10-Q 1 for073105.txt 10-Q FOR JULY 31, 2005 U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: July 31, 2005 Commission File Number: 0-27002 INTERNATIONAL DISPLAYWORKS, INC. (Exact name of Registrant as specified in its charter) Delaware 94-3333649 (State of or other jurisdiction (I.R.S. Employer Identification No.) of incorporation or organization) 1613 Santa Clara Drive, Roseville, California 95661-3542 --------------------------------------------- ---------- (Address of principal executive offices) (Zip Code) (916) 797-6800 (Registrant's telephone number, including area code) 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 a check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] The number of shares outstanding of the registrant's Common Stock, par value $0.001, as of August 22, 2005 was 31,751,393. INTERNATIONAL DISPLAYWORKS, INC. INDEX Part 1 Consolidated Financial Information Page Number ----------- Item 1. Consolidated Financial Statements (Unaudited): Balance Sheets at July 31, 2005 and October 31, 2004..................3 Statements of Operations for the Three and nine months ended July 31, 2005 and 2004....................4 Statements of Cash Flows for the Nine months ended July 31, 2005 and 2004..............................5 Notes to Financial Statements.........................................7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations......................13 Item 3. Quantitative and Qualitative Disclosure About Market Risk............18 Item 4. Controls and Procedures..............................................18 Signatures....................................................................20 Certifications................................................................21 2

5 Supplemental disclosure of non-cash information: In connection with the acquisition of Three-Five (Beijing) Co. Ltd the Company paid $8 million in cash, incurred an estimated $282 thousand in expenses related to the acquisition and acquired the following assets and liabilities:

6 INTERNATIONAL DISPLAYWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The accompanying consolidated financial statements include the accounts of International DisplayWorks, Inc., and its subsidiaries (collectively referred to as the "Company" or "IDW"). The un-audited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ended July 31, 2005 are not necessarily indicative of the results that may be expected for the 2005 fiscal year. For further information, refer to the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 2004. The accompanying consolidated balance sheet at October 31, 2004, has been derived from the audited consolidated financial statements at that date, but does not include all disclosures required by generally accepted accounting principles. 2. ORGANIZATION Description of Business International DisplayWorks, Inc. (the "Company"), headquartered in Roseville, California, was incorporated in the state of Delaware in June of 1999. On October 31, 2001, the Company merged with its parent, Granite Bay Technologies, Inc., a California corporation. The Company, together with its subsidiaries, all of which are wholly owned, is engaged in the design, manufacture and worldwide distribution of liquid crystal displays (LCDs), modules, and assemblies for major original equipment manufacturers (OEMs) with applications in telecommunications, utilities, automotive, industrial, medical, and consumer products. The Company's manufacturing operations are in Shenzhen and Beijing, People's Republic of China (PRC) where we manufacture Liquid Crystal Displays (LCDs) and LCD modules using various display technologies such as chip-on-glass ("COG"), chip-on-board ("COB"), chip-on-flex ("COF"), surface mount technology ("SMT"), and tape automated bonding ("TAB"). The Company also provides enhanced services by adding other components such as back lighting, and keypads to module assemblies as well as having the capabilities to produce complete turn-key products. On April 8, 2005 the Company, through its wholly owned subsidiary International DisplayWorks (Hong Kong) Ltd, acquired 100% of the outstanding shares of Three-Five Systems (Beijing) Co., Ltd. ("Three-Five Beijing") located in Beijing, PRC where it has a long-term land lease and owns the building in which it assembles thin film transistor ("TFT") and super-twist nematic ("STN") displays. The acquisition will provide the Company with increased capacity, a faster qualification to market with TFT products due to the fact that the factory is already qualified with certain customers and increase the Company's customer base. The acquisition, which was accounted for by the purchase method of accounting, consisted of an $8 million cash payment, a $0.3 million of expenses, the assumption of $2.4 million in debt and an earn-out provision based on specific revenue targets. The Company estimated expenses of $0.2 million at April 30, 2005 and have now finalized these expenses at July 31, 2005. As part of the acquisition the Company recorded a $2 million value for inventory acquired. 