialize in custom liquid crystal display, or LCD, components and technology. We collaborate closely with our customers in providing our design and manufacturing services. Our LCD modules are used in mobile handsets and other wireless communication devices as well as in office automation equipment, industrial controls, medical equipment, and instrumentation. In addition to our traditional LCD module business, we are pursuing the commercialization of our liquid crystal on silicon, or LCoS™, microdisplays following substantial research and development over the past two years. We market our services in North America, Europe, and Asia through a direct technical sales force. Motorola is our largest customer.

Industry Overview

Liquid Crystal Displays

      Prior to the introduction of LCDs in the 1970s, most commonly used displays and indicators had substantial limitations as to their use, especially in terms of size, life, and power consumption. LCDs were developed in response to these limitations, especially the demand for greater information content and less power consumption than was possible using light emitting diode, or LED, technology. LCDs, sometimes called flat panel displays, provide high-information content displays at competitive prices. LCDs now appear in products throughout the communications, office automation, industrial, medical, and commercial electronics industries. LCDs are one of the fastest growing of the established display industry segments, primarily because of their widespread application in mobile communications devices, a fast-growing segment of the electronics industry.

      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 liquid crystals align themselves in a predictable manner when stimulated electrically. The alignment produces a visual representation of the desired information. LCDs can display information in black and white or in a wide range of color combinations. LCD displays consist of a matrix of dots, called pixels, which are arranged in rows and columns that can be selectively energized to form letters or pictures. A principal advantage of LCDs over other display technologies, such as LEDs, is the ability to include thousands or even millions of pixels in a single display, which allows for greater information content.

      There are two types of LCDs, active matrix and passive matrix. Active matrix LCD displays are relatively complex devices that require manufacturing operations involving very large capital investments. Active matrix LCD displays are used in larger, high-information content applications, such as laptop computers. Passive matrix LCD displays are less complex and less expensive to manufacture. Passive matrix LCD displays are used in such applications as mobile handsets, pagers, office equipment, data collection terminals, point of sale equipment, medical devices, transportation instrumentation, and industrial instruments and controls.

The Custom Passive LCD Market

      Stanford Resources estimated that the worldwide market for passive LCD display modules was approximately $2.8 billion in 1998. This market includes displays used in mobile handsets and other wireless communication devices as well as in office automation equipment, industrial controls, medical equipment, and instrumentation, but excludes displays for use in low-end consumer products, such as watches and calculators, according to Stanford Resources. Of the $2.8 billion market, $1.4 billion represented LCD displays used in mobile handset applications. Mobile handsets are the largest and fastest growing market for LCD modules. According to Gartner Group’s Dataquest, the worldwide market for mobile wireless handsets has grown from 18.7 million units produced in 1993 to 283 million units in 1999. This represents a compound annual growth rate well in excess of 50%. Industry sources project that mobile handset production will exceed 400 million units in

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2000. Additional fast growing markets for LCD display modules include pagers, personal digital assistants, or PDAs, and palm top computers.

      The increasing complexity and functionality of handheld products, such as wireless computing devices, require OEMs to increase the visual performance and information content of the displays incorporated into their products. At the same time, the market continues to demand that OEMs incorporate displays with reduced power requirements and lower costs. Custom passive LCDs address these requirements for high performance, increased information content, low power, and low cost.

      OEMs also seek ways to differentiate their products from the products of their competitors. Custom-designed display modules provide OEMs a cost-effective means to achieve this differentiation. In designing its product, an OEM must determine whether to use standard “off-the-shelf” display modules, to design its own custom display modules for production by a custom display manufacturer, or to enter into arrangements with a third party for custom display design and production. In making a decision to engage third parties for custom design and production, OEMs recognize that standard “off-the-shelf” displays make it more difficult to differentiate their products from those of their competitors. In considering whether to design their own display modules, OEMs often recognize that their greatest strengths consist of consumer brand name recognition, market research and product development expertise, and highly developed sales and distribution channels. Advanced design and manufacturing processes require increasing investments for research and development, personnel, and equipment. Competitive market conditions require a shorter period of time from product conception to delivery, product differentiation, improved product user friendliness, and continually enhanced product performance and reduced product cost during the life cycle of the product. As a result of these factors and increasingly sophisticated and complex technology, 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. As a result, there has been a trend toward outsourcing the design and production of components such as display modules.

      In addition to design and production, OEMs have increased their use of third-party suppliers to add additional components to their products. This permits the integration of more of the manufacturing steps into fewer locations. This trend toward integration and outsourcing decreases the number of suppliers necessary to produce a final product and results in lower costs.

The Emerging Microdisplay Market

      Market trends demand high-information, power-efficient displays with increasing functionality and smaller sizes at relatively low costs. Microdisplays based on liquid crystal on silicon technology provide a response to those demands.

      Liquid crystal on silicon microdisplays are a form of LCD in which liquid crystalline material is suspended between a glass plate and a silicon backplane rather than between two glass plates. The silicon backplane, essentially an integrated circuit, provides drive signals for each pixel element of the display as well as logic functions, such as serial to parallel conversion and data storage. Because silicon integrated circuits, a highly developed technology, form the basis of these displays, liquid crystal on silicon technology permits a very high-information, high-performance display in a small size and at a relatively low cost.

      Microdisplays are no larger than a thumbnail, but contain all of the information appearing on a high-resolution personal computer screen. The tiny image on a microdisplay can be projected onto a screen or other surface for individual or group viewing or used in a portable application that is viewed through a magnifying device similar to a viewfinder. Various types of projector applications represent the most common current use of microdisplays. Projectors can cast the information on a distant large screen, as in front projectors, or shine the image through a translucent screen, as in rear projectors. Potential near-term microdisplay applications include use in office projection equipment, high-definition televisions, and computer monitors. Potential longer-term applications include use in wireless access to the Internet through mobile handsets, pagers, and PDAs as well as in wearable computing equipment using head-mounted displays, which allow hands-free access to large amounts of information.

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      A well-developed front projector market currently exists. These products are typically referred to as audio-visual projectors and are generally fixed or portable products used in business applications. Most front projectors currently use transmissive polysilicon microdisplay technology. Reflective liquid crystal on silicon technology, however, is expected to provide more information at a lower cost.

      Emerging market segments are beginning to develop for large, cost-effective, higher-resolution computer monitors and television screens. Current display technologies for computer monitors and high-definition televisions encounter serious barriers related to cost, resolution, and dimensions when used for high-resolution large screens. Many companies are considering the incorporation of microdisplays into large, high-resolution screens to enable affordable display solutions.