7 Under the terms of the agreement the Company may use up to $2 million of the inventory on hand, valued at market prices. Existing inventory used in excess of the $2 million will be purchased from Three-Five Beijing at current market value. The Company is under no obligation to purchase inventory in excess of the recorded $2 million. At July 31, 2005 the Company had consumed $2.3 million of the inventory on hand at acquisition valued at market prices and has accrued a liability for the $0.3 million in excess of the $2 million acquired at acquisition. Management has used their best estimates to determine that the book value of the assets acquired as recorded on the books and records of Three-Five Beijing is fairly stated. The excess of fair value of the acquired assets over cost was accounted for by a write-down on pro-rata bases of the long-lived assets that were purchased. The Company paid the purchase price from its existing credit facility with Wells Fargo HSBC Trade Bank N.A. and cash generated from operations. 3. INVENTORIES

7. LINE OF CREDIT The Company has a $20,000,000 credit line with Wells Fargo HSBC Trade Bank N.A. The credit line, which expires on March 30, 2006, has an interest rate of prime plus 0.5% per annum or LIBOR plus 3% with a 30-, 60-, 90- or 180-day option, an unused line fee of 0.1%, and includes certain financial covenants. At July 31, 2005, the outstanding balance was $13,251,000. Based on the covenants of the loan, there was approximately $6,749,000 available under the line at July 31, 2005. At July 31, 2005, because of borrowings to acquire the Beijing factory, the Company was in non-compliance of certain covenants of the agreement with Wells Fargo HSBC Trade Bank N.A. The bank has waived the non-compliance and the Company is not in default of any of its agreements. The Company is currently in the process of revising the covenants of the Trade Bank line of credit to avoid non-compliance issues in the future. The Company expects to have the new covenants in place before the end of its current fiscal year. 8. STOCKHOLDERS' EQUITY Stock Option Plans During the nine months ended July 31, 2005, there were 805,800 options granted at a price equal to or greater than market price at the date of the grant. There were 16,500 options that were cancelled or expired, and 756,500 options were exercised under the employee stock option plans at prices that ranged from $0.15 to $6.70 per share. The following table illustrates the effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation", to stock-based employee compensation: In December 2004, the FASB issued SFAS No. 123R that amends SFAS No. 123 "Accounting for Stock-Based Compensation," to require public entities (other than those filing as small business issuers) to report stock-based employee compensation in their financial statements. The Company will be required to comply with the provisions of SFAS No. 123R as of November 1, 2005, the beginning of its next fiscal year. The Company currently does not record compensation expense related to its stock-based employee compensation plans in its financial statements. The Company currently makes a pro-forma disclosure of the expense related to its Stock-Based compensation plans. 9

Common Stock Issued During the nine months ended July 31, 2005, the Company issued 1,133,323 shares of common stock. Of these 51,948 shares of the Company's common stock were issued accordance with the employment agreement with the Company's Chairman and CEO as a signing bonus at a share price of $3.85, the fair market value as of the date of the agreement. The expense related to the issuance of these shares was accrued on the Company's books in the fiscal year ended October 31, 2004. The Company issued 2,500 shares as compensation to a consultant as total compensation for services rendered to the Company's procurement department at a share price of $5.45, the fair market value as of the date of the agreement. Accordingly, stock issued for services during the period was approximately $214,000. The Company issued 322,375 shares of the Company's common stock through exercise of warrants at exercise prices from $0.16 to $1.75 per share. The Company issued 756,500 shares of the Company's common stock through exercise of stock options issued under the Company's stock option and incentive plans at exercise prices from $0.15 to $6.70 per share. 9. COMMITMENTS On November 23, 2004 the Company entered into a lease for the relocation of the Company's corporate headquarters. The lease began on May 1, 2005 coinciding with the expiration of the lease for the premises that the Company previously occupied. The term of the lease is five (5) years with an option to renew for two additional three-year terms. The initial annual rent is $129,600. On February 17, 2005, the Company entered into a one-year eight-day lease to relocate the Company's office facility in Hong Kong. This lease replaces the lease on the current premises which has expired. The annual rental is $9,076. On March 30, 2005 the Company signed a one-year renewable agreement with The Wells Fargo HSBC Trade Bank N.A. for a $20,000,000 revolving line of credit at an interest rate of prime plus 0.50% per annum or LIBOR plus 3% with a 30-, 60-, 90-, or 180-day option which includes certain financial covenants. This line replaces the Company's current asset-based line with Wells Fargo Business Credit, Inc. On April 30, 2005 the Company, through its subsidiary IDW (Beijing) Co., Ltd. completed the renewal of a RMB 20 million (approximately $2.5 million US dollars at current exchange rates) mortgage on its Beijing factory. The term of the loan is one year at an interest rate of 6.14%. 10 On July 12, 2005 the Company entered into a lease for sales office facilities in Scottsdale Arizona. The lease begins on September 1, 2005. The term of the lease is five (5) years with a one-time buy out option at the end of the first thirty six (36) months by paying a buy out fee of seven thousand two hundred ($7,200) dollars. The initial annual rent is $27,700. 10. SEGMENT AND GEOGRAPHIC INFORMATION The Company produces displays and display modules for the end products of OEM, ODM and EMS manufacturers and hence operates in one segment. However, the Company has four major geographic territories where it sells and distributes essentially the same products. These are the United States, China (including Hong Kong), Asia (excluding Hong Kong and China) and Europe. The sales and assets by geographical area were (in thousands):

11. Acquisition of Three-Five Systems (Beijing) Co., Ltd. On April 8, 2005 the Company, through its wholly owned subsidiary International DisplayWorks (Hong Kong) Ltd, acquired 100% of the outstanding shares of Three-Five Systems (Beijing) Co., Ltd. ("Three-Five Beijing") located in Beijing, PRC where it has a long-term land lease and owns the building in which it assembles thin film transistor ("TFT") and super-twist nematic ("STN") displays. The acquisition will provide the Company with increased capacity, a faster qualification to market with TFT products due to the fact that the factory is already qualified with certain customers and increase the Company's customer base. The acquisition, which was accounted for by the purchase method of accounting, consisted of an $8 million cash payment, a $0.3 million of expenses, the assumption of $2.4 million in debt and an earn-out provision based on specific revenue targets. The Company estimated expenses of $0.2 million at April 30, 2005 and have now finalized these expenses at July 31, 2005. As part of the acquisition the Company recorded a $2 million value for inventory acquired. Under the terms of the agreement the Company may use up to $2 million of the inventory on hand, valued at market prices. Existing inventory used in excess of the $2 million will be purchased from Three-Five Beijing at current market value. The Company is under no obligation to purchase inventory in excess of the recorded $2 million. At July 31, 2005 the 11 Company had consumed $2.3 million of the inventory on hand at acquisition valued at market prices and has accrued a liability for the $0.3 million in excess of the $2 million acquired at acquisition. The following table summarizes the fair values of the assets acquired. The acquisition was accounted for using the purchase method of accounting, as required by Statement of Financial Accounting Standard No. 141, Business Combinations." Under this method of accounting, the Company allocated the purchase price to the fair value of assets acquired. Management has used their best estimates to determine that the book value of the assets acquired as recorded on the books and records of Three-Five Beijing is fairly stated. The excess of fair value of the acquired assets over cost was accounted for by a write-down on pro-rata bases of the long-lived assets that were purchased. The Company paid the purchase price from its existing credit facility with Wells Fargo HSBC Trade Bank N.A. and cash generated from operations.