      Significant development efforts are currently being directed to portable microdisplays as a potential method for delivering high-information content at low cost and with low power consumption in mobile, hand-held communications devices. It is widely assumed that converged voice and data communications devices have the potential to become a new class of products in mobile communications, probably integrated with PDA functions, such as phonebooks and calendars. In concept, the functions of the telephone, e-mail, pagers, PDAs, and the Internet are expected to become integrated. Delivery of high-information content over the Internet on a small, direct-view display, however, presents difficult technological challenges. Portable microdisplays used with a viewfinder offer a potential solution because they can deliver as much information as a computer monitor in a very small, lightweight, and power-efficient package.

      The portable microdisplay market is just beginning to develop. Market potential currently is uncertain and is limited by such factors as the availability of sufficient wireless communications bandwidth, the uncertainty of customer acceptance, and the possibility of alternative technologies. Nevertheless, many major vendors of mobile handsets, pagers, and PDAs have prototype programs underway to develop new converged mobile communications products with large information content at low cost, and many of these vendors are beginning to assess portable microdisplays for use in these products.

The Three-Five Approach

      We seek to provide our customers with high-performance, information-rich, low-power consumption displays that have competitive advantages in terms of size, cost, and product differentiation. To accomplish this goal, our research and development activities focus on technological developments intended to meet the current and future requirements of our customers. We add value for our customers through our ability to integrate the design and production process, which reduces the time between product conception and market introduction. Our emphasis on customization and technological leadership has positioned us to develop new custom product solutions for our customers as they seek displays with more information content at lower cost.

      Our custom product solutions provide OEMs with the following benefits:

	•		access to specialized design and manufacturing technology and expertise;
	•		accelerated design process and reduced design and manufacturing costs through the use of our specialized personnel, equipment, and facilities;
	•		reduced reliance on multiple suppliers for components and integration of their production processes; and
	•		the ability to concentrate their own resources on the design, production, and distribution of their core products.

      By eliminating the duplication and overlap of investment and resources, we and our OEM customers are able to work together and grow at a faster rate than would otherwise be possible. We concentrate on the development of our display technologies and their applications to products, while our customers devote time and resources on market development for these products.

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      Our historical target market consists of high-end monochrome passive matrix LCD display modules of 1/4 VGA (320 x 240 pixels) or less resolution, primarily those having smaller than three-inch diagonal screen sizes. We do not address low-end LCD display markets, such as watches and calculators. Our target market for LCoS microdisplays consists of displays of SVGA (800 x 600 pixels) or higher resolution.

Strategy

      Our strategy is to enhance our position as a major, worldwide supplier of custom-designed and manufactured displays for application in various high-growth segments of the electronics industry. Key elements of our strategy include the following:

Target Leading Customers in High-Growth Industries

      We identify industries that we believe have the greatest long-term potential for growth. We recognize that our growth and development is closely aligned with the growth and development of the industries we serve. Current targeted industries include mobile handsets and other wireless communications, data collection, office automation, medical equipment, and industrial controls.

      Within an industry, we target leading companies that we believe would benefit from our design and manufacturing services. Targeted customers typically are Fortune 1000 manufacturing companies whose products require display devices. Our sales and engineering staffs then attempt to demonstrate the benefits that the potential customer would derive by outsourcing to us the design and production of display devices required in their products.

      Once we establish a relationship with a new customer, we endeavor to develop new programs for other product groups within the customer’s business. For this reason, we specifically target customers with multiple divisions or product lines.

Expand Customer Base

      We intend to intensify our efforts to diversify our customer base. We also plan to target specialized markets that have substantial volume requirements. We will continue to seek opportunities in growing and emerging markets, both in the United States and internationally.

Establish Close Relationships with Customers

      We seek to establish strong and long-lasting customer relationships through our fundamental business practice, which we refer to as “customer partnering.” Customer partnering involves aligning our prospects with those of our customers and seeking to make our engineering and production staffs seamless extensions of the product design and production departments of our customers. This includes our engineers spending a significant portion of their time assisting customers with their own research and development efforts at their facilities. In addition, our customers’ engineers spend a significant amount of time conducting research and development in our facilities.

      We stress product solutions for our customers’ products. We view each customer’s new product as our own and take pride in creating and implementing innovative engineering solutions that differentiate the customer’s product from competitive products. In connection with this philosophy, we have positioned ourselves to provide a rapid response to our customers and their worldwide operations.

      To achieve our customer partnering goal, we emphasize corporate cultures, customs, and communications that complement those of our customers. A thorough understanding of our customers’ products and business goals enables us to anticipate customer needs and to develop new design and production solutions for their products.

      We continually attempt to enhance the competitive position of our customers by providing them with innovative, distinctive, and high-quality display devices on a timely and cost-effective basis. To do so, we work

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continually to improve our productivity, lower our costs, and speed the delivery of our product solutions. We endeavor to streamline the entire design through delivery process by maintaining an ongoing engineering and manufacturing improvement effort.

      We continue to provide customer support after product design has been completed and production has been commenced. Through such follow-on activity, we conduct quality enhancement and cost-reduction efforts to maintain the competitiveness of our customers’ products.

Provide Advanced Custom Design and Manufacturing Services

      We seek to design, prototype, and manufacture, on a timely and cost-effective basis, a wide range of innovative, distinctive, and high-quality display devices for operational control and information display functions required in the end products of OEMs. Our design processes utilize advanced computer-aided design software to provide custom solutions for customers’ products in time frames and on cost bases that we believe are substantially shorter and lower-priced than industry norms.

      We utilize flexible manufacturing systems that can accommodate low-volume product runs in Arizona and high-volume, price-sensitive runs in Manila and Beijing. Our LCD facility in Arizona allows us to supply a majority of our LCD requirements. Production in Manila and Beijing, with advanced, efficient, and highly automated manufacturing processes utilizing state-of-the-art manufacturing and test equipment, provides us with low-cost, high-volume production capacity. We anticipate that our ability to design, prototype, and manufacture product solutions will be enhanced by the expansion of our engineering personnel, our increased design capacity, and our ability to meet our LCD requirements. We continue to increase our production personnel and add sophisticated manufacturing equipment to meet expanding capacity requirements. We will continue to explore the most advanced and cost-efficient production methods for each product solution.

Leverage Research, Development, and Engineering

      We continually strive to develop and acquire new technologies that provide practical solutions for our customers. We conduct an active research and development program that

	•		continually improves our products and creates new products,
	•		increases our efficiency,
	•		reduces our costs,
	•		improves the speed, efficiency, and performance of our design and manufacturing processes,
	•		develops new design and manufacturing processes and techniques,
	•		enhances the quality, cost-effectiveness, and value of our services, and
	•		utilizes new technological developments.

      We plan to expand our research and development efforts through increased expenditures and the hiring of additional personnel to meet the expectations of our customers and to satisfy our goal to design and produce the most advanced product solutions on a timely and cost-effective basis. We currently are exploring the development and expansion of existing LCD technologies as well as new technologies, such as active addressing, sunlight readable LCDs, color LCDs, plastic LCDs, bi-stable LCDs, graphics and color graphics, organic and polymer light emitting displays, and pixel-related display technologies. New technologies also include our LCoS microdisplays, which address the increased demands for high-information displays in a small size and at a relatively low cost.

Products and Services

      We currently engage in the design and manufacture of LCD display modules and the development and commercialization of manufacturing technologies for use in various products of OEMs.

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LCD Display Modules and Services

      We currently emphasize custom designed LCD display modules. A manufacturer of a complete system or product requiring a specific type of visual display, such as a mobile handset, medical instrument, business machine, or hand-held data collection device, represents a typical buyer for a custom LCD display module. For each custom display module, we work directly with our customer to develop and produce the original design and to manufacture the display module in accordance with the customer’s specifications. At a minimum, each module includes an LCD, a custom LCD driver, and a flexible connector. We also provide value-added services by assembling additional components onto the module, such as keypads, microphones, speakers, light guides, and optics. In 1999, LCD custom display modules accounted for approximately 95.0% of our net sales.

      We have developed a sophisticated design process to meet the specific needs of our customers’ applications. Each design project normally involves a cross-functional team of our engineers who are assigned to a customer program. The team consults with the customer’s engineers throughout the design, prototype development, and manufacturing process. We continue 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.

      The difficulties in developing a custom LCD module include unclear customer expectations, evolving customer requirements, and changing customer end-product specifications. These factors result in lengthy lead times for market introduction of customers’ products. To overcome the traditional obstacles involved in custom design and development, we have developed the four phase program development process described below. We combine our program development process with our philosophy of being a “seamless extension of our customer.” This results in a very flexible, responsive, accurate, and fast development cycle that enables our customers to introduce their products into the market rapidly. Our program development process consists of the following phases:

	•		Feasibility and concept phase. We work closely with our customer to understand its requirements. Customer input varies from rough sketches to detailed specifications. Experienced LCD module design engineers work to develop conceptual solutions to customer requirements that include both design and cost parameters.
	•		Prototype phase. We conduct a design review with the customer; complete at our Arizona facility a proposed design, including the electrical, mechanical, and optical features of the LCD display module; and deliver a prototype to the customer.
	•		Pilot phase. We perform a thorough design review with our customer, involving an analysis of performance, cost, and volume production considerations. A successful pilot phase results in the completion of any design changes, the ordering of the tooling required for production, and the delivery of manufacturing samples. We generally conduct the pilot phase primarily in Manila.
	•		High-volume production phase. We complete any required changes in the manufacturing process, receive necessary tooling, and commence high-volume production. The production takes place either in Manila or Beijing.

      We also design and produce standard or “off-the-shelf” devices, which involve designs that are adaptable to various uses with little or no modification. Standard devices encompass a wide variety of display devices having varied applications. Standard display devices include solid state lamps, multi-digit numerical displays, integrated displays, and bar graph displays. In 1999, our standard devices accounted for less than 3% of our net sales and consisted of non-LCD devices.

New Proprietary LCDs

      We are pursuing two new technology initiatives for our LCD module business. First, we have patented a new type of sunlight readable LCD display that we call Liquid Crystal intense Display, or LCiD™. This lower information content device provides a multi-colored, emissive-looking display at passive LCD prices. We also have

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created a higher information content display with numerous gray shades but at the price of a more typical LCD. This new product is called Liquid Crystal active Drive, or LCaD®. This technology is based, in part, on technology we license from Motif, Inc. and additional proprietary technology that we have developed.

      LCiD display devices include a display from as little as one line by five character dot matrix to as large as four line by 20 character dot matrix, all available in a variety of colors. We began production shipments of LCiD in the fourth quarter of 1999. We expect that LCiD displays will be used primarily in lower information content applications requiring high contrast, desired color, and ease of readability from full sunlight to complete darkness. Typical applications for standard LCiD display devices include automotive instrumentation, appliances, hand-held instrumentation devices, vending equipment, stereo equipment, embedded computing equipment, remote sensing equipment, outdoor monitor equipment, and industrial controls.

      LCaD display devices would typically have 1/4 VGA (320 x 240 pixels) resolution. The LCaD display would consist of a complete display system incorporating an LCD panel, lighting, memory, an LCD controller, and interface electronics. While we have not begun production shipments of these devices, target applications for the LCaD 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.

LCoS Microdisplays

      The display market demands continually greater information content at reduced prices. In response to these demands, we are pursuing the commercialization of our liquid crystal on silicon, or LCoS, microdisplays following two years of extensive research and development activities. Our LCoS technology provides very high-information content in a small size and at an expected relatively low cost. The information presented by these displays is magnified for view, generally either in a projector or in a viewfinder. We believe that the inherent capability of our LCoS technology provides a cost-effective solution to increased information demands.

      Our current plan for the development of our LCoS microdisplay business is to respond in an efficient manner to industry developments and changes, to develop a dedicated organization infrastructure, and to develop or lead the market to a common LCoS module platform. To meet our business objective of becoming the leading supplier of microdisplay visual systems, we must rapidly commercialize LCoS microdisplay technology on a cost-effective basis. This requires us to focus on common LCoS module platforms that provide economies of scale, rapid time to market, and broad market penetration. Specifically, our strategy calls for a business preparation phase and a business growth phase. We are currently in the preparation phase in which we are emphasizing research, development, and licensing opportunities to expand our technology portfolio, design engineering of LCoS products for a significant number of OEMs, and management to establish an organization infrastructure. The business growth phase calls for resources to be deployed primarily in high-volume manufacturing, marketing, sales, and business development.

      We are developing a broad range of LCoS microdisplay products to offer customers. The table below sets forth various resolutions with pixel count, or the number of color dots on a screen, and potential uses for our LCoS microdisplays. We currently have multiple LCoS solutions, which we have prototyped for customer evaluation. We are focussing on products with the capability to produce all of the following resolutions:

      We believe that the initial markets for our LCoS microdisplay products will be in front projectors, monitors, and high-definition television sets. Currently, the front projector, rear projection, and high-definition

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television markets are being served by active matrix polysilicon microdisplays and DMD microdisplays. Polysilicon microdisplays are manufactured by several large Japanese companies. These products are incapable of producing cost-effective resolutions above XGA without the further expense of adding special optics and are generally more expensive than anticipated costs for LCoS microdisplays. DMD microdisplays are a proprietary product of Texas Instruments. Although DMDs have no inherent resolution limitations, they are relatively expensive to manufacture, especially at higher resolutions. The expected relatively low cost for LCoS microdisplays makes them more suitable for competitive consumer marketplaces, such as portable business projectors, monitors, and high-definition televisions.