12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF THE FINANCIAL CONDITION AND RESULTS OF OPERATIONS Except for statements of historical facts, this section contains forward-looking statements involving risks and uncertainties. You can identify these statements by forward-looking words including "believes," "considers," "intends," "expects," "may," "will," "should," "forecast," or "anticipates," or the negative equivalents of those words or comparable terminology, and by discussions of strategies that involve risks and uncertainties. Forward-looking statements are not guarantees of our future performance or results, and our actual results could differ materially from those anticipated in these forward-looking statements. We wish to caution readers to consider the important factors, among others, that in some cases have affected and in the future could affect our actual results and could cause actual consolidated results for fiscal year 2005, and beyond, to differ materially from those expressed in any forward-looking statements made by or on behalf of the Company. These factors include without limitation, the ability to obtain capital and other financing in the amounts and times needed, realization of forecasted income and expenses by the PRC Companies (as defined herein), initiatives by competitors, price pressures, changes in the political climate for business in the People's Republic of China, the loss of one or more of our significant customers, and other risk factors listed from time to time in the Company's SEC reports including in particular, the factors and discussion in our Form 10-K/A for the year ended October 31, 2004 and the factor listed below regarding the equipment acquisition. The following discussion is presented on a consolidated basis, and analyzes our financial condition and results of operations for the three and nine month periods ended July 31, 2005 and July 31, 2004. Overview We design and manufacture liquid crystal display (LCD) products and are a supplier to several Fortune 500 companies, major Japanese and other Asian and European corporations and smaller companies operating in a variety of end-markets. Our principal product focus is on the small form factor (SFF) LCD market, which includes 7" displays or smaller. Our customers include original equipment manufacturers (OEMs), original design manufacturers (ODMs) and electronic manufacturing services providers (EMSs), collectively referred to as "our customers," serving markets such as mobile phones, handheld games, portable media players, medical devices, printers, consumer electronics, and industrial and telecommunications equipment. We assist our customers in the design and development of their products and provide full turnkey manufacturing services. We offer a broad suite of services and solutions, including outsourced design, component purchasing, electronic subassemblies and finished products assembly, post-assembly testing and post-sales support. We provide value-added custom design and manufacturing services, in which we design and develop products that are sold by our customers to their end customers and markets using their brand names. We support a broad product portfolio, with offerings in three SFF LCD technologies: monochrome super-twisted nematic (STN), color super-twisted nematic (CSTN) and thin film transistor (TFT). In addition, we support an extensive set of production techniques for manufacturing our LCD modules: surface mount (SMT), chip-on-board (COB), chip-on-glass (COG), chip-on-film (COF) and tape carrier package (TCP). We believe that we compete successfully on a variety of factors including product quality, customer service, global account and sales coverage model, value-added design and manufacturing services, and broad set of product offerings. In addition, we believe that our China-based operations provide us with a competitive cost structure and access to a highly educated engineering work force. Unlike many of our Asian competitors that are largely based in Taiwan, Hong Kong, Japan and Korea but may have certain of their manufacturing operations in China, we operate all of our product design, manufacturing, engineering support, front end glass manufacturing and post-sales support operations in China. Our presence in China and our customer-driven engineering focus allow us to closely monitor our manufacturing resources for quality, as well as to align our design and manufacturing capabilities with our customers' local manufacturing operations. Our locally-based personnel thus have the ability to work directly and collaboratively with the growing number of China-based OEMs, ODMs and EMSs. 13 Critical Accounting Policies and Estimates The discussion and analysis of our financial condition presented in this section are based upon our financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America ("US GAAP"). During the preparation of our financial statements we are required to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates and judgments, including those related to sales returns, pricing concessions, bad debts, inventories, investments, fixed assets, intangible assets, income taxes, pensions and other contingencies. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under current conditions. Actual results may differ from these estimates under different assumptions or conditions. Business Combinations We account for business combinations in accordance with FASB Statement No. 141, Business Combinations. The Company completed the acquisition of Three-Five (Beijing) Co., Ltd on April 8, 2005. The purchase price paid for the acquisition was below the book value of the assets acquired. There has not yet been an independent valuation of the value of the assets. Management has used their best estimates and knowledge to determine that the book value of the assets acquired as recorded on the books of Three-Five Beijing is fairly stated. The excess of fair value of the acquired assets over cost was accounted for by a write-down on a pro-rata basis of the long-lived assets that were purchased. Revenue Recognition We recognize revenue from product sales in accordance with Staff Accounting Bulletin (SAB) No. 104 "Revenue Recognition in Financial Statements." SAB No. 104 requires that revenue be recognized when all of the following conditions are met: o Persuasive evidence of an arrangement exists; o Delivery has occurred or services have been rendered; o Price to the customer is fixed or determinable; and o Collectability is reasonably assured. We recognize revenue from the sale of our products when the products are shipped from our factories in China, provided collectability is reasonably assured from the customer. Sales revenue is recorded net of discounts, rebates and prompt payment discounts. Returns and adjustments are booked as soon as they have been assessed for validity. Accounts Receivable We maintain an allowance for doubtful accounts for estimated losses resulting from the inability or unwillingness of our customers to make required payments. We determine the adequacy of this allowance by regularly evaluating individual customer receivables and considering a customer's financial condition, credit history and current economic conditions. Inventories Inventories are stated at the lower of cost or market. Cost is determined on the weighted average-cost basis. Costs included in the valuation of inventory are labor, materials (including freight and duty) and manufacturing overhead. Provisions are made for obsolete or slow moving inventory based on management estimates. In November 2004 the FASB issued Statement No. 151, Inventory, an amendment of ARB No. 43, Chapter. While retaining the general principle of ARB 43, Chapter 4, it amends ARB to clarify that: 14 o abnormal amounts of idle facilities, freight, handling costs, and spoilage should be recognized as charges of the current period and o allocation of fixed production overheads to inventories should be based on the normal capacity of the production facilities. Implementation of FASB Statement No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005 and should be applied prospectively. Early application is permitted. The Company does not expect that implementation of FASB Statement No. 151 will have a material financial impact on the results of operations. Stock Based Compensation In December 2004, the FASB issued SFAS No. 123R that amends SFAS No. 123 "Accounting for Stock-Based Compensation," to require public entities (other than those filing as small business issuers) to report stock-based employee compensation in their financial statements. The Company will be required to comply with the provisions of SFAS No. 123R as of November 1, 2005, the beginning of its next fiscal year. The Company currently does not record compensation expense related to its stock-based employee compensation plans in its financial statements. The Company currently makes a pro-forma disclosure of the expense related to its Stock-Based compensation plans (See footnote No. 8 to the financial statements). Income Taxes Pursuant to Financial Accounting Standards Board ("FASB") Statement of Financial Standards ("SFAS") No. 109, "Accounting for Income Taxes," income taxes are recorded based on current year amounts payable or refundable, as well as the consequences of events that give rise to deferred tax assets and liabilities. We base our estimate of current and deferred taxes on the tax laws and rates that are currently in effect in the appropriate jurisdiction. Changes in laws or rates may affect the current amounts payable or refundable as well as the amount of deferred tax assets or liabilities. At July 31, 2005, we had approximately $6,879,000 of net operating loss carry forward available resulting in approximately $2,394,000 of deferred tax assets which are not included in our balance sheet due to uncertainty of realizing them. Results of Operations Comparison of the Three and Nine Months Ended July 31, 2005 and 2004. Revenue - Revenue was $23,600,000 and $11,620,000 for the quarters ended July 31, 2005 and 2004 respectively, an increase of 103%. Net sales were $64,323,000 and $31,975,000 for the nine months ended July 31, 2005 and 2004, respectively an increase of 101%. The increase for the three months and nine months ended July 31, 2005, can be attributed to the continuing success of the Company's marketing plan which realigned the Company's customer base to eliminate low volume customers and replace them with high volume customers. Additionally, the company increased capacity to accept additional orders through the addition of the LCD line at our