      We believe another market for LCoS microdisplay products will be converged wireless products requiring high-information content displays for e-mail and access to the Internet. Use of an LCoS microdisplay in a viewfinder application would enable a person to carry a portable device capable of delivering the same SVGA resolution as on the person’s desktop or laptop computer. This has the potential to allow portable access to the Internet and critical information, such as calendars, maps, e-mail, and documentation, in a handheld product. The high resolution of the device would avoid scrolling or time-consuming text conversions in accessing the World Wide Web for needed information.

      We plan to offer a range of LCoS product solutions with different levels of integration from individual light valves to fully integrated displays. By adopting a modular approach to configuring and selling our LCoS microdisplays, we will have the opportunity to price our products on a value-added basis and to rapidly introduce new LCoS products. We will have undertaken extensive development efforts before the first sale of LCoS products, and we expect to incur substantial losses in the microdisplay business until the volume production of LCoS microdisplays. We currently expect initial production to commence in late 2000.

Sales and Marketing

      We approach sales and marketing on three levels: engineer to engineer, salesperson to procurement, and factory to factory. Our approach is to treat an existing program as a marketing platform for the next program. Our engineering, marketing, and sales groups provide ongoing services to our customers throughout the life of product programs. These services include implementing continuous improvement tools related to both the product’s cost and technical performance. This service function allows us to market future sales within our customer base.

      We market our services primarily in North America, Asia, and Europe through a direct technical sales force resident in those areas. A staff of in-house, Arizona-based engineering personnel directs and aids all sales personnel. We have 15 sales personnel worldwide.

      Our sales to customers in Europe represented approximately 35.2% of net sales in 1998 and approximately 46.7% of net sales in 1999. Our sales to customers in Asia represented approximately 12.1% of net sales in 1998 and approximately 35.3% of net sales in 1999.

      Recently, we signed an exclusive distributorship agreement with Mitsui Co., Ltd. of Tokyo, Japan. Under this agreement, Mitsui will market and sell our LCiD, LCaD, and LCoS products to customers in Japan.

Customers

      Our strategy involves concentrating our efforts on providing design and production services to leading companies in five primary industries: mobile handsets and other wireless communications, data collection, office automation, medical equipment, and industrial controls. As a result, we generally derive our net sales from services provided to a limited number of customers.

      Our largest customer is Motorola. Sales to Motorola accounted for approximately 86.1% of our net sales in 1999, 63.6% of our net sales in 1998, and 34.6% of our net sales in 1997. Hewlett-Packard accounted for 32.0% of our net sales in 1997. No customer other than Motorola accounted for more than 10.0% of our net sales in 1998 or 1999. Sales to Motorola currently are made through multiple national and international buyers, and products are

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delivered to diverse geographical regions throughout the world including Asia, North America, and Europe. Substantially all of our net sales to Motorola have been for mobile handset applications, and we are currently in design or manufacture on at least 15 programs. Motorola has an LCD module allocation process in which it designates key LCD module vendors, including us, and communicates to each vendor the anticipated annual range of purchases. Although the allocation process does not provide a guarantee of business to us, it provides an indication that purchases by Motorola during 2000 could exceed 1999 levels. See Item 1, “Business — Special Considerations — Motorola accounts for a significant portion of our sales.”

Backlog

      As of December 31, 1999, we had a backlog of orders of approximately $46.3 million. The backlog of orders as of December 31, 1998 was approximately $23.3 million. Our backlog consists of product orders for which confirmed purchase orders have been received and which are scheduled for shipment within 12 months. Most orders are subject to rescheduling or cancellation by the customer with limited penalties. Because of the possibility of customer changes in delivery schedules or cancellations and potential delays in product shipments, our backlog as of a particular date may not be indicative of net sales for any succeeding period.

Manufacturing Services, Facilities, and Quality Control

Manufacturing Services

      We have organized our manufacturing geographically to optimize the combination of technology and labor factors. This organization enables us to compete solely on the basis of cost, if necessary, with suppliers of similar products and services throughout the world. Our advanced manufacturing techniques include surface mount technologies, chip-on-board, chip-on-flex, chip-on-glass, flip-chip, tape automated bonding, and sophisticated testing systems throughout these processes.

      We seek to increase our value to our customers by providing responsive, flexible, total manufacturing services. To date, our manufacturing services have been concentrated on the manufacture of LCDs and assembly of display modules that we have designed. We provide extended manufacturing services beyond these core services, however, if the customer requires them. Extended services may include adding additional components, such as keypads, microphones, speakers, light guides, and optics, or the turnkey manufacture of a complete assembly.

Manufacturing Facilities

      We currently conduct manufacturing operations in Arizona; Manila, the Philippines; and Beijing, China. The Arizona facility houses a Class 1000 “clean room” and LCD fabrication and prototyping operation. We utilize 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 Manila and Beijing during full-scale production. In addition, the facility has the largest fully automated LCD production capacity in North America. This highly automated line enables us to eliminate substantially our dependence on foreign suppliers of LCDs. Facility personnel include a team of experts ranging from LCD research scientists to specialized engineers with backgrounds in electronics, mechanics, chemistry, physics, and manufacturing. We maintain a wide variety of state-of-the-art testing and quality control equipment at the facility.

      We conduct high-volume display module manufacturing in Manila and Beijing. In Manila, we are a party to a sub-assembly agreement with Technology Electronic Assembly and Management Pacific Corporation, or TEAM, under which TEAM supplies direct manufacturing services at a facility that TEAM owns and that is located on land TEAM leases from the Philippine government. We also are party to a lease agreement with TEAM under which TEAM leases space to us with respect to the manufacturing operations services that TEAM performs under the sub-assembly agreement. At the leased facility, TEAM manufactures, assembles, and tests devices that we design pursuant to procedures set forth in the sub-assembly agreement in accordance with our specifications. Under the sub-assembly agreement, TEAM supplies only the direct labor and certain incidental services required to manufacture our products. We own the manufacturing, assembling, and testing equipment,

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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 that TEAM uses at the Manila facility. We pay TEAM for the direct manufacturing personnel based upon a negotiated available hourly rate. We employ 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.

      Our sub-assembly and lease agreements with TEAM extend through December 31, 2000, and each is renewable from year to year thereafter. The sub-assembly agreement requires us 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 us 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 we have not experienced any material interruption of operations to date, these circumstances could affect our ability to obtain products pursuant to the sub-assembly agreement. Our inability to obtain products under the sub-assembly agreement, even for a relatively short period, would have a material adverse effect on our operations and profitability.