North Campus facility in Shenzhen. The North Campus line generated revenue from CSTN or color passive displays revenue starting in March of 2005. In April, the company began revenue production of TFT color modules from its Beijing factory acquired from Three-Five Beijing Co., Ltd. Cost of Goods Sold - Cost of sales was 82% and 79% of net sales for the quarters ended July 31, 2005 and 2004, respectively. The 3% increase, as a percentage of sales, is due to a 2% increase in raw material costs, a 1% increase in non-recoverable VAT, a 2% increase in depreciation (primarily from the startup of North Campus) offset by a 2% decrease in direct labor, utilities and overhead compared to the same period a year ago. Cost of sales was 82% and 78% for the nine months ended July 31, 2005 and 2004, respectively. The 4% increase, as a percentage of sales, was due to increased raw material costs, non-recoverable VAT and depreciation (primarily from the startup of North Campus) offset by decreases in direct labor, utilities and overhead compared to the same period a year ago. 15 General and Administrative - General and Administrative expenses increased 49% to $1,837,000 from $1,234,000 for the quarters ended July 31, 2005 and 2004 respectively. As a percentage of sales, General and Administrative expenses were 8% and 11% for the quarters ended July 31, 2005 and 2004, respectively. The Company anticipates that as sales continue to increase this percentage relationship to sales will continue to decrease in future periods. Approximately 55% of the dollar increase over the same period last year is attributed to the Three-Five Beijing acquisition in addition to increased number of employees and employee related expenses, increased professional fees (in part due to outside consulting fees in connection with Sarbanes-Oxley Section 404 compliance), increased insurance costs, increased depreciation expense, offset by favorable exchange rate expense and reduced bad debt expense. The Company anticipates that costs associated with Sarbanes Oxley Section 404 compliance will continue through the fiscal year end as the Company prepares for its initial certification. For the quarter ended July 31, 2005 the significant elements of general and administrative expense include employee related expenses of $1,087,000, rent and utility costs of $17,000, insurance costs of $155,000 and professional fees of $191,000. General and Administrative expenses increased 55% to $5,532,000 from $3,579,000 for the nine months ended July 31, 2005 and 2004 respectively. As a percentage of sales, General and Administrative expenses were 9% and 11% for the nine months ended July 31, 2005 and 2004, respectively. The Company anticipates that as sales continue to increase that this percentage relationship to sales will continue to decrease in future periods. This cost increase is attributed to the increased number of employees and employee related expenses, increased professional fees (in part due to outside consulting fees in connection with Sarbanes-Oxley Section 404 Compliance), increased insurance costs, increased depreciation expense, increased rent and utilities attributed to North Campus pre-opening, offset by favorable exchange rate expense and reduced bad debt expense. The Company anticipates that costs associated with Sarbanes Oxley Section 404 compliance will continue through the fiscal year end as the Company prepares for its initial certification. For the nine months ended July 31, 2005 the significant elements of general and administrative expense include employee related expenses of $2,810,000, rent and utility costs of $408,000, insurance costs of $312,000, depreciation of $199,000 and professional fees of $794,000. Selling, Marketing and Customer Service - Selling, Marketing and Customer Service expenses increased to $745,000 from $633,000 for the quarters ended July 31, 2005 and 2004 respectively, an increase of 18%. As a percentage of sales, Selling, Marketing and Customer Service expenses were 3% and 5% for the quarters ended July 31, 2005 and 2004 respectively. The increased expense can be attributed to the increased number of employees and employee related expense, commission expense (due to increased sales) and travel expense. Significant elements of this expense consist of employee related expenses of $247,000, commission expense of $332,000 and travel expense of $60,000 for the quarter ended July 31, 2005. Selling, Marketing and Customer Service expenses increased to $1,918,000 from $1,507,000 for the nine months ended July 31, 2005 and 2004 respectively, an increase of 27%. As a percentage of sales, Selling, Marketing and Customer Service expenses were 3% and 5% for the nine months ended July 31, 2005 and 2004 respectively. The increased expense can be attributed to the increased number of employees and employee related expense, commission expense (due to increased sales) and travel expense. Significant elements of this expense consist of employee related expenses of $584,000, commission expense of $892,000 and travel expense of $142,000 for the nine months ended July 31, 2005. Engineering, Design, and Project Management - Engineering, design and project management expenses were $273,000 and $123,000 for the quarters ended July 31, 2005 and 2004 respectively, an increase of 122%. As a percentage of sales, engineering, design and project management was 1% for the quarters ended July 31, 2005 and 2004 respectively. The increase is attributable to increased salary costs resulting from the addition of field engineering support personnel to work directly with customers during the product development and implementation phases. A significant element of this expense includes employee salary and related expenses of $230,000. Engineering, design and project management expenses were $525,000 and $454,000 for the nine months ended July 31, 2005 and 2004 respectively, an increase of 16%. As a percentage of sales, engineering, design and project management was 1% for the nine months ended July 31, 2005 and 2004 respectively. The increase is attributable to increased salary costs resulting from the addition of field engineering support personnel to work directly with customers during the product development and implementation phases. A significant element of this expense includes employee salary and related expenses of $443,000 for the nine months ended July 31, 2005. 16 Interest Expense (net) - Interest expense increased 195% to $248,000 from $84,000 for the quarters ended July 31, 2005 and 2004 respectively. The increase is attributable to increased borrowings on the Company's line of credit related to the acquisition of Three-Five Beijing. Interest expense (net of interest income of $26,000) increased 28% to $426,000 from $333,000 for the nine months ended July 31, 2005 and 2004 respectively. The increase is attributable to increased borrowings on the Company's line of credit related to the acquisition of Three-Five Beijing. Other Income / Expense - Other expense was $50,000 for the quarter ended July 31, 2005 compared to income of 10,000 for the comparable quarter ended July 31, 2004. The primary components of other expense were customs fees expense of $66,000 offset by rental income of $9,000 and other income of $6,000. Other expense was $27,000 for the nine months ended July 31, 2005 and other income was $63,000 for the nine months ended July 31, 2004. The primary components of other expense were customs fees expense of $66,000 offset by rental income of $32,000 and other income of $7,000. Net Income - Net income was $984,000 ($0.03 per share basic and diluted) and $370,000 ($0.01 per share basic and diluted) for the quarters ended July 31, 2005 and 2004 respectively. Increased sales are the reason for increase in net income. Net income was $3,472,000 ($0.11 per share, basic and diluted) and $543,000 ($0.02 per share basic and diluted) for the nine months ended July 31, 2005 and 2004, respectively. Increased sales are the reason for the increased net income. Liquidity and Capital Resources Adjusted for non-cash items, net income for the nine months ended July 31, 2005 and 2004 resulted in net cash outflows from operations of $1,804,000 and $3,204,000 respectively. Increases in accounts receivable of $7,477,000 due to increased sales, inventories of $1,582,000 due to increased sales, prepaid expenses and other current assets of $173,000 and decreases in accrued liabilities of $581,000 offset by increases in accounts payable of $2,716,000 were the primary reasons for the cash outflows. Cash used in investing activities was $12,171,000 ($8,282,000 for the acquisition of Three-Five Beijing) and $1,224,000 for the nine months ended July 31, 2005 and 2004 respectively. The funds not related to the Three-Five Beijing acquisition were used primarily for tenant improvements and equipment installation at the Company's North Campus which houses the new LCD line. Cash inflows from financing activities were $9,868,000 and $23,910,000 for the nine months ended July 31, 2005 and 2004, respectively, primarily from the issuance of common stock for exercise of stock options of $1,442,000, and an increase of $8,853,000 in outstanding debt on the Company's line of credit to acquire Three-Five Beijing. Cash inflows from financing activities for the nine months ended July 31, 2004 were $23,910,000 primarily from two private placements of the Company's common stock in December 2003 and May 2004 netting approximately $22,840,000. The Company requires capital to repay certain existing fixed obligations, to provide for additional working capital and to invest in capital equipment to grow in accordance with its business plan. On March 30, 2005, the Company signed a credit agreement with The Wells Fargo HSBC Trade Bank for a $20,000,000 revolving line of credit to be secured by the Company's assets. This line replaced the Company's asset-based line of credit which only allowed for borrowing against eligible accounts receivable. The line has certain financial covenants, a term of one year and is renewable. Management believes that current cash flow from operations will be sufficient to maintain payments under the Wells Fargo HSBC Trade Bank line of credit, and will be sufficient to meet its short term and long term requirements. As of July 31, 2005 the Company was not in compliance with certain covenants of the Wells Fargo HSBC Trade Bank line of credit. The bank has waived the non-compliance and the Company is not in default of any of its agreements. The Company is currently in the process of revising the covenants of the Trade Bank line of credit to avoid non-compliance issues in the future. The Company expects to have the new covenants in place before the end of its current fiscal year. However, to meet anticipated growth plans, as well as possible future business acquisitions or capital expenditures, the Company may require additional capital, and may evaluate or seek additional capital through debt or equity financing that will provide flexibility to move rapidly to take advantage of growth opportunities that may be presented in the future. Off-Balance Sheet Arrangements As of July 31, 2005, the Company has no off-balance sheet arrangements. 