      Our Beijing facility is a high-volume display module manufacturing facility similar to our current facility in Manila. We initially leased a facility in Beijing on a temporary basis, and we commenced manufacturing at this facility in the third quarter of 1998. We completed the construction of our permanent facility in Beijing in July 1999, and all production in the fourth quarter of 1999 occurred in that new facility. We employ all of the direct and indirect manufacturing employees at the facility, including technicians, supervisors, and engineers.

Quality Control

      We recognize the need to maintain a strong reputation for quality as a means of retaining existing customers and securing additional orders from them as well as attracting new customers. We have an extensive quality control program and maintain at each of our facilities quality systems and processes that meet or exceed the demanding standards set by many leading OEMs in targeted industries. We base our 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. We perform product life testing to help ensure long-term product reliability. We analyze results of product life tests and take 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 and evaluate delivery and quality only after receiving the product. Therefore, many customers preview a company’s quality by viewing the quality systems employed. We have received ISO 9002 and QS 9000 certification of our Manila manufacturing facility. ISO and QS are quality standards established by international organizations that attempt 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 achieving an ISO 9002 or QS 9000 certification does not assure that we will obtain future business, it is a factor that enables our customers to recognize that our production processes meet these established, global standards of performance.

Components and Raw Materials

      Components and raw materials constitute a substantial portion of our product costs. The principal components and raw materials we use in producing our displays consist of LCD glass, application specific integrated circuits, or ASICs, circuit boards, molded plastic parts, lead frames, and packaging materials. Our procurement strategy is to secure alternative sources of supplies for the majority of these materials. Many of these, however, must be obtained from foreign suppliers, which subjects us to the risks inherent in obtaining materials from foreign sources, including supply interruptions and currency fluctuations. Our ability to produce a majority of our own LCD requirements in our Arizona facility, however, has substantially reduced our dependence on foreign suppliers. With one exception, our other suppliers generally are meeting our requirements, and we believe our strategic supplier

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alliances have further strengthened our relations with offshore suppliers. We experienced material shortages of ASICs in 1999 as a result of the increased worldwide demand for cellular handsets. These shortages prevented us from meeting customer demand for certain of our products in 1999. Similar shortages in the future could have a material adverse effect on our business.

Research, Development, and Engineering

      We conduct 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 we provide. Our goal is to provide our customers with new solutions that address their needs. Research and development personnel concentrate on LCD technology, especially on improving the performance of current products and expanding the technology to serve new markets. We also conduct research and development in manufacturing processes, including those associated with efficient, high-volume production and electronic packaging.

      With the availability of our high-volume LCD manufacturing line in Arizona, we are focusing our research and development efforts on new display technologies. We expect that these advanced display technologies will enable us to provide our customers with differentiating products or products that provide higher information content. These new technologies include active addressing, sunlight readable LCDs, color LCDs, plastic LCDs, bi-stable LCDs, graphics and color graphics, organic and polymer light emitting displays, and pixel-related display technologies. These products may be available for use in custom devices or in standard devices. We have undertaken a significant research and development program and made substantial investments with respect to the development of our LCoS microdisplays for potential use in projectors, monitors, high-definition televisions and portable applications. We expect that the majority of our available research and development personnel hours will be dedicated to LCoS microdisplays in 2000.

      In October 1999, we signed a letter agreement with Tecdis S.p.A., a European-based LCD company, to form an ASIC design center in Chatillon, Italy. The ASIC design center will be known as Dora and will focus on the design of ASICs necessary to drive the LCDs we and Tecdis design for our respective customers. Recently, STMicroelectronics announced its participation in Dora and its agreement to manufacture the ASICs designed by Dora.

Intellectual Property

      We rely on a variety of intellectual property methods including patents, trade secrets, trademarks, confidentiality agreements, licensing agreements, and other forms of contractual provisions to protect our intellectual property. Although our existing core business does not depend on any intellectual property protection, we are manufacturing more advanced display products in which there are intellectual property issues. For example, our LCiD technology is patented. We have also filed for patents on our LCaD technology and have signed a license agreement with Motif to license the technology that forms the basis of LCaD. The license applies to all Motif patents relating to its active addressing chips and system. The term of the license extends from June 1997 until the expiration of the Motif patents. We have also applied for numerous other process and product patents, all related to display technologies. There can be no assurance that any of these patents will be issued to us.

      We have also taken several steps to both protect and advance our LCoS microdisplay technology.

	•		We filed several patents relating to our LCoS microdisplay technology. These patents cover the areas of product design and manufacturing process technology.
	•		In July 1999, we purchased the assets, including all production and test equipment, specialized laboratory equipment, and supporting design documentation and software, of the former Light Valve business unit of National Semiconductor. We also hired several key scientists of that business unit and acquired an exclusive, paid-up, royalty free license on all of the patents and intellectual property related to that business unit. This license covers all intellectual property relating to the processing,

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			packaging, and testing of light valves and the integrated circuits necessary to manufacture and sell both light valves and light engines.
	•		In August 1999, we licensed the microdisplay technology of S-Vision Corporation, a former microdisplay competitor that recently ceased operations. Under this agreement, we acquired an irrevocable, royalty free, fully paid-up, worldwide license to the intellectual property associated with S-Vision’s digital backplane and optical systems, which provides us rights to manufacture certain microdisplay products and patented optical engines. In addition, S-Vision assigned to us a patent relating to the design and manufacture of microdisplay products.

Competition

      We believe that Hosiden, Hyundai, Optrex, PCI, Philips, Samsung, Seiko-Epson, Seiko Instruments, and Sharp constitute the principal competitors for our passive LCD devices. Most of these competitors are large companies that have greater financial, technical, marketing, manufacturing, vertical integration, and personnel resources than we do. Our sales, profitability, and success depend substantially upon our ability to compete with other providers of display modules. We cannot provide assurance that we will continue to be able to compete successfully with these organizations.

      We currently compete principally on the basis of the technical innovation, engineering service, and performance of our display modules, including their ease of use and reliability, as well as on their cost, timely design, and manufacturing and delivery schedules. Our competitive position could be adversely affected if one or more of our customers, particularly Motorola, determines to design and manufacture their display modules internally or secures them from other parties. Other large companies are currently pursuing microdisplay solutions. Texas Instruments has developed a product that competes with our LCoS technology, and IBM and JVC are producing a similar liquid crystal on silicon display based on their own technology. Numerous other established and start-up companies are also pursuing similar and related technologies that may compete with our LCoS technology.

Environmental Regulations

      Our operations create a small amount of hazardous waste, including various epoxies, gases, inks, solvents, and other wastes. The amount of hazardous waste we produce may increase in the future depending on changes in our 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.

Employees

      As of December 31, 1999, we employed a total of 2,114 persons, of whom 1,166 were employed through third-party contracts. Of our direct employees, 192 were full-time and 14 were temporary employees at our principal U.S. facility in Arizona and U.S. sales offices; 247 were employees at our manufacturing facility in Manila; 487 were employees at our manufacturing facility in Beijing; and 8 were employees at our Three-Five Systems Limited subsidiary in Swindon, England. We consider our relationship with our employees to be good, and none of our employees currently are represented by a union in collective bargaining with us.

      TEAM provides the personnel engaged in the direct assembly of our devices in Manila under the sub-assembly agreement between us and TEAM. As of December 31, 1999, 1,166 persons performed direct labor operations at the Manila facility through the sub-assembly agreement with TEAM.

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Executive Officers of the Registrant

      The following table sets forth certain information regarding our executive officers:

      Jack L. Saltich has served as a director and the President and Chief Executive Officer of our company since July 1999. Mr. Saltich served as Vice President of Advanced Micro Devices from May 1993 until July 1999; as Executive Vice President of Applied Micro Circuits Corp. from January 1991 until March 1993; and as Vice President of VLSI from July 1988 until January 1991. Mr. Saltich held a variety of executive positions for Motorola from July 1971 until June 1988. These positions included serving as an Engineering Manager from May 1974 until January 1980, an Operation Manager from January 1980 until May 1982, a Vice President and Director of the Bipolar Technology Center from May 1982 until June 1986, and a Vice President and Director of the Advanced Product Research and Development Laboratory from June 1986 until June 1988.

      Jeffrey D. Buchanan has served as a director and Executive Vice President - - Finance, Administration, and Legal of our company since June 1998; as Chief Financial Officer and Treasurer since June 1996; and as Secretary since May 1996. Mr. Buchanan served as our Vice President — Finance, Administration, and Legal from June 1996 until July 1998 and as our Vice President — Legal and Administration from May 1996 to June 1996. Mr. Buchanan served from June 1986 until May 1996 as a business lawyer with O’Connor, Cavanagh, Anderson, Killingsworth & Beshears. 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.

      Carl E. Derrington has been our Chief Manufacturing Officer since May 1999. Dr. Derrington joined our company in 1986 as a Director of Research and Development. Since that time, Dr. Derrington has served as a Plant Manager from January 1986 until September 1987, a Director of Engineering from September 1987 until August 1989, a Director of Manufacturing from August 1989 until April 1996, and a Director of Manufacturing Engineering from April 1996 until April 1999.

      Robert L. Melcher has been our Chief Technology Officer since October 1999. Prior to joining our company, Dr. Melcher was employed at IBM in a variety of management positions since 1970. He served as the Program Leader for Projection Displays from 1993 to 1999 and immediately prior to that he was Director of the Physical Sciences Department from 1990 to 1993.

      Robert T. Berube has been our Principal Accounting Officer since July 1998 and has served as our Corporate Controller since July 1990. Mr. Berube served as Chief Financial Officer of Electronic Research Associate, Inc., a manufacturing company, from July 1977 until April 1990.

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SPECIAL CONSIDERATIONS

      You should carefully consider the following factors, in addition to those discussed elsewhere in this Report, in evaluating our company and our business.

Motorola accounts for a significant portion of our sales.

      Our business depends to a significant extent on Motorola’s success in the mobile handset business, particularly in the various major mobile handset programs in which we participate. Any material delay, cancellation, or reduction of orders from Motorola could have a material adverse effect on our business.

      Motorola has been our largest customer during each of the last five years. Sales to Motorola accounted for approximately 86.1% of our net sales in 1999, 63.6% in 1998, 34.6% in 1997, 65.1% in 1996 and 80.5% in 1995. Throughout this period, substantially all of our sales to Motorola were for mobile handset applications.

      We anticipate that sales to Motorola in 2000 will exceed 1999 levels and that the percentage of our net sales attributable to Motorola will stay in the current range in 2000 as a result of increased worldwide demand for mobile handsets.

      A decline in sales to Motorola could occur at any time. For example, an unexpected reduction in Motorola mobile handset programs reduced our net sales to Motorola from $73.7 million in 1995 to $39.5 million in 1996 and $29.2 million in 1997. Since Motorola has no long-term contractual commitments to purchase any of our products, we could experience similar declines in our net sales in the future.

We are subject to lengthy development periods and product acceptance cycles.

      We sell our display modules to OEMs, which then incorporate them into the products they sell. OEMs make the determination during their product development programs whether to incorporate our display modules or pursue other alternatives. This requires us to make significant investments of time and capital in the custom design of display modules well before our customers introduce their products incorporating these displays and before we can be sure that we will generate any significant sales to our customers or even recover our investment. During a customer’s entire product development process, we face the risk that our display will fail to meet our customer’s technical, performance, or cost requirements or will be replaced by a competitive product or alternative technological solution. Even if we complete our design process in a manner satisfactory to our customer, the customer may delay or terminate its product development efforts. The occurrence of any of these events would adversely affect our operating results.

We do not have long-term purchase commitments from our customers.

      Our customers, including Motorola, generally do not provide us with firm, long-term volume purchase commitments. Although we have begun to enter into more manufacturing contracts with our customers, these contracts clarify order lead times, inventory risk allocation, and similar matters rather than provide firm, long-term volume purchase commitments. As a result, customers can cancel purchase commitments or reduce or delay orders at any time. The cancellation, delay, or reduction of customer commitments could result in our holding excess and obsolete inventory or having unabsorbed manufacturing overhead. The large percentage of our sales to customers in the electronics industry, which is subject to severe competitive pressures, rapid technological change, and product obsolescence, increases our inventory and overhead risks.

      Our operating results have been materially and adversely affected in the past as a result of the failure to obtain anticipated orders and deferrals or cancellations of purchase commitments because of changes in customer requirements. For example, we made two announcements in 1998 that sales would not meet our expectations because of delays in customer programs.

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We depend on the market acceptance of the products of our customers.

      We do not sell any products to end users.  Instead, we design and manufacture various product solutions that our customers incorporate into their products. As a result, our success depends almost entirely upon the widespread market acceptance of our customers’ products. Any significant slowdown in the demand for our customers’ products would adversely affect our business.

      Because our success depends on the widespread market acceptance of our customers’ products, we must identify industries that have significant growth potential and establish relationships with OEMs in those industries. Our failure to identify potential growth opportunities or establish relationships with OEMs in those industries would adversely affect our business.

      Our dependence on the success of the products of our customers exposes us to a variety of risks, including the following:

	•		our ability to provide significant design and manufacturing services for customers on a timely and cost-effective basis;
	•		our success in maintaining customer satisfaction with our design and manufacturing services;
	•		our ability to match our design and manufacturing capacity with customer demand and to maintain satisfactory delivery schedules;
	•		customer order patterns, changes in order mix, and the level and timing of orders placed by customers that we can complete in a quarter; and
	•		the cyclical nature of the industries and markets we serve.

Our failure to address these risks may cause our sales to decline.

We face intense competition.

      We serve intensely competitive industries that are characterized by price erosion, rapid technological change, and competition from major domestic and international companies. This intense competition could result in pricing pressures, lower sales, reduced margins, and lower market share. Many of our competitors have greater market recognition, larger customer bases, and substantially greater financial, technical, marketing, distribution, and other resources than we possess. As a result, they may be able to introduce new products and respond to customer requirements more quickly than we can.

      Our competitive position could suffer if one or more of our customers decide to design and manufacture their own display modules, to use standard devices, to contract with our competitors, or to use alternative technologies. In addition, our customers typically develop a second source, even for displays we design for them. These second source suppliers may win an increasing share of a program, particularly as it grows and matures, by competing primarily on price rather than on design capability.

      Our ability to compete successfully depends on a number of factors, both within and outside our control. These factors include the following:

	•		our success in designing and manufacturing new product solutions, including those implementing new technologies;
	•		our ability to address the needs of customers;
	•		the quality, performance, reliability, features, ease of use, pricing, and diversity of our product solutions;
	•		foreign currency fluctuations, which may cause a foreign competitor’s products to be priced significantly lower than our product solutions;

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	•		the quality of our customer services;
	•		our efficiency of production;
	•		the rate at which customers incorporate our product solutions into their own products; and
	•		product or technology introductions by our competitors.

Shortages of components and materials may delay or reduce our sales and increase our costs.

      Our inability to obtain sufficient quantities of components and other materials necessary to produce our displays could result in reduced or delayed sales or lost orders. Any delay in or loss of sales could adversely impact our operating results. We obtain many of the materials we use in the manufacture of our displays from a limited number of foreign suppliers, particularly suppliers located in Asia, and we do not have long-term supply contracts with any of them. As a result, we are subject to economic instability and currency fluctuations in these Asian countries as well as to increased costs, supply interruptions, and difficulties in obtaining materials. Our customers also may encounter difficulties or increased costs in obtaining from others the materials necessary to produce their products into which our product solutions are incorporated.

      Materials and components for some of our major programs from time to time have been subject to allocation because of shortages of these materials and components. During 1998, we occasionally delayed sales of our LCD modules as a result of the unavailability of LCD polarizers and IC drivers, or ASICs. During 1999, we experienced difficulties obtaining our requirements for ASICs as a result of a worldwide shortage. These shortages resulted in lost sales opportunities. Similar shortages in the future could have a material adverse effect on our business.

We must maintain satisfactory manufacturing yields and capacity.

      Our inability to maintain high levels of productivity or satisfactory delivery schedules at our manufacturing facilities in Manila, Beijing, or Arizona would adversely affect our operating results. 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 personnel and equipment. As is typical in the industry, at times we have experienced lower than anticipated manufacturing yields and lengthening of delivery schedules. We may encounter lower manufacturing yields and longer delivery schedules as we continue to ramp up our high-volume LCD line to greater production levels and begin to manufacture LCoS microdisplays. In addition, the complexity of manufacturing processes will increase along with increases in the sophistication of display modules.

Our emerging microdisplay business may not be successful.

      Our emerging microdisplay business, from which we expect to derive substantial revenue, faces many uncertainties. If we fail to successfully address these uncertainties, and our microdisplay business is not successful, our sales may not grow at the rate we anticipate.

      Manufacturing an LCoS microdisplay involves a significantly different procedure than manufacturing a typical liquid crystal display. Although we added additional equipment to our Arizona LCD manufacturing line in 1998 to enhance our ability to manufacture LCoS microdisplays, the manufacture of microdisplays will require us to overcome numerous 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;
	•		the implementation of new manufacturing techniques;
	•		the incorporation of new handling procedures;
	•		the maintenance of cleaner manufacturing environments; and

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•

the ability to master tighter tolerances in the manufacturing process.

      We could experience significant problems in commencing volume production of LCoS microdisplays. These problems could result in the delay of the full implementation of high-volume LCoS microdisplay production. In addition, lower than expected manufacturing yields could significantly and adversely affect us because of the relatively high cost of the silicon backplanes used in LCoS microdisplays.

      Various target markets for our microdisplays, including projectors, monitors, high-definition televisions, and portable microdisplays, are uncertain, may be slow to develop, or could utilize competing technologies. Many manufacturers have well-established positions in the projector and monitor markets. As a result, we must provide these manufacturers with lower cost, comparable performance microdisplays for their products. High-definition television has only recently become available to consumers, and widespread market acceptance is uncertain. Penetrating this market will require us to offer lower cost alternatives to existing technology. In addition, the commercial success of the portable microdisplay market is uncertain. Gaining acceptance in this market may prove difficult because of the radically different approach of microdisplays to the presentation of information. The failure of any of these target markets to develop as we expect, or our failure to penetrate these markets, will impede our anticipated sales growth. Even if our technology successfully meets our price and performance goals, our customers may not achieve commercial success in selling their products that incorporate our microdisplay technology.

Our business depends on new products and technologies.

      We operate in rapidly changing industries. Technological advances, the introduction of new products, and new design and manufacturing techniques could adversely affect our business unless we are able to adapt to the changing conditions. As a result, we will be required to expend substantial funds for and commit significant resources to

	•		continue research and development activities on existing and potential product solutions;
	•		engage additional engineering and other technical personnel; and
	•		purchase advanced design, production, and test equipment.

      Our future operating results will depend to a significant extent on our ability to continue to provide new product solutions that compare favorably on the basis of time to introduction, cost, and performance with the design and manufacturing capabilities of OEMs and competitive third-party suppliers. Our success in attracting new customers and developing new business depends on various factors, including the following:

	•		utilization of advances in technology;
	•		innovative development of new solutions for customer products;
	•		efficient and cost-effective services; and
	•		timely completion of the design and manufacture of new product solutions.

Our efforts to develop new technologies may not result in commercial success.

      Our research and development efforts with respect to new technologies may not result in customer or widespread market acceptance. Some or all of those technologies may not successfully make the transition from the research and development lab to cost-effective production as a result of technology problems, competitive cost issues, yield problems, and other factors. Even when we successfully complete a research and development effort with respect to a particular technology, our customers may determine not to introduce or may terminate products utilizing the technology for a variety of reasons, including the following:

	•		difficulties with other suppliers of components for the products;
	•		superior technologies developed by our competitors;
	•		price considerations;

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	•		lack of anticipated or actual market demand for the products; and
	•		unfavorable comparisons with products introduced by others.