17 Backlog The Company's cancelable backlog at July 31, 2005 was $12,680,000. Debt Outstanding On July 31, 2005 we had $2,565,000 of debt due within a year in addition to $13,251,000 due on our credit line. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Currency Fluctuations We sell a majority of our products in U.S. dollars and pay for our material components in U.S. dollars, Hong Kong dollars, Chinese RMB and Japanese yen. We pay labor costs and overhead expenses in U.S. dollars, RMB and Hong Kong dollars. The exchange rate of the Hong Kong dollar to the U.S. dollar has been fixed by the Hong Kong government since October 1983 at approximately HK$7.80 to US$1.00 through the currency issuing banks in Hong Kong and accordingly has not in the past presented a currency exchange risk. This could change in the future as there has been discussion in some circles concerning the advantages of the floating rate. Effective July 21, 2005, China adopted a managed floating currency system whereby the official exchange rate will be based on market supply and demand with reference to a basket of currencies and will no longer be pegged to the US dollar. The daily trading price of the US dollar against the RMB will be allowed to float within a band of 0.3 percent either side of the central parity published rate by the People's Bank of China which is currently set at 8.11 RMB per US dollar. It is currently possible to hedge against movement in the RMB exchange rate through conventional means. We do not currently hedge against this exposure and are thus exposed to exchange rate movement. We incur approximately 30% of our expenses in RMB and have negligible RMB revenue; an increase in the value of the RMB would thus have an adverse affect on our operating margins and minimal effect on our monetary assets denominated in RMB. The Company currently has outstanding debt denominated in RMB of 20,000,000 equating to approximately 2.5 million US dollars at the current exchange rate. We also incur liabilities in Japanese yen from the purchase of raw materials. We do not currently hedge against this exposure and are thus exposed to exchange rate movement. Interest Rate Risk Our principal exposure to interest rate changes is on our credit line which is based on prime rates in the U.S. Inflation Risk Although inflation has remained low in recent years in the markets in which we currently sell and expect to do so for the foreseeable future, the general inflation rate in China is higher with wage inflation expected to run between five and ten percent annually. Such inflation represents a risk to our profitability if sustained and not compensated for by a movement in exchange rates or productivity improvements. ITEM 4. CONTROLS AND PROCEDURES Our management, with the participation and under the supervision of our Chief Executive Officer and our Chief Financial Officer, reviewed and evaluated the effectiveness of the design and operation of our disclosure controls and procedures, as of the end of the fiscal quarter covered by this report, as required by Securities Exchange Act Rule 13a-15, and concluded that our disclosure controls and procedures are effective to ensure that information 18 required to be disclosed in our reports filed with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934 is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective to ensure that we record, process, summarize, and report information required to be disclosed in the reports we filed under the Securities Exchange Act of 1934 within the time periods specified by the Securities and Exchange Commission's rules and regulations. During the quarter ended July 31, 2005, there have been no changes in our internal control over financial reporting, or to our knowledge, in other factors, that has materially affected, or are reasonably likely to materially affect our internal control over financial reporting. We continue to enhance our internal control over financial reporting, primarily by evaluating and enhancing our process and control documentation and increasing our systems security, in connection with our ongoing efforts to meet the requirements of Section 404 of the Sarbanes-Oxley Act of 2002. We discuss with and disclose these matters to the Audit Committee of our Board of Directors, our Board of Directors and our auditors. 19 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this amendment number 3 to report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized. INTERNATIONAL DISPLAYWORKS, INC. Date: September 6, 2005 /s/ Jeffrey G. Winzeler -------------------------------------------- Jeffrey G. Winzeler, Chief Financial Officer (Principal Accounting Officer and Principal Financial Officer)

INTERNATIONAL DISPLAYWORKS, INC 10-Q