      The nature of our business requires us to make capital expenditures and investments for new technologies. For example, our capital expenditures, including tooling and licenses, for LCoS microdisplays, currently our largest research and development effort, have been over $7.0 million to date. To facilitate the development of our LCoS microdisplay products, we also made an equity investment of $3.3 million in Inviso, Inc., formerly Siliscape, Inc., during 1998 and purchased assets and technology of the former Light Valve business unit of National Semiconductor Corporation for approximately $3.6 million during 1999. We may be required to make similar investments and acquisitions in the future to maintain or enhance our ability to offer technological solutions.

      Significant expenditures relating to one or more new technologies, especially LCoS microdisplays, that ultimately prove to be unsuccessful for any reason could have a material adverse effect on us. In addition, any investments or acquisitions, such as Inviso and the assets and technology of the former Light Valve business unit, made to enhance our technologies may prove to be unsuccessful.

We face risks associated with international operations.

      Our manufacturing operations in Manila, Beijing, and Arizona and our sales and distribution operations in Europe create a number of logistical and communications challenges. These international operations also expose us to various economic, political, and other risks, including the following:

	•		management of a multi-national organization;
	•		compliance with local laws and regulatory requirements as well as changes in those laws and requirements;
	•		employment and severance issues;
	•		overlap of tax issues;
	•		tariffs and duties;
	•		possible employee turnover or labor unrest;
	•		lack of developed infrastructure;
	•		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 us. Any actions by our host countries to reverse policies that encourage foreign investment or foreign trade also could adversely affect our operating results. In addition, U.S. trade policies, such as “most favored nation” status and trade preferences for certain Asian nations, could affect the attractiveness of our services to our U.S. customers.

We depend on our manufacturing operations in the Philippines.

      Any disruption or termination of our manufacturing operations in Manila or air transportation with the Philippines, even for a relatively short period of time, would adversely affect our operations. The Philippines have been subject to volcanic eruptions, typhoons, and substantial civil disturbances, including attempted military coups against the government, since we commenced operations at the facility in 1986. We have made cumulative capital investments in the Philippines amounting to approximately $14.3 million through December 31, 1999. We believe that our manufacturing operations in Manila constitute one of our most important resources and that it would be

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difficult to replace the low-cost, high-performance facility or the highly trained production staff in the event of the disruption or termination of our manufacturing operations in Manila.

      Our operations in Manila also depend on the business and financial condition of the third-party subcontractor that owns the manufacturing facility, which is located on land the subcontractor leases from the Philippine government. The subcontractor operates the facility utilizing equipment, processes, and documentation that we own and supervisory personnel that we employ. The subcontractor provides us with direct production personnel and leases space to us. The subcontractor also utilizes additional space in the facility to produce products for other entities unrelated to us. The failure of the subcontractor to fulfill its obligations to us would adversely affect our operating results. Our agreements with the subcontractor extend through December 31, 2000 and are renewable from year to year thereafter, but may be terminated by the subcontractor or us upon 180 days written notice.

Our new operations in China are unproven.

      We commenced manufacturing operations in Beijing, China, during 1998 in a leased temporary facility. During 1999, we completed the construction of a permanent, high-volume LCD module manufacturing facility in Beijing, which is similar to our Manila facility. We have made cumulative capital investments in China amounting to approximately $10.9 million through December 31, 1999. Our operations and assets are subject to significant political, economic, legal, and other uncertainties in China. The Chinese government recently has been pursuing economic reform policies, including the encouragement of foreign trade and investment and greater economic decentralization. The Chinese government, however, may not continue to pursue these policies, may not successfully pursue these policies, or may significantly alter these policies from time to time. China currently 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 laws may be inconsistent. As the Chinese legal system develops, the passage of new laws, changes in existing laws, and the preemption of local regulations by national laws may adversely affect us. We 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; and
	•		a deterioration of the general political, economic, or social environment in China.

      In November 1999, the United States and China signed an agreement that will lift trade barriers between the two countries and that advances China’s efforts to join the World Trade Organization. Special interest groups have raised objections to these efforts and we cannot be certain whether or to what extent trade relations with China will continue to improve. Any developments that adversely affect trade relations between the United States and China in the future could adversely affect us by increasing the cost to U.S. customers of products manufactured by us in China.

We face risks associated with international trade and currency exchange.

      Political and economic conditions abroad may adversely affect the foreign manufacture and sale of our displays. 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 our ability to manufacture or sell displays in foreign markets and to purchase materials or equipment from foreign suppliers.

      While we transact business predominantly in U.S. dollars and bill and collect most of our sales in U.S. dollars, we collect a portion of our revenue in non-U.S. currencies, such as the Chinese renminbi. In the future, customers increasingly may make payments in non-U.S. currencies, such as the newly created Euro. In addition, we account for a portion of our costs, such as payroll, rent, and indirect operating costs, in non-U.S. currencies, including Philippine pesos, British pounds sterling, and Chinese renminbi.

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      Fluctuations in foreign currency exchange rates could affect our cost of goods and operating margins and could result in exchange losses. In addition, currency devaluation can result in a loss to us if we hold deposits of that currency. The Philippine peso suffered a major devaluation in late 1997, and the Chinese renminbi has experienced significant devaluation against most major currencies over the last five years. Hedging foreign currencies can be difficult, especially if the currency is not freely traded. We cannot predict the impact of future exchange rate fluctuations on our operating results.

      The risks described above are particularly important since international sales represented approximately 82.0% of our net sales in 1999 and approximately 47.3% of our net sales in 1998. Sales in foreign markets, primarily Europe and China, to OEMs based in the United States accounted for almost all of our international sales in both of these periods. In the future, we expect sales to OEMs based in Europe and China to increase.

Variability of customer requirements may adversely affect our operating results.

      Custom manufacturers for OEMs must provide increasingly rapid product turnaround and respond to ever-shorter lead times. A variety of conditions, both specific to individual customers and generally affecting the demand for their products, 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 our business. On occasion, customers require rapid increases in production, which can strain our resources and reduce our margins. Although we have increased our manufacturing capacity, we may lack sufficient capacity at any given time to meet our customers’ demands if their demands exceed anticipated levels.

Our operating results have significant fluctuations.

      In addition to the variability resulting from the short-term nature of our customers’ commitments, other factors contribute to significant periodic and seasonal quarterly fluctuations in our results of operations. These factors include the following:

	•		the timing of orders;
	•		the volume of orders relative to our capacity;
	•		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.

      Accordingly, you should not rely on the results of any past periods as an indication of our future performance. It is likely that in some future period, our operating results may be below expectations of public market analysts or investors. If this occurs, our stock price may drop.

We must effectively utilize our Arizona facility.

      The effective utilization of our Arizona facility and its high-volume LCD manufacturing line is critical to our success. We utilize the high-volume line to produce a majority of our own requirements for LCDs